Cheap P Cs: The Model T Of The Digital Age

They'll bring the middle class into the wired world. But will they bring prosperity to computer makers?

For years, Gerald Busenitz refused to buy a personal computer. The 49-year-old owner of an 1,800-acre farm in Newton, Kan., told his disappointed son that he would just have to keep doing his homework on a PC at school--the family couldn't justify $2,000 for a machine he didn't even know how to use. "If I buy a tractor, I can make the farm more profitable," he told his wife, Margie. "But a PC? I just couldn't see it."

He can now. On Mar. 2, the Busenitzes took the plunge, bringing home a Compaq Presario--for $999 including a monitor. "I think the price has gotten to be about right--plus, we had a good year," says Busenitz.

That's just what executives at Compaq Computer Corp. had hoped would happen last spring, when they redesigned Compaq's low-end home PCs and cut price tags to below $1,000. Other PC makers quickly followed, and by yearend, sub-$1,000 PCs accounted for 30% of all computers sold through U.S. computer and electronics stores. A third of those sales were to people who had never before purchased a PC.

UBIQUITOUS. In short order, the flood of new buyers nudged the penetration of PCs to 43% of U.S. homes--up from the 40% range where it had been stalled for three years, according to IDC/Link. From January, 1997, to January, 1998, the average selling price of a home PC dropped 30%, to $1,169. By Christmas, 1998, analysts expect top PC makers to offer $600 machines--setting the stage for PCs to find their way into 60% of U.S. homes by 2002, according to projections by Forrester Research Inc.

If those numbers prove accurate, the home-PC business is in for at least several more years of steady growth--from 12 million units a year now to 17.5 million by 2002, figures Forrester. And American society will be in for another profound change at the hands of technology. Why? Because the PC will no longer be simply a staple of white-collar households, but a nearly ubiquitous tool for most Americans--like the telephone or the automobile. Even now, the new cheap PCs are bringing blue-collar families into the Digital Age. According to a survey by Forrester, the median income of people intending to buy such PCs is $27,000, vs. $50,000 for current PC owners. That means that the electronic realms where home-PC owners roam will be opened to millions more citizens--to shop, to chat, and to explore.

The new online masses are apt to bring huge changes to the Web--and perhaps new riches for people doing business there. Indeed, investors are already bidding up shares of companies such as Yahoo! Inc. and Excite Inc. on the assumption that the millions of consumers snapping up cheap PCs will bring more traffic to those Web sites--driving up ad rates and generating many more transactions. Electronic commerce could quickly change from a bonanza for the few--such as Amazon. com--to a huge business for all sorts of online merchants.

But the arrival of the new mass-market computer heralds painful changes for companies that make PCs. While the number of PCs sold through U.S. stores grew 54% for January over last January, revenues grew a measly 10%, says Computer Intelligence.

There's a parallel crunch in the corporate computer market--the cash cow that enabled companies such as Compaq to compete so hard in home PCs. Watching prices contract in home PCs, machines not vastly different from what they use, corporations have demanded price cuts, too. In 1998, prices for all kinds of corporate hardware, from PC servers to notebooks, are expected to fall as much as 20%. James D. Poyner Jr., an analyst at Oppenheimer Securities, estimates that profit margins on corporate PCs will drop to the low teens, close to the single-digit margins on some home PCs. When the year is over, predicts International Data Corp., computer makers around the world will have shipped 13.4% more PCs. But thanks to price cuts, their revenues will be up only 4.4%.

PRICE WAR. That means a profit pinch ahead and the casualties are already mounting. On Mar. 6, Compaq announced that its first-quarter sales had fallen short of its optimistic forecast. Revenue, it warns, will likely be flat with last year's final quarter, at about $7.25 billion, and profits are likely to drop 25% for the year--to $1.4 billion. On Mar. 4, Intel Corp. stunned investors by announcing that first-quarter sales would fall 10% below the fourth quarter's, its worst quarterly revenue drop in a decade. And Intel is expected to post its first year-over-year profit decline since 1989. Analysts think it will earn $5.9 billion, down 15% from 1997's record $6.5 billion. One factor affecting the chip giant: the inroads made by the likes of Advanced Micro Devices Inc., whose inexpensive Pentium clones go into the new cheap PCs.

As often happens, there's a momentary pause in final demand as buyers await lower prices. The PC industry knows what to do now: stage a price war. "We've been at the edge, and it seems we just jumped over," says Oppenheimer's Poyner. "The question is whether the industry jumps back."

Indeed, this year's jolt may be anything but routine. Increasingly, PC makers are bracing for a fundamental change in their industry--a wrenching shift to a new, lower-margin business model. They will, most likely, come to resemble the consumer-electronics companies with whose products theirs are increasingly in competition.

When the dust clears, the personal computer will have morphed into a true mass-market phenomenon--the Model Ts of the Digital Age. Just as Henry Ford's car for the masses profoundly changed where and how Americans lived, the next generation of low-priced computers will revolutionize the computer industry, the Internet, and lifestyles. With personal computers in 60% of homes, for example, the number of Americans surfing the Web could explode. Assuming it gets easier to use, "the impact could be as great as the impact of the TV," says Paul Saffo, director of the Institute of the Future.

Already, you can see the beginning of the revolution. Cheap PCs will make Web-surfing, electronic learning, and digital commerce so much a part of daily life that many families will have multiple PCs. In a recent BUSINESS WEEK/Harris Poll of 1,009 people, 25% of those who bought a PC last year were adding one to their home.

But price alone will not put the personal computer on a par with cars, phones, and TVs in the lives of Americans. "We're doing what we need to do to move to 60%," says Microsoft Chairman William H. Gates III. But reaching the 36% of Americans who still say they see no need for a PC will require more than cosmetic changes and low prices. "As the price drops, computer manufacturers are forced to get volumes up," says Arno A. Penzias, a Nobel prize-winning physicist who is now chief scientist of the Bell Laboratories unit of Lucent Technologies Inc. "The only way to do that is to make things less intimidating. The real winners are people who can make these things look friendly."

Computer makers and folks who build the technology that go into them are paying close attention. If PC makers don't do it, somebody else will. "All I want to do is send E-mail and access Web sites," says Robert Anderson, a West Palm Beach (Fla.) nurse, who recently passed up a home PC and bought a $199 WebTV setup. He's one of 250,000 customers for the service that lets you surf the Net via TV. "I don't want to worry about all those icons and stuff," he explains.

But how can PC makers, whose margins are shrinking--perhaps permanently--fund development of innovative products? They can't. Those that once tried have pulled back. Compaq collaborated with Mattel Inc.'s Fisher-Price on PC add-ons for kids and with Thomson Consumer Electronics on a deluxe TV-PC combo. Neither project bore fruit. And now, with a new price war beginning in the sub-$1,000 market, most computer makers are riveted on more immediate goals. "We don't want to go pioneer new markets when we're in share-gaining mode for the next two to three years," says Hewlett-Packard Co. consumer-PC chief Webb McKinney.

So, ironically, 15 years after Apple Computer Inc. set out to build "a computer for the rest of us" with the easy-to-use Mac, it may be up to Intel and Microsoft to finish the job. These companies have the profits to fund research and development for the industry and are starting to do so. Since 1996, Intel has invested some $450 million in startups pushing the edges of multimedia, videoconferencing, and Web content, and now it is attacking the consumer-PC market more directly. On Mar. 4, it announced it will develop a separate microprocessor family, called Celeron, aimed at the low-end consumer market. Intel's push: to make the PC better at handling visual information. Intel, says Chairman Andrew S. Grove, won't "make compromises that will make that [PC] interface less friendly."

Microsoft says its main focus this year is on simplifying its software. That starts with Windows 98, due out in June. The plan is to tightly integrate its Internet Explorer browser with the Windows operating system, making the now-familiar browser format a fundamental way of using all kinds of computer functions. The company plans similar integration for its Windows NT network operating system, which is due out by early '99. Microsoft also hopes to work to make desktop PCs behave more like TV sets--easy to use and quick to turn on and off. That means no "booting up" and an end to maddening software crashes. "Can you imagine if your TV crashed when you tried to change channels?" asks Paul Voois, chairman of videophone maker 8x8 Inc.

Before the PC is reinvented, though, the industry may have to revamp how it does business. Already, Wall Street analysts are making massive downward revisions on their earnings estimates for Compaq, Micron Electronics, IBM, and HP. Some analysts think PC margins may keep eroding to the range of consumer electronics. That means even greater pressure on manufacturers to slash prices and build market share.

Inevitably, the result will be more industry consolidation. Analyst Vadim D. Zlotnikov of Sanford C. Bernstein & Co. figures the top five players command a 10%-to-13% cost advantage on key components over smaller rivals. Those five--Compaq, Packard-Bell, HP, Dell, and IBM--will increase their combined market share from 34% of PC sales in 1996 to an estimated 46% in 1998, he says, elbowing out AST Research, Acer, and Apple.

Count on a continuing drive for market share among the leaders. Never mind that a failed market-share grab led to Compaq's first-quarter woes. Officially, the company blames disappointing demand. But rivals and computer distributors say much of Compaq's problem stems from special deals that the PC leader offered to get them to increase orders.

"LIKE A DOG." Meanwhile, IBM may have even more PC products sitting on dealers' shelves than Compaq. IDC analyst Jay Bretzmann says IBM has an eyebrow-raising 40 weeks' worth of PC servers in the reseller channel. Compaq has 16 weeks' worth, and HP some 10 weeks'--both closer to typical levels for these products. Wall Street expects bloated PC inventories to cut into first-quarter earnings, which IBM has already signaled could fall 10% below last year. IBM declines to comment.

The result: Compaq and IBM will clear out inventories by slashing prices. That's going to put even more heat on second-tier players, already feeling the pinch of the new bargain-hungry PC buyers. Toshiba and AST left the home-PC business last year. Even IBM, which lost $300 million on its consumer PCs in '97, is growing weary. "We're not particularly interested in chasing a lot of volume in businesses where we can't make money," says IBM CEO Louis V. Gerstner Jr. "We'll be in the consumer-PC space, but we'll be there selectively."

There's not much hope for getting customers to trade up to more powerful--and profitable--models anytime soon: There's no new software to overtax today's inexpensive but speedy Pentium machines. Existing PCs will run Windows 98 just fine, and Microsoft's industrial-strength Windows NT 5.0 won't be out until 1999. "An 18-month-old PC may seem like a dog, but that's still a pretty nifty machine," says U S West Chief Information Officer David R. Laube. "It can certainly think a lot faster than I can type."

That means computer makers must adjust costs now or wither. The No.1 cost-efficiency mantra is death to inventory: by letting resellers assemble computers as orders come in from customers, PC makers can limit the amount of inventory in stock and get it sold faster, before prices fall. Yet while Compaq and IBM intend to use such tactics, they'll still be far behind direct-sales juggernaut Dell Computer Corp. The build-to-order king, whose costs are roughly nine percentage points less than rivals, continues to roll along. Michael Kwatinetz of DMG Technology Group expects Dell to post a 50% jump in profits, to $294 million, on a 49% rise in sales this quarter.

That leaves PC makers looking for new ways to make profits. One route is to broaden the line card with new products. The company that has cleaned up this way is HP, which has built a massive business selling PC printers and the ink and paper that go with them. It's unlikely that other PC makers can match HP's printer business, but, argues Poyner, they need to try to squeeze profits from non-PC sales--things such as digital photo printers, videoconferencing gear, and hi-fi speakers.

Eventually, PC makers may have to think a lot bolder. "The railroads thought they were in the railroad business--until cars, buses, and trains showed them they were in the transportation business," says Antonio Perez, head of HP's printer business. "The PC industry has a chance to remain the center of the home-computing universe." But only if PC makers realize that as much as they've changed the world so far, they now have to change themselves--and ultimately, the machine that got them here.

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