Pc Makers Think Beyond The Box

To replace falling hardware profits, they're heading off in surprising directions

Hardly a week goes by that some wild-eyed startup doesn't announce a scheme to give away personal computers--as if the PC were some throwaway rather than the machine that ushered in the Information Age. On Mar. 31, following in the footsteps of Free-PC, NuAuction, and DirectWeb, New York-based Gobi said it would hand out free PCs to consumers who sign up for three years of Internet service. Meanwhile, emachines Inc. keeps cranking out PCs priced as low as $399, and startup Microworkz Computer Corp. says it will soon sell them for $299. "Where is this all going?" asks Brett B. Faulk, director of retail product marketing at Compaq Computer Corp. "It's anybody's guess. It's hard to draw rational conclusions from irrational pricing."

Problem is, selling PCs the old-fashioned way is starting to look nearly as irrational. Why? Two years of free-falling prices are squeezing the life out of margins, threatening to leave PC makers gasping for profits. A 17.3% drop in the price of the average desktop computer last year shrank industrywide revenues by 3.6%, according to market researcher International Data Corp. And those doldrums look to be the state of things to come. Analysts expect prices to plummet nearly 15% this year, capping industrywide sales growth at less than 5%. "I would not be surprised to see a number that's pretty close to flat PC revenue," says Jerre L. Stead, CEO of Ingram Micro Inc., the biggest distributor of computer-related gear.

Worse, prices also are tumbling on notebooks and industrial-strength PC servers that have delivered the bulk of profits for top PC makers in recent years. The average price of a PC server has fallen 13.4% over the past two years, says idc. "It's getting harder to find places to hide," says Merrill Lynch & Co. analyst Steven M. Milunovich. "PCs are a tough business--and it's likely to get tougher."

That's why PC makers are scouring their balance sheets and searching their souls as they grapple with an unavoidable reality: The PC alone can no longer deliver the financials of old. "Clearly, we can't be a one-trick pony any longer," says Michael D. Lambert, head of Dell Computer Corp.'s server unit.

GIZMOS. Suddenly, PC makers are heading off in surprising new directions. Dell and Compaq are developing E-commerce businesses--whether it's collecting monthly Internet service fees or becoming online sellers of everything from printers to carrying cases. Hewlett-Packard Co. has its own E-business spin: In addition to selling servers the traditional way, HP and its partners will host others' Web-site operations on HP servers, collecting a monthly service charge or fee on transactions. "This way, we're no longer chasing the bouncing ball of hardware margins down the stairs," says Nick J. Earle, chief marketing officer for HP's enterprise-computing unit.

Other PC makers think new gizmos are the answer. Compaq and Packard Bell NEC Inc. are preparing non-PC products such as cell phones and newfangled devices that act as Web-access machines. And some PC makers are simply backing out of parts of the market. In February, Acer America Corp. announced that it will close its U.S. retail PC effort, while Hitachi has shuttered its U.S. subsidiary.

Experts say bigger players may yet make an exit, possibly even IBM. Analysts have been calling for Big Blue to abandon the cutthroat home-PC market and focus on more profitable PC sales to corporations. IBM says it has no such plans, but it is clearly struggling in the PC market. In the 1998 annual report, Chairman Louis V. Gerstner Jr. declared that "the PC era is over"--some 80 pages before IBM disclosed that it lost $992 million pretax in PCs that year, after losses of $161 million and $39 million in 1997 and 1996.

Even Dell, the one computer maker that has defied gravity, with revenues soaring 50% over the past several years, is not nearly so cozy with the PC these days. "We are very focused on changing from a model of 65% desktop PCs to about 45%," says Dell's Lambert. Indeed, Dell is following the lead of Compaq, IBM, and HP, investing heavily to develop heavy-duty storage systems, which carry 50%-plus gross margins.

For those that successfully branch out into new, higher-margin areas, PCs could become, well, just another business. If Compaq's services and storage businesses continue to grow at current rates, by 2002 they will reap profits of $3.5 billion and $3 billion respectively, vs. $3 billion for PCs, says CBIC Oppenheimer Corp. analyst James D. Poyner Jr. Other PC makers could similarly offset flagging computer profits. At Gateway Inc., CEO Theodore W. Waitt figures non-PC sales could be 20% of his revenues over the next few years--and a larger percentage of earnings.

It's possibilities like this that have Compaq taking one of the more ambitious approaches. Besides storage and services, the No. 1 PC maker is launching an aggressive Web strategy. On Jan. 26, it created a stand-alone company around its AltaVista search engine. The goal: to make it a top-notch portal and, ultimately, cash in by taking it public. Meanwhile, Compaq hopes to boost sales of Shopping.com, an online store it purchased in January, by promoting it on Compaq PCs and on AltaVista.

WALLFLOWER. Other PC makers want in on the Internet action as well. And who can blame them? They own the screen on which Amazon.com Inc. and Yahoo! Inc. have built their vast fortunes, yet they have little to show for it. "They just watched the market caps of all these profitless Internet startups zoom out of sight--and they didn't get any of it," says senior analyst Matt Halperin of Boston Consulting Group.

Best-positioned are those with established Web-selling operations--notably, Dell. On Mar. 3, Dell unveiled its Gigabuys.com site, where consumers can choose from 30,000 products, ranging from digital cameras to computer bags. In the future, Dell will fold this service into its 12,000 Premier Pages--specially designed Web pages for corporate customers--so they, too, can buy this broad array of products from Dell.

In May, IBM will follow suit when it unveils a Web site, code-named Project Odyssey, to sell its entire line of PC products directly to small businesses and consumers. Since IBM currently sells only its Aptiva home PCs and one Thinkpad laptop online, this could boost its cybersales to $10 billion to $15 billion, with PC products accounting for more than half, says Richard Anderson, general manager for IBM's enterprise Web-management unit. And since giving customers control over ordering and configuration cuts handling and service costs, IBM's expenses would be 5% lower for products sold online, say insiders.

Ultimately, these launches into cyberspace could morph into sweeping new business models in which PC companies make money not on their hardware but on the services they can bundle with their boxes. Already, Gateway and Compaq get a share of monthly revenues from Internet service providers featured on their machines. And the more subscribers they sign up, the more advertisers will pay to get their ads displayed to these potential shoppers.

That's the vision of many "free PC" upstarts: Break even on the machine and make a killing on E-commerce. So far, most of these schemes just don't add up. Take Free-PC, which plans to give 10,000 PCs to consumers who are willing to give up 20% of the screen to ads. One big snag: Some 49% of home-PC users don't even look at ads, says Dataquest Inc.

BIG SHIFT. However wobbly today's free-PC pioneers may seem, don't rule out their success in the longer term. Analysts say that as broadband connections such as cable modems become popular, monthly Internet service bills will rise to $50 or more. That could provide a deep enough revenue stream to subsidize PCs. "I haven't seen a way for the economics to make sense yet, but they ultimately will," says Sky Dayton, CEO of Earthlink Networks Inc., an Internet service provider based in Pasadena, Calif.

Some new plans already look better than others. Gobi, for example, will give away PCs to customers who pay $26 per month for three years, as well as a $30 startup fee and a $45 shipping fee. Since Gobi buys the PCs directly from contract manufacturer Solectron Corp. and charges a slight premium for ISP service, CEO Ganesh Ramakrishnan says Gobi can break even. Profits would come from a cut of the E-commerce his customers will conduct. "We're not a gimmick," says Ramakrishnan. "We have a sustainable business model." That may be more than even the biggest PC makers can say if they don't move quickly past PCs.

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