Commentary: Can Compaq Escape from Hardware Hell?

Ever since margins for many kinds of computers began tumbling in the late 1990s, a variety of companies have begun to look "beyond the box" for succor. Most have focused on selling technology services--everything from help-desks that charge $25 per call and $175-per-hour-consulting gigs to multibillion-dollar outsourcing deals to run entire corporate information technology departments.

Eager to emulate IBM's (IBM ) success, the likes of Dell (DELL ), Hewlett-Packard (HWP ), and Gateway (GTW ) are taking a crack. In the latest such move, Compaq Computer Corp. (CPQ ) CEO Michael D. Capellas on June 25 unveiled his plan to spend $500 million to create services units. "I see this as a great opportunity--if we step up to it," said Capellas in a memo to employees.

"A BUSINESS LIFETIME." Capellas is surely on to something. As IT spending for hardware has plunged in recent months, the race is on for manufacturers to tap into the lucrative services market. It's a huge and growing industry with countless possibilities. High-priced consultants from Accenture, PricewaterhouseCoopers, and others help clients dream up IT systems that solve business needs--say, by cutting costs through centralizing procurement. Other firms called systems integrators specialize in figuring out what computers, software, and other devices to use to construct such systems. And then there's outsourcing, in which companies such as Electronic Data Systems Corp. (EDS ) and Cap Gemini actually run and maintain systems for clients.

Trouble is, breaking in is no easy task. And even if PC makers succeed, selling services will not provide a quick escape from hardware hell. First, these companies must confront daunting cultural, organizational, and competitive challenges that will take years to work through. "For a newcomer [like Compaq], it would take at least a business lifetime" to become a major player, says Richard H. Brown, CEO of EDS.

Just ask Big Blue, which is only now reaping the benefits of a grueling eight-year makeover. While it still makes a vast variety of products, CEO Louis V. Gerstner Jr. has made tough decisions in recent years--most notably, getting out of the retail PC business--to steer the giant into services. Staffers had to be persuaded that it's better to sell rivals' hardware if they land a big consulting gig in the process. And IBM had to build a staff of 148,000 techies capable of solving almost any IT problem.

The payoff has been big. IBM's $33 billion-a-year Global Services division is booming. Despite the economic downturn, it had its best first quarter ever, and it has already landed three billion-dollar deals in 2001--as many as in all of 2000. One reason: IBM has been giving away hardware at discounts of up to 70% to land services gigs, say industry sources. "They're crashing a lot of parties with their annoying ability to discount beyond anything anyone else can do," says one rival. "No one else has a $40 billion services business to fall back on."

Now IT wannabes like Compaq want to get in on the fun. Leaders like Sun Microsystems (SUNW ), Oracle (ORCL ), and EMC (EMC ), though not as big in services as IBM, use service contracts for things like training classes or quick equipment installation to drive sales of their products. Such contracts can also provide a cushion in a down market. Oracle's better-than-expected profits in the second quarter, for instance, were largely a result of its lucrative service contracts.

Expect more of the same. Corporations binged on hardware during the Net boom. But now sales of computer gear are expected to fall from 15%-plus annual growth rates to the high single digits. Most corporations are now focused on squeezing financial gains out of those investments--not on buying more. That could mean more spending on services. IDC expects the $437 billion IT services market to grow 12% a year through 2005. What's more, plenty of opportunity exists to find big niches: Market leader IBM has only a 9% market share. "There's lots of room for strong players to come in and participate," says HP services chief Ann M. Livermore. "Customers need solutions to business problems--not just another hot box or piece of software."

SECOND TRY. Still, it's not an easy shift. After all, Compaq has already tried--and failed--at a frontal assault on the services game. The main reason for its $8.4 billion acquisition of Digital Equipment Corp. in 1998 was to get its army of technicians. Yet Compaq's share of the services market has remained flat at around 2%.

Moreover, even a successful move into services won't necessarily make much difference on the bottom line. It's simply the law of large numbers. Having grown to gargantuan size, product companies can't rely on still-small services units to bail them out, no matter how fast they grow. HP's consulting unit, for example, grew 43% in the first half of 2001, even as overall corporate revenues shrank 1%.

What's more, manufacturing companies aren't always naturally suited for jumping into services. Hardware companies prosper by building a handful of standard models at as low a cost as possible--and the fewer people employed, the better. That's why most have outsourced everything from manufacturing to logistics in recent years. The critical talent of the services giants, on the other hand, is managing the armies of people needed to solve the limitless problems clients want solved. Admits HP's Livermore: "It's very difficult to be a company that has outsourced most of what it makes vs. being a company whose people are the competitive advantage." For Compaq and its ilk, that means years of hard work and hard choices--and no quick financial lift for these onetime high fliers.

By Peter Burrows and Andrew Park

With David Rocks in New York, and bureau reports

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