How Low Can Big Blue Go?

IBM is gaining in the price war for the high-end server market

Last summer, as IBM (IBM ) was beefing up its line of high-end computer servers, General Manager Rod Adkins decided that employees needed a boost. Mugging for a company video, he pulled on a pair of boxing gloves and shiny trunks, climbed into a makeshift ring and, in a mock fight, promptly knocked out his opponent. The logo on the other guy's trunks: Sun Microsystems Inc. (SUNW )

Turns out that was just round one. As demand dries up, server makers are now hitting harder than ever on price, transforming this high-end business into a game of how low can you go. IBM is looking tough to beat. On Oct. 4, it unveiled its most powerful servers yet. They came out just two weeks after Sun started selling its brawniest box, the Starcat. While Sun's servers are in some ways more powerful, the Regatta sells for about one-third the price, ranging from $450,000 to $1.7 million per box. "This is a Sun-IBM shoot-out," says Jonathan Eunice of research firm Illuminata Inc.

IBM's assault couldn't have come at a worse time for Sun, the leader in the $19 billion global market for Unix servers. Spending on big-ticket computer equipment continues to suffer as anxiety over the terrorist attacks and the U.S. response compounds the already jittery tech market. Sun had to warn Wall Street on Oct. 5 that its fiscal first-quarter loss will grow to at least $170 million, and revenue will fall 30% from last year as dot-com and telecom business evaporates. That forced Sun CEO Scott G. McNealy to cut 9% of his workforce, ending his quest to weather the downturn without layoffs.

IBM's latest salvo in the server wars is also bad news for its other competitors. The No. 3 and 4 players in the market, Hewlett-Packard Co. (HWP ) and Compaq Computer Corp. (CPQ ), already weakened, are ill-equipped to fight a price war. As they try to sell shareholders on their proposed merger, they are fighting to hang on to customers who fear the deal's distractions will translate into lousy service.

The real fight, though, is between IBM and Sun. Three years ago, IBM realized that Sun was trouncing it in high-end server sales. So it focused on lower prices and improved technology. By 2000, IBM was offering discounts of more than 50%, sometimes throwing in free gear or services. The strategy worked. IBM raised its market share to 20% in this year's second quarter, up from 15% last year, according to UBS Warburg.

PRICE LURE. With only 1% of revenue and 4% of operating profits from high-end Unix servers, IBM can afford to dramatically slash hardware prices. That helps lure in high-margin services and software business. Sun, by contrast, depends on its most expensive servers for 10% of revenue and 25% of operating profits, says Toni Sacconaghi Jr., an analyst with Sanford C. Bernstein & Co. The lower IBM prices, combined with new added features, means savings "in the millions," says Regatta customer Joe Giacometti, who buys technology for grocery giant Ahold USA Inc.

Sun is hardly taking it lying down. It is about to release lower-priced servers to appeal to cash-strapped customers. And when spending on tech gear picks up, Sun executives also believe the rewards of continued investment in research and development will boost its lead on IBM. Says McNealy: "If they don't get us this year, they won't get us."

With Unix server revenue projected to fall 9% this year, the real game for both IBM and Sun may simply be snatching customers from HP and Compaq. Together, HP and Compaq own 27% of the market, but questions about their proposed marriage are causing many customers to consider switching.

Other long-term customers are willing to give HP and Compaq the benefit of the doubt for now. "At this point, focus is everything," says R. Craig Murphy, chief technology officer at airline-reservations giant Sabre Inc. (TSG ), which agreed this summer to move to Compaq servers in a long-term contract. But as the IBM juggernaut chugs along, getting and keeping more customers like Murphy won't be easy for any of Big Blue's rivals.

By Andrew Park in Dallas, with Peter Burrows in San Mateo, Calif., and Spencer E. Ante in New York

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