The Glitch in the Tech Turnaround

Pricing pressure is keeping suppliers in the dumps

Steven J. Randich is one happy tech buyer. In his 2 1/2 years as chief information officer at NASDAQ, he has twice upgraded the exchange's stock trading system. Then, it took a full second for a trader to get confirmation of a buy or sell order; now, it takes just one-tenth the time. But what makes Randich most happy? He was able to upgrade while cutting costs 25% by switching from mainframes to lower-cost computers and mercilessly pressuring suppliers. "Prices just keep going down like there's no bottom," he says. "It's almost fun."

For buyers, yes. It's misery, though, for people selling computers, software, and services. The industry is gradually recovering from its deep, long slump. Market researcher IDC expects worldwide tech spending to grow this year for the first time since 2000 -- by 2.3%. PC unit sales are expected to be up 6.9%. Server shipments should climb 7.8%. But for techdom, there's a giant glitch: The continuing slide in pricing.

The Commerce Dept.'s tech price index dropped 3% in the first quarter from the year before, matching declines in each of the three previous years. While leaders such as Microsoft (MSFT ) Corp. haven't been pinched by pricing pressures, some segments are doing poorly indeed. In February, the U.S. producer price index for computers registered a 21.9% decline from the previous year. "Buyers are in the driver's seat these days," says Merrill Lynch (MER ) & Co. analyst Steven Milunovich.

That has huge implications. During the 1990s, tech sales grew at more than 10% a year, fueling healthy profit margins. Now, margins have been compressed by pricing pressures, and industry analysts and executives don't see prices firming anytime soon. Milunovich says it could take a year or two because of overcapacity. Some think even that is optimistic. Dan McNicholl, chief information officer of General Motors (GM ) North America, predicts the industry's happy days may never return. Most tech companies negotiating with General Motors Corp. "leave the table crying," he says.

While many tech execs are moping, corporations get a lot more bang for their buck. In the past, PC prices slid with every improvement in chip technology, and raging price wars hastened the declines. Now, similar deep discounts are commonplace for high-powered server computers, complex communications gear, and run-the-business software. Even annual maintenance fees, which used to be set in concrete, are sometimes negotiable. All that adds up: The modest rise projected in tech sales this year masks a bigger jump in demand. Erik Brynjolfsson, professor at Massachusetts Institute of Technology's Sloan School of Management, predicts the price compression will boost corporate and economic performance, causing a measurable increase in productivity this year. "The ripple resulting from productivity and efficiency will be felt throughout the global economy," says Dell Computer (DELL ) Corp. CEO Michael S. Dell in a letter to BusinessWeek.

Some of the pressure is coming from dominant tech companies such as Dell looking to exploit rivals' vulnerabilities. When the tech bubble burst in late 2000, Dell set about demolishing the competition. Because its direct-to-buyer sales model is more efficient than selling PCs through retailers, it can set prices ultralow and still make a healthy profit. Since then, Dell's share of the worldwide PC market has climbed from 10.7% to 15%, says Merrill Lynch. "There has been a total reshifting of the profit pools, leadership, and technology," says Dell President Kevin B. Rollins. "People are waiting to see when the industry will go back to normal. It won't happen."

Other industry giants are holding firm on price. SAP (SAP ), the German software giant that leads the market for corporate applications, vows it won't slash prices, even though it acknowledges competitors have offered deep discounts to win big deals. "This could damage the market," says CEO Henning Kagermann. "Sometimes it's better to walk away than to sell too low."

Weak players don't have a choice: They must drop prices or die. Novell (NOVL ) Inc., the Provo (Utah)-based seller of networking software, is so desperate for sales that it recently advertised a 50% price cut for one of its top products, ZENworks software for managing desktop computers on a network. And the real crunch comes when tech companies negotiate with corporate customers. Concedes Chris Stone, Novell's vice-chairman: "We get squashed."

Consolidation could eventually relieve pricing pressures, but it has been slow in coming. In April, 95 tech companies merged or were acquired, down from an already anemic 124 deals the year before, says Thomson Financial. Companies aren't going out of business at a rapid rate, either. One hang-up: Many weak players have reduced expenses so much that they're near breakeven and are conserving cash. Novell, for instance, has $780 million squirreled away. These companies have staying power, but, by hanging around and slashing prices, they're dragging down the whole sector.

Moreover, tech companies won't get pricing power unless they shift the way they do business. That's a tall order. An ever larger share of the market has become commoditized -- not just PCs but server computers and some software. Unisys (UIS ) Corp., the once-moribund seller of services and computers, has held firm on prices by getting out of commodity markets and focusing on places where its expertise isn't easily matched by others. For example, it handles transaction processing for financial services and telecom companies. "We know the margin and cash flow we want, and we stick to our guns," says CEO Laurence A. Weinbach.

As demand picks up for tech gear and software, look for the stronger companies to ever-so-gradually firm up their prices. And the weaklings? After negotiating with the likes of GM, they'll still be leaving the table crying.

By Steve Hamm in New York, with Andrew Park in Dallas

    Before it's here, it's on the Bloomberg Terminal.