Is Shakeout Looming For PC OEMs?

For years, the PC industry has defied gravity as well as expectations. As other sectors of the economy have risen and fallen periodically, reacting to consumer desires and interest rates, the market for PCs has thrived: Double digit growth rates, hundreds of millions (often billions) in profits, and a predictable holiday season to pad margins.

What goes up must come down, of course, and after six years of tremendous growth--a period that began with the introduction of Windows 95 in late 1994--all indicators point to a major slowdown in PC sales. While Gateway looks to celebrity shill Michael J. Fox to boost sales, Michael Dell predicts "consolidation" in the OEM PC market, with at least a few of the top 10 escaping the carnage in the coming year. This past holiday season was the weakest in years for PC makers, and profits, while still strong, are not growing as they have in the past. What's going on?

PC makers who adopted Dell's build-to-order model have traditionally been able to keep growth and profits strong, even during a moderate downturn in sales. This is because the build-to-order model (we'll call it Dell Direct) does not keep hardware stockpiled in inventory, which means the company does not have resources (i.e. capital) stuck on the shelf until it is replenished with sales. Under Dell Direct, the just-in-time order model means that often, payments for orders come in before the PC maker's bills come due. This model works especially well for PCs, because the technology changes so fast that systems even a few months old must be discounted, owing to new chips constantly coming online.

The Dell Direct model has drawbacks, and one of them is that advance orders for expensive components (like CPUs) are based on demand from previous quarters. (Even in a build-to-order world, a company cannot risk being without key components like chips, which cannot be ordered quickly from another manufacturer.) With one poor quarter, a PC OEM can be left with lots of "old" chips that must be sharply discounted in order to sell. This is what has happened for PC QEMs, and bargains now abound for PIII-based systems with slow (sub-1GHz) chips. The holiday season was so slow that OEMs are now bringing P4 chips in the back door while they are unable to move PIIIs out the front.

So we know the what of the downturn, but not the why. Clearly, higher interest rates put pressure on consumer spending. If you buy on credit, when rates go up you put off non-essential purchases with the expectation that rates will be lowered. But I don't think the Greenspan effect is the only reason. PC technology, simply put, is "good enough." With a few exceptions, for the majority of users there is no compelling reason to upgrade from a 500MHz PC to a 1GHz PC. Even the Microsoft effect has not gotten users to bite: the company has announced a $200 million ad campaign to move Windows 2000, sales of which have been sluggish. Recent market research also indicates that consumers are putting their money into mobile devices like PDAs and cell phones, not PCs.

Is the party over? Not so fast. Make no mistake: PC makers still earn plenty of money. They may be facing a future of sub-30 percent growth rates, but they won't be begging. When a company with the power and market share of Dell. slashes prices, the] ripple effect can indeed cause others to lose their margins and collapse; but computer sales will continue. Still, until current PC technology offers some major, compelling reason to upgrade, consumers may concentrate on bleeding-edge devices, and let PC OEMs simply bleed.