Low PC margins endanger Dell's core business

Dell Computer Corp.'s own success in driving PC prices down to current lows could force the original build-to-order computer maker to look elsewhere for profits.

PC profit margins, laid barren by an almost year-long PC price war, could remain depressed until 2004, meaning Dell will need to turn its attention more toward higher-margin infrastructure products like servers and storage, said Ashok Kumar, analyst at U.S. Bancorp Piper Jaffray Inc., in Menlo Park, California.

"Over the next few years, scaling up the enterprise with servers, storage, and services will be the main theme [for Dell]," Kumar said. "Growth in storage and second-generation Intel server architecture will be instrumental in diluting the impact of lower margin PC sales."

Dell fired the first volley of the PC price war in the Fall of 2000. Since then, PC prices have fallen steadily. Aggressive discounting from chip suppliers such as Intel and Advanced Micro Devices (AMD) has also aided the drop in PC prices.

The fierce campaign for PC market share forced competitors like IBM, Hewlett-Packard, and Compaq to follow suit. The discounting that followed decimated PC gross profit margins, which fell from an industry average of 24.9 percent in the last quarter of 2000 to 19.9 percent on the first quarter of 2001, according to IDC, in Framingham, Massachusetts. Many PC makers, such as Gateway, reported single-digit PC margins for the same time period.

Plummeting personal computer prices have made PC profit margins so low that Dell PC competitors such as IBM, Compaq, and Hewlett-Packard (HP) now view PC sales as merely a component of larger network infrastructure and service agreements.

IBM is in the process of integrating its PC sales division back into its normal sales and distribution channel, eliminating it as a standalone unit, according to a confidential, internal IBM memo. The move reflects a change in priorities from IBM when it comes to the way it views the importance of PC sales versus other technology sales, like servers and software.

Similarly, Compaq earlier this year combined its commercial and consumer products groups into one. The move was part of a companywide change in approach to PC sales from standalone products to components of an overall service package.

"PC pricing became more and more competitive late last year and early this year and has maintained this year," said a Compaq spokesperson. "The market is really not driven by PCs anymore. The real opportunity exists in services and high-end infrastructure solutions."

The PC price war contributed to a negative 6.5 percent operating margin for HP's PC division during the third quarter, according to estimates from UBS Warburg, a U.K.-based industry and financial analyst group. HP remains committed to its PC product line but, like IBM and Compaq, is also realigning itself as more of a services company that provides PCs a part of larger product packages, HP executives said.

A shift by Dell to further embrace enterprise infrastructure products and service offerings will be challenged by Dell's modest share of such markets, said Kumar.

Undaunted, Dell apparently will maintain its current course of underselling competitors on all product and service fronts, a company spokesman said.

"We will continue to expand our resources in the enterprise arena. We want to continue to hone and define our direct model. We'll continue doing what we've been doing. A lot of people are saying this is a price war, but we really see it more as a business model war," Dell spokesman Venancio Figueroa said.

"Dell is displaying our convergence theme," explained UBS Warburg analyst Don Young. "They slashed prices and took down expenses last fall, got a jump on the competition, got a lot of market share. But starting in Q1 [2000], and now evident on a broad scale, the competition is responding to Dell's new pricing and Dell's share gains are ending."

"I still think the PC hardware operating margins are converging and falling," Young said. "The companies [Dell, HP, IBM, Compaq] are more similar today than they've been at any time before. Dell is clearly the best, but its relative advantage is shrinking."

"I'm not convinced that PC hardware margins will recover and there will be great pricing power restored to the PC players," Young said.

A price increase from Dell does not seem likely, according to a Figuvroa, who said, "We're going to continue to drive down costs. That helps us with our profitability."

"On the direct front, we're every bit as competitive as Dell," a Compaq spokesperson said. "But they've permanently eroded margins in the market place."

Dell president and COO James Vanderslice expects ongoing competition in the PC market to create its share of industry casualties. Offering an example of the PC marketplace over the next several years, Vanderslice said, "It's going to be Beirut."

Dell is the No. 1 PC maker in the world by units shipped with a 12.9 percent market share, followed by Compaq with a 11.9 percent share, HP with a 7.6 percent share, and IBM with a 6.3 percent share, according to IDC research from the first quarter of 2001.

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