For Profit-Hit PC Makers, It’s Time for Act II

Maybe IBM chief Lou Gerstner was exaggerating when he declared an end to the personal computer era.

But the era of high PC profits, at least, is indeed over. And that shift is fueling massive changes at some of the biggest companies in the country.

“It’s a very, very funny time in the computer industry,” says Hewlett-Packard Chief Executive Lewis Platt.

Others might argue it’s anything but funny.

Like its traditional high-technology competitors, the long-revered Silicon Valley maker of printers and computers froze in the face of new, more efficient rivals, betting that improved technology and demand for Internet access would make up for the falloff in what it could charge.

That theory has run out of steam. With the Asian economic crisis, free-falling prices for components and wide-open possibilities for what future Internet on-ramps will look like, every major computer company is being forced to reinvent itself.

Already, it’s clear that the industry will soon look very different. But the paths computer makers will take diverge wildly, from low-cost, high-volume specialists to high-margin service professionals to entrepreneurs who want to rent you a PC in exchange for a cut of your online purchases.

The urgency behind those experiments is that personal computer prices are falling so fast that it looks like a death spiral for those in the industry who don’t come up with new ways of earning money.

That point was brought home this year, when the pace of new unit sales to consumers finally stopped going up fast enough to make up for the price declines.

Revenue from consumer sales has peaked, some analysts say, as computers made their way into a record 50% of U.S. households. That means there may never be more money coming out of the home than there is today.

Last month, for example, the number of personal computers sold to consumers through retail outlets rose 21% over the same period a year ago. But the average selling price of Windows-based PCs fell 19% to $928, according to PC Data of Reston, Va.

The bottom line: Revenue in the category, which doesn’t include direct-sellers Dell Computer and Gateway, fell about 2%. There have been similar declines in three of the first four months this year, said PC Data analyst Stephen Baker.

Desktop computers sold to companies are also getting cheaper.

And that means things will be tense for the next several years. Platt, who plans to step down soon as CEO of Hewlett-Packard, predicts more consolidation in the hardware industry, with many computer companies casting longing looks at the phenomenal growth of software and services start-ups.

Some, like HP and Compaq Computer, are trying to morph into service-oriented companies.

Yet, given HP’s admission that it badly underestimated the impact of the Internet on its own business, the company looked awkward last week pitching its plan to advise companies on how to embrace it. And Compaq, the biggest PC seller in the world, barely mentioned its core product at its recent Houston meeting for thousands of customers. Instead, it called the biennial conference “Better Answers for the Web-Enabled Enterprise,” referring in part to consulting services.

Compaq spent $9 billion last year to buy Digital Equipment Corp., which specialized both in consulting and in making mainframe computers, and still hasn’t been able to handle the bottom dropping out of PC prices. In April, the board forced out CEO Eckhard Pfeiffer.

But there are few alternatives to jumping onto the services bandwagon, which boasts no inventory and no cost of goods.

IBM, which lost $1 billion in its PC business last year, has led the way among big hardware companies in pitching e-business advice. Meanwhile, it hasn’t abandoned its efforts to innovate in the area of smaller computer parts, from chips to disk drives that are sold to rivals like Dell at $7 billion a year.

IBM Personal Systems Group President Dave Thomas said IBM can still make money in the desktop and portable computer business, where it trails only Compaq in retail market share. But to make that happen, the company must use some fancy footwork, focusing on service packages, financing and other sidelines.

“Compaq realized that just being a PC hardware business is going to be very difficult,” Thomas said.

And then there’s Dell.

By eliminating the retailer from the sales chain, the Round Rock, Texas-based company profits where others can’t, and it has forced Compaq and IBM to change the way they sell. Learning from Dell and from Pfeiffer’s mistakes, Compaq Chairman and acting Chief Executive Ben Rosen has cut the firm’s resellers from 40 to 4.

Dell has also been ahead of the pack in saving money by shifting sales and support functions to its own Web site. It now counts a third of its sales from the Web.

Yet fast-growing Dell kept its average selling price higher than the rest of the industry--$2,350 last fiscal year--in part because it was focusing more on companies and consumers who could tell they were getting more bang for the buck.

Then Dell saw that it had to move to fat-profit corporate servers and notebook computers to stay ahead in PCs. “Our competitors were using servers to subsidize their PC businesses. We went in and scorched that,” said Vice President Brian Wood. In 2 1/2 years, Dell has moved to No. 2 in servers.

Dell has rejected the IBM service approach, subcontracting much of its maintenance but maintaining accountability for it. “If remaking the old IBM model was so effective, why are people buying from us?” Wood said.

But as its business-customer-dominated sales growth slips from above 50% closer to 40%, Dell has taken a deep breath and decided to go after consumers seriously.

But it’s a gamble to assume that ordinary consumers will buy PCs sight unseen.

“We turn out to be one of the great untold stories in the consumer space,” said Paul Bell, Dell’s vice president for home and small-business customers. “Our consumer business is already growing at 80%, but a third of computer buyers haven’t heard of us.” That will change shortly, with Dell’s largest television ad campaign and still lower prices.

But Dell’s turn downstream makes some investors nervous, and the company’s highflying stock has retreated to $37.31 from its 52-week high of $55.

With good reason: Every revolution devours its young, and Dell’s great structural insight is no longer unique. In fact, the road to ubiquitous, cheap appliances is paved on the backs of companies that went the low-cost route.

Packard Bell once offered some of the lowest-priced computers while holding top market share, but it has nearly vanished.

Today, super-cheap, stripped-down machines are announced seemingly every month: Microworkz sells one sans monitor for $299 and EMachines sells for $399.

Even scarier for the old-line PC companies, the chaos has been exacerbated by utterly new business models. That includes handing out free computers to consumers who agree to watch ads on them or providing cheap, monthly-fee computers for those who agree to subscribe to Internet services. Dell says it is most worried about those new models.

To hedge against the new Internet-centric business models, the big computer makers are linking with Internet service providers themselves and taking commissions for signing up new customers.

But while every computer maker is trying to cash in on the Internet frenzy, some appear to be missing one of its ugliest lessons for the bricks-and-mortar crowd: It’s hard to compete with companies that don’t mind losing money.

“You can gussy it up,” Dell’s Bell said, “but whoever has the lowest price position wins.”