STRATEGY - When the chips are down
It's easy to blame the Asian crisis for fewer sales of PCs and equipment in the US. But the real reasons aren't always that simple.
During just three days at the beginning of March, the unthinkableuipment in the US. But the real reasons aren't always that simple. happened on the New York Stock Exchange. On 4 March, Intel issued its first ever profit warning, saying it had overestimated demand from PC manufacturers, and that its Q1 revenue would be 10 per cent down on Q4 1997. Two days later, Compaq, another darling of Wall Street, warned it would break even only in Q1. The culprits were stiff price competition and a hint of over-stuffed inventories.
Just for good measure, chip and mobile communications giant Motorola issued a profit warning on the intervening day, blaming projected flat sales on the Asian crisis, price competition and slow demand.
These were only the tip of the iceberg - a dozen other high-profile IT companies had issued similar warnings in the early part of this year (see box, page 33). Although it wasn't among them, IBM slashed the price of business PCs to shift excess inventory before the end of March (see PC Dealer, 1 April).
Other PC companies are remaining tight-lipped, and analysts have said that almost any indirect PC vendor could face similar problems during the first half of this year. Not surprisingly, observers have been wondering whether the PC industry will catch a chill when Intel and Compaq sneeze.
Reports of a terminal slow-down have been fuelled by some Wall Street analysts, who claim a profit warning from the world's largest PC vendor means the whole industry is set for decline. To some extent this may be true.
Bloor Research has found that businesses are increasingly reluctant to part with a wad of cash, simply to replace their perfectly good 486 PCs with the latest Pentium II monsters. Nor do they want to embark on a major roll-out, only to find that the PCs they installed at the start of the project are out of date before the last machines are even on users' desks.
'It's becoming very much a replacement market, which is being driven by the upgrade cycle Microsoft and Intel have pushed people into,' says Bloor chief analyst, Rob Hailstone. 'People are showing signs that they don't want to do this any more It's difficult to justify the cost.'
The home market is showing signs of going the same way. The majority of families with school-age children already have home PCs, which they are unlikely to replace without good reason.
But perhaps, for most PC companies, the problems of early 1998 may prove only temporary. As the market has become more commoditised, the early months of every year are lean ones for PC vendors. The industry knows this, but has so far failed to find a way around the problem.
This was acknowledged by Dave House, chairman and CEO of Bay Networks, when the network developer issued its own Q3 profit warning in March. He said: 'In recent years, revenue in the March quarter has been below that achieved in the December quarter - we are disappointed we did not break this historical pattern.'
According to Emmanuel Lalloz, head of PC research at Context, the profit warnings are a sign of heavy channel-stuffing, which was prevalent in the last quarter of last year. 'Every year there seems to be a big glut in Q4, and every year it's worse,' he says.
Meanwhile, Context claims that Compaq shipped 24 per cent more machines than its dealers sold during Q4 last year. IBM shipped 42 per cent more, AST 44 per cent, and Apple 63 per cent, compared with an industry average of 28 per cent. In most cases, under-shipments during the other three quarters demonstrably failed to make up the difference.
Compaq is said to have had eight weeks' inventory stockpiled at the start of the year, and several manufacturers have transferred stock from the US to Europe and Asia. This year's cash-flow problems have been amplified by the transition from shipping-from-stock to building-to-order. Indirect vendors expected this to be under way by Q4, but in practice, implementation has been slow, resulting in more inventory build-up. 'The transition to build-to-order has been harder than manufacturers expected, so they are still building to forecast,' says Ian Darbyshire, programme manager for EMEA tracking at IDC. 'This went awry in Q4 1997 and there was a lot of over-forecasting.' However, the indirect vendors have no choice but to get their build-to-order models right, so this should be the last year when such problems give rise to profit warnings. 'The big threat in this industry today is Dell,' says Lalloz. 'The Dell model is simple and efficient, and it is hard to replicate if you have thousands of dealers in the channel.'
Analysts never cite Dell and Gateway in conversations about who might be in trouble next. Price competition, cited by Compaq as the main reason for its own profit warning, is certainly stiff. In the past year, the US has seen a move toward sub-$1,000 PCs (or even sub-$500 PCs with low-cost designs based on Cyrix's MediaGX chip) as users opt for value rather than bells and whistles. Component prices have fallen more than 30 per cent, which may account for the high number of disk manufacturers to issue warnings this year, including Iomega, Quantum and Seagate. But low prices tend to stimulate a market rather than depress it.
'If anything, price competition will help the PC market grow,' says Dataquest analyst Julio Abella. 'It will extend the market for customers who are very sensitive to price, such as consumers and small businesses.' As for the Asian economic crisis, the effects of this may have been over-played.
Asian firms such as Fujitsu have obviously been hit hard. But most US and European manufacturers have relatively small sales in the Far East, and favourable exchange rates mean they can buy Asian components cheaply.
'It's a handy excuse at the moment,' says Hailstone.
But Intel's problems seem slightly more serious than those of PC and component makers. The company blamed a downturn in short-lead orders for its March profit warning, which could perhaps have been caused by inventory gluts in the channel. But the current model of strong sub-$1,000 PC sales is of less benefit to Intel, since it is traditionally weaker in this sector. It is also facing increasing competition from rivals such as Cyrix and AMD, which have reduced the time during which Intel can sell its top-end processors at a premium to just a few months. Since these premium sales finance much of Intel's R&D effort, the company may have to work hard to maintain its current level of profitability. 'Intel will perhaps be less profitable for a couple of quarters before the market moves to Pentium II,' says Abella.
But Intel remains bullish. On the same day as the profit warning, it announced plans for Celeron, its low-cost Pentium II for the sub-$1,000 market. Intel says, this year, its R&D will soar by about 23 per cent to $3 billion, and it expects gross margins to increase by 50 per cent a year in the long term.
'We have not changed our manufacturing capacity, our product ramp plans or our launch schedules as a result of Q1,' says an Intel representative.
The financial analysts on Wall Street, who focus on short-term revenue and profit, may be worried about the state of the PC market. But technology analysts who specialise in the PC sector, and take a more rounded and long-term view, are mostly confident that the industry will bounce back.
'It's a blip, not a disaster,' says Darbyshire. 'In the next two quarters, we'll probably see the market coming back a bit below forecast, but after that we'll see normal, healthy growth.'
Lalloz also thinks the problem is short term. 'Demand is still strong, and is building in most countries in Europe,' he says. 'By the summer, when the glut is gone, the situation will get better. I think 1998 is going to be a good year for the PC industry, and 1999 will be even better.'
Context predicts unit sales in western Europe will grow by 17.4 per cent this year, compared with 14.7 per cent in 1997. In the UK, it expects the figure to be 18.5 per cent, compared with 17.1 per cent last year.
IDC's estimate for desktop and portable PC sales growth in western Europe is 13.8 per cent this year, compared with 14.1 per cent last year and just 8.5 per cent in 1996.
Europe remains particularly strong. 'All the evidence in Europe seems to show the market is still healthy here,' says Abella. 'In Q4 1997, Europe was the strongest region in the world. This is likely to continue in Q1 of 1998.'
Only Bloor Research remains less optimistic. 'I'll be surprised if the PC market picks up again to what we've seen before,' says Hailstone, though he believes sales of other devices such as thin clients and Web TVs may make up some of the shortfall. It is important to maintain a sense of perspective.
'Compaq had very high growth indeed last year, so you're comparing this Q1 with very high sales,' says Terry Ernest-Jones, research manager at IDC. 'So the warnings are just saying that growth is not going to be so high.'
A history of the profit warnings
Seagate
Seagate warned in January of substantial losses in Q2 because of weak demand and price competition. The actual loss was smaller than expected.
Adaptec
In January, the company warned Q3 earnings would be less than half of Wall Street's expectations. The company cited the lower cost PCs, plus weaknesses in high-end PC sales and poor sales channels.
Network Computing Devices (NCD) The NC manufacturer blamed slow demand for its thin-client hardware as the reason for its expectation of reduced revenue and modest losses in the first half of 1998.
Fujitsu The world's second-largest IT company after IBM, Fujitsu warned in February that its full year to 31 March would see profits slashed by 78 per cent, and sales down two per cent. It blamed the Asian crisis, falling PC and memory chip prices, and slow demand.
VLSI In February, chip maker VLSI warned Q1 revenues would sink below both Q4 and Q1 last year because of a slowdown in orders and shipments, combined with the Asian crisis and inventory adjustments.
Dallas Semiconductor The chip maker expects its Q1 revenue to be down six per cent, though still in profit. It blames the Asian crisis and weakness in core markets.
Cabletron The network giant originally warned of a small loss or break-even in Q4, citing a sales shortfall, a price squeeze, the Asian crisis, and inventory-related charges. The company's actual results were even worse, with an operating loss of $63 million in Q4, partly due to restructuring and acquisition charges.
Intel On 4 March, tier-one vendor Intel issued its first ever profit warning.
It said Q1 revenue would be down 10 per cent from the $6. 5 billion taken in Q4 1997 because of weaker-than-expected demand from PC manufacturers, which it blamed on the seasonal post-Christmas slump. The actual results were eight per cent down on Q4, at $6 billion.
Compaq The one-time darling of Wall Street caused the biggest stir on 6 March, warning it would roughly break even in Q1, with sales similar to Q1 last year.
The manufacturer blamed price cuts in the US business market on having to match its competitors. In order to reduce channel inventories, Compaq plans to introduce its own price cuts and aggressive promotions in Q2.
Motorola The chip and mobile communications giant blamed the Far Eastern economic crisis, plus price competition and a slowdown in the chip market, when it warned Q1 sales would show no increase on the same period last year.
Quantum The disk drive manufacturer expects its Q4 revenue to be 20 per cent down on the same period last year, breaking even or making a small profit.
The company blames excessive inventory and aggressive pricing.
Bay Networks The company forecast that its Q3 revenue would be down 10 per cent on Q2 because of weaker than expected demand. However, it is still expected to exceed Q3 last year. The company's share price actually rose after the warning.
Iomega Despite the popularity of its famous Zip drives, Iomega warned of a Q1 loss of $10 to $25 million, citing weak sales and high inventories.
Netscape One of the few software companies to issue a warning, the browser and net server specialist warned of a Q4 loss. The reasons given were poor sales in Europe and Asia, price competition and lengthening sales cycles for enterprise software. Actual losses of 17 per cent were one-third down on the warning.