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Thursday, March 4, 1999

An Investment Opinion
by Dale Wettlaufer

PCs Are Not TVs

On our message boards recently, we've been having a pretty fast and furious discussion about the sustainability of the PC industry and the inherent dangers of a discontinuous technological innovation hurting the industry. To frame the issue, some people believe that the PC will go the way of the television. The thought goes that the growth rate of PC spending will slow and the excess returns will disappear in a highly, if not perfectly, competitive business.

A couple of problems arise from this sort of thought. First, when Zenith and the American-made television died off, it's not like all manufacturers of televisions stopped generating economic returns on investments in the television business. It's just that Zenith couldn't compete with manufacturers that were better equipped to deal with a mature industry and who could suck out the excess returns that were still left in the industry.

Second, from a utility viewpoint, the TV stopped evolving around that time. Incremental advances in picture tube technology and other advances didn't really add new dimensions of usefulness; they just added to an already substantial utility value found in the device.

Third, TV manufacturers that just focused on TVs were probably doomed to fail anyway. But a company that saw itself as a consumer electronics manufacturer willing to invest its cash flow into new market segments could keep generating shareholder value. Sony didn't just say, "Well, the TV game is up, so we had better lie down and die." They reinvested cash in VCRs, Walkmans, CD players, stereo equipment, PlayStations, etc.

I've always argued that PC companies are less like "technology companies" than they are precision manufacturers. Much of their economics come from being manufacturing services. Look at the economics of companies like Jabil Circuit (NYSE: JBL) or Solectron (NYSE: SLR) to check this. Same low margin/high turns model of doing business. The computing and communications device of tomorrow may not even be the box you're reading this on right now. It could be a thin tablet with a CPU and other electronics stuffed in there. It could be something different. But the PC manufacturers do think about this sort of thing. If something becomes the high volume consumer electronics device of its day, there's some value in the option that current PC original equipment manufacturers (OEMs) morph into that sort of business.

Look at Dell's (Nasdaq: DELL) announcement with IBM (NYSE: IBM) today. Part of the Dell story that is still intact is the expansion of the products the company manufactures. The richening of the company's product mix to include things other than PCs -- servers, workstations, and what now looks like even higher-level enterprise computing systems such as storage systems -- has accounted for its increasing returns to shareholders and its avoidance of some of the negative price inflation in plain vanilla PCs. So when you look at Dell or Gateway (NYSE: GTW) or Micron Electronics (Nasdaq: MUEI), the direct PC manufacturers, there are the economics of being a precision manufacturer as well as the option to get into other product categories.

Another part of the economics of direct PC companies come from being the distribution and retailing channel. Compaq (NYSE: CPQ) might be a manufacturer, but it deals extensively with indirect distribution, acting as its own retailer/distributor for a tiny fraction of sales. Part of the value that the distributors and retailers have captured for themselves is captured in the economics of the direct PC companies. Gateway has enhanced its value by going after the bricks-and-mortar retailing model with its Gateway Country stores. With 75% of the PC market still buying computers that way, that's a pretty fat target. So this is where the company is seeing some attractive incremental returns, and this is where it's investing. Both Dell and Gateway are also going after the Web-based retail market for things other than PCs -- software, peripherals, accessories, and services. These are not trivial opportunities -- they are moves intended to capture market share from less efficient and less well-financed competitors.

For Dell, some of the excess returns come from being a service company in addition to being just a plain vanilla manufacturer. You might ascribe that to its "brand value," but its superb logistics support and delivery of customized boxes (taking the value from value-added resellers, or VARs) is what differentiates it and creates extra return. So when you look at a company like a Dell, it is part electronics manufacturer, part retailer, part distributor, and part value-added reseller. Micron wants to get there too. The more service it can put into its business, the more its business can look like Dell's. Then there's also the option to get into other market segments and richen the product mix and increase operating dollars on a capital base that is not expanding as rapidly.

Finally, because there are so many services being developed that are complementary to the PC, the PC product cycle won't just die off. High bandwidth programming, IP-based telephony, and new applications to present information and interact in dimensions that don't look anything like what happens on today's PCs are all attracting tons of financial and human capital to develop them. You're not going to run these things on a 1998 PC, let alone the huge installed base of 386 Wintel machines that are out there.

In all, sure, the PC market is subject to discontinuous technology innovations and eventual maturity, but it's also run by people who are thinking about these things. The odds are that the PC industry is not going to die tomorrow or next year. Even if that were the case, the forward-thinking PC companies are going to reinvest their free cash flow to deal with it and go off in another direction. Depending on the company's cash flow, management, the date on which the competitive advantage period for the industry and certain companies ends, and the potential value of new market opportunities, there's value to the options available to today's PC companies. To what extent the market realizes this and values it appropriately is your call.

Call Your Boss a Fool.

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