WSJ: Mergers Can't Make The PC Business Profitable

Who’s number one in personal computers, with 57% of the market? Dell, Compaq, IBM, H-P, NEC? Nope, the answer is Other — literally thousands of companies with 4% to four-thousandths of a percent market share.

Only slightly more sophisticated than ball bearings, PCs have become commodities sold more on the basis of designer colors than innovative features.

Selling commodities is helped by scale, hence the rationale for merging Compaq and Hewlett Packard. But will this do anything to change the industry, to bring stability, and to end the vicious price wars? Not a chance. Both companies lose money selling PCs, and getting larger means they can drown in red ink together. Wall Street seems to agree. Both stocks dropped sharply after the deal was announced on Tuesday. PCs will never consolidate like the auto industry, because you and I, or more importantly the guy in a bamboo warehouse in Shenzhen, can build our own.

That wasn’t true at Compaq’s 1982 inception, which includes the fairy tale of three engineers scratching out a design on a place mat at the House of Pies restaurant in Houston. From that, Compaq out-innovated IBM, built a strong dealer channel and thrived on high margins.

But by 1987, Intel realized PC vendors were wrapping plastic around their microprocessors and other off-the-shelf parts, and, with very little innovation, making more money then Intel. So Intel hollowed out the PC, standardizing everything, and helped mavericks like Michael Dell and Gateway’s Ted Waitt by giving them access to the same technology as the big boys. These new guys sold direct, by 800 number and eventually the Web.

In the mid ’80s, based on a small magazine ad, I called a computer company in Austin and priced out a PC-AT, the high end of its time. They wanted $2,800, which was a huge discount to the $6,000+ that IBM or Compaq was asking. I then asked how much for 50 of them. I heard a guy, who years later I figured out was Michael Dell, yell out to someone, probably in his dorm room, “how fast can we build 50 of them,” and then calmly quote me $2,500.

Compaq, however, clung to their control of an increasingly ravaged dealer channel, and lost margins and market share year in and year out. Today, it’s hard to spend more than $1,600 on the fastest PC.

These same price pressures also punished Apple Computer, which Steve Jobs has temporarily saved by selling computers in Ruby and Tangerine. That’s value added? Compaq was the first to put an e-mail button on their keyboards. I wonder how I lived without it.

Lower margins remove PC vendors’ ability to do R&D and innovate; Intel and Microsoft basically do it all. Even attempts to innovate, Compaq with a chip from DEC named Alpha and H-P with Merced (a joint venture with Intel), proved too expensive. Both are now in Intel’s hands, killing any last hopes of computer makers capturing value out of the PC. This same thing may play out in the network equipment business, as Intel has eyes on someday hollowing out Cisco’s market and high margins.

In the computer business, Hewlett Packard was always the anomaly. A late entrant, it is often regarded as the company that stands between consumers and Microsoft. It’s tough to charge money for that. What they do make money on is toner and ink, which H-P gladly sells inside of cartridges at markups that would make Tony Soprano blush.

There is no value selling desktop PCs, so both H-P and Compaq, jealous of leader Sun Microsystems’s high margins, have backed into selling servers, those boxes that sit in data centers and run data bases or serve up Web pages. But rather than the predicted increase in margins, I suspect they will just drag down Sun’s margins too.

Services were the other market that was to save PC players — supporting the PCs after the sale, or even helping specify which PCs to buy in the first place. Almost exactly a year ago, H-P tried to buy the consulting practice of PricewaterhouseCoopers for $18 billion. H-P’s board wised up when they realized consultants don’t scale — you have to hire 30% more to grow 30%, and fire 30% when business turns down that much.

I first heard H-P CEO Carly Fiorina speak at a conference the day she made Fortune magazine’s cover as the most powerful woman in American business. As a star at Lucent at the time, she placed high on the smug index, almost guaranteeing quarterly results. And why not? She controlled over half the market for high-margin telecom equipment sold to government-sanctioned monopolists. She left to become CEO of H-P, replacing long-time CEO Lew Platt who ran off to run a winery, which strangely also marks up red liquid consumables.

Carly’s career move was a smart one, as Lucent soon imploded. But poor Carly had entered a low margin businesses with no guarantees and where the only visible salvation is to merge your way to profitability, or die trying.

Technology changes so fast it leaves behind those who can’t or won’t innovate. Industries naturally evolve into horizontal components, with some layers being enormously valuable and some not so much. The stock market sorts this out over time, providing access to capital to those who innovate and have prospects for high margins, and starves those who don’t. The lesson of this merger is that a business without innovation, even if it’s growing, becomes worthless over time.