DECONSTRUCTING THE COMPUTER INDUSTRY
It sure looks like an industry on the skids. The signs are everywhere and grow more painful every day: Worldwide leader IBM Corp. is shedding 40,000 workers this year, for a total of 100,000 since 1985. No. 2 Digital Equipment Corp. ousts its founder, after taking $3.1 billion in charges over two years to cut 18,000 jobs and vacate 165 facilities. Wang Laboratories Inc. files for Chapter 11 protection. France's Groupe Bull lays off 8,000 workers and closes 8 of 13 factories; Italy's Olivetti downsizes by 20%; Siemens Nixdorf plans to lose 6,000 workers. And the list goes on.
"Think," an industry byword in IBM's heyday, is giving way to "Shrink." It's not just computers that are getting smaller, it's most of the companies that make them, too. They're deconstructing--shutting factories, cutting jobs, spinning off subsidiaries, farming out work, and slashing managements.
DOLDRUMS. Even the younger generation is feeling the pinch. Relative kids such as Apple, Sun Microsystems, and Compaq are attacking costs, too. Apple Computer Inc. and Compaq Computer Corp. have laid off thousands to cut overhead and stay a step ahead of the hundreds of wannabes nipping at their market shares. Only in Japan, it seems, have companies avoided downsizing. But they may be next. Sales are slowing, and Fujitsu Ltd. reported a $160 million loss for the first half of fiscal 1992.
What's going on? Like all manufacturers, computer makers are under pressure to slash costs. But they also face a unique challenge. In their business, every 18 months, advances in microprocessor technology double the amount of computing power a dollar will buy. These powerful chips and standardized software have already turned PCs into a low-margin commodity, and PCs have become the industry's biggest part (chart, page 93). Now that computer makers are building large-scale systems--including machines that will surpass IBM's biggest mainframes--from the same cheap chips, the harsh economics of the PC are sweeping computerdom. "The computer-systems business is rapidly evolving to become similar in structure to the PC business," says John Levinson, computer analyst at Goldman, Sachs & Co.
Already, the industry's net income has plunged from 6.5% of revenues in 1986 to 0.12% last year, excluding special charges, according to Standard & Poor's Compustat Services Inc. That's billions in earnings up in smoke--a figure reflected in the dismal performance of computer stocks (chart, page 93). And the forecast is for more of the same, as powerful microcomputers gobble up more of the market. "We never plan to see margins come up again," says Peter Bonfield, chairman of Britain's ICL PLC.
NICHE-PICKING. So the business is a disaster, right? Not at all. Although falling prices have slowed revenue growth, from nearly 20% annually five years ago to the low single digits, demand for computer gear remains strong. Lower prices are inviting more customers. And there's plenty of new technology on the drawing boards--pen-based PCs, handheld "digital assistants," and massively parallel supercomputers--to create demand well into the new century.
But before then, the old industry has to deconstruct. With gross margins of 40% and falling, the vertically integrated companies that thrived on margins as high as 70% must do some painful soul-searching. They now have to choose at which points along the "value chain" they can most profitably apply their skills and resources. They may write software, build parts, or make complete systems. They may sell computers built by others. They may team up with partners. Or they may just help customers choose and install computers to solve specific problems. But even the mightiest, it seems, can no longer do it all.
The pattern for the industry's future structure has already been set--again, by the microprocessor revolution. In the past decade, the industry has splintered into an array of specialty companies. Each focuses on a different part of the value chain: chips, disks, distribution, data-base software, customer service, and so on. And, as a whole, they are proving more efficient than old-line, integrated makers. Again, there's an analogy to what's happening in hardware itself: Computing power has fragmented, breaking out of the monolithic mainframe and spreading to flexible networks of powerful, desktop machines.
Big Blue and other giants grew up as vertically integrated organizations, a la General Motors, because that's how companies worked then--and because there was little choice. They had to build their own chips, circuit boards, disk drives, terminals, printers, tape drives, and even the boxes the stuff went into. They wrote software, too, and fielded teams of salespeople, consultants, and technicians. Tens of thousands of employees, dozens of plants, and huge investments in research and development were involved.
But the PC changed all that. In 1981, when IBM chose an Intel Corp. microchip and Microsoft Corp. software for the IBM PC, it inadvertently sowed the seeds of its own deconstruction. Because anybody could buy the same parts, everybody got into the business. From Taipei to Tampa, from Delhi to Dublin, an infrastructure of suppliers sprang up to feed the right bits and pieces to thousands of assemblers.
With the PC market saturated with players, gross margins hurtled below 30%. As long as the big companies had a healthy business in "big iron"--minis and mainframes--this didn't hurt bottom lines much. But those core businesses have slowed. And now, sooner than DEC or IBM expected, big machines are threatened with extinction by low-cost, micro-based alternatives. "It has unfolded beyond our wildest imagination," says Gilbert P. Williamson, president of NCR Corp., acquired by American Telephone & Telegraph Co. in 1991. NCR's big thrust these days is building machines using multiple microchips that can do transaction-processing work for a retailer--but for a fraction of what it would cost with a mainframe.
FREE MARKET. So the falling tide is lowering all boats. McKinsey estimates the companies that in 1986 built and sold finished computer systems were capturing about 80% of the total profits being generated by computer sales. The reason: Older, high-margin systems from the big computer makers still dominated. These computers all had proprietary software that kept the customers locked in--and paying high prices.
By 1991, however, systems makers were getting just 20%. Why? Because the PC had cut out the fat--and not just by lowering costs. The PC and other "open" systems such as minis and workstations using Unix software made it possible for customers to choose from a wide range of machines that all ran the same programs. They turned the industry into a free market. And the market soon reallocated profits. The biggest chunk, 49%, simply stayed in the pockets of customers in the form of lower prices--an economic surplus that "customers are unlikely to give back," notes Michael Nevens, a McKinsey principal.
That's not all. Computer makers also gave up profits to suppliers of components, software, and services, whose share of the pie rose from 20% in 1986 to 31% in 1991, according to McKinsey. In effect, the market said that chipmakers and software writers added more value than the folks cobbling those parts into systems and should be rewarded accordingly. That's why, as computer makers scramble, companies such as Intel and Microsoft, suppliers of the main chips and software, respectively, for the IBM PC market, are lapping up the gravy.
This explains the frenzy of deconstruction within the old vertical empires. Without fat profit margins on complete systems to mask inefficiencies, big companies can no longer afford in-house divisions--unless they're really competitive. And in many cases, the best way to improve performance of a division or factory--indeed, just to measure it--is to expose it more fully to market forces.
Clearly, that's the motive behind IBM Chairman John F. Akers' massive deconstruction project announced last December. He broke the sprawling company into 13 semiautonomous units. This past September, he created yet another, just for making and selling PCs. Each of those units is likely to subdivide until there's "a whole host of little companies under the IBM umbrella," says President Jack D. Kuehler. The free-standing units will keep their own books, and before long, it will be apparent where IBM can be truly competitive--and where it might cut its losses. "There will be some fallout and dislocations," says Kuehler. "Some won't make it." But if all these Baby Blues are operating at peak performance, the sum of the parts will be greater than today's whole--to shareholders and customers.
`YOU'RE THE BEST.' The risk, of course, is that computer makers whose divisions can't cut it will quickly hollow out, shutting more plants and laying off more workers. That could boost short-term profits. But they would soon lose manufacturing and design knowhow, making them less able to bring innovations to market. And that would be the beginning of the end for a computer maker. "You have to have something where you're the best," says Charles E. Exley Jr., retired chairman and CEO of NCR.
The companies that dig out "best of breed" capabilities in their organizations and free them to compete can hope to rebuild profits. Of course, most of the industry's best gigs are already taken: Even if you're great at operating software, Microsoft has that about sewn up. Ditto Intel in microprocessors; Conner, Quantum, and Seagate in disk drives; Andersen Consulting and Electronic Data Systems in systems integration; and so on.
The deconstructionists can take heart, though, from some examples of surprising innovation by their compatriots. Consider Hewlett-Packard Co.'s printer division, in Boise, Idaho: A decade ago, the minicomputer maker saw a chance to carve out a new niche in laser printers. It freed the division to pursue the new market--regardless of whether the printers would help sales of other HP machines. And now, HP has 43% of the $5.4 billion U.S. market.
GET A FOCUS. There are already some promising possibilities among IBM's deconstructed units. Adstar, which used to design disk and tape drives primarily for use in IBM computers, is now mounting a massive effort to sell its drives on the open market, even for use in computers that will compete with IBM's. Another unit is beginning to sell memory chips and other components outside, so Big Blue will have a chance to prove what it has frequently asserted--that it has world-class capabilities in chipmaking. In fact, IBM may come to resemble its Japanese rivals. Those electronics giants have always built components for the open market as well as for internal use.
Success in chips and other components may be essential if big players want to avoid even more downsizing--to the hollow extreme of deconstruction epitomized by Dell Computer Corp. As Chairman Michael S. Dell acknowledges, his fast-growing company's value added--its "core competency," as the management gurus would have it--is not computer technology at all, but distribution and marketing. Dell is set up to excel in two areas: handling orders and queries from 30,000 customers a day and providing an endless supply of new models and options. Dell does no real manufacturing--only final assembly and testing. And in many cases, it doesn't even design the machines it sells: Dell engineers, using input from a vast customer base, create specifications for new computers and hire subcontractors to build them.
The message is focus, as Sun Microsystems Inc.'s huge success attests. The leader of the technologically demanding workstation business builds no components itself; it relies on outside subcontractors to build the guts of its systems (box). That leaves it money to spend where it can really add value: the Solaris operating software and Sparc, its microprocessor design.
Of course, IBM and Digital can't just turn into Dell or Sun overnight--nor should they. Despite the battering they have sustained, the big players have enormous skill and unmatched assets, not least their tight relations with blue-chip customers and decades of experience creating comprehensive information systems for specific industries.
Solving complex information-handling problems for corporations is an obvious way of adding value--and replenishing profits--for old-line makers. IBM, for instance, is pursuing a variety of professional services, including writing custom software, outsourcing, and most recently, management consulting.
Before they can reap profits in new businesses, however, computer makers need to trim more costs in the old ones. That would have been a lot easier if they had started sooner. But in many cases, management assumed the slowdown in hardware profits was caused by the recession, not by fundamental changes in the industry. "A lot of people in our industry, including myself early on, didn't see that clearly," says James A. Unruh, CEO of Unisys Corp.
FINNISH LINE. One company that caught on early was Britain's ICL. Having survived a brush with extinction in 1981, ICL pared product lines and limited its marketing to a few key types of customers. More important, management punctured old assumptions. For example, when it bought a Finnish PC maker, Nokia Data Systems, instead of remaking the company in the ICL image, Bonfield encouraged his managers to pick up some fresh pointers from the younger organization (page 98). "If you've got the same structure you've got now in two years," he says, "you'll be out of business."
Digital Equipment, on the other hand, has only just grasped the need for a massive overhaul. Under former CEO and founder Kenneth H. Olsen, the company split into 150 business units--none with bottom-line accountability. The new CEO, Robert B. Palmer, has moved to consolidate those, to just 10 units, each of which will have profit-and-loss responsibility. "Clearly, we have some business units that can be more independent," Palmer says. One early candidate: the $775 million disk-drive business. But he has no plans to spin out subsidiaries as IBM and some other big players have done, he says.
Once regarded as a basket case, Unisys now looks like a winner in the deconstruction game. Pressed by the enormous debt that former Chairman W. Michael Blumenthal took on in the 1986 merger of Sperry and Burroughs that created the company, Unisys had to come to grips with reality early. Unruh says he saw that "the economic model had changed and the cost structures of the past were obsolete."
The resulting makeover has put Unisys well ahead of IBM and others in many respects. Unisys began selling computers that were designed and produced by other companies. It has pared its work force by 54% since 1986, in part through divestitures. It stopped making some PCs, began phasing out two entire lines of mainframes, shut several factories, and narrowed its marketing to focus almost entirely to four industries: government, financial services, telecommunications, and airlines. The idea, says Unruh, is to understand those industries extremely well and help customers there install complex information systems, which may not be 100% Unisys-built.
NO SACRED COWS. Unruh has had the company back in the black for four quarters, after three years of losses, and has pared debt to a more manageable 59% of capital--down from 65.7% at the peak. But it took measures that were painful in human terms (page 100). And, Unruh says, there can be no end to honing operations. "Our phrase is 'a little restructuring every day.' "
Every day and every way. As deconstruction ramps up at IBM, it's clear there can be no artificial boundaries--no sacred cows. That means the mainframe division no longer can squelch projects just because they might compete with its machines. Indeed, with the future of traditional mainframe technology dimming, IBM has several projects under way to create chip-based alternatives. Adstar, for instance, is teaming up with a small Silicon Valley company to produce a "file server" that could replace a mainframe as the hub in data networks. "We want to jump in and use the new technologies," says Kuehler. "I'm not trying to protect our old ways."
One new way IBM is catching on is partnering. A major fact of life in the deconstructed computer industry is that more products are of ambiguous parentage--a blend of hardware and software from many sources. Indeed, even as it fragments, the industry is developing a thick web of strategic alliances, joint ventures, technology-licensing deals, and consortiums aimed at divvying up development costs, getting products to market quicker, and pooling technologies and skills. So IBM is working with Apple and Motorola Co. on a new generation of chips and software. Meanwhile, Apple works with Japan's Sharp Electronics Corp. on handheld computers, and IBM teams up with Toshiba Corp. on screens and memory.
FASTER, FASTER. Such globe-spanning alliances may be the only way for some computer makers to stay in the game. Take Groupe Bull. It sells NEC Corp. mainframes, IBM workstations, and personal computers from Zenith Data Systems, which it acquired in 1990. Bull has sold 4.7% of its equity to NEC and 5.7% to IBM and is developing new computers that IBM will sell, too. Also, it has joined Olivetti and Siemens Nixdorf in Trans European Information Systems, a venture that is bidding on pan-Europeanprojects.
"Do I worry about being hollowed out?" asks Michel Bloch, president of Bull Systems Products, the company's main product-development group. "Yes, it's a permanent concern. But everything in life is a trade-off. We had to think in terms of cost and time to market."
Indeed, next to cost, the biggest motivation for deconstruction is speed. The vertically integrated companies often have trouble keeping up with the product cycles being set by tightly focused component makers. In PCs, product cycles have telescoped from two or three years in the late 1980s to as little as six months now. Miss a beat--as Compaq did in 1990 when other PC makers used Intel's i486 first--and profits vanish.
DRACONIAN. Compaq rebounded this year by slashing prices and overhead, which has put its stock back on Wall Street's buy lists--for the moment. But the outlook for computer stocks remains murky. Some analysts say it's no longer possible to forecast the long-term profitability of computer companies. Over the past several years, investors have been trampled after rosy turnaround plans failed, to be followed by more draconian cuts. Who's to say that more unpleasant surprises aren't in store? "I don't detect any management team that has a real good plan that is several years forward-looking," says Barry Bosak of Smith Barney, Harris Upham & Co.
Steven M. Milunovich, computer analyst at Morgan Stanley & Co., says he has begun looking at companies altogether differently: Forget technology and focus on marketing clout. He likes Sun, because its identity as workstation leader is planted so firmly in the minds of computer buyers that it doesn't matter if Sun's technology isn't always ahead. Still, Milunovich warns, "nothing's safe as a predictor for the long term. You constantly have to, more than in other industries, reassess the situation. The pieces are constantly moving."
And what does the industry's fragmentation mean for overall U.S. competitiveness in computers? Judging from the PC industry, the U.S. can field a lineup of aggressive specialty firms that is unmatched anywhere. Unlocking the resources that have been hidden inside the vertically integrated monoliths can only make those companies better at what they do. Competition will goad them to innovate at a ferocious pace. New products may surface that might not have in earlier times.
That's the gleam of a bright future that computer makers can focus on. But in the here-and-now, there is still a painful transformation to struggle through. A massive industry in the midst of deconstructing itself is not a pretty sight.John W. Verity, with bureau reports