Another Delay for the PC Party?


By Megan Graham-Hackett Questions about whether an upgrade cycle is looming for personal computers have been lingering for the last two years. Recall the 20% PC unit growth in the U.S. in 1995, spurred by the introduction of Microsoft's Windows 95 operating system, and it's easy to understand why the industry is hungrily anticipating another such event. Last year, worldwide PC units grew just 1%, after declining about 4% in 2001, according to Framingham (Mass.) research outfit International Data Corp.

It appears that an upgrade cycle is materializing, but it's so slow that no one would call it that. We at Standard & Poor's think PC upgrades will occur on a gradual, as-needed basis, vs. a massive adoption wave. Indeed, another debate centers on whether huge upgrade cycles are a thing of the past. Chipmaker Intel (INTC) says a PC's lifespan has grown to roughly four years, vs. three years, but this theory isn't based on any hard data. Since no standard lifecycle for a PC exists, perhaps companies shouldn't expect en masse upgrades in the future.

OPEN QUESTIONS. If Intel's four-year theory is true, then the 1999 PC push that drove worldwide units up 24% (according to IDC) should lead to a replacement cycle in 2003. As the first quarter came to a close, however, the outlook has soured a bit. IDC recently cut its unit forecast for 2003, to 6.9% growth in worldwide PC shipments, vs. the prior estimate of 8.3%.

We at S&P have been predicting roughly 5% unit growth for 2003 since January. However, this estimate doesn't reflect the potential impact of the war in Iraq. We haven't adjusted our number yet because we've already factored in a weak PC demand environment for the first half of the year. Plus, the length of the war is still questionable. If operation "Iraqi Freedom" continues into the summer, we think PC demand in the all-important second half of the year will likely drop, and we would trim our forecast accordingly.

While overall demand for PCs appears lackluster, some vendors are likely to do better than others. In the fourth quarter of 2002, Dell Computer (DELL

, ranked 3 S&P STARS, hold) increased its market share to 15.7%, from 13.2% in the same period a year ago, according to IDC. Meanwhile, Hewlett-Packard (HPQ

, ranked 3 STARS) lost share during the same period. HP's market share fell to 16.1%, from 18.5% in the fourth quarter of 2001 (adjusted for the May, 2002 acquisition of Compaq). The third-largest vendor, IBM (IBM

, ranked 4 STARS, accumulate), slightly increased its market share to 5.8%, from 5.7% a year earlier.

WI-FI HIGH HOPES. Low-cost producer Dell may continue to gain share this year, but the pickings could be slim. Rival HP has improved profitability at its PC unit (although it clearly has more work to do) and since HP is now more price-competitive, Dell may not be able to lure value-seeking customers away from HP as easily as it did in 2002. And IBM seems to be holding a healthy market share in PCs. Its profits, however, are less dependant on PC sales than other vendors.

One bright area for the industry is in the mobile applications. With Intel's launch of its Centrino chipset, which uses the Pentium-M chip (Centrino enables wireless Internet access, while the Pentium-M chip improves battery performance for notebooks), many PC vendors hope that accelerated notebook sales will offset weak desktop sales as customers crave wireless Internet access (or Wi-Fi, short for wireless fidelity.)

A surge in notebook sales, however, may not happen until next-generation Wi-Fi is widely accepted. Centrino is now offered only with the standard 802.11b technology, which operates at 11 megabits per second. Other vendors offer newer 802.11a and 802.11g systems that run at 54 megabits per second (see BW Online, 3/17/03, "Laptop Makers Don't Want This Intel Inside"). But these newer systems won't likely be certified until the end of 2003, which may limit corporate demand -- especially if info-tech departments delay purchasing the faster systems until they're certified. Mobile Internet looks hopeful, but we think it's still too early to know whether the optimism surrounding Wi-Fi is a sign of real demand.

TRENDS TO WATCH. Based on recent stock-price performance, it seems that investors no longer anticipate a rapid PC upgrade cycle. The S&P Computer Hardware Index declined 1.1% year-to-date through Mar. 31, modestly outperforming the S&P 500-stock index, which fell 3.6%. We should have a clearer idea after PC makers report first-quarter earnings and give forward guidance, and as the length and impact of the war becomes more obvious. It's also worth watching consumer sentiment and spending patterns, and to look for improving corporate spending.

We note that our neutral recommendations on Dell and HP are based on valuation and the current macroeconomic uncertainty, while we've been more positive on IBM with an accumulate recommendation. We believe IBM shares are trading at an attractive valuation (at a discount to their intrinsic value based on our discounted cash-flow analysis) given its diversified line of computer hardware equipment, application and system software, and related services, as well as its unique ability to offer a complete package of these products to customers. Analyst Graham-Hackett follows computer hardware stocks for Standard & Poor's


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