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Special Report: A PC Rebound? By Amey Stone, Associate Editor BusinessWeek November 12, 2002

PC Stocks: New Reasons to Hope With the industry finally seeing signs of better times ahead, investors who have sworn off these shares have reason to rethink their stance. Many -- if not most -- investors have learned to hate the personal computer business over the past two years. Not only are PC stocks off 50% or more from their highs but the industry suffers from falling prices, commoditization, and cutthroat competition. "I think it's an unpleasant business that's too mature and has too many vendors, where prices have to keep coming down," sums up Robert Burgoyne, an independent money manager in Ellicott City, Md. "There's just not enough profit to go around." True enough -- for now. But stocks have rallied sharply off their lows as the PC business recently has shown signs of stabilizing. In the past two months, Dell Computer (DELL) has climbed from $24 to $29, and Hewlett-Packard (HPQ) has jumped from $11.50 to around $15. Even lowly Gateway (GTW) had a surge, going from $3 to $3.70 in November alone. Upgrade Cycle. Dan Niles, an analyst with Lehman Brothers, was one of the first to change his tune on the group. Since last summer he has upgraded Dell, HP (twice), and IBM (IBM ). "We felt demand was improving, and that has certainly proved to be the case," he says. PC orders are up, inventories are low, and business investment is rising as corporate profits get better. Niles expects Dell, which reports earnings on Nov. 14, and HP, which reports on Nov. 18, to detail an improved environment. Much of the uptick in demand is expected to come from a PC upgrade cycle, now that corporate machines are an average of three years old. A survey of info-tech buyers by Gartner Group and Soundview Technology Group released on Nov. 6 found that buyers' "intent to spend" on PCs has risen for the first time in five years. Soundview analysts expect 10% unit growth in 2003, with buying beginning in the second quarter. A forecast of 10% growth when stocks have already rallied 25% or better doesn't portend much of a PC market rally. Walter Winnitzski, an analyst at First Albany, thinks the PC industry won't ever again match the 15% to 20% annual growth it enjoyed before the market bubble. "Unit growth will be at best half where we were pre-bubble," he says. Beyond PCs. The best reason for long-term investors to consider PC stocks at current levels is that the industry is starting to move beyond the PC business. Already, Dell is achieving much of its growth from sales of data storage and corporate servers. It's also moving into printers and networking, and in mid-November it will introduce a new handheld computer. Gateway, in a riskier gambit to reorient its sputtering business, in mid-October began selling third-party consumer-electronics products such as digital cameras and MP3 players in its stores. And on Nov. 4, it also debuted a high-end plasma-screen TV. Computer makers have a tremendous opportunity to innovate beyond the beige box. "People say the PC is dead," says Joseph Tzeng, managing director of venture-capital firm Crystal Ventures. "I don't think so." While U.S.-based manufacturing of PCs may cease (he believes that almost all electronics manufacturing will be outsourced to China), "PCs are going to morph many different ways." They'll be integrated into various appliances, home-entertainment systems, and business applications. "Lots of innovation can still can be done," Tzeng says. Tough Choice. Having been a cash cow for so many years, the PC business has provided these companies with great financial stability that makes at least a few of them reassuring choices while the economy is still wavering. As of their most recent financial statements, HP had $11 billion in cash, Dell had $4 billion, and Apple had $4 billion in cash and short-term investments. Even Gateway has more than $1 billion in cash and marketable securities. The way First Albany's Winnitzki sees it, the PC companies must choose one of two business models: One is to be the low-cost commodity producer – an approach that he says has made Dell "the best house in a lousy neighborhood." The other option -- of which he says IBM is the best example -- is to sell complete services and support to customers, "cradle to grave." The big problem with the clear strategic winners, such as Dell, Microsoft, and Intel (INTC ), is their valuations. Money manager Burgoyne thinks Dell and Intel are particularly expensive, with their stocks trading at 36 and 30 times 2003 earnings, respectively. Even though Winnitzki likes Dell's model, "It's hard for me to see significant upside [in the stock] at these levels," he says. No Slam Dunks. Other PC stocks are cheaper -- but riskier. Winnitzki worries that HP is trying to pursue both of the business models he outlined by providing a low-end commodity product as well as offering a full range of services to its corporate customers. Virtually all of HP's profits still come from the increasingly competitive printer business. Gateway is struggling to find the right balance between retail and direct sales. And Apple leads in innovation, but it suffers from stagnant customer growth. "I don't see what its next big opportunity will be to grow its installed base," says Winnitzki. Following such a sharp run-up, none of the PC stocks is a slam dunk. "Obviously, you shouldn't expect the same kind of performance over the next three months," concedes Niles. But he still feels the PC business is "one of the better areas in tech," especially when compared with telecom and networking. With a recovery looming, a PC sector that investors have learned to hate may at least deserve a long glance. Stone covers the markets for BusinessWeek Online as a Street Wise

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