March 21, 1997 6:30 PM ET
Compaq to stop paying 'blood money,' analyst says
By Robert Lemos and Lisa DiCarlo

  Dell Computer Corp. and Gateway 2000 Inc. have rested on their laurels long enough. A leaner, meaner Compaq Computer Corp. is going to invade the direct-to-consumer market.

The result: eventual savings of as much as 10 percent for the consumer, a greater share of the market for Compaq, and major pain and suffering for distribution companies, which up until now have quietly skimmed their "blood money" off the top, as one computer executive put it.

Briefing institutional investors after a week-long tour of the industry, Prudential Securities Inc.'s Senior Analyst Don Young offered his conclusions this morning in a conference call.

The Compaq executive team is on the road this week to meet with key distribution channel partners and clients, according to Young, who covers the PC and enterprise server markets.

Dell and Gateway 2000 are "in denial," Young said. Those two companies are not the only ones, however-Compaq, of Houston, currently denies any reports that it is extending its reach into the direct-to-consumer market, though officials admitted that it was re-engineering its business model.

"We have no plans to make direct sales a significant part of the revenue stream," said Compaq spokesman Mike Berman. "We are re-engineering our manufacturing to ring out inefficiencies to better support our channels and customers."

Direct sales are currently less than 2 percent of Compaq's revenue in the North American market, Berman said.

Although Compaq's foray into direct marketing has not generated significant revenue, that might change. The company has moved to a build-to-order manufacturing model, which has helped eliminate costly finished goods from the channel. In October, Dick Snyder, Dell's senior vice president and general manager of North America, was hired to be Compaq's senior vice president and general manager of worldwide sales, marketing, service and support.

In addition, Compaq has been hit by analysts for carrying as much as $2 billion in finished goods inventory on its balance sheets.

"The biggest sign that Compaq is coming [to the direct market] is the balance sheet," said Young. Inventories are expected to shrink to direct-model levels by the March quarter, showing Compaq's drive to re-engineer its business from a filling-orders-from-stock to a build-to-order model, he said.

"The bottom line is that Compaq had to respond," said Young. He estimated that Dell, of Austin, Texas, would have overtaken Compaq in worldwide market share in about three years. And by the end of 1998, Dell would have matched Compaq in the critical business desktop market.

The majority of Compaq's sales will still come through the reseller channel, but Young sees Compaq targeting small and midsize businesses-the largest area of growth in the market-as potential targets for direct marketing.

Compaq's re-engineering will fan out to affect computers sold in stores and those sold directly, Young predicted. This spells big wins for consumers, who will save more than 10 percent on the street price of Compaq computers, bringing Dell's low direct-market prices finally in range, he added.

Direct-market resellers, which add services and software to Compaq's basic offerings, also will win. "In short, [the direct market business] will be implemented no differently from [Dell] and [Gateway] over the next couple of years," Young said.

But not everyone is happy with Compaq's alleged strategy. Young estimates that over $2 billion can be saved in distribution, warehousing, and marketing costs by skipping the channel-money that had been going to distributors' pockets. These "contra-revenues," as Young calls them, will be translated into savings for the consumer, but will put many kinds of distributors out of business.

In terms of market share, Young believes that the suspected new strategy will be a big win.

"Compaq's entry into the direct market will expand the market, but I suspect that Dell's and Gateway's profitability-at least 150 percent returns on invested capital that we see today-will come at risk," he said.

Prudential Securities downgraded the stocks of Dell and Gateway, of North Sioux City, S.D., early this week, citing Compaq's designs on the market as adding uncertainty to the market.

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