The TSC Streetside Chat: PC Analyst Charles Smulders

Chip stocks, including behemoth Intel(INTC Quote), have recently taken a pummeling, given the emerging consensus that the year's second half won't bring the hoped-for recovery in demand. A big reason for that is still-anemic PC sales.

To get a better fix on the outlook for PC demand, we talked to Charles Smulders, an analyst at research firm Gartner Dataquest.

On the heels of last year's sales decline for PCs, Gartner Dataquest forecasts that the market will see low double-digit growth this year. But Smulders highlights some worrying trends that are likely to check demand in the future.

Among them: Hardware technology has improved so much that businesses don't need to replace their PCs as often as they used to.

In other words, demand remains currently weak not just because companies can't afford to buy new computers, but also because they don't think they need to. That suggests that even when the economy improves and corporate coffers start to fill up again, tech spending may not rise as much as some onlookers hope.

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TheStreet.com: This week Gartner increased its forecast for PC sales in 2002, up from an earlier forecast in February. What's the new number, and why did you raise your outlook?

Charles Smulders: We're anticipating global growth of 5.4% [up from a forecast of 4.3%]. That should be considered a marginal upgrade.

We upgraded it in light of the first quarter, which saw slightly stronger consumer sales than expected. Last time we did the forecast, we didn't have the Q1 number.

TheStreet.com: So you're basically projecting that level of demand forward?

Charles Smulders: We now have one quarter out of four, so that gives us a little better visibility. But as I stressed, the change is marginal.

In the final year results, much will be determined by what happens in the fourth quarter. By that time we will see whether there are true signs of improved business confidence because of economic improvement.

TheStreet.com: How does 5% growth compare to recent years?

Charles Smulders: Historically we've seen the worldwide PC market grow anywhere from between 10% to 24% per year, up until the end of 2000.

We've been collecting data as far back as 1985. But clearly the smaller unit volumes back in the '80s make higher growth rates more achievable. As the market becomes larger and matures, the growth rates begin to slow down.

So, for example, in 1999 we saw units grow by 23%. In 2000 growth slowed to 14%, and in 2001, which was the worst year in the industry's history, the market fell by 4%.

TheStreet.com: How has consumer demand for PCs been holding up relative to business demand? What's the breakdown in sales of the consumer vs. corporate markets?

Charles Smulders: If you look at 2001 in units on a worldwide basis, 30% of sales were from consumers and 70% were to what we call the professional market, which is business, education and government combined.

On a worldwide basis the consumer market certainly buoyed PC sales through 1998-2000. In 2001 as economies, particularly the U.S., deteriorated, we saw the consumer market decline sharply.

In the professional market, 1999 was the last really big growth year as companies prepared for Y2K. Following that we've seen the market slow down.

TheStreet.com: In terms of demand, do you think consumers see a technological need to upgrade their PCs? Some people have suggested that gains in technology are outstripping what people can actually use on a day-to-day basis.

Charles Smulders: There are some structural issues in the PC market that determine growth rates, and these have had a major impact on growth in the last year. The first is economic conditions, and clearly, with the U.S. market accounting for approximately 35% of worldwide shipments, as the economic conditions have deteriorated, we have seen the worldwide PC market weaken considerably. That began with the consumer market in the fourth quarter of 2000.

In the professional market, factors that are affecting the market are economic conditions, but underlying that is also a second issue -- that of saturation. In the developed regions such as western Europe and the U.S., pretty much everybody who needs a PC in the business market has one. What that means is that going forward, growth patterns are going to be heavily determined by replacement cycles.

TheStreet.com: People used to talk about a three-year replacement cycles for PCs, but some would argue that doesn't apply anymore.

Charles Smulders: I think that is correct. We are certainly seeing even large corporations extending the life cycle of their PCs. The reasons are that the performance that is being delivered on even an average desktop PC is beyond most needs and is allowing end users to extend beyond the three years.

[Previously], three years had been a typical average in the corporate market. At that point, you need to upgrade because it becomes more expensive to support as it gets older, rather than that you can't run certain applications.

TheStreet.com: So advances in technology have basically meant that people now need to buy computers less frequently.

Charles Smulders: Historically, when [technological advances in] software outpaced hardware, then there was a need to upgrade your hardware to take advantage of the new software applications.

Certainly for the last few years hardware has outpaced software, and therefore the need to upgrade has been less. For example the last significant need to upgrade was when the market moved to Windows 95. At that point, in order to run Windows 95, you needed to upgrade your hardware.

That is particularly important in the professional market. In the consumer market we see applications that require more processing power -- for example digital imaging, video editing, advanced game users. They are still looking for more megahertz, better performance. But even in that market users have the opportunity to upgrade less frequently if they choose.

TheStreet.com: Despite slow sales of PCs generally, you've pointed out that consumer notebook sales held up well in the first quarter. Can you give some more details on that trend?

Charles Smulders: We don't yet have the data for the second quarter. But in the first quarter in the retail notebook market, we saw year-over-year growth of 66%. A year ago was a very weak quarter, but even so, given the overall market performance, that certainly was a bright spot. By comparison, retail desktop sales were flat for the same period.

We've certainly seen a number of strong quarters of growth for the retail notebooks. Driving this trend is the fact that price performance offered and the entry-level prices on these products are now at a point which makes them much more attractive to the users. Entry-level prices are now under $1,000.

We question whether we are reaching a critical point in terms of notebook adoption. A further driver in some regions is wider deployment of wireless networks. With these factors in place, there is certainly the potential for an acceleration in the migration away from desktops to notebooks.

TheStreet.com: Is that a trend that could help push up PC demand? Who would benefit from it?

Charles Smulders: Notebooks have a shorter life span than desktops. Therefore they need to be replaced more quickly, which means unit sales opportunities over time are greater.

Also, as the market moves to notebooks, white-box competition against the major brands should be less. The term "white box vendors" describes companies that assemble mainly desktop PCs from components and sell them to customers. These companies have little or no brand name recognition. In the notebook markets, there's more proprietary technology, which makes it much more difficult for these players to compete against the major brands. [And] users tend to be wary of them.

Worldwide, the leaders in notebooks are Toshiba, Dell (DELL Quote), HP (HPQ Quote), IBM (IBM Quote)and Sony (SNE Quote).

TheStreet.com: Let me move on to a couple of market share questions. After the HP merger with Compaq, the new company now has the largest market share in PCs. Do you have any thoughts on whether they'll be able to hold onto that? Or will they lose market share?

Charles Smulders: The new HP has the largest market share if you count [the former two companies' market share] together.

The most important factor that has defined PC vendor success in the last five years has been their ability to operate an efficient supply chain -- as opposed to having the newest technologies. If you look at the market in that sense, if there is a single factor that led to Compaq being acquired, it was their inability to operate their PC supply chain efficiently.

Dell has done a tremendous job in supply chain terms. Its industry leadership here has been the principal factor in its success and, until the merger, its No. 1 position in the market.

So the new HP's challenge is to merge Compaq's technology with an industry-leading supply chain. I think that is going to be a major challenge for them.

TheStreet.com: Given that there's bound to be some amount of post-merger confusion at HP, and Gateway (GTW Quote)is still restructuring, do you expect Dell to keep gaining market share?

Charles Smulders: I would anticipate that they will continue to gain market share through 2002 based upon the current market conditions and the restructuring challenges that many of their competitors are facing.