The problems facing personal computer manufacturers are well known by now. Corporate and consumer PC demand has been sluggish for more than six months. With the overall market stagnating, market share has become paramount. The industry has plunged into a vicious price war, and, not surprisingly, profit margins have plummeted across the board. Of all the major U.S. PC manufacturers, only Dell ( DELL) managed to turn a profit in its latest quarter.

David Bailey
Computer Hardware Analyst,
Gerard Klauer Mattison
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Despite all this, the stocks have held up well. The Philadelphia Stock Exchange Computer Boxmaker Index gained 15% in 2001, as investors remain convinced that a combination of normal seasonal patterns and the Federal Reserve's aggressive series of interest-rate cuts will bring about a recovery in the second half of the year.

But David Bailey, computer hardware analyst at Gerard Klauer Mattison, isn't convinced. Read on to find out why.

TSC: A lot of the companies you cover are way off their highs, but they're not cheap. You have Gateway (GTW) and Hewlett-Packard (HWP) at 20 times forward earnings and Dell at 30 times forward earnings, and they're not in a very good spot. DRAM prices are below $3, channel inventories are up from February and there's a price war that looks like it'll get worse before it gets better. Why do you think these stocks are doing as well as they are?

Bailey: People consistently turn to the PC sector as one of the historically better-performing groups of stocks, and I think there's still somewhat of a halo effect around the segment. I don't know if that's deserved anymore, because the growth rates have slowed dramatically for all these companies, and not just because of the current economic problems. We think, going forward, the growth rates will be slower than their historic rates.

TSC: How fast can they grow?

Bailey: It varies dramatically, but at this point, it looks like, best case, around 15% over the next couple of years. This makes it increasingly difficult to justify the current P/E ratios, considering that the earnings estimates are very fluid at this point.

TSC: It seems that no matter whom you ask, Dell is everybody's favorite PC company. Everybody thinks they're the only one that can possibly win this war. Would you agree with that?

Bailey: Dell is clearly the best-positioned PC company because of their low cost structure. As products become increasingly standardized, typically, the company with the low cost structure ends up gaining the most market share. But that doesn't mean that's necessarily going to lead to robust revenue and earnings growth going forward. All these companies have strategies in place to diminish their reliance on the desktop, but it's yet to be seen how successful those efforts will be.

TSC: The worst-case scenario on Dell is that they gain a ton of market share and in the process drive prices down to such a point where their own profit margins are significantly lower than they've been even in the recent past. What's the best-case scenario?

Bailey: It's two-pronged. One is that they either drive someone out of the business or force some consolidation, which opens up more market to them. Longer term, it's that the customers that they gain today with desktops become customers for their servers and storage, which have higher growth rates and higher margins.

TSC: Do you think an IBM (IBM) or a Hewlett-Packard would just pull out? You'd need a big company to pull out to make a real difference in market share, I'd think.

Bailey: At this point, it's difficult to see any of the major vendors pulling out of the market. It's possible that one of the vendors will reduce its exposure to the consumer market, similar to what IBM did a few years ago. But it doesn't appear likely that any will pull out completely. They all see it as strategic and important from a customer-control point of view. As far as the idea that some of these companies might merge with each other, there aren't any obvious combinations that make sense for those companies. It would benefit Dell by taking some of the supply out of the market. But it doesn't necessarily improve the competitive position of any of the companies out there.

TSC: Everybody is assuming that the PC industry is going to normalize, that we're in some sort of trough and we'll come out of it. If we're willing to grant the assumption, what could spur that?

Bailey: The most important factor would be an improvement in the macroeconomic conditions. The efforts being made by the vendors are primarily led by Dell, in that they're slashing prices to increase demand. We don't believe that that's increasing overall demand. It's just allowing vendors to take share. It's more or less a zero sum game. Neither companies nor consumers are willing to buy a PC unless they absolutely need it, so the macroeconomic issue is the most important factor.

There will be some pretty significant products. Itanium, Intel's ( INTC) new 64-bit processor, could boost the PC manufacturers' ability to drive deeper into the enterprise with servers. Windows XP could help consumer sales. But most of these offerings are more evolutionary than revolutionary. They'll improve demand on the margins, but won't cause an inflection point in demand unless there's a significantly better economic environment.

TSC: Got a single word to sum up your thinking about this sector?

Bailey: Skeptical. We do think that things will get better, primarily because it's difficult to see a scenario that's much worse. But we don't know if it will ever be a robust sector again.