WORKGROUP

STRATEGIC

Vendors Battle for

Retail Presence

December 11, 1995

Prepared By:

Workgroup Strategic Services, Inc.

75 Congress Street

Portsmouth, N.H. USA 03801

603 - 431 - 4409

1995 - Workgroup Strategic Services, Inc.

Vendors Battle for Retail Presence

The retail marketplace for personal computers is the single most cutthroat distribution segment in which vendors compete. Walk into any computer superstore or mass merchandiser and you will see marvels of technological wizardry, all at rock bottom prices. Retail sales for PCs have climbed from barely a blip on the computer industry radar to almost half of all PC sales today. Retail outlets have evolved into distribution channels with incredibly competitive dynamics.

Think about the issues vendors and retailers are currently struggling with in selling PCs to consumers.

Introduction - Remember When?

The emergence of a significant retail distribution channel for personal computers is a relatively recent phenomenon. Sales of PCs through consumer electronics, mass merchandisers and computer superstores really began around 1990. In the short five years since, the computer superstore has emerged to become a credible outlet for high tech multimedia based computers for the consumer end user and a low cost source for corporate buyers. One of the surprising elements of the original computer superstore and mass merchant customer base was the corporate buyer looking to add a PC or two to the departmental LAN at work. Retailers found the corporate customers were looking for product availability and the low prices, many times allowing the corporate customer to expense a PC rather than jump through hoops for a capital budget item.

As retail channels emerged, Packard Bell moved into the leadership role in consumer electronics stores, followed by Commodore, may they rest in peace. In the mass merchant stores, Packard Bell also held a dominant role, early on showing its merchandising savvy. Analysts may have questioned the quality of the Packard Bell PCs, but the company sold thousands to first time buyers with its low prices and wide availability. Packard Bell continues to dominate retail channels.

Back in 1990, Workgroup Strategic Services estimates the computer superstores sold two percent of all PCs in the United States. Computer dealers still ruled the storefront business model, selling about sixty percent of all PCs in the United States. This type of traditional dealer quickly realized the larger retail channels would begin to encroach on its customer base, and for good reason. With the increase in the available outlets for computer purchases, the customer suddenly had a variety of sources for computer hardware and services. Therein lies the problem for dealers. Large retail chains have incredible buying power, their business model reflects a volume perspective, and their prices were consistently lower than a traditional dealer's price. Dealers were used to bundling service within a hardware sale, at that time margins ran close to fifty percent, with plenty of room to pay for the additional service a dealer provides. Suddenly, dealers had to compete more aggressively on price, with the end result of a lower margin structure for hardware products. Suddenly hardware sales could not fund the service and support a dealer's customer demanded. Since service and support still carried high margins, savvy dealers moved toward a service business model for revenue. Most shut down or reduced their storefront presence and began to look more like a value added reseller or integrator.

Changing Channels

To better understand the nature of PC distribution channels dynamics some definitions are in order. Workgroup Strategic Services uses the following definitions for computer distribution channels and end user market segments.

Direct Sales Force - Computer vendors' use of its own direct sales force. This type of sales is usually reserved for a vendor's top revenue producing accounts. Many times the consulting, integration and other services will be outsourced to a third party support firm. Examples include Hewlett Packard and Digital's use of account representatives to service its top 100 customers.

Direct Marketing/Mail Order - Computer vendors that use direct mail and telemarketing to drive sales. Examples include Dell, Gateway 2000, IBM Direct, as well as smaller mail order vendors.

VARs/Assemblers/Systems Integrators - Resellers that offer value added expertise to the sale of hardware. Usually this involves LAN, WAN and multivendor integration activities. The systems integrators differ from typical VARs in that they offer higher levels of consulting and Business Process Reengineering services. Assemblers usually focus on build to order products, relying more on a production line business model than service and support.

Computer Stores with Outbound Sales - This type of retailer is the traditional computer dealer. Many have moved toward service and support to generate revenue and higher margins; for this reason they have developed outbound sales forces that target corporate customers for network integration, service and support. Dealers such as MicroAge franchisees are examples of computer stores with outbound sales.

Computer Superstores - Very large retail outlets that tend to follow a high volume, low margin business model. The typical advantages of a computer superstore are low prices, wide product selection, and product availability. While their business model clearly follows the box pushing mentality, some computer superstores are developing service, support, and training products for its customers. CompUSA and Computer City are examples of computer superstores.

Consumer Electronics Stores - Retail outlets that offer myriad electronics products. Typically part of a national chain, consumer electronics stores offer a wide range of products but do not have the large, voluminous facilities of the consumer electronics superstores. Radio Shack is an example of a consumer electronics store.

Consumer Electronics Superstores - Similar to the consumer electronics stores but with the added leverage of size. Consumer electronics superstores carry the wide range of electronics products but look and feel more like a discount warehouse than the small local electronics dealer. Examples of consumer electronics superstores are Circuit City, The Wiz and Fryes.

Office Product Superstores - Similar to the consumer electronics superstores except for the product focus on office supplies and equipment. Office product superstores tend to have the same look and feel as the consumer electronics superstores, and they offer very little in the way of service and support for the customer. Staples, Office Depot, and Office Max are examples of office product superstores.

Warehouse Clubs - Discount membership outlets that offer low prices and very little service and support. Warehouse clubs tend to have a limited selection of computers, most models seem to be somewhat behind the technology curve. Sam's Club and BJ's Wholesalers are examples of warehouse clubs.

Other Mass Merchants - This type of retailer includes outlets such as Sears, Montgomery Ward and others that sell a wide range of consumer products. Most sell items ranging from clothing to automotive accessories. For the most part, this type of outlet offers little in the way of service and support. The exceptions are outlets such as Sears, which has a dedicated Business Center and sales function.

Market Segment Definitions

Small Office/Home Office - The businesses in this segment tend to have less than a dozen employees. Many are run out of the owner's home. This group is the fastest growing market segment for PCs. Their needs are very similar to the larger businesses in that the computer is a crucial element of the firm's business. Home Office users are those that use the home as their primary work environment.

Small Business - Small businesses have less than 100 employees. This type of computer customer is usually Intel/LAN based.

Medium Business - Medium businesses have more than 100 employees but do not have the revenues of the larger Fortune 1000 companies. This type of computer customer is usually Intel/LAN based, but many are using or considering multivendor computing environments.

Fortune 1000 Firms - This group of the largest 1000 companies in the United States tends to have different service and support needs than the smaller businesses. Fortune 1000 firms tend to use higher level management information systems and would be more likely to use high level outside consultants as part of its service and support needs.

The Way We Were

As Table One shows, it was the value added channels (VARs/assemblers/systems integrators and computer stores with outbound sales) that supplied the bulk of the personal computers to end users from 1993 onward. Direct sales efforts, from the vendors and direct marketing/mail order firms, provided over one quarter of all PCs at that time. This channel segmentation shows that corporate customers were primarily using partners that provided value added services, with only limited use of the direct marketing/mail order channel that deals with a high volume/low service sales model.

At the same time, corporate customers (defined as small business or larger) purchased the vast majority of PCs. The SOHO and home segment combined to purchase less than one quarter of all PCs sold in 1993.

Today's Channel Outlook

By 1995, all retail outlets have increased their market share, at the direct expense of those channels that usually offer value added services. Vendor direct sales, VARs, and traditional dealers (computer stores with outbound sales) all lost ground to the emerging retail outlets of the computer superstores, consumer electronics superstores and office product superstores. It would be easy to dismiss this channel change as the result of price conscious corporate buyer until one looks at the changing customer mix in the market segments for PCs.

In 1995 the SOHO and home market segments have grown to 30% of all PCs sold in the United States. Small business purchases grew to 12.5% of the total PCs sold. Further, the Fortune 1000 and medium business segments are now a smaller part of the overall PC market in 1995. This shift in the customer market segments also points to the shift in the PC distribution channels over the same time period. Table two shows that as the typical PC buyer comes from smaller and smaller businesses, purchase behavior changes. Smaller companies, and particularly SOHO customers, have more simplistic computing environments. This small business/SOHO customer usually has an Intel based computing environment, with limited network complexity. Most have not moved to multivendor environments that require higher levels of service and support. This type of customer usually has different budgeting and purchase procedures than the Fortune 1000 companies. Small business customers have shorter budget cycles and more flexibility in choosing computers than the larger firms with company wide PC standards and capital budget processes.

Table One

Source: Workgroup Strategic Services, Inc.

Fast Forward to 1998

Workgroup Strategic Services believes the shift in computer distribution channels and market segments will continue through 1998. In fact by that time, SOHO and home users will purchase over 37% of the PCs sold in the United States. Corporate customers, defined as small business or larger, combined to purchase almost 70% of the PCs in 1995. In 1998, this market segment will account for less than 63% of the PCs purchased in the United States.

Table Two

Source: Workgroup Strategic Services Inc.

During this time, all of the retail channels will increase their presence in the market. As Table One shows, all of the superstore outlets, the consumer electronics stores, and the warehouse clubs will increase their market share at the expense of those channels that offer value added services. This change clearly mirrors the smaller number of large business customers who requires service and support with the purchase of a PC.

What the heck happened?

Early on, discounts to computer dealers and retailers (the difference between suggested list price and the dealer/retailer's cost) typically ran from thirty to fifty percent. In other words, there was a lot of room to make your money back for any type of service or hand holding the seller provided the customer. Two things contributed to an escalating war of discounts for computer products. The first dynamic was the standardization of computer components, in particular the Intel processors and Intel's rapid pricing moves, designed to entrench Intel as the core CPU platform of choice. Secondly, this low buck commodity component strategy enabled smaller 'clone' manufacturers to emerge, with low cost production and marketing, that drove PC prices through the floor. First tier vendors reacted until the cycle became a way of life. Every three months, computers seemed to be faster, cheaper, smaller…..everywhere. Playing the low margin game eventually killed off many of the second tier vendors, those that remain still play in the low margin legacy created by the cloners. This low margin playing field means that even the largest buyers of computer products are now lucky to see discounts in the teens.

Vendors then sought to match the appropriate distribution channel to the product, pricing, and customer service and support required for each target market. The price sensitive retail channel provided little more value than pricing and availability, all that a sophisticated consumer or corporate buyer requires. The traditional computer dealer ran for the hills of the high margin service and integration products. Customers that needed higher levels of support or integration looked to the dealers and value added resellers. As dealers moved out of the retail and/or storefront space, the computer superstores filled the void, chains such as CompUSA, Computer City, and others continue to thrive.

Table Three

Packard Bell Retail Model Pricing

Packard Bell Model Configuration Retail Outlet Price
Legend 102CD

Legend 406CD

Axcel 455

Force 480

Pentium 75

8 MB RAM

850 Hard Drive

1 MB Video

4x CD-ROM

14.4 fax/modem

Sears

Circuit City

OfficeMax

Elek-Tek

$1599

Source: Workgroup Strategic Services

Vendors began to package computers for each type of distribution channel and customer. Pure consumer based PCs were developed, sporting ease of use features, bundles of software, on line capability and robust multimedia technology. In fact, the consumer PC market is now one of the most competitive technology areas in the computer business today. But the margins are still low. What to do…

Hitting the Price Point

How do the vendors compete so fiercely on technology features, while still hitting competitive price points for each model of PC? Packard Bell is the master at price positioning. During a recent retail pricing study, Workgroup Strategic Services found four separate Packard Bell models that all had similar configurations, all priced at $1599 (see Table 3).

Packard Bell has a very effective strategy of using multiple model lines and pricing points to differentiate its PCs. As Table 3 shows, similar configurations have the same price point but are sold through different retail outlets under different model names. While there are some differences in the physical configuration and layout, they are too subtle for the typical consumer to understand. Packard Bell's goal is to provide the different retailers with slightly distinct product lines and configurations. For example, Sears will usually have Packard Bell systems with larger hard drives and less RAM than other retailers. With myriad product lines and choices, Packard Bell can fine tune the available configurations to the retailer's target customer.

Figure One

Hewlett Packard Retail Model Pricing

Source: Workgroup Strategic Services

Further, during the same study, Workgroup Strategic Services found the pricing between retailers for vendor's PCs were virtually identical. In looking at the top retail chains as shown in Figures 1-4, Workgroup found pricing for particular models to be nearly identical except for differences in the available RAM and hard drive size.

Figure Two

IBM Retail Model Pricing

Source: Workgroup Strategic Services

As shown in Table 3, pricing for the same system across different retail chain varies by only $100. Most models sell for the same price in all retail outlets. This clearly highlights the sensitivity of vendors in hitting their target price points.

Figure Three

NEC Technology Retail Model Pricing

Source: Workgroup Strategic Services

Battling Down The Aisles, The Vendors React

The successful vendors have looked at all aspects of their manufacturing, distribution, and marketing strategies to leverage any and all cost efficiencies possible to lower prices. Many OEMs are leaving the bulk of the computer design to Intel's default component selection. While this provides little room for value added design, OEMs are relying on standardized components and compatibility while taking advantage of the quick time to market advantage realized in offering 'vanilla' products.

Figure Four

Packard Bell Retail Model Pricing

Source: Workgroup Strategic Services

Manufacturing

Vendors have two problems to solve in looking at their manufacturing capability. The first concern is to develop the most cost effective production line possible. Vendors now competing so fiercely on price will pass any cost savings or efficiencies downstream to the retailer and consumer. Vendors are carefully cultivating relationships with their suppliers, looking for Just In Time delivery for parts and price breaks wherever they may be found.

To further complicate the problem, vendors must now apply new design standards to the development of consumer based PCs. Acer's Aspire line uses new colors and textured design features to make its PC look like one integrated unit, with the look of an appliance more than a high tech computing device. Others, such as Packard Bell, are using unique footprint configurations to save desk space and help the PC blend into the background of the desktop. Some vendors have also incorporated a remote control, very much like one's TV/VCR set up, to power up and run the computer.

Inventory Control

Retailers are using very sophisticated inventory forecasting and control systems to minimize their exposure to slow moving products. According to most of the retailers Workgroup Strategic spoke to during this recent study, very rarely does product stay on the shelf long. In most cases, the retailer will go back to the vendor for price adjustments or markdowns. Some of the rebates, markdowns and sales for consumer PCs are driven by Intel's CPU price/performance segmentation strategy. Once Intel announces a new processor and subsequent CPU price cuts, all of the vendors must fall in line and cut prices on their current models, making way for the next generation of consumer PCs.

Although the retailers use scientific forecasting techniques, Intel's rapid processor introduction and price segmentation strategy puts more pressure on retailers to turn inventory. At this point the retailers look to the vendors for help through markdown soft dollars.

Managing Returns

All vendors offer thirty day return policies for desktop PCs, while fifteen days is the standard return policy for laptops. All specify the PC returned include all of the original packing. In reality, a vendor can be liberal with its return policy, granting the retailer some extra days to qualify returns and offering a higher level of total returns from the retailer to the vendor. Most allow about 8% of the total purchases to be returned, much higher than the actual DOA rate of one or two percent, and about average for the level of returns due to 'buyer remorse.'

To combat high returns, many retailers tie sales commissions to returns, incenting the sales person to make sure the customer will keep the PC. On the vendor side of the equation, efficient supply allocation lessens the need to go back and adjust prices or provide markdowns to the retailer.

Vendors are tightening their return policies, asking for more rigorous testing of components before authorizing returns. Vendors are trying to manage the total level of returns as well as ensuring that retailers are not taking advantage of liberal return allowances as an inventory control mechanism.

Once a computer is returned, vendors must manage the delivery and reuse or disposal of PCs as carefully as the front end process of manufacturing and distribution. Packard Bell for example, is probably the best at turning around PCs and either repackaging the computer for sale or stripping out the components for use as parts inventory for production. Packard Bell's turnaround from the time a PC arrives as a returned item to when it is heading back out the door to be sold is one week. All vendors are now looking very carefully at the entire back end management of returned PCs. Some PCs get repackaged, others are sold through brokers and auctioneers, some occupy space in landfills. Vendors are investigating ways to maintain value for returned PCs, whether they are sold outright, become parts inventory, or used through leasing services and the like.

Soft Dollars

Soft dollar programs are one of the most flexible areas for vendors to use in supporting retailers. Soft dollar programs are used to help the retailer fund advertising and promotional campaigns, train its sales and technical support staff, and provide Point of Sale (POS) material for the customer. Soft dollar programs include price adjustment policies, rebates, and retroactive markdowns for slow inventory. The importance of vendor provided soft dollar programs is twofold. Vendor support for advertising and promotions brings the customer into the store with a product or brand in mind for purchase. Secondly, once the customer is in the store, the shelf positioning, POS materials, and rebate or sale offers now become important in closing the sale. In effect, the vendor soft dollar program creates the image recognition, or demand creation. Once in the store, the promotional materials and special pricing closes the sale for the customer.

Since vendors must be very careful to offer consistent pricing to all retailers, it is the soft dollar programs and funding that are negotiated on an ad hoc basis. There is a lot of room for movement within soft dollar programs to tailor funding and support for the retailer. Some retailers charge for end cap displays, others work out shelf locations based on overall pricing and volume purchases. Some take advantage of training and education for staff, others want help in funding weekly advertisements.

One of the traditional soft dollar promotional tools, the spiff, seems to have fallen by the wayside. Vendors do not use this type of sales incentive much anymore. Many retailers found the spiff incentives tended to change the store profitability mix, incenting the sales staff to sell systems that did not have the profit margin of others. Even though the sales staff may enjoy the pocket money from spiffs, retail outlets found spiffs tended to skew its total margin structure. Some retailers will now pool spiffs to split among all sales staff rather than use this money for individual incentives.

Corporate Sales

Although the vendors are not proactively driving corporate sales through retailers, most computer superstores now have a corporate sales department. At this point, retailers say corporate sales tends to be reactive, servicing corporate accounts that come to the superstore for products. In time, computer superstores may increase the capability of its outbound corporate sales to capture higher levels of revenue to commercial accounts.

The Future of Retail

With the increasing complexity of the PCs and operating systems, driven by power and ease of use needs, comes an increased need for customer support. Retailers are finding that its customer base, that so readily bought into the Windows 95 promotion, now requires significant technical support. Users typically must add RAM and larger hard drives to run Windows 95 adequately and many are still stymied by Plug and Play and Windows 95's new interface. Systems that come bundled with Windows 95 may experience higher than normal returns due to the consumer's lack of experience with the new operating system. While industry return rates average about 8-10% of all shipments, only one percent or so have specific problems, the rest are returned due to 'buyer remorse.'

Microsoft's support lines have been flooded with calls from new users. Will computer superstores and other retailers find they need to provide more support for its customers?

Workgroup Strategic Services Analysis

Coming Full Circle

The retail channels, in particular the computer superstores, drove the traditional computer dealer into a value added business model where dealers rely less and less on the storefront to draw customers. Computer superstores replaced the dealers as the retail storefront source of consumer PCs, originally offering only low prices, product availability and little else for value added activities.

As retailers are now discovering, consumer PC buyers require significant amounts of service and support. A careful look at today's retail chains also shows a movement toward training, service and support products for the consumer. In fact, Microsoft's recent Windows 95 promotional blitz was clearly designed to capture add on sales for retailers. Microsoft set up the pricing for Windows 95 to allow for 4 points of profit margin for retailers. At a street price of $89.99, retailers keep about four dollars for themselves. What most were counting on were the additional sales of RAM, hard drive storage products, and fast modems that are associated with the new requirements of Windows 95. As technology evolves, and operating systems become more complex, retail customers also require the installation of memory, processor upgrades and the like; something retailers now perform with their own technical staff.

So we have come full circle, the traditional dealer was pushed out of the retail space, not able to offer the rock bottom prices of the larger retail chains. Now the new breed of retailers, the computer superstore and mass merchant outlets, are developing service oriented products for its customers. This is a reaction to a consumer need for training and education as computers and operating environments become more complex.

In addition, the large retail chains see service, support and training as high margin revenue opportunities. In this way, the computer superstores and mass merchandisers are evolving into a similar business model as the traditional computer dealers. In this case however, the new breed of retailers is working with a more narrow margin structure, but is able to take advantage of the buying power inherent in its large size. In essence, the retailers are reinventing the storefront but with the advantage of large volume buying power. Because these large retail chains have more access to capital, and are already in a lean business model, Workgroup Strategic believes they will continue to evolve toward more value added services, but only to the extent that the new service products are appropriate for the retail customer and continue to be profitable. Workgroup Strategic believes retailers will slowly find a balance between customer service and support needs and the cost and opportunity of providing such products.