First tiers adapt or die

The word "commodity" owes its origins to the Latin word "commodus", which means "convenient". The implementation of the term among IT professionals is closer to its root than its modern definition: "Something useful that can be turned to commercial or other advantage; an article of trade or commerce; an advantage or benefit."

In the IT world, a commoditised product is like clothing, and until then it`s like a diamond. Clothing is globally available from many vendors, and so is cheap. Diamonds are expensive and available only from the diamond cartels. Getting them from somewhere else probably means breaking the law. Everyone knows they are just rocks, that the cartels stock-pile to inflate the price, and that they could be made cheaply in a factory, but no one mentions the obvious in case everyone else laughs at them.

Whether or not a product deserves the label "commodity" - in the IT sense of the word - comes down to perspective. To some, the emperor has no clothes. To others, he`s clothed in diamonds.

The distinction between perspectives becomes apparent in the IT world when moving up the brand chain. At the top of the stack are the first-tier vendors: HP, IBM and Dell. No one would be surprised to find any or all of their products in any given corporate environment. They hold themselves above the rest with a trusted name, rather pricey products and, with the exception of Dell, enormous research and development spend.

The first-tier vendors argue that their products are not commodities.

"From a hardware point of view, PCs are becoming more and more of a commodity, and I think a lot of companies view PCs as commodities," says Roger Deacon, sales manager, IBM SA Personal Computing Division. "However, we don`t believe PCs are commodities because of the value that IBM adds to their PCs that make them a total non-commodity product. Our focus is on after-sales service. We have Think Vantage technologies that help our customers reduce their total cost of ownership over the time that they write the machines off. The hardware cost accounts for 15% to 20% of the total cost of ownership. Our tools that we put in the machine reduces 80% of that TCO - it can be as much as a 50% saving on that 80%."

Constantly nipping at the first tiers` heels are the second-tier vendors: Acer, Fujitsu, Gateway, NEC, Toshiba, and others. The brands are recognised, but thanks to other people doing their R&D for them, their costs are contained.

Some of their products can be found in some corporations, but are more likely to find them in smaller companies, SMEs and homes. They admit that some of their products are commoditised, but that there`s enough space to add value in ways that differentiate the brand.

"I think what commoditisation means is that you`re looking at vendors selling more similar products at more similar prices," says David Drummond, country manager, Acer South Africa. "The market has moved on from 10 years ago, where we had proprietary graphics, sound, and a few standards bodies, like MCA or EISA.

"Those proprietary components have largely gone, to be replaced by standards-based building blocks. The corporate manager is looking for technical features, the brand reputation for reliability at a non-exorbitant price and good after-sales service in SA. If hardware is a standard, the purchaser has to look at what`s around the hardware to choose Acer rather than any other brand."

We don`t believe PCs are commodities because of the value IBM adds to their PCs that make it a total non-commodity product.

Roger Deacon, sales manager, IBM SA

Next on the ladder are the local vendors. Those on the third tier have typically good success on their home turf, but don`t usually play for high stakes. In SA, Mecer, LightEdge and Sahara are all examples. R&D usually doesn`t go further than the conveyor belt and anti-static flooring, and the companies simply plug part A (made in Taiwan) into socket B (made in China) to get a computer out at the end of the line. Apart from geography and buying power, there`s not a lot of difference between the second and third tiers. At this level, commodities are the business model.

"Commoditisation is something that`s happened in a lot of industries," says Bobby Richter, technical director, LightEdge, "but it`s becoming more apparent in the computing industry as you get devices that are more application-specific. Customers are walking in to LightEdge with a specific function in mind rather than a specific product in mind."

Trying to scrape a living together, way down at the bottom, are the white box vendors. Joe`s Corner Computer Store - a species on the constant edge of extinction - will custom-make a PC for SMEs and home users, deliver it, and Joe himself will offer support.

Joe`s Corner Computer Store and the IBMs and Dells of the world may seem poles apart, but they do have one thing in common: they all use the same parts from the same manufacturers to build computers that do much the same thing. The same goes for tiers two and three. They all use Intel or AMD processors, Seagate or Western Digital hard drives, Nvidia or ATI graphics cards. They are all, in essence, commoditised.

IBM argues that it sets itself apart from the rest with its TCO tools and after-sales service - mentioned above - and adds some non-standardised components into the mix. "You would see IBM parts in an IBM box. There are some unique things in the machine that are IBM-specific. I think that it will stay like that," says Deacon.

I think the profit margin that companies make is proportionate to the value they add.

David Drummond, country manager, Acer SA

However, the effects of commoditisation are clearly visible on the current first-tier landscape. The HP/Compaq deal was driven in part by the lack of profitability in the two companies` PC businesses. Likewise, the admission that the deal didn`t deliver all that was promised - which led to the axing of CEO Carly Fiorina - was due to the continued bad performance of the PC business. Its third quarter 2004 results showed $6.5 billion revenue going through the PC business, while scraping only $78 million in profit. And that was the best quarter in four years.

IBM is moving out of the PC business, getting Lenovo to take the reigns. The number nine PC vendor doesn`t only do PCs, but is into consumer electronics too - a highly commoditised arena that is holding increasing interest for traditional PC vendors. Even IBM`s $11 billion PC business runs on fine margins, sometimes making a loss. Lenovo is known for playing in the low-end PC space and not showing much interest in R&D.

Dell has earmarked consumer electronics as a major growth area for the direct-model computer company. And if ever there is proof that a PC is a PC is a PC, it`s Dell. Not particularly interested in R&D spend, Dell uses other people`s technology, slaps its sticker on it, and then concentrates on minimising its stock holding and maximising its profits. Dell`s model works - the company, unlike its first-tier brethren, has a profitable PC business.

Finally there is the most uncommoditised company of all - Apple. While technically not in the top tier in terms of market share, Apple sets itself aside with its niche market and high-value product. When everyone else went Intel, Apple stuck to its PowerPC chips. When everyone else went Microsoft, Apple repurposed the BSD kernel for OSX.

But even Apple has seen the writing on the wall - it is dropping the long-time PowerPC partner and going for Intel processors, the bedrock of PC commoditisation. Once it ports to Intel, Apple`s OSX will technically be able to run on any of the stock-standard PCs in the market.

Whether commoditisation is a good or a bad thing depends on what there is to gain or lose from the deal. For customers large and small, commoditisation of the PC is the best thing since sliced bread was commoditised. Not only are there brewing price wars between the competing vendors that guarantee a better deal, there are also more services year on year, at a fixed price point.

The first and second tier players really have to define and differentiate themselves, so users get better support contracts, more management software and lots of freebies thrown in to justify the extra cost of a high-tier brand. What`s more, component commoditisation has led to greater PC standards throughout an organisation, which means lower cost of management for the IT department.

For the upper tiers, it`s a bad thing (although they would never admit it). The large multinationals are not as nimble or price-competitive as the lower tier competitors. They are forced to justify their higher prices with value-adds, which is a much tougher sell in some cases. It`s certainly more complex to communicate that a PC plus support is a better deal than just a PC, especially since every medium to large company has its own support department already, or outsources the whole lot to an on-site support partner. Hence all the movement up at the top - everyone is still trying to understand how to sell a commoditised product with a high margin.

"I think the profit margin companies make is proportionate to the value they add," says Drummond. "If you cast your mind back 10 years to when there were high level of proprietary content in PC, that content was charged for highly. In keeping ahead of the trends, there`s much more value-add in PCs than previously required.

"Those focused on volume are continuing to make profits and are enjoying staying in business. But the expense level`s difficult to sustain."

[Commoditisation] is very bad for traditional PC assemblers if they`re not prepared to change their mindset.

Bobby Richter, technical director, LightEdge

LightEdge`s Richter believes customers are buying less by brand, and more by functionality. The danger for branded products is that if they`re not offering that specific functionality, the customer would rather switch brand than forgo a wanted feature.

"It`s good and bad," says Richter. "It`s very bad for traditional PC assemblers if they`re not prepared to change their mindset. We have a brand of machines that we manufacture and assemble. We assemble according to what we perceive to be the customer needs.

"But we`ve had to start a parallel range that is functionality-based. This type of situation is causing people who traditionally supply the channel to invest in another channel and product to provide that functionality. We`ve had to refocus our financial resources to create functionality-based devices."

The one ace that tier one still holds is the perception of the risk of lower-tier machines. "Larger organisations will only buy from tier one, while smaller organisations don`t seem to be that bothered about it," says Deacon.

"It depends on how much they`re investing in their PCs. If they`re investing a lot, they don`t want an issue to come along and bite them later. If you look at the risk of buying clone PCs, if you buy five or 10 machines, the risk is not that big, so you`re not bothered about it."

It`s not as though there hasn`t been time to think about how to deal with the encroaching threat. PCs have been heading for commoditisation since IBM`s PC was cloned by Compaq in 1983. Then Intel`s work on its "building blocks of computing" accelerated the process in the 1990s.

"I think there was a key point in the 1990s where Intel took a greater role in the design and manufacture of chipsets, rather than leaving that to independent vendors. That was a key turning point towards commoditisation," says Drummond.

What should really have all the brands sweating is that commoditisation continues to move up the value chain. Now that the desktop has been conquered, the low-end server is falling towards commoditisation fast. If trends continue, mid-range and perhaps high-end servers could eventually be added to the commoditised IT products list.

"I think the entry-level and dual-processor space has reached that level of commoditisation already," says Drummond. "The high-end and storage solutions still have a significant level of proprietary value-add.

"We`re seeing the emergence of new brands in the entry-level server space, but I think it takes longer for new brands to emerge in the server space. People are happy to try out new brands in their client machine, but will hesitate to integrate a new machine into the data centre where it could have implications on the management of data centre itself."

With the first tiers still uncertain of how to deal with commoditisation in PCs, they had best form a working strategy if they want to protect the still-profitable server arena, where the top tier brands enjoy most of their success - and profit.

Should they fail to transform with the changing environment, the emperors will certainly not be wearing diamonds in the future.