Digital Waves Off 'What's Wrong' Talk

It Sticks by Products and Spending, Despite Recent Results

By William M. Bulkeley, Staff Reporter
The Wall Street Journal

Oct 28, 1988

Earnings are dropping. Sales growth has slowed sharply. The stock price has plummeted more than 50% in the past year.

Time for a change? At many companies, yes. At Digital Equipment Corp., no.

"Digital is doing very well in spite of what you hear," insists Kenneth H. Olsen, the folksy founder and chief executive officer and never one to worry about what outsiders think. With only minor tinkering, Digital will stay the course, he says, producing bread-and-butter midrange computers, in systems that connect better in networks than those made by industry giant International Business Machines Corp.

But, will the things that worked so well for the last five years succeed in the changing computer market? Midrange computers, the company's lifeblood, are increasingly viewed as dinosaurs. Digital's 16% sales growth in its latest quarter, while far better than that of other midrange computer makers, slowed from previous periods because of sluggish demand. New computers from IBM will make it harder for Digital to enter companies using IBM. And at the low end, powerful personal computers from Apple Computer Inc. and Compaq Computer Corp., and engineering workstations from Sun Microsystems Inc., are setting off margin-busting price wars.

William Zachmann, president of Canopus Research, a consulting firm in Duxbury, Mass., says, "The essence of Digital's strategy is to take business away from IBM faster than the little vendors take it away from Digital. The problem is that over time, there will be less to take away from IBM, and the alternatives (to Digital) get more credible."

But consultants and analysts are reluctant to criticize Mr. Olsen severely because past blasts have proved premature. Digital has acquired a starry reputation as a fast-growing large company.

During the past five years, when most other big companies were either restructuring, refinancing or making acquisitions, Digital doubled its sales and almost quadrupled profits solely through internal growth. In the year ended June 30, net income was $1.31 billion, or $9.90 a share, and sales rose to $11.48 billion. While many firms shrank, Digital's work force grew 42% to 121,500 in five years.

Digital sharply expanded overall market share, despite its failures in the booming personal computer market. Mr. Olsen has been featured on business magazine covers, and a new biography dubs him "The Ultimate Entrepreneur."

Mr. Olsen promises more of the same, based on what he sees as continued advantages over IBM in having a consistent computer design across the line of products and having better ability to make its computers communicate. Analysts agree that Digital remains well-positioned. "As far as new business in the midrange, it's all being won by Digital," says George Colony, president of Forrester Research Inc., a Cambridge, Mass., company that advises many large corporate computer buyers.

But Digital's stock, which hit a high of $199 last year, has been battered. Yesterday it closed at $93.50, down 12.5 cents, in New York Stock Exchange composite trading. Even after last year's crash, Digital stock kept falling, as the company has failed to slow spending in line with the industrywide sales slowdown. And analysts take Mr. Olsen at his word when he pledges continued investment in the business. Susie Case, an analyst with First Boston Corp., sees "several more years of aggressive spending," that will help make Digital the only midrange computer maker likely to sharply increase sales, she says, but the spending may block significant earnings growth until 1991.

Although Digital has reined in expenses in recent months, profits are being hurt by investments in new facilities to make semiconductors and disk drives. And Digital continues to expand its sales and engineering staffs. Mr. Olsen concedes, "Any word on investments now is considered bad for the shareholder." But he adds, "We'll live with that. Our investments eventually pay off."

Nevertheless, Digital has to shift its focus beyond midrange computers because that market is slowing precipitously. Midrange computers, costing $20,000 to $500,000, are used by many companies in branch offices and departments, where secretaries and other staff people, working at terminals connected to the midrange computer, do word processing, send electronic mail and check data.

Now, many corporate customers are hooking groups of personal computers together in local area networks, letting them communicate directly with IBM mainframe computers, and bypassing the midrange computers altogether. Marty Gruhn, senior vice president of Sierra Group, a Phoenix, Ariz., market researcher, says that she asked 50 data processing managers whether such networks were cutting into midrange purchases. "Ninety percent of the guys we talk to say, 'absolutely,'" she says.

For future growth, Digital plans to increasingly sell its networking expertise and software to create and manage networks of many computers, including those made by competitors.

William Strecker, Digital's vice president for product strategy, says that the growing need of customers for big international computer networks gives Digital a competitive advantage. "Hardware has become pretty routine. Software and networks and integration will be the only way to add value."

But it is at the desktop, the computer industry's biggest growth area, that Digital faces its sharpest challenge and is making its sharpest strategic changes. After several feckless efforts to make a personal computer that customers wanted, it recently announced it would buy personal computers from Tandy Corp. and resell them under its own label. It marks the first time that Digital, with its legions of engineers and pride in its own designs, will resell someone else's computer.

After a slow start, Digital has rebounded sharply in the engineering workstation market by slashing prices on its low-end VAXstations. Domenic LaCava, vice president for low-end systems, says it has moved into second place and is "on track to surpass Sun shortly."

In another uncharacteristic move, Digital decided to buy a microprocessor from Mips Computer Systems Inc., Sunnyvale, Calif., to produce a powerful workstation that uses the industry standard Unix operating system. The decision meant canceling Digital's own project to build a microprocessor and a departure from its message of compatibility across the whole computer line.

Indeed, Digital's own product development has been spotty lately. "Everything announced this year was a play on a prior platform," says Jay P. Stevens, an analyst with Dean Witter. He predicts Digital won't announce its new high-end system, code-named Aquarius, until next summer. "That's a three-year cycle, and the way the industry works today, a product cycle is 1 1/2 years," he says. "Something got off track."

Mr. Olsen says that in the next nine months, Digital will introduce computers to replace about 70% of its product line. The key to its strategy is linking many different hardware and software products. "We tie them together. That's our place in the world," he says.

But the payoff may be difficult to realize. Complex software and networks "require a repricing strategy," says Dale Kutnick, an independent consultant in Redding, Conn. "There's a fantastic opportunity for companies that can bring that to market, but it's a mid-1990s thing before it's high revenue and profit."

Copyright Dow Jones & Company Inc