Cover Story

The PC Wars: IBM vs. the Clones

A horde of copies is hurting sales. Can Big Blue bounce back?

By Geoff Lewis in New York
With Katherine M. Hafner in San Francisco, Dori Jones Yang in Hong Kong, Scott Ticer in Los Angeles, and Kenneth Dreyfack in Chicago, with bureau reports
Business Week

July 28, 1986

Up five flights of stairs, in an old building on the outskirts of Taipei, a young woman sits eating chicken and rice with chopsticks. Scattered around her are boxes of printed circuit boards and stacked precariously in piles, plastic computer cases. the woman is taking a break from her $1.30-an-hour job testing components for the 100 IBM-compatible personal computers that her company, Aquarius Systems Inc., will turn out today.

A thousand miles across the East China Sea in Kumi, South Korea, a new, $250 million factory churns out 300 Samsung PCs a day. After they're tested, they'll be flown to Samsung's U.S. distributor in Boston.

On a quiet suburban street in Austin, Tex., a 35-year-old computer consultant tinkers in his garage with a customized copy of the IBM Personal Computer. He sells them to friends for well below what dealers charge for IBM PCs -- but he still clears $200 to $1,000 per machine.

Everyone's doing it: building copies of International Business Machines Corp.'s PC. The machine, once IBM's exclusively, has become a generic product that anybody with a few hundred dollars and some elementary electronics knowhow can assemble. Some 3.6 million "clones," more respectfully known as IBM compatibles, will flood the $35 billion world market this year, predicts market researcher Dataquest Inc. That's a million more PCs than IBM will sell.

MORE CAUTIOUS

Just three years ago the PC symbolized the overwhelming power of the IBM name. Although the machine incorporated few innovations and no distinctive technology, by mid-1983 the IBM logo had made it the dominant personal computer sold to businesses. Now more than 200 clone suppliers are trying to undo that. Their machines, with names ranging from the obscure Fountain to the familiar Compaq, use the same software and work with the same hardware options as the IBM PC. Frequently they also claim to be cheaper, faster, and even more reliable. Already, a group of 45 companies -- excluding IBM -- is drawing up standard specifications for a new generation of IBM PC-compatible hardware using more powerful microprocessors.

The rise of the clones is clearly hurting IBM. As recently as last winter, the company was hoping that its PC sales would rise about 15% in 1986, to $7 billion, and help overcome sluggish sales of larger computers. But IBM's chief executive, John F. Akers, is more cautious now. He predicts that total U.S. dollar sales of personal computers will rise modestly "if at all" this year -- despite an increase in unit sales. If the same holds true for IBM, it won't meet its revenue target for PCs -- and margins on the machines will fall. The PC problem, combined with the overall computer slump, contributed to IBM's disappointing second-quarter results: Earnings were off 8%, to $1.3 billion, or $2.12 a share, even though revenues rose by 7%, to $12.3 billion. The earnings decline would have been even worse were it not for the favorable effects of the weaker U.S. dollar on currency translations, which contributed 14% to IBM's first-half net.

Perhaps nothing dramatizes IBM's personal computer problems more than the reaction of big corporations, traditionally the company's most loyal customers. IBM's name and reputation for service attract the bulk of these -- up to 70% by some estimates. But the clones are making headway. Says Richard W. Botterill, manager of office information systems at U.S. National Bank of Oregon: "If I can put two machines in for the price of one, it's a blessing and a much better utilization of our corporate assets."

Botterill isn't alone: Burlington Northern, Hughes Tool, Martin Marietta, Aerojet General, Beckman Instruments, and Helene Curtis have all bought clones. One airline, which asks not to be identified, may soon buy more than 100 clones.At International Paper Co., technical coordinator Joshua Beall says that tight budgets can reduce the choice to buying a clone or doing without a PC. Computer stores have gotten the message: In June, BusinessLand Inc. and ComputerLand Corp., IBM's two largest retailers, began selling Asian-built PC clones under their own brand names.

Some frustrated customers wind up swearing at clones that fall short on compatibility or reliability, but most seem to swear by them. At Coca-Cola Bottling Co. of Los Angeles, Robert B. Moneymaker, senior technical specialist, says of his 12 Tech Personal Computers: "When we took them apart, it was the same electronics as IBM." He claims that the machines, built by a local startup, have been more reliable than IBM PCs.

What's bad for IBM is worse for other established computer makers. Tandy, Kaypro, AT&T, and Italy's Olivetti -- which builds clones for AT&T and is the No. 2 personal computer maker in Europe -- are prospering with their own clones. But NCR, ITT, Wang Laboratories, Texas Instruments, Hewlett-Packard, Sperry, Commodore, and Atari are not. And even Compaq Computer Corp. (page 67), the most successful of the cloners, hasn't increased its market share this year. The big winners have been Asian imports that didn't exist a year ago -- brands such as Leading Edge Model D and Epson Equity, which between them have 10% of the market.

Whether the clones will help or hurt Apple Computer Inc. isn't clear yet. Jean-Louise Gassee, an Apple vice-president, says it's an advantage that Apple machines aren't compatible with OCs -- it means Apple's Macintosh stands out even more as the alternative to the IBM standard. But as the clones have doubled their portion of the retail computer business (chart, page 62), Apple's share has dropped by a quarter since 1985, to 21%. So far, Apple hasn't been forced to cut prices, but it may have to sacrifice some of its current 50% to 60% gross profit margins to keep from drowning in a sea of clones.

Sooner or later, the clone-makers will have to battle IBM. Publicly, the company says it isn't fazed by the clones. But industry observers believe it is deeply concerned and is planning steps to shore up its market share. "From what I hear, the PC has become the issue in Armonk," says Michele S. Preston, an analyst at L. F. Rothschild, Unterberg, Towbin. In early July, IBM extended temporary reductions in dealer prices, essentially dropping "street" prices for its basic PC by 18%. IBM also cut the wholesale price of the PC/AT, its top-of-the-line PC and a product that cloners are concentrating on. The moves effectively made these models competitive with the clones.

Winning back control of the market is trickier than that, however (page 66). If IBM continues to battle the clones on price, it could sacrifice its 50%-plus gross margins. If it ignores the clones and concentrates on more expensive versions of the PC for corporate customers, it risks losing more of its retail market share. Stores and other "resellers" account for 60% of IBM PC sales. A moderate course -- gradually filling out the IBM line with more proprietary products -- could be too slow to stem the tide of clones. "Within IBM, there's going to be a wrestling match between those who insist on high margins and those who insist on market share," says Francis R. Gens, a vice-president at market researcher International Data Corp.

How did IBM wind up in this predicament? The dozen planners who put together the first PC chose inexpensive, widely available components and avoided the proprietary parts that went into other IBM computers. The idea, inspired by the Apple II, was to build an "open system." Anybody could write software or build add-on hardware for it. IBM even went a step further than Apple: It used an off-the-shelf operating system from Microsoft Corp. the open architecture was the key factor in making the IBM PC such a rapid success. But "We knew then that if we could do it, so could anybody else," recalls Bernard B. Heiler, a member of the original PC group and now president of GTE Corp.'s GTEL subsidiary.

SITTING DUCK

IBM planned to keep ahead of imitators by updating the product continually, adding a feature here, cutting a price there. At first, all it had to do to eliminate copycats was catch up with demand. With the notable exception of Compaq, most of the early cloners retreated after 1984, when IBM got its factories up to full speed.

But IBM didn't execute its strategy well. Instead of a moving target, the IBM PC became a sitting duck.,. The basic PC and PC/XT models are technologically the same as the products IBM brought out five years ago. Even the newer PC/AT, which used a more powerful microprocessor, is limited by memory constraints of the IBM operating systems.

William C. Lowe, president of IBM's Entry Systems Div., maintains that "we have not fallen behind." He argues that IBM constantly uses its technological and manufacturing skills to improve its PC. But others disagree. "They broke their own rules," says John C. Dean, formerly of IBM and now an analyst at Montgomery Securities in San Francisco. "They had learned in mainframes that the way to keep ahead was to change the hardware and software often." Doing so, IBM has limited clones to about 10% of the mainframe market.

Pricing has also made IBM vulnerable. Even when it cut manufacturing costs, the company was slow to pass along the savings. "IBM tried to keep prices high for too long," asserts H. L. Sparks, a former IBM PC sales executive and now marketing vice-president for clone maker Tandon Corp. "They left too much room."

The cloners were ready. "We realized a year ago that there was a window opening up in the marketplace," says Stephen Dukker, president of Thompson, Harriman & Edwards, a Chicago cloner. Last summer, Taiwanese suppliers began flooding his office with flyers describing inexpensive IBM PC components. Unlike earlier Taiwanese versions, these weren't built around software that had been illegally copied. Dukker, who was running a $44 million mail-order computer parts business, decided to get into PC cloning. In the first month, he says, his company sold 6,000 clones of the $2,670 IBM PC/XT -- for $700 each.

Hundreds of entrepreneurs had the same idea. IBM even helped them -- inadvertently. To squelch rumors of a new PC model that were slowing sales last summer, Lowe announced that IBM wouldn't soon introduce new products that would make the basic PC or mid-range PC/XT obsolete.

Meanwhile, the electronics bazaars of Hong Kong and Taipei were selling everything needed to duplicate an IBM PC -- from circuit boards to semiconductor chips. By redesigning the basic PC with fewer parts, and by purchasing less-expensive disk drives and chips, these backyard entrepreneurs could sell their models for as much as 75% below the IBM price. The parts add up to less than $400 and need only about $10 worth of direct labor to assemble. For a major supplier such as Tandy Corp., which builds many parts itself and punches out 18,000 clones a month, the costs are much lower.

Ads for off-brand clones now fill computer magazines. Dr. John A. Sarkaria, a 25-year-old medical resident, got into the cloning business last year when he looked under the cover of his own PC clone and was surprised to see how simple it was. After cobbling together a couple of home-made PCs, he took $20,000 from a medical school loan and $20,000 from his in-laws and launched Tech Personal Computers Inc. in Santa Ana, Calif. After a slow start, Sarkaria now expects revenues of $12 million from sales of PC clones this year.

Michael Dell, 21, may rank as the Horatio Alger hero among cloners, though. He began selling computers from a University of Texas dorm room two years ago and now claims that his PCs Limited will do $60 million in sales this year.

A worldwide infrastructure has sprouted to supply the cloners with parts. With more than 6 million IBM PCs in use around the world, every nook and cranny of the IBM design has been examined and reproduced. Several suppliers even sell software for the ROM-BIOS -- a chip containing programs that make the hardware and software work together. The proper ROM-BIOS is essential for making a clone operate just like the original PC. But copying the IBM chip is illegal, and writing the software for one that duplicates IBM's chip requires expert programmers.

Phoenix Technologies Ltd. has taken care of the problem. The Norwood (Mass.) company sells "compatibility suites," a set of five software packages including its own ROM-BIOS. Phoenix, which is expected to have $40 million in sales this year, numbers among its clients AT&T, Xerox, Tandy, and Texas Instruments. Phoenix used to charge $100,000 for the right to make copies of its ROM-BIOS but now charges royalties as low as $10 per chip. Its competition, Award Software Inc. in Los Gatos, Calif., charges as little as $7.

'VERY EASY'

Another important stop for clone-makers is Chips & Technologies Inc. This Silicon Valley startup produces a $ 48 kit that helps computer makers undercut IBM by substituting five chips for 63 on an IBM PC/AT. "We make it very easy for the clone guys to get into business," says President Gordon A. Campbell. Only 18 months after its founding, Chips & Technologies is bringing in $ 12.5 million in annual revenues. Recently, executives from Chips & Technologies and Phoenix traveled to China together to show the Chinese the latest cloning methods.

Making legitimate clones has become big business in Asian countries. Two years ago, Multitech and Mitac, the two largest producers in Taiwan, thought they couldn't compete in the U.S. Now both are setting up North American marketing for their clones. Taiwan will export $730 million in kits and finished PCs this year, up from $500 million last year. Some 70% will go to the U.S.

South Korea has scored the biggest hit so far with the Leading Edge Model D, a computer assembled by Daewoo Telecom. Leading Edge Products Inc., a Canton (Mass.) distributor with good dealer connection, had little success in 1984 with a Japanese-built clone, but the Model D clicked. AT $1,495, it had the same internal memory and disks as an IBM PC that sold for $2,100. But it also had better graphics, a larger screen, and a 15-month warranty, compared with the industry standard of 90 days.

Dealers who were cutting 20% or 30% off IBM list prices to move merchandise loved the Model D. Nine months after the first ones hit the stores, Leading Edge has shipped 100,000 units. Sources close to the privately held company say it's possible that Leading Edge will have revenues of $400 million this year -- mainly thanks to the Model D. "There ain't no magic," shrugs Leading Edge Chairman Michael Shane. "There are only two things: features and price."

The success of the Model D proved that there was an untapped market for low-priced, IBM-compatible products. Businesses used them to stretch budgets. So did schools, local governments, and consumers. U.S. sales growth for all personal computers has slowed from more than 30% last year to about 5% this year, but demand for low-priced products has doubled. And as prices drop, cloners predict the market will expand further. "At under $1,000, all of America opens up," grins Shane.

Leading Edge's success has encouraged other Korean companies. GoldStar Semiconductor Ltd. and Samsung Semiconductor & Telecommunications Co. are now building clones, and Samsung has started shipping 70,000 AT clones worth $150 million to Micro Direct, a Boston-area distributor.

The next big Korean player will be Hyundai Group, whose plans for computers seem no less ambitious than its plans for autos. Hyundai is gambling that it can finally open the mass-merchandise channel to PC clones. Target stores, a unit of Dayton Hudson Corp., has already signed up. Caldor and Best Products are running market tests. Although mass merchandisers and electronics stores generally have stuck to home computer brands such as Commodore, PC clones in the $500-to-$1,000 range may change their thinking. Dukker of Thompson, Harriman & Edwards is convinced that "the PC is going in the direction of the Crazy Eddie-type distributor in 1987."

WET BLANKET

By then, computer dealers may be glad to see the less-expensive clones go. Battered by the price wars on IBM products, many dealers took in those clones because, even though the prices were low, they sold at closer to list and thus turned a better profit. Now the clone market is crowded, and no-name brands are undercutting products such as the Leading Edge Model D. Most dealers aren't sure they can sell enough $600 clones to support their overhead. Chain stores might, however. Tandy Corp. Chairman John V. Roach already sells his PC clone for $700. If clones wind up in electronics stores -- he thinks they won't -- that's O.K.: Tandy has 6,500 of them.

IBM's Lowe isn't spilling any state secrets, but the No. 1 computer maker has a few options for throwing a wet blanket over the clones. First, IBM is likely to make price cuts to clear out the inventories of aging models such as the midrange PC/XT, the cloners' favorite target. Then it may introduce a series of new products that will put it ahead of the pack -- at least temporarily. They could appear as early as September.

A widely rumored entry is an under-$1,000 version of the original PC that incorporates many of the technological tricks that IBM used in its portable PC Convertible. With custom circuits, IBM cut the number of nonmemory chips in the Convertible to 18 -- down from 90 on the PC. With a robotized assembly line in Austin, Tex., IBM could crank out a desktop version for under $300. That would give it a product to compete in the $400 million education market against Apple.

Although widely anticipated, that product introduction is far from assured. "They clearly can be the low-cost manufacturer," says InfoCorp analyst David Carnevale, "but the question is: Can they be profitable enough?" Manufacturing costs are only part of the puzzle. IBM has a 10,000-employee PC division, a direct sales force, and increasingly expensive dealer marketing programs to consider. IBM might conclude that it can't afford the risk to its margins, says Daniel R. Carter, president of Cordata Technologies Inc., a Thousand Oaks (Calif.) cloner. "It might be logical for IBM to say, 'The hell with it, I won't fight in that mud."' In June, citing IBM's history of sticking to high-margin businesses, Akers told securities analysts that if parts of the computer business became "conclusively commodity-like, you'll probably see the IBM company departing that part of the industry."

'DOOMSDAY THEORY'

There's little chance that IBM will walk away from the rest of the PC market, however. The company is especially keen on holding its corporate customers. It is promising them that software due out next year will finally let them connect their PCs to mainframe computers and other systems efficiently. Then PCs will start doing what IBM always hoped they would: putting more demands on mainframes and getting customers to buy more multimillion-dollar machines. Those deliver better than 70% gross margins.

IBM is counting on new technology to make the PC the right workstation for such networks. A new operating system -- the software that controls basic computer functions -- is due out early next year. That will be important for running sophisticated applications software. It will also let the computer do several things at once, so that an office employee could work on a project at the same time the computer is calling across the network to another system.

Cloners are betting that when IBM announces its new products, probably next spring, it will try to "close" the system by using more proprietary technology. Lowe has said new PCs will take advantage of custom chips, and many IBM watchers predict that these will be used to make cloning more difficult.

"The worse things get for IBM -- the worse their share loss and the worse their profits -- the more their reaction will be proprietary," forecasts Harvey C. Allison, an analyst at Wertheim & Co. The most extremely measure -- what IDC's Gens terms "the doomsday theory" -- would be for IBM to close down its architecture completely. But Lowe dismisses that notion: "I don't know of any means that are being considered to eliminate anybody."

A LONG BATTLE. The cloners believe that IBM can't move to a closed system quickly. For one thing, even if the new operating system and hardware live up to expectations, there are thousands of applications packages written for the old operating system and hardware. For the future products there are none. "If IBM leaves the present standard behind, it literally doubles the potential market for the rest of us," says Tandy's Roach. "It would be so bad for IBM's revenues it wouldn't be worth the risk."

Moreover, the cloners are certain to copy whatever IBM does. "You can't hite anything in silicon [chips] anymore," asserts Neil J. Colvin, chairman of Phoenix Technologies Ltd. Once a chip is sold in a system, it can be opened up, photographed, analyzed, and then recreated -- all without violating copyrights.

So IBM will have to compete with the clones for some time. And the clones will continue to pour on the pressure. A few, including Compaq and Olivetti, are ready to beat IBM to market with products based on the Intel 80386, the new micro-processor that IBM will build into its next generation of machines. Lowe isn't worried. He argues that customers will want the newer, faster models he'll be selling. "Do people really want a brand-new version of a five-year-old car?" he asks. Log on next year for the answer.

Copyright 1986 McGraw-Hill, Inc.