Just How High can Digital Equipment Climb?

Information Processing

Computers

It has kept ahead with a stream of innovations -- but it's facing stiffer competition

By Leslie Helm in Boston, with John W. Verity in New York
Business Week

July 20, 1987

By any measure, Digital Equipment Corp. is on a winning streak. After hitting a bad patch four years ago, DEC has transformed itself from a sincere but somewhat eccentric company into the computer phenomenon of the late 1980s.

Besides strengthening its position in traditional technical markets, the minicomputer company has capitalized on superior networking products to penetrate some of IBM's largest commercial accounts. DEC's 1988 revenues should be double those of 1984, and pretax income should be five times as high. Its momentum has made the company a Wall Street star: Its shares first split and then doubled in the past year, to $ 173. Is there no end in sight?

'HELL BENT'

Somewhere, there is. Not so long ago, after all, International Business Machines Corp. seemed invincible, while analysts wrote off DEC as a has been. So far, DEC's rally shows no sign of slowing. But now, a few analysts are beginning to place bets on when the laws of gravity will catch up with Dec. At Goldman, Sachs & Co., analyst John Levinson has taken DEC off his buy list. Robert H. Randolph of International Data Corp. also has his doubts. "In the latter part of 1988, there will be a slowdown at Digital," Randolf says. "Everybody is gunning for Digital now."

Of course, DEC's performance could slow a bit and still be remarkable. Analysts say its net income jumped about 80%, to $ 1.1 billion, in the year ended June 30, on a 24% increase in revenues, to $ 9.4 billion. Moreover, founder and Chief Executive Kenneth H. Olsen seems more determined and better prepared than at any time in DEC's 30-year history to stave off a downturn. In contrast with past growth spurts, DEC has kept costs under control, boosting net margins since 1985 from 5.7% to 12%. Olsen has put aside his distaste for marketing and hired thousands of salespeople. Perhaps most important, over the past year the Maynard (Mass.) company has introduced a major new product every four weeks or so to try to capitalize on its growing reputation among customers as a viable, full-line competitor to IBM. Continuing to pump out new products is DEC's primary strategy for growth and for smoothing out swings caused by product cycles. "They're hell-bent on market share," says Goldman Sachs' Levinson.

The company's performance since 1985 has been built on a wide range of machines, from desktop workstations to clusters of minicomputers, that run the same software and thus are able to communicate easily with one another. Virtually alone among major computer makers, DEC was ready to deliver these networking features just as customers began to demand them for automating laboratories, engineering shops, and office departments. Indeed, DEC has expanded out of its traditional technical markets into the commercial markets dominated by IBM. For example, Toys "R" Us Inc. just ordered $ 14 million worth of VAXs to control cash registers at its retail stores and to communicate with warehouses.

Impressive as this success has been, DEC scored its biggest gains while operating in what Shearson Lehman Brothers analyst Stephen Dube calls a "vacuum" -- little competition from rivals with comparable products. Now, that situation is changing rapidly. DEC's attempt to expand its product line is taking it into the preserves of tough competitors that have major clout in their markets.

The company most likely to put DEC on the defensive is IBM. Big Blue has priced its new 9370 minicomputers aggressively to compete with VAXs. And to keep customers from switching to DEC, IBM has promised them networking software to make its minis, mainframes, and PCs communicate more fluidly. That could erase certain of DEC's networking advantages. "IBM is talking about offering these [networking] functions in 18 months," scoffs William R. Johnson Jr., a vice-president at DEC. "We already have them." To International Data's Randolph, the more salient point is that "IBM is finally mobilized and attacking." And it is winning orders, such as a $ 400 million office automation contract with Ford Motor Co. that it beat DEC out of last year.

CRITICAL TEST

Most analysts expect DEC to keep the gains it has won against IBM's midrange computers. But the more critical test will be its effort to push into new markets -- most of them in the commercial sector. There, the key to success is speedy processing of transactions, such as credit checks, done by instantly drawing information from numerous data files. That's different from doing calculations quickly, the task at which the VAX excels. To make the VAX better in transaction processing, Digital needs more powerful machines, special software, and better disk drives. The company is working on all of these products, though analysts don't expect to see many of them before yearend.

At the other end of the spectrum, DEC is trying for the first time since it failed in 1982 to compete with IBM's personal computers to get back into the desktop market. A year after introducing an engineering workstation, DEC still trails far behind leaders Sun Microsystems Inc. and Apollo Computer Inc. DEC not only needs to catch up with them, it also must block new personal computers such as the Apple Computer Inc.'s Macintosh II and the IBM Personal System/2 Model 80, which can double as engineering workstations. To do so, DEC has taken an uncharacteristically aggressive move: It slashed the price of its basic workstation by 50%, to $ 4,600.

DEC's new aggressiveness will boost pressure on costs. The company has increased its sales force by 55% since 1985, to 7,000, and is still hiring. This helped prompt Levinson of Goldman Sachs to stop recommending the stock. He also argues that DEC's earnings have been inflated by the foreign-exchange benefits of a weak dollar. While the company's overseas revenues grew 47% in the quarter ended Mar. 28, domestic sales grew only 11%. Levinson also sees an increasing competitive marketplace reducing DEC's win rate on big contracts.

BY THE WAYSIDE

In spite of the challenges, DEC's near-term prospects look good. In the heated battle over workstations, DEC holds key advantages: a war chest of $ 2.5 billion, a wide range of software for the VAX, and ample manufacturing capacity. As for IBM, a recent poll of data processing executives by PainWebber Inc. and Computer Decisions magazine found that although 60% of the respondents were IBM customers, 91% viewed DEC positively, while only 71% looked kindly on IBM.

Customers that recently signed on with DEC are likely to generate further future sales. At the same time, many of DEC's traditional competitors are falling by the wayside. McDonnell Douglas Corp. recently decided to stop packaging its computer-aided design software with Data General Corp. computers, opting instead for DEC and IBM machines, which were in greater demand.

Is all this enough to keep DEC flying high? Even with a few ups and downs, Morgan Stanley & Co.'s Carol E. Muratore thinks it is: "DEC has a compelling story. It will be a third the size of IBM in the early 1990s." Now, that would be a winning streak.

GRAPHIC: Picture, CEO OLSEN, RESNICK/PICTURE GROUP; Chart, DEC'S LATEST WINNING STREAK IS A HOT ONE, DATA: SHEARSON LEHMAN BROTHERS, PAUL GRANGE