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Hold On To Your Seats
By John Latta
(May 6, 1999)

WAVE Issue #9047

Introduction
At 4th Wave for the last 5 months we have been consumed by our multiclient study on Information Appliances. At times we just could not keep up with the news as we also sought to carry out our obligations under the study. Things are looking up now that the report has been released. We recognize that some of our coverage has not been as complete as we would have liked.

As many of you know our approach to understanding and evaluating markets leans to the analytical side. This study was a tremendous learning experience as it stressed our analysis methodology as we probed for answers. Getting buried in numbers, various fragmented data points and, in some cases, incomplete data was a challenge - especially when the task was to understand the underlying trends and to look forward. From all of this we were able to develop a plausible end game for the development of the market over the next 10 years. The results have been very well received. With these insights we have a foundation from which to make new observations and extend/challenge our thinking. This was especially the case this week during the Embedded Processor Forum, which we reported on in WAVE 9046.

We believe that there is a significant shift in the market taking place now. Yet, one can counter that these are incremental steps that, in the end, will have little consequence. Why is this not the Network Computer all over again, one might ask? It was just a flash in the pan only to disappear. Or, another observation could be that it is just preposterous to claim that the PC is facing declines. Both the report and our observations this week only reinforce the conclusion that major changes are underway. This short article is to collect some of these observations and to address some of the questions posed by - what are the implications?

Times of Turmoil
Consider the following as indicators of the state of the turmoil in the computing, PC and 3D industries.

With the stock market at 11,000 virtually all the traditional metrics of evaluation have been discarded. Valuations as multiples of P/E ratios are being tested at new heights. Underlying much of this turmoil is inverted economics which now implies that revenue, profitability and market value are not related. This is very important in the technology sector because the market is the source of growth capital. Yet, inverted economics cannot sustain itself. Company evaluation must eventually be linked to the value it creates for its shareholders. Yet, by looking at the trends in the stock market one could certainly doubt the last sentence.

There is a major asymmetry in the market in digital connectivity at work and at home - no pun intended for our friends at @Home. That is, at work narrowband connectivity is virtually non-existent while broadband it is omnipresent in the form of 10mb/s or beyond Ethernet, while the totally opposite situation prevails in the home. Broadband connectivity is virtually non-existent and narrowband is omnipresent. This asymmetry is responsible for significant market turmoil in the rush to correct it. Yet, fundamentally this is a last mile problem that is very expensive to rectify. Yet, the stock market and investment decisions are coloring actions to address the asymmetry. Just look at the AT&T deals to scoop up cable companies, as an illustration. As we observed in the study - infrastructure is where the action is in the early development of new markets. Another element of turmoil is that the best connect rates, when broadband passes the home as part of the cable infrastructure, are only 15% of the cable homes passed. Why do not consumers want this great technology with the same enthusiasm as those offering it is an obvious question.

Technology, largely in the form of digital products, is seeking to impact consumers and create large new markets. Yet, consumers, which is the mass market, could care less that it is digital. For those of us in a technology centric world it seems crazy that consumers do not appreciate the fine technology we have for them. Much has been made about technology based toys but they remain a trace market compared to the $15 billion toy market which had 3.4 billion units with a net ASP of $4.51 in 1998. When market reality collides with market expectations it creates turmoil. The techno-centric world is clueless about the consumer.

Disruptive technology, i.e., see Clayton Christensen and his book Innovator's Dilemma, is creating no end of turmoil. Disruptive technology has been with us all along but now we have some metrics from which to judge it. One end result of such disruption is the life and death of companies - certainly a factor of turmoil. One could ask the question is the Internet a disruptive technology? Or, even, are Information Appliances disruptive technology? Our conclusion is very much - yes. However, to understand these forces one must go well beyond the elemental characteristics of disruptive technology. Yet, there is no doubt that a substantial component of today's turbulence is due to disruptive technology.

In order to protect market greed and the consumer's disrespect for property values it has reached the point that virtually every shred of content will or could be copy protected. This may make Hollywood feel good but keep in mind that the consumer has yet to speak via the market. How many copy protection standards bodies have had consumer representation on them? The market voting on Divx has certainly not been overwhelming in favor of the forces of protection. Turmoil lies ahead on this one.

Close to home, companies centered in 3D technology crave for stability. Yet, profits are elusive, the pace of technology appears to move faster that Moore's law, the PC increasingly competes with the home video game platform and mainstream business applications refuse to appear. Consider this simple observation - 3dfx, a relative upstart in the 3D chip and board business, had $202.6m in 1998 revenues while Evans and Sutherland, an originator of 3D graphics, which started in 1968, had $191.8m in sales for the same year. One can only wonder if 3D technology is disruptive upon itself. Certainly Clayton Christensen made this case in the disk drive business.

Fundamental Forces
There are forces behind or supportive of this turmoil that are not easily modified. These include: Consumers dominate the economy. In the US GDP consumer spending makes up 67.7% of the GDP while spending by businesses makes up only 15.5%. In the PC sector approximately 65% of the unit sales of PC are to business and only 35% to consumers. Guess where the future growth will be?

There are basically only two classes of markets: big and niche. Big markets are consumer centric and niche markets everything else. Thus, companies that seek the middle ground will eventually find themselves being pulled to either end of this spectrum. Most companies fear big markets because if they cannot compete it is usually terminal.

Business models are at the center of business macroeconomics, company strategy and company valuation today. The Internet has turned the concept of what is a business model upside down. We maintain that this has only begun.

In a product and service world reliant on digital technology, Moore's law still drives innovation and economics. MIPS or transistors are free, due largely to Moore's law. As a result microprocessors are everywhere and this has only begun.

Media is going digital. The value to all is too great to overcome. However one should not confuse media with content. That is, as a result of our study we forecast that casual media is today, and will be in the future, the major driver with content lagging behind.

Forecasting the Future or Out-of-Box Inversion
It was observed this week by Donald A. Norman that consumers move slowing to shape new markets. We challenge this. The cell phone industry went from 1.2m users in 1987 to 55m in 1997. Certainly the attach rate to the Internet, including the online services such as AOL, has grown at high rates in the last 3 years. More importantly, the ability to shape new markets must be supported by investment. Here the Internet has shown the willingness of investors to bet on very high returns, as reflected in the high company evaluations and to do this in a short period of time. The market is based on expectations for future earnings. Thus, in spite of slow consumer action, if this is really the case, there must be an underlying infrastructure and the creation of new products and services. If the perceived gain is high, the markets will move quickly to seize the opportunity with the expectation of market share. Further, even if it can be claimed that consumer move slowly they are very rapid to use and discard products. Short time to market and short product life cycles, especially in new markets is the norm.

The digital consumer is an oxymoron. This is a technically centric distortion. Do not think PCs or even DVD but Wal Mart, school, the Dr's office and Safeway. Deer Hunter was successful in Wal Mart. When one thinks big markets this means all demographics not those that shop at Fry's.

The Internet is a transient. The Internet is not the end game but only a platform for digital connectivity. The analogy with power at the turn of the century applies to the Internet.

The PC has a problem. It is not consumer focused and makeovers will not do. Increasingly, for many consumers its major role is as an access device to the Internet and there is nothing keeping this from putting the PC in a secondary role in this function. In consumer markets the PC as a multifunction device is a detriment.

3D has a problem. The business model is devoid. Today's PC market is largely based on being predatory on 2D accelerators. This puts 3D chips into a market sweet spot of $20. Aside from niche markets the only mass market 3D is for games. Yet, the PC is struggling as a game play platform. When a game developer with only an ok Playstation title can sell 1m units and a good PC title sells only 200,000 units there is a problem. The asymmetry of the PC vs. video game console market is dramatically illustrated by the next generation Playstation. Sony will likely invest in excess of $750m in fabs for the next generation chips. Yet, the cost of the chips will exceed the selling price of the unit. However, one cannot lose sight of the simple fact that in this $51 billion company the Playstation and related income provided 26.5% of the profits of for the first half of the 1999 fiscal year. For Sony the Playstation is a business model issue - it is ok to lose money in the short term on the platform for the following reasons: this is the basis for the largest source of future revenue and profits the company will have. The profits will be made in higher gross margin games not the platform. The problem with 3D on the PC is that it has no flexibility in its business model. As a result PC 3D pales in comparison to Playstation 2 3D. We were struck this week by the quality of the imagery from the Playstation demonstration. 3D on the PC just cannot compete in an unsubsidized environment. It is all about business models.

These new markets are in for a shock when it comes to government involvement. The PC industry lives in this dream world of unfettered open market competition as the well spring of innovation. Certainly the Microsoft anti-trust trial has shattered that illusion. Having lived inside the beltway for over 20 years and interacted on the Hill I can only say that the PC industry is grossly naïve. There are basically only two simple rules for government involvement in industries and peoples lives: (1) the vast majority of actions by Congress are driven by the intent to get more votes in the next election and (2) government is used as a lever in markets. Why did it looked so stupid that Vice President Gore claimed he was responsible for the Internet. This was just a vote collection trick that backfired. Why is the Congress so interested in the Internet - it impacts people's lives and therefore a source of votes. Further, government will be thrust into a role of arbitrating markets as per (2). This is exactly what happened in the lobbying for cable unbundling. Here AT&T and AOL were pitted against each other in a fierce campaign at the FCC. In addition, few realize that one of the most powerful lobbying organizations in Washington is the NAB (National Association of Broadcasters). Why do you think they got the HDTV spectrum for free when public policy is to auction spectrum? This all brings us to another inconsistency - government indifference to technology markets. This is just not in the cards.

Market duds are already evident in the mad scramble to seize the opportunity. The set top box (STB) is in for a rude splash of cold water. Who wants it outside of the cable MSO's? There is every indication that retail sales of STB will go very slow if they even make it on time to meet the FCC mandate. Yet, the problem is larger that this - what consumer need is being met by the STB? Take for example, the current craze on personal television - a form of STB with a hard disk to allow consumers to record television programming. Have you ever timed the total amount of commercials during the national news or a movie which is shown by over the air broadcasting? Is TiVo or Replay going to implement automatic commercial elimination? No way. They want to cultivate advertisers not eliminate them. Who wants to pay $500 or more for a box to emphasize commercials? You have to be kidding. Yet, all of this masks a more fundamental market issue which was developed during the study - the future markets will transition from products to services. Just as the cell phone and DBS has transitioned from the product to service the same will be the underlying trend in these new markets. Further, merchant semiconductor chips are dead. Just as the discreet transistor has died the same will apply to even the X86 as a processor.

Underlying all of this is a huge market. Our preliminary and conservative estimate in the study is at a Total Available Market (TAM) of $62.1 billion of which $54.6 billion is services. One only has to keep in mind it is all about disruption, opportunity and consumers. A difficult triad for any company to execute within.

This last week only served to drive home that the transition, to what we have called the fifth era of computing, is well underway. It is not about the PC industry reborn but a new beginning.

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