Dell, the Conqueror

Last spring, after listening to Dell Computer founder Michael Dell speak at

length about the future of technology, a young business student stood up to ask

a question: If Michael Dell were back at the University of Texas where he

started his company from a dorm room in 1984, what kind of company would he

start today? "Well," Dell said bluntly, "it wouldn’t be a PC

company."

Especially if he had to tangle with the likes of Dell. Since the 19-year-old

college dropout hit the computer scene, he has been shaking things up by taking

efficiency to new highs, squeezing every last centavo out of the cost of

building and selling PCs. For 17 years, rivals have struggled to keep up. Now,

it looks as if they have lost the fight. Dell, the undisputed low-cost leader,

declared a brutal price war a year ago just as the industry slipped into its

worst slump ever. The result has been nothing short of a rout. While Dell has

chalked up $361 million in profits this year, the rest of the industry has

logged $1.1 billion in losses. Rivals Gateway and eMachines are on the ropes.

And with its decision to be purchased by Hewlett-Packard, even longtime PC king

Compaq Computer has cried uncle. "When we sell these products, we make

money. When our competitors sell them, they lose money," crows Michael

Dell.

Trouble is, Dell’s recent success is the result of a dangerous game. Sure,

Dell is now the world’s No 1 PC maker, vaulting from 10% of the market in 1999

to 13% in July, powering it past Compaq for the lead. But to make its market

share gains so staggeringly fast, Dell depth-charged prices, dropping gross

margins from 21.3% in October to 17.5% in July. Only by laying off 5,000 people

has the company stayed solidly in the black. And that’s bound to get harder to

do. With PC revenues pegged to fall 10.8% this year–the first annual drop ever–price

wars are expected to take profits even lower. Not even a rebound promises

relief. History has shown that PC makers don’t hike prices on buyers who have

grown accustomed to ever-cheaper technology. "If margins do come back, it

would be an industry first," says a top Dell executive who recently left.

"If they don’t, there has got to be a Plan B."

"Faith and hope"

Dell insists Plan A is giving him A-plus results, so why

switch? In the coming months he aims to do even more of the same: push his

low-cost approach harder than ever in PCs, while applying the same tactics to

markets with juicier margins: computer servers, storage, and networking. His bet

is that software giant Microsoft and chipmaker Intel will continue to invest

heavily in technology advances. He can then buy their sophisticated software and

chips to sell ever more powerful gear with ever fatter margins. Once he gets a

foothold, he’ll start lowering prices, deflating rivals’ profits, and

stealing their customers. "Every single time Dell targets a new market, the

naysayers say it’s too high-end," says Joel Kocher, Dell’s former No 2,

who now runs website manager Interland. "Look at what has happened. As the

technology shows signs of commoditization, Dell lightning strikes."

Only this time, if Dell continues his price-savaging

indefinitely, investors could be the ones zapped. That’s because Dell’s

model works best in boom times, when huge volumes can make up for shrinking

profit margins. But with the long-term forecast calling for slower PC growth,

Dell will have a harder time keeping its bottom line afloat. That has some

investors rethinking Dell’s earnings potential. Chris Faber, a portfolio

manager with investment firm Cash Flow Return on Investment Global Advisors,

figures the cash generated by Dell’s existing businesses over the next 10

years will be $17.7 billion. Divide that by Dell’s outstanding shares, and you

get just $6.80 per share–far from Dell’s current $22.57 stock price. What’s

holding up the other $15.77? "Faith and hope" that Dell will find its

way out of this PC-profits trap, says Faber.

That leaves but one path: Dell must snare an amazing amount

of market share in very little time. A Credit Suisse First Boston analyst thinks

Dell will need to catapult from 13% to 23% worldwide share in two years just to

keep profits flat. McCarthy says Dell can do it, but that’s fast even by Dell

standards. In 1993, when Dell predicted his company would jump from 4% to 18% of

the US market, it took six years. This time Dell will be up against big players

like IBM and HP, who are desperate to remain full-line computer providers. But

hike market share he must–especially if the price war continues at this pace.

Should that happen, Dell’s operating margins could fall to 5.5% from 7% over

the next two years. And PC sales are expected to grow just 8% annually over that

time, hitting 144 million units in 2003. For Dell to manage $2.6 billion in

profits–a smudge more than it posted in its 2001 fiscal year, ended February 2–it

would need 23% of the market.

Slim R&D

Sound like an impossible task? Not to Michael Dell. Supremely

confident in his efficiency machine, he thinks he can do even better. He says

Dell can reach 40% market share, although he won’t say by when. And he seems

to think he can do it without making a major acquisition. Indeed, sources say

Dell was approached about whether it was interested in buying Compaq, but no

serious talks ensued. Both Dell and Compaq CEO Michael Capellas declined to

comment.

If Dell can make such massive gains, the chance of any

innovation by PC makers may fade for good. A Dell with 40% market share in, say

2005, would be a $100 billion-plus behemoth with huge influence over suppliers

and rivals. Add in its bare bones spending on research and development–a

measly 1.5% of revenues–and no rival is likely to risk spending loads on

R&D. That would leave all the innovation to Microsoft and Intel–and if

they happened to get it wrong, the PC business would suddenly look like the TV

industry: lots of affordable, reliable electronics, but few new killer products

to spur sales. "Dell envy took the industry from ‘innovation is king’

to ‘efficiency is king’," says Kocher. "It’s a market taker, not

a market maker."

Indeed, some blame Dell for the lack of innovation that has

contributed to the PC industry’s woes. Since Dell’s efficiency jehad, the

R&D budgets of all the PC makers have been falling, as they race to keep up.

Compaq spent 6% of its 1991 revenue on R&D. That slipped to 3.5% in 2000.

"Dell has made this a cost game," says Capellas. "Price

compression is killing innovation."

Then again, Dell never fancied himself a product innovator.

Rather, his brilliance is in identifying innovative business models–and then

executing them to perfection. Dell argues that while the company hasn’t

created whiz-bang inventions, it has produced cheap computers for buyers and

huge returns for shareholders. Dell says his company has injected a discipline

that will be necessary for the industry’s long-term health. "The easiest

way for the industry to increase profitability is for Dell to gain market

share," says Dell.

Virtual touch

How does he pull it off? His edge starts with the

direct-selling approach he defined in his college days. By taking orders

straight from customers, Dell builds its PCs to demand rather than an inexact

sales forecast. That means the customers get what they want, Dell doesn’t have

to build unwanted inventory, nor does it have to pay a distribution fee to a

middleman like a retailer. And since Dell collects its cash an average of 30

days before it ships a PC, the approach is basically self-financing.

Dell has taken this basic idea light-years beyond any other

manufacturer of complex tech products. At any given moment, there’s just four

days of stock in Dell’s warehouses, down from seven days a year ago. That

compares to 24 days for Compaq–a gigantic edge in a market where the price of

chips, drives, and other parts typically falls 1% a week. By taking advantage of

the latest prices in components, Dell lowers its cost of production, giving it

the happy choice of either undercutting rivals’ prices or taking a higher

profit.

Dell never stands still. Last year, it required suppliers to

use sophisticated supply-chain software from i2 Technologies that wires them

straight into Dell’s factory floor. Now, its plants can order supplies over

the Net many times a day. That lets the factory keep a few hours’ worth of

parts on hand, replenishing only what it needs throughout the day. The software

saved Dell $50 million in the first six months of use.

Indeed, Dell has been a master at cutting costs with the help

of the Internet. It was the first PC maker to sell on-line, setting up shop in

cyberspace less than a year after Netscape’s 1995 IPO launched the Net boom.

Today, 50% of Dell’s sales are placed on-line. That allows Dell to do the work

of hundreds of telephone sales people with just tens of on-line staffers. When

corporate customers connect with Dell, they too get the virtual touch. Since

1997, the company has created more than 60,000 custom Dell stores on the Web for

its corporate buyers. With that data streaming in, the company stays in constant

touch with demand. Bemoans a former HP executive: "Michael Dell’s laptop

gives him more information each day than we got in a quarter’s time."

Now, Dell gives customers fast, convenient service that

others can’t touch–including three-day delivery of PCs with all their custom

software pre-loaded. When cable giant Cox Communications begged HP to sell to it

directly to avoid the hassle of going through a reseller, the company refused.

"We said no mess," says Scott Hatfield, Cox’s CIO who bought his

18,000 PCs from Dell and saved 20%. Health insurer Blue Shield of California

switched to Dell this spring when it promised to deliver PCs in three to four

days, vs the three weeks the company typically waited with Compaq. It also saved

the insurer about $1 million on 700 new PCs–including the cost of toting away

its old PCs in accordance with federal rules on disposing of health data.

Dell’s rivals must feel the same way. The company is

driving down PC and server prices almost daily to steal share. Since July 2000,

the average price of a Dell computer has fallen 18%, to $1,850. That’s wooing

entirely new clients. US Bancorp Piper Jaffray analyst Ashok Kumar says that in

August, 40% of Dell’s current corporate accounts were new wins, vs 10%

historically.

Bold talk by competitors about matching Dell’s prices

typically doesn’t last long, either. After pledging to match Dell in May,

Gateway backed off that claim two months later. Then on August 29, the company

announced that it would lay off 4,600 workers and retreat from foreign markets.

Compaq also claimed it could withstand Dell’s price war. Under Capellas,

Compaq has made huge improvements in asset management by cranking up its own

direct sales effort and slashing its inventory. But it still can’t earn a

decent return and hold off Dell at the same time–a key reason Capellas needed

to sell the company to HP.

Worries

The failure of rivals to make good on their claims has

emboldened Dell. On the day the HP/Compaq deal was made public, Dell banged out

a gleeful e-mail to a BusinessWeek reporter: "It looks like the market has

spoken on this deal," wrote the 36-year-old native Texan. He punctuated the

missive with a grinning happy face.

Still, it’s not all smiles at Dell’s Round Rock (Texas)

campus. Market watcher IDC expects PC industry revenues to fall in not only this

year, but another 2% in 2002–partly because buyers seem content to hold on to

their PCs longer than in the past. There could be a small sales uptick when

Microsoft’s Windows XP software ships in October, but not enough to reverse

the bigger trend: The average life span of a corporate PC could rise to four

years by 2004, from 3.3 years in 1999, says researcher Gartner.

What’s more, it’s not clear that markets Dell wants to

turn into commodities, such as servers, storage, and networking, are ripe for

the conversion. Starting with the desktop in 1984, Dell has been able to

commoditize other Wintel markets–first the notebook, and then low-end servers.

It lets rivals pioneer a market and then charges in with its low prices and

low-hassle service. But now it has to move out of its comfort zone, as it

targets markets that require tons of white-glove customer service and where

Microsoft and Intel have yet to earn their stripes.

Dell’s future success in servers, for example, depends on

acceptance of Microsoft’s Windows 2000 server software and Intel’s Itanium

chip. Technology from Intel and Microsoft has become standard for many

lower-level jobs, but companies still rely on higher-end Unix machines and IBM

mainframes for the biggest, most lucrative tasks. Worse, Dell has thinned its

already slim ranks of engineers in two layoffs this year. Since Dell already

spends less than the rest of the industry on R&D, that could hurt its

nascent efforts to develop more robust servers.

Storage could be even more challenging for Dell. This market

is expected to hum along at 15% growth over the next few years, thanks to the

unending need for companies to store the rising tide of Net data–whether or

not they buy other gear. With margins still a hefty 25%, the business is

dominated by tech heavyweights EMC, IBM, and Network Appliance. They have been

the storage suppliers of choice because they’ve developed sophisticated

products to handle huge amounts of data from a variety of different computers.

Indeed, Network Appliance CEO Daniel Warmenhoven figures just 20% of storage

sales could be called commodity. Storage executives say it will be years before

the bulk of the market will be vulnerable to Dell.

Tough boss

Dell realizes his storage prize is still off in the future.

Insiders say that Dell is in talks with EMC to form a strategic partnership that

would let Dell sell EMC storage devices with its servers. That way, it could get

a cut for landing new business for EMC, and it wouldn’t lose server business

to rivals who have their own storage–particularly the new HP, which will get

Compaq’s $5.2 billion storage unit that dominates the lower reaches of the

storage industry. "If Dell’s worried about anything (regarding HP’s

purchase of Compaq), it has to be storage," says former Dell senior

executive Carl Everett.

Dell is confident his direct approach will win in the end.

His response to snags is to push managers to crank harder on his tried-and-true

model. When top managers in Europe didn’t deliver big market-share gains last

year, they were shown the door. Says President Kevin Rollins: "They didn’t

completely understand the direct model. They just didn’t get it. So we had to

replace a lot of our management team."

Is Dell sticking too long with the method that has made him a

great name in 20th century business? He insists that to let up now would be

foolish. "I’m going full blast and I’m not slowing down," says

Dell, whose 14% stake in the company is worth an estimated $8 billion. "I’m

having a great time. This is fun." Unfortunately, in his business, fun can

turn to agony in a nanosecond.

By Andrew Park in Austin, Texas, and Peter Burrows in San Mateo,

California in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc