Last spring, after listening to Dell Computer founder Michael S. 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 Inc. and eMachines Inc. are on the ropes. And with its Labor Day decision to be purchased by Hewlett-Packard Co., even longtime PC king Compaq Computer Corp. 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 Corp. and chipmaker Intel Corp. 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 J. Kocher, Dell's former No. 2, who now runs Web-site manager Interland Inc. "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. Credit Suisse First Boston analyst Kevin McCarthy 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 U.S. 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 smidge more than it posted in its 2001 fiscal year, ended Feb. 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 D. 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 jihad, 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 Inc. 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 online, 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 online. That allows Dell to do the work of hundreds of telephone sales people with just tens of online 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 Cox Communications Inc. begged HP to sell to it directly to avoid the hassle of going through a reseller, the company refused. "We said no mas," says Scott Hatfield, the cable giant'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 is simply relentless about taking market share," says Dataquest Gartner analyst Martin Reynolds. "They feel unstoppable at the moment."
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. U.S. 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 Aug. 29, the company announced that it will 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, says analyst Brooks Gray of Technology Business Research.
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 (Tex.) campus. Market watcher International Data Corp. 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 is having 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. Says Sun Microsystems CEO Scott G. McNealy: "Dell is a grocery store. They're not in the PC business any more than Safeway is in the food manufacturing business."
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, Tex., and Peter Burrows in San Mateo, Calif.
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Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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