For Dell, the future ain't what it used to be

Thursday’s decision by Blackstone’s private equity partners to give up on buying Dell marks the end of an era.

The failed bid is an important story on many levels. I'll ignore for now the temptation for schaudenfreude after Michael Dell’s faulty prediction 15 years ago that Apple was worthless and should be liquidated. (Friday’s closing market cap: Apple $367 billion, Dell Inc. $23 billion).

Let’s also ignore that the end of the Blackstone bid appears to assure the success of Michael Dell’s $13.65/share offer to buy Dell Inc., funded by Silver Lake Partners. With this, shareholders must set aside very real concerns about Mr. Dell’s proposed buyout, particularly the conflict of interest from a CEO-founder who IPO'd his company and now wants to buy it back after the shares have fallen 2x since he returned as CEO in January 2007.

Instead, let me focus on two key insights Friday — from stories Friday by Bloomberg and the Wall Street Journal — on the real story on why the buyout collapsed.

The first reason was the collapse of the PC industry. As the Blackstone notice to Dell Inc. remarked (as quoted by the New York Times):

While we still believe that Dell is a leading global company with strong market positions, a number of significant adverse issues have surfaced since we submitted our letter proposal to you on March 22nd, including: (1) an unprecedented 14 percent market decline in PC volume in the first quarter of 2013, its steepest drop in history, and inconsistent with Management’s projections for modest industry growth; and (2) the rapidly eroding financial profile of Dell.

Or as IDC reported on April 10:

Worldwide PC shipments totaled 76.3 million units in the first quarter of 2013 (1Q13), down -13.9% compared to the same quarter in 2012 and worse than the forecast decline of -7.7%, according to the International Data Corporation (IDC) Worldwide Quarterly PC Tracker. The extent of the year-on-year contraction marked the worst quarter since IDC began tracking the PC market quarterly in 1994. The results also marked the fourth consecutive quarter of year-on-year shipment declines.

The second reason was the rapid collapse of the financial prospects of Dell Inc. To quote from the WSJ,

Another issue, some of the people said, was a seeming freefall in Dell's forecasted operating income. While some Blackstone executives initially had hoped the predictions were worst-case scenarios, in due diligence they concluded the predicted outcomes were spot on, and the numbers could come in even lower, the people said.
…
Dell, in the March 29 filling, predicted adjusted operating income of $3 billion for the fiscal year ending next January—a stark contrast to the $5.6 billion the company had predicted the previous July.

Dell hoped to diversify into other areas, but that has failed. As the Bloomberg story reported: “the enterprise-solution business, heralded by analysts as Dell’s future, was years away from competing meaningfully in that market…”

In other words, we’re at the tail end of the PC era. Although it’s coming more rapidly than expected, the outcome is as predictable as it was for bookstores, record stores or newspapers. Dell had hoped to diversity its way out of the problem, but so far those efforts have failed.

The implications seem as bleak for the rest of the PC industry. As part of a “Dogs of the Dow” value investing strategy, I own a few hundred shares of Intel, which has gone nowhere in the past two years. Microsoft has done only slightly better, due to hopes (IMHO unfounded) that it will someday benefit from the shift to smartphones and tablets. Even Apple has major exposure to personal computers, where it has been gaining share as its tablet share (but not unit sales) has fallen.

More significantly, in the late 20th century Dell was the winner of the commodity PC industry, but then was out-commoditized by Mark Hurd at HP. Right now the commodity business is going badly for both.

From 1960-2000, we saw the collapse of the mainframe, minicomputer and workstation industry. It wasn’t the low-cost firms that survived to the bitter end, but the high value-added ones. The others morphed into something else (NCR: ATM machines; Burroughs and Univac: IT services), exited or died.

Given that HP and Dell have negligible presence in the most rapidly growing computing segments — smartphones and tablets — what’s left 10 years from now will be two very different companies. HP’s done a better job of diversifying than Dell, but neither’s prospects are terribly attractive.

Boy Dell was wrong

October 6, 1997, Jai Singh writing in CNET News.com:

When it comes to the state of Apple Computer, everyone has an opinion.
…
[T]he CEO of competitor Dell Computer added his voice to the chorus when asked what could be done to fix the Mac maker. His solution was a drastic one.

"What would I do? I'd shut it down and give the money back to the shareholders," Michael Dell said before a crowd of several thousand IT executives.

August 9, 2011, John Paczkowski writing in All Things Digital:

A new milestone for Apple. The company briefly overtook Exxon Mobil as the world’s most valuable company Tuesday, edging past it after days volatile stock market trading. Earlier today Apple’s market cap rose to $341.5 billion, just above Exxon’s $341.4 billion for a few moments before slipping back down again. …

An astonishing achievement for a company whose market cap bottomed out at $630.9 million back in 1982.

Incidentally, at $341.5 billion, Apple’s market cap is more than twelve times that of Dell’s $26.54 billion.

Why aren’t the Dell shareholders rioting with pitchforks in Round Rock? They’ve lost more than 70% of their investment since January 2000 and more than half of the value of the stock in mid-2008. Meanwhile, Apple stock is 5x its 2008 peak and 14x its price in early 2000.

The Siren Call of Silicon Valley

The morning paper reports that Dell is the latest major IT company to be lured by the sirens of Silicon Valley. I suspect it won’t be much more successful than any of its predecessors.

The Merc leveraged Dell’s Tuesday press release to extend their report last week that the company was leasing 240,000 square feet in Santa Clara, and had 341 open jobs posted in the Bay Area.

The Dell news release summarized the decision:

Dell today announced plans to open the Dell Silicon Valley Research and Development Center, a new facility that will support Dell’s strategic expansion of solutions capabilities, including the areas of networking design and development, storage development and cloud computing. The new site complements Dell’s Israel Research and Development Center, announced last month in Ra’anana. Dell believes that with recruitment of additional staff, its workforce at the Silicon Valley site will grow to more than 1,500 team members over the next five years.

The new facility will allow Dell to consolidate much of its current Northern California operations in phases over the next several quarters. It will combine the operations of several area companies Dell has acquired, including Zing (Sunnyvale), Ocarina (San Jose), Scalent (Palo Alto), and Everdream (Fremont) into approximately 240,000 square feet of leased space in two adjacent buildings on Great America Parkway in Santa Clara.

In other words, Dell’s decision to expand here was largely motivated by the need to more effectively manage its SV acquisitions.

This is exactly parallel to Qualcomm’s decision almost four years ago to buy a 320,000 square foot campus to consolidate its own Bay Area acquisitions, notably SnapTrack (which later made Steve Poizner a household name) and most recently Atheros. The only difference is that Qualcomm bought its land — and thus appears here for the long haul.

The older Merc story notes two foreign telecom companies expanding here recently: Huawei and Nokia (although Nokia’s research center has been in Palo Alto for at least five years). Motorola, British Telecom and Deutsche Telekom are also here, as are most of the Japanese electronics companies and SAP of Germany.

But will it matter? Perhaps the sirens of Silicon Valley won’t be luring Fortune 500 (or Global 500) companies to their deaths, but will they actually help these firms succeed?

Digital Equipment Corp. (DECWRL) and Xerox (PARC) had major research labs in Palo Alto 30 years, but they did nothing to stem their eventual declines. IBM invented the disk drive and the floppy disk in San Jose, but then dumped that operation to Hitachi in 2002 and now the Cottle Road facility is a strip mall. (The still have their 1977 Santa Teresa Lab and their 1986 Almaden Research Center, but both are at the edges of the valley and not closely integrated into it.)

So for Dell, Qualcomm and others, the Silicon Valley branch office provides a convenient way to integrate acquisitions (and for the startups to find a friendly acquirer.) But I can’t think of a single example of a foreign or US company whose SV operations have made a significant difference in their ultimate success: the key decisions are made elsewhere, and most of the value is added elsewhere as well.

Mark Hurd for CEO

Levi Sumagaysay of Good Morning Silicon Valley (the Merc) has a wonderful summary of Dell’s many woes, including unhappy shareholders, a $100m fine to the SEC, allegations of shipping defective computers and a recall of servers infected with malware.

Some of this is just normal bad news and some of it suggests a lack of attention to execution that was once Dell’s hallmark and source of competitive advantage.

However, the revelation (and SEC fine) of Dell’s financials from 2002-2006 were inflated by $1+ billion in “loyalty payments” (kickbacks?) from Intel suggests that the core business has been in trouble for a while, as rivals like HP have copied Dell’s once-unique operational efficiency (and as the model has broken down with the rise of laptops).

Michael Dell’s return as CEO in 2007 was assumed to be the solution to the company’s post-bubble woes, but so far the second time around has been much harder. Given the no-confidence vote in Mr. Dell by 25% of the company’s shareholders, perhaps it’s time to find a new CEO.

If they need a commodity IT turnaround specialist, I know just the guy: Mark Hurd. He’s turned around two companies already — NCR and HP — and now finds himself unexpectedly with time on his hands.

Yes I know that Hurd probably has a non-compete clause, but under California law (where HP has its headquarters) it’s difficult to enforce them except under very narrow circumstances. (Ex-Compaq CEO Michael Capellas — jettisoned by Carly Fiorina after the acquisition — is also available, but nothing in his resume suggests he is prepared for today’s brutal commodity price wars.)

So hiring the now-tarnished Hurd might be seen as risky, but desperate times call for desperate measures. He’s still as talented as he was a year ago, and the 134% increase in share price during his reign is unmatched by big tech CEOs not named Steve.

Perhaps the outside directors of Dell should give Mr. Hurd a call: he lives in Atherton, Calif.

Dellphone commoditization

Dell is developing an Android smartphone, reportedly for China Mobile, the world’s largest mobile phone carrier.

All the conventional analysis makes sense: Dell wants to be in smartphones to line extend down from netbooks. There’s the obvious question of whether a smartphone is more like a netbook or like an MP3 player, where Dell entered last summer and predictably failed. One nice thing for Dell is that it didn’t have a retail store to compete with the iPod, but for cellphones the operators will supply the distribution.

I don’t quite get why CM needs Dell. HTC has already shipped two Android phones, and overall there are three Taiwanese and one Chinese handset vendor to choose from. Maybe Dell offered an aggressive price to break its Dellphone into the cellphone business in the world’s largest market.

Of course, this illustrates the number rule of Dell: if Dell enters your market, you’re a commodity. As with any other open source software, Android commoditizes handset operating systems, in this case enabling easy entry by handset makers who know nothing about making usable handset software. WIth help from suppliers like Qualcomm or TI, I’m guessing there will be more than a dozen Android handset vendors by Xmas 2010.

If Android succeeds in product proliferation and commodization, will it gain significant market share? WIll it cut price premiums for Apple, Nokia or RIM smartphones? Right now, those would be much harder predictions to make.

Openness in the news

A few tidbits highlighted in the inner pages of a friend’s WSJ this morning. All are about (to some degree) IT openness.

Comcast is partnering with Clearwire (and thus Sprint) to resell its WiMax service to its existing cable modem subscribers. In integrating its offerings, Comcast is seeking to increase switching costs. More fundamentally, either this suggests that Comcast realizes that revenue growth in its core business is over, or it decided it needs to bundle in-home and coffee shop Internet access for residential users to compete with AT&T (DSL + Wi-Fi hotspots) and other integrated telecom companies.

Meanwhile, Clearwire is eager to generate revenue and win WiMax adoption before the more widely endorsed LTE tsunami comes flooding in.

The EU has forced major mobile phone makers to adopt a standard recharger plug by 2010. Nominally to reduce the number of chargers in landfills, of course it’s really about forcing an open standard to reduce switching costs. While I think this is exactly the sort of trivial economic micromanagement that governments should avoid, fortunately the government didn’t have to push too hard as European and US telecom trade associations had previously brokered the plan.

Alas, the format is the relatively new (and incompatible) micro-USB instead of the ubiquitous mini-USB that I already have on all my hard disks and some of my existing cameras and cellphones.

Dell is rumored (by the WSJ and earlier reports) to be planning an Android device aimed squarely at the iPod Touch. This makes a lot of sense, since for many users, the value of the iPT comes from its WebKit web browser, a mail client, Google maps and an RSS reader. Assuming Android has gotten around to fixing their awful email client, the open source (and thus inherently commoditized) platform makes perfect sense for the company that seeks to copy Apple’s new technology innovations (and old production innovations) as its core commodity business declines.

As with other Dell technology efforts, it would enable the low R&D company to build upon the R&D efforts of others, a classic (if decades old) example of open innovation.

Happy Birthday, Mike

Driving into work this morning, the drivetime radio show’s list of celebrity birthdays for Feb. 23 included the usual entertainers such as Peter Fonda (70) or Dakota Fanning (15). They didn’t list important historical figures born this day such as G.F. Handel or W.E. B. Dubois.

However, they did mention Michael Dell, aged 44 today — entrepreneur, CEO, author, economic ambassador and philanthropist.

Unfortunately, the news today was not pretty for a man whose fortunes are tied to his eponymous company. When I got back from teaching my entrepreneurship class, I found this AP article in my in-basket.

Sector Snap: PC makers down on report
Associated Press, 02.23.09, 03:06 PM EST
pic

Shares of computer makers fell Monday after Morgan Stanley analysts said that the recession will pull down PC demand further this year than previously forecast.

After visiting Asia, where most PCs are made, the analysts led by Kathryn Huberty, now expect PC revenue to drop 24 percent this year and unit volume to fall 11 percent. They had previously expected a 10 percent revenue decline.

Teasing out the numbers, this means that the average selling price for PCs will fall about 15%.

The article goes on to report that analysts reduced revenue and profits estimates on HP, Dell and Apple, and the corresponding shares were all down about 4-5% on the news. In other words, as I argued last night they expect the entire industry to be hurt, rather than just the high cost producers.

Of course, the 15% is just an aggregate figure. Some people will buy at the same price point they bought last time, while others will drastically shift their demand. And some won’t be buying at all: an 11% fall in unit sales is equivalent to a 2 year replacement cycle being stretched out by 3 months (or 25% of the market delaying by a year).

Note: I couldn't verify if anyone refers to Michael S. Dell as “Mike.” I’m guessing if you’re worth $15+ billion, your inner circle is pretty closely guarded.

Dell catches a 10-year-old trend

On Thursday, Dell’s 10-Q report suggested that it’s getting ready to dump some or all of its factories. The development was noted in a front page Wall Street Journal story on Friday and picked up by the NYT and FT this morning.

The irony of Dell outsourcing the manufacturing that has formed its historic source of competitive advantage is hard to understate. To quote from the 10-Q:

We were founded on the core principle of a direct customer business model which included build to order hardware for consumer and commercial customers. The inherent velocity of this model, which included highly efficient manufacturing and logistics, allowed for low inventory levels and the ability to be the industry leader in selling the most relevant technology, at the best value, to our customers.

But the key paragraph of the 10-Q announces the intended reversal:

We are actively reviewing all aspects of our logistics, supply chain, and manufacturing footprints. This review is focused on identifying efficiencies and cost reduction opportunities while maintaining a strong customer experience. Two examples of this include; our announcement on March 31, 2008, that we will close our desktop manufacturing facility in Austin, Texas, and the sale of our small package fulfillment center in the second quarter of Fiscal 2009. … In addition, we anticipate taking further actions to reduce total costs in design, materials, and operating expenses.

The WSJ counts the factory sale as a done deal, while the other reports are more tentative. All attribute the change to increasing cost pressures (i.e. commoditization) of the PC industry.

The WSJ notes that Dell had already moved to outsource laptop production to Taiwanese makers such as Foxconn. While IBM once made its own laptops, now all remaining US laptop makers (i.e. HP and Apple) have their laptops made by Taiwanese companies. Gateway solved their laptop supply problem by selling themselves two years ago to Acer (of Taiwan).

Actually, Dell’s decision to sell its factories and switch to CM is a decade behind the times. With my postdoc in 2000-2001, I studied Apple’s supply chain revitalization, including its decision to sell all its factories from 1996-1999. HP also began the process of shedding its factories and switching to CM use in this same time period.

The FT notes that Dell’s new supply chain guru is Michael Cannon, former CEO of Solectron (one of the earliest CM firms). This presumably played a role in Dell being willing to let go of its historic source of advantage.

But it does raise the question: if Dell can’t gain competitive advantage from manufacturing — and its direct-build IT logistics model has been widely copied — what will it to do avoid commodization? The temptation will be to move upmarket to a differentiated product, but Dell has failed in its previous attempts to do this because it contradicts Dell’s corporate culture (and customer reputation) as the low cost leader.

On the other hand, you can’t be the low cost leader if you have the same cost structure as all your competitors. Dell will be using the same component parts assembled in the same sort of CM factories as HP (and Acer and Lenovo and Toshiba). Other than an occasional feature on a new laptop, there’s negligible differentiation among the top five, so their similar features and cost structure — in the face of softening demand — is a recipe for further price wars.

Photo of a Dell factory from the BBC

I can’t tell you why

This morning’s Wall Street Journal says that Dell is readying a new MP3 player to compete with the iPod. Unlike its failed effort in 2003, this would also include a client application and download service for both music and video. As CNET notes, the Page B1 article makes a nice trial balloon.

It seems like Michael Dell dreams of surpassing Steve Ballmer’s success with the Zune. In the US, Apple has 70+% and Microsoft has 4% (Both Apple and Dell are much less influential overseas, so Dell has to hope that he can first gain US market share.)

To make this work, Dell would have to move from assembling products from standard parts to being able to do its own systems integration. Of course, that is why they bought Zing last year (presumably for something close to $50 million).

It’s not completely clear, but providing its own service would appear to shift to a differentiation strategy — away from its historic strength as a low-cost, commodity producer with low R&D. It certainly is part of an ongoing (and mostly unsuccessful) effort to achieve a consumer market share comparable to what it has with big business.

Why is Dell doing this? The story brings to mind a song by my favorite band: I Can’t Tell You Why.

Not all R&D created equal

As a UCI postdoctoral student in 2000, I was adapting parts of my dissertation to be an e-commerce study of Apple Computer. The idea was that the study (released as a working paper) would stand side-by-side with other PC industry e-commerce studies done by my colleagues on Dell and Gateway.

At the time, Dell was still riding high as the cost leader of the PC industry, earning record profits from relentlessly commoditizing the Wintel PC business. At best, Apple seemed to be demonstrating a dead cat bounce from the depths of its near-death experience in 1997.

One of the arguments I had with my colleague, Jason Dedrick, was whether Dell did more R&D than Apple. While Dell had low R&D intensity, at the time it was much bigger than Apple, so the reported cash R&D figure was higher than Apple’s. I argued that Apple was still doing more innovation, no matter how big Dell’s number looked, because we knew that Dell (unlike Apple) was not spending significant money on either developing software or on being the first to bring new technologies to the PC industry.

This week, Dell CEO Michael Dell was interviewed by Walt Mossberg of the WSJ at the newspaper’s annual “D” conference. I wasn’t there, but there’s a summary of the interview on the WSJ blog and the Barron’s blog, as well as some video highlights.

Dell confirmed the point I was making back in 2000-2001 when arguing with Jason. Here’s my transcription of the relevant portion of the taped interview:

Mossberg: The former Dell of CEO of Dell — Kevin Rollins — appeared at this conference a few years ago. And I'm paraphrasing here — it's not an exact quote — but he said something like “R&D was a waste of money.” Was that the Dell philosophy at the time and is it now the Dell philosophy?

Dell: No. (long pause … then video cut) We'll spend roughly $600 million year in R&D, so certainly not an insignificant committment to developing new technology and new products. I think it's also to remember that there's tens of billions of dollars of R&D spent in the industry

In other words

• most of our “R&D” is really just product development
• we don’t do much research
• we rely on the rest of the industry to create technological innovations for us.

Now there’s nothing wrong with using open innovation to support a generic cost leadership strategy: historically Dell lets component suppliers do the technology innovation, and then copies at lower costs the innovations of companies like Apple, HP or IBM (now Lenovo). I personally think that Michael Dell is silly to feel embarrassed about being a not-very-innovative company: solving key supply chain problems and being a relentless cost-cutter made him worth $16 billion. Much as I like innovation, I’d trade places in a heatbeat (even if it meant moving to Texas).

In fact, it would be stupid for him to try to make Dell into Apple. There’s only one Apple, and even Sony (with its brand and 50+ years of innovation) has been unable to match it in PCs and music players. If Dell tries to combine its traditional strategy of cost-cutting with bits and pieces of innovation, it will become “stuck in the middle” (as our old undergrad strategy textbook used to call it), neither fish nor fowl — in other words, like HP for much of the past decade.

The problem instead appears to be execution. When Dell comes out with products, then need to be good ones, even if they’re not first to market. As the news article in CNET made clear, the company needs to improve its product design:

[Dell] promised that the PC maker will not be a technology laggard going forward.

"We've tripled our resources in design and user experience," the company's founder and CEO said in an interview with technology journalist Walt Mossberg at the D6 conference here.

Business execs (like politicians and even judges) lose their way when they care about what other people think of them, rather than doing what they know is right. For Dell’s shareholders, let’s hope that Michael Dell returns to his winning formula, suitably updated to allow for today’s greater consumer expectations of product design and usability.