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To Dell and Back
By Robert Hunter
TODAY I FIND myself asking a question that's become a rite of spring for journalists around the country: Where's my damn Pulitzer?
With all due respect to New York Times columnist Thomas Friedman, who picked up his third award Monday, I was robbed. Sure, Friedman's trenchant and emotionally charged commentary on the Middle East last year was powerfully affecting. I'd go so far as to say that if he weren't so rumpled looking he could be a Major Television Personality, like, say, Alan Keyes.
But, hello?!?!? Did the Pulitzer committee not see my Sept. 7 column about Dell Computer (NASDAQ:DELL - news) entitled ``The PC Market Is Going Straight to Dell''? Besides making readers lots of money, I also talked about the future of the PC business with unusual precision and clarity. There were several informative charts and graphs, and I put things in context by referring to related topics like former Yahoo (NASDAQ:YHOO - news) Chief Executive Tim Koogle's hairstyle. Surely a package of content like that is worthy of some Pulitzer consideration, no?
Friedman's sycophantic fan club might argue that the other 40-odd columns I wrote last year were hastily researched, poorly written and generally in bad taste. True enough. And I'd even acknowledge that some of my Dell column was mere conventional wisdom. My first contention — that the company would benefit from the disastrous merger of Hewlett-Packard (NYSE:HWP - news) and Compaq Computer (NYSE:CPQ - news) — was the same view the market took in sending Hewlett's stock down 20% and Dell's stock up 0.5% in the two days following the merger announcement. Nonetheless, if you bought Hewlett stock based on the advice of Merrill Lynch analyst Tom Kraemer, who wrote on the day of the announcement that ``this move makes HP look much more like IBM (NYSE:IBM - news) and, in our opinion, makes strategic sense,'' you've lost 26% thus far. If you bought Dell based on my advice, you've made 25%. Talk about views you can use.
What was especially novel about the column, however, was that it laid out a rough time-table of when you should think about moving your money elsewhere. Not only was I right about that — events have progressed even faster than I predicted.
Dell has benefited from the Hew-Paq merger in a major way, just as many said it would. Last week, at its annual analyst conference, Dell made a series of announcements that were surprisingly positive given the PC industry's troubles. The big headline grabber: The company said it expects first-quarter revenues to come in at $7.9 billion, a 2% decline from the typically busy February quarter but $200 million greater than Wall Street's expectation.
But it was Dell's announcement that it would double revenues, to about $60 billion, in the next four to five years that was truly remarkable. The goal implies annual revenue growth of 15% to 19%. How can it pull off such a feat? Dell says it'll approach the enterprise market (servers, storage and networking in particular) with the same cost-conscious fervor that fueled its growth in the PC market. By 2007, for example, Dell says its nascent LAN-switches business should rake in annual sales of $1.5 billion. It did, however, predicate this long-term revenue goal on a robust economy and a stronger corporate IT market — assumptions that could prove a bit too rosy.
Dell also impressed analysts by promising even more cost cutting. Last year, the company shaved $1 billion from its operating expenses, mostly through staff reductions and facility realignments. This year, Dell says, it can cut more than $1 billion, with continued facilities adjustments as well as product-design savings, supply-chain improvements and other overhead reductions. To be sure, the easy cuts have already been made, and some analysts think the next round of cuts will be tougher to pull off. But Dell deserves the benefit of the doubt here, given its track record.
Indeed, Dell's cost-cutting obsession has helped it gain significant market share. In 2001, Dell vaulted from No. 5 to No. 1 in the global PC market, thanks to a vicious yearlong price war. And Dell thinks its position is continuing to improve in 2002. President and Chief Operating Officer Kevin Rollins told analysts last week that ``without a doubt'' Dell had benefited from the Hew-Paq merger. ``Companies will no longer have those two to keep each other honest, so we're getting invited in,'' he said. ``More and more doors are opening up to us.''
This company is nothing if not confident. But excessive confidence might ultimately be Dell's undoing. Back in September, I wrote that Dell's business model — achieving ever-greater efficiencies to drive down prices and gain market share — wasn't enough to prosper in the PC land of the future. Businesses are upgrading computers less often these days, and consumers aren't bucking up for a new gray box every year or two as they once did. Instead, I argued, Dell should be busy innovating, creating the next generation of personal computers or digital hubs or whatever they'll ultimately be called. This criticism still applies — and perhaps even more so.
First, the short-run concern. Since Dell is gleefully forsaking pricing power to grab market share, it will find it increasingly difficult to lay off any rising costs on customers. This seems to be happening already. Dell's first-quarter revenue upside should have produced a corresponding uptick in earnings — but Dell stood by its previous guidance of 16 cents a share. That means its profit margins are being squeezed. The biggest culprit: rising components prices, particularly for DRAM memory chips and flat-panel monitors. When profit margins were fatter, minor bumps in components prices weren't reason for alarm. From now on, they will be.
In the long run, Dell's stubborn commitment to its business model could prove costly — particularly in the PC market, which, by now, has clearly petered out. According to a March study by Odyssey Consulting, 39% of American households don't own a PC — unchanged from 2001. The biggest reason those households continue their boycott: They see no compelling reason to own a PC. Companies like Apple Computer (NASDAQ:AAPL - news), Sony (NYSE:SNE - news) and Microsoft (NASDAQ:MSFT - news) are trying to create the next-generation machine that'll woo even the staunchest holdouts. Dell has no interest in doing so. Instead, it believes, arrogantly, that it can swoop in and produce whichever machine the market settles on at a lower cost than its creator, driving down prices and grabbing market share. But is any business model really so perfect that management can bet the future on it, rather than on the products the company creates? I don't think so. No business model is forever.
The stakes are especially high in the new markets Dell is trying to break into — namely the enterprise IT market, which will drive the company's growth in the next few years. Its strategy took shape last October, when Dell announced that it was teaming up with EMC (NYSE:EMC - news) to resell EMC's storage products. The move was an admission that the parsimonious Dell's efforts to build its own storage business had failed. From now on, Dell will join up with existing players initially, with the ultimate goal of commoditizing, cutting costs and improving profit margins. A Dell spokeswoman says the company is confident that it will succeed.
The thing is, enterprise products aren't standardized, and might never lend themselves to Dell's approach. Moreover, if the economy and IT spending remain soft, you can kiss Dell's ambitious — to say the least — revenue goals goodbye. Dell sees itself as competing with HP and IBM in the enterprise market. But these companies are among the most innovative around. I'm skeptical Dell will make much of a dent without creating compelling new products in its own right.
Despite all of this, Dell's stock remains pricey, trading at around 36 times current-year earnings estimates. Should a company that refuses to innovate despite a stagnant core market be rewarded with such a high multiple? Nope.
So if you listened to me last September and racked up a quick 25% gain, congratulations. Now, you'd be wise to take your profit and move on. There are plenty of other widget makers out there to choose from — and they don't come with preloaded Managerial Hubris 1.0.
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