Does Dell Stack Up?

The company that triumphed by selling ''good enough'' technology wants to challenge IBM and Hewlett-Packard. Is it good enough?
Russ BanhamOctober 1, 2003

When Michael Dell, chairman and CEO of Dell Inc., made the startling pronouncement last year that the Round Rock, Texas-based technology giant will double its revenues to $60 billion during the next several years, he sent a clear signal that the company plans to move well beyond its PC roots. Achieving growth of that sort in a weak economy will require many things, first among them a strong commitment to corporate customers. Those customers have snapped up Dell’s low-cost PCs and servers in astounding numbers, but will they give Dell the same respect accorded to the two unquestioned leaders in corporate IT, IBM and Hewlett-Packard?

That question is very much on the mind of Dell CFO Jim Schneider, who joined the company in 1996, the year in which it made its first foray into the enterprise space, with low-cost (and low-end) servers. “There’s good news and bad news about being in finance here,” says Schneider. “The good news is you’re involved in everything. The bad news is you’re involved in everything.”

To date, he has been involved in plenty of cost cutting, helping to trim $1.3 billion last year. But despite Dell’s vaunted efficiencies, his work is far from done. Michael Dell has said that his ambitious revenue target will co-exist with a further $2 billion in cost cuts. “In this business, you grow or die,” says Dell. “At the moment, enterprise computing offers us the best revenue growth and market-share opportunities.”

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How does Dell plan to grow so fast and become ever leaner? Primarily by moving “up the stack,” extending its proven business model to a range of products and services essential to corporate computing. It’s a path Dell has followed for several years, and if Merrill Lynch’s projection of 27 percent annual growth in enterprise product sales through 2006 hits the mark, analysts believe $60 billion is possible—even with a modest 5 percent annual growth in Dell’s core PC, notebook, and workstation business. “I think it’s doable,” says Merrill Lynch analyst and first vice president Steven Milunovich. “As various technologies commoditize over time, Dell’s direct-to-the-customer strategy presents a highly attractive cost advantage that’s tough to ignore.”

The company has been steadily expanding its array of business-oriented products for several years. It introduced servers in 1996, enterprise storage equipment in 1998, storage-area networks in 1999, network switching equipment in 2001, and printers and projectors just this year. In fact, the company tries to downplay any notion that it is a recent entrant in the corporate space, but it’s clear from Michael Dell’s comments and other developments that the company is now targeting enterprise customers like never before. The key question for Dell will be whether it can be a true enterprise player simply by doing more of what it does well or whether it will have to make fundamental additions and changes to a business model that has performed almost flawlessly.

A Focus on Finance

Dell founded his eponymous company in 1984 on a simple concept—a direct business model that eliminates retailers, which add time and cost to moving and selling products. The model allowed Dell to build every product to order, from a home PC to network switches, at very competitive prices. “Dell is the poster child for built-to-order technology,” says Navi Radjou, principal analyst at Cambridge, Massachusetts-based Forrester Research. “If you look at IBM and HP, they tend to produce equipment based on forecasted demand. That requires them to source adequate material and have enough inventory and capacity available to meet the projected demand. Dell’s model is the reverse—sell first, build later.”

CFO Schneider says that makes his job demanding, to say the least. “When we enter a quarter, I have to tell Wall Street how we stand, even though we have little or nothing booked yet. I’m envious of other CFOs who enter a quarter with a backlog and already know whether they’ll make their numbers,” he says.

Fortunately, Schneider says, Dell’s staff understands that. “Everyone here is very analytical and has a good finance bent,” he says. “They know that if they’re not focused on finance, we can’t survive.”

The company has no more than two hours’ worth of inventory at any time, and no more than three days of inventory across its entire value chain. Inventory turns at an astounding 73 times a year, compared with an average 5.4 times across the high-tech industry. “Dell’s inventory turns at a rate well above the average for the industry, so not surprisingly, Dell enjoys an industry-leading negative cash-conversion cycle of 37 days,” says Radjou.

As impressive as that is, Dell faces a number of challenges and questions. For example, will an improving economy dampen its low-cost appeal? The company has benefited in the past three years from the economic downturn’s impact on cash-strapped IT budgets, making its various lines of low-cost hardware, storage solutions, and services cost-effective buys. But if IT budgets expand, enterprise customers may opt for more-expensive, higher functionality gear from Dell’s competitors. And with component prices firming, Dell may have difficulty reducing costs further even as competitors such as HP vow to price more aggressively.

There are other potential impediments: Dell’s professional services have been criticized by some customers and even some technology analysts who are otherwise bullish on the company’s prospects. Services make up $4 billion of Dell’s revenues today, but the company is hoping to more than double that in the next few years to make good on the CEO’s $60 billion projection.

Then there’s IBM, which is not only closing its cost/performance gap with Dell but is also expected to challenge the company at its own game: Big Blue will cut prices on enterprise products in 2004, thanks to a successful supply-chain initiative that saved $5.6 billion last year and will save an anticipated $6 billion this year.

Another question is whether Dell’s reliance on standardization will actually work against it. “Dell likes to wait until the components that go into a product are standardized and available from a number of suppliers at competitive prices,” explains Richard Gardner, a securities analyst and managing director at the San Francisco office of Smith Barney. “Then it enters the field with the same kind of manufacturing and fulfillment expertise that it brought to PCs.”

Translation: Dell is innovative as far as its processes go, but not necessarily with its products. Last year, according to information provided by Dell, the company spent only 1.3 percent of its $35.4 billion in sales on R&D, compared with 5 percent by HP, 6 percent by IBM, and 10.5 percent by the technology industry on average.

“Dell benefits from others’ technological breakthroughs,” says Mark Melenovsky, an analyst at IDC in Framingham, Massachusetts. “By competing in a standards-driven market, it leverages the R&D of other companies.” Michael Dell rejects the idea that his company is merely a techno-mimic, pointing out that it holds some 750 patents.

Still, whereas other vendors strive to be the first with a new technology, Dell plays a different game. “They let others do the innovations, wait until they become standardized, and then move in with their own version of the product,” says Galen Schreck, a Forrester analyst. “Meanwhile, other vendors are adding fluff to increase market share—little tack-ons to their products that aren’t really necessary and add cost. Dell cuts right through that, figuring out what customers must have without the fluff. There are many places where Dell is ‘good enough,’ a quality product from a name brand that you don’t have to pay a premium for.”

Customer Perspectives

That approach earns both praise and caution from customers. “We migrated from Sun Microsystems to Dell for cost reasons,” says Bill Hicks, senior vice president of IT at Precision Response Corp., a Plantation, Florida-based customer-care outsourcing service provider. “Four years ago, we had standardized Dell on the desktop when Dell pitched the idea of clustering four of its servers to give us the processing speeds we needed to run our database infrastructure—basically what the one server from Sun was doing for a lot more money, given the cost of maintaining, upgrading, and supporting the system. Dell charges no maintenance fees for the first three years.”

Tom Jennings, Precision’s CFO at the time (he left the company in July), ran the numbers and figured a return on investment within nine months, given monthly savings of $18,000. But cost was not the only reason for the migration. “Down the road, we expect additional savings due to the flexibility of clusters,” explains Jennings. “If we need more power, we simply add another inexpensive server to the cluster. And if one of the servers shuts down for some reason, the other three keep functioning. When the Sun big box failed, the whole thing failed.”

The advent of clustering—the tying together of standard off-the-shelf PCs, modular servers, switches, and storage systems into veritable supercomputers with very high capacity-utilization rates—has broadened Dell’s enterprise appeal. Clustered systems are inexpensive, easy to upgrade and maintain, and scalable. Dell ranks number one in the Intel-based cluster market with a 37.1 percent market share, and in the first quarter, it sold and installed 96 clusters, up from 85 in the previous quarter.

Dell’s increasing technological sophistication pleases many customers, but it’s rarely what wins an initial sale. A case in point is Noveon Inc., a Cleveland, Ohio-based diversified chemical manufacturer and distributor with $1.1 billion in 2002 revenues and 30 locations worldwide. Noveon became a Dell client last year when it bought 1,200 desktop and laptop PCs, then purchased a cluster of 100 servers for routine tasks such as file and print and E-mail, and added storage equipment from Dell and EMC. Noveon also selected Dell’s services arm to develop an infrastructure road map. “Dell’s price on the PCs got them in the door, and we thought that would be the end of it,” says Todd Nelson, Noveon’s vice president of global IT.

“But during the rollout of the PCs, Dell provided a few servers and we liked them. When we started to plan our infrastructure road map, they offered their services. We checked with our consultant at Meta Group thinking maybe they were not a real player, and then compared Dell’s references against other vendors, like IBM, Compaq, and HP, that had presented bids for the hardware and infrastructure consulting services, and Dell was stronger.”

But when it came time to buy network switching equipment, Noveon stuck with Cisco. And it also passed on a bid from Dell to provide global outsourcing services for PC help-desk support.

For others, doubts run deeper. Online Taxes Inc. recently switched to hosted IBM servers because of what it perceived as Dell’s inferior service. “I was worried about Dell’s technical expertise to provide what I needed,” says William White, president of the St. Joseph, Missouri-based Internet income-tax preparation company. “They couldn’t point me in the right direction when I had a problem. The last thing I wanted was the plug pulled during tax season. Basically, they lost a good customer.” White says he recently signed a half-million-dollar contract with IBM, “but if I needed a new PC, I’d log on to Dell’s Website in a minute to buy it.”

One thing seems certain: Dell’s move up the stack will be fiscally conservative: no huge acquisitions of the HP-Compaq or IBM-PricewaterhouseCoopers variety. Dell tried that in 1999, buying Convergenet Technologies as part of its entrance into the enterprise storage market. The company was long on R&D talent but short on product, and when dreams of an initial public offering failed to materialize, many engineers bailed, leaving Dell with little to show for its trouble.

Today, the company seems more interested in partnerships than sole domination. It has a strategic relationship with EMC, a market leader in information-storage systems, software, networks, and services, under which Dell manufactures the Dell/EMC CX200, bringing in annual revenue of more than $1.2 billion ($320 million in the last quarter). It’s a critical arrangement for Dell because, as Smith Barney’s Gardner notes, “Dell’s move up the chain to larger enterprises requires a more sophisticated storage line with things like data mirroring and backup. EMC brings these functionalities to the table.”

In April, Michael Dell and Oracle CEO Larry Ellison announced a partnership whereby Dell’s clustered servers and Oracle’s database would be sold together, optimized for the Linux operating system and thus aimed squarely at corporate data centers. Prior to that, it partnered with Lexmark, a Lexington, Kentucky-based printer manufacturer, to produce its own line of laser and inkjet printers. Dell projects that printing represents a market opportunity of about $50 billion. Although its current 1 percent market share is trivial, its low-price inkjet and laser printers (about $150 and $300, respectively) are expected to give market leader HP stiff price competition in an area that has been a major profit center for HP.

In addition to partnerships, Dell’s fortunes may hinge on its ability to simply bide its time. Consider network switches, yet another area in which Dell’s value proposition is low price. “They’re offering a commodity line of stackable switches, which have all the features a midrange enterprise needs to get by,” says Forrester’s Schreck. “They don’t really compete against Cisco, which supplies the giant pipes. But when you open the door to the wiring closet, you might see Dell switches reaching out to the cubicles. That’s their play. For now.” But as the networking business becomes more commoditized, Schreck predicts that Dell will “chew its way into more expensive gear. They’ve always been disciplined about knowing when to enter a market—it’s the thing that really sets them apart.”

Dell is also betting that companies will show discipline as well. “There was a lot of excess spending on high-priced technology that didn’t make sense during the Internet bubble in the late ’90s,” says Michael Dell. “Companies are smarter now. More are investing in standards-based technology because of the tremendous value it provides, as much as 90 percent less in cost while achieving new levels of computing power.”

As for making good on the further $2 billion in cost cuts that Dell has promised, CFO Schneider is unruffled. “I don’t think there is ever a limit to reducing costs,” he says. “If we can take out even a few cents per unit by tweaking our manufacturing processes and supply chain, the sheer magnitude of units we sell adds up to a billion dollars of savings pretty quickly. Our attention to controlling operating expenses remains relentless.” Michael Dell has the utmost confidence in Schneider’s ability to slash and build. “Jim is a master at making the Dell business model sing,” he says.

Dell’s emphasis on low-cost, standards-based computing is certain to appeal to CFOs, and to force IBM, HP, and others to take Dell very seriously across its ever-expanding product line. At the same time, its competitors will seek to copy what they can and tout what sets them apart, be it fat R&D budgets, services and consulting expertise, or deep experience in addressing corporate IT needs. That should all be good news for cash-strapped corporate customers. Good enough, anyway.

Russ Banham is a Seattle-based writer. He is the author of The Ford Century, a 100-year history of Ford Motor Co.

Selective Service

One knock against Dell as a more broadly focused enterprise supplier of IT has been its spotty service offerings. Forrester Research analyst Galen Schreck chides the company’s management services as “spartan.”

“They’re focused on physical deployment—you buy 100 servers from them and they send in someone to come out and configure them,” says Schreck. He dubs that the “Home Depot” model. “You go to Home Depot, or Dell, because you want the products, not the help. But you go to IBM because you want the help. Maybe after you spend $1 million at Dell, you go to IBM and spend another $5 million on services. That’s a missed opportunity for Dell,” he says.

Dell CFO Jim Schneider agrees that the company needs to add more muscle, but for now he believes its new flat-rate menu-type approach to professional services will drive more business and revenues. “When I came here, we didn’t have an enterprise business, and this quarter it will represent more than $2 billion in revenues,” he says. “Certainly, we want to be in a position to help companies get on the platforms we sell and support. We did one acquisition to beef up services [the May 2002 acquisition of Plural] and would like to find others that fit. We’ve also hired some people to build this organically. But in terms of scale, you’re not going to hear any acquisition announcements that will cause your jaw to hit the table. We’re not going to buy EDS.”

Schneider points to surveys that speak well of Dell as a service company, such as its top ranking by Technology Business Research in customer satisfaction in Intel-based servers for 21 of the past 22 quarters. “I’m not going to say the phones don’t get tough to answer during the holiday season,” says Schneider. “When you’re selling 6 million units in a quarter, there will be some questions. But we typically come out on top in third-party surveys.” —R.B.

But the gulf between PC-oriented customer service and high-end corporate services is a large one. Schneider says that Dell aims to satisfy every customer, “from consumers to GE.” —R.B.

Pay as You Grow

As Dell CFO Jim Schneider continues to focus on cost cutting, some analysts have speculated that salaries may not be a place to look. Dell’s recent decision to reduce stock-option grants may force it to hike the cash compensation of executives in order to retain top talent, some say. In fact, some analysts argue that Dell’s operating margins were artificially inflated in recent years because it gave such a big chunk of compensation in options. Schneider agrees that changes are in order, but disputes the idea that salaries will need to be bumped up to compensate for a rescinded perk. “We were giving options to everyone, including lower-level administrative employees,” he says. “I’d lunch with them and ask them, ‘If I give you 1,000 options that might have a value of $15,000 someday or $500 right now, which would you prefer?’ And they said the latter.”

Schneider says the change in Dell’s approach to options is almost inevitable. “We’re not a young, immature company anymore. When you’re young, you give more options out to attract people. But now we’re an established, large-cap company. People in this environment don’t value options like they did a few years ago. That led us to reduce options.”

The goal, Schneider says, is to be competitive with peer companies, and “frankly, we were above our peer group in giving out options.” So down with options, up with cash? Not necessarily. “We don’t believe we need to increase cash compensation significantly across the board to make everyone whole,” says Schneider. —R.B.