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DELL INC.
For Dell, PC business gets tougher
Rivals have closed the gap on costs, forcing Round Rock giant to respond.
AMERICAN-STATESMAN STAFF
Monday, May 15, 2006
At Hewlett-Packard Co.'s sprawling campus north of Houston, workers still build servers that power corporate computer networks and Web sites.
But the production lines for desktop and notebook computers are long gone. Like most of the industry — Round Rock-based Dell Inc. being the key exception — H-P farmed out the bulk of its personal computer production to other manufacturers years ago.
It's a decision that's starting to pay off. After a decade of playing catch-up, the rest of the PC industry is on Dell's heels, having sharply reduced Dell's cost advantage in building computers.
The world's No. 1 PC seller still makes a healthier profit on computers than anyone else in the industry, but its top competitors — H-P in particular — are starting to rival its manufacturing and supply-chain prowess.
"It may not happen uniformly, across the board," technology analyst Roger Kay said, "but at a given moment, you can take a snapshot and find there's not much difference in H-P's costs and Dell's costs."
The results will be clearer this week, when the two companies report financial results. Dell has warned that its first-quarter profit would be less than forecast.
"It's still about $1 billion in profit," Dell spokesman Jess Blackburn said. "We're still in business."
Still, the warning prompted alarm from investors, and some analysts downgraded the stock on fears of a challenge to the core of Dell's business model. The nuts and bolts of buying parts, assembling them and shipping the finished products aren't sexy, but it's where the money is made or lost in the personal computer business.
For all of its stylish iPods and Macintosh computers, Apple Computer Inc. still trails Dell in its share of the computer market by miles. H-P and Lenovo Group Ltd., have stayed in the hunt by fixing the basic building blocks of the business. Recently, they've made some big gains.
For years, Dell's lickety-split manufacturing and supply chain let it undercut everyone else's prices. It still saves shipping expenses by building bulky desktop computers close to where its customers are, at factories like those on Parmer Lane in North Austin.
The company also cut costs by keeping threadbare stores of inventory. The PC divisions at H-P, IBM Corp. and Gateway Inc. were bleeding money just trying to compete.
Those days are gone. After years of trying to replicate Dell's low-cost manufacturing and direct-sales models, IBM, H-P and Gateway outsourced the last of their PC production to contract manufacturers after the tech downturn in 2001.
They adopted more just-in-time manufacturing methods. At the same time, they continued to increase their own direct-sales options.
And notebooks — which all vendors, including Dell, buy from Asian manufacturers — now make up a larger percentage of total PC sales.
As a result, Dell's advantage on inventory costs has been shaved to just 1 percent to 3 percent, Citigroup analyst Richard Gardner said in a research note April 21, when he downgraded the stock to "sell." Five years ago, Dell's advantage was 8 percent to 12 percent.
Though Dell still saves money by selling directly to customers, Gardner said, its now-profitable competitors are willing to eat the middleman's charge paid to retailers, which allows them to cut prices further.
That leaves Dell "with a mere 5 percent price advantage . . . versus 15 to 20 percent five years ago," Gardner wrote.
Dell CEO Kevin Rollins said in February that the company would get more aggressive on pricing to win back market share, but analysts say that will cut into profit margins. It did the same in 2001 and ended up torching competitors and taking their customers — at one point increasing its shipments 16 percent annually while the rest of the industry declined.
But that strategy might not be as successful now that Dell's rivals are getting their houses in better shape.
Until recently, IBM's former PC business was losing millions, enough to persuade Big Blue to sell it to Lenovo Group Ltd. in December 2004. Lenovo, which became the world's No. 3 computer maker with the acquisition, whipped the business into leaner shape and turned a profit on it within a year. It's now headed by Bill Amelio, a former senior executive at Dell.
Gateway remains a shadow of its former self, but it performed enough corporate liposuction to start producing a profit.
Taiwan's Acer Inc. came on the scene more recently, but its aggressive push in Asia and Europe — not to mention its budding U.S. business — is another potent challenge, especially for notebooks.
Reputation tarnished
And Dell has some of its own problems. The company long had used its direct relationships with customers to build a reputation of high-quality products and attentive service. Though Dell has debated claims that its quality and customer service have slipped, there's little doubt its reputation has suffered.
Consumer Reports readers dropped Dell to No. 5 for its service related to desktop computers and No. 4 on notebooks, according to the June issue.
"In the consumer space, we shipped a lot of systems and grew very quickly," Blackburn said. "And we have acknowledged that we did not increase our service and support to meet the demands of a lot of new computer users."
The company has become a whipping boy for bloggers, who have pilloried its customer service with chronicles of bad experiences. Others point to its reduced hardware warranties, which dipped from three years to three months before recently rebounding to a year.
"Once it's lost, even if you make improvements, it's very difficult to convince customers . . . you have improved," said Chris Denove, author of a J.D. Power book titled "Satisfaction: How Every Great Company Listens to the Voice of the Customer."
"A company makes a large mistake allowing its customer service to slip," Denove said. "It's much less expensive to maintain a high level of service."
Dell is spending millions of dollars to shore up and expand after-sale service, product quality and staff training. Its spending on those programs was a key reason its first-quarter profit would fall short of forecasts, the company said. And though analysts disliked the cost, most said Dell made a wise decision to address the issue.
"Dell's direct relationships with customers — and the loyalty and (sales) opportunities that these relationships create — are perhaps the company's most valuable asset," Gardner said in a note May 8, after Dell issued its earnings warning.
If they have customers on the line, Dell's sales reps can push upgrades, peripheral products and enhanced services, all keys to boosting profit on increasingly low-profit machines.
Options limited
Dell would much rather stick to the healthier profits in corporate and government sales. But growth in those markets has slowed in the saturated North American and European markets. And though Dell's sales have risen rapidly in emerging markets such as China, it doesn't draw as big a chunk of its revenue from those areas yet.
Consumer sales are about 15 percent of the company's business, but they're arguably the trickiest to manage. Through the middle of last year, the company swung from consumer prices that were too high to ones that were too low. In the first quarter, Dell's shipment growth trailed the industry average for the first time since at least 1989.
Dell revamped its lineup, cutting prices on the low end while courting gamers on the high end, beefing up its XPS brand and buying custom PC maker Alienware Corp.
Several analysts have suggested Dell take a crack at selling some pre-built computers in retail stores. So far, the company has resisted those calls, saying its direct feedback from customers is too valuable.
Dell also faces challenges selling to small- and midsized businesses, which often buy computers from resellers who also provide service. The practice is even more popular outside the United States, where some of the industry's strongest growth is now.
Resellers have long been a valuable sales channel for H-P and IBM. Dell doesn't have a formal program for resellers, but more of them are getting their machines from the company, an eWeek.com report said Thursday.
Critics also have said Dell has lost sales by not using Advanced Micro Devices Inc.'s chips. That company's Opteron server processors are popular with a growing number of businesses, and some gamers favor its Athlon desktop processors.
Dell continues to use only Intel Corp. processors, though Alienware, which Dell plans to operate as an independent unit, sells AMD-powered machines.
Reluctant to change
Dell seems unlikely to change. At a time when profit margins are under pressure, it is reluctant to add another line of chips that would cost more money in terms of design and support. Rollins and Chairman Michael Dell are quick to point out the company's failed foray into retail more than a decade ago.
Dell's direct model allows customers to customize their machines, rather than buying them as-is off the shelf, Blackburn said. And, he said, "there's no point in adding that extra layer of cost" from retailers.
Kay, who has watched the PC industry for more than a decade, said Dell might benefit from putting some products on store shelves and adding AMD chips.
"Your strengths become your weaknesses," Kay said. "If it worked really well for a really long time, it's hard to get used to the idea that it doesn't work as well anymore.
"It's a great model," he said, "but I think the model needs to be tweaked."
dzehr@statesman.com; 912-5932
