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Dell: Time for a New Model?

By Olga Kharif Back in 1984, Michael Dell started a computer company with $1,000 and a cool new idea: To sell PCs directly to consumers, bypassing retail stores and system integrators and offering limited customer support but dramatically lower prices.

For years, that direct, low-cost sales model worked perfectly. It allowed Dell (DELL) to make high margins while selling computer gear for less than its rivals. As a result, it now holds a leading 17.9% share of the world PC market and has grown much faster than competitors Hewlett-Packard (HPQ) and IBM (IBM). But lately, this same sales approach might be hampering Dell's growth.

Increasingly, industry analysts believe it's time for Dell to tweak its sales model. After all, times have changed. And to keep growing Dell may need to change, too, and not just in appearance -- last summer Kevin Rollins took the CEO reins from Michael Dell.

MIGHTY HIGH TARGET. As things stand, Dell's growth prospects are less than stellar. Even after recent downward revisions, the Street's expectations might still be too high. While most analysts predict 20% earnings growth in the next few years, 16% to 18% might be more realistic, says Zack Schroeder, an analyst with BB&T Asset Management in Raleigh, N.C. And while the consensus projects sales to rise 16% in that period. Schroeder believes 12% to 15% will be more like it.

Such growth concerns have sent Dell's stock down 7.5%, to $39, since January. Dell claims that growth will come.

After the market close on April 6, Dell reaffirmed its guidance for the fiscal first quarter, when it expects to earn $0.37 a share, up 32% from the prior year, on $13.$4 billion in sales, a 16% increase on the year-ago quarter. The company also announced it will spend $2 billion on its stock repurchase program in the current quarter, more than double its prior guidance. During its analyst conference slated for Apr. 7, Rollins is expected to outline his plans for turning Dell, with $49.2 billion in revenue last year, into an $80 billion company within three to four years. That target may take longer to reach if Dell's growth slows down.

SOFTWARE AND SUPPORT. Today, Dell's stripped-down service is working against it in many new markets. In servers, rivals like Fujitsu and IBM can now not only meet Dell on cost (IBM's Express boxes sell for less than $500, similar to low-end Dell servers), but also offer many more services, says Susan Eustace, co-founder of tech consultancy WinterGreen Research in Lexington, Mass.

For instance, IBM can help its small-business and corporate customers integrate disparate software systems, like payroll and inventory. "The [server] product is a commodity, and the differentiation is to be able to offer software and support," says Eustace. And as Dell is weaker than IBM in both, she believes its 4.2% world market share in low-end servers will actually decline in the next year.

While Dell's overall server sales might still grow (demand for such boxes should skyrocket in the next five years, thanks to wider adoption of videoconferencing and over-the-Internet calling), Dell will need to strike more partnerships or beef up its services through acquisitions to keep up with the market, Eustace says.

TOO FAR AWAY. Dell's lack of retail presence could hurt as well. In desktop and notebook PCs -- which contribute 79% of sales -- much future growth will come from outside of Dell's U.S. stronghold, where PC sales have slowed. About 80% of total PC unit sales from now to 2010 will come from developing markets like China and India, according to tech consultancy Forrester Research. But Dell is struggling there.

Here's why: Because of cultural and technological reasons, customers in those markets buy computers from stores and system integrators, says Forrester analyst Simon Yates. That's not surprising, considering that in India, where PC ownership should jump from 7.9 million units to 78 million by 2010, most people don't have Web access. Many rural areas lack phone lines, and most people know little about computers. So they go to local stores or computer specialists to ask for advice and to make their purchases.

And because Dell doesn't have a strong presence there, consumers buy their computers from local heavyweight HCL Technologies, HP, and IBM, whose PC division is now owned by China's Lenovo. As a result, Dell gets a measly 4% share China's PC shipments, according to tech consultancy IDC.

EURO SLIPPAGE. In India, China, and many other fast-developing markets, Dell's market share has barely moved up over the past year. "We're going against competitors who've been in the business there much longer," argues a Dell spokesperson. "We feel good about our growth. We'll just have to expand our customer relationships."

But even in Europe, where Dell slightly raised its share of the overall PC market in 2004, it's losing ground in notebooks, the fastest-growing PC segment. From fourth-quarter 2003 to the same period last year, Dell's market share slipped from 8.4% to 8.3%, according to IDC. Such declines -- this time, to Taiwanese manufacturer Acer -- used to be as foreign to Dell as high prices.

What's happening? "In a lot of countries, it's very hard to reach customers without the retail presence," explains Roger Kay, an analyst at IDC.

THREE OPTIONS. The consequences of that reach far beyond PCs. Today, more than 80% of Dell's printers -- a product line that has generated lots of buzz among financial analysts in the past year -- are sold or given away with purchases of PCs, says Charles LeCompte, president of imaging consultancy Lyra Research in Newtonville, Mass. Thus, the lower the PC sales growth, the lower, potentially, are the printer sales.

Bottom line: Dell has three options. One, it could stick with the direct-sales model, waiting for markets like India and China to mature technologically. Two, it could exit the PC business, as IBM has done. Or three, it could establish more of a retail presence in developing countries to ensure that it grabs a chunk of their PC sales in the next few years. That can be done through a partnership with or purchase of a local manufacturer already commanding a substantial market lead over U.S. companies in countries like India and Russia. Or Dell could set up relationships with retailers and system integrators in these countries.

For the time being, however, Dell says it's sticking with option No. 1. "We're completely committed to the direct-sales model and have no plans to go retail outside of the U.S.," says a Dell spokesperson.

MURKY OUTLOOK. Indeed, investors wouldn't likely be enthusiastic about any moves away from the direct-sales model. After all, that could reduce Dell's margins. Today, at 8.6%, they're way higher than HP's 5.4%. However, much faster revenue growth that might result from modifying that model could cover up some of that disappointment. More important, it might allow Dell to reach its $80 billion target faster.

Of course, even if Dell's growth slows as expected, chances are investors will stick with the stock. After all, most other tech companies can't grow above the high single digits, says Larry Eakin, senior director of large-cap-growth equity at Armada Funds. Yet, Dell shares have already lost some ground, and for the first time in years, the future looks murky. Times have changed. Maybe Dell should, too. Kharif is a reporter for BusinessWeek Online in Portland, Ore.

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