Whose Lunch Will Dell Eat Next?
Dell Computer Corp. (DELL ) and Hewlett-Packard Co. (HPQ ) compete fiercely in the personal-computer market, yet they have had a cozy relationship in printers for the past four years. Dell hawked HP printers and ink cartridges in a deal that generated more than $100 million a year for HP. But on July 18, Dell said it plans to launch its own line of printers by yearend. Five days later, HP fired off a terse letter to Dell, cutting off all printer shipments immediately. Dell doesn't care. It's bent on dinging HP's most profitable business--printers.
With rivals back on their heels because of the soft economy, Dell is playing hardball. It's moving aggressively into a broad range of new markets, including printers, handheld computers, storage, and networking gear. And it's swinging for the fences: By 2007, the Austin (Tex.) company wants to double sales, to $60 billion, with half of that coming from non-PC businesses--compared with a mere 19% of its $32 billion revenue today.
That's a Texas-size stretch goal. Sure, growing the PC business from $26 billion to $30 billion over the next five years is reasonable. But to deliver the other $30 billion in revenues, Dell will have to expand sales in non-PC categories a scorching 38% a year. With growth in markets such as printers, computers, and storage slowing, probably to single digits, Dell would have to make its numbers out of the skin of HP, IBM (IBM ), Sun Microsystems (SUNW ), and Cisco Systems (CSCO ). While its efforts in switches and storage look promising, printers and handheld computers will be harder markets to tackle. Add up the numbers, and Dell will have a tough time meeting its $60 billion target. "Those goals imply very aggressive assumptions, particularly in light of anemic hardware growth," says Joel Wagonfeld, an analyst at Banc of America Securities.
Dell's fortunes do look better than its rivals, though. The summer savaging of tech stocks has left Dell largely unscathed. Its $67 billion market capitalization now exceeds those of Oracle (ORCL ), Sun (SUNW ), EMC (EMC ), and even HP. On July 11, Dell raised revenue and profit projections for the second quarter of fiscal 2003, which ends Aug. 2. It said sales for the period would hit $8.3 billion, a 9% increase from last year, and earnings would be about $508 million, a 17% jump from last year, excluding a $742 million restructuring charge.
To rev growth, the 18-year-old company plans to bring the superefficient business model it perfected in the PC business into new markets. The formula is simple: sell directly to customers to cut out costly middlemen, buy components in huge volumes to get the lowest prices, and force suppliers to locate within a few miles of Dell's facilities so parts can be delivered only hours before they're needed. Such supply-chain efficiency allows Dell to radically undercut rivals' prices. The resulting price wars suck profits out of a business until only Dell can make money.
It worked like a charm in the server market. When Dell started selling low-end servers in 1996, market leader Compaq Computer Corp. enjoyed gross profit margins north of 40%. Today, they're half that, Compaq is no longer independent, and Dell is the second-largest seller of low-end servers, with 20% of the market, compared with 35% for the combined HP and Compaq.
Now, Dell is ready to run the same play in other sectors. BusinessWeek has learned that on Aug. 12, Dell and partner EMC Corp. will bring out the first model in a new family of storage devices aimed squarely at the slice of the storage market dominated by HP. The new boxes, ranging in price from $30,000 to $140,000, will be designed by EMC, and at least one will be manufactured by Dell. Analysts say the duo could slash average storage prices to 1 1/2 cents a megabyte, down from 3 cents today.
No company will feel the pressure from Dell's moves more than HP. Since its $19 billion acquisition of Compaq this year, HP is Dell's most formidable competitor, with the largest market share in PCs and low-end servers. HP's printing-and-imaging division is its cash cow, expected to record operating profits of $2.8 billion for fiscal 2002, which ends Oct. 31, according to Credit Suisse First Boston. Those profits help HP offset losses in PCS, servers, and storage, which are expected to total $1 billion this year. But now, Dell is gunning for those earnings. "There's a profit pool that some of our competitors are using to subsidize the PC and server business," Kevin B. Rollins, Dell's president and chief operating officer, told analysts on July 9. "That's something we have to go after."
HP has reason to worry. Dell takes only a small percentage of the estimated $600 million to $1 billion in printers that it resells yearly for HP, Lexmark International, Canon, and Epson. That could change, however, if Dell sells printers and ink under its own brand. Although Dell has yet to outline its plans, analyst Charles Wolf of Needham & Co. says it is likely to break into the business by striking a deal with one of HP's rivals, perhaps Lexmark or Epson. Dell would buy printers and cartridges from its partner, then start gobbling up market share by slashing current prices by as much as half, starting a price war that would puncture the industry's 60% gross profit margins. Dell has plenty of room to cut prices. It operates at a lean 10% operating expense-to-revenue rate, compared with 21% for HP. Dell could wind up wiping out 25% of HP's printer profits, Wolf estimates.
At first blush, printing would appear to be a tough market for Dell to crack. Getting an existing player to go along with a price war could be difficult since that would damage its cushy profit margins. Distribution also could be a headache. Dell's hallmark is direct sales, but most printers and ink cartridges are sold through dealers and retail stores. Meanwhile, HP, which has a 41% market share according to Lyra Research Inc., is in the midst of launching 50 new ink-jet printers this year, the result of $1.2 billion invested in new technology. "We're not sitting here panicked," says Chris Morgan, vice-president for sales and marketing at HP's printing-and-imaging business.
Still, Dell holds key advantages. It can offer volume discounts on components and expertise in manufacturing and distribution that should help it lure a manufacturing partner. It also holds out the opportunity for huge sales volume. "If Dell can compete quality- and price-wise with HP, printers will be a big hit," says Scott D. Phillips, systems administrator at First Magnus Financial Corp., a Tucson bank that buys servers and switches from Dell. Lexmark and Epson declined comment.
Dell is trying to use its trademark efficiency to reset the economics of other industries. It's pushing into the market for switches, which direct traffic on computer networks, putting it on a collision course with Cisco Systems Inc. and 3Com Corp. (COMS ) Cisco is the behemoth of the $15 billion market, with a 60% share. But with the slowing economy, customers are more interested in price and convenience than whizzy technology, says IDC analyst Jason D. Smolek. That gives Dell an opening: After introducing bare-bones switches last year, the company released more sophisticated switches in June that undercut the prices of products from Cisco and others by over 50%.
One new market is proving ticklish for Dell. The company is considering moving into handheld computers, where Palm Inc. is the top player, with a 32% share, and HP is second, with 19%. The appeal? Gross margins are better than 20%, nearly twice those of PCs, analysts estimate. But when Dell approached manufacturers in Taiwan about making a device that sells for $299--that's $200 less than the cheapest HP iPAQ--some balked, saying that they couldn't make a profit at that price. Still, analysts think Dell may find a partner and offer its own device by Christmas. "The question is: Do you want to be the one who gets the volume or not?" says Needham's Wolf.
Dell isn't slowing down in the PC business, either. The company, which does 80% of its business with corporate customers, has long eschewed the consumer-PC market. But with competitors such as Gateway Inc. hurting, Dell is going for the jugular. While the overall U.S. home PC market declined 6% in the first quarter, Dell's revenues zoomed 74%, to $1 billion, shooting it to No. 2 from No. 4, according to IDC. Now, Dell is broadening its lineup of ready-built PCs and opening kiosks in shopping malls, where it can reach consumers face-to-face for the first time.
Clearly, Dell thinks this is the time to hit its competitors hard. "This is a well-thought-out chess game," says Andrew J. Neff, senior managing director at Bear, Stearns & Co. The question is, are Dell's rivals watching the board?
By Andrew Park in Dallas, with Faith Keenan in Boston and Cliff Edwards in San Mateo, Calif.