Dell Computer, the no-fuss PC sales machine, has set the standard for a successful direct-distribution company. But Dell is now reworking its bare-bones formula in an attempt to branch out from the PC market into more sophisticated, and profitable, computer systems.


With $31.2 billion in revenues and 28% of the U.S. market share for PCs, Dell is devising a strategy to take on the likes of IBM and Sun Microsystems in the market for servers and other higher-margin business equipment. Dell is also planning to add hand-held devices and printers, long Hewlett-Packard’s profit driver, to its product line. And, for the first time, Dell has said it will begin to work with retail dealers.


Founded by Michael Dell, 37, in his University of Texas dorm room, the company is the master of direct-delivery in the computer industry, carrying only five to seven days of inventory at any time. Competitors have been catching up to Dell, but their cycles are still weeks behind, slowed by their dependency on retail outlets.


“So far, nobody has been able to match Dell,” says Gerard Cachon, professor of operations and information management at Wharton.  With computer prices declining, Cachon adds, Dell’s quick turnaround gives it an added advantage over competitors.


Dell, headquartered in Round Rock, Tx., reported second-quarter revenues of $8.46 billion and earnings of $501 million. Revenues were up 11% over the same quarter a year ago. These figures, however, can’t disguise the PC market’s generally unhealthy outlook. “The basic problem is the desktop PC business is strategically a terrible business,” says David Croson, professor of operations and information management.


While the industry showed signs of revival in the first quarter of 2002, it lost ground again in the second quarter. Worldwide PC shipments in the second quarter of 2002 declined 0.6% from the same period last year, according to preliminary results from Dataquest Inc., a unit of Gartner, Inc.  In the U.S., PC shipments reached 10.6 million units, a 0.8% decline from the previous year.


“The market undoubtedly saw the effects of inventory overhang from the first quarter, but at the same time we have yet to see any significant return to corporate buying, and in the consumer market buying appears to have fallen back further in some regions,” notes Charles Smulders, vice president of Gartner Dataquest’s Computing Platforms Worldwide group.


The second quarter, for the first time, also laid out a new competitive landscape for Dell, following the merger of Hewlett-Packard and Compaq. Hewlett-Packard moved into first place in the worldwide rankings, but just 0.6 percentage points higher than Dell. However, the merged companies’ combined shipments were down 16.1% from a year ago while Dell grew 13%. In the U.S. Hewlett-Packard has an 18% share of the PC market.


“The problem with PCs is that they are a commodity. You can’t make money selling computers for, what is it now, $599?” says Morris Cohen, professor of operations and information management and co-director of the Fishman-Davidson Center for Service and Operations Management. “There hasn’t been a killer app in a few years so if you stick to PCs you’re selling a commodity with a shrinking price and a shrinking margin. Unless there’s some technological push, it’s like selling refrigerators.”


To cope, Cohen adds, Dell is looking to diversify its products and move into more profitable areas, including servers, communication switches and other sophisticated business systems. “They have definitely set a standard for what you call the direct model. Now they are looking at their next generation of systems development and trying to extend and enhance their model throughout the full value-chain and supply-chain network.”


But Dell is not operating in a vacuum. It faces a combined Hewlett-Packard with its own clout in the PC market and with suppliers. “To some extent that’s why Dell wants to do things like printers because they don’t have that and HP-Compaq does,” says Cohen. “Dell is up against a more diversified competitor that has some very profitable lines of business that they don’t have. One approach would be to match them.”


Dell has already experienced some success in higher-end businesses including servers, but that market demands sophisticated customer service. According to Cohen, “Dell is trying to introduce a certain degree of differentiation in the quality of service they provide to their customers right now. They already offer a completely differentiated product because it is made to order. The next challenge is to allow the customer to also specify the speed in terms of the channel of distribution and different types of delivery options …  on a per order basis. That’s the kind of challenge they’re working on now.”


Furthermore, while Dell has enjoyed a strong reputation for consumer service, that reputation has recently taken a hit. “When they saw the market in 2000 starting to soften, they were fast to cut back on labor,” says Cachon. “They do a lot of outsourcing of customer service and some of the service hasn’t really been as good as it should have been. But I doubt that’s going to be something they can’t fix over time.”


Despite its low-margin strategy, Dell has invested in brand development, with television ads featuring its impish Dell Dude proclaiming: “You’re getting a Dell.” But Croson says that may have its limits. “The only way to differentiate from the competition is branding, but constant advertising is expensive and requires cash outflow,” he notes. “Consumers are more sophisticated about the fact that they are buying ‘Intel Inside’ and not Dell outside.”


Finally, Dell is even moving away from its signature direct-distribution model. In August the company announced it would, for the first time, work with computer dealers to sell so-called White Box systems (unbranded individually customized PCs sold in retail stores). This market makes up more than 30% of the nation’s PC sales. Dell has said it is looking for modest revenues of $380 million from this line of business in the first year.


While Dell will sacrifice some of its margins to middlemen dealers, the strategy is not likely to cannibalize its direct, Internet-based business, suggests Cachon. And while Dell may be entrenched in a slow-growing commodity business, it has profited as a financial company, Croson adds. “One thing people don’t know about Dell is that its PC business has really not been all that profitable in the late 1990s. Dell made a lot of money with purely financial transactions, selling put options based on the public perception that its stock was going to go up. They have earned hundreds of millions of dollars through financial transactions which had nothing to do with PCs.” Cohen points to another of Dell’s financial strategies: Because the company doesn’t need to pay its suppliers for 30 days, its tight inventory allows it to hold cash longer than its competitors.


But company earnings are dependent on share-price growth, adds Croson. “It’s like any derivative transaction. As soon as one little thing goes wrong, the problems pile on each other.”


According to him, Dell’s recent strategy announcements signal that the company is grasping for new direction. “I think they are searching for a more profitable strategy. This symptom of floundering around when one strategy isn’t working is a common sign of trouble. They are in a situation now where if they want to grow they have to do something new.”


The choices, he says, are difficult. Sticking with the low-end PC business dooms Dell to tight margins forever. But moving more into high-end products, such as servers, puts Dell in a market glutted with competitors struggling with overcapacity following the Internet bust. “The high-end market is promising but temporarily awful. The low-end is permanently awful. You don’t get a lot of benefit by avoiding the blood bath in the high-end, then going into the scorched earth of the low-end.”


Croson suggests that the company pull back, focus on maintaining customer loyalty and “figure out what the business would look like if it turned into a cash cow rather than floundering around looking for high growth. That might be unacceptable to management [because] it looks like giving up, but you can do a lot worse than that.”


Meanwhile, in the leadership area, Michael Dell, who owns 12% of the stock, remains very much involved in the company’s future. “The rule is that you get rid of the founder fairly soon in the course of a company’s development,” says Cohen. “It’s very rare to see a founder remain in an important role. He or she usually has the major idea and can’t execute. You’ve got to give Michael Dell credit; he’s beaten the odds.”


Cohen suggests that Dell’s newest ideas may create a dangerous lack of focus. “There’s always that risk, but they also have a strategic risk in just staying still. They can afford to try this.”


Dell’s main worry is the unknown, Cachon adds. “The biggest risk to Dell is that the whole concept of a PC could change. What happens if people buy boxes that hook up to their TVs, or there is some radical technological shift. That’s probably their greatest risk over the next five to 10 years.”