... has never been keen on mergers and acquisitions. But as the company strives to climb out of its doldrums, a shopping spree might be just the thing. The company formerly known as the world's No. 1 PC maker is on a mission to revive slumping sales and profit margins, with founder and CEO Michael Dell vowing to shake up everything from internal operations to its famous distribution model.
“DELL GROWS UP?”
Mr. Oreskovic's suggestion reminded me of a paper written by a team of four students in the Freeman School MBA program at Tulane University in December 2004. In that report titled "Dell Grows Up" the student team outlined …
... specific steps for Dell to implement in order to maximize its EBITDA and market cap by Q2 2005. Given the dramatic changes recently announced with IBM (NYSE:IBM) and Lenovo forming a joint venture, Dell must act quickly to seize these opportunities and redefine its place in this evolving strategic group (page 1).
In addition to Dell, the strategic group they analyzed included Hewlett-Packard (NYSE:HPQ); International Business Machines (IBM); and Sun Microsystems Inc. (JAVA). The student team recommended that Dell undertake two strategic acquisitions in order to redefine its competitive position.
One of their recommendations was to acquire Sun: "... acquisition of Sun Microsystems could translate into sales growth of US$ 3 billion (page 16)." Another recommendation was to partner with or acquire Founder Electronics:
Despite having strong ties to the Chinese government, Founder may still be open to a strategic alliance with a strong brand such as Dell to increase their slice of the Chinese PC pie. Furthermore, Founder’s ties to the Chinese government may offer the needed political leverage for Dell’s future success in China. ... Dell stands to realize almost US$ 3 billion in new revenue via an alliance with or acquisition of this firm (Dell Grows Up page 15)."
The purpose of this post is to calculate the loss in market value suffered by Dell shareholders as a result management’s failure of capitalize on strategic acquisition opportunities available in December 2004. For background see Chapter 6 "The Battle for Your Desktop" in my book Competing for Customers and Capital.
FORMERLY KNOWN AS THE WORLD'S # 1
In the quarter ended May 2002, Dell’s revenues were just over $8.1 billion. Its stock closed at $24.36 and its market cap was $68.3 billion. In the quarter ended April 2002, the last one before the merger with Compaq kicked in, Hewlett-Packard’s revenues were a shade over $10.6 billion. Its stock closed at $17.10. Its market cap was $33.8 billion. Just under half of Dell’s.
Now roll the clock forward to Friday January 11, 2008. On that day Dell’s stock closed at $20.70. Its market cap was $46.5 billion. HPQ’s stock closed at $45.00 and its market cap was $155.8 billion. Put another way, five years later HPQ was worth more than three times Dell. What caused this reversal of fortunes?
The answer is simple: Carly Fiorina took the bold strategic decision to acquire Compaq. Though subsequently she was fired for her foresight by a dysfunctional board, the success of her decision was clear even before she left HPQ. If you’re interested in the true but untold story of her extraordinary performance at the helm of HP take a look at my May 19, 2007 post “Carly Delivered While Investors Fiddled.” Over the same period Michael Dell tried to grow his revenues organically by sticking with his worn out business model.
THE LIMITS OF DELL’S BUSINESS MODEL
The limits of Dell’s business model were apparent even in early 2002. Remember Dell's business model? It was "selling computer systems directly to consumers" which "eliminates retailers that add unnecessary time and cost." Well and good for its time. But, this model does not fit either the Asian or European consumer market and it was not designed for the corporate desktop customer in any market. When I wrote the first draft of Chapter 6 it was clear to me that:
Dell needed to find a way to duplicate its marketing efficiency with the corporate buyer. To serve this segment Dell needed either to develop its own direct sales force or negotiate a change in the purchasing behavior of corporate customers. Both of these options take time and changing the purchasing behavior of customers with high switching costs is a complex and costly process.
To motivate corporate buyers to switch to Dell required significant investments by the customer to change order and billing practices. This required design and installation of new accounting and control systems to manage end user buying decisions (Competing for Customers and Capital, pages158-59).
Even as the calendar is off and running into the New Year, Michael Dell has yet to bridge the gap between his old domestic-direct-to-consumer model and the new international-integrated-business model he needs. Dell’s greatest strength historically – its direct to consumer business model – has become its greatest weakness.
In a moment I will go on to describe the drag on revenues and earnings caused by this business model of limited view. For now let's look briefly at the metrics required to document its impact on sales revenue, earnings and market value.
OPTIMAL SHARE AND ENTERPRISE MARKETING
A company's "optimal" market share and sales revenue occur when the earnings from the last sales dollar are just equal to the cost of producing it. The relevant costs are what I call "enterprise marketing expenses."
There's a huge difference between the costs of "narrow marketing" and "enterprise marketing." Narrow marketing is advertising and promotion expenses. Enterprise marketing is much, much more. To begin with, it includes selling, general and administrative (SG&A) expenses. SG&A expenses capture advertising and promotion, of course, but also salaried employee expenses, including sales force expenses. In addition, enterprise marketing includes R&D expenses.
In short, enterprise marketing includes almost all the expenses that influence the customer experience. In marketing-speak, this is where the money behind every customer touch-point gets counted. Whether it’s the cost of designing a new keyboard, of a promotion snuck in with an invoice, of multiple phone conversations with a customer service rep, of the lead story in DealBook or MarketWatch covering something the CEO did or said, or the cost of designing a completely new product, they all are counted in Dell’s enterprise marketing expenses. If you want to dig into the details on this topic you’re welcome to review my audio slide show "Enterprise Marketing Expenses."
DELL’S LOST EARNINGS
The following chart shows Dell's actual earnings compared with its maximum earnings as reported by the Freeman School student team in Dell Grows Up (Chart 2,page 8). Maximum earnings occur when a company optimizes spending on enterprise marketing.
This chart covers the period beginning with the 2nd quarter 2002 through the 3rd quarter 2004. Note, the date-line is synchronized on the quarter ending March 2002 because two of the four players in this group file quarterly reports that corresponded with the calendar year. Dell’s reporting quarter actually ended on May 3, 2002.
In early 2002 Dell’s actual earnings ($590 million) fell short of maximum earnings ($709 million) by $119 million. By June 2004 the short fall increased to $267 million. Over these ten quarters Dell left just under $2.5 billion in earnings on the table by under-investing in market opportunities, keenly apparent even to students in December 2004.
DELL’S EXTRAORDINARY UNDER-SPENDING
The next chart documents Dell’s extraordinary under-spending on enterprise marketing. In early 2002 it was clear that Dell faced an uphill battle with its own culture by trying to grow organically.
In the second calendar quarter, Dell actually spent $801 million on enterprise marketing. In order to capitalize on the opportunities driven by its off-the-scale enterprise marketing efficiency and the rebirth of the PC market, Dell should have spent nearly $1,484 million on enterprise marketing. That was an 85% short-fall from optimal expenses.
In every one of the following nine quarters the short-fall between actual and optimal spending exceeded 100%. Cumulatively over the ten quarters Dell under-spent by some $11 billion. As a result, the difference between the company’s actual sales revenue ($11.7 billion) and its optimal sales revenue ($19.7 billion) in mid-year 2004 was $8.0 billion USD.
DELL’S EIGHT BILLION DOLLAR CHALLENGE
The differences between Dell’s actual and optimal revenues of $8.0 billion cannot possibly be achieved without a major change in its scale of operations. The only way to achieve such a change of scale in a single year is through acquisition. The MBA team recognized this challenge and outlined a strategy to meet it:
Realization of a revenue increase of this magnitude in this relatively short timeframe will require Dell to look beyond organic growth and incremental increases in current spending. In the United States, the landscape for acquisition is decidedly limited. However, Sun Microsystems does present an attractive possibility especially in the light of their seeming undervaluation and recent management woes. Acquisition of SUNW could offer Dell a host of capabilities to better compete in the domestic B2B market, specifically with regard to the back office. Sun’s proven innovation, market longevity, and brand could offer Dell greater credibility with enterprise clients. There exist some cultural barriers to a seamless assimilation of these two companies, chiefly Sun’s aversion to the Wintel platform in favor of proprietary hardware and software architectures. Sun would bring to the table greater gross margins and its $1.4 billion quarterly investments in [enterprise marketing] (Dell Grows Up, page 14).
That $1.4 billion would have closed the gap between Dell’s actual and optimal enterprise marketing expenses. The comment about Sun’s preference for proprietary solutions is particularly prescient, given its newly minted open-standards strategy led by the give-away of its vaunted Solaris Operating System. But there’s still more to chew on in that MBA student report:
A domestic growth focus is not sufficient to aid Dell in capturing the firm’s potential sales revenue growth. While Dell is currently focusing primarily on B2C customers in Europe, opportunities exist for a B2B push. In order to facilitate this expansion, Dell must once again look outside the firm for potential partners or acquisitions. This time, however, the target or targets should be in the IT services or business consulting arena. … Moving eastward from Europe, the most obvious target for international growth for Dell is China (Dell Grows Up, page 14).
CLOSING DELL’S REVENUE GAP
Acquiring Sun Microsystems revenues on top of Founder Electronics would have brought Dell within a stone’s throw of the $20 billion revenue target envisioned by my MBA students in their December 2004 report. In June 2004 Dell’s stock closed at $35.47 giving the company a market value of $89.3 billion.
At that time, valued more than HPQ ($61.3) and SUNW ($15.6) combined. If Dell had followed the course of acquisitions recommended by the students, in June of 2005 the company’s stock most likely would have closed at just north of $76 a share creating a market cap of $192 billion. That number is almost four times Dell’s market cap as of last Friday, not counting the potential appreciation in its stock price in the ensuing two and a half years.
This is just one of the many strategic stories that can be told after analyzing the competition for customers and capital. If only Michael Dell had listened to the numbers.