Dell, You Can't Make a Tune Out of Just One Note

This is the third story in my series on “The Battle for Your Desktop” staring Dell Inc. (DELL), International Business Machines (IBM), Hewlett-Packard (HPQ) and Sun Microsystems (JAVA).

The first was based on a report “Dell Grows Up” by MBA students in the Freeman School of Business at Tulane University. In that post “If Only Michael Dell Had Listened to the Numbers” I summarized the student team’s recommendation that Dell undertake two strategic acquisitions in order to redefine its competitive position. Their report covered the 10 quarters from March 2002 through June 2004. In the second post “Dell’s Magic Marketing Machine: New Metrics You Can Use” I applied and compared three different measures of enterprise marketing performance based on financial accounting data. The simplest of these metrics was enterprise marketing cost per dollar of revenues [CPD].

The purpose of this post is to compare the CPDs of all four companies over the 10 quarters from September 2005 through December 2007 and reacquaint you with a new measure of earnings quality which I developed in my book Competing for Customers and Capital. This measure correlates actual with maximum potential earnings. Actual earnings are taken from EDGAR Online I*Metrix reports. Maximum potential earnings are calculated from these data. Theoretically the maximum occurs when a company optimizes expenses by earning exactly what it spent to produce its last dollar of revenue. The costs of producing revenues are described in my audio slide show “Enterprise Marketing Expenses.”

DELL AND HPQ NOW HAVE EQUAL SELLING COSTS
In the last post I predicted that Mr. Dell could in fact find the new local customers “who want to touch before buying,” as he was quoted saying in a New York Times article by Steve Lohr. He could also find those customers who are less comfortable buying computers by phone “… at Wal-Mart stores in the United States, at Carphone Warehouse outlets in Europe and at Bic Camera stores in Japan.” But selling through these and other discount retailers surely will undermine his competitive marketing advantage. Which is to say it would increase Dell’s cost per dollar revenue, which at the time was lower than any of its peers. It turns out that this already has happened.

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From September 2006 through December 2007 Sun’s enterprise marketing costs per dollar of revenue fell from 49¢ to 35¢. This remarkable achievement puts Sun back in play. Even IBM’s CPD fell a bit, from 28¢ to 26¢. But more telling from Dell's perspective is that HPQ’s dropped from 17¢ to 13¢. Combined with DELL's increased CPD from 10¢ to 13¢, the two now have equal selling costs.

DELL FELL SHORT
As the next chart shows, Dell was not quite able to harness the power of maximum earnings. In every quarter, the company’s actual earnings were less than maximum. For example in March 2006 that difference between the two approached $300 million. Only in September of 2006 were actual and maximum earnings equal. Note the date-line in this chart is synchronized on the quarter ending September 2006, because two of the four players in this group [IBM and JAVA] file quarterly reports that corresponded with the calendar year. Dell’s reporting quarter actually ended on August 4, 2006.

The cumulative opportunity loss [COL] resulting from Dell’s failure to maximize earnings (by optimizing enterprise marketing expenses) amounted to $843 million over the ten quarters. That’s 9.4% of actual earnings. Not to mention the trend is unfavorable.

HPQ WAS IN THE MONEY
You probably are thinking: Okay, but did anyone actually maximize earnings? Good question. The answer is yes, almost. This chart tells the story. HPQ's actual and maximum earning were equal in four of the ten quarters. Another remarkable achievement.

HPQ’s cumulative opportunity loss [COL] was $191 million. That’s just a bit less than 1% shy of actual earnings. And the trend is very favorable.

IBM WAS IN THE MONEY TOO
IBM management steered the company to within 1.1% of maximum earnings. Hitting the number exactly on the head in two quarters: December 2005 and December 2006. Though the cumulative opportunity loss was no small change ($338 million USD).

JAVA WASN’T CLOSE
Lest you think Mr. Dell is the only one in the group to fall short, JAVA’s Jonathan Schwartz looked positively lame by this same measure. Sun’s cumulative opportunity loss [COL] over the ten quarters was $1,415 million, or some 2.47 times actual earnings.

But there are moderating circumstances behind this assessment. In the first three quarters before he was appointed by the board to replace Scott McNealy as CEO of Sun Microsystems, the company lost money. As a result, JAVA’s “maximum potential earnings” were $0.00.

Judging by actual earnings beginning when he took over in April 2006, Mr. Schwartz has done reasonably well, only losing money in September 2006. But he left a lot of money on the table by not capitalizing on the company's rapidly declining cost per dollar of revenue. Perhaps JAVA's new open systems strategy, the acquisition of MySQL and the new ticker symbol eventually will propel the company toward realizing more of that lost potential.

THAT ONE NOTE TUNE
When I was in college a popular dorm joke went something like this: One of the students, call him Jake, could often be found in the rec room hours on end playing his guitar. When visitors heard him, they thought it strange that he kept picking the same note on a single string over and over again. One finally asked why Jake played like that. “Oh, that’s simple” one of the residents said, “Everyone else has been looking for that note. Jake’s the only one to find it!”

Michael Dell knows his one note tune – the direct to consumer model – is out of date. In Steve Lohr’s New York Times article he definitively said:

We created this incredible supply chain, and that sort of stagnated,” Mr. Dell acknowledges. “We squandered that away. Some of our competitors jumped over us in a Darwinian way. Now it’s our turn.

But selling through discount retailers won’t carry the day. This analysis shows retail only will confound the problem by driving up Dell's cost per dollar of revenue and further shrinking its margins. Do you see any better options?

Comments

[PeytonBiddle]

Please elaborate on how you are calculating "maximum potential earnings"!

[Victor J.Cook, Jr.]

Peyton,

I elaborate on the equation for maximum earnings potential in my August 8, 2007 post on "Morgan Stanley, Merrill Lynch and the Fable of Three Bears." Check it out.

If you really want to dig in the dirt there's a link in that post to an audio slide show I did on "The Rule of Maximum Earnings," based on Chapter 5 in my book "Competing for Customers and Capital."

If you still have questions, or want actually to apply this to a business, you should get your hands on a copy of my book, then go to Appendix A "Definitions and Derivations" pages 250-252 and code the expressions into a spreadsheet and test them on financial accounting data.