Dell: Where's the Competitive Advantage?

by: Jaded Consumer

There was a time when Dell (DELL) was the king of computer sales. Dell marched past everyone. After Dell passed her firm, Carly Fiorona tried to retake the top-vendor crown by having her company, Hewlett Packard (NYSE:HPQ), buy Compaq (the reason HP's stock symbol is now HPQ). This worked -- for a bit. But the combined company was itself promptly surpassed by Dell in U.S. market share. Dell looks unstoppable, no?

Based on their relative growth rates, it seems Dell is likely to achieve the worldwide title again.

What has Dell got going for it?

Founded by Michael Dell while he was in college, the company offered what others didn't: it offered what people wanted. Instead of providing a couple of fixed configurations, Dell offered to custom-prepare the exact configuration buyers wanted. Since you can't have an inventory of custom machines, retail stores were incompatible with his sales model, so Dell shipped directly to customers, cutting out the middle man.

Online sales were a big boost for Dell: it allowed Dell to make sales to people who hadn't found a Dell catalog laying around. It put a Dell store on every connected desktop. Dell was lauded as a supply-chain wizard, and its lean, low-inventory operation was the envy of PC vendors. Tying up less capital in inventory amplified its return on equity. Fast delivery and custom assembly mated with highly-competitive prices to create a virtuous cycle of sales and fulfillment. Dell snared numerous institutional contracts to supply whole enterprises with computer hardware, locking in ongoing order streams from businesses, schools, and students.

What's not to like?

First: Dell has no moat.

Everything Dell does correctly can be copied by careful operators. Custom computer preparation (e.g., RAM amount, hard drive number and capacity, CPU speed, and screen size) is now so ubiquitous that the absence of options is now the exception. Supply-chain management may not be easy, but the careful operator can duplicate Dell's feat: Apple (NASDAQ:AAPL) now tops Dell in supply chain management. Like Disney (NYSE:DIS), it's well-known in its market, but not unassailable, Dell has no readily-identifiable, durable, competitive advantage over industry peers even if its prospects for continued profitability appear solid.

But Dell has another problem.

Dell is also a commodity vendor. When selling commodities (in the absence of market manipulation), sellers bid each other down in the fight for sales and to choke off each competitors' margins. (The alternative is to offer a differentiated product that cannot be considered a commodity, because lacks the requisite of commodities: true substitutes.) Unlike HP, which has substantial intellectual property in its high-margin software and consulting businesses, and can offer enterprises a differentiated deliverable, Dell is just a box vendor.

The math on commodity vendors is not good. Without a differentiating feature like customization (which, being now standard, is no longer differentiating) or single-source software (which HP can offer to enterprises and Apple can offer to consumers), one expects Dell to compete chiefly on price against rivals like Acer and Lenovo (OTCPK:LNVGY) for the world's commodity PC business. Lenovo, which bought IBM's (NYSE:IBM) PC business when IBM realized commodities weren't its bag, is growing globally -- and so is Acer.

Dell has serious competition, even as it claws back the top-PC-vendor crown from HP. Fighting on price has an unsurprising result: reduced profit margins. Anyone surprised by this hasn't thought about how the business works. In the PC business, margins can get so thin the size of the profit can depend on the fees manufacturers glean from software vendors to install teaser applications and other garbage-ware on their customers' computers before they are shipped -- a practice that is so irksome that some buyers now actually pay resellers to remove the advertisement-ware, which in turn threatens the manufacturers' ability to make profit on the machines at all.

How safe are profits in a market like that?

Michael Dell, who once famously said that if he ran Apple he'd close shop and give the money back to the shareholders, has had to watch Apple's market capitalization pass and dwarf that of his own company. Being one of only two companies to increase customer satisfaction may place Dell ahead of its dreadful showing last year, but leaves the cost-cutting commodity vendor in poor position relative to Apple.

Yet, it's much worse even than that: Michael Dell has had to watch Apple beat Dell in Dell's own area of strength -- supply chain management. Is there nothing Dell can do that others can't learn to do better?

Acer, which passed Apple in U.S. sales share by purchasing Gateway (GTW) (which Apple had just passed), was itself passed by Apple, now #3 behind HP and Dell. Oddly reminiscent of Dell's rise and return, no? Will Apple become the next commodity vendor?

To avoid the commodity competition trap, Apple must maintain the distinctiveness of its products and work to increase the value of its platform. Apple has some advantage here, though. The fact that Apple need not pay an operating system licensing fee to an outside vendor for each hardware unit sold means that Apple's marginal costs will be better than other commodity vendors', ensuring that in a cutthroat commodity fight Apple has an edge in lowering unit costs.

In short, if Apple and a competitor were to sell the same hardware at the same price, Apple's profit could still be higher on each unit -- because Apple owns and need not pay for the operating system software every vendor must install. Still, falling margins isn't fun for anyone. Apple had best fight to maintain and build distinctiveness, to better resist being treated as a commodity vendor in the PC space.

For Dell, it's too late. Unable to make a distinctive or profitable product in the music space, Dell stands as a vendor of commodity PCs and their commodity peripherals (while hoping customers don't need printer supplies in an emergency, and can wait for Dell to ship them). Dell's profitability will depend on its ability to build machines more cheaply than competitors like Lenovo and Acer while offering them at the prices low enough to compete against rivals fighting for share.

My vote on Dell shares: don't own.

Folks interested in profit in the computer hardware industry might do well to look not at sales share but profit. Since the fight for share can run contrary to the development of profit, mere share should be ignored until one is satisfied with the profitability of the underlying business. (In a business that's satisfactorily profitable, of course, share can be a useful indicator of competitiveness; but without profitability, who cares about share?) HP and Apple both offer hardware to compete with Dell, but each offers distinctiveness through software and services that enhance each company's profitability. (HP's software and service offerings tend to be oriented toward enterprise customers, to whom HP also sells consulting services; Apple's software and services seem aimed at consumers and specific market niches in which Apple can offer all-Apple technology solutions.

In this sense, the companies are not exactly head-to-head competitors -- Apple doesn't make printers or offer enterprise consulting -- despite both also being PC hardware vendors). HP and Apple certainly sell computers, and there is overlap with the commodity business for the simple reason that the companies' computers have substitution options from firms like Dell, Acer, and Lenovo.

However, in the market segments where the companies' distinctive features are valuable, HP and Apple will enjoy superior profits on the similar sales, leading to superior overall profitability.

With Dell's margins compressed while the company stands beset by numerous competitors in a commodity business, one would like to see a better angle into the computer business.

Disclosure; No position in DELL or HPQ, despite liking HPQ, but long Apple shares and call LEAPs.