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#2 Dell Tries Harder, Compaq Hurts

Written By: R. Krause
Published On: February 1 2000

Vendor Genesis

Current CEO Michael Dell founded Dell Computer Corporation in 1984. Dell claims to be the #2 computer systems maker in the world. (We question that statement - IBM and Compaq surpass Dell in both sales and employees). Mr. Dell started the company while still in college, selling PCs out of his dorm room. Since then, he has built the company into a $25+ Billion powerhouse. Dell has refined the direct sales business model to the point where it has become the model for the industry.

Dell's original product set was desktop computers, choosing to build strength in one market before moving to another. After desktops came notebooks, followed by servers. Dell holds the #5 market position for notebooks, but its real success has come in servers. In 1996, Dell had a market share of approximately 3%, today its US market share is approximately 25%. Dell has achieved this tremendous growth through a combination of pricing, delivery, and refinement of the direct-sales model. Dell's largest product segment is desktop sales at 58% of its revenue, servers account for 17% of its revenue. It is primarily a product-focused company, deriving less than 10% of its revenue from services.

Dell competes anywhere an Intel-based server is found: enterprise computing, client/server environments, small offices, web sites. Although Dell has historically focused on the Windows NT environment, it recently instituted Linux as a factory-installed choice on its servers. This gives it a jump on Compaq and IBM, its nearest market share competitors both above and below. One area where Dell is not a serious competitor is the UNIX market. (Linux is a variant of UNIX, but the two markets are considered to be separate). Because it eschews the UNIX market, and sticks primarily to Intel-based systems, we still consider Dell to be a niche player.

Dell's revenues for 1999 are estimated at $25.2 Billion, with income of $1.86 Billion, giving a growth rate of approximately 38% for revenues, but only 27% for income. Recent chip and display supply problems have caused an expected shortfall for the current quarter. Dell has also blamed customer Y2K slowdown/concerns for part of the shortfall.

Vendor Strategy and Trajectory

Dell is working to be the US and worldwide market share leader for both PCs and Intel-based servers, also called PC servers. It presently holds the #1 share in the US for PCs, but is still #2 worldwide (WW). In PC servers, it is currently #2 in both US and WW shares. However, it has been gaining on Compaq (presently #1).

Dell has accomplished this through a number of strategic decisions:

1) Sell direct, and do it well by refining the supply chain to an-almost-unheard-of degree.

2) Form a tight relationship with Intel (for hardware).

3) Leverage the Internet for sales and support.

As mentioned above, if you consider Intel-based systems a niche, then Dell is presently a niche player. (A very big niche, but a niche nonetheless.) Unlike IBM, HP, and to a lesser extent Compaq, Dell has not yet tried to expand much beyond the Intel market. Part of the reason for this is that IBM and HP had a successful non-PC business before PCs took over the world. It was therefore easier for them to become and remain total systems houses. Compaq expanded beyond Intel through acquisition, and so it has been more difficult for them to match the IBM/HP fully-rounded product offerings. Although "Intel only" has been a successful strategy for Dell to date, we expect they will want to expand their markets.

We admire Dell's single-mindedness regarding products. It has latched onto something it does very well, and has stayed with it, constantly refining the business model. One high-tech Chief Scientific Officer has likened Dell to a car lot, because of the common view that Dell is just a distribution channel for Intel Corporation. Although we see the validity in the statement, we also point out that this "car lot" has been far more successful than most of its competition, including the above-mentioned CSO's company.

Dell will continue to focus its investment on delivering products for which it believes there is a very large market. For example, Michael Dell has stated that UNIX is losing market share to Windows NT, so Dell Computer will not pursue an aggressive UNIX strategy. For those markets where there is significant, but not tremendous, revenue potential, we believe Dell would form strategic alliances where necessary. For the most part, acquisition is not part of Dell's game plan. However, we can envision circumstances under which purchasing a company or technology will take place.

Vendor Strengths

Price/performance:

Dell has been very strong in the product cost and product functionality categories. Dell high-end servers (for example, the PowerEdge 8450 and 6450) are price/performance leaders in TPC-C benchmark testing. In the case of eight-CPU servers, Dell's PE 8450 benchmarked about 1.3% lower in tpmC (see Glossary), but at a cost approximately $95K lower than Compaq's ProLiant 8500, the next-best (in price/performance) Intel server audited. This is not an isolated occurrence - Dell has performed similarly in recent years.

Product functionality:

Although Dell does not spend as much on research and development (R&D) as its main competitors, their products continue to have competitive feature sets in terms of CPUs, density, storage, and I/O capability. Dell servers are known as good products with few (if any) deficiencies with respect to what customers want - a good product at a reasonable price.

Product Cost:

Dell's servers continue to be lower priced than their main competition. This is a function of two key circumstances:

1) (1) Their supply chain is the most streamlined in the business, resulting in lowered costs. As an example, the number of inventory "turns" is an amazing 50+ per year, resulting in near-zero inventory carrying costs. This performance has led Compaq to try to emulate Dell's business model.

2) (2) The direct sales model reduces the ancillary sales costs, such as the cut taken by Value-Added Resellers (VARs) as part of the channel strategy that most/all of the competition uses.

It is also likely that Dell uses its clout to garner significant pricing advantages from Intel and its other suppliers, but until recently that clout was confined to PCs, so we think it less a factor in the server market, where Compaq has more pull.

Customer Satisfaction

Dell is a consistent winner in customer satisfaction surveys, including those taken by Computerworld and Technology Business Research (TBR). Although customer satisfaction is more an indicator of strength than an actual strength, it shows that Dell consistently does what is necessary to keep customers happy. This points to commitment by Dell, rather than reactive behavior.

Corporate Viability:

Although Dell's earning have suffered lately (primarily from shortfall in the desktop area), Dell has a very strong balance sheet, and its return on invested capital is quite high. Dell occupies a lead position in most of the Intel-based product markets. A recent survey from Technology Business Research shows that Dell leads in customer satisfaction for Intel-based servers, among IT professionals who purchase more than 500 PCs per year. Strong financials combine with high product satisfaction means strong corporate viability.

Vendor Challenges

Product Technology:

Of the "Big Four" Intel server vendors, Dell spends the least on research and development. As a percentage of revenues, Compaq spends three times as much as Dell. IBM and HP spend more than four times as much (as a percentage of revenue) as Dell. This lends credibility to the popular notion that Dell is merely a distribution channel for Intel.

Dell once relied on Intel for most of its Main Logic Boards (MLBs) and chipsets, the heart of the server. It still relies on Intel to a greater extent than its main competitor, Compaq. Although this reliance on the company whose name defines this market might be seen as leading in technology, we believe that IBM and Compaq have the edge here. This is for two reasons:

1) IBM and Compaq spend more money/effort on original R&D, leading to technology differentiation from the "vanilla" Intel offering. Differentiators include things such as "hot-plug" and "hot-add" PCI under Windows NT, in advance of the general market.

2) Although Intel still sets the standard for CPUs and some other technology areas, they have had an increasing number of technology embarrassments recently (e.g. "Saber" MLB not working perfectly with certain PIII Xeon "flavors", "Coppermine" shipment delays).

This does not mean that Dell servers are poor quality - they are not. It just means that Dell presently cannot use technology as a positive differentiator relative to the other key Intel server players. We do not believe Dell can over come this challenge without massive R&D investment or by acquiring a company whose primary strength is R&D. We think each of these scenarios is unlikely (<20% probability).

Corporate Service and Support:

Dell service and support had been viewed as lagging behind Compaq and IBM. By contracting with IBM's service group to act as Dell's service arm (in addition to the existing service agreements Dell has in place), we expect this perception to change to the point where it is no longer a negative. Until that time, we believe IBM has the edge in this area.

Lack of Product Breadth:

Dell is an Intel house, first and foremost. Although this formula has yielded tremendous success, the growth curve has been slowing for the past two years. There are hints that Dell wants to become a systems house similar to the rest of the "Big Four". One such is the purchase of ConvergeNet to beef up their storage offerings. Dell will either need to buy or strike a deal with another systems vendor to be able to expand beyond the Intel world. Dell's aversion to acquisitions means a marketing alliance is much more likely (75% probability).

Within the Intel space, Dell should consider working with Advanced Micro Devices (AMD). Although Intel-only has gotten them this far, the recent earnings shortfall indicates that having a second source for a fallback would help. It would also keep Intel "honest", i.e., keep them from taking their relationship for granted. Since AMD cannot presently support multiprocessing, a deal with AMD would not affect the current server offerings. However, if AMD ever releases its Poseidon/HotRail chip set - designed to support multiprocessing - this would provide Dell some leverage.

Vendor Predictions

Dell will continue to increase sales and revenue over the next five years. We expect Dell to close the Compaq/Dell market share gaps for both US and worldwide markets (75% probability). We do not expect Dell to pass Compaq in the server market, although we believe they will throw a good scare into Houston. Now that Compaq appears finally to have figured out that they need to do more direct sales, Dell's advantage in this area will shrink. We believe it will take Compaq another 1-2 years before they "stabilize" the loss of share to Dell. Once this happens, Dell will need to look for other ways to go after Compaq, but we expect they have already started this process.

As Dell's market share increases, someone's market share will decrease. We expect that to be a combination of small players and HP. We expect Compaq will lose a little, but will recover. We do not expect the small players to recover. We expect HP will stabilize at a percentage slightly lower than its current share.

Until Michael Dell decides he is tired of "the game", we do not expect Dell to be acquired by other vendors. We also do not expect a significant number of acquisitions by Dell, no more than two or three in the next five years.

Vendor Recommendations

For Dell to overtake Compaq in the Intel-server market, the following will need to happen:

1) Compaq completely blows their streamlined-product-delivery initiative, or

2) Compaq makes a mistake (or series of mistakes) of earth-shaking proportions, or

3) Dell/Intel develops surpassing technology which Compaq is not able to meet or beat

Although we think #1 is more likely (30% probability) than either of the other two (<15% probability), we do not think any of the above is likely. Theoretically, Dell could pressure Intel to provide Dell-only technology, but we think Intel would be foolish to do so - unless they plan to buy Dell (5% probability). We therefore expect Dell to maintain a #2 market share, albeit a strong #2. We also expect IBM will try to reinvigorate their Netfinity product line, which will apply pressure on Dell from below.

Because of the relatively limited upside, we expect Dell to consider modifying their market focus from Intel-only to multiple architectures. However, we do not expect them to change in the foreseeable future. (80% probability of no change) When/if Dell decides to expand beyond Intel, they should first "test the waters" by forming a strategic alliance before making the major commitment of either an acquisition or ramping up their internal R&D. As mentioned above, we believe strategic alliances will be Dell's modus operandi (75% probability).

User Recommendations

Dell's low price and price/performance sells are attractive to many customers, as is obvious from their rapid market share growth over the last five years. Dell has shown a willingness to do whatever it takes to win key accounts, especially when they can displace Compaq. Current Compaq customers may want to use this to their best advantage in negotiations either with Compaq or Dell.

Users interested in price/performance (especially for transaction processing) will find Dell's high-end servers attractive, although the perception is that they sacrifice a little reliability relative to IBM. Users must decide if the advantages of price/performance and system density (i.e., amount of computing power per square foot) outweigh the slightly decreased reliability.

Customers planning to purchase Dell systems should also compare five-year operational and service/support costs to those of other vendors, and negotiate accordingly. Current (non-SCO) UNIX customers will find minimal interest in Dell's product set, unless they are considering changing their infrastructure to Intel-based or mixed-environment.

Customers needing servers for 24x365 operation should consider alternative vendors, but this is related to the Windows OS, not the Dell hardware per se. We cannot yet recommend Linux-based systems, because of Dell's lack of track record in this area. However, based on Linux's robustness, we expect Dell to develop a track record within the next 3-6 months. We also believe Dell has the lead on Compaq and IBM in the Linux space, because of its decision to ship Linux as a factory-installed option.



 
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