Dark Days at Dell

The tech industry's lean, mean direct sales machine is on the fritz, and there don't seem to be any easy fixes. What gives?

These are the dog days of Texas summer, with grass bleached yellow and the mercury hitting 100 by noon. But nowhere is the heat being felt like it is inside Dell's (DELL ) no-frills compound outside Austin. For company founder and Chairman Michael Dell and Chief Executive Kevin Rollins, this summer has been one mishap after another: a massive recall of potentially self-igniting laptop batteries, a dismal earnings report, and an announcement that the computer maker is under Securities & Exchange Commission scrutiny for the way it counts revenues. By mid-August, Rollins was being asked on CNBC about how long he would occupy the tandem corner office he shares with Michael Dell.

Rollins looked to be the picture of calm in the face of the rebuke. But make no mistake, this is a pivotal moment for a tech icon. Dell may not have hit a wall in quite as dramatic a fashion as did Eastman Kodak (EK ) or IBM (IBM ). For all its problems, it is still expected to make nearly $3 billion this year. Yet its predicament may be intractable. Dell remained slavishly loyal to its core idea of ultra-efficient supply-chain management and direct sales to consumers, even as rivals have stepped up their game and markets have shifted to take away some of Dell's key advantages. Instead of adapting, critics say, Dell cut costs in ways that compromised customer service and, possibly, product quality.

ONE-TRICK PONY. Says one top tech executive in reference to Dell's lean, mean direct-sales machine: "They're a one-trick pony. It was a great trick for over 10 years, but the rest of us have figured it out and Dell hasn't plowed any of its profits into creating a new trick."

The same operational focus that made Dell and Rollins so formidable when they were on top may get in the way of finding another big idea. "Dell's culture is not inspirational or aspirational," says Geoffrey Moore, a tech consultant and author of Dealing with Darwin: How Great Companies Innovate at Every Phase of Their Evolution. "This is when they need to be imaginative, but [Dell's] culture only wants to talk about execution."

And Dell's execution isn't what it used to be. The company will make about $900 million less in net income this year than it did in 2005, analysts estimate. It has slashed prices to maintain PC market share (19.2% in the second quarter) at the expense of operating margins, which slid to just 4.3% in the quarter ended Aug. 4 from 8.7% the year before. With the stock trading around 22, off its 2000 high of 58, blue-chip investment houses have fled. Fidelity Investments (FMR ) and Goldman Sachs (GS ) are among those that have cut their Dell holdings by a third or more since Jan. 1 (see "Insider Trades in 2006").

Dell is spending $115 million to improve service, and its scores have improved recently. Still, some buyers have jumped ship. Peter Shoesmith, the network operations manager at 74-attorney firm Cummings & Lockwood in Stamford, Conn., once spent $300,000 a year on Dell PCs and servers. Today, he uses Hewlett-Packard (HPQ ) almost exclusively. For Shoesmith, Dell's products proved too hard to maintain and operate. "They grew too fast and tried to produce too many products at the same time," says Shoesmith. He would consider using Dell again but says "it'll take a lot for us to jump back."

RESTLESS TROOPS. At Dell's suburban Round Rock (Tex.) headquarters, many employees who once used Excel spreadsheets to track the rising value of their stock option grants now find Dell's hard-driving culture too much of a grind. Richard Snyder, an alum of Dell and HP and now CEO of Austin-based Forgent Networks (FORG ), gets a stream of disaffected workers applying for jobs. "They don't feel they're part of something at Dell, and they generally leave because they feel frustrated," says Snyder. "Dell is not a fun place to work, and it's less fun now than it used to be."

These various defections have the technorati buzzing about whether Rollins will be next to go. Dell turned down BusinessWeek's requests to interview Rollins and Michael Dell, and it wouldn't respond to specific questions about the business. But many who are close to the company doubt that Rollins will walk the plank anytime soon, if only because the two executives have been in lockstep since Rollins came from consultancy Bain & Co. in 1996. Michael Dell shows no signs of backing off: He has spent $70 million to buy 2.9 million shares on the open market since Jan. 1 and holds 10% of the company. In a conference call with analysts on Aug. 17, Dell said his execs "are confident we're making the right long-term decisions for our customers and shareholders."

While Dell's problems may seem to have sprung up only recently, Rollins may have revealed the limits of its model in an interview with BusinessWeek back in 2003. "There are some organizations where people think they're a hero if they invent a new thing," he said. "Being a hero at Dell means saving money."

OUTDATED MODEL. But it was clear some time ago that Dell's model was not keeping pace and was not going to be such a big advantage in the future. It's becoming harder for Dell to run one of its most profitable plays: luring customers to its Web site with cheapo models and then getting them to buy a $2,500 box with all the bells and whistles. Now PCs are so powerful that most consumers are fine with preconfigured models in stores. Some of Dell's other operational advantages are fading, too. Notebook PCs are becoming a far larger percentage of the market, but the Asian contract factories that make them for Dell also make them for other companies, eroding Dell's build-to-order advantage. And while experts believe Dell got the best prices on components when it was outgrowing all of its rivals, these days newly ascendant HP and Asian rivals Lenovo Group (LNVYG ) and Acer are offering plenty of growth themselves.

Even Dell's decision in May to end its exclusive deal with Intel (INTC ) by using chips from Advanced Micro Devices (AMD ) could cause short-term pain. The move was cheered by investors, but it comes just as Intel is introducing chips that close AMD's technology lead. "This may not be such a bad thing [for Intel]," says one Intel insider. "Exclusivity was great when Dell was growing faster than the rest of the world. But being tied to the hip to a company that is struggling isn't necessarily a good thing." This source thinks Intel may now tighten its links to Apple Computer (AAPL ) and HP.

So why hasn't Michael Dell—clearly a brilliant guy—changed tactics? For starters, say rivals and Dell alums, shifting gears would upset investors who expect hyper-profitability from Dell's hyper-efficiency. And having stuck to his guns in the past, he can't risk letting customers think that "Direct from Dell" is no longer the cheapest, smartest way to go. That message isn't just a slogan, either: Inside Dell, ideas that break from the model are discouraged, say former Dell managers. Notes one: "You had to be very confident and thick-skinned to stay on an issue that wasn't popular. A lot of red flags got waved—but only once."

RELUCTANT RECRUITERS. Now the cost focus may be making it harder to bring in fresh blood. Three respected headhunters contacted by BusinessWeek said they would rather recruit from Dell than for it because working with the company is so difficult and unprofitable. About two years ago, says one, Dell began an online bidding process to determine which firms would get its recruitment work. "They're trying to extend the process they use for buying memory chips and LCD screens to professional services," says the headhunter.

Dell insiders point to one small example of the pressure to maintain performance. In its efforts to diversify, Dell jumped into televisions back in 2003. TVs, like all electronic products, have to meet regulatory standards limiting how much electromagnetic interference (EMI) they produce. Dell, wanting to do better than meet the government standard, set an EMI level well below the legal limit, say two former Dell employees. Those first models made a splash, and management wanted to keep momentum for the fall 2004 launch of LCD and plasma models. But in testing they didn't meet those higher goals, according to internal memos, copies of which were obtained by BusinessWeek.

Redesigning the TVs to lower emissions would have taken weeks or months, and forced Dell to miss the launch dates. After ordering suppliers to work around the clock and hiring contract engineers to try to fix the problem, Dell lowered its standards, according to the former employees. The memos indicate that some TVs would ship without meeting the company's EMI goal, though they still would meet legal standards.

NEW PRODUCT DUDS. Other attempts to expand beyond PCs have come up dry. Dell dropped its DJ music player in January after tepid sales. Its stolid brand image doesn't help it in fast-growing consumer markets, and a tightfisted approach to research and development stunts new-product innovation. While Dell sells straight-up TVs, for example, HP just introduced a big-screen TV that can wirelessly grab whatever music, movies, and photos you have on your PC.

As hard as things look, Dell is nowhere near as bad off as it was in 2001, when the tech bubble burst and companies stopped buying. Today, Dell is still adding new employees. Maybe they'll bring some bright ideas with them.