Thursday, February 8, 2007

Peasants and PCs

There's been a bit of hype in the media lately regarding Michael Dell's return to running the company he founded. It brings up memories of the whole Compaq merger mess, which was Carly Fiorina's "me, too" response to the rise of Dell Computer. Fiorina, with her degree in medieval history, set out to out-Dell Dell and was instead undone by her own shortsighted ignorance. It's a classic example of how you should be careful what you wish for, because you just might get it.

Dell became a giant in the PC world by manufacturing customized PCs out of standard components, like electronic Lego sets. Dell sourced the cheapest components it could get from vendors, then relentlessly optimized the assembly process, driving out costs. Forgoing the traditional bricks and mortar retail channel and its associated margins and overhead, Dell sold its wares directly to customers, first via telephone and later on the Internet.

Back in those days the average new PC cost in excess of $2000. Dell's model shaved literally hundreds of dollars off the cost of a computer, while allowing users to customize the machine to meet their specific needs. The resulting custom machines still cost less than comparable non-custom systems from Compaq, HP and IBM. Dell's business grew exponentially, and as the market softened toward the end of the dot com boom, they ate everybody's lunch.

Carly's strategy was to merge with Compaq, cut redundant PC employees, trim product lines and adopt the same Lego-like approach to PC manufacture as Dell, using industry standard components. In addition, Carly decimated HP's costly research and development operations and bowed out of the expensive microprocessor market, where players like Intel and IBM routinely spend billions designing a new processor or building a single chip factory. HP threw away its own PA-RISC processor architecture, as well as the Alpha processor architecture it inherited from Compaq, instead teaming up with Intel to develop a new processor called the Itanium (which promptly tanked in the market upon its oft-delayed debut). They also began producing commercial hardware based on the same Intel chip architecture found in desktop PC's. Such systems are relatively cheap to design and produce, and can be clustered together for performance rivaling that of old style "big iron" mainframe systems.

The hope was to turn HP into kind of a combination of Dell and IBM. HP would churn out commodity PCs at the lowest possible price, while making a fortune in the commercial space by providing service and support for the existing installed base of HP, DEC and Compaq servers and mainframes (the way IBM makes its money). Unlike Dell, they'd be able to offer a soup-to-nuts range of products to large commercial clients, from mainframes down to desktop PCs. Also unlike Dell, these efforts would be well-supported by the cash that pours in from their lucrative printer business, where HP printer ink sells for more per-ounce than gold.

Carly's smash and grab strategy was, surprisingly, not even a short term success. The dot com boom imploded, trashing demand across the board. HP barely kept its head above water, in spite of laying off thousands and essentially destroying its position as a technology developer and leader. While revenues have since increased, what remains of HP is essentially making all of its profit off of selling printer ink and providing support for legacy products. Neither of these is a viable long term strategy for growth.

HP is however doing well these days compared to Dell. With PCs selling for roughly half of what they did a few years ago, shipping costs can add up to as much as 10% to the price of a Dell – comparable to the retail margins HP deals with on machines sold at your local BestBuy. Customization is far less important today too, since most PC's now come with a dizzying array of features satisfying virtually any user's needs. And consumers like dealing with a local retailer who will handle any issues they have, as opposed to shipping boxes back and forth to Dell or trying to converse with a support engineer in Bangalore. Combined, these factors make HP's retail PCs price competitive with Dell's offerings for the first time in a decade.

But the writing is on the wall for the PC market in general. HP may be doing better than Dell, but margins for both are abysmal. The bean counters at IBM already foresaw this development, selling their entire PC business to Chinese manufacturer Lenovo and retreating to the lucrative corporate service and support market. IBM is so convinced the PC market is a profit-free zone that they've even begun unloading their shares in Lenovo.

The only company making decent margins off of personal computers these days is Apple, and their design-centric approach is notably different from HP's or Dell's. Now that they're leveraging standardized components (manufactured by Intel, the same as in Dell's and HP's boxes) to lower costs and improve interoperability with Windows software, they stand poised to seize much of the high end retail PC marketplace, and hence the lion's share of the remaining profits in that business.

Meanwhile, the clock is ticking for HP's remaining profitable businesses. It's only a matter of time before those old high-maintenance commercial HP systems are replaced with new commoditized beasts built around the same standard technology that powers desktop PC's, eroding both hardware margins as well as HP's service and support business. Likewise, it's also only a matter of time before the printer market is invaded and conquered by Chinese manufacturers, who will easily be able to undercut HP's inflated prices and rob the giant of its remaining profits. In fact Kodak just announced they're entering the market with Chinese-made printers selling for the same or less than comparable models from HP and other rivals. Worse, they're claiming the ink for their printers will cost less than half as much. If they succeed, they'll drive the margins out of the printer business the same way Dell drove them out of the PC business.

Whatever longterm "victory" Carly and her sycophants may want to claim over Dell is liable to be a pyrrhic one at best. HP may end up being the last American giant in the PC playground, but that playground is looking more and more like a worthless quagmire that nobody wants to inhabit. By crippling HP's research and development and destroying the company's iconoclastic culture, Fiorina left behind an empty castle that's rapidly sinking into a treacherous swamp. But then, that's a position that describes much of corporate America these days, and indeed the nation as a whole following over two decades of smash and grab, kleptocratic mismanagement.

In that light, having a technology company run by a woman with a degree in medieval history makes plenty of sense. Our kleptocracy is rapidly turning America into a feudal society, erasing several hundred years of social and economic progress. This does not leave us well-positioned to compete in the global economy with societies across the globe that are rapidly modernizing.

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