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The smartest price war ever

Venture capitalist J. William Gurley explains why Dell's decision to throw down the gauntlet on pricing is anything but irrational.

    War! What is it good for?
    --Edwin Starr

    The recent titles on PC industry trade articles speak volumes with regard to the current state of the industry. "Dog Watch," "Will PCs Rebound? Doubt it," and "A PC Pessimist" are three examples that highlight the current view: The PC industry is in a tough spot.

    Worldwide growth is slowing from the once-guaranteed 20 percent-plus per year to somewhere closer to the 10 percent to 15 percent range a year, while U.S. growth is barely up and could easily decline. And while the current state of the economy is always mentioned as a contributor, analysts seem worried about something greater: saturation.

    If this were not enough, Dell Computer, the investment community's perennial favorite, launched an aggressive price war in the fourth quarter, which continues unabated now six months later as we near the end of the second quarter. Referring to the current price battle in the May 11 issue of The Wall Street Journal, IBM's Lou Gerstner noted, "Price wars in a commodity business are really dumb."

    All of which begs the question: Is this a commodity business? Or has Michael Dell become smitten with a strategy that, in Lou's words, is "less than smart"?

    In a business context, commodity is often used to describe a product or service where differential advantage is difficult to achieve, and as such, pricing is typically the sole determinant in terms of the customer's purchase decision. Interestingly, the issue with Gerstner's statement may not be in the adjective, but rather in the object of that adjective. It would be hard to argue that the personal computer is not a commodity product. However, it is not at all clear that the PC industry is a commodity business.

    If a commodity product is one for which no one can establish a differential advantage, then it would follow that a commodity business is one where no participant can obtain a differentiated business advantage. However, even in tough times, Dell's business model stands head and shoulders above its competitors'. Dell's competitive advantage comes not from building better boxes per se, but from building them smarter and faster, and consuming fewer resources in the process.

    Much has been written about Dell's direct model, which removes the middleman, along with his margin, from the sales process. And others have noted that Dell's incredible five days of inventory allow it to pass on component price declines faster than anyone else in the industry. But perhaps the unique aspect of Dell's business advantage is its negative cash-conversion cycle. Because the company keeps only five days of inventory, manages receivables to 30 days, and pushes payables out to 59 days, the Dell model will generate cash--even if the company were to report no profit whatsoever.

    Dell is clearly the low-cost leader when it comes to looking solely at the income statement. The company has continued to generate a substantial profit margin even as others have struggled. For instance, IBM's personal-systems division lost $58 million on revenue of $3.17 billion in the first quarter. Dell's balance-sheet advantage is the added kicker here. Even in an environment where a price war eliminates all profitability--including that of Dell--the company will remain cash-flow positive. No wonder, then, that Dell would be willing to start a price war, and no wonder that IBM would find it "dumb."

    Reasons to go to war
    Dell's price-war timing is particularly clever. First, the tough economic environment leaves stocks depressed and investors more forgiving of lower expectations. Why try to hit home-run numbers when you are not likely to get much credit for it? Second, with most customers eyeing their own bottom line, they are much more likely to be influenced by the low-price sales pitch. Lastly, the weak economic environment makes it even more difficult for Dell's competitors to fight back, which is exactly what Dell is counting on.

    By pushing for market-share gains through a price war mechanism, Dell has presented its competitors with a true lose-lose dilemma. On the one hand, you can try to maintain market share by pricing alongside Dell. The problem is that because of its business model advantage, Dell can stand in the deep end of the pool forever. If you wade down there with them, you are likely to run out of oxygen before too long. Currently, Gateway is the only player that has followed this path, and understandably so. As the only other large player with a completely direct strategy, Gateway is best equipped to ride out the war.

    The other possible response, and the one that has been chosen by IBM and HP, is to declare the price war "irrational." The problem here is that along the way you lose market share, and Dell continues its tear that led it to become the No. 1 maker of PCs in the world in the first quarter of 2001. Sitting out the war is equally as dangerous as entering it, which is precisely why Dell's decision to push the pedal during these tough times is so remarkably shrewd.

    There is something else that makes the timing of this assault astute. Though Dell's competitors are well aware of the advantages it has, they have yet to "catch up" in terms of operating efficiency. As such, it makes sense for Dell to go for the knockout punch now while the size of the advantage is so obvious. Waiting will only give the others time to study the relative advantages and mimic them.

    There is a real risk that Dell's price-war moves will permanently raise the bar in terms of the business plan needed to be competitive in the PC industry. In the past, every downtick in gross margin has been permanent, and the rest of the income statement has adjusted accordingly.

    In this light, the decision by some to sit out the war may be the first step toward sitting out the industry. The screws are turning deeper, and Michael Dell is asking everyone to put up or shut up--hoping that they choose the latter, and hoping that they eventually exit the business.

    J. William Gurley 2001. All rights reserved. Above the Crowd is a monthly publication focusing on the evolution and economics of high-technology business and strategy. This column can also be found on CNET online and in Fortune magazine. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Benchmark Capital, a venture capital firm in Menlo Park, Calif. Benchmark Capital and its affiliated companies and/or individals may, from time to time, have positions in the securities discussed herein. ABOVE THE CROWD is a service mark of J. William Gurley.