Dell's dog days of summer

Perhaps the only thing hotter than Austin, Texas, in mid-July is the pressure now on Dell executives after another poor quarter.

Dell on Friday again disappointed its investors, warning that both revenue and profit would be below expectations for its second fiscal quarter. Analysts polled by Thomson First Call had been expecting $14.2 billion in revenue and earnings of 32 cents per share. But Dell now expects to record $14 billion in revenue and only 21 cents to 23 cents per share in earnings, a solid dime off expectations.

What's gone wrong with the PC industry's low-cost wonder? To start, analysts wonder if Dell's costs are on the rise. Also, after years of wowing investors and the PC-buying public with its online sales and marketing, the resurgence of the retail market in PCs is hurting the company just as its corporate customers ease back on purchases, according to analysts.

Dell executives worship at the altar of the direct-sales model. For almost 20 years, Dell has used mail-order, telephone and the Internet to avoid the channel and inventory problems that can be a painful part of life for retail businesses. Even though it wasn't always true, Dell also managed to create an impression that it was a price leader, when its real advantage was that its costs were lower than retail-heavy companies like Hewlett-Packard and Gateway.

And that's still the message from the company with the leading market share in the PC industry. "The direct model remains our not-so-secret weapon," Chief Executive Officer Kevin Rollins told shareholders Friday.

Over the last few years, consumers have become the driving force behind the PC market, and more often than not they want to buy systems from retailers, said Samir Bhavnani, an analyst with Current Analysis.

The U.S. retail PC market is growing at a 25 percent clip, Bhavnani said, much faster than the 9 percent growth rate of the overall market. Dell is missing out on this category and companies like HP, Gateway and Acer are benefiting, he said.

But this is also coming at a time when the main part of Dell's business, the commercial PC market, has decided to take a break from buying new systems. Dell says 85 percent of its business comes from commercial entities, and those organizations buy PCs in upgrade cycles, said Charles Smulders, an analyst with Gartner. The last cycle started around 2002, three or so years after companies started buying PCs ahead of the perceived Y2K problems. It's now coming to an end, and business customers aren't expected to upgrade again until they've done extensive testing of Microsoft's Windows Vista, which is scheduled to arrive in the first part of 2007. That would put the next upgrade cycle around 2008.

"Wall Street always overreacts. They run up one side and then they run up the other side like a bunch of lemmings."

--Roger Kay, analyst

Dell also suffers from a dependency on desktops and U.S. sales, Smulders said. Desktop PCs account for 36 percent of Dell's overall revenue, the company said in its report for the first fiscal quarter. Sales in North and South America make up 65 percent of Dell's total revenue, with the U.S. comprising the largest part of that segment. In the U.S., commercial desktop shipments are expected to decline by 4.5 percent this year, said Richard Shim, an analyst with IDC.

Several more immediate concerns are also plaguing Dell and the rest of the PC industry. Intel's aggressive launch schedule for its Core 2 Duo chips has sent ripple effects throughout the industry as the world's largest chipmaker dumps old processors on the market to make way for the new chips. The resulting price pressure has caused problems for Intel's partners and competitors, as well as Intel itself.

Normally, when a company cuts prices, demand and unit shipments rise. But Dell doesn't appear to have seen significant shipment increases during the quarter, and has been doubly hurt by the fact that its competitors, notably HP, have greatly improved their cost structures, said Richard Farmer, an analyst with Merrill Lynch, in a research report distributed Friday.

"The market was caught by surprise that Intel was bringing forward their product launches; they thought they had a longer lead time to get rid of their inventory," Smulders said. "Intel's actions have sort of shaken up the industry and put additional pressure on the pricing environment in the second quarter."

Dell has tried to work its way up the PC price list, with heavy emphasis on its XPS lineup of PCs and its purchase of boutique PC maker Alienware. But those efforts do not appear to have overcome relentless pressure--caused by Intel's actions and the renewed strength of competitors--at the low end of the market. Plus, Dell has an image problem.

Consumers have savaged Dell over the past year or so for its poor customer service and support. Although this year the company made it a priority to correct those problems, it's not clear how long it will take Dell to regain consumer trust.

During Dell's last disappointing earnings conference call, Rollins announced that Dell would spend $100 million to hire new support personnel and retrain existing employees. Turnover has been abysmal within Dell's customer support organization, and the company has finally recognized that it needs to improve this crucial link to customers, said Roger Kay, an analyst with Endpoint Technologies Associates.

One other reason that Dell's earnings will be far lower than expected could be the amount of investment happening behind the scenes to improve not only support but product design, Kay said. There's lot of work going on inside Dell to improve the look, feel and performance of its products, he said. "They are doing a lot of engineering that they might not have been doing in the past."

Dell has also been unable to shift its revenue burden away from the PC market in favor of higher-margin businesses like servers and enterprise services. And within the server market, for example, a sizeable segment of the customer base has shifted from buying generic rack-and-stack servers, to looking at things such as manageability software and ease of use, said Illuminata analyst Gordon Haff. Dell offers manageability software but doesn't emphasize it as much as competitors do, Kay said.

"Plain vanilla boxes that are cheap to buy aren't completely out of vogue, but there are other considerations," he said.

Despite all the bad news, Dell's challenges are hardly insurmountable, said Forrester Research analyst Ted Schadler. The company already has taken actions such as simplifying its discount and rebate strategies to give consumers a better idea of the price they'll pay when they come to Dell's Web site, he said. Dell also plans to experiment with two shopping mall-based company-owned stores that don't carry inventory but give buyers a chance to try out Dell gear in person.

And, of course, financial markets aren't known for their restraint. "Wall Street always overreacts. They run up one side and then they run up the other side like a bunch of lemmings," Kay said.

Dell for years poked fun at the rest of the PC industry, while the company grew at more than 20 percent despite a sharp industry downturn. Now Dell is faced with the reality that it might have to change its stripes a bit to compete in a new era. The company has spent the last several years trying to convince the press and analysts that it is more than just a PC company, that servers, storage and enterprise services will help it continue to grow. But when things go astray in the PC market, it's very clear just how dependent Dell is on the product that vaulted it to prominence.

Even in the PC industry, what comes around, goes around. Michael Dell told a conference crowd in 1997 that Steve Jobs should consider shutting down a struggling Apple Computer and returning the money to shareholders. Jobs is probably smiling today.

Michael Kanellos contributed to this report.