Kevin Rollins

Michael Dell's dilemma

June 13, 2011: 11:15 AM ET

Dell's earnings and stock price are up. But is its CEO making the bold moves needed to compete with IBM and Apple?

By Katie Benner, writer

FORTUNE -- Dell Inc. isn't the No. 1 PC maker anymore, and to hear Michael Dell, the company's founder and chief executive, tell it, that doesn't much matter. Dell is a diversified technology company, offering everything from servers to systems integration. And, he insists, its future has never been brighter. "Dell has an earnings growth story. Dell is expanding margins. Dell is acquisitive. Dell has strong cash flow," he tells Fortune in an interview at the company's Round Rock, Texas, offices. "Dell is on the offensive," says Dell.

All those things are true -- to a certain extent. The company recently reported quarterly earnings of nearly $1 billion, handily beating expectations thanks to strong corporate demand for PCs and servers. Several analysts upgraded the stock. It has indeed done some deals, including a recent $940 million purchase of data-storage company Compellent Technologies  and the $3.9 billion acquisition of Perot Systems in 2009. As for being on the offensive? The CEO has been telling anyone who will listen that his company has moved beyond personal computers, a low-margin business that represents about 55% of Dell's top line -- and about 70% when you add in PC-related software and peripherals.

None of that erases the fact that Dell (DELL) is struggling to find its identity in a world dominated by giants like Oracle (ORCL), IBM (IBM), and even Hewlett-Packard (HPQ), which offer corporate customers a far larger menu of hardware, software, and service than Dell. (On the consumer side, Dell faces the seemingly unstoppable Apple (AAPL) juggernaut.) For all of Michael Dell's optimism, it is hard to see him transforming the company from its current position as a PC maker and solid niche services player (it does well with midsize businesses and industries such as government and health care) into an IBM-slaying tech titan.

From interviews with a dozen current and former employees, Dell emerges as a cautious manager who has struggled to anticipate the market and technology shifts reshaping his industry. Fortune has learned that he repeatedly blocked former CEO Kevin Rollins's efforts to expand beyond PCs, starting in 2002, by trying to acquire storage-gear maker EMC (EMC). "I couldn't get Michael to agree," Rollins says, speaking publicly for the first time since he left Dell. "He was worried that it would be too destabilizing for the company."

Dell's risk-averse management style -- and his failure to spot key trends such as the rise of mobile phones and tablets -- flies in the face of his public persona as one of America's great tech entrepreneurs. But Michael Dell's innovations have been centered on business models and logistics, not technological breakthroughs. His company doesn't churn out patents and inventions. It spends about 1% of revenue on R&D. In contrast, Apple spends 3% of sales on research, and HP more than 2%.

With a management reluctant to spend on big acquisitions and in-house research, some analysts believe the company won't be able to keep pace with its larger peers. "Dell won't be destroyed, but it needs to take more aggressive steps or remain a small player that doesn't grow that much," says Shaw Wu, an analyst at Sterne Agee.

The return of Michael Dell

Michael Dell retired as CEO of Dell in 2004, then returned to the top job in 2007 to rescue the company. But Dell, who remained chairman, never really left, essentially acting as Rollins's co-CEO. "We made decisions regarding strategy and operations together," Rollins says. "It worked amazingly well until we had real disagreement about the company's direction."

By 2002, Dell and Rollins had begun to debate whether the business mix was too PC-heavy. Rollins wanted to buy EMC, which the market valued at around $16 billion. (Today's value: $57 billion.) According to four former senior executives, Dell didn't want to make what he called a "bet the company" move; he also was spooked because services firm ConvergeNet didn't thrive after Dell bought it in 1999.

Instead, Dell wanted to diversify by making other consumer goods, including printers, televisions, and MP3 players. "Michael thought these businesses could generate sufficient organic growth without the risk of a big acquisition," says Louise O'Brien, who was vice president of corporate strategy. The problem, she says, was that the traditional Dell model for driving down costs didn't work in those areas the way it had for PCs. "They required more investment in R&D -- being low cost and fast to market wasn't enough differentiation to succeed," O'Brien adds.

Michael Dell (at left) and Kevin Rollins, then CEO of Dell, in 2006

With little in its product pipeline, Dell had to rely on PC sales. It slashed prices to boost volume and demanded deep discounts from suppliers. The Securities and Exchange Commission alleged in a lawsuit that the company did not disclose to investors that it depended on "exclusivity payments" from Intel (INTC) to meet financial targets, estimating that those funds accounted for between 10% and 76% of Dell's operating income from 2003 through 2007. Michael Dell, Rollins, and the company settled the lawsuit in 2010 and can't comment on the charges.

In January 2007, Rollins was fired, but business didn't improve with Dell alone at the helm. While he tried to figure out how to reverse Dell's slide, rivals were developing mobile phones and competitors that focused on corporate customers had pushed into services such as IT outsourcing and systems integration. IBM bought PwC Consulting in 2002, and HP in 2008 announced a $14 billion deal to buy EDS. Dell acknowledges that he should have diversified sooner, "but we looked out and saw that we could grow from $5 billion to $10 billion to $15, then $30 billion" on computers alone, he says.

As a result, PCs still dominate the Dell income statement, while services and software, which generally boast higher margins, remain a footnote, despite the recent Perot acquisition. IBM's $56.4 billion services business (almost as large as Dell itself) accounted for 56% of revenue and 39% of pretax income in 2010. HP's $34.9 billion services division was 28% of revenue and 49% of earnings from operations. At Dell the services business generates $7.7 billion, or 13% of revenue. Credit Suisse analyst Kulbinder Garcha estimates that about half of Dell's services revenue comes from hardware maintenance and support, not the consulting-type businesses that are the most profitable.

Dell has made it clear he has no plans to buy his company's way into leadership in the software and services race; he prefers to acquire entrepreneurial companies, with which he feels a kinship. "Startups bring new ideas, new talent, and fresh thinking into the company," he says.

Weaknesses and strengths

In his 1999 book, Direct From Dell, Dell wrote, "When you've got only single-digit market share -- and you're competing with the big boys -- you either differentiate or die." Dell has single-digit share in software, networking, and services, according to Credit Suisse -- but it is struggling to distinguish itself from the competition. It lacks a proprietary operating system, so, like Acer, Asus, Samsung, LG, HTC, and others, it relies on Windows, Android, and Linux to make the brains for its gadgets. Meanwhile the company's services division builds solutions around the software and hardware that customers already have -- tucking in changes and new items where it can. In contrast, companies like IBM and HP often create top-to-bottom solutions that incorporate their own software and equipment.

That's not to say Dell doesn't have its strengths. The stock is up 20% this year. It has a strong foothold selling hardware to smaller companies, and as they need more sophisticated technologies and services, Dell is a natural partner. It also does well with government, education, and health care clients, thanks in part to its Perot acquisition. Many analysts and even a few former employees believe Dell can carve out a healthy business simply by dominating its niches -- acting more as an IT specialty store than a supermarket.

Dell doesn't see his company that way, though. "Things are changing here," he says. "Dell is winning." Maybe for now, but one has to wonder if the CEO has the right plan for doing battle long term with the big boys of tech.

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