Margins in Computer PCs are on its last legs. Fierce overseas competition, high expectations from customers of ideal PCs, and the never-ending of “me too” tablets and ultrabooks have left the profit margins of the regular personal computer market eroded. Dell’s (NASDAQ:DELL) recent 2012 Analyst Meeting reveals a few notable facts here: 1. Revenues in the Consumer PC Market (including desktop, laptops and displays) are down another 5% YoY and Operating Income of the Consumer Business is an absolute tiny 3.2% of revenues (Dell’s revamped XPS laptops also were a large driver of operating income).
Dell’s supply chain management (SCM) used to be the de-facto operations case study for business students everywhere. By 2005 it was apparent that Dell’s competitors were integrating SCM in a similar fashion. Yet in a market where desktops have been largely replaced by laptops (and eventually smartphones and tablets), the efficiency of desktop customization adds very little to bottom line today. Remember Hewlett Packard’s (NYSE:HPQ) ex-CEO Leo Apotheker? He was fired last year (largely, amongst other blunders) for his corporate (“save HP”) strategy. His strategy? Mimic IBM (sold Lenovo in 2005) and sell HP’s Personal Computer segment. Apotheker felt that the unprofitable segment was largely a drain on HP’s resources. The problem? HP had the largest market share of global PC market. Shareholders thought this was a terrible idea and gave him the boot. A year later, Whitman (CEO of HP) is keeping its personal computer segment, but still doubling up on enterprise / cloud solutions as the future driver of profits.
Michael Dell isn’t going to make the same mistake as Leo and try to sell off his PC business, but Dell clearly has to do something. While short of abandoning the personal computer market, Dell is looking to quickly expand in the Enterprise software space. “Organic and Inorganic” growth are the takeaways that Dell stated in its Analyst Meeting. Just cross out organic already. Dell will be continuing and accelerating its acquisition pace. Why? Because it’s competitors (HP, IBM, Intel, Microsoft, SalesForce etc.) are making the same plays for the enterprise market. One of Microsoft’s cloud solutions (Azure) has begun making traction as a platform as a service (PaaS). This is one of the many interesting reasons why Microsoft (NASDAQ:MSFT) is one of the most popular stocks among hedge funds (see the 10 most popular stocks). Enter the bidding wars for the enterprise software market. If it hadn’t been Dell, Quest Software was going to be bought out by someone else.
Dell’s eventual goal is to enter prospective enterprise buyers and promise them a complete package. Provide Dell’s CRM, servers (cloud with SaaS, IaaS, PaaS, or self-managed), network security, computers, technical consulting, a complete and only Dell solution. Once Dell completes its purchase of Quest, it gets a multitude of data-management software. More importantly, it gets Dell in the door. Eventually the hope is (and this is not always the case) the different modules of software and hardware parts will run better together under a unified solution (marketing and senior management love “unified solutions”). Dell will be able to go to current customers of Quest and promise to replace their current infrastructure with a Dell branded solution at a fraction of its current cost and a brand new solution.
More importantly, and this is frequently realized by the shareholders, fully integrated enterprise software (especially platforms, aka Azure) are incredibly difficult to switch. After a year of using a specific piece of software exclusively, companies have developed specific workflows that will only work for that software. By now, Quest’s customers only know how to efficiency manage their data with Quest software; they don’t know any other way. Having previously worked in analyzing enterprise software solutions, there’s one strong takeaway. Even if you can provide a better software solution that promises 10% improvement, managers are unwilling to sign off on these projects (at least not without a very long vetted process). Their rationale? At best, 10% improvement for the corporation that senior management won’t notice. If this new software flops, I’m going to get fired.
Dell’s sales teams will go to the customers, promise them Dell’s unified solution is the best. Promise them a complete solution customized to the client’s specific needs. HP, IBM, Microsoft and all the big players will be doing the same. To do this, you need the entire software and hardware suite. Sales might promise them an advanced version of the product that won’t come out for another year, but once you’ve got your solution through the door – you can bet that the customer won’t be able to easily switch in the future. This isn’t on the difficulty of switching your servers from Dell to HP now (already near impossible). The difficulty is now switching your entire company from Dell to HP. As my MD used to joke, signing contracts with enterprise vendors was like being married in a country where divorce is illegal.
The takeaway isn’t to be long Dell. In fact, quite the contrast. (David Einhorn’s bullish stance on Dell back in February was big, but we can see they’ve recently cut holdings by 15%.) The bidding wars are going to continue for enterprise solution companies. The synergies will largely be squabbled away with teething issues of newly integrated software, ie. HP’s recent difficulty with integrations with cloud acquisitions. The takeaway should be to pay specific attention to companies with a market cap under 2 billion, that have specific vendor relationships already, and are used exclusively for enterprise software with either strong growth or high profit margins. Dell is looking to provide a complete solution, but is still missing pieces. The prudent investor will be figuring out what the missing pieces are. For beginners, watch out for movement for Brocade (NASDAQ:BRCD) and QLogic (NASDAQ:QLGC) (companies which both provide hardware infrastructure for companies and are not too large for takeovers). Investors should compose a basket of likely targeted companies. Software acquisitions are at a record pace for the year. For motivation, remember that 3PAR (bought by HP in 2010) tripled in market capitalization over the course of 18 days. Good luck hunting.