Why is Dell going private?
I should start with a quick recap of Dell’s situation: Michael Dell and tech investment firm Silver Lake Partners have proposed to take Dell private in a transaction funded in part by a $2 billion loan from Microsoft. The proposal has angered shareholders who believe the company is worth more than what was offered, and two competing proposals have emerged from Carl Ichan and Blackstone Group. Dell now apparently faces an extended period of limbo while the competing proposals are evaluated.
Given how messy this process could be, it’s reasonable to ask why Michael Dell started it in the first place. I’m surprised at how many conflicting explanations have surfaced:
—The deal is largely a tax avoidance scheme, according to Slate (link). Like many tech companies, Dell has accumulated a large pool of profit overseas which it can’t bring back into the United States without paying 35% income tax on it. If Dell takes itself private, it can use that money to pay off the interest from the buyout without paying tax on it.
—It’s a financial shell game according to some financial analysts, including Richard Windsor, formerly of Nomura. His scenario is that after Dell takes the company private, it will sell or spin out the PC half of the company to pay off the buyout. That will leave Michael Dell and his partners owning Dell’s IT services business at low cost (link).
—It’s a way for Michael Dell to get some peace. In this scenario, Michael Dell is a sensitive man who’s grown tired of taking criticism from investors. The buyout is a way to get away from them. This explanation showed up in a large number of press reports immediately after the proposal. For example, here’s PC World: “Michael Dell apparently grew tired of running his company to the whims of a stock market that often favors immediate return over long-term investment.” (link)
—It’s a necessary prelude to broad organizational changes at Dell. The Economist put it this way: “Making the kind of wrenching operational changes Silver Lake typically prescribes would be tricky for a public company anxious not to panic shareholders.” (link)
—Michael Dell did it to save his job. According to BusinessWeek, Michael Dell was afraid that an activist shareholder might take over the company and force him out as CEO. So he proposed the deal as a pre-emptive strike. (link).
The problem with analyzing a company’s motivations is that you tend to assume there’s a logical explanation for the things it did. Often there’s not. Company managers are frequently fearful or misinformed, and sometimes they just make dumb mistakes. It’s possible that’s happening with Dell. But if we assume a basic level of rationality, then we can probably discount some of the proposed explanations. For example, I personally doubt Dell can pay off the deal by selling the PC business, because I don’t think anyone would buy it. It’s not like there’s another Lenovo out there hungry to get into PCs, and Google already bought one floundering hardware company; I doubt it has the appetite for another.
I’m also skeptical that after a lifetime in business Michael Dell is so thin-skinned that he can’t stand shareholder criticism. If you have the ego and drive to build up a company from scratch to the size of Dell, you usually don’t care much about complaints from puny mundane humans.
And I find it hard to believe that Dell had to take the company private in order to reorganize it. If Dell took a machete to the PC business, I think most investors would cheer rather than panicking.
The explanation I lean toward is that Michael Dell was afraid he wouldn’t be left in charge long enough to finish transforming the company. You can make a case that as 15% owner and with a base of investors focused on long-term gains, his position was secure from takeover threats. But after I looked in more detail at the company’s finances, and some market trends, I started to suspect that he felt a lot less secure than you’d expect. There are big storm clouds on the horizon for Dell, and they’re darkening rapidly. Those trends also threaten the rest of the PC industry.
A storm’s a-brewin’
Dell’s problems have been developing for years. The company’s power probably hit its peak in about 2005, when it was the world’s #1 PC vendor with about 17% of the market. Dell was the upstart beast that had dethroned the PC powers like Compaq, HP, and IBM. But after 2005, the PC industry adapted many of the flexible manufacturing practices that had made Dell so powerful. PC sales also shifted toward notebooks, which are much less customizable than the desktop computers that made Dell successful. The company’s market share started to erode. Dell tried for several years to turn around the PC business through innovation and new product categories, with no effect. Then in late 2008 it changed strategy and started evolving itself into an IT services company (like IBM, but supposedly aimed more at small and medium businesses). Starting with Perot Systems, Dell made a long series of IT services acquisitions, a process that has continued to this day.
Throughout this process, Dell gradually lost PC share, dropping to 12% by 2011. But because the PC market was growing, Dell’s actual PC shipments were more or less flat, giving the company a financial cushion to fund its transition to services.
Then in 2012, the situation changed. For the first time in years, overall PC unit sales shrank. What’s more, Lenovo (the new upstart beast in the PC market) was taking share from the other leaders. The combination of a shrinking market and a growing Lenovo caused a big drop in Dell’s PC sales.
Worldwide PC (desktop and notebook) unit sales
Dell revenue (fiscal years)
I think the most disturbing thing for Dell about this revenue drop is that it happened in the face of the launch of Windows 8. Traditionally, new Windows launches have usually led to a nice uptick in PC sales as customers buy new hardware to go with the new software. Even the unpopular Windows Vista didn’t reduce PC sales. I’m sure Dell was expecting some sort of Windows 8 bounce, or at least a flattening in any decline. Instead, as we learned from the latest PC shipment reports, PC shipments dropped after the launch of Windows 8 (link). That indicates that the channel was probably stuffed with new Windows 8 PCs that have not yet sold through.
People who live in the world of smartphones and tablets are probably saying “so what?” But I doubt that was the reaction at Dell.
If you haven’t worked at a PC company, you’ll have trouble understanding how profoundly disturbing the current sales situation is for Windows licensees. The PC companies married themselves to the Microsoft-Intel growth engine years ago. In exchange for riding the Wintel wave, they long ago gave up on independent innovation and market-building. In many ways, they outsourced their product development brains to Microsoft so they could focus on operations and cost control. They trusted Microsoft to grow the market. Microsoft is now failing to deliver on its side of the bargain. Unless there's a stunning turnaround in Windows 8 demand, I think it’s now looking increasingly likely that we’ll see a sustained year over year drop in PC sales for at least several more quarters.
This is an existential shock for the PC companies. It’s like discovering that your house was built over a vast, crumbling sinkhole.
Prior to the PC sales decline, I think Michael Dell probably assumed that his PC business could continue to fund its growth in services for the foreseeable future. He has probably now reconsidered that assumption. If Lenovo continues to grow and the market continues to shrink, Dell’s revenue will drop further, and the company could be in a world of financial trouble a year from now. It’s the sort of trouble that can get a CEO fired even if he does own 15% of the company.
So here’s the sequence of events: By fall of last year, the troubles with Windows 8 were already becoming clear to the PC companies (remember, the Windows licensees have much better information on customer purchase plans than we get from the analysts). Michael Dell must have realized that he was headed for a significant decline in revenue. At the same time, we now know, one of the company’s major shareholders approached Michael Dell to float the idea of a buyout. That was apparently the trigger that started the whole buyout process.
Put yourself in Michael Dell’s shoes: the shareholders are getting restless already, and you know the situation is likely to get worse in the next year. Proposing a buyout now would be a pre-emptive strike to keep control over the company you founded. That’s what I think happened.
What happens next? After more confusion, someone will eventually win the bidding Dell. All of the bidders seem to agree that Dell should continue to invest in services, so the real debate is over what happens to the PC business. Michael Dell says if he wins, Dell will re-engage with the PC market (link):
“While Dell's strategy in the PC business has been to maximize gross margins, following the transaction, we expect to focus instead on maximizing revenue and cash flow growth.”
In other words, Dell will cut its PC prices.
It seems strange that Dell would want to refocus on PCs after treating them like a cash cow for years. If the business was unattractive when PC sales were growing, why would it be attractive now? Maybe Dell decided that it needs strong PC sales to get its foot in the door to sell services. That seems like a reasonable idea. But shouldn’t the company have known that years ago?
Or maybe Dell feels that the interest and principal payments on its buyout will be smaller than the profits required of a public company. That might allow Dell to compete more aggressively in PCs while it still invests in services.
Maybe that’s the purpose of Microsoft’s $2 billion loan, to let Dell stay in PCs while it also grows services. It says something sad (and alarming) about Microsoft’s business if it now needs to pay companies to stay in the PC market.
What it means to the rest of us
I think the Dell deal is just the beginning of the Windows 8 fallout. There are several other, bigger, shoes waiting to drop.
What will the other major PC licensees do? If you’re working at a company like HP or Acer, everything about this situation feels ugly. Your faith in Windows has been broken, you’re losing share to Lenovo, and now Microsoft is subsidizing one of your biggest competitors. I’d be tempted to fly out to Redmond and demand my own handout. And I’d also be willing to look at more radical options. There are several possibilities:
—Exit the PC market. HP considered this in 2011, but backed away after a change in CEO. I wonder if the company will think about it again. Meg Whitman says no, that the PC business is important to HP’s other businesses, such as servers, because they buy many of the same parts. Exit PCs and you costs will go up because you won’t have the same purchase volumes. That’s a pretty backward endorsement of the PC business, but I guess it’s possible.
Acer doesn’t really have the option of dumping PCs. They make up most of its business, so it has to stay in computing hardware, one way or another.
—Find a new plough horse. In this option, you replace Windows with a platform that has better growth prospects. That lets you continue to use your clone vendor skills, but in a market that’s growing. Acer and HP are both dabbling in Chrome netbooks (link) and Android tablets. I wouldn’t be surprised to see many more experiments along these lines. But it’s not clear how much market momentum Google can generate for its tablets and netbooks. HP and Acer could easily spend a lot of money for very few sales, and in the meantime create a rift with Microsoft that would be hard to return from if Windows 8 does eventually take off.
—Reinvest in creating differentiated devices. This is the other option: get off the clone treadmill and be more like Apple, a device innovator. The trouble with this is that many years ago, the PC licensees laid off the people who knew how to build new markets and new categories of computing device. Recovering those skills is like trying to grow a new brain – very slow, and hard to do when your head is stuffed with other things. You need to be incredibly patient during the learning process, and accept that there will be failures along the way. It’s hard for public companies to show that sort of patience.
So maybe you buy a company that knows how to make new-category devices. For example, you could have bought Palm. As time goes on, HP’s handling of that transaction looks more and more like a business Waterloo.
There aren’t many other hardware innovators that you could buy. RIM, maybe? Or HTC? But then you’re in a meatgrinder smartphone market dominated by Samsung and Apple. The PC market, even if it’s shrinking, might look more inviting.
Personally, I’d look at buying Nook. Not necessarily because I want to be in the ebook business, but to get a team that knows how to design good mobile devices and is familiar with working on a forked version of Android.
I don’t think any of these three options look very attractive, but the slower the takeoff for Windows 8, the more desperate the Windows licensees will get, and the more likely that they’ll try one or more radical “strategic initiatives” in the next year.
What if Microsoft gave a party and nobody came? The situation for Microsoft is becoming more and more complicated. Windows is not dead. It has an enormous installed base of users who are hooked on Windows applications and won’t go away in the near future. However, Microsoft faces some huge short-term and long-term challenges, and many of its possible responses could make the situation worse rather than better.
I think it’s pretty clear that we’ve entered a period of extended decline in Windows usage, as customers use tablets to replace notebooks in some situations and for some tasks. The tablet erosion may be self-limiting; I don’t think you can use today’s tablets to replace everything a PC does. If that’s the case, Windows sales may eventually stabilize and even resume growing once the tablet devices have taken their pound of flesh.
On the other hand, it’s equally possible that tablets and netbooks will continue to improve, gradually consuming more and more of the Windows market. That’s certainly what Google is hoping to do with Chrome. What would happen if Apple made a netbook and did it right?
Microsoft had hoped to head off all these problems with Windows 8. By combining the best of PCs and tablets, Windows 8 was supposed to stop the tablet cannibalization and also set off a lucrative Windows upgrade cycle. Unfortunately, at least for the moment, Windows 8 is looking like the worst of both worlds – not a good enough tablet to displace the iPad, but different enough to scare away many Windows users.
This puts Microsoft in a nasty dilemma. If it believes that Windows 8 sales will eventually rebound, then Microsoft should invest heavily in keeping its PC partners engaged. In that context, the $2 billion loan to Dell is a reasonable stopgap to prevent the loss of a major licensee.
On the other hand, if Windows sales are entering a long-term period of gradual decline, Microsoft should be doing the exact opposite. Rather than spending money to keep licensees, it should be allowing one or more of them to leave the business, so the vendors that remain will still be profitable and willing to invest. It’s better for Microsoft to have seven licensees who are making money than ten licensees who all want to leave and are investing heavily in Chrome or Android or other crazy schemes.
Microsoft also faces a difficult challenge with Lenovo. Even if Windows sales turn up, Lenovo has been taking share so fast that it will be hard for other Windows licensees to grow. At current course and speed, Lenovo is likely to end up the largest Windows licensee. In the past, Microsoft didn’t care if one licensee replaced another; they were interchangeable. But Lenovo has close ties to the Chinese government, which has repeatedly shown that it’s willing to lean on foreign tech companies. That has to make Microsoft uncomfortable.
In that case, the $2 billion investment in Dell starts to look like a defensive measure to get someone to compete against Lenovo on price. But if Microsoft subsidizes a price war in PCs, that might give the other licensees more reason to disinvest, enabling Lenovo to gain share even faster.
This is the true ugliness of Microsoft’s situation. It is in danger of falling into a series of self-defeating actions:
—To combat tablets, it creates a version of Windows that accelerates the Windows sales decline.
—To keep its licensees loyal, it makes Windows overdistributed, which increases licensees’ incentive to leave.
The situation is becoming more and more fragile. As I said above, I don’t expect Windows to collapse instantly. But many companies are reconsidering their investments in it, a process that is likely to eventually give customers second thoughts as well. We could end up with an unexpected series of events that combine to break the loyalty of Windows users and start a migration away from it that Microsoft couldn’t stop.
The key question is whether Google, Apple, or some other vendor can give Windows customers and licensees an attractive place to run away to. So far they haven’t, but the year is still young. I’ll talk more about the possibilities next time.