Has Dell finally hit the glass ceiling?

It has long been seen as a truism in tech circles that, once their annual revenues reach $30bn, the industry’s giants face an inevitable slowdown. The law of large numbers and the arrival of new technologies, usually bringing with them a new generation of corporate champions, leaves the older guard struggling to maintain their earlier, dizzying ascent.

For Dell, the magic number may have been more like $50bn.

The company, famously founded by Michael Dell in his University of Texas dorm room, went on to perfect a low-cost, direct-sales approach that became a model for companies in many other industries, appears to be running out of steam.

That was the message in a rare profit warning from the world’s biggest PC maker late on Monday. Its second sales disappointment in successive quarters, and the first time it has failed to meet Wall Street profit forecasts since the tech collapse of 2001, the news has added to gathering doubts about whether the model that took Dell to the top of its industry will sustain it through the next phase of its expansion.

From a growth rate of 19 per cent for all of last year, Dell’s revenues have been steadily slowing in 2005, hitting a new low of 11.2 per cent in the most recent quarter, a far cry from the 16 per cent or so that, until this year, had been thought sustainable over the longer term.

Behind that slowdown lies an unpalatable truth that comes with success. “Dell used to always beat the market – now, it is the market,” says Roger Kay, a PC industry analyst and president of Endpoint Technologies Associates.

The latest PC market figures seem to confirm this. According to Gartner, some 55m PCs were shipped in the third quarter of this year, a rise of 17.2 per cent from the year before. Dell’s own shipments rose only slightly faster, at 17.6 per cent, a sign that its days of devouring other companies’ market shares may be coming to an end.

With two thirds of its sales still coming from PCs rather than newer markets such as servers or printers, that will weigh on its overall performance for some time to come.

Worse, Dell is stuck in those parts of the PC markets that face the slowest growth – a potential problem for the months ahead, as a far stronger upgrade cycle than most analysts had anticipated begins to peter out.

With roughly one in three PCs sold in the Americas bearing its brand, the company has struggled to meet constant demands in the consumer market for lower prices and higher levels of service.

In the UK, meanwhile – its biggest market outside the Americas, accounting for an estimated 25-30 per cent of European sales – Dell’s exposure to the fiercely competitive market for corporate desktop PCs has left it out of the faster-growing consumer business.

Though it has always had a reputation for low prices, Dell has traditionally enjoyed a pricing advantage over its most aggressive rivals. That cushion, though, is slipping as buyers demand better deals and average the selling prices of PCs fall, and Dell has started to yield the low end of the market to others. Acer, for instance, saw its shipments jump nearly 55 per cent in the third quarter.

At the same time, some of the advantages of Dell’s much-envied business model – a combination of direct sales over the internet and telephone, together with a build-to-order system that squeezed inventory out of the system – have slipped away.

Many of its notebooks, the hottest part of the PC market, are bought from manufacturers in Taiwan, leaving it with no manufacturing cost advantage over rivals who use the same suppliers.

Also, other manufacturers have copied some of its methods. Traditionally, Dell had a 10-15 per cent cost advantage over rivals, according to Richard Gardner, an analyst at Citigroup. That advantage has now narrowed to 5-10 per cent, he estimates. Further eroding the gap is the willingness of other companies to accept a lower profit margin than Dell: that eats into another six percentage points or so of the company’s superior margin, calculates Mr Gardner.

With growth in its core markets slowing and the luxury of being able to adjust prices at will without destroying profit margins evaporating, Dell faces a dilemma. Should it chase the market lower, accepting lower prices and profits? Or, as it has chosen so far, should it move upmarket, towards higher-margin parts of the business – and risk becoming increasingly marginalised?

Part of Dell’s historical success was built on its ability to provide a “good enough” product built on open standards while competitors over-invested in high end products, says Richard Farmer, an analyst at Merrill Lynch. Now, he says, Dell’s increasing need to “refocus on higher value products and services” raises questions about whether it faces a threat from competitors with disruptive business models of their own.

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