If you have been reading this blog for a while you have probably figured out by now that my posts are a scheme on my part to write about topics that interest me in a way that is more interesting for readers. This blog post about Dell founder Michael Dell is no different. I try to work within a 4,000 word count on each blog post. For this post both for brevity and due to the nature of what I do for a living, I’m going to limit the discussion mostly to pre-2002 events.
As is usual, the Michael Dell quotes are in bold text:
1. “I believe that you have to understand the economics of a business before you have a strategy, and you have to understand your strategy before you have a structure. If you get these in the wrong order, you will probably fail.” Dell’s statement about economics is a reference to microeconomics and not macroeconomics. The distinction between these two types of economics was explained at the 2016 Berkshire shareholder meeting by Charlie Munger who said: “Microeconomics is what we do, macro is what we have to put up with.” Understanding microeconomics is essential if you want to be successful in business since as Munger went on to say business is essentially microeconomics. In his “Five Minute University” bit on Saturday Night Live, Father Guido Sarducci explained business simply: “You buy something and you sell it for more.” It is really quite simple. The math that determines whether you can “sell it for more” is called “unit economics.” How much can you profit from the sale of each unit of what your business produces?
Dell said in the quote above that once you have an understanding of the economics you need a strategy. What is a strategy? My most complete post on strategy is about Michael Porter, who has said: “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different. The essence of strategy is choosing what not to do. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.” After you have a strategy then you can create a structure says Dell. The original structure at Dell was three people assembling PCs working at a six foot table and two more people answering the phone with Dell performing the rest of the necessary functions at the company. The structure of Dell’s business has evolved many times, but always in relation to the underlying economics and the strategy of the business.
2. “When I was 19, I saw what I thought was a huge opportunity to change the way personal computers were made and sold. In high school I purchased and took apart one of the very first IBM PCs. I made two interesting discoveries: 1) none of the parts were made by IBM 2) the system that retailed for $3,000 actually cost IBM about $600. I immediately saw this as an opportunity. I started upgrading my own systems, using the same components as IBM, and selling them. The idea grew from there.” What a 19 year old Michael Dell saw in the PC business was “unit economics” that were quite favorable. Dell saw the opportunity to take $600 in components and transform that into a product that people would pay $3,000 for. Even better, none of the parts were made by IBM so there was no real barrier to entry and as a result IBM did not have wholesale transfer pricing power over his business. Dell was able to find favorable unit economics because Bill Gates also had a favorable strategy with respect to IBM. The most important business decision that took place in the earliest days of Microsoft was Gates’ decision to license Microsoft Basic to MITs (the manufacturer of very first PC known as the Altair) on a non-exclusive basis. This decision by Gates was enabled by the fact that multiple people and businesses can possess the same software at the same time at essentially no incremental cost (software is non-rival). Gates understood the difference between a license and an outright sale which was an essential enabler for both Microsoft and companies like Dell. Gates explained the history of one of the most important deals in business in this way: “The contract with IBM called for us to do all this work on the design of the machine and all this software. We didn’t get paid that much–the total was something like $186,000–but we knew there were going to be clones of the IBM PC. We structured that original contract to allow them. It was a key point in our negotiations.” Paul Allen elaborated: “We already had seen the clone phenomenon in the MITS Altair days. Other companies made machines that succeeded because they were similar to the Altair. For us it had been easy to modify our software so it worked on those machines too.” Not only was Dell able to surf on the phenomenon created by Gates and Allen, he was also able to create his own moat by making some key decisions as will be explained below.
3. “We started the company by building to the customer’s order. And interestingly enough, we didn’t do it because we saw some massive paradigm in the future. Basically, we just didn’t have any capital to mass-produce.” “While that was a great way to start the business, it turned out there was a lot more we could do with it, in terms of building relationships with suppliers, reducing inventories and receiving direct input from customers.”’ Most important, the direct model has allowed us to leverage our relationships with both suppliers and customers to such an extent that I believe it’s fair to think of our companies as being virtually integrated. That allows us to focus on where we add value and to build a much larger firm much more quickly. I don’t think we could have created a $12 billion business in 13 years if we had tried to be vertically integrated.” Dell started his business at a very auspicious time. Powerful forces were transforming the economy and that created massive opportunity for many business. In his 1999 essay Michael Mauboussin pointed out “source of value creation is shifting from physical capital to intellectual capital— from atoms to bits.” Better information technology systems (i.e., bits) allowed Dell to create a vertically integrated solutions with only a fraction of the capital that would have been needed in the traditional business world. Professor Gerald Davis describes this phenomenon:
“In 1950 it might have made economic sense to assemble cars in giant vertically integrated factories in Detroit and ship them from there to the rest of the world. Today, the parts of a business are like interlocking plastic bricks that can be snapped together temporarily and snapped apart when they are no longer needed. Information and communication technologies (ICTs) make starting an enterprise trivially easy, from creating a legal structure to hiring temporary employees to contracting out for production and distribution. Coordinating activities used to be the corporation’s strong suit. Now the corporation is increasingly out-maneuvered by alternative forms of enterprise that are more flexible and less costly. The barriers to entry are falling across a wide swathe of industries. In his famous 1937 article “The Nature of the Firm,” Nobel Prizewinning economist Ronald Coase explained, “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price system. The most obvious cost of ‘organising’ production through the price mechanism is that of discovering what the relevant prices are.” But what if discovering the relevant prices becomes trivial? What if the inputs of a firm, including labor, can be priced and ordered as they are needed? What if, in place of long-term employees, firms were able to contract for workers if and when they were needed for specific tasks—the way that customers can use the Uber app to order a ride?”
4. “Inventory velocity is one of a handful of key performance measures we watch very closely. It focuses us on working with our suppliers to keep reducing inventory and increasing speed.” “We tell our suppliers exactly what our daily production requirements are. So it’s not, “Well, every two weeks deliver 5,000 to this warehouse, and we’ll put them on the shelf, and then we’ll take them off the shelf.” It’s, ‘Tomorrow morning we need 8,562, and deliver them to door number seven by 7 a.m.’” “Because we build to our customers’ order, typically, with just five or six days of lead time, suppliers don’t have to worry about sell-through. We only maintain a few days—in some cases a few hours—of raw materials on hand. We communicate inventory levels and replenishment needs regularly—with some vendors, hourly.” Dell did not have much capital when he started so he turned a weakness into a strength. Bill Gurley and Jane Hodges described the Dell strategy in a classic article from 1998:
“From a corporate perspective, the best measure of fitness is return on invested capital (ROIC). This measure matters most because over the long haul, capital flows toward investment opportunities with a high ROIC. Inefficient companies, on the other hand, are eventually starved of the cash they need to survive. To understand just how indispensable technology has become, you have to follow the basic math of return on invested capital. To get ROIC, you divide EBIT, or earnings before interest and taxes, by invested capital. Now let’s divide the numerator and the denominator by annual sales. This restates ROIC as operating margin multiplied by asset turnover. In other words, the two components that define a company’s fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital…. companies that lack competitive information technology will be in serious trouble. They will resemble a 40-year-old trying to win Wimbledon with a small wooden racquet. Their business models may no longer be economically sustainable. Companies like Dell have reached an interesting new stage in the evolution of business–negative working capital. They collect money from customers before they have to acquire components or spend money. This phenomenon allows these companies to grow without raising capital, even if day-to-day profitability is zero.”
Gurley elaborated on Dell’s advantage in another article: “Dell’s incredible five days of inventory allows it to pass on component price declines faster than anyone else in the industry. But perhaps the unique aspect of Dell’s business advantage is its negative cash conversion cycle. Because it keeps only five days of inventories, manages receivables to 30 days, and pushes payables out to 59 days, the Dell model will generate cash–even if the company were to report no profit whatsoever.” Michael Mauboussin describes the results in his essay Atoms, Bits and Cash in November of 1999.
5. “We’re free cash flow people.” Dell shares this attribute with many great operators like Costco’s Jim Sinegal. One of my post popular blog posts was on Jeff Bezos. One focus of that post is on his views on the right financial drivers of his business. Bezos is quite clear about what he seeks:
“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”
Justin Fox explains:
With free cash flow what counts is when the money actually changes hands. So if you have a business where your customers pay you quickly, you manage your inventory well, and you’re able to take your time in paying your suppliers, your free cash flow can be consistently positive even when your net income is not. Which is exactly the kind of business that Jeff Bezos and his colleagues have constructed at Amazon over the past decade. According to my instructor in such matters, Harvard Business School finance professor Mihir Desai, the key metric of a company’s cash-generating prowess is the cash conversion cycle, which is days of inventory plus days sales outstanding (how long it takes your customers to pay you, basically), minus how many days it takes you to pay your suppliers. Super-efficient retailers such as Walmart and Costco have been able to bring their CCC down to the single digits. That’s impressive. But at Amazon last year, the CCC was negative 30.6 days.
6. “The computer industry when [we] entered it had gross margins of 40 percent plus. On top of that, you had dealers with margins of 20 to 30 percent. So the end user was paying a pretty incredible premium over the cost of goods for the product.” “The basic idea was to eliminate the middleman.” “Every breakthrough business idea begins with solving a common problem. The bigger the problem, the bigger the opportunity.” Jeff Bezos famously said that the profit margins of his competitors are Amazon’s opportunity and Dell was an early believer in that approach to business. The longer I am involved the business the more I appreciate the value of being in a business with high gross margins. Life is just better when gross margins are high since you have headroom for sales and marketing as well as profit. By contrast, businesses with low gross margins tend to be soul crushing slogs where every penny spent is another way to go out business. Of course, high gross margins alone are not enough to make a business attractive. You also need a large market. And a moat. At one point I changed the focus of my career from the communications business to the software business and I must admit that a major motivation for the shift was the high gross margins available in software. There were other reason that attracted me like better scalability, but high gross margins are a wonderful thing to have in a business. As Warren Buffett has said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
7. “If we can buy something that’s very similar to something we can create ourselves, we believe it might not be valuable for us to create it. On the other hand, if we’re thinking about creating something that nobody else has, that’s worth doing.” “Dell Computer came along and said, “Now wait a second. If I understand this correctly, the companies that do nothing but put chips on motherboards don’t actually earn tremendous profit doing it. If we want to earn higher returns, shouldn’t we be more selective and put our capital into activities where we can add value for our customers, not just into activities that need to get done?” I’m not saying those activities are unimportant. They need to get done very, very well. But they’re not sources of value that Dell is going to create. When the company started, I don’t think we knew how far the direct model could take us. It has provided a consistent underlying strategy for Dell despite a lot of change in our industry. Along the way, we have learned a lot, and the model has evolved.” Dell is talking about a point made by Andy Grove, who said once: “You have to understand what it is that you are better at than anybody else and mercilessly focus your efforts on it.” Professor Michael Porter argues “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match.” Grove is saying that a business should find this comparative advantage and focus resources on it with passion. Businesses that try to do everything, often end up doing close to nothing.
8. “The consumer has better information, you have transparency of pricing. You can’t trick the consumer anymore. The businesses that had an advantage because they sold things in a geographic area where people had limited information, and they couldn’t travel to go buy something else. Those folks are in real trouble. The Net kind of destroys that business model.” “At the root of any economic system is the cost of transactions. You have something you want to sell, I want to buy it, and what that transaction ultimately costs is tied to the cost of communicating information. The Internet is the latest evolution of communication technology-tremendously powerful because it enhances the flow of information. So basically it’s like a big vacuum that sucks friction out of the economy.” Simply increasing product advertising is often not a solution to increasing sales due to higher levels of transparency enabled by Internet. When customers are as well informed as they are today the best way to acquire customers cost effectively is almost always with an organic customer acquisition strategy, meaning they are attracted to the service because it is a great service. Businesses that must sell their products with huge advertising budgets are losing their edge in the Internet era. Jeff Bezos of Amazon puts it this way: “In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts. Your brand is formed primarily, not by what your company says about itself, but what the company does.”
9. “Ideas are commodity. Execution of them is not.” “Coming up with the ideas is not the hard part for us. We got more ideas than we know what to do with. The hard part for us is prioritizing the best ones, picking them, and fielding teams to go after them all. We’ve gotta be careful. Because if we go after too many of them, well then we’ll fail to execute, because we won’t have the people, the resources. It’s sort of one foot in front of the other.” “People look at Dell and they see the customer-facing aspects of the direct-business model, the one-to-one relation-ships. What is not really understood is that behind these relationships lies the entire value chain: invention, development, design, manufacturing, logistics, service, delivery, sales. The value created for our customers is a function of integrating all those things.” “If you want to sustain excellence over a long time, you’d better come up with a system that works well. Anyone can sprint for a little while, but you can’t sprint for forty years.” In my blog post on John Doerr I quoted John Doerr as saying “We believe that ideas are easy, execution is everything.” A good idea or invention is necessary, but it is far from sufficient to achieve success in business. It takes an entrepreneur to take an idea or innovation and turn into genuinely scalable business. That means a “roll up your sleeves” and a “make the trains run on time” effort from a team of people. Bill Gates said once: “Being a visionary is trivial. Being a CEO is hard. All you have to do to be a visionary is to give the old ‘MIPS to the moon’ speech — everything will be everywhere, everything will be converged. Everybody knows that. Which is different from being the CEO of a company and seeing where the profits are.” The great CEOs I have seen over the years like John Stanton and Jim Barksdale are masters of execution.
10. “The inspiration initially was my own curiosity about technology and what it could do for people. But I had a sense of urgency about it in 1984. Like all windows of opportunity, they eventually close.” “You have to focus on the point of impact where you can really make a difference in something in a meaningful way. That’s going to evolve. Where you might have had an impact on something three years ago. If you did that same thing now, you wouldn’t have enough of an impact to matter.” Sometimes an opportunity comes along and it has a time stamp. You either grab that opportunity right then and bet big or it is gone. As an example, Bill Gates famously dropped out of Harvard to move to Albuquerque, joining Paul Allen in writing software for the Micro Instrumentation and Telemetry Systems Altair computer they first saw in a Popular Electronics magazine at a newsstand in Harvard Square. The price of the MITS computer in 1975 was $397. It was primitive and lacked easy-to-use software, but even then they could see the potential for this device since they experienced how valuable having access to a computer could be. Despite being their youth, especially in the context of how business was conducted at that time, Gates and Allen realized that if their business was not formed immediately they would miss the opportunity. Gates recalls: “When we saw [the Altair], panic set in. ‘Oh no! It’s happening without us! People are going to write real software for this chip!’” Dell saw his own opportunity and grabbed it. Charlie Munger’s advice is that a person needs a combination of patience and yet aggressiveness when the opportunity is right.
11. “Assets collect risks around them in one form or another. Inventory is one risk, and accounts receivable is another risk. In our case—with 70% of our sales going to large corporate customers—accounts receivable isn’t hard to manage because companies like Goldman Sachs and Microsoft and Oracle tend to be able to pay their bills. But in the computer industry, inventory can actually be a pretty massive risk because if the cost of materials goes down 50% a year and you have two or three months of inventory versus 11 days, you’ve got a big cost disadvantage. And you’re vulnerable to product transitions, when you can get stuck with obsolete inventory.” “Consider what to do with the investment that could be freed up by shedding inventory and other assets now on the balance sheet.” “One of the big changes that is brought about by information technology is that the cost of those connections and those linkages has gone down dramatically. So if you’ve got an operation that builds a component, the cost to communicate worth that operation in an information sense, if it is done electronically goes to zero. That means you can build a linkage between that components supplier and a manufacturer and make it very, very efficient. That enables you to scale more quickly, gives you more flexibility, you can manage supplier networks in a more dynamic fashion, and get things off your balance sheet that aren’t your specialty, and companies can really hone in on something that they’re really great at.” The many ways in which Dell grew by having great financial strategies and tactics is underappreciated. Dell had a succession of great CFOs over the years and it shows. Combine a great CFO and a great information technology infrastructure and that is rocket fuel for success. CFOs take a lot of criticism from engineers since they often put limits on spending. Which reminds me of a story. A CEO I knew took the company’s leadership team on a retreat to a resort that had a large swimming pool filled with hungry alligators. One night the CEO said to the executives: “A person should be measured by courage. Courage is what made me CEO. This is my challenge to each of you: if anyone has enough courage to dive into the pool, swim through those alligators, and make it to the other side, you will be my successor.” While everyone was laughing at the CEO’s crazy offer, they suddenly heard a loud splash. When they turned to look at the source of the splash they saw the CFO of the company in the pool, swimming for his life. Amazingly he swam so fast that he avoided the alligators and was able to make an exit using a ladder at the other side the pool with only a fraction of a second to spare. The shocked CEO approached the CFO and said, “You are amazing. I’ve never seen such courage in my life. You are clearly the right person to be my successor. Tell me what I can do for you.” The CFO, panting for breath, looked up and said, “Well, first of all, you can tell me who the hell pushed me into the pool!”
12. “Try never to be the smartest person in the room. And if you are, I suggest you invite smarter people… or find a different room.” Dell has always had a range of talented people working with him. One example is Thomas J. Meredith, who was at one time Dell’s chief financial officer. There are many other people who have contributed to the success of Dell over the years, many of which are mentioned in this article: entitled: Inside Dell Computer Corporation: Managing Working Capital http://www.strategy-business.com/article/9571?gko=d8c29 As Charlie Munger has said: “Acknowledging what you don’t know is the dawning of wisdom. I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”
Dell on Going Private: http://www.cnbc.com/2014/09/23/after-going-private-dell-isnt-looking-back.html
Gurley and Hodges Fortune Article: http://archive.fortune.com/magazines/fortune/fortune_archive/1998/10/12/249302/index.htm
WSJ on the Dell Model: http://www.wsj.com/articles/SB944003985432882680
Technology Review Article on Dell: https://www.technologyreview.com/s/401105/direct-from-dell/
Mauboussin on CAP: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/cap.pdf
Mauboussin on Measuring the Moat: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf
Mauboussin on Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf
Mauboussin: Atoms, Bits and Cash: http://giddy.org/dbs/neweconomy.pdf