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February 6, 2013

Dell Buys Dell In Order To Expand Its Datacenter Server Business

Nicole Hemsoth

The term “The Innovator’s Dilemma” was coined by Harvard professor Clayton Christensen, in a book of the same name, to describe what happens when new technology comes along to make old business models obsolete. Even innovative companies tend to focus on meeting the needs of their existing customers rather than cannibalizing their own products in order to meet a growing new market.

Michael Dell’s decision to buy his own company and take it off the public stock market is part of his strategy to solve his own Innovator’s Dilemma. He needs to focus on and expand his datacenter server business to replace his declining PC business.

Companies such as Dell, Microsoft and Intel all made their fortunes as pioneers in the personal computer business. They created the PC business and destroyed most of the mainframe and minicomputer makers in the process.

Now is the era of the next generation of devices. The PC business has been slipping under the shadow of hand-held devices, and the PC generation companies are facing the same kind of Dilemma they created for big computer makers four decades ago.

That’s why Dell and HP have started moving heavily into the next new disruptive business: servers and related products appropriate for datacenters. That’s a difficult transition to make. They must redirect investments from their large, existing markets into new businesses even though those markets are (for now) much smaller and the payoff won’t come for years. Shareholders don’t like the short-term hit on profits that requires. They bid down the stock, making the companies look like failing enterprises and worrying existing and potential customers. Competitors eye each other’s every move in order to try to outflank them.

Dell began looking at the server market half a dozen years ago with an eye to making big inroads into the datacenter business. It’s even making Intel’s dilemma a little worse by exploring the potential of ARM chips and microservers as a potential high-volume business in the datacenter, where Intel’s chips still dominate. Intel is, of course, responding to that threat as well.

“Dell clearly needed to undergo significant restructuring to better anticipate the future,” says technology analyst Rob Enderle, who has followed Dell and its competitors for decades. “They wanted to go back to a startup mode, where they could better surprise their competitors with a company better designed for the next decade.”

That future includes more than just servers and high-performance computing. It’s also working on mobile devices, tablets and other consumer products. But Dell, like Microsoft, Intel, Hewlett-Packard and others of the same generation, have never been very successful breaking into those markets. So those companies are all aiming at the next wave, in datacenter servers, software and services.

Dell is putting a big emphasis on its corporate clients, focusing on technologies and products such as blade servers, rack servers, cloud computing, datacenter virtualization, networking and power and cooling systems—with client support services to help implement all these systems.

This deal should allow Dell to focus on efforts such as better integrating its different products into its servers. For example, in the last few years it bought several companies, such as data storage company Compellent Technologies and networking company Force10, but has not yet put them together into compelling packages.

Going private seemed like the best way to make this happen. The Wall Street Journal cites sources who say that CEO Michael Dell approached the company’s board of directors last year to explore the idea. The board formed a four member committee to investigate other options, including remaining a publicly-traded company, selling out to a larger corporation, and separating the PC business from the software and services businesses, which have higher margins. But none of the alternatives seemed feasible.

A big question is whether companies using Dell’s servers and other products in their datacenters will be willing to continue buying its products while the transition takes place.

It will cost Dell $24.4 billion to buy out the public shareholders. Mr. Dell, who is still one of the richest people in the country with a net worth of about $16 billion, is putting in an undisclosed amount of his own fortune, and possibly loan guarantees, to make it happen. That’s a big show of faith in his own ability to make the transition.

Investment company Silver Lake Partners is putting in $1 billion. Microsoft, which has been closely tied with Dell since its founding, has also offered Dell a $2 billion loan, helping ensure that it will have a future in Dell’s new markets. Bloomberg reports that Dell is also seeking $13.8 billion in loans, which may cost Dell $1.2 billion in interest payments. On the other hand, Dell has been paying out over $500 million a year in dividends to shareholders, which will now end.

Just securing that financing will be tough. If it succeeds in that effort, however, it’s good evidence that outsiders have faith that Mr. Dell, who will once again be the company’s biggest shareholder, can make the transition happen.

Rival Hewlett-Packard, facing the same Innovator’s Dilemma, is in a better financial position to execute its own transition. It has issued a press release pointing out that debt-heavy buyouts “tend to leave existing customers and innovation at the curb,” and is offering to help those customers out by selling them its own products. Still, HP is facing its own problems, including a disastrous acquisition of business software company Autonomy, which it now charges with fraud for falsifying its financial records to seem much more profitable than it is in order to inflate the purchase price. That forced HP to write off $8.8 billion, creating an enormous hit on its profitability.

Overall, Michael Dell is making a very bold move. But he’s also facing a big Dilemma. Bold moves are the only kind that deal with that kind of change.