Hardware: the backlash to the backlash

Summary:The hardware business: a lot of work for little to no profit. The perfect candidate for tech companies to scratch off the balance sheet? Not a chance.

The hardware business has gotten a bad rap.

IBM saw the writing on the wall and sold its PC division to Lenovo in 2004.

CNET wrote at the time:

The deal will let IBM continue its shift from selling so-called commodity products to selling services, software and high-end computers. Although the company helped make PCs a global phenomenon, IBM makes little profit from PCs and often loses money.

Not long after, Dell followed suit.

Peter Pham explains it nicely from a financial point of view:

Dell is actively remaking itself into a server and IT services company moving away from the thin and vanishing consumer electronics market. Their consumer business accounts for only 20.7% of their revenue but only 3.9% of their income. At this point Dell could stop selling computers to consumers and nothing about the company’s futures growth prospects would change. If anything the PC business is a boat anchor dragging down the company’s return on invested capital.

Hewlett-Packard, of course, found itself in the same boat when Leo Apotheker took over.

At the time, upon acquiring enterprise software company Autonomy (and axing Palm), Apotheker said:

We believe this bold action will squarely position HP in software and information to create the next-generation information platform, and thereby, create significant value for our shareholders.

The message from all of these large, publicly-traded technology companies? The hardware business -- both the manufacture of devices and the sales of them -- is cutthroat, low-margin and a drag on a company's growth. After all, just look at the companies operating at the extreme edge of that playing field -- components manufacturers like hard-drive makers Seagate, Samsung and LaCie, who have for years fought viciously as the entire sector went south. These companies are selling more storage than ever, and there are more devices than ever in which to put that storage. So what's the problem?

Margins, that's what. If you sell millions upon millions of products but make very little on them, you may end up well behind the guy selling hundreds of products that cost the same to make but are priced considerably higher. It's why Wal-Mart makes an astounding $422 billion in revenue but just $16 billion in profit, while LVMH -- owner of Moet & Chandon champagne and Louis Vuitton, among others -- makes $7 billion profit on $30 billion in revenues. Sure, Wal-Mart makes twice as much profit as LVMH -- but it has to work 14 times harder to get it.

You can't blame tech's public giants for eyeing the industry equivalent of Hennessy cognac -- enterprise software and services -- and salivating at the margins. Who wants to ship endless boxes of low-margin hardware when you can move less high-margin software for more money? Hanes, or Hublot?

Along the way, though, they forgot two things: first, that there's only so much room in a rarified sector like that; second, that having an incredible footprint with so many customers can pay off in other ways, provided you develop new revenue streams to pitch to that existing base.

Yet so many of the biggest technology companies abandoned this group. For IBM, it made sense; the company was never really a consumer player at its core. For Dell, it was foolish; the company had big enterprise aspirations but a ragtag team with which to compete. For HP, the world's most popular PC maker, it was almost foolish -- until CEO Meg Whitman reversed an earlier decision made by dismissed chief Leo Apotheker.

Despite a different business model -- carriers and long-term contracts and all that -- similar things have been observed in the mobile sector, even though smartphones are flying off the shelves like never before. (If you don't believe me, just ask HTC or Motorola.) After all, who wants a business that makes less money with each passing quarter, despite increasing sales?

Someone with something else to sell, that's who. Apple long ago demonstrated that a vertical stack -- key components, the devices themselves, the software that runs on them and the services that are sold through them -- have competitive advantages in terms of market differentiation, supply chain efficiency and, ultimately, revenues. Your product cannot be a commodity if you're the only one selling it. What was once a pain point for Apple -- we think different -- became an asset when its products gained traction with consumers.

It takes a diverse portfolio to create an integrated product. As Apple was building its stack, the Dells and Motorolas of the world were hacking theirs down. The whole time, Microsoft and Google were sitting on the sidelines, watching it all play out. Now they're both entering the fray -- Google, with its Motorola Mobility acquisition; Microsoft, by its increasingly friendly overtures toward fallen comrade Nokia and the introduction of its Surface tablet. Each company realizes that it can't keep selling advertisements and software, respectively, without securing the path to potential customers.

The hardware era is back. You could argue that it never really left -- consumers and businesses have been buying gadgets with ever-increasing frequency. But as software and services became more vibrant, enabling blank displays to light up with productivity and possibility, the biggest technology companies are beginning to realize again that their huge footprint with consumers could be a real asset. Nevermind the short-term, profit-thin outlook on hardware -- it's worth leaving on the balance sheet when you can use that group as a vehicle to sell high-margin software and services. Better still, the combined package makes for a better functioning (no compromises), more competitive (unique features) product.

John Gruber put it nicely earlier this week:

The math no longer works out for the Windows you-sell-the-hardware-we-sell-the-software model. It works for unit share (cf. Android), but it doesn’t for profit share. Nothing works sustainably in business without profit -- profit is the oxygen companies breathe.

It's becoming apparent that when you're a company sinking deeper underwater, taking one last big gulp of oxygen only works when you're using it to find more elsewhere, at the surface. Or to return to an earlier metaphor, it costs a lot to maintain a bridge -- but it might cost even more when your commerce can't flow across it.

I realize I've taken considerable liberty in conflating the consumer-enterprise split with the software-hardware divide in this post. But the lessons to me are the same:

  • You can't sell software and services without a piece of hardware to run them
  • You can't sell products without an audience
  • Multiple revenue streams are key to business resilience as markets shift

We've said many times before on ZDNet that "It's the ecosystem, stupid" -- but that term is most impactful when it's expanded to include not just the operating system but the entire family of components, physical or digital, that make up the consumer experience around a product.

We're now seeing tech's titans embrace this vision. It's about to get interesting.

Photo: Samsung's Galaxy S III. (Samsung)

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Topics: Hardware

About

Andrew Nusca is a former writer-editor for ZDNet and contributor to CNET. He is also the former editor of SmartPlanet, ZDNet's sister site about innovation. He writes about business, technology and design now but used to cover finance, fashion and culture. He was an intern at Money, Men's Vogue, Popular Mechanics and the New York Daily Ne... Full Bio

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