Hardware: the backlash to the backlash

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.

TOPICS: Hardware

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)

Related on ZDNet:

Topic: Hardware

Andrew Nusca

About Andrew Nusca

Andrew Nusca is a former writer-editor for ZDNet and contributor to CNET. During his tenure, he was the editor of SmartPlanet, ZDNet's sister site about innovation.

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  • The long and winding road

    The impact of all this on investors changes depending on your starting point. When IBM abandoned the PC business, assets were being shifted from a low-margin activity to higher-margin activities. This was the appeal of the same idea to Apotheker. The gotcha with HP was that they were not nearly as far along as IBM was in transitioning to an enterprise supplier; they would have had to go through a period of serious revenue decline while they sorted things out. That scared people, so Apotheker got axed.

    In the case of Microsoft, they are shifting assets from what has been a high-margin business into a low-margin business. Whatever the long run strategic arguments might be for doing that, in the next five to ten years it will mean lower return on assets for Microsoft. That's not opinion, it's arithmetic.

    The argument in the article turns on Microsoft's ability to create "non-commodity" devices. That is how they might someday equal Apple's feat of turning participation in the hardware business into a high-margin activity. But Microsoft can only do that if they stop selling their operating system to others. It is precisely that activity that turns Windows-running hardware into a commodity.

    Such a transition for Microsoft is every bit as tricky as Apotheker's design for HP. In the long run it's probably right, but so many things could go wrong that customers and investors will be terrified along the way.
    Robert Hahn
    • Well put!

      Thanks for posting.
    • The middle way, along that winding road.

      When MS was first introducing Windows Phone 7, they talked about a "middle way" between Apple's not letting the carriers touch iPhone and the Android way of giving carriers and OEMs full control of the device and OS. I think they may want to do something similar with Windows. Microsoft's thinking may be to do the "non-commodity" high-margin "flagship" [post-]PCs themselves, and sell Windows licenses to a few down-market OEMs who can meet the demand of everything [i]outside[/i] of the "fat middle."

      As for investors, if they haven't revolted after a decade or so of essentially flat stock prices, they never will.
      • Here they go again

        The trick there is selling selectively without getting hauled into court for Restraint of Trade. "You stay out of my segment and I'll stay out of yours" is pretty much the definition of it.
        Robert Hahn
  • Capitalism at work

    When a business is hugely profitable, it draws in competitors, reducing profits. When a business is no longer profitable, competitors leave, reducing pricing pressure on those companies that remain, allowing profits to increase. A smaller number of hardware companies will get better economies of scale, have more bargaining power with suppliers, and have a market share that warrants investing in innovation, improving the quality of the products. It's all good.

    • until they break the rules of conduct that capitalism expects

      After all, Ayn Rand decided to break her own rules and take social security (in her husband's name, which makes one wonder why she couldn't collect using hers...)

      Since "John Galt" and who he is and all that...
  • Wow!

    Andrew, you've nailed it. Superb article.
  • Very well put!

    This is a great summary of a very real trend. The real difference with Apple and the other companies mentioned here is that they aggressively innovated where the others were massively producing the same commodity laptops/desktops with little distinction. Apple had similar laptop/desktop products, but they forged a new path with the entrance to the media market, phone market, and then essentially rewriting/defining the tablet market. These other companies are caught in the innovators dillema and Apple handled it in an almost textbook way that has obvious positive results. Saying this is a shift to a hardware game is fine, but I still think I am seeing a lot of too little too late. For other companies to win in this hardware battle they are going to need a lot more innovation than they currently employ.
    • Exactly. They are not innovating, they are playing the "Me too!" game.

  • Can anyone then explain what happened to Kodak?

    Kodak had a premier name and business model: film. That product was becoming legacy so they started working with digital. Later they integrated with hardware (cameras) and software/cloud (Ofoto/Kodak Gallery) and still their premier service of print. With all of this vertical integration, they still failed. Based on this article is seems as though this was the transition moves to make, yet it failed. Can anyone help explain why?
    • Film behind every tree

      I'm sure the reasons are numerous and complex, but I'll give you two: distribution and the corporate culture as it related to cameras.

      At the height of its power, Kodak was a distribution powerhouse. You could hardly walk 100 yards in the United States without running into a place to buy Kodak film. It took a lot of people to make that work, and the bureaucracy that did it swung a pretty big bat within the company. If they didn't like an idea, the idea was toast. I'm only half-kidding when I say that Kodak missed a bet when they didn't try to turn into a snack company like Frito-Lay.

      Kodak viewed cameras as a way to sell film. Their product cycles were long and slow, pretty much tied to changes in the physical configuration of film: from big rolls to smaller rolls, to film cassettes, to film disks... each generation of film required a new line of cameras. But beyond that? Nada. The brave new world of digital imaging, with cutthroat competition among camera manufacturers who innovated constantly, and who had to make money on cameras because there was no film, was just too far from where Kodak lived. They made some headway by trading on their name, but they were never a serious player.

      Distribution channel changes are a hidden cause of trouble in a lot of these "tech" failures.
      Robert Hahn
      • Digital cameras on phones!!

        Ate Kodak's lunch and dinner at the same time.

        Who needs a separate camera (other than pros) when one is built into their always-carried device?

        Who needs film when that always-carried device can show the photos on demand?
  • I agree with many of your points,

    and I don't think that e.g. Microsoft's plan to manufacture their own tablets is going to dramatically change the market. As IBM, HP and Nokia have found out, staying competitive in the consumer markets is hard work. One issue though is very important in the consumer market: Branding. Here, I think Microsoft seems to be plagued by design (or decisions) by committee. What does the "Microsoft" brand stand for in the consumer market? What does the "Windows" brand stand for in the consumer market? Ecosystems ("works with")?, software (traditional Windows, Office)? or hardware (mice, XBox, tablets)? Most consumers I have spoken to with regards to PC purchases etc., have mostly been interested in the brand (is HP or Dell best?), rather than the operating system (indeed, I've seen some people buy an Apple computer and then discovering to their surprise that the UI was not "the usual one").
    Microsoft seemingly hopes that the existing, huge "traditional" Windows desktop/laptop market can be turned into an even bigger tablet/mobile/smartphone market by labeling everything "Windows". Unfortunately, I fear that the large manufactures of consumer electronics (e.g. Samsung and others) will be able to churn out tablets/smartphones/"intelligent" devices where the consumer will mainly be interested in price and what the device can do: If it can communicate, access e.g. Facebook, youtube and the other popular mass sites/services, then the consumer won't care about the operating system (or its manufacturer) any longer. The operating system as a consumer product (or product defining component) may soon be dead. The winners: The largest manufacturers of electronic/electric consumer goods, content providers and companies with strong consumer brands.
    • So who are you again?

      [ul][i]One issue though is very important in the consumer market: Branding... What does the "Microsoft" brand stand for in the consumer market? What does the "Windows" brand stand for in the consumer market?[/i][/ul]Probably a lot less than Microsoft thinks. One of the things that stunned most computer makers during the "PC revolution" of the 1980's was how few people had ever heard of them. Executives at quite large companies like Digital Equipment and Texas Instruments assumed that they had reputations that could be used to help them enter the PC business. In fact, most small businessmen considered "IBMcomputer" to be one word. They'd never heard of these other guys, or if they had, they associated them with thermostats (Honeywell) or cash registers (NCR). Back then, most corporate IT shops were still in thrall to IBM mainframes, so there was no relief there either.

      People who frequent ZDNet think of Microsoft as this big company we've all heard of, but unless you have a relative who treats you as tech support, you don't realize how little average people know about this stuff. Ask them what browser they're using and they don't know. "It's on the computer." Windows? That too is "the computer."

      IBM took no chances with this when they introduced the PC: they flooded every advertising medium with a hundred million dollars (serious money in 1981) worth of 'Charlie Chaplin' ads to introduce the product. Apple has done the same thing to introduce themselves to consumers. Does Microsoft understand that they are going to have to do it as well? So far I haven't seen anything like the level of spending from Microsoft that will be necessary to move a product like the Surface. Maybe it's coming. It had better be.
      Robert Hahn
      • The story (and fate of IBM) may indeed be instructive

        As you write, the IBM PC was publicly advertised (unlike its usual computer products). But, initially IBM simply didn't think of it as a business machine. It was intended for home/educational use. The popularity among small/medium businesses took IBM by surprise, and to begin with there was really not much useful software available. But unlike most other PCs, the IBM looked the part (it was designed in the IBM terminal style (e.g. the huge on/off switch) and of course the keyboard was actually taken from an IBM terminal). Many were sold because of the "cool" factor ("I'm just learning how to program"), and were extremely expensive by todays standards. However, many small businesses that did not have IBM computers, did have the very well renowned IBM Selectric typewriters - and your bank and or accountant would normally be reassured by the IBM brand wnich represented real capital value. In a very short time, "killer applications" as well all kinds of compatible hardware very produced, and of course clones (and portables, the foundation of Compaq) came along. An ecosystem was born. Microsoft DOS was originally delivered as an "IBM" branded product (IBM DOS). Then came the disaster, when IBM decided that the IBM PC family should be reinvented as a proper, professional IT product: New MCA hardware and new OS/2 software was marketed and failed miserably; users did not want to buy new computers and peripherals, and even less buy and learn new programs. The other partner in the OS/2 project decided on another tactic, and Microsoft (without IBM) developed Windows NT which was much more compatible with existing hardware and software. Because of the MCA-hiccup, clones (including those made by established computer makers) were making up the bulk of the market, and Microsoft had a rapidly growing OS and software business catering to this market. As is well known, IBM did make e.g. the very built ThinkPad portables, but eventually the whole consumer/client PC business was sold to Lenevo, originally a hardware subcontractor. IBM is still a successful business (and does actually still make entry level servers with Windows) - but it should be remembered that before the "IBM PC revolution" IBM's profits alone were bigger than the combined turnover of all the other computer manufacturers put together...
      • Samsung and MS have got that mass brand advertising has to be done

        People think Apple was just naturally successful, but not without saturation prime time advertising.

        Samsung has been doing it recently, rather than relying upon resellers, and see how that has catapulted them to eating into Apple's market share.

        MS had been mass advertising with Win7 on TV last year, and having product placement in films of laptops with mysterious Windows logos (perhaps warming us up to the idea?).

        However, I think that MS has realised that without their own 'real' hardware, the popular perception of their brand is still rather vague. Hence the Surface to focus public perception on something tangible.

        Up until these, MS has had to rely upon use of their logo in some cormer of their OEMs' ads, which is hardly a focus on them. Now they can reverse the perception from being a piggy-backer on hardware, to being the driving force.
      • Advertising alone doesn't do it,

        you have to have a clear strategy regarding the message you want to deliver, and where I think Microsoft may have a confused approach. The latest presentation of the Surface was reported by the popular news networks, the next day the same networks could report that Nokia Windows 7 mobile phones will not be able to upgrade to the new Windows 8. All the complicated discussions (e.g. on ZDnet) aren't read by the typical consumer, but the result is clear: Log on to ebay, and you will be able to buy unused Lumias for half price (with the caveat "no returns accepted"). Like many ZDnet commenters have pointed out, I don't think that Lumia owners have been cheated or let down in any practical sense, but I think that damage has been done to the Windows brand. When you first stage a successful media event, and the popular media then find a fly in the ointment, it is a sign of bad brand management, again a sign of much bigger issues within the giant Microsoft Corporation. I think that while Apple, IBM and Microsoft all started out as IT / tech companies (catering to different markets to start with), the turning point for Apple was that with the iPod, Apple stopped being (or at least marketing itself) as a tech company, instead turning itself into a (luxury/upmarket/trendy) consumer goods supplier. Unlike IBM and Apple, Microsoft did not opt for the full-service IT manufacturer model, instead Microsoft built its empire on specializing in software, while other companies specialized in applications, printers, PCes. A hugely successful model, one that isn't easily replaceable and indeed the new in-house attempt may fail (it's not "only" a question of getting the desired hardware manufactured, remember that Lenovo, Fujitsu HP etc. have logistics, service, support and sales organisations and partners in every country on the globe). I have the impression that Microsoft still sees itself as a technology company, and that the product name itself (Windows) can magically be applied to any new line of business and create success. In that case Windows Phone 7 is a marketing failure which demonstrates the opposite.
  • Grandpa-Box Hardware Vs Mobile Hardware

    You need to distinguish between the market for PC hardware (the old "Grandpa Box") versus the market for newer mobile devices. The former is circling the plughole, the latter is going gangbusters right now. While Lenovo can consider doing well with 2% net profit on PCs, companies like Samsung are probably doing a lot better than that.

    The trouble with the PC business is that Intel and Microsoft have too much control. They get the lion's share of the profits, everybody else has to settle for crumbs. Contrast this with Android, where Google is happy to settle for peanuts in direct fees (relying on advertising for indirect revenue), and the device makers are free to build whatever hardware they like and charge what they like. The result? An amazingly wide and ever-growing ecosystem of products for customers to choose from.

    One reason why Microsoft is not having success with Windows Phone is that it is trying to maintain the same level of control it has with desktop Windows. This stifles the innovation that the device makers are able to bring to bear, and the customers see the result of this as mediocre products they don't want to buy.
  • Only indisinguishable products become commodities

    Dell offers such a bewildering number of PC and notebook products that even its service tags have become insufficient in ID'ing all the device drivers you need if changing the OS or such. Shopping their product line is more like shopping a long cereal aisle. You then add in similar line-ups by HP, Acer, Lenovo, et al, you can see why margins are so slim for the overall PC/notebook hardware market. You look at Apple's approach, however, where there is a very clear and distinguishable product line, you give the average consumer something to get a handle on, as well as making life easier for accessory makers.

    I'm not too sure which economic or marketing theory says you have to either give consumers either too many nondescript choices in products or none at all, but that seems to be the way too many companies seem to think. Kodak for instance had a bunch of nondescript camera models, but their pocket camcorders, especially the Zi8, were highly regarded. There was some anticipation for its announced successor, the Zi12, but when Kodak decided to leave the camera business, it made no distinction between its nondescript products and ones that had some reputation, which made anyone familiar with the camera industry wonder what the hell is wrong with Kodak. When HP so abruptly dropped the TouchPad and was making noises about leaving the PC market altogether, all that was met with similar "what the hell is wrong with HP?" discussions. There are now a large number of happy HP TouchPad owners running Android ICS on their super bargain tablets, and who still roll their eyes at HP's behavior in all that.

    It might be that "commoditization" is one of those buzzword concepts that become increasingly completely misunderstood the further it makes it up into the corporate hierarchy.
    • Exclusively at BigBox!

      One of the reasons you see this proliferation of model numbers is that their distribution channels demand it. Best Buy doesn't want you looking up a model they have on Amazon, or finding it at WalMart. WalMart wants a model number no one else has for the same reason. So the manufacturer changes the size of the disk drive by 200MB, assigns a new number, and away they go.
      Robert Hahn