Tuesday, July 27, 2010

Of Dell and supplier side economics and illusory competition

The Register has done a fine piece by Andrew Orlowski exposing how Dell didn't sell its computers, it sold its customers. To Intel.

Practical monopoly power has its privileges, and you wonder how others with such power in the computer based cloud handle the same influence, given the notion that power tends to corrupt.


Guambat mentioned the Dell SEC settlement a few posts back, but assumed it was your run of the mill(ion) dollar financial frauds. Many thanks to Mr. Orlowski for explaining the fraud was on the PC market more than the financial market.

The Justice Department should have brought this case against Intel and Dell years ago.

Having the SEC do it now is sort of like how the IRS was used to bring in Al Capone when the police couldn't or wouldn't.


Dell's fraud settlement explodes PC market myths
On Thursday, Dell agreed to pay a settlement for fraudulent accounting from 2001 to 2006. The company admitted no wrongdoing, as is the custom in such settlements.

The SEC settlement casts the entire PC market in an entirely new light.

Intel was Dell's most important component supplier. Every ten years or so, Intel unveils a truly competitive processor architecture, from which the company reaps the reward for several years.

But there are times when Intel isn't so competitive.

So the supplier made financial arrangements (in the form of credit memos rather than "payments") to ensure its number one customer maintained exclusivity. These had been going on for many years in the form of 'Market Development Funds' - but new inducements (initially dubbed MOAP, or Mother Of All Programs) were introduced in around 2001, on top of the MDF programme. These were so great that over a five-year payment, the supplier ensured the purchaser traded in the black for five years.

Intel's rebates amounted to 38 per cent of Dell's operating profit in the fiscal year 2006, and rose to 76 per cent (or $720m) in one quarter alone, Q1 2007. While almost all of the Intel funds were incorporated into Dell's component costs, Dell did not disclose the existence, much less the magnitude, of the Intel exclusivity payments.

Knowing that Intel's processors were regarded as less competitive, Dell kept returning to Intel for better and better deals. Intel considered it a price worth paying. In 2003 Dell considered investing in AMD, filings reveal, and shifting a quarter of its CPU procurement to AMD. Intel's response was a new "Tactical and Strategic Fund" worth $258m for a year. Dell closed down the discussions.

Dell was getting lazy - and greedy. Dell began to see the Intel rebates as a financial instrument - to top-up its balance sheet. The arrangements were disguised on the balance sheet, while Dell maintained a "Strat Fund" - what the SEC calls a "cookie jar", that it could dip into at will.

"Dell would often seek additional rebates," SEC explains, "in order to close a gap between its forecasted and its earnings targets. Dell was quite open with Intel about the reasons it was requesting additional money".

For example, in Q4 FY 2004, Dell needed a $25m lump payment after forecasting a shortfall. Dell hadn't failed to hit an earnings target since 2001, and thanks to the payment, it duly met its forecast. None of this was known to investors; Dell CFO Kevin Rollins explained to investors it had met its targets because of efficiency savings and lower component costs. The SEC calls the latter claim "materially misleading"

In another quarter, a $70m lump payment was made so Dell could meet its forecast, in another, $125m. Intel even agreed an "Opteron Fund" worth $275m specifically to keep Dell from defecting.

Ironically, Intel was only six months away from shipping a competitive server processor - Woodcrest - when Dell finally announced AMD as a supplier in May 2006. Intel responded by lopping an arbitrary $250m from the funding arrangement. SEC notes:

"This dramatic cut in the MCP payments did not reflect any contemporaneous meaningful purchase of AMD processors or substitution of AMD processors for those of Intel. Rather, Intel's reduction in MCP payments reflected Intel's response to Dell's announcement of an intention to use AMD products in the future."
While vowing to put its customers' needs first, Dell was keeping competitive products away from its customers, in order to meet short term quarterly financial targets.

It's hard not to conclude that the PC processor market is now a monopoly cast in granite - and that the SEC settlement has come too late to introduce any meaningful competition.

When AMD ceased operating as an independent company in late 2006, it ended twenty years of independent competition (and for much of the time, litigation) against Intel.

AMD was originally an official Intel licensee, the second source supplier that IBM required, until 1986.

It settled all outstanding lawsuits against Intel for $1.25bn last year - about eight months' revenue of its final year as an independent company.

SEC notes somewhat ruefully that five previous antitrust investigations into Intel's market funds had failed to bring results. They certainly failed to bring the funding to light in time for AMD's best crack at the market - the years from 2001 to 2006.

One small detail seems to have escape[d] a lot of people's attention - and it's that Intel now formally marshals the competition in some interesting ways. Last year Intel and Taiwanese foundry TMSC signed an interesting agreement whereby TMSC is allowed to create variants of the Atom processor which are then rebadged as Intel designs and sold into the OEM channel.

In doing so, funnily enough, the PC chip market takes a step closer to the potato chip market. PepsiCo's Frito-Lay offers the illusion of competitive market by offering up apparently independent brands of snacks. You just wouldn't know it. Frito-Lay's UK operation is better known as Walkers, and Walkers still offers Smiths crisps in certain markets. ®

Read more of the story.

And read more of Andrew Orlowski.

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