Is Private Equity Giving Hertz a Boost? (NYTimes, 09/23/07)

September 23, 2007
Is Private Equity Giving Hertz a Boost?
By ANDREW ROSS SORKIN
LAST fall, Mark P. Frissora, the newly hired chief executive of Hertz, kept running into the same question from potential investors.
Hertz, which Ford had sold just 11 months earlier to a consortium of private equity firms for $14 billion, was trying to sell shares to the public in an offering that valued it at $17 billion. As Mr. Frissora tried to drum up interest in the offering, skeptical investors kept asking him the same question: Why was Hertz worth $3 billion more in less than a year?
“I had to spend the first 15 minutes of every road-show meeting trying to explain this,” Mr. Frissora said in a recent interview, still sounding somewhat exasperated by the experience.
His job was not made any easier by the fact that the private equity investors — the Carlyle Group, Clayton, Dubilier & Rice and an investment arm of Merrill Lynch — had piled $12 billion in debt on the company, and then paid themselves a $1 billion dividend, which amounted to nearly half of the $2.3 billion in cash they had invested.
“Very smart investors thought there couldn’t possibly be any value left,” Mr. Frissora said.
Judging by the company’s share price, many investors have changed their minds. Since the initial public offering in November, Hertz’s shares have risen 43 percent from their $15 offering price, to $21.51.
Indeed, Hertz now looks as if it was not necessarily the model of the big, bad buyout that its fiercest critics had suggested. Its private equity owners looked at the business with fresh eyes and made a number of changes that improved operating performance. By streamlining how the company cleaned and refueled vehicles, they doubled the number of cars that could be processed every hour and re-rented. Hertz was able to do so without huge reductions in the work force: it cut less than 5 percent of 32,000 jobs.
Even so, the private equity guys also saddled Hertz with billions of dollars in debt, which is taking its toll on the company. Interest expenses of $901 million pushed Hertz’s net income down to $116 million in 2006, from $350 million the year before. That gives the company less maneuvering room should the economy — or its own revenue — slacken. Still, analysts say they remain uniformly optimistic because Hertz’s pre-debt performance has been improving sharply this year. And while it carries a big pile of debt, it has less than other recently privatized companies and just slightly more than Avis Budget.
Still, it is unclear whether Hertz is the exception or the rule of the recent buyout boom. Tightening credit markets pose a threat to all companies carrying big debt loads. For example, Freescale Semiconductor, which was taken private last year, saw its debt trade at 91 cents on the dollar last week amid concerns about the company’s financial prospects. But default rates on corporate debt currently remain near record lows of about 0.7 percent. If interest rates rise and debt payments skyrocket, some private equity darlings could stumble. In the 2001 recession, the default rate rose to 8.3 percent.
“Hertz is an example of a success story, but you have to be unbelievably courageous to believe history won’t repeat itself with some other companies,” said Steven Rattner, co-founder of the Quadrangle Group, the private investment firm, who has been sounding the alarm about the dangers of cheap debt. “We’re not magicians or alchemists.”
Nonetheless, a close look at the industry over its three-decade history shows that, on average, the firms have actually managed to improve, at least marginally, the businesses they own. “The empirical evidence is actually quite good,” said Steven N. Kaplan, a professor at the University of Chicago Graduate School of Business, who conducted the seminal study on the subject in the 1980s. “There is no evidence in any large sample study that they harm operating performance.”
No one has completed studies of the most recent boom, which has its own set of new wrinkles: bigger targets, higher premiums and much bigger upfront fees, all of which strain comparisons with private equity’s performance in earlier decades. Few academics appear to be studying the operational performance of recent buyout targets, but Edith Hotchkiss, a finance professor at Boston College, has been running the numbers. She is scrutinizing 176 companies taken over from 1990 to 2006, and her conclusion so far is positive.
“We continue to see operating gains,” she says, but she cautions that profit margins among the current takeover targets don’t match the operational returns of earlier decades. “The magnitudes are not as high,” she says.
SO how, exactly, did Hertz justify the $3 billion in new value before its I.P.O.? Easily, Mr. Frissora said, as he leaned back in a chair in a conference room at Spencer Stuart, the recruiting firm that brought him to Hertz. But his candid answer was not a complete ode to Hertz’s private equity owners.
He said a third of the value was simply a result of “market-related timing”: because of increased air travel, shares of other travel-related companies had jumped sharply since Hertz was acquired.
“It had nothing to do with private equity,” he said nonchalantly, though he gave his bosses at the private equity firms credit for making a good bet on the market. Mr. Frissora ascribed another third of the increase in value to the performance of Hertz’s equipment rental business — not its traditional car rental business, but equipment used in construction — which took off as a result of the housing boom and better internal processes. Again, it is not an improvement that can be attributed entirely to the private equity owners.
And finally, he said, “They bought it at a discount.”
Ford, he explained, was in distress and needed cash quickly when it sold Hertz. Rather than pursue an I.P.O. and take in the risks associated with an offering, Ford chose to sell. It was a heated auction, but “Ford could have gotten more money for it if they had done what private equity did,” he said.
It is a refrain heard again and again by shareholders across the country who feel that they have been shortchanged by corporations too quick to sell when private equity comes calling. Laura B. Resnikoff, an associate professor and the director of the private equity program at the Columbia Business School, who is doing a case study on Hertz, said she grapples with the issue constantly. “A good management team at a public company could do all of this, of course. And yet, we don’t see management teams doing it.”
Why?
“The rate of change that private equity forces on portfolio companies is something most public companies are not comfortable with,” she said. Nor are public shareholders always willing to shoulder the burden of high debt loads. Perhaps most crucially, management often does not have the same incentives as a private equity owner to pursue such drastic change.
At public companies, which seek to deliver steady returns to shareholders, executives are often rewarded for playing it safe. At a private-equity-owned business, the system favors risk-taking: Management can earn huge pay packages if turnarounds succeed — and face quick dismissal if the status quo continues.
At Hertz, inertia seemed to rein. In the 25 years before Mr. Frissora’s arrival, the company was run by only two chief executives. Neither reported to Ford’s chief executive; each reported to a manager three layers below the chief financial officer. And its managers were paid some of their bonuses in Ford’s poorly performing stock, hardly an incentive to increase performance.
George W. Tamke, a partner at Clayton, Dubilier & Rice and Hertz’s chairman, says the company was “a corporate orphan.” For the most part, Ford had left it alone as long as it hit its quarterly forecasts. That bred an insular culture that helped create a great brand, but not great business practices. For example, Hertz had its own printing facilities for marketing materials; it had never considered using an outside printer. The unit also had more than 600 computer programmers to manage its system, and even had its own security department. Forget about outsourcing. “They insourced everything,” Mr. Frissora said.
Some think Hertz still isn’t lean enough. Christina Woo, an analyst at Morgan Stanley, who has been particularly bearish on the industry, in part because of too much price competition, suggests that Hertz still has ample expenses to slash.
Nonetheless, it appears that private equity has brought a new sense of discipline to the company. Mr. Frissora says he has to have weekly conversations with Mr. Tamke, and monthly updates with the private equity owners, who often pepper him with questions and suggestions. Those conversations are on top of the regular board meetings.
And the private equity firms have added new, more complex measuring sticks: return on capital; Ebitda, for earnings before income, taxes, depreciation and amortization; and a focus on cash flow. “They hadn’t thought about that before,” Mr. Frissora said.
In contrast to previous Hertz executives, whose salaries under Ford were so low they didn’t have to be disclosed, Mr. Frissora has been paid handsomely for his work. His salary is $950,000, but with bonuses, stock options and other grants he was given before Hertz’s I.P.O., his payout is now worth more than $30 million, at least on paper, and he stands to make even more money if Hertz’s share price goes up. He also has invested $6 million of his own money in Hertz.
At a Hertz outpost in a parking lot on the outskirts of O’Hare Airport in Chicago, the changes under private equity’s watch are easy to see.
When Mr. Frissora joined Hertz from auto supplier Tenneco last year, he sent a team of managers to O’Hare for a “waste walk-around.” Armed with stopwatches, digital cameras and clipboards, the group members evaluated every aspect of the business, from the airport shuttle buses to the lighting in the bathrooms.
What did they find? The time it took to refuel and clean cars between uses was far too long. There were too many steps.
When a customer dropped off a car, it would be moved to a waiting pen, then taken to a gas pump. From there, an attendant would have to pull the car up to the cleaning station, where it would be vacuumed. It would then go through a washer. “And someone would run out of supplies every 15 minutes,” Mr. Frissora said.
At the end of the evaluation, he made changes almost on the spot. Within days, the seven cleaning stations were moved to where cars are refueled so cleaning could be done at the same time. Eight hours of supplies were provided so that nobody ran out.
According to Mr. Frissora and his private equity bosses, the changes doubled the number of cars that could be processed every hour. That meant Hertz could have more cars on the road and fewer cars in its fleet.
Mr. Frissora also noticed another inefficiency: Too many Hertz cars were sitting idle on the weekends at airport areas, but were sold out in locations away from the airport in Chicago and nearby cities, where renters needed them for short trips. So now 20 employees, called “transporters,” arrive every Thursday night at O’Hare and shuttle more than 300 cars off the airport lot into cities for the weekend. On Sunday nights, they take them back to O’Hare.
Now Hertz plans to use more transporters all over the country. The various changes at O’Hare have added $1 million in revenue.
Then there is the greatest inefficiency: the buying and selling of cars. Some rivals, like Enterprise, are so good at it that rental income is just icing on the cake. Hertz, however, had been getting so much of its fleet from Ford for so long that it didn’t bargain hard on price with other companies. “I’m used to beating each other up a bit on price,” he said.
So Hertz has put into place professional purchasing methods, centralizing the process so it can wring better deals from automakers. Hertz was also taking too long to sell cars; it took an average of 36 days once Hertz took the car off the lot, found the title, fixed the car and found a dealership or auction to sell it. “Every day that the car sits it’s depreciating,” Mr. Frissora said.
Now, Hertz has cut the time to 15 days, saving the company $30 million a year. And it is selling cars directly to the consumer online and using its facilities as a virtual dealership.
Hertz is aggressively renting environmentally friendly hybrids, a move that has helped in marketing and the bottom line. The hybrids have been so popular with customers, who pay $6 a day more to rent one, that it plans to expand its fleet to about 3,500 by the end of 2008.
And if Mr. Frissora can pull it off, Hertz will solve most rental car customers’ biggest nightmare: paying sky-high prices for gas when returning a car. He wants to offer gas at a competitive rate — which alone might make the buyout worth it.

From Russia With Cash: Seeding a Hedge Fund (NYTimes, 09/23/07)

September 23, 2007
From Russia With Cash: Seeding a Hedge Fund
By RON STODGHILL
ANDREI VAVILOV — Russian multimillionaire, well-connected energy magnate and nascent hedge fund manager — smiles broadly in a Manhattan restaurant as a lawyer, a lobbyist, an economist and a former congressman praise him over shots of vodka and a lavish spread of lamb, salmon and beef tenderloin.
They toast Mr. Vavilov, 46, as an architect of Russia’s fledgling market economy and a maverick financier whose philanthropic contributions to universities in the United States and abroad have produced important financial research.
“Congratulations on your newest venture, this hedge fund of yours,” says Thomas B. Evans Jr., a former Republican representative from Delaware. “I mean, I don’t know much about it, but I am sure it will be a big success.”
If Mr. Evans is hoping to learn more about Mr. Vavilov’s new fund, the IFS Hedge Fund, he may have a long wait. Throughout his career, Mr. Vavilov’s bookishness — he is fond of wire-rimmed glasses and a buzz cut — has belied his reputation as a shrewd back-room operator whose business and political relationships have followed a circuitous and largely silent path from Moscow to London to New York. Even by the standards of hedge fund managers, whose activities are often shrouded in secrecy, Mr. Vavilov occupies uniquely murky territory — at the intersection of shadowy Russian oil riches and fast money on Wall Street.
Mr. Vavilov, who survived an assassination attempt about a decade ago while working in the Russian government, says he personally pocketed $600 million when he sold his oil company, Severnaya Neft, five years ago. Since then, he says, he has invested $200 million in his hedge fund, which he incorporated in the Bahamas in 2004. He has yet to raise money from outside investors, but he is setting up shop in New York to do exactly that — at the very time that hedge funds, started by everyone from former Wall Street trading stars to former professional hockey players, are encountering the potentially brutal uncertainties of a national credit squeeze and market turbulence.
In the first eight months of this year, the average hedge fund generated after-fee returns of 6.1 percent, compared with 6.9 percent during the same period last year, according to Hedge Fund Research, a Chicago firm. In each year, those returns only slightly outpaced the Standard & Poor’s 500-stock index, and a basket of stocks linked to the index typically carries less risk than investments in the more highflying world of hedge funds. Investors who place their money with hedge fund managers expect them to handily outperform the S.& P. 500 over time, and they are willing to cede hefty fees to them for the privilege of doing so.
For his part, Mr. Vavilov — who says his fund has garnered annual returns of more than 20 percent since its start in 2004 by placing global, macroeconomic bets that he declines to describe in any detail — remains unbowed by the challenges sweeping across the hedge fund landscape. He says that he is positioning himself to play a central role in the potential privatization of a Russian government fund that holds $130 billion in oil proceeds, and that his hedge fund should be a beneficiary if that state fund is privatized.
He also says he brings another advantage to the table: smarts. “We’ve created a strategy that allows me to get high returns without some of the risks that are associated with volatility,” he says. “I sleep well and don’t have insomnia worrying about what’s happening to my money.”
As the prices of oil and other natural resources like nickel and aluminum have soared, Mr. Vavilov joins the ranks of wealthy Russian business titans trying to put fresh riches to work here and in other markets outside their country. They say they are doing so in order to protect assets from corruption at home and to gain financial legitimacy in the West.
“What you see is a glut of oil money in Russia seeking its way into calmer waters,” says Ariel Cohen, a senior research fellow at the Heritage Foundation, a conservative research organization in Washington. “These Russian tycoons and oligarchs are looking to place their money in jurisdictions with more rule of law, and where they are not subject to expropriation by the state.”
IN recent years, many of Russia’s wealthiest tycoons have gone on an overseas spending spree. Some of their transactions have been high profile, like Roman A. Abramovich’s purchase of the Chelsea soccer club in London and the oil giant Lukoil’s purchase of Getty Petroleum, a deal orchestrated by Vagit Alekperov. Other transactions have drawn less attention, like Vladimir O. Potanin’s acquisition of a 35 percent stake in Plug Power, a fuel cell developer, for $241 million this year.
Many of the financiers behind these deals benefited lavishly from the pell-mell business privatizations of the years when Boris N. Yeltsin was Russia’s president and, having weathered the tumult that followed, now either toe the line in Vladimir V. Putin’s Russia or leave the country. Much of this has occurred against a backdrop of widespread graft.
“There is really no such thing as local capital in Russia, only local corruption,” says Martha Brill Olcott, an analyst at the Carnegie Endowment for International Peace in Washington. “The challenge for Andrei Vavilov will be succeeding in a market where things are mostly black and white, instead of Russia, a country where deals are done in the gray.”
Mr. Vavilov has never been charged with a crime, and he says that anyone who does business in Russia is unfairly tainted by the country’s image as a haven for rampant corruption. Still, since his days serving as a deputy finance minister of Russia from 1992 to 1997, Mr. Vavilov has been saddled with suspicions that he grew rich through dishonest, insider deals. In 1997, Russian federal prosecutors began investigating whether Mr. Vavilov embezzled $231 million as part of a fighter-jet deal, according to Mr. Vavilov and others with knowledge of the inquiry. The investigation is continuing, and Mr. Vavilov has repeatedly denied any wrongdoing.
“If you succeed in Russia, everyone wants to get a piece of you,” he says. “Unfortunately, envy and jealousy is a big thing in my country and when you make a lot of money, people want some of it. I spend a lot of money on lawyers.”
Mr. Vavilov brings more than attorneys to his new role as a hedge fund manager. He is also a Russian senator, with a seat in the upper house of Parliament. And he has criticized Russia’s central bank as not being more aggressive about how it invests the assets in the $130 billion government fund, also known as a stabilization fund, which the country maintains to protect the federal budget from fluctuations in the price of oil.
Along with many others, Mr. Vavilov has also advocated privatizing the stabilization fund. He is among several business and political figures in Russia angling for access to those billions, and he sees his hedge fund as a logical repository for some of that money — as well as cash from well-heeled American investors.
“I am confident that there will be no shortage of money coming in,” he says. “I don’t have to lift my fingers; people will line up to put money in. The money is the last thing that I am worried about.”
Some people think that such confidence might be misplaced. “It’s a very tough time these days to start a hedge fund, regardless of strategy,” says Nicole M. Boyson, an assistant finance professor at Northeastern University. “Most investors are like, ‘Yikes, why would I go into a hedge fund when I already scared of the plain-vanilla market.’ ”
Still, some experts say, Mr. Vavilov has one competitive advantage over most hedge fund upstarts: $200 million of his own money is invested in the fund. “Look, it’s always a tough sell unless you have an angle,” said James R. Fenkner, chairman of Red Star Asset Management, a hedge fund based in Russia. “But guys like Vavilov didn’t make this kind of money working the night shift. And to start a fund with $200 million of your own money is already a heck of an edge.”
AS Mr. Vavilov recasts himself as a hedge fund manager, he is spending more time outside Moscow. He has also gained entree to the clubby world of top-tier hedgies. In April, for example, he flew his private jet — a Boeing 737 — to Las Vegas to attend an exclusive gathering of fund managers organized by Drobny Global Advisors, where he mingled with other millionaires amid conversations about such arcane investments as Turkish glassmaking stocks and Brazilian farmland. He says his taste for socializing goes only so far, however, and that he passed on participating in the conference’s charity poker tournament, called Hedge Against Poverty.
“It is not fun for me to gamble,” he says. “You know why? I always win.”
He says he relishes being the outsider, a role accentuated by his strained English and need for an interpreter. Born and raised at the boundary of Europe and Asia in Perm City, a small town in the Ural Mountains, he moved to Moscow as an adolescent. He says his father worked as a patent researcher in Moscow; his mother was a construction engineer. He showed an early aptitude for math and science and, after his father died, contributed to the family finances by working as a computer programmer in high school.
He attended the prestigious Moscow Institute of Management, then enrolled in graduate studies in economics and mathematics at the Russian Academy of Sciences, where he received a doctorate in economics in 1987. After the collapse of the Soviet Union, several of his former academic mentors recruited him into government work — Yeltsin made him a deputy finance minister in 1992. Just a few years later, Mr. Vavilov was overseeing major bond issues for the government, working closely with Western banks to structure the deals. He helped pushed through privatizations and a flurry of other market reforms during these years, all of which Yeltsin advocated as a means of modernizing the Russian economy.
Many of the Russian reforms threatened entrenched political and financial interests in the country and inevitably led to discontent. Critics in Russia and overseas have said that shady transactions followed some reforms and netted riches for insiders.
As an architect of reforms, Mr. Vavilov earned plenty of enemies in Russia, political analysts say.
“He’s a bit of a threat to the old establishment,” says Michael D. Intriligator, a specialist in Russian economic policy at the Milken Institute and a professor at the University of California, Los Angeles. “He’s a brilliant guy, but not very well liked.”
Mr. Vavilov was the target of an assassination attempt in 1996 when his car was blown up in a Kremlin parking lot; he was not in the vehicle at the time. But, some people say, he still has enemies. “I still don’t think he has an appreciation of how many people are out for him,” says Ms. Olcott of the Carnegie Endowment.
When he left the finance ministry in 1997, he founded the Institute for Financial Studies, a Moscow-based research group that today employs 15 specialists in macroeconomic theory and finance. Among its missions has been creation of sophisticated financial models that he says form the core of his hedge fund strategies. He says the work has led to improvements in assessing risks in global currency and derivatives markets.
After gaining a seat on the board of Gazprom, the Russian energy giant, he bought a controlling stake in Severnaya Neft, a small independent Russian oil company on the brink of bankruptcy, with, he says, a $25 million private bank loan collateralized by the company’s assets. He says that under his stewardship, which included extensive cost cuts, the company invested heavily in oil production. Its reserves nearly doubled, he says, after it tapped into four promising oil fields in western Siberia. In 2002, Mr. Vavilov sold Severnaya to a major Russian oil company, Rosneft, for $600 million — in cash, he notes.
“It was a big achievement for me from all points of view,” he said. “When I bought the company, nobody even took it seriously. It became one of the fastest-growing companies in the country.”
Shortly after selling his company in 2002, he was elected to his senate seat as a representative of Penza, a city southeast of Moscow. The transition, some of his political critics in the Russian press have speculated, was shrewdly calculated — anyone who has a seat in the Russian Parliament is immune from prosecution. But Mr. Vavilov scoffs at that notion.
“I joined the senate because I like to work for the public, not just in business,” he says. “The public interest is more important to me.”
Some hedge fund managers question whether his plate — filled as it is with politics, philanthropy and constant travel — is too full to fight it out with some of the sharks prowling the waters in the industry. As Mr. Fenkner of Red Star says of Mr. Vavilov: “He’s not as hungry as most hedge fund managers are.”
Mr. Vavilov enjoys all of the accouterments available to millionaires. He has a palatial Moscow home — equipped with an underground tunnel connecting it to his research center offices — as well as a residence in Monaco. His wife, Maryana Tsaregradskaya, is a Russian actress, and the couple, who have been married 13 years, have a 2 1/2-year-old daughter. Mr. Vavilov sold his Beverly Hills home for $13.5 million a few months ago and is shopping for a home in Manhattan. So far, he says, he is leaning toward a penthouse in the Time Warner Center at Columbus Circle.
“I’m not hungry, I’m O.K.,” he says. “I’m lucky enough to support my family. But I strongly believe in my ideas.”
His grand idea about Russia is that its government, long smothered beneath an unmanageable pile of foreign and domestic debt, is now contending with a very different issue. “The biggest problem in Russia isn’t debt, it’s surplus,” he says.
Thanks to rising oil prices, Russia has $130 billion in the stabilization fund at a time of heated debate among the country’s leaders and economists over how to avert a pension crisis. According to government estimates, its population of working-age adults is shrinking and may fall to 108 million from its current 140 million over the next two decades, a result of fast-declining birth rates and higher death rates among the working class, primarily men.
AS a result, Russian leaders are debating about how to fix the country’s pay-as-you-go pension system, from collecting unpaid taxes from businesses to more radical measures that would shift the country away from a state-guaranteed program. Mr. Putin has even encouraged larger family sizes to bolster the working-age population.
Yet few in Russia have been more critical of the current system — or strident about how to fix it — than Mr. Vavilov. He has pressed his case for pension reform at international conferences and on the op-ed pages of Moscow newspapers. He argues that the $130 billion fund could be more effectively invested in order to shore up the pension fund’s finances.
“This money is basically under a mattress now,” he says. “Figuring out how to invest this money should be the main goal of this administration.”
He is urging the Russian government to invest the stabilization fund’s assets in the capital markets, using strategies developed at his research organization and which he says he has put to work in his hedge fund. Some analysts think that a more sophisticated approach in how the stabilization fund handles its assets is long overdue, and they say Mr. Vavilov’s thoughts are worth considering.
“You don’t necessarily think of Russians as savvy investors,” says Barry W. Ickes, a professor at Pennsylvania State University and financial director at the New Economic School in Moscow. “They have tended to be very insular and domestic with their wealth. His ideas are very intriguing.”
And if his hedge fund doesn’t wind up being a receptacle for pension fund proceeds, how will Mr. Vavilov raise the money he needs to give his fledgling venture a boost? In response, he, well, hedges. “Right now, I’m talking to everyone,” he says. “It’s like a beauty contest.”

Can Michael Dell Refocus His Namesake? (NYTimes, 09/09/07)

September 9, 2007
Can Michael Dell Refocus His Namesake?
By STEVE LOHR
Round Rock, Tex.
ON a recent afternoon at his company’s headquarters here, Michael S. Dell is seated in a spacious conference room named Dobie Hall — in honor of the University of Texas dormitory where, in 1984, he started the computer giant that bears his name.
He boasts that Dell Inc. has just reported quarterly profits that exceeded Wall Street projections. It’s an encouraging sign, he says, that the company — buffeted by high-profile production problems and accounting shenanigans — is finally regaining momentum.
Over the last few years, Dell, once the gold standard among PC makers, has simply overlooked major growth trends in personal computing. It missed significant shifts in notebook computer sales and the consumer market as a whole, lagged competitors in international sales, and lost the profit edge that it enjoyed from its superior procurement-and-supply network. Hewlett-Packard, having overcome its own woes, passed Dell last year as the largest seller of PCs worldwide.
Dell’s ills also extend beyond the nuts-and-bolts of making and marketing PCs. After a yearlong internal investigation, Dell conceded last month that some managers had falsified quarterly results to meet sales targets from 2003 to 2006. The company expects to reduce earnings over those years by $50 million to $150 million, tiny sums compared with the billions of dollars in profits it earned during that same period. (Dell posted annual sales of about $57 billion last year.) Yet the accounting disclosures suggest a corporate culture in which at least some senior managers felt under such pressure that they doctored the numbers; the disclosures have prompted a Securities and Exchange Commission investigation.
“The company was too focused on the short term, and the balance of priorities was way too leaning toward things that deliver short-term results — that was the major root cause,” explains Mr. Dell, dressed for the Texas summer in a short-sleeved polo shirt and jeans.
The recent setbacks would be humbling for any company, but especially so for Dell, a smooth-running machine for years and a model of the efficiencies that the shrewd use of technology and customer information can produce. Dell was widely admired beyond the technology industry, and it was cited in business-school studies alongside companies like Wal-Mart Stores.
Successful entrepreneurs, of course, are hardwired by inclination and necessity to look beyond immediate hurdles for opportunities, and Mr. Dell is no exception. He says he is not leading a simple turnaround, but rather a long-term campaign to transform a company known for a cultlike adherence to a certain way of doing business.
As the company surged to the lead in the PC industry, the “Dell model” relied on direct sales over the Internet and by telephone rather than through retail stores, cutting prices to gain market share, focusing on computer hardware rather than services, leaning heavily on the American market and avoiding acquisitions. But since Mr. Dell reclaimed the role of chief executive in late January, he has changed all that.
At internal meetings, he repeatedly emphasizes that the Dell model “is not a religion,” according to staff members. Moreover, Mr. Dell — who once ran a company famous for its laserlike devotion to next week rather than next year — no longer champions short-term goals and fixes. “We’re moving the needle in terms of getting focused on the right long-term issues,” he says.
But re-engineering the Dell model will be a daunting challenge. “Dell continued to do the same old thing, when it was no longer working,” observes David B. Yoffie, a professor at the Harvard Business School. “This is going to be about changing the way they do business at many levels.”
“Dell can do it,” Mr. Yoffie adds, “but it’s going to take a lot more innovation on more fronts than the company has shown in the past.”
LAST year was, to borrow a term, the annus horribilis for Dell. Its problems kept building throughout 2006: sluggish growth, disappointing financial results, complaints about customer service, even a high-profile safety recall of notebook computer batteries. Not all of these were the company’s fault. For example, Sony made the batteries that could overheat and catch fire, causing other companies like Apple to also issue recalls.
But there was no disputing that Dell had stalled. Wall Street, as well as Dell’s own board, had become impatient with the company’s management. So a change came quickly early this year, at the end of January. Dell’s outside directors voted unanimously that the company needed a single leader instead of having a chairman (Mr. Dell) and a separate chief executive (Kevin B. Rollins, who had been C.E.O. since 2004).
At the time, Mr. Dell was attending the World Economic Forum in Davos, Switzerland, and when the board asked him to become chief executive, he agreed. There were a few long walks, he recalls, when he was “deep in thought” about how to proceed, but he did not hesitate about taking over. He had built the company, after all, and his name was on every box it shipped.
“I have a responsibility,” he says.
So, on Jan. 31, Mr. Dell became chief executive — again — and Mr. Rollins, a former Bain consultant who joined Dell in 1996, was out. Mr. Dell describes Mr. Rollins as a “great business partner and friend.” Other executives at Dell also point to Mr. Rollins’s contributions over the years, as the operating field general beside Mr. Dell during the years of torrid growth. But Mr. Rollins, they say, was seen as the foremost practitioner, and advocate, of the old Dell model, even when pushing the same buttons no longer worked.
Still, Dell executives are quick to say that Mr. Dell’s return as chief executive has nothing to do with any sharp differences between him and his predecessor. Rather, it was due to the depth of Dell’s troubles and the need for someone to assume control and forcefully take the company on a different path.
“It’s not all about Michael versus someone else before,” says Paul D. Bell, a senior vice president. “Michael was here. He was chairman. But it was up to Michael to take the first-mover role in driving change and he did it.”
Mr. Dell began shaking things up immediately. He has recruited senior executives to lead the company’s marketing, consumer products, operations and services business. He is also paring layers of middle management as part of a plan to trim Dell’s payroll by 10 percent, or roughly 8,800 workers.
In recent months, the company has stepped beyond selling over the Internet and by telephone — the famous Dell direct model. It has forged retail agreements to sell computers at Wal-Mart stores in the United States, at Carphone Warehouse outlets in Europe and at Bic Camera stores in Japan. More retail deals are in the works.
Rethinking the retail business was a matter of necessity. A lot has changed, Mr. Dell notes, since the company tried and abruptly exited retail sales in 1994. The shift in the consumer computer market and toward notebooks, which customers want to touch before buying, is part of it. So is Dell’s need to do better in markets abroad, where people are less comfortable buying computers by phone or over the Internet. “We’re going after those new customers with retail partners,” Mr. Dell says.
He also moved quickly on another front. Whereas the Dell of old shunned acquisitions, the company is now willing to go shopping. It has made three deals in the last two months — business and consumer software companies — and there will be more, Mr. Dell says. But he says that they will be limited to purchases of smaller companies and start-ups, with 50 to 500 employees, to add technology and expertise that promise to “turbocharge growth” in businesses earmarked for investment and rapid expansion, like services, consumer offerings, international sales and building data centers tailored for big Web companies.
The consumer market looms large for Mr. Dell. Consumers were traditionally an afterthought at Dell, which garners more than 80 percent of its sales from corporate customers. Home computer users generally had to settle for business computers that were tweaked a bit for the masses and were little more than bland, generic boxes.
But in recent years, consumers became picky. Where users once focused on price, processing speed and storage capacity, they now looked for stylish, well-designed machines as well — a trend common throughout the entire consumer electronics business, but one that was lost on Dell.
“On the consumer side, we’re drastically changing what we’re doing,” Mr. Dell says. “We’re only touching the surface of the opportunity now.”
Ronald G. Garriques, who joined Dell from Motorola in February, is guiding the change in Dell’s consumer strategy. Selling machines with more flair in retail stores is part of the plan, said Mr. Garriques, president of the global consumer group, a new position at Dell. But he suggests that Dell will take a hybrid approach, offering hardware options, extra features and services through its Dell.com site on machines that it also sells in stores.
Dell’s direct online relationship with customers, Mr. Garriques says, can help it develop services that link PCs, software and cellphones. To illustrate Dell’s thinking, he describes as a possibility a service that would allow parents to use Web maps and cellphone signals to track family members on the screen of a Dell PC in the kitchen. “With Dell’s direct-to-consumer model,” he says, “we can bring that as a solution to families.”
Such offerings, he says, don’t have to generate big profits on their own. “Great services sell a lot of devices that use those services,” says Mr. Garriques, noting how Apple’s iTunes music service has fed iPod sales.
Dell also hopes to offer services on hardware beyond PCs. Last month, the company agreed to buy Zing Systems, a Silicon Valley start-up that makes software for hand-held devices that manage and exchange entertainment wirelessly, without the need for a PC. Zing’s founder is Tim Bucher, a former product designer at Apple.
Stale design remains an issue, and something the company has to continue to address if it wants to lift consumer sales. It recently recruited designers from around the world and more than doubled the size of its design group, to 80, in the last year. Dell designers now speak of product “love” and “lust,” observes Ken Musgrave, the director of industrial design — a far cry from just a few years ago, when design always took a back seat to competitive pricing.
In June, Dell introduced notebook computers in eight colors. And color, Mr. Musgrave says, is merely the “first level of personalization” for Dell. He showed off prototype notebook shells in different materials and designs, noting that Dell’s build-to-order system gives it the freedom to make highly stylized and personalized machines in limited runs of just dozens to a few hundred. “There are a lot of different design levers to pull for the future,” he says.
AS soon as he took over as chief executive, Mr. Dell declared a two-month “amnesty” to encourage people to discuss problems and deal with them quickly, without fear of being fired or demoted. Otherwise, Mr. Dell says, managers might have understated troubles and defended past decisions.
One common issue, he says, was that there was “no central leader” in areas like manufacturing, services, sales and marketing. A decentralized organization of many go-it-alone groups, focused on regional markets, made sense when Dell was growing from $5 billion to more than $55 billion in annual revenue over the previous decade, faster than any technology company in history. Then, chasing growth opportunities was the priority.
Dell’s marketing epitomized the fragmented approach. When Mark Jarvis joined Dell as its chief marketing officer in April, he did an inventory of the advertising and marketing firms that worked for the company worldwide. The total count was 869. “The company didn’t really evolve, it just grew,” he says.
Mr. Jarvis is now moving to streamline Dell’s marketing. In the last month, he has cut in half the number of the company’s marketing and ad agencies. By the end of October, he says, Dell will select a lead worldwide agency. One goal, he says, is greater consistency in the themes, message and approach of the company’s marketing. The new internal marketing slogan is “One Company, One Brand, One Beat.” Already, there is a change in the look of Dell ads. Themes like ease of use and personalization are prominently featured.
Mr. Jarvis, a former Oracle executive, says Dell’s brand is widely known and respected, but often not linked to a clear message. So he wants to give the brand a makeover, saying that in the consumer market, it needs to be “much cooler and go away from low prices; a lot of people see us as a cheap PC company, and that’s not where we want to be.”
In the corporate market, Dell plans to pitch itself as the company that can simplify information technology for businesses, part of an effort to gain market share from competitors like I.B.M., Hewlett-Packard and Sun Microsystems. When asked how his long-term agenda will change the company, Mr. Dell is direct: “It will push us much more into solutions and services from products. That doesn’t mean products go away. But there’s going to be a big element of doing more for customers through services.”
The services strategy is long overdue. Services is a bigger market than hardware, and corporate customers were asking Dell to do more to help them manage their data centers more efficiently, according to current and former company executives. But Dell was slow to react, and the lapse illustrates the perils of doggedly sticking to the old model and ignoring a promising new market. Instead of making long-term investments in building a services business, Dell just kept its eye on hitting quarterly sales targets by peddling Dell hardware and other companies’ software.
Dell recruited Stephen F. Schuckenbrock last December from Electronic Data Systems to lead its services business. Today, Dell garners $5 billion a year in services revenue, but most of that comes from technical support and maintenance on Dell machines.
Mr. Schuckenbrock wants Dell to help corporations run their data centers, while reducing hardware budgets, energy consumption and staffing. Mr. Schuckenbrock predicts that services will grow three to four times faster than the company’s overall growth rate. A former Dell executive, who requested anonymity because he is forbidden to discuss company matters, said a recent internal report concluded that the company’s annual revenue from services could reach $20 billion over the next five to seven years.
Dell is already a major reseller of VMware, the dominant maker of virtual machine software used to juggle operating systems and applications on a single server. Dell plans to expand the relationship with VMware by offering virtualization services and its own data-center tools. In July, Dell bought SilverBack Technologies, a start-up that makes software to monitor and manage computers. The goal, Mr. Schuckenbrock says, is to offer “the best point of view, technology and solutions to optimize industry-standard data centers.”
Until a year or so ago, Dell tried to sell its standard products to leading Web giants like Yahoo, Salesforce.com and Microsoft. But those customers wanted something different. Eventually, Dell listened and designed circuit boards, cabling, racks and power management systems to suit the requirements of large individual customers. (Google, which still designs and builds its own computers, is not yet among them.) Prototypes can be built in weeks, with thousands of the custom-made computers shipping in months. That rapid response, says Brad Anderson, a senior vice president, is “really back to Dell’s roots.”
Mr. Anderson says that the biggest initial hurdle for Dell on these big deals is its reputation as a producer of commodity computers. “It takes time to convince them that Dell is committed to novel products and real innovation,” he says.
DELL still faces formidable obstacles as it tries to regain its footing. Just three years ago, Dell’s hyperefficient operations gave it margins that were six to eight percentage points higher than those of its principal rival, Hewlett-Packard, according to a recent report by Sanford C. Bernstein. Today, Dell has no such edge.
“We created this incredible supply chain, and that sort of stagnated,” Mr. Dell acknowledges. “We squandered that away. Some of our competitors jumped over us in a Darwinian way. Now it’s our turn.”
To solve his operating headaches, Mr. Dell brought in Michael R. Cannon, the chief executive of the Solectron Corporation, a contract manufacturer, as Dell’s head of global operations in late February. Mr. Cannon is convinced that Dell can regain its advantage by tightly integrating regional operations into a close-knit global network. “Manufacturing is going to be a core competence at Dell,” Mr. Cannon says, “and there is a lot of room for innovation.”
But the Dell manufacturing machine has sputtered recently. It has had trouble perfecting the bright colors on its new notebook computers, resulting in shipment delays and irritated customers. Dell says it is moving swiftly to correct the production problem, caused in part because it significantly underestimated demand for its new notebooks.
Dell’s corporate comeback, its founder says, will not always go smoothly. “Hey, we’ve got a lot of work to do,” Mr. Dell concedes, “and we’re just getting started.”
And the man once known as a by-the-numbers, short-term thinker is now, apparently, planning many years ahead. Asked about how long he intends to remain chief executive, Mr. Dell compares himself to Wal-Mart’s founder.
“I’m 42 years old. I think that would put me on the young side for C.E.O.’s,” he says. “I don’t think Sam Walton became a C.E.O. until he was 45.”
So how long will he remain C.E.O., then? “A long time,” he responds.

When Balance Sheets Collide With the New Economy (NYTimes, 09/09/07)

September 9, 2007
Re:framing
When Balance Sheets Collide With the New Economy
By DENISE CARUSO
TODAY’S sophisticated knowledge economy is stuck with the equivalent of an abacus for measuring the actual financial value of corporate assets and liabilities.
At issue is a growing collection of crucial resources known as intangibles: assets or liabilities that have no obvious physical presence, but that represent real value or vulnerabilities.
Patents, trademarks, copyrights and brand recognition are most commonly recognized as intangibles. But as the nature of doing business has changed, the list has grown.
For example, the most valuable assets of an innovation-based company today — its intellectual property, software investments, staff and managerial expertise, research and development, advertising and market research, and business processes — have no natural home on the balance sheet.
They can be recorded as expenses or sometimes, in the case of intellectual property, as liabilities, says Nir Kossovsky, the chief executive of Steel City Re, which assesses and insures companies’ intangible assets. But often, they do not make their way onto the accounting ledger at all.
Reputation is one such intangible asset; ask Mattel about its value, after its third recall of toys this summer. Or JetBlue Airways, which built a stellar reputation for customer service but neglected to fortify its computer network. When that network failed in the winter and stranded thousands of customers, the company’s stock price and good name both took tremendous hits.
What’s more, the market is demanding that companies prove that their business conduct is environmentally and socially conscious — not on the basis of ideology, but because to do otherwise exposes them to financial risk.
The vulnerability of a global economy to cataclysmic risk, from terrorism to pandemics and extreme weather, is also pushing companies to disclose processes and strategies they have to ensure continuity after a disaster.
But because accountants have found it impossible to determine the value or the risk of such assets with certainty or objectivity, official financial accounting rules give intangibles a wide berth.
Instead, each company makes its own valuation of intangibles, guided only by very general accounting standards. “There is not the rigor and uniformity that governs the valuation of ‘tangibles.’ In all cases, there is little relationship to market value,” said Mr. Kossovsky, who is also the executive secretary of the Intangible Assets Finance Society, an advocacy group that is working to develop new standards and practices for monetizing intangible assets.
Yet today’s markets are being transformed by intangibles, and a growing number of companies are scrambling to find the methods that will help them better use, develop and communicate about them. “In the last three years, investors have been looking at how social and environmental issues translate directly to market value,” said Jed Emerson, a senior fellow at the Generation Foundation (the philanthropic arm of Generation Investment) who is credited with developing an approach to assessing intangibles called the blended value proposition.
“Mainstream business is less and less able to function without paying attention to these things,” Mr. Emerson added. “Ten years ago, at the World Economic Forum, the talk was all about opening new markets and currency exchanges. Today, it’s about AIDS and education systems in South Africa, and things that you wouldn’t have historically heard major C.E.O.’s voicing concern about.” Stakeholders in emerging markets “want to know how investment translates to jobs, environmental concerns, etc.”
Over the past couple of decades, finance experts and strategists have developed many methods to better value various intangibles — methods that corporations and governments are widely adopting.
For example, one of the earliest approaches, the “triple bottom line” (for “people, planet and profit”), was ratified early this year as the standard for urban and community accounting by the United Nations International Council for Local Environment Initiatives. According to the consulting firm Bain & Company, a more recent approach to valuing intangibles, called the balanced scorecard, was being used in about 57 percent of international companies by 2004.
As yet, none have been adopted as a standard by the official financial accounting bodies. But it is only a matter of time until they do, according to Sara Olsen, founding partner of the Social Venture Technology Group, a San Francisco firm that specializes in developing nonfinancial valuation methods.
Ms. Olsen noted that leading business schools are already training students in these new, inclusive valuation methods, and that many companies are also busy teaching others how to credibly analyze their own intangible assets.
Leading public companies recognized the value of the process some time ago. In April, Fast Company magazine teamed up with the S.V.P. Group and the social investment strategy firm HIP Investor to rate the human and social impact of 21 companies that say they have sustainability practices in place, including Wal-Mart Stores, United Technologies and McDonald’s.
“I would put money on it, that within a generation this will be a commonly accepted management practice,” Ms. Olsen says, with its own standards body like the Financial Accounting Standards Board that maintains, updates and oversees enforcement of best practices for valuing intangibles.
Many who have been working in this area agree. Not only is the change inevitable, they say, but it is well under way.
“Some people think the logic of econometrics was handed down by God, but it’s actually the result of 40 or 50 years of economists and accountants arguing about corporate performance,” said Mr. Emerson of the Generation Foundation. “We’re now at the early stages of evolving that process. Today it’s a very different conversation, and all these efforts to capture value more wholly — at the corporate level, across companies, and at the broader level of society — are positive examples of innovation.”
Denise Caruso is executive director of the Hybrid Vigor Institute, which studies collaborative problem-solving. E-mail: dcaruso@nytimes.com.