Original URL: http://www.theregister.co.uk/2010/07/26/after_the_dell_settlement/

Dell's fraud settlement explodes PC market myths

Getting sick on cookie jars and bags of chips

By Andrew Orlowski

Posted in Hardware, 26th July 2010 15:09 GMT

Analysis Even us jaded hacks, who think we've seen everything in the business, can find our chins hitting the trackpad. So it is with the Dell legal settlement last week. It may have a familiar ring to it, as it concerns a kind of business arrangement almost 20 years old - but don't let that fool you. It's the scale of the amounts involved that is truly jaw-dropping. The SEC settlement casts the entire PC market in an entirely new light.

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.

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. The 80386 in 1986 and the Pentium Pro (P56) in 1995, the fastest chip in the world at the time, are the prime examples. But there are times when Intel isn't so competitive. This was the certainly case when AMD introduced the Athlon in 2000 and attacked the server market with the 64-bit Opteron in 2004. Against Opteron, Intel could only respond with an ageing 32bit architecture based on P6, and an esoteric boutique processor, the Itanic. Intel was loathe to see its key customers acknowledge its rival's competitiveness.

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. Equally Intel prized Dell exclusivity so highly, it was losing its grip on reality.

Dell became pro-active in seeking top-ups.

"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", since the lower costs were not reflected elsewhere in the market - they were the result of an exclusive Dell-Intel funding arrangement. 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."

The SEC's investigation into individuals continues. A separate investigation by New York State's Attorney General into Intel's exclusivity funding also continues.

Too little, too late?

We now know that Dell was nowhere near as profitable as its financial statements implied, and much of the commentary since Thursday has focussed, rather myopically, on this small point. (It's a big deal if you're a Dell investor or employer - but surely not the salient point here.) The bigger picture begs to be revealed, so let's recap.

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 remarkable how the needs of the Dell customer came way down the priority list. Dell executives complained that the adoption of Opteron hadn't brought cost savings. But AMD provided a "faster, smarter, more efficient and cheaper processor", as we noted at this parish. For its part, Intel had made wrong bets and become complacent - but instead of taking the hit and accelerating competitive processors to market, Intel bought its way out of trouble.

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.

AMD will no doubt dispute this. 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.

New York State's lawsuit suggests that the reach of the funding was wide indeed. It alleges that IBM benefited by $130m from Intel simply for not launching an AMD product. HP benefited by almost $1bn. Again, you might suppose Intel might have found better use for such resources - such as R&D.

One small detail seems to have escape 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. ®