Hard Problems, Gross Margins and Smart People
For people without a finance background, gross margins are the "mark-up" that a company adds to the cost of manufacturing its products before passing them through to the customer. A 60% GM means that for every $100 NetApp charges a customer, we spend $40 manufacturing our product, and $60 goes to other things, like salaries, equipment, rent, taxes and profit. Dell has 20% GM, so for every $100 from the customer, $80 goes into manufacturing the product, and only $20 goes to other things.
People ask lots of questions about high gross margin companies. Are you ripping off your customers? Aren't you afraid that your business will commoditize, and your gross margins will fall? Won't Dell win in the end, because they've figured out how to be profitable at 20% GM - that is they've figured out how to have a much lower mark-up than you?
The answer to all of these questions is "No." To understand why, you have to look at how we spend that $60. It's not like it all goes straight to profit. We spend it largely on hiring smart people and building the environment for them to do their job.
In essence, being a high GM company means that the customers have really hard problems that they are willing to pay someone to solve.
When you ask whether the gross margins are going to fall (will the business commoditize), the real question you are asking is whether the customer is either going to stop having really hard problems or stop being willing to pay money to have them solved.
In storage, I see no end of hard problems. I see customers' data growing, and I see customers worried about consolidating, operating and protecting increasing amounts of data. I see the burden of ownership for data getting worse as businesses rely more and more on the data they own, and as the legal requirements increase to keep data accessible yet private. No end of problems in sight.
Dell is an interesting case. In some businesses, a low GM means that there are no hard problems to solve. A grocery store has a low GM, and that just means that meat and vegetables are "well understood" - there's little value anyone can add. In Dell's case, there are hard problems involved in making PCs faster and better every year; it's just that Dell outsources the solving of them. Much of Dell's manufacturing costs go to companies like Microsoft, Intel, or - for storage - EMC, all of which have much higher GMs than Dell. The difference between Dell and a grocery store is that for a grocery store it is low margins all the way down, but for Dell, the high margins and smart problem solvers are one layer back. (I should say, there are plenty of smart people at Dell. It's just that they focus on improving the manufacturing process itself, lowering costs there, and not on improving the products or solving customer problems.)
When Dan Warmenhoven, CEO of NetApp, says that he doesn't worry about commoditization of our business, he doesn't mean that there will be no commoditization at all. There are certainly parts of storage, like basic RAID shelves, that are commoditizing, and I'm sure there will be more. What he means is that customers still have plenty of hard problems they want solved. Good news for gross margins.
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