In silicon valley, hardware is hot again

5 July 2012 Peter Burrows and Ashlee Vance Since the mid-1990s Liam Casey, PCH International’s chief executive officer, has helped technology companies with the nastiest task in Silicon Valley: building hardware. It’s long been considered scut work—dirty, complicated, low-margin stuff,…

5 July 2012

Peter Burrows and Ashlee Vance

Since the mid-1990s Liam Casey, PCH International’s chief executive officer, has helped technology companies with the nastiest task in Silicon Valley: building hardware. It’s long been considered scut work—dirty, complicated, low-margin stuff, beneath the dignity of software companies. Far better to write a few brilliant algorithms and then rack up profits by selling them over and over. PCH specialized in helping gadget-makers outsource as much as possible, finding cheap overseas manufacturers, streamlining supply chains, and negotiating airfreight contracts.

Casey has lately noticed a renewed appreciation for nuts and bolts. Silicon Valley is interested in hardware again, and Casey is riding the trend. Earlier this year PCH purchased a small San Francisco engineering consultancy called Lime Lab. He plans to hire 30 product development experts by yearend and to bring over some of the company’s electrical, mechanical, and industrial engineers from China to help clients design and build their products. “Hardware is the new software,” says Casey, who adds that the unit has booked contracts worth $10 million.

On June 18, Microsoft (MSFT) unveiled a pair of homegrown Surface tablets, a move that puts the company in direct competition with its traditional PC partners. Instead of crowing about the device’s apps, Microsoft executives gushed about its magnesium finish, kickstand, and a clever cover that doubles as a keyboard. Less than two weeks later Google (GOOG) announced it had worked with laptop maker Asustek Computer to build its own tablet, the Nexus 7. It’s suddenly hard to find a large technology outfit that traffics only in bits. Amazon has been making Kindles since 2007. Oracle (ORCL) purchased server maker Sun Microsystems in 2009 to wrap its databases in iron.

For decades, the accepted wisdom of the Valley was that the best way to get rich was to build software. By hooking the world on Windows and Office—and outsourcing the low-margin business of building, selling, and servicing computing hardware—Microsoft created an extraordinarily profitable business and became the world’s most valuable technology company. Oracle followed the same playbook in the world of data centers, as did Google in Web search. IBM (IBM) prospered after selling its PC business to China’s Lenovo in 2004, enabling it to focus on corporate applications and consulting gigs. The model for hardware manufacturers became Dell (DELL), which innovated mainly by figuring out how to sell commodity gear more cheaply than the other guy.

“They all thought they could get someone else to do the hard work,” says Hartmut Esslinger, founder of Frog Design, which helped create the first Apple (AAPL) Macintosh computer. The idea that a 20-month-long design and production process could be handled by assigning a couple of engineers to find a Chinese factory “was just too easy and seductive,” he says. “Now they’re realizing that their hardware partners don’t have the vision to create anything holistic. And meanwhile, Apple is eating their breakfast, lunch, and dinner.”

Apple’s phenomenal success over the past decade has brought hardware back in vogue. By controlling all aspects of a product—the physical equipment, the software, and an online service to connect everything—it creates products that customers are willing to pay a premium to own. Horace Dediu, who runs equity analysis firm Asymco, estimates that Microsoft makes about $78 of operating profit on every PC sold. Apple, meanwhile, brings in $195 in profit for every iPad. In 2011, Apple earned more than Microsoft ($26 billion in net profits, vs. $23 billion) for the first time since 1990.

It’s become much less painful to build gadgets, even for the little guy. Marc Barros, a co-founder of camera maker Contour, says retailers like Best Buy (BBY) might eat up $70 on a $200 device. In the age of social media and e-commerce, he can sell directly to consumers. If professional investors won’t risk their money on a hardware startup, entrepreneurs can turn to Kickstarter or another crowdfunding site and walk away with millions. And an ecosystem of hardware service providers are helping to streamline operations; Barros is in talks with PCH International and hopes to reduce his “non-product cost” (such as warehouses and shipping) from 15 percent to 5 percent of the sale price.

Descriptions such as software company or hardware company are becoming less meaningful. “The lines aren’t just a little blurry now,” says Steve Perlman, a serial entrepreneur whose latest company is an online gaming service called OnLive. “They have essentially been wiped out.” In the past, brilliant coders tended to get the biggest pay packages in the Valley. Now even Facebook (FB), the poster child of the social media era, is paying top dollar to hire product designers, possibly to build a phone, according to an executive who competes with the social network for talent and asked not to be identified because Facebook’s plans are not public.

The renewed interest in hardware is even spurring a small stateside manufacturing boom. This month Tesla Motors (TSLA) began rolling out its Model S sedans, which are produced in a Fremont (Calif.) factory not far from where an Apple manufacturing plant was shuttered in the early 1990s. Earlier this year Advanced Micro Devices (AMD) spent $330 million to acquire SeaMicro, a startup that designs and builds specialized servers in Silicon Valley. Google, too, is manufacturing its new Nexus Q entertainment device in the Bay Area.

Hardware is so important in some industries—especially those that deal with media consumption—that it might be the difference between life and death. The Nook e-reader has given Barnes & Noble (BKS) a fighting chance, while Borders, its gadget-less rival, went bankrupt in 2011. Says Perlman: “In some businesses, it’s either you do the hardware or you don’t survive.”