On June 21, HP Inc., in what the company billed as an “Update [to] Its Printing Sales Model,” announced that it was taking a charge of $225M in both Q3 and Q4 of this year – about $450M in total – that reflects a move to reduce channel inventory of printer supplies; essentially the company is taking back/buying back almost one-half billion dollars in supplies from its channel partners. In Q2, the company reported $3,099B in supplies sales, continuing a declining sales trajectory that has been quite evident:
|$ in millions||3,601||3,684||3,455||3,239||13,979||3,101||3,099|
The scope of this move is breathtaking (and completely unprecedented in the imaging industry to our knowledge) – at a monthly revenue run rate of approximately $1B in supplies, HP is taking a 22.5 percent revenue buyback in two consecutive months, and reducing supplies sales overall for FY16 by the same $450M. Moreover, $450M in revenue takeback, at a generally accepted 60 percent gross margin level, translates into somewhere in the $260M-$300M as an operating profit hit. Zowie. Even for HP, that is a lot of money.
In a quick analyst briefing at an HP-sponsored analyst event in Boston, Tuan Tran, VP and general manager of the LaserJet and Enterprise Solutions Group, explained that the move was triggered by two unrelated events – the HP sale of its Exstream, Output Management, TeleForm and LiquidOffice assets to the Waterloo, Ontario-based Open Text Corp. for $315M the day before, and HP’s desire to shorten its overall supplies channel supply chain metrics – effectively reducing the amount of inventory its supplies channel partners customarily carry. The supplies move, Tran comments, enables HP to avoid any financial (capital gains tax) penalties associated with the Open Text windfall by taking a counterbalancing loss hit, while making a strategic move to improve its supplies operating model. Tran indicated the products represented in the move were both ink and toner SKUs, but no specific mix was revealed. Rudimentary math says at average sale prices of, say, $50 -$60 (mix of ink and toner ASPs), the buyback included somewhere between 7.5 million and 9 million cartridges; however when asked, HP officials declined to acknowledge exact numbers. If the buyback was heavily ink-based, the number could exceed 10 million cartridges. Despite the move, on the call HP reiterated what it has said previously: that net supplies revenues, in constant currency, remain on track to “stabilize” by the end of 2017, which we assume means the firm expects the decline to continue for about another 16-18 months until it levels out?
Even observers outside the printing and imaging industry took notice – The Wall Street Journal headline read “HP Hits a Jam With Printers,” noting “HP Inc. tried to put a positive spin on a big change in its printing business Tuesday — reducing its global inventory of ink and toner — but since supplies makes up most of HP’s profits, investors saw through it.” The WSJ coverage included a sharp question from the announcement webcast Q&A session with analysts – specifically Toni Sacconaghi, from Bernstein Research, who pointed out that the firm conducted an earnings call last month in which HP executives gave no indication of issues in its supplies biz, much less a $450M buyback. Sacconaghi asked the HP executive team on the call, “we had an earnings call less than four weeks ago and you said you were comfortable with supplies inventory levels … you said that … so unequivocally given that you're now coming back … and saying, ‘That's not the right supplies channel inventory level for the new economic reality of what supplies is today.’ Has the market changed in the last four weeks?”
Cathie Lesjak, HP's Chief Financial Officer explained “if we continued to manage our supplies business the way we had been managing it, then the channel inventory levels were the right levels. We have now made a decision that it's important to adjust to the changes in the marketplace … with a change in the way we're going to manage this business, we need to bring channel inventory levels down in an absolute way, but we're also going to manage them with a much tighter range.” Enrique Lores, HP's president of Printing, added “it really is not just a change in inventory level, we are changing … the processes that we use to manage supplies. We are changing the metrics and this will enable us to operate in this different and more efficient way going forward.”
The move is designed to shorten the overall supplies inventory ballast in the channel – which has historically been very high compared to other faster-turning hardware SKUs. It has been fairly common practice in the print supplies business to target first-tier wholesalers (United Stationers/Essendant, Supplies Network, et al.) to maintain 45-60 days of supplies inventory, translating to a six-to-eight annual turns ratio – but that turn metric gets much worse for older SKUs associated with sometimes more than decade-old legacy printers. OEMs generally require first-tier wholesalers to carry some inventory of their entire active SKU line, which can translate to literally hundreds of individual items, many with very low turns ratios. The turns ratio metric becomes even more critical for channel players when overall demand is in secular decline, the number of active SKUs grows daily, and therefore, overall profits decline from intense market pricing pressure and fewer turns, equalling a horrendous profit squeeze. When customers are not making money selling your product, the OEM loses leverage and power in the buyer-seller equation.
In response to a later question, Dion Weisler, HP's president and chief executive officer, uncovered more of the warts in the existing supplies marketing model. “All of this is really driven by what we call the omnichannel experience … the end customer can now have multiple outlets from which to purchase. ... As a result of that and the growing trend of online transactions and the global nature of business, there's a lot more transparency in the market with regards to pricing. This has cause a lot of disruption for our channel partners.” This is a critical point for the following reasons:
- The internet channel enables instant, worldwide price comparisons, which has led to a “race to the bottom” in supplies prices and excruciatingly bad channel margin pressure. The bottom line is that while everybody at every level of the channel sells HP printer supplies, nobody makes any meaningful money selling them. It is a Hobson’s Choice – the channel has to sell HP supplies because overall market demand and presence is so dominant and it is a recurring purchase motion, while acknowledging that incredible price competition eliminates meaningful profit opportunities. Analogous model? Coca Cola. You can’t operate a supermarket without selling Coke because the demand is omnipresent (will shoppers come to your store if you don’t sell Coke, or some similar market staple?), but widespread and differing price promotions, bundled sales, back-end channel rebates, BOGOs and other marketing stunts ensure that profits on Coke sales are few and far between, if any.
- The imaging industry has long viewed supplies sales as a multi-channel effort, with differing channels delivering a different set of buyers with different shopping/buying needs, varying levels of purchase volumes and price sensitivity, and average sale prices. Internet shopping instantly informs potential buyers of the absolute best price available anywhere for a given SKU, enabling a buyer to make an easy comparison to the price offered by their customary channels – which will almost invariably be higher. Why will it be higher? Because there is so much inventory in the market, sold by HP at differing price levels while executing numerous “push” promotions (aka channel loading), resellers have varying margin requirements or immediate needs to reduce inventory, or are simply trying to drive sales and build its customer base by whatever means necessary. It is the Wild West with no apparent sheriff. Supermarkets attempt to drive floor traffic by offering loss leaders — big discounts/promotions on staples such as Coke — in the belief that shoppers will buy other, more profitable items during the visit, and perhaps build a loyal customer base. On any given weekend, five or six supermarkets in your city will likely be offering soft drink promotions that often essentially amount to a near giveaway, thereby creating the perception that any store selling those items at regular prices is out of step or overcharging. Ouch. There are no “hidden” or protected channels anymore. A large corporate buyer with a multi-million-dollar high discount (“best customer”) contract stationer deal can usually find a lower price online than they are being charged, in minutes, for a single unit toner cartridge purchase. Ouch. Try explaining that discrepancy to your Fortune 50 customer…
- In his opening remarks on the announcement webcast, Weisler commented, “First, managing the four Ps. That's product, price, promotion and place. It is incrementally challenging in today's omnichannel world. Our customers have more choices than ever on how and where they shop. With increased transparency to inconsistent pricing. These challenges are most problematic in our supplies business, which we operate through direct and indirect motions across Tier 1 and Tier 2 partners globally. The resulting price variability in this omnichannel reality, has created confusion for our customers and has been disruptive to our partners and to HP.”
- The mature and declining nature of the printer supplies industry dictates that any channel heavily invested in selling printer supplies has encountered only increasing price and margin pressure as sellers viciously compete amongst themselves for fewer buyers and smaller volumes.
- Because it is extremely difficult to increase end demand for printing supplies (which can only be accomplished by getting users to print more … now, that is a challenge), OEMs have historically resorted to “push,” marketing tactics to drive supplies revenues – finding new and different ways to incent distributors and retailers to increase their inventories of supplies with end of quarter one-time discounts, rebates, sales quotas or targets, baker’s dozen offers, financing offers, and many others. When you are consistently loading the channel on one end while actual ongoing demand is in decline, something’s gotta give folks. Something has.
- In the weeks before the end of a quarter, most industry wholesale supplies distributors wait for their phone to ring with their OEM sales rep offering the deal of the day if they will buy before the end of the month. Not a modus operandi that fosters price stability in the market. What can happens is that, as an example, a Tier 2 (or even Tier 1) direct HP supplies customer is offered HP supplies from some offbeat sources in the channel for a lower price than they can buy it from HP. That usually doesn’t go over well. Try explaining to Staples why they can buy HP supplies in the open market for the same, or less, than they get them from HP.
Weisler explained this phenomenon as follows: “we see a decreasing impact from promotional pricing of supplies and an ongoing dilution of our value proposition. We have seen an increased level of inefficiency as we first invest promotional dollars to sell supplies into our broad channel network, and then leverage additional funds to push the inventory through to end users. Consequently, we believe that promoting supplies at high frequency and high discount levels has become a less attractive strategy. Given these challenges, we are convinced that we need to fundamentally change how we run and manage our supplies business to drive a more consistent value proposition to our channel partners and our end customers.” Short form – push no longer works for driving supplies sales, especially when the channel expects the OEM to drive pull demand and demand is declining, and, tighter industry supplies margins means OEMs can no longer afford to do both. Weisler summarized it as follows, “To harmonize global pricing and improve margins over time, we're going to make a one-time investment to reduce the level of supplies inventory across the channels. Our goal is to achieve substantially all of the reduction over two quarters. This will support our strategy of maintaining a more consistent value proposition by shifting from today's push model, to a pull model driven by market demand.”
- Special bids – almost all OEMs have special bid and quote programs, offering lower than market prices, thereby enabling a reseller to make a bid on a public sector or large corporate buy. Price motions such as this can trigger repetitive requests for even lower prices from multiple resellers, or, cause the winning reseller to dump low priced inventory into the market when projected bid sales fail to materialize.
- Gray market problems – the pattern of “Wild West” price instability also creates an ideal environment for fostering gray market activity. Weisler explained, “To harmonize global pricing … This action is expected to help reduce disruption by minimizing unofficial channels, eliminating gray marketing activity, and ultimately allowing for less price variability and a consistent value proposition.”
- Weisler emphasized the pivot in HP’s supplies strategy: “We will focus more on selling through the value of our branded supplies products and less through promotions and pricing. We plan to leverage the remaining savings from [promotional pricing] to incremental investments in marketing to drive print relevancy [i.e., demand] as well as, to strengthen our HP supplies brand value. Weisler explained some channel implications of the move, “Actually, our channel partners welcome this. It doesn't change the nature of the real demand for printing and therefore the real demand for supplies. What it does do is smooth out the curves and enable us to have more consistent pricing in the market. That's good for our partners, they prefer that … It has a pretty solid and positive impact to our working capital to our partners because they no longer have to stock unnecessary inventory, it's fairly well received by them.”
You could look at this latest move in the context of other moves HP has made over the last several years to gain more market control of its supplies business in an attempt to reduce the “Wild West,” nature of that business, and presumably seller profit margins through more tightly controlled availability. For those keeping score at home, in the last two years, HP has rationalized and reduced the number of direct supplies buyers by more than two thirds by some industry estimates – a move that did not endear HP to a number of long-time HP supplies sellers heavily invested in their product line. One could speculate that from one perspective, the width of HP’s direct channel for supplies needed to be narrowed to simply reflect the reality of lower overall demand for HP supplies products in the marketplace. This latest move, which is an even bigger one than the channel rationalization, tends to indicate that the winnowing of the channel partners move didn’t deliver the desired results.
In Part II of this analysis, we will examine some of the other implications behind this major HP move.