For those who have watched HP Inc.’s performance for a while, especially since last year’s separation from what became the Hewlett Packard Enterprise entity, not many would expect the firm’s low-margin PC operation to be its shining light in a quarterly report during a period when the overall PC market continues to be mired in the doldrums – but go figure.
Dion Weisler, HP’s president and CEO, framed the surprising strength of the company’s PC operation by pointing to a raft of attributes he says the group has displayed including “awe-inspiring innovation,” healthy channel inventories, and a strategy shift to target more premium segments and buyers such as gaming users – which Weisler credited with share gains “at the expense of our competitors, especially in the high-end premium category. … We are building on a rich heritage and delivering experiences that amaze our customers and partners. ... Our products and solutions contain the magic that differentiates HP from the competition,” Weisler pronounced.
Despite the warm words, Weisler had to report yet another quarter in which the company’s revenues declined: “In Q3, our revenue trajectory improved, down less than 1 percent year-over-year in constant currency, driven by strength in Personal Systems, offset by expected declines in Printing.” Weisler reminded listeners that, “As we previously said, we believed overall revenue declines would moderate in the second half of the year. And that is exactly what is happening.” What the CEO didn’t say is when the company could expect overall revenues to grow, or even when the declines would end.
But Profitable …
The half-full-glass perspective for HP Inc. is that the company “achieved all of our financial objectives,” Weisler declared, explaining, “This quarter's results are all about focus and execution,” which included a (GAAP) EPS achievement of 49 cents compared to 39 cents in FY15’s Q3, and exceeding the guidance of between 34 and 37 cents HP provided in Q2. The strong EPS delivery was driven by net earnings from HP’s continuing operations, which were up 20.4 percent year over year to $843 million. The nicely positive earnings performance was delivered despite the a decline in gross margin of 0.5 points year over year, in part caused by “a reduction in supplies margins largely due to the impact of the changes in the supplies sales model, partially offset by gross margin expansion across Personal Systems,” said CFO Cathie Lesjak. She added, “Gross margin was down 1.1 points quarter over quarter, due primarily to unfavorable mix and competitive pricing in printing, partially offset by favorable product premium mix in Personal Systems.”
But it wasn’t simply more expensive PCs that triggered the EPS uptick, explained Lesjack – cost reductions were major contributors. She noted “steady progress [we] have made improving our cost structure … primarily in SG&A,” pointing out that non-GAAP operating expenses declined 25 percent year over year by $1.1 billion. Lesjack also revealed savings in productivity improvements and restructuring actions – including a headcount reduction of 1,000 employees, with 700 more heads expected to roll before the end of the FY.
Lesjak noted that “Personal Systems operating profit rate was 4.4 percent, up 1.6 points year over year, driven by gross margin expansion and tight expense management … [while in] Printing, net revenue was $4.4 billion, down 14 percent year over year, or down 10 percent in constant currency.” It is an obvious struggle when you are putting a positive spin on a printer hardware placement decline of 10 percent because it was significantly better than the 16 percent decline reported in Q2. Lesjack still described that performance as “good progress … as the cost actions we continue to implement increased the number of positive NPV (Net Positive Value) units that could be placed.”
HP Q3 FY 16 Summary (source: HP.com)
Printing – Several Notable Highlights, But the Slide Continues
In Q3, HP’s printing unit represented only 37 percent of the company’s revenues, but 73 percent of its non-GAAP operating profit at 20.4 percent operating margins, compared to 4.4 percent margins in Personal Systems – though the firm forecasts margins in Printing will return to a more typical 17 percent range. Printing revenues were represented as 64 percent supplies, 29 percent commercial hardware, and 7 percent consumer hardware, and the company claimed it gained 2 market share points sequentially in laser units and 1 percent in inkjet hardware sales.
The firm noted these quarterly highlights in printing:
• Execution of Supplies sales model change on track
• Constant currency growth in Graphics for the 12th consecutive quarter and strong drupa orders
• MPS revenues up year over year, and Instant Ink enrollees grew sequentially
• Launched eight new printer models including world’s smallest all-in-one inkjet
Weisler acknowledged a Q3 lowlight – “We were more challenged in our business ink products where we drove pricing discipline and lost some share.” So, HP is being undercut in business inkjet, no doubt by Epson and Brother, despite claiming it gained 1 percent in inkjet hardware sales.
Lesjack broke out the 10 percent printer hardware sales decline as “approximately 5 to 6 points of the year-over-year decline to the market and the rest of the decline is split between less attractive units and channel inventory reductions in Q3 2016.” In Supplies she noted that revenue was down year over year 13 percent in constant currency; approximately 7 points of the constant currency decline was associated with the planned reduction of supplies sales into the channel, with the remainder being a combination of the separation-related channel inventory build in Q3 2015 and declines in Four Box Model drivers. Loosely translated, this means supplies sales sagged because of the $450M supplies channel buyback announced in June, a 35 to 40 percent decline in supplies overall as part of the revenue mix to 64 percent of the total, and an acknowledgement that the company stuffed the channel with supplies inventory when HP and HPE split last year. The three-point year-over-year increase in operating margin uptick was driven primarily by a gain of $280 million from the software asset divestiture announced in June, minus the $245 million supplies channel inventory reduction and related marketing investments. Lesjack spelled out that the $45 million differential gain was “reinvested back into getting our channel inventories lower for the new model that we’re executing on, as well as incremental investments we’re making in marketing in order to drive better awareness and preference for HP branded supplies.”
Lesjack also revealed that “R&D for Printing was up both year over year and sequentially due to the ramp up of an investment to support A3 copiers and 3D printing.” (Note – It is unusual for HP to use the word “copier” when relating to its Printing products.) She also reiterated that “We believe declines in supplies revenue in constant currency will continue, but moderate. Supplies revenue is still expected to stabilize by the end of 2017.” So, the company is sticking with its previously stated forecast that it expects supplies sales to decline for five more quarters before it levels out. Major ouch.
What is Next?
Shareholders like it when you directly address those pesky rudimentary questions about the future of their money. Weisler left that unenviable task to Lesjak, who offered the following outlook for Q4. “In [PCs] … we expect the market to be down mid to high single digits year over year with incremental pressure in the commercial segment. … In Printing, we expect to continue to make progress on our cost structure, giving us the opportunity to place more NPV positive units … we expect print revenue and hardware unit declines to continue to moderate year over year.” In short, for shareholders scoring at home, expect more revenue declines in both PCs and printers – so the current Q3 PC uptick appears to be an aberration – enjoy it while it lasts. Lesjack did offer the following positive note however: “[In Q4] we expect Printing revenue to be better sequentially as compared to lower quarter-on-quarter revenue growth in Personal Systems.” Unfortunately, for HP staffers, continued revenue declines will, in all likelihood, lead to lower profits, and more headcount reductions in 2017.
More significant changes are in store regarding the printer and supplies channel and inventory realignment announced in June – you remember, the $450M buyback. In response to an analyst question, Lesjak commented “as we are bringing down channel inventory, we have not made the formal change to our channel inventory levels, our ranges. We will do that at the beginning of FY 17 once we get through the actions that we’re taking.” Weisler also commented, “[in] supplies, in Q3, we began to execute the sales model changes … we made a strategic decision to evolve how we run and manage our supplies business in recognition of the changing market dynamics, giving global price transparency.” Yes, it was, at least in part, about gray market problems. “To harmonize pricing, we determined an increase in marketing, combined with a reduction in channel inventory levels, was necessary … We will continue to implement operational changes to our supplies inventory management in the fourth quarter and we’ll provide a further update on our Q4 earnings call.” Bottom line: it appears HP will be dictating and/or actively managing supplies channel inventory levels in 2017 in an effort to reduce gray marketing and inventory dumping – all part of an overall effort to increase channel profit margins on HP supplies, making them more attractive for the channel to sell compared to generally higher-margin aftermarket supplies products.
Tough Challenges, Unexpected or Unintended Consequences
The old proverb warns “Be careful what you ask for because you might get it,” and HP is dealing with the reverberations of interconnected market and HP-directed initiatives. Consider:
HP is all-in with its campaign to replace laser printers with its PageWide inkjet machines – but already butting heads with Epson and others in the business inkjet arena. But what if they do succeed?
- Every PageWide inkjet machine that replaces a possible LaserJet sale will do so at a lower average sale price: the PageWide line is priced under comparable LaserJet models. So while every PageWide inkjet machine sale keeps the customer an HP owner, it results in lower hardware revenues.
- Every page printed on a PageWide inkjet machine that replaces a LaserJet printed page lowers HP’s supplies revenues – because the PageWide line CPPs are priced under comparable LaserJet CPPs.
- Since overall pages are declining, the company is monumentally challenged to maintain hardware and supplies revenue levels while pushing product lines which, if they sell well, will result in declining hardware and supplies revenues. So, the company has to significantly capture more pages – and richer pages – even if it replaces tons of LaserJets with PageWide inkjets in the office simply to maintain existing revenue levels.
- HP has already been burned by aggressive pricing and marketing by Epson, et. al., in the SMB office printer arena; if that continues, LaserJets will be replaced by inkjets, but not HP inkjets.
The company faces a stiff challenge in its broad efforts to drive pull marketing efforts for its critically important supplies business. Aftermarket supplies, regardless of brand, always offer higher profit margin percentages than their OEM counterparts – though at lower average sale prices, they don’t offer the same overall profit dollars. Over the last several years, HP has drastically pared down the number of its authorized supplies channel partners at several distribution levels in an effort to gain more leverage with its supplies channel and stop the hemorrhaging of supplies share to the aftermarket. The $450M supplies inventory buyback from the channel now in progress is an indicator that the thinning out of the channel hasn’t succeeded.
Now, HP executives have said more and significant supplies channel controls or restrictions will be implemented in 2017. Unfortunately, with every passing quarter, the weaker HP printer and supplies revenue become, the weaker its leverage becomes at all levels of the channel. Further, the more fragmented the sales of supplies become – splintering into an omnichannel world no longer dominated and controlled by the power of retail and contract stationer giants such as Staples and Office Depot/Max – it becomes exponentially more difficult for any OEM to control the distribution of its products – especially if it is a broadly distributed, market share leader. We don’t know what HP’s channel plans are for supplies in 2017, but I hope they are selling front row seats to the unveiling because it is probably going to be noisy and rough. At all levels of the channel, the power of printer OEMs is weakening as the importance of printers and printing diminishes.
Even if HP succeeds in implementing whatever supplies channel plans it has in mind, the firm can’t control what the aftermarket, non-authorized HP channel players, and other OEMs do in their quest to sell more printers, more cartridges, or capture more pages.
As printing declines in importance, it is likely inevitable that the consolidation of OEM, aftermarket, and channel players will continue. Unless HP adds to its market power and leverage by acquiring players into its sphere with market share and reach, customers, and technology, its influence will decline. But any company with near 50 percent share of a market could face antitrust resistance to any move it makes to consolidate its market power by acquiring competitors.
The dealer acquisition frenzy and consolidation wave that is underway in the BTA channel will challenge HP to evolve its approach to that channel as competing OEMs buy up dealerships – locking them out – and the growing power of regionals and dealer aggregators give them much stronger leverage with all OEMs for both hardware and supplies sales.
While the U.S. economy and market remains relatively healthy compared to other world regions, the weakness in emerging market economies – including stalwarts such as Brazil – means those areas, still highly dependent on printers and printing, and facing a strong U.S. dollar for import, are not going to help turn around OEM printer company fortunes anytime soon.
Stay tuned folks — the fun is just starting.