Hewlett-Packard: How Much Do You Spend On Cartridges?

| About: HP Inc. (HPQ)


The printer/ink business model generates high operating margins.

The printer division is a division with healthy growth ahead.

The printer division and cash per share add up to ~$30 a share.

If you are in marketing, or perhaps read outside of the financial press, you might have either read the blog or books of Seth Godin. Many of his books are wonderful, and some are even totally free. His blog is the most read marketing blog in the world.

I read both, and his latest blog post about the lifetime value chain, with Hewlett-Packard's (NYSE:HPQ) terrible customer service to printer owners as an unfortunate example, incited my curiosity... How important is this printer business to HPQ, and how is it doing?

This is what Seth Godin had to say about HPQ dropping the ball, I'm quoting a big part of his post, but with the sincere recommendation to check out his writing for yourself:

HPQ offers inkjet printers at a slight loss, knowing that over time, they'll more than make it back in high-priced toner. When a customer shows up at their website then, searching for a new feature like eprinting or getting their wireless to work, it's both an opportunity and warning sign. Drop this ball and it costs thousands of dollars in lost profit.

At every step along the journey, HP drops the ball. The website, knowing my model and serial number, shows me pictures with instructions that don't match my printer. The site won't let me into the chat support window, because my printer is out of warranty. And when I call, they put me on hold and then route me to an overseas call center. After fifteen minutes, I'm told, "your printer is obsolete, you should buy a new one."

The thing is, a customer is never out of warranty, even if his product is.

Twenty minutes ago, HP knew everything they needed to know to tell me that I needed to buy a new printer. Think of all the ways they could have used this as an opportunity to make it more likely that the new printer would be an HP printer. Instead, they punished me for a quarter of an hour and then demanded I buy something new. They broke the chain.

Sure, I had to buy something, so I bought a Canon (NYSE:CAJ).

Printers and PCs account for more than 40% of the operating profit of HPQ, according to Morningstar. The printer/ink business model generates high operating margins (18%, according to CEO Meg Whitman), and customers are somewhat locked-in. Because they invested in the machine. So if HPQ is really dropping the ball on this one, at least we know it's significant.

Meg Whitman (NYSE:CEO) talked about the printing business at the Morgan Stanley Technology Media and Telecom conference.

So, printing is a slow growth business, but is a Tale of Two Cities. The emerging markets are actually growing quite rapidly, and then the ability to print from your mobile, when people understand they can print from their smartphone or their tablet, it's remarkable what printing acceleration that we see. So, this is going to be a slow to low growth business, but a business where we are the market leader, we have all the IP, it's a great business for us.

Now, a key to the printing business is you have to gain share or hold share in your hardware business, because it is a system business. You place the printer and then what follows is an annuity of ink supplies or toner supplies.

A number of years ago, probably five or six years ago, HP made a decision not to invest in the next-generation of multifunction printers. And it turns out that multifunction printers is now a big market segment and a growing market segment of laser. Good news is even before I arrived there was a change in decision there, and in the last eight to nine months we have introduced 16 new multifunction printers, which we are now gaining share in an important business. And those printers will pull with them an annuity of toner.

And so you can see our ink business is growing. Our inkjet placements are growing, our laserjet placements are growing. And the view is that the toner will follow as we gain share and by the way some of the highest toner usage segment, so single function printers use a lot less toner than multifunction color printers, as you might imagine.

So, this is a well articulated strategy. This is a business we know very well.

It is in some ways the very best part of HP. And so, we focus that strategy, we've made the appropriate investments, we've taken costs out. The merger of our PC business and our printing business in terms of go-to-market has played out very well. So, I think you can look forward to really quite strong performance from our printer business.

And well, people say it's not too sexy, it depends on your definition, I suppose. I happened to really like the 18% operating margins on the cash flow. I think that's a pretty attractive part of the business. But it is actually the digital on and off (rim), and so I do think that's something that holds a lot of interesting promise (inaudible).

It appears Meg Whitman holds the printing business in high regard and sees a bright future ahead for this division. This is not a business HP is consciously neglecting or phasing out. It's vital to future cash flow. That customers like Seth Godin are lost in this way is either an accident or because the company is unaware its service is not optimal to retain clients.

To see if this trend is visible in the numbers, I turned to the company's filings. In the annual and quarterly reports, the print division is not broken down separately. It's thrown in with products, which accounts for roughly 75% of revenue. However, on the quarterly earnings call, a little more detailed information is revealed:

Q1 2014 earnings call:

Operating margin for the first quarter were 16.8% up, 0.5 points over the prior year. Printing revenue was down 2% or 1% in constant currency, and while total supplies revenue declined, we did see growth in ink supplies over the prior year.

The overall printing market saw hardware unit growth for the second successive quarter, driven by strength in laser. For the third successive quarter, HP outperformed the market gaining two points of share over the prior year in total and in both, ink and laser, respectively.

Q4 2013 earnings call:

In addition to the product innovation happening across HP, we are driving significant business model innovation as well. In printing, we are seeing success with our Ink Advantage program and our newly launched Instant Ink offering. In software defined networking, we launched the new app store that coupled with our network developer will create the industry's first enterprise class open ecosystem.

Our printing business delivered an excellent quarter with continued strong profitability. We outperformed the market for the second successive quarter, getting 4 points of total unit market share over the prior year. Revenue for the quarter was down 1% but we saw a growth of 1% in constant currency. For the second consecutive quarter, we grew unit placement, which was up 6% over the prior year, driven by strength in laser volume and our SMB home business.

Q3 2013 earnings call:

In printing, we once again delivered a solid quarter. Business initiatives like Ink Advantage and new products like Officejet Pro X continue to take hold with strong customer adoption. As a result, we are seeing strength in our Ink in the Office program. Overall, we grew hardware unit sales for the first time since 2011, gaining one point of share in both Ink and Laser over the prior year and five points of share in Laser over the prior quarter. The printing team has done a very good job executing the strategy we laid out last October.

Although revenue is down, profitability is inline with our expectations and the topline is stabilizing. Printing revenue was down 3.6% over the prior year and 1.4% in constant currency while margins were 15.6% essentially flat over the prior year.

To summarize it for you, revenues from the segment have declined over these three quarters, but the number of hardware units sold gives rise to some optimism. Even though Seth Godin went with Canon this time, overall HP is gaining market share with hardware units.

Period Revenue growth* Revenue growth in constant currency* Margin
Q3 2013 -3,6% -1,4% 15,6%
Q4 2013 -1% 1% -
Q1 2014 -2% -1% 16,8%
*compared to same quarter last year

We can take this to mean a few things. Either the competition is doing an even worse job, or Seth Godin's experience is not representative of that of the typical client of the printer division.

However, the experience was seemingly aggravating enough to write a blog post and make an example out of HP. Given how important the printer business is to HP and how much profit trickles down to the bottom line, it is advisable for the company to review its service to existing customers.

Let's translate the words of the CEO Meg Whitman ("So, I think you can look forward to really quite strong performance from our printer business") into a profit growth of 10% annually on this division. Print is probably going to be around for a while, and customers are semi-locked, so the business is likely to be solid for at least the next 5 years.

The printer division is not reported separately from the computer division, but IDC published data from its worldwide quarterly peripherals tracker that helps to figure it out. With HP's 40% market share and the worldwide $13 billion quarterly market, revenue from the printer segment could well be ballpark $20 billion annually. At 16% margins, that amounts to $3.2 billion Free Cash Flow.

That puts net present value of the printer business by itself at ~$22 per share by discounted cash flow calculation. In addition, HP holds $8 per share in cash.

HP trades at just $32. Just the printer business and the cash amount to $30 of value. Some working capital is necessary to run the business, but not anywhere near $8 per share. Basically, you are getting the rest of the business for $2. Just looking at its print business, HP is still significantly undervalued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.