There's no question that HP (NYSE: HPQ) looks like a value stock. The company expects to produce around $2.17 in per-share adjusted profits this year, putting the price-to-earnings ratio at a miserly 9. HP is valued at about $30 billion, just eight times its full-year guidance for free cash flow. That's the kind of depressed valuation that usually piques my interest.
But I have no interest in investing in HP. The problem isn't how much money the company makes; it's how the company makes its money. HP sells PCs, printers, and supplies for those printers. PCs account for the bulk of revenue, but the printing business accounts for the bulk of profit.
2018 Operating Income
2018 Operating Margin
Data source: HP.
Within the printing segment, supplies account for about two-thirds of total revenue. HP follows a razor-and-blades model for its printing business. It sells low-margin hardware, which then needs a continuous supply of high-margin supplies. It's safe to say that most of HP's printing profits, and thus a majority of its overall profits, comes from selling printing supplies.
Image source: HP.
A crack in the status quo
This model has worked well for a long time. It's not that people weren't aware that printer ink is expensive -- it's part of the human condition to be annoyed at the high cost of printer ink. It's more that there were limited alternatives to buying supplies from anyone but HP, brick-and-mortar retailers, or HP resellers, especially on the commercial side.
It's taken a while, but e-commerce seems to now be in the process of seriously disrupting HP's printing supplies cash cow. HP reported a 3% year-over-year decline in printing supplies sales in its fiscal first quarter. The company blamed commercial customers for increasingly shifting their purchases online, where HP has a lower market share. Customers have also become more price sensitive, which puts pressure on supply pricing.
Third-party ink cartridges aren't new, but HP is finding it harder to compete. CEO Dion Weisler explained during the first-quarter earnings call that the growth of e-commerce has enabled aftermarket manufacturers to invest in better technology faster than in the past, which has led to "a faster deceleration in our aftermarket share on some newer platforms than we expected."
I wouldn't be all that concerned if HP's pricing was only marginally higher than aftermarket alternatives. A commercial customer isn't going to switch away from HP for supplies if the savings are small, especially considering aftermarket supplies may or may not be of the same quality. But the savings aren't small. HP loses badly on pricing.
How badly? Here's a list of current prices for a few ink and toner cartridges on both HP.com and inkjets.com, a third-party ink seller. The third-party cartridges are remanufactured but compatible with the stated models:
OfficeJet Pro 8710
952XL High Yield Black
Color LaserJet Enterprise M553dn
508X High Yield Yellow
LaserJet Pro MFP M521DN
55X High Yield Black
Data sources: HP and inkjets.com.
Pricing is just as lopsided on the consumer side. In fact, Costco offers ink cartridge refills at some locations starting at $6.99. That 952 XL Black cartridge in the preceding table can be refilled at Costco for $14.99.
This doesn't strike me as a sustainable situation for HP.
Not a bet I'm willing to make
To invest in HP today, you have to be willing to bet that the status quo is going to remain largely intact for the foreseeable future. You have to believe that HP will continue to be able to charge inflated prices for printing supplies while not losing much market share.
Given that HP is now admitting that online aftermarket sellers are a big problem, that's a leap of faith I just can't make. Winning back market share is going to require lower prices, and lower prices will lead to declining margins. That could hit HP's bottom line hard given its dependence on printing supplies.
Maybe HP's high-margin supplies business is more sustainable than it looks to me right now. Maybe, if it does decline, it will decline slowly enough to be offset by growth elsewhere, like 3D printers.
Or maybe HP's supplies business is finally being disrupted. Razor-and-blades business models don't seem to last forever. Just ask Gillette.
HP was caught off guard by online competition in the first quarter. If this is the beginning of a reckoning in the printer supplies business, even a beaten-down valuation isn't enough for me to want to buy the stock.
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