Monday, August 3, 2009 3 comments ++[ CLICK TO COMMENT ]++

Thoughts on the printer business and Lexmark

I started researching printer companies after getting interested in Lexmark. I ran across a freely-accessible story from Barrons on Ricoh, a Japanese printer company. Those interesting in printing company may want to see how Ricoh is doing and its plans for overcoming the tough business environment. Although the product mix is somewhat different, you can see the initiatives Ricoh is undertakig compared to Lexmark.

On another note, I ran across a good blog entry chronicling Lexmark's fall at Lowell's: Under the Hood. Lexmark is supposedly headquartered in Lexington, Kentucky (never knew that) and the blog is written by a local who seems to have worked at the company many years ago. It seems like a rant and is a very bearish piece that suggests that Lexmark may not have many years left before it collapses completely. It's still good to get the opinion of the bears.

However, investors should always keep in mind that there is a huge difference between a good stock and a good business. Customers or the general public will always perceive high growth, glamorous, businesses as being the best. Unless you were a good growth investor, such businesses are generally poor investments. The stock tends to be overvalued and public opinion is most positive near peaks. I vividly remember reading an article about two years ago, which described some employees in Japan literally crying during their annual meeting and thanking senior management for a job well done. This, it should be noted, was when Toyota was posting recording profits and public opinion was strongest. Its stock price was also at its peak. Needless to say, that was probably the worst time to buy the stock in the last 3 or 4 years. Similarly, public opinion of Apple is very high these days. Yet, I'll bet that anyone who purchased stock in the last few years will underperform the market for the next 10 years. Needless to say, the best time to buy Apple was when it was considered one of the worst companies and no one wanted to even cover it, back in the early 2000's.

Lowell's piece is very informative and seems to capture some dynamics of the industry. Anyone interested in Lexmark or any printer business should check it out. Let me quote some insightful points...

The printers are relatively expensive to buy, but are narrowly profitable or even unprofitable - especially with inexpensive 'low end' inkjet printers - for their makers. Printer sales can be fairly volatile - up one quarter, down the next. All of the active printers that a manufacturer has in the market are considered the 'installed base' of printers.

Compared to printer costs, supplies tend to be relatively inexpensive. Even though they cost less to customers, they offer a high profit percentage for their makers. Supplies sales also tend to be much more stable and reliable, because supplies are generated from multiple years of sales of printers. In other words, supplies are not generally subject to excessive swings like printers are.

Most of the printer industry tries to offset each high-dollar, low-margin printer with several low-dollar, high-margin supplies sold over the life of that printer. The initial printer sale yields little profit (or a loss - as Lexmark has admitted they lose money on many of their inkjet printers), while supplies sales from that printer help (eventually) drive high profits.

This business model is often called a razors-and-blades model for its similarity to how Gillette made enormous profits: Sell the razors for as little as possible, and make it up with profits from blades.

As the installed base of printers ramps up, more and more of the company's revenues (and, of course, profits) come from supplies sales. Eventually, the more stable and reliable supplies business will outpace the more volatile printer business. Over the past 5 years, supplies have accounted for between 60 and 70% of Lexmark's revenues.

The above is an excellent description of the nature of the printer business. So what happened to Lexmark:

Lexmark was in the vanguard of the low-priced printer movement, offering the same (or more) functionality for lower prices than the competition. For a few years, this was Lexmark's main competitive edge in the inkjet market. But in 2003, HP - who had almost always used its market leadership to demand premium prices - changed its strategy and began to match Lexmark's pricing.

The author goes on to point out how the structure of the business may mask deteriorating fundamentals (bolds are by me):

But when a company loses money on its initial printer sale, funny things start to happen to the business model. If it grows too fast, then the losses from printers can drain the profits from supplies: In other words, building the business for long term profit can require the sacrificing of profitability in the short term. Conversely, if printer sales drop dramatically, then the business can appear enormously profitable: Management can enhance short-term profit even while destroying long-term business fundamentals.

What is described above is kind of scary for anyone reading the financial statements. The author is suggesting that selling less printers may appear highly profitable (because companies don't make any money on printers, and in fact lose money at times). But it will hurt long-term printer supplies revenue. In other words, the financial statements may show increasing profits while the company is actually deteriorating.

I wonder how true this is for Lexmark. Its earnings have been declining over the years but is that worse than it seems? Is it actually worsening its long-term profitability to minimize profit declines in the near-term?

Anyone considering an investment needs to be sure that the 'upside-down economics' being described isn't masking long-term problems. I haven't read the annual report yet but hopefully Lexmark reports printer unit sales. That may give an indication of how bad things really are.


3 Response to Thoughts on the printer business and Lexmark

August 3, 2009 at 5:12 PM

Thanks for including my commentary in your profile of Lexmark.  You can get a PDF of Lexmark's annual report here, and you can also see my predictions for and comments about their second quarter earnings announcement here.  The numbers you find in both places should fit the 'death spiral' story I laid out in the article you referenced.

Sivaram Velauthapillai
August 3, 2009 at 5:48 PM

Thanks for the write-up Rob. It was really good and captured elements that are hard to discern. I really liked your theory that declining sales may seem good in the short-run but is terrible in the long run.

I'm doing my research and we'll see if a bullish case can be made.

Plan Maestro
August 3, 2009 at 8:35 PM

May I concur? That is a very interesting feature in installed base business models and it is very counter intuitive.

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