GLG News by Edward Crowley

Implications: Industry consolidation is, to some extent over because there is no one left to acquire!  Our News posting and client report identifies how this is an excellent strategic move for Ricoh, and a significant threat to Canon.

Analysis: As I mentioned in my news article earlier this week, and in my client report which we published on the day of the announcement - this is an excellent move for Ricoh for several reasons:

Implications: The bottom line:  Ricoh now has one of the broadest distribution channels in the market, they have the broadest product line in the market, and they now have one of the strongest service delivery teams in the business.   The competitive impact:  Canon is the biggest looser.  IKON was their largest distribution channel in North America for their highly profitable copier / MFP line.  HP is now threatened by a serious contender who has shown a willingness be aggressive in building capabilities through acquisitions.  Xerox is now eclipsed by their Japanes rival. This is another in a serious of brilliantly executed strategic acquisitions by Ricoh. 

Analysis: Three years ago I wrote an article in which I described Ricoh as the 'sleeping giant' of the imaging industry.  When I said this, I was describing a company which was aggressively pulling together a broad product portfolio, an extensive distribution network, and excellent services capabilities in order to become one of the top three hardcopy firms in the world.  The combined firms revenues will be over $26B (USD) with over 100,000 employees world-wide.

The bottom line - this move provides a significant boost to Ricoh's US and Western Europe distribution and significantly adds to their ability to deliver advanced Managed Print Services offerings (the fastest growth sector in the market).

At the same time, this makes Canon's largest copier distribution channel (IKON) 'captive' to a key competitor (RICOH).  IKON is also a significant distributor for HP.

Ricoh now has distribution which is as strong as Xerox, a product line which is the broadest in the industry, and the advanced services capabilities equal to anyone in the industry.  The firm has put together a string of acquistions (roughly one every twelve months) to become one of the top three hardcopy imaging firms. 

The imaging landscape is rapidly changing, and Ricoh is becoming one of the key firms to watch.

Implications: The Portland (OR) Oregonian featured a lengthy piece concerning layoff rumblings around HP's Corvallis and Vancouver inkjet-printer-related divisions, including quotes from an HP Vice President and his concern for future growth (or lack thereof) in the inkjet business. The news trickle made it to Boise, where much of HP's LaserJet business is centered, with speculation (Idaho Statesman: "Will Boise be hit by more Hewlett-Packard layoffs?") on whether or not down-sizing will make it east of the Cascade Mountains, from Oregon and Washington to Idaho. And then The Oregonian is back with a impressively cogent editorial today, "Shifting Winds in Corvallis", noting the 24-year run of HP's successful inkjet business and the beginnings of a shift away from the industry's razor-and-blades as a business model, and speculating what the future holds for the largest private employer in the Corvallis OR area. Does this signal a fundamental breakage in HP's business model? 

Analysis: There are several key implications for investors in the hardcopy companies such as HP (HPQ), Eastman Kodak (EK), Lexmark (LXK), Epson, and Canon(CAJ). 

First, this could signal trouble for companies such as Epson and Lexmark who rely upon the ink jet market for a large portion of their revenues?  If HP, with all of their economies of scale and their scalable ink jet technology, cannot grow this business, then the second tier would definitely be in trouble. 

Kodak has staked a significant portion of their ‘growth hopes’ on their fledgling ink jet business.  Already the firm has found the higher priced hardware / lower priced supplies model is broken and they have had to respond with lower hardware pricing.  Could this be the final blow for an already struggling business?

Lexmark’s model has been struggling for several years.  According to our detailed financial model for Lexmark, this business has driven as much as $400M in hardware losses annually into Lexmark’s profit and loss sheet.  Does this provide further impetus to either sell or shutter the unprofitable ink jet business?

Secondly, this could indicate a basic 'break' in the ink jet business model.  As the price of color lasers declines (Samsung had a model in Office Depot last Christmas for $99), will color laser become the model of choice for the consumer - replacing ink jet? 

We believe there are segments of the hardcopy industry which continue to be incredibly profitable and vibrant.  The question is whether this segment of the industry has reached a stage of maturity and saturation which will represent a continual drag on profitability for those firms who insist on keeping a position in the market?  In either case this segment of the market will bear close scrutiny over the coming months and years.

This also reinforces the Photizo Group position that the industry business model is fundamentally changing to include a services component as opposed to just the traditional razor blades model. 

Implications: Lexmark's inkjet business is doomed to failure primarily because the brand is positioned to appeal to the 'cost concious' buyer who will not use enough cartridges for Lexmark to recoup the hardware loss from the initial sale.  There is a very strong correlation between usage (pages printed) and the price of the printer.  The lower the price, the lower the usage.  Lexmark's position as the 'price leader' is unsustainable. In terms of the stock buy-back, it is essentially an effort by the executive team (headed by Paul Curlander) to retain control of the company.  The firm is using debt fueled stock purchases as a way to reduce the number of outstanding shares to a level where the executive team can continue to drive the companies perormance without being required to respond to concerns by outside shareholders.

Analysis:

 In order to understand Lexmark's dilemma, one must understand the underlying financial model of the inkjet business.  Lexmark's model is based upon an assumption of using 3 to 4 cartridges per year per printer.  At this rate, Lexmark breaks even in six to nine months as the high margin supplies recoup the significant hardware and merchandizing losses on the initial sale.   While Lexmark attempted to move the brand upward through the addition of wireless functionality, this functionality is very easy to copy and provides little perceived differentiation.

With volumes from Lexmark's largest OEM customer (Dell) declining rapidly, Lexmark must either accept a gradual decline in volumes, or, invest in driving branded unit growth which requires investing significant market development funds. 

Lexmark's stock buy-back strategy will not fundamentally change the equation.  This is a continuation of Lexmark's stock buy-back strategy which has simply resulted in decimating the firms large (at one time over $1B) cash reserves in order to mask the under performance of the stock and a failed strategy by the executive team (primarily driven by the CEO - Paul Curlander).  Now the firm is continuing this strategy, but since the firm has used up it's cash reserves, the firm will now finance this through debt.

The bottom line, the firm will continue in its downward spiral as long as the current management team is in place.

Implications: Lexmark is facing a "perfect storm".  The unprofitable inkjet division continues to decline.  Should the firm let the ink jet product line continue to decline (and accept an eventual 'phase out' of the product segment), or drive product placements and accept the associated hardware losses? At the same time, the firms profitable laser printer business is under attack from HP.  Can the top business printer exec - Marty Canning, turn around this decline? And finally, the companies consistent lack of a turnaround strategy continues to go unanswered, as the CEO, Dr. Curlander, engineers a debt fueled stock buy-back in order to retain control of the company. Will the company make fundamental changes, or will it enter a phase of decline that cannot be reversed?

Analysis:  The Photizo Group model has predicted a decline in Lexmark's profitability during the last half of 2008 after the company had pumped up  earnings in the first half of the year by reducing ink jet shipments.  Based on this article, it now appears that the Lexmark model is again (for the 6th quarter in a row) right on target!

Lexmark is facing a significant dilemma.  The firm has to either accept a decline in this already challenged product line to the point of 'no return' or, drive new product placements which will have a significant negative impact on the firms financials.  The much touted 'breakthrough' wireless products have met a 'ho hum' reception from the market, while they have proven very easy to replicate.  The firm continues to have a significant brand image problem in the intensely competitive consumer ink jet market, and despite this, the firm sticks to the same basic strategy that it has had for the last five years in this segment - "engineer a better product".  The executive team refuses to accept defeat and withdraw from the segment, so this market continues to be a drag on earnings and management talent.

At the same time, the once highly profitable business printer (laser) division is under attack from HP and other competitors.  The firm has lost its technology advantage and the current management team appears to be losing their grip on the firms vertical market differentiation, the key advantage the firm has had in the market.

And perhaps the greatest blow of all is the loss of loyalty from the companies real core strength - it's extremely experienced, and (formerly) dedicated workforce.  However, as the company continues to decline while top execs receive generous bonuses, the companies moral is falling and commitment and loyalty of the workforce is rapidly fading.

Despite the lack of action from a very weak board, the executive team appears to be worried and is utilizing a debt based stock buy-back strategy in order to avoid losing control of the company.  This seems to be a classic case of "Nero fiddling while Rome burns".   Neither the board nor the major investors appear willing to step in and try to shake up the top management team in order to turn this business around.

Unfortunately, at some point this will make a great Harvard Review case study.  But for now, it appears that the company is going to continue to be an interesting play for 'short' players as it continues its long decline.

Implications: HP (NYSE HPQ) has dominated the printing landscape for over 20 years.  With a dominant share of over 50% in most categories, the firm is the leader in the industry. At the same time, the highly profitable annuity stream from supplies drivers more than 50% of HP's profitability annually.  It literally is the core profit pool for the company. In the third week of June, HP quietly shuffled the management and organization of the Imaging and Printing Group (IPG), the group which owns the printing business.  The number of functional units was compressed from five to three, with four executives below the key executive (Vyomesh Joshi) driving the entire business.  Interestingly enough, three of these executives are relatively new to HP. The core question is, will this serve to fine tune HP's already admirable success, or will it prove to be a business disruption ont he scale of Xerox's (NYSE XRX) missteps in the late 90's?

Analysis: Jim Lyon's article does an admirable job of queuing up the issues.  The key question in my mind is will this disrupt the organization, or refocus the organization?  Typically HP's reorganizations have been very well thoughout and have been communicated rather succinctly to both investors and the press.  This reorganization had a bit of a 'hurried' feel to it.  And what was the impetus for the change?

My belief is that HP's CEO (Mark Hurd) has listened to Vyomesh Joshi (affectionately called VJ) statements about the industry going through a basic shift, and the challenges to the traditional revenue model, and that he has taken these changes to heart.  And as such, he is proactive adjusting the business to anticipate market changes, not just react to market changes.

And what exactly is VJ predicting for the business.  The biggest theme is essentially that content is moving digital, and in order to drive growth, HP (or any printing equipment vendor) must be offering the software and online applications which will leverage this content to ultimately either capture the resulting pages, or, generate revenue from the online application / content itself.

My view is simple.  The greatest risk to the market leader is complacency.  I think Mark Hurd is making changes which will, if nothing else, shake up the organization and ensure the firms most profitable division does not fall into complacency.  And, I think it will work!

Implications: Heidelberg's stock (HDD) is falling precipitously, from the mid 40's last August to the 10's today.  I see several scenarios playing out: Business as usual:  The stock will continue to perform poorly since the company is chasing the wrong target market.  At some point (perhaps now) the stock becomes attractive as a purchase for someone like Hewlett Packard (HPQ) who does not have a product in this category. Refocus:  Heidelberg  utilizes its existing technology base (which is excellent) but refocuses on the highly profitable and growing High Volume Transaction Output (HVTO) space.  This is the space for companies that are printing credit card statements and other high value 'transactional' materials on very high speed printers.  In this case, Heidelberg would play extremely well and gain a significant competitive advantage. The question is, which path will Heidelberg take?  In either case, the stock appears to be reaching the bottom. 

Analysis: The commercial printing and publishing industry is going through significant changes.  While one segment of the market, traditional 'press' printing, is going through a steep contract, other segments such as the HVTO market are experiencing rapid growth.  Heidelberg is caught in the middle of these two trends.

Some explanation is in order.  The traditional commercial printing space consists of large 'offset' presses that print a static piece of information (i.e. a newspaper or book) over hundreds of thousands of times at a very high speed.  The market for this type printing is going through a rapid decline as many of these publications increasingly shift to electronic formats.  Historically, Heidelberg has sold their sophisticated very high speed digital press technology into this market space.  They promised printers the opportunity to capitalize on the new emerging market of printing variable data (i.e. addresses on billing statements) by replacing their traditional presses with new digital presses from Heidelberg.  

Unfortunately, Heidelberg is selling the right product to the wrong people.  Heidelberg's target market continues to be a in a 'press mind set'.  These firms buy Heidelberg's equipment in order to be able to 'offload' small jobs to the digital presses due to their rapid set up time.  However, this group still sees their focus as printing, largely, very high volume print jobs that do not contain any variable data.

The right people to sell to are the firms (such as VistaPrint (VPRT)) who are using digital presses to print High Volume Transaction Output jobs (i.e. credit card statements) and other types of high value output.  These companies are buying Xerox (XRX) IGen presses and Kodak (EK) Digimaster products to print variable data on critical documents.  And most importantly, they are often turning what was a cost center (i.e. printing a credit card statement) into a profit center by selling ad space or promoting their own products on the transactional document.  This 'transpromotional' or 'transpromo' printing is becoming widespread and driving significant growth into those firms who are focusing in this area.

Heidelberg has some of the best technology in the industry.  The firm is highly innovative and continually produces products that offer significant leaps in functionality and performance.  However, they cannot seem to move away from their sales and marketing 'comfort zone', the traditional press guy with ink under his fingers.  The question is, will they get the message before it is too late?

Implications: The Photizo Group has identified Managed Print Services or MPS as a key dynamic which will fundamentally change the shape of the printer and copier markets and how decisions for these products are made.  This will impact all of the major players including HP (HPQ), Lexmark (LXK), Xerox (XRX), Oce (OCE), Samsung, Brother, Konica Minolta, Sharp, Okidata, Ricoh, and the remaining players in the market.  This is an important dynamic to understand since our analysis indicates that MPS engagements will account for over 1/3 of all printer, copier, and MFP devices in business by 2012.  Companies who are able to capitalize on this trend will gain control of the devices in-place in business, and as a result capture the highly profitable supplies stream which is the lifeblood of profits for equipment manufacturers.  This is critical information for investors to understand as they evaluate which companies will win, and which will lose in this incredibly dynamic market.

Analysis: As the market shifts to a MPS based model, some firms will win, and others will lose.  The biggest winner will be the firm that is able to position themselves as 'the' source for MPS engagements.  According to Photizo Group research, no firm is currently the clear leader.  The Photizo Group MPS Decision Maker Study shows the strongest vendor is HP with a 55% unaided awareness level.  However, for a firm to be perceived as the dominant leader in this space, they must have in excess of 75% unaided awareness.

Today, some firms are beginning to pull ahead.  HP has just surpassed Xerox to grab the leadership position.  Canon and a host of other 'second tier' competitors are quickly moving up the curve.  The bottom line is that this is, in my opinion, THE metric to watch over the next two to three years as the market begins a massive shift in its basic purchasing model.

Implications: Kodak recently reported an after tax lost of $135M (or 42 cents per share), however, on Friday the firm restated the loss to $152M (or 53 cents per share).  While the firm indicated that these changes are due to health care costs and post-retirement benefit increases, and not due to operating results, the negative results continue to reinforce problems with Kodak's basic strategy.

Analysis: Kodaks basic business model is broken.  Sure, the firm is benefiting from the enthusiasm generated by their dynamic CEO (Antonio Perez) for Kodak's digital strategy, and current cost cutting efforts, however the firm is fundamentally in trouble. 

The firm is currently sporting a P.E. Ratio of 19.6, higher than Hewlett Packard and most other companies in the sector.  The market has reacted positively to announcements of cost cutting efforts and to the company's recent announcement of Ink Jet Products.  We believe this will continue to sustain the stock price through the end of the year, despite the deterioration in the fundamental business model.

Kodak entered the market this year with 3 new ink jet models (the Photizo Group published a detailed analysis of this product earlier this year) which are competitive but not disruptive.   The problem is that  Kodak is entering a mature and highly competitive market which will have only a nominal impact on the firms overall results.  The Photizo Group's financial model for Kodak indicates that, at best, it will take two to three years for Kodak's ink jet business to reach a level of critical mass that will materially benefit the company.

While the company's efforts are being refocused on ink jets and other 'digital' imaging products, the core businesses of silver halide film processing and cinema film (a very large and key profit sector) are going through fundamental changes.  Silver halide is giving way to both pure digital prints (prints that you take on a digital camera and then send via email or share in some other electronic form) and prints which are printed on ink jet, dye sublimation, and even Hewlett Packard's Edgeline photo kiosks.   This is a well documented transition that ultimately will result in the silver halide market being a very small fraction of its future glory.

In the Cinema film business (copying films for movie theaters), there is a transition underway to digital projection equipment which utilizes 'downloaded' films instead of traditional film reals.  While this transition has been gradual since major chains have yet to adopt this technology, there will be a point when major film chains do adopt the technology and then the transition will be rapid.  Unfortunately for Kodak, this is a major profit center, representing yet another cornerstone of the business model which is under attack.

The net result - Kodak's core business model is declining, and the 'great hope' for the future is entry into a very competitive market segment which will take years to reach critical mass.  Our prognosis - Kodak will continue to be challenged, and the financial results will begin to deteriorate sooner, rather than later.  While cost cutting and restructuring is a good idea - it can only go so far. 

Implications: VistaPrint (VPRT) is on a roll. After turning in very solid earnings for Q4 (ending June 31st), the firm announced an agreement with OfficeMax to extend their unique printing model to one of the largest Office Supply Store chains in the United States. This is a very key step in expanding VistaPrint’s model beyond the internet to retail, and in turn, reaching an even broader swathe of small business owners. VistaPrint’s unique model allows them to provide small businesses with the economies of scale normally associated with high volume print production runs. A recent ruling in a German court upheld their patents infringement suite against print24 GmbH and uniptedprint.com – reinforcing VistaPrint’s unique business model has some real legs to it (at least from an intellectual property perspective). With great financial results, and a broadened distribution model, it is going to be interesting to see how far this firm can go!

Analysis: Vista Print has announced a partnership with OfficeMax which will allow it to offer it’s printed materials via in-store kiosks. If you are not familiar with VistaPrint, these are the guys who developed a model for delivering customized print material (business cards, invitations, and now direct mail pieces) in very small volumes at ‘high volume printing’ prices. Traditionally, press shops would not touch small runs for small business owners without charging a premium due to the expense associated with setting up the run. VistaPrint developed technology which essentially ‘aggregates’ many small orders and prints them on high volume digital presses at a very low cost.

This model has fueled tremendous growth. The firm reports Q4 revenues which were up 60% to $72.5 million versus the prior year with net income of $5.4 million. Full year revenue climbed 68% to $255.9 million from the prior year while net income increased to $27.1 million from $19.2 million. To date the firm has fueled all of this growth using an on-line internet ordering model.

With this announcement, the firm expands its reach to anyone shopping in an Office Max store. Will this drive massive growth? Probably not. However, it does show how the management team is not just sitting back and enjoying their existing growth. They are clearly planning for the future and how to continue to drive growth beyond the current internet only model.  Is it a sign that the current internet model is 'maxed out'.  I don't believe so.  There are still plenty of small businesses that have not used VistaPrint and who are using the net.   In my mind, this is clearly a case of the Management Team taking a longer term 'strategic action' and not a sign of future weakness in the current business.

The question now is whether the firm will be able to drive operational efficiencies in order to create the same type of top line growth as they have seen in revenues.

Implications: Lexmark is actually two very distinct companies.  A highly profitable laser printer business which dominates the market for vertically focused printing applications in large enterprizes, and, an unprofitable inkjet division selling to consumers via retail. Those who are truly knowledgeable about Lexmark understand the distinctly different businesses (as opposed to assuming the inkjet attributes apply to the laser business). Unfortunately, the inkjet business is like an albatross which is slowly pulling down the profitable laser business.  And without a change in the management team, it is highly unlikely that this situation will change.

Analysis:

Lexmark has two very distinct business units. One is a highly profitable laser printer business which sells into 'front office' vertical industry applications in large accounts. This business has a very strong reputation with IT managers for robust products, with high duty cycles, and unique features suited to specific vertical applications (retail pharmacy, finance, etc..). In fact, Lexmark currently owns a dominant share position in the vertical market space (for example, 100% of national pharmacy chains use Lexmark). While this space is currently under attack from HP (we have discussed this in our latest research note), it is a healthy, profitable business.

The second business is the consumer inkjet business. While this business is most visible due to it's retail focus, it is also a profit drag on the company. There are a number of negative dynamics operating in this business (too many to discuss in detail in this article). Perhaps the most critical dynamics are:

1) Dramatically declining sales volumes from their OEM partner (Dell);

2) A brand which is perceived to be the 'low cost' / 'cheap' vendor - which means Lexmark must primarily sell on price; and,

3) Increasingly competitive environment.

In order to maintain it's installed base (and subsequently) it's supplies revenue stream. Lexmark must grow branded shipments in order to make up for the decline in OEM sales. Given Lexmark's brand position, and its price leadership position, the effort to grow branded share will drive significant hardware losses for the near future.

Based upon our financial model for Lexmark, we expect to continue to see a very negative environment for the near future. And most importantly, we do not expect to see a significant shift in strategy. And this spells trouble for Lexmark. While changes are a foot, they are not significant enough to signal a real change in strategy.

Unfortunately, a real change in strategy is unlikely until the current CEO, Dr. Paul Curlander, is replaced.  Dr. Curlander believes the company can save itself by designing better products (the current interaction being adding wireless features to inkjets).  Since he is also Chairman of the Board, which was handpicked by Dr. Curlander, the likelihood of real management change is very small.

Implications: While I agree with Mr. Howe's assessment regarding the near term impact (the ruling effectively maintains the status quo), the long term impacts are potentially significant.  Particularly if the Judge upholds the Jury's ruling that Lexmark has "market power".  If this is upheld, the ramifications are very significant and this is why we can expect the case to be appealed.

Analysis:  An in-depth analysis of this case (the Photizo Group has recently published a report on this ruling) reveals that while the Judge did rule that Lexmark's prebate program is valid, and he also ruled that SCC did not suffer damages (however he left the door open for SCC's customers to sue for damages), he has yet to rule on the jury's findings that Lexmark has market power.

Market power is critical because, if it is established that Lexmark has market power, the firm will be open to numerous suites for antitrust practices and potentially 'market tieing' practices.

The case is also important because remanufacturers have been making gains against Lexmark.  The Photizo Group's financial model for Lexmark indicates that remanufacturers are gaining an incremental 1 to 2% of Lexmark's supplies (with the total reman / compatible market making up over 15% of the Lexmark supplies market).  In a financial model which is highly leveraged against supplies profits, allowing the remanufacturers to continue their incremental gains is bad news for Lexmark.

In summary, our assessment is that the only good news for Lexmark would have been a 'win' in this case.  A draw is only slightly less negative than an outright loss.  And this is definitely a draw!

Implications: Based on the recent stock price it appears that the street believes HP has peaked.  I disagree for several reasons including: Strength in HP's core profit machine - IPG - is not only gaining ground in HP's traditional markets, but also making significant gains in new incremental markets. Mark Hurd has brought just the right leadership style to a very large and complex organization.  As a result, we are seeing very strong performance across each business sector as the division level executives are free to execute the best strategies for their business. While the business margins are strong, improvements are possible through both cost and SG&A reductions.  The executive team realizes this and is focused on reducing cost.

Analysis: HP is hitting on all cylinders, and I believe the firm is going to continue to drive growth (in both revenue and profits) for several years.  No other IT organization is as well positioned to provide the infrastructure required for business organizations, while still offering compelling consumer products (cameras, printers, and PC's).  I believe HP has not reached the top yet for several reasons:

Strength in HP's core profit machine - IPG - is not only gaining ground in HP's traditional markets, but also making significant gains in new incremental markets.  HP is gaining in the profitable digital press segment, copier / MFP segments, and wide format printing segment.  VJ (EVP of IPG) is doing an excellent job of continuing to invest in new technologies, while reaping margins where he can, and still being aggressive on pricing to gain share in those high growth segments where gaining footprints is critical.

Mark Hurd has brought just the right leadership style to a very large and complex organization. As a result, we are seeing very strong performance across each business sector as the division level executives are free to execute the best strategies for their business.   HP has traditionally been a highly 'divisionalized' organization with each division operating as it's own business.  Mark Hurd has managed to leverage this 'division focus' while still bringing the focus to HP's overall objectives. 

While the business margins are strong, improvements are possible through both cost and SG&A reductions. The executive team realizes this and is focused on reducing cost.  The executive team is clearly focused on driving cost reductions and they have shown their ability to do this in the past.  While HP is not 'bloated' by any means, like any large organization, it has the potential to become more efficient and reduce cost.

Even at today's price, HP has a relatively low PE ratio (16.43 on May 11th) versus 18.06 for Canon, 19.01 for Electronics for Imaging, and 53.69 for Eastman Kodak.  The stock has plenty of room to grow and clearly the company is doing everything possible to maximize shareholder value.

Implications: It is easy to view the imaging market very negatively due to poor financial results from Lexmark, Xerox, and others.  However, the industry is actually very healthy as indicated by this article.  A few key points: The top hardware providers produced over $4B in profits from their imaging business in the fourth quarter of 2006.  For the entire year, they generated $14.6B in 2006 from the imaging business. HP, Canon, and Ricoh collectively captured over 73% of the total operating profits produced by the top 13 imaging firms (this only counts operating profits from their imaging business - not PC's or other technology sectors). The industry has benefited form a relatively benign pricing environment and robust demand.  But will it last?

Analysis: This article provides insight into the profitability for the imaging industry.  The Operating Income index in the article tracks profitability for the top 13 imaging companies including Xerox, Lexmark, HP, Konica Minolta, Ricoh, Canon, Epson, Okidata, Oce, Heidelberg, Brother, Samsung, and Kyrocera Mita.  The index is based just upon the imaging (printer, copier, MFP, supplies, and associated services) business for these firms, it does not count non-imaging sectors such as semiconductors, PC's, or displays.

During 2006, profitability rose to an all time high with the index reaching 1.085 (with 1.00 being the profitability of the industry in January of 2004).  This is a significant rebound after the index dropped to as low as 0.85 during the intense price wars of 2005. 

In dollar terms, the industry generated $14.6B in profits during 2006.  This is up significantly from 2004 and 2006.  The industry benefited from a benign pricing environment and strong demand, particularly in the highly profitable laser printer technology segment. 

The leaders in terms of share of profitability were Canon (35%), Hewlett-Packard (25%), and Ricoh (10%).  Xerox (5.5%), Epson (4.5%), Konica Minolta (4%), and Lexmark (3.1%) significantly lagged the leaders.

But will this profitability environment last?  It is very likely that as the competitive environment heats up due to MFP introductions and increased pricing pressure, total industry profitability will be strained.  However, based on this analysis it would appear that even in this environment the strong (HP, Canon, and Ricoh) will continue to get stronger while the weak will struggle to maintain profits.

(Note:  The index does not cover the entire industry - there are many software, supplies, and component firms involved in the imaging industry which are not represented in the index.  However, it does provide a good 'view' bellwether of the industries over all profitability.) 

Implications:

A highly secretive ex-Canon inventor, Kia Silverbrook, is preparing to make a 'technology / product' announcement at an ink jet technical conference in Prague next week.  Lyra, an industry tracking firm, is touting this as a 'game changing' technology.  But is it truly game changing, or is it merely being hyped as a game changer in order to sell industry analysts reports?

The Photizo Group believes that while this technology (a page array ink jet technology called Memjet) holds promise as a game changing technology in the high end production printing and copying space, distributed printing companies such as HP, Lexmark, Okidata, Ricoh, Konica Minolta, and even Xerox have little to fear from the technology.

In fact, in an upcoming report, the Photizo Group will propose that this technology is likely to have far less impact than Kodak's ink jet announcement (which is turning out to be less than stellar to begin with!).

Analysis: The Photizo Group's upcoming flash: "More Hype Than Substance" (provided as part of our Imaging Industry Advisory service) will explore the potential impact of this technology in depth, however, the summary is as follows:

1) Based upon a review of the patents and discussions with patent experts, many of the patents appear to be for 'concepts', not practice.  In essence Silverbrook is trying to come up with 'ideas' and patent them as opposed to patenting proven prototypes or technology.  While this is very questionable from a intellectual property protection point of view, it certainly hurts the credibility of the inventor.

2) The page wide array technology is extremely difficult, somewhat expensive, and certainly difficult to manufacture.  While HP is certainly capable of this technology (see the Photizo Group's: "Edgeline" Flash), Silverbrook Technologies has not even announced any major printer OEM that has agreed to manufacture this technology.  In the words of one industry technology expert, "the manufacturability of this is highly questionable".

3) Why does the market even need a 50 PPM color ink jet?  The company is touting a 50 PPM $199 color ink jet targeted at the consumer market.  This is fine, but it falls into the 'who cares' category.  When the typical print job is 3 pages long, and most ink jet users are not even printing more than a 100 or so pages a month, this is definitely overkill.

The bottom line, I am not convinced that the technology is real.  It appears to be much more hype than fact at this point.  Again, ti does have potential for the 'high end' of the market, but for the markets the inventor is targeting, this seems to be a solution without a problem!

Implications:

Ricoh has announced an agreement with IBM to purchase the IBM Print Systems over the next three years.  This is the 'high end' printing group that IBM kept after spinning off printer maker Lexmark.

While this only represents a $1B increase in revenues to Ricoh, it is strategically important for several reasons:

1) This completes Ricoh's product line and positions them to effectively compete with Xerox in the production printing market.  This is a highly profitable business which consumes vast amounts of toner (the black gold for the industry).

2) This provides Ricoh access to IBM's sales and marketing organization. This is a strong compliment to Ricoh's already broad distribution channels.

This is only the most recent in a long line of acquisitions by Ricoh including Gestetner, Savin, Hitachi Koki's printer business and Danka Europe. 

This also has implications for Lexmark and Xerox.  Lexmark currently sells workgroup printers and MFP's to IBM Print Systems.  Over time, we expect that this highly profitable business will disappear.  Xerox now has a formidable competitor who offers as broad of a product line and, most significantly, a compelling offering in it's profitable production printing space. 

Again, this is not a large acquisition, however, it is a very strategic one that will position Ricoh well for the future!

Analysis:

Ricoh has a long-held strategy of growing market share and market reach through acquisition. During the last ten years, the firm has acquired Gestetner (Europe), Lanier (US), Hitachi Koki’s Printer Division (Japan), Danka Europe, and now, IBM’s printer division. While this is initially being called a joint venture, the agreement calls for IBM’s printer division to be fully absorbed by 2007.

This acquisition is key to Ricoh for several reasons:

1)It provides Ricoh with products to compete in the high page volume (and very profitable) production printing space. IBM’s InfoPrint series fills a gap at the high-end of Ricoh’s product line and further positions them to compete with Xerox.

2)The agreement provides continued access to IBM’s Global Financing arm and IBM’s global distribution and sales network for the InfoPrint branded products. One would imagine that Ricoh will attempt to expand this access to a much broader set of Ricoh’s product line (currently IBM sources workgroup printers and MFP’s from Lexmark, not Ricoh).

3)This adds a nice $1B business to Ricoh’s revenue base, further strengthening their position as one of the top five imaging companies worldwide.

I have long called Ricoh a ‘sleeping giant’ who has a market presence and product portfolio that is often underrated. This acquisition firmly positions Ricoh for continued growth in the profitable production printing space.

The acquisition also has implications for both Lexmark and Xerox. Ricoh now has the breadth of product line to present a clear threat to Xerox's business, particularly in the production printing space.

In terms of Lexmark, while this represents a relatively small portion of Lexmark's sales ($175M out of over $5B). However, it represents a much larger portion of profits ($112M) due to the fact that IBM tends to sell into high usage environments which are very profitable.

2006 IBM Business Estimate

                            Revenue         Profit

Hardware                  $31M             $7M

Supplies                 $144M              $105M

Total                     $175M              $112M

Source: Photizo Group - Lexmark Financial Model

Currently, IBM purchases laser printer engines from Lexmark to sell into these profitable workgroup applications. However, Ricoh has competing engines (particularly in the multifunction product category). It will be highly probably that Ricoh will, over time, substitute their engines for Lexmark's.

Implications: According to Lexmark, vertical printing applications are key to both their strategy and their profitability. HP is clearly attacking this market segment in order to capture incremental growth. 

As this article indicates, not only has HP hired away a key executive (Bruce Dahlgren, formerly Sr. VP and GM of North America sales and marketing), but, they are also hiring away the key sales representatives who handle these enterprise accounts.

So what does this mean for Lexmark?  At a minimum, Lexmark will see increased pricing pressure as they aggressively attempt to hold onto key enterprise accounts. In the worst case, they will see a significant decline in profitability as they loose these key accounts to HP.

Analysis: According to this article, HP is preparing to attack Lexmark's profitable 'front office' vertical applications. 

Before diving into the evidence, it is important to understand how Lexmark and HP have owned two different spaces within large enterprise accounts.  Historically, HP has owned the 'back office' corporate headquarters applications which consisted of printing emails, memos, presentations and other general office documents.  Conversely, Lexmark has owned the 'front office' applications which typically reside in branch offices and other customer facing outlets.  A classic example of this is that in many retail pharmacy accounts, Lexmark owns 100% of the retail pharmacy label printing application but has minimal presence in corporate headquarters.  Conversely, HP has owned the corporate headquarters applications but had little presence in the retail location.

It is very import to understand that while the space owned by Lexmark is smaller in terms of unit shipments, the supplies usage and customer loyalty in this space makes it hugely profitable.  And here in lies the attraction for HP.  This represents one of the few, untapped, profitable growth areas for HP in the distributed printing market. So, there is a clear motivation for HP to capture this space.

So what evidence is there that HP is targeting this space?  Multiple items, including:

1) HP's top IPG executive (VJ) has publicly stated (in their Oct. 3rd product announcement) that they want to capture this space.

2) HP hired away Lexmark's top executive in this business area, Bruce Dahlgren, with the focus of creating momentum in the Solutions Printing space.

3) As the article highlighted here indicates, HP has been hiring away key sales executives.

Can HP be successful? I believe so.  Does this have big implications for Lexmark?  Absolutely!  This will be a very interesting space to watch, and one which may have big implications for Lexmark's performance.

Implications:

Ricoh’s acquisition of Danka’s Europe operations is important for several reasons:

1)This places a significant reseller of Canon’s MFP products in the hands of a key competitor – Ricoh.

2)Ricoh has been acquiring key channel partners globally (Gestetner in Europe, Danke in Europe, and Lanier in the US) and increasing its power in the key copier / MFP channel.

3)This helps to position Ricoh to move upstream by enhancing their direct sales / service delivery capabilities.

Ricoh is a ‘sleeping’ giant. While the firm has a relatively low profile, they have been building a channel and technology base which will ultimately position them as the key competitor to the Canon / HP alliance. The question is, who is next in Ricoh’s acquisition list?

Analysis:

Ricoh has acquired a series of technology and channel firms over the last ten years: Gestetner, Lanier, Hitachi Koki, and now, Danka. The firm was one of the first ‘copier’ companies to invest heavily in moving to Multifunction Printer (MFP) technology and to invest in the networking and software expertise required to appeal to the IT buyers who have traditionally controlled printer purchases (the copier decision has, until recent years, resided with the purchasing function – not IT).

Ricoh’s latest acquisition of one of the larger European copier / MFP resellers – Danka will have significant implications for other brands who have traditionally sold through Danka including Canon and Konica Minolta. The firm is clearly building a strong technology and distribution base to challenge HP and Canon’s Printer / MFP dominance. Another vendor who should be very concerned is Xerox. By acquiring Danka Ricoh has, in effect, created a significant ‘direct’ sales force which can effectively compete with Xerox.

Ricoh’s long stated goal has been to build a presence which can challenge the HP Canon alliance. While Ricoh has done an excellent job of building the technology base and distribution channels, they still lack the strong global brand that HP brings to the HP / Canon alliance. Will Ricoh continue to ‘acquire’ their way to dominance? Who’s left? A Konica Minolta / Ricoh combination would create a true powerhouse. But would Konica Minolta be interested?

A Ricoh / Xerox merger would create a strong technology base with a globally recognized brand. However, the cultural gap would be significant (and the firm does not currently provide any engines or have any collaboration with Xerox, a typical first step to a merger). The fact is, the number of meaningful acquisitions is very limited. So can Ricoh continue to grow through acquisition? Yes, but the remaining acquisitions are going to be fewer, and more difficult to obtain.