Hardware manufacturers based in the United States have been through the wringer. After being pummeled by the Great Recession, Hewlett-Packard, Lexmark, and Xerox—along with many others in the industry—were surprised to find that the hardcopy market stayed soft even after the economy began improving. Eager to keep costs down as the economy struggled to recover, end users remained reluctant to print when they returned to work. Office workers also embraced new, more efficient document-management tools and managed programs designed to keep print volumes low. In addition, new electronic gadgets such as smartphones and tablets became increasingly popular, further eroding the need to print.
Each of the three U.S. hardware firms has undertaken expensive and sometimes painful course corrections to get their respective businesses back on track in the post-recession market. Today, each of the U.S. hardware manufacturers is pursuing a path that will make it more profitable. While they certainly want to drive more sales, all three companies now focus more time and attention than ever before on launching new products and services that will grow their bottom lines along with revenue. And they are seeing some results. With varying degrees of success, HP, Lexmark, and Xerox have shored up their businesses at least partially over the past couple of years. While the hardware sales and unit shipments continue to trend downward, HP, Lexmark, and Xerox have stabilized their revenues and improved margins.
Even the Mightiest Struggle
With a fiscal year that runs from November 1 to October 31, HP was the first company in the digital hardcopy industry to report its earnings for the first quarter of FY15. On February 24, the firm reported its total Q1 revenue was $26.8 billion, a decline of about 5 percent compared to the first quarter of the prior fiscal year. Revenue in all of HP’s six business units was either flat or declining in Q1 FY15 compared to the same period last year and sales were down in all regions including the Americas, Europe, the Middle East, and Africa (EMEA) and in Asia Pacific.
For the fifteenth consecutive quarter, HP’s printer business experienced a year-over-year decline in sales during Q1. Revenue from the HP business unit formerly known as the Imaging and Printing Group (IPG) dropped from $5.82 billion during Q1 2014 to $5.5 billion during the quarter just ending, a drop of 5 percent. Declining from $3.8 billion in the year-ago period to $3.6 billion in the first quarter of 2015, supplies revenue was off 5 percent. Commercial hardware sales fell from almost $1.4 billion during the first quarter of last year to just over $1.3 billion this year, a decline of about 2 percent, while consumer hardware sales declined from $673 million to $626 million, a drop of about 7 percent (see Chart 1).
Sales of HP’s printer hardware and consumables may be falling, but the group’s profitability has been trending upwards for four solid years. While the former IPG unit’s operating margins have not grown sequentially each and every quarter, they have increased approximately 7 percent since the first quarter of FY 2012. In the Q1 FY15, the unit had a whooping operating margin of 19.2 percent, which is the highest operating margin I recall the group ever attaining.
HP’s printer business is uniquely positioned to make money. Sourcing its LaserJet print engines from a Japanese technology provider, Canon, HP is able to reap the benefits of an increasingly weaker yen regardless of the fact that it is a U.S. company. In addition to improving the margins on its LaserJet hardware and supplies, HP says that the value of its high-margin MPS contracts has experienced double-digit growth this year. The company has also successfully improved the margins on its inkjet products. Thanks to initiatives like the Ink Advantage program, which provides consumers in certain markets the ability to purchase less expensive supplies if they purchase slightly more expensive hardware, HP has added to the margins its inkjet machines deliver while preserving much of the profits its consumables deliver.
Lexmark Looks For Higher Margins Too
Like HP, Lexmark has set a course to profitability based on marketing higher-margin products. This is a reversal of sorts from Lexmark’s original business plan. For years, the company drove down hardware prices to place more machines, which would hopefully gobble up lots of high-margin cartridges. The plan never really worked, however, so it has been discarded. For the past few years, Lexmark’s management team has consistently stated the company seeks to generate a sustained operating margin of between 11 to 13 percent. To achieve this, Lexmark is looking to sell more products from what it calls its “Higher Value Solutions portfolio,” which consists of Perceptive Software and managed print services (MPS). The firm is also looking to market more machines that will support high-print volumes and generate high-margin consumables revenue.
While Lexmark has not had an operating margin in the 11 to 13 percent range since 2011, the company is enjoying a certain amount of recovery. Lexmark’s total annual revenue grew 1 percent during FY14 to $3.7 billion and its non-GAAP operating margin for the year came in at 10.6 percent, missing the firm’s goal by 40 basis points (see Chart 2). Although the revenue growth was somewhat anemic, I suspect that Lexmark’s management team feels pretty good about FY14. Last year was the first time in a decade the company’s total revenue grew and there are signs that margins will improve in FY15 regardless of the fact that they dropped slightly last year.
I am cautiously optimistic about Lexmark’s ability to be more profitable this year for several reasons. In 2014, Lexmark managed to grow sales of its so-called Higher Value Solutions products and, at $1.1 billion, these offering made up about 30 percent of the company’s total sales last year. Lexmark’s MPS revenue was key to the growth experienced by the Higher Value Solutions. Lexmark reported that its MPS sales reached a new high-water mark last year, up nearly 14 percent to $821 million in FY14 from the $722 million record set the year prior.
Looking at Lexmark’s quarterly sales trends in terms of products over the past three fiscal years (see Chart 3), it appears that Lexmark has been successful in realigning its product mix toward higher-margin products as the company moves away from entry-level products. Sales of large workgroup hardware were up over 3 percent last year and software sales jumped almost 23 percent to $322 million. As the sale of Lexmark’s high-margin products grew, sales of entry-level laser devices dropped along with revenue from inkjet machines, which the firm said it would stop marketing in 2012. Exiting the inkjet market has put pressure on Lexmark’s financial performance but that headwind should diminish this year.
Lexmark’s laser supplies sales are also soaring to new heights. After reaching almost $2.1 billion in FY13, which Lexmark called a record, laser supplies rose another 5 percent last year to total almost $2.2 billion including both MPS and transactions sales. Although Lexmark has successfully grown its higher-margin MPS business, non-MPS hardware and supplies sales continue to make up the vast majority of Lexmark revenue. Up 1 percent, non-MPS revenue totaled $2.3 billion in 2014 or almost two-thirds of Lexmark’s total revenue. This revenue includes sales of laser and dot-matrix hardware and supplies not included in MPS contracts, along with revenue from parts and services related to non-MPS hardware maintenance.
Xerox Pursues High-Margin Services
Xerox made its intentions clear long ago that it would pursue the higher margins associated with services as it grows its traditional technology business. Although the company has increased its total revenue through some major acquisition, Xerox has yet to realize any significant margin improvement despite investing billions in growing its service portfolio. But there are signs that Xerox’s margins are improving.
By far, Xerox’s biggest investment into higher-margin services came in early in 2010 when the firm completed its $6.4 billion acquisition of Affiliated Computer Services (ACS). At the time the deal was concluded, Xerox said the buyout would transform it into “the world’s leader in business process and document management” services. The top-line impact of the ACS acquisition was impressive. While most firms were dealing with sagging revenue in the wake of the recession, Xerox reported its total annual revenue grew 43 percent to $21.6 billion in 2010, primarily because of the addition of the ACS business. Its adjusted total operating margin, or “segment margin” in Xerox speak, jumped from 5.5 percent in 2009 to 8.7 percent after the acquisition.
At first, it looked like the ACS acquisition would solidify Xerox’s business. The firm’s segment margin improved to 9.4 percent for FY11 and Xerox experienced a modest revenue gain of just over 1 percent, but there have been few improvements since. Xerox’s segment margin has been pretty much flat on an annual basis for the past three years and total revenue has declined (see Chart 4). Any financial gains that have accrued from the services have been more than offset by poor hardware sales.
Looking at unit shipments, Xerox’s equipment placements had a lackluster year in 2014. Shipments of A4 color and monochrome MFPs were down 7 percent and 23 percent, respectively, while A4 color printer shipments remained flat. In addition, shipments of mid-tier A3 monochrome MFPs and monochrome digital production machines were both down 13 percent, while shipments of color production units fell 7 percent. The only category of Xerox equipment that experienced any unit growth in FY14 was shipments of mid-tier A3 color MFPs, which increased by a modest 1 percent. Xerox’s annuity business also experienced some modest growth at least in the last quarter. Sales of unbundled supplies and paper increased 1 percent from $550 million in Q4 FY13 to $554 million during the same period last year. Unfortunately, Xerox did not provide the unbundled supplies and paper figure for the full year.
Xerox now generates more than half its revenue from services and that transformation is due largely to the ACS acquisition. Last year, Xerox reported that its services business grew 1 percent to $10.6 billion and represented just over 54 percent of its $19.5 billion total revenue. Document Technology revenue was off a total of 6 percent in 2014, dropping to $8.36 billion from $8.91 billion in fiscal 2013. For the year 2014, however, Xerox reported its total segment margin climbed 40 basis points to 9.4 percent. Sequentially, Xerox’s segment margin grew 3 out of 4 quarters last year.
2015 Guidance
Moving into the first half of fiscal 2015, HP, Lexmark, and Xerox seem to be enjoying a good tailwind. HP finds itself with some margin elasticity that should allow it to lower prices or make marketing investments to spark more sales—or perhaps do both. Lexmark also appears to be heading in the right direction as it continues to successfully bring to market and sell higher-margin goods and services. Of the three U.S. companies, Xerox seems to be the firm with its hardware business stuck in a rut. However, last year the company improved its profitability, albeit modestly, and its third-party supplies business is growing. Perhaps a stronger U.S. economy will allow the company to continue to improve in 2015.
With all the good news, there is one headwind that all three U.S. firms face. Volatile exchange rates could frustrate the OEMs’ growth strategies especially overseas. Over the past few years, the steadily weakening yen has given Japanese manufacturers a competitive advantage. The yen-dollar exchange rate was approximately ¥120 to the $1 as of this writing, which is close to a seven year low. And the yen isn’t the only currency the dollar is strengthening against. Thanks to an increasingly robust U.S. economy and geopolitical issues in Russia, the Middle East, and the European Union, the value of greenback has gained on a range of currencies such as the euro, which reached an 11 year low relative to the dollar as I was writing this article. Other currencies that have lost ground to the dollar include the British pound, Brazilian real, Indian rupee, Russian ruble, and others.
All three of the U.S. hardware manufacturers have warned that their 2015 business will be impacted by volatile exchange rates. Lexmark expects its total revenue to decline 3 to 5 percent in fiscal 2015 in part because of the FOREX pressures and Xerox warned that earnings per share (EPS) will be down this year. Xerox predicts its adjusted EPS for the entire fiscal year will be in the $1.00 to $1.05 range compared to an adjusted EPS of $1.07 in FY14. HP indicated an increasingly strong dollar “is having a significant impact on HP’s financial outlook” for the current fiscal year. The executive team, however, has suggested that the firm’s printer business will not be as adversely affected as the company as a whole.
With all the foreign exchange rate pressure, I expect that prices will come down this year, which may impact the U.S. firms’ bottom lines. HP has signaled its connection with Canon should minimize the risk of taking a big margin hit if it lowers prices. Apparently, HP is benefiting from the weaker yen along with its supplier. Xerox could also benefit from its relationship with a Japanese supplier. Fuji Xerox is doing well this year so it may be willing to make some concessions to its minority stakeholder so Xerox can gain a competitive edge. Lexmark is the firm most exposed to the ill effect of FOREX but it too may not be at a terrible disadvantage. Most of Lexmark’s business is now in the Americas and its dollar-based domestic business will not have to endure punishing exchange rates. The firm will also benefit from stronger domestic demand as the unemployment picture continues to improve.
Of course, all of the hardware manufacturers doing business in the U.S. should enjoy strong demand this year. I look forward to reporting just how well they perform as we move through 2015!
