Mergers & Acquisitions: A $20 Billion Growth Opportunity

Most industries experience consolidation – there are few exceptions and the office products and supplies industry is certainly not one of them. In the first section, we explained our rationale for believing the aftermarket has passed a significant tipping point and then hinted toward the foundation that’s been established for the aftermarket manufacturers to increase market share at the expense of the OEM’s.

In this section, we’re going to expand on why we believe the prospect for an upcoming battle for market share is motivating a new phase of consolidation as the OEM mergers endgame moves toward its final stages.

The Global OEM Portfolio

OEM	TTM Sales ($M)	TTM Profit ($M)	Profit %	Comment
Hewlett Packard	48,000	3,800	8%	Acquiring Samsung Printer Div.
Canon	32,000	1,835	6%
Sharp	20,000	(2,100)	(11%)	Sold to Foxconn
Ricoh	17,000	250	1%	Nov 2016 – profits down 85%
Kyocera Mita	12,300	900	7%
Xerox (excl. Conduent)	11,000	275	3%	Splitting in two – complete end 2016
Konica Minolta	8,500	266	3%	Nov 2016 – Profits down 30%
Seiko Epson	8,500	380	4%
Brother	5,300	275	5%
Okidata	4,213	100	2%
Lexmark	3,500	(40)	(1%)	Sold to Apex / Ninestar
Samsung (Est.)	1,300	26	2%	Selling to Hewlett Packard
	171,613	5,967	3%

 Figure 1 – The Global OEM Portfolio

There are twelve companies on this list of OEMs but, a quarter of them (Lexmark, Samsung, and Sharp), are already in the process of being merged into other entities.

Hewlett Packard split into two separate entities at the end of 2015 and Xerox did the same in a process that was completed by the end of 2016. Both of these restructurings were designed to separate the mature hardware and supplies business from the (perceived) higher growth potential of the consulting and services businesses. In establishing standalone enterprises focused on printing and supplies both entities are (or will be) better positioned for the merger endgame!

We believe this group of OEM manufacturers will continue to consolidate and, within a few years, it’s possible we could be down to as few as four or five companies. This is typical late-stage industry consolidation behavior.

Sharp

Sharp, with $20 billion in global sales, had been in a steep decline and lost over six billion dollars of its net asset value between 2010 and 2016. Foxconn stepped in to rescue an otherwise bankrupt corporation, mainly because they wanted the screen display technology for the Apple iPhone they assemble, and most likely not for the relatively small office printing and supplies business. It’s difficult to imagine Foxconn (as a contract manufacturer) committing long-term to the office equipment business so, either expect to see it closed down, or sold to one of the remaining Japanese OEM’s.

Lexmark

A $3.6 billion cash offer was simply too good to ignore. Lexmark, having exited the ink business in 2012, already knew it did not have the scale to compete with the larger players and did not have the resources, capital structure, or energy, to survive as an independent player in the merger endgame. In selling the business, it appears they acted in the best interest of their shareholders.

Hewlett Packard

HP didn’t waste any time after it’s restructuring with the announcement of its acquisition of Samsung’s printer division.

Think for a moment about this development.

Perhaps it really was motivated by a desire to establish a stronger presence in the so-called “A3” market as we’ve read in the press. We know Managed Print Services, widely adopted in this channel, are a “sticky” sale where the isolated cost of an ink or toner cartridge is obscured under the complexity of a cost-per-page model bundling cartridges with service, repair, and (sometimes) even hardware. Long-term contracts are certainly an effective way to protect market share from circling predators!

But think also about the following;

Hewlett-Packard knows (along with all the other OEMs) they have lost the battle to eliminate aftermarket products from the competitive environment and that they need to position themselves to defend against the increasing threat posed by the aftermarket manufacturers and Tier-2 resellers.

Whatever icing is put on the cake to explain the importance of a past and future relationship with Canon, the acquisition of the Samsung Printer Business is a massive development.

We regularly use an example of a $100 OEM cartridge sale and its associated manufacturing cost of $10. With $90 of gross margin, you’d think the OEM’s would be in a strong position to defend their market shares.

However, take a look at the chart below – it helps demonstrate another compelling reason why the Samsung acquisition is to take place.

We know (give or take a bit) it only costs around $10 to make a new-build cartridge that has a retail sale price of $100. However, the fully loaded cartridge cost is estimated at over $70 once hardware subsidies, marketing costs, legal costs and channel distribution (reseller margins) are all factored in. Look at the call-outs in the above chart. A portion of HP’s current cartridge cost (when manufactured by Canon) has to be the payment that’s made to Canon. We don’t know what that actual number is but, whatever it is, it’s not part of the Samsung cost structure. In our model, HP will improve its margin on cartridges from 27.5% to 42.5% after Samsung is fully incorporated. All the other costs are assumed to be the same but, in the future, HP will not be paying Canon a share of the value chain as the industry moves closer to its endgame.

Now let’s take a look at the competitive threat by introducing three aftermarket elements as shown in the chart below.

1. The Tier-1 resellers selling aftermarket remanufactured cartridges generally sell at about a 30% discount to the OEM cartridges and there are a total of $51 margin dollars in the value chain assuming a $70 sale price.
2. If the Tier-1 resellers elect at some point to sell new-build aftermarket cartridges, then our assumption is they will also capture the incremental margin dollars resulting from the manufacturers lower cost of goods sold increasing their share to 88% of the $56 then available. It’s not expected there would be a reduction in retail prices.
3. With the Tier-2 resellers represented in the final column of the chart, this is where it starts to get interesting. At an average 50% discount to OEM retail prices and a 30% discount to aftermarket Tier-1 prices, there’s still room for $38 margin dollars or 76% of the projected sale price. Furthermore, this is a channel where the OEM has less influence to distort normal competitive behavior.

The chart below is a little trickier to understand but it’s really important to do so in order to understand the OEM thinking and what’s driving their endgame.

There are three important points:

1. The total margin dollars and how they are distributed.

2. Who has the balance of power (as labeled above each of the chart columns) in the relationship between manufacturer and reseller as determined by the share of margin dollars? If the reseller margin (blue) is greater then the manufacturer margin (orange) then the reseller holds the balance of power and vice versa.

3. The different value propositions – OEM at $100, Tier-1 aftermarket at $75 and Tier-2 aftermarket at $50

1. Let’s consider the HP and Samsung examples first

We’ve already established the Samsung acquisition will reduce HP’s cost as Canon is cut out of the picture. However, because HP (along with all the other OEM’s) has the balance of power in their relationship with the resellers, none of this increase in their margin will be shared with the reseller and retail prices will not change.

2. Now let’s look at the aftermarket and the existing remanufactured cartridge model through Tier-1 distribution

Over 80% of the margin dollars go to the reseller so they clearly have the balance of power in their relationship with the aftermarket producer.

At this time, Tier-1 resellers have not adopted new-build compatible cartridges. Perhaps the OEM’s dominant power position has been leveraged to exert influence – who knows! However, even if this should change for any reason, then any improvement in the total margin dollars will most likely go to the reseller because they have the balance of power and will demand the extra margin dollars while maintaining the ability to keep the selling price unchanged.

The potential adoption of New-Build aftermarket cartridges by the Tier-1 resellers would be unlikely to represent an increased threat to the OEM’s and their existing market shares.

3. New-build compatible cartridges through Tier-2 distribution

This is the sector of the resale channels from where the potential threat of disruption comes. The OEM’s have much less influence over the behavior of this sales channel and when combined with the value proposition, it clearly has the potential to start to erode OEM market share. As shown in the graphic below, new-build cartridges have a lower cost, unrestricted supply, potentially less legal concerns, and higher quality than remanufactured cartridges. Tier-2 resellers leveraging these attributes should be able to establish a clear competitive advantage over the OEM’s and the Tier-1 resellers of remanufactured products.

We will be exploring more with regards to the Tier-2 reseller’s opportunities and tactics for developing increased market share later in the paper. Have no illusions – there’s no silver bullet, no overnight solution to accomplish this! It will be hard work and, anything short of the service and value proposition currently provided by the Tier-1 resellers will be inadequate and will fail.

It’s the threat of loss of market share that’s contributing to the mergers and acquisitions activity now taking place between the OEM’s, as the strongest acquire the weakest and attempt to extract as many costs from the business model as they can. The OEM’s can’t afford to lose market share and they can’t afford to protect it in a protracted price war with the resellers. Given that it’s unlikely the Tier-1 resellers will make any change to the existing pricing model, then the threat can only come from the Tier-2 sales channels.

Most industries experience consolidation – there are few exceptions and the office products and supplies industry is certainly not one of them. In this section  we’re going to explore some scenarios for the reseller’s merger endgame and the impact this may have on the future of the aftermarket for office products and supplies and on the independent resellers.

The Resellers

There are many resellers of office products and supplies. At first sight, most observers would automatically assume it’s a very competitive, and diversified reselling environment.

In fact, by our estimate, there are over 5,000 resellers in the United States alone. However, on a closer look, and as demonstrated in the chart below, 83% of the estimated $25B in U.S. ink and toner retail sales are conducted by less than 2% of the total number of resellers.

For the purposes of developing an understanding of the reseller’s potential mergers endgame, there are two events of particular interest to us. Firstly, the busted Staples, Office Depot acquisition and, secondly, (very much related) the definition of the market as may be determined by government authorities, for the purposes of deciding whether or not a proposed acquisition should be allowed. Having an understanding of these will help to better understand what may happen in the future.

There have been many studies surrounding the characteristics of industries over time but, it’s generally accepted that in most industries, there will be consolidation and that market concentration will develop. In order to measure how concentrated an industry is, two calculations are widely used by Fair Trade Authorities, such as the FTC, in determining whether or not proposed acquisitions should be allowed to proceed.

1. The Concentration Ratio (CR) is calculated by adding the percentage share of the largest enterprises in the particular market or industry. Usually, the top three are used (hence the label CR3) so, for example, if the top three companies have a 50% share then the CR3 = 50%.

2. The Herfindahl-Hirschman Index (HHI) is calculated by squaring the market share of all competitors and summing the total. For example, if the leading enterprise has a market share of 25% then 25 x 25 = 625, if the next largest player has a share of 15%, then 15 x 15 = 225, a running total of 850, and so on until all market participants are accounted for.

The highest value for the index would be if there was a pure monopoly – i.e. one enterprise with 100% market share or 100 x 100 = 10,000. The opposite end of the scale would be pure competition, for example, 10,000 competitors each with one, one-hundredth of one-percent market share – i.e. (.01 x .01) = 0.0001 x 10,000 = 1.

With that brief foundation now let’s take a look at the resellers in the office products and supplies space.

There are four scenarios shown in the following four tables. Scenario One and Three explain a pre-merger and post-merger market for Office Products and Supplies while Scenario Two and Four explain a pre-merger and post-merger market just for Office Supplies (ink and toner only).

Scenario 1 – Let’s look at this concept from the perspective of the United States market for all office products and supplies (estimated at an $85 billion annual market) with regards to the shares held by the various resellers in the various reselling channels.

Table 1: The United States Market for Office Products – Competitive Landscape

Channel	Count	Total Sales ($M)	Share %	HHI
Tier-1 Reseller Big-Box	9	$67,450	66.7%	946
Tier-1 Dealer	100	$7,364	16.2%	4
Tier-1 Reseller (Internet)	4	$6,625	8.9%	31
Tier-1 Reseller	2	$1,900	4.2%	12
Tier-2 Dealer	500	$1,090	2.4%	0
Tier-3 Dealer	5,000	$750	1.6%	0
Grand Total	5,615	$85,179	100%	993

 

Scenario 2 – Now let’s look at the same concept with a narrower definition of the market – i.e. the United States resellers market for ink and toner (excluding all other office products) and widely estimated as a $25 billion annual retail market.

Table 2: The United States Market for Ink & Toner Products – Competitive Landscape

Channel	Count	Total Sales ($M)	Share %	HHI
Tier-1 Reseller Big-Box	9	$16,674	79.2%	1,311
Tier-1 Dealer	100	$4,050	8.6%	1
Tier-1 Reseller (Internet)	4	$2,219	7.8%	20
Tier-1 Reseller	2	$1,045	2.2%	3
Tier-2 Dealer	500	$599	1.3%	0
Tier-3 Dealer	5,000	$412	0.9%	0
Grand Total	5,615	$25,000	100%	1,355

 

Look at how much difference there is between Table 1 and Table 2 with regards to the two key measurements, market share concentration, and the HHI index! Simply by narrowing the definition of the market from all office products to just that of the market for ink and toner, we can see the largest sales channel controls nearly 80% of ink and toner sales, with an overall HHI of 1,355.

By definition, the FTC would define the overall office products market as “not concentrated” (HHI = less than 1,000) but the market for ink and toner as “moderately concentrated” (HHI is between 1,000 and 1,799).

Scenario 3 – Now let’s look at the same two scenarios already summarized in Table 1 and Table 2, but assume that Staples had successfully acquired Office Depot.

Table 3: The United States Market for Office Products – Competitive Landscape

Channel	Count	Total Sales ($M)	Share %	HHI
Tier-1 Reseller Big-Box	8	$67,450	66.7%	1,631
Tier-1 Dealer	100	$7,364	16.2%	4
Tier-1 Reseller (Internet)	4	$6,625	8.9%	31
Tier-1 Reseller	2	$1,900	4.2%	12
Tier-2 Dealer	500	$1,090	2.4%	0
Tier-3 Dealer	5,000	$750	1.6%	0
Grand Total	5,615	$85,179	100%	1,677

 

I’ve highlighted the cells in Table 1 and 3 that have changed – in Table 1 they’re green and in Table 3 they’re red.

You can see one big-box enterprise is eliminated as Office Depot is merged with Staples. Overall the reseller count drops from nine to eight, the overall HHI score increases from 993 to 1,677. This is still within the FTC boundaries of a “moderately concentrated” industry but, a big increase (684) from the pre-merger index score, and approaching the threshold for being judged as a “highly concentrated” industry.

Scenario 4 – Now let’s look at the final Table 4 and compare the more narrowly defined market for ink and toner before and after the planned acquisition of Office Depot by Staples.

Table 4: The United States Market for Ink & Toner Products – Competitive Landscape

Channel	Count	Total Sales ($M)	Share %	HHI
Tier-1 Reseller Big-Box	8	$16,674	79.2%	2,234
Tier-1 Dealer	100	$4,050	8.6%	1
Tier-1 Reseller (Internet)	4	$2,219	7.8%	20
Tier-1 Reseller	2	$1,045	2.2%	3
Tier-2 Dealer	500	$599	1.3%	0
Tier-3 Dealer	5,000	$412	0.9%	0
Grand Total	5,615	$25,000	100%	2,234

 

Once again I’ve highlighted the cells that changed. In Table 2 they’re green and Table 4 they’re red. You can see one big-box enterprise has been eliminated as Office Depot is merged with Staples and the reseller count drops from nine to eight. The HHI score increases from 1,355 to 2,234 and the defined market now becomes a “highly concentrated” industry with a substantial increase of 879 index points resulting from the proposed acquisition event.

Had the FTC used the market for ink and toner for assessing whether or not Staples should have been permitted to proceed with their acquisition of Office Depot, then I don’t think the outcome would have been any different, as their objections would most likely have been similar. As it was, the FTC used the market for office products (excluding ink and toner) and further narrowed the market to argue that the Staples / Depot merged entity would have had monopolistic power in the B2B contract stationary sector. Staples failed to provide a counter-argument to the FTC’s position and ultimately withdrew from the deal.

The four scenarios I’ve explained above are plotted on the Industry Consolidation Curve shown below. This helps demonstrate the concept of what the FTC was concerned about with regards to Staples proposed acquisition of Office Depot and the progression toward increased market concentration and reduced competition.

The Big Box Retailers – Staples and Office Depot

Staples made it clear during the 15-month failed acquisition process that they feared the increasing threat posed by Amazon, while also claiming there was significant competition from all the other traditional office products and supplies resellers. While competition from resellers such as CDW, Insight, Walmart, Target, Costco, Sam’s, and even the OEM’s is unarguable, the Court accepted the FTC’s argument that the threat from Amazon in the B2B contract stationary market was in the future, not the present, and was, therefore irrelevant to the proceedings.

The B2B contract stationary business conducted by Staples and Office Depot are the “crown jewels” of these two big-box resellers.

• As we know, neither Staples nor Depot can shrink their “brick and mortar” retail footprint fast enough to accommodate consumers changed buying habits. Walk-in retail is threatened by changing consumer purchasing habits, not specifically by Amazon.

• Both Staples and Office Depot have their own powerful e-commerce platforms to compete with Amazon.

• We know Amazon has a renewed focus on its Business Services initiative, relaunched back in April 2015, and it is this threat that probably keeps the Staples and Depot executives awake at night.

However, while this may become a significant threat in the future, the difficulty for Amazon is their expertise is more geared to B2C than B2B and a B2C solution is not what B2B customers are generally looking for.

There’s a high level of integration between Staples / Depot and their B2B customers that Amazon cannot currently match. At least for now Amazon will most likely continue to find it quite difficult to win substantial portions of this B2B business.

When looking at the financial indicators for Staples and Office Depot, it’s clear that Office Depot is the weaker of the two entities. However, they’re hardly in a distressed situation, announcing better than expected earnings in November 2016 and the sell-off of their European and other overseas operations. This indicates they are gearing up for a focused U.S. strategy and increasingly cost-efficient operations.

As a result of its failed acquisition, Staples had to pay Depot a $250 million break-up fee. While both Depot and Staples, at time of writing, are trading at close to book value, Depot has informed its shareholders it’s authorized to spend up to 100% of that breakup fee buying back its own shares.

• If the leadership at Depot doesn’t believe in its future then they wouldn’t be likely to be spending this windfall on a buy-back of their shares.

• Depot is able to continue to finance closing their traditional twenty-five thousand square foot stores out of cash-flow.

• The target count for the traditional store footprint is down to 1,200 or so by the end of 2018. This represents a reduction of over 40% from the peak at the time of the 2013 merger with OfficeMax.

• Depot is accelerating the opening of their “stores of the future” with 120 or so of this 5,000 square-foot, “local neighborhood” style stores, planned by the end of 2017.

I find it quite difficult to project what may come next in this sector of the reseller market. We know there’s not going to be a combination of the two big guys, from which the most synergies could be extracted, and from which a more powerful enterprise could probably be created. We know both Staples and Depot have positive cash flow and strong balance sheets while Depot, at least, believes its shares are under-valued. Neither enterprise is distressed, or likely to be going out of business so, where may they be going?

Some possibilities:

1. Amazon acquires either Staples or Office Depot

2. A Chinese investment group acquires either Staples or Office Depot

3. U.S. Private Equity acquires either Staples or Office Depot

4. Staples continues to acquire the best Tier 1 dealers

5. Depot continues to wring-out synergies from OfficeMax acquisition

6. Otherwise, continue as-is

Longer-term, I do think both Staples and Depot face significant challenges and, of the potential scenarios listed above, I think, for now, a combination of options four, five and six are the most likely. Potential acquirers will sit on the sidelines while the market continues to mature.

What about the other two channels?

The Independent Resellers

The outlook here may be more predictable. It’s interesting that Office Depot still considers a brick and mortar presence to be important for local markets, as indicated by way of their plans for opening 120+ of their new “stores of the future” retail concept. These plans indicate that Office Depot believes there’s still a need for a physical presence in local markets. This implies there may also be an opportunity for independent resellers leveraging their local footprints, so long as they develop capabilities to match the service and performance standards of Depot and Staples. However, regardless of whether or not the independent resellers can effectively compete with Staples and Depot in their local markets, I expect a significant thinning of the ranks. The strongest Tier-2’s will acquire the best of the Tier-3’s and will then, subsequently be acquired by the strongest Tier-1 players. Many of the weakest Tier-3 will simply go out of business.

The Internet Resellers

What most people may think of in terms of e-commerce and the future, may not be the way it plays out, at least not in the short and medium term. As we know, Amazon is the powerhouse of e-commerce even though Staples and Office Depot also have strong e-commerce portals.

It’s clear Amazon wants to break into the B2B office products channel and, we know, from Staple’s efforts to convince the FTC to allow their acquisition of Office Depot, that they (Staple’s) fear the threat of Amazon in this B2B space. Fortunately, at least in the short term, for Staples and Depot, it appears the Amazon B2C platform is not suitable to meet the needs of the typical B2B customer they currently serve. However, given Amazon’s resources, it may only be a matter of time before they figure out a solution to this problem, and start to win share in this lucrative segment of the market.

Overall, we believe the scope for new entrants in the Internet Reseller Channel, at least in terms of competing with Amazon, eBay, NewEgg, LD Products and even Staples and Office Depot, is very limited.

It’s possible, of course, that we could see some consolidation with Staples, Depot or even NewEgg perhaps acquiring LD Products. However, I don’t see significant changes taking place with the current leaders that make up the Internet Reseller Channel, apart from the relentless advance of Amazon and the possible entry of Alibaba. However, Alibaba is a whole different story and I’ll try and tackle that at a later time.

In the next section, we’ll be summarizing the mergers endgame before moving on to our perspective on the Consumer Adoption Curve and the likely opportunity for aftermarket office supplies in terms of improved market share. When viewed in conjunction with the mergers and acquisitions and the Chinese money, then it becomes much clearer in terms of understanding why it’s likely there’s to be a significant shift in market shares.

The market shares between OEM and aftermarket have been unchanged for many years. In this section, we’re going to explain about the ink and toner product lifecycle and the consumer adoption curve as it relates to aftermarket alternatives. You’re going to learn that the stagnation of the aftermarket proposition is mostly related to OEM blocking strategies and not to the lack of consumer acceptance of the aftermarket value proposition .

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The  Five Steps of the Consumer Adoption Process

1. Product Awareness
2. Product Interest
3. Evaluation
4. Trial
5. Adoption / Rejection

The Five Stages of Consumer Adoption

Consumer adopter distributions follow a bell-shaped curve over time that can be divided into five categories:

1. Innovators (2.5%) – a small group of people eager to try new ideas and take risks
2. Early Adopters (13.5%) – individuals respected by their peers and with a reputation for successful use of new ideas
3. Early Majority (34%) – seldom leaders, take more time to deliberate before willing to adopt a new idea
4. Late Majority (34%) – skeptics only willing to adopt a new idea after the average adopter has already done so
5. Laggards (16%) – traditionalists, the last to adopt an innovation and maybe after it’s already obsolete

In terms of office printing and ink and laser supplies, we’re in a late-stage, mature industry. Laser printing came on the scene first, back in the mid-1980s and ink arrived a little later, during the early 1990s. The aftermarket remanufacturing industry was born in the mid to late 1980s and the innovator and early adopter consumers quickly propelled the aftermarket remanufactured cartridges to a 20% share by the mid-1990s and 30% by the end of the millennium. With a far smaller share of the color market (less than 10%), aggregate aftermarket share has stagnated around 20% ever since!

In order to progress this far, all five stages of the Consumer Adoption Process were satisfied – product awareness, consumer interest, evaluation, trial, and adoption. Furthermore, all these thresholds were crossed during the 1990s despite the products being technically inferior to the OEM versions. With a 30% market share (on monochrome laser) by the year 2000, consumer adoption was deep into the early majority stage and had “crossed the chasm” of consumer acceptance. According to consumer adoption theory, the aftermarket alternatives should have gone on to even broader market acceptance and growth of market share.

Now, at this point, it would be easy to get bogged down in a narrative of ink versus laser, and monochrome versus color printing. We all know the aftermarket has faced many technical challenges within these different categories that may have affected progress along the consumer adoption curve. It’s not difficult to argue that the five stages of the consumer adoption process were not satisfied (for example) within the color laser printing sub-category and that the process broke down at stage five as products were rejected because they failed to meet consumer expectations. However, aftermarket monochrome products were adopted despite their technical inferiority so why not color? What else changed that prevented consumer adoption from continuing to develop?

The OEM wake-up call

I doubt the OEM’s ever imagined a bunch of entrepreneurs would come up with a means to recover and remanufacture their original cartridges. They were surely confident their government-granted monopolies (by way of thousands of patents) would ensure no loss of market share. So, they did what all monopolists do, they exerted their power (in this case over the resellers), charged high prices for the cartridges, and enforced strict terms for continuing to allow them to buy and resell their cartridges.

However, the resellers didn’t like being dictated to in this manner so they gave the aftermarket remanufacturers a break by providing a distribution outlet for their cartridges. As a result, consumers became aware of the cheaper alternatives, expressed an interest and quickly adopted the lower priced cartridges, despite their inferior technical performance.

This was the OEM’s “wake-up” call that led them to understand the aftermarket represented a serious long-term threat to their business model. The OEM’s have always had a go-to-market business dilemma – they have to price the printers low enough for mass adoption and then sell the cartridges at a high enough price to subsidize the losses incurred developing the installed base. If a significant loss of market share on the cartridges takes place, then the business model collapses.

It was these developments that led to the introduction and fine-tuning of numerous blocking tactics to restrict the aftermarket from taking share.

The OEM Blocking Tactics

Rebates:

The first and most effective blocking strategy was the continued deployment and fine-tuning of the rebate model. By introducing sales quotas for their approved distributors and tying their quarterly rebate checks to performance against that quota, the OEM’s are effectively able to control market share through the big-box retailers and other Tier-1 distributors and resellers. In leveraging their knowledge that the reseller’s sales compensation plans are usually based on the top-line (i.e. $100 OEM cartridges) and that investors and the financial community usually react favorably to top-line growth, they knew they could significantly restrict the impact of aftermarket cartridges. Remember, this has nothing to do with customer acceptance of the aftermarket cartridges, this is the result of powerful OEM’s exerting their influence over the resellers in order to restrict consumer access to alternatives.

Think about this one – has the aftermarket share of color been restricted to 8% or so for the last decade because of poor quality products or because of OEM sales quotas and rebate incentives? 

Industry Consolidation:

As the big-box retailers, Tier-1 resellers and aftermarket manufacturers have consolidated, it’s played directly into the hands of the OEM’s and their blocking strategies. It’s far easier for the OEM’s to exert influence over a smaller number of enterprises than it is a larger, more diverse group of resellers and competitive manufacturers. At first glance, you may think the larger a reseller of OEM products becomes then the more powerful it becomes and, should, therefore, be able to exert more influence over the OEM’s. However, this is simply not the case. The resellers all dance to the tune of the OEM’s, taking the easy option for top-line sales over profit maximizing alternatives (i.e. aftermarket cartridges).

Control of Distribution:

During 2012-14 HP cut a reported 10,000 resellers off from their products and imposed strict reporting requirements on its remaining authorized distributors, including the requirement to report whom they were selling HP brand products to. Imagine having to tell your supplier who your customers are, especially when they’re already selling directly to consumers and bypassing distribution in some markets. Now, a manufacturer is entitled to set the terms for resellers of its products so there’s nothing inherently wrong with HP from doing what they did, but, let’s look under the hood for an underlying strategy behind these tactics.

HP already had all the sales so did it really matter that a lot of the resellers were small businesses and perhaps of little importance to HP? Did they really have a negative impact on HP’s image and brand as HP seemed to imply and, as a result not deserve the right to resell HP’s products? Or, did HP consider it necessary to weaken these resellers by denying them access to their products, because they represented a potential future threat to their business model? Unlike the Tier-1 retailers and resellers, HP could not control the smaller independents with rebate dollars – someone who sold $50,000 of HP products per year and got maybe two or three thousand back in rebates – it just wasn’t enough money for HP to impose a controlling strategy.

Core Recovery:

How to restrict aftermarket share, well just start competing for the cores. The aftermarket setup vast core recovery programs during the 2000s, providing the raw materials for growth so, the leading OEM’s simply followed suit. By reducing the number of cores in the supply chain available to the remanufacturers they developed another powerful weapon to restrict development of the aftermarket share.

Engine Diversity:

Never again would the OEM’s make the same mistake and allow a single “engine” to develop a large installed base as they did with the original “SX” engine in the late 1980s and early 1990s. Today the life-cycle for hardware is drastically reduced with new models coming out at quicker intervals. It takes time and research and development expense for the aftermarket to develop new products, it takes a time to recover enough cores to place a new product in distribution and to be sure there are sufficient cores to keep it stocked in distribution. There’s risk involved for the aftermarket to determine whether a new product announcement from the OEM is going to be successful or not and whether they should devote their efforts to developing an aftermarket alternative. The more new products launched by the OEM’s the higher these aftermarket expenses and risks become. Back in the early days and ten products covered 80% of the market, now it takes hundreds of products to cover 80% of the market.

Cartridge Technology:

There’s a lot of technology on an ink or laser cartridge these days and you have to ask yourself, is all this necessary or, is it a tactic to thwart the aftermarket from gaining market share? Starting with Seiko Epson on their ink cartridges back in the early 2000s, and continuing at an increasingly rapid pace, has been the placement of encrypted chips on almost every OEM cartridge that comes to market. It’s difficult to accept that every feature incorporated into these chips has been developed for the purpose of improving the consumers’ experience as opposed to blocking the aftermarket cartridges.

Simply having the ability to plant a firmware update on their hardware that temporarily, or permanently disables aftermarket cartridges, carries far more potential to erode consumer confidence than any conventional brand marketing can achieve.

Legal:

The constant threat of patent infringement, the seeking of ITC General Exclusion Orders to restrict imports, and the bringing of the First-Sale Doctrine into play and placing a heavy cloud over remanufacturers with regard to the responsibility for knowing the core used for remanufacturing was sourced from the United States market after a legitimate “first-sale” in that same market.

Perhaps, by selectively ignoring potentially infringing and potentially counterfeit products sold through channels such as online marketplaces like Amazon and eBay, the OEM’s can watch the aftermarket resellers contribute to their own downfall. With the Tier-2 and Tier-3 resellers desperately trying to figure out e-commerce and flooding these marketplaces with low-priced products, what better way for the aftermarket to erode its own reputation for quality, while simultaneously playing directly into the OEM’s marketing strategy to discredit lower priced alternatives?

Traditional Marketing:

There’s an acronym out there known as “FUD” – it stands for fear, uncertainty & doubt and is usually invoked intentionally in order to put a competitor at a disadvantage. OEM FUD campaigns have been aggressively deployed since the aftermarket first appeared on the scene.

Below are links to four FUD campaigns launched by Hewlett-Packard. Take a look and decide for yourself whether these are dragging up memories of toner bombs and other quality issues from twenty years ago or whether they legitimately apply to the products available from the top tier aftermarket manufacturers and remanufacturers that exist today.

As you’re thinking about whether these FUD campaign videos apply to today’s market or not, think also about the fact that the OEM’s already sell the very aftermarket products they denigrate in their marketing collateral. They have to, in order to support their MPS programs.

They sell managed print service contracts to their largest, their very best, premium customers who may have thousands of printers deployed throughout their organizations. These printer fleets are always made up of a variety of OEM hardware – i.e. there may be HP, Lexmark, Oki, Kyocera Mita, devices etc. When any of these OEMs prepare a multi-year managed print services contract to whom do they turn to for cartridges to fit on these devices? Well, you can be sure it’s not their OEM competitors. HP is not going to Lexmark, and Lexmark is not going to HP, for cartridges to fit into the devices they need to service so, they go to Clover or LMI Solutions and source aftermarket cartridges – the same cartridges they would prefer to have everyone believe are technically inferior and unsuitable for consumers to use!

This is the ultimate hypocrisy in terms of “do as I say, not as I do!”

Logistics & Customer Service:

The OEM’s, the big-box retailers, the Tier-1 resellers and distributors, the Tier-1 aftermarket remanufacturers, all have done a great job in terms of logistics and customer service. All have invested heavily in information technology to ensure they have the ability to deliver quickly, reliably and cost-effectively. All have invested in state-of-the-art customer response systems (CRM) to ensure they can quickly and efficiently pull up customer history and records for purchasing patterns and problem resolution. The Tier-2 and Tier-3 resellers have allowed their larger competitors to get ahead in this crucial aspect of modern day business and, of course, it has now become part of the overall blocking strategy.

Blocking Tactics – Conclusions:

It’s difficult not to be impressed with this long list of defensive strategies that have been deployed by the OEM’s. For sure, they are tough, intelligent competitors. They know their competition and they know how to neutralize the market players in order to achieve their goals. In fact, the OEM blocking strategies and communications have been so effective that I think even the resellers of aftermarket products have come to believe its negative messaging!

The thing is, this blog is about the consumer adoption curve and product life cycles but, so far, I’ve only spent a little time specifically on this topic. However, the reason for this is that the aftermarket ink and toner cartridges have already been through the first stages of the adoption curve, successfully reaching the “early majority” stage and even “crossing the chasm” toward greater adoption. Consumer interest and adoption is not the issue here, it’s the story of how and why, despite the consumer interest, the path to a greater share of the overall market has been blocked.

The importance of the fact that consumers have already demonstrated a willingness to adopt the aftermarket value proposition must not be underestimated. Knowing this is a huge advantage for independent resellers who want to restart their business development. The challenge is not whether customers want the products, it’s figuring out effective ways to circumvent the OEM roadblocks and to start to increase market share.

What next?

Well, it’s time for the aftermarket to fight back.

To schedule a no-obligation consultation with us to learn more about our turnkey digital business transformation service for office products resellers please click on the link below.

The quality of the aftermarket product proposition today compared to when it passed those first critical consumer acceptance thresholds back in the 1990s is simply night and day. However, with the big, powerful retailers and resellers firmly in the pocket of the OEM’s, there’s been no effective path to get the aftermarket message to consumers and to educate them on the value proposition and the availability of these quality alternatives. Remember, this was not the case when the resellers in the 1990s gave the aftermarket industry a break, putting their products into the distribution channels and allowing consumers to become aware and to adopt them.

In the next section, we’ll be presenting our view on where the battlegrounds will be, and what tactics may be utilized in the fight for market share. The success of many of the OEM blocking tactics is dependent on the existing cartel arrangement, (big-box retailers, Tier-1 resellers and distributors, and the Tier-1 aftermarket manufacturers), being preserved. Sure, it’s possible one of the big guy’s could break ranks and influence change but, I think that’s unlikely.

Our focus will be on the Tier-2 and Tier-3 resellers and distributors, with whom the OEM’s have little to no influence over how they conduct business. In conjunction with the newly emerging Chinese superpower manufacturers of high-quality new-build compatibles – now, that’s a new partnership which has the potential to carry on where those early pioneers of the aftermarket for ink and toner started out.

With the emergence of the Chinese aftermarket ink and toner manufacturing superpowers, we anticipate new battles for market share will take place between the OEM and aftermarket brands. In this section of the paper, we’re going to explore where these battles are most likely to take place. We’ve already explained the aftermarket tipping point, explored scenarios for the OEM and aftermarket manufacturer merger endgames, the reseller merger endgame, and the consumer adoption curve as it relates to aftermarket ink and toner. The scene is now set to explore possibilities for market share development.

Directly below is an illustration showing how office products get to market in North America. We already explained in Section 4 how the OEM’s, leveraging their power over the distribution channels, effectively control market share between the original and aftermarket products.

Now take a look at the second graphic below illustrating how, the 90% of consumers buying office products, choose to do so from the Big-Box and Tier-1 resellers and, consequently, only have access to the products offered by the OEM’s and Tier-1 aftermarket manufacturers. Remember also, our earlier explanation with regards to how the OEM’s control their market pricing and market shares through the rebate programs and other carefully deployed aftermarket blocking tactics.

There’s no way for the Tier-2 [Chinese] aftermarket manufacturers to access the 90% of consumers who currently choose to purchase through the Big-Box and Tier-1 resellers because these resellers elect not to place the Tier-2 products into distribution for their customers to select from.

The OEM’s, big-box and Tier-1 resellers have effectively organized themselves (or been organized) into a cartel, and there’s no way for market shares to substantially change unless this cartel arrangement is breached.

Note our comment at the foot of the graphic that the small group which makes up, what we’ve termed “the Tier-1 aftermarket manufacturers” (Clover Imaging Group, LMI Solutions, and Turbon) have, in fact, already effectively lost their Tier-1 status to the emerging Chinese superpowers. The Chinese aftermarket manufacturers have cost, capital and product (new-build) advantages and therefore, over time, have the power to breach the cartel that currently controls pricing and market shares.

Here are four scenarios that could potentially develop from these circumstances:

1. The OEM’s eliminate the Chinese threat

The OEM’s surely recognize the emergence of the Chinese superpowers and the threat they pose to their business model. Of course, they want things to remain as they currently are, with an ongoing and steady decline of the aftermarket share due to shrinkage in the monochrome market and with their continued success preventing the aftermarket from breaking into the color market.

How better to achieve this, and simply neutralize the Chinese threat in the process, than by encouraging the big-box and Tier-1 resellers to transition from their current suppliers (Clover and Turbon) over to the Chinese? Remember, the OEM’s control both pricing and market shares and, so long as the current cartel structure is preserved, they can ensure there will be no change to the pricing model or to the overall trend in market shares.

In this scenario, the cartel could be preserved, and the Chinese simultaneously neutralized, simply by encouraging the Tier-1 reseller’s to replace their current suppliers. In doing so they’ll probably get lower prices than they currently do from Clover, LMI, and Turbon, increasing their already substantial margins on aftermarket products in the process.

Don’t forget, the OEM’s could also choose to buy compatibles directly from the Chinese in order to support their MPS contracts, just like they’ve already done with Clover and LMI. In doing so, they’d further neutralize the Chinese and make it less likely they’d go down a path to support resellers outside the cartel and attempt to build market share at the expense of the OEM’s.

Development of this scenario would provide a big boost to market share for the Chinese and a big loss to the current suppliers. However, so far as the OEM’s are concerned, it’s just a pocket shift and overall they could achieve their goal of keeping things the way they are. The cartel would be preserved – just one group of members would be changed from the current incumbents to a new group of [Chinese] members.

Of course, Clover, LMI, and Turbon aren’t going to roll over and let this happen without a fight. They provide a lot of services to the big-box resellers and Tier-1 dealers that the Chinese would struggle to replicate so, it would be a disruptive change requiring significant adjustments by the resellers in order to try and make it work. Perhaps the OEM’s increase their rebates by a point or two for a few months to help pay for the transition – who knows?

Scenario Conclusion:

The OEM’s are clever, very clever. They know how to play this game so don’t be surprised if some variation of this scenario plays out. Furthermore, it’s not like they must do all or nothing – they may start off with small, seemingly innocuous moves that we may not even hear about, and then more aggressively when necessary. We rate the chances of the OEM’s playing a leading role in the Chinese increasing their share at the expense of the existing players at a modest, 2 out of 5.

2. Amazon figures out the B2B Channel

All the aftermarket manufacturers (Chinese as well as domestic) are already selling on Amazon, both directly and indirectly. So far, only a relatively small segment of consumers (mainly B2C) have chosen to buy their ink and toner cartridges from this channel.

What if Amazon decides to step deeper into the fray? We know they’d like more of the action in the office products vertical – we just don’t know how much they want it!

We know they’ve captured consumers (mainly B2C) of office products through their marketplace, and we know they have a decent understanding of the market. We know they’d like the B2B business and we know they’ve re-vamped their Business Service Division in order to try and win more of this business.

We also know Walmart is making a big push into e-commerce and we’ve recently heard analysts speculating about the potential advantages they may develop over Amazon if they’re able to leverage their 5,000 stores as distribution and pick-up centers – just as Best Buy has been successfully doing over the last couple of years.

What if Amazon also views Walmart’s strategies as a potential threat and decided to snap-up OfficeDepot to counter them? Not only a massive step up for them in terms of the B2B contract stationery business but also 1,400 retail locations that could counter the potential advantages Walmart may be able to develop. Furthermore, what could Amazon stock those OfficeDepot retail locations with, in the future besides office products?

Scenario Conclusion:

Amazon has a lot going on and it would be enormously risky for them to take on a brick and mortar retailer such as OfficeDepot and to integrate it into its existing business. Furthermore, even if they did, then in order to improve the overall OfficeDepot business model, they’d face the same issues we’re going to explain in the following “break-rank” scenario. Bottom line, why would Amazon contemplate buying OfficeDepot if the constraints to improve its business model (i.e. aftermarket cartridges) involved putting the business they had acquired at risk? Overall, we rate the chances of this scenario playing out at a slim 0.5 out of 5.

3. A Big-Box Retailer breaks ranks

After the Staples deal to acquire OfficeDepot failed, Depot has come out of the mess with all guns firing. They appear to have a plan and are taking decisive action. Their CEO, Roland Smith, declared back on May 16th, 2016, when the deal finally collapsed, that the company’s future would depend on “bold new action”.

Well, what if they decided to take bold new action, unilaterally exited the cartel, and gave more prominence to aftermarket cartridges? Remember the gross margins on OEM sales (after factoring in rebates) are 10-15% whereas they’re 65%+ on aftermarket cartridges – potentially even more if they were sourced directly from the Chinese. 

OfficeDepot and the impact of switching from OEM to aftermarket

	OEM	Aftermarket	Total	Future	Change
Sales	$3,800M	$250M	$4,050M	$1,580M	-$2,470M
GM %	10%	65%	12.5%	65%	+52.5%
GM $	$380M	$162.5M	$542.5M	$1,027M	+$484.5M

 

Let’s assume OfficeDepot currently has $3.8 billion in OEM cartridge sales at 10 points of gross margin and $250 million in aftermarket cartridge sales and decided to exit OEM and only offer aftermarket.

Let’s assume that action resulted in a loss of 50% or $1.9 billion of their existing OEM cartridge business. Then, the remaining $1.9 billion was discounted by 30% (per the aftermarket model) so it became $1.33 billion. However, this $1.33 billion is at 65 points of margin, not 10 points.

As shown in the table – that’s a new total of just over $1 billion margin dollars, a pick-up of nearly $500MM!

Of course, this is a radical scenario with many implications beyond the risk of losing nearly $2.0 billion in cartridge sales. This strategy would put the customer (not just product) retention at serious risk. If ink and toner are 40% of a typical customer’s spend on office products, then a $2.0 billion loss in cartridge sales would be likely to compromise $5.0 billion in overall customer sales. That’s putting 40% of their North American top line at risk!

Scenario Conclusion:

Much as the management at OfficeDepot may look at the attractive margins on aftermarket ink and toner, and much as they may want to take bold steps forward, we just don’t see a successful transition path to the scenario I’ve described. So, bottom line, this is not a viable path for breaking the cartel and increasing aftermarket share. Unfortunately, Depot is trapped inside the existing cartel arrangement, so we have to rate the likelihood of this path developing as zero out of five.

4. Tier 2 & 3 Resellers emerge, empowered by the Chinese

The OEM’s don’t have much influence over the strategies and tactics of the Tier-2 distributors and the smaller independent office products resellers. Because they don’t have much influence, this group may represent a potential future threat to the OEM’s, particularly if they were to combine with the newly emerged Chinese aftermarket manufacturing superpowers. This possibility must be worrisome for the OEM’s and may account for specific actions, like HP’s massive shake-up of its authorized reseller program between 2012 and 2014. This strategy may have been specifically targeted toward weakening a category of resellers they could not control and that (when sufficiently weakened) they did not believe had strong prospects for competing successfully with them in the future. In other words, despite their actions leading to strong levels of resentment within a large group of resellers, they did not believe this action was going to come back and bite them in the future!

Think for a moment about SGT’s acquisition of the global Cartridge World franchise. There are 500 or so franchise locations throughout North America and a similar number scattered in other markets around the globe. This acquisition is a prime example of a Chinese superpower acquiring distribution in order to bypass the current cartel. This is not a franchise focused on the dog-eat-dog world of internet related bottom-feed pricing. This is a franchise focused on its quality, its brand and its physical presence in prominent local markets. This is a franchise focused on the “blue ocean” of OEM conversions, not the “red ocean” of random internet business with high customer churn and razor thin margins.

Think for a moment about OfficeDepot’s “store of the future” strategy – this isn’t so different from the Cartridge World concept. A smaller, physical presence in local markets with the ability to leverage relationships and minimize customer churn by continuing to deliver a first-class customer experience.

Think for a moment about BestBuy. Everyone was predicting they didn’t have a future, that they would become a showroom where you could touch and feel products you were interested in before leaving to go and find the best deal online. Who would have thought BestBuy could successfully adapt and to now be showing promising signs of surviving such a major battle against Amazon and other online retailers? What does this developing success story tell us in terms of customers wanting to physically deal with someone as opposed to something? The internet has not eliminated the human desire to interact with real people!

What could all this mean for the smaller independent resellers and their future in the office products and supplies space?

Firstly, the focus on the “red ocean” of random e-commerce initiatives should be curtailed and there must be a new emphasis on doing what OfficeDepot, Staples, Tier-1 independent dealers and a franchise like Cartridge World, are doing. These organizations all appear to believe a strong physical presence in local markets is important to their future business prospects. The Tier-2 dealers need to adopt a similar approach.

It should not be beyond their means to do so. Firstly, they have ready and willing partners to select from in terms of the Chinese superpower manufacturers. Secondly, the Tier-2 distributors of these Chinese products have the import and the logistics expertise to get products quickly and economically to the reseller’s customers. In being prepared to leverage these products and capabilities alongside an upgrade of their individual technology platforms, then there’s a possibility to have a meaningful impact in the medium to longer term. However, to be successful with this approach will mean developing sufficient trust and confidence in their capabilities that are necessary to satisfy the performance requirements of the “blue ocean” caliber customers currently served by the Tier-1 retailers and resellers.

To schedule a no-obligation consultation with us to learn more about our turnkey digital business transformation service for office products resellers please click on the link below.

Scenario Conclusion:

The development of a sales channel outside of the existing cartel has already started and its future success is likely. For me, the big question is not whether or not this development will succeed, it’s more about what the scale of its success will be. If we assume there are 5,000 independent Tier-2 and 3 resellers left in the United States and Canada, and that (for example) Cartridge World makes up 500, or 10% of this number. Is it going to be just 10% that recognize the opportunity to empower themselves for success, or is it going to be 25% or more? Just imagine 1,500 resellers leveraging technology to transform their businesses, just imagine if they each had an average of $1 million in annual sales – that adds up to $1.5 billion in aggregate. Now, that’s a potentially significant sales channel development story that would keep the OEM’s awake at night!

Because of the strength of the existing cartel and its ability to block the growth of the aftermarket, I believe further development of this independent sales channel, that’s outside the control of the cartel, is the only viable path to achieving increased aftermarket share. I rate its longer-term likelihood of success at a strong 4 out of 5!

Conclusions:

The important point to understand is that we’re entering a new phase in the development of the office products vertical, that change is likely and, as always, there will be winners and losers. For those that are prepared, change will bring opportunity.

For the smaller, local resellers that focus on their value proposition, including developing their ability to compete effectively with the service routinely provided by larger companies, there will be opportunities that can benefit their businesses. However, if instead, they choose to get caught in an online price game with poor quality, potentially infringing products or inadequate information technology systems, then they’ll be poorly positioned and will fail to benefit at all.

The aftermarket products are well positioned from a technology perspective, from a cost perspective, and from a competitive perspective. Remember, for example, unlike the OEM’s, the aftermarket value chain doesn’t have to give up any margin dollars subsidizing hardware development or distribution costs.

The biggest potential losers, (if the smaller resellers are motivated to step up), stand to be the OEM’s and the big-box retailers. A move from 20% to 35% aftermarket share represents an annual shift of over $3.5 billion retail dollars. We know a change of this scale cannot take place through the cartel and, if it’s to take place at all, then only the independents can make it so.