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Shades of gray: Tight economy spurs concern over unauthorized technology sales

When the tough economy drives more businesses to the gray market for cheaper IT, legitimate resellers pay the price.

With money tight for small and large enterprises alike, the temptation for businesses to turn to the gray market for cheaper technology goods is strong. And, the repercussions for legitimate resellers -- those who play by the rules -- are serious.

"We frequently run into situations where the competition is purchasing through non-authorized channels and selling to end users below our cost," said Arlin Sorensen, the president and CEO of Heartland Technology Solutions, a Hewlett-Packard and Cisco Systems reseller based in Harlan, Iowa. The practice can have a very real impact on his firm's ability to win business. "Gray market competition drives down our margins, and sometimes completely knocks us out of a deal."

The gray market refers to any alternative distribution channel where products have been intentionally removed from the authorized chain of distribution. This takes a number of forms: Gray market resellers often sell used products as new or sell counterfeit products as branded goods. And the cost to the industry is huge. According to the Alliance for Gray Market and Counterfeit Abatement (AGMA) president, Ram Manchi, $58 billion annually is lost to gray market sales.

Growing gray market hurts legitimate resellers

Although difficult to quantify, there is anecdotal evidence that the tough economic conditions are making gray market transactions more attractive to cash-strapped end-user businesses.

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"Budgets being so reduced, it's reasonable to assume that customers are looking more at the gray market products," said Bob Olwig, vice president of business strategy for WorldWide Technology Inc., in St. Louis, a $2.5 billion reseller. Although his company has just experienced its best year ever, he admits that sometimes it is a struggle to convince customers to buy new equipment from an authorized dealer. "Customers are definitely weighing the pros and cons of whether that's worth it when money is so tight," Olwig said.

"The number of deals with some level of gray market product in them has increased over the last 12 months," agreed Sorensen. "The current economy drives more people to be willing to cut corners than in normal times, as cash flow is a huge concern."

But doing so is fraught with risk for user organizations. "Too often they fall for a deal based on price," Sorensen said. "Later, they wrestle with warranty issues or support in general from the vendor if the product has come through an unauthorized channel."

"The federal government has to be especially concerned about buying gray market and/or counterfeit gear because of the risk of having it deployed into sensitive applications and networks," Olwig said. His company works with a number of original equipment manufacturers (OEMs) in an attempt to secure the supply chain in a way that ensures equipment comes through the channel with integrity.

AGMA: Gray market pits VARs against VARs

According to the "KPMG Gray Market Study Update," published in 2008, more than 38% of resellers have received offers to resell products from gray marketers. A full 66% of those that receive such offers say they actually buy from the gray market. Nearly 25% report that their gray-market purchases amount to 11% to 30% of their annual purchases. The reason they give in? Lower prices and -- frequently -- faster delivery of products.

"The fact that authorized resellers are participating in the gray market hurts those people who are playing by the rules," said Matt Behan, a principal at KPMG LLP's contract compliance services group. "The biggest excuse people give is that they have to do it because their competitors are doing it. But what it comes down to is that some people are quite happy to buy and sell gray products and make money while paying lip service to the idea that the problem needs to be fixed."

Although vendors try to be vigilant about tracking down and stopping gray-market activity, "the war is pretty large, the battleground is worldwide and vendors are not making a lot of headway," Sorensen said. "I'm sure [the vendors] are doing more than any of us realize, but I perceive it to be a war where they win a few but are struggling to track down the real culprits."

Phyllis Massey, manager of brand protection at HP, said the firm uses a combination of incentives and education to curb gray-market activity. Legal prosecution, while sometimes pursued, is kept to a minimum, especially when it comes to keeping authorized resellers from straying into gray territory, she said.

"We are very committed to supporting our strongest partners who live within the terms and conditions of their contracts," Massey said. "A huge percentage of our business is managed through our travel partners. And by keeping products readily available, pricing them correctly and providing the right incentives, we've put together a number of programs that make participating in the gray market less attractive."

Compared to 2002, when KPMG first issued a study of the gray market, "a lot more companies are aware of abuse and have started monitoring their partners," Behan said. This includes performing regular partner reviews and attempting to identify those places in the supply chain where gray-market goods enter the market. "Still, they are still struggling with how best to manage it," he said. Among other things, the 2008 KPMG survey showed that vendors lost between 5% and 8% of their profits to the gray market. "And when times are hard, like they are now, IT companies are operating on smaller margins and know that anything they can do to recover those revenues goes straight to their bottom lines."

Ultimately, say resellers, the best tool they have in the market is education. "If we are able to point out that support and warranty are at risk on gray-market product, most clients will walk away from unauthorized deals even when the prices are significantly cheaper," Sorensen said.

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