Black Gold: Hewlett-Packard Shifts Emphasis From Printers to Ink

Everyone's heard about the mutually destructive price war raging among personal computer manufacturers. Wall Street is obsessed with it. But when people talk about the "price war" around Hewlett-Packard's (HWP Quote) Palo Alto, Calif., headquarters, nobody's thinking about PCs. They're thinking of printers, the products that, more than anything else, determine H-P's fortune.

For months, H-P has been engaged in an intense battle to increase its share of the market for inexpensive inkjet printers. The fight is taking a predictable toll on profit margins. But make no mistake, the printing business offers something that the PC business doesn't: the chance to sell ink. Known as consumables, printing supplies are extremely high margin items capable of more than offsetting losses on printers themselves. And because of them, H-P's strategy of chasing printer market share could have a big payoff.

H-P has been dominant for years in the overall printer market, a good portion of which includes high-margin laserjet printers. But the company hasn't always had much stomach for playing in the low-end inkjet segment, which industry analysts generally define as printers selling for less than $100. Fearing the damage that a price war could inflict on profit margins in its imaging segment, the company sat back for years while competitor Lexmark (LXK Quote) built a big business in cheap inkjet printers. And when H-P finally did go after the low-end market, it did so very tentatively, selling printers through wholly owned subsidiary Apollo Consumer Products, which the company created in 1999. The introduction of Apollo was largely seen as a defensive move, an attempt to test out the market without endangering the H-P brand.

H-P has since lost its reserve, having gained a strong position in low-end inkjets by pricing its products aggressively low in recent months. The company now boasts that it holds more than 40% of the U.S. retail sub-$100 market, while market research firm Dataquest puts H-P's share at just over 26%, equal to that of Lexmark.

Gangbusters H-P coming on strong in the sub-$100 inkjet market
Company	Market Share, Q1 2001	Market Share, Q1 2000
Lexmark (LXK Quote)	26.1%	22.5%
Hewlett-Packard (HWP Quote)	26.1%*	9.2%*
Canon (CAJ Quote)	23.5%	34.5%
Epson	14.2%	18.5%
Compaq (CPQ Quote)	8.3%	12.6%
Xerox (XRX Quote)	1.7%	2.8%
* includes Apollo brand
Source: Gartner Group

H-P isn't willing to go for market share at any price, claims Cathy Lyons, vice president and general manager of the company's imaging and printing supplies business. "There are some companies that give away the hardware platform in order to increase the sell-base," says Lyons. "We prefer to take a more balanced view of things." But the bottom line tells the story. Operating margins in H-P's printing segment fell to 8.2% in its first quarter from last year's 13.5% and 12.8% in the fourth quarter of 2000.

The company hopes margins will bounce back when it starts shipping a new low-end product that it claims will have a lower cost structure than the Apollo brand. Investors can expect to hear some details on this next move Wednesday, when H-P holds its analysts meeting in Palo Alto.

But shrinking profit margins on printers may not really matter that much.

"In the end, this is a battle over consumables, not about printers," says SG Cowen analyst Richard Chu. "In the past, consumables has been the holy grail for everybody. Most of H-P's competitors have been willing to lose a fair amount of money on the boxes up front to get a shot at the consumables. H-P has been consistently profitable on the boxes. I think they're willing now to change that model, and fund that business with losses on the low end." (SG Cowen hasn't done recent underwriting for H-P.)

The attractive thing about consumables is their ability to transform one-time hardware purchases into relatively stable annuity streams. This reframes the way companies view the issue of how low to go on price. "They look at it as life-cycle pricing," says Stephen Dube, an analyst at Dresdner Kleinwort Wasserstein. "You make an estimate of what you make on the printer plus what you make on the supplies. There's no question that more of the money is in the supply side over a number of years. The printers can literally be a giveaway. It's the classic Gillette story with the razors and the blades."

Fine Print Breaking down H-P's 2000 earnings

Source: The Company

The consumables business isn't exactly at its peak at H-P. Revenue in that segment grew 10% in an otherwise dismal first-quarter earnings report. That's about half its historical growth rate, and it's not easy to tell where things will go from here. Sluggish PC sales could remain a drag on both sales of printers and printer supplies. On the other hand, further gains in printer market share could help. Optimistic analysts think the percentage growth rate of consumables could be back in the high teens by the end of the year.

It's hard to overstate the importance of the printer business for H-P. PCs, storage, servers, services -- the company does a lot of things. But above everything else, H-P is a printer company. Around half its revenue and 66% of its profits came from its imaging business last year. And this year printers are playing an even more important role. Chu thinks pretty much all of the $1.10 per share he estimates H-P will earn in 2001 will come from the imaging segment. Moreover, he says, pretty much all of the profit in that segment will come from consumables.

Although it's more than 50% off its 52-week high, H-P isn't exactly a cheap stock. At just under $30 a share, it still trades at more than 25 times its estimated 2001 earnings.

But H-P's printer business goes a long way toward justifying that valuation, thinks Chu. "I'd pay 30 bucks just for that franchise," he says. "And you get the computing systems and services effectively for free. Maybe those deserve to be valued at zero. But they're probably worth more than that."