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H-P's Problem With Printers

Investors cheering a strong quarter are dismissing a tough road in the company's most profitable unit.

Hewlett-Packard

(HPQ) - Get Report

investors received a much-hoped-for boost Wednesday as the company's new chief executive, Mark Hurd, and his seemingly no-nonsense manner are buoying hopes that fundamental improvements aren't far off.

Indeed, much of the reaction on Wall Street after H-P's second-quarter financial report, which detailed

better-than-expected results, was highly laudatory toward Hurd, who has been on the job just seven weeks.

Shares rose almost 3% to $22.17 in midday trading Wednesday.

However, traders were shrugging off some troublesome points: a projection for third-quarter earnings below target and, more importantly, heightened difficulties that have emerged in H-P's crown jewel, the printing and imaging business.

With printing and imaging providing the bulk of H-P's profit, any weaknesses need to be shored up sooner rather than later. Still, the company has embarked on a plan that will sink margins in the intermediate term, marking a business unit that investors can't afford to ignore.

H-P's imaging and printing group grew sales 5% to $6.4 billion from last year's second quarter, but its operating profit fell 15% to $814 million. Hurd said late Tuesday that the company wants to lower prices on its hardware to increase demand for associated supplies, which carry higher margins. "It is the right thing to do for the long-term health of the business," he said.

As evidence that this strategy can be successful, Hurd cited expected share gains and improved demand for hardware units in the printing imaging group, up 12% from the same quarter last year, a growth rate that represents the highest year-over-year unit growth since the fourth quarter of 2003. Still, he said the expected uptake of the related supplies won't be seen for six to nine months. Supplies sales rose only 4% from the second quarter last year.

Further, the group's operating profit fell to 12.7% of sales from 15.4% in the first quarter and 15% in the same quarter a year ago. Hurd said the group is still running with a goal of hitting operating margins between 13% and 15%, but some analysts weren't so sure that remains realistic.

"We see no easy or even hard way out of the impending mess in printers," said analyst Charlie Wolf with Needham, in a research note to clients. "In the printer market, H-P faces two equally unattractive choices. The company can cut prices and margins on hardware sales to maintain market share. Or it can maintain hardware margins and face the loss of market share and, with it, sales of high-margin consumables."

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So far, the company seems willing to sacrifice margin on the hardware sales to maintain share, but executives were unwilling to say that this was a war of attrition. "We're not looking to tank the industry," said CFO Bob Wayman. "We don't think of this as a relentless price-cutting model in an attempt to get one more point of share by next week. That's not what we are after here."

Wayman also characterized the recent price cuts as not so much an attempt to undercut competitors such as

Lexmark

(LXK)

and

Dell

(DELL) - Get Report

but as a corrective measure. "What we did is get back in line to correct a mispositioning in the marketplace that occurred six months or so ago."

Nonetheless, the signs clearly point to a brutal printing and imaging environment heading into the all-important back half of the year. Needham's Wolf reduced his estimates for H-P through 2006 because of the reduced profitability in imaging and printing.

How this pricing environment plays out in the overall company's fundamentals will be clearer in the next six months, but the pressure has elevated for H-P's other business units to improve their profitability as printing and imaging struggles with its own margin compression.

For now, investors seem willing enough to give Hurd the benefit of the doubt, but the goodwill won't carry on indefinitely. Over the next few months, H-P's stock may get some fuel from announcements regarding the repatriation of foreign-based earnings -- an announcement is expected during the current quarter -- and a long-term plan from Hurd about his vision.

But if printers continue along a path toward commoditization, investors will rightly doubt the prospects for fundamental improvements at H-P.