Can HP's Printer Biz Keep Printing Money?

A growing market and HP's relentless innovation should fend off rivals old and new

If Vyomesh Joshi, head of Hewlett-Packard Co.'s $20 billion printer business, is a man on the hot seat, he sure isn't sweating. On June 23, Dell Computer (DELL ) Corp. redoubled its year-old onslaught on the printer market by launching three new products, undercutting HP's pricing by at least 10%. But just days later, as Joshi soars across the sky in a five-seat corporate jet high above the beaches of San Diego, he is the picture of confidence. Clad in black slacks and a deep-blue dress shirt, he leans forward in his leather chair and looks incredulous that anyone could believe Dell is a threat to his business. "I'm very confident in our situation," he says, waving his arms to punctuate the point. "Innovation is still important in this business."

There are abundant reasons for his self-assurance. With nearly 40% of the worldwide market, HP's printer business has singlehandedly carried the computing behemoth through several tumultuous years. Dubbed the company's "crown jewel" by CEO Carleton S. Fiorina, Joshi's division chipped in 28% of HP's $72 billion in sales in 2002 and 105% of its $3.1 billion in operating profits -- other units lost money. The cash cow stabilized HP's passage through the tech downturn, not to mention last year's controversial acquisition of Compaq Computer Corp. "It has been everything for HP over the last two years," says Bear, Stearns & Co. analyst Andrew J. Neff.

Can Joshi keep printing money? The odds are in his favor. HP is investing heavily in innovative printers and inks and should be able to stay ahead of rivals. And the market continues to show robust growth, especially in lucrative niches such as digital photography.

Still, HP's printer business is facing a growing number of obstacles. Dell began rolling out lower-priced printers last September and vows eventually to apply the margin-busting business model that worked so well in PCs to the printer biz. At the same time, growth trends are moving away from HP strongholds, such as black-and-white laser printers, where HP claims 70% of the market. Instead, consumers and businesses are buying more color printers and all-in-one devices that can print, fax, scan, and copy -- markets where HP faces tougher competition from Canon (AJ ), Lexmark, and Xerox (XRX ).

Meanwhile, long-term hurdles are cropping up in HP's lucrative ink business. Customers typically spend twice as much on ink cartridges and toner than on the actual printer over the life of the product. At HP, inkjet supplies carry 35% profit margins and generated $2.2 billion in operating profits last year -- over 70% of the company's total. But buyers and legislators are beginning to revolt, distressed at the cost and environmental impact of zillions of discarded ink cartridges. The European Parliament passed a bill late last year that could force manufacturers such as HP and Lexmark to eliminate by 2006 chips in their ink cartridges that sometimes hinder customers from refilling and reusing the cartridges. Says former HP printing exec and now Quantum Corp. CEO Rick Belluzzo: "Animosity can build up when people think you have a lock on them that's leading to increased pricing."

Despite the challenges, Joshi is weaving an ambitious plan that he believes will keep the printer unit ahead. Leveraging the $1 billion HP spends annually on printer research and development (more than double Dell's total R&D budget), HP will deluge the printer market this fall with 100 new products, from higher-speed inkjet printers to better-performing all-in-one units. At the same time, Joshi is going after new growth opportunities, such as the digital-printing-press market, which it entered through its 2002 acquisition of Indigo. HP also is ramping up a 400-person printing-and-imaging consulting team that helps companies efficiently manage documents across an organization and lower printing costs.

All told, HP expects its printing business to maintain double-digit growth in profits and revenues this year. "Out of the trillions of pages printed every year, only 4% go through HP devices," says Joshi. "The other 96% is our opportunity." Some analysts agree: Sanford C. Bernstein & Co. estimates that Joshi will be near his targets this year, with printer sales up 10%, to $22.4 billion, and operating profits up 9%, to $3.6 billion.

Joshi's plan is pivotal to HP's ongoing success. So far, the company has surprised many with how well it has integrated Compaq over the past 14 months. The merger has resulted in $3.5 billion in annual cost savings. Second-quarter 2003 profits of $659 million more than doubled the sum of HP and Compaq's year-ago profits. And shares have jumped 46% in the past year, to $21. But as Fiorina now endeavors to prove that the combined company can get growth revved up, she will need the printer cash cow as much as ever.

Joshi, a 23-year veteran of HP's printing business, has clearly sparked the organization since he took the helm two years ago. He exudes both enthusiasm and humility. When the 48-year-old native of India landed a job at HP in San Diego out of college, he had only $200 and a TV to his name -- and had to rent an apartment across the street from work because he couldn't afford a car. Now, on a sweltering June afternoon the diminutive Joshi strides through the printer unit's Corvallis (Ore.) offices and throws his arm around managers. As staffers brief him, he fires off questions, doles out advice, and rarely lets one of them go without exchanging a high five.

Joshi has plenty of reason to smile. For starters, HP is the dominant player in an industry that is riding lucrative trends. Despite the digitization of information, people continue to print more and more pages. Market researcher IDC predicts that the number of pages printed will continue to climb at least 6% annually, to 1.8 trillion by 2006.

Ink consumption is growing even faster. With digital cameras surpassing traditional cameras in sales earlier this year, printers have emerged as the film developers of the 21st century. Color prints, which are about four times more expensive than black-and-white, are expected to jump to 30% of office printouts by 2007, up from 10% today, according to Gartner Dataquest. This bodes well for HP, whose market share for U.S. ink supplies has grown from 51% to 56% in the past three years.

Beyond ripe market conditions, HP is in a strong position to stave off competitors such as Dell. The PC market is based on standardized components -- Intel's chips, Microsoft's software -- so manufacturing efficiency, Dell's real strength, is of paramount importance. But innovation in the printer industry is widely dispersed and closely held among various competitors. So Dell, which sells printers made by Lexmark International (LXK ) Inc., can't turn the printer market on its head unless it owns and improves its own technology. And that seems unlikely. Printer makers, including HP, typically pour 5% to 6% of revenues into R&D, vs. the 1% to 2% invested by Dell. "Printer technology isn't standardized enough to make it work in Dell's favor," says analyst Steve Baker of market researcher NDP Group.

Dell concedes that it will take several years to penetrate the printer market, but execs such as No. 2 Kevin Rollins say they expect to have a "market-changing" impact eventually. "We know a lot about customer satisfaction and how to deliver quality products at competitive prices," says a Dell spokesman.

HP also has been moving quickly to meet shifting tastes among printer buyers. Xerox and Canon have trounced HP in the highest-performance, all-in-one printer market -- HP has only 1% of the market for machines over $2,000. But elsewhere HP has adapted and innovated. It claims 52% of the market for lower-end, all-in-one inkjet machines. Over the next two years, the lower-end market is expected to soar 113%, to $2.5 billion, while the high-end market is projected to grow 31%, to $10.2 billion, according to Gartner Dataquest.

HP's biggest long-term worry is the little-understood threat to its ink business. While the European Parliament's actions present little imminent danger, it's a symptom of rising dissatisfaction with the cost and environmental impact of supplies. Already that discord is surfacing in the fast-growing cottage industry of refilling and reselling ink cartridges. Lyra Research Inc. predicts the aftermarket will grow to 30% of the $15 billion U.S. market for toner and cartridges in 2006, up from 21% this year. That will put pressure on HP's profits in the years ahead. "The writing's on the wall," says Meta Group (METG ) Inc. analyst Steve Kleynhans. "The current model of printer supplies won't continue beyond a couple more years."

Joshi is carefully hedging HP's bets. On one hand, the company is delivering some products that let customers replace only ink, not the entire cartridge, when it runs out. On the other, he's betting that ink presents an opportunity for innovation. HP has dozens of chemists on staff who study the effects of ozone and pollutants on ink molecules. For its high-end photo-printing products, HP is promising images won't fade for 73 years. That, it claims, is more than double the image permanence of traditional photos and 10 times that of prints from rivals Dell and Lexmark. "They don't have this kind of investment," says Joshi.

Meanwhile, Joshi & Co. are branching into new businesses, such as Indigo's digital publishing. While these refrigerator-size digital-printing presses generated only $200 million for HP in 2002, Joshi expects Indigo to contribute $1 billion by 2006.

That's the kind of innovation Joshi and HP are banking on to keep their printer business second to none. Rivals may be eyeing the lucrative market, but Joshi is still flying high.

By Ben Elgin in Corvallis, Ore.

    Before it's here, it's on the Bloomberg Terminal.