Understanding HP's Changing Profit Margins

A recent report developed by three industry leading firms (Photizo Group, gap intelligence, and Cypress Labs) sheds light on Hewlett-Packard Co.'s (HPQ) evolving hardware model for laser printer products. Laser printers have traditionally been key to HP's Imaging and Printing Group [IPG] divisions profitability. In turn, the IPG Division has been the key profit driver for HP's total profit pool. Understanding how hardware profit margins are changing for this key product segment is critical to understanding HP's current and future profitability.

The study clearly indicates three major trends impacting HP's hardware margins. They include:

1. Generation to generation prices are falling faster than costs driving reduced hardware margins;
2. "Entry" laser printers (printers costing less than $250 for mono lasers and $500 for color lasers) are significantly less profitable than workgroup laser printers; and,
3. Color laser printers also offer significantly reduced hardware margins relative to the traditional workgroup laser hardware margin model.

Perhaps most importantly, the report indicates that this change in HP's hardware margin structure has the potential to drive industry-wide margin declines as competitors lower prices in an attempt to create a competitive advantage versus HP.

Perhaps one of the most interesting findings is the significant disparity between 'workgroup' hardware margins and entry hardware margins. As the first graph shows, entry margins are actually negative for both color and monochrome lasers -- resulting in a hardware margin model that is very similar to the troublesome inkjet hardware model (money losing hardware with profits being driven by supplies).

Today, entry products represent the largest portion of the market and the market mix of low-end products is increasing. This is a global trend that is consistent across almost all vendors and market. This has significant implications for overall industry profitability.

Note that this margin represents the combined margin for HP and Canon (CAJ) (Canon makes HP's laser printer engines). As a result, HP's individual margins represent some portion of this total hardware margin picture.

The second graph shows how this model plays out against the industry as a whole (using Photizo Group's proprietary model). As the model shows, even though workgroup mono is only 36% of the total market revenue, it represents over 80% of the industry profitability.

So does this mean that HP is losing its edge in the market? Not at all. While HP's hardware margins are declining, many competitors are in worse positions. HP is able to leverage its dominant share position (greater than 50% in most laser markets) to drive significant economies of scale. As a result, even though HP must share margin with Canon, they still often have a 'margin' advantage.

So what's in store for the future? Expect more competition, and a continuation of the current declining margin trend. There are strategies for minimizing the margin erosion trend. The most successful vendors will not only be cognizant of the trends, but also will actively move to counter this trend. For the investment community, understanding the changes in hardware margins is absolutely key to crafting successful investment strategies and identifying the which companies will be winners, and which will be losers.