Hewlett-Packard (NYSE: HPQ ) has fallen on hard times. A series of bad acquisitions, management turnover, a few bad quarters, and a dismal outlook for personal computers have resulted in a beaten down stock price -- less than 9x earnings. At today's prices, HP represents a solid value, driven in part by the value of HP's printing business. Printing is a cash cow, and according to my estimates, its milk accounts for 40% of the value of the company.
HP is No. 1 in the printing market with 42% market share, which is more than the next two competitors combined. HP uses a razor blade business model: printers are sold at low cost, encouraging frequent upgrades to a wide array of printers with non-standard ink cartridge or toner fittings. HP then generates a recurring stream of revenue from cartridge sales. The economics of HP's printing business are phenomenal. To put it in perspective, printer ink costs more than blood by volume and more than caviar by weight.
The high price of ink isn't an accident. HP creates thousands of printer and ink SKUs, which makes it nearly impossible for independent replacement-ink vendors to operate at a profitable scale compared to HP. Check out the number of HP printer SKUs refills offered at Staples (Nasdaq: SPLS ) -- and also notice that Staples doesn't even sell generic ink. HP's engineers purposely design cartridge holdings to be difficult to copy with "compatible" refills, even going so far as to manipulate the chemicals in the ink (i.e. if your generic refill doesn't have the right viscosity, it'll jam the printer). Consumer Reports has labeled generic refills as a false economy because they frequently don't work.
To maintain the ink-cash machine, HP spends $1 billion a year on ink research and development and holds 9,000 patents related to imaging and printing, 4,000 of them for consumable supplies such as ink and cartridges. "Typical ink development might have five PhD chemists working on it for several years and of course an army of technicians," says Nils Miller, an ink and media senior scientist for HP, "and that was just to develop it." HP will also sue to enforce patent rights.
Bears will point out that tablets from Apple (Nasdaq: APPL ) and Amazon (Nasdaq: AMZN ) have reduced the need to print out documents. That may be partially true; however, in my humble opinion, we're still decades away from a paperless world, and professional researchers seem to agree with me. IDC predicts the market for printers and ink will hold steady for at least the next five years.
The printing business generates revenue of $25 billion annually at a 15% operating margin (before unallocated corporate overhead). By comparison, Lexmark (NYSE: LXK ) generates 6.5% operating margins and trades at 8x earnings. After allocating corporate overhead and deducting taxes, my estimate of earnings power for the printing unit is $2.9 billion. A multiple of 10x, which is a reasonable premium to Lexmark, implies an enterprise value of $29 billion. In other words, the printing business alone is worth 40% of HP's total enterprise value of $71 billion.
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