Printers Lead HP Back From the Brink

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Last week, tech giant Hewlett-Packard (NYSE: HPQ  ) reported Q1 earnings. For the first time in a long time, the company posted better-than-expected adjusted EPS of $0.82, compared to an average analyst estimate of $0.71. Moreover, whereas the company was hit with multibillion dollar acquisition writedown charges in each of the previous two quarters, there were no unsettling surprises this time.

Part of HP's better Q1 performance was due to changes in the timing of when two major services contracts will end. HP had expected the contracts to end last quarter, but instead they will end during the second half of the year. This allowed the services business to earn a small profit, whereas many analysts were expecting a loss. However, an even more important driver of HP's performance was the printing division. The printing group was the only business unit (aside from financial services) to see a year-over-year earnings increase. Printing is the one business where HP has a clear leadership position, and the company seems poised to capitalize on its strength there to offset weakness elsewhere in the company.

Printing margin expansion
HP's printing revenue actually declined by around 5% from last year. However, earnings before taxes jumped 25% from $761 million to $953 million as operating margin increased to 16.1%. The revenue decline can largely be explained by HP's decision to cut down on sales of low-end consumer printers. HP loses a significant amount of money up front when selling these printers, and the proliferation of generic ink has made it harder for HP to sell enough ink to offset the initial loss. Exiting this business will thus improve profit despite reducing revenue.

In addition to this mix shift away from low-end consumer printers, HP benefited from two major company initiatives to boost margins. The first, "Ink Advantage" has reduced ink prices in emerging markets in order to boost HP's market share compared to generic ink providers. This is part of a broader shift away from the previous "razor/razor blades" business model toward a model where HP does not take an up-front loss selling each printer.

The second program, "Ink in the Office" aims to move small and medium-sized business customers from laser printers to high-quality, fast inkjets. HP relies on Canon (NYSE: CAJ  ) for laser technology, whereas inkjets use HP's IP. HP believes that shifting more businesses from laser printers to inkjets will improve the customer value proposition while boosting HP's margins. This strategy could put long-term pressure on Canon, which has benefited significantly over the years from its relationship with HP in laser printing.

Lastly, HP's printing margin probably benefited from the recent decline of the yen. In previous quarters, the strong yen drove down printing margins because HP had to pay more for laser components built by Canon in Japan. With the yen exchange rate now becoming a tailwind, HP could see further printing margin upside in future quarters.

Beginning a comeback
Meg Whitman's turnaround plan for HP still has a long way to go. However, last quarter was a good down payment on future improvements. The strength in printing is particularly comforting, as it will provide a strong base of profitability to fund investments elsewhere in HP.

The massive wave of mobile computing has done much to unseat the major players in the PC market, including venerable technology names like Hewlett-Packard. However, HP's rapidly shifting its strategy under the new leadership of CEO Meg Whitman. But does this make HP one of the least-appreciated turnaround stories on the market, or is this a minor blip on its road to irrelevance? The Motley Fool's technology analyst details exactly what investors need to know about HP in our new premium research report. Just click here now to get your copy today.

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Adam Levine-Weinberg

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry!

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