HP (NYSE:HPQ) could shift 20% to 30% of its notebook production out of China in response to rising tariffs, higher production costs, and American national security concerns, according to Nikkei Asian Review. The report claims that HP, the world's second-largest PC maker, could start building a new supply chain in Thailand or Taiwan later this year.

That decision isn't surprising, since other U.S. companies have shifted their production out of China as the trade war escalated, but could it cause issues for HP's PC business -- which generated anemic growth in the first half of the year?

HP's Envy laptop.

Image source: HP.

Understanding the main headwinds

HP generated 64% of its revenue from its personal systems business last quarter. That unit -- which produces desktops, notebooks, and workstations -- posted double-digit sales growth throughout 2018. Unfortunately, that growth hit a brick wall this year:

Personal Systems

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Q2 2019

YOY revenue growth

14%

12%

11%

2%

2%

YOY = year over year. Source: HP quarterly reports.

That slowdown was caused by longer upgrade cycles and Intel's (NASDAQ:INTC) ongoing shortage of CPUs. A strong dollar also throttled the unit's sales -- on a constant-currency basis, its first- and second-quarter revenues rose 3% and 5%, respectively.

HP generated 57% of its personal systems revenue from notebooks, 33% from desktops, and the rest from workstations and other products during the second quarter.

During the quarter, HP's personal system shipments fell 1% annually, with a 5% drop in notebooks offsetting its 6% growth in desktops. HP attributed its weak notebook shipments to soft demand from the consumer market, which offset the stronger sales of its security-oriented enterprise notebooks. Meanwhile, desktop shipments were buoyed by enterprise upgrades and stable demand for its OMEN gaming PCs.

A family takes a picture with a convertible HP laptop.

Image source: HP.

By category, HP's personal systems commercial revenue rose 7%, but its consumer revenue slid 9% -- mostly due to the anemic demand for its new notebooks. However, HP offset those shipment declines with higher prices -- which boosted the unit's total revenue 2% annually.

Will the unit's margins expand or contract?

Those higher prices, along with tighter cost controls, boosted the personal system unit's operating margin both sequentially and annually during the first quarter.

Personal Systems

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Operating margin

3.6%

3.8%

3.9%

3.8%

4.2%

Source: HP quarterly reports.

Those stable margins indicate that HP's personal systems unit can afford a slight bump in operating expenses as it shifts some of its notebook production out of China. Once it resumes normal production in Taiwan or Thailand, which are insulated from tariffs and the trade war, its gross and operating margins could expand again.

But expanding margins aren't guaranteed. Labor costs could be significantly higher in Taiwan and Thailand, which would nullify the benefits of lower tariffs. HP's ability to keep raising prices to offset its lower shipments could also be limited, since demand for new PCs remains soft.

On the bright side, component prices (especially for memory chips) are expected to remain low, and the resolution of Intel's chip shortage could revive consumer interest in higher-end notebooks. Therefore, investors should anticipate a short-term hit to HP's operating margin as it moves its supply chain, but that dip should be temporary.

What did HP tell us so far?

HP hasn't officially announced these plans yet. During last quarter's conference call, CFO Steve Fieler stated that management's guidance for 5% to 10% adjusted earnings growth "incorporated the impact" of previous tariff hikes but didn't account for any future hikes.

Fieler noted that HP could pull "a number of levers" to "mitigate the gross exposure from these tariffs" -- including the optimization of its manufacturing facilities, adjustments to pricing, and other strategies. CEO Dion Weisler didn't mention moving HP's supply chain out of China but stated that it would "continue to assess and respond to the situation and the potential impact to our business."

Is this the right move for HP?

Shifting the production of notebooks out of China could be a smart long-term move for HP. The company could incur some higher operating expenses by doing so, but it will also shield its slower-growth notebook business from surging tariffs or national security concerns from both the U.S. and China.