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The Starting Line: Race to low end may trip printer makers

Cheaper printers may please consumers, but they irritate shareholders. Just ask Lexmark International.

    Cheaper printers may please consumers, but they irritate shareholders. Just ask Lexmark International.

    The printer company this week reported third-quarter earnings and sales that met or beat analyst estimates, yet its stock price has fallen more than 12 percent since Friday. The quarter may have been a relatively good one for Lexmark, but some analysts believe things are about to take a turn for the worse as the entire printer market slides into a price war waged before an indifferent consumer audience.

    "For the whole industry, it's been kind of like, 'Where's the bottom?'" said Larry Jamieson, senior consultant with Lyra Research, a market research firm for printing and imaging.

    To some extent, the downward trend's genesis traces back to Lexmark.

    The company in recent years has set out to carve a strong position for itself in low-end printers, and it's done just that. Lexmark improved its ties with PC manufacturers like Dell Computer, expanded into new products such as devices that combine fax or scanning capabilities with basic printing, and--despite heightened competition from Hewlett-Packard and others--protected and perhaps increased its market share.

    "They seem to be holding up pretty well," Jamieson said. But broader trends are hurting Lexmark.

    Hewlett-Packard's aggressive pricing is part of the problem. As HP has moved to regain its footing in the low-end arena, Lexmark has been quick to match it price for price. Lexmark's Z23 and HP's 656C can be had for $49 these days, if you include Lexmark's $30 rebate.

    Those price cuts coupled with a slow economy have hurt Lexmark.

    Many analysts thought the printer industry could withstand a slower economy because printer companies make their money on consumable supplies--inkjet cartridges and paper, for example. Even if people bought fewer printers, the supply sales were supposed to grow at the same rate they always had.

    They didn't.

    Printer unit sales are growing faster than cartridge demand, Lexmark executives told analysts. That seems to indicate that printer users simply aren't using up cartridges as fast as they used to.

    Lexmark's profits have taken a direct hit from lower-than-expected cartridge sales. The company's inventory has increased each of the past three quarters, to $577.9 million at the end of September, compared with $551.8 million in June and $488.1 million in March. More critical, Lexmark in the third quarter shed only about 40 percent of its "end of life" (read: obsolete) products; the company's original goal was to completely eliminate that inventory.

    Because of its inventory issues, Lexmark has to cut back on manufacturing until the excess product is sold, most likely at fire-sale prices. The company expects gross margins on supplies to fall in the fourth quarter because of lower production.

    Hardware sales aren't much brighter. Printer companies for years have used money-losing printers to draw new customers for supplies, but these losses may be a bit much: Third-quarter revenue from inkjet printer sales fell only 2 percent year over year, but gross margins plummeted, perhaps to as low as negative-20 percent, by at least one analyst's estimate.

    "The Lexmark (financial) model is stable, but it is not fully immune to economic weakness, which our models had, perhaps overzealously, assumed," Bernstein analyst Toni Sacconaghi wrote Tuesday. "Yesterday's results suggest there is some, albeit modest, cyclicality in the Lexmark supplies stream that we had not forecasted."

    The company blamed the economic slowdown for its problems. Many Wall Street analysts agree, and believe Lexmark's profit margins will improve.

    "We do not believe these represent normalized operations," said Gibboney Huske, an analyst with Credit Suisse First Boston.

    Hard copies less popular?
    Lyra Research's Jamieson believes there could be a more permanent shift at work.

    No one doubts that the recession is forcing consumers to be pickier about purchases in general. But there's also a change in the overall behavior of printer consumers, Jamieson said.

    Printers have become more durable, so they have a longer lifespan, Jamieson said. And although the overall amount of printing has increased, the average individual isn't printing as much as in the past, he added. The trend is particularly apparent among consumers in the niche targeted by Lexmark: the low-end market.

    "With the average low-end users, if they're printing 50 pages a month, that's a lot," Jamieson said. "To a great extent, people are doing stuff on the screen...The other thing is, people are getting used to e-mails, so they're not printing them out anymore."

    The printing industry has pinned much of its hopes on digital photography. Yet even that hasn't been as fruitful as printer companies had hoped, Jamieson said. "It turns out that people will look at lots of photos, but they won't print a lot of them," he said.

    Printer sellers may have to learn to live in a market in which growth is bound to slow, regardless of the economy. The market is becoming saturated with good printers that are getting cheaper all the time.

    Lexmark "faces some challenges in the near term," Deutsche Banc Alex Brown analysts George Elling and Sabrina Ricci wrote. "For example, the company indicated its concerns with lower price points, as well as reduced demand for both inkjets and laser printers."

    To a large extent, it's Lexmark's own fault. Lexmark was a pioneer in sub-$100 printers because it needed to carve a niche outside of Hewlett-Packard's printing juggernaut.

    "Lexmark was really the one who pushed new price/performance points that forced everyone else to follow suit," Jamieson said. "They aggressively went after it."

    Great for consumers. Painful for investors.