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HP, a day after earnings

Hewlett-Packard is taking its lumps and making changes after its disappointing third-quarter earnings report.

For Hewlett-Packard, the third quarter was a Pyrrhic victory.

The computer giant won in the fight to protect its PC and printer revenue, and market share during the quarter, but lost on profits.

While PC unit shipments grew by 16 percent year over year and printing and imaging revenue increased by 10 percent year over year, lower profits on PCs and printers during the quarter forced HP to miss analysts' expectations for profit in the third-quarter, ended July 31, by 3 cents a share.

Though analysts had predicted a difficult quarter for HP, they found HP's missteps in the PC market the most troubling.

HP launched an aggressive new PC pricing strategy during the quarter, offering desktop PCs at prices as low as $349. The move, designed to crush competitor Dell, backfired when component prices failed to decline as quickly as HP expected during the quarter.

HP Chief Executive Officer Carly Fiorina said that in retrospect the company pushed too hard on prices. As a result, HP's Personal Systems Group swung from a $21 million gain during HP's second quarter to a $56 million loss during its third quarter.

"We took prices a little further than we needed to, particularly in relation to component prices, which did not decline as rapidly as anticipated," Fiorina said on Tuesday.

Although HP has moved quickly to cut costs and reduce its PC prices since its merger with Compaq Computer and even increased unit shipments during the second calendar quarter, PCs continue to test the company, analysts said on Wednesday. Although HP has moved quickly to cut costs since its merger with Compaq Computer, by increasing its ability to compete on price with Dell and even increasing unit shipments during the second calendar quarter, PCs continue to test the company, analysts said on Wednesday.

Several analysts suggested in Wednesday reports that HP should make changes to strengthen its PC business, including shifting more emphasis to direct sales, in an effort to balance the company's goals of maintaining profitability and gaining market share.

"We believe PC profitability suffered from miscues in desktops, validating Dell's direct-model advantage," UBS analyst Benjamin Reitzes wrote in a report. "HP must manage its own prices--but more importantly--its own channel transition, more effectively," Reitzes wrote.

Dell offered some special promotions, but did not directly follow HP's lower pricing during the second quarter. On Wednesday, however, the PC maker announced price cuts of as much as 22 percent on various products, dropping the price on some Optiplex business desktop PCs by $50, for example.

To ensure a fourth-quarter profit, analysts said HP would need to make some changes.

"If HP does not aggressively shift its business toward the direct channel, Dell's competitive advantage will remain intact, and HP could face the unenviable choice between market share or profit losses going forward," Bill Shope, an analyst with J.P. Morgan Securities, wrote in a Wednesday report.

An HP representative responded by saying that HP prefers to allow customers to determine how they purchase PCs from HP.

The company, which positioned the Personal Systems Group loss as an anomaly caused mainly by seasonal sales trends and aggressive pricing, has begun corrective action by increasing the prices of some models, the representative said, but did not provide details.

The company also said it expects its PC group to turn a profit during the fourth quarter and for its fiscal year.

HP on Wednesday appeared to have begun adjusting some PC prices and configurations.

The company changed PC configurations advertised on its HPshopping.com Web site. Where HPshopping once touted the Pavilion a210e for $349, the desktop now lists at a starting price of $439 on the site. HP arrived at the higher price by adding a CD burner and floppy drive to the PC's standard configuration, as shown on the site.

Technically, the changes do not represent price increases, as customers can still reach the lower price by swapping out components such as the CD burner. But HP can carve out additional profits by selectively adding components, which boost its selling prices, analysts said.

HP today; tomorrow the industry?
PC component cost changes will force all PC manufacturers to make some adjustments, but few are expected to raise their prices across the board.

Manufactures may tackle the trend by changing their current model configurations or by coming out with more expensive models, which they will tout as offering better features.

"Given the way the market works, I don't think anyone ever has to increase prices," said Steve Baker, analyst with NPD Techworld. "What you have to do is revisit PC model configurations."

PC makers can compensate for DRAM increases, for example, by shifting to smaller memory allotments or delaying the move to a faster processor.

If component prices skyrocket--something that is unlikely to happen--some manufacturers may back off the lowest-priced PC, including the $349 to $399 desktops and the $799 to $899 notebooks.

"You might see more emphasis on $499 and $599 (desktops)--places where there's a little more of a cushion," Baker said.

Notebooks, HP Personal Systems Group's ace in the hole, are also unlikely to be immune to components' price trends.

HP and others are likely seeing the same component price pressures on notebooks as on desktops, Baker said. If that trend continues notebooks priced at $799 and below may become rarer.

Adding features such as 17-inch screens also works to shift customers to higher-priced notebooks, Baker said.

"A lot of it comes down to value for the price. People are not dumb. If they're going to get the best deal at $799, they're going to go for that price," Baker said.