Lexmark can live without Compaq

For all the bombast from Hewlett-Packard and Compaq Computer about competing against the likes of IBM, stock market players on Tuesday decided that the biggest loser in an HP-Compaq merger wouldn't be a seller of PCs, servers or "big iron" hardware, nor a software peddler, nor a consulting and technology services provider.

Instead, Wall Street turned a collective glare upon the main rival for HP's most profitable division. Shares of printer maker Lexmark opened Tuesday's trading almost 12 percent below their previous close and finished the regular session down 9.4 percent on fears that the company would suffer from the defection of one of its leading customers.

If the HP-Compaq deal gains regulatory approval, HP, the No. 1 printer maker, is likely to end Compaq's dealings with Lexmark, the No. 2 printer company.

Fortunately for Lexmark, even a top-ranked customer doesn't amount to much of the overall sales slice. In fact, no single company generates a large portion of Lexmark's business.

Compaq and Lexmark in May 1998 announced a deal that called for Lexmark to build Compaq-branded printers. Although Lexmark now counts the Houston-based PC maker as one of its largest clients, it also builds printers for Samsung, Xerox, Fujitsu and Kodak, which sell them under their own names.

Such manufacturing deals generate less than 15 percent of Lexmark's total inkjet printer sales, estimates Marco Boer, consulting partner with IT Strategies.

But landing Compaq as a customer helped establish Lexmark's manufacturing reputation, said Jim Forrest, managing editor of Hard Copy Supplies, a printing-supplies trade journal published by market research firm Lyra Research.

"That was a feather in Lexmark's cap, signing that Compaq deal," Forrest said. "But I don't think (HP merging with Compaq) is going to hurt Lexmark a lot."

Analysts believe that a minor percentage of the printer company's total revenue comes from Compaq. For instance, Credit Suisse First Boston analyst Gibboney Huske predicts that Lexmark's Compaq-related revenue this year will be about $300 million, or about 7 percent of overall sales. UBS Warburg analyst Benjamin Reitzes sees Compaq accounting for about 5 percent of the Lexington, Ky.-based company's overall sales.

Lexmark itself suggested that Compaq is even less vital to business than analysts believe. Inkjet printer sales to Compaq generated less than 3 percent of overall revenue in the first half of this year, Lexmark said in a statement Tuesday. However, inkjet printer companies generally make the bulk of their profits not from printers themselves, but from related supplies such as cartridges and paper.

HP competitors equal Lexmark friends
Assuming the HP-Compaq merger is approved, earnings and revenue next year for Lexmark could be hurt as Compaq shifts its printers to HP's inkjet business.

"As all of (Lexmark's) earnings are driven by cartridge revenue, any earnings impact would be delayed for a year or two, but 2002 revenue could be reduced," Huske wrote in a research note. "We will adjust our model when the timing and specifics of the deal become clear."

But in the long run, whatever Compaq generates can be easily replaced by business from other PC sellers that bundle printers with their machines, analysts said.

"Over time, we believe that the HP-Compaq deal will only drive more additive partnerships to Lexmark as other PC makers (such as Dell) look to expand offerings to increase competitiveness," Reitzes said. "However, in the more immediate term, it seems there could be modest downside to 2002 earnings-per-share estimates as the Compaq situation sorts itself out."

Although the U.S. market might not be affected, a Hewlett-Packard engorged by Compaq becomes a more visible PC company around the world. In fact, HP's greater size with Compaq could convince the company's PC rivals overseas to be less enthusiastic about HP printers, analysts said.

"It puts Lexmark in that much better of a competitive position," Boer said. "There are enough other markets in the world where companies would love to bundle a lower-cost inkjet, and now those companies and Lexmark have mutual competition with HP-Compaq."

And government scrutiny of the merger might help the inkjet printer industry as a whole.

Hewlett-Packard has been waging a price war with other printer makers since Lexmark's introduction in recent years of printers cheaper than $100, and HP has gained share as a result. Figures from the second quarter indicate that HP boosted its share of the worldwide market for inkjets to 41 percent from 38 percent.

Now HP could ease on prices to avoid drawing antitrust accusations, CS First Boston' s Huske said.

"With the increased regulatory scrutiny associated with the acquisition and incremental market share gains, we expect HP to temper its aggressive inkjet pricing to some degree," Huske said.

"We continue to expect new low-end printers will be launched at existing price points, rather than break new pricing ground."