According to sources (Apple Insider and The Unofficial Apple Weblog), Hewlett-Packard has stopped buying iPods from Apple Computer because of a contract dispute. The analysis in the Apple community is summed up by TUAW’s comment that “HP iPods accounted for only 7% of the 4.58 million iPods sold last quarter. Might this have something to do with the fact that Apple doesn�t appear to be losing any sleep over HP�s lack of [iPods in] stock�?”

Apple’s in the wrong here, assuming that the reports are accurate, but HP’s the company making the wrong strategic moves in this situation, not Apple. Here’s why…

Think about these numbers for a minute. If indeed HP has accounted for 7% of Apple‘s 4.58 million iPod sales, we’d be talking about a mix of 20GB and 40GB units (the only two that HP‘s cobranded at this point). At HP Shopping.com these two units are priced at $299 and $399, respectively. Let’s assume that the sales were an even 50/50 split of models, so the average price of a unit is $350.

Seven percent of 4,580,000 is 320,600 units. At an average price of $350, we’re talking about a cool $112 million in gross sales revenue. Now let’s push this number around a bit more. Probably, Apple‘s selling HP these iPods at half their retail price (actually, probably a bit more than that, but let’s just run with this for a minute), or $175 unit. That means that Apple would be grossing sales of $56 million in the most recent quarter that we have numbers, within incurring any marketing or distribution costs because HP’s doing the sales, buying the coop ad space in PC Mall, Tiger Direct, and other sales sites, and of course HP (or more likely their outsourced distribution and warehousing partner UPS) is taking care of distribution. All Apple has to do is sign the contract and drop ship tens of thousands of units from its Asian facility directly to Hewlett-Packard. Not a bad deal for Apple, all in all.

Meanwhile, from the HP perspective, they’re getting a cut of an innovative market-leading product (probably while they ready their own entry in this crowed marketplace, but that’s another story) that lets them demonstrate, as I wrote about in What exactly does HP invent nowadays?, that they are inventing a new way of doing business, a way that doesn’t rely completely on in-house inventions. Almost makes up for the foolishness of saddling their printer division with the terminally ill PC division (see my article HP stumbles, saddles printer division with loser PC division for my thoughts on that subject).

The few million that they’re seeing in profit from the co-branded product (I’m shooting in the dark, guessing that they see about a 15% profit on the retail price) isn’t a huge revenue stream, of course, but it’s not chump change either. It’s still $16.8 million in the most recent quarter, which we can reasonably project to an annual budget credit of at least $75 million in profit (I’m assuming a slow but steady ramp up of sales throughout 2005. Actually adding the iPod Photo and joint-promoting it with the HP digital cameras could in fact double this figure if they craft the interface properly). Not so bad when HP’s overall cost of sales is incredibly low because there’s no development or research cost.

The essence of the situation is that apparently HP wants guarantees in its contract that if Apple drops the price on the iPod units within channels, that HP will also see a drop in the price of its units. Why Apple wouldn’t agree to this is beyond me, but for HP to stop selling units while “negotiating” the terms of this contract is nonsensical. It’s what my Mum would call ‘cutting off your nose to spite your face’ and it’s clearly backfiring.

Indeed, I would think that Hewlett-Packard is sick of bad publicity. It’s been a long time since they’ve had a real winner in the marketplace and even the cornerstone division of printers has seen increasing pressure from other, more nimble companies. Of course, HP doesn’t actually make their own printers – it’s all outsourced to manufacturing partners in the Pacific Rim – but it’s sure in their best interest to be selling lots of them!

As HP transitions to a “services” company, it will continue to learn that being aware of its market reputation and managing the buzz is vitally important. Companies that don’t feel HP is thinking clearly and strategically about its product line are companies that aren’t likely to hire them as service providers either.

At the end of the day, I believe that HP is absolutely correct in insisting that its channel price for iPod units, and especially the new iPod Photo, are tied to the actual market price of the units from Apple, but I also think that its decision to let its stock of HP iPods run out and then simply turn away customers is incredibly poor judgment. Every customer that turns to Apple for an iPod turns away from HP as a technology provider and the lifetime cost of that event might be much, much more than a temporarily shrunk profit margin on a single consumer electronics product.