Photo books are replacing 4x6 prints as the most important products in the printing business. Photo: Shutterfly.

Photo site offers lens into the post-print world.

At lunch on a recent afternoon in Silicon Valley, Shutterfly CEO Jeffrey Housenbold is remarkably upbeat, considering the miserable year the overall photo business is having.

Almost any way you slice it, people are making fewer glossy prints in a rough economy. The numbers are off for at-home printing (down 2%), photo-counter printing (down 6%) and kiosk printing (down 12%), according to the Photo Marketing Association. The only big growth category? The under-the-table printing that people do for free at work. (That’s up 42%.)

Fortunately for Housenbold the photo recession hasn’t hit online photo finishers like Shutterfly (SFLY) as hard as some other parts of the industry. In fact, Shutterfly and rivals like Eastman Kodak’s (EK) Kodak Gallery and Hewlett-Packard’s (HPQ) Snapfish are still growing – partly because they’ve embraced ideas like photo books, social networks and smartphones to push their business beyond the old-fashioned glossy print.

The expansion beyond prints isn’t new, but it’s accelerating.

Though photo sites have offered items like custom books, and stationery for nearly a decade, those items have recently become a major driver of sales. A few years ago, Shutterfly got 80% of its revenue selling prints. Last year it was just 39%.

“The 4×6 print has evolved,” Housenbold says. “Now it’s a photo book.”

Say goodbye to that box of unsorted photos

It should come as no surprise that 4×6 prints aren’t exciting anymore. They’re commodities that sites often sell for little or no profit in hopes of attracting new customers. Plus, though they have long been a mainstay of family photo albums and shoeboxes, loose prints are a pain to manage and store; bound photo books are far easier to handle, and far more profitable.

CEO Jeffrey Housenbold is looking for ways to hook new customers, and make it easier for existing customers to buy. Photo: Shutterfly.

That sea change is critically important for Redwood City-based Shutterfly. Unlike some of its rivals, which are subsidiaries of large companies with healthy war chests, Shutterfly is a standalone public company. If its business depended on simply selling 4×6 prints cheaper than the competition, it wouldn’t stand a chance.

As more complicated items like photo books gain popularity, Housenbold and his team are under pressure to dream up new ways to attract customers and entice them to spend more money – a challenge that the former eBay executive relishes.

One way to do that is to make photo books less intimidating. Surveys show that most people who start making one abandon the process before it’s printed – a simpler process could be worth millions in added sales.

With that in mind, Housenbold challenged his engineers to invent a way for consumers to make a photo book in less than 5 minutes for less than $15. They came up with Simple Path, a service that automatically lays out digital photos on photo book templates, saving customers the hassle of organizing a book themselves.

It’s an approach that analysts applaud. “The core consumer is likely to be a time-starved mom who may even get a guilty conscience about not printing,” says Liz Cutting, imaging analyst at NPD Group. “If you can make it easy, you will be her savior.”

Web-only albums?

Housenbold is also chasing customers who might not want to print at all – at least, not yet. In this age of cell phone cameras and social networks, there are more and more of those: The percentage of camera owners who don’t bother printing rose from 19% in 2007 to 24% last year, Cutting says. (NPD is readying this year’s survey, and she wouldn’t be surprised to see the percentage of non-printers rise again.)

To hook those customers, Shutterfly has embraced social networking. New closed groups on the site allow people to share photos with a specific circle of acquaintances – say, a Little League team or an elementary school class – rather than share everything with everyone. Housenbold says the feature is proving to be an effective way to attract customers who might otherwise use a competitor’s service.

Housenbold has some other plans to attract younger users who are likely to avoid printing and simply upload their photos to Facebook. He says Shutterfly will soon experiment with simple gifts young people can send each other in the mail, and might even dive into the market for “virtual goods” – digital items that people can buy and exchange in social networks.

But in the short term, he’s focused on the last three months of the year, Shutterfly’s make-or-break season. Not only does Shutterfly do more than half of its annual sales in the fourth quarter, it does more than a third in the three weeks after Thanksgiving, as people use the service for holiday cards and photo book gifts.

Lately Housenbold seems to be feeling optimistic. The last time Shutterfly reported earnings, he said to expect full-year sales of between $205 million and $220 million, a sunnier outlook than he gave three months earlier. Can he hit those numbers? We’ll see – but the photo industry could certainly use the good news.

HP Executive Vice President Vyomesh Joshi isn't as close to Hurd as colleagues Livermore and Bradley are. Photo: HP.

If HP CEO Mark Hurd does merge the PC and printing businesses, what will that mean for printing chief Vyomesh Joshi?

A few months back, I spent some time at Hewlett-Packard (HPQ) headquarters with Joshi, who’s known around HP simply as “VJ.” We talked about how he led the printing group to become a sales and profit powerhouse, the how the slowdown in printer sales growth is unfolding, and how he’s trying to get things going again. And we talked about how he’s doing under Hurd, an unsentimental numbers guy who hasn’t been shy about saying the printing business needs to shape up.

For example, Hurd arrived at the company in 2005 and quickly identified large corporations as a growth area for the printing business. Hurd told Joshi that his printing executives didn’t have the right experience to win corporate customers, and brought in new talent including sales exec Bruce Dahlgren. That wasn’t an easy experience, Joshi said, but HP culture has enough humility to admit when it’s time for outside help.

Hurd has also pushed the printing unit to cut costs from profitable but slow-growth product lines like single-function printers, and invest the savings in promising areas like multi-function printers, commercial printing, and managed print services. Again, Joshi said it wasn’t easy to cut some of the businesses he had helped to build, especially when they were still profitable. But he insisted that Hurd’s approach makes sense.

So I wasn’t exactly shocked earlier this week when the Wall Street Journal reported that Hurd might merge HP’s PC and printing units into one giant entity – a move that would almost certainly put PC division chief Todd Bradley in charge of the combined operation, and leave Joshi’s future up in the air. It’s not that Joshi and Hurd don’t get along – the two clearly respect each other’s talents. But Hurd doesn’t have the same kind of rapport with Joshi that that he has with Bradley and enterprise chief Ann Livermore. And it doesn’t help that Joshi’s business has been going through a tough time over the past few years while the enterprise and PC units have improved.

If Hurd does merge PCs and printing, there would be some precedent. He has already folded outsourcing unit EDS into the enterprise technology group run by Ann Livermore, giving her dominion over a portfolio that includes servers, software and services – a staggering 47% of HP’s revenue.

Similarly, putting printing and PCs under one executive could simplify some things. Just as Livermore is the go-to person for corporate relationships, the PC and printer executive would manage retail, small business and consumer; under the current structure, the PC and printer units have sometimes jockeyed for control of the overall consumer strategy and retail approach. It could also yield some financial benefits; analyst Doug Reid at Thomas Weisel Partners estimates that combining the units could boost operating margins by up to 60 basis points by fiscal 2012.

Whatever happens, Joshi will be fine. He has spent nearly 30 years with HP (his big anniversary is next summer, I believe), including nine as a top executive. He serves on the board of Yahoo (YHOO). Perhaps most important, he’s not only loved inside HP, he’s loved among executive recruiters as well. If Joshi does leave HP in a management shuffle, and a high-profile Silicon Valley CEO job opens up, there’s a good chance he’ll be on the short list. (AAPL) (DELL)

The Interact S605, Lexmark's new high-end home office inkjet, comes with a touchscreen. Image: Lexmark

In this era of Kindle books, text messages and Facebook photos, printed information is taking it on the chin – and perhaps no company has been hit harder than Lexmark. The Kentucky-based printer company is one of the worst performing stocks in the hardware sector this year, down about 30%.

But Lexmark (LXK) CEO Paul Curlander hopes a new line of printers will help him climb off the canvas.

The eight new machines for small and medium-sized businesses, which Lexmark is launching today, sport eco-friendly features designed to conserve paper and ink. Some have touchscreens. And they should get more attention than usual, thanks to expanded distribution deals Lexmark signed earlier this year with retailers like Staples (SPLS), Office Depot (ODP) and OfficeMax (OMX).

“We’re trying to make inkjet a bigger piece of the business market,” Curlander tells Fortune. “We want to move down from the enterprise space into small and medium business, and get device prices down into the $199 to $399 range.”

Even with these fresh products, Curlander is in for a bruising battle. Last year Lexmark’s nemesis, printing giant Hewlett-Packard (HPQ), shipped about six times more inkjet printers, and nine times more laser printers.

Under the unique economics of the printing business, that size difference can be particularly significant. Companies like HP and Lexmark often sell printers at a loss, expecting to make profits later from sales of ink and toner.

So Lexmark’s market share disadvantage hurts more than just its pride; lower volumes make it tougher for the company to keep costs low on money-losing hardware, and to later milk those customers for profitable ink sales.

In part because of those economics, Lexmark’s business has suffered over the past few years. Sales shrank from $5.1 billion in 2006 to $4.5 billion in 2008, and its share has continued to slip this year; industry leader HP’s sales rose from $26.8 billion to $29.4 billion over a similar period.

Now Lexmark has a comeback strategy that’s focused not on the low-end consumer market but on businesses, who are likely to buy color laser printers and multi-function inkjets that fax and copy as well as print. Those customers, the thinking goes, are more likely to bring in healthy ink sales down the road.

Most on Wall Street are not convinced that Lexmark's strategy will work. Bank of America has an underperform rating on the stock, saying it’s too soon to tell whether Lexmark’s strategy has legs. Deutsche Bank has a hold, saying it’s skeptical that Lexmark can grab market share without simply slashing prices.

Still, Curlander sounds upbeat. The company has survived thus far by cutting expenses in proportion to declining revenues, and it has held on to niche customers like pharmacies and bank branches, where its printers are popular.

Now Curlander is talking up Lexmark's push into managed print services, industry lingo for consulting on how businesses can get their printing done with less waste and less money.

He waves off the observation that Lexmark isn't alone on the services bandwagon; HP and Xerox (XRX) are saying many of the same things about helping customers print less. "We're actually doing it," he says. "I'm not convinced they are."

One of the things Lexmark does have going for it, ironically, is that investors have punished the stock rather mercilessly of late  – enough that a few investors are banking on a rebound. Among the Lexmark bulls is respected Bernstein Research analyst A.M. Sacconaghi, who has an outperform rating on the stock.

His bullish case: Lexmark's sales have actually held up pretty well considering the overall doldrums in the printing market, which Sacconaghi believes are due more to the battered global economy than to an Internet-fueled decline in printing.

Lexmark’s failure to hedge against currency fluctuations makes its cash flows look worse than they are. Its laser business is healthy. And in early August, Lexmark stock was at $16.70 – so cheap that investors were valuing its still-sizable inkjet business at basically zero.

Others might be starting to come around on Lexmark; the stock is up 13% since Sacconaghi made that case in a note last month. Even so, Sacconaghi has a lofty price target of $25 on the stock – which means if Curlander wants to prove his supporters right, these new printers had better be good. (AMZN)

Jon Fortt talks to Kenworth about a practical use for cloud computing.

HP printer sales are dropping, but high-profit ink sales remain strong. Image: HP

Where's the most expensive popcorn in the universe? At the movie theater, of course. Theaters know you'll pay because you're a captive audience. That explains how Hewlett-Packard (HPQ) made so much money from ink sales last quarter, even though printer sales are slipping: by raising ink prices.

HP printer owners, after all, are themselves a captive audience; they'll probably pay a little more for ink rather than ceasing to print altogether, or shelling out cash for a whole new printer. Partly because of their willingness to play along, HP offset printer sales that dropped 8% last quarter by boosting its extra-profitable ink sales by 9% over a year ago. (Not all of the increase came from higher ink prices, of course – but it sure helped.)

The ink maneuver is really about more than ink. It also helps us understand how HP CEO Mark Hurd managed to produce pretty good numbers on Monday for the quarter that ended Oct. 31, and why he is comfortable promising Wall Street more of the same in a chaotic economy. HP announced profits of $2.7 billion on sales of $33.6 billion, a 19% increase over last year thanks to the purchase of EDS; next year the company projects sales of $127.5 billion to $130 billion, a big jump over 2008 because of the EDS revenue. Because HP has so many employees and such a broad portfolio of products and services, Hurd has a lot of levers he can pull to hit its profit targets, even in times like these.

Besides the ink price lever, there are others: Cut travel. Postpone hiring. Mandate time off. And there are riskier moves that are also effective, like postponing PC price cuts. (HP plans to do all of these in the coming weeks, with caution.)

In a sense, this is the sort of environment where Hurd, a detail-oriented efficiency nut, seems most in his element. In the nearly four years since he took the reins at HP, he has worked the company over like a drill sergeant, trying to get operations as predictable as possible.

One can't predict the future, of course, but one can prepare for scenarios. Hurd expects his executives to tell him how they'll manage to hit their numbers if memory prices jump so high, or if corporate technology spending slows a given amount, or if printer sales take a dive. Perhaps the printer division will tighten its belt more than usual this quarter to deliver profit, and next quarter will be the PC division's turn. The trick is to know the business so well that you can avoid squeezing any division too hard for too long.

"We are more confident in the bottom line than we are in the top line," Hurd said when answering an analyst's question about the future. In other words, we can't control how much customers buy, but we can control how much we spend.

Time will tell whether Hurd's plan will work as well in practice as it does on paper; somehow recessions tend to befuddle even the most brilliant business minds. But one must admire the profit-making flexibility that HP's diverse business affords it. In this way it's different from Dell (DELL), which mostly sells business hardware; or Cisco (CSCO), which sells enterprise Internet equipment. Even Apple (AAPL) and IBM (IBM), despite their broad variety of products and services, don't match HP; Apple focuses on consumers and IBM on businesses, while HP manages both.

But HP investors should be warned: no business is completely recession proof, and the best-laid plans go astray. Movie popcorn may be profitable, but if prices get too high – or if times get too tough – eventually, customers just stay home. (MSFT)

When is great not good enough? When you're Hewlett-Packard's printing group.

A few years ago, the $28 billion business, headed by veteran Vyomesh Joshi, was the goose that kept laying golden eggs. It supplied most of the company's profit while the PC group lost money and the corporate technology group struggled. Now new leadership and smart acquisitions have fixed the PC and corporate businesses, and printer sales are showing signs of weakness.

Though the printers and ink have so far pulled in a healthy $2.4 billion in profit this year for HP (HPQ), the growth rate is slowing. To cut costs, Joshi last week announced a reorganization that trims the printer group from five divisions to three. The consumer hardware and ink businesses will be collapsed into one unit, laser printers and other enterprise operations will be collapsed into another, and graphics will be the last.

But while HP's printing shakeup may keep profits healthy for now, it won't bring new money in the door. The only quick way to do that would be to reverse a troublesome trend: Consumers, who make up the bulk of HP printer sales, are no longer bingeing on ink. HP had hoped that its advances in its printer technology would inspire more folks to avoid professional photo finishers, but that hasn't really happened. And since HP is already the biggest company in inkjet printers, it can't grow much by simply stealing customers from rivals.

In a twisted way, HP brought this on itself. A big part of the reason why the printing group is seen as troubled now is that investors have high expectations after it delivered reliable sales growth for so many years. Especially in the last decade, as home PCs became as common as televisions, HP played a big role in establishing the printer as a must-have accessory for producing everyday fare like book reports, letters and photos. Now it's easy to see that printing isn't as necessary to the PC experience as it used to be, with online social networks like Facebook and MySpace based largely on sharing information electronically, not printing it. But as printing sales growth slows, investors still expect the division to make up for it somehow.

For growth, HP is looking to markets like large businesses and commercial print shops, where rivals like Xerox (XRX) have more experience. (See HP's printer challenge.) The good news about those: they print a lot. The bad news: it won’t be as easy for HP to turn big profits. So to fund those efforts, HP is mercilessly cutting costs from its older, slower-growth printer businesses. Joshi has already jettisoned the digital camera business and outsourced much of manufacturing for black and white laser printers, and he's still looking for more cost savings.

All of which makes sense – but is HP cutting too much, too fast? Under CEO Mark Hurd, the business groups have adopted a disciplined approach to innovation where each group funds tomorrow's hit by cutting costs out of yesterday's – a tactic few investors would argue with. But the downside is, innovation can't be plugged into a spreadsheet, or put on a schedule. Just look at Apple's (AAPL) computer business – it achieved only anemic growth for years, until a boost from the iPod, retail stores, and a switch to Intel (INTC) chips recently put the shine back on the brand, but Apple continued to invest in it.

So far, analysts say there's no indication that HP is slicing too far. Which is good – because I've heard you want to be careful with a golden goose.

Xerox technology chief Sophie Vandebroek is placing bets on technologies to spur growth. Image: Xerox

Xerox (XRX) PARC has come a long way. A generation ago, the Palo Alto Research Center famously developed many of the technologies that led to modern PCs from folks like Apple (AAPL) and Dell (DELL), but never got them beyond the lab. Today the unit is determined to get its inventions out of the lab, even if it means sacrificing secrecy.

To underscore that point, the company's normally secretive Silicon Valley researchers and their colleagues from around the world held an open house this week to show off surprising projects they're developing. Among them: A blood scanner that uses a twist on laser printing technology to spot rogue cells, a type of paper that can be erased by ultraviolet light and reused, and a new hybrid plastic that's partly made of corn and grass.

I sat down with Chief Technology Officer Sophie Vandebroek after the demonstrations to talk about how she manages the tough trade-offs in Xerox's technology development –- building versus buying, managing risk and partnering up with other companies. Here's as edited transcript of our conversation.

Companies that I've talked to in Silicon Valley are all talking about "technology transfer" — how to get ideas out of the lab and into products. A lot of it seems to come down to minimizing the risk associated with spending R&D dollars, making sure they don't go to waste.

If you do research, in the explore phase, they won't all become commercial successes.

Right, right, by nature. So PARC is now doing more consulting work, and that's kind of a risk hedge — you know you're going to get paid for that. Why is that model better than the models that a lot of other folks are adopting, and how can you be sure you're taking big enough risks to get a big payoff down the road?

When a project doesn't have risk, I don't want to do it in research. It goes into the business groups directly. A corporation has research centers to make sure that we do the most risky projects. Whether it's the smart document technologies, or some of the clean tech opportunities, or even reusable paper, if they succeed there's potentially a great reward. So there's a portfolio of smaller projects that are high risk, but also high return if they're really successful. So on a yearly basis, and sometimes even faster if we have breakthroughs, we will grow some of these projects into what we call incubation programs. We scale them up as much as ten times, to make sure that we invest enough.

But often the really big, game-changing research projects don't fit well into a formula, because either they don't fit into an existing business that you have.

Yeah, that's more challenging.

So I imagine a big part of your job, in positioning Xerox to be successful in the next decade, is making sure there's a good chance that you've got one or two of those. What do you do with those projects that might be a threat to the way the organization runs today?

There are those projects. What we do then is we find an open innovation partner. We have to go to market either with a partner, or do what PARC has done several times and incubate a new company. We can also look for a startup, where we can contribute some of our intellectual property to that startup in return for equity in the company.

If you're going to radically grow your business, it's going to come either from risky projects or acquisitions. So are you more involved in the merger and acquisition process now than a CTO might have been five years ago?

I would say for sure. Definitely.

Why is that important?

I'm involved in two different ways. One way is, we see this company, it looks really great, can you assess the technology? Just kind of asking my advice. Hand in hand with that would be looking at our research and saying, OK, which partners are still missing? So what do we recommend to the business teams either as partners in the go-to-market solution, or are there some technology elements we might be interested in acquiring so we can do something disruptive? We're always scoping out the technology landscape to see what other smaller companies are doing that could make them acquisition targets, and what are large companies doing that could make them partners.

As sales growth slows, the focus shifts to services

HP Executive Vice President Vyomesh Joshi wants to use software and services to drive printing profits. Courtesy: HP

Even during the bad times, Vyomesh Joshi’s printing business at Hewlett-Packard (HPQ) was the go-to place for good news. As recently as 18 months ago, the affable executive vice president’s unit accounted for more than half of the overall company’s operating profits.

But things have changed since HP’s dramatic turnaround took hold. HP’s computing group grew profits 75 percent in the October quarter by stealing market share from Dell (DELL) and riding the popularity of laptop computers. Meanwhile the Technology Solutions Group, which sells servers and other tech plumbing to big companies, is doing well too – last quarter operating profit jumped 31 percent to $1.4 billion. “Because of our footprint, because of our global nature, we are what we talked about in the fourth-quarter call,” Joshi says. “We are meeting our expectations.”

Which means Joshi's Imaging and Printing Group no longer needs to prop up the rest of HP. It’s a good thing, too – because Joshi has his own transformation to worry about.

Why a transformation? With printer revenue growth slowing, the old business model for printers just isn’t good enough anymore.

Of course, the old model is still brilliant, and serviceable. It generally works like this: HP sells printers relatively cheaply, and charges a premium for ink. Because HP is the biggest technology company in the world by revenue, it has enormous reach and component pricing power to add new features. So the more the world prints using HP equipment, the more money HP makes.

But lately there are challenges. Look at HP’s financial results, and you’ll see that HP’s momentum in printer and ink sales is slowing – the inkjet market that HP dominates “is likely to post only modest growth in 2008,” J.P. Morgan (JPM) analyst Bill Shope wrote in a report earlier this month. There are plenty of reasons for that — the overall home and office printer business has matured somewhat, for one — but the reason for the printer slowdown doesn’t particularly matter. The real issue is what HP is going to do about it.

I sat down with Joshi (who goes by V.J.) at HP headquarters in Palo Alto recently to talk about that; and of course, he has a plan. The key, he says, is to take the business from being about printers to being about printing.

It’s a clever turn of phrase that needs some explanation. What Joshi means is, he’s scouting out ways that HP can keep making money and churning out profits without having to rely as much on selling more printers and packs of ink to every single customer.

For a sense of how Joshi hopes to accomplish that, look no further than Snapfish, HP’s online photo service. With Snapfish, customers upload their digital photos and order custom prints, calendars and other things. The high-margin service has become the largest of its kind on the Internet, and not just because of the website; through Snapfish, HP also powers photo services for the likes of Wal-Mart (WMT), Costco (COST) and Walgreens (WAG). Through those sites, HP gets customers to pay for using its technology, without HP having to go through the trouble of actually selling them the printers, paper and ink.

“I really believe that what we learned in photo was that this is the only way we can accelerate the analog to digital transformation,” Joshi says. “This is all about pages.” As in, making sure customers get more of them printed, whether that's at home, at Wal-Mart, or at Snapfish.

The software and services push isn’t just about the consumer and small business markets, either — in fact, Joshi sees the biggest opportunity to make gains in large businesses. There, he hopes to overpower copier makers like Xerox (XRX) and print services companies that lease equipment to businesses and charge them only for the pages they print. He also hopes to sell new equipment to companies that will allow them to produce more of their marketing materials in-house rather than send them out to a print shop. His pitch? HP is more efficient, and we can prove it. Put your printers on the network, use HP software to track how much you’re printing, and we’ll save you money.

“We go to the enterprise customer and talk to the Chief Information Officer and say, ‘Do you know how much you spend on imaging and printing?’ Most of the CIOs have no idea,” Joshi says. “We tell them, on hard costs, on supplies and hardware, probably you are spending 1 percent of your revenue. But soft costs, like helpdesk and things that you don’t know, probably you are spending 2 to 3 percent of your revenue.”

HP’s salespeople then propose to save them 30 percent of costs, and improve productivity 30 percent by bringing in HP equipment and software.

Saving money is an attractive lure, especially during a business slowdown, but Joshi’s printing pitch is still likely to be a tough sell. Customers might be slower to change basic office functions during tough times, even with the promise of cost savings. And to justify a switch to HP’s model, a company needs to consider how its spending on printed material spans marketing, facilities and technology budgets.

"I'm not saying it can't be done, because obviously they're already very dominant with printers — but getting people to switch to one machine is a bit of a cultural change," says Shaw Wu, analyst with American Technology Research. Wu says these days he still tends to view HP's printing business as a cash cow that helps fund HP's other operations. "If V.J.'s right, these moves will provide upside opportunity; we're not modeling that as a growth contributor."

Plus, HP’s digital transformations aren’t always smooth. Late last year the company announced that it will stop developing its own digital cameras, despite the obvious tie-ins with the printer business; HP hasn’t been gaining enough market share for cameras to become a significant source of revenue and profit growth. And HP’s effort to create and sell on-demand DVDs of movies and TV shows, a business that was supposed to launch late last summer in partnership with Wal-Mart, seems to be having trouble getting off the ground.

But particularly with large businesses, HP is in position to make a strong case for its latest printing push. The largest enterprises — the ones with the most to gain from the cost-saving plan — are already buying something from HP, whether it’s PCs, servers or consulting services.

If HP can convince them to buy print services too, Joshi may have found a key to that transformation.

Inside HP's plan to get more bang for its research buck

Prith Banerjee, former dean of the engineering school at the University of Illinois at Chicago, brings new ideas to his role as director of HP Labs. Image: HP

It’s a tale nearly as old as Silicon Valley itself. Nearly 30 years ago, a young Steve Jobs visited the scientists at Xerox’s Palo Alto Research Center and spied the first computer that had a mouse and desktop icons. Jobs soon commercialized similar ideas at Apple’s (AAPL), but Xerox couldn't seem to take the brilliant concepts from its own labs and turn them into marketable products.

Today Hewlett-Packard (HPQ), the valley’s largest tech company, wrestles with a similar problem. Though HP’s advanced research group once invented wonders such as the scientific calculator, the thermal inkjet printer and commercial LED lighting, these days executives feel HP Labs and its $150 million annual budget could do more to boost the company’s bottom line.

This issue has fresh urgency now that HP has topped $100 billion in annual sales. The company will need big, marketable ideas to fuel future growth. Can HP Labs deliver?

The challenge falls to Prith Banerjee, a noted scientist and startup veteran who joined HP last May as director of HP Labs. Banerjee, 47, was previously dean of the College of Engineering at University of Illinois at Chicago; he has also founded two electronic design software startups. AccelChip was sold to Xilinx early last year, and he still serves as chairman and chief scientist of Binachip.

At HP, Banerjee wants to transform the labs from an idea farm into a hit factory. Rather than send the 600 HP Labs scientists out to pursue dozens of personal-interest projects, Banerjee will encourage them to pool their talents and tackle big problems that are likely to yield money-making discoveries. Shane Robison, HP's chief strategy and technology officer, says the retooled organization ideally should help add hundreds of millions of dollars in revenue to HP's core businesses of personal computing, imaging and printing, enterprise systems and software.

A Different Focus

“HP Labs today does a lot of cool things — about 150 research projects – but it does so many things that none of the projects get enough resources to have a high impact,” says Banerjee. “My message was, let’s try to narrow the focus” to about 30.

Banerjee’s vision borrows heavily from the culture of Silicon Valley venture capital firms, which fund fresh new ideas and try to nurture them into the next Intel (INTC) or Google (GOOG). Traditionally, HP Labs scientists have had little incentive to transform concepts into products. But in the future, research efforts that fail to meet benchmarks won’t get more funding, according to HP executives; instead, more resources will go to larger projects that are meeting goals and are likely to mature into profitable new businesses.

Much like in a VC firm, once a project is ready to begin the process of becoming a product, researchers who worked on it will move to the product team. "When a startup company gets formed, you don't just bring in the technology," Banerjee says. "You convince the people who created the technology go along, and you bring in people who are experts in building products. That's the same thing we plan to do at HP Labs."

It's a colossal shift in the way innovation happens inside a Silicon Valley giant, and competitors will be watching. If Banerjee succeeds at leading the reinvention of HP’s research culture, it could both drive earnings and provide a blueprint for other tech behemoths that struggle with growth. But this is also not the first time a mature enterprise has tried to change its culture and adopt the creativity of a nimble startup. Perhaps because big companies are run by managers and not by entrepreneurs, these kinds of efforts typically fail.

Still, HP can find inspiration in stories like Chandrakant Patel's. As a Fellow in HP Labs, Patel began experimenting a decade ago with large-scale cooling technologies, based on a gut sense that the Internet would give rise to energy-guzzling data centers full of computers that would run too hot. Though HP managers didn’t grasp the importance of his research at first, Patel soldiered on. Using social skills he honed during college when he took a job selling encyclopedias door to door, Patel found allies within the company who helped him find a market for a new kind of software-driven thermostat system designed for server farms.

Today, Patel’s project has bloomed into a product called Dynamic Smart Cooling. And since electricity costs have become the most expensive part of running a data center, demand for the invention is obvious in the global warming era; HP expects it to generate hundreds of millions of dollars in sales.

Another project called BRAIN, a system for predicting the future through betting patterns, also offers an example of the type of work HP Labs wants to encourage. HP economists and engineers worked together to design a system that analyzes a group of people's bets in a given market, factors in each person's appetite for risk, and uses that information to predict what will actually happen. Though the project began as an academic exercise, Bernardo Huberman, an HP Labs manager, was determined to put it to profitable use. The financial division suggested using it at the beginning of a quarter to predict what revenues would be at the end; when that experiment went well, HP began using it to predict component prices, helping the company to buy the critical building blocks of its products at the lowest cost and thus increase profitability.

Uncertainty Ahead

HP is not alone in its ambition to improve the profitability of its advanced research efforts. At Cisco (CSCO), the company has also been working on system to get more bang for its R&D buck. “Innovation typically is when you take a number of inventions and you put them together to create something that is disruptive,” says Cisco senior vice president Marthin De Beer, who leads the company's Emerging Technologies Group. “We really focus now on the latter part — on innovation.” That focus means Cisco more widely solicits ideas, chooses the best to develop, and creates new startup-like business units to incubate them. The jury is still out on how well the system will work for Cisco, though one of the first products to emerge, TelePresence video conferencing, has generated buzz.

Likewise, it will take years before investors can be sure whether HP’s revamp of its labs is bearing fruit. Many of the research areas that the company identifies in 2008 won’t yield products until 2013, though the new model could produce some benefits sooner. For instance, HP’s personal computing group has set up a team called the Innovation Program Office that seeks to grab good ideas from inside and outside the company and turn them into products more quickly.

Along the way, there are many things that could go wrong as companies try to improve the batting average of advanced research. Chuck Geschke, who left Xerox PARC with his friend John Warnock and 25 years ago co-founded Adobe Systems, notes that no one has yet cracked the unique code for making advanced research consistently pay off. “There must be something special, because not everyone’s able to do it as well as they anticipate,” Geschke says. And perhaps there is no perfect formula at all. “You have to accept the fact that if you’re really pushing the envelope, some of what you do won’t work out.”

HP executives are conscious of the balance between focusing the research and leaving room for the unexpected. Phil McKinney, chief technology officer for the PC group, said Banerjee and the company’s chief technology officers have been working to make sure that under the new structure there’s room to pursue ideas that at first blush don’t seem like home runs.

“You want to be careful that you don’t become so restrictive in your strategic direction that you end up with blind spots,” he says. “How do we give enough flexibility in the model to let the researchers work on something that they’re personally interested in, and they think it might be something, but it’s very early-stage?”

It will be important for executives to get this right. The researchers who work in the top advanced technology labs are highly sought after, and will have no trouble finding work if they become unhappy at HP.

As Patel talks about his work with data center cooling, a similar theme emerges. He was free to pursue his research even before the company saw its value, and that freedom is one of the primary reasons he has remained with the company for more than 20 years.

“My boss could have said, ‘Why are you wasting time on this?’ But to his credit, I can’t remember anybody in HP Labs questioning me about all of this modeling that I was getting into,” Patel says. “What remained constant was autonomy. Nobody really questioned me.”

As HP Labs undergoes a transformation, there certainly will be more questions. But executives hope they’re the type that spark innovation rather than stifle it.

In this example of how "Ads for Adobe PDF powered by Yahoo" will work, this photo club newsletter has ads in a righthand panel. Image: Adobe

We've got ads on web pages and ads in e-mail. Next will we have ads in digital documents?

Yahoo (YHOO) is beginning to publicly test a new type of online advertising it hopes will prompt publishers of newspapers, magazines and newsletters to let readers freely access their digital archives. As part of a fledgling partnership the company is announcing today with Adobe Systems (ADBE), Yahoo can now make its contextual text ads appear alongside Adobe PDF documents in a format similar to a search engine.

It's an interesting concept — but it's not likely to give either company the kind of boost it needs online.

Under the program, "Ads for Adobe PDF powered by Yahoo," publishers can choose to have their PDF documents matched with ads from Yahoo's network. The ads will appear only when the documents are viewed on an Internet-connected computer, and they will reside in a side panel away from the content. Publishers that have agreed to test the program include IDG InfoWorld, Wired, Pearson's Education, Meredith Corporation and Reed Elsevier.

We've been here before. Two years ago, a few companies with names like ReadNotify, Remote Approach and PDFtracker launched services designed to either monitor who was reading PDFs, or to track the ads placed in them. The concept didn't seem to take off.

And even if the more sophisticated technology from Yahoo and Adobe fares better than those companies did, this program isn't going to help either company tackle its biggest online challenges: It's got going to allow Yahoo to catch up to Google (GOOG) in online advertising anytime soon, and it's not going to help Adobe drive sales of its most popular online tools.

A peek at Adobe Photoshop Express (Photos 1/6)

Based on the briefing I got on the service, and what I can gather about the program, there are a couple of significant issues that could keep it from generating much money in the foreseeable future.

First, neither company was able to give me even a rough estimate of how many PDF pages out there are good candidates for the program. (One billion? Ten?) Many PDF pages are generated not for pleasure reading but for official uses — government-mandated documentation, for example. Those don't lend themselves to ads.

Second, neither Adobe nor Yahoo would give me a clear sense of whether their tests show that people actually click on ads in PDFs. They said they expect people will click on PDF ads somewhat less often than they click on in-browser ads. Also, it doesn't help that advertisers will have little control over what kinds of PDFs their ads appear in, and publishers will have little control over what kinds of ads show up in their PDFs. (It's not difficult to imagine inappropriate ads appearing in a Little League newsletter.)

Google’s YouTube video ads: How they work: Photos (1/9)

Third, and perhaps most important, ad-enabling a PDF is a somewhat cumbersome process at this stage. To get Yahoo ads onto a PDF, publishers have to sign up for an account with Adobe, and then upload their PDF files to an Adobe server. Adobe will then e-mail back an ad-enabled version of the document. This is fine for lightweight PDFs of 5 megabytes or less – but publishers who want to experiment with ad-enabling an entire newspaper or an issue of a magazine will find it too unwieldy. Adobe and Yahoo told me they're working on a process that's friendlier to large publishers.

Since this is still in its early stages, we'll have to cut Adobe and Yahoo some slack as they figure things out. And the fact that they have some major publishers signed onto the program might help them develop the product more quickly.

Said Todd Teresi, senior vice president of the Yahoo Publisher Network: "We are optimistic that because of the type of content that will be available, our advertisers are going to get a very strong experience similar to what they expect when they're in similar environments on the Web."