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Executives

John Morgan

Paul A. Rooke - Chairman, Chief Executive Officer and Chairman of Executive Committee

John W. Gamble - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Shannon S. Cross - Cross Research LLC

Ryan Jones - Barclays Capital, Research Division

Nick Morton - Citigroup Inc, Research Division

Eric Garfunkel

Jeffrey S. Kochel - Forest Investment Associates

Kathryn L. Huberty - Morgan Stanley, Research Division

Lexmark International (LXK) Q4 2012 Earnings Call January 29, 2013 8:30 AM ET

Operator

Thank you for standing by, and welcome to the Lexmark International Fourth Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded on Tuesday, January 29, 2013. I would now like to turn the call over to John Morgan, Lexmark's Director of Investor Relations. Please go ahead, John.

John Morgan

Good morning, and thank you for joining us. Chairman and CEO, Paul Rooke, and EVP and CFO, John Gamble, are with me this morning. After their prepared remarks, we'll open the call for your questions as time permits. [Operator Instructions] Please note that Paul and John will be referring to specific earnings presentation slides by page number. Those slides were posted to our Investor Relations website located at investor.lexmark.com earlier this morning. Paul and John will be referring to non-GAAP measures during the presentations unless otherwise noted. Pursuant to the requirements of Reg G, Regulation G, the company has provided reconciliations of GAAP to non-GAAP measures and a discussion of management's use of non-GAAP measures in the supplemental materials section of the earnings presentation slides.

Lexmark anticipates that the record date of its first quarter 2013 dividend will be March 4, with an anticipated payment date of March 15. Please note that future quarterly dividend payments are subject to Board approval. We have also included our anticipated dividend schedule for 2013 in the supplemental section of the earnings presentation.

Following the conclusion of this conference call, a complete replay will be made available on our Investor Relations website. As a reminder, any of today's remarks that are not statements of historical fact are forward-looking statements and involve certain risks and uncertainties that are disclosed in the Safe Harbor section of our earnings releases and SEC filings. Actual results may differ materially from such statements, and Lexmark undertakes no obligation to update any forward-looking statements. With that, I'll turn it over to Paul.

Paul A. Rooke

Thank you, John, and good morning to everyone. As John said, we'll be using a presentation slide deck. We'll refer to the slide numbers as we go to keep everyone on the same page. So let's begin.

Starting with Slide 4, our fourth quarter financial results reflected better-than-expected revenue and free cash flow. Our strong free cash flow performance was our 11th consecutive year of positive free cash flow. Fourth quarter revenue exceeded the October guidance and also grew sequentially, but was down year-to-year due to the headwinds of economic weakness, primarily in Europe, and the natural decline from our decision to exit inkjet. Our non-GAAP earnings per share were driven below our expectations by 2 factors related to taxes, a higher-than-expected tax impact due to a mix shift in earnings to higher tax geographies and the delay in the enactment of the R&E tax credit.

Now for 2013, our full-year guidance shows an overall revenue decline, reflecting a more accelerated inkjet exit decline and continuation of a stagnant ink imaging market, but assumes continued revenue growth in our strategic areas of Managed Print Services and Perceptive Software, and growth in earnings per share. We remained focused on creating a higher value portfolio for Lexmark, shifting from a hardware-centric company to a solutions company, and we made continued progress in the fourth quarter.

Perceptive Software and Managed Print Services both grew again in the quarter, with Perceptive Software achieving strong double-digit revenue growth. We began the transition to the new laser product line we announced in the fourth quarter, further advancing our smart MFP leadership that includes a growing array of workflow solutions powered by Perceptive Software. We also completed the acquisition of Acuo Technologies, significantly advancing our healthcare solutions leadership.

We are working to increase our profitability, and remain committed to our long-term operating margin assumption of 11% to 13%. The majority of the significant restructuring action we announced last August is complete, driven by the inkjet exit to improve our profitability. We are focused on executing the remaining portions of this action and, when complete, are expected to deliver ongoing annual savings of $95 million, with $85 million in 2013.

Finally, we continue to maintain our capital allocation discipline to deliver shareholder value. Our focus is squarely on the needs of business customers as we build and grow our solutions business through organic expansion and acquisitions, where we added to our strategic software capabilities with 4 acquisitions in 2012. We remain committed to our capital allocation framework of returning greater than 50% of our free cash flow to shareholders through dividends and share repurchases, on average, having returned more than $500 million since July of 2011.

Now on Slide 5, you can see the fourth quarter financial highlights. Revenue for the fourth quarter was $968 million, better than expected, driven by good ISS performance, with stronger-than-expected supplies revenue, partially offset by less-than-expected Perceptive Software revenue despite strong double-digit growth. Revenue also grew sequentially, driven by a good ISS laser hardware and supplies revenue performance.

Now on a year-to-year basis for the fourth quarter, while revenue was down 9%, we saw continued revenue growth in our strategic focus areas, with Perceptive Software revenue growing 37% for the quarter and 62% for the year. Managed Print Services also grew 3% in the quarter and 7% for the year, marking 12 consecutive years of Managed Print Services growth. Now while we had revenue growth for the year from MPS and Perceptive Software, this was more than offset by the headwinds of a weaker European market and currency, and the planned ongoing decline from the inkjet exit. Our operating income margin was 7.7% for the fourth quarter, down year-to-year and down sequentially, largely as expected.

Now there are a few dynamics to note here. First, gross profit margin was down sequentially, driven by the expected selloff of the remaining branded inkjet exit hardware, but down slightly more than expected due to aggressive laser hardware discounting on the prior generation laser products as we transition to the new line. Second, while operating expense was down year-to-year for the fourth quarter, with reductions in ISS more than offsetting increased software investments to drive future growth, it was up sequentially, and up more than our October guidance. This was due to the stronger-than-expected cash flow performance in the quarter, requiring funding at the minimum levels of our broad-based employee annual incentive compensation program. And finally, while Perceptive Software's revenue was up strongly year-to-year, it was less than we expected, driving a larger-than-expected operating income loss as we continued to invest for growth. We did limit Perceptive Software's expense level in the fourth quarter as planned, but it wasn't enough to overcome the miss in expected revenue and gross profit. Now going forward, while we will continue to drive double-digit revenue growth, we're working also to deliver a positive software operating margin in 2013.

Now for the full year, we improved our gross profit margin year-to-year, a record margin for the fourth consecutive year as we continued to shift the mix of our business to higher value hardware and software. We also held our expenses flat overall while adding several strategic software acquisitions. This resulted in about a 10% operating margin, less than our target range, but expected to improve for 2013 and beyond with the previously announced restructuring actions underway to improve cost and expense.

Earnings per share were $0.61 for the fourth quarter, down year-to-year and below our October guidance, driven by the unfavorable tax impact I mentioned earlier, and John will expand on this in his remarks. Finally, we also generated $101 million of free cash flow in the fourth quarter and $251 million for the year, much better than expected, driven by good working capital performance.

Now moving to Slide 6, you can see how the composition of our revenue is shifting as we evolve to an imaging and software solutions company. On the left, you can see 3 sections: the inkjet exit section is the revenue we're exiting, comprised of the past consumer inkjet; and the remaining business inkjet, which we announced last August, that we're exiting. Inkjet exit revenue is expected to decline over time at a rate of over 40% year-to-year, as the trailing supplies revenue from the installed base naturally decreases. The imaging solutions section is comprised of both MPS and non-MPS revenue. The MPS part is our enterprise Managed Print Services revenue, which has been consistently growing in excess of the market. The non-MPS portion is that which flows through our partners, some of which flows through transactional partners and some of which flows through copier dealers that are managing fleets of our devices as a service. And the third section is the Perceptive Software revenue.

Now combining the imaging solutions and Perceptive Software revenue, the red and blue sections together, this represented 85% of our total fourth quarter revenue, and will continue to grow as a percent of our total revenue as the inkjet exit revenue declines over time. And for the fourth quarter, imaging solutions and Perceptive Software, on a combined basis, declined 5% as the growth in perceptive and MPS revenue was more than offset by the non-MPS decline.

Now combining the Perceptive Software and MPS revenue, only the blue sections, representing higher value-add, longer-term solution relationships with customers, this combined software and services business grew 8% in the fourth quarter. Additionally, we expect that as the software revenue grows and the margins expand here, this will be a significant driver of future profitability.

Now on Slide 7, you can see our unit share position in the high-usage, large workgroup segments or A4 or letter-size format lasers. This large workgroup A4 laser devices are increasingly displacing the larger copier A3 or 11-by-17 format devices due to their smaller-size, lower-cost and improved functionality. And according to IDC, for the last 4 quarters, ending third quarter of '12, Lexmark continued to grow share in this large workgroup A4 laser segment, and this is important since these are higher usage devices, which drive supplies revenue.

Now moving to Slide 8. Over the last year, Lexmark has been recognized across several key areas. We were recognized as a Managed Print Services leader by 4 leading independent research firms. We were also recognized as a leader in smart MFPs. This leadership position, further strengthened by our laser announcements last quarter and the seamless integration with Perceptive Software's growing array of solutions, combined with the world-class MPS tools, processes and skills we've built and refined over the past 13 years, enables not only superior execution, but also brings additional, unique business process value to our customers.

As further proof, our overall management services revenue grew again this quarter and, within the last 24 months, we competed for and won 15 new Managed Print Services contracts with companies listed on either the Global 500 or Fortune 500 list, which represent incremental business to Lexmark. We continue to believe this is a clear indicator that our value proposition resonates strongly, and continues to be differentiating with these large, discriminating customers. Additionally, we were recognized as a leader in healthcare document management and imaging software, as reflected with our best-in-class recognition for Perceptive Software. I would also add that our recent acquisition, Acuo Technologies, further strengthens Lexmark's leadership position as a content software provider in the growing healthcare segment.

Now on Slide 9, it's important to see how our recent actions fit into the larger strategy we're driving. To drive our strategy, we've been making a number of key investments over time. First, we've been investing in smart MFP solutions and managed print solutions since the early 2000s and continue to do so. Starting mid 2010, we've now made 6 acquisitions, from our initial acquisition of Perceptive Software to the recent acquisition of Acuo in the fourth quarter. And while we've been investing, we've also been divesting our consumer inkjet business, starting late 2007 and then our business inkjet business last year, all with the end in mind of becoming a world-class, end-to-end solutions provider.

Now to give you a little more color on the Acuo acquisition, you can see on Slide 10 that we acquired Acuo at the end of the fourth quarter, and it is now part of our Perceptive Software unit. Acuo is a leading provider of software for the healthcare sector, specializing in vendor-neutral archiving software, a class of software that enables access to medical images, stored across the multiple proprietary scanning systems found in medical facilities like x-rays, ultrasounds and CT scans. Acuo's software, combined with Perceptive Software, will now enable Lexmark to provide a unique healthcare offering, giving physicians a single enterprise-wide view of all patient medical records, including documents and now medical images, all accessible from any electronic medical record system. The Acuo acquisition, it's a good example of how we're continuing to move towards our vision of creating broader, higher-value, industry-specific solutions for our customers.

So turning to Slide 11, while we have increased the breadth and depth of our technology portfolio with the acquisitions, the competitive advantage comes in how we integrate these together to provide differentiated, seamless, industry-specific solutions that can help our customers capture, manage and access key unstructured content that today they're completely missing, processing manually or having difficulty accessing. And we believe this combination of imaging technology expertise, with content and process management technology and expertise, focused on creating industry-specific, customer-specific solutions, makes Lexmark unique.

Now we have competed successfully in the enterprise segment for over 20 years against broad-based competitors by going deeper with our customers, providing them industry-specific, customer-specific solutions. By leveraging this expertise and combining it with these new technologies, we are now creating broader, higher-value, industry-specific solutions for our customers.

Now on Slide 12, you can see how we're creating synergies between the imaging solutions unit and the Perceptive Software unit to grow each faster. The Imaging Solutions unit, the red part of this slide, is leveraging its global, large account presence and infrastructure to open doors quickly while integrating the new Perceptive Software capabilities into our industry solutions, enabling Lexmark to penetrate even further into these accounts. And the cash-generating capability of the imaging unit also continues to provide funds for additional growth.

Now Perceptive Software, the blue part, is providing more advanced software capabilities to further differentiate and grow our Managed Print Services offering. Additionally, Perceptive Software's presence and expertise in health care, higher education and back-office operations provides further access for the imaging unit to expand into as well.

Now on Slide 13, you can see another recent example of how our expanding solutions value proposition is resonating with large enterprise customers. With our 5-year MPS win at Anheuser-Busch InBev in Europe, Lexmark will build upon the broad range of solutions and services capabilities we already provide for Anheuser-Busch in North and South America, and now extend them into Europe. On the right, you can see a recent solutions win by Acuo, our recent acquisition, at the Department of Defense, a large, 9-year contract to consolidate medical images across U.S. Army and Navy facilities around the world.

Now as a reminder, on Slide 14, Lexmark's overall capital allocation framework is to return more than 50% of free cash flow to shareholders, on average, through quarterly dividends and share repurchases, while pursuing acquisitions that support the strength -- support the strengthening and growth of the company. In the fourth quarter, Lexmark paid a dividend of $0.30 per share, totaling $19 million, our fourth -- our fifth consecutive quarterly dividend payment. Since mid-2011, Lexmark has returned more than $500 million to shareholders through quarterly dividends and share repurchases. In addition, we have reinvested more than $500 million to grow the company through 6 acquisitions since mid-2010. And finally, for the first quarter, we are planning to continue share repurchases.

Now on Slide 15, you can see our longer-term revenue growth assumptions. Earlier, I discussed how we are creating synergies between the imaging solutions unit and the Perceptive Software unit to grow each faster. Based on these synergies, we expect to grow the Imaging Solutions revenue greater than or equal to the market, leveraging the differentiation obtained through Perceptive Software's solutions portfolio, along with the industry growth trends towards MPS and workflow solutions. Similarly, we expect to grow Perceptive Software greater than the market, leveraging the expanded reach through Lexmark's worldwide large account presence and relationships and continued investment in software development, marketing and sales. And while the inkjet exit is currently a large headwind, it is a declining headwind, and we expect it will be less than $100 million by 2015. Therefore, as we grow imaging solutions and Perceptive Software together, against a declining inkjet headwind, the underlying revenue growth will emerge.

Now moving to Slide 16, you can see our revenue guidance for full year 2013. It reflects an overall 8% to 10% decline, driven by several dynamics. For the inkjet exit revenue portion, the gray part, we're assuming a more accelerated decline of over 40%. Now for the strategic imaging and software solutions revenue portion, the red and blue parts, we're assuming a slight decline, less than last year, driven by combined MPS and Perceptive Software growth of about 15%.

Now looking ahead on Slide 17, you can see our first quarter, full-year 2013 and long-term outlooks. For the first quarter, our outlook is for revenue to be down 11% to 13% year-to-year. We expect earnings per share for the first quarter, excluding restructuring and acquisition-related adjustments, to be in the range of $0.80 to $0.90. For the full year 2013, our outlook is for revenue to be down 8% to 10% year-to-year. We expect earnings per share for the full year, excluding restructuring and acquisition-related adjustments, to be in the range of $3.90 to $4.10. Long-term, our outlook is to grow revenue at or above the market with an operating margin in the range of 11% to 13%. I'll now turn it over to John Gamble for his more detailed comments on our financials.

John W. Gamble

Thank you, Paul, and good morning. The discussion that follows is on a non-GAAP basis and reflects non-GAAP adjustments, unless otherwise noted.

Let me begin with a discussion of 4Q '12 earnings per share, which at $0.61 was below our guidance range. Chart 19 provides a bridge from the guidance we provided in October to our actual results. Segment operating performance in 4Q '12, meaning segment performance at an earnings before tax level, was consistent with our guidance. Specifically, ISS performed well and better than expected in the quarter, as both hardware and supplies revenue was above our guidance, as was operating income. Strong supplies sales reflected strong end-user demand. Also, our reporting shows that channel inventories did decline in the quarter, but less than expected. Geographically, declines in channel inventory in EMEA and Latin America were partially offset by increases in channel inventory in the U.S. Increased profit from strong supplies sales more than offset both weaker hardware margins, reflecting aggressive pricing as we sold through our remaining branded inkjets as well as older laser models following the launch of our new laser line last October, and increased operating expense as our very strong cash flow in the quarter resulted in Lexmark exceeding the minimum threshold in the cash flow metric of our broad-based employee annual incentive program.

Perceptive Software showed strong total and organic revenue growth in the quarter, but at a level that was below our expectations. This resulted in operating losses at Perceptive, and all other had higher operating expenses, again, as our very strong cash flow in the quarter triggered higher incentive compensation expense. In total, for Lexmark, this higher incentive compensation expense due to strong cash flow performance impacted 4Q '12 earnings by $0.06 per share. Taken together, our pretax results were about as expected, and had tax been as expected in 4Q '12, we would have resulted in EPS of about $0.86.

Higher-than-expected tax expense in 4Q '12 resulted in a tax rate of 40.7%, and negatively impacted EPS by approximately $0.25 per share. Two main factors caused this result. First, timing of the passage of the U.S. R&E credit negatively impacted net income by $6 million or $0.09 per share, and our fiscal year '12 tax rate increased by approximately 3 percentage points from the level we had expected to 29.3%. This higher tax rate resulted in an increase in fiscal year '12 tax expense of about $11 million or $0.16 per share, all of which was reflected in 4Q '12, resulting in the 40.7% tax rate incurred in 4Q '12.

This increase was principally caused by a shift in the geographic distribution of our fiscal year '12 earnings, specifically, a large increase in the percentage of our income earned in the United States. For Perspective, the differences between our U.S. and non-U.S. tax rate is as high as 30 percentage points. And at this rate difference, a shift in pretax income of approximately $35 million to the U.S. from non-U.S. geographies, can drive a change in tax expense of this order of magnitude.

U.S. earnings were strong relative to expectations in 4Q '12, reflecting good operating performance, as well as the growth in U.S. supplies channel inventory I mentioned earlier. Earnings outside the U.S. were much lower than expected as performance in Latin America and Asia Pacific were weaker than expected, and as supplies channel inventories declined in EMEA and Latin America. In general, the shift in mix of earnings toward the U.S. reflects the stronger dollar we saw in 2012 versus 2011, and the relatively stronger U.S. economy. Reported non-GAAP EPS of $0.61 reflects the net operational performance consistent with our expectations and this much higher-than-expected tax expense. In addition to the better ISS performance referenced above, we had very strong cash flow in 4Q '12, and made good progress on the restructuring and the exit of inkjet technology we announced last August.

Turning to Slide 20, total revenue for the fourth quarter exceeded our guidance range, reflecting stronger-than-expected supplies revenue. The 9% year-to-year decline in total revenue was unfavorably impacted by 5 percentage points of lower revenue from our previously announced decision to exit inkjet. It was also impacted by the economic weakness we are still seeing outside North America. The currency impact was smaller than prior quarters at negative 1 point year-to-year. Total revenue for 2012 was down year 9% versus 2011, reflecting a decline of 6 percentage points due to our exit from inkjet and 3 percentage points from currency. ISS segment revenue in 4Q '12 increased sequentially due primarily to growth in laser hardware and supplies revenue. ISS revenue declined 10 percentage points year-to-year, reflecting 5 percentage points from lower inkjet revenue and 1 point of unfavorable currency. The remaining decline reflects weakened end markets outside the U.S.

For calendar year 2012, the ISS revenue decline of 11% reflects a 6% decline in inkjet revenue due to our inkjet exit and 3% due to weaker foreign currencies. Geographically, excluding the impact of currency, laser revenue showed growth in North America. This growth was more than offset by reductions in non-U.S. geographies, primarily EMEA. Managed Print Services continue to grow in both 4Q '12 and calendar year '12, up 3% and 7% respectively. Perceptive Software revenue in 4Q '12 grew 37% year-to-year with organic growth of 16%. Calendar year '12 Perceptive revenue was up 62% versus 2011, with organic growth of 21%. Total revenue, excluding inkjet-labeled imaging solutions, plus Perceptive, was down 5% in 4Q '12 and 4% in calendar year '12 versus the prior year. The impact of currency was negative 1% and 3% respectively.

As shown on Slide 21, geographically in 4Q, the growth in U.S. was more than offset by declines outside the U.S. All regions were impacted by our planned exit from inkjet technologies and, outside the U.S., by the weakened demand environment. The decline also reflects the impact of the stronger dollar. These same dynamics impacted the full year.

Now moving to Slide 22, in 4Q '12, large workgroup laser hardware revenue declined 11% year-to-year, reflecting AUR declines, driven by discounting to sell prior generation laser product ahead of the full launch of new products we announced last October. There was a slight unit decline. However, we did see unit growth in North America and EMEA. We also saw strong growth in MFPs in 4Q '12, our largest unit quarter for large workgroup MFPs ever. Small workgroup laser hardware revenue declined 11% year-to-year, driven by a decline in units. Small workgroup laser hardware AUR increased in the quarter due in part to an increase in the mix of MFPs and color lasers. Large workgroup now represents 78% of total hardware revenue.

Supplies revenue in 4Q '12 declined year-to-year in both laser and inkjet. Laser supplies revenue was stronger than expected, as we saw strong end-user demand in North America, and we did not see as large a decline in supplies channel inventories as was expected. As I referenced earlier, in North America, channel inventory increased during the quarter. Declines in EMEA and Latin America channel inventory during 4Q '12 exceeded the growth in North America. In 4Q 2012, Software and Other revenue growth was primarily driven by the 37% growth in Perceptive Software.

Turning to Slide 23. In calendar year '12, large workgroup laser hardware revenue declined 9%, reflecting AUR declines, driven by 3 percentage points of negative currency, as well as the aggressive pricing environment and due to product transitions that I previously mentioned. For the full year, large workgroup units were flat with growth in MFPs, principally color MFPs, offset by declines in single-function units. Small workgroup hardware revenue declined 10%, driven by a decline in units. However, small workgroup MFP and color units both grew year-to-year. Small workgroup AUR was down slightly due largely to negative currency, partially offset by a positive mix of more MFP and color units. Supplies revenue in calendar year '12 declined in both laser and inkjet. Laser supplies revenue declined 5%, was largely due to negative currency of 3 percentage points. Growth in Software and Other for the year was primarily driven by the 62% growth in Perceptive Software.

As shown on Slide 24, gross profit margin for the full year of 2012 was a record 38.9%, up about 50 basis points versus 2011. This is the fourth consecutive year of record gross profit margin. This increase was driven by 350 basis points of positive product mix, driven by relatively less inkjet hardware and relatively more laser supplies and software. This increase was partially offset by reduced product margins, principally hardware and the impact of currency. ISS gross profit margin for the full year increased 10 basis points year-to-year driven by favorable mix, primarily reduced inkjet hardware, partially offset by lower product margins driven by hardware pricing and currency. Perceptive Software gross profit margin for the full year declined 100 basis points year-to-year, driven by unfavorable product mix, as growth in lower-margin professional services outpaced the growth in higher-margin licenses, subscriptions and maintenance.

Gross profit margin for 4Q declined 220 basis points year-to-year, driven by 530 basis points to lower product margins, principally in inkjet and laser hardware, reflecting the discounting discussed earlier. This was partially offset by 260 basis points of positive mix, principally driven by inkjet hardware being a lesser percentage of the mix. The sequential decline in gross margin was driven by 420 basis points of unfavorable product margins, again principally in inkjet and laser hardware, reflecting the discounting discussed earlier. ISS gross profit margins in Q4 decreased 270 basis points year-to-year, again, driven by lower product margins. Perceptive Software gross profit margin in Q4 declined 50 basis points year-to-year, driven by unfavorable product mix.

Turning to Slide 25, operating expense in 4Q '12 declined year-to-year, driven by lower ISS expense, reflecting expense reductions from our 2012 restructurings, including the exit of inkjet announced in August. These reductions were partially offset by increased investments in Perceptive Software, including the acquisitions completed over the last 4 quarters. 4Q '12 operating expense increased sequentially and was higher than expected due to increased incentive compensation expense of approximately $6 million, triggered by the strong free cash flow performance achieved in 4Q '12. Operating expense for the full year of 2012 was relatively flat versus 2011, reflecting increased Perceptive Software investments, offset by reduced expense in ISS.

As shown on Slide 26, operating income and operating income margin declined in 4Q '12 year-to-year and sequentially. 4Q '12 and calendar year 2012 operating margins reflect the weaker currency and demand environment and the net negative impact of lower inkjet supplies and hardware due to our exit from that technology. The operating expense and cost benefits related to the restructuring we announced in August will not be fully realized until 2013. ISS segment operating income drove the majority of the 4Q '12 and calendar year 2012 year-to-year decline. For 4Q '12, despite being stronger than guidance as indicated previously, the year-to-year decline was driven by 3 main factors: declining inkjet supplies as we exit the inkjet technology; deeper discounting on hardware as we sold off remaining branded inkjet hardware; and on laser hardware as we sold prior models following our product launch last October. We expect both of these factors to be mitigated in 1Q '13. And lower laser supplies, reflecting the net declines in channel inventories.

For calendar year 2012, negative currency and the net impact of reduced inkjet hardware and supplies more than explain the reduced ISS operating income. Somewhat offsetting this was a lower operating expense. Perceptive Software had operating losses in 4Q '12 and calendar year 2012 with the 4Q '12 weaker than we had expected. Perceptive showed strong total inorganic revenue growth, but at levels that were below our expectations. This miss in revenue drove the operating losses.

Turning to Slide 27, net earnings and EPS for both 4Q '12 and calendar year 2012 were below our expectations, as well as down from 2011, reflecting the weaker operating income and an increase in our effective tax rate I discussed previously. I will discuss more about our expectations for our tax rate in 2013 later in the presentation. In 4Q '12 and calendar year 2012, this was partially offset by a reduction in shares outstanding of 12% and 11% respectively.

Turning to Slide 28, our cash flow performance in 4Q '12 was very strong, reflecting improved working capital performance. Cash flow from operations and free cash flow were very strong in 4Q '12, principally reflecting cash generated from working capital of $43 million. Cash was generated in accounts receivable, inventory and accounts payable. For calendar year 2012, free cash flow of $251 million was 103% of non-GAAP net income, exceeding our goal of 90% to 100%. Cash flow from operations and free cash flow included restructuring payments of $38 million for the full year and $26 million for 4Q '12.

Worldwide cash was $906 million and U.S. cash was $36 million at 12/31/12. U.S. cash flow was very strong in 4Q '12, consistent with the shift in our geographic income in the period.

Non-GAAP adjustments for the fourth quarter of 2012, consisting of restructuring and acquisition-related costs and expenses, were $49 million on a pretax basis or $0.52 per share. This includes $32 million or $0.34 per share related to the restructuring announced in August. We have made very good progress on the August restructuring plan. The majority of the expense reductions announced were completed by the end of December. Ongoing actions related to rightsizing of our inkjet supplies manufacturing operations, as inkjet supplies revenue declines, will continue into 2015. We sold a significant majority of our remaining branded inkjet hardware in 4Q '12, and should sell the limited remaining branded, as well as the remaining OEM hardware in the first half of '13.

Total cost of the August 2012 restructuring are still expected to be $160 million. We are on target to achieve the 2013 savings on the restructuring of $85 million we announced in August and the ongoing savings of $95 million beyond 2013. Due to the worldwide distribution of these expenses, the effective tax rate on restructuring and acquisition costs and related expenses is lower than the effective tax rate on our non-GAAP earnings. This results in our overall GAAP effective tax rate, excluding discrete items, for 2012 being 32.7%, which is higher than our non-GAAP tax rate of 29%.

Please turn to Slide 29 for my forward-looking comments for 1Q 2013. We expect first quarter revenue to be down 11% to 13% year-to-year. This guidance is equivalent to sequential revenue performance of down 9% to 11%, which reflects a normal sequential trend for the laser portion of the ISS business, with larger declines in the inkjet businesses we are exiting. The 1Q outlook includes a decline in inkjet revenue year-to-year, with an impact to total revenue of approximately negative 7 percentage points. Also impacting revenue is a decline in laser supplies, reflecting an assumed reduction in first-tier laser supplies channel inventory, mostly in the U.S. As we indicated at the time, laser supplies first-tier channel inventories increased in 1Q '12. We expect continued strong growth in software and solutions.

GAAP EPS in 1Q 2013 is expected to be $0.43 to $0.53 per share. GAAP EPS in 1Q 2012 was $0.84. In 1Q 2013, non-GAAP adjustments made up of restructuring and acquisition-related costs and expense are expected to be $0.37 per share. This includes restructuring cost of $0.16 per share and $0.21 per share of acquisition-related costs and expense. Non-GAAP EPS is expected to be $0.80 to $0.90 per share. Non-GAAP EPS in 1Q 2012 was $1.05.

Slide 30 provides a walk down of non-GAAP EPS from 1Q '12 to 1Q '13. Lower shares outstanding in 1Q '13 and the recognition of the 2012 R&E tax credit of $6 million in 1Q '13 provide an approximate $0.20 per share benefit to EPS in 1Q '13 versus 1Q '12. The decline in EPS in 1Q '13 relative to 1Q '12 was driven principally by lower earnings in ISS. This decline reflects the weaker demand environment outside the U.S., and is driven by both the impact of inkjet exit, which was partially offset by lower operating expense from our 2012 restructurings, and a decline in laser supplies revenue. The reduced laser supplies reflect the channel inventory movements I referenced earlier.

As we look beyond 1Q '13, the supplies channel inventory issue should be mitigated. We are expecting improved income performance from Perceptive to possibly impact EPS in 1Q '13 and throughout the remainder of the year. In the first quarter of 2013, we expect the gross profit margin percentage to be slightly above 1Q 2012. Operating expense is expected to be below the $275 million incurred in 4Q 2012. Operating income margin in the first quarter is expected to be down from the 11% level achieved in the first quarter of 2012. We expect the effective tax rate for 1Q 2013 to be about 19%. This rate assumes an ongoing effective tax rate for both GAAP and non-GAAP of 26.5% in 2013 and includes the recognition of the U.S. -- of the 2012 U.S. R&E tax credit benefit of approximately $6 million in 1Q '13.

Our guidance is based on foreign exchange rates as of December 31, 2012. At these rates, the currency impact on revenue is expected to be negligible in 1Q 2013 versus the 1Q 2012 and versus 4Q 2012.

Our expectation for the 2013 calendar year are shown on Slide 31. We expect revenue to decline 8% to 10% versus 2012. Inkjet revenue is expected to decline over 40% from the $640 million we had in 2012. This results in an approximately negative 7% impact on year-to-year total revenue in 2013. Overall, by the end of 2013, inkjet revenue should decline to be less than 8% of total revenue. Total imaging and software solutions revenue, which excludes inkjet revenue, is expected to be down slightly, reflecting our expectation that the weak demand environment we saw during the last 3 quarters of 2012 outside the U.S. will continue through early 2013.

Combined MPS and software should grow about 15% in 2013. Non-GAAP EPS is expected to be $3.90 to $4.10 per share, and reflects the operating margins at the low end of our 11% to 13% target. We expect Perceptive Software to be profitable in 2013. We are expecting continued strong revenue growth from Perceptive, but will manage expenses more conservatively to deliver profitability for the year. The ongoing effective tax rate for 2013 of 26.5% is lower than the non-GAAP rate of 29% in 2011. The lower tax rate reflects a higher mix of non-U.S. income in 2013, as the U.S. is impacted more significantly by the decline in inkjet revenue, and we expect some recovery in operating performance outside the U.S. as we move through 2013. In addition, shares outstanding are expected to decline as we continue to execute our capital allocation strategy.

For calendar year 2013, free cash flow will be negatively impacted by the approximately $38 million of restructuring payments principally related to our August 2012 restructuring announcement. This will result in free cash flow being 80% to 90% of non-GAAP net income in 2013. Going forward, beyond 2013, we expect free cash flow to be 90% to 100% of non-GAAP net income as we have previously indicated.

With that, we'll go ahead and open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is coming from the line of Shannon Cross of Cross Research.

Shannon S. Cross - Cross Research LLC

My first question has to do with the ramp that you're expecting this year. With a guidance that's sort of below expectations in first quarter, can you give us some ideas? And I think you've gone through -- obviously, your commentary was quite comprehensive, but if you could kind of walk through what you see are sort of the really key drivers of the sequential improvement we're going to need to see in EPS.

Paul A. Rooke

Sure. Shannon, as we move beyond first quarter, we expect, first of all, our hardware margins to see some improvement there because we'll be completing that inkjet hardware selloff, and we'll be completing the transition to our new laser line, so that should have some upward pressure there on our hardware margins. The supplies channel impact will be less because, as we mentioned, it had grown in the first quarter of last year. We're assuming it'll be taken down largely in the U.S. here in the first quarter of this year, so we will get beyond that. And then we expect Perceptive to make money and be profitable here in '13. So we expect as we go to the right that profitability will continue to improve. And then we plan to continue our repurchases, so that'll continue to reach our share count. So I think those are probably the major factors.

Shannon S. Cross - Cross Research LLC

Okay. And then if you can talk a little bit about usage and what you're seeing from a customer standpoint. Obviously, you had some increase in channel inventory. But when you sort of dig down, what are you seeing your customers doing? And are there regions that have been stronger than others, are there verticals? Just any color you can give on sort of the underlying dynamics behind what you're seeing in terms of supplies decline.

Paul A. Rooke

I think on a machine-to-machine basis, if you will, the decline that we saw kind of mid last year has stayed there as people are tightening their operational budgets and things, so they're watching that usage close. So we see that still down at that lower level that we saw back kind of mid-year. Having said that, we're -- our Managed Print Services piece of that is continuing to grow, our business there, and capture more install bases, so that's kind of countering that effect. And overall, the customers, I think, are largely just trying to make this thing called printing that has been historically inefficient more efficient. And that's where our Managed Print Services strengths come through, in helping them make their print infrastructure in a more orderly fashion.

Operator

Our next question comes from Ben Reitzes of Barclays.

Ryan Jones - Barclays Capital, Research Division

This is Ryan, in for Ben. I just wanted to ask a little bit about the pricing environment right now. I know it's a very competitive environment with a lot of your competitors also coming out with broad product refreshes. Can you just speak to pricing and how it trended in the fourth quarter?

Paul A. Rooke

For us, specifically, we had some unique things going on, one being the inkjet exit, selloff of hardware so, of course, we were aggressively discounting that to move that out. We've got a little bit yet to go here in the first quarter of this year. The other unique thing is that we were transitioning to our line that we announced -- a new line that we announced in the fourth quarter, so we were -- we saw a little more aggressive discounting there as we were selling off the remaining volume of our prior-generation lasers. So those are the 2 things that were, I think, unique dynamics there pressuring the hardware margins in the fourth quarter. Overall, I mean, it remains a very competitive market, and we stay quite competitive with our prices there. But I think overlaying the market, we had those 2 particular dynamics hitting us in the fourth quarter.

Ryan Jones - Barclays Capital, Research Division

And then for a follow-up question, your tone for the fiscal '13 guidance for Managed Print Services and Perceptive just seems a little bit softer than it was -- than the actual was for 2012. Could you speak to your thoughts behind a little bit more conservatism around those segments?

Paul A. Rooke

Yes, I wouldn't say they're more conservative. We ended up the year on -- let me take Managed Print Services, 7%. And if you adjust that for currency, we were probably in the double-digit range, which, compared to what I'm hearing from several of our competitors, seems to be well above the growth rates they're seeing. So we think we did -- even in a pretty tough market, did pretty well in our Managed Print Services in '12, and we expect that to continue in '13. On the Perceptive Software side, I mean, we grew 62% for the year there, and we expect this continued double-digit growth as we go into '13, which, I mean, what we've done so far has been many, many times the market growth. So I -- as I look into '13, our assumptions are staying quite aggressive there because that is -- there is a growth that we're using to transition to a solutions company.

Operator

Your next question is coming from the line of Jim Suva of the Citi.

Nick Morton - Citigroup Inc, Research Division

This is Nick, filling in for Jim here. I was hoping you could give some color on the macro demand for print devices. I believe Xerox is predicting mid-single-digit decline in this segment. And also, if you could give a little color on your appetite for acquisitions in software and services

Paul A. Rooke

Yes. Nick, overall, yes, when we look at 2012, I mean, we don't have the full year market numbers yet, but certainly, through to the third quarter, it was down negatively for the imaging market, and I would expect full year to reflect that as well. As we look into '13, certainly, I think it's going to be flat to down. Again, as you heard in our comments, we're assuming a more stagnant imaging market, so it's kind of more or the same is what we're assuming on the macro demand for imaging. On the acquisition side, yes, certainly, we continue to be looking -- it's part of our strategy and we're continuing to look at candidates that make good strategic fit as we continue to shift our business to these higher-value solution and software areas. So we do plan to continue that.

Operator

Your next question comes from Toni Sacconaghi of Sanford Bernstein.

Eric Garfunkel

This is Eric Garfunkel, calling in for Toni. My question was if you could go into a little more detail on the changes in channel supplies inventory, specifically kind of how much the year-over-year impact was overall from the supplies drawdown, and then how much you believe you built in the U.S.?

Paul A. Rooke

Eric, we don't give specifics on that, but I can give you the color on it. We've been, through 2012, commenting about the channel levels for supplies being a little higher than normal. And so what we saw there in the fourth quarter was primarily the European channel come down and the U.S. went up. And so now we're expecting the U.S. to come down here in the first quarter, and we'll see whether happens, but that's what we've got in our assumptions there. So those are the primary dynamics. The other thing on a year-to-year in the first quarter is that a year ago in the first quarter, it did go -- the channel went up, and so you got this little more -- a larger delta there between -- on a year-to-year compared to the first quarter on supplies.

Eric Garfunkel

Well, the reason that I asked that question more specifically is that on the tax rate, I think that John mentioned that there was about a $35 million swing in profit by geography, part of which was attributable to changes in supply drawdowns. And so the magnitude of that number would seem to suggest a pretty high -- some pretty significant build. And also, just in terms of the tax rate, is there any reason why you chose not to preannounce, given that it was just such a material change versus your original guidance?

John W. Gamble

Well, in terms of the specifics or the comments around the tax rate, again, the channel movements were just one of several impacts that impacted that shift in income, including just general performance in Latin America and Asia. So I don't think you can attribute everything just to the changes in the channel inventory. And in terms of our announcement process, we...

Paul A. Rooke

Eric, we have a process we follow, and so we executed our process, and that's how we do it.

Operator

Your next question comes from Brian Alexander of Raymond James.

Jeffrey S. Kochel - Forest Investment Associates

This is Jeff Kochel, in for Brian. Just real quick, I know your guidance assumes a negligible impact from FX because you're basing it off of year-end currencies. But by our -- since things have moved, it looks like in your favor, by our calculations, looks like it could be like maybe 25 to 50 basis points and a tailwind for your margin. Can you kind of help us get a sense of the sensitivity there, and just basically on how the movement in currencies could impact your expectations for '13?

John W. Gamble

So in terms of currency impact on Lexmark, toward the back of the slide deck in the supplemental section, there actually is a chart, which goes through and lays out for 2012 the split of our revenue by currency and our cost and expense by currency. So the best thing I can suggest is you take a look at that chart. It can give you a perspective on the -- on how currency impacts us. It's actually Page 37.

Operator

Our final question will be coming from the line of Katy Huberty of Morgan Stanley.

Kathryn L. Huberty - Morgan Stanley, Research Division

If you look at workgroup laser units, they declined low single digits in 2012, and there was a clear mix shift towards MFP and large workgroup. And yet, laser supplies revenue declined 5%, so that decline outpaced workgroup laser unit. Just wondering if you could reconcile that to why aren't we seeing better laser growth, given the mix shift to high-end and MFP? And would you expect laser supplies growth to improve in 2013?

John W. Gamble

Yes, so if you take a look at the major factors that drove supplies in 2012, currency was about 3 points. So that was part of it. And then, really, the bulk of the rest of the decline was driven by OEM. Our branded business really did much better, and I think a lot of what you're seeing right now is the growth in our branded units and our branded MFPs. And we expect the trend in branded, which has been positive, to continue to be positive and then to drive the future benefit that we hope to see in supplies.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay, great. And then just quickly, Perceptive growth has come in below expectations for a couple of quarters. Can you talk about how some of the management transitions in Europe and other initiatives you have in place to improve that business are going and why aren't you expecting a more considerable improvement in Perceptive organic growth in 2013?

Paul A. Rooke

Well, I think we have pretty aggressive growth assumed for 2013. And as you saw, we had a pretty decent growth there in 2012. In reality, Katy, sometimes, as you're growing a business as quickly as we are, it's tough to predict some of these deals and the timing of the closures. We had a few that slipped last quarter into fourth quarter, and we've closed the majority of those here -- closed them in the fourth quarter. We had a few similarly move from for 4Q to 1Q, and some of those have actually already closed in 1Q. So it's just we're growing a young business here rather rapidly, and I think that will improve as time goes on. But we're happy with the changes we've made in Europe, to your question there, and we're expecting good things here in 2013.

Operator

With that, I would like to turn it back over to Paul Rooke, Lexmark's Chairman and CEO for closing remarks. Please go ahead, Paul.

Paul A. Rooke

So in closing, our fourth quarter performance, while impacted by the higher-than-expected tax rate, delivered better-than-expected revenue and cash flow. We remain confident in our strategy, committed to improving profitability and focused on delivering value for our shareholders. And we believe the investments we are making in our high-usage hardware and high-valued software technologies to bring new and differentiated solutions and services to market will drive long-term growth in our business, sustain margins and drive long-term value for Lexmark and our shareholders. With that, I'll turn it back over to the operator to close out the call.

Operator

Thank you, that does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day.

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