Lexmark International, Inc. Q1 2009 Earnings Call Transcript

Lexmark International, Inc. (LXK)

Q1 2009 Earnings Call

April 21, 2009 8:30 am ET

Executives

John Morgan - Director, Investor Relations

Paul J. Curlander - Chairman of the Board, CEO

John W. Gamble Jr. - Executive Vice President , CFO

Analysts

Shannon Cross - Cross Research

David Bailey - Goldman Sachs

Toni Sacconaghi - Sanford C. Bernstein

Kathryn Huberty - Morgan Stanley

Ben Reitzes - Barclays Capital

Bill Shope - Credit Suisse

Bill Fearnley - FTN Midwest Research

Richard Gardner - Citigroup

Presentation

Operator

Thank you for standing by and welcome to the Lexmark International first quarter 2009 earnings conference call. (Operator Instructions)

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 today. Chairman and CEO Paul Curlander and Executive Vice President and CFO, John Gamble, are with me this morning. After their prepared remarks, we’ll open the call for your questions as time permits. We ask that you to please limit yourself to one question and one follow-up, if needed, so that we can get to everyone.

Following the conclusion of this conference call, a replay of this call will be available on our investor relations website located at http://investor.lexmark.com.

I’d also like to mention too of our upcoming events. On March 19^th, we’ll be participating in JP Morgan’s Global Technology, Media, and Telecom Conference in Boston and we’ll be participating in Sanford C. Bernstein’s 25^th annual strategic decisions conference in New York City on March 28th.

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 Curlander

Thank you, John. During the first quarter, we saw weaker market conditions than in the fourth quarter of 2009 that led to weaker than expected end user demand for both hardware and supplies across all geographies, particularly in the business market, as well as some incrementally negative currency shifts, which combined resulted in our revenue coming in slightly below the low end of our guidance range.

Despite this shortfall, earnings per share exceeded our expectation as earnings in the quarter were primarily helped by our ongoing efforts to reduce cost and expense.

Revenue for the quarter was $944 million dollars, down 20% year-to-year.

Hardware revenue in Q109 was down 30% year-to-year, primarily due to unit declines in both inkjet and laser units, negative currency impact, and lower pricing.

Supplies revenue in Q109 was down 16% year-to-year with declines in both laser and inkjet supplies.

Earnings per share in the quarter were $0.75. Excluding restructuring and related charges, earnings per share in the first quarter would have been $0.89, down 23% year-to-year.

Earnings per share, compared to Q108, were impacted by several factors, primarily year-to-year declines in supplies revenue due to the ongoing transition of our inkjet strategy and lower end user demand during this economic downturn. We also were impacted by the negative impact of year-to-year currency changes and lower product growth margins, partially offset by an 18% reduction year-to-year in operating expense and an overlapping 30% reduction year-to-year in corporate cost and expense in our other segment.

In the first quarter, net cash used by operating activities was $86 million, with major factors being a significant first quarter pension contribution, along with increases in work in capital driven by a reduction in accounts payables as well as excess inventory, much of this in supplies.

Our first quarter supplies revenue declined 16% year-to-year, a higher percent decline than anticipated in our January guidance. This was driven by a weaker than expected end user demand, lower than expected revenue per page, due to incrementally negative currency impacts, similar offset by less channel shrinkage than expected.

As we look forward in the second quarter of 2009, we expect overall supplies revenue to decline at about the same rate as in the first quarter with year-to-year declines in both laser and inkjet supplies due to the ongoing transition in our inkjet business and weakness in end user demand.

As we look forward in Q209, we expect overall supplies revenue to decline at about the same rate as in Q109 with year-to-year declines in both laser and inkjet supplies due to the ongoing transition in our inkjet business and the continued weakness in end user demand, also impacted by negative year-to-year impacts from the relative strength of the US dollar and further shrinkage in supply channel inventories.

Now let’s talk about each segment. As we discussed in our latest 10K filings in our analyst meeting on March 26, due to the strategic change and the customer focus of our inkjet business, we now refer to our segments by their internal divisional names. The Printing Solutions and Services Division or PSSD, which is primarily focused around our laser business, and the Imaging Solutions Division or ISD, which is primarily focused around our inkjet business.

Now let’s talk first about the Printing Solutions and Services Division. In the first quarter, PSSD revenue was $599 million, down 19% year-to-year, driven by declines in both hardware revenue and supplies.

The lower hardware revenue was due to lower units, the negative impact of currency year-to-year, and lower prices.

PSSD operating income, excluding restructuring, was $95 million, down 34% year-to-year, primarily due to the lowest supplies revenue and lower hardware growth profit, partially offset by lower operating expenses.

PSSD laser use for the quarter were 25% year-to-year and were less than expected due to weaker end user demand in all geographies in both the enterprise market and small and medium business.

Despite the unit decline, we continue to see good growth in our laser multi-function products, driven by strong growth in our work group multi-function devices and good growth in our management services business.

During the quarter, we continued our major rollout of a new laser product line with the introduction of a new line of monochrome laser MFP’s, including the X460 series, which features our award winning and customizable e-task interface, two-sided scanning and printing and access to Lexmark’s broad range of industry workflow applications, prices starting at $999 dollars.

During the quarter, we continued to receive ongoing industry recognition and awards on our new laser products.

Now let’s talk about the Imaging Solutions Division or ISD. In the first quarter, we continued the shift of our inkjet strategy to focus on devices, customers and countries that drive our higher paid usage. As a result, our ISD revenue was $345 million, down 20% year-to-year, impacted by our strategy transition, as well as the negative effects of year-to-year currency changes.

ISD operating income, excluding restructuring, was $55 million, down 31% year-to-year, as lower supplies revenue was only partially offset by fewer hardware units and lower operating expenses.

For the first quarter, ISD unit sales decline 30% year-to-year, due to impacts on the ongoing shift in our inkjet strategy and the weak global market; however, overall inkjet unit sales were slightly better than expected and were helped by our expansion of shelf space in US superstores during the quarter.

In the first quarter, we had growth in our higher end branded inkjet units, driven by strong growth in our branded wireless inkjet units and strong growth in our professional series products.

As part of our ongoing to reduce cost structure and expense, today we are announcing an additional restructuring program, including the planned closure of our remaining inkjet print head manufacturing facility in Mexico, as well as some continued restructuring of our workforce worldwide.

Overall, these actions will result in pretax charges of approximately $50 million with cash cost estimated at about $10 million dollars. We expect these actions to be substantially complete by the end of Q1 of 2010 and we expect 2010 cost savings of over $20 million dollars.

As we look into the second quarter, we expect ongoing weakness in the global economy with weakness in end user demand in both hardware and supplies and year-to-year unit declines in our sales of both inkjet and laser hardware.

We expect year-to-year currency shifts to negatively impact revenue and margins. In addition for supplies, we also expect shrinkage of channel inventory levels as well as seasonal sequential decline in inkjet supplies.

These factors are driving our expectation of a year-to-year decline in revenue in Q209, comparable to our revenue decline in the first quarter.

In the second quarter, we currently expect GAAP earnings per share to be in the range of $0.17 to $0.27 with about $0.33 per share in restructuring-related charges.

Earnings per share, excluding restructuring-related charges are expected to be in the range of $0.50 to $0.60. However, despite the current economic weakness, we see many positives in our business and some growing strengths. In our Printing Solutions and Services Division, we are continuing the rollout of our new laser product line with improved features, performance, and print quality, and including a significant expansion of our laser MFP and color laser lines.

Overall, between the fall of 2008 and spring 2009 announcements, we will have introduced 70 new laser products, reflecting the results of increased laser R&D investment over the last several years.

During first quarter, we continue to see good growth in our laser multi-function products and hope to continue this momentum with the new laser multi-function product line. We continue to have good growth in our management services business and continue to win new contracts with our enterprise customers and we believe in our enterprise value proposition to help our customers to print less and to significantly reduce the cost and improve the sustainability of distributed printing as a powerful proposition as our customers are looking to lower their cost and expense.

In our Imaging Solutions Division, while we are still transitioning the business, we are encouraged due to the significant expansion of our retail shelf space and US offered superstores that we announced in the first quarter, the increased customer activity to improve inkjet product line, driven by our focus on models and the introduction of our professional series products. The increased industry recognition and rewards that now was given Lexmark the most awarded line of wireless inkjet printers in the industry, the continuing sequential increases in the retail sellout of our professional series inkjets here in the US, and our number two overall wireless market share position, and the ongoing good growth and the retail sellout of our wireless inkjets in our top five countries.

In both laser and inkjet, we continue to invest in our core print technology and product development and are driving a strong pipeline of future Lexmark products.

While our near term results are clearly where we would not like them to be, we are continuing to better align ourselves with the current market environment, including continuing to take actions to reduce our fixed infrastructure and business support costs, which are projected to generate savings of about $190 million this year.

We continue to maintain a conservative capital structure and a solid balance sheet, all of which positions us well to prudently invest in the future and successfully compete.

I’ll now turn it over to John Gamble for his more detailed comments on our financials.

John Gamble

Thank you, Paul, and good morning.

Consistent with previous calls, I’ll first discuss our results of the first quarter of 2009 relative to the prior year, then relative to the fourth quarter of 2008. I’ll then discuss selected changes on the balance sheet and certain items of cash flow. Finally, I’ll finish with more detail regarding our guidance for the second quarter.

I will call out the impact of restructuring related expense as we walk through the P&L. In the supplemental slide deck posted on our investor relations website, we have included details on the income statement line items impacted by the restructuring related activities.

Please note that my comments will be segment specific by PSSD and ISD.

Now let me begin with the P&L. Total revenue for the quarter was $944 million, down 20% compared to last year, down 13% sequentially from 4Q. These results were slightly below our guidance expectations, driven by the strengthening of the US dollar during the period and weaker market conditions.

Geographically for the first quarter, U.S. revenue of $422 million declined about 14% year-to-year. Europe revenue for $351 million declined about 23% year-to-year. The remaining geographies declined about 26% versus a year ago.

The currency impact on Lexmark revenue for Q109 versus Q108 was approximately negative 7%. The currency impact on Lexmark revenue in Q108 versus Q109 was approximately positive 5%.

Supplies revenue in the first quarter declined 16% year-to-year. This decline was slightly larger than anticipated, reflecting both lower end user demand, primarily in PSSD and weakening foreign currencies during the quarter. Year-to-year, price increases partially offset the negative impact to foreign currency. In Q109, we did see a decline in channel inventory in both inkjet and laser supplies, but not to the extent we had expected.

Channel inventories remained high at March 31 and we expect to see further channel inventory declines in Q209.

Worldwide we believe end user demand for Lexmark laser pages declined in Q109 versus Q408, reflecting the weak economic environment and user demand also declined for inkjet supplies in Q109, primarily due to our transition in the business and the resulting smaller install base.

Hardware revenue in the first quarter declined 30% year-to-year and declined 25% sequentially. Year-to-year, the hardware revenue decline was primarily due to hardware volume as well as negative currency effects on US dollar revenue and lower hardware pricing. Sequentially, the decline in hardware revenue is more than explained by lower hardware volume.

PSSD revenue for the quarter was $599 million, a decline of 19% from the same quarter in 2008 and a decline of 17% sequentially from Q408.

The year-to-year and sequential declines were driven by declines in both supplies and hardware revenue. PSSD hardware revenue declined 30% versus Q108. This decline was driven primarily by lower unit volume, negative impact on revenue of weakening foreign currencies, and lower pricing.

PSSD laser hardware units declined 25% in the first quarter versus the prior year. Despite the continued weak market conditions, we saw good growth in laser MFP’s. PSSD laser hardware average unit revenue decline 5% year-to-year in the first quarter.

ISD revenue for the quarter was $345 million, down 20% from the same quarter in 2008, and a decline of 6% sequentially from Q408. The year-to-year decline was driven by declines in both supplies and hardware revenue. The sequential decline of 6% is primarily driven by lower inkjet hardware revenue. ISD hardware revenue was down 32% versus Q108. Again, this decline was driven primarily by lower unit volume as well as the impact of weakening foreign currencies and continued price pressure. These negative effects were partially offset by the continuing positive impact of our improving mix toward higher priced hardware devices.

ISD hardware units declined 30% year-to-year in the first quarter. In the quarter, we saw good growth in sales of higher end devices. ISD hardware AUR in the quarter declined 3% versus the prior year, reflecting the impact of weaker foreign currencies, as well as continued price pressure, which were partially offset by the positive mix shift.

Gross profit margin for Q1 was 35.3%. Excluding restructuring related charges of approximately $5 million, gross profit margin would have been 35.8%, down 170 basis points versus the prior year and up 540 basis points sequentially.

The 170 basis point first quarter decline versus last year was principally due to a 450 basis point decline in product margins, driven by lower hardware margins reflecting primarily the net impact on effective US dollar price, of weakening foreign currencies, and continued general pricing pressure.

This product margin decline was partially offset by a favorable mix shift reflecting a higher relative percentage of supplies versus hardware. Sequentially, the 540 basis point increase was due to a 320 basis point increase reflecting favorable product mix. Again, more supplies relative to hardware, and a 220 basis point increase reflecting favorable product margins across both hardware and supplies, primarily reflecting cost improvements in supplies and manufacturing and distribution support functions.

Other expense for the quarter was $259 million, with restructuring related expense of approximately $8 million. Excluding this impact, operating expense was $251 million, a reduction of $55 million versus Q108.

SG&A in the quarter was $153 million, a reduction of $47 million from Q108, reflecting lower expense levels in both marketing and G&A. SG&A was lower broadly, reflecting the benefits of our restructuring and other expense reduction measures as well as weaker foreign currencies.

R&D in the quarter was $97 million, a decrease of $8 million from Q108.

Sequentially, operating expense excluding restructuring related expenses declined $32 million versus the fourth quarter, driven by sequential reductions in marketing and sales and R&D.

Operating income in Q1 was $75 million. Excluding total restructuring and related costs and expenses of $13 million, operating income was $87 million, down $47 million from Q108 and up $41 million sequentially from Q408. The reduction in Q109 operating income versus Q108 was driven by lower income in both PSSD and ISD, reflecting the current market weakness, partially offset by lower other segment expenses. The increase in Q1 versus Q408 was primarily due to higher ISD income and lower other segment costs and expenses.

Excluding restructuring related activities, PSSD operating income in Q109 of $95 million was down $49 million versus last year and up slightly sequentially. The reduction versus last year has been driven by lower gross margin dollars, primarily reflecting the negative impact of weaker foreign currencies on both supplies and hardware, as well as the lower supplies volume we are seeing due to the global economic situation, partially offset by lower operating expense. Again, excluding restructuring related expenses, ISD operating income in Q109 of $55 million was down $25 million versus last year and up $25 million sequentially. This reduction versus last year is driven by lower supplies revenue, reflecting the actions we are taking to reposition the ISD business and the global economic situation as well as the impact of weaker foreign currencies. These impacts were partially offset by less hardware revenue and lower operating expenses.

Other segment expenses, consisting primarily of costs related to centralized supply chain, IT, and other operating expenses, primarily G&A, were $62 million in Q109 excluding restructuring related activities. This was $27 million lower than Q108 and $14 million from Q408, both driven by our focus on expense reduction and less negative transaction effect from the impact of weakening foreign currencies.

Operating income margin in Q1 was 7.9%. Excluding restructuring related expenses, operating income margin was 9.3%, a decline of 220 basis points from the first quarter of 2008 and an increase of 500 basis points sequentially.

Concerning financing and non-operating costs, in Q109, the net interest and other was an expense of $4 million, up from $6.2 million net income in the Q108, primarily driven by increased interest expense related to the Q208 debt issuance. Sequentially net interest and other were favorable $1.2 million.

Our effective tax rate in Q109 was 16.2

Net earnings for the quarter were $59 million. Excluding the $11 million after tax cost from restructuring related activities, net earnings in Q109 were $70 million. Q108 net earnings were $102 million, or $111 million excluding after tax restructuring related expenses.

GAAP earnings per share for the quarter were $0.75. Excluding restructuring related activities, EPS would have been $0.89. This compares to Q108 GAAP earnings per share of $1.07 or $1.16 excluding restructuring related activities.

Now moving to the balance sheet and cash flow items, cash flow from operations for the quarter was negative $86 million. In quarter, restructuring related cash outflows were $19 million and we made pension contributions of $79 million. Excluding the Q109 restructuring and pension contribution, cash flow from operations was a positive $12 million. This level was much weaker than the generally strong cash flow we generate due to a significant increase in our inventory base in the quarter. Inventory declined in the period only slightly and did not keep pace with the decline in our revenue. This was particularly true in supplies.

Our receivables and payables performance remained relatively good in Q109. We are expecting improved cash flow in Q209 as we focus on improving inventory turns and reducing inventory while maintaining good receivables and payables performance.

Also, in Q209 and each of the remaining quarters of 2009, pension contributions should be approximately $5 million.

First quarter capital spending was $68 million and we are expecting about $70 million Q209. In 2009, our capital spending in much heavier in the first half of the year. For full year 2009, we continue to expect about $225 million in capital spending. The second half of 2009, spending much lower than first half spending.

Since the end of December, accounts receivable decreased $12 million. Inventory decreased $8 million. Accounts payable decreased $84 million and accrued liabilities declined $78 million dollars.

Depreciation in the quarter was $44 million and includes $2 million of restructuring related accelerated depreciation.

Cash and total marketable securities at the end of Q109 was $811 million. Total long-term debt at the end of Q109 was $650 million with maturities on the debt in 2013 and 2018. At quarter end, we have $491 million of share repurchase authority outstanding. No shares were repurchased in the quarter.

During the quarter, an agreement was reached in which Lexmark participated regarding the copyright fees to be paid on all-in-one devices sold in Germany after 2001. Lexmark had accrued about $41 million in copyright fees related to these devices and the settlement requires Lexmark to pay approximately $39 million. This settlement resulted in a $2 million gain in Q109 with a $39 million payment scheduled to be made in July 2009.

Before moving to restructuring, I would like to briefly address our Q109 EPS performance versus guidance. In Q109, Lexmark exceeded our guidance EPS range by $0.14 per share despite supplies revenue being weaker than anticipated. This improved performance versus guidance reflects significantly lower operating expense and other costs due to the additional cost reduction actions I reference at our analyst meeting last month and good execution on our restructuring plans as well as an improved hardware mix within each division and a $0.06 per share benefit from one-time items, including the German copyright fee settlement, insurance settlements, and other items. These positive effects more than offset the negative impact of lower than expected supplies revenue.

Now let me move to restructuring. As part of an ongoing plan to consolidate manufacturing capacity and reduce costs worldwide, Lexmark today announced the planned closure of its remaining inkjet cartridge manufacturing facility in Mexico, located in Juarez, by end of first quarter 2010, as well as other actions to continue to reduce cost and expense. These actions will result in pretax charges of approximately $50 million of which $45 million expected to be incurred in 2009. The cash cost for the program are expected to be $10 million of which $8 million expected to be incurred in 2009.

Restructuring charges in the first quarter of 2009 related to these actions were approximately $2 million. Lexmark expects these actions to be substantially completed by the end of Q1 2010 and currently expects 2010 cost savings of over $20 million with 2010 cash savings to exceed $15 million. In 2009, expect savings of $5 million of which $3 million will be cash. The $5 million in additional 2009 savings in cost and expense from this restructuring increases the cumulative savings I referenced at our recent analyst day to $190 million from $185 million.

The restructuring plans announced in October 2007 and July 2008 are substantially complete. For the restructuring announced in January 2009, we continue to expect the overall program parameters, costs, and benefits be about the same as discussed last quarter.

In Q109, total pretax restructuring and related costs and expenses were $13 million. In Q109, restructuring cash outflow was $19 million and savings from our 2007, 2008, and 2009 restructuring actions were $24 million.

In Q209, restructuring and related cost and expenses are expected to approximately $31 million. Savings in Q209 from the 2007, 2008, and 2009 restructurings are expected to be about $33 million. More details regarding the breakdown of costs are available in the supplemental slide.

Now for my forward-looking comments concerning Q209. We expect Q209 versus Q208 revenue to decline on a percentage basis, an amount consistent with the percentage decline incurred in Q109. This reflects our expectations with the continuing weakness of the global economy to negatively impact hardware unit sales with unit declines year-to-year in our sales of both inkjet and laser hardware.

For supplies, we are expecting the continued economic weakness and the shrinkage of the current channel inventory levels to result on year-on-year supplies revenue declines consistent with that incurred in Q109.

GAAP EPS is expected to be $0.17 to $0.27 in Q209. GAAP EPS includes expected restructuring charges of $0.33 per share. Non-GAAP EPS, excluding restructuring and related costs and expenses, is expected to be $0.50 to $0.60.

GAAP EPS in the second quarter of 2008 were $0.89, which includes a net restructuring benefit of $0.07 per share. Non-GAAP EPS in Q208 were $0.96.

EPS in Q209 is expected to be weaker than Q109, primarily due to the sequentially lower ISD supplies revenue and the absence of the one-time benefits that occurred in Q109 that I referenced earlier.

All of the comparisons that follow exclude the impact of restructuring. In the second quarter, we expect gross profit margin percentage to be down versus the 35.8% we achieved in Q109.

Operating expense is expected to be about flat with the $251 million incurred in Q109.

Operating income margin in the second quarter is expected to be below the 9.3% achieved in the first quarter of 2009.

For Q209, we expect our ongoing effective tax rate to be about 16% before any discrete items.

We project full year 2009 capital spending to be approximately $225 million and we expect full year depreciation to be approximately $210 million, including the impact of accelerated depreciation related to facility closures.

The guidance provided is based on foreign exchange rates as of 3/31/09. Based on these rates, the currency impact on Lexmark revenue in Q209 versus Q208 is expected to be about negative 8%.

Now, before opening the call up for your questions, I would like to point out that our financial position remains strong. We continue to have a solid balance sheet and good liquidity with over $800 million in cash and current marketable securities, a revolver of $300 million that does not expire until Q1 2010, and AR facility of $100 million. Our strong financial structure continues to position us well to invest in the future and compete effectively even during challenging times like these.

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 line of Shannon Cross of Cross Research. Please go ahead.

Shannon Cross - Cross Research

Paul, if you want to take this, discuss the recent court ruling and the static control litigation, how we should think about the potential impact to your business, how you’re communicating any changes with your channel, and your options going forward.

Paul Curlander

Let me first say that this is ongoing litigation, so we can’t really comment on ongoing litigation, but what we can say is that we execute the Lexmark return program globally and every geography, it’s very popular with our customers because we give them choices. It drives in significant collection of empty cartridges, environmentally a very strong program for Lexmark. In every geography, we have contracts where we basically enforce those contracts with chips that do functional things as well as help with the enforcement.

Only in the US do we have the additional protection of the intellectual property single use license. Now this latest ruling in the district court had to do with that single use US license. So what that really means is that beyond that the US is like every other country in the world where we execute return programs. We expect to continue to execute the return program just as we have been doing and we don’t see a change in our business related to that. Again, the litigation is ongoing. It’s not over.

Shannon Cross - Cross Research

John, if you could talk specifically about how you’re looking at improving work in capital, maybe changes you put in place, any specifics you can give us?

Paul Curlander

Sure. As we said, the largest area of focus is in terms of our inventory improvements. So obviously we’re very focused there on making sure we properly balance production with demand and there’s ongoing efforts there. A lot of the inventory issue was really in the supplies area. So we’re very focused on improving whip and turns within our facilities as well as entire supply chain around supplies.

Bottom line is we didn’t as rapidly as we wanted to get inventory down at the same rate as which revenue declined and we think we’ll have a path forward to make significant improvements as we move through the rest of the year.

The other area which wasn’t nearly as significant, but where we certainly are focused, is in receivables. Our collections remain very good. Our collections days didn’t move materially. On internal measures, they’re still in the mid-30’s, but the days did go up about two days from fourth quarter. So we’re very focused obviously on refocusing on delinquencies and making sure that we drive those down as we look into the second quarter.

The impact of the economy on that, we’ll have to determine as we move through the quarter. Obviously a major effect that occurred in the first quarter, which we will not see again in the second quarter, not specific to work in capital, is the pension contribution which we had talked about in January, which we did indeed make in March, which should not have to recur in the second quarter, only about $5 million dollars versus $79 million.

Operator

Your next question is coming from the line of David Bailey of Goldman Sachs.

David Bailey - Goldman Sachs

Could you give us a little more detail around your comments about the decline in supplies in Q2? The decline in Q1 was worse than expected even though there was a smaller correction in channel inventory. Do you expect a similar decline in Q2 with a more pronounced bleed of channel inventory. So I’m trying to figure out if you’re trying to say the demand is going to improve in Q2 on the supply side.

John Morgan

David, a couple things. First, as we look at the first quarter, supplies came in less than expected and the main reason it came in less than expects is because we saw a weakening in end user demand for supplies particularly in the business market, but actually we saw some weakening in both inkjet and laser side.

We also saw in the first quarter a negative currency effect. In the second quarter, it was down what we had expected and those two things were partially offset by less shrinkage than what we expected.

As we look into the second quarter, we see the deterioration in end user demand on supplies. We’re kind of assuming that that’s going to be about the same in the second quarter. I think on the inkjet side we’re estimating it a little bit more in OEM area that we might be a little weaker in terms of end user demand in the quarter and that moves around quarter-to-quarter. Overall, we’re thinking the end user demand is about the same.

In terms of the impact on shrinkage, what we’re expecting to see is some more shrinkage, because we didn’t get as much as what we had expected in the first quarter. Also, we typically tend to see some shrinkage on the inkjet side in some areas as we move toward the beginning of the third quarter, which is really a very slow time for ink jet supplies. So really what you’re seeing in terms of looking at the second quarter, we’re thinking end user demand is going to be about the same and thinking we’re going to get about the same amount of shrinkage roughly as what we saw in the first quarter. Overall, the net is we think the decline in revenue is about the same as what we saw year-to-year in the first quarter.

David Bailey - Goldman Sachs

Why do you think the shrinkage in Q1 was less than expected?

John Morgan

I think when you get the weakening in end user demand, this is what causes it, because we’re planning to ship in a certain amount. We’re thinking a certain amount is coming out and we’re thinking the overall inventory level is coming down a certain amount.

When you don’t sell out as much, you get less shrinkage. Also, We continue to see currency movement, so we continue to be doing price increases outside the US and this also tends to drive a little bit more inventory back into the channel. So between the weaker sellout and the timing of some price increases driven by the currency movements, we had less shrinkage. So we’re going to see some more in Q2.

Operator

Thank you. Your next question is coming from Toni Sacconaghi of Sanford Bernstein. Please go ahead.

Toni Sacconaghi - Sanford C. Bernstein

I wanted to follow-up on the supplies question. My analysis suggests that supplies in the laser business decelerated pretty meaningfully from Q4 to Q1 on a year-over-year basis. I think you were down about mid-single digits in Q4 year-over-year for laser supplies and you were down about mid-teens in Q1 year-over-year, whereas in the inkjet business, it actually looks like your supplies growth rate got a little bit better in Q1 relative to Q4. So please correct me if those are directionally wrong, but I think given the numbers that you provide, they’re probably directionally correct. Why did you see such pronounced weakness in end user demand on the laser side and what gives you confidence that that was just a one quarter phenomena?

John Morgan

Toni, I would say overall your analysis is directionally correct. In the laser side, we did see a significant erosion in end user demand between the fourth quarter and the first quarter. As we look forward into the second quarter, we’re not assuming a recovery on that level of demand.

Our current assumption is we’re not getting worse and we’ll find out that’s true or not as we go through the quarter, but our assumption in second quarter outlook is that we have that same weakened level of end user demand that we saw in the first quarter.

Toni Sacconaghi - Sanford C. Bernstein

Paul, what do you think drove that significant weakening in end user demand specific to the laser business in Q1, is that an install base phenomena? Is that an employment? Is that a substitute issue to remanufacture cartridges? Is that changes in inventory at the customer level? When you’re talking about a 10 percentage point deceleration, that’s pretty significant and I’m surprised there’s not more anxiety about where that might go.

Paul Curlander

Toni, there’s a lot of focus on this inside Lexmark. This is one of the major issues we spend our time on. Don’t think there’s been a lack of focus on this issue. As you look at the business overall, we do believe on the laser side this is being driven by employment levels, usage, and cost cutting efforts in primarily in business accounts. That’s what we think.

As we look at our managed print services business, where we really can track people’s usage. We see decline there in the high single digit in terms of usage from where we were back in third or fourth quarter timeframe. So we’ve seen an erosion in customer usage driven by primarily enterprise, but certainly businesses of all sorts.

As we look in the open channel, back on the enterprise side, again, most of that enterprise business certainly demands conservative business is covered by contracts. There’s no loss to re-man in those accounts.

Now, if you look at the open channel, we’re seeing a little bit larger decline than that minus 7%, but here we moved prices pretty significantly. Again, we think that customers are using less. It’s possible that there’s some loss to re-man in those areas. It’s hard to say. It’s possible there’s some inventory shrinkage in the second channel or in customer accounts. It’s hard to say. We can’t really tell from the data that we have, but we’re very focused on re-man. We continue to address our cartridges. We continue to sell private label on our re-man business. We continue to work very hard in our enterprise accounts. We think fundamentally that businesses are putting a concerted effort on printing less and also have fewer people. This is the major factor that we’re seeing in this end user demand.

Toni Sacconaghi - Sanford C. Bernstein

Can you comment on where you are in your ISD retail expansion and what benefit either in terms of a build in channel inventory or a build in actual sell through units you saw in Q1?

John Morgan

In terms of the expansion that we described in the first quarter, we’re pretty much there. There may be a SKU or two that rolls over here in the second quarter, but the bulk of it was done in the fist quarter.

In terms of impact on our ISD hardware revenue and units, all of that impact from OSS will sell out impact. So we had a good start in OSS with the expansion in terms of the sellout. That looks good and continues to look good through the first couple weeks of April.

Operator

Your next question is coming from Kathryn Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

…the balance sheet. Is it fair to assume that you need to slow manufacturing pretty significantly in this second quarter and if that is the case, how do you balance the lower manufacturing utilization with what you can do on shutting some of those facilities down and what do you think the net impact is to gross margins sequentially given the need to change?

Paul Curlander

We’re not sure we heard all your question. We kind of heard the back end of it. What we’re focused on from an inventory perspective is clearly trying to slow down the inputs, we’re trying to slow down our production. The biggest issue for us is around supplies and we’re very focused on that. We’re focused on that in the laser side and we’re focused on that on the inkjet side. On inkjet side, we just announced another plant closure. So we’re consolidating our inkjet production now into our remaining facility, which is in the Philippines. So as we do that, the need to reduce production there are being accommodating as we work through that transition.

On the laser side, we got more work to do. Obviously we do plan some slowdown on productions significantly and there will be impacts in our plans. You’re quite right that as we do that, there then are some additional issues that can flow into gross profit. We continue to work very hard on cost and all of those factors are figured into the guidance for second quarter.

Kathryn Huberty - Morgan Stanley

Is there any line of sight as to the 70 new laser products plus some expanded distribution driving market share gains and ultimately the install base so that you can get back to laser supplies growth? Or is that too far off to have any visibility into?

Paul Curlander

If we take a look at the market right now, we don’t have good date globally, but if we look at just things like US distribution, looking at the nature of the distributors in the US. Overall laser units were down about 26% market units. Lexmark was down less than that. 25% was decline overall, but our branded business was quite a bit less than that. The OEM business was very weak for us.

So as I just look at the market data we have, we look like we’re doing better than the market. Relative to market share, in our analyst day presentation, Marty showed the slide on our work group products that showed that we were gaining market share through every quarter of 2008.

So we think on the working side, we are gaining share. We think we’re declining less than the rest of the competitors out there, but really we’re going to have to wait to recovering….laser unit growth again in the market and probably for Lexmark as well. But in the meantime, given what we’ve done in improving our laser multi-function products, we are seeing good growth in laser multi-function products here in the first quarter. As that continued, we were seeing in 2008 and certainly in the fourth quarter of 2008 and with the broadening that we’re doing of our multi-function line, we would certainly hope to continue that momentum on the multi-function side.

On the color side, we’re looking to improve our momentum there and, again, we’re expanding our color line also. With introduction of the C5-40, X5-40 class devices and as we showed at analyst day we have some additional workgroup products. They’re not yet announced.

Operator

Thank you. Your next question is coming from Ben Reitzes - Barclays Capital. Please go ahead.

Ben Reitzes - Barclays Capital

On the laser side, you had units. Obviously I realize branded were better, but units dropped off from about negative 8% last quarter to negative 25% and supplies went down not nearly as much, even though the supplies decelerated or the decline got worse in laser supplies. It didn’t seem like it was as much as the decline in units changed sequentially on a year-over-year basis, if you follow me. It seems that your Q2 you’re assuming a pretty similar laser printer environment. Would it make sense that laser supplies, a negative 25% unit environment could get worse or do you think it kind of levels of that mid-teens decline? The declines seem like they’re on a little bit of a lag stone, the laser printer decline as to where you are in units, and I’m just wondering if there’s further catch-up on decline in supplies on the laser side?

John Morgan

As you point out, there’s two different factors going on. Supplies are driven much more by install base and the usage per unit in the install base, whereas the unit sales are totally disconnected from that. Clearly what we saw was a deceleration in the business market environment between fourth quarter and first quarter.

Our assumption in the second quarter is that business environment is the same as the first quarter. Could it decelerate more? It could. Could it get better? I don’t know. It might. But as we usually do when we do our outlooks, we don’t try and guess what’s going to happen. We just assume that same environment and that’s kind of what is reflected in that outlook.

As we look at supplies, obviously if hardware is decelerating at a greater rate, ultimately you see that reflected in supplies at some period of time. So a lot of that I think is going to be determined by how long this economic downturn is.

In terms of our outlook on supplies, clearly we have a view for where our supplies business should be. We have a view of what we’re going to sell in the second quarter and all of that is rolled into our estimate on the supplies. So we think that what we’re expecting in the second quarter in hardware and supplies is consistent with what we know about how the install base works and again the assumption that deceleration in the business market environment stabilizes between first and second quarter and we’ll see if that’s the case.

Ben Reitzes - Barclays Capital

With you guys getting in the office superstore channel and it was kind of late in the quarter, does that make it harder to cut channel inventory or what are the dynamics behind that in terms of your efforts to cut cartridge and even hardware inventory when you’re entering such an important new channel?

Paul Curlander

The office superstore statement and that’s what we made is really a retail announcement. The bulk of our supply inventory is on the laser side, which is the biggest piece of what we need to do is not in office superstores. So really it’s a focus on the inventory that we’re holding through our major distributors. Also, as John pointed out in terms on work in capital, we’re looking at Lexmark’s inventory as well on supplies.

So I think relative to office superstores, I think our view there is just a positive. It’s going to drive more sellout for us and if not the source or the key element relative to our inventory. Although clearly, when you put stuff in office superstores, there is channel inventory.

Ben Reitzes - Barclays Capital

Did you see conditions worsen throughout the quarter on the business market?

Paul Curlander

We saw it weaken quite a bit from what we’ve seen in the fourth quarter and this is why the units lasers at the minus 25 is much worse.

Ben Reitzes - Barclays Capital

And March was worse than January?

Paul Curlander

We don’t break down the quarter by month. I’m talking about the quarter overall.

John Morgan

When you’re comparing hardware and supplies revenues, just please keep in mind that there’s a very significant impact to currency effects on revenue year-on-year, in the first quarter as well as the second quarter. So we seem to be a little careful with that comparison.

Operator

Your next question is coming from the line of Bill Shope - Credit Suisse.

Bill Shope - Credit Suisse

Given the performance this quarter, I was wondering if you could help us understand how we should think about free cash flow for full year 09. I understand you can’t give us a quantitative outlook, but can you tell us if you think it will be positive or negative and given that, do you think this will have any impact on your efforts to renew the revolver in first quarter 2010?

John Morgan

So in terms of cash flow, in terms of a full year forecast, we don’t forecast that far out. In terms of near term, second quarter obviously we’re expecting to make very significant improvements versus what you saw in the first quarter and obviously our intention and our goal would be to drive a positive result.

As you looked historically at Lexmark, we have had very, very good cash flow performance historically. So without giving a full year forecast, I can assure that we’re heavily focused on improving the situation that occurred in the first quarter and our expectation is it will see very significant improvements.

In terms of the revolver, that’s something we’ll start working on and have been working on, and as we move through that process you’ll see it go into the market. At this point, I’d say market conditions are probably the most meaningful impact on revolver renewal versus our performance. Obviously the market or any type of financing now is somewhat difficult.

Bill Shope - Credit Suisse

Are you seeing any derivative impacts from your competitor efforts to reduce consumable channel inventory, either in laser or inkjets?

Paul Curlander

We’re not seeing anything that’s very different than what we normally see. I mean we always see when our competitors come to the end of the quarter, there may be some level of channel load that may impact open to buy dollars, but that’s just business as usual. So we’re not seeing anything that’s markedly different.

Operator

Thank you. Your next question is coming from Bill Fearnley of FTN Midwest. Please go ahead.

Bill Fearnley - FTN Midwest Research

On the other costs, they’re down sharply year-over-year. Should we be expecting the other expense to be running about $60 million per quarter?

John Morgan

We don’t forecast by segment, but we indicated that operating expense is going to about flat and so you can see the amount of the expense that’s directly in that segment. So you can draw your own conclusions. Obviously we’re heavily focused on reducing cost and expense and as we said for several years, we’re more focused in overhead cost than anywhere else. So you can be assured we’re continuing to focus on anything which isn’t directly related to the customer or development.

Bill Fearnley - FTN Midwest Research

Can I ask a follow-up question on the channel inventories. Focusing on the hardware side, what are the trends here quarter-to-quarter and year-over-year in inkjet and laser hardware inventories and any additional color by geography would be helpful as well. Either you’ve got new channel initiatives, you’ve got new products, you’ve got some potential issues with sell through, but any additional color on inventory by geography and product would be helpful as well. Thanks.

Paul Curlander

Well overall on channel inventory in the hardware side, it’s not quite the issue we have on supplies. In terms of geographies, we may be sitting a shade high on channel inventory on hardware. That’s kind of inkjet statement I would say.

On the laser side, we saw some shrinkage in channel inventory in hardware, certainly in the first quarter. So I think overall what happens is when the market demand slows down, you end up with a little bit more inventory in the channel, but we’re also under fairly tight credit conditions in our channel partners, so their desire to hold much excess channel inventory is at an all time low. So from their perspective, they cut off their orders pretty quickly when something like that happens.

Operator

Thank you. Your next question is coming from Richard Gardner of Citigroup. Please go ahead.

Richard Gardner - Citigroup

Paul, first of all, I wanted to clarify, did you say earlier in response to a question that the bulk of the excess supplies channel inventory was on the laser side of the business not the inkjet side?

Paul Curlander

You talking about the Lexmark inventory?

Richard Gardner - Citigroup

No, actually the channel inventory.

Paul Curlander

We have high channel inventory in both lasers and inkjet and we’re expecting shrinkage in both laser and inkjet. Probably a little bit more inkjet shrinkage here in the second quarter than laser, because the inkjet inventory often needs to come down, because the beginning of the third quarter is a very slow period for sales.

John Morgan

The statement on inventory was internal, right? That we said more of the excess inventory, of our inventory, was in laser supplies than inkjet supplies.

Richard Gardner - Citigroup

Thank you, both. Then I was wondering if you could give us some sort of sense of how many weeks of inventory, supplies inventory, need to come out of the channel. We had actually been hearing from some of your competitors that inventories exiting the March quarter had gotten down to levels where they didn’t expect any further de-stocking and definitely doesn’t sound like that’s consistent with your experience. Is it one week, two weeks, or more than that?

Paul Curlander

Well we don’t quantify our estimates on the channel inventory. In terms of the amount of shrinkage we’re looking for in the laser side, probably it’s less than what we had in the first quarter on the inkjet side. Maybe a little more than we had in the first quarter.

John Gamble

I was wondering, finally, if you could quantify how much channel fill benefit there was to inkjet unit shipments during the March quarter and whether we should be expecting inkjet units to be flat or up or down in the second quarter. It sounds like now you finished the channel expansion, perhaps we should expect inkjet shipments to be down sequentially in Q2.

Paul Curlander

Well if we look at the first quarter, in terms of the benefit the inkjet shipments for the channel expansion we announced, as I said earlier, is essentially none. That we had sellout and that’s what drove our results.

Typically, as we go from first quarter to second quarter, seasonally you see fewer inkjet unit sales. So that’s not unusual for that to occur. What’s going on for Lexmark is obviously a little unusual, because we’re transitioning our business.

So as we talked about on our analyst day, in US and Europe, we’re very focused on driving high end units, but also we said that in emerging markets we’re doing some additional pullback. So both of these things are going through our business.

In the first quarter, we had growth in our high end inkjet branded units and certainly we’re hoping to continue to drive that as we go forward in time, but again, as I said, there’s seasonal things to give you sequential decline and there’s also the transition we’re doing in emerging markets with some further pullback.

So that gives you some color. Obviously we don’t give out guidance around the inkjet units or laser units for the next quarter.

John Gamble

I think John is going to kill me, but if I could flip one more in. You had talked about doing two 5% price increases in US dollar terms or thereabouts. I’m not sure you put a specific 5% number on it, but could you talk about whether you’ve completed those two price increases and whether you have plans for any additional price increases at this time.

Paul Curlander

Well relative to the US, we’ve executed those price increases. Our challenge really is the currency movement and trying to be harmonized around the world. We’ve seen a lot of currency movement even during the first quarter. We’re probably not quite to where we’d like to be in terms of harmonization, but we’ve also done a lot of increases. Probably our focus as we look forward is to try and stabilize the channel, but we’ll have to evaluate that depending on how the currency moves.

John Gamble

Thank you, Paul.

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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