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Lexmark International (NYSE:LXK)

Q1 2013 Earnings Call

April 23, 2013 8:30 am ET

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

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

Kathryn L. Huberty - Morgan Stanley, Research Division

Scott D. Craig - BofA Merrill Lynch, Research Division

Shannon S. Cross - Cross Research LLC

Benjamin A. Reitzes - Barclays Capital, Research Division

Ananda Baruah - Brean Capital LLC, Research Division

Jim Suva - Citigroup Inc, Research Division

Kulbinder Garcha - Crédit Suisse AG, Research Division

Chris Whitmore - Deutsche Bank AG, Research Division

Benjamin James Bollin - Cleveland Research Company

Operator

Thank you for standing by, and welcome to the Lexmark International First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded on Tuesday, April 23, 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 will open the call for your questions, as time permits.

Please note that Paul and John will be referring to specific earnings presentation slides by page number. These 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 their presentations unless otherwise noted. Pursuant to the requirements of 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 GAAP to Non-GAAP Reconciliations section of the earnings presentation slides.

Following the conclusion of this conference call, a complete replay will be made available on our IR website.

Lexmark anticipates that the record date of its second quarter 2013 dividend will be May 31, with an anticipated payment date of June 14. Please note that future quarterly dividend payments are subject to board approval. We've also included our anticipated dividends schedule for the remainder of 2013 and 2014 in the supplemental section of our earnings presentation. Also, if you haven't already done so, please take a moment to register to attend our Investor Day in New York City scheduled for 2 weeks from today, on May 7. Event details and a registration portal can be found on the landing page of 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 the call over to Paul.

Paul A. Rooke

Well, 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. It was a solid quarter for Lexmark overall. Our first quarter financial results delivered revenue and earnings per share at the high end of the guidance range, a record first quarter gross profit margin percentage and solid cost and expense management. We continued our progress in creating a higher-value portfolio for Lexmark, shifting from a hardware-centric company to a solutions company, with double-digit revenue growth for both Managed Print Services and Perceptive Software, while advancing our strategic software capabilities with 2 acquisitions.

We are working to increase our profitability and remain committed to our long-term operating margin assumption of 11% to 13%. The restructuring action we announced last August, driven by the Inkjet Exit, to improve our profitability, is substantially complete. And we will -- and we still expect 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've added 8 strategic software acquisitions since 2010. We remain committed to 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.

On Slide 5, you can see the first quarter financial highlights. Revenue for the first quarter was $886 million, at the high end of the guidance range, driven by good ISS performance. On a year-to-year basis for the first quarter, while overall revenue was down 11%, we saw a continued revenue growth in our strategic focus areas, with Perceptive Software revenue growing 54% and Managed Print Services growing 10% in the quarter. Now while we had revenue growth from MPS and Perceptive Software, this was more than offset by the headwinds of a continued weak economic environment and the planned ongoing decline from the Inkjet Exit.

Our operating income margin was 9.1% for the first quarter, down year-to-year but up 150 basis points sequentially, as expected. Now there are a few dynamics to note here. First, our gross profit margin percentage was up 380 basis points sequentially and 40 basis points year-to-year. Second, operating expense was down sequentially and year-to-year for the first quarter, as expected, with reductions in ISS more than offsetting increased software investments to drive future growth. We're beginning to see the benefits of the previously announced actions to improve our cost and expense structure in 2013 and beyond. And finally, Perceptive Software's revenue was up strongly year-to-year again, but less than we expected, driving a larger operating income loss than we had planned. We're taking additional actions to further reduce Perceptive Software's cost and expense growth to improve profitability without negatively impacting revenue growth. Now going forward, while we will continue to drive double-digit revenue growth, we are committed to delivering a positive software operating margin in 2013.

Earnings per share were $0.88 for the first quarter, at the high end of the guidance range.

Moving to Slide 6, you can see how the composition of our revenue continues to shift 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 faster than the market, the non-MPS portion of 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.

Now 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 86% of our total first quarter revenue and will continue to grow as a percent of our total revenue as the Inkjet Exit revenue declines over time. For the first 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 and longer-term solution relationships with customers, this combined software and services business grew 17% in the first quarter. Additionally, we expect that, as the software revenue grows and the margins expand here, this will be a significant driver of future profitability.

On Slide 7, you can see our unit share position in the high-usage, large workgroup segment for A4 or letter-sized-format lasers. These large workgroup A4 laser devices are increasingly displacing the larger copier A3 or 11x17 format devices, due to their smaller-sized, lower-cost and improved functionality. According to IDC, for the last 4 quarters ending fourth quarter of '12, Lexmark continued to grow share in this large workgroup A4 laser segment. This is important since these are higher-usage devices, which drive supplies revenue.

Moving to Slide 8. Over the last year, Lexmark has been recognized across several key areas. We were recognized as the managed print services leader by 4 leading independent research firms. We're also recognized as a leader in smart MFPs. This leadership position, further strengthened by our new laser introductions late last year; the seamless integration with Perceptive Software's growing array of solutions; and the world-class MPS tools, processes and skills that we've built and refined over the past 13-plus years, enables us to bring superior execution and unique business process improvement to our customers. As further proof, our overall Managed Print 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 lists, which represents 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 KLAS recognition for Perceptive Software. And with the recent addition of Acuo Technologies, a leader in the growing vendor-neutral archive segment, Lexmark's leadership position as a content software provider in the growing healthcare segment has been further strengthened.

Now on Slide 9, you can see how our recent actions fit into the larger strategy we're driving. To drive our strategy of becoming an end-to-end solutions provider, 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. Second, we've been aggressively investing in software solutions, with 8 acquisitions from our initial acquisition of Perceptive Software in June 2010 to the recent acquisitions of AccessVia and Twistage in the first quarter. Finally, while we've been investing, we've also been divesting, including the exit of our consumer inkjet business, starting late 2007, and then our business inkjet business last year. We recently announced the sale of our inkjet-related technology and assets to the Funai Electric Company for approximately $100 million, and John will talk more about this later. These actions are all being taken 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 Twistage and AccessVia acquisitions, you can see a brief description of each of these software companies on Slide 10. Both are now part of the Perceptive Software unit.

Twistage is an industry-leading cloud-based provider solutions for managing rich content like video, audio and images. When combined with Lexmark's Perceptive Software, we can now help our customers capture, manage and access a much broader range of unstructured content, all within the context of the business processes and core enterprise applications. AccessVia is an industry-leading provider of signage solutions, both paper and digital, for the retail market. This adds another key offering to our growing suite of MPS and workflow solutions for retailers. We're excited about what each brings to expanding and strengthening our strategic software capabilities. These acquisitions are good examples of how we're evolving and 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 just completely missing, processing manually or having difficulty accessing. 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. We've 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 with these new technologies, we're now creating broader, higher-value, industry-specific solutions for our customers.

On Slide 12, you can see how we're creating synergies between our imaging solutions and Perceptive Software units to grow each faster. The imaging solutions unit, the red part of the 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. The cash-generating capability of the imaging solutions unit also continues to provide funds for additional growth.

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 healthcare, higher education and back-office operations provides further access for the imaging solutions unit to expand into as well.

And as a reminder, on Slide 13, 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 and organic growth that support the strengthening and growth of the company. In the first quarter, Lexmark paid a dividend of $0.30 per share, totaling $19 million, our sixth consecutive quarterly dividend payment, and repurchased $21 million of stock. Since mid-2011, Lexmark has returned more than $500 million to shareholders through quarterly dividends and share repurchases. And for the second quarter, we are planning to continue share repurchases and paying a quarterly dividend.

On Slide 14, you can see our longer-term revenue growth assumptions. Earlier, I discussed how we're 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 the Perceptive Software solutions portfolio, along with the industry growth trend towards MPS and workflow solutions. Similarly, we expect to grow Perceptive Software revenue 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 15. You can see our revenue guidance for full year 2013, that 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%. 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%, with MPS being less than 15% and Perceptive Software being greater than 15%.

Now looking ahead. On Slide 16, you can see our second quarter, full year 2013 and long-term outlooks. For the second quarter, our outlook is for revenue to be down 6% to 8% year-to-year. We expect earnings per share for the second quarter 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, and we expect earnings per share for the full year 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. As John indicated earlier, the discussion that follows is on a non-GAAP basis and reflects non-GAAP adjustments unless otherwise noted.

Please turn to Slide 18. Let me begin with a discussion of our 1Q 2013 earnings per share, which at $0.88 was at the high end of our January guidance range. ISS performed well and better than expected in the quarter. Supplies revenue was above our expectation. And we had good cost and expense control in the quarter. Our reporting indicates that channel inventories declined slightly in the quarter, less than we had expected. Perceptive Software showed strong, above-market total and organic revenue growth in the quarter, but at a level that was below our expectations. The lower-than-expected revenue resulted in an operating loss at perceptive.

Turning to Slide 19. Total revenue for the first quarter declined 11% and was at the high end of our guidance range, reflecting stronger-than-expected supplies revenue. Inkjet Exit revenue declined 34% year-to-year, unfavorably impacting overall revenue by 6 percentage points. The remaining revenue, comprised of laser and Perceptive Software revenue, declined 5% year-to-year. The impact of currency movements were minus 1% year-to-year, with no impact sequentially.

The year-to-year decline in ISS segment revenue of 13% reflects almost 7 percentage points from declining Inkjet Exit revenue. The remainder of the decline was principally in laser supplies, about 1/2 of which was due to changes in channel inventory. As you may recall, in 1Q '12, supplies revenues benefited from channel inventory growth ahead of a price increase.

1Q '13 reflects 10% growth in MPS as we continued to benefit from our strong solutions capability to win new MPS placements. Perceptive Software revenue in 1Q '13 grew 54% year-to-year, with organic growth of 15%. The 54% growth was driven by very strong growth in licenses at 97% and in subscriptions and maintenance of 53%.

Now moving to Slide 20. Large workgroup laser Hardware revenue, which now represents 83% of total Hardware revenue, declined 2% year-to-year. MFP units were strong as we saw unit growth in both mono and color MFPs. Color units overall were strong, growing over 10% in the quarter. Small workgroup laser Hardware revenue, which now represents 16% of total Hardware revenue, declined 19% year-to-year, driven by declining units. Although units declined 18%, we saw strong growth in color MFPs, up over 20%.

Supplies revenue declined year-to-year in both laser and inkjet. As I indicated earlier, supplies channel inventories declined less than expected in 1Q, favorably impacting our performance versus our January guidance. On a year-to-year basis, however, as supplies inventories grew in 1Q '12, the impact of supplies channel inventory on year-to-year supplies growth was negative.

Software and Other revenue growth was primarily driven by the 54% growth in Perceptive Software. Perceptive saw very good organic growth as well, up 15%. During the quarter, perceptive saw strong placements of content solutions in healthcare and insurance applications and intelligent capture applications in accounts payable, bills of lading, as well as other insurance applications. Geographically, all regions were impacted by our planned exit from inkjet technologies and the generally weak demand.

As shown on Slide 21, we delivered record 1Q gross profit margin. Gross profit margin increased 380 basis points sequentially, driven by 440 basis points of positive mix, principally driven by a lower relative level of inkjet hardware as well as positive impacts from laser hardware and supplies and increased license and subscription revenue. This was partially offset by 60 basis points of negative product margins. The 40-basis-point year-to-year improvement is driven by 200 basis points of mix, principally lower inkjet hardware and higher license and subscription revenue. This was partially offset by 160 basis points of product margins.

ISS gross profit margin improved 390 basis points sequentially driven by favorable mix, principally reduced inkjet hardware. Perceptive Software gross profit margin improved 450 basis points year-to-year driven by the growth in Perceptive's higher-margin products. Licenses grew 97% and subscription and maintenance grew 53% year-to-year.

Turning to Slide 22. Operating expense declined $10 million year-to-year, driven by lower ISS expense and partially offset by increased investment in Perceptive Software. The ISS expense reduction was driven by our 2012 restructuring and solid overall expense management.

As shown on Slide 23, operating income and operating income margin improved sequentially but declined year-to-year, consistent with our January guidance. ISS segment operating income drove the majority of the 1Q year-to-year decline. The year-to-year decline was driven by 2 main factors: declining inkjet supplies as we exit the inkjet technology and lower laser supplies revenue, reflecting the impact of channel inventory growth in 1Q '12. Reduced operating expenses from the restructuring helped to offset these factors.

Perceptive Software revenue growth was above market but less than expected, resulting in operating losses during the quarter. Operating losses were consistent with 1Q '12. We remain committed to delivering positive operating income in the segment for the full year of 2013. As Paul Rooke mentioned, our expectation is that revenue growth in 2Q '13 relative to 1Q '13, as well as actions to mitigate growth in spending related to acquisitions, will deliver improved sequential operating income from performance -- operating income performance in 2Q '13.

Turning to Slide 24. Earnings per share were at the high end of our January guidance range. EPS was down versus 1Q '12, as the lower operating income was partially offset by lower tax expense and shares outstanding. The ongoing effective tax rate, excluding discrete items, was approximately 26.5%, as expected. Discrete tax benefits of approximately $5 million were reflected in the quarter. This was slightly less than the -- than expected as the $6 million benefit of the 2012 U.S. R&D tax credit reflected in 1Q '13 was partially offset by other discrete items. Average shares outstanding of 64.7 million were an 11% reduction versus 1Q '12.

Turning to Slide 25. During the quarter, Lexmark announced the sale of inkjet-related technology and assets to Funai Electric Company for approximately $100 million. This transaction is expected to close this quarter. We do not anticipate any material impact on Lexmark's Inkjet Exit revenue from this transaction. Also, no disruption of service or support for Lexmark's customers and distributors is expected as Funai becomes the manufacturer for Lexmark's aftermarket inkjet supplies. Upon close, Funai will acquire more than 1,500 inkjet patents, inkjet-related research and development assets and tools, Lexmark's manufacturing facility in the Philippines and other inkjet-related technology and assets.

We continue to generate -- we -- sorry. We expect to generate a gain from this sale transaction net of related expenses. This gain will impact our GAAP results but will not be included in our non-GAAP results. This has not yet been reflected in our 2Q '13 or fiscal year '13 guidance. Cash proceeds from the transaction will be predominantly non-U.S.

Turning to Slide 26. Cash flow from operations and free cash flow were lower than expected for the quarter. We continue to expect to deliver free cash flow for 2013 equal to 80% to 90% of non-GAAP net income. In general, seasonality and timing-related factors drove 1Q '13 free cash flow well below this level of performance.

Working capital was negative approximately $10 million in 1Q '13 and is generally negative in the first quarter. Prepayments for services paid on an annual basis, such as purchased software maintenance, were almost $10 million on a significant portion of the prepayments to be made in the year.

Annual employee bonus payments are made in the first quarter, equal to $12 million in 1Q '13. Debt issuance, redemption and accelerated interest payments of approximately $10 million, related to our $400 million debt issuance completed in early March and the redemption of our $350 million bonds due June of 2013 at the end of March, and restructuring and acquisition-related payments were over $23 million in 1Q '13. This reflects about 50% of expected payments for all of 2013.

Collectively, these items negatively impacted free cash flow about $65 million in the quarter and drove the relatively weak performance. As I indicated, we believe these items are generally timing related and continue to expect to deliver on our free cash flow goal for 2013. We will also continue our share repurchases in 2Q '13. We continue to maintain the strong liquidity position with $880 million of cash, along with other significant sources of liquidity.

Working capital performance remained strong, with a net 4-day improvement year-to-year. Cash was generated in accounts receivables and inventory, while accounts payable consumed cash in the quarter. The sequential increase in working capital is driven by the relative timing of sales and production in March versus December. On a monthly measurement basis, working capital improved 4 days in the March quarter.

In early March, we issued $400 million of debt, primarily to refinance $350 million of debt maturing in June. During the quarter, we incurred over $1.5 million of additional interest expense during the period after the completion of the debt issuance but before the existing bonds were redeemed. This redemption was completed at end March and resulted in the onetime charge of approximately $3 million recorded as loss on early extinguishment of debt. This charge is excluded from non-GAAP results.

Non-GAAP adjustments for the quarter, for the first quarter of 2013, consisting of restructuring and acquisition-related costs and expenses, were $30 million on a pretax basis or $0.34 per share. This includes $9 million or $0.10 per share related to the restructuring announced last August. We have made very good progress on the August restructuring plan. The significant majority of the expense reductions announced have been completed. We have essentially completed the sale of the remaining branded inkjet hardware inventory and should sell the remaining OEM hardware in 2Q '13.

Total costs of the August 2012 restructuring are still expected to be $160 million. We're on target to achieve the 2013 savings on the restructuring of $85 million we announced last August and the ongoing savings of $95 million beyond 2013.

Please turn to Slide 27 for my forward-looking comments for 2Q 2013. We expect second quarter revenue to decline 6% to 8% year-to-year. This guidance is equivalent to sequential revenue performance of down 2% to 4%, which reflects normal sequential trends for the laser portion of the ISS business, with larger declines in the inkjet business we are exiting. This outlook includes a decline in inkjet revenue of almost 40% year-to-year, with an impact to total revenue of approximately negative 7 percentage points. Laser supplies are expected to grow year-to-year, reflecting an assumption of no change in first-tier laser supplies channel inventory. We expect continued strong growth in software and solutions.

GAAP EPS in 2Q 2013 is expected to be $0.42 to $0.52 per share. GAAP EPS in 2Q 2012 was $0.55 per share. 2Q '13 GAAP EPS excludes the estimated gain in the sale of inkjet-related technology and assets to Funai. The gain on the sale of inkjet-related technology will be disclosed when the transaction closes.

In 2Q 2013, non-GAAP adjustments made up of restructuring expense and acquisition-related items are expected to yield a net cost of $0.38 per share. This includes restructuring costs of $0.14 per share and an estimated $0.24 per share from acquisition-related cost and expense. Non-GAAP EPS is expected to be $0.80 to $0.90 per share. Non-GAAP EPS in 2Q 2012 was $0.89 per share.

In the 2Q '13, we expect gross profit margin percentage to increase year-to-year, operating expense dollars to be about flat sequentially, and operating income margin percentage is expected to increase year-to-year. We expect the effective tax rate for 2Q and the remaining quarters of 2013 to be about 26.5%. When modeling the full year 2013 rate, keep in mind that there was a $5 million discrete benefit in 1Q '13, which reduces the estimated effective tax rate for 2013 to about 25%.

Turning to Slide 28, we provide a walk-down of non-GAAP EPS from 2Q '12 to 2Q '13 assuming the midpoint of our 2Q guidance range. The decrease in EPS in 2Q '13 relative to 2Q '12 was driven by lower expected earnings in ISS, other, due to the decrease in income from inkjet. This is partially offset by improved profitability in laser, as we expect growth in both laser revenue and income. Perceptive income is expected to be substantially better in 2Q '13 than 1Q '13, reflecting both continued growth and actions to mitigate growth in spending-related acquisitions. This overall expected reduction in operating income is partially offset by the benefit of lower shares outstanding.

Turning to Slide 29. Our full year 2013 expectations are unchanged and include a revenue decline of 8% to 10% versus 2012. Inkjet revenue is expected to decline over 40% from the $640 million we had in 2012. This results in approximately negative 7% impact year-to-year total revenue in 2013. By the end of 2013, inkjet revenue should decline to be less than 10% 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 preceding 3 quarters outside the U.S. will continue through 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 operating margins at the low end of our 11% to 13% target. We expect Perceptive Software to deliver positive operating income for the year. We are expecting continued strong revenue growth from Perceptive, but we'll manage expenses more conservatively to deliver profitability for the year.

For calendar year 2013, free cash flow will be negatively impacted by the approximately $40 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 Brian Alexander from Raymond James.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

John, if I look at the EPS guidance for 2013 and use the midpoint of $4.85 for the second quarter, it implies that the second half earnings needs to be about 57% of the year. And historically, that hasn't been the case. So I realize the seasonality of the business is different, with inkjet no longer part of the mix, and I know you're expecting perceptive to go from a loss to a profit. So really, the question is, how much confidence do you have in that aggressive earnings ramp in the back half of the year? And if you can maybe rank the key levers that you think will get you there. And specifically, how much comes from Perceptive?

John W. Gamble

Well, just in terms of the things that will drive the improvement, right, we are expecting an improvement in Hardware margins. We talked about in the first half how we had incurred some negative costs from the liquidation of our prior generation of laser models that we're completing in the first and second quarter of this year, which obviously that will be over. So we're expecting to see our Hardware margins be higher. We're also expecting that we're going to -- as we -- as you said, see better profitability out of Perceptive. So as we put those 2 things together, we expect it should drive more gross profit, and that should help us deliver on the numbers that we're talking about that you referenced.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

And then just on perceptive, maybe more comments on what gives you confidence that you can kind of balance the growth and profitability, which has been a struggle in recent quarters. And this is a relatively new business for you guys, so where are the cost actions targeted? And how do you specifically plan to catalyze growth going forward? And has the level of profitability that you expect for this year come down versus last quarter? Or is it unchanged? I think all you've really told us is that you expect it to be profitable.

Paul A. Rooke

Brian, we're encouraged by the growth that we're seeing in Perceptive. As you saw, another quarter here with 54%, 15% organic. And as you saw, the margins or the gross profit margins on Perceptive are quite good. So we expect that to continue. I would characterize what we're doing in the cost and expense side is slowing the growth. And as we bring in these new acquisitions, there's opportunities there to extract cost and expense out of that to gain those synergies that we've planned. So I would characterize that there is continued tuning of our cost and expense level there as we continue to drive that growth. And the point here is we're projecting those lines cross and becomes -- starts to become profitable for us.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Has that target changed versus a quarter ago, the -- your profit forecast for Perceptive?

Paul A. Rooke

We said -- we had forecasted that we will be profitable for the year, and that remains the same.

Operator

Your next question comes from the line of Toni Sacconaghi of Sanford Bernstein.

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

Your SG&A was up sequentially and year-over-year, despite the fact that revenues were considerably lower. And I would've thought you would have had some benefit from restructuring savings. So perhaps you can discuss what's going on there and, in doing so, give us a sense of how much of the $85 million in savings from the restructuring you've captured year-to-date.

John W. Gamble

So in terms of SG&A, right, the things affecting SG&A, obviously, we've done a few acquisitions, and the additional expense related to the acquisitions is acting to offset some of the reductions that have been incurred -- have been generated from the restructuring. Also this quarter, we had a -- we had some legal settlements which affected our SG&A and drove it up a bit, which are unusual and onetime in nature. But we are on track with the restructuring. We said that we would -- we expect it to deliver on the level that we had committed for 2013 and we're on track to do that. The bulk of the actions that needed to be executed to deliver on the 2013 savings are complete, so we think we're on track to do what we indicated.

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

But just to follow up on that one. Specifically, if we think about the rollout of savings over the course of the year, you've said the actions are complete, but were you -- should we be expecting a -- effectively linear savings? So of the $85 million, do you think you captured $20 million in Q1? Or was it substantially lower than that?

John W. Gamble

We captured a little less than a linear amount of savings in the first quarter, but I'd say, most of the actions will have been completed as we exit 2Q.

A.M. Sacconaghi - Sanford C. Bernstein & Co., LLC., Research Division

Okay. And then just to follow up: On the Funai sale, you underscored several times that there would be no revenue impact associated with the IP transfer and the transfer of the manufacturing facility. Will there be any impact on profitability given that, ultimately, you are no longer vertically integrated, you're actually purchasing from a third party? So how do we think about the profitability impact of inkjet supplies on a go-forward basis under Funai manufacturing relative to what it was before?

John W. Gamble

Toni, as we mentioned, we don't really expect a material impact on either the revenue or the cost line item. Yes, there obviously is some impact from using a third-party manufacturer, but we think that's something we can mitigate. And so you have some impact but nothing that we would consider material.

Operator

Your next question comes from the line of Katy Huberty of Morgan Stanley.

Kathryn L. Huberty - Morgan Stanley, Research Division

Can you talk about why laser supplies inventories did not come down as much as you expected and whether you're thinking that laser supplies inventories will come down more in 2Q and 3Q? Or do you think current levels are sustainable?

Paul A. Rooke

Katy, this one's a hard one to predict since we don't control the channel. And as we indicated, last year this time, we had a price action going on, which tends to drive purchases ahead of that. And so that's why we had the increase last year. So we're assuming it's going to hang where it is. Again, it's an assumption, and we'll see. But we feel good about the levels we have there, and that's what we planned.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. And then you talked about flushing out some of the older laser hardware inventory, and that's impacting profitability and should improve as you move through the year, but can you talk about how the new laser products are selling and whether that improved mix will help in the second quarter and beyond?

Paul A. Rooke

There are 2 dynamics here on the hardware margin improvement side. One was the inkjet, as we will be done with that here in the second quarter. And the laser transition is running well. It is -- the remaining end-of-life laser products are certainly a minority of what we're shipping now, and that'll just continue to get better as we go through the year and, of course, we get better margins and let -- on the new line versus what we were -- or have experiencing there with the end-of-life products. But the reception on the products is very strong, the analysts. We received a number of awards and recognition on it. Our channel is quite excited about the new functionality, particularly as the A4 functionality has now met the sort of the feature functions that you might have classically seen in an A3 copier. So this gap that we talked about, closing that gap against the A3 copiers now with the smaller, lower-cost, highly function device are now true, and the channel is quite excited about it.

Operator

Your next question comes from the line of Scott Craig of Bank of America Merrill Lynch.

Scott D. Craig - BofA Merrill Lynch, Research Division

Can you guys maybe outline, from an acquisition standpoint, how you're thinking about the rest of the year in the software and the Managed Print Services business to assist in the growth? Well, maybe outline more what you're thinking from an organic versus an inorganic basis for the year for the 2 businesses.

Paul A. Rooke

Scott, we don't project out our future acquisition plans. I'd say it is still a part of our strategy, and I think we've been fairly consistent in the acquisitions we've made to date. As you can see, they're all in this near adjacency of managing unstructured content, capturing it and managing it, as I've described in my comments. We are investing organically in those acquisitions that we've made to date, although we said, as I mentioned, we're going to be taking some actions to kind of slow the rate of that growth. But nonetheless, we're making organic investments in those acquisitions. On the Managed Print Services side, we had another good quarter, 10% growth, which I think, we believe, is well ahead of the market rates, ahead of our competitors. And that's what we're experiencing and seeing out there with the wins that we're achieving. We're continuing to invest there. And there, it's about product, of course, but it's as much, if not more, about service, the skills, the processes, the tools that you use to manage large fleets of devices on an international basis, and we're continuing to invest in those. And I think we expect to see continued growth in our Managed Print Services business here throughout the year.

Scott D. Craig - BofA Merrill Lynch, Research Division

Okay. Just to follow up on the perceptive business. You guys mentioned a couple of times how maybe the revenue wasn't quite at the levels you had expected. Is that more of a macro issue? Or was there a sales, execution issue or something else in there that you guys are addressing?

Paul A. Rooke

Yes, the software segments that we're participating in continue to grow. We believe we're well in excess of any market growth rates there, but it's not a macro issue per se. Those markets are growing. It's more, as we're taking a young business and growing it, our ability to always predict exactly which deals are going to fall which side of the quarter. Most of these tend to be deals that just weren't able to be completed on the quarter that we expected because of contractual things that are going on, some deferrals, but more of that than, say, losses or any macroeconomic effect.

Operator

Your next question is coming from the line of Shannon Cross of Cross Research.

Shannon S. Cross - Cross Research LLC

I was curious if you could talk a little bit about the pricing environment you're seeing on lasers. And specifically, I'm talking about any pricing actions from some competitors who may have more flexibility given depreciation of the yen. So what are you seeing sort of transactionally, and then on MPS? Because Sony recently met with HP, they noted they saw some outside of the U.S.

Paul A. Rooke

Shannon, I'd say the pricing environment remains aggressive. It has been and continues to be, whether you're talking about on the Managed Print Services side or the non-MPS or more transactional side. So I would say it remains aggressive. I wouldn't say there's been a sea change or anything relative to pricing. But I mean, we're in the -- our business is largely skewed to the enterprise space where you tend to have large deals, highly special bids, so it's -- that continues.

Shannon S. Cross - Cross Research LLC

Okay, great. And then just curious on the supply side in terms of you've noted the declines were a little bit better than you'd expected. Was that predominantly just on inkjet? And within that, I'm just curious, from the standpoint of inkjet itself, how do we think about the decline in supplies? So far, you've been running sort of better than anticipated for the last few quarters. I realize you're winding down the program, but is it possible that perhaps it has a little bit longer of a tail than expected?

Paul A. Rooke

The inkjet tail is a difficult one to predict. We -- I mean, we've got an assumption we're running with. As you mentioned, it's running a little better or less of a decline than our assumption, but we're seeing, on average, kind of 40 plus. And I think, as we move towards the end of the tail, it will pick up more of the decline. But these tend to have a fairly long tail, as you know. We've laid it out for you, and you can those out here for the next several years, but it -- we think it'll certainly be in this, the range that we've outlined. In terms of the channel, yes, again it's hard to predict to what they will buy or won't buy on any given quarter. The decline was a little less than we had expected, so that's just the way it landed this quarter.

Operator

Your next question is coming from the line of Ben Reitzes of Barclays.

Benjamin A. Reitzes - Barclays Capital, Research Division

Your perceptive losses, I just wanted to talk about that in a different light. Roughly running at $0.10 a quarter, which it sort of seem like they're offsetting any benefits from the repurchases. And it feels like, if you turn that around, obviously there's significant leverage considering what you earn. I -- can we get a better feel for how you take that $0.10 and at least get it to 0 as we go throughout the year? Because that seems like it's running at a $0.40 hit a year, and that's way over 10% of earnings. So it seems like that a lot of the story lies in the ability to turn that segment around and get it to at least 0.

Paul A. Rooke

Ben, it's really around continuing the growth that we're on, both in revenue, and therefore growing gross profit in absolute terms because, as you see, the margins there, which -- are quite good on the Perceptive Software. So as we continue to grow that revenue, we expect the gross profit growth to continue while slowing in the rate of growth of our cost and expense. And then that begins to cross over and our gross profits exceed our expense, and you got profits. So that's our plan. We want to continue to grow the business, so we're being very targeted in, the areas, in our cost and expense growth. It's not a reduction in absolute, it's more a slowing of the growth because we do want to keep growing the software in excess of the market as we've outlined, and we're doing that. And so I think, as we see that continued growth as we move to the right, these dynamics should play out.

Benjamin A. Reitzes - Barclays Capital, Research Division

Well, let -- I want to clarify the guidance on perceptive. Is it -- are you -- is your guidance that you'll get to breakeven on the P&L for perceptive at some point this year, or that you'll be fully profitable so that you'll earn back the $8 million loss and the perceived loss next quarter?

John W. Gamble

Yes, the guidance says that, for calendar year 2013, perceptive will be profitable. So we'll have to earn back the losses in the first quarter, yes.

Benjamin A. Reitzes - Barclays Capital, Research Division

I just want to sneak in the Funai, $100 million. Are -- how is that going to be used? Can you not use it for share repurchases because it's overseas? Just -- and that's my final one. I'm sorry I snuck that in.

John W. Gamble

That's okay. So yes, the bulk of the cash that we -- that will be paid will be overseas, so -- but effectively, Ben, we'll just keep executing our capital allocation framework. It's free cash flow, and we'll execute our capital allocation framework and return, on average, over 50% of free cash flow to shareholders.

Operator

Your next question is coming from the line of Ananda Baruah of Brean Capital.

Ananda Baruah - Brean Capital LLC, Research Division

You're guiding essentially seasonal for the laser business, but it also sounds like you're paying homage to the softer demand environment out there. Can you just talk about, I guess, business tone through the quarter, any shifts in tone that you saw? And then when we think in the context of your annual guidance for this year, what do you view as the biggest risks to the annual guidance this year, I guess, sort of what kind of demand environment or economic environment through the year are you baking into your annual guidance, in the context of your seasonal guidance?

Paul A. Rooke

Ananda, as we went through the quarter, as you saw, we had good growth, good solid growth, in our core strategic areas of Managed Print Services, 10%. I mean, you may not see that from our competitors, we'll have to see what they report. But 10%, I think, is a very strong MPS number here for the quarter. On the software side, I think 54% is extremely strong, even 15% organic, very strong. We're working on the -- of course, we got the Inkjet Exit, which is going to have this decline. And we're working on the non-MPS areas there to shore those up so they don't work against the MPS and software elements. As we look at our full year with the revenue guidance of minus 8% to minus 10%, a lot of that will be driven by the Inkjet Exit. So the key thing is making sure that we have that laser, if you will, and Perceptive together be a -- we have less, a small decline there. And that's where we're focused and that's where the growth of MPS, the growth of software, eliminating any declines we have in non-MPS there to make sure we achieve that. That's the big chunk of where we're focused.

John W. Gamble

And just so you remember, right, we always forecast based on current FX rate, so foreign exchange is always a significant impact on our business. So just obviously, that's always a risk because if there's a significant movement in foreign exchange. And we need to deliver on the things we talked about earlier in terms of hardware and improving the profitability of perceptive. And obviously for us, supplies is what drives the profitability of the entire company, right, so supplies need to deliver, as we're forecasting.

Ananda Baruah - Brean Capital LLC, Research Division

And to follow up on Perceptive. Can you remind us what the international exposure is for Perceptive? And do you have, I guess, international growth baked into your Perceptive expectations for this year?

Paul A. Rooke

Well, we do have international growth baked into our Perceptive growth. We don't break out the mix, but it's relatively small in comparison.

Operator

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

Jim Suva - Citigroup Inc, Research Division

Congratulations on the excellent sale of your ink business and making progress there. It sounds like the -- or that cash will be off seas -- overseas, and therefore, you won't be able to repatriate back to the U.S. But my question is, will you be able to shift it around in other seas -- overseas geographic locations without any tax impact? And if so, would you kind of earmark this for a kind of more accretive M&A? Or how should we think about that cash and the use of it over there?

John W. Gamble

Well, to the general question, yes, in general, cash outside the U.S. can be used in any jurisdiction. I mean, there can be some tax effects, but certainly nothing like trying to use it that -- not -- like the tax effects of repatriating it to the U.S. So in general, yes, it's usable in any international location. So -- but we've indicated -- and again, you just -- the capital allocation framework, we're just trying to execute to it. So we will -- we said we'd use just under 50% generally for acquisitions, and we'll continue to try to execute on that plan as well.

Jim Suva - Citigroup Inc, Research Division

Great. And then a quick follow-up on that same topic is, when we think about the sale price, you'd mentioned that there were patents going with it. Are these onetime sale patents? Or is there some type of royalty stream? Or does Lexmark have, I want to say, like a free option to use those patents should they see a need further down the road? Or any type of – or is it just a severing, and you sold it, and you go about your ways?

John W. Gamble

They're onetime sale patents. We don't maintain an ongoing royalty stream.

Operator

Your next question is coming from the line of Kulbinder Garcha of Crédit Suisse.

Kulbinder Garcha - Crédit Suisse AG, Research Division

The question is just on really the business slightly beyond the current quarters. I guess, can you speak about when you might expect the imaging solutions business and perceptive business combined, having your business x inkjet, actually start growing? Isn't that a possibility? Are you ready for the fact that business might be in decline over the next few years? And given the -- a question, I guess, on the cost base, for Paul, how much more flexibility do you have in operating cost to keep taking that down so that if your x inkjet business declines 5% or 6% next year, you could keep actually taking some costs out of the business? Any comments around that would be helpful.

Paul A. Rooke

As we look at our business going forward, we clearly segment it out so you can see the relative declines in growths in the various pieces. And so our ability to get growth overall depends on that rate of decline of inkjet versus the increase in the non-inkjet piece. And there, you've seen non-inkjet piece being driven right now by management services and Perceptive. And as we work on the non-MPS piece as well, then when those -- obviously, that big base, the strategic segments in that overcomes the decline, and it will overcome the decline here in over the next couple of years because it -- as we projected, that inkjet piece becomes a smaller and smaller piece, and at that point, then we've got a real chance of getting top line growth. In terms of the cost, yes, we're always working on cost and expense. Costs, looking at our core infrastructure across the business as well as design points in our products. We just released a new set of products, and we've worked on cost hard there. And as we look at our future pipeline, well, we'll continue to work on cost opportunities there. So that's an ongoing element and an ongoing lever for us as we look to improve our profitability.

John W. Gamble

And our guidance for this year is that, that portion of the business is only down slightly. And our guidance for the second quarter effectively, right, implies that, that business is effectively flat, right, excluding inkjet.

Operator

Your next question is coming from the line of Chris Whitmore of Deutsche Bank.

Chris Whitmore - Deutsche Bank AG, Research Division

I wanted to follow up on that last question, if I could. I'm trying to understand how the laser Hardware business performed versus your expectation. I was surprised to see the unit weakness given the broad refreshes. Can you comment on what you're seeing around demand for laser hardware placements?

Paul A. Rooke

Yes. As you saw there, the large workgroup being down 2% in revenue, it was about a point in currencies, so it was more flattish there. And the work -- we watch that closely because the large workgroup is what drives 70% to 80% of our Hardware business, and it drives the majority of the supplies. So that's the one that we watch closer than any. And the small workgroup, we were down certainly more than what we had liked. We were a little less promotional, I would say, this quarter than we've been. We did -- although, having said that, we had good 20-plus-percent growth in our color MFPs in the small workgroup. Where we saw most of the declines was in the mono, single-function kind of categories. So we're focused on that as well because small workgroup does drive very lucrative supplies and we've got some work to do there. But overall, the hit was more in the small workgroup than the large workgroup.

Chris Whitmore - Deutsche Bank AG, Research Division

And if your supplies, excluding the channel inventory, adjustment are declining. It sounds like in a mid-single-digit rate. Please correct me if that's not correct. But if that's the case, how does a down 11% unit quarter kind of change the inflection on the supplies trajectory from a consumption standpoint? Why aren't we seeing better placements of those higher-end units? And at what point does that start to drag through the supplies?

Paul A. Rooke

Yes, well, a big part of the decline in the laser, obviously, was the channel dynamic. The rest of it was just kind of this, the economic environment that we see ourselves in. We started to see it, say, mid last year, and that continues with us. So it's -- at the same time, we're driving hard on our workgroup placements. You saw the MPS growth. And it's just a function of that installed base and the puts and takes with it. And as well as we hope that the economic stagnation that we see ourselves in, probably more non-U.S. than U.S., comes back to life, but it's hard to predict, we'll see. But that's how I would characterize the non-channel pieces more, so the -- not economic kind of malaise or stagnation that we're seeing out there impacting supplies.

John W. Gamble

And again, as we look forward in the second quarter, as we indicated, we expect laser supplies to grow.

Chris Whitmore - Deutsche Bank AG, Research Division

And what's driving that growth, I guess, is my question.

John W. Gamble

Well, the biggest switch, obviously, is the fact that the channel inventory isn't really a headwind anymore, all right? And we're just expecting to see paced growth continue. And without that headwind, we're expecting to start to see a little bit of growth.

Operator

Your next question is coming from the line of Ben Bollin of Cleveland Research.

Benjamin James Bollin - Cleveland Research Company

Two questions. The first, I believe you said on the call you won 15 global managed service contracts. I'm not sure if you said in the quarter or the year, but I was hoping you could tell us how many contracts you actually pursued in that same time span, essentially what your close rate was, what the competitive environment is like in that process. And then the second, could you talk about the headcount and how it's allocated between the perceptive business and then ISS?

Paul A. Rooke

Okay. Well, first of all, Ben, the 15 was over the last 24 months, and that was -- those are -- the reason we point that number out is because these were all competitive wins, meaning new acquisitions of installed bases and accounts that we don't have. and, secondly, in Fortune 500 class environments, so these are big customers that we're acquiring from our competitors, but that was over the last 24 months. So one a quarter statement. So it's more an indicator of our ability to win more than our fair share. We don't disclose our close rates, but I would say a good indicator is the growth in our MPS business. And there, you saw that, a 10% number here this quarter. And I think, to a degree that continues well above our competitors and the market rate, then we're winning more than our fair share. Relative to your question on headcount, we don't allocate that out between the business units. So we just don't disclose that.

Operator

Our final question will be coming from the line of Brian Alexander of Raymond James.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

All right, just a follow-up, back to Chris' question on laser supplies. And John, you said it should grow in Q2. I think, last year, Q2 was the easiest comparison for laser supplies. And then you built inventory in the second half. So I guess the question is, do you think you could sustain laser supplies growth in the second half of this year? Or might not that happen because of the comparisons?

John W. Gamble

Well, again, so I guess all I can really reiterate is the guidance we've given, right? And the guidance we given -- we've given is that, effectively, the non-inkjet portion of the business is expected to be down only slightly in 2013, and we are expecting to see a little bit of growth, flat to a little bit of growth in the second quarter. So as we move through the rest of the year, we'll obviously talk about that and give you a lot more detail, but those are the 2 pieces that I can reiterate.

Paul A. Rooke

And I would say our branded business do expect to be up. We got a little bit down in OEM and, of course, the channel year-to-year impact that we talked about.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

And since most of the decline is on the small workgroup side, down 18% in units and it's been down for the last 5 quarters, I think it's only 16% of your hardware sales coming from small workgroup. But what percentage of your installed base, printed pages, come from those devices? So we can just get a better sense for what the headwind might be from the decline in those units.

Paul A. Rooke

Yes, I would say, we don't break out the pages, but the large work would obviously have the -- more than its share in hardware units, whereas the small group would be the smaller piece of it. But it's still quite profitable, and we're focused on it and plan to do better.

Operator

Thank you. 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

Well, in closing: It was a busy first quarter, operationally delivering solid revenue and earnings per share at the high end of the guidance while announcing 2 strategic acquisitions and negotiating the sale of our inkjet-related technology and assets. So we remain confident in our strategy and committed to improving profitability in delivering value for our shareholders. And we believe the investments we're making in our high-usage hardware and high-value software technologies that bring new and differentiated solutions and services to the 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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