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Executives

John Morgan

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

Martin S. Canning - Executive Vice President and President of Imaging Solutions & Services

Scott T. R. Coons - Vice President, Chief Executive Officer of Perceptive Software and President of Perceptive Software

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

Analysts

Bill C. Shope - Goldman Sachs Group Inc., Research Division

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

Shannon S. Cross - Cross Research LLC

Asiya Merchant

Scott L. Shiffman - Sterne Agee & Leach Inc., Research Division

Lexmark International, Inc. (LXK) 2013 Investor Day May 7, 2013 10:00 AM ET

John Morgan

Good morning, everyone. My name is John Morgan, and I'm Lexmark's Director of Investor Relations. And it's my pleasure to welcome you again to Lexmark's 2013 Investor Day. We thank you for your interest in Lexmark and for joining us this morning both in person and over the webcast.

Let me take you through today's agenda. First up will be Lexmark's Chairman and CEO, Paul Rooke. Following Paul will be Marty Canning. Marty is the President of Lexmark's Imaging Solutions and Services. Scott Coons who is President and CEO of Lexmark's Perceptive Software will follow Marty's presentation. Next, CFO, John Gamble will present a financial overview, then we'll open it up for Q&A. At the conclusion of Q&A, Paul Rooke will provide some closing comments. We're targeting to wrap up at around 12:45.

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. Lexmark management will be referring to non-GAAP measures during the 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 reconciliation section of its earnings presentation slides.

With that, it is my pleasure to turn the meeting over to Lexmark's Chairman and CEO, Paul Rooke.

Paul A. Rooke

Well, thanks, John, and good morning. Lexmark is changing. Lexmark is transforming. As you saw with the displays and the various solutions that we have over here on our showcase as you walked in today, you can see the we're combining and leveraging our well-established competitive advantages with our newly added capabilities to focus on an even broader challenge our customers have. And they're excited. They're excited about what we're doing and where we're going. So I want to spend some time upfront with you to describe that future for you and how the actions we're taking to date are helping to shape that future. When I'm done, Marty and Scott will dive a little deeper into their respective parts of the business. And finally, John will bring it home and discuss how our financial model is evolving as well along with these changes in our business.

So let me start with the key messages for investors to help frame our discussion here this morning. So first, Lexmark is uniquely positioned. As we build the unique combination of output, content and process management technologies and capabilities, we believe we are well positioned to solve the unstructured information challenge facing all customers today and do it better than our competitors. Second, as we evolve our position, we are transforming Lexmark to create a higher value portfolio. For example, our focus on higher usage hardware and higher value software is driving annuity growth from supplies, software and services. And as we build the synergies between our Imaging unit and the Perceptive Software units, it will enable us to grow this faster. In fact, for 2013, we're guiding for growth in our high-value segments, as well as earnings per share. And as we move into 2014 and beyond, we are committed to maintaining our long-term operating margin goal of 11% to 13%. And third, Lexmark generates strong cash flow and is executing a balanced and disciplined capital allocation framework to deliver shareholder value. We've delivered 4 consecutive years of record gross profit margin percentages and 11 straight years of positive free cash flow. And with this, we are building and growing our solutions business through both organic expansion and acquisitions while also returning more than 50% of free cash flow to shareholders through dividends and repurchases.

And today, we are known primarily as a provider of printing solutions. However, as we've added to our portfolio of technology and capabilities, we're providing more than just printing solutions. In fact, we've assembled a unique combination of output, content and process management technologies that provide a rich spectrum of solutions to a much broader problem facing customers today.

So what do these capabilities position us to do? I'm getting caught up on the slides here, one second. So first, just a little background to help describe the -- this broader problem that we're solving, the problem we see many of our customers dealing with day in and day out. We're all familiar, of course, with the printed page, and putting information on paper has long been an effective medium for communicating information. It also became the way to store and process information. And as we all know, as printing and copying technology advanced and is proliferated, more and more paper then became stored and processed. The trouble with this is that the information becomes trapped on paper, resulting in manual search and retrieval of information. Therefore, painfully slow processing of information. Then there's the explosion of the digital world. Now, mobile computing that is driving the exponential growth in digital information, but also incompatible formats: e-mails, text documents, presentation formats, video, audio, the list goes on and on. We also have large enterprise systems with databases and applications designed to manage and process large volumes of structured information, but they also like the flexibility to deal with the growing diversity of unstructured information, both paper and digital, and the unstructured processes surrounding this information. The reality is that while information is everywhere, it fuels our critical business processes. The problem is that it resides in many forms across many locations. And as businesses and organizations grow, so does their pile of information. And with the growing diversity of technology, simple things often become more complex.

And what we observe and what we hear from our customers is that the information and the process that's using this information can be classified in 2 worlds, structured and unstructured. The structured information represented here in the graphic by the purple icon is data that's easily formatted by rows and columns and managed by the core systems that all companies have. For example, ERP systems, electronic medical record systems in healthcare, student information systems in education. But outside the structured world, there's a large quantity of information that doesn't fit into the structured role for a variety of reasons represented here by the orange icon and all the others outside the circle. In here, we find the information may be trapped on paper. It may be in digital form but not in the format where the content can be processed by a core structured system, like I mentioned, documents, e-mails, video, audio, images. Also the processes that need this unstructured content end up being manual or disconnected from the core as well. And so this problem presents itself in most companies through the inability of the structured, the core enterprise systems and applications to actually see the unstructured information or adapt their processes to deal with this unstructured information all in a world of changing regulations, tighter compliance and price for higher efficiency. But the limited visibility and flexibility of these core enterprise systems is just part, part of the problem.

The problem is also presented through the unstructured content itself and the processes surrounding it. Unstructured content, it continues to grow in diversity, both paper and digital across multiple locations, making it even more difficult to manage and more difficult to find the relevant information at the time you need it for more informed decisions. Also this unstructured content often drives these unstructured inefficient processes, which can take the form of manual paper-based workflows like invoice processing, employee onboarding, incident management just to name a few, or it could be digital processes that are simply just disconnected from the relevant content they need because the information is trapped in silos across the enterprise that can't easily be searched or accessed and -- or is even trapped on paper documents and must be manually searched and processed. And while paper remains a big part of this unstructured information challenge, we still often find that companies don't have a handle on even how much they print. Paper, while inefficient for storage, or the movement of information is still a usable and very common medium for transacting business with customers and suppliers. Therefore, since paper-based documents remain a key part of this unstructured information challenge, print must be managed. Also given the diversity of all the print output devices and the distributive nature of these devices across an enterprise, you know them as well as I do: network printers, MFPs, faxes, copiers, reproduction centers, even outsourced print, many customers still have little visibility as to how many devices there are, how many pages are actually being printed or how this could even be optimized to print only when and where it's necessary.

So the fundamental challenge is one of connecting: connecting people, processes and information because most of the information and processes important to business are unstructured and outside its visibility and control. In fact, the research has shown that 80% of the content and 2/3 of the processes are unstructured and 2/3 of the organization still don't know how much they even print. And you take all that together, that's the broader unstructured information challenge we are attacking. Now this ultimately shows up in our customers' businesses as slower ineffective customer service, impacts to the top and bottom lines, and it's just the fundamental inability to adapt quickly to change.

But what if, what if you could connect it all? What if you could connect all of the unstructured information such that all of it, whether it be printed or digital, is instantly available and available in the context of your processes? Furthermore, what if the manual or disconnected processes could be automated and integrated with the core processes and information? And finally, what if the print infrastructure could be optimized and managed to ensure that people only print when and where it's needed while even scanning and extracting content from paper documents all automatically and seamlessly.

So in response to this challenge, Lexmark is rapidly moving from a provider of only Printing Solutions, which I would contend as a partial response to this fundamental unstructured information challenge, to a broader provider of unstructured information solutions, a more complete response to the challenge, encompassing output management, content management, both paper and digital, and process management for those manual paper-based or content-disconnected process challenges. And while this brand proposition is unique, what makes Lexmark even more unique in this proposition is the combination of these 3 elements. The first is that we own the key, the essential collection of technologies required in solving this unstructured information challenge, as I mentioned, content management, process management, output management. And because we own these technologies, it gives us a unique ability to be flexible, more responsive in creating innovative solutions for our customers as their needs change. Second, we bring deep industry experience, serving multiple industries. You saw them out here in the showcase like retail, manufacturing, banking, insurance, healthcare, education, government. Our people are knowledgeable in these industries, they're familiar with the issues in these industries and we bring ideas. Ideas for solutions to those challenges. And because of our industry knowledge, we can also bring best practices and benchmarks that we see across these industries in dealing with the unstructured information challenges. And as a result, we bring industry-specific solutions to these problems, not one-size-fits-all solutions. And third, we listen. This customer intimacy means we seek to understand the customers' specific challenges and are more collaborative with them in designing solutions to those challenges. We're also more responsive because of our focus and because of our ownership of these key technologies in bringing not just an industry-specific solution but a customer-specific solution as well.

So let me play just a quick video to kind of help bring this all together, this new proposition, bring it together for you.

[Presentation]

Paul A. Rooke

All right. Now here you can see how our recent actions fit into this larger strategy we're driving. Now to drive our strategy of becoming an end-to-end solutions provider, we'll be making a number of key investments over time. So 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 of 2010 to the recent acquisitions of AccessVia and Twistage here in the first quarter. And finally, while we've been investing, we've also been divesting, including the exit of our Consumer Inkjet business starting in late 2007 and then our Business Inkjet business last year. We recently announced the sales of our Inkjet-related technology and assets to the Funai Electric Company for $100 million. These actions are all being taken with the end in mind of becoming a world-class end-to-end solutions provider. And to help you put this together, to help you understand how our recent software acquisitions in the context of this broader unstructured information solutions strategy, how they fit together. So let me show you this.

First, in the upper right box, we have built a successful output management capability and customer base across the industry segments we serve and are recognized as a leader here. We continue to invest in these technologies, the products and services to maintain our leadership position in output management with our smart MFPs and our management solutions. Now more recently, as you can see in the upper left box, we've invested in a number of software capabilities to help us manage and connect the range of unstructured content across the enterprise as we mentioned, such as documents, video, audio, images, to the core structured systems and applications. So starting with Perceptive in 2010, an ECM provider, we've been adding capability to manage even richer media like audio and video content with Twistage, industry-specific content; with Acuo for medical images and healthcare; Nolij for student information and education; and recently, AccessVia for printed and digital signage in retail.

On the unstructured process side, as you can see in the bottom box here, we've added intelligent capture and extraction of unstructured content with Brainware; business process management with Pallas Athena; and federated search with Isys. And while each of these technologies are indeed important by themselves, the real value lies in the combination of these technologies to create solutions that solve this unstructured information challenge while also being easy to install, maintain and use.

Now here you can see how we're creating synergies between our Reimaging Solutions and our Perceptive Software units to grow each faster. The Imaging Solutions Unit, the blue 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 large accounts. The cash-generating capability of the Imaging Solutions unit also continues to provide funds for additional growth.

Now Perceptive Software, the purple part of the slide, 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, back-office operations provides further access for the Imaging Solutions unit to expand into as well. In fact, this is working. We're beginning to win software solution deals in ISS accounts across a range of industry segments. In fact, over the last 2 quarters, we have won over 15 new capture, content and process software deals across a range of ISS banking, retail, manufacturing, government and healthcare accounts, and our sales funnel continues to strengthen. We're also beginning to see the reverse happen as well, where ISS is beginning to capture MPS, Managed Print Services deals in Perceptive Software healthcare accounts. And as we grow our solutions offering and build more customer references, we expect these synergies to continue to grow.

Now we believe this combination of imaging technologies with content and process management software technologies does put us in a unique position competitively. Against others who may bring pure hardware solutions, as you can see on the horizontal access, or pure software solutions on the vertical access, we have the ability to combine both hardware and software into more integrated solutions that are seamless, easier to install and use. And even against broader solutions providers, there in the middle purple section, we are unique with this combination of imaging and software technologies, particularly as it applies to solving this unstructured information challenge with real solutions that bridge or connect the paper and digital worlds.

Now here you see the total addressable market for Lexmark. For the output segment, you can see the large opportunity that the imaging market brings. However, while it's expected to be flat to down overall, there are subsegments that we are attacking to provide growth here. And for the combined content and process management software segment, you can see it's expected to grow about 10% per year, bringing market growth for Lexmark expansion.

Now here you can see our revenue assumptions for 2013 and 2014, both in composition and expected growth. So for 2013, we are expecting solid growth in our Managed Print Services and our Perceptive Software with combined growth of about 15%. The non-MPS segment is expected to decline, given the stagnant global economic environment. And as we've discussed for some time, the Inkjet Exit revenue is expected to decline more than 40% year-to-year, leading to a 7-point headwind on our expected overall revenue performance here in 2013. Now expect this level of inkjet decline again in 2014. However, this will have less impact on our overall revenue as it reduced -- as it is reduced only about 6% of total revenue. We also expect continued growth in Managed Print Services and Perceptive Software, again, expected to deliver combined growth of about 15% year-to-year, which should drive this combined higher value revenue to about 30% of our total revenue. And with this growth, we expect total revenue for the strategic segments to grow, assuming no impact from currency or larger declines in the imaging market.

Now as a reminder, 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 second quarter, Lexmark approved the dividend of $0.30 per share, totaling $19 million, our seventh consecutive quarterly dividend payment, and has initiated the repurchase of $20 million of stock. And since mid-2011, Lexmark has returned more than $600 million to shareholders through quarterly dividends and share repurchases.

All right. So that's where we're headed. At this time, I'd like to turn it over to Marty Canning, our Lexmark Executive Vice President and President of the Imaging Solutions and Services unit, to talk about our future directions in ISS.

Martin S. Canning

Well, thank you, Paul, and good morning, everyone. As Paul said, my comments will be focused on Lexmark's Imaging Solutions and Services business and describing how we're leveraging the combination of Lexmark's Technology Solutions, Managed Print Solutions and Business Process solutions to improve paper-based processes and fleet management capabilities for our customers.

In terms of total revenue, as you can see on the right, and according to IDC and Lexmark estimates, the total laser market was a very large $70 billion in 2012 with an estimated compound annual growth rate from 2012 to 2016. That's expected to be flat to down. But underlying the total revenue growth are important dynamics seen here by adding units and pages to this analysis. First, in terms of the unit market, the bar on the left, IDC estimates total laser units in 2012 at 39 million. And when we segment the market by what they buy, distinguishing between small workgroup and large workgroup, we see the leverage associated with large workgroup in terms of pages per placement and therefore on revenue, where approximately 20% of the units drive 80% of the pages and revenue as you can see on point one.

And as we also see in point number two that A4 workgroup MFP-based technology, designed to print on 8.5x11 inch paper, and the technology that Lexmark is a leader in is growing much faster than A3 technology, 11x17 or a ledger-size paper typically used in copier-type devices.

Another important dynamic seen in the third point is how customers buy, distinguishing between Managed Print Services and non-Managed Print Services. And as Lexmark has a leadership position in Managed Print Services, which is growing 8% to 10% over the strategic period, while the non-Managed Print Services market is expected to decline 3%. So let's dive into Imaging Solutions.

To begin with where we're headed, we're focused on the laser market and specifically 2 areas relative to financial performance. The first is growing our laser revenue faster than the market with our Managed Print Services business growing faster than our market and our non-Managed Print Services business approximately equal to the market.

Second, from a profitability perspective, our plan is to improve our laser profitability through operating income improvements, driven by laser supplies profit realized through the lower-cost design improvements and workgroup install base growth along with ongoing cost and expense reductions. These initiatives will help offset our Inkjet Exit decline. So that's the addressable laser market and a view of where ISS is headed. Let's shift the discussion to the ISS core capabilities that will allow Lexmark to outperform the market.

The ISS core capabilities include our technology, our Managed Print and Business Process solutions, along with industry expertise and customer intimacy. Our focus is on delivering best-in-class solutions at each individual level, but ultimately it's the industry-specific solutions that will create the greatest customer value and competitive differentiation. Let's look at each of these core capabilities and Lexmark's leadership position in terms of how they'll help Lexmark drive growth through enterprise, small and medium business and international expansion.

Let's begin with the enterprise. Technology Solutions are at the core of our differentiation and internal development of technologies like smart A4 MFPs are enabling us to challenge the A3 copier install base by helping our customers save time with unmatched workflow functionality, save money by lowering acquisition cost 20% to 53% and lowering the operational cost 20% to 35%, while reducing space required 60% to 72%. These advantages of A4 technology, combined with Lexmark's strength in the segment, has enabled us to achieve leadership in important market segments, like smart MFP, where we had a #1 share in 2012 according to IDC data.

And we've extended our strength and leadership in this space with a significant product launch that refreshed approximately 70% of our laser line in late 2012 and featured advanced technology in areas such as solutions and services readiness, high-performance and improved sustainability. And these advancements have also resulted in Lexmark being recognized by BLI with the Mono Line-up (sic) [Line] of the Year award and will also contribute to our gross profit expansion referenced earlier.

Similarly, our Managed Print Solutions have been recognized for leadership by industry expert such as Gartner, IDC, Forrester and Quocirca, where they cited specific strengths in our global capabilities like our industry expertise and solutions approach applied to over 5,000 assessments to date, leveraging a single global system supporting proactive services like asset management and consumables management and the strength of our governance processes.

But our greatest recognition has come from our customers, through an MPS growth rate that has been over 2x the market from 2009 to 2012, a customer retention rate of over 96% over the past 4 years, and 15 global or Fortune 500 wins over the past 24 months, each a competitive takeaway from our largest competitors like HP or Xerox.

An example of a recent win is the new 5-year MPS agreement with Anheuser-Busch InBev in Europe. This is an agreement that builds on the successful implementation of a similar deal with Anheuser-Busch InBev's corporate headquarters and breweries in North America. And business process solutions combine the leadership just discussed with technology and Managed Print Solutions with the leadership Perceptive Software brings to capture, manage and access unstructured information. And as we grow the Perceptive suite of solutions, this is a big differentiator for our Managed Print Services and smart MFP investments.

An example would be the Lexmark distributed Intelligent Capture solution. This solution could apply through a new account opening process in a branch bank, for example. Here, the smart MFP is used as a distributed capture device in the branch bank and equipped with the ability for the smart MFP to confirm compliance of the required documents and signatures. Once completed, the information is classified, key information extracted using the leading Perceptive Intelligent Capture software. A final confirmation is performed and the information is efficiently moved to a workflow for final processing, saving cost and manual intervention.

With our broad Managed Print Services presence and our smart MFP leadership, this offers a large opportunity to launch more process solutions than ever before. In addition to the technology we bring, we also bring deep industry knowledge that helps us create industry-specific solutions. This is another area of strength for Lexmark, especially in banking where we have the primary share in 9 of the top 10 banks worldwide and 7 of the top 10 U.S. banks; retail, where we have 9 of the top 10 of both the worldwide and U.S. retailers and federal agencies, where we serve 8 of the top 10 federal agencies.

And finally, in addition to technology and industry experience, we bring a level of customer intimacy that further differentiates us. Let's let you hear from one of our MPS customers directly about Lexmark's ability to differentiate. Let's watch this short video featuring Mike Kikkert, Director of IT, Republic Services, talking about his experience with Lexmark.

[Presentation]

Martin S. Canning

Customer intimacy is a critical piece of who Lexmark is and how we differentiate and we are happy but not complacent with our 96% MPS renewal rate and we'll continue to drive innovation in this area.

I'd like to shift gears now to expansion opportunities we see in our customer segments and geographical mix. I'll begin with the SMB customer segment illustration you see on this chart. The point here is that Lexmark has a customer segment distribution that's almost the opposite of the market in terms of enterprise versus SMB mix. We have a strong share position in enterprise accounts for all the reasons just discussed, but compare it to the market mix, we are underdeveloped in SMB. This is a real opportunity for growth if we can leverage our strengths in the enterprise to grow SMB. The good news is we think the same ISS strengths apply to SMB in terms of our Technology Solutions like smart MFP and our Business Process Solutions packaged for the channel.

And we also offer our MPS solutions as needed by our partners who wish to offer this level of service. We're seeing a very strong reaction from the channel to our new A4 smart MFP products, both mono and color, and our partners are very interested in leveraging our MPS tools and processes to deliver their own Managed Print Services offerings with cloud-based efficiency, while driving differentiation with targeted business process solutions.

The early indicators look positive beginning with the copier channel partner acceptance. The copier channel is very important because it's a channel that focuses on a full offering of products and services that has historically been an A3 stronghold. Over the past 36 months, we've increased the number of copier channel partners that have elected to work with Lexmark A4 products solutions and services by over 650 dealers. And as they become fully productive, this sets us up well given the forecast for the smart A4 MFP units, which are projected to grow at 3x the growth rate of A3 units over this strategic period.

Finally, from an international expansion perspective, we have #1 or #2 share position in A4 large workgroup in 8 of our top 10 countries. As you can see on the map here, Asia is our greatest opportunity, with China being the largest. If we can match our share performance with the rest of the countries, and we believe that we can. Also on the map, near the bottom, you can see the market opportunity shows the Americas and EMEA are very large but slightly declining in terms of growth. While Asia is growing because of the market growth and our smaller presence there currently, we see Asia as a growth opportunity as well.

So in conclusion, ISS will outperform the imaging market by: First, leveraging technology ownership, industry expertise and customer intimacy; second, delivering value and differentiation through Managed Print Services and Business Process solutions; and third, strengthening our participation in SMB and Asia.

Now let me hand it off to Scott Coons, Vice President and CEO, Perceptive Software.

Scott T. R. Coons

Thank you, Marty. Good morning. I'm pleased to be here today to update you on Perceptive Software and the role that Perceptive plays in Lexmark's growth strategy.

Much has changed for Perceptive since I last spoke to this group 2 years ago. So before we delve too deeply in the state of our business, I'd like to start with some background about the business problems we solve for our customers and what Perceptive has accomplished in the last few years.

Paul painted a picture of the global expansion -- the global explosion of digital content and all its forms, which has made creating and sharing information incredibly easy, but keeping control of that information nearly impossible. When enterprise applications came along, ERPs such as Oracle, or SAP, for example, organizations invested heavily in them with a hope that they would bring order to the chaos. But these systems only organize part of the data and automate some of the processes needed to get the job done. The result is a frustrating disconnect, missing information that hinders an organizations' ability to make decisions. This is the unstructured information challenge.

Organizations have decided to bridge this gap between the structured and unstructured and this is where Perceptive Software brings real value, providing complete visibility and control of all critical information with process and content management technologies. We provide customers all the information they need to drive their processes and make the best business decisions, so that they can focus on the business areas where human interaction is vital. What differentiates Perceptive Software technologies is that we bring all of this unstructured content from throughout the enterprise into the context of the customers' core system. That includes ERP systems such as Oracle and SAP as an example, the electronic medical record system or the student information system. We connect people, processes and information.

We put the information in the context of the business process, in the context of the users role and make it accessible within the application in which the customer is comfortable, where they spend their day, which leads to quick user adoption and rapid return on investment.

So this starts with content management, which is the capability to capture information, manage it and then most important, provide access to it, allowing the customer to harness the value represented by that content, this turns information into knowledge that helps the customer make better business decisions. Business processes and content need to be tightly intertwined to help organizations run efficiently. Business process management entails discovering the bottlenecks in the current business process, designing an improved process, executing that improved design and then constantly measuring and analyzing it to ensure continuous improvement.

The market opportunity for this technology is bright, as organizations worldwide intend to continue their investments in ECM and BPM software. According to Gartner and IDC, both the enterprise content management and business process management sectors will continue to grow worldwide while. Together, the ECM, BPM capture and search markets represent nearly a $15 billion opportunity in 2016, as the market is expected to grow at approximately 10% a year. A recent Gartner report on IT spend by industry shows that the industries where Lexmark and Perceptive focus are prime consumers of enterprise technology, nearly $2 trillion annually.

Whether it's the traditional Perceptive sectors such as education and healthcare, where Lexmark's traditional strengths including retail and manufacturing, there is a lot of green space for what we have to offer. We need only a small part of that spend in order to be successful.

Let's talk about where we are headed in terms of revenue, product capabilities, solution offerings and key growth drivers. A few years ago, we were an ECM company. Today, we offer additional capabilities and a stronger platform. As you saw, the markets we are in are projected to grow. And the industries we serve are prime consumers of enterprise software. That combination leads us to our own expectations for growth. Perceptive revenue grew 62% from 2011 to 2012 finishing at $162 million. We expect our growth trend to continue and are projecting a compound annual growth rate of more than 30% from 2012 to 2016. This growth will be both organic and through acquisition, leading us to a revenue goal of $500 million in 2016. And as Paul mentioned, we are taking steps to continue to improve profitability as our revenue grows over the strategic period.

Let's talk about Perceptive's 4 core capabilities: capture, content, processes and search. Let's start with capture. The value starts with capturing discrete pieces of information and automatically providing order, hierarchy and meaning to that information. An important part of our capture story is Perceptive data capture, which is the core of our capture offering. This product allows us to extract data from content in a way that no other technology can.

And let me spend a little more time on this product because we believe it to be very unique. Perceptive Capture has the almost human ability to learn as it goes, by giving this system just a few examples of various document types, such as invoices, resumes or bills of lading and telling the system what data is important to extract for each document type, the system will automatically and correctly classify and extract data on each new document it sees moving forward, again getting better as it goes.

Other technologies can capture data, but they don't do so intelligently. The old approach is based upon determining anchor points on the document and building templates to handle each document class, instead of extraction rules separately and then hoping that the template can accommodate the nuances of varied individual documents. Perceptive Capture, on the other hand, with its intelligent and unique approach provides an incredibly flexible capture platform that allows customers to focus on higher value activities. And then in a few minutes, we'll show you how one of our global enterprise customers uses Perceptive Capture. And additionally, we are demonstrating this technology in the solutions showcase.

Once information is captured, we help customers manage that information, ensuring the right people have access to the right information at the right time. This is our content management offering. Businesses need a way to store, organize, manage and access their content. This includes keeping it secure, protecting it and maintaining records in compliance with industry standards and company policy, as well as the ability to access the right content, where they need it and in the form that they need it.

And we're excited to be able to offer rich media management capabilities within Perceptive content, with technology we recently acquired from Twistage. Now our customers can seamlessly incorporate rich media, video, audio and photos into their content management system, workflows and business processes. Additionally, with the acquisition of AccessVia, we have extended our content capabilities from content management to content creation, via AccessVia's powerful content authoring tools. We are excited to leverage this capability across all of the industries that we serve.

Process management goes hand-in-hand with content management to help organizations run efficiently and provide superior customer service. With our 4 pillars of effective process management, discover, design, execute and improve, we provide organizations all the tools they need to capture and manage their business processes. Process, mining and discovery is the missing step in most business process management initiatives. Perceptive process mining allows organizations to uncover and measure both structured and unstructured processes. Our software creates a visual animated map of the process, allowing customers to compare their design to the real-world execution of that design, providing realtime feedback and predictive analytics that foresee future areas of concern well in advance of process bottlenecks.

Our fourth capability is search. Most organizations have multiple silos of content because it simply isn't feasible to consolidate all information needed to run critical processes into 1 management system. Enterprise and federated search are critical components to solving the problems associated with siloed content. The need to access data across multiple content systems, systems such as Microsoft SharePoint and other ECM repositories. Websites, file shares and even email, in a secure fashion, is the key to unlocking an organization's investments in these systems.

The Perceptive platform is the strong technical foundation to which all of these technologies are connected. Our enterprise software platform brings all of our capabilities together to power highly scalable and repeatable solutions, delivering the customers content and processes to those who need them, when they need them, however they need them.

So you can see the Perceptive Software offering is much broader today than it was just 2 years ago. Now as proud as we are of those innovative products and our powerful platform, our promise to our customers is to combine these products into real solutions with a heavy focus to the unique requirements of each industry that we serve.

So when we talk about solutions, we mean the combination of our product capabilities along with hardware and services that solve the very real and specific business challenges our customers face. Using manufacturing as an example, it might include a lot of capture, a little bit of search and some content and some process, but this will be different from industry to industry and solution to solution as each solution requires a customized mix of our various product lines, tailored to that specific business problem.

Solutions leverage our deep domain expertise and best practices in key industries. We take the innovative platform and product features our engineers create and put them in the context of our customer's business processes, bringing our customers the solutions they desire in an easy to consume offering.

So let's talk about how we're going to leverage our capabilities and unique approach to drive growth. We see 3 key drivers of our growth: enterprise expansion, software channel expansion and international expansion. Lexmark has a powerful global business platform and strong relationships with many large global enterprise customers in key industries in more than 170 countries. And our plan is to continue to leverage those relationships to place Perceptive products and solutions globally.

Perceptive has a broad portfolio of products and solutions that have application in every industry. Many of these customers can use the entire software offering, some of them have existing systems and will only need part of our capabilities. The key is that we can sell the full stack of technologies to work together, or we can sell pieces of it independently adding value to a customers key systems. Now it's important to note that many Lexmark customers already have ECM or BPM solutions. And of course, we're always open to replacing those systems and we do frequently replace competitors, but we can also offer complementary capabilities. So if an enterprise customer is happy with their existing content management solution or process management solution, we will show them how Perceptive Capture can make them more efficient or how Perceptive search can add value to their existing processes.

Lexmark provides deep domain expertise in the industries that we serve. That expertise helps us create compelling solutions to our customers business problems. And our commitment to providing a superior customer experience helps ensure efficient implementation, quick user adoption and a rapid return on their technology investment. To appeal to the Lexmark enterprise customer, we are also expanding all of our solutions both horizontal across all businesses and industries and vertical and specific industries. When we combine our knowledge of the customer's business with innovative technologies, we provide solutions to real business problems via scalable, repeatable solutions.

We are continuing to invest in the horizontal solutions used by our customers across all industries. Our back-office solutions apply our powerful intelligent data capture and business process management technology to automate and streamline complicated and costly processes. So let's look at an example of accounts payable invoice processing.

Now Perceptive can capture content from any source. We can capture invoices in digital or paper form. Once captured, the invoice is then routed through our intelligent data capture engine, our unique technology classifies the document without user input and extracts all of the pertinent invoice information, as well as the line item details from the invoice. A process that was manual and time-consuming can now be completed in seconds with no human interaction. If certain confidence levels are met, the data is automatically uploaded into the ERP system.

Now if the customer requires an approval process, where the vendor is not in a system or any other business rule, fire as an exception, the invoice is automatically routed to our business process management software, where the document is placed in the queue for the finance department to resolve the discrepancy. Using our e-forms technology, the extracted data is presented to the AP workflow users in an easy-to-read format.

With minimal processing, the invoice is reviewed and any issues resolved based upon the organization's business rules. Perceptive then automatically routes invoices to the appropriate approver who can review and improve the invoice at anytime, from any location, using the device of their choice.

The reconciled invoice data is then uploaded directly into the ERP system to create the payment. And because the invoice is linked to the vendor record in the ERP at that time of capture, accounting can quickly access all of the vendor content stored in Perceptive with a single click. The ability to improve and invoice more quickly, accurately and with less manpower results in great savings.

Let's show you a brief video of a Perceptive customer, talking about their experience with Perceptive Intelligent Capture.

[Presentation]

Scott T. R. Coons

You can see how valuable perceptive capture is to the Siemens organization. It is important to point out that invoice processing was already automated at Siemens and that the 30% improvement figure referenced in the video was gained from replacing another product with our perceptive intelligent capture.

So now I'll be sharing an example of how we're leveraging our deep domain expertise to enhance our vertical solutions, specifically in the health care space. Perceptive has long been a leader in the health care clinical support technology. In fact, KLAS, the leader in health care IT vendor performance analysis, named Perceptive Best in KLAS again in 2012. Our domain expertise and commitment to the industry help us foresee the importance of bringing clinical and traditional content together within the context of the patient. We enhance this product vision through the acquisition of Acuo Technologies.

Acuo is a health care vendor neutral archive leader that's used in top health care facilities worldwide, identified by KLAS as a V&A market pioneer. Acuo's capabilities in managing clinical content combined naturally with Perceptive's overall health care strategy, allowing us to deliver a true content-based patient record. Even the industry analysts are excited about this. Gartner says our health care vision should make hospital CIOs rethink their strategy regarding enterprise content management. Other analysts have stated that this deal makes Perceptive the most formidable ECM company in health care.

So this gives us the ability to provide users a single enterprise-wide view of all patient medical information from within the electronic medical record, the EMR, from business content to rich media content. This means that any content, traditional content like physicians' notes and consent forms, clinical content like X-rays and ultrasound images, across all of the ologies to rich media content like staffing and patient education videos and even surgical videos from any source are all available to the clinician from the patient's record in the EMR. Now while the EMR is vitally important, it does not give clinicians the entire patient picture because that only presents a portion of the full medical record.

So here's an example. A physician is making rounds and needs to check on a patient that was recently admitted. The physician would start by accessing the patient information in the EMR. Without Perceptive solution, the physician has to go to various departments to view relevant content. With Perceptive solutions, physicians will have immediate access to all patient information from prescriptions to X-rays, ultrasounds, CT scans, surgical videos and more, from directly within the EMR, regardless of the department in which it was conducted or the technology used to create it and store it. This data is then presented in the context of the patient, so all clinical content living outside that record is presented. This immediate and longitudinal view of the patient drives both the efficiencies and better patient care.

Another key driver of our growth is the expansion of our channel, working with our partners in Lexmark's channel to sell and deploy our technology to customers across the globe. Over time, we expect more and more of our revenue to be driven via the channel, utilizing the channel as simply the more efficient way to grow, allowing us to scale at a much lower cost. We will focus resellers and specific industries or tier levels such as Jenzabar, a student information system software provider, which has quickly generated momentum in our higher education practice. Netsmart, the largest U.S. behavioral health EMR, is quickly adopting our entire software portfolio to enhance their software offerings to the behavioral health space. We will continue to OEM our software to other technology companies, allowing them to extend their own solutions.

One key strategy for us is to introduce our existing OEM customers, customers such as Kaspersky, Jive, and EMC to our new capabilities such as enterprise search and rich media management, for example. We also leverage our alliance partners in the system in a greater ecosystem, companies like Accenture, Deloitte and Capgemini, to be their process and content management partner in their large enterprise pursuits. We will look to leverage our very strong and long-standing alliances with companies such as Microsoft, SAP and others. Many of alliance technology partners have long brought us into deals, but we will continue to pursue these alliance partnerships into formal reselling relationships with Perceptive Software moving forward.

Finally, we will continue to expand internationally. We have joined Lexmark offices across the globe in establishing Perceptive Software teams on 6 continents. We now have research and development underway in 8 time zones, and we continue to use our follow-the-sun model for providing product support across the globe. More than half of Lexmark's traditional business is outside the U.S., and there's a tremendous green space in the ECM and BPM markets internationally. This combination provides tremendous opportunity, and we expect a significant portion of our continued growth to be outside of the United States. Siemens was a great example of our recent global win. Other global multinational wins include Kohler, AP Moller-Maersk in Denmark, British American Tobacco in the U.K. These customers join our many long-standing global customers, customers like 3M, Aebis and Capgemini to name a few.

I hope I've been able to convey the sense of excitement that we feel at Perceptive. Lexmark has put us into a tremendous growth position. We continue to leverage Lexmark's ability to acquire tremendous technologies and the people who created them, combining Perceptive's domain expertise with Lexmark's to create solutions to bring real value to a broad enterprise customer base. We are cultivating mutually beneficial relationships with software and technology partners who are joining Lexmark teams around the world as we expand Perceptive's global footprint. I'm confident Perceptive is well positioned to continue to grow to meet its long-term financial goals, and we're very excited about the future.

Thank you. I'd now like to turn things over to John Gamble, Executive Vice President and Chief Financial Officer.

John W. Gamble

Thanks, Scott. Thank you, Scott. As John Morgan indicated earlier, the discussion that follows is on a non-GAAP basis and reflects non-GAAP adjustments unless otherwise noted.

As our business is evolving, so was our financial model. We thought perhaps the best way to discuss this change is by answering some of the specific questions we have been getting from investors and analysts over the past several quarters. Specifically, these questions include details on the Inkjet sale and its impact going forward, Perceptive Software operating income performance and how well it moved to profitability in 2013, our revenue and EPS guidance for 2013, and given our guidance for the first half of 2013, how will we achieve our full year estimate, in 2014, how we will offset the income loss by the decline in inkjet supplies revenue and capital allocation strategy and how can we continue to pay to investors through dividends and share repurchases, on average, greater than 50% of free cash flow given our current low U.S. cash position. I will address each of these questions in the coming slides.

Starting with the sale of the inkjet-related technology, the sales transaction to Funai Electric Company for $100 million closed on April 30. We're happy to have completed the transaction and believe it will be beneficial to both Lexmark and Funai. Only about 25% of the cash proceeds of the transaction were U.S. The gain on the transaction is still to be finalized but is expected to be $0.73 to $0.83 per share. It will be reflected in our GAAP results only and will not impact non-GAAP results. No material impact on our inkjet supplies revenue or our inkjet supplies cost is expected from the transaction.

As part of the transaction, Funai acquired our Cebu, Philippines manufacturing facility and has become the supplier of principally all of our inkjet supplies. Lexmark will continue to sell inkjet supplies to the existing install base and will continue to support those customers. Funai also acquired over 1,500 inkjet-related patents, inkjet-related research and development assets and tools and other inkjet-related technology and assets.

Now shifting to Perceptive Software. For 2013, we expect to continue the accelerated growth of Perceptive Software and achieve profitability. Our expectation is to deliver 35% to 45% revenue growth in Perceptive versus the $162 million achieved in 2012. This is less than the 54% we achieved in 1Q '13 and reflects strong organic growth, as well as the benefits of revenue from acquisitions completed to date. As Scott discussed earlier, we are already seeing significant benefits from the Acuo, Twistage and AccessVia acquisitions, and they have accelerated our revenue growth.

To achieve profitability in 2013 in addition to delivering our revenue goals, we need to do 2 things: first, improve our gross profit margins to 72% to 74%. This improvement from the 69% delivered in 1Q '13 and 2012 reflects both improved product mix, as well as high-margin licenses, subscriptions and maintenance become an increasingly larger portion of revenue and achieve higher margins and professional services and maintenance as cost reductions executed in 2Q '13 are reflected in our margins in the remainder of the year. Second, we need to limit the increase in Perceptive Software operating expense to 15% to 20% from 2012 levels. This was a quarterly expense levels slightly above the level shown in 1Q '13. We believe both of these initiatives are achievable, and as we have indicated, we expect Perceptive to be profitable for the 2013 calendar year.

This next slide reflects our general assumptions for 2013 and the longer term. This is more of a summary for your reference as the next several slides provide context for our views regarding 2013 and 2014. Our discussions of 2013 and 2014 revenue assume FX rates as of March 31, 2013, and that the combined laser imaging and ECM, BPM software markets are flat to up slightly in the 2013 to '14 period, as Paul Rooke discussed earlier. For 2013, we're expecting revenue to decline 8% to 10% relative to 2012. This decline is driven by an expected greater than 40% decline in Inkjet revenue, which causes 7 percentage points of the total decline. Inkjet Exit revenue is expected to decline to 11% of total revenue for 2013 from 17% in 2012.

Our strategic focus areas of laser imaging and software are expected to, in total, be down slightly. Within this, Perceptive Software is expected to grow well above market at the 35% to 45% level I just discussed. Also, our Managed Print Services revenue is expected to continue to grow above market, as it did in 1Q '13, growing 10%. Combined MPS and Software are expected to grow at least 15% in 2013.

For 2014, we have not provided a revenue forecast but have provided our view as to the expected performance of significant drivers of our revenue. Inkjet Exit revenue should again decline greater than 40% and be only about 6% of total revenue for calendar year 2014. We expect our strategic focus areas of laser imaging and software to grow revenues slightly in 2014. Within this, Perceptive Software should again grow on the order of 30%, both through organic growth as well as acquisitions. Also, MPS is expected to continue to grow faster than the market. Together, MPS and Software will again grow more than 15% and then total represent about 40% of total Lexmark revenue for 2014.

Moving now to EPS. 2013 EPS is expected to be $3.90 to $4.10 per share. Our assumptions for the improvement versus the $3.51 delivered in 2012 are as follows: operating income for 2013 is expected to be flat to up slightly from 2012, as shown by the combined ISS segment and Perceptive Software bars. Within ISS, operating income is negatively impacted by lost Inkjet gross margin, reflecting the lower inkjet supplies gross margin due to declines in inkjet supplies revenue, partially offset by lower losses on Inkjet hardware. Positively impacting ISS operating income is the lower cost and expense from the restructurings announced in 2012, net of lower laser hardware and supplies income in 2013. These 2 items resulting in ISS operating income being down in 2013 relative to 2012. Perceptive Software operating income is expected to positively impact 2013 versus 2012 as it becomes profitable, as discussed earlier. Combined, the ISS and Perceptive Software impacts negate each other, resulting in total Lexmark operating income expected to be about flat in 2013 as compared to 2012. EPS is expected to be up in 2013 versus 2012 as average shares outstanding will decline, reflecting share repurchases executed in both 2012 and 2013. Also, the tax rate in 2013 is expected to be lower than 2012. These net effects drive the expected higher level of EPS in 2013.

To achieve our 2013 outlook, the second half of 2013 EPS will need to be approximately $0.54 per share higher than the first half guidance we have provided. This slide provides the first half to second half EPS bridge. ISS is expected to deliver above 1/3 of the improvement with Perceptive delivering slightly greater than 1/3 and the remainder driven by lower shares outstanding and reduced other expenses. Within ISS, laser supplies revenue and margin are expected to be up in the second half of 2013. This reflects 2 factors. First, consistent with historical patterns, laser supplies pages are expected to be up in the second half of 2013 relative to the first half, driving the bulk of the improvement. Second, we are expecting some improvement in gross margin percent, reflecting improved cost and price mix. Also within ISS, laser hardware margins are expected to improve in the second half of 2013 as we saw aggressive pricing as we liquidated our prior model laser hardware in the first half of 2013, following our product launch in 4Q '12. Partially offsetting these improvements, inkjet supplies revenue is expected to decline in the second half of 2013 relative to the first half, reducing both revenue and margin. Perceptive operating income is expected to improve in the second half of '13, reflecting the cost reductions and revenue growth I discussed earlier. Shares outstanding will decline in the second half of 2013, reflecting our continued share repurchases, and we are expecting lower other costs in the second half as well. Partially offsetting these benefits will be a higher tax rate as the discrete benefits we had in 1Q '13 are not expected to recur.

For 2014, we are not attempting to provide a projection of operating income or EPS, but we want to provide a view as to how we are working to offset the negative impact on income of declining inkjet supplies revenue in 2014. As we have indicated earlier, inkjet supplies revenue and margin are both expected to decline more than 40% in 2014. This slide provides a view of the 3 areas on which we are focused to offset the significant majority of this decline. First, for laser supplies, we expect gross profit margin to increase, driven by 2 factors. Design cost reductions. The new laser models launched in 4Q '12 offer longer-life printing components, and as such, have gone to a toner bottle architecture. In the new models, several components previously included in the toner cartridge are now in the printer. And as such, our cost of delivering toner is lower and our supplies margins are higher. We also increased the yield on our cartridges, which acts to reduce our cost of delivering toner. Also, our continued success with placing large workgroup devices through MPS as well as the channel should lead to slight growth in laser supplies revenue in the 2013 to '14 time frame. Second, for cost and expense, we expect ISS and other cost and expense will decline over the period. This will be driven by the remaining benefits from the 2012 restructurings as well as ongoing costs and expense reductions. Third, for Perceptive Software operating income, we expect continued improvement driven by continued revenue growth and holding operating expense increases well below the level of revenue growth. Also over the long term, our continued share repurchases will also act to increase EPS. As we look beyond 2014, the headwind from declining inkjet revenue in any given year will be substantially reduced.

As Paul discussed earlier, we remain committed to our capital allocation framework and returning more than 50% of free cash flow, on average, to shareholders. Year to date, including actions committed for 2Q '13, we will have returned $79 million to shareholders. We also executed the Acuo acquisition just before year-end 2012 and completed the Twistage and AccessVia acquisitions in the first quarter. Our cash balance remained strong at $880 million at the end of March prior to receiving the proceeds from the Inkjet sale. We have also refinanced our debt and have no near-term maturities. Despite our relatively low level of U.S. cash and given our significant liquidity, including over $450 million in credit and receivables facilities, we are comfortable we can continue to execute our return of capital to shareholders and our acquisition program.

So in closing, Lexmark has a strong financial position with the proceeds from the sale of our Inkjet technology further strengthening this position. We continue to grow Perceptive Software faster than the market and successfully execute on our acquisition strategy. We are continuing to maintain this growth and for Perceptive to be profitable in 2013. As we look to the second half of 2013 and 2014, we expect cost and expense reductions, improved laser supplies margins and revenue and improving operating income at Perceptive to offset the declines at inkjet supplies in revenue and margin. We remain continued -- we remain confident in our ability to continue our history of strong cash generation. We will continue to execute our capital allocation framework, continuing on our acquisition program and returning, on average, over 50% of free cash flow to shareholders.

With that, I'll ask Paul, Marty and Scott to join me up here, and we'll be happy to take your questions.

Question-and-Answer Session

Bill C. Shope - Goldman Sachs Group Inc., Research Division

Bill Shope, Goldman Sachs. Look, I think overall in this meeting, you really clearly described the transformation and where you're taking the company, and I think that's certainly very helpful for investors. I guess as we look forward to that path and particularly the cost of the transformation, you've clearly outlined that there's more M&A to be done, more organic investments that need to be done. What makes you comfortable with the idea that the split between 50% of cash flow going to shareholders versus 50% going back to the business is appropriate?

Paul A. Rooke

Yes. Well, we -- first of all, we've been executing it pretty consistently and branded -- we've got some plans here that were still not done, and it takes an effort, but we think with the cash flow that we have coming into our core business and the balanced approach that I think we've been taking with our acquisitions that we plan to continue with, we see it's -- we think it's quite executable. It's not like we're sitting here without a core business that is in trouble. I mean, it's a very solid business. You can see from all of the presentations here today, it's strong, it has high cash flow. And we're using that, obviously, to fuel the smaller piece in the software group, and we're doing it in a fairly thoughtful way that we think is quite [ph] -- that could be done.

John W. Gamble

We also have a very significant cash balance, which provides us a tremendous amount of flexibility in terms of the way we execute our acquisitions and our location. So we feel that we are very flexible in the way we can execute and that we should be able to -- certainly be able to deliver the growth we talked about given our capital availability and the liquidity we have available to us and continue to distribute a lot of cash back to shareholders as we've done.

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

Toni Sacconaghi from Bernstein. I have a couple of questions about Perceptive. I think when you provide segment profitability for the company, you provided for ISS, for Perceptive, and then you have an Other group that has a significant level of negative profitability. So on a truly allocated basis, the Perceptive profitability, I assume, would include some of those other costs or losses. So the profitability on a fully allocated basis is dramatically lower, and I'd like you to just confirm mechanically whether some of those other segment costs do indeed take on Perceptive. And then maybe you can talk little bit about when you think about Perceptive as a $500 million company longer term, what do you think the appropriate operating margin is for that company? How do you think about that on a go-forward basis? And then I have a follow-up depending on how you answer.

John W. Gamble

Sure. In terms of the other cost, the amount that actually go to Perceptive would be relatively small. If you think about the amount of, let's call it, administrative cost that a software company would drive relative to a hardware company with significant distribution and other capabilities in terms of manufacturing, the level of central cost, which would be allocated toward Perceptive if you did it on new spaces would be relatively small. So yes, something would go there, but not a really large number. In terms of operating margin, we would expect Perceptive to be able to operate like a very strong software company should. So margins on the 20s. So exactly where in the 20s. We'd like to make some progress toward the 20s before we give that. But it should operate in the 20s.

Paul A. Rooke

So this year, we wouldn't achieve that, obviously, but we'll take our first step towards that.

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

What has been the -- I mean, when I look at software companies that have $200 million plus in revenue today, which is about the run rate -- you're going to be above that given your guidance for this year, they typically have operating margins in the 15% to 20% range at this level of scale. So what is ultimately the disconnect in profitability today? And why does that improve with the scale? I know it's obvious, but you sort of said that it would improve a lot and with scale and we've had scale over the last couple of quarters and it hasn't improved. So what is the disconnect with benchmark peers today at similar levels of profitability? And how do we have the confidence that you ultimately get there over time?

John W. Gamble

So bottom line is the decisions we made around how we wanted to accelerate, 2 things, right. We wanted to substantially accelerate the building of the platform that Scott spent a lot of time talking about because we believe it would not only accelerate Perceptive's growth but also margins growth in ISS because that's what allows us to stitch the platform directly to the MPS offering and deliver far greater integrated solutions than we otherwise could. So we accelerated those investments. We did it on purpose. The second thing was global expansion. We invested heavily in global expansion to try to make sure we could get the capability that we were building in that platform into all of the geographies where Lexmark currently exists. And those 2 investments were made knowingly and aggressively so we can grow faster. And quite honestly, given the base of profitability we have as a company and our strong cash flow, we felt we could do it, and that for the longer term, we would be advantaged. So we understand now it's time to turn it into profitability for the company, and we think that's where we headed. But that was the plan.

Paul A. Rooke

And I'll add a third element. You heard Scott talk about the channel expansion. I'd say the vast majority of Scott's [indiscernible] is generated directly right through [ph] the large account direct sales force. As we expand that channel component, that mix software, the close of a [ph] channel, then we'll get some leverage there as well.

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

Okay. Sorry, last follow-up, and then I'll save the floor. But it's all on the same topic. So if I think about global expansion, I think one of the things you had talked about when Perceptive was acquired that 70% or 80% of its revenue was in the U.S. and that you're going to leverage Lexmark's global distribution. You've made those investments. Can you update us on what percentage of Perceptive's business is international today relative to at the time of acquisition? And then just on the investments, I understand the notion that you've been trying to build out the platform. But given the growth rate that you're aspiring to and given what will -- it appears to be an inevitable set of additional acquisitions, how did those investments really temper? I mean, if you're going to go from $200 million to $500 million, you're going to have to do more channel expansion, you're going to have to do more global expansion. So again, it's not like your growth rate is coming from 60 to 10 and all of a sudden, the profits come flowing in. How do we get conviction that this can be managed towards peer levels given the aggressive track that we have and that we haven't seen it today?

Paul A. Rooke

Let me take the first one. We have invested internationally to expand [ph] the sales force, to expand our software beyond the U.S. We don't break it out, but it is running at much higher growth rate than what our domestic U.S. software growth would be. And you see examples of it. I mean, we highlighted one, there is Siemens, to just give you a feel of -- these aren't small international customers that we're talking to. These are large international customers, some of which are Lexmark customers, some of which are not. And in this case, actually, this is one that we broke into directly with Perceptive Software. So you can see more of those as we expand internationally, not just in Europe, but Latin America and Asia as well.

John W. Gamble

And so in terms of the -- just the spending, we -- as Paul said, we invested heavily in expanding that sales force. And the realization of revenue per head there is just not worth -- not at full level yet. So as that completes -- so we don't think we need to invest more at this point in additional sales resource internationally to drive substantially more revenue. It's really around the capabilities and having those -- having the sales follow with success. And we think that's happening, and I'm sure Scott will address that. In terms of R&D, the increase in investment around specific development objects, and they were very specific and well defined. And as they complete, those resources then go back into a normal pool and the growth of the resources no longer needs to occur because they're available to invest in platform expansion the way you described. So -- and there were several very substantial investments, which are completing in 2013, which we think gives us confidence that the level of growth in R&D will mitigate.

Shannon S. Cross - Cross Research LLC

Shannon Cross, Cross Research. Another question on Perceptive and, actually, just your software businesses in general, when you acquire, how are you integrating in the R&D effort, the sales effort, management, back offices as you brought in several of these smaller companies? And then I have a follow-up.

Paul A. Rooke

Scott will talk to you some of those pieces and John will talk about some of the back office pieces.

Scott T. R. Coons

The new acquisitions come in under the Perceptive umbrella, and we fully integrate all functional areas of the business. Now we're we have some -- if it's an organization or an acquisition that has a unique capability in the industry, we have to allow them to operate a little bit independently in terms of how they sell or how they market. But at the end of the day, we're building one platform. We want to make sure they were not building the same things over and over within the platform so that all of R&D comes together, marketing functions come together, and back-office functions come together.

John W. Gamble

Yes. All the systems are integrated generally within 6 months. They all run on our core systems that are run across Lexmark and Perceptive. All back-office functions are integrated into our Global Shared Service Centers generally within 6 months. If not 6 months, with 9 months. And we've been fairly successful with doing that. We have a standard template for acquisition integration in a playbook, which we execute actually starting before closing, and it's been going relatively well. It gets better every time. We messed up every time. We're getting to the -- pretty good.

Shannon S. Cross - Cross Research LLC

Great. And I'm curious, the ECM solution you talked about, is -- are there any grants or subsidies within ObamaCare? Because we've done a lot on ERP and obviously, there's fair amount of money floating around out there, if you can you define it correctly. So I'm just curious as to whether or not your solution is sort of covered within that.

Scott T. R. Coons

Yes, it can be. Many of our health care customers actively write grants to receive funding to start to meet meaningful use requirements. And then that revenue that comes in are spend on many different types of technologies, process and content management are being one of those typically.

Shannon S. Cross - Cross Research LLC

Okay, great. And then my final question is just on China. You talked about China being -- and Asia, frankly, being the big growth opportunity. I know you had some initiative in Japan historically, and I think that sort of slowed down over the last few years. But I'm curious, how are you going to go after China because it's not the easiest market to penetrate. The big guys, Ken [ph] Enrico [ph], Fuji Xerox, they're all going after it as well, more on the multinational side. But how do you get in and -- get in with the distributors? Is this -- how are you going to sort of offset the cost here? And what are your plans for China? And any goals you can give us in terms of share?

Scott T. R. Coons

Yes. What I'd basically say, Shannon, is we look at this hard because of the questions you're asking, channel type of market versus where we think our value proposition plays. I mean, that's fundamentally what we've determined, that Managed Print Services, our smart A4, workgroup products, we think they have applicability. We've been over. We've been talking to these customers and the extension from that platform, leveraging the Perceptive Software Solution plays as well. We need to execute better. As you saw, I referenced in our top 10 geographies, 8 of the top 10, we have the #1 or #2 share, okay? And you go into China, we have the #5 share. So just basically executing at the level we execute in the rest of the world is a significant gain for us at the geographical growth to that. And it's clearly an area we're going to focus on.

Paul A. Rooke

Shannon, I mean, following this -- we've been up against the big, broad-based competitor [ph] since our beginning and how we've established the presence we have is by going deep not wide, so going deep in these industries. So China's all the same industries that every other geography is. So maybe that's some of the largest banks in the world, some of the largest manufacturing operations, et cetera, et cetera. So the stated solutions and the same approach that we described here -- in the morning, we will fly in, in China as well. And I think we'll have similar success, similar points of differentiation there that we see everywhere else in the world. And I'll tell you, when you look at China, you talk about some of the software opportunities, back-office operations in China, paper-based workflow in China, it's there and it's big. So we think normally from the Managed Services, smart MFPs, extending it into some of the workflow applications that we've just described here will have full applicability in China, which is very large [indiscernible].

Unknown Attendee

Soren Garcia [ph] on Perceptive, how much of that $162 million is maintenance? And how should we think of the growth into 2013? And is there any going to be any like accounting, what, the deferred write-off come back into 2013, deferred revenue purchase accounting write-offs come in? Or have you -- is that $162 million number a non-GAAP number?

John W. Gamble

So $162 million is a non-GAAP number. And actually, in our investor package, as we publish each quarter, there's a P&L for Perceptive, where you can see how much is maintenance and subscription. For each quarter, I think 2012 and '13 are both in there.

Unknown Attendee

But how should we be thinking about the growth for the maintenance? Is it going to -- should we think about it as maintenance growth will be sort of like license growth lagged 1 year?

Scott T. R. Coons

There's always a tail, so you just have to do the math. There's just this tail. As licenses grow over time and maintenance and support continues to grow, it takes a period of time. Because obviously, we can't recognize all the maintenance -- yield on maintenance and support immediately. We have to recognize it over time. But our renewal rates are extremely high so...

Unknown Attendee

I guess a little tricky too as you move to SaaS models.

Scott T. R. Coons

Then you have to factor in SaaS and everything else.

Unknown Attendee

Can you talk a little bit about -- your Legacy is -- as a hardware company, you're trying to become more of a merger between hardware and software. Doesn't always work out well for a lot of people who've tried to do that. And I guess what I want to get a little bit more information on is just how you're approaching the sales process. Because a lot of times, you're going to sell a hardware product and you're talking to one specific person within that organization. And then when you're trying to sell a software product, that might be usually another person. So can you talk a little bit about how you're managing that sales process or how you're approaching it? And then secondly, can you talk a little bit about the employee retention that you've had in terms of the software acquisitions that you've made? What percentage of the employees have stuck with the company, say, a year after acquisition?

Paul A. Rooke

Yes. So I'll address first, and Scott, you can take the employee retention. Yes, first of all, there are existence -- companies that exist out there that are selling hardware and software together quite successfully. My competitive chart have all the names. I know that there are some very large ones, IBM being a very large example of companies that -- a company that's quite successful in selling a whole mix of hardware and software and, of course, very large solutions. And so it can be done, but it does take focus, takes effort. And you just don't magically throw them together and expect it to happen. And so we've been working hard. One of the position is just the hardware and just expanded portfolio of things that we're just going to introduce to customers or bigger idea here or bigger position. So what you see here is the bigger position that kind of unifies the hardware and software together, this idea of attacking the unstructured information challenge and presenting that to the customer, because they are dealing with a number of these challenges. So we're trying to put it in the context of something that actually unifies them. And at any given account, now we'll have an account exec who's on point, who is there to represent the full body of what Lexmark has to offer, whether it's coming from ISS or Perceptive. And then as the customer responds to that, our proposals and so forth, then we'll dive down and maybe that they buy it on the software first or hardware first, then whatever it is and then we'll bring in the experts as needed. But you have a set of account executives that run across the whole sales organization and representing the full breadth of what we offer in a core proposition that we think is unique. So it can be done. We're in the process of doing it. As we bring these pieces and parts together, there's training. Obviously, that goes on to get everybody up to that same level where they can represent that but it can be done. And they're already being done by many companies out there that do sell hardware and software together today. But it -- but I care because it's a solution. It's a solutions company not a hardware company that happens to sell software or vice versa. It's truly a solutions company, attacking varied key pain points across all these industries. And so remember, that's how we differentiate. We're going deep and so in any -- like you see in the showcase, if any of these industries we walk into, we will be very familiar with the pain points that exist there. And so our solutions will approach those pain points, which the customer -- which will resonate with the customer and then we bring this solution, which may be made up of a whole variety of pieces and parts. We're really trying to communicate and showcase actually and see the little flags, and you may have half a dozen pieces and parts. But you put them together for each combinations to represent that solution. But it takes effort and focus, and we are focused there and undergoing a good bit of training to make that happen in a very smooth fashion. Scott, why don't you touch on the software retention.

Scott T. R. Coons

Sure. If I can add just something to what you just said. Well, I think what's very interesting, as the Lexmark sales team brings in the Perceptive solutions, we have no problems getting to the right people because Lexmark has done such a tremendous job of taking care of their customers over the years. There's this trust. You're taking care of us. Obviously, we're going to give you a shot at the software solution. And I think that the opposites hold true as well. And Paul mentioned it would brought in MPS solutions into the Perceptive customer bases. But it starts with trust, and people take us to the right people.

Paul A. Rooke

Yes. So we're maybe talking to the facilities person or the -- even the CIO relative to an output management or Managed Print Services deal. And so as we present the broader proposition and the other areas of value that we bring, it's a simple question. So who -- can you direct us to the [indiscernible] and even that has not been a problem at all. If we want to talk to the accounts payable people about -- at Siemens about their accounts careful pain point, absolutely, they bring us right in over there. And we may bring some other skills, obviously, to that meeting that are deeper in that area as in maybe management services. But the orchestration that went into account, yes, we're doing it.

Scott T. R. Coons

In terms of retention, it's going extremely well. The companies we buy, we share the strategy with them, with their leadership. They get it. They want to be part of something bigger. They want to grow their business, and they get the overall picture. And they want join what they believe to be something special. We don't have a problem convincing them to come on board. We don't have an issue with them staying, and retention has been extremely high.

Unknown Attendee

[indiscernible]

Paul A. Rooke

We don't[indiscernible].

Scott T. R. Coons

I don't think we've ever accounted it because there hasn't been an issue.

Unknown Attendee

Can you please address how you're thinking about the impact of the yen and the advantage it gives to some of your competitors from a pricing standpoint for the rest of the year, how that's impacting your guidance?

Paul A. Rooke

Yes, it has obviously shifted. But I'll first start with saying it's not that the market isn't already competitive. It is competitive. We're in these large enterprise deals and they're all special bid. We're all against the same competitors we've been knocking heads with for many years. So while it may get a little more competitive, it's hard to see that because it's already very extremely competitive. And by the way, in the enterprise segment, all of who we compete against is a competitor that's U.S.-based actually, a couple of competitors that are -- who are U.S.-based. Whereas, many of our Japanese competitors, while we do run into them occasionally in the enterprise, but a lot of them are in the small, medium business space in this -- in the channel, if you will, not so much in the enterprise. These are large enterprise engagements. So we don't see them. Up here.

Asiya Merchant

Asiya from Citi. Just a quick question. There was some macro environment, macro effects that affected Perceptive's revenues in the first quarter. I think you talked about it on the earnings call and said there was some deals slippage into Q2. Now that we're midway, almost midway through the second quarter, can you update us on how the signings and backlog looking for Perceptive?

Paul A. Rooke

I can give an update on the current quarter at hand, but I will say, first of all, I mean, we're pushing Scott and his team hard. And they're actually growing quite dramatically, both organically and with the acquisitions that are added on. So first of all, I don't want to mislead you, we're happy. I mean, were growing quite rapidly in the software business. Now it doesn't mean we're setting some tough growth targets for them. And some of these as we're growing a rather young business, we're going to get better at predicting when they fall, right? And some of these deals just give a little further extended out at the end of a quarter in terms of getting them closed, all the contract details tied up and so they move into the next quarter. And we'll get better in time, I think, in terms of our ability to precisely forecast that. But I would say, it's more -- any less of a macroeconomic as it is just getting the deals done. It's not that we're losing them, it's just trying to predict exactly when they're going to close in this quarter or the next quarter. Europe, I mean, Europe has expanded internationally. I mean, as we were standing up our European sales force, I mean, it wasn't the best environment to go and start selling into. But nonetheless, even when we look at the software growth numbers for 2012, they were down, the growth rates for the market, the software market. But they predicted them up here this year and so we'll see, see how that goes, but -- and I would say, these quarterly dynamics in our software business are more us just getting better trying to predict a very rapid growth rate here and trying to get more precise at that. And sometimes, they just fall, happen to fall a little later than we had thought.

Scott L. Shiffman - Sterne Agee & Leach Inc., Research Division

Scott Shiffman, Stern Agee. Just a few questions around the balance sheet. Maybe if you can just talk about your philosophy around leverage, if you can still stay conservative. When it comes to ratings, your credit ratings, maybe just talk about your level of commitment to your investment grade credit ratings. And when you talk about acquisitions, if there's the right deal out there, where you have to take leverage a little bit higher, but you may sacrifice your investment grade ratings, would you consider that?

John W. Gamble

Sure. So in terms of credit ratings, in terms of leverage, we think of the leverage often in terms of credit ratings as you ask. We think having an investment grade rating is very important because of the fact that when you take a look at the size of the transactions that Marty's team does, they're very substantial, and we're competing against very large competitors. So one of the things that's beneficial to us is to be able to have the sales guy very easily say, "Our credit rating is the same as blank competitor that is always into transaction with us." So we think that's important and it's a sales tools. And so we work on the try to maintain that. In terms of exactly how the rating agencies will treat our performance, that's difficult to predict. In terms of looking forward, we have traditionally done acquisitions, which are called bite-sized, let's say. Perceptive is the largest transaction we've done. We would never rule out a larger transaction. We would never rule out a more strategic acquisition. But if you take a look at our history, you can see the types and size of transactions we've generally executed over the last 3.5 years.

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

I don't know if we have to reintroduce ourselves for the record. I have a couple of follow-ups. I think at your Analyst Day 2 years ago you noted that the market growth was 2% to 4%. It's just 2 years later and you're discussing the market growth being flat to down. So that's, call it, a 4-point swing in 2 years. What's your conviction that the laser market actually grows at that rate and what are the odds that we come back 2 years from now and the market growth is another 4 points lower going forward. And how do you -- how does that change your strategy at all until if there was more evidence pointing to that?

Paul A. Rooke

It's a bit hard to predict what we monitor regularly. I think some things that happened certainly since this meeting. A couple of years ago, we have had some more economic stagnation around the world that has -- we see it in our quarterly guidance numbers, as companies tend to defer hardware purchases, for example, and just keep using what they have and extend it out a little further. As we went through last year, we had some usage slowdowns as against some of that economic weakness starting to enter in and still remains with us to this day. So those factors are happening out there, which I think are turning to dampen it, and so that's why you see us talking more flat to down as opposed to 2 to 4 up. But our position in the laser market, we're not the largest competitor there. There's lots of upside for Lexmark, even in a $70 billion market that's fairly flat to slightly down. And so we're attacking these segments that are actually growing within the $70 billion market like Managed Print Services or smart MFPs, and there's a lot of room to run there, particularly in the enterprise, but also, as Marty talked about, some of the small to medium opportunities that we see, where we can extend those same kind of value-added capabilities into the small, medium business market. So it's a very large market, whether it's up slightly or down slightly. I mean, it's just -- it's a large market. It's not -- we don't see it taking a downturn and also catering 15% to 20%. Paper is still very embedded in business. We see it -- and I mean, you can see the solutions showcase over here is full of real customer examples of where paper is still a very viable medium in the marketplace today. Yes, it's used less for storage, but it is still used for carrying and communicating of information with customers and suppliers, and we see that still today, which I think is holding up the market to where it is. But the economic kind of headwinds that we have, I think that flattened it or dampened it a bit from where we were a few years ago.

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

How intrinsically deflationary do you believe MPS is? So if you took a case example of 5 large MPS deals and you said this is what they were spending per year on an average basis in hardware and supplies and clearly, you pitched them on a lower cost, typically, and you guys got to track this so you should be able to give us an estimate because you pitch it all the time. How deflationary ultimately is that? Is it 25%? I mean, what are the purported savings that you're providing for folks? And I appreciate that you may gain share, but we really think the market is moving that way, isn't that a compellingly deflationary ongoing force that the market is going to face going forward?

Paul A. Rooke

Marty, do you want to comment on that?

Martin S. Canning

Yes. Toni, I'll start with the assumption you just made that I would say we're growing. We're growing our Managed Print Services pages, we're growing on Managed Print Services revenue. John said on his conversations, 10% just adjusting the first quarter. Do we drive savings for the customer? Of course, we do. Are all those savings attributable to the manufacturers that are supplying them? No. Of course, not. We're improving processes and we're doing lots of other things that are helping drive savings, but savings can be 25%, 35%, 40%, okay. As you mentioned, we're taking share. I used the statistic in my presentation. Over the past 24 months, we've won 15 global or Fortune 500 accounts, each a competitive takeaway, meaning we had none of that. That's why it's incremental to us. The other piece is not everybody in the marketplace is in Managed Print Services, that is providing Managed Print Service. There's far more competitors in the channel than there are competing for an enterprise Managed Print Services. So when we go out and we win a large percentages and by the way, Gartner projects that Lexmark has more large enterprise Managed Print Services wins than anybody else in this marketplace right now, we're taking share and we see it reflected in our results.

Paul A. Rooke

There are other levers. I mean, as you do -- and you heard the customers say it, the MPS is not the same as MPS, the same as MPS, I mean, there's a lot of people that say MPS isn't really executed. But when you really execute a full thorough MPS, I mean, you have a loyalty that comes to you in terms of when -- said another way, in a non-managed environment, there are less barriers to other re-fillers the things that can come in and in fact, that installed base, with the Managed Print service, you have a natural barrier there in terms of enhancing your suppliers loyalty, which is I think a profit driver. You also, in many cases, attract or gain services and maintenance and parts and things that maybe wouldn't normally get in a non-Managed Print Service so there are some things revenue gains that we get in addition to reducing pages and so forth, as you point out. The other thing is obviously with -- when you have a Managed Print Services, you're getting in and out of these workflows. So now these added software licenses and opportunities come forth, which is another tailwind for us. So the Managed Print Services is a fundamental thing that while, yes, you're going in and reducing pages and optimizing pages, there are other tailwinds that come with that, that we think are quite attractive for us.

John W. Gamble

You're also improving the mix of supplies to hardware and the customer, so we reduce devices substantially and improve the mix of hardware and supplies, which makes it a more profitable model for us in general because supply, obviously, is where all the profitability is generated.

Unknown Attendee

Marty, you said a 650 number new channel partners, if you will.

Martin S. Canning

Copier channel.

Unknown Attendee

So my inference was you showed us a couple of slides before that. There was a split between enterprise and SMB that Lexmark was skewed away from the industry, if you will. So a couple of questions. One, the 650 number, is that a growth or a net number?

Martin S. Canning

That's a net number.

Unknown Attendee

Net adds?

Martin S. Canning

Yes.

Unknown Attendee

And that's over 4 years?

Martin S. Canning

That's right.

Unknown Attendee

Do you have a sense as to how many -- I mean, I don't mean those exactly, but how many was added in last year, 2 years ago, 3 years ago kind of thing? Well, let me ask this another way. I mean, if you have a direct sales guy, it takes some period of time for that person to become, hopefully, productive, is there a skew or lag for the -- for your channel partners to also become more fully productive, if you will?

Martin S. Canning

Yes. I guess the way I'd answer is that I think we've been adding partners at an increasing rate, okay, if that's helpful to you. And those partners are becoming efficient faster now because of the solutions and the technologies that we're equipping them with.

Unknown Attendee

So would you -- if, say, 2 years now, if that's split over 50-50 in terms of SMB to enterprise, would you be happier or not happy?

Martin S. Canning

Yes. Let me be careful, the 650 is associated with the copier channel, okay. That's 1 small piece of SMB and that slice that's up there, okay. The copier channel is very important to us because they sell the full breadth of services and have all the capabilities and are moving a lot of their business from A3 to A4, which is a highly compelling relationship for us. But there are IT resellers, they're all kinds of other channel partners up there that make up that 2/3 of the market that you saw graphically illustrated on the chart, okay.

Paul A. Rooke

Anything else? Okay. We'll wrap it up.

John W. Gamble

Thank you.

John Morgan

So thank you for joining us today. Before we close it out, I want to recap the key messages for investors. First, Lexmark is evolving to provide a much broader proposition for our customers and is now uniquely positioned to be a provider of unstructured information solutions. Second, Lexmark is transforming to a higher-value portfolio consisting of Managed Print Services, higher usage hardware, higher value software and the associated annuity streams from them. We're also creating synergies, as you heard, between our imaging unit and our software unit to accelerate our growth. Third, we expect to grow our strategic segments and that this growth will emerge as the Inkjet Exit headwind naturally declines. And fourth, we expect to maintain a long-term operating margin of 11% to 13%, and we expect improvements in both laser and Perceptive Software income, along with other expense reductions, to offset the Inkjet Exit income declines. And finally, Lexmark remains strong financially, generating strong cash flow with a disciplined execution of our capital allocation framework to deliver long-term shareholder value.

Now before you go, there's a survey in your folder. If you can just take a few minutes to fill it out for us and leave it in your folder, we would appreciate it. So that concludes our meeting, and we do thank you for your interest in Lexmark.

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