Lexmark Q2 2006 Earnings Conference Call Transcript (LXK)

Lexmark International, Inc. (LXK)
Q2 2006 Earnings Conference Call
July 25, 2006 8:30 am ET

Executives

Paul J. Curlander - Chairman of the Board, Chief Executive Officer
John W. Gamble - Chief Financial Officer, Executive Vice President
John Morgan - Director, Investor Relations

Analysts

Richard Gardner - Citigroup
Cindy Shaw - Moors & Cabot, Inc.
Richard Farmer - Merrill Lynch
Benjamin Reitzes - UBS
Kathryn Huberty - Morgan Stanley Dean Witter
Shannon Cross - Cross Research
Kevin Hunt - Thomas Weisel Partners
William Fearnley - FTN Midwest Research
Bill Shope - JPMorgan Chase & Co
William Hand - Bear, Stearns & Co.
Keith Bachman - Banc of America Securities
Toni Sacconaghi - Sanford C. Bernstein & Company, Inc.
Chris Whitmore - Deutsche Bank

Presentation

Operator

Thank you for standing by and welcome to Lexmark International second-quarter 2006 earnings conference call. During the company's opening remarks, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session.

(Operator Instructions)

As a reminder, this conference call is being recorded on Tuesday, July 25, 2006.

I would now like to turn the call over to John Morgan, Lexmark's Director of Investor Relations. Please go ahead, John.

John Morgan

Thank you. Good morning and thank you for joining us today. With me today for Lexmark's second quarter 2006 earnings conference call are: Lexmark's Chairman and CEO, Paul Curlander; and Lexmark's CFO, John Gamble.

After their prepared remarks, we will open the call for your questions as time permits. Due to time constraints and increasing participation during this portion of the call, after one question and a follow-up if needed, we will need to move on to the next person in the queue. This will help us to get to as many of your questions as time will allow. If there is still time remaining at the end, we will take additional follow-up questions as time permits.

Currently, in the upper right-hand corner of our Investor Relations website, located at http://investor.lexmark.com, you can access supplemental information slides that we hope you will find useful. Following the conclusion of this conference call, a complete replay will be made available at this site.

As a reminder, any of today's remarks that are not statements of historical fact are forward-looking statements that 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. Lexmark undertakes no obligation to update any forward-looking statements.

With that, I will turn it over to Paul.

Paul J. Curlander

Thank you, John. Today we are announcing second quarter earnings-per-share that exceeded our expectations and revenue that was in line with the guidance we provided you in our April earnings release.

Despite the year-to-year decline in revenue, considering the circumstances this was a pretty good quarter for Lexmark.

In the second quarter, we had good unit sales performance in our key branded product segments. We made good progress on our planned restructuring and we generated solid cash flow while continuing to invest in our core strategic initiatives.

Second-quarter revenue of $1.229 billion was down 4% year-to-year. Overall, hardware revenue for the quarter was down 7% year-to-year, as a decline in inkjet unit shipments was partially offset by growth in laser units. Overall, supplies revenue for the quarter was down 1% year-to-year and below our guidance as the decline in inkjet supplies was partially offset by growth in laser supplies.

Earnings per share of $0.74 significantly exceeded our expectations. On an operational basis, excluding $0.35 per share of restructuring-related charges and a $0.02 per share benefit due to the resolution of tax matters, earnings per share would have been $1.07. Earnings per share exceeded our guidance, principally due to higher-than-expected gross margins in both hardware and supplies.

In the second quarter, net cash from operating activities was $142 million.

For the quarter, supplies revenue was down 1% year-to-year due to weaker-than-expected end-user demand for both laser and inkjet supplies, but primarily in inkjet. As we look ahead through 2006 we see the potential for continued erosion in inkjet end-user supplies demand due to weak OEM sales that we are experiencing and the reduction in inkjet volumes due to the actions announced in January to discontinue low-profit inkjet sales.

Our current expectation is for third-quarter 2006 supplies growth in the low- to mid-single-digit range, with much of this growth coming from the reductions in channel inventory in the third quarter of 2005.

In the consumer market segment in the second quarter, revenue was $516 million, down 10% year-to-year. Consumer segment operating income was $69 million. Excluding restructuring-related charges, consumer segment operating income in the second quarter would have been $88 million, up 11% year-to-year.

For the quarter, inkjet unit shipments declined 25% year-to-year with growth in all-in-ones more than offset by declines in single-function printer sales. However, branded inkjet unit sales in the second quarter were down much less than 25% year-to-year, indicating good branded unit growth in our targeted growth segments of inkjet all-in-one.

For the quarter, hardware price declines were fairly mild sequentially. However, year-to-year price declines continue to be significant.

In the third quarter in the consumer segment, our hardware component shortage, which is now largely resolved, will negatively impact earnings per share about $0.05 per share, primarily due to incremental airfreight. This is already included in our third-quarter guidance range.

In the business market segment, second-quarter revenue was $713 million, up 1% year-to-year. Business segment operating income was $149 million. Excluding restructuring-related charges, the business segment operating income would have been $163 million, down 13% year-to-year, as the business market segment was negatively impacted by price declines and mix changes.

During the quarter, laser hardware pricing remained aggressive. For the second quarter, laser unit shipments were up 4% year-to-year with strong growth in branded low-end mono lasers, branded color lasers, and branded laser all-in-ones being partially offset by declines in OEM sales.

In the second quarter we continued to make progress on our core strategic initiatives. Most notably, we strengthened Lexmark's position in two of our five key growth segments during the quarter with announcement of the new Lexmark C500n entry color laser, the Lexmark X340 entry laser all-in-one, and the Lexmark X642e workgroup laser all-in-one.

We have also continued to receive additional industry recognition and awards on our recently introduced mono and color laser products at price points ranging from $149 to over $11,000 from publications and test labs, including Buyers Laboratory, InfoWorld, BERTL, and CRN Test Center.

As we look forward to the third quarter of 2006, we expect revenue to be flat to down in the low-single digit range year-to-year.

We expect third-quarter 2006 earnings per share to be in the range of $0.65 to $0.75, excluding the impact of restructuring-related charges. Sequentially, we expect third-quarter 2006 earnings per share to be lower, primarily due to increased inkjet hardware sales, less favorable laser mix, increases in the APC LCM reserve from the increased hardware pipeline, and the air freight from the previously mentioned inkjet component shortage.

As we look to the longer term, the distributed output market -- where Lexmark is exclusively focused -- presents a number of attractive growth opportunities, such as low-end mono lasers, color lasers, laser all-in-ones, inkjet three-in-ones and inkjet four-in-ones, where we are currently under-represented.

With our increasing R&D spend, we continue to strengthen our competitive position and improve our ability to pursue these growth opportunities. This, coupled with the steps we are taking to focus on more profitable opportunities in inkjet and to restructure our operations, makes us optimistic about the future.

Overall, Lexmark's financial position continues to be strong. In the second quarter, we generated a solid cash flow and at quarter end, we had about $570 million in cash and marketable securities on the balance sheet.

In the second quarter of 2006, we returned $300 million to shareholders by repurchasing 5.7 million Lexmark shares. Over the past nine quarters, we have repurchased 32 million shares of Lexmark stock, returning almost $2 billion to shareholders.

With that, I will turn it over to John Gamble for some more detailed remarks on our financials.

John W. Gamble

Thank you, Paul, and good morning. Before I begin my standard comments, let me update you on the hardware component issue impacting our inkjet hardware business, which we discussed with you on the April earnings call.

At this point in time, we believe we have largely resolved the component shortage. The component shortage did not have a significant impact on either revenue or income in the second quarter. We also do not believe we will experience a significant product shortage related to this issue in the third quarter, and therefore do not believe revenue in the third quarter will be meaningfully impacted.

We will, however, incur incremental manufacturing and distribution costs in the third quarter, made up primarily of incremental air freight to expedite product delivery estimated at approximately $5 million to $10 million.

Using the center of this range of cost, the impact on 3Q EPS is estimated at $0.05 per share. We do not expect to incur further mitigation costs beyond the third quarter.

Moving to my standard commentary, consistent with previous calls I will first discuss our results of the second quarter relative to the prior year, then relative to the first quarter of 2006. I will also comment on the P&L for the first half of 2006 compared to the first half of 2005. I will then discuss selected changes on the balance sheet and certain items of cash flow. Finally, I will finish with more detail regarding our guidance for the third quarter.

I will call out the impact of restructuring as we walk through the P&L.

In the supplemental slide deck posted on our investor relations web site, we have included details on the income statement line items impacted by the restructuring in 1Q and 2Q. Also included in the supplemental slide deck, we have included details on the income statement line items impacted by FAS-123R stock-based compensation expense, which amounted to approximately $10 million in the quarter.

Let me start with the P&L. Total revenue for the quarter was $1.229 billion, down 4% from last year, down 4% sequentially from 1Q, and was in line with the guidance we provided in April. The first-half revenue was $2.504 billion, down 5% year to year.

The primary driver in the lower year-to-year revenue in both the second quarter and first-half is lower printer revenue, principally driven by the company's previously announced decision to exit lower-profitability inkjet sales.

Geographically, for the second quarter, U.S. revenue of $531 million declined 7% year-to-year. Revenue in EMEA of $450 million was about flat year to year. The remaining geographies were down 6% versus a year ago.

For the first half, U.S. revenue of $1.105 billion was down 7%. Revenue in EMEA of $960 million was down 5%. The remaining geographies were about flat versus last year.

Laser and inkjet printer revenue in the second quarter was down 7% from 2005. As Paul indicated earlier, inkjet hardware shipments declined 25% and laser unit shipments were up 4% year to year in the second quarter.

Inkjet hardware average unit revenue increased approximately 8% year to year, as price declines were offset by a mix shift to AIOs. Laser average unit revenue declined approximately 6%, impacted mostly by unfavorable price changes. The first-half revenue was down 13% versus 2005.

Laser and inkjet supplies revenue in the second quarter was down 1% from 2005. First-half revenue was up 1% year to year.

Business segment revenue for the quarter of $713 million was up 1% from 2005 and up 4% sequentially. The increase from last year is primarily due to higher supplies revenue. The increase from 1Q06 was driven by higher hardware revenue. The first-half revenue was $1.402 billion, down 2% versus 2005.

Consumer segment revenue for the quarter was $516 million, down 10% compared to a year ago and down 12% sequentially. The year-to-year decline was due to declines in both hardware and supplies revenue. The sequential decline was primarily driven by lower supplies revenue, as well as a decline in hardware revenue. The first-half revenue of $1.103 billion was down 9% compared to 2005.

Gross profit margin for 2Q was 34%. Excluding the impact of $16 million of restructuring-related costs, gross profit was 35.3%, up 70 basis points from 2005 and up 220 basis points sequentially. The 70-basis-point improvement versus last year is principally due to a 250-basis-point improvement in mix, mostly from a decrease in the percentage of inkjet hardware partially offset by hardware margin declines in both inkjet and lasers.

The 220 basis point sequential improvement was due to a 320-basis-point improvement in product margins. Approximately half of this improvement is due to the reduction of lower costs per market and advanced purchase commitment accruals in the quarter, which reduces costs of goods sold. These reductions reflect both a reduction in hardware inventory in the quarter and a reduction in hardware orders requiring [inaudible] and advanced purchase commitment.

The large sequential benefit reflects the difference between the benefit realized in 2Q06 as compared to the increased cost of goods sold incurred in 1Q06 as these LCM APC accruals increased in that period. The remainder of the 320-basis-point improvement in product margins reflects increases in both hardware and supplies margins. Partially offsetting the higher product margins was 100 basis points of negative mix due to a lower percentage of supplies sold in the quarter.

The first-half gross profit margin, excluding restructuring-related expenses and the curtailment gain, improved 40 basis points from the same period last year. Cost of sales included $1 million of FAS-123R stock-based compensation expense in the quarter and $2 million year-to-date.

Operating expense for the quarter was $314 million. Restructuring-related expense of $37 million impacted operating expense this quarter. Excluding this impact, operating expense was $277 million, an increase of $9 million year to year.

SG&A was $184 million, a decrease of $1 million from 2005.

R&D was $93 million, an increase of $10 million from 2005.

This quarter's operating expense also includes $9 million of FAS-123R stock-based compensation expense, with $7 million and $2 million impacting SG&A and R&D expense respectively. Excluding the impact of FAS-123R expenses, operating expense is flat as reductions in SG&A are being executed to fund increased investment in R&D.

Sequentially, operating expense, excluding restructuring costs and curtailment gains, increased $15 million versus the first quarter due to a $9 million increase in SG&A expense, primarily from demand generation actions, and a $6 million increase in R&D investment.

The first-half operating expense was $540 million, excluding restructuring-related expenses and curtailment gains of $58 million. This is down $15 million year-to-year. 2006 results include $17 million of FAS-123R stock-based compensation expense, with $13 million and $4 million in SG&A and R&D, respectively.

The operating-expense-to-revenue ratio in 2Q was 25.6%. Excluding the restructuring-related costs, the operating-expense-to-revenue ratio was 22.6%, an increase of 170 basis points from 2005 and an increase of 200 basis points sequentially.

The 170-basis-point increase from prior year was driven by lower revenue and FAS-123R expenses. Sequentially, the 200-basis-point increase is due mainly to the operating expense increase described previously.

The first-half operating-expense-to-revenue ratio of 21.5%, excluding restructuring-related expenses and the curtailment gain, increased 50 basis points from the same period last year.

Operating income was $104 million. Excluding the restructuring-related expenses of $53 million, operating income was $157 million, down $19 million from last year and down $3 million sequentially.

Compared to 2005, excluding restructuring-related activities, the business segment operating income of $163 million was down $24 million versus last year and up $8 million sequentially.

The consumer segment operating income of $88 million was up $8 million versus last year but down $9 million sequentially. Please note; all FAS-123R expense of $10 million is recorded in other expenses and does not impact business or consumer segment reported results.

Other expenses -- consisting primarily of costs related to centralized supply chain, IT and other operating expenses, primarily G&A -- were $94 million, an increase of $3 million from 2005 and an increase of $2 million sequentially. For the first-half, operating income, excluding restructuring-related expenses and curtailment gains, was $317 million, down $20 million compared to last year. Excluding the $20 million of FAS-123R expense incurred in the first half of 2006, operating income is flat versus last year.

Operating income margin was 8.4%. Excluding restructuring expenses, our operating income margin was 12.8%, a decline of 90 basis points from second quarter 2005 and an improvement of 20 basis points sequentially.

Concerning financing and non-operating costs, the interest and other was a net income of $3.6 million, a decline of $3.4 million from 2005 and a decline of $1.9 million sequentially from 1Q. This decline reflects lower cash and marketable securities balances due to our continued share repurchases, which I will discuss in more detail later.

The tax rate for 2Q was 28.5%, lower than the 31.7% rate we had forecast. This primarily reflects a $2.5 million benefit from the settlement of our 2002 and 2003 IRS tax audits.

As a company, we continue to expect that the U.S. research and experimentation credit will be extended retroactively and will apply in full to 2006. If this occurs, we expect our full-year tax rate to be approximately 29%. As this has not yet occurred, our full-year tax rate without these R&E credits, and excluding any benefits for costs related to tax settlements similar to that achieved this quarter, is expected to be slightly over 31%.

As a reminder, the tax provision in 2Q05 was impacted by $53.1 million resulting from our 2Q05 decision to repatriate $684 million during 2005 under the American Jobs Creation Act.

Net income for the quarter was $77 million, down $3 million from last year. Excluding after-tax restructuring costs of $37 million and $2.5 million of tax benefits, net income in 2Q06 was $111 million. 2Q05 net income, excluding the $53 million tax impact of cash repatriations under the American Jobs Creation Act, was $133 million.

GAAP earnings per share for the quarter were $0.74. Excluding restructuring-related expenses and the $0.02 tax benefit, 2Q06 EPS was $1.07, significantly stronger than the $0.70 to $0.80 range we indicated in the April earnings call.

As I indicated earlier, revenue was down 4% versus last year. Our much stronger-than-expected earnings were due to many positive factors in the quarter, but were primarily driven by the increases in sequential hardware and supplies margins, as previously described. Specifically, versus our expectations, more favorable pricing in inkjets and mix in laser and greater cost reductions resulted in higher hardware and supplies margins in the second quarter.

Moving to the balance sheet, cash flow from operations for the quarter was $142 million, a sequential decline of $78 million and down slightly from last year. Accounts receivable decreased $24 million from March. Inventory increased $19 million in the quarter and accounts payable decreased $24 million since the end of March.

Accrued liabilities, primarily reflecting the restructuring charge taken in the quarter, increased $48 million since the end of March.

For the quarter, capital spending was $47 million. Depreciation was $53 million. Currency of the euro was accounted for at $1.25 compared to $1.26 in 2Q 2005.

Cash and marketable securities at the end of 2Q was $570 million, down $196 million since March. Cash decreased due to share repurchases of $300 million that occurred in the quarter. In 2Q, we repurchased 5.7 million shares at an average price of $52.75. At quarter end, we had $730 million of share repurchase authority outstanding.

The restructuring actions that we announced in January are going according to plan. We still expect the implementation costs to be incurred in 2006 to be approximately $130 million, or $80 million in cash costs. We continue to expect the $130 million will be incurred, such that about $50 million will impact cost of sales and about $80 million will impact operating expense.

We still anticipate about $50 million in savings in 2006 and, on an ongoing basis in 2007 and beyond, we expect approximately $80 million annually in savings.

In the second quarter, we incurred $53 million in pre-tax restructuring costs and related expenses. This is higher than the $40 million we had forecast in April. The $13 million increase primarily reflects an earlier-than-expected recognition of costs related to employee separations based on the final terms of agreements reached with the French Works Council.

As we indicated earlier, we continue to expect the charges incurred in 2006 to be about $130 million, and to achieve savings of $50 million in 2006 and $80 million on an ongoing basis. Savings in the quarter from restructuring were slightly over the $10 million we had forecast.

Year-to-date, we have incurred $103 million in pre-tax restructuring costs and related expenses, and $10 million in curtailment gains. Savings in the first-half were over $25 million, including the curtailment gain.

In the third quarter, approximately $23 million of pre-tax restructuring costs will be incurred. Approximately $13 million will be in cost of sales, with the remaining estimated $10 million impacting operating expenses. The third-quarter savings are estimated to be slightly over $10 million.

Now for my forward-looking comments concerning 3Q.

Before getting into our detailed guidance, I would like to briefly address the sequential trend in our earnings in 3Q. As Paul mentioned, we expect EPS in the third quarter to be $0.65 to $0.75, excluding the impact of restructuring charges. If we also exclude the expected impact of the component shortage we discussed earlier, this would be $0.70 to $0.80 per share.

This reduction versus our 2Q06 EPS, excluding restructuring, is primarily due to a significant reduction in hardware gross margin dollars. This is due to three factors:

1. We expect an increase in inkjet units and revenue, and therefore hardware losses on inkjet hardware in the quarter;
2. We expect a weaker mix of laser hardware units in the quarter due to a significant increase in the mix of color and low-end mono laser hardware; and
3. Hardware inventory is expected to increase in the quarter in preparation for fourth-quarter shipments, resulting in increased combined lower-cost per market and advanced purchase commitment accruals, and therefore increased cost of goods sold in the quarter.

LCM APC provided a benefit in the second quarter.

Now for our detailed guidance. We expect third-quarter revenue to be flat to down in the low-single-digit range on a percentage basis versus both 2Q 2005 and sequentially versus 1Q06.

Also, in 3Q05, we experienced lower-than-expected supply sales, partially reflecting a contraction of channel inventory impacting both the inkjet and laser businesses. At present, we do not expect this channel inventory dynamic to recur in 3Q06 and, as such, supplies revenue growth rates in 3Q06 are expected to be higher than end-user demand and higher than we have seen in the first-half of 2006.

We are currently expecting year-to-year supplies revenue growth in the range of low- to mid-single digit percentage growth rate in the third quarter.

We expect EPS to be in the range of $0.65 to $0.75 per share, excluding the $0.16 per share impact of the cost of the restructuring. GAAP EPS, which includes these restructuring expenses, is expected to be $0.49 to $0.59. Included in our guidance is the FAS-123R option expense, estimated at $10 million, with a $0.06 per share impact and a $0.05 per share impact from the cost of the inkjet hardware component shortage. EPS in the third quarter of 2005 was $0.59.

In the third quarter, we expect the gross profit margin percentage, excluding the impact of the restructuring costs discussed earlier, to be slightly above last year's 29.4% and down sequentially versus the 35.3% we achieved in 2Q, as I described earlier.

The operating-expense-to-revenue ratio, excluding restructuring expense in the third quarter, is expected to be slightly higher than last year's 21.9%. Versus the second quarter of 2006, operating-expense-to-revenue ratio, excluding the restructuring expense, is expected to be about flat.

Operating income margin in the third quarter, excluding the cost of the restructuring actions, is expected to be up somewhat from last year's 7.5%. Versus the second quarter of 2006, operating margin, excluding the cost of the restructuring actions, is expected to be down significantly from the 12.8% we achieved this quarter.

Despite our strong 2Q06 operating margin, we still believe that our operating margin, once we have completed our restructuring, will be in the range of 8% to 10%.

The effective tax rate in 3Q06 is expected to be slightly over 31%.

Capital spending for 2006 is expected to be approximately $230 million and depreciation is expected to be approximately $160 million, excluding $45 million of accelerated depreciation related to restructuring.

For the full year, we expect a pre-tax impact of FAS-123R to be approximately $39 million.

In closing, while we continue to have more work ahead of us, we are financially strong with a solid balance sheet and a business model that continues to generate good cash flow, even during challenging times.

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

Question-and-Answer Session

Operator

Thank you. The floor is now open for questions.

(Operator Instructions)

Your first question is coming from Richard Gardner with Citigroup. Please go ahead.

Richard Gardner - Citigroup

Thank you very much. I had a question regarding inkjet margins. I was wondering if you could talk about your expectations for sequential inkjet margin trends, given all the puts and takes -- in other words, industry pricing, mix, the move away from the 20% of your least-profitable business over the past two quarters -- and then the LCM and APC charges. Thank you.

Paul J. Curlander

Let me say a few things. Clearly, as we look into the third quarter we are expecting to see a significant step up in inkjet unit shipments. If we look at pricing in the first quarter and the second quarter, it has been kind of benign sequentially, obviously still significant on a year-to-year basis from where we were in the first quarter and first half of 2005. As we look into the third quarter, we are expecting to see more pricing activity on the inkjet side. That, along with the increased hardware shipments, is having a significant effect sequentially.

From a mix standpoint, on a year-to-year basis, we are seeing improvement in mix because we are getting much more all-in-ones versus single-function. I would expect that to continue to be in effect in the third quarter.

As John pointed out, in terms of LCM APC, we are going to see a negative impact on the bottom line due to an increase in the pipeline in the third quarter.

Richard Gardner - Citigroup

Just as a quick follow-up -- Paul, why would gross margin only be up slightly year over year, given that you have gotten out of your least profitable 20% of the inkjet business, you have closed one of your inkjet supplies facilities, and you are expecting a significant decline in year-over-year inkjet unit shipments? It seems like all of those things would be positives for gross margin on a year-over-year basis.

Paul J. Curlander

Yes, I think there are also some negatives from a gross margin standpoint as well. Clearly on a price mix standpoint year to year, we have seen a significant impact. That continues to be true in the third quarter. I think less inkjet hardware helps offset some of that. But clearly, as we go into the third quarter we are also seeing a step-up in laser, the low-end mono and color lasers.

The business model there is evolving. That is much more like an inkjet model in terms of people taking losses upfront versus the historic models that we have seen in the past. So to the extent that we continue to progress in those segments that we are very focused on, those things tend to be detriments as well.

Richard Gardner - Citigroup

Okay. Thank you.

Operator

Thank you. Our next question is coming from David Bailey with Goldman Sachs. Please go ahead.

David Bailey - Goldman Sachs

Thank you very much. Last quarter, you said that you saw some unexpected weakness in U.S. laser demand but that Europe was okay. I was wondering if you could give us an update on that.

Also, why do you think they pulled down channel inventory of consumables, both on the laser and the inkjet side?

Paul J. Curlander

Relative to laser demand, I do not know that I recall saying we saw some unexpected weakness in the U.S. last quarter, but what I would tell you is that the overall laser market demand is pretty good. As I look at the first half, I think it is a little slower than what we saw in 2005 but overall, I think market demand is pretty good.

On channel inventory, we did not make any comments on channel inventory. In general, we have limited visibility to channel inventory. We certainly have estimates. My sense, looking at our estimates is that overall in the first half, you always have ups and downs, but I do not think it has been a significant factor in what we have seen in our supplies results here today.

David Bailey - Goldman Sachs

I am sorry, I thought you had said they had pulled down channel inventory for consumables in laser and inkjet this quarter. Did I misunderstand that?

Paul J. Curlander

I am sorry, that was last year. That was John's reference to last year. I was talking about this year.

Yes, in third quarter 2005, we clearly saw shrinkage in channel inventories. That remark was focused on the fact that in our third-quarter guidance for supplies growth, we are expecting stronger supplies growth than we have seen in the first half. That is primarily going to come from that shrinkage we saw in channel inventory in the third quarter of 2005.

I am sorry for that confusion.

David Bailey - Goldman Sachs

Thank you.

Operator

Thank you. Our next question is coming from Cindy Shaw with Moors & Cabot. Please go ahead.

Cindy Shaw - Moors & Cabot, Inc.

Thank you. On the inkjet unit growth, you mentioned that hardware units for inkjet in the second quarter were down 25% year over year. I know you have exited the 20% of the units that you found were least favorable, but I am hearing some conflicting things about getting some good results from your new inkjet products, the all-in-ones and such.

Why would your unit growth be down so much more than we might have anticipated, just from getting out of the unprofitable segments you did not like?

Paul J. Curlander

The way to think about that is obviously we do have the discontinued business -- and you are right, that is kind of the 20% factor. Obviously, 25% down is weaker than the 20%.

As you look at the minus 25% though, the thing to understand is that the branded business is down much less than the 25%, so obviously OEM is pulling us down to that minus 25%. Also, weakness in single-function inkjets, and some of that is a remnant of pulling out of some of the bundles, which is part of the discontinued business.

The segment that we are focused on is driving inkjet all-in-ones. As I look from first quarter, second quarter in terms of our year-to-year performance, inkjet all-in-ones are actually stronger on a year-to-year basis in the second quarter than in the first quarter.

On the branded side, it was really very strong, particularly in three-in-ones and four-in-one flatbed inkjets, which is a key focus segment for us.

Obviously we do not like minus 25%, but in the focus segments that we are trying to drive on the branded side, we are seeing strong growth. Obviously OEM is pulling us down.

Cindy Shaw - Moors & Cabot, Inc.

Can you comment -- do you think you are competing effectively with HP's scalable print technology on the high end of the inkjet?

Paul J. Curlander

I think a couple of things. For us, the vast volume of what we ship tends to be under $100. Obviously scalable print technology does not play there. The four-in-ones that we are shipping up in the above-$100 range are really doing pretty well on a year-to-year basis, certainly here in the US. Obviously we would like to continue to focus on that and drive that growth.

Operator

Thank you. Our next question is coming from Richard Farmer with Merrill Lynch.

Richard Farmer - Merrill Lynch

Thank you. Paul, can I ask about the status of your distribution network, including retail shelf space? Did that expand or contract, or stay the same in the second quarter versus the first quarter? What are your expectations for the growth or decline in your distribution network going forward?

Paul J. Curlander

I think as you look at the first-half, what I would say overall is that we probably in the mass channel retail, about the same. The consumer electronics stores, obviously we came down and that really was related to the business we walked away from. As we did that, we saw some of those bundle boxes fall off the shelf, so we lose stand-alone sales as well as just bundled sales when that happened.

Office superstores, I think our shelf space in the first half was not great -- really Staples being our primary distribution outlet there. As we move into the second half, we see some improvements coming in office superstores. We are getting on the shelf now in OfficeMax, so we feel pretty good about that. In terms of mass, again about the same. CES we would hope to be at the same if not better, but we will see as we go through the second half, but certainly up in office superstores.

Richard Farmer - Merrill Lynch

One follow-up, if I could, on mix. The shift from inkjet to laser, obviously part of that is your exiting the low-end of your inkjet business, but if we look beyond the seasonal changes that are coming next quarter, and beyond the anniversary of this period of exiting the low-end of inkjet, do you expect the rate of mix shift we are seeing is going to continue towards the laser in the long-run, or is that something you think will begin to moderate in the mix in your business?

Paul J. Curlander

The first thing I would point out to you is that from a market perspective, the laser market is growing faster than the inkjet market today. If you look at the first quarter, laser market IDC, if you roll everything together, it was around up 14%, 15% type of thing. The inkjet market was probably down about 4% or 5% in units, so the overall market is growing faster in laser. You would kind of look at that and think that you might get a positive mix shift off of that as you go forward in time.

Obviously, on the inkjet side though, we are very focused on the growth segments and that is true in laser. Those growth segments are growing very fast, and to the extent we can continue to strengthen ourselves in those segments, and that is the key in investing in R&D, we would hope to get growth faster than the market. We will see how the mix evolves for Lexmark between laser and inkjet. Obviously we would like to get the inkjets growing a lot faster than where we are right now, but again, in our branded all-in-one segment, growth is pretty good in the second quarter. Obviously from our outlook, we are hoping to get a lot of hardware shift here in the third quarter. We will see how it plays out.

Operator

Thank you. Our next question is coming from Ben Reitzes with UBS. Please go ahead.

Benjamin Reitzes - UBS

Good morning, thank you. Paul, could you just elaborate on the comment that you guys made? I believe John said it, that you do not expect channel inventory reductions for supplies in the third quarter.

Usually after major declines in the hardware, the supplies follow, I guess because the retailers maybe do not have as much of your products on the shelves. If you could elaborate on that, as to why the 25% cut in inkjet would not result in more channel inventory reductions, that would be great, particularly on the inkjet side. Also, if you think lasers offset that, if that is really embedded in the comments -- that you have inkjets going down but lasers are just that strong. Then I have a follow-up.

Paul J. Curlander

Relative to channel inventory in the third quarter of 2006, we have some suspicions as to what might happen but obviously, we do not know. We do not know and we do not know and we do not drive that [partition].

I think the point John was making is that we saw a significant shrinkage in channel inventory in the third quarter of 2005. We were very surprised at the time when that happened, but it was pretty significant. His point is we are not right now expecting that type of significant decline in the third quarter of 2006. As such, to the extent that you had one significant decline in '05 but not in '06, then you get kind of a tailwind in terms of your supplies growth.

That was the point that John was on, that we are expecting a tailwind to get a little bit stronger supplies growth in the third quarter than we have seen in the first half. That really was his point.

Sequentially, we are looking to be up in inkjet hardware, so the 20%, the 25% declines are all year to year, not sequential, and usually channel inventory works more off your sequential situation than year to year.

Benjamin Reitzes - UBS

Then, you have given a little bit of color on the OEM dynamic. I asked you this last quarter. I guess the update is, when does OEM stop being a drag on the overall unit growth, particularly for inkjets, but overall as well? If you think about your business, is it 1Q next year, big picture, or do the comps get a lot easier starting in any quarter this year?

Paul J. Curlander

Ben, as you know, it is hard to comment on the OEM business.

One thing I would point out is that, similar to the discontinued business that we have on the branded side, there is some of that over on the OEM side. Beyond that, I really cannot comment on our OEM business, obviously because it is not our business. It is somebody else's business.

Operator

Thank you. Our next question is coming from Katie Huberty with Morgan Stanley. Please go ahead.

Kathryn Huberty - Morgan Stanley Dean Witter

Thank you. If I look at the consumer segment as a whole, year-over-year revenue trends decelerated from the first quarter. Do you now feel like you have the right mix of both products and channels so that you can begin improving year-on-year growth over the next several quarters?

Paul J. Curlander

I think as we talked about, Katie, on the consumer side, obviously we were down 25% year to year, which was a greater decline than what we saw in the first quarter. Obviously OEM was pulling some of that down. The branded year-to-year decline was much less than that minus 25%. Single function is weak for us. Some of that is a result of lost shelf space when we walked away from some of the bundles.

The focus for us is all-in-ones and we are seeing strong growth in our branded all-in-ones, particularly the three-in-ones and the four-in-one flatbed products. We are seeing that growth now. Obviously it is getting more than offset by the business we are discontinuing and what is going on with single-function and OEM.

As we go forward in time, obviously we are looking to improve our products. We are not yet where we would like to be in terms of the product line but we are at a point where we think we should be able to drive year-to-year growth in our branded all-in-ones, and that is certainly the focus here in the third quarter.

Kathryn Huberty - Morgan Stanley Dean Witter

Just to follow-up quickly on that comment, June quarter marked the largest R&D expenditure in the company's history. What is the typical lag between spend and actual new product launch?

Paul J. Curlander

That varies depending on the segment. Some of the product development times can be years. I think from the time we have stepped up our R&D starting back in 2003, we have seen a lot of new products in a lot of new segments in the market.

Getting back to 2003, we have made a significant improvement in our low-end mono segment, because before that we really did not have strong Lexmark technology there.

You just saw here in the second quarter that we announced the Lexmark technology low-end all-in-one -- the first time ever.

Since we started uplifting R&D, we have a low-end color laser, the C520 class devices -- never had that before.

On the inkjet side, you see a much broader range of four-in-one inkjets, stuff that we just never had before.

These are the incremental segments that are being driven off the uplift in R&D. Of course, I would point out the laser all-in-one segments, the high-end, the workgroups, and the very strong announcement for us this year, and that was obviously several years coming.

We are filling in gaps in the line across the growth segments that we are focused on and we are going to continue to do that. We have not filled in all the gaps yet that we would like to, so we have more to do.

Operator

Thank you. Our next question is coming from Shannon Cross with Cross Research. Please go ahead.

Shannon Cross - Cross Research

Just a couple of questions. In terms of the cash usage, obviously you used cash to repurchase shares. I am curious as to your conversations with the board, what level of cash they are comfortable with. If you go back long enough, you ran at $150 million but we are just curious as to what the board and what management are thinking on cash usage.

Paul J. Curlander

It is hard for us to comment on conversations we have had with the board. I will tell you overall, in more challenging times -- this is a little bit more challenging time for Lexmark than we would like to have -- we are more comfortable with higher levels of cash than lower levels of cash.

We obviously do not give any forward-looking guidance relative to where we are going to take the cash or where we are going to take share repurchase but I think we have given you all the data that we can relative to that.

We have told you that we have $570 million of cash and marketable securities sitting on the balance sheet. We have $730 million of authorization remaining. We certainly have indicated in the past our desire to take excess cash that we do not have an operational use for to give that back to the shareholders through share repurchase.

Other than that, I really cannot comment on where we might go with that cash or share repurchase.

Shannon Cross - Cross Research

The just a follow-up in terms of your mix in inkjet. Can you talk a little bit about sort of percentage of sales right now that are coming single-function versus all-in-one? How should we see that trend? I am almost talking big-picture. Do you think you will get to a point where you basically will not sell single-function anymore, or it will be only be at Target, which it sort of is right now? I mean, there are just a few other places.

I am just curious as to whether or not you see that ever as being a segment you really would sell much in.

Paul J. Curlander

I think in the market overall, single-function continues to decline as the overall percent, I think you would probably think that is going to happen for Lexmark as well.

It is still a significant volume so we are not focused on walking away from single-function. We would continue to pursue it, so I think you will continue to see some erosion on that percent that would track the overall market as we go forward in time.

Operator

Thank you. Our next question is coming from Kevin Hunt with Thomas Weisel. Please go ahead.

Kevin Hunt - Thomas Weisel Partners

Thank you. I just wanted to follow up on your comment. You indicated you expect a significant step up in the units in this third quarter. I was wondering if that implies you will actually get to a year-over-year growth position in terms of hardware units? If not, then maybe when we could expect you to start growing your unit base again?

Following up on that, any kind of color you might give us on your installed base at present. I have to believe it is declining at this point. Do you have a feel of what that might be doing right now?

Paul J. Curlander

The step up in inkjet units from second quarter to third quarter is somewhat of a seasonal thing. Obviously we are expecting to get a sizable step up there, but that is not unusual as we go from the second to third quarter.

That does not imply necessarily year-to-year growth because we are still walking away from the 20% of the business that we have talked about. I would expect it to still be down on a year-to-year basis.

We obviously do not give guidance on unit growth -- certainly do not give any guidance beyond the next quarter but obviously this year, as long as we are walking away from this discontinued business, that is going to be a tough thing in terms of year-to-year unit growth.

On the installed base, I agree with you. There is no question when you walk away from business like that and have that type of year-to-year unit decline, you are going to see some erosion in the installed base. We certainly think we are seeing that. That is why when we talk about supplies, we talk about where we are but the ongoing pressure in the near-term, because of this discontinued business and the slowdown that we are seeing in the OEM sales, that hurt the inkjet supply sales a little bit more in the near-term, as we continue to build our capabilities in the growth segments that we talked about.

That is how we see it overall.

Kevin Hunt - Thomas Weisel Partners

Do you see that the installed base, even though it might be declining, is it necessarily a bad thing in your view, even though you are walking away from less-attractive units?

Paul J. Curlander

Actually, I see a lot of good things relative to where we are. We are walking away from inkjet business that did not return acceptable profitability over life. That is business we do not want to have. We do not want to sell it. If that erodes the installed base, that is a good thing, not a bad thing.

We are focused on where are the future growth segments, so inkjet all-in-ones are growing. That is a good thing.

In the near-term, we are going to continue to see this impact from discontinuation of inkjet sales, but that is a good thing that in the near-term is a little bit of a negative, but long term we think is going to be positive.

I see a lot of good things in here. This is what we had expected to do this year and obviously we are on track to get to where we thought we were going to be with that.

Operator

Thank you. Our next question is coming from Bill Fearnley with FTN Midwest Securities. Please go ahead.

William Fearnley - FTN Midwest Research

Good morning. A couple of questions on pricing here. For the third-quarter pricing expectations, what is your view for inkjet and laser hardware? Did you see anything that happened during 2Q06 that changed your opinions for the upcoming quarter? Then I have a follow-up.

Paul J. Curlander

Relative to pricing, we did not see a lot of sequential pricing in inkjet. We saw a little bit but not a lot. We are really expecting that to pick up in the third quarter and that is always our assumption. We will see if that materializes. The market does not look that strong out there to us on year-to-year basis, so I think it is possible that the pricing action could pick up.

On the laser side, we have been seeing very aggressive pricing in lasers. If you take a look at the laser business on a year-to-year basis, very aggressive prices year-to-year in low-end mono lasers. Certainly in color lasers we are seeing very aggressive pricing.

The enterprise space is seeing very aggressive pricing bids. That is not easy to see in terms of street prices but that is out there. We would expect that to continue into the third quarter.

Sequentially, we are expecting to see some pricing impact on both the laser side and the inkjet side. That is captured in the guidance.

Operator

Thank you. Our next question is coming from Bill Shope with JPMorgan. Please go ahead.

Bill Shope - JPMorgan Chase & Co.

Thank you. Another question on the OEM segment. I realize you do not have complete visibility there, but can you comment at all on the OEM inkjet supplies trends you saw during this quarter? Then, off of that, do you have any idea of where it might trend in the third quarter?

Paul J. Curlander

We really cannot comment on the OEM side of the business. I think the best we can do is talk about the supplies business overall. If you look at the supplies business for the first half, we are up 3% in the first quarter, down 1% in the second quarter. It kind of averages plus 1%. That is kind of where we are because we do not think the channel inventory movement was a big factor on that growth rate.

We obviously in the near-term are expecting more pressure on the supplies growth because of the discontinuation of the inkjet business and weakening OEM hardware sales that we talked about.

Then we have this tailwind effect that is coming into the third quarter because of shrinkage last year in the channel inventory.

I think that is as complete a picture as we can give you on this, because again, we really cannot talk about the OEM customers business.

Bill Shope - JPMorgan Chase & Co.

Looking at pricing into the third quarter, at what point in the quarter do you tend to get a sense of how aggressive back-to-school pricing will be in the inkjet space? Is it mid-August, later in August? When do you tend to get a sense of that?

Paul J. Curlander

Obviously we get some sense of that when we cut the deals with the retailers for what the promos will be, so we have some sense clearly coming into the quarter.

You know, things happen as you move through the quarter so every month is important. In our business, typically the last month of the quarter is a very important quarter in terms of volume, in terms of actions that people take. I would expect to see some pricing things through the quarter.

Obviously we have already seen some things in the deals we have cut. We will have a better feel obviously when we do the next release as to what actually happened to us.
Operator

Thank you. Our next question is coming from Bill Hand with Bear Stearns. Please go ahead.

William Hand - Bear, Stearns & Co.

Thank you. Paul, you talked about lower end-user demand for both inkjet and laser supplies. Can you talk about the growth numbers for each segment quantitatively in the second quarter? Historically, or at least the last couple of quarters, you have given those numbers.

Paul J. Curlander

I do not think we have ever given those numbers. We kind of talk about the supplies growth overall. Qualitatively, all I can tell you is that we were down 1%. Lasers were up. Inkjets obviously were down more than minus 1%.

That is all that I am aware of that we have ever done with that.

William Hand - Bear, Stearns & Co.

Thank you. Just a quick follow-up. Any update you can give us on change in activity you are seeing in refill/reman side? Obviously, you talked about lower end-user demand, but do you think there is increased traction from refillers or reman?

Paul J. Curlander

I think a couple of things. I assume your question is focused on the inkjet side, Bill? You focused on inkjet primarily, I guess? So on inkjet, in terms of retail penetration on refill/reman, it is kind of a single-digit type of effect. That has been fairly stable over time.

As we go out and do surveys of our customers, we see an increasing percentage of people indicating they have used or tried reman, and that is certainly a much more significant number than a mid single-digit type of thing.

Clearly we think there is pressure in the market for that to continue to grow. We are very focused on continuing to drive loyalty to our products. One of the primary things we utilize is the price in the marketplace, so sticker price as well as promo price. Twin packs is another thing we are doing.

We are also very focused on the Internet side of what might be flowing there and we are really trying to gear up to make it much easier to buy off of our website and to attract Internet sales of supplies to the Lexmark website.

In addition, we continue to work on collection. We continue to evaluate what we might want to do on the remanufacturing side, similar to what we do over on the laser side. So all of those things are part of that.

Operator

Thank you. Our next question is coming from Keith Bachman with Banc of America. Please go ahead.

Keith Bachman - Banc of America Securities

Thank you. I have a two-fold question. Paul, I am not sure if you commented, but I wanted to get some feedback on how you anticipate the supplies growth to be in Q1. I know you mentioned it was down roughly 1% this quarter. Does it get better or worse in Q3?

Paul J. Curlander

Keith, I think we are going to see stronger supplies growth in Q3, but I need to differentiate between what I call the baseline of supplies and the tailwind we are going to get from the inventory change in the third quarter of last year.

As I look at the first half, again I think the overall supplies growth rate that we saw was about 1%. I think of that as a baseline of where we are as we roll into the third quarter. I think there is downward pressure in the near-term because of the business that we are discontinuing in inkjet that did not drive profitability over life, and certainly by the slowdown on the OEM side.

So you can kind of think of that 1% in the near-term, under pressure -- long term, obviously we hope to get that moving in the other direction.

Then you have this tailwind that is coming from the shrinkage in channel inventory last year that, as John was speculating on in his comments. We do not expect to see that type of channel movement this year. That is going to give us a boost on year-to-year growth.

That is why we end up with our guidance of low- to mid-single digit type of growth and compare that positive low- to mid-single digit versus a -1 that we saw in the second quarter.

Keith Bachman - Banc of America Securities

Okay, let me ask a follow-up on a separate question then; like all tech companies, a lot of option investigations. Have you guys conducted internal investigations? Can you give us any color on any issues that may or may not be there, please?

Paul J. Curlander

What I would tell you, Keith, is that we do not believe we have any of the issues that you are reading about in the newspapers, so we do not think that is a problem for Lexmark.

Operator

Thank you. Our next question is coming from Toni Sacconaghi with Sanford Bernstein. Please go ahead.

Toni Sacconaghi - Sanford C. Bernstein & Company, Inc.

Thank you. Your guidance this quarter is for EPS to be down around 30% to 35% sequentially. Typically, your EPS historically has only been down low-single digits sequentially. Now, you have beaten your guidance by $0.30 or more in each of the last three quarters. How much of this guidance is conservatism?

I heard clearly your stated reasons for why you expect hardware gross margins to go down and for EPS to go down. But quite frankly, most of those reasons are seasonally typical reasons. You always have an increase in inkjet units and revenue. Your hardware inventory always goes up in advance of Q4. This time, you actually have a sequential acceleration in supplies growth, which should be helping your margins.

How do we reconcile what appear to be pretty normal seasonal factors that you have outlined with a dramatic reduction in EPS? The inevitable investor question is, are you being conservative in bracing for the possibility of terrible pricing? If that does not happen, we are going to see an EPS pattern that is more consistent with what you have delivered over the last few quarters?

I have a couple of follow-ups.

Paul J. Curlander

I will want tell you, obviously we have a number of assumptions built into our third-quarter outlook. We recognize that it looks a little different than maybe some patterns you have seen in prior years.

I would tell you that in terms of the pattern, certainly some of this was evident in the third quarter of 2005. I think that pricing obviously is something we are thinking about here. I obviously think the model N laser is changing a little bit, in the extent with low-end lasers and color lasers being more like an inkjet model. I think that is somewhat different than what we have seen in prior years.

You know, these are our estimates of what we think could happen. As you pointed out, our track record speaks for itself.

I do not think this is conservative guidance. I think this is how we see things right now as we look forward and we see negative factors and we do not see a lot of positive factors sequentially because the supplies thing is a year-to-year statement, but on a sequential basis, we would expect supplies to be down seasonally.

That is not really a help as you look at sequentially what is going to happen. We see lots of negatives that we talked about. Even though they may be seasonal, we do not see a lot of positives to offset that.

But again, there are a lot of assumptions that are baked into it, as always, in the guidance.

Toni Sacconaghi - Sanford C. Bernstein & Company, Inc.

We should assume that you provided your guidance for this quarter just as you have for the last three quarters?

Paul J. Curlander

I think you should assume that we have gone through our models as best we can, taking a look at the results we had from the second quarter and the overages we had from the second quarter, particularly in hardware and supplies margins. We have taken a look at what we think the key factors are and, to the best of our ability, we have projected where we think this will come out, given the set of assumptions we think are reasonable as we look forward in time.

Obviously we have a very volatile business, because you have a lot of different segments that have very different gross margins. As you get mix movement in products, as you get pricing movements, as we continue to work on costs, sometimes these things are a little hard to totally project as we go forward in time.

I think this has been some of the issues that have helped us in the prior quarters, as you pointed out.

Operator

Thank you. Our final question will be coming from Chris Whitmore with Deutsche Bank. Please go ahead.

Chris Whitmore - Deutsche Bank

Thank you. You characterized the laser market as being healthy. However, I look at your unit growth numbers in that segment and it has declined every quarter for the past six quarters. Can you provide some color as to what is happening in that space, either from a market share standpoint or a demand standpoint, that would explain that slowing unit growth trend?

Paul J. Curlander

If I just compare first quarter versus second quarter, obviously in the first quarter, we have plus 7% unit growth, second quarter we have plus 4%, so clearly that looks like a decline.

What I would tell you is that underneath that though, we have a mix issue going on between the branded hardware sales and the OEM hardware sales.

On the branded side, we actually had an improvement in year-to-year growth rate from the first to the second quarter, really driven by strong growth in low-end mono lasers, strong growth in laser all-in-ones, which to us is a segment where we have not traditionally been strong, and really very strong growth in color lasers which, as far as we can tell probably was stronger than the market, occurred in the second quarter. On the branded side, we are seeing some good results.

On the OEM side, it is dragging us down on a year-to-year basis. Those are kind of some of the mix things that are going on in there.

Operator

Thank you. At this time, I would like to turn the floor back over to John Morgan for any closing remarks.

John Morgan

Thank you for joining us today. That does it from here. Good-bye.

Operator

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time. Have a wonderful day.

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