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Deep value, long/short equity, contrarian, hedge fund manager
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I’ll admit that I’m a sucker for deep value stocks. When I spot a stock that appears to be selling well below its intrinsic value and seems to offer extremely favorable risk-reward prospects, I get giddy. Is that wrong? I hope not, because it feels so right.

So how do I spot deep value plays? I use screeners, glance at favorite plays recent picks in Motley Fool’s CAPS community, and read articles from similar minded folks. A couple of weeks ago, I spotted one of my favorite players at TMF green thumb Lexmark (NYSE:LXK) and I became interested. Value Expectations also mentioned it in their “30 Attractive Companies Under $30” piece, so I decided to take a closer look.
Overview
Lexmark develops printing and imaging products for both home and office purposes. They manufacture laser and inkjet products and also sell dot matrix printers. Their products are sold in more than 150 countries and roughly 59% of their revenues are derived from international sales, with about 2/3 of that coming from Europe. Rather than spending an enormous amount of time describing what they do, I’ll simply suggest that you check out their web page if you want to learn more.
What makes Lexmark attractive to me is their historical sales record when compared to the stock’s current selling price. While their profitability has declined over the past six years, they have still been able to rake in a significant amount of free cash flows over the past few years. Under $17, that could make this quite a bargain. But before jumping into earnings and cash flows, let's take a glance at the foundation that all of it is based upon --- the balance sheet.
The Balance Sheet and Liquidity
Lexmark’s executives seemed to go to great lengths to talk about their strong balance sheet in their 1st Quarter earnings call. After examining LXK’s balance sheet, I felt as if the executives slightly exaggerated how great things were. My biggest qualm with their interpretation is that they suggested that having a ‘credit facility’ made their balance sheet strong. I imagine their credit facility is somewhat dependent on their cash flows. While having access to credit undoubtedly makes them more liquid, I don’t think it automatically gives them a “solid balance sheet.” Nevertheless, they are not in poor shape by any means.
Lexmark has a 72% Liability/Value ratio if we take their accounts at face value (and I rarely do). However, that might be propped up a bit. I worry that their inventories might be slightly overstated (due to the economic environment) and I’m extremely frustrated by their lack of disclosures in regards to their “other assets.” It's unclear to me what items were thrown into this basket.
Is goodwill in there? Based upon a scan of their most recent 10-K, it would appear that they do have “goodwill”, but I have no clue how sizable this account might be. It’s completely possible that there are other intangible assets in this account, as well. Given the fact that “other assets” constitute nearly 10% of LXK’s total assets, I think more visibility into this account is needed. As such, I have decided to indiscriminately discount it by 60%. If I can’t see it, it isn’t there, but I’ll give them the benefit of the doubt on 40% of it.
After discounting inventories by 20% and discounting “other assets” by 60%, I came up with adjusted stockholders equity of $598.8 million:
After these adjustments, I come up with an adjusted Liability/Value ratio of 78.7%. A bit higher than my original number, but still not terrible. That leaves Lexmark with adjusted assets of $7.64 per share.
As for liquidity, it’s not too bad. Current ratio is at 1.71 and quick ratio is at 1.11. I also use another metric for liquidity that I call the “Huney ratio.” I figure that since I made this metric up, I should at least get to name it after myself. Essentially, this metric is similar to the quick ratio except I add in cash flows from operations for the prior four quarters. Thus the formula is “(Liquid Assets + CFOs for Prior 4 Qtrs)/Current Liabilities)”. It came up with a Huney ratio of 1.31.
One final thing to consider is Lexmark’s pension obligations. Seeking Alpha writer Saj Karsan mentions this issue in a recent article. While I don’t believe it would be prudent to ignore that issue, I personally do not worry about it too much because the shortfall will decline as the market rises over time.
Overall, the liquidity picture looks alright and the balance sheet is not a huge cause for concern. I would like to see LXK lower their long-term debt of $648.8 million a slight bit, but it appears to be quite sustainable.
Earnings, Cash Flows, and Margins
Now it’s time to shift gears and look at the earnings and cash flows pictures. The first chart gives a glimpse at Lexmark’s earnings, cash flows, and a few other figures over the past six years. These are all raw numbers and denominated in millions:
The second chart is similar to the one above, except it shows some of the relevant figures from above in per share terms on a constant basis. I used 78.4 million shares to run this analysis, which was the stated number of diluted shares for LXK as of March 31, 2009:
From the above chart, one can see that Lexmark has had strong earnings and free cash flows. However, there is one disturbing trend --- both seem to be gradually moving downwards. In order to get to the bottom of this, I started looking at LXK’s revenues, expenses, and margins --- all of those are displayed in the below chart:
click to enlarge
Surprisingly, we find out that revenues have not declined significantly. Nor have LXK’s gross margins shifted in any dramatic style. These figures fluctuate a bit, but they mostly stay in a steady range. Rather, it’s LXK’s operating expenses that seem to be the real killer. If we examine that more closely, we find that their research and development (“R&D”) and selling, general, and administrative expenses (“SG&A”) are the culprits.
Both R&D and SG&A have been trending upwards despite the fact that revenues have not really been increasing. If you look at the last three lines of the chart, you can see that the decline in operating margin correlates strongly with the rise in R&D as a percentage of revenues (“R&D/rev) and SG&A as a percentage of revenues (SG&A/rev)
Valuation
The trickiest part about doing a valuation for Lexmark is trying to predict whether their negative growth will continue into the future. Will Lexmark eventually hit a steady state or will they continue to slowly drift downwards? One of my bigger concerns is the fact that I rarely see Lexmark printers. Hewlett Packard (NYSE:HPQ) seems to dominate the market. I’ve seen a number of other brands in stores and at the office, but I can’t recall seeing too many Lexmark printers. All the same, Lexmark sells enough to be profitable --- even if not completely visible.
I decided to use an 11% cost of capital (“COC”) for Lexmark. I normally do not spend too much time coming up with a COC for companies --- I glance at the interest paid on their debt, look at their leverage, and try to play things conservatively. 11% might be a bit high, but it seems like a safe figure to me.
For all of my scenarios, I decide to come up with an initial year free cash flow ("FCF") forecast and simply use a long-term growth rate (“LTGR”) to project FCFs into the future. My difficulty was deciding what LTGR to use. I decide to run three sets of scenarios: the first uses a 3% LTG rate, the second uses 0% growth, and the last uses a -3% LTGR. Here are the results:
Think of the results as more of a set of possibilities. It allows us to see how Lexmark might be valued depending on what direction it goes in the future.
Analysis
I give Lexmark a probable valuation of $28 based on my research and valuation scenarios. This is sort of a hybrid between Scenario #6 with -3% growth and Scenario #6 with 0% growth. This might be a bit conservative, but I feel it’s a safer valuation than one that assumes LXK will continue to grow in the future.
My downside probable valuation is $22. This comes from Scenario #4 in the -3% Growth chart.
My upside probable valuation is $45. This comes from Scenario #8 in the 3% Growth chart. This gives me a rather large probable valuation range of $22 - $45, which shows how LXK’s stock could jump significantly if the company where able to shift their profitably upwards in minor ways. Still, I see a slight decline before eventually reaching a steady state as more likely.
For the next five years, I’d give a downside risk at $5. This is based on moderately high leverage, an LXK’s adjusted net tangible assets with a further discount to their “other assets” account, and short-term negative profitability scenario.
Upside potential is $60. I see this as unlikely, but for this to happen, the market would have to become very bullish again and Lexmark’s profitability would have to start moving back upwards towards the $3.50 free cash flow range.
Conclusion
I can find a lot of reasons to be negative on Lexmark, but I can also find a lot more reasons to be positive on the stock at the current levels. Under $17, it would appear the market is assuming that LXK’s profitability will decline at a massive rate. Risk-reward favors the long side greatly.
I would consider this a moderate risk stock that offers a decent possibility of a 100% gain over the next few years. However, I believe gains in the 60% - 80% range are more likely. That’s not bad considering the company’s historical free cash flows and net assets. Overall, this is a good value play with strong upside potential.
For my KaChing $10 million simulated portfolio, I have initiated a 1% position in LXK. As I am currently building up my cash cushion, I have not added this to my actual portfolio. However, if the price were to stay suppressed for the next few months, I might consider adding a position at some point.
Disclosure: Authors holds no position in LXK.
Source: Lexmark: Solid Value Play Under $18