Lexmark International, Inc. Q2 2009 Earnings Call Transcript

Lexmark International, Inc. (LXK)

Q2 2009 Earnings Call

July 21, 2009 8:30 am ET

Executives

John Morgan - Director, Investor Relations

Paul J. Curlander - Chairman of the Board, CEO

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

Analysts

Kathryn Huberty - Morgan Stanley

David Bailey - Goldman Sachs

Ben Reitzes - Barclays Capital

Richard Gardner - Citigroup

Bill Shope - Credit Suisse

Shannon Cross - Cross Research

Toni Sacconaghi - Sanford C. Bernstein

Bill Fearnley - FTN Midwest Research

Mark Moskowitz – JP Morgan

Ananda Baruah – Brean Murray

Chris Whitmore – Deutsche Bank

Presentation

Operator

Welcome to the Lexmark International second quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the call over to John Morgan, Lexmark's Director of Investor Relations. Please go ahead, John.

John Morgan

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

Following the conclusion of this conference call, a complete replay of this call will be made available on our investor relations website located at http://investor.lexmark.com. I would also like to mention two upcoming events. On September 8^th, we will host an open house for securities analysts and investors and Lexmark’s New York City office. This meeting will include demonstrations of the upcoming 2009 inkjet All-In-One’s designed for small and medium businesses. The following day, on September 9^th, we will be participating in Citi Investment Research’s 2009 Technology Conference also in New York City. Please visit our Investor Relations website to register for the open house at our New York City office and to obtain more information regarding our other upcoming events.

As a reminder, any of today’s remarks that are not statements of historical fact are forward-looking statements and involve certain risks and uncertainties that are disclosed in the Safe Harbor section of our earnings releases and SEC filings. Actual results may differ materially from such statements and Lexmark undertakes no obligation to update any forward-looking statements.

With that, I’ll turn it over to Paul.

Paul Curlander

Thank you, John. While second quarter results were in line with our expectations, global economic conditions continued to negatively impact Lexmark in the overall distributed printing market. During the second quarter we saw international market conditions further weaken, primarily in Europe, while the U.S. market continued to be weak but somewhat stable.

Despite the market conditions we made good progress in the quarter on our key strategic initiatives in both divisions. Revenue for the quarter was $905 million, down 25% year-over-year. Hardware revenue in the second quarter was down 29% year-over-year primarily due to declines in both inkjet and laser units, negative currency impact and lower pricing. Supplies revenue in the second quarter was down 18% year-over-year with declines in both laser and inkjet supplies.

Earnings per share in the quarter were $0.22. Excluding restructuring related charges, earnings per share in the quarter would have been $0.55, down 42% year-over-year. Earnings per share compared to the second quarter 2008 were impacted by several factors, primarily year-over-year declines in supplies revenue due to the ongoing transition of our inkjet strategy and lower end user demand during this economic downturn, the negative impact of year-over-year currency changes and lower product gross margins partially offset by a 22% reduction year-over-year in operating expenses and overlapping 20% reduction year-over-year in corporate costs and expense in our other segments.

In the second quarter net cash generated by operating activities was $84 million. Our second quarter supplies revenue decline of 18% year-over-year is a slightly higher percent decline than what we expected. This was driven by weaker than expected end user demand, partially offset by less cash shrinkage than we expected.

As we look forward into the third quarter we expect overall supplies revenue to decline at about the same rate as in the second quarter with year-over-year declines in both laser and inkjet supplies due to the ongoing transition in the inkjet business and a continued weakness in end user demand, as well as the negative year-over-year impact of the relative strength of the U.S. dollar.

Now let’s talk about our two divisions. In our printing solutions and services division (PSSD), second quarter revenue was $624 million, down 18% year-over-year driven by declines in both hardware and supplies revenue. The lower hardware revenue was due to lower units, the negative impact of currency year-over-year and lower prices. PSSD operating income excluding restructuring was $88 million, down 44% year-over-year primarily due to the lower supplies revenue and lower product margins partially offset by lower product operating expenses.

PSSD laser units for the quarter were down 21% year-over-year but up sequentially and were about as expected as stronger than expected sales in U.S. laser units about offset the miss in expected international sales. Despite the overall year-over-year laser unit declines in the second quarter we had good growth in our color laser units and we continued to see good growth in our laser multifunction products driven by strong growth in our workgroup multifunction devices.

During the quarter we continued the roll out of our new laser product line with the introduction of a new family of workgroup color laser printers and MFPs, the C730 and X730 series with printer pricing starting at $699 and multifunction pricing starting at $1,799. The X730 series features Lexmark’s award winning ETask interface and embedded solutions framework which enables the implementation of customized, industry specific solutions to streamline paper based workflow, increasing productivity and lowering cost for our customers.

We also added to our growing line of mono laser multifunction devices with the introduction of a small workgroup MFP, the Lexmark X204N, priced at $299 and featuring the smallest equipment in its class During the quarter we continued to see good growth in our enterprise managed print services business and announced a multi-year global services agreement with BASF, one of the world’s leading chemical companies, to lower their costs and improve their document processes.

As we look back at the first half of 2009, according to our internal analysis, Lexmark continued to be number one in the U.S. printer market in laser product awards received with more than twice the awards of any other vendor.

Now let’s talk about our industry solutions division (ISD). In the second quarter we continued to encounter weak overall market divisions as we continued the shift of our inkjet strategy to a focus on devices, customers and countries that drive higher page usage. As a result, our ISD revenue was $281 million, down 25% year-over-year with declines in both hardware and supplies revenue. ISD operating income including restructuring was $31 million, up 15% year-over-year as lower supplies revenue was more than offset by fewer hardware units and lower operating expenses.

For the second quarter ISD unit sales declined 43% year-over-year due to impacts from the ongoing shift in our inkjet strategy and the weak global market. Overall, inkjet unit sales were less than expected due to weaker than expected international sales primarily in Europe and weaker than expected OEM sales. US branded inkjet unit sales came in as expected with strong growth year-over-year in the retail sell out of our professional series products, helped by the expansion of our sales space in U.S. office superstores announced earlier this year. Also in the second quarter we continued to have strong growth in retail sell out of our branded wireless inkjet units in all of our top countries.

Relative to project awards, according to our internal assessment during the first half of 2009, Lexmark inkjets received 30% of the U.S. industry inkjet awards. This is a significant increase from 2008 making us number two in the industry inkjet awards received and is a strong recognition of the evolution and improvement in our inkjet products over the last two years as we shifted our focus to service small and medium business customers.

Last week we previewed some information about our fall 2009 inkjet All-In-One product line that will be officially released on September 1. We will deliver eight new inkjet All-In-One’s focused on meeting the needs of small to medium sized businesses. All of these products will feature Lexmark’s new Vizix technology with a separate print head and ink cartridge architecture, wireless connectivity and the new, environmentally friendly Eco Mode that allows users to save paper and energy. Three of these new inkjet models include a web connected color touch screen user interface with prices ranging from $199 to $399. Product shipment is scheduled to begin in September and we will showcase this new line up as business ready inkjet All-In-One’s at the Lexmark Securities Analyst Open House on Tuesday, September 8^th, in New York City.

Now as we look into the third quarter we expect revenue to be slightly down sequentially. We expect GAAP earnings per share to be in the range of $0.22-0.32. Earnings per share excluding restructuring related charges is expected to be in a range of $0.40-0.50 with the sequential change primarily driven by the expected seasonal decline in laser supplies and the sequential increase in inkjet unit sales.

Despite the current economic weakness, we see many positives in our business and some growing strengths. In our printing solutions and services division we are continuing the roll out of our new laser product line which includes features, performance and print quality and including a significant expansion of our laser MFP and color laser lines.

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

During the second quarter our product and sales images drove good growth in both our color laser and laser multifunction units. We continue to have good growth in our management services business and continued to win new contracts with our enterprise customers. We believe our enterprise value proposition to help our customers print less and to significantly reduce cost and improve the sustainability of distributed printing is a powerful proposition as customers are looking for ways to lower their cost and expense.

In our imaging solutions division, while we are still transitioning the division, we are encouraged by the significant expansion of our retail shelf space in U.S. office superstores that we announced earlier in the year, the increased customer receptivity of our improved inkjet product line due to our focus on large models and the introduction of our Professional Series products, the increased industry recognition awards that has now given Lexmark the most awarded line of wireless inkjet printers in the industry, the continuing sequential increases in the retail sell out of our Professional Series here in the U.S. and the number two overall wireless market share position and the ongoing good growth in the retail sale out of our wireless inkjets in our top countries.

In both laser and inkjet we continue to invest in our core two technologies and product development and are driving a strong pipeline for the future of Lexmark products. While our near term results are clearly not where we would like them to be, we are continuing to better align ourselves with the current market environment including continuing to take actions to reduce our fixed infrastructure and business support costs, resulting in an operating expense reduction of about $125 million or 20% year-over-year in the first half of 2009.

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

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

John Gamble, Jr.

Thank you Paul. Good morning. Consistent with previous calls I will first discuss our results of the second quarter of 2009 relative to the prior year, then relative to the first quarter 2009. 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 related expense as we walk through the P&L. In the supplemental slide deck posted on our Investor Relations website we have included details on the income statement line items impacted by the restructuring related activities.

Now let me begin with the P&L. Total revenue for the quarter was $905 million, down 21% compared to last year, down 4% sequentially from 1Q and in line with the guidance provided in April. Geographically for the second quarter, U.S. revenue of $388 million declined about 10% year-over-year. Europe revenue of $353 million declined about 25% year-over-year. The remaining geographies declined about 31% versus a year ago.

The currency impact on Lexmark revenue for 2Q09 versus 2Q08 was negative approximately 7%. Supplies revenue in the second quarter declined 18% year-over-year. This decline was slightly larger than expected reflecting lower end user demand in both PSSD and ISD reflecting the weak economic environment partially offset by less than expected channel shrinkage.

Hardware revenue in the second quarter declined 29% year-over-year and was about flat sequentially. Year-over-year the hardware revenue decline was primarily due to lower hardware volume as well as negative currency effects on U.S. dollar revenue and price declines. PSSD revenue for the third quarter was $624 million, a decline of 18% from the same quarter in 2008 and an increase of 4% sequentially from 1Q09.

The year-over-year decline was driven by declines in both supplies and hardware revenue. PSSD hardware revenue decreased 27% versus 2Q08. This decline was driven primarily by lower volume as well as the continuing negative year-over-year impact from weakening foreign currencies and lower pricing.

PSSD laser hardware units declined 21% in the second quarter versus the prior year. Despite the continued weak market conditions we saw good growth in color lasers and continued good growth in laser MFP’s. Sequentially we saw good growth in laser units including good growth in workgroup lasers. PSSD laser average unit revenue declined 7% year-over-year in the second quarter primarily due to the impact of weaker foreign currencies.

ISD revenue for the quarter was $281 million, down 25% from the same quarter in 2008 and a decline of 19% sequentially from 1Q09. The year-over-year decline was driven by declines in both supplies and hardware revenue. The sequential decline of 19% is primarily driven by lower inkjet supplies revenue.

ISD hardware revenue was down 36% versus 2Q08. Again, this decline was driven primarily by lower unit volume as well as the impact of weaker foreign currencies. These impacts were partially offset by the continuing positive impact of our improving mix towards higher priced hardware devices.

ISD hardware units declined 43% year-over-year in the second quarter. ISD hardware units were down significantly in EMEA driven both by generally weaker economic conditions across EMEA as well as higher relative unit shipments in 2Q08 as we recovered from the EMEA distribution center fire we had in 1Q08.

ISD hardware AUR in the quarter increased 13% versus the prior year which was the result a positive mix shift towards higher end devices. Gross profit margin for 2Q was 31%. Excluding restructuring charges of approximately $22 million, gross profit margin would have been 33.4%, down 360 basis points versus the prior year and down 240 basis points sequentially.

The 360 basis point second quarter decline versus last year was principally due to a 660 basis point decline in product margins driven by lower hardware margins reflecting the net impact on effective U.S. dollar price on weakening foreign currency and price declines. This product margin decline was partially offset by a favorable mix shift reflecting a higher relative percentage of supplies versus hardware.

Sequentially, the 240 basis point decrease was due to a 200 basis point decrease in product margins driven by higher supply costs as we adjusted supplies manufacturing to reduce inventory. The remainder of the decline was due to a decrease in product mix driven by lower relative percentage of supplies versus hardware.

Operating expense for the quarter was $253 million with restructuring related expense of approximately $10 million. Excluding this impact, operating expense was $243 million, a reduction of $69 million versus 2Q08. SG&A in the quarter was $150 million, a reduction of $59 million from 2Q08 reflecting lower expense levels in both marketing and G&A. SG&A was lower broadly, reflecting the benefits of our restructuring and other expense reduction measures as well as weaker foreign currencies.

R&D in the quarter was $93 million, a decrease of $10 million from 2Q08. Sequentially, operating expense excluding restructuring related expenses declined $8 million versus the first quarter driven by sequential reductions in R&D and marketing and sales.

Operating income in 2Q was $28 million. Excluding total restructuring and related costs and expenses of $32 million, operating income was $59 million, down $50 million from 2Q08 and down $28 million sequentially from 1Q09. The reduction in 2Q09 operating income versus 2Q08 was driven primarily by lower income in PSSD partially offset by lower other segment net expenses and higher ISD income. The decrease in 2Q09 versus 1Q09 was primarily in ISD.

Excluding restructuring related activities, PSSD operating income in 2Q09 of $88 million was down $69 million versus last year and $7 million sequentially. This reduction versus last year was driven by lower supplies revenue and profit due to lower end user demand and the net impact of weaker foreign currencies. Hardware gross profit is also down, the majority of which reflects the net impact of weaker foreign currencies and lower prices. These negative impacts were partially offset by a significant reduction in operating expenses.

Again, excluding restructuring related expenses, ISD operating income in 2Q09 of $31 million was up $4 million versus last year and down $24 million sequentially. This increase versus last year is driven by a significant reduction in operating expenses and the positive income impact of lower hardware revenue. These impacts were mostly offset by lower supplies revenue reflecting actions we continue to take to reposition the ISD business and the global economic situation.

Other segment, consisting primarily of costs related to centralized supply chain, IT and other operating expenses primarily G&A, was a net cost of $59 million in 2Q09 excluding restructuring related activities. This was $15 million lower than 2Q08 and $3 million lower than 1Q09, both driven by our ongoing focus on costs and expense reductions.

Operating income margin in 2Q was 3.1%. Excluding restructuring related expenses, operating income margin was 6.6%, a decline of 300 basis points from the second quarter of 2008 and a decrease of 270 basis points sequentially.

Concerning financing and non-operating costs in the second quarter of 2009, the net interest and other costs were an expense of $7 million, up $10 million from the second quarter of 2008’s $3 million net income and up $3 million expense sequentially. The 2Q increase year-over-year was driven by increased interest expense related to the 2Q08 debt issuance as well as lower net income.

In the quarter we also incurred an expense of $0.8 million related to the implementation of FAS 115-2. This loss reflects estimated credit losses related to our holdings of certain asset backed and corporate debt securities.

Our effective tax rate in 2Q09 was 18.4%. This was higher than the 16.2% we saw in 1Q09 as we now expect our effective tax rate for 2009 to be approximately 17%. This increase reflects an expected reduction in the non-U.S. percentage of our 2009 income. The 2Q09 effective tax rate was above the 17% rate reflecting a total tax expense that needed to be reflected to bring the effective tax rate for the first half results to this higher level. As we referenced last quarter, our expected tax rate in 2009 could be volatile as regional economic conditions continue to change, impacting our operations and the regional mix of our income.

Net earnings for the quarter were $17 million. Excluding the $26 million after-tax cost from restructuring related activities, net earnings in 2Q09 were $43 million. 2Q08 net earnings were $84 million or $90 million excluding after-tax restructuring related expenses. GAAP earnings per share for the quarter were $0.22. Excluding restructuring related activities, EPS would have been $0.25 per share. This compared to 2Q08 GAAP earnings per share of $0.89 or $0.96 excluding restructuring related activities.

Now moving to the balance sheet and cash flow items. Cash flow from operations in the quarter was $84 million. In the quarter restructuring related cash outflows were $10 million. As we discussed last quarter, 1Q09 cash flow from operations was weak reflecting two main factors; a $79 million pension contribution made in March 2009 and increased days of inventory.

As we indicated in April, we expected significant improvements in cash flow in 2Q as pension contributions would be only $5 million and we expected significant improvements in inventory performance. In 2Q09 cash flow from operations did improve significantly driven by improved inventory performance. Receivables performance in terms of days outstanding was also good, remaining in the 30 days. Receivables balances did not increase significantly in 2Q09. We are comfortable with collections performance through June.

Payables were a significant use of cash during the quarter. However, payables days performance although down from 1Q remained reasonable and consistent with terms. The significant use of cash from payables in the quarter was driven by low production levels in May and June as we acted to reduce inventory levels. This dynamic should not recur in 3Q. Overall, we expect to deliver continued relative working capital improvements as we move through 3Q.

In terms of specific numbers, since the end of March accounts receivable increased $2 million, inventory decreased $55 million, accounts payable decreased $56 million and accrued liabilities declined $5 million. Second quarter capital spending was $70 million and we are expecting about $50 million in 3Q09. In 2009 our capital spending was much heavier in the first half of the year. For full year 2009 we continue to expect about $225 million in capital spending. Depreciation in the quarter was $63 million and includes $20 million of restructuring related accelerated depreciation.

In terms of other items impacting cash flow in 3Q09, in both 3Q09 and 4Q09 pension contributions should be $5 million in each quarter. Also, as we discussed last quarter an agreement was reached in 1Q09 in which Lexmark participated regarding the copy write fees to be paid on All-In-One devices sold in Germany after 2001. Under the terms of this settlement, Lexmark will make a payment of approximately $42 million in 3Q09.

Cash and current marketable securities at the end of 2Q09 was $810 million. Total long-term debt at the end of 2Q09 was $650 million with maturities on the debt in 2013 and 2018. At quarter end we had $491 million of share repurchase authority outstanding and no shares were repurchased in the quarter.

Now let me move to restructuring. For the restructuring plans announced in January and April 2009 we continue to expect the overall program parameters, costs and benefits to be about the same as discussed last quarter. In 2009 total pre-tax restructuring and related costs and expenses were $32 million.

In 2Q09 restructuring cash out flow was $10 million and savings from our 2007, 2008 and 2009 restructuring actions were $33 million. In 3Q09 restructuring related costs and expenses due to the restructuring actions are expected to be approximately $17 million. Savings in 3Q09 from the 2007, 2008 and 2009 restructurings are expected to be approximately $36 million.

We continue to aggressively focus on cost reductions both in cost of goods sold and operating expenses. We expect 2009 operating expense to be at least $175 million below 2008 levels. More details regarding restructuring and other cost and savings are available in the supplemental slide deck.

Now for my forward-looking statements comments concerning 3Q09. We expect 3Q09 versus 2Q09 revenue to decline slightly. This reflects our expectation for the continuing weakness of the global economy to negatively impact both PSSD and ISD. For supplies revenue we are expected continued economic weakness to result in year-over-year supplies revenue declines consistent with that we incurred in 2Q09.

GAAP EPS is expected to be $0.22-0.32 in 3Q09. GAAP EPS includes expected restructuring charges of $0.18 per share. Non-GAAP EPS excluding restructuring related costs and expenses is expected to be $0.40-0.50. GAAP EPS in the third quarter 2008 was $0.42 per share which includes restructuring charges of $0.21 per share. Non-GAAP EPS in 3Q08 was $0.63 per share. EPS in 3Q09 is expected to be weaker than 2Q09 primarily due to an expected seasonal decline in laser supplies revenue and related income and sequential [de]crease in inkjet unit sales.

All of the comparisons that follow exclude the impact of restructuring. In the third quarter we expect gross profit margin percentage to be down versus the 33.4% we achieved in 2Q09. Operating expense is expected to be up slightly from the $243 million incurred in 2Q09. Operating income margin in the third quarter is expected to be below the 6.6% achieved in the second quarter of 2009.

For 3Q09 we expect our ongoing effective tax rate to be about 17% before any discrete items. We project full year 2009 capital spending to be approximately $225 million and we expect full year depreciation to be approximately $210 million including the impact of accelerated depreciation related to facilities closures.

The guidance provided is based on foreign exchange rates as of 06/30/09.

Now before opening the call up to your questions I would like to point out that our financial position remains strong. We continue to have a solid balance sheet and good liquidity with $810 million in cash and current marketable securities. Our strong financial structure continues to position us well to deliver innovative products and compete effectively even during challenging times.

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

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Kathryn Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

You mentioned a number of positives surrounding the hardware product line including expanded shelf space, a large jump in industry awards and the new products you announced this year. If we layer in what you expect to launch in the third quarter and possibly even easier comparisons stabilizing demand as we end this year and go into 2010 would you expect margins to be pressured for several quarters as the mix shifts back towards hardware in the next three or four quarters assuming your hardware strategy is successful?

Paul Curlander

As you know, we only give guidance one quarter forward. Obviously a little bit of what you see in our third quarter guidance is already a higher percentage of hardware versus supplies which is impacting the margin. It is hard to predict what we are going to see in the market. Currently we feel very good about where we are with our laser product line and we saw an improvement in lasers albeit a lesser decline than what we had in the first quarter but certainly we saw a much strong performance in U.S. lasers with growth in color and multi-function devices. So we feel good about that.

On the inkjet side, we have been pleased with the performance of the existing professional series of products which really is a repackaging of our existing technology. We have been getting a lot more awards and doing pretty well in the professional series seeing good growth year-over-year in the retail sell out. We are very hopeful for these new products coming in the September timeframe. We really feel from a technology perspective that we have executed what we set out to do.

We think there is a significant differentiator in the user interface in the high end models and so we would hope to see good performance out of those things and I think that as you indicated to the extent you get a stronger mix of hardware versus supplies we are going to see margin pressure from that.

Kathryn Huberty - Morgan Stanley

Just a quick follow-up, what do you need to see in order to resume share buybacks?

John Gamble, Jr.

We generally don’t forecast what we are thinking about share buybacks. Obviously what we are focused on here is improving our operating performance and income performance. That will drive cash flow. Exactly what we will do in terms of share buybacks we are not going to forecast at this time.

Also, I understand that I said capital spending was $70 million in the quarter. It actually was $79 million and I just want to correct the statement I made in my remarks.

Operator

The next question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

Can you give us a little more detail on your channel inventory levels particularly on the supply side? Why was it less than expected and is there a big difference between what you are seeing in inventory levels from business to consumer?

Paul Curlander

In the quarter we had expected to see the shrinkage in both laser and inkjet channel inventory. What happened was we saw less than expected shrinkage in lasers. Actually lasers were probably about relatively flat during the quarter so we didn’t see that shrinkage. On the inkjet side we saw relatively slightly more shrinkage than what we had expected. As we look into the third quarter what we are thinking is we really don’t expect to see shrinkage in the channel. Part of that is even though we got less than what we expected in the second quarter as you project out into the third quarter and look at the inventory levels we think we will have then we also look at the sequential seasonal pick up in supplies.

From a week’s of inventory standpoint we think that will be okay. It is always an inexact science trying to project forward but again, we saw less than expected in terms of the second quarter and we are expecting to see in the third quarter the channel remains somewhat stable.

Operator

The next question comes from Ben Reitzes - Barclays Capital.

Ben Reitzes - Barclays Capital

I wanted to ask you a hypothetical. There is a prevailing thesis out there and consensus there is a massive PC upgrade cycle about to take place. Humor me for a minute. How would that impact Lexmark? Are you coupled with PC? Are you not? Do you not see any correlation? If there were to be an up tick in enterprise spend how would you participate? Would there be a lag? How do you think of that?

Paul Curlander

The way we think about it is really over the last 5-6 years we have become much more uncoupled from PC’s. As I look at the distributed printer market, PC’s over the last few quarters have done much better than what the printer market has done. Particularly as we focus on the enterprise side is we find enterprise customers don’t necessarily put those together. In fact what we are seeing in the enterprise market right now is you really need to position a compelling cost reduction story for enterprise customers to want to do any type of upgrade or change in their distributed environment.

On the inkjet side, again there was a time when we were very coupled with PC’s but as we move away from consumers and focus on small and medium business again, I think it is a little bit more like the enterprise side. We need to have something compelling in terms of either technology or cost reduction to cause people to want to swap out. Certainly as we look at business inkjet and small business we really do believe a lot of people keep using them and then once they upgrade so we somewhat see that cycle there.

Ben Reitzes - Barclays Capital

Just with regard to cash flow in the quarter it was $5 million. So what is it going to be like in the second half? Should it snap back significantly positive or does the payables trend continue? Normally when a company has a payables situation like you had in one quarter it snaps back within a quarter or two. Can you just give us a little more guidance on cash flow? You already gave us the components of CapEx and D&A. What should we expect?

John Gamble, Jr.

Specifically in terms of payables what you saw in the second quarter was as we took the actions we took to improve inventory and you certainly saw that improvement in inventory in the quarter. It significantly reduced our production in there for purchases in the latter half of the quarter. So that had a very significant impact on payables balances and therefore a big use of cash. As you indicated, generally that situation doesn’t continue so we would be hopeful we would see some type of improvement in the net inventory payables position as you move through the quarter.

In terms of specific cash flow guidance, we don’t give specific cash flow guidance but in terms of those two working capital elements you would expect to see some improvement there assuming we continue to manage inventory well which is our focus.

Operator

The next question comes from Richard Gardner – Citigroup.

Richard Gardner - Citigroup

I wanted to ask a question regarding product margin. I know you typically have talked about year-over-year changes in product margins but can we talk for a minute about sequential change? I was hoping you could give us specifically a sense of how much of the sequential degradation in product margins was due to things like competitive pricing versus inventory write downs versus incentives that you are offering to the OSS channel to take product, currency, accounting things, product mix or the supplies capacity under absorption you are going through because of inventory reductions? I guess in general what I’m trying to get a sense for is how much of the degradation in margins sequentially was related to things that are not recurring and how much is related to things that are probably going to continue forever or at least for the next several quarters?

Paul Curlander

I won’t be able to quantify the factors for you. The factors we see out there right now certainly pricing is very aggressive. Every quarter that goes by we see more aggressive pricing. Part of it on the hardware side really is around the currency shifts that occurred even though currency has moved some since the fourth quarter but still on a year-over-year basis the currency is very negative from a hardware perspective. Outside of the U.S. in general we did not see competitive movements in price to reflect the currency movement. We have seen aggressive impacts from a currency perspective.

Beyond that whenever the market is this weak you see aggressive pricing and we continue to see that. We continue to see that. Every quarter we see things we thought would never happen and they happen and it just continues to get worse. That is probably the primary factor 1Q to 2Q. The other thing that happened and John mentioned it was from a supplies perspective we worked hard on our inventory in the quarter. One of the things you do to get inventory down is you cut back on production. We did quite a bit of that on our supplies in the second quarter and as a result we did get additional cost and to the extent we can get back to more normal production of supplies we would expect that to improve as we go forward in time.

I do believe pricing will continue to be aggressive in the market.

John Gamble, Jr.

When we call out our margin bridges, generally we try to put them in order of impact. I would say that probably period to period the impact on supplies cost from what Paul referenced was relatively significant as well.

Richard Gardner - Citigroup

Is there anything about the agreements with the Office product superstores that is depressing margins on the inkjet side or the laser side that is unusual or unlike other agreements you have had with your channel partners in the past? Where are we in drawing down, how low do you want to take your own internal inventories, how much more do we have left there on that inventory draw down?

Paul Curlander

Relative to the office superstores, I can’t talk about the specific [T’s] but let me make a few general comments. In terms of hardware sales, if you look at mass versus say CES and office superstores it is more expensive to sell hardware in office superstores and CES just because this is what the channel tends to demand. Mass is much more efficient in terms of moving hardware into the market place. The big difference that we find is that the pages generated by the products sold in office superstores and CES are much, much greater than mass. This is why the profit equation closes. To the extent we sell more higher price product we are going to generate more pages going forward in time. That is the business model we are focused on there.

Your other question regarding internal inventory is clearly we are unhappy with the inventory days we had at the end of the first quarter. We took some action on that and saw some improvement but as John pointed out we are going to continue to focus on inventory. We think we can do better.

Operator

The next question comes from Bill Shope - Credit Suisse.

Bill Shope - Credit Suisse

Can you give us an update in terms of what you are seeing in terms of the bone in the remanned market trends and whether or not that has changed given the weak macro environment?

Paul Curlander

What we are seeing relative to supplies in general is a pretty aggressive environment in the history of supplies. If you look in the U.S. just because of the economic downturn I would say probably all of our customers have come to us asking for price down. Obviously we try to be responsive to our customers. We also got in a situation where people start looking aggressively at third-party re-manned and we may have to make some adjustments in our pricing relative to that. In Enterprise we worked very, very hard to ensure we do capture the slides in our large accounts but we have to compete.

Outside of the U.S. in enterprise obviously the increased prices in local currency. This just brings more attacks from third-party re-man so we see this very extensively outside of the U.S. Obviously we again need to be very competitive with that which typically then impacts pricing. One of the processes we have in responding certainly in the enterprise space is we do collect up our empty cartridges very aggressively. We get a significant percentage of them back. We remanufacture the cartridges and we participate in that part of the market as well. So we have several weapons to compete for the supplies and we are out there doing that aggressively.

Obviously this is impacting supplies pricing in the market place right now. That is kind of what we are seeing. Do we think we can get more penetration? To the extent that we can see it we combat it. We think we win more than we lose there. To the extent that we don’t see it because it is more of an open channel, currently we would have to think there is some additional penetration there and we look at that very aggressively in terms of trying to do private label deals beyond just what Lexmark does in re-manned to try to offset some of that as well.

Bill Shope - Credit Suisse

I understand all the drivers behind the supplies pressure you are talking about continuing for the third quarter. I guess on amore positive note, are you seeing any anecdotal evidence to suggest you may be seeing a cyclical bottom in supplies whether it be in enterprise or consumer? Can you give us a sense of what supplies demand looks like by geo?

Paul Curlander

What I would say is I don’t think we have seen anything in the second quarter that would say we are at a cyclical bottom. It is possible we are but I can’t say as I look from first quarter to second quarter that we saw improvement either in demand or any demand in the market that would tell us that. I do think relative to supplies geographically we did see a little bit of a deceleration internationally, particularly in Europe, in the second quarter. U.S. was probably more as we had expected although on the inkjet side maybe a little bit less than expected in the U.S.

So I think overall we are just seeing weakness in end user demand for supplies and I don’t think this is unique to Lexmark. I think that this is across the market. We are kind of seeing that impact in all geographies. I would call out maybe Europe as a bit more deceleration in the second quarter than others.

Operator

The next question comes from Shannon Cross - Cross Research.

Shannon Cross - Cross Research

Somewhat of a follow-up to the last question, can you talk about end user demand from the standpoint of what you are seeing in terms of page usage, page volumes? Some of the survey data we have been working with shows that office page volumes are down but not down dramatically and other comments from your competitors have been similar. Is there anything specific you can point to in terms of what you think the actual office volume is doing maybe as you look at office and then on the inkjet side?

Paul Curlander

On the [inaudible] side, we have a pretty good view in terms of our distributed fleet management accounts. We would see high single digit in some cases, and low double digit types of declines in our customers in usage. We are seeing every click on every page. We think that is pretty compelling. As we look at what has happened with the distribution channel and supplies and looking at the market overall, again we would see very high single digit, low double digit types of impact in terms of office usage. If others think they see different that may be, but in terms of what we are seeing we are pretty certain that is what is out there in the market right now.

On the inkjet side, I think the impact in terms of end user demand is there but maybe not quite as much as what we see in the office segment. We think businesses have been more aggressive either through layoffs or trying to cut costs in terms of reducing printing. On the consumer side we are also impacted by our transition so that is Lexmark unique. But we do think there is some impact from the market environment on inkjet but not as extensive as what we have seen in the office environment.

Shannon Cross - Cross Research

Can you talk a little bit about your hedging strategy and how we should think about currency going forward? Anything you have been able to do to sort of offset? I would have thought maybe there was a little bit more not benefit from currency but given what the dollar has done it might have had a little bit less impact this quarter than perhaps when you provided guidance.

John Gamble, Jr.

The only hedging we really do is around transaction hedging. We don’t really hedge anything other than specific transaction exposures. We don’t do cash flow hedging. That is the strategy we have followed for an extended period of time and we haven’t really changed that.

Operator

The next question comes from Toni Sacconaghi - Sanford C. Bernstein.

Toni Sacconaghi - Sanford C. Bernstein

I wanted to revisit this question about the impact of supplies manufacturing on margins. I think in your prepared remarks you said that factor negatively impacted company gross margins 200 basis points sequentially. That is $0.20 a share in a quarter so that is $0.80 a year annualized. It is a huge force and I want to understand it better. It very clearly from your comments, and please correct me if I am mistaken, was by far the largest sequential factor affecting gross margins. I want to understand exactly what that was because it applies not an absorption rate that was higher per unit. It actually implies more manufacturing cost this quarter on a sequential basis.

So can you please better clarify what exactly that minus 200 basis point negative impact on margin sequentially was from supplies manufacturing?

John Gamble, Jr.

I didn’t say 200 basis points from supplies manufacturing. I think what we indicated was there was a 200 basis point impact from product margins and then the largest impact within that, not meaning all 200, was from supplies manufacturing and specifically significantly lower volumes that we produced in period as we reduced inventories. Again, I didn’t mean to imply that it was all 200 basis points. It was not.

Of the factors that resulted in 200 basis point degradation in product margins it was the largest factor.

Toni Sacconaghi - Sanford C. Bernstein

So it was at least 100 basis points given that it was the most significant factor. What I would like to try and understand is ultimately why did your costs go up effectively if you produced less?

John Gamble, Jr.

It is around fixed absorption right. Our fixed absorption is lower when our production units are significantly lower.

Operator

The next question comes from Bill Fearnley - FTN Midwest Research.

Bill Fearnley - FTN Midwest Research

A question here on the March 2009 channel initiative. Will it cost you more in the second half if the market remains weak and the competition remains aggressive? Do you think you will get back into the largest CE chain in the U.S. here in the back half of the year in preparation for the holiday season?

Paul Curlander

Let me talk about the second one first. Obviously we are interested in continuing to improve our distribution. We are focused on consumer electronics. I can’t make any predictions on what is going to happen there. We continue to work on it and we are hopeful at some point we will get back in. Again, we can’t predict when that might be.

In terms of the second half, clearly we are very focused around launching the new products here in September. Not totally sure what you meant by costs. Were you focused on channel costs or cost of products?

Bill Fearnley - FTN Midwest Research

Costs in terms of what it costs you for incentives and programs and that type of thing? Particularly in the OPSS channel.

Paul Curlander

I think as I pointed out before the cost of hardware is higher in the office superstores but we get a lot more pages off those devices. I think to the extent we ramp up sales there we will be seeing that incremental cost on that hardware but again, we are going to drive more pages so the business is pretty compelling for us to be in OSS versus other parts of the channel. Again, we are hopeful that we will go out with these new products and that we will see good growth with them through office superstores.

Bill Fearnley - FTN Midwest Research

If I could shift gears, on research and development any additional details on R&D, how we should be thinking about the trend for R&D spending? The R&D expense for the quarter was lower than we had expected. Should we be thinking about this level of R&D spending in the second quarter as the new level for R&D or should we expect it in raw dollars to tick back up especially as you talk about developing new products and technologies?

Paul Curlander

I think the way to think about R&D is it is down this year and I think we said that as we came into the year R&D would be down. What we are doing with R&D is we are protecting it during this downturn. It doesn’t mean it doesn’t have some decline but basically less than 10% in overall expense and 20% in the first half. Our focus on R&D is primarily around optimization and consolidation of some of our platforms. To say that differently we have put a lot of effort into expanding the product set and our reach in the market place. We don’t want to back away from that. We want to get more efficient in how we serve that and we think there is efficiency that can be had. You should be clear even though we are going to have less R&D in 2009 than in 2008 we continue to strengthen the company and our focus is to continue to cover the market with a strong pipeline of products. So that is how we are thinking about it.

Operator

The next question comes from Mark Moskowitz – JP Morgan.

Mark Moskowitz – JP Morgan

The first question revolves around market share. Can you update us on your laser business? Do you feel you declined in line with the market or did you decline better or worse given your weakness you saw in the first quarter?

Paul Curlander

Well relative to lasers, the data is only out there for the first quarter. If you kind of look at the first quarter data what we see is that as branded hardware units, those units declined less than the market. So we believe that we gained share. But the OEM side declined more than the market. We believe we lost share on the OEM side. Within the branded piece, our workgroup we think was particularly smaller decline than the markets and we gained share in workgroup. We gained share in color and we gained share in laser multifunction devices as well. We feel pretty good about how we are doing in laser and we certainly hope the market does improve but relative to what the market is doing we feel like especially in color and MFP’s we are doing well.

Mark Moskowitz – JP Morgan

As far as the OpEx structure can you talk about the incremental leverage you hope to drive when you get to your target model? Are you still in an area where you can sustain 20% declines in the next few quarters? Year-over-year? Does that set you up for the potential to drive $0.20 to $0.30 incremental?

John Gamble, Jr.

We are continuing to focus on OpEx reductions and you see the level of OpEx we are at this year and obviously the level of OpEx we ran for the last two quarters of last year. So you can imply reductions that you can see there going forward. In terms of specific levels of OpEx as we look out beyond this quarter and into next year I think all we can say is we are continuing to focus on trying to drive improvements in our fixed cost structure which includes our operating expense structure. So we are continuing to focus on that. We have had good success this year. We need to have continued success. That is the focus we are on.

Operator

The next question comes from Ananda Baruah – Brean Murray.

Ananda Baruah – Brean Murray

You made comments a couple of times around Europe being a little bit weaker than you had anticipated going into the quarter. Can you talk about what you saw in the environment that may have become incrementally worse in Europe whether it be in consumer or in office? You also made a couple of comments relative to U.S. results being more or less in line. I was just wondering if you could delve into the dynamics in both of those regions a little bit more.

Paul Curlander

As we look at Europe we kind of saw a deceleration from the first quarter in just about every category. Probably the biggest in inkjet hardware relative to what we had expected but we also saw some deceleration in laser hardware and certainly in supplies for both laser and inkjet. On the U.S. side, we came in as expected or above expectation on the inkjet and laser hardware sales. I think that clearly as we look at the market on the laser side we are benefiting from our strong enterprise value propositions. We are doing pretty well in our management services closing a lot of new accounts because of the compelling cost down proposition. So if I look at our industry in the U.S. we are doing pretty well in financial services. Not that financial services is necessarily buying a lot of equipment but we have compelling cost down propositions which they find attractive.

I think that on the inkjet side, clearly with the professional series product and the office superstore expansion we are getting good sales out growth there and that helped us in the second quarter. I think these are the positives and the market we think is somewhat stable certainly from first quarter into second quarter in the U.S. versus Europe.

Ananda Baruah – Brean Murray

You commented earlier that there is nothing you saw in Q2 that was signaled necessarily any kind of cyclical bottoming I guess but it sounds like the U.S. is a little bit more stable for you. Would those comments be predominately more skewed towards your international business and do you sense that things might be demand decelerating at a meaningful rate internationally? In the market in general.

Paul Curlander

The question before was specifically on supplies and it was not geographically specific. We were talking about supplies we couldn’t call a bottom. I think in the U.S. again we have seen the market somewhat stable from first quarter to second quarter. I would say that probably the laser market was about the same first quarter to second quarter in the U.S. just looking at the data that we can see. The inkjet market looking at the market data was probably a little bit weaker in the U.S. in the second quarter than the first quarter although we did better due to some unique Lexmark things.

Internationally, clearly we saw a deceleration in the second quarter particularly in Europe but all those geos were a little weaker for us in the second quarter.

Operator

Our final question comes from the line of Chris Whitmore – Deutsche Bank.

Chris Whitmore – Deutsche Bank

I wanted to understand your market share trends in inkjet a little bit better if you could provide some color. Looking at the data it looks like year-over-year unit growth actually weakened despite the ramp of the office superstores in the U.S. I wanted to understand if you think you are losing share outside the U.S.?

Paul Curlander

I think if you look at inkjet what you are seeing there is we are declining more than the market because we are driving the transition. In inkjet clearly as I look at second quarter say versus first quarter results we saw a significant deceleration in the OEM results in inkjet. We saw impact from the pull back we decided last December to do in the emerging markets particularly around the low end. We see an ongoing pull back in the low end in general because we are moving away from consumer and going to small and medium business.

Where we see positive results is in what I would call the high end inkjets on the branded side and if you were to look at IBC market share data in the U.S. you would see us actually picking up share in the first quarter in the $100-199 price. Historically we have always been below $100, actually below $50, and now you are starting to see us pick up share in this $100-199 segment and obviously the focus with the new products we are coming out with in September is the $199 to $399 segment. So I would say in inkjet, OEM obviously losing share, low end losing share because of our pull back and what we are doing in the emerging markets as well around that.

We are gaining share in the high end inkjets and we do see that certainly in the U.S. IDC data in the first quarter.

Chris Whitmore – Deutsche Bank

Can you talk about pricing specifically in that higher price band, north of $100 price points, in the inkjet market?

Paul Curlander

I think what you see across the board in inkjet is aggressive pricing. You see a lot of promotions coming from the competition in all the price segments. I wouldn’t say there is anything unique about the $199 to $299 to $399 segment.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!