Lexmark International Q3 2009 Earnings Call Transcript

ID:

Lexmark International, Inc. (LXK)

Q3 2009 Earnings Call

October 20, 2009 8:30 am ET

Executives

John Morgan - Director of IR

Paul J. Curlander - Chairman of the Board, Chief Executive Officer

John W. Gamble Jr. - Chief Financial Officer, Executive Vice President

Analysts

Bill Shope - Credit Suisse

Shannon Cross - Cross Research

David Bailey - Goldman Sachs

Tony Sacconaghi - Sanford Bernstein

Bill Fearnley - FTN Equity Capital Markets Corp.

Mark Moskowitz - JP Morgan

Ben Reitzes - Barclays Capital

Kathryn Huberty - Morgan Stanley

Ananda Baruah - Brean, Murray, Carret & Co.

Presentation

Operator

Good morning and welcome to the Lexmark International third quarter 2009 earnings conference call. (Operator's Instructions) This conference call is being recorded on Tuesday, October 20^th, 2009. I would now like to call 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 EVP and CFO John Gamble are with me this morning. After their remarks we'll open the call for your question as time permits. We ask that you please limit yourself to one question and one followup, if needed, so that we can get to everyone. Following the conclusion of this conference call, a complete replay 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 December 3^rd we'll be participating in the Credit Suisse Technology Conference, and on December 8^th we'll be participating in the Barclays Capital Global Technology Conference. Please visit our investor relations website to obtain more information regarding our upcoming events. 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, and Lexmark undertakes no obligation to update any forward looking statement. With that I'll turn it over to Paul.

Paul J. Curlander

Thank you, John. During the third quarter, stronger than expected customer demand resulted in good sequential growth for Lexmark, exceeding our expectations for both revenue and profit in the quarter. Both divisions exceeded expectations and geographically, all regions improved sequentially in revenue and profit.

During the quarter we also continued to improve the fundamentals of the business with well received new product introductions in both inkjet and laser segments, continued significant expense reductions now totalling about $180 million of reduction year to date, and a strong sequential increase in our cash flow.

We're also announcing today some additional restructuring actions which will result in a program cost of $120 million, but will drive additional cost and expense savings of $70 million in 2010 and an annualized savings of $110 million starting in 2011. Revenue for the third quarter was $958 million, up 6% sequentially and declined 15% year to year which was an improvement from 2Q 2009 performance.

Hardware revenue in the third quarter was up 13% sequentially and better than expected. Although hardware revenue declined 24% year to year, this was also an improvement from second quarter performance. Supplies revenue in the third quarter was up 4% sequentially and was better than expected as both laser and inkjet sell out exceeded expectations.

Supplies revenue declined 12% year to year, again, an improvement from second quarter performance, and overall supply channel inventory was about flat sequentially.

Earnings per share in the quarter were $0.13. Excluding restructuring related charges, earnings per share in the third quarter were $0.65, a 3% increase year to year. In the third quarter, net cash provided by operating activities was $147 million, 75% increase sequentially from the second quarter and up 26% year to year.

Now let's talk about our two divisions. In our printing solutions and services division or PSSD, third quarter 2009 revenue was $654 million, up 5% sequentially and down 14% year to year, an improvement in year to year hardware and supplies revenue performance from second quarter 2009.

PSSD operating income excluding restructuring was $98 million, up 11% sequentially and down 24% year to year, again an improvement from second quarter 2009 year to year performance.

PSSD laser units for the quarter were down 22% year to year, but up sequentially and were better than expected. Despite the year to year laser unit decline in the third quarter, we continue to have good year to year growth in our branded color laser units and our workgroup laser MFP with both categories benefiting from our strong new product introductions over the last 12 months.

During the quarter we continued the rollout of new laser devices with the introduction of 10 new laser products including the T656, a new mono workgroup laser printer featuring our intuitive easy to use e-Task touch screen interface. Now while we have used the e-Task interface on laser MFPs for some time, the T656 is the first printer to use this interface. This allows us to implement many of our industry workflow solutions on this single function device which is priced lower than corresponding MFPs. The customer reaction and press reviews have been very positive on this product.

During the quarter we had strong growth in our enterprise management services business and continue to close new enterprise deals with customers such as Kingfisher in the UK to help improve their document based processes. According to data from the first half of 2009, we have continued to gain market share in our branded workgroup laser sales. According to our internal analysis for September year to date, Lexmark continued to be number one in the US printer market in laser product awards received with more than twice the awards of any other vendor.

Now let's talk about our imaging solutions division, or ISD. In the third quarter, ISD revenue was $304 million, up 8% sequentially and down 18% year to year, an improvement in year to year hardware and supplies revenue performance from the second quarter. ISD operating income excluding restructuring was $34 million, up 8% sequentially and up 29% year to year. ISD units for the quarter were down 38% year to year, but up sequentially with strong sequential growth in high-end inkjet units.

Now, despite the overall year-to-year inkjet unit decline in the third quarter, we continued to have good growth in the retail sellout of our wireless inkjet units and our professional series products helped by the expansion of our shelf space in US office super stores announced earlier this year.

According to IDC data for the first half of 2009 we gained market share in our branded inkjet sales in the above $100 segment in the US and Europe, and according to our internal assessment for September year to date, Lexmark inkjet products received 26% of the US industry inkjet awards. Now this is a significant increase from 2008, making us number two in industry inkjet awards received and is a strong recognition of the evolution and improvement of our inkjet products over the last two years as we have shifted our focus to serving SMD customers.

On September 1^st we announced eight new inkjet all-in-ones focused on meeting the needs of small to medium sized businesses. In early September we had an open house for analysts in New York City showcasing these new inkjet all-in-ones. All of these products feature Lexmark’s new Vizix technology with a separate print head and ink cartridge architecture, wireless connectivity, and a new environmentally friendly eco-mode which allows users to save paper and energy.

Three of these inkjet models include a web-connected color touch screen user interface with prices ranging from $199-$399. And while it is a little early to comment on the retail sellout of these new inkjet products, we have secured good shelf space in all three national office superstore chains and in regional consumer electronics chains. And overall reaction to the products has been quite positive.

Now as we look into the fourth quarter we expect revenue to be up slightly sequentially. We expect GAAP earnings per share to be in the range of $0.11 to $0.21. Earnings per share excluding restructuring related charges are expected to be in the range of $0.50-$0.60.

Now, overall we are encouraged by the improved customer demand we saw during the third quarter and the ongoing improvements that we are driving in the fundamentals of our business, including the significant refresh and upgrades in our latest inkjet product line in the last few months, the share gain at our key focus segments of Workgroup Laser and Business Inkjet, the ongoing cost and expense reductions and the new cost expense actions we have announced today, the strong sequential improvements over the last two quarters in our cash generation, and despite our expense reductions, we continue to invest significantly in our core print technology and product development and are driving a strong pipeline of future Lexmark products.

And while it could be a long recovery for the overall printer market to return to its prior levels, we do believe that we are making Lexmark into a leaner and stronger competitor, improving our products and service offerings and our competitive position.

We also continue to maintain a strong financial position with a solid balance sheet and with over $900 million cash and current marketable securities. I'll now turn it over to John Gamble for his more detailed comments on our financials.

John W. Gamble Jr.

Thank you, Paul, and good morning. Consistent with previous calls I'll first discuss our results of the third quarter of 2009 relative to the second quarter of 2009 and relative to the prior year. I'll then discuss selected changes on the balance sheet and certain items of cash flow. Finally, I'll finish with more detail regarding our guidance for the fourth quarter. I will call out the impact of restructuring related expense as we walk through the P&L. I will provide more details on the restructuring action we are announcing today.

In the supplemental slide deck posted on our investor relations website we have included details on the restructuring announced today and 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 $958 million, up 6% sequentially and down 15% compared to last year. The currency impact on Lexmark revenue in 3Q09 versus 2Q09 was positive approximately 3% and the currency impact on Lexmark revenue for 3Q09 versus 3Q08 was negative approximately 3%. Our revenue exceeded the expectations we discussed at the July earnings call by over six percentage points driven by stronger than expected supply and hardware revenue.

Geographically for the quarter, revenue grew sequentially versus 2Q09 and in all geographic regions, but each declined when compared to a year ago. US revenue of $418 million declined about 15% year to year. Europe revenue of $352 million declined about 12% year to year. The remaining geographies declined about 20% versus a year ago, but overall the 3Q09 year to year revenue decline improved in all international geographies as compared to their 2Q year to year decline.

Supplies revenue grew sequentially approximately 4% versus 2Q09, reflecting growth in inkjet as well as laser supplies. Supplies revenue declined 12% versus 3Q08, approximately six percentage points better than the year on year decline in 2Q. This improvement occurred in both inkjet and laser supplies and is driven by a smaller decline in end-user demand in 3Q09 versus 2Q09. We also saw the benefit of the weakening US dollar.

Hardware grew 13% sequentially in the quarter, but declined 24% year to year. Sequentially, the hardware revenue improvement was driven by growth in both laser and inkjet hardware revenue. PS and SD revenue for the quarter was $654 million, an increase of 5% sequentially and a decline of 14% from the same quarter in 2008. The sequential improvement was primarily driven by hardware revenue. The year to year decline was driven by declines in both hardware and supplies revenue, but was an improvement from 2Q09 year to year performance.

PS and SD hardware revenue improved 14% sequentially, but declined 22% versus 3Q08. The sequential improvement was driven by a stronger mix of workgroup placements and higher volume. The year on year decline was driven primarily by lower volume partially offset by a stronger mix of workgroup placements. PS and SD laser hardware units increased sequentially 4%, but declined 22% versus the prior year.

Despite the continued weak market conditions, we saw year on year growth in color lasers and workgroup laser MFPs. PS and SD laser hardware average unit revenue was about flat year to year in the third quarter.

ISD revenue for the quarter was $304 million, up 8% sequentially, but down 18% from the same quarter in 2008. The sequential improvement was driven by growth in both supplies and hardware revenue. The year on year decline was driven by declines in both supplies and hardware revenue, but was an improvement from 2Q09 year to year performance.

ISD hardware revenue was up sequentially 10%, but down 30% versus 3Q08. The sequential increase was driven by positive product mix toward higher priced hardware devices and higher unit volume, partially offset by lower pricing. The year on year decline was driven primarily by lower unit volume and negative price, partially offset by positive mix.

ISD hardware units grew sequentially 16%, but declined 38% year to year in the third quarter. The sequential growth was driven by strong growth in higher priced ISD units. ISD hardware AUR increased 14% year to year in the third quarter, primarily due to the continued positive mix shift toward higher end devices.

Growth profit margin for 3Q was 32.7%. Excluding restructuring related charges of approximately $12 million, growth profit margin would have been 33.9%, down 20 basis points versus the prior year and up 50 basis points sequentially. The 20 basis point third quarter decline versus last year was principally due to a 330 basis point decline in product margins primarily driven by lower hardware margins.

This product margin decline was partially offset by a favorable mix shift reflecting a higher relative percentage of supplies versus hardware. Sequentially, the 50 basis point increase was due to a 190 basis point increase in product margins driven by improvements in both supplies and hardware. The product margin was partially offset by negative mix, driven by a lower relative percentage of supplies versus hardware.

Operating expense for the quarter was $289 million with restructuring related expense of approximately $39 million. Excluding this impact, operating expense was $250 million, a reduction of $57 million versus 3Q08.

SG&A in the quarter was $158 million, a reduction of $39 million from 3Q08, reflecting lower expense levels in both marketing and G&A. SG&A was lower broadly, reflecting the benefits of our restructuring and other expense reducing measures.

R&D in the quarter was $92 million, a decrease of $18 million from 3Q08, reflecting our actions to consolidate platforms and fewer new laser introductions versus last year.

Sequentially, operating expense excluding restructuring related expenses of $250 million, increased slightly as expected, versus the second quarter, driven by increases in marketing and sales and the impact of the weakening US dollar.

Operating income in 3Q was $24 million. Excluding total restructuring and related costs and expenses of $51 million, operating income was $75 million, down $4 million from 3Q08 and up $15 million sequentially from 2Q09. The reduction in 3Q09 operating income versus 3Q08 was driven primarily by lower income in PS and SD, partially offset by lower other segment net expenses, and higher ISD income. The improvement in 3Q09 versus 2Q09 was primarily in PSSD, although all segments showed improvement.

Excluding restructuring related activities, PS and SD operating income in 3Q09 of $98 million improved $10 million sequentially, but was down $30 million versus last year. The sequential improvement was driven by improved hardware revenue and margin and higher supplies revenue partially offset by higher operating expenses. The year on year decline in operating income was driven by lower supplies revenue and the net impact of weaker foreign currencies.

Hardware gross profit is also down, reflecting the net impact of weaker foreign currencies and aggressive market pricing. These negative impacts were partially offset by a significant reduction in operating expenses. Again, excluding restructuring related expenses, ISD operating income in 3Q09 of $34 million was up $3 million sequentially and up $8 million versus last year. The sequential increase was primarily driven by increased supplies revenue. The year on year increase in operating income was driven by a significant reduction in cost and operating expenses, and lower hardware volume and revenue. These impacts were partially offset by lower supplies revenue.

Other segment consisting primarily of costs related to centralized supply chain, IT, and other operating expenses primarily in G&A was a net cost of $57 million 3Q09 including restructuring related activities. This was $3 million lower than 2Q09 and $19 million lower than 3Q08, both driven by our ongoing cost and expense reduction initiatives.

Operating income margin in 3Q was 2.5%. Excluding the restructuring related expenses operating income was 7.8%, an increase of 120 basis points sequentially and 90 basis points from the third quarter of 2008.

Concerning financing and other operating costs, in the third quarter of '09, the net interest and other costs were an expense of $11 million, up $4 million sequentially and $6 million from the third quarter 2008. The sequential increase was driven by a $3 million charge incurred during 3Q09 due to the write down of an equity investment. The increase versus 3Q08 was principally the result of the reduction of interest income.

Our effective tax rate in 3Q09 was 25%. This was higher than the 18.4% we saw in 2Q09 as we now expect our effective tax rate for 2009 to be approximately 18%, up one percentage point from our prior expectation of 17%. Our estimated effective tax rate for the full year 2009 was impacted by the effect of the restructuring we announced today on today’s expected worldwide taxable income for 2009, as well as our expectation of the mix of our income that will be generated outside the US.

The 3Q09 effective tax rate was above the 18% rate we expect for all of 2009, reflecting the total tax expense that is needed to be reflected in 3Q09 to bring the effective tax rate for the year to date results to the 18% level. As we referenced last year, 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 $10 million. Excluding the $41 million after-tax cost from restructuring related activities, net earnings in 3Q09 were $51 million. 3Q08 net earnings were $37 million or $55 million excluding after tax restructuring related expenses.

GAAP earnings per share for the quarter were $0.13. Excluding restructuring related activities, EPS would have been $0.65 per share. This compares to 3Q08 GAAP earnings per share of $0.42 or $0.63 excluding restructuring related activities.

Now moving to the balance sheet and cash flow items, cash flow from operations for the quarter was $147 million. In the quarter, restructuring related cash outflows were $14 million. Since the end of June, accounts receivable increased $28 million, inventory decreased $32 million, accounts payable increased $63 million, and accrued liabilities increased $24 million.

Third quarter capital spending was $51 million and we are expecting about $37 million in 4Q09 which equates to our full year 2009 expectation of about $235 million capital spending.

Deprecation in the quarter was $52 million and includes $8 million of restructuring related accelerated depreciation.

As we discussed last quarter, an agreement was reached in 1Q09 in which Lexmark participated regarding the copyright fees to be paid in all-in-one devices sold in Germany after 2001. Under the terms of this settlement, Lexmark made a payment of $43 million in 3Q09.

Overall, as expected, we delivered significant working capital improvements during the quarter. Inventory balances and days both improved significantly, consistent with our expectation. Accounts payable, resources of cash in the quarter, as performance continued to remain reasonable and consistent with terms, improved inventory performance through the quarter enabled improved accounts payable performance. Receivables performance in terms of days outstanding remained good in 3Q. Although receivables balances increased in 3Q09, we are comfortable with collections performance through September. We expect to drive continued improvements in working capital performance in 4Q09.

In terms of other items impacting cash flow, pension contributions of $5 million were made in 3Q09 and pension contributions of $2 million are expected for 4Q09.

Cash and marketable securities at the end of 3Q09 was $909 million, up $810 million from the end of 2Q09. Total long-term debt at the end of 3Q09 was $650 million with maturities on the debt in 2013 and 2018. In the third quarter we completed a new three year $300 million revolver with this new facility expiring in 2012. We also completed the annual renewal of our $100 million accounts receivable facility during the quarter.

At quarter end we had $491 million of share repurchase authority outstanding. No shares were repurchased in the quarter.

Now let me move to restructuring. As Paul indicated, as part of Lexmark's ongoing plans to improve the efficiency and effectiveness of all of our operations, the company announced additional restructuring actions today. The company continues its focus on refining its selling and service organization, reducing its general and administrative expenses, consolidating its manufacturing capacity, and enhancing the efficiency of the supply chain infrastructure. The actions taken will reduce cost and expense across the organization with a focus in manufacturing and supply chain, service delivery overhead, marketing and ales support, corporate overhead, and development positions as well as reducing cost through consolidation of facilities through supply chain and manufacturing.

The company expects these actions to be principally complete by the end of the first quarter of 2011. These October 2009 actions are expected to impact about 825 positions worldwide and will result in total pretax charges of approximately $120 million with approximately $55 million to be incurred in 2009 and $65 million 2010 and '11.

The company incurred $33 million in charges related to this restructuring in 3Q09. The company expects the total cash flow of this plan to be approximately $105 million.

Lexmark expects these October 2009 actions to generate savings of approximately $2 million in 2009, $70 million in 2010, and ongoing savings beginning in 2011 of approximately $110 million. These ongoing savings should be split approximately 60% to operating expense and 40% to cost of goods sold. Ongoing cash savings of approximately $105 million are expected beginning in 2011.

In 3Q09, total pretax restructuring and related cost and expenses were $51 million. In 3Q09, restructuring cash outflow was $14 million and savings from our 2007, 2008, and 2009 restructuring actions were $36 million.

In 4Q09, restructuring and relate costs and expenses due to all restructuring actions are expected to be approximately $38 million. Of this amount, approximately $23 million is related to the October 2009 restructuring announced today. Savings in 4Q09 from the 2007, 2008, and 2009 restructurings are expected to be about $39 million.

We continue to aggressively focus on cost reductions both in cost of goods sold and operating expenses. We now expect 2009 operating expense to be down at least $200 million versus 2008. More details regarding restructuring and other costs and savings are available in the supplemental slide deck.

Now for my forward looking comments concerning 4Q09. We expect 4Q09 versus 3Q09 revenue to increase slightly sequentially. For supplies revenue versus 4Q08, we are expecting year on year supplies revenue declines to be about the same rate or improve slightly from what we incurred in 3Q09. In 4Q09 we expect supplies revenue to decline year to year due to lower end user usage and a difficult compare from the significant increase that occurred in 4Q08 in supplies channel inventory that we do not expect to repeat in 4Q09. We expect this decline to be partially offset by improved supplies rice per page.

GAAP EPS is expected to be $0.11-$0.21 in 4Q09. GAAP EPS includes expected restructuring charges of $0.39 per share. Non GAAP EPS, excluding restructuring and related costs and expenses is expected to be $0.50-$0.60. GAAP EPS in the fourth quarter of 2008 was $0.23 per share which includes restructuring charges of $0.52 per share. Non GAAP EPS in 4Q08 was $0.75 per share.

In 4Q08, Lexmark incurred a tax credit, resulting in a negative tax rate for the period. For comparison purposes if in 4Q08 Lexmark had an effective tax rate of 18% as we are projecting for 4Q09, our non GAAP EPS in 4Q08 would have been $0.43 per share. EPS in 4Q09 is expected to be lower than 3Q09 primarily due to the sequential growth in hardware sales which is a headwind on sequential growth margins, but important for future supplies generating which is the profit and cash generation engine of our business.

All of the comparisons that follow include the impact of restructuring. In the fourth quarter we expect growth profit margin percentage to be down versus the 33.9% we achieved in 3Q09. Operating expense is expected to be about flat from the $250 million incurred in 3Q09, but down significantly from 3Q08. Operating income margin in the fourth quarter is expected to be below the 7.8% achieved in the third quarter of 2009.

For 4Q09 we expect our ongoing effective tax rate to be about 18% before any discrete items. We project full year 2009 capital spending to be approximately $235 million and we expect full year depreciation to be approximately $210 million which includes $49 million impact of accelerated depreciation related to facility closures.

The guidance provided is based on foreign exchange rates as of 9/30/09. Based on these rates, foreign exchange is expected to have a benefit on 4Q09 revenue versus 3Q09 of approximately 1% and a benefit versus 4Q08 of approximately 5%.

Now, before opening the call up for your questions I would like to point out that our financial position remains strong, the execution on cost and expense reductions has been solid and we now expect 2009 operating expense to be more than $200 million below 2008 levels. We delivered strong cash generation performance in 3Q. We continue to have as solid balance sheet and good liquidity with $909 million in cash and current marketable securities at quarter end.

In the third quarter we completed a new three year $300 million revolver and completed the annual renewal of our $100 million AR facility. Our strong financial structure continues to position us well to deliver innovative products and compete effectively, even during challenging times. With that we'll go ahead and open it up for questions.

Question-and-Answer Session

Operator

Thank you. The floor is now open for questions. (Operator's Instructions) Your first question is coming from the line of Bill Shope of Credit Suisse.

Bill Shope – Credit Suisse

Okay, great. Thanks, guys. Can you comment on the supply chain and channel inventory dynamics from the recent inkjet refresh and how it may have impacted the quarter? And longer term, can you give us a sense on hardware profitability in light of the higher relative ASPs for the new products. And I understand this may be a qualitative answer.

Paul J. Curlander

As we look at the supply chain inventory dynamics, I would say that there really was not much impact of the changeover in inkjet. Basically as we look at our business, the sellout is about the same as our sell in, and we are not really seeing any inventory dynamics or impact relative to our revenue.

In terms of hardware profitability, clearly when you look at office superstores versus say a mass channel, it is more expensive to move hardware through there, and the issue though really is around pages. We get a significantly greater number of pages off the hardware sold through OSS. So as we look at total lifetime profitability, what we see is a much better result. So I think the way to think about hardware, clearly as you move between channels you see an impact, but long term we think it is going to be an overall benefit, and this is what we are counting on to really transition the supplies long term for the business.

Bill Shope – Credit Suisse

And then a similar question on the supplies side. Can you discuss the profit trends within laser and inkjet supplies for the quarter and how did currency impact that in the third quarter?

Paul J. Curlander

Well, as we take a look at supplies we saw improved performance in both divisions. Bulk laser inkjet supplies were still down year to year, but certainly better than what we had seen in the second quarter, and as John pointed out, the improvement really came in terms of sellout pages, which is good news to us.

From a currency perspective there has been a lot of dynamics over the last 12 months. Clearly we did a lot of price increases on harmonization, and we also did price increases separate from harmonization. On the inkjet side we have seen those price increases come through. On the laser side we have had much more of an issue because a significant percentage of the lasers are covered by contracts and are locked in at local currency prices. So we are seeing much less of any price increases come through and much less of the harmonization come through. Now, as currency has started to move back with the weaker dollar, we have seen some help from that. So certainly we got that in the third quarter, but still overall as I look at laser supplies, the overall currency price change, still a negative drag on a year to year basis in third quarter.

Operator

Thank you. Your next question comes from the line of Shannon Cross of Cross Research.

Shannon Cross – Cross Research

Hi, thank you. Just a followup on the supplies commentary you just made, can you talk a little bit more on what you're saying in terms of end user demand? It sounds like things are getting a little better, so I'm curious as to the inkjet side versus the laser side, any comments you have gotten from customers, the things you have seen on maybe some of your managed print services contracts where you have more of an idea on page volume, and then again what you saw in terms of inkjet in the channel with the new product launch. I would assume you have some cartridges out there in the channel.

Paul J. Curlander

Yeah, Shannon, I think you are on the key point. Relative supplies in the quarter were a good news story. We saw improvement in end user demand, we saw improvement in sellout pages on a year to year basis. It was above expectations and so clearly we feel pretty good that these were all good signs in terms of customer demand.

As we look at inkjet versus laser we saw improvements in both inkjet and laser in terms of less decline on a year to year basis in sellout pages, and again, both were greater than our expectation. I think that as we look at overall usage, currently usage has been impacted by the economic downturn. We have seen it probably more on the business side, I think, than on the inkjet side. In NPS contracts we continue to see a usage impact on a year to year basis. I would say a we looked in third quarter, probably less than what we had seen say in the first half so that is another good sign, but it is still down on a year to year basis, but the good news it looks like it's certainly got better in the third quarter.

Shannon Cross – Cross Research

Can you give a little more detail on the channel flow that you saw in the fourth quarter of last year and how we should sort of think about that from a magnitude basis?

Paul J. Curlander

Yeah. I think that if you look year to year, we saw a significant increase in channel inventory in the fourth quarter last year and that was due primarily to slowdown and sellout, but also due to buy ahead based on the price increases that were down the quarter internationally. The magnitude of that is that it’s basically bigger than the currency hop that you now see on a year to year basis as you project into the fourth quarter. So you roll those together and there is a significant offset of that channel inventory build, but still, channel inventory build probably is a little bit bigger factor perhaps than the currency on a year to year basis.

So what we are really seeing coming through on the laser side year to year in fourth quarter is the decline in usage that we are seeing with the customers. On the inkjet side it is a decline in usage primarily driven by the transition that we are doing in inkjet, but also some economic factor.

Operator

Thank you. Your next question comes from the line of David Bailey of Goldman Sachs.

David Bailey – Goldman Sachs

Great. Thank you very much and good morning. Could you help us understand what triggered another round of restructuring at this point, given that you saw the year over year declines lessen in Q3?

Paul J. Curlander

Well, I think it's a couple of things. First of all, we feel very encouraged by the pickup in demand that we saw in the third quarter and so we view that as certainly a very positive trend. That said, overall our revenue is still down 15% year to year. We see a lot of competitive pressure in pricing. As John had indicated, pricing on a year to year basis on a sequential basis in inkjet is certainly out there, and we continue to see our competition taking aggressive cost and expense actions.

So we're focused on continuing to improve the efficiency of our processes, of our support structure. We think there is opportunity and we’re going to go ahead and do it so that's a net. And as we indicated, our focus is to make Lexmark stronger, which we think we're getting stronger certainly in terms of getting our operating expense levels down, in terms of the improving cash flow that we are seeing, certainly in terms of the product set we're much stronger than where we were 12 months ago, but we want to get even leaner so that is the focus that we're on.

David Bailey – Goldman Sachs

And just to followup on that can you give a little bit more detail? Are you seeing actually incrementally aggressive pricing on the inkjet side and then what are you seeing on the laser side?

Paul J. Curlander

On laser as we went from 2Q to 3Q I think that probably the good news there was certainly the improvement in hardware margins. Some of that is in terms for the mix that we saw as we went between the quarters, but the other is cost improvements that we're getting in the product line.

On the inkjet line, as John had pointed out, as we went sequentially the mix improved significantly so that was good news, but a lot of that was offset in AUR relative to pricing declines that we saw in the market. And as we look at the inkjet market, it continues to be very competitive.

Operator

Thank you. Your next question comes from the line of Tony Sacconaghi of Sanford Bernstein.

Tony Sacconaghi – Sanford Bernstein

Yes, thank you. Paul, I'm sorry to revisit this once again, but in terms of your supplies growth expectation on a year over year basis for the fourth quarter, I think you are calling for a roughly in line or a little bit better to this quarter. Your comparison is 11 points easier and the benefit of currency should be about five points stronger. So just optically it actually feels like supplies should be better than your outlook, particularly if you believe there were really no changes in channel inventory and that end demand may be picking up. So I know you tried to address some of this in previous questions, but can you help address those specifics?

John Morgan

Yeah. Let's go through it again because I think it's an important point and clearly we've spent a lot of time over this internally looking at supplies. As we look year to year there's really three factors going on. The first factor is that there is a decline in usage from where we were in the third quarter of 2008. As we came into the economic downturn we saw an impact on usage, but then we saw another impact in the first quarter and then another impact in the second quarter. So as we look year to year there has been a decline and that is still there, and we are still projecting that to be there in the fourth quarter of 2009.

Second thing is we have significant channel inventory build in the fourth quarter of 2008. Sot his is hurting year to year comparisons on supplies because sell in, in fourth quarter 2008, which wasn't great because of the slowdown in sellout, but it certainly benefited from the cannel inventory build. That's a significant factor that's there. Now those two significant negatives are being partially offset by the currency on a year to year basis and some of the price increase coming through that we've done.

So when we roll those together, our conclusion is looking at that is that we expect the year to year change in supplies to be about the same as what we saw in the third quarter, about that 12% decline, perhaps slightly better than that.

Now let me talk about sequentially because we have looked hard at sequentially as well and one of the things that I think is a little different in the fourth quarter projection is we're not expecting a significant sequential uplift in supplies versus what we perhaps have seen in prior years. Obviously we didn't see it in 2008 from 3Q to 4Q, but if you go back to 2007 and earlier, we did see sequential uplifts in supplies.

I think there's a couple of factors here that are also playing on the fourth quarter supplies. First of all, as we look at 2009, we have never seen a year where we've had such significant hardware declines on a year to year basis for each of the first three quarters, lasers and inkjets. And when we roll that into the model, the model projects really very little sequential uplift compared to what we've seen in prior years so that's certainly a factor.

Secondly, we had a good sequential uplift in supplies in third quarter which is highly unusual. In fact, in general our supplies decline second quarter and third quarter. So as we look at the third quarters supply numbers we wouldn’t really expect as big an increase third quarter and fourth quarter because it was already pretty good. So if you'd ask me three months ago, a slight sequential increase in supplies third quarter to fourth quarter which is what we’re projecting, we would've thought that's very good versus what we were thinking at that point in time. So I think that has a little bit of a difference in terms of that impact sequentially.

The last thing is, and this one's a little bit harder for us internally to quantify is we did not see an increase in channel inventory. Channel inventory is about flat sequentially, but we do know that beyond this year of channel inventory that we track, that over the last certainly three quarters we've seen shrinkage in second-tier channel inventory and pantry stock of customers, and it's possible that some of this improvement in sellout did go into this unreported inventory that's out beyond the first tier which could possibly shrink in the fourth quarter.

So we though tit prudent to project the supplies as we did, but it really is all these factors that are combined for the guidance that we've given.

Tony Sacconaghi – Sanford Bernstein

Thank you for that clarification. And then on R&D spending, you had mentioned that R&D spending was down in the quarter because of fewer new product launches. Is there opportunity for R&D to decline outside of the restructuring announced today given that it's dramatically higher as a percentage of revenue relative to history? So beyond what you announced today which or may not include some reductions to R&D programs, but could R&D spending go down given that you're coming off a period of probably your highest new product introduction intensity in history?

Paul J. Curlander

Well, let me say this in general about operating expense. We have not given any guidance yet for 2010 operating expense, but our thought is that overall operating expense will be down in 2010 and certainly this restructuring will help drive that.

In terms of R&D, we've ramped up R&D, essentially all on the laser side over the last four or five years. We did that to drive the expansion of the product line and in terms of where we were trying to get to in terms of the segments covered, we're just about there. I mean, there's a couple of things we still would like, but we're just about there. And what our focus is now is to drive the efficiency and productivity of research and development. So we don't want to back away from the product segments that we're covering because that takes ongoing investment, but we want to continue to improve the efficiency and productivity.

So what you see this year in terms of declines in R&D is primarily two factors. First factor is that push for more efficiency and we see some of that coming through. And also, John just made an accurate statement which is there are fewer laser announcements this year than what we did last year. We still just introduced 10 new laser models in the quarter, but it is less than last year and so that also is a factor.

But the real factor as we go forward is we're going to be trying to drive efficiency in our processes, we are going to be trying to drive efficiency in how we utilize our international R&D locations versus our domestic R&D locations. We're protecting R&D in terms of the overall restructuring relative to insuring we can continue to cover and drive segments that we are now in and can have the best products. But the reality is we are looking to get more efficient there and improve that as we go forward in time. And that is a little bit of what you see in this restructuring that we just announced.

Operator

Your next question is coming from the line of Bill Fearnley of FTN Equity Capital Markets Corp.

Bill Fearnley - FTN Equity Capital Markets Corp.

Good afternoon. A question for Paul, if I could on the March 2009 channel initiatives. How are they going and what's been your biggest success and biggest disappointment so far and will it cost you more for the next few quarters as the overall market remains weak and our research suggests competition gets more aggressive here? And then a follow-up, would be do you want to get back into the larger CE chain in the US in 2010? Do you want to and do you think you might get there?

Paul J. Curlander

Okay. Well, relative to the office superstore expansion, things continue to progress well there. Honestly, we're seeing a strong year to year growth. I think there's two factors with that. One is we've dramatically improved our shelf space and our products that go into that shelf space so it all starts with the products and the products are much stronger now than they were a year ago, but also the shelf space is much stronger. So both of those things are contributing and I think in terms of what we had hoped to accomplish with office superstore, we've made a big step here in 2009 with that.

I think in terms of you say what could have gone better — I think that is really kind of your second question around consumer electronics. Obviously consumer electronics landscape changed back in January of 2009 when Circuit City went bankrupt, but I think that clearly we'd like to be in the largest consumer electronics chain. We'd like to be in Best Buy. I would remind investors that Best Buy continues to sell Lexmark supplies. We continue to be well represented on the Best Buy website and they sell both our hardware and supplies on their website and we continue to cover them from a sales perspective and we hope at some point in time that we will have the opportunity to be back on the retail shelf. Obviously we can't project that because it's not our decision to make, but we continue to focus on that and that's something that we'd like to have.

Operator

Thank you. Your next question is coming form the line of Mark Moskowitz of JP Morgan.

Mark Moskowitz – JP Morgan

Thank you. Good morning. I want to talk a little more about the near-term improvements in terms of the customer adoption. Can you talk a little about how much of the incremental improvements have been because of pantry fill with existing business at your customers versus maybe incremental penetrating within your customers? Are you winning a new department or new locations?

And the follow-up to David's question earlier on restructuring, should we think about today's announcement as more of a buffer to margins or is it going to be something where you actually try to drive margin expansion?

Paul J. Curlander

Well, let me talk to the first part and I'll ask John to make a comment on the second part. Mark, as you talk about pantry fill, are you focused on supplies or hardware here?

Mark Moskowitz – JP Morgan

I'm talking about both.

Paul J. Curlander

Okay. We'll talk about both. In terms of supplies, we had a better than expected sellout of our supplies to sell out of the channel. We have no data. We have no indication that this went into pantry fill or anything else other than consumption by the customer. I commented on that in regards to Tony's question as that's a possibility, but we have no data on that. So our belief is that we did see a fundamental pickup in customer consumption in the third quarter and we think that from a supplies perspective that's pretty positive.

In terms of hardware, we continue to focus on new accounts and continue to focus on further penetration of the existing accounts. I think that although the hardware is down on a year to year basis, our management services business is up strongly. It was up strongly in the third quarter and it's been up every quarter this year, a lot of that driven by the US. Although in the third quarter, all of our geographies were up in management services.

So this in general is incremental hardware for us. Typically it is new accounts. I referenced one new account that's given us permission to use their name, Kingfisher, one of the major retailers in Europe, was a big management services win for us which we announced this last quarter. So we continue to get new accounts, but we continue to work very hard to expand penetration in existing accounts. And so we’re seeing both of those things right now and so we're seeing a lot of activity. Obviously on a year to year basis hardware is still down, but we saw an improvement in terms of second quarter year to year to third quarter year to year and we're hopeful as we go into the fourth quarter and we're projecting a sequential increase in our hardware as we go into the fourth quarter.

John Morgan

In terms of the impact of the restructuring, as Paul said, it's an ongoing activity to improve the efficiency of the business and drive out cost and expense, and so as he indicated, we expect our operating expense to be down next year. But in terms of specific margin levels, there's a lot of things that go into margins and so we're not going to forecast margins for next year, but we certainly can indicate we are continuing to drive cost and expense out of the business and we do expect OpEx to be down next year.

Operator

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

Ben Reitzes – Barclays Capital

Well, along the lines of one of the previous questions there, you were challenged about the ink cartridge sequential growth. In '05 to '07 you also grew hardware sequentially on average about 10%. I know you just mentioned in the last question that you expect sequential growth in hardware, but if you back into your guidance, it looks like only slight sequential growth in hardware. Could you just give an answer like you gave earlier on supplies, why you only expect a slight sequential growth in hardware sequentially? It would seem you still have channel fill of the new products. Maybe those products are sold on consignment so you still need to see a lot of sell through on the ink side?

And in typical years you usually were up 10% in hardware sequentially. So if you could that for hardware, that would be great. Thanks, Paul.

Paul J. Curlander

Well, I think relative to hardware we do expect sequential growth in hardware. I think the issue as we go into the fourth quarter is two things. First, we are seeing the building momentum hopefully around our inkjet products and so we're expecting good sequential growth there on the laser side.

US has been stable in the last couple of quarters, but the pickup internationally was also good to see in the third quarter so we're hopeful there on the laser side as well. So within the guidance, clearly we are expecting hardware to be much more sequential improvement than what we’re talking about in supplies.

Ben Reitzes – Barclays Capital

Okay. And then secondarily, your inventory has been declining in the last couple of quarters more than I would have thought. Perhaps that has been a hit to margin. Do you see your owned inventory flattening out and is there a positive effect on margins as a result in the future rolling into the fourth quarter and next year, John?

John Morgan

So I think as we look at owned inventory in the near term, I think we expect to continue to improve days. It may not necessarily result in lower dollar levels, but we certainly expect to improve days and so I think the trend that you've seen recently in terms of improved performance is going to continue.

Operator

Thank you. Your next question is coming from the line of Kathryn Huberty of Morgan Stanley.

Kathryn Huberty – Morgan Stanley

Thanks, good morning. Paul, we've seen retailers and distributors bring down inventory levels pretty aggressively, especially in printers this year. Now demand is coming in better than expected. Lexmark is taking market share in lasers and presumably in inkjet as we go into the next couple of quarters. Why wouldn't we see the channel start to bring up absolute inventory levels if not in December going into next year?

Paul J. Curlander

Okay. I think that’s possible that we may well see that. Clearly we've seen a lot of shrinkage, particularly in the retail side as we've gone through the year. I think the retailers probably are not yet ready to make that bet that they're going to see so much pickup in demand, but we're thinking that in terms of Lexmark uniquely, we think that there will be pickup in demand as we put our stronger products into the shelf space that we've now secured from a retail perspective. The market overall may be a little bit more of a question from that perspective in the retailer’s mind. We don't know, but clearly I think if you have a good fourth quarter they're going to have to go up in inventory.

Kathryn Huberty – Morgan Stanley

Okay, thanks.

Operator

Thank you. Your next question is coming from the line of Ananda Baruah of Brean, Murray, Carret & Co.

Ananda Baruah – Brean, Murray, Carret & Co.

Hey. Thanks, guys. Another question around the restructuring. I guess your OpEx dollar levels look like this year now will be more or less 240 to 250 fourth quarter, so is it right to think of these dollar levels as kind of the new base OpEx level? And then just trying to think in the context of the restructuring, I get that you're trying to drive efficiencies throughout the supply chain and throughout your manufacturing processes, but is that an attempt to get ahead of what you think is going to happen with revenue or is this kind of the new base OpEx level and that is truly just to drive efficiencies kind of at the new base level?

Paul J. Curlander

Well, let me say a word about efficiencies and maybe John could comment on the OpEx levels. I think that from our perspective, we've taken the approach throughout 2009 that we're not going to count on revenue coming back in terms of determining where we need to take our cost levels and our operating expense levels. So we've been focused on how do we go do that? And as we do that we've been protecting our ability on sales coverage. So we want to keep the coverage that we have, we want to protect our ability on developing products, and what we want to work on is our overhead on our infrastructure be it supply chain or geographic sales support or corporate overhead. These are the things that we want to take expense and cost out of.

So we're protecting our ability to go grow the company and drive future growth, but we're focused intensely on how we get more effective and efficient. So we haven't stopped just because we see some pickup here in the third quarter and our view is we hope that we see continued pickup and certainly we're expecting it in terms of hardware as we go into the fourth quarter. But we're going to go and take the structure out because we think it's dictated in terms of the competitive pressure that's out there in the market as well as actions that we do see by our competitors in terms of improving their infrastructure. So that's where we're focused. Maybe John can comment on OpEx?

John Morgan

Well, the OpEx levels you quoted for the last couple of quarters are correct and we gave guidance for the fourth quarter and in terms of orderly levels, we're operating at about the levels you indicated currently. In terms of going forward, all I'm going to specifically is we do expect it to go down. There is other factors that certainly could result in some increases in specific areas of OpEx, but overall we're managing to try to manage the total OpEx spending down and that's the focus of the company.

In terms of these reductions we're executing to, if you take a look at what we've done over the past several years, it's very consistent with the things we've been doing for quite some time. We're going to continue to try to make the operations we listed here more efficient and more cost effective. So we're continuing to work on this. It's an ongoing exercise and it's going to continue now and it's going to continue into the future. So we're continuing to try to become more and more efficient with our operating expense.

Operator

Thank you. With that I would like to turn it back over to Paul Curlander, Lexmark's Chairman and CEO for closing remarks. Please go ahead, Paul.

Paul J. Curlander

Thank you. In closing I'd like to briefly recap what we've discussed today. Stronger than expected customer demand resulted in good sequential growth for Lexmark, exceeding our expectations for both revenue and profit in the quarter. Both divisions exceeded expectations and geographically all regions improved sequentially in revenue and profit. Overall we are encouraged by the improved customer demand that we saw during the third quarter and the ongoing improvements that we are driving in the fundamentals of our business including the significant refresh and upgrades in our laser and inkjet product line over the last 12 months, the share gain and our key focus segments of Workgroup Laser and Business Inkjet, the ongoing cost and expense reductions and the new cost expense actions we have announced today, the strong sequential improvements of the last two quarters in our cash generation, and despite our expense reductions we continue to invest significantly in our core print technology and product development and are driving a strong pipeline of future Lexmark products.

While it could be a long recovery for the overall printer market to return to its prior levels, we do believe that we are making Lexmark into a leaner and stronger competitor, improving our products and services offerings and our competitive position. And with that I'll turn it back over to the operator to close out the call.

Operator

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

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