Lexmark International Q3 2006 Earnings Call Transcript

Lexmark International Inc (LXK)
Q3 2006 Earnings Call
October 24, 2006 8:30 am ET

Executives:

John Morgan – Director, Investor Relations
Paul Curlander – Chairman and Chief Executive Officer
John Gamble – Chief Financial Officer and Executive Vice President

Analysts:

Laura Conigliaro – Goldman Sachs
Toni Sacconaghi – Sanford Bernstein
Ben Reitzes – UBS
Richard Gardner – Citigroup
Richard Farmer – Merrill Lynch
Shannon Cross – Cross Research
Keith Bachman – Bank of America Securities
Katie Huberty – Morgan Stanley
Bill Shope – JP Morgan
Bill Hand – Bear Stearns
Bill Fearnley – FTN Midwest Research
Jesse Tortora – Prudential Equity Group
Chris Whitmore – Deutsche Bank

Presentation

Operator

Welcome to the Lexmark International Q3 2006 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 – Director, Investor Relations

Good morning, and thank you for joining us today. Before we get started, I just want to remind everyone that we will be holding our 2006 analysts day briefing in the Board Room of the New York Stock Exchange on Thursday, November 9. For more information, please visit the Upcoming Events section of our Investor Relations Website located at http://investor.lexmark.com. Currently in the upper right-hand corner of the Website, you can access today's earnings release, as well as the supplemental information slides for Q3. Now, with me today for Lexmark's Q3 2006 earnings conference call, are Lexmark's Chairman and CEO, Paul Curlander; and Lexmark's Executive Vice President and CFO, John Gamble.

After their opening remarks, we will open the call for your questions as time permits. Due to time constraints and increasing participation during this portion of the call, we ask that you please limit yourself to one question and if needed, one follow-up. Following the conclusion of this conference call, a complete replay will be made available from our investor relations website. 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. Lexmark undertakes no obligation to update any forward-looking statements. With that, I'll turn it over to Paul.

Paul Curlander – Chairman and Chief Executive Officer

Thank you, John. Well, today we're announcing our Q3 results and all things considered, this was a good quarter for Lexmark. Highlights for the quarter include results that exceeded our expectations, particularly in operating income and earnings per share growth, revenue grew for the first time this year. We had strong branded unit growth in our key focus segments of low end monolaser, color laser, laser all-in-ones and inkjet all-in-ones. We continue to generate solid cash flow and we continue to make progress on our core strategic initiatives, particularly around new product introductions and investment in brand development.

Q3 revenue was $1.235 billion, up about 2% year to year. Supplies revenue for the quarter was up 6% year to year and at the high end of our guidance range. Hardware revenue for the quarter was down 3% year to year, as a decline in inkjet unit shipments, driven mainly by our previous decision to exit low profitability inkjet business, was partially offset by growth in laser units. Earnings per share of $0.85 significantly exceeded our expectations. On an operational basis, excluding the $0.10 per share of restructuring related charges, earnings per share would have been $0.95.

EPS exceeded our guidance principally due to better than expected hardware margins. I would also point out that excluding restructuring, operating income grew 40% year to year. We continue to generate good cash flow in the quarter, with net cash from operating activities of $167 million and that makes $528 million YTD. Now, let's talk a little bit more about supplies. For the quarter, supplies revenue was up 6% year to year, with laser supplies growth somewhat greater than this and inkjet supplies growth somewhat less than this. Our estimates are that more than 50% of this 6% growth is attributable to year to year changes in channel inventory. As we look ahead, we see the potential for continued erosion in inkjet and user demand, due to the weak OEM sales we're experiencing and the reduction in inkjet volumes due to the actions announced in January to discontinue low profit inkjet sales.

Our current expectation is for Q4 2006 year to year supplies revenue to be flat to up in the low single digit range. In the consumer market in Q3, revenue was $539 million, down 5% year to year. Consumer segment operating income was $62 million. Now, excluding restructuring related charges, consumer segment operating income in Q3 would have been $67 million, up 99% year to year. Now for the quarter, inkjet unit shipments declined 19% year to year, with growth in inkjet all-in-ones more than offset by declines in single function printer sales. However, branded inkjet unit sales in Q3 were down much less than 19% year to year, indicating strong branded unit growth in our targeted segment of inkjet all-in-ones.

In the business market segment, Q3 revenue was $696 million, up 8% year to year. Business segment operating income was $147 million. Excluding restructuring related charges, the business segment operating would have been $153 million, up 6% year to year. In Q3, laser unit shipments were up 8% year to year, with strong growth in our branded unit sales being partially offset by declines in OEM unit sales. Branded unit sales were driven by strong growth in branded color lasers, laser all-in-ones, and low end monolaser printers.

Now, we're also making progress on our core strategic initiatives in both the product segment expansion and brand development. Now, on the product side we continue to announce new products that strengthen our position in our targeted growth segments. In inkjet during Q3 we announced the Lexmark X4570, which is a strongly positioned entry 4-in-1 product priced at $99. Inkjet 4-in-1's are an important growth segment for us. We've been seeing good growth in our 4-in-1 sales this year and we believe the X5470 will be a strong addition to the line and will help to us continue this momentum.

Earlier in the quarter, we announced our C770 family of work group color laser printers, including the X772e color MFP. Yesterday, we introduced our new C530 family of color laser printers, which offer the fastest rated color speed under $500 and the best color price performance in their class. In fact, one of the models in this new family, our C534dn color laser has just received PC Magazine's Editor's Choice Award in this category.

We also announced yesterday our new E series of low end and midrange monolaser printers, featuring new and innovative technology, incorporating more than 40 new patents and patent applications and delivering improved speed, reliability, energy efficiency, and one of the quietest laser products in the industry. Most importantly, we continue to garner recognition for our products and programs from channel partners, the technical press and testing laboratories. For example, of our business, a leading channel publication yesterday named the Lexmark X644e laser all-in-one as its 2006 Tech Innovative Product of the Year In the Printing and Imaging Category based on voting by channel partners and editors of the publication. In addition, Lexmark was named Runner-Up for 2006 Innovative Company of the Year, finishing second only to IBM among 300 other technology companies.

During the quarter, we launched the next step in our brand development initiative, with the start of a new television advertising campaign, along with radio, print and outdoor advertising in targeted geographic and market segments. This integrated campaign highlights Lexmark's deep and proven experience in helping enterprise customers to be more productive, while highlighting the opportunity for small and medium businesses and consumers to benefit from our business class expertise. And while we're just getting started with this new campaign, the initial feedback from our retail and channel partners has been excellent.

As we look forward to Q4 2006, we expect revenue to be flat to down in the low single digit range year to year. We expect Q4 EPS to be in the range of $0.80 to $0.90, excluding the impact of restructuring related charges. As we look to the longer-term, the distributed output market presents a number of attractive growth opportunities, such as low end monolasers, color lasers, laser all-in-ones, inkjet three-in-ones and inkjet four-in-ones, where we are currently underrepresented. With our increasing investment in R&D and our focus on building Lexmark's brand we continue to strengthen our competitive position and improve our ability to pursue these growth opportunities. This, coupled with the steps we're taking to focus on more profitable opportunities in inkjet and to restructure our operations, makes us optimistic about the future. Lexmark's financial position continues to be strong.

In Q3, again, we generated solid cash flow and we ended the quarter with over $0.5 billion in cash and marketable securities on the balance sheet. Year to date, we have returned nearly $0.75 billion to shareholders by repurchasing approximately 14 million Lexmark shares. Now, with that, I'll turn it over to John Gamble for his more detailed remarks on our financials.

John Gamble – Chief Financial Officer and Executive Vice President

Consistent with previous calls, I'll first discuss our results of Q3 relative to the prior year, then relative to Q2 2006. 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 Q4. I will call out the impact of restructuring as we walk through the P&L. In the supplemental slide deck posted on our Investor Relations Website, we have included quarterly details on the income statement line items impacted by the restructuring. Also included in the supplemental slide deck, we have included quarterly details on the income statement line items impacted by SFAS 123R stock-based compensation expense, which amounted to approximately $10 million in Q3. In addition, we have included information on YTD performance.

Let me start with the P&L. Total revenue for the quarter was $1.235 billion, up about 2% from last year, about flat sequentially from Q2 and grew more than the guidance that we provided in July. Geographically for Q3, U.S. revenue of $563 million declined about 2% year to year. Revenue in EMEA of $418 million was up about 5% year to year. The remaining geographies were up about 3% versus a year ago. Laser and inkjet printer revenue in Q3 was down 3% from 2005.

As Paul indicated earlier, inkjet hardware shipments declined 19% and laser unit shipments were up 8% year to year in Q3. Inkjet hardware average unit revenue increased approximately 4% year to year, as price declines were offset by a mix shift to AIO's. Laser average unit revenue declined approximately 1% year to year, as price declines were mostly offset by a mix shift to more color lasers and laser all-in-ones. Laser and inkjet supplies revenue in Q3 were up 6% from 2005, with this growth principally driven by growth in laser supplies. Last year in Q3 2005, we experienced lower than expected supply sales, partially reflecting a contraction of channel inventory, impacting both the inkjet and laser businesses.

This channel inventory dynamic did not occur again in Q3 2006 and as such, supplies revenue growth rates in Q3 2006 are higher than end user demand and higher than we have seen in the nine months of 2006. We believe more than 50% of the growth we saw in supplies revenue in Q3 2006 was due to this channel inventory dynamic. Business segment revenue for the quarter of $696 million was up 8% from 2005, but down 2% sequentially. The increase from last year is due to increases in both laser supplies and laser hardware revenue. The sequential decline from Q2 2006 was driven mainly by lower supplies revenue, which has been the typical seasonal pattern.

Consumer segment revenue for the quarter was $539 million, down 5% compared to a year ago but up 4% sequentially. The YoverY decline was due to a decline in inkjet hardware revenue. The sequential increase was primarily driven by higher inkjet hardware revenue. Gross profit margin for Q3 was 32.6%. Excluding the impact of $4 million of restructuring related costs, gross profit was 32.9%, up 350 basis points from 2005 and down 240bps sequentially. The 350 basis point improvement versus last year is principally due to a 340 basis point favorable product mix shift, driven by a decline in inkjet hardware and an increase in laser supplies revenue. The 240 basis point sequential decline was driven by increased inkjet hardware sales and also from the overall increase of the combined lower cost or market and advanced purchase equipment accrual.

Cost of sales included $1 million of FAS 123R stock-based compensation expense in the quarter. Operating expense for the quarter was $287 million. Restructuring related expense of $9 million impacted operating expense this quarter, with $9 million also impacting last year's Q3. Excluding these impacts, operating expense was $278 million, an increase of $12 million year to year. SG&A was $184 million, an increase of $6 million from 2005. R&D was $93 million, an increase of $6 million from 2005. This quarter's operating expense also included $9 million of FAS 123R stock-based compensation expense, with $7 million and $2 million impacting SG&A and R&D expense respectively. Excluding the impact of FAS 123R expenses, operating expense increased by $3 million due to increased investment in R&D.

Sequentially, operating expense, excluding restructuring-related costs and curtailment gains, was approximately flat versus Q2. The operating expense to revenue ratio in Q3 was 23.3%. Excluding the restructuring-related costs, the operating expense to revenue ratio was 22.5%, an increase of 60bps from 2005 and primarily flat sequentially. The 60 basis point increase from prior year was driven by FAS 123R expenses and increased R&D investment. Operating income was $115 million. Excluding the restructuring related expenses of $13 million, operating income was $128 million, up $37 million from last year and down $28 million sequentially.

Compared to 2005, excluding restructuring related activities, the business segment operating income of $153 million was up $9 million versus last year and down $10 million sequentially. The consumer segment, again, excluding restructuring expenses, had operating income of $67 million, up $33 million versus last year, but down $21 million sequentially. Please note all FAS 123R expense of $10 million is recorded in other expenses and does not impact business or consumer segment reported results. Other expenses, consisting primarily of costs related to centralized supply chain, IT and other operating expenses, primarily G&A, were $91 million, an increase of $6 million from 2005 and a decrease of $2 million sequentially.

Operating income margin was 9.3%. Excluding the restructuring expenses, our operating income margin was 10.4%, an improvement of 290bps from Q3 2005 and a decline of 240bps sequentially. Concerning financing and non-operating costs, the interest and other was a net income of $4 million, a decline of approximately $1 million from 2005 and about flat sequentially from Q2. The tax rate for Q3 was 28%, lower than the 31% rate we had forecast. This primarily reflects the lowering of our full year 2006 expected effective tax rate by one percentage point to just over 30%. This reduction reflects changes in the expected geographic distribution in our mix of both operating income and restructuring expenses. The change in full year rate resulted in a $2 million, or $0.02 per share benefit in Q3 2006.

You may remember that Q3 2005 also had a benefit of approximately $5 million, or $0.04 per share from a similar change in the expected 2005 full year effective tax rate. As a Company, we continue to expect that the U.S. research and experimentation credit will be extended retroactively and will apply in full to 2006. If this occurs, we expect a tax benefit in Q4 of approximately $6 to $8 million. This would lower our effective tax rate for the year by approximately 1.5 percentage points. As this has not yet occurred, our full year tax rate, without these R&E credits, is expected to be slightly over 30%, as I indicated earlier.

Net income for the quarter was $86 million, up $15 million from last year. Excluding after-tax restructuring related costs, net income in Q3 2006 was $95 million. Q3 2005 net income, excluding restructuring related expenses, was $77 million. GAAP earnings per share for the quarter were $0.85. Excluding restructuring related expenses, Q3 2006 EPS was $0.95, significantly stronger than the $0.65 to $0.75 range we'd indicated in the last earnings call. Our much stronger than expected earnings were due to many positive factors in the quarter, but were primarily driven by better than expected hardware margins.

The component shortage issue that we discussed with you over the last few quarters is resolved, with a net cost to Lexmark in Q3 2006 of about $7 million, or $0.05 per share. This amount is included in both our GAAP and non-GAAP results. Again, this was made up primarily of the incremental air freight to expedite product delivery.

Now moving to the balance sheet and cash flow items. Cash flow from operations for the quarter was $167 million, a sequential increase of $25 million, and an increase of $36 million from last year. Accounts receivable increased $10 million from June. Inventory increased $46 million in the quarter, primarily in anticipation of seasonal sales. Accounts payable increased $78 million since the end of June. Accrued liabilities decreased $12 million since the end of June. For the quarter, capital spending was $52 million.

Depreciation was $45 million and currency of the Euro was accounted for at $127 compared to $122 in Q3 2005. Cash and marketable securities at the end of Q3 was $562 million, down slightly since June. In Q3 we repurchased 2.3 million shares for$130 million at an average price of $56. At quarter end we had $601 million of share repurchase authority outstanding. This quarter's repurchases were lower than the $300 million we repurchased in each of the first two quarters of 2006. In the first half, we repurchased stock at a much higher rate than cash generation, using excess cash available on the balance sheet.

As we have indicated, we use excess available cash to repurchase shares and at this point in time, do not intend to add debt to finance share repurchases. Of our $562 million of cash and marketable securities at quarter end, about 2/3 was overseas. The restructuring actions that we announced in January are going according to plan. We still expect the total implementation and related costs to be incurred in 2006 to be approximately $130 million, or $80 million in cash costs. We now expect the $130 million will be incurred such that about $40 million will impact cost of sales and about $90 million will impact operating expense. We anticipate savings to be at least $50 million in 2006. On an ongoing basis in 2007 and beyond, we expect approximately $80 million in annual savings.

In Q3, we incurred $13 million in pretax restructuring costs and related expenses. Approximately, $4 million in cost of sales, with the remaining $9 million impacting operating expenses. This is lower than the $23 million we had forecast but no impact to the full year expectation. Savings in the quarter from restructuring were slightly over the $10 million we had forecast. In Q4, approximately $14 million of pretax restructuring costs will be incurred. Approximately $3 million will be in cost of sales, with the remaining estimated $11 million impacting operating expenses. Q4 savings are estimated to be slightly over $15 million.

Now, for my forward-looking comments concerning 4Q. We expect Q4 revenue to be flat to down in the low single digit range year to year. We expect EPS to be in the range of $0.80 to $0.90 per share, excluding the $0.010 per share impact of the cost of the restructuring-related activity. GAAP EPS, which includes these restructuring expenses, is expected to be $0.70 to $0.80. Including in our guidance is the FAS 123R option expense estimated at $9 million, with $0.06 per share impact. EPS in Q4 2005 was $0.71. We recognized that our 4Q EPS guidance reflects a different sequential pattern than we have seen historically. As we look at 4Q, we expect the usual pattern of increased hardware sales, increased supply sales, and the associated increased operating expense.

What's different in our current outlook, for example, as compared to last year, is that we expect less gross profit dollar growth sequentially due to less benefit from lower APC/LCM accruals. In addition, the sequential increase operating expense is larger than last year, primarily due to the timing of the 2006 media spend. Also there was a $0.02 EPS benefit in Q3 2006 from the adjustment of the YTD tax rate we are not expecting to recur in 4Q. As a result, overall, we expect EPS in 4Q to be $0.80 to $0.90 per share, excluding the cost of restructuring-related activity. In terms of our specific discussion of margin levels, in Q4, we expect the gross profit margin percentage, excluding the impact of the restructuring costs discussed earlier, to be above last year's 28.3% and down sequentially versus the 32.9% we achieved in Q3.

The operating expense to revenue ratio, excluding restructuring related expense in Q4, is expected to be higher than last year's 19.9%. Versus Q3 2006, operating expense to revenue ratio, excluding the restructuring expense, is expected to be lower. Operating income margin in Q4, excluding restructuring related expense, is expected to be up from last year's 8.4%. Versus Q3 2006, operating margin, excluding the cost of restructuring actions, is expected to be down from the 10.4% we achieved this quarter. Despite our strong YTD operating margin, we believe that our operating margin once we have completed our restructuring will be in the range of 8% to 10%. The effective tax rate in 4Q 2006 is expected to equal the expected full year rate of slightly above 30%. Again, this does not reflect any benefit from the potential extension of the U.S. research and experimentation tax credit.

Capital spending for 2006 is expected to be approximately $200 million. And depreciation is expected to be approximately $160 million, excluding $40 million of accelerated depreciation related to restructuring. For the full year, we still expect the pretax impact of FAS 123R to be approximately $39 million. In closing, while we have more work ahead, Lexmark's financial position and cash flow remain strong, allowing us to continue to invest in strengthening our competitive position and drive our long-term success. With that, will go ahead and open it up for questions.

Questions-and-Answer Session

Operator

Operator instructions. Your first question is coming from Laura Conigliaro - Goldman Sachs.

Q - Laura Conigliaro - Goldman Sachs

Maybe you can start off by giving us some of your views on the stock. Because you're now at 100 million shares flat and doesn't that really limit your options for buybacks? You said last quarter that you had looked at the liquidity. You felt very comfortable with the liquidity. Can you tell us what your latest observations are on that?

A – John Gamble

It's John Gamble. We continue to look at the liquidity. We look at it ourselves, we also speak with advisors. And to date, we don't see an impact in liquidity and don't believe we're in a situation where a lower share count is currently an issue. Obviously, if it started to become one, we would have to do something about that. But at this point in time we don't think there's an issue.

Q - Laura Conigliaro - Goldman Sachs

Does that mean that you would still continue your buybacks?

A – John Gamble

Well, we don't forecast whether we're going to continue to buy back or not. But in terms of whether or not at the current levels liquidity would impede us being able to do that, I think the answer is no.

Operator

Your next question comes from Toni Sacconaghi – Sanford Bernstein.

Q - Toni Sacconaghi – Sanford Bernstein

Yes, thank you. I just wanted you to confirm your comments about supplies inventory in the quarter. Are you effectively saying that there was a build on a sequential basis, or on a YoverY basis? I think sequential is more relevant. A sequential build in supplies inventory, and if so, how much? And could you, could you comment on whether there was also a build in hardware inventory in the quarter? And why you feel confident in your assessments of each of those?

A – Paul Curlander

As you know, when it comes to channel inventory, it's hard to be confident because we don't have that data. We can't see channel inventory directly. We can only see it indirectly. We get partial reporting. So at best, what we have is estimates. And historically, that's been a little bit difficult for us to call. What we think, and what we meant to imply about what we said on channel inventory, is that on a year to year basis, obviously we saw a significant effect from the shrinkage that occurred in Q3 2005. In Q3 2006, sequentially, again, we can't see this directly, just an estimate. We believe there was a slight build in the supplies inventory, very slight, not much, and not unusual as what you see sequentially, typically. But maybe just a slight build. So, the real issue was on the year to year basis. Relative to hardware inventory in the quarter, I think in the U.S. we saw some build in laser inventory, primarily around some big deals that were getting staged into the channel from a timing perspective. That's about all I can think of as I think around the world.

Q - Toni Sacconaghi – Sanford Bernstein

How do we reconcile your comment that supplies sales were not indicative of supplies consumption? Because wouldn't that have to be on a sequential basis where you're saying, ‘Look, we ship more inventory into the channel than was actually pulled out of the channel?’ How can you make that statement on a YoverY basis?

A – Paul Curlander

Well, first, on a YoverY basis, we talk about 6% supplies growth. What we believe, again, these are estimates based on
what we think about channel inventory; what we believe is that the end year demand consumption was not as much as that
6% year to year. Because the 6% is inflated by the shrinkage that impacted our sell-in back in Q3 2005. So, what we're saying is that we think, against that 6% we're thinking that more than 50%, and, again, that's a guess. I would say slightly more than 50% Was due to that year-to-year change in channel inventory. On a YTD basis, I think the end user consumption we saw is not too different than what we saw in the first half of 2006.

Operator

Your next question comes from Ben Reitzes – UBS.

Q - Ben Reitzes – UBS

Yes, good morning. Thanks a lot, guys. Paul, could you talk about unit trends in a little more detail? For instance, in the past, you've said that your OEM compares tend to get easier after Q4. I'm wondering if you still believe that directionally? It appears the OEM business is extremely weak and that actually had an impact on some of your supplies commentary as well. And then could you talk about as well how you feel you're doing in the office superstore channel versus the consumer electronics on the inkjet side on the branded side and your progress there? We've noticed maybe some gains and losses and it's hard to reconcile how you are really doing.

A – Paul Curlander

Okay. Well, first, relative to the OEM business, I don't recall ever making any comments about forward-looking on OEM and certainly never said anything about some changes we predict after Q4. All I can tell you is that for this quarter, on a YTD basis, OEM sales are down in both the laser and the inkjet business. It's kind of hard to predict going forward but no question, we've seen a weak year in OEM sales. On the office superstore versus CES, on the branded side of inkjet, the issue for us this year is that when we discontinued the unprofitable business or less than profitable business, we obviously lost some shelf space. And there was some negative halo effect around what we did there. And so we got hurt, certainly, in the first half of 2006. What I would say since then is we've been improving ourselves. I can't say we're necessarily better than where we were a year ago. We're different than where we were a year ago. But as I look back from the low of the first half where we lost some shelf space, what's happened to us as we've improved in some areas and we're not so good in others. I think while we've improved some, in CES, think it's a mix story. But certainly we feel like we've improved our position, like at Circuit City, as an example. I think in office superstores, we've improved our position at OfficeMax, as an example. Certainly, Staples continues to be a key officer superstore for us but that was true last year. And we're getting some SKU's now back into Depot and into CompUSA. So, there are some pluses and minuses across the board.

Operator

Our next question comes from Richard Gardner – Citigroup.

Q - Richard Gardner – Citigroup

Great. Thank you very much. Paul, you mentioned that better than expected hardware pricing was the key to the EPS upside in the quarter. I was wondering if you could give us a little bit more color on a number of fronts? With that inkjet laser or both, was it primarily mix, was it benign industry pricing, lower than expected costs? What exactly were the factors there?

A – Paul Curlander

Well, it was a combination of things. I would say that we saw some better hardware pricing than we had expected on both the inkjet and the laser side, but maybe more on the laser side perhaps in the quarter. What I would say about pricing overall is relative to inkjet, what we've gone to now is to kind of talk about the AUR movement. And John indicated earlier on inkjet, the AUR was up 4% on a year to year basis. Obviously, price year to year is pulling that AUR down. Mix is pulling it up as we move away from the single functions and move to an all-in-one kind of mix. But clearly, hardware pricing this year is nothing like we saw in 2005. So, if people want to use words like mild or whatever, it hasn't been anywhere what we saw last year. On the laser side, we talked about AUR's down 1% year to year. Again, pricing would be pulling that down. Mix would be pushing it back up to that -1. I think we see some aggressive pricing in laser. So, when we say it was less than what we had thought in Q3, it doesn't mean it wasn't aggressive in a lot of places. Certainly in the enterprise space, large bids continue to be very aggressive in the laser space. Color laser prices certainly are down in the range of 25% year to year. So, that's pretty aggressive pricing. A lot of aggressive promotions going on certainly in the channel around low end monolasers, color lasers, laser all-in-ones. So, a lot of things going on out there but it was obviously not to the extent that we had anticipated it in our guidance.

Q - Richard Gardner – Citigroup

Just a follow-up. I was surprised you didn't cite inkjet supplies margins as one of the reasons for the upside in the quarter. In that vein, I was just hoping you could give us an update on the status of the Scotland supplies fab, whether the closure of that fab was complete, as of the end of Q3? And whether that did contribute to an increase in the inkjet supplies margins in Q3?

A – Paul Curlander

We didn't cite inkjet margins as a reason for the difference versus guidance because we had expected where we came in with inkjet margins. Certainly inkjet margins are up. Certainly we saw a positive from the actions that we have taken and we have completed the closing of the facility in Scotland.

Operator

Our next question comes from Richard Farmer – Merrill Lynch.

Q - Richard Farmer – Merrill Lynch

Thank you. Paul, just a follow-up on the supplies growth. I understand your inventory comments. But as you look at your internal models on some of the other variables, how are they tracking relative to what you're expecting? I'm thinking of things like the ink usage per installed device to the degree you can measure it and the mix of low yield versus standard cartridges, end market demand, things outside of the inventory changes that you mentioned? And I guess to the degree that your comments are different for inkjet versus laser, if you can distinguish those, that would be helpful. Thank you.

A – Paul Curlander

Well, what I would say for both inkjet and laser is that as we've gone through the year, our models have been tracking approximately on target as we go through. Again, this is not an exact science, but you never know exactly what the install base, is what the usage levels are, what the loyalty levels are and that's always a challenge. But I would say overall, as we've gone through the year, both inkjet and laser, we've been certainly within the range of exactness that we would expect to see.

Q - Richard Farmer – Merrill Lynch

Okay, thanks. And one follow-up, if I could on the buyback question that was asked earlier. You mentioned that you used your access for buybacks. What do you estimate is the level of excess cash on your balance sheet at the moment?

A – Paul Curlander

We don't give a specific excess cash on the balance sheet level. Right? So, we've been asked in the past; What level of cash that we require to run the business? And what we've said is, we don't require any specific level. We can operate as any company does with debt or without. But we have made it clear that we don't intend to borrow in order to repurchase.

Operator

Our next question comes from Shannon Cross – Cross Research.

Q - Shannon Cross – Cross Research

A question on color laser, just in terms of the growth rates and sort of the longer-term business model. Obviously, it's an important driver going forward for the industry in general. What are you seeing in terms of margins and pricing? I think pricing was down significantly. But I'm just curious, has this become an inkjet-like business over time where, I don't know if you lose money on the hardware, but you certainly don't make a lot? And then, when I say you, I mean the industry, and then just have to make it up on supplies?

A – Paul Curlander

Yes, Shannon, I think it's pretty clear that the color laser business has become like the inkjet business. Clearly, people are being very aggressive on prices, taking losses up front, they're hoping to make it back over the life of the product in the supplies. For us, it's a very important market. The market this year is growing pretty nicely overall if we look throughout first half. We've not seen the Q3 data. But again, that market is up about 25% year to year in units. And we're having a very good year this color laser this year. We're growing much faster than that market growth. We're doing very well across our product line. Obviously, the new C530 products we just introduced, we expect to do very well with. But we do very well in the low end as well as the work group color lasers.

Q - Shannon Cross – Cross Research

Okay. And just to clarify, so are you losing money on the hardware and making it on the supplies? Is that basically the situation we're at now?

A – Paul Curlander

Yes, that's kind of what we said.

Operator

Our next question comes from Keith Bachman – Bank of America Securities.

Q - Keith Bachman – Bank of America Securities

Hi. Thanks very much. I have two. On the guidance, I still want to try to get some clarification. Could you comment on two of your expectations contained within your guidance? Number one is mix, and particularly on the supplies side, what are you anticipating supplies revenue to do? And then secondly, comment on expectations, I'm assuming that you're embedding in, Paul, I think you used the word ‘benign’ as reflecting what most investors are saying, benign pricing. But if you could clarify those two? And I have a follow-up, please.

A – Paul Curlander

Relative to the supplies revenue, what we're expecting in Q4 is for supplies revenue year to year to be flat to up in the low single digit range. And that's not too different from what he we saw in Q3 once you factor out the year to year channel inventory impact as we talked earlier. On the pricing side, although we saw less than expected pricing moves in Q3, we're expecting more aggressive pricing in Q4 embedded in. Certainly on the inkjet side, we've got Black Friday deals, which obviously are much more aggressive than what we've been doing YTD and so we expect to certainly see impacts there. Over on the laser side, again, enterprise bids continue to be very aggressive and we've got some bids that will be rolling out in Q4 that we won but certainly we're very aggressive. So we see some impacts there as well to look forward in Q4. So, net is we're anticipating a tougher price environment in Q4 than we saw in the third. And that's rolled into our guidance.

Q - Keith Bachman – Bank of America Securities

Okay. Well, let me ask a clarification, then. In terms of Lexmark's over the past few quarters has had some pluses and minuses in terms of the supplies inventory drawing down channel inventories, as well as adding to it. We haven't heard over the last few quarters, even the last few years, those same type of comments from Hewlett-Packard or Canon or even Epson to that extent. Why is it that Lexmark sees more volatility in its supplies business than some of your major competitors?

A – Paul Curlander

Well, I don't know that we do see more volatility in our supplies business. It's hard for me to comment on what the other guys see. And it's certainly hard for me to comment on what they say about what may be occurring inside their business. Just for us, clearly it's a big factor and we do talk about big moves, like we saw in Q3 last year. Obviously this year, we've not seen those kinds of dramatic moves. We didn't see that in Q3, much more of a normal type of sequential movement. And we talk about it because it does impact the year to year growth and we just want investors to understand what we think is in the run rate versus what we think is the result of an unusual occurrence in Q3 2005.

Operator

Our next question comes from Katie Huberty - Morgan Stanley.

Q - Katie Huberty - Morgan Stanley

Just looking at the balance sheet, both inventory and payables increased more than 10% sequentially. Does that indicate your expectations for strong Q4 unit volumes, or is that reflective of some of the recent product announcements?

A – Paul Curlander

Well, on the payables side, we're obviously focused on, over time as part of our cash cycle initiative to keep pushing payables to a bigger number through negotiation with our suppliers, not by just not paying them, by negotiating a longer pay period. On the inventory side, I think what you see in that growth is reflective of a couple of things. Clearly, we had some shortages in certain areas in the first half and I think we've fixed those as we went through Q3. We obviously have the seasonal increase in inventory to prepare for Q4 and we're certainly hoping to sell a lot of hardware here in Q4. And as you've pointed out, we've had a lot of new product introductions, which also tends to inflate inventory as well.

Q - Katie Huberty - Morgan Stanley

And then just quick clarification on the cash commentary, is it right that you have just under $200 million of U.S.-based cash today, if we assume two thirds is international?

A - John Gamble

Right, so about one third of the total of $562 is domestic.

Operator

Our next question comes from Bill Shope – JP Morgan.

Q - Bill Shope – JP Morgan

Okay, thanks. With five quarters of negative inkjet unit growth so far, do you feel like you have a better sense or can you give us a better sense of when you may approach an inflection point where inkjet hardware units could either flat line or start to show some growth? Or when you pushed through your install base and shifted all the units towards the higher usage printers? And then second question, can you give us a sense of what overall branded inkjet unit declines were this quarter?

A – Paul Curlander

Well, relative to the split between brand and OEM, Bill, we don't disclose that. Again, all I can tell you is it's much less than the 19% we saw overall. Relative to the inkjet unit growth, it's hard to predict as we go forward in time. Obviously, we started the focus on moving away from the less profitable business back in Q1 2006. And so in first quarter next year, we'll be lapping that initiative. Other than that, it's very hard for us to look forward and predict what the growth is going to be. Obviously, OEM is a significant piece of what we do on the inkjet side and that's a little hard to call, as we discussed a little bit earlier today.

Operator

Our next question comes from Bill Hand – Bear Stearns.

Q - Bill Hand – Bear Stearns

Thanks. Paul, can you talk about what investors should be thinking in terms of expectations for Lexmark's long-term growth rate once you've digested the exit of the low end bundled inkjet business? Is it still reasonable to assume around 4% to 5% top line growth, that's both hardware and supplies? I think you talked about that type of growth at your analyst meeting.

A – Paul Curlander

Bill, we actually haven't said. We haven't given long-term guidance as to what we expected to do. You're quite correct. We talked about the market growth in the 4% to 5% range and we talked about long-term objective for us to grow faster than the market. But obviously, as we're going through the transitions we're in right now, we're a ways from 4% to 5%. The other issue for us is supplies growth, and you look back in 2003 or 2004, supplies were going at a much faster rate. Obviously right now, with the decline we're seeing in the inkjet business, we're seeing declines in inkjet install base. And what we want to do is get through this transition period and get focused on growing inkjet units and growing them at a profitable way and I'm not talking in terms of the up front margin. We're talking about over the life of the product. As we do that, we're going to have to then suffer, for a little white, until we can start getting the install base growing again and getting supplies growing again. So this also impacts what type of growth rate we might see in what you might call the mid-term to the longer-term. So, the net is we don't give any long-term guidance. The market is growing in the 4% to 5% range. As we look out strategically, we certainly would like to get to growth rates greater than that. And obviously on inkjet, we're going to go through a transition here while we stop the unprofitable business and try to get ourselves onto better footing.

Operator

Our next question comes from Bill Fearnley – FTN Midwest.

Q - Bill Fearnley – FTN Midwest

A couple of other questions on supplies. When you talk about refill and reman, Paul, any update on your thoughts there? Number two, should we expect any more rebate type programs for new inkjet models? And then could you give some more detail on the mix of cartridge types? I don't catch that you guys talked about inkjet cartridge types, specifically, what the mix was for the quarter. Thanks.

A – Paul Curlander

Relative to the mix on the cartridges, we continue to see a trend towards more of the standard yield cartridges versus the high yield cartridges. And that's going to be an ongoing trend as we go forward in time. And so, that obviously puts pressure on inkjet supplies revenue growth. Relative to refill and reman, there's no question that that's a factor out there in marketplace. It's hard for us to know exactly what level that is. And we focus on the inkjet side, historically what we've seen in U.S. retail is we've seen inkjet reman penetration in the mid to high single digit type of range. But when we go out and do surveys of our customers, we're certainly seeing much higher percentages than that in terms people saying that they're using, if only occasions, or remaned or refilled products. They range anywhere from 25% to 40% in some geographies. So from our standpoint, we focus on this several ways. Obviously, the price of the cartridges and the availability of the cartridges is a key element relative to this. Also we've made a change this year in our inkjet drivers, when ink is low, on our branded business, by directing people back to our Website. And we're obviously trying to drive more sales back into the Lexmark Website, in addition to what we sell through retail. I think beyond this, we're looking at things like the Cartridge Collection Program, as you referred to. We don't call it the rebate anymore. It's the Lexmark Cartridge Collection Program. And obviously we've just introduced that on the inkjet side for the first time and we're looking at how that goes. The response so far has been very positive from both the press and from the channel. So certainly, we're encouraged by that. But also this has been a very popular program over on the business side, so we expect it to be popular on the consumer side as well. And we're currently evaluating what we might do with that as we go forward in time.

Operator

Our next question comes from Jesse Tortora – Prudential Equity Group.

Q - Jesse Tortora – Prudential Equity Group

How has the reception been to your new laser product introductions, particularly by the VAR's and customers in the SMB space? And the same question for your new all-in-one inkjets from retailers and customers?

A – Paul Curlander

Well, on the laser side we've seen some very strong positive reaction. Certainly the new color lasers, the C520 fast devices have been very strongly received. And the media just gave us, PC Magazine's Editor's Choice Award on the C530. over the e series, new low end to midrange model products, again, I think a very strong set of positives there. A lot of new technology in those products. A lot of improvement in energy savings and in quiet operation, in addition to being more reliable and being higher speed. So overall, feel pretty good about that. On the inkjet all-in-one, the X5470 has had a terrific reception from the channel and it looked like we're off to a pretty good start from a sales perspective as well. We got a lot of distribution in the X5470, even though we've been struggling some with distribution, as we talked about earlier, in terms of shelf space. 5470 was pretty much taken almost across the board, certainly in the U.S. and we're off to a good start around the world with that product.

Q - Jesse Tortora – Prudential Equity Group

And if I could just give a follow-up here, what do you attribute the decline in the OEM laser businesses to? Is there any chance it's partly attributable to you guys going more aggressively to SMB space with your own branded products?

A – Paul Curlander

I don't think it has any relation to what we're trying to do in SMB. We can't talk a lot about OEM because we have some major OEM customers. But all we can say is their sales are down. I don't think it has anything to do with Lexmark's actions on the branded side.

Operator

Our next question comes from Chris Whitmore – Deutsche Bank.

Q - Chris Whitmore – Deutsche Bank

Just one question. Hoping to get color around the percentage of current cartridge sales that go to support product lines or segments that you've exited on the inkjet side? Thanks

A – John Gamble

Chris, we don't break out the inkjet sales from that perspective. I think just qualitatively, what we can say is that as we discontinue business, you're exactly right. There is an impact on supply sales as well. And there's an impact to supply sales certainly this year as we exit that business. And there's certainly going to be a ripple effect over into '2007 from that decline in install base as well. And this is the point we were trying to make earlier, that we're going have to drive inkjet units on we get through this transition. And as we do that, hopefully build back the install base and start to grow again. But unfortunately we don't break out that in specific detail.

Q - Chris Whitmore – Deutsche Bank

Is it in the 10% of total cartridge sales neighborhood?

A – John Gamble

Again, Chris, we don't break it out. I'm sorry.

Operator

Our next question is a follow up from Toni Sacconaghi - Sanford Bernstein.

Q - Toni Sacconaghi - Sanford Bernstein

Yes. Thank you. Hewlett Packard grew its total printer units at 15% this quarter. They're about 50% the market. I think x the 20% unit growth that you exited in inkjet, your total unit volumes would have been low single digit. So using that data, and correct me if you think either is wrong, it appears as though the market's probably growing close to 10% overall. You're growing low single digits. The question is, do you believe that the key to getting the market unit growth or better is more around securing channel distribution or is it more around enhanced brand and product relative to your competitors?

A – Paul Curlander

Well, Toni, I'm not sure I agree with your statement on the market data, but I'll leave that to the side. What we see overall on the inkjet business YTD, and again, we only have first half information, is units are about flat worldwide. What we see in the laser market probably is up around 15% YTD overall. But when you roll those together, I think the market – inkjet kind of dominates in terms of units, so I would expect it to be very different than the kind of number you were speculating on. But setting that aside, I think what's key for Lexmark is all three of the things you pointed out. I think first of all, we're looking to enhance our products. And this is why we've uplifted the R&D. We're not where we want to be in places like color lasers, in laser all-in-ones. I think we do feel pretty good about where we are with our low end monolasers right now. We feel very competitive there. But we have a long ways to go still in color laser and laser all-in-one to get the product set and the technology that we want. I think over on the inkjet side as well, we need to enhance the product line and we're certainly focused on doing that and we want to be a lot stronger in all-in-ones. We want to be a lot stronger in the inkjet technology itself. And we're investing in these areas to do that. Secondly, I think channel distribution is a key thing for us. And this is a focus we're putting on the consumer side. We're not represented as well as we would like to be, certainly in U.S. retail and around the world. I think certainly in small and medium business, we're not yet as represented as much as we would like to be. So, there's work for us to do there on the channel path to markets. And then on the brand, I think brand continues to be a challenge for us. No question that our brand awareness is not what the market leader has. But I think we've continued to improve that. And I think we can build the business. We built this business over a lot of years with the level of brand awareness that we have, so clearly we can do it. But we would like to start to augment that with some brand development and we've been doing that. And I think we see some movement in the numbers, certainly in terms of the investments that we've made.

Operator

Our next question is a follow up from Bill Fearnley – FTN Midwest Research.

Q - Bill Fearnley – FTN Midwest Research

Just a quick follow-up. Could you make any commentary about linearity of demand for the quarter versus expectations, inkjet, laser hardware and then also supplies as well? Thanks.

A – Paul Curlander

We usually don't break that out. So, there's not much I can add. We just kind of talk overall for the quarter.

Q - Bill Fearnley – FTN Midwest Research

But in the past, you've said that it's back end quarters. But are you adding any other detail versus your expectations for the past quarter? You've made comments about back end loaded in the past, Paul. I just want to see if it's similar to what you've seen in the past. Thanks.

A – Paul Curlander

Typically, in quarters for technology companies, the last month in the quarter is the biggest month of the quarter. I think, certainly in Q3 when you have the summer, you've got parts of the world that nothing happens. So, that's a typical pattern you see. And there was nothing unusual certainly for us I think in this Q3.

Operator

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

John Morgan

Okay. Well, thanks, everybody, for joining us today. That will do it from here. Goodbye.

Operator

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

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