Lexmark International's CEO Discusses Q1 2014 Results - Earnings Call Transcript

Apr.22.14 | About: Lexmark International, (LXK)

Lexmark International, Inc. (NYSE:LXK)

Q1 2014 Earnings Conference Call

April 22, 2014 8:30 a.m. ET

Executives

John Morgan - Director of Investor Relations

Paul Rooke - Chairman and CEO

John Gamble - EVP and CFO

Analysts

Toni Sacconaghi - Sanford Bernstein

Shannon Cross - Cross Research

Kathryn Huberty -- Morgan Stanley

Ben Reitzes -- Barclays

Brian Alexander - Raymond James & Associates, Inc.

Kulbinder Garcha - Crédit Suisse AG

Bill Shope - Goldman Sachs

Jim Suva - Citigroup

Ananda Baruah - Brean Capital

Ben Bollin - Cleveland Research

Operator

Thank you for standing by, and welcome to the Lexmark International First Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded on Tuesday, April 22, 2014.

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

John Morgan

Good morning, and thank you for joining us. Chairman and CEO, Paul Rooke; and EVP and CFO, John Gamble, are with me this morning. After their prepared remarks, we'll open the call for your questions as time permits.

Our first quarter earnings release and earnings presentation were posted to our Investor Relations website located at investor.lexmark.com earlier this morning. As with our prior calls, we will be referring to specific slide numbers from the earnings presentation deck, again, this morning.

Also note that we will be referring to non-GAAP measures during today's presentation unless otherwise noted. Pursuant to the requirements of Regulation G, the company has provided reconciliations of GAAP to non-GAAP measures and a discussion of management's use of non-GAAP measures. These reconciliations have also been posted to our IR website.

Lexmark anticipates that the date of its second quarter 2014 dividend will be May 30, with an anticipated payment date of June 13. Please note that future quarterly dividend payments are subject to board approval. We have also included our anticipated dividend schedule for 2014 and 2015 in the Supplemental section of our earnings presentation.

Following the conclusion of this conference call, a complete replay will be made available on 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 and Lexmark undertakes no obligation to update any forward-looking statements.

With that, I'll turn the call over to Paul.

Paul Rooke

Thank you, John and good morning to everyone. As John said, we'll be using a presentation slide deck, we'll refer to the slide numbers as we go to keep everyone on the same page. So let's begin.

Starting with Slide 4, you can see the first quarter’s financial highlights. Overall it was a solid quarter for Lexmark. Revenue for the first quarter was $881 million, down less than 1% year to year and better than expected with Laser and Perceptive Software revenue growth nearly offsetting the Inkjet Exit decline.

Excluding Inkjet Exit revenue, revenue grew 6% year to year driven by strong Perceptive Software and management services revenue growth of 38% and 12% respectively. Combined, these higher value solutions represented 28% of total revenue for the first quarter.

Laser supplies revenue also grew 9%. Overall we were pleased that the strong revenue growth from our high-value areas offset the headwinds of the planned ongoing decline from the Inkjet Exit. And we also continued working to increase our profitability. We delivered year-to-year operating income improvement in the first quarter and an operating margin of 10.4%. This was driven by strong growth in the high-value segments with a solid gross profit margin along with good cost and expense management.

Operating expense was down significantly sequentially and about flat year-to-year for the first quarter. Again, increased software investments from our recent acquisitions to drive future growth were mostly offset by expense reductions in ISS, including the benefits of the previously announced actions to improve our cost and expense structure. And we remain committed to our long-term operating margin assumption of 11% to 13%.

Earnings per share were $0.92 for the first quarter, exceeding our guidance and declining only slightly year-to-year. Increased pretax earnings and lower shares outstanding were offset by a higher tax rate.

Finally, we continue to maintain our capital allocation discipline to deliver shareholder value. In the first quarter, we paid our 10th consecutive quarterly dividend and repurchased $21 million of the company’s outstanding shares for a combined return to shareholders of $40 million.

Now moving to Slide 5. There are two key points about Lexmark that I’d like to share. First, we are transforming Lexmark to a higher value portfolio. To achieve this, we’re focused on a broader opportunity helping our customers solve their unstructured information challenges. This opportunity is complementary to printing but it goes well beyond printing, incorporating high-value solutions and software.

We see the market for these high-value solutions expanding with Lexmark well-positioned to increase our participation in these markets. In fact, our management services and software areas are growing faster than the market and combined, are expected to exceed $1 billion this year.

Second, Lexmark continues to create shareholder value. We’ve achieved a record gross profit margin percentage for five consecutive calendar years, indicative of the progress we’re making in shifting our business to these higher value markets.

We’ve also generated positive free cash flow for 12 consecutive calendar years. This ability to generate strong cash flow continues and we're continuing to deploy this cash by staying disciplined in the execution of our capital allocation framework.

And under that framework, we remain committed to building and growing our solutions business through organic expansion and acquisitions as we focus on solving the unstructured information challenges of business customers. In addition, we remain committed to returning greater than 50% of our free cash flow on average to shareholders through dividends and share repurchases.

Now turning to Slide 6. As we listen to our customers, they tell us they’re struggling with their ability to connect the growing amount of unstructured content that today sits outside of their core enterprise systems. As a result, their people are disconnected from the very information they need to help make more accurate and timely decisions.

This unstructured information is both paper-based and digital. Digital content includes work files, spreadsheets, emails, video, images, and paper-based content includes mail, documents, notes, and forms. So we see the opportunity to combine our imaging and software technologies to create powerful industry-specific solutions to these problems, connecting this unstructured printed and digital information with the processes, applications and people that need it most.

Now on Slide 7, you can see Lexmark’s addressable market opportunity, covering the key areas of content, process and output management in which we participate. Overall it’s a large market, about $80 billion with our focus on the high-value growth segments of managed print services and content process management software which are expected to grow double-digit rates over the 2013 to 2017 strategic period.

On Slide 8, you can see the world-class platforms we’ve created to address these unstructured information challenges. In the upper left block, to help our customers optimize their print environment, we have an output management platform that gives visibility to their fleet of devices around the world, so their printing is optimized for the time and place it's needed.

In the upper right block, we also have a comprehensive content and process management software platform to capture and manage these unstructured contents and the associated processes so that the content is instantly available at the time and place it's needed. And any manual processes are automated and integrated with the businesses’ core systems.

So while we have world-class platforms that can scale with any size customer and be tightly integrated with their core systems, what differentiates us is how we create unique industry specific solutions from these platforms. At the bottom of the slide whether it’s a print-on-demand signage solution for a retailer to make quick price changes in the store, a solution automatically captured bill of lading information to accelerate the cash cycle for a manufacturer, a solution to enable a physician to see the complete patient record in a large hospital electronic medical record system or automating the invoice processing in a shared service center of a large multinational. This is where Lexmark shines.

Now on Slide 9, I want to make two points about why we believe we’re well positioned to grow. First, we differentiate ourselves through this unique combination of a key technology ownership, deeper industry experience and superior customer intimacy. In other words, our unique combination of output content and process management technologies focused on this unstructured information challenge combined with the deep industry expertise of our people to understand the unstructured information challenges across the range of industries, combined with our direct sales force that engages directly with our customers to listen and respond with unique solutions gives us the competitive advantage over our competitors.

Secondly, we are creating synergies to accelerate our growth by leveraging the large enterprise presence of our Imaging Solutions business to grow Perceptive Software faster while leveraging Perceptive Software’s unique software solutions to differentiate our managed print services offerings and grow our imaging business faster.

On Slide 10, Lexmark continues to be recognized as a leader in our key focus areas of output content and process management. These management services and MFP accolades showcase our leadership position driven by our world-class Smart MFPs, the seamless integration with Perceptive Software's growing array of solutions and the world-class Managed Print Services capabilities we've built and refined over the past 15 years.

And as proof of this leadership position, within the last 24 months, we've competed for and won 20 new management services contracts with companies listed on either the Global 500 or Fortune 500, which represent incremental business to Lexmark and our overall Managed Print Services revenue grew again by double digits in the first quarter. We continue to believe this is a clear indicator that our value proposition resonates strongly and continues to be differentiating with these large discriminating customers.

We also continue to gain accolades in the content and process management space. The synergies Lexmark is bringing to accelerate Perceptive Software's R&D and sales capabilities through our organic investments and acquisition is certainly contributing to this. For example, the strength in combination of Perceptive Software's content management capabilities with newly acquired vendor neutral archiving and connectivity solutions are contributing to our growing recognition as a health care content software leader. As per the proof of this leadership position, our overall software revenues grew again by double digits in the first quarter.

Now moving to Slide 11, you can see how the composition of our revenue continues to shift as we evolve to an Imaging and Software solutions company. On the left side, you can see the shift on our revenue over the last three years. Inkjet Exit revenue, the great portion is expected to decline over time at a rate of over 40% year to year as the trailing supplies revenue from the installed base naturally decreases.

Now the Imaging Solutions section, the purple part, is comprised of both MPS and non-MPS revenue. The MPS part is our Enterprise Managed Print Services revenue and the non-MPS portion includes revenue that flows through our partners, some of which flows through transactional partners and some of which flows through copier dealers that are managing fleets of our devices as a service. And then the third section, the blue part, is the Perceptive Software revenue.

Now combining the Imaging Solutions and the Perceptive Software revenue, the purple and blue sections together, this represented 89% of our 2013 revenue and will continue to grow as a percentage of our total revenue as the Inkjet Exit revenue declines over time.

Now combining the MPS and the Perceptive Software revenue, only the bottom 2 sections, representing higher value add, longer-term solutions relationships with customers, this combined software and services business grew to comprise 26% of the total revenue in 2013. We also expect to increase to more than 30% in 2014.

And as I mentioned earlier, the MPS and software markets are growing and our growth is well in excess of the market, indicating that our value propositions and our ability to execute them is resonating with our customers. Additionally, we expect that as our software revenue grows and the margins expand here, this will be a significant driver of future profitability.

Now on the right side of the slide for the first quarter, Imaging Solutions and Perceptive Software revenue represented 92% of total revenue. MPS and Perceptive Software revenue on a combined basis comprised 28% of total first quarter revenue.

Now on Slide 12, you see the growth of just the higher-value MPS and Perceptive Software revenue over time. On the left side, the combined MPS and Perceptive Software revenue approached $1 billion in 2013 and is expected to grow about 15% to exceed $1 billion in 2014. On the right side, the combined revenues grew 18% in the first quarter with strong Perspective Software growth of 38% and solid MPS growth of 12% year-to-year.

In fact, looking at Perceptive Software’s revenue alone on Slide 13, you can see on the left side that it grew 48% in 2013 with strong growth across licenses, maintenance and professional services. By the end of 2016, we’re driving to grow Perceptive Software’s revenue to $500 million and also expand its operating margin to about 25% as we scale the business.

Now on the right side, you can see Perceptive Software’s revenue growth of 38% in the first quarter driven by strong 30% growth in license and subscription revenue. We also delivered a $6 million improvement in operating income year-to-year.

Now on Slide 14, you can see our capital allocation framework. Since the first quarter of 2011, we’ve returned 93% of free cash flow to shareholders through dividends and repurchases. In addition, we have reinvested more than $725 million to grow the company through a targeted set software acquisitions since mid-2010.

And then looking ahead on Slide 15, you can see our second quarter, our full year 2014 and long-term outlooks. For the second quarter, our outlook is for revenue to be down 2% to 4% year-to-year. Excluding Inkjet Exit, we expect revenue to grow slightly for the second quarter and we expect earnings per share for the second quarter to be in the range of $0.85 to $0.95.

For the full year 2014, our outlook is for overall revenue to be down 2% to 4% year-to-year and improvement from our prior guidance with revenue excluding Inkjet Exit to be up slightly. We expect earnings per share for the full year to be in the range of $3.80 to $4. In the long term, our outlook is to grow revenue at or above the market with an operating margin in the range of 11% to 13%.

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

John Gamble

Thank you, Paul, and good morning. As John indicated earlier, the discussion that follows is on a non-GAAP basis and reflects non-GAAP adjustments unless otherwise noted.

Lexmark performed well relative to our expectations in 1Q ’14 as revenue growth and EPS each exceeded our guidance range, although free cash flow was negative as expected reflecting $70 million in payments primarily related to variable compensation programs and to legal judgments and settlements accrued in the prior quarter. Free cash flow was slightly better than expected reflecting strong working capital performance again in 1Q ’14.

Even with this negative free cash flow in 1Q ’14, we continue to expect to deliver free cash flow for the year at the low end of our target range of 90% to 100% of non-GAAP net income. Strategically, we continue to make very good progress in MPS software and solutions.

As shown on Slide 17, 1Q '14 EPS of $0.92, which exceeded our January guidance range reflected a strong improvement in operating performance relative to 1Q ‘13. As you recall, there was a $0.09 per share tax benefit in 1Q ’13 related to the delay in passage of the 2012 U.S. R&E tax credit legislation resulting in this 2012 tax credit being recognized in 1Q ‘13. Excluding this benefit, 1Q ’14 EPS exceeded 1Q ’13 by about $0.06 a share reflecting very good operating performance as well as lower shares outstanding.

ISS operating income was very strong as stronger laser revenue and income growth offset substantially all of the income decline from the 40% decline in inkjet revenue. Perceptive Software despite having slightly negative operating income was substantially stronger than 1Q ’13. This combination resulted in improved operating income in 1Q ’14 relative to 1Q ’13.

As compared to the midpoint of our January guidance range, stronger than expected ISS operating income drove the improvement in EPS. Increased laser supplies revenue and income was partially offset by lower than expected hardware margins and Perceptive Software operating income being slightly lower than expected. We had expected Perceptive Software to be marginally profitable in 1Q ’14 down from 4Q ’13 as first quarter is seasonally a weak quarter.

Turning to Slide 18, combined laser plus Perceptive Software revenue growth of 6% was highlighted by growth in MPS, laser supplies and Perceptive Software. Inkjet revenue declined 40% year-to-year unfavorably impacting overall revenue by 6 percentage points.

In ISS, we continue to benefit from our world-class MPS capabilities and strong solutions to both win new MPS placements and maintain our very high customer retention. MPS grew 12% in the quarter. Laser supplies continued the recent trend of good growth reflecting our ongoing success in MPS and increased mix of large workgroup hardware. Perceptive Software revenue growth in 1Q was again quite strong driven by strong growth in subscriptions, maintenance and professional services which collectively grew 45% plus growth in licenses of 21%.

Now moving to Slide 19, hardware revenue declined in the quarter in both large and small workgroup reflecting unfavorable category mix as well as aggressive pricing particularly in the channel. Laser hardware units however grew year-to-year with large workgroup units up 3%. This continued growth in large workgroup reflects our continued success in MPS and strengthens our future supplies. Small workgroup units declined slightly. Large workgroup, laser unit growth was highlighted by over 20% growth in both mono MFPs and color MFPs.

Total supplies revenue declined only 1% in the quarter versus 1Q ’13 as laser supplies revenue growth of 9% year-to-year offset substantially all of the 39% decline in inkjet supplies. Laser supplies channel inventory grew in 1Q ’14, which we believe partially reflects channel purchases ahead of legacy laser supplies price increases in North America that took effect in early April.

We also believe that almost a third of the 9% year-to-year growth in laser supplies revenue was due to net growth in laser supplies channel inventory. We continue to see strong end-user demand for the laser supplies as is evidenced by the recent strong laser supplies revenue growth rate. This reflects continued good performance in MPS and large workgroup hardware. All geographies experienced year-to-year laser supplies growth in the quarter. For perspective, laser supplies revenue in 1Q '13 was relatively weak and therefore 1Q ’14 growth was versus a relatively easy compare.

The inkjet supplies decline of 39% was slightly better than we had expected. Inkjet supplies channel inventory declined in the quarter as it’s expected with the declining level of our inkjet supplies revenue.

Software and other revenue growth of 13% was primarily driven by the strong growth in Perceptive Software of 38%. Perceptive Software saw good organic growth as well of 12%. Healthcare continued to perform well in 1Q ’14 as our strategic focus on enterprise clinical content management, the ability to handle all forms of unstructured clinical content across the healthcare system continues to take hold with customers. This improving traction is also occurring outside the U.S. including a major vendor neutral archive win at a large hospital group in Asia-Pacific.

Higher education was also strong in 1Q ’14 as again our broad suite of content and capture technologies including newly launched Intelligent Capture for Transcripts developed from technology acquired in the Brainware acquisition broadens our capabilities.

Geographically, we saw growth in U.S. and strong growth in Asia. Excluding Inkjet Exit, the U.S. grew 10%, EMEA declined less than 1% and other geographies grew 9%. Perceptive Software saw growth in EMEA driven by earlier investments in sales or marketing and the recent acquisition of Saperion.

As shown on Slide 20, we delivered solid 1Q ’14 gross profit margin. Gross profit margin increased to 110 basis points year-to-year driven by favorable product mix reflecting relatively more large workgroup laser hardware and laser supplies and lower relative level of small workgroup laser and inkjet hardware. This was partially offset by unfavorable product margins. The sequential decline is driven by product margins principally reflecting the unfavorable pricing referenced earlier. This was substantially offset by improved product mix reflecting a higher mix of laser supplies relative to laser hardware.

ISS gross profit margin improved 20 basis points year-to-year, driven by favorable mix primarily reduced inkjet hardware. Perceptive Software gross profit margin declined slightly year-to-year as our mix of license and subscriptions revenue was lower in 1Q ‘14 relative to 1Q ’13. Subscriptions grew a strong 58% in the quarter while license revenue was up 21%. We are beginning to see more customers consider purchasing under a subscription model, which is a positive long-term trend for Perceptive. Sequentially, the gross profit margin decline is consistent with our expected sequential patterns.

Moving to Slide 21, operating expense was up slightly year-to-year as increases at Perceptive primarily due to acquisitions were offset by reductions in ISS. The $37 million sequential reduction versus 4Q ‘13 primarily reflects the absence of the legal judgements and settlements incurred in 4Q'13, lower variable compensation and reduced marketing expense.

As shown on Slide 22, operating income improved year-to-year, driven by the $6 million improvement in Perceptive Software. Operating income margin percentage also improved year-to year and we remain committed to achieving our long term target of 11% to 13%.

Skipping to Slide 24, free cash flow was negative for the quarter as expected, as discussed during our January earnings call. Our 4Q'13 free cash flow of $166 million was extremely strong reflecting outstanding working capital performance that we did not expect to be repeated in 1Q' 14.

As we indicated this strong 4Q'13 working capital performance would negatively impact our 1Q'14 free cash flow as would about $70 million in payments, principally related to variable compensation programs and legal judgements and settlements accrued in the prior quarter.

The negative free cash flow of $34 million in 1Q'14, was actually somewhat better than we had expected, reflecting again very strong working capital performance. Cash conversion improved 8 days year-to-year, as we had exceptional accounts receivable and payable days performance in 1Q'14.

To provide some perspective, the $132 million of free cash flow generated over the combined 4Q'13 and 1Q'14 period is about 99% of non-GAAP net income over that period, at the high end of our 90% to 100% target range. We continue to expect to deliver free cash flow for 2014 at the low end of our target range of 90% to 100% of non-GAAP net income. We continue to maintain a strong liquidity position with $985 million of cash, along with other significant sources of liquidity.

Please turn to Slide 25 for my forward-looking comments for 2Q 2014. We expect second quarter revenue to decline 2% to 4% year-to-year. This guidance is equivalent to sequential revenue performance of down 1% to 3%, which reflects normal sequential trends for the laser portion of the ISS business, with larger declines in the Inkjet business we are exiting.

This outlook includes a decline in Inkjet revenue of over 40% year-to-year, with an impact to total revenue of approximately negative 5 percentage points. Laser plus Perceptive Software revenue is expected to show continued growth. We expect continued strong growth in MPS.

Laser supplies revenue is expected to be flat to up slightly in the quarter. This reflects no change in channel inventory during the quarter versus an increase in channel inventory equivalent to over 2.5 percentage points in Laser supplies revenue growth in 2Q'13. For perspective, 2Q'13 was a very strong quarter for Laser supplies revenue, negatively impacting the 2Q'14 growth rate.

In 2Q'14, Perceptive Software is expected to have a strong -- have strong revenue growth. We expect Perceptive to be profitable in each of the remaining quarters in 2014 and for the year as a whole driven by continued to strong revenue growth coupled with ongoing moderation of expense growth.

GAAP EPS in 2Q 2014, is expected to be $0.47 to $0.57 per share. GAAP EPS in 2Q 2013, was $1.47 per share. 2Q 2013 GAAP results included a pre-tax gain of approximately $71 million, net of related costs on the sale of Inkjet related technology and assets.

In 2Q 2014, non-GAAP adjustments made up of restructuring expense and acquisition related items are expected to be $0.38 per share. This includes restructuring cost of $0.10 per share and an estimated $0.28 per share from acquisition related costs and expense. Non-GAAP EPS is expected to be $0.85 to $0.95 per share. Non-GAAP EPS in 2Q 2013 was $1.04.

In 2Q'14, we expect gross profit margin percentage to increase year-to-year. Operating expense dollars to be about flat sequentially and operating income margin percentage is expected to be down slightly. We expect the effective tax rate for 2Q to be about 30.5%. We expect the effective tax rate for the full year of 2014 to be about 29%. This rate assumes the U.S. R&E tax credit will be passed in 2014.

If the U.S. R&E tax credit does not pass, our 2014 tax rate will be approximately 30.5%.

The increase in the 2014 tax rate from the 26.4% effective rate in 2013 primarily reflects positive discrete items incurred in 2013, such as the 2012 U.S R&E tax credit that was reflected in 2013 results due to the delay in its passage.

Please turn to Slide 26. Assuming the midpoint of our 2Q guidance range, the decrease in EPS in 2Q'14 relative to 2Q'13 is driven by two main factors. First, higher effective tax rate in 2Q'14, driven by discrete benefits in second quarter of '13, as well as the absence of the U.S R&E tax credit in 2Q'14, partially offset by the benefit of lower shares outstanding and a lower expected operating income in ISS other in 2Q'14.

Lower revenue and income from Inkjet supplies will be partially offset by improved Laser operating income. ISS other operating income is expected to decline more than in 1Q'14 as Laser supplies growth is expected to be lower in 2Q'14 than 1Q'14. The lower ISS and other operating income is being partially offset by improved profitability in Perceptive Software in 2Q'14, relative to 2Q'13.

Turning to Slide 27, we expect full year 2014 revenue to decline 2% to 4%, as we continue our shift to higher value solutions revenue. This is slightly better than our previous guidance, reflecting improved revenue performance in 1Q'14, and in our 2Q'14 guidance.

Inkjet revenue is expected to decline over 40% from the $405 million we had in 2013. This results in an approximately negative 5 percentage point impact on year-to-year total revenue in 2014. Total Laser plus Perceptive Software revenue is expected to be up 1% to 3% in 2014. Combined MPS and Perceptive Software revenue is expected to exceed $1billion, growing about 15% with MPS growing less than 15% and Perceptive Software greater than 15%.

On Slide 28, we summarize our full year 2014 and longer term financial assumptions. Non-GAAP EPS for 2014 is expected to be $3.80 to $4.00 per share, unchanged from our prior guidance. This reflects operating margins at the low end of our 11% to 13% target. As mentioned earlier we expect the effective tax rate for the full year of 2014 to be about 29%. This assumes the U.S R&E tax credit will be passed in 2014.

For calendar year 2014, free cash flow is expected to be at the low end of our target range of 90% to 100% of non-GAAP net income. With that we'll go ahead and open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is coming from the line of Toni Sacconaghi of Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

I was wondering if you could comment on the relationship between hardware and supplies for the Laser business. If I look back over the last nine quarters, Laser hardware revenues have been down in eight of those nine quarters, but Laser supplies revenues have been up in seven out of those nine quarters. Conceptually is this sustainable on a go forward basis and what would you suggest as the rule of thumb in terms of the relative growth rates between your Laser hardware revenues and your Laser supplies revenues, and I have a follow-up please.

Paul Rooke

And Toni, as we talked before our hardware revenue is very focused in a large workgroup segment, that 85%, 86%, 84% of our hardware revenue is in the large workgroup versus the small workgroup. So we're skewed more to that. So we actually ship fewer units and deliver more supplies and so I think the strength that we're seeing in our supplies is largely driven by that strength in the large work group install base as we grow that, particularly through managed print services and other initiatives.

We have experienced some pricing and mix things as you saw here this quarter. So that environment continues to be aggressive there and that as the units, for example this quarter we had unit growth in our large workgroup of 3% and at the same time we had hardware revenue decline, largely driven by the AUR [ph] decline year-to-year. So we're focussed really on improving that quality of the install base largely driven by this large workgroup presence over time and I think that's, what's driving that, what can make it sustainable for us.

Toni Sacconaghi - Sanford Bernstein

And then separately on Perceptive, you’re calling for a significant profitability ramp certainly through 2016, but it also sounds like through the remainder of this year. When I think about it conceptually, organically Perceptive only grew at 12%. So if you're going to hit your $500 million target, you're going to have to do a number of acquisitions. Given typically when you do acquisitions, you have to invest a lot in them. So how do we think about that trade off, clearly if you don’t do acquisitions your profitability should improve substantially? But if you are going to do acquisitions, how's it really plausible that profitability in the near term or in the longer term is going to improve as dramatically as appears to be forecast?

Paul Rooke

So overall, you’re correct on the revenue ramp to $500 million by the end of 2016, will acquire a combination of both organic and acquisition growth. We had strong organic growth of 12%. The market is certainly less than that, so we're pleased with organic growth. Obviously our software growth was even stronger at 38% because of the acquisitions that we've done to date here. But that does, the revenue projection does include the assumption of both organic and acquisition. Overall the plan to expand the margin is to grow that revenue at that continued pace while moderating our cost and expense growth and you saw that beginning to appear through the last three quarters of the last year. We took a little bit of a dip here in the first quarter. Revenue was just off a little more than we expected due to some deferrals in some deals and so we're off a little bit this first quarter. But we expect next three quarters to be in positive territory to achieve the good profitability increase in Perceptive Software year-to-year in 2014.

Now on your point on acquisitions, it varies very much by the acquisition, the size and scope of what we're doing there, some requires some investments, some have synergies, cost synergies that actually counter that. So that's something we just, we just manage through. But we're confident in our projection here that we can achieve $500 million and improve the margin as we expected by 2016.

Operator

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

Shannon Cross - Cross Research

Thank you very much. Could you talk a bit about the competitive landscape you’re seeing and you noted pricing pressure on large workgroup, was down 10% year-over-year. How much is that sort of pressure on MPS contracts versus not, or what are you seeing in terms of price aggressiveness out of some of the Japanese competitors? Then I have a follow-up, thank you.

Paul Rooke

Shannon, let me separate it in two pieces. And the MPS first of all continues to be aggressive. It's been aggressive and it remains aggressive. So nothing's changed there and as you see we're having success in the MPS area with 12% growth again here this quarter. So we're pleased with the proposition and acceptance of that by our customers driving that growth. On the non-MPS side, more of the channel or transactional part of our business, we are seeing more competitive pricing pressures in that piece from a range of competitors. So that's been a little bit more aggressive here this quarter and you saw that in the impacts on our AURs in both small and large workgroup. We also had, it wasn't all price, some of it was mix driven. We saw a little less color, more mono or black and white in the small workgroup. And so we had some mix, category mix shifts as well that affected that AUR.

Shannon Cross - Cross Research

Okay, great. And then on the Laser supplies side. HP had called out a more aggressive market from an aftermarket perspective and you guys made no commentary about what you’re seeing in third party supplies. So I'm just curious as to, I know you provide them as well as you get competed by them. So can you give an idea of what you've seen any benefits from litigation that you've had, just where you're sort of that with regard to the aftermarket?

Paul Rooke

The aftermarket supplies market for our install base is obviously critically important for our business. So we put a lot of focus on it, both on management of our customers and their accounts, the use of the supplies, particularly managed print services. One of the advantages of that is that we're managing that environment and managing the supplies consumables delivery to those accounts. So loyalty of our install base is a very important thing we watch closely and even in the non-MPS environments which we don't manage, we're constantly working with our customers there to sell the proposition, the value of regional supplies versus refills. But it takes constant vigilance and focus on it in order to achieve the loyalty rates that we're enjoying. But it’s a constant ongoing effort and focus for us.

Operator

Thank you. Your next question is coming from the line of Katy Huberty of Morgan Stanley. Please go ahead.

Kathryn Huberty -- Morgan Stanley

Yes, thanks. I believe you said that guidance for 2Q assumes no change in channel inventory. Just wanted to get your thoughts behind that given the price hike in April, why wouldn’t we see channel inventory come down? And then just as a follow up on the pricing discussion, the channel is that all on hardware or have you seen any pressure on supplies?

John Gamble

So in terms of channel inventory, Katy, as is our practice, right, given that it’s very difficult for us to know what the channel is going to do. We tend to build our forecast around assuming that the channel will stay flat. And as you know, over the last several quarters, we’ve seen increases as we indicated in the first quarter about a third of the 9% growth in channel was -- in laser supplies was related to the channel. In the last -- in the fourth quarter we indicated that we saw increases in channel inventory and again about a quarter of the 8% growth that we had in laser supplies was related to the channel inventory.

So at this point our best guess is it will probably be flat. But as you know, we don’t have full visibility. We really only see the first tier, so it’s very hard to predict.

Kathryn Huberty -- Morgan Stanley

Okay, and then just on Perceptive profitability, I think the intention is to roll out a platform such that when you bring in a new business, you can get it profitable faster than you have in the past. Can you just give us an update on the timing of rolling out that platform and whether it can have an impact later this year?

Paul Rooke

We’re making good progress on our software platform. As you saw in our slide deck, the ability to bring together capture content process and search, all that very integrated comprehensive platform is rapidly becoming a reality. In fact, some of those pieces are already in place. Our ability to take a new acquisition and plugging into that is becoming a reality and easier, but it very much Katy depends on these specific acquisitions, what it is, what technology we’re acquiring, what level of code for example -- it’s -- what state of the code it’s in and how much modification we have to do. But it becomes easier as you point out that we have a well defined, integrated architecture in place.

John Gamble

And as Paul mentioned earlier, if you look back at the first 10 acquisitions we did, right, a lot of them were technology based where we were adding technology to extend the platforms. So they did require investment to integrate. As you look forward and you’ve seen some of it recently, more of the acquisitions will be -- we’ll always have technology basis, but they won't be purely technology based. So you’re going to see more and more cost synergies be available to us as we add new companies, because our existing technology platform is so broad and they’ll be more overlapped and our global organization more full in software. So we would expect the mix of acquisitions will start to change and include more acquisitions where a lot of the benefit, where there is a significant benefit around cost synergy, not just around technology accretion.

Operator

Thank you. Your next question is coming from Ben Reitzes of Barclays. Please go ahead.

Ben Reitzes -- Barclays

Yeah, thanks. Another one on Perceptive, though I mean to be clear so far, like in the latest quarter and maybe recent quarters, the issue that is impacting profitability to be lower than you expected is this coding issue. Is it getting everything to work together when you have all these disparate sets of code or what is the main issue so far that we can point to in the latest quarter, two or three that caused it to be lower? It sounds like going forward, it’s going to get easier. But I want to nail down what the problem has been so far and how it gets easier a little more.

John Gamble

Ben, well first I’d say this quarter was a little lower but it was really around revenue growth that grew really well. We thought we were going to see a couple of more transactions closed that would have improved profitability slightly. But again, as we indicated, the first quarter tends to be seasonally weak for us. So we expected them to be slightly profitable. So the fact that they had a loss of under $2 million, it was a little worse performance than we expected, but not really material. And third and fourth quarter last year, the performance was actually fine, right. So -- and we saw a very good revenue growth and we saw a nice improvement in profitability year on year. So we think we’re still on track to drive improved margins as we go through ’14.

We think we’re going to see nice revenue performance in the second quarter and we’re expecting to see continued improvement overall as we look forward in margins. The comments around the technology platform, it was announced at our recent customer event this month, it's called the Evolution Platform and it's rolling out and there’s pieces of it rolling out now as Paul indicated and we’re very excited about it, but that really isn't affecting our profitability right – the level of R&D spending that we expected in late 2013 and 2014 is really where we are, so that really isn’t an impact on profitability, it's really just around the rate of revenue growth and it's very high, we just were looking for it to be slightly higher.

Ben Reitzes -- Barclays

Okay, great. So that platform’s going to do it, then just toning down the competition, did you say – did you feel like it was – the competition is more coming from with the aggressive pricing and large work group, more coming from traditional printer competitors or the copier folks defending their turf and how does that play out throughout the year?

John Gamble

I’d say the – across-the-board, not just the traditional copier dealers, but non-copier players.

Operator

Thank you, your next question comes from Brian Alexander of Raymond James, please go ahead.

Brian Alexander - Raymond James & Associates, Inc.

John, I think you said channel inventory helped by three points and buying ahead of April price increase helped as well, can you quantify how much you think that might have contributed to the 9% supplies growth in the quarter and then how should we think about laser supplies growth for the balance of the year especially noticing that the comparisons don’t get any easier, I know you talked about flat to slightly up for Q2, is that kind of the right trajectory for the back half of the year or should we expect something different?

John Gamble

So my comment about the buying ahead of the price increase was giving the reason why we believe channel inventory increase, so they’re not additive, they’re the same thing. And in terms of the second quarter, I think what we’re trying to indicate is, we’re expecting sell-in or the revenue we generate to be flat to up slightly but that because in the second quarter of last year there was an increase in channel inventory in the order of 2.5 points that is actually depressing the level of growth that we expect that you’ll see in the second quarter assuming the channel inventory is flat in the second quarter.

So what you’re looking at is, a growth rate excluding the movement in channel inventory of 2.5% to 3.0% or something like that right, so which again isn't – that isn't the bad performance and a little less than we’ve been seeing the last three quarters, but again supplies are not – the level of channel inventory we see is very incomplete. So it's difficult for us to be exact but again we think supplies performance certainly over the three quarters and then again looking into next quarter has been relatively good.

Paul Rooke

Setting aside the channel increase the rest of it we’re very encouraged by the page growth that we’re seeing over the last several quarters which we think is indicative of the installed base particularly from large workgroup and MPS focused that we’ve had.

Brian Alexander - Raymond James & Associates, Inc.

And then just on supplies margins, what inning are we in in terms of capturing the benefit of lower cost, laser supplies, is that helping profitability currently, is that something you think will boost supplies margins in the future or should we think of that as more of a benefit to the customer in terms of lower price supplies over time?

John Gamble

I think we’re still very early right, I mean it's the new product set that has the different architecture that allow the supplies margin to increase with time [ph], brings our cost down in delivering supplies, let’s put it that way, and those products really started selling in volume in third quarter of last year, so it's still early.

Paul Rooke

It takes time to turn the installed base obviously soon.

Operator

Thank you, your next question is coming from the line of Kulbinder Garcha of Crédit Suisse, please go ahead.

Kulbinder Garcha - Crédit Suisse AG

Thanks. Maybe a question for John, I understand you don't want to forecast channel on supplies given it's a challenge. Can you just tell us, in terms of weeks of inventory, where we are at the end of Q1? Do have a sense of that? Because obviously, you worked, how much it contributes to growth, I'm curious on absolute level in terms of weeks where we are versus any historical norm. And then I guess just the additional point around that. This continued divergence that we've seen between hardware and supplies. It sounds like, given the move to higher value systems, using this could sustain through the whole of this year, potentially, where you could have supplies, laser supplies growing on the hardware business contract. You don't see any kind of ceiling to that at least for the foreseeable future? Is that correct?

John Gamble

And so in term for your first question, we don’t really give a week’s number again. It’s because we just have incomplete visibility, it’d be very difficult for us to do, so we don’t really give weeks numbers. We have however indicated kind of directionally what that Laser supplies channel did each quarter of last year I believe. So we’ve indicated it has increased, but we haven’t really given a week’s numbers, but it’s certainly higher.

Kulbinder Garcha - Crédit Suisse AG

Actually is there any – or how about the question in different way. Is there any sign do you see John that this is exceptionally high and it could be a problem six or nine months from now, just on those levels, no [ph] kind of action just seeing in the market, there is a concern in the near term I guess.

Paul Rooke

I would say that the ins and outs of the channel will come and go over time, what we’re focused on is sellout, and is there sustainable growth in pages from our installed base? And that’s why we’re encouraged by setting aside the fluctuations whether it would be up or down in the channel we’ve got good page growth from our installed base and that’s again indicative of the initiatives that we’re focused on which to your second question the class of hardware, the quality, we’ve always said, it’s the quality of the installed base not the sizes in installed base that matters here. And so our focus on large workgroup mono and color, MFPs and so forth help drive the growth in pages that we’re seeing. But it requires constant diligence to stay on that and growing that installed base maintaining the loyalty as we mentioned last quarter and our retention rate for our MPS contracts was a 100%, so that ability to not only win large accounts, but maintain them, then continuous to drive and improve that quality in installed base.

Operator

Thank you. Your next question is coming from the line of Bill Shope of Goldman Sachs. Please go ahead.

Bill Shope - Goldman Sachs

Thanks. Could you give us a bit more a bit more color on the trends you’re seeing in laser hardware cost structure relative to the mix and pricing dynamics you’ve talked about earlier? And considering that how should we think about how this may impact hardware profit trends as you progress through this year.

Paul Rooke

Bill, we continue to work on our cost structure on all of our the broad range of hardware that we have, where we saw during the first quarter it was a little more price aggressiveness which obviously impacted those hardware margins. But it’s something we’ve historically focused on and continue to focus on as we not only introduce new generations of equipment working on the fundamental design and the cost result that ongoing cost improvements even on once we announced a model continuing to drive that cost down, any given quarter obviously price can rake quicker sometimes than some of these cost improvements. So but it’s something we’re constantly focused on to hold those margins.

John Gamble

When we announced the new product line last year we did indicate that the hardware cost was up some, because we put more of the technology in the hardware, but that lifetime cost benefit was substantial because that came out of the supplies. And therefore total cost to deliver supplies including the hardware was -- went down and that was the benefit we are expecting to see, but that was specific to the change in architecture that occurred over a year ago.

Bill Shope - Goldman Sachs

Okay. So no material changes in hardware cost structure versus your prior expectations as you progress through this year, is that fair.

John Gamble

That’s fair.

Bill Shope - Goldman Sachs

Okay. And then I guess a question related to – I guess a longer term question on supplies usage, do you have any updated views or metrics on supplies usage within the average MPS contracts versus what you’ve seen your traditional, more transactional accounts is that – and particularly how that’s trending relative to each other?

Paul Rooke

I wouldn’t cite any statistics here but I think overall you can have some very non-MPS large accounts that are good usage types of accounts, they just have chosen to buy hardware supplies separately as oppose to wrapped up in a management services deal. I would say though that as we’re talking earlier the loyalty in the Managed Print Services account tends to be a bit higher just because we’re managing that total environment versus in the other way, we’re not, so I think that’s probably the key differentiator there between the two.

Operator

Thank you. Your next question is coming from the line of Jim Suva of Citi. Please go ahead.

Jim Suva - Citigroup

I have two questions. The first is considering the EPS beat of about I think it was around $0.07 and this is kind of operational driven even though I think you mentioned that it was driven somewhat also by stronger ISS income. Was that -- what's the reason why you’re not taking your full year guidance at the lower end up higher or changing the full year guidance, is that because of the timing of the ISS since more -- the $0.07 benefit this quarter was more of a timing or why aren’t you taking your guidance up higher? And the second question is on the Perceptive Software, it seems like it’s making progress, but on the income a bit slightly lower than expected as you call out on Slide 17. Can you help us understand about why the income is a bit slightly lower than expected? Thank you.

John Gamble

So in terms of our full year guidance, again we took the revenue up a little bit because if you take a look at the first quarter actuals and the second quarter guidance, we’re running a bit ahead of the level that we talked about. So we thought it was worthwhile to take the revenue guidance up slightly. We did the same thing around our income level. We’re kind of consistent with the $3.80 to $4 range that we provided. So there was really no point that at this point in changing the -- in changing the guidance range for the full year. But we’ll continue to monitor that and obviously we continue to try to drive -- try to drive more profitability through the business and we’ll see how it goes during the year.

In terms of Perceptive, I think it’s just consistent with the previous discussion we had; right which is Perceptive has grown very well. The fact is that the first quarter is a seasonally weak quarter for us in software because of the customer base that we have. We had expected them to be marginally profitable. They were slightly worse than that, so they had a small loss, less than $2 million. And that’s just driven by the fact that although they had very good revenue growth, we were hoping for just a little bit more. And as we said third and fourth quarter of last year, we’re actually quite good and we’re expecting the rest of this year to see very nice growth and a nice improvement in margin trend.

Operator

Thank you. Your next question is coming from the line of Ananda Baruah of Brean Capital. Please go ahead.

Ananda Baruah - Brean Capital

Hi, thanks guys for taking the question. Paul, just wondering if you could comment on -- and John, as well -- on how the types of acquisitions may change going forward. I'm asking this because the comment you made with regard to the needing to make advancements around extended technology, let's call it wave one of doing acquisitions and how that’s going to anticipate [ph] and be a driver of leverage going forward. So just wondering if that's actually correct and the kind of acquisitions will change, if they are, what might a -- what might they begin to look like?

Paul Rooke

I think, when we first started in on that, we were adding to our -- we started with Perceptive which gave us a content management platform. Since then we’ve added a number of pieces dealing with capture and search and so forth and we built out a large majority of that platform. So to John’s point earlier, others may have more overlap with what we’ve already put together adding additional customer breadth or additional industry depth, skills and so forth, so you might see some of that which provide opportunities for more cost synergies than perhaps we’ve seen historically. But setting it aside, I mean we’re all about, as we evolved to a solutions company we got our eye on technology. We continue to have our eye on technology, very differentiated technology that we think we can leverage now with our platform to create even more unique solutions across the range of industries. And that’s what we’re about. While we have world class platforms, the way we go to market is by industries. So adding particular industry expertise and skills, things are as equally important as even adding technologies.

Ananda Baruah - Brean Capital

I got it. That’s good. I mean -- yeah, the industry expertise. How would you -- what might an industry expertise acquisition look like? Or did I take that out of context?

Paul Rooke

There may be opportunities to for acquisition targets that may have similar technologies to what we’ve bought in the past, but have more access to different customers or different segments of that industry. So it just -- it varies very much by target. So I’ll just leave it at that.

Operator

Thank you. Our final question will be coming from the line of Ben Bollin of Cleveland Research. Please go ahead.

Ben Bollin - Cleveland Research

Good morning, thanks for taking the call. One item in particular, you highlighted the platform cost improvements. Are those reflected in the long term 11% to 13% margin targets? And a second part to that, what percent of the base that these new products need to be for it to be meaningful to your margin expansion and further improvements?

John Gamble

Ben, for new supplies right in hardware and supplies?

Ben Bollin - Cleveland Research

No, you’ve talked about the platform cost improvements that you’re making, because you searched [ph] some of the building materials out of supplies and place them in the hardware, trying to understand if that is reflected in your 11% to 13% EBIT margin targets long-term and then if not or what percent of the base those products need to be for it to start to be meaningful to your margin?

John Gamble

So it's absolutely in our targets going forward and it needs to become a significant part of the base, right. It needs to probably become the majority of the supplies that we ship for it to be meaningful in terms of the impact on margin, which happens over time right.

Ben Bollin - Cleveland Research

Okay, and follow up, you highlighted within the quarter perceptive deals, some of them slipped in the quarter, can you talk a little bit about why they slipped, what you’re seeing out there if there’s been any change in behavior or some execution, something that you did or if it was on the customer end?

Paul Rooke

No, there was no change in environment, the software markets that we’re in are growing quite nicely. I think it was just matter of they didn’t close as quickly as we had planned, but with these large deals I mean that’s likely – it tends to be a bit lumpy quarter-to-quarter depending on how good we are predicting how fast they will close. So we’re not indicating these are losses, they are more, just we didn’t close as quickly as we had expected. But we’re – having said that we’re very excited about the growth we saw during the first quarter, as John mentioned in his comments about very good growth in the healthcare segment, the education segment, with some of these highly differentiated solutions that we have. So there is good interest, good activity in our proposition in the market, we just didn’t close them as quickly as we had planned.

Operator

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

Paul Rooke

In closing, it was a solid first quarter. Operationally, we delivered total revenue growth of 6%, excluding the Inkjet Exit revenue. We achieved this by delivering strong MPS, Perceptive Software and laser supplies revenue growth. We also delivered operating income growth and continue to improve Perceptive Software's profitability year-to-year. We remain confident in our strategy. We believe the investments we're making in our high usage hardware and high-value software technologies to bring new and differentiated solutions and services to market, we’ll drive long-term growth in our business, sustain margins and drive long-term value for Lexmark and our shareholders.

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 lines at this time and have a wonderful day.

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