Lexmark International's (LXK) CEO Paul Rooke on Q2 2014 Results - Earnings Call Transcript

| About: Lexmark International, (LXK)

Lexmark International Inc (NYSE:LXK)

Q2 2014 Earnings Conference Call

July 22, 2014 08:30 am ET


John Morgan - Investor Relations

Paul Rooke - Chairman of the Board, Chief Executive Officer

Gary Stromquist - Interim Chief Financial Officer and Vice President, Principal Financial Officer and Principal Accounting Officer


Ben Reitzes - Barclays Capital

Katy Huberty - Morgan Stanley

Shannon Cross - Cross Research

Kulbinder Garcha - Credit Suisse

Toni Sacconaghi - Sanford Bernstein

Ananda Baruah - Brean Capital

Jim Suva - Citi

Bill Shope - Goldman Sachs

Ben Bollin - Cleveland Research

Brian Alexander - Raymond James


Thank you for standing by, and welcome to the Lexmark International Second Quarter 2014 Earnings Conference Call. During the company's opening remarks, all participants will be in a listen-only mode. Afterwards, we will conduct a question and answer session. (Operator Instructions) As a reminder, this conference call is being recorded on Tuesday, July 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. Thank you for joining us. Chairman and CEO, Paul Rooke; and Vice President and Interim CFO, Gary D. Stromquist, are with me this morning. After their prepared remarks, we will open the call for your questions as time permits.

Our second 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, 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 record date of its next dividend will be August 29th, with an anticipated payment date of September 12, 2014. Please note that future quarterly dividend payments are subject to board approval. We have also included our anticipated dividend schedule for the remainder of 2014 and 2015 in the Supplemental section of the earnings presentation.

Following the conclusion of this conference call, a complete replay will be made available on our IR 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 it over to Paul.

Paul Rooke

Thank you, John. Good morning, everyone. As John said, we will be using a presentation slide deck and we will 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 second quarter financial highlights. Overall, it was a good quarter for Lexmark, exceeding our second quarter guidance for both, revenue and earnings per share. We are also expecting continued strong performance during the second half of 2014. Based on such expectations we are increasing our full-year guidance for both, revenue and earnings per share.

For the second quarter, revenue was $894 million, a slight increase year-to-year and better than expected with Laser and Perceptive Software revenue growth offsetting the Inkjet Exit decline. Excluding Inkjet Exit revenue, revenue grew 5% year-to-year. The higher value solutions of managed print services and Perceptive Software, combined grew 11% and represented 29% of total revenue for the second quarter.

Supported by strong Managed Print Services growth of 14%, our overall Laser business grew 5% during the second quarter, which included 7% laser hardware revenue growth, largely driven by 9% large workgroup hardware revenue growth, and 5% laser supplies revenue growth.

Perceptive Software while seeing lower revenue growth overall this quarter, continue to see solid customer acceptance along with software subscriptions and maintenance revenues growing 89% and 35%, respectively. Overall, we were pleased with the solid revenue growth from our high-value areas offset the headwinds of the planned ongoing decline from the Inkjet Exit.

We also continued working to increase our profitability. We managed to offset the Inkjet exit profit decline with operating income growth in the strategic segments to deliver about flat operating income year-to-year in the second quarter.

An increased gross profit margin from solid growth in the high-value segments, along with good cost and expense management yielded an operating margin of about 11%. We remain committed to our long-term operating margin assumption of 11% to 13%. Earnings per share were at $0.99 for the second quarter, exceeding our guidance. On the year-to-year basis, earnings per share declined with a slight increase of pretax earnings and lower shares outstanding more than offset by higher tax rate.

Finally, we continue to maintain our capital allocation discipline to deliver shareholder value. In the second quarter, we increased our quarterly dividend 20%, paid our 11th consecutive quarterly dividend and repurchased $19 million of the company's outstanding shares for a combined return to shareholders of $41 million.

Now moving to Slide 5, there are two key points about Lexmark that I would like to reinforce. First, we are transforming Lexmark to a higher value portfolio. To achieve this, we are 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 and we see the market for these high-value solutions expanding with Lexmark well positioned to increase our participation in these markets. In fact, our Managed Print 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 have achieved the record gross profit margin percentage for five consecutive calendar years, indicative of the progress we are making in shifting our business to these higher value markets. We have also generated positive free cash flow for 12 consecutive calendar years. This ability to generate strong cash flow continues and we are 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 are 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, it's both paper-based content like mail, documents notes and forms. As well as digital content, such as, word files, spreadsheets, e-mails, videos and images, 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.

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 is a large market about $80 billion with our focus on the high value growth segments of Managed Print Services and content and process management software, which are expected to grow at double-digit rates over the 2013 to 2017 strategic period.

Now, Slide 8, you can see the world-class platforms we have 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 this unstructured content and the associated processes, so that the content is instantly available at the time and place it is needed and any manual processes are automated and integrated with the businesses core systems.

In April of this year, we announced the launch of Perceptive Evolution, a cloud-based customer-centric platform that will further unite our products and give customers and partners' greater flexibility in how they deploy and use these technologies. The Perceptive Evolution platform provides users with a single consistent user experience across all product categories, within a hybrid cloud architecture offering customers the data security of an on-premises system, with the flexibility of a cloud deployment, and unifying our technologies within this common platform, will also enable Lexmark's R&D efforts to be more efficient and agile.

At the bottom of the slide, while we have world-class platforms that can scale with any sized customer, we tightly integrated with the core systems. What differentiates us is, how we create unique industry-specific solutions from these platforms, whether it is creating a print-on-demand signage solution for a retailer to make quick price changes in the store or a solution that enables a physician to see the complete patient record in a large hospital electronic medical records system, this is where Lexmark shines.

On Slide 9, Lexmark continues to be recognized as a leader in our key focus areas of output, content and process management. We were recently recognized for the third consecutive year as a leader in Managed Print Services by Quocirca. These Managed Print 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 have built and refined over the past 15 years.

As a proof of this leadership position within the last 24 months, we have competed for [121] new Managed Print Services contracts with companies listed on the either the Global 500 or Fortune 500, which represents incremental business to Lexmark. Our overall Managed Print Services revenue grew again by double-digits in the second 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. Here, we were recently recognized for the first time by Gartner as a leader in enterprise search, a key technology component in our content and process software platform mentioned on the previous slide.

The synergies Lexmark is bringing to accelerate Perceptive Software's R&D and sales capabilities through our organic investments and acquisitions is certainly contributing to this recognition. While there's often focus on the latest quarters' hardware or software revenues, it is important not to lose sight of what we are building in terms of annuity revenue.

We have added Slide 10 to help illustrate this. Here at the top, you see Lexmark's total annuity revenue for the second quarter on a trailing four-quarter basis. This includes annuity revenue from the laser supplies and extended warranty contracts on our hardware, as well as software subscriptions and software maintenance contracts.

As of the second quarter this grew 8% year-to-year and represents about 70% of total Lexmark revenue, excluding any Inkjet revenue. This annuity revenue growth is important as it provides a more predictable profitable revenue stream that helps to weather the ups and downs of economic cycles.

This annuity revenue grows, as we expand our imaging install base and our software install base. On imaging side, seeing on the lower-left, this annuity revenue base is growing about 7%. On the Software side, seeing on the lower-right, this annuity revenue base is growing about 44% and Software revenue from subscriptions grows faster than perpetual licensed revenue. This will also help drive more predictable annuity revenue.

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. You can see the shift in our revenue over the last three years on the left side. For the second quarter, on the right side, now, Inkjet Exit revenue's great portion is expected to decline over time at a rate of about 40% year-to-year as the trailing supplies revenue from the installed base naturally decreases.

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 actually managing fleets of our devices as a service.

The third section, the blue part is a Perceptive Software revenue. Now, combining the Imaging Solutions, and the Perceptive Software revenue, the purple and blue sections together, this represented 93% of our second quarter 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 two sections, representing longer term higher value-add solutions relationships with customers. This combined Software and Services business grew to comprise 29% of total revenue in the second quarter.

As I mentioned earlier, the MPS and software markets are growing and our growth is well in excess of the market, indicating our value propositions and our ability to execute them is resonating with our customers and potential 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 Slide 12, you can 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, as expected to exceed $1 billion in 2014.

Now, on the right side, the combined revenues grew 11% in the second quarter, driven by strong MPS growth of 14% and strong growth in Perceptive Software subscriptions and maintenance. Now Perceptive Software's overall revenue growth was lower at 3%, with a decline in perpetual licenses revenue offsetting the higher growth in the other areas.

Now this perpetual license decline was due to a tough compare with last year's exceptionally strong perpetual license revenue performance which included a single large multi-million dollar license deal.

Perpetual licenses were also lighter in the second quarter, primarily due to two additional factors. First, several million dollars of license deals we expected to close in the second quarter were delayed that are now expected to close in the third and fourth quarters.

Second, for several large deals we did win in the second quarter, the customers chose to purchase through a subscription model, rather than a perpetual license, deferring our recognition of the revenue from the second quarter. In other words, we are pleased that customer demand for our software offerings remained strong for the quarter. However, the timing and form of the revenue was different than we expected.

Despite these dynamics, we still expect Perceptive Software to grow in the mid-teens for the year, greater than the market and be profitable for the year, driven by continued revenue growth along with planned cost and expense improvements for the second half as we continue to methodically capture cost synergies across the business.

Now, we added Slide 13 to put a little more color on the dynamics of when customers choose to purchase software through a subscription model versus a perpetual licensing model, a dynamic not unique to Lexmark.

First at the top of the slide is just a simplified graphic to highlight the basic difference between a perpetual license sale and a subscription sale. The upper left, with the perpetual license model, the software license is sold upfront followed by ongoing maintenance revenue over time.

The upper right with the subscription model, there is no license sold upfront. Instead, there is a quarterly subscription revenue stream that is received over time. While this is a short-term impact of less license revenue upfront, it builds a long-term base of ratable profitable revenue for the future.

Perpetual and subscription sales are both, positive for us and we feel that it is important to allow our customers the choice of selecting the pricing model that works best for their enterprise.

To see how this is working in Perceptive Software, at the lower left graph, you can see that year-to-year trailing four-quarter comparison for perpetual license and subscription revenue is trailing four quarter view helps smooth out the lumpiness from perpetual license sales to enterprise, so you can see the ongoing trend.

Now, each includes license and maintenance revenue, but excludes Professional Services since those can be singular events.

Now, first, you can see strong double-digit growth overall and across all segments, including Perpetual License revenue. Second, you can see subscription revenue growing much faster than the traditional perpetual model of license and maintenance revenue as we see more customers choosing to purchase software on a subscription basis over time.

Finally, while this lower-left graph is backward looking, we have also included the graph on the lower right to give you a feel for the growing future value from these subscription contracts. This graph represents the next 12-month value or annualized subscription contract value for the total number of subscription contracts as of the second quarter. As we grow this, it will add to the growing base of annuity revenue for Lexmark that I highlighted earlier.

Now, Slide 14, you can see our capital allocation framework. Since first quarter 2011, we have returned 90% 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 of software acquisitions since mid-2010.

Looking ahead on Slide 15, you see our third quarter full year 2014 and long-term outlooks.

For the third quarter, our outlook is for revenue to be flat to down 2% year-to-year. Excluding Inkjet Exit, we expect revenue to grow slightly for the third quarter. We expect earnings per share for the third 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 flat to down 2% year-to-year, an 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 $3.95 to $4.15, also an improvement from our prior guidance, reflecting our strong first half performance and continued progress expected in improving the profitability of our business.

Our long-term outlook is to grow revenue at or above the market with an operating margin in the range of 11% to 13%.

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

Gary Stromquist

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.

Starting with Slide 17, overall, Lexmark performed well relative to our expectations in 2Q 2014. Revenue growth exceeded our April guidance, led by Laser business with strength in MPS, large workgroup and laser supplies, while Perceptive Software perpetual licenses came in below our expectations as deal timing and customers choosing a subscription plan impacted 2Q revenues.

As Paul referenced, customers that select a subscription plan impact the current period, but is positive in the long-term as it builds our base of more predictable software annuity revenue. Overall, we still expect Perceptive Software to have total revenue growth in the mid-teens for the full year of 2014.

Gross profit margin was strong at nearly 41%, representing a slight increase year-to-year and year-to-date. Pretax earnings grew year-to-year, sequentially, and year-to-date versus the prior-year as strength in our laser business more than offset the Inkjet Exit headwind.

Our EPS also exceeded our guidance, but was down year-to-year as increased pretax earnings and lower shares outstanding were offset by higher effective tax rate. Free cash flow of $76 million was strong and greater than 100% of 2Q non-GAAP net income. In addition, cash cycle performance was particularly strong during the quarter driven by good execution. With our strong first half performance and expectation of continuing this performance in the second half, we are raising our full year outlook for both, revenue and EPS.

Now let us look at some of the details, moving to Slide 18. 2Q EPS of $0.99, exceeded our April guidance and compares to the EPS of $1.04 in 2Q '13. The year-to-year decline is driven by the impact of the higher effective tax rate.

Operational performance showed a slight improvement year-to-year. We saw a strong improvement in Laser operating performance relative to 2Q 2013. ISS laser revenue and operating income grow substantially offset the income impact of the 33% decline in Inkjet Exit revenue.

Perceptive Software 2Q 2014 revenue grew 3% year-to-year and we were encouraged by the growth in subscription revenue and maintenance revenue, which will help us build more predictable base of software annuity revenue. We expect overall Perceptive Software revenue growth rate for the full year to be in the mid-teens and we continue to project Perceptive Software will deliver positive operating income in 2014.

As compared to the mid-point of our April guidance range, stronger than expected ISS operating income drove the improvement in EPS, led by increased Laser supplies' revenue and gross profit which was partially offset by lower than expected Perceptive Software revenue and operating income.

Turning to Slide 19, combined Laser plus Perceptive Software revenue growth of 5% was highlighted by strong growth in MPS, large workgroup and laser supplies, plus growth in Perceptive Software's subscription and maintenance annuity revenue.

In ISS, we continued 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 14% year-to-year in the quarter. Laser supplies continued the recent growth trend reflecting our ongoing success in MPS and increased mix of large workgroup hardware.

Inkjet Exit revenue declined 33% year-to-year impacting overall revenue about four percentage points. Perceptive Software revenue grew in 2Q, driven by growth in software annuity revenue comprised of subscriptions and maintenance which collectively grew 43%. Perpetual license revenue declined year-to-year compared to the strong 2Q 2013 performance.

Perpetual license revenues were heavily impacted by the timing of deal completion. A number of deals expected to close in 2Q has slipped to 3Q or later. Perpetual license revenue was also influenced by customers in the quarter selecting a subscription model.

Now moving to Slide 20, hardware revenue grew in the quarter driven by large workgroup revenue. Large workgroup hardware revenue grew 9%, driven by 7% growth in units and increased average unit revenue, reflecting our continued success in MPS. Large workgroup laser unit growth was driven by 20% growth in MFPs.

Small workgroup units grew 6% year-to-year, also driven by 16% MFP growth. Small workgroup AUR declined, driven by a higher mix of mono products in 2Q 2014.

Laser supplies revenue growth of 5% year-to-year offset most of the 32% decline in Inkjet Exit supplies. We believe laser supplies' channel inventory was about flat in 2Q '14 as expected. Based on our estimates, relative year-to-year channel movements negatively impacted 2Q '14 laser supplies growth by about 2.5 percentage points. We continue to see good end-user demand for Laser supplies, reflecting the continued growth in our MPS and large workgroup installed base.

The Inkjet Exit supplies revenue decline of 32% was better than we had expected. Geographically, excluding Inkjet Exit, we saw growth in all geographies year-to-year, highlighted by 10% growth in Europe. All geographies experienced year-to-year Laser supplies growth in the quarter.

Turning to Slide 21, we delivered solid 2Q '14 gross profit margin. ISS gross profit margin improved 30 basis points year-to-year, driven by favorable profit margins, primarily on Laser hardware offset by less Inkjet Exit supplies.

Perceptive Software gross profit margin declined year-to-year, due primarily to the decline in higher margin perpetual license revenue. Sequentially, Perceptive Software's gross profit margin improved, driven by improved professional services margins.

Skipping to Slide 23, operating income was near the low end of our long-term operating income margin target of 11% to 13%. 2Q year-to-year, ISS operating income was essentially flat as the strong laser performance offset the decline in Inkjet Exit supplies. The decline in Perceptive Software was offset by improvements in all other, all other improved year-to-year, sequentially, and year-to-date, driven by cost and expense reductions.

On Slide 24, pre-tax earnings grew year-to-year, sequentially and year-to-date. The decline in net earnings and earnings per share year-to-year is explained by higher effective tax rate for 2Q '14 in comparison to 2Q '13, which benefited from several discrete tax items.

Moving to Slide 25, free cash flow of $76 million for the quarter was strong, due primarily to improved working capital performance. 2Q '14 cash conversion improved 13 days year-to-year as we continued our strong accounts receivable and accounts payable days' performance, driven by process improvements and good execution. In addition, we had solid inventory management. We expect cash conversion days to remain roughly in the range of the last three quarters' performance.

We continue to expect to deliver free cash flow for 2014 near 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 just over $1 billion of cash along with other significant sources of liquidity.

Please turn to Slide 26 for our 3Q '14 forward-looking comments. We expect third quarter revenue to be flat to down 2% year-to-year. This guidance is equivalent to sequential revenue performance between flat to down 2%, which reflects normal sequential trends for the Laser portion of the ISS business, with continuing declines in Inkjet Exit revenue. This outlook includes a decline in Inkjet Exit revenues of slightly less than 40% year-to-year, with an impact to total revenue of approximately negative three percentage points.

Laser plus Perceptive Software revenue is expected show continued growth. We expect continued strong growth in MPS. Laser Supplies revenue is expected to be roughly flat year-to-year in the quarter. This reflects no change in channel inventory during the quarter or some estimated increase in channel inventory 3Q '13.

Excluding the estimated growth and prior-year channel inventory, 3Q '14 laser supplies revenue would be expected to increase 2% to 4% year-to-year. In 3Q '14, Perceptive Software is expected to return year-to-year growth percentage in the mid-teens. We expect Perceptive to be profitable for the full year, driven by continued revenue growth coupled with cost and expense improvements.

GAAP EPS in 3Q '14 is expected to be $0.44 to $0.54 per share. GAAP EPS in 3Q '13 was $0.53 per share. In 3Q '14, non-GAAP adjustments made up of restructuring expense and acquisition related items are expected to be $0.41 per share. This includes estimated restructuring costs of $0.12 per share and estimated $0.28 per share from acquisition related cost and expense.

Non-GAAP EPS is expected to be $0.85 to $0.95 per share. Non-GAAP EPS in 3Q 2013 was $1.02 per share. In 3Q '14, we expect gross profit margin percentage to be down slightly year-to-year, operating expense dollars to be up slightly sequentially and operating income margin percentage is expected to be down year-to-year.

Please turn to Slide 27. Assuming the mid-point of our 3Q guidance range, the decrease in EPS in 3Q '14 relative to 3Q '13 is driven by lower expected operating income in ISS in 3Q '14. Lower revenue and income from Inkjet Exit supplies will be partially offset by improved laser operating income.

Turning to Slide 28, we expect full year 2014 revenue to be flat to down 2% year-to-year, as we continue our shift to higher value solutions revenue. This has increased from our previous guidance, reflecting improved revenue performance in the first half of 2014 and in our 3Q '14 guidance.

Inkjet Exit revenue is expected to decline approximately 40% year-to-year. This results in an approximately negative four percentage point impact on year-to-year total revenue in 2014. Total Laser plus Perceptive Software revenue is expected to be up slightly in 2014. Combined MPS and Perceptive Software revenue is expected to exceed $1 billion, growing 11% to 13%.

On Slide 29, we summarize our full year 2014 and longer-term financial assumptions. Non-GAAP EPS for 2014 is now expected to be $3.95 to $4.15 per share, a $0.15 per share increase from our previous guidance range. This reflects operating margins near the low end of our 11% to 13% target. 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 the fourth quarter of 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 is primarily driven by discrete benefits in the prior year which are not expected to repeat in 2014.

For calendar year 2014, free cash flow is expected to be near the low end of our target range of 90% to 100% of non-GAAP net income.

Moving to Slide 30, to achieve the mid-point of our full-year EPS range, our EPS in the second half will need to increase $0.25 per share versus the first half. This is expected to be driven by improved operational performance led by increased Perceptive Software and laser profitability and the positive benefit of an expected lower effective tax rate due to the assumed U.S. R&E tax credit and by reduced average shares outstanding.

Turning to Slide 31, the mid-point of our revised full year guidance is an improvement in EPS of $0.15 per share compared to our January guidance reflecting both, operational and non-operational improvements.

When we provided the January guidance, we indicated that we expected Laser margin improvements, Perceptive Software growth and margin expansions and expense reductions would only partially offset the Inkjet Exit headwind, leaving an operational gap of about $0.20 per share year-to-year. This new outlook reflects the progress we are making in closing the $0.20 per share gap which is now expected to be about $0.09 per share.

To achieve this new outlook, the drivers are the same as what we told you in January, with Laser and other cost and expense improvements now providing a larger portion of the offset and Perceptive Software a smaller portion. Non-operational areas improved by $0.05 per share, primarily driven by lower than expected net interest expense.

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

Question-and-Answer Session


Thank you. The floor is now open for questions. (Operator Instructions) Your first question is coming from the line of Ben Reitzes of Barclays Capital.

Ben Reitzes - Barclays Capital

Hi. Thanks. Could you just talk a little more about, you said your Laser supplies channel inventories were flat and could you talk about the condition of supplies and how it's looking sequentially throughout rest of the year? What gives you confidence that there is not a hit coming and how is usage trending? Then I have a follow-up. Thanks.

Gary Stromquist

Okay. In the second quarter, the Laser Supplies grew 5% year-to-year and that was with channel inventory flat. As I mentioned in my comments, our estimate from prior year was that channel inventory grew or had an effect of that of 2.5 percentage points, which says effectively we saw something between 7% to 7.5% growth in the second quarter, which if you go back to the growth we had in the first quarter, we on the surface had 9%, but we indicated that about a third of that was channel inventory, so that gave you about a net 6%

For the first half, we had six and about 7% or 7.5%, so we had good growth in our laser supplies with flat channel inventory. As I mentioned in the third quarter, our assumption is that the channel inventory is flat as well. Last year we saw growth in channel inventory, which would have an effect to say supplies in the third quarter will grow somewhere in the 2% to 4% growth range. We have got now three quarters where the growth of supplies are quite good in the, say, 4% to 6% range with relatively flat channel inventory this year.

Ben Reitzes - Barclays Capital

My follow-up is just what's the reasoning behind it is? Do you feel like you are in a really good place for your mix towards the higher end of workgroup and do you feel usage has now kind of stabilized as folks have balanced the impact of MPS? Is this the new growth rate? Just in terms of sustainability and why we are seeing such a good number.

Gary Stromquist

Yes, Ben. We are encouraged by these growth rates certainly. We believe it is driven by the initiatives that we have been pursuing for some time, MPS growth, large workgroup growth, all of the things we have been talking about and we see that coming through in our performance.

Now, will it sustain at that 6% to 7%? Our modeling is a bit less, so what we have got in our guidance is a little less than that in the second half, because quarter-to-quarter this will vary certainly, but on average we think running in that kind of low single-digit is about right. The drivers are fundamentally sound and we are encouraged by what we see here.


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

Katy Huberty - Morgan Stanley

Thanks. Good morning. The stronger Laser business sounds like it is a combination of execution and some economic recovery, so just curious what you think has been causing the deal slippage in the Perceptive business, because obviously the economic and execution result was a little bit different there this quarter.

Paul Rooke

Katy, in the Perceptive, break it into its elements as you saw us describe there, we were very encouraged by the subscription growth and continued maintenance growth. The lower point here this quarter was on the perpetual licenses, so first of all we were up against a very tough compare last year. You know, it was a record perpetual license quarter for us, if you look back in history of Perceptive here and we had a very large singular deal that made it a tough compare.

Setting that aside, we had some deals that slipped. We feel very good about those deals. We expect them to land here in the second half. It just the timing there, it's tough to predict exactly on these large enterprise deals. As we have said, it can be a bit lumpy as those close.

Secondly, we saw some of this choosing of subscription versus paying for a license deal upfront, so we put little more color on that in our deck this time to help us all understand those dynamics, but it's a good thing by the way because it helps build that longer term ratable revenue base for us. It's just we had a bit of the short-term impact here in the quarter.

As we look at our business going forward, we still expect the growth of Perceptive Software to be in the mid-teens, so we expect to be profitable for the year. The mix of perpetual and subscription quarter-to-quarter may vary a little bit. I think we will get better as customers settle in on the trends there, but we view that as all positive that we are continuing to gain customers. It just the form and the timing was a little bit different than we expected.

Katy Huberty - Morgan Stanley

Okay. Then as a follow-up, over the last two years OpEx in the September quarter was flat to down sequentially and you are guiding at up a little bit. Just curious what’s driving that, particularly as you talk about cost cuts to get the Perceptive business back to profitability?

Paul Rooke

Yes. I wouldn't say there's anything abnormal there. It's up slightly, but you are right. We are focused on executing the restructuring that we had planned, so we will see that come through here in the second half, but there is nothing really to note there.


Thank you. Your next question is coming from the line of Shannon Cross of Cross Research. Please go ahead.

Shannon Cross - Cross Research

Thank you. Can you go a bit into more detail on what kind of cost cuts and optimizing you are planning on doing within Perceptive to get back to profit ability, because last quarter you had said you were going to be profitable the next three quarters? Obviously there was probably some of the license revenue that impacted you this quarter, but how key is it to you that you have license versus subscription in order to hit your profitability targets or are there incremental areas that you are looking to cut?

Paul Rooke

Shannon, certainly the less license revenue than we expected here is quarter impacted our profitability this quarter in Perceptive. As I said, we expect to be profitable for the year, but we are continuing to work on Perceptive's cost and expense base. We have been focused on these cost synergies as we are adding these acquisitions. In certain ones you can get quicker, some you get over time as you work to consolidate and shift work and bring in those acquisitions to get them fully integrated.

The cost and expense improvements that we project here in the second half are really due to just our methodical ongoing capturing of the cost synergies within that business and that will benefit that model going forward as we optimize that cost base for the expected revenue stream.

Shannon Cross - Cross Research

Okay. Then can you talk a bit about ReadSoft and how you are thinking about it? What kind of profit abilities? We haven't had a lot of conversations obviously on the ReadSoft acquisition given the bidding war that's going on, but any color you can give us on it would be helpful.

Paul Rooke

Shannon, ReadSoft is a good strategic fit for Lexmark. We feel that Lexmark is the right home for ReadSoft. We have put a very strong offer for their shareholders and we expect them to accept it and we expect to close on ReadSoft. Our expectations for the Software business, the 2016 expectations remain unchanged and certainly ReadSoft will help us get there, but we are focused right now on closing the ReadSoft deal.


Thank you. Your next question is coming from the line of Kulbinder Garcha with Credit Suisse. Please go ahead.

Kulbinder Garcha - Credit Suisse

Thanks. Just a couple of questions for me, on the Perceptive side, given the deal slippage you talked about and given the improvement in visibility and the shift towards subscription, are you calling for just a reacceleration in revenue growth in that business beyond even the third quarter sustainably? How should we think about the impact of M&A on the Perceptive revenue line going forward?

On the hardware side, can you speak about the sustainability in growth there, you said it was slightly macro, slightly execution, but it doesn’t mean more fundamental going on in terms of sheer shift on the hardware side? Thanks.

Paul Rooke

On the Perceptive side, we did have some deal slippage, but that is just timing within the quarters that we fully expect to close on those deals. It's a timing thing. The move to subscription may be a more sustainable move we will see as customers choose, but, again, we view that as a positive. As you aggregate all of those dynamics, as we said, we still expect Perceptive's growth to pop back here in the third quarter and for the year to be in the mid-teens .Again, we had a very tough compare this quarter, which dampened the overall growth.

From an M&A perspective, we are working a funnel of candidates, the most notable one here being the ReadSoft offer that we have out there that Shannon mentioned, but that is not in our outlook. It is a separate activity that we have, so we are continuing as part of our capital allocation continuing to look both, at organic investments as well as acquisitions as well.

On the hardware side, we are very encouraged. As Gary noted, the supplies growth there again is driven by- as you look at our business, if you look at some of the slides there, I think, 84% of our hardware is large workgroup-driven, so that is where we focus these large accounts managed print services driving that hardware growth.

Now it can be a bit lumpy as well from quarter-to-quarter, so we had a very good quarter. This quarter, we expect hardware though to continue to grow. Share-wise, again, we are focused on share in the large workgroup segment and we are holding our share there, but again, we are focused on pages not necessarily winning the share wars in units. Our belief is about the building the quality of our installed base which drives supplies and you can see that in our supplies results.


Thank you. Your next question is coming from the line of Toni Sacconaghi of Sanford Bernstein. Please go ahead.

Toni Sacconaghi - Sanford Bernstein

Yes. Thank you. On Perceptive, you talked about mid-teens growth for the year. I think on an organic basis that points to 0% to 5% growth for the year. A, can you confirm that?

Then on that, that’s obviously considerably lower than your belief that you can grow perceptive on a sustained basis double-digits, I appreciate the migration of subscription, but over time that should kind of normalize, so can you talk about the extensible difference in your growth rate for Perceptive this year on an organic basis relative to your longer-term outlook? I have a follow-up, please.

Paul Rooke

Okay. Yes, Toni. Certainly, this quarter, we had a negative organic, which is dragging the numbers down. Some due to the compare, but it was certainly a perpetual license impact there and we will see. Our objective remains same of growing organically, they are greater than the market, but this quarter certainly dampened that growth rate, but long-term we feel like we can grow greater than market organically and with acquisitions on top of that.

Toni Sacconaghi - Sanford Bernstein

Just on the follow-up. If I look at your guidance for Q3, you are calling for EPS to be down 12% year-over-year even though there may be some push out and software licenses that you hope to close. Yet when I look at Q4, you are calling for EPS to be up 6% and you have a tougher tax rate compare in Q4, so I'm just trying to understand the dynamic of why certainly on a year-over-year basis you seem more cautious about Q3.

Is that just a dose of healthy conservatism there or I appreciate your tax rate is going down in Q4, but I think year-over-year the tax rate actually ends up being a hurt in Q4 relative to Q3, so why the seemingly disparate outlook between Q3 and Q4?

Gary Stromquist

Tony, this is Gary. Relative to Q3, our guidance $0.85 to $0.95 and as you mentioned we did $1.02 last year. The tax rate year-to-year for third quarter is effectively the same. I think last year was about 31, this year I mentioned would be 30, so it's not really driven by the tax rate so much, but I did mention last year that we had supplies channel inventory growth, which helped the supplies growth last year to drive a little more profit into it 3Q.

Fourth quarter this year, the tax rate actually, because we have assumed that Congress will reenact the R&E tax credit, we actually have a tax rate in the fourth quarter that's almost two percentage points lower than what we saw last year that will benefit us. We also have assumed that shares outstanding are going to be less. Then we have also just assumed good strong performance on both, the Perceptive business as well as ISS into the fourth quarter.


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

Ananda Baruah - Brean Capital

Hi. Thanks for taking the questions. Two if I could. The first one is with regard to placement. I guess you guys are calling for a seasonal September quarter and that's in the context of large workgroup placement being increasingly strong over the last three quarters.

I guess, I was wondering if you could go through what the incremental drivers of strength have been, as you guys - levers been and you guys anecdotally are talking about expected ongoing strength in the second half of the year, so why would that suggest only normal seasonal growth in the September quarter given the recent strength? Then I have a follow-up. Thanks.

Gary Stromquist

Okay. The normal seasonal strength, as you know, the annuity side of our business supplies tend to be a very large portion of the revenue, so that tends to drive a lot of the seasonality of what we see.

We do anticipate end of the third quarter continued growth in our ISS business as I mentioned, and we expect Perceptive to come back to a more normal growth rate in the mid-teens into our third quarter

Ananda Baruah - Brean Capital

Then what were the drivers of the incremental workgroup unit growth strength?

Gary Stromquist

Yes. I think, Ananda, it’s a lot of the same initiatives, a lot around Managed Print Services. I mean, we are growing our Managed Print Services double-digits and it was 14% here in the second quarter, so as those deals rollout along with some large account deals as well that are non-MPS, as those rollout over time here through the second half then it helps to continue that strength.


Thank you. Your next question is coming from the line of Brian Alexander of Raymond James. Please go ahead. Brian, your line is open.

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

Jim Suva - Citi

Deals that kind of got slipped out, can you give any characteristics around it? Were they like very big megadeals that were just more complicated? Whether it's shifting more to a subscription model that just the user has to get more familiar and comfortable with or was it more a geographic or industry-specific?

Paul Rooke

Jim, I'm not sure I caught all your questions. What I heard was that you were asking about the slips and trying to characterize the slips in our Perceptive Software business this quarter.

These were large deals, complex deals, so it is more around that and the timing of closing these large enterprise complex deals. I mean, that was the net of it. It was geographically probably more North America than say Europe. That's how I would characterize it.

There were other deals that then we did win. Like going into the quarter, we expect them to be perpetual license deals that then by when all the smoke cleared on the deal it was a subscription deal, so that revenue essentially gets the recognition of revenue moves out of the quarter then it starts to build that subscription revenue over time, so obviously you have an impact to that in the quarter.

Jim Suva - Citi

Great. Then as a follow-up, can you give us a little bit of details on what to expect for share count kind of for Q3 and Q4? Then also am I correct that ReadSoft is not included in the outlook or is it?

Paul Rooke

ReadSoft is not. We are focused on closing ReadSoft, but it is not in the outlook and I'll let Gary comment on the shares.

Gary Stromquist

We plan to continue to implement our capital allocation framework that we have been dealing, so we are planning to continue to buy shares, which in the second quarter the average shares used for the calculations were 63.4, so what you will see is this probably drop 200,000 to 300,000 going into the third quarter, in that kind of a range.


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

Bill Shope - Goldman Sachs

Great. Thank you. I have two questions. One, the clarification. The first one, the clarification, it sounds like we should assume laser supplies channel inventory will end up being flattish for the year, so first of all is that correct? Then the second question, a bit more of a structural question to understand supplies channel inventory, your MPS business would presumably require less supplies channel inventory over time than standard deals. Is that true? Is that happening or are you seeing that have less of an impact on the overall picture, presumably because of usage?

Paul Rooke

Okay. As I mentioned in my prepared comments, for the third quarter, we have assumed the channel inventory will be flat. Again, that is just an assumption, because as we have said before, the channel inventory is a result of what our channel partners decide that they want. I would say is probably a reasonable assumption. We have said, but as we go into the fourth quarter, we would also make an assumption that it would be flat, but again it would be based on what our channel partners ultimately want to hold.

Relative to the fulfillment of MPS supplies versus, I will just call it traditional supplies, your assumption is correct. The MPS supplies are fairly predictable in terms of how they come in, what customers they come in from and how they come in and we typically select partners in each region that we want to fulfill these, so the demand goes one or two partners and it's reasonably predictable and that channel inventory does tend to be less than the traditional side, where there is more variability in terms of customer might shop around as to what reseller they want to use quarter-to-quarter and it tends to move around more.

Gary Stromquist

Bill, I think it's fair to say that as our business grows, our Laser business then they will hold more. As our supplies usage and support the sell-through grows then they will hold more inventory in support of that.

Bill Shope - Goldman Sachs

Okay. That's helpful. Thank you.


Thank you. Your next question is coming from the line of Ben Bollin of Cleveland Research. Please go ahead.

Ben Bollin - Cleveland Research

Good morning. Two questions, the first, when you look at the Laser supplies business in your own visibility, can you talk to the methodology towards your forecast. How much of that business is under contract and what types of data sets are you evaluating when you are making those forecasts?

Ben Bollin - Cleveland Research

Well, we actually have very complex models that we use to forecast the supplies business. Relative to your contracts question, with an MPS, where we have an MPS contract with the customer, that's probably a very direct kind of a contract where we can kind of predict the usage and the loyalties are 100% there.

The next part of our business would be what is under special bid and that's where when the customer buys hardware, we also special bid to them the supplies for a price possibly little better than what they would just buy in their channel. Certainly, there is a bit of a contract there with the special bid, but I would call that looser than, say, an MPS contract.

Then the third piece would just be open channel business, where a customer just goes wherever they want to in the channel and they buy it and there's just no contract at all.

Ben Bollin - Cleveland Research

Second part, looking at Perceptive, why would a customer select subscription over the perpetual license in Perceptive? Are there any long-term implications on retention rate based on the two license models?

Paul Rooke

I think, Ben, to the second part of your question, you have to work on loyalty in both cases, right? One, in the perpetual, you are making sure that the maintenance contracts are consistently renewed and the subscription you are making sure the subscription contracts are renewed, so you get focused on loyalty in both cases, but the software tends to be sticky. Once you are in, it provides a very good model.

Why somebody chooses subscription versus perpetual? I mean, every company is different, but some are opting to go more of the less upfront expense. Upfront for the license and just have a more predictable model in their expense stream over time. It kind of a pay-as-you-go even though it is more contractual based, but it is more of that mindset that tends to steer in that way.


Thank you. Our final question will be coming from the line of Brian Alexander of Raymond James. Please go ahead.

Brian Alexander - Raymond James

Thanks. I don't know what happened before, so just back to Perceptive. Sorry if this was asked. Just to clarify, when you look at the aggregate performance of the business, was the overall progress in line with your expectations and the entire variance on a reported basis was driven by timing and the form of adoption? I'm talking about revenue and profitability. I've a couple of follow-ups.

Paul Rooke

Yes. Brian, yes, I would characterize it. From a customer acceptance, the timing was off less than we expected, because we expect more deals in the quarter and those moved to the right on us, so the timing was less than we expected, but we do expect to win those deals that did move.

On the subscription, again, we won those deals. As expected, it is just form was different than we expected, but overall that's why we have characterized these dynamics as we feel good about it, because customer wise we still won the deals, some of them moved to the right, but we still feel we are going to win them.

In terms of the model, the business model and the profitability, we are continuing to work on cost and expense here as we move to the right as we try to capture more and more of these synergies that we have been planning. As we look into the second half, we continue to see strength in Perceptive, and we expect to bring profitability there with continued revenue growth as well as some the continued cost and expense improvements.

Brian Alexander - Raymond James

Just a follow-up, then I have one more after this. If the organic growth doesn't accelerate and you don't get back to double-digit organic growth in Perceptive, what is plan B? Does that mean you look to acquire more companies? Does that mean you look to actually invest more in sales resources or do ultimately accept that the $500 million goal may not be achievable?

Paul Rooke

Well, certainly we are focused on plan A, Brian. Our goals for 2016 remain unchanged, but organic growth, you got to have organic growth, so we took a little dip here for all of the reasons we talked about, but we expect to get that back on track. We will continue the M&A activities as you will, but the organic growth is very important to us and we are focused on that.

Brian Alexander - Raymond James

The final one is just on the revenue guidance for the year, so I think you are raising it by 2% versus what you had before. If you could just talk about the sources of upside, it seems like the ink supplies runoff is a bit slower than you anticipated. By my math, that is contributing to a fair amount of the change in your guidance, so even if it is just directional, can you give us details about how you are thinking about the revenue outlook for the second half versus what you were thinking before for the second half in terms of hardware, ink supplies, laser supplies and Perceptive? Thanks.

Gary Stromquist

As you mentioned, our full-year guidance is about 2% improvement. Your question relative to the Inkjet Exit, we have pretty much said all year that we expect that to be about 40% down and then that is still our assumption for the whole year. I mean, it maybe was a little less than that in the second quarter which helped us some, but we expected to be about 40 for the full year, so we don't really expect to benefit from that.

Our guidance is better just for the fact that our first half was better. I mean, our first half was close to flat year-on-year. Our third quarter outlook is better. It is flat to down 2% and we just see the strength really in our first three quarters of this year are better than what we had thought they would be.


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 good second quarter for Lexmark. Operationally, we delivered total revenue growth of 5%, excluding Inkjet Exit revenue. Overall, this growth in our strategic segments offset Inkjet Exit headwind for both, revenue and operating income and we achieved it by delivering strong revenue growth for management services, laser hardware and laser supplies, software subscription and maintenance revenue, all encouraging signs that our strategy is working, so we believe the investments we are making in our high usage hardware and high value software technologies to bring new and differentiated solutions and services to market will drive long-term growth in our business, sustain margins and drive long-term value for Lexmark and our shareholders.

With that, I will turn it back over to the operator to close out the call.


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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