Lexmark Q4 2006 Earnings Call Transcript

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Lexmark International, Inc. (LXK)
Q4 2006 Earnings Call
January 30, 2007 8:30 am ET

Executives

John Morgan - Director, Investor Relations
Paul J. Curlander - Chairman of the Board, Chief Executive Officer
John W. Gamble - Chief Financial Officer, Executive Vice President

Analysts

Richard Farmer - Merrill Lynch
Ben Reitzes - UBS
Laura Conigliaro - Goldman Sachs
Toni Sacconaghi - Bernstein Research
William Shope - J.P. Morgan
Kathryn Huberty - Morgan Stanley
Keith Bachman - Banc of America Securities
Shannon Cross - Cross Research
Ben Bollin - Cleveland Research
Bill Fearnley - FTN Midwest Research

Presentation

Operator

Thank you for standing by, and welcome to the Lexmark International fourth quarter 2006 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, January 30, 2007. I would now like to turn the call over to John Morgan, Lexmark's Director of Investor Relations. Please go ahead, John.

John Morgan

Thank you, Elsa. Good morning, and thank you for joining us today. With me for Lexmark's fourth quarter 2006 earnings conference call are Lexmark's Chairman and CEO, Paul Curlander, and Lexmark's Executive Vice President and CFO, John Gamble. After their prepared remarks, we will open the call for your questions as time permits. We ask that you please limit yourself to one question and, if needed, one follow-up so that we can get to everyone’s questions.

Following the conclusion of this conference call, a complete replay will be made available from our investor relations website located at http://investor.lexmark.com. Currently, in the upper right-hand corner of this website, you can access today’s earnings release as well as the supplemental slide deck for the fourth quarter, which includes the reconciliations of GAAP and non-GAAP financial information.

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

With that, I’ll turn it over to Paul.

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Paul J. Curlander

Thank you, John. Well, today we’re announcing our fourth quarter results that overall represent a good quarter for Lexmark. Highlights for the quarter include: strong revenue growth in our business segment in both core hardware and supplies revenue; strong branded unit growth in our key focus segments of low-end mono-lasers, color-lasers, laser all-in-ones, and inkjet all-in-ones; continued solid cash generation; and continued progress on our core strategic initiatives, particularly around new product introductions and investment in brand development.

Fourth quarter revenue was $1.369 billion, about flat year to year. Supplies revenue for the quarter was up 4% year to year and at the high-end of our guidance range. Hardware revenue for the quarter was down 2% year to year, as decline in inkjet unit shipments, driven mainly by our previous decision to exit low profitability inkjet business, was partially offset by strong growth in laser units.

Earnings per share were $0.91 in the quarter. On an operational basis, excluding the $0.14 per share of restructuring related charges, earnings per share would have been $1.05. Now, this $1.05 includes a lower tax rate for the quarter than the 30% rate we had included in our fourth quarter earnings per share guidance, and John Gamble will give you some more details on this.

In the fourth quarter, we continued to generate good cash flow, with net cash from operating activities of $143 million in the quarter, and $671 million for the year. Now, let’s talk a little bit more about supplies. For the quarter, supplies revenue was up 4% year to year, with strong growth in laser supplies partially offset by a decline in inkjet supply sales. This strong laser supplies growth was driven by strong end-user demand that exceeded our supplies model.

For the first quarter of 2007, we believe laser supplies growth should return to a growth rate more in line with the model.

As we look ahead, we see the potential for continued erosion in inkjet end-user demand due to the weak OEM sales we’re experiencing and due to the reduction in inkjet volumes resulting from the actions announced in January, 2006 to discontinue low profit inkjet sales. Our current expectation is for first quarter 2007 supplies revenue to decline year to year in the low- to mid-single digit range.

In the consumer market in the fourth quarter, we saw the usual sequential seasonal uplift in demand. However, on a year-over-year basis, we believe the total market unit sales were about flat to slightly down year to year. For the quarter, our consumer market revenue was $597 million, down 11% year to year.

Consumer segment operating income was $50 million. Now, excluding restructuring related charges, consumer segment operating income in the fourth quarter would have been $53 million, up 22% year to year.

For the quarter, inkjet unit shipments declined 18% year to year, with growth in inkjet all-in-ones more than offset by declines in single function printer sales. However, branded inkjet unit sales in the fourth quarter were down much less than 18% year to year, with strong branded unit growth in our targeted segment of inkjet all-in-ones.

In the business market segment in the fourth quarter, we saw some slowdown in overall market demand compared to the earlier quarters of 2006. However, despite this market slowdown, Lexmark had a strong quarter in laser printer sales. Our business market revenue in the fourth quarter was $772 million, up 11% year to year.

Business segment operating income was $157 million. Excluding restructuring related charges, the business segment operating income would have been $165 million, up 4% year to year.

In the fourth quarter, laser unit shipments were up 15% year to year, with strong growth in our branded unit sales, driven by growth in low-end mono-lasers, workgroup mono-lasers, color lasers, and laser MFPs.

Now, as we step back and look at 2006 overall, I believe we made good progress last year. First, in response to a disappointing second-half of 2005, we announced a number of actions in January, 2006, that were implemented during the year, including the discontinuation of about 20% of our worldwide inkjet business that did not return an acceptable level of profit over the product life. While this negatively affected revenue in 2006, this improvement in the quality of our installed base will have a positive effect over time.

Also in 2006, we executed a restructuring plan to consolidate our manufacturing capacity and to improve our cost and expense structure. This initiative incurred a cost of $135 million in 2006, and is expected to drive annualized savings of about $80 million per year.

Most importantly in 2006, we continued to make progress on our core strategic initiatives in both product segment expansion and brand development. As a result of our increased R&D investments, 2006 was a strong year for new product introductions, with new families of low-end mono-lasers, color lasers, laser MFPs, and inkjet all-in-ones. These new products received significant industry recognition and awards. In fact, last year, the top U.S. independent test labs awarded Lexmark more laser printer awards in our class of products than any other leading printer brand.

2006 was also a strong year for branded unit growth in our key focus segments, with strong growth in low-end mono-lasers, color lasers, laser MFPs, and inkjet all-in-ones, including a strong finish to the year with sales of our inkjet four-in-ones, driven by the new X5470 four-in-one, which was launched in September, 2006.

In late 2006, we launched the next step in our brand development initiative with the start of a new television advertising campaign, along with radio, print and outdoor advertising in targeted geographic end-market segments. This integrated campaign highlights Lexmark's deep and proven experience serving 75% of the top banks, retailers, and pharmacies, while highlight the opportunity for small and medium businesses and consumers the benefit from our business class expertise. We will be continuing this campaign in 2007.

Looking back on 2006, we made significant progress on all these initiatives, but there is still more to do. We are not yet where we want to be in terms of our product line or market position in several of our key growth segments. We need to continue to invest and to improve in order to drive our long-term growth.

Now, as we look forward to the first quarter of 2007, we expect revenue to be down year to year in the low- to mid-single digit range, reflecting a weak OEM outlook and my earlier supplies guidance.

We expect first quarter 2007 earnings per share to be in the range of $0.93 to $1.03, excluding the impact of restructuring related charges.

As we look to the longer term, our focus in 2007 will be to drive our branded unit growth in our key growth segments. Distributed output market presents a number of attractive growth opportunities, such as low-end mono-lasers, color lasers, laser MFPs, inkjet three-in-ones and inkjet four-in-ones, where we are currently underrepresented.

With our increasing investment in R&D and our focus on building the Lexmark brand, we continue to strengthen our competitive position and improve our ability to pursue these growth opportunities.

Lexmark's financial position continues to be strong. In the fourth quarter, again we generated solid cash flow and ended the quarter with over $0.5 billion in cash and marketable securities on the balance sheet.

For the year, we returned almost $900 million to shareholders by repurchasing approximately 16.5 million Lexmark shares. Over the last two years, we have returned almost $2 billion through share repurchase.

I’ll now turn it over to John Gamble for some more detailed remarks on our financials.

John W. Gamble

Thank you, Paul, and good morning. Consistent with previous calls, I’ll first discuss our results of the fourth quarter relative to the prior year, then relative to the third quarter of 2006. Next, I’ll indicate our full year results. I’ll then discuss selected changes on the balance sheet and certain items of cash flow. Finally, I’ll finish with more detail regarding our guidance for the first quarter. I will call out the impact of restructuring as we walk through the P&L.

In the supplemental slide deck posted on our investor relations website, we have included quarterly details on the income statement line items impacted by the restructuring. Also included in the supplemental slide deck, we have include quarterly details on the income statement line items impacted by SFAS-123R stock-based compensation expense, which amounted to approximately $10 million in the fourth quarter.

In addition, we have included information on calendar year performance. Now let me start with the P&L.

Total revenue for the quarter was $1.369 billion, about flat compared to last year, up about 11% sequentially from 3Q, and at the high-end of the range that we provided in October. Total revenue for 2006 was $5.108 billion, down 2% year to year.

Geographically for the fourth quarter, U.S. revenue of $577 million declined about 3% year to year. Revenue in EMEA of $510 million was up about 3% year to year. The remaining geographies were up about 2% versus a year ago.

Geographically, for the full year, U.S. revenue declined 5% year to year; EMEA revenue declined 1% year to year; and the remaining geographies increased approximately 1% year to year.

In 2006, Dell represented about 15% of revenue.

Laser and inkjet printer revenue in the fourth quarter was down 2% from 2005. As Paul indicated earlier, inkjet hardware shipments declined 18%, and laser unit shipments were up 15% year to year in the fourth quarter. Inkjet hardware average unit revenue increased approximately 1% year to year as price declines were more than offset by a mix shift to all-in-ones.

Laser average unit revenue declined approximately 4% year to year, due to product mix shift as well as price declines. For the 2006 calendar year, laser and inkjet printer revenue was down 8% from 2005.

Inkjet hardware shipments were 14.7 million units, down 20%, and laser unit shipments were 2.1 million, up 9% from 2005.

For the calendar year, inkjet hardware average unit revenue increased approximately 2% year to year, reflecting our product mix shift to all-in-ones, driven by our initiative to exit low profitability inkjet business, mostly offset by price declines.

Laser average unit revenue declined 9%, reflecting year to year price declines and the product mix shift to low-end lasers.

Laser and inkjet supplies revenue in the fourth quarter was up 4% from 2005, with strong growth in laser supplies revenue being offset by a decline in inkjet supplies revenue. For calendar year 2006, laser and inkjet supplies revenue was up 3%. Again, good growth in laser supplies was partially offset by declines in inkjet supplies.

As we have discussed, we see the potential in 2007 for continued erosion in inkjet supplies end user demand due to the reduction in inkjet hardware unit sales, reflecting both our decision to focus on more profitable printer placements and weakness in our OEM business.

Business segment revenue for the quarter of $772 million was up 11% from the same quarter in 2005, and sequentially from 3Q06. Year to year and sequential growth was driven both by increased supplies revenue and increased hardware revenue. For the year, business segment revenue was up 3%.

Consumer segment revenue for the quarter was $597 million, down 11% compared to a year ago but up 11% sequentially. The year-over-year decline was due to declines in both inkjet hardware and, to a lesser extent, inkjet supplies revenue. Conversely, the sequential increase was driven mostly by growth in inkjet hardware and, to a lesser extent, inkjet supplies revenue.

For the year, consumer segment revenue was down 8%, reflecting declines in both hardware and supplies revenue, as our decision to focus on more lifetime profitable business and weak OEM sales negatively impacted hardware sales as well as supplies.

Gross profit margin for 4Q was 30.8%. Excluding the impact of approximately $3 million of restructuring related costs, gross profit was 31.1%, up 280 basis points from 2005 and down 180 basis points sequentially. The 280 basis point improvement versus last year was principally due to a 350 basis point improvement in mix, mostly from a decline in inkjet hardware and more laser supplies, partially offset by hardware margin declines and less benefit from the adjustment of lower of cost or market and advanced purchase commitment reserves. The 180 basis point sequential decline was principally driven by increased inkjet hardware sales.

Full-year gross profit margin was 32.2%. Excluding the impact of $42 million of restructuring related expenses, gross margin was 33.0%, up 1.7 percentage points from 2005. The 170 basis point improvement was principally due to a 330 basis point mix improvement of less inkjet hardware and more laser supplies, partially offset by hardware margin degradation in both inkjets and lasers.

Cost of sales included approximately $2 million of FAS-123R stock-based compensation expense in the quarter, and $6 million for the year.

Operating expense for the quarter was $319 million. Restructuring related expense of approximately $16 million impacted operating expense this quarter. Excluding this impact, operating expense was $303 million, an increase of $30 million year to year.

SG&A was $206 million, an increase of $17 million from 2005.

R&D was $97 million, an increase of $13 million from 2005.

This quarter’s operating expense also includes $8 million of FAS-123R stock-based compensation expense, with approximately $7 million and $1 million impacting SG&A and R&D expense respectively. Excluding the impact of FAS-123R expense, operating expense increased by $23 million, due to investment in R&D and brand initiatives.

Sequentially, operating expense excluding restructuring related costs was up $26 million versus the third quarter, mostly driven by increased branding initiatives and R&D investment.

Full-year 2006 operating expense was $1.204 billion. Excluding restructuring related expense net of curtailment gains of $83 million and $10 million in 2006 and 2005 respectively, operating expense in 2006 was $1.120 billion, up $29 million. R&D was $371 million, up $34 million, with SG&A at $750 million, down $5 million.

Calendar year 2006 operating expense includes $34 million of FAS-123R stock-based compensation expense, with approximately $27 million and $7 million impact SG&A and R&D respectively.

Excluding these expenses, operating expense is down slightly in 2006, as reductions in SG&A funded R&D investment.

The operating expense to revenue ratio in 4Q was 23.3%. Excluding the restructuring related costs, the operating expenses to revenue ratio was 22.1%, an increase of 210 basis points from 2005, and about flat sequentially.

The 210 basis point increase from prior year was driven by increased R&D investment, marketing, and FAS-123R expenses.

Operating income in 4Q was $103 million. Excluding the restructuring related expenses of approximately $19 million, operating income was $122 million, up $8 million from last year and down $6 million sequentially.

Operating income for all of 2006 was $443 million. Excluding restructuring expense net of curtailment gains of $125 million and $10 million in 2006 and 2005 respectively, operating income was $568 million in 2006, up $24 million from 2005.

FAS-123R expense impacting operating income, was $10 million in 4Q and $41 million in calendar year 2006. Compared to 2005, excluding restructuring related activities, the business segment operating income in 4Q of $165 million was up $7 million versus last year and up $12 million sequentially.

Excluding restructuring expenses in both 2006 and 2005, calendar year 2006 business segment income of $636 million was down $31 million versus 2005. The consumer segment, again excluding restructuring expenses, had operating income in 4Q of $53 million, up $9 million versus last year but down $14 million sequentially.

Excluding restructuring expenses in both 2006 and 2005, calendar year 2006 consumer segment operating income of $303 million was up $68 million from 2005. Please note all FAS-123R expense of $10 million in 4Q and $41 million for the full year is recorded in other expenses and does not impact business or consumer segment reported results.

Other expenses, consisting primarily of costs related to centralized supply chain, IT, and other operating expenses, primarily G&A, were $96 million in 4Q excluding restructuring related activities, an increase of $9 million from 2005 and an increase of $4 million sequentially.

Other expenses, again excluding net restructuring related expenses in 2006 and 2005, were $371 million for all of 2006, up $14 million from 2005. Excluding FAS-123R expenses, other expenses were down $1 million in 4Q and $27 million for the full year 2006.

Operating income margin in 4Q was 7.5%. Excluding the restructuring expenses, our operating income margin was 8.9%, an improvement of 60 basis points from fourth quarter 2005 and a decline of 150 basis points sequentially. Operating income margin for full year 2006 was 8.7%. Excluding restructuring related expenses net of pension curtailment gains, operating income margin was 11.1%, up 0.7% from 2005.

Concerning financing and non-operating costs, the interest and other in 4Q was a net income of $3.7 million, down $0.8 million from 2005 and down $0.3 million sequentially. For the full year, our net interest and other was net income of $16.8 million, down $3.1 million.

The effective tax rate for 4Q was 15.9%, lower than the 30% rate we had forecast. This primarily reflects the $8 million benefit from the retroactive extension of the U.S. research and experimentation credit, which applied in full to 2006. The tax rate also reflects a net benefit from the resolution of several principally non-U.S. tax matters, and a lower incurred rate, due principally to a favorable geographic mix of income.

The effective tax rate for calendar 2006 was 26.3%, reflecting the items just referenced. For 2007, we expect the tax rate to be approximately 27%.

Net income for the quarter was $90 million, up $8 million from last year. Excluding after-tax restructuring related costs of approximately $13 million, net income in 4Q06 was $104 million. 4Q05 net income was $82 million. Net income for the current year was $338 million, excluding after-tax restructuring related costs of approximately $94 million, and pension curtailment gains of approximately $7 million in 2006, net income was $426 million.

As you will remember, 2005 GAAP net income of $356 million was negatively impacted by $57 million in non-recurring items, principally the $52 million tax expense related to funds repatriated under the American Jobs Creation Act.

Adjusted 2006 net income was up $13 million or 3% versus adjusted 2005 net income of $413 million.

GAAP earnings per share for the quarter were $0.91. Excluding restructuring related expenses, 4Q06 EPS would have been $1.05, stronger than the $0.80 to $0.90 range we indicated in the October earnings call. The $0.80 to $0.90 range excluded the tax benefit of $8 million, or $0.08 per share realized in 4Q06 related to extension of the U.S. R&E credit.

For comparative purposes, applying the 27% tax rate expected for 2007 to our pre-tax, 4Q06 results, excluding restructuring expenses, yields an EPS of $0.93 per share.

Calendar year 2006 GAAP earnings per share were $3.27. Excluding restructuring related items and pension curtailment gains, 2006 EPS would have been $4.12, up $0.74 or 22% versus 2005 EPS, again adjusted for the 2005 non-recurring items referenced earlier.

Now, moving to the balance sheet and cash flow items. Cash flow from operations for the quarter was $143 million, a sequential decline of $24 million and a decline of $79 million from last year. The $143 million generated this quarter is a strong performance, as it includes restructuring cash outflows of $36 million. Cash flow from operations for 2006 was $671 million, up $91 million from 2005. This includes $60 million of restructuring cash outflows.

Accounts receivable increased $15 million from September, inventory declined to $6 million in the quarter. Accounts payable declined $7 million since the end of September, and accrued liabilities increased $18 million since the end of September.

For the quarter, capital spending was $58 million, and we ended the year at $202 million. Depreciation in the quarter was $41 million, of which $2 million was accelerated depreciation. Depreciation was $201 million for the year, and included $40 million of accelerated depreciation related to our facility closures.

Currency of the Euro was accounted for at $1.288 compared to $1.190 in 4Q 2005, and was at $1.255 for calendar year 2006 versus $1.247 for 2005.

Cash and marketable securities at the end of 4Q was $551 million, down $11 million since September.

In 4Q, we repurchased 2.1 million shares for $141 million, at an average price of $66.50. At quarter end, we had $460 million of share repurchase authority outstanding. For the full year of 2006, we repurchased 16.5 million shares for $871 million, at an average price of $52.84.

Of our $551 million of cash and marketable securities at year-end, over two-thirds were overseas.

The restructuring actions that we announced in January of 2006 are now principally complete. Our inkjet cartridge facility in Rosyth, Scotland has been closed and our laser toner facility in Orleans, France has also ceased operations. Total headcount impacted by the actions was over 1400, with over 875 net reductions and over 525 positions moved principally to low-cost countries.

Implementation and related costs incurred in 2006 was $135 million, not including the $10 million benefit from pension curtailment gains. Of the $135 million restructuring related costs, $42 million impacted cost of sales and $93 million impacted operating expense. Total cash outflow is expected to be slightly over $80 million, of which $60 million has been incurred to date.

The 2006 savings were $61 million, and on an ongoing basis in 2007 and beyond, we expect approximately $80 million annually in savings.

In the fourth quarter, we incurred $19 million in pre-tax restructuring costs and related expenses, approximately $3 million in cost of sales, with the remaining $16 million impacting operating expenses. This is higher than the $14 million we had forecast in October, primarily reflecting costs incurred to the exit of facilities in Europe.

Cash outflow in the quarter was $36 million. Savings in the quarter from restructuring were slightly over the $15 million we had forecast.

In July of 2006, we announced that an additional 100 positions would be impacted as part of the restructuring effort. These additional actions will be completed in 2007.

For 2007, restructuring and related expense are not expected to exceed $5 million in any given quarter. We will identify these costs for you each quarter. In 1Q07, restructuring and related expenses are expected to be about $0.03 per share.

Now, for my forward-looking comments concerning 1Q.

We expect first quarter revenue to be down in the low- to mid-single digit range year to year. Although we continue to make progress in branded hardware unit sales growth in our focus segments, we are expecting weaker OEM hardware unit sales in 1Q07 versus last year.

Also, as Paul indicated earlier, supplies revenue is expected to be down year to year, driven by a decline in inkjet supplies revenue. We expect GAAP EPS to be in the range of $0.90 to $1 per share. Excluding $0.03 per share of restructuring expense, EPS is expected to be in the range of $0.93 to $1.03.

EPS in the first quarter of 2006 was $0.78, or $1.03 excluding 1Q 2006 restructuring related charges and pension curtailment benefit.

In terms of our specific discussion of margin levels, the 2006 percentages that I am comparing to are non-GAAP and exclude the impact of 2006 restructuring related charges and pension curtailment benefit.

In the first quarter, we expect the gross profit margin percentage to be above last year’s 33.1%.

Regarding operating expense, as we indicated at our November analyst meeting, we will continue to increase investment in development to extend the success we have had with the new products, based on Lexmark technology launched in the last several quarters.

We will also make selected investments in marketing and sales to capitalize on these award-winning products. As a result, the operating expense to revenue ratio in the first quarter is expected to be higher than the 22.1% we incurred in the fourth quarter of 2006.

Operating income margin in the first quarter is expected to be down from last year’s 12.6%. Versus the 8.9% achieved in the fourth quarter of ’06, operating income margin is expected to be up. We continue to project operating margins will be in the range of 8% to 10%.

The effective tax rate in 1Q07 and the full year is expected to be approximately 27%. Capital spending for the full year 2007 is expected to be approximately $235 million, and depreciation is expected to be approximately $150 million.

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 Richard Farmer with Merrill Lynch. Please go ahead.

Richard Farmer - Merrill Lynch

Thank you. Paul and John, as you know, IBM’s exiting its printing business in a joint venture with Ricoh. Eventually, a full sale to Ricoh. How do you expect that to effect Lexmark's OEM business? If I heard you correctly, Paul, I think you mentioned you expect some weakness in OEM laser in your outlook. Is that the factor you’re referring to? More generally, can you help us quantify the effect on revenue and earnings from the IBM transaction?

Paul J. Curlander

Well, Richard, in general, I just cannot make any comment on our OEM business. That certainly applies to IBM. We’re their supplier. We have confidentiality agreements relative to our business with them, and any questions about the business, you’ll have to direct to them.

What I can tell you is that when I look at our laser shipments, the vast majority of laser shipments are Lexmark branded shipments. That’s our focus, to drive Lexmark branded shipments. We had really a very good year in 2006 on our branded sales. We would expect that to continue as we go into 2007. That’s our primary strategy. That’s how we intend to drive the growth in the business, is through branded sales.

OEM as always is an opportunistic thing. We do it if it’s incremental volume and if it makes business sense.

Relative to my comments about a weaker outlook for OEM in the first quarter, fourth quarter was a little unique of all the quarters this year in 2006 because in general, OEM laser units were down in every quarter of ’06, except the fourth quarter. They were up for that quarter.

But as we look into the first quarter, we do see a weaker OEM outlook in lasers as well as inkjets, and that’s just an overall statement, talking about our laser OEM business.

Richard Farmer - Merrill Lynch

Thank you.

John Morgan

Okay, Operator, let’s go and take the next question, please.

Operator

The next question is coming from Ben Reitzes with UBS. Please go ahead.

Ben Reitzes - UBS

Good morning, thanks a lot. In the quarter, SG&A was more than I expected. I’m not sure about everybody else, but can you just talk about your spending levels on that line, and what your outlook is for ’07 there, in terms of the impact on operating margin?

Then, I have a follow-up, if I’m allowed. I can’t remember and I don’t want a lecture.

Paul J. Curlander

SG&A on the quarter was up, principally around marketing and branding initiatives. In 2006, the timing of some of our branding and marketing initiatives was a little different than 2005, and that led to some of the increase in the fourth quarter.

If you look at SG&A year over year though, it was down significantly, and in that, I think you see the -- excluding the impact of FAS-123R, in that you see the effect of the restructuring that we did, so we did see the benefit from the restructuring flow through the SG&A line as you look at the full year 2006 expenses.

Ben Reitzes - UBS

All right, and Paul, big picture, I mean, you’re expecting revenues to be down in the first quarter. Obviously you don’t give full year guidance, but with the trends you’re seeing in supplies being down year over year, big picture, do you expect to grow EPS going forward, or should we expect EPS declines? Just any big picture thoughts about how you can grow your EPS would be helpful. Thanks.

Paul J. Curlander

Well, Ben, as you know, we don’t give guidance beyond the first quarter. I think the key thing for the investment community to focus on to look at Lexmark in 2007 is our number one focus is to drive branded unit growth. That’s what we’re going to do. Obviously, as we’ve talked in the past, to the extent we do that, that obviously has near-term negatives in terms of operating income.

We’re also very focused on investments. Investments in R&D to drive the product line and investments in marketing. On the R&D side, we’re going to have a step up again in 2007, so both the additional hardware units and the investments, these are near-term negatives overall as we look at the business.

In terms of the first quarter, you mentioned the revenue being down. Let me just say a few more words on that. I think that what we do expect in the first quarter is we expect to continue to make progress in our branded unit sales. We have had good laser unit sales, branded laser unit sales throughout 2006. We had a very strong fourth quarter on branded laser unit sales, and we expect a good first quarter of 2007 on branded laser unit sales.

On the inkjet side, obviously we’ve been impacted by the discontinuation of about 20% of the business. As we come into the first quarter of 2007, we’re starting to lap that. We did have a little bit of the business in the first quarter of ’06 that we were committed to through agreements with our retailers that was discontinued after that, so first quarter is a little bit of a mixed quarter, but nonetheless we expect to see improvement in our branded inkjet unit sales on a year to year basis in the first quarter as well.

We’re not as optimistic, unfortunately, on the OEM side, either laser or inkjet, and we have the impact in supplies being down.

So as I look at first quarter, again I feel very good about what’s going on with branded laser unit sales. OEM, again, that’s not the primary strategy and it kind of is what it is. On the supply side, again, we expect to have good laser unit, laser supplies growth. Obviously we’re looking at a little bit of a decline in the inkjet supplies.

Operator

Thank you. Our next question is coming from Laura Conigliaro with Goldman Sachs. Please go ahead.

Laura Conigliaro - Goldman Sachs

Thank you. Can you give us some more color on the weakness that you cited in the business segments, particularly since your own end-user demand there exceeded your supplies? Was it competitive? Where did you see it?

Paul J. Curlander

Laura, in terms of what we saw in the fourth quarter, we saw some weakness certainly in the channel. We saw it both in the U.S. and in Europe, so I would say some sales in the small and medium business. We certainly saw some delays in some large account buying as well.

I’ve not seen market data for the quarter. We have certainly seen the total for U.S. distributor sales out, which is something that we get which gives a pretty good view of what happened in the U.S. market, and it was the weakest quarter of the year.

I think primarily we saw it in the channel, we saw it in large accounts, but as you pointed out, in Lexmark, we had a very strong laser sales result in the fourth quarter, both branded and overall.

Operator

Thank you. Our next question is coming from Toni Sacconaghi with Sanford Bernstein. Please go ahead.

Toni Sacconaghi - Bernstein Research

Yes, thank you. Good morning. I was hoping you could clarify the contributors to your guidance for weaker supplies. It seems like a pretty strong inflection point from one quarter to the next in terms of year-over-year growth rate. I heard at least three or four contributing factors and Paul, maybe you can prioritize them: the withdrawal from inkjet, which I think has been pretty consistent over the year; a weak OEM, which I think has been pretty consistent over the year; above trend in the laser business in Q4, which sounds like it’s incremental and new; and perhaps channel inventory, which maybe you can comment on, whether it changed in the fourth quarter. Can you tell us which of those four factors ultimately has caused you to provide a significant deceleration in supplies outlook for Q1?

Paul J. Curlander

Well, I think all these are factors, Toni. Let me maybe say a little bit more about fourth quarter, then we can go into the first quarter.

In the fourth quarter, we were really surprised by the laser supply sales. They came in significantly above the model in the quarter. Certainly that’s good. We’ve had a very good trend in our branded laser unit sales, so we may be seeing some things coming up over the model, but as we look at that, really we don’t have a firm reason to believe that will be significantly over the model as we move into the next quarter. Sometimes it happens in a quarter that you just get a strong set of sales. Obviously we hope that will continue, but we’re not counting on that.

I think one of the major factors as we look at a 4% growth in the fourth quarter year to year in supply sales, and we look at being down low- to mid-single digit in the first quarter, is that movement of laser supplies growth back to a growth rate more consistent with the model versus what we saw in the fourth quarter.

The second thing we saw in the fourth quarter was around the inkjet supplies. In the inkjet supplies, they actually came in under the model in the fourth quarter. And some of that is due to lower end-user demand and some of it is due to shrinkage in channel inventory.

As we look into the first quarter, I think this gets aggravated by the weaker OEM environment that we’re looking at in lasers as well as in inkjet, but certainly in inkjet, and so we’re projecting a little bit more erosion there.

We’re also projecting some shrinkage in channel inventory there. Our track record on predicting channel inventory movements isn’t the best, but nonetheless, from what we see, we think there will be some more shrinkage there, so that’s a factor there as well.

I think it’s that combination of factors.

Toni Sacconaghi - Bernstein Research

If I could follow up, please. You’re spending a lot more in terms of both R&D and SG&A, and as of yet, there really doesn’t seem to be any notable improvement in inkjet. The reason I say that is your inkjet unit growth was down 18% versus a much easier compare this quarter. It was down 19% last quarter. But your ASP erosion has been much more, much less benign this quarter. ASPs were up about 1%. They were up 8% in Q2, up 4% last quarter. So it feels like despite the fact that your spending on inkjet, your unit growth against easier compares is not improving and your ASP, or average revenue per unit is actually getting worse. Can you comment on the dynamics there?

Paul J. Curlander

Well, what I would point to is that clearly we’re giving you the growth rates on inkjet units overall. Underneath that, there’s a dynamic that’s not visible to you, and I try to give you some color as we go through the earnings release, but obviously the dynamic is not visible.

When we look at that minus 18% in the fourth quarter, the branded inkjet units declined much, much less than minus 18%, so what that says is that in the piece of the business we want to continue, we’re already seeing growth in our branded inkjet sales. We’re certainly seeing strong, all-in-one sales and very strong inkjet four-in-one sales.

As I look at the full year of 2006, inkjet units declined 20% I think John indicated, and if you look at that number, branded inkjet sales declined much, much less than 20%, again showing that in the parts of the business we want to grow as we go forward in time, we are seeing that improvement in branded inkjet sales.

What’s offsetting this is a very weak and declining environment on the OEM side, and that’s been a problem through 2006. It certainly was a problem in the fourth quarter, and we expect it to be a problem in the first quarter as well. So we see the results of the spending in R&D and marketing. We can see it in our branded units and the part of the business that we want to continue. Obviously we’re just coming into the point now where we’re starting to lap that discontinuation on a year to year basis, and we’re expecting to see improvement in our branded unit sales.

So that’s kind of the sense that we have as we look at it.

Operator

Our next question is coming from Bill Shope of J.P. Morgan. Please go ahead.

William Shope - J.P. Morgan

Okay, great, thanks. Given that your restructuring actions are largely complete now, can you comment on whether or not you see any room for potential incremental restructuring actions in ’07?

Then also, can you give us some color on inkjet shelf space trends over the holidays?

John W. Gamble

With regard to restructuring, we indicated as we went through kind of 2007 what we expect to happen that there will be some restructuring as we move through the year. We said probably less than $5 million a quarter, and it’s kind of ongoing actions that we’re working generally around the G&A functions, generally around the supply chain functions, and we’ll continue to try to optimize those functions and drive down their costs and make them more efficient.

Paul J. Curlander

Bill, relative to retail shelf space, obviously as we’ve talked before, when we did the change in our business to discontinue the stuff that didn’t drive the profit level we were looking for, as we moved away from the bundles in retail, and net the zero bundles that customers couldn’t break, we took a hit in shelf space. We lost shelf space beyond the proportion of just exiting those bundles.

As we worked through the year, we worked to improved our shelf space. We’ve seen some good improvement. As I look at the end of the year compared to where we were back at the end of the first quarter, I can certainly see improvement in a number of key retailers in the U.S. You can see improvement in Lexmark shelf space in retailers like Circuit City. We certainly got some SKUs on the shelf in OfficeMAX and Office Depot that we didn’t have before. We got some SKUs on the shelf in CompUSA.

So we certainly made improvement as we went through the year. That said, we’re not yet where we want to be in terms of shelf space. We continue to invest in R&D. A lot of those results of those investments are not yet visible on the inkjet side. Clearly we had some strong products during 2006 that did help drive our growth, things like the X5470, but we continue to invest and we’re very focused on improving our position in inkjet all-in-ones in 2007. So that’s a key focus for us as we go into this year.

William Shope - J.P. Morgan

Okay. Thank you.

Operator

Our next question is coming from Katie Huberty with Morgan Stanley. Please go ahead.

Kathryn Huberty - Morgan Stanley

Good morning. Can you help us get comfortable with your inventory position during 2007, given it declined less than normal in the December quarter in the context of your expectation for revenue declines in the first quarter?

Paul J. Curlander

Katie, I think if you take a look at our inventory position year-end ’06 compared to year-end ’05, we’re carrying more inventory on a year to year basis, but the vast majority of that is actually in the supplies business. In the supplies business, we tend to be a little less concerned with inventory because it continues to be good because we sell supplies without a lot of price pressure over an extended period of time.

Some of the reasons why we’re carrying more supplies inventory year-end ’06 versus year-end ’05 are a couple of things. First, as we consolidated our supplies manufacturing capacity, things like closing the Rosyth facility, that changed the whole regional distribution structure of our supplies, and what we’re doing now is we’re shipping supplies out of Asia, out of Mexico into Europe, so we’re carrying more inventory as we have those finished goods moving around the world.

The second thing we did is we changed the transport mode on our supplies to try and cut some costs. We used to go by air on a lot of our supplies in the inkjet side, and now we’re going by ocean, which is also driving up inventory for us.

The third thing is that we exited 2005 with too low a level of supplies inventory, and we had a lot of supply shortage issues in the first quarter of 2006. So even though we’re carrying a lot more inventory because of transportation, that’s not inventory that’s usable in terms of finished goods at the point of sale of the customer, so we’ve actually increased that as well as we go into the first quarter of 2007, just to make sure that we’re not short.

So we’re carrying a little excess there right now, and that’s really the reason for the difference you saw in the trend year-end ’06 versus year-end ’05.

Operator

Our next question is coming from Keith Bachman with Banc of America. Please go ahead.

Keith Bachman - Banc of America Securities

Hi, thanks. A clarification and a question, please. On the clarification, Paul, I’m still not clear on the significant degradation Lexmark supplies in the March quarter. You’ve been running pretty close to 2%, 3%, 4% throughout the balance of ’06. As you indicated, it’s going to be down on a [year over year] basis mid- to low-single digits. Is the primary driver on the inkjet side or is it on the laser side? Because you said you exceeded plan on the laser side. I’m still unclear about why the significant change in the March quarter.

Paul J. Curlander

If I were to identify one driver, I would have to say it’s inkjet, because inkjet is the supplies that are declining. The reason that I talked about the laser is that yes, we do 4% in the fourth quarter, but the laser result was very strong and above the model.

Keith Bachman - Banc of America Securities

So Paul, what’s the driver for the change in inkjet, because the installed base has been going down pretty consistently through the year with your restructuring actions in trying to get out of low-end business. Why the significant change in the March quarter then?

Paul J. Curlander

I think it’s the installed base movement. I think that continues to be an issue as you go approximately minus 20% quarter after quarter after quarter in inkjet units. That compounds the situation.

Also, we see a weakening OEM environment. Some of it is because we came a little bit under the model in the fourth quarter, so we’re projecting a little bit more erosion in the first quarter along with that trend.

The key for us is we need to drive branded inkjet unit growth, and this is the focus that we’ve been on. It feels like it’s been a long journey through 2006 as we discontinued that business and again, first quarter ’07 is a little bit of a mixed quarter. But that’s our focus, is to turn that unit growth positive.

We certainly feel good about the fact that it declined a lot less than the minus 18% or minus 20% we had for the year, and we believe that as we continue to invest in R&D and improve the product set, we’re going to improve our shelf space and drive those units.

In the meantime, we’re obviously seeing erosions in the installed base off of a long sequence of quarters of declines in inkjet unit sales. And again, the comparison is really against what we shipped two to three years ago and the rate there, because that’s what is falling out of the installed base, being replaced with a smaller set of units right now. That’s the fundamental problem.

Keith Bachman - Banc of America Securities

Paul, if I could get my final one in, if it took a while for the reaction of the inkjet supplies business, should we therefore assume that the weakening supplies growth rate would continue for a number of quarters then, perhaps even throughout the balance of 2007?

Paul J. Curlander

I think that you can look at some of the data that’s in the slide deck and you take a look back at the units there in 2004 that will be falling out of the installed base certainly by 2007 but probably between 2006 and 2007, and you look at that level of shipment that we had and the level of shipment that we just had in 2006, I think it’s going to be tough to match that level of ’04 shipment in ’07, so that says that yes, we can see some continued degradation, and that’s why I mentioned it in my comments up front and John mentioned it in his comments up front as well.

Operator

Thank you. Our next question is coming from Shannon Cross of Cross Research. Please go ahead.

Shannon Cross - Cross Research

Good morning. I just wanted to talk a little bit about your laser shipments in terms of growth. If you could provide any specifics with regard to growth rates on color, on mono-laser, and then also, I was just curious as to what you’re seeing in the marketplace with the MFP segments. Both Xerox and Canon are launching competitive products into that segment to fight back against what yourselves and HP have been able to take in terms of share, so what do you expect to see in the low-end, black-and-white, multi-function, pricing, you know, going into 2007? Because again, it seems to us that it’s going to get pretty competitive with so many pretty strong players in there.

Paul J. Curlander

Shannon, we don’t give out the growth rates on the individual segments, but I can tell you that in the fourth quarter, certainly we had very strong growth rates in color laser, in laser multi-function. I think we also had strong growth rates in our low-end mono and workgroup mono. That’s not something we’ve had for a while but our services business, a lot of good wins in the latter part of the year helped drive some more workgroup mono shipments in the fourth quarter, so we feel pretty good about that.

MFP segment has been a big segment for us in 2006. We had a lot of new product introductions. A lot of introductions in the workgroup MFP segment, a $1500 to $2500 devices. Those devices have done very, very well in the marketplace. We think that we’re at a strong competitive advantage against the competition with that.

You know, as we go into 2007, yes, we’re going to see competitive announcements. This is a very competitive market. Market pricing on the laser side I think has been somewhat aggressive through the year, to be honest with you. Certainly in the enterprise environment, it’s been very aggressive. Certainly in Europe, we’ve seen some very aggressive pricing. Color lasers certainly have been aggressive as we’ve gone through the year as well.

I think that this is just part of the business. We continue to focus on driving our technology and advancing our products. We feel pretty good about where we are, and this is usual for us to be competing with HP, Xerox, Canon in the laser business.

Shannon Cross - Cross Research

So no incremental pressure on the cost per page in monochrome in the enterprise, like we saw with some of the copier guys this quarter?

Paul J. Curlander

We haven’t projected a lot of that into our first quarter outlook, but again, competitive things change, so we’ll see how it plays out and we can talk again in three months.

Shannon Cross - Cross Research

Our next question is coming from Ben Bollin, Cleveland Research. Please go ahead.

Ben Bollin - Cleveland Research

Good morning. Two quick questions. The first, when you look at the enterprise business segment, it increased as a percentage of revenue year over year. The revenue was up year over year, and yet operating income was actually down year over year, and this is really a big profit driver. What are the biggest pressures in that business? In the future, how do you compete more effectively with third-party supply vendors? Then I have a brief follow-up.

Paul J. Curlander

Well, I think what you’re seeing in the enterprise segment is first of all, we’re seeing very good market opportunity. I think the laser market was really pretty good in 2006 overall, a little slowness in the fourth quarter but overall, the laser market was pretty good. I’m sure overall market unit growth was in the double digit range.

As I look at Lexmark's competitiveness there, I think we have dramatically improved our competitiveness, certainly through 2006 with the product launches that we had in our laser MFP area and our color laser area and our low-end mono-laser area, and obviously with our services business and our services tools and the things that we’re doing there. We’ve got a lot of strengths around solutions and services in that business, and we continue to improve ourselves in small and medium business.

That said, what you’re seeing in year to year growth in 2006 is a couple of things. First, we’re seeing some pretty significant mix shifts in lasers, and that’s impacting hardware margins. We’re seeing some aggressive pricing in lasers as well, but I think mix may be even the bigger story.

The laser model is shifting. Historically, our business has been a workgroup mono-laser kind of business. Margins on those boxes have been very good. Supplies driven off those boxes have been very good.

What we’re seeing now is as we drive much more color laser content, color laser business model is much more like inkjet where people take losses up front and they have a much more lucrative supply stream that comes after.

So as we grow our capabilities in color laser, we see that change in the laser model and we see those negatives in up-front hardware margins that we haven’t seen historically, and so that mix shift to the color and to a more low-end mono is hurting the margins over on the laser side.

That, with the increased investments that we’re making in lasers and R&D to help us in things like laser multi-function and color and low-end mono-lasers and all the solutions and services tools that we’ve delivered into the market, that’s obviously a big piece of investment that we’re making as well.

So when you take a look at 2006, clearly we’ve got some good growth there. We’ve got some good supplies growth there. That’s being offset by the margin erosion because of the mix and by the investments. That’s a near-term phenomenon. Long-term, that investment is going to drive us strongly into these growth segments. Clearly even though we take a loss up front on color lasers, it’s going to drive a very profitable supply stream afterwards, and we just need to get more of that going.

So the key for us is to continue to drive branded unit growth in color lasers and laser MFPs, low-end mono-lasers and the supplies will come. We saw a very strong fourth quarter, much stronger than what we had expected in laser supplies. Some of that may well be due to what we’ve driven off the installed base. We’re not projecting as much of it into the first quarter, but we’re certainly hopeful that some of that was due to the strong track record we’ve had in branded laser unit shipments all through 2006.

So I think the trend is going in the right direction. I think the results are very good on the laser side, and the supplies will come. Of course, we continue to invest to improve our position.

Ben Bollin - Cleveland Research

Okay, and a brief follow-up. If you look at 4Q, if you exclude restructuring and use the normalized tax rate, could you explain to me what EPS would have been, or how you got to the figures again?

John W. Gamble

What we indicated in our discussion was if you take the $1.05 that we reported for EPS excluding restructuring charges, and you were to apply the tax rate which we’re forecasting for 2007, that you would get an EPS of about $0.93. You can get there just by taking the pre-tax income, which you can calculate and then applying the 27% tax rate and you’ll get to the net income and therefore, EPS that you’re looking for. But that is basically why we provided that information, so that you had a basis of comparison if the tax rate had been at the rate which we’re forecasting for next year.

Operator

Thank you. Our final question will be coming from Bill Fearnley of FTN Midwest. Please go ahead.

Bill Fearnley - FTN Midwest Research

Yes, I was wondering if I could ask a follow-up here on supplies. Paul, could we get your latest thoughts on re-man and also an update on your efforts in the cartridge collection programs. Will we be seeing more of those in inkjets?

Then, for a follow-up, recently some competitors have made some exclusive deals for inks in the office product supplies channel. I’m wondering if you folks are going after those same types of deals as well. Thanks.

Paul J. Curlander

Bill, relative to re-man, we continue to focus on all the opportunity in supplies. Certainly there is a segment of customers out there that are happy with re-manufactured supplies, and we see that as an incremental opportunity for Lexmark. We’ve been very focused on it in the laser side for quite some time.

With our return program, we have really driven a lot of cartridge collections on the laser side over the years, which has allowed us to get into the re-manufacturing business, and we obviously sell a lot of re-manufactured laser cartridges as well.

On the inkjet side, we’re not as advanced as we’d like to be. We haven’t gotten as much going in terms of collections there. We’re very focused on how we can advance that as we go forward in time. So what we would like to do is to improve those collections on the inkjet side, ultimately be able to re-manufacture those cartridges and participate in the after-market there as well.

Relative to exclusive deals, we certainly have great interest in doing any deal that we view to be incremental to us, and so Lexmark has done some private label deals in the past with people on both the laser and the inkjet side, to the extent that we see those to be incremental. So certainly we have interest in those as we go forward in time.

Bill Fearnley - FTN Midwest Research

And is the cartridge collection program that you just launched, how is it versus your expectations out of the gate? I realize it’s just a single SKU, but any preliminary indications on how the inkjet cartridge collection program is working?

Paul J. Curlander

Well, relative to customer satisfaction, customer satisfaction appears to be pretty good. We’ve done a lot of focus segments around the inkjet cartridge collection program. It’s still very early. We certainly haven’t seen any problems with it. I don’t know yet what level of returns we will get off of it, which to me is a very key factor as we go forward in time, and so we’ll be looking at that and looking, if we don’t get what we’re looking for, how we can modify that to drive the result that we need.

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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