Lexmark: The Falling Knife Worth Catching

| About: Lexmark International, (LXK)

Six months ago, shares of Lexmark (LXK) fell from $48 to $38 in a single day, following the company's earnings release. The company was subsequently discussed on this site, and though the stock did seem undervalued, there remained a number of risks on the horizon. Last week, however, the stock fell big once again, this time from $38 to $32, as the company missed expectations and guided lower for the rest of the year. At this price, there appears to be a large margin of safety to help mitigate this company's operational risks.

Lexmark has a P/E of just 7, despite having more cash than it does debt to the tune of $600 million. Excluding this net cash balance from the company's market cap gives the stock a P/E under 6.

At such a high earnings yield (which is simply the inverse of the P/E ratio, or 17%) one might expect this to be a company in serious trouble. But that's not the case. In fact, though the company does operate in an industry where it needs to constantly innovate to remain competitive, there are some tailwinds on the horizon which should actually help the company's earnings in the long-term.

A few years ago, the company changed its strategic focus. It no longer wanted to be a low-end supplier of printer hardware and supplies. In this market segment, printer manufacturers have low margins as they compete to serve mass-market consumers who are mainly interested in low prices. Lexmark instead invested in printers and products that businesses need to enhance productivity. This transformation appears to be working, as Lexmark is seeing market share gains and revenue and profit growth in its higher-priced products.

But the overhang from the company's slow exit from its lower-margin segment remains. As competitors in this segment have become more aggressive on pricing, Lexmark has chosen not to participate, which has hurt revenue and profit. However, these legacy products are becoming a smaller and smaller portion of the company's overall makeup. As Lexmark continues to invest in and grow its now core business segment, the company should be able to eventually stem the overall revenue declines.

Another issue that has reduced earnings in the short-term (which is never good for the stock price but creates opportunities for long-term investors) are high non-manufacturing costs that hit the company's first quarter earnings. Management believes it has identified the problem (related to configuration, distribution and shipping) and that it can improve overall margins by approximately (no exact number was cited) 200 basis points. These temporary costs are hurting earnings now, but could provide a rather significant boost to earnings over the next few quarters.

Unfortunately, despite the large cash balance and cheap stock price, it doesn't appear as though a large buyback is on the horizon. Most of the cash appears to be held in overseas subsidiaries, and would therefore be subject to repatriation taxes if used for buybacks. Management did say, however, that it does have room under its current authorization and may buy back shares with excess cash generated from its U.S. operations.

Despite the fact that Lexmark needs to innovate to continue to succeed, it appears so cheap that even a technology-shy value investor may be interested. Furthermore, as the company cuts costs and continues its transition toward higher-margin business customers, it may look forward to a period of earnings strength despite the low price at which its stock trades.

Disclosure: I am long LXK.