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Lexmark International, Inc. (NYSE:LXK)
Q2 2007 Earnings Call
July 24, 2007 8:30 am ET
John Morgan - Director of IR
Paul Curlander - CEO
John Gamble - EVP and CFO
Brain Mansfield - Goldman Sachs
Eric Garfunkel - Sanford Bernstein
Richard Gardner - Citigroup
Shannon Cross - Cross Research
Jeff Embersits - Shareholder Value Management
Richard Farmer - Merrill Lynch
Matt Whittaker - FTN Midwest
Jennifer Thorwart - UBS
Thank you for standing by and welcome to the Lexmark International Second Quarter 2007 Earnings 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 24, 2007.
I would now like to turn the call over to John Morgan, Lexmark’s Director of Investor Relations. Please go ahead, John.
Good morning and thank you for joining us today. With me for Lexmark’s second quarter 2007 earnings conference call are Paul Curlander, Lexmark's Chairman and CEO, and John Gamble, Lexmark Executive Vice President and CFO. After their prepared remarks, we will open the call for your questions as time permit. 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'll find today's earnings release as well as the supplemental slide deck for the second quarter, including 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 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.
Thank you John, today we're announcing second quarter financial results which are much lower than our expectations as we ended the quarter. Although, this is not the quarter we had expected due to shortfalls in our consumer market segment, as we start today, we would like to highlight some things in the quarter which we believe are important to understand about Lexmark.
First, the business market segment came in about as expected, relative to the guidance we gave on April 24th. This included double-digit unit growth in our branded laser sales and continuing good growth in laser supplies revenue, included some significant wins by our large account sales team, including a major win at Bradesco Bank, the largest private bank in Brazil. This included the introduction of a new line of printers and MFPs focused on rapidly growing color laser segment as well as ongoing awards and industry recognition of Lexmark's color laser and laser MFP products.
For the quarter, we had strong branded unit growth in the key growth segments of color lasers, laser MFPs and inkjet all-in-ones. Total branded hardware revenue in the second quarter continues to show good growth year-to-year. During the quarter, we launched our inkjet wireless home printing initiative, with the announcement of the first of three new wireless and wireless capable models. And net cash from operating activities was $124 million in the quarter, as Lexmark continues to have a strong financial position and strong balance sheet.
Now, let's turn to the details of our second quarter results. Second quarter revenue was $1,208 million, down 2% year-to-year and within the guidance range we gave on April 24th. Earnings per share were $0.07 in the quarter and would have been $0.65 excluding a net $0.02 per share benefit from restructuring related activities.
Both GAAP and non-GAAP earnings per share included tax benefit of about $0.05 per share. Now this earnings per share result is significantly below the guidance range of $0.82 to $0.92 that we provided you on April 24th. This shortfall in earnings per share in the second quarter, compared to the April guidance was in the consumer market segment, and as we indicated on July 9th was largely driven by several factors.
An ongoing decline here in inkjet supplies revenue, which in the second quarter was greater than our expectations, with lower average unit revenue on inkjet hardware due to aggressive pricing and promotion. Higher than expected product cost in the quarter and a negative period impact from the increase in the inkjet branded unit volume from that assumed in our second quarter guidance.
For the quarter, overall hardware revenue was down 7% year-to-year as OEM hardware revenue declines will more than offset the good branded hardware revenue growth. Supplies revenue for the second quarter was up 1% year-to-year as good growth in laser supplies revenue was almost completely offset by declines in inkjet supplies revenue.
Supplies revenue growth in the second quarter slightly exceeded our guidance range, with laser supplies revenue coming in higher than expected and inkjet supplies revenue coming in lower than expected.
We believe the shortfall in inkjet supplies revenue is due primarily to less than expected end-user demand for inkjet cartridges and a mid-shift between cartridges resulting in a higher percentage of moderate-use cartridges.
We believe we're seeing shrinkage in the install base of inkjet products due to weak branded unit sales over the last several years, the reduction of our units in 2006 to improve the lifetime profitability of unit sales and the ongoing decline in our OEM unit sales. This decline in end user demand was greater than expected in the second quarter and was below our model.
As we look ahead, we see the potential for continued erosion in inkjet end-user demand. Our current expectation is for the third quarter 2007 supplies revenue to decline in the low to mid single-digit range year-to-year, as continued good growth in laser supplies revenue is more than offset by decline in inkjet supplies.
In the consumer market segment in the second quarter, our revenue was $474 million, down 8% year-to-year. Consumer segment operating income excluding restructuring was $14 million, down 84% year-to-year. This decline was largely driven by the same factors causing the shortfall in second quarter guidance as well as increased investment year-to-year in research and development, and demand generation.
Inkjet unit shipments in the second quarter were up 3% year-to-year, a significant improvement from the 10% decline in first quarter, as strong growth in branded inkjet units was almost offset by declines in OEM unit sales. Branded inkjet unit sales in the second quarter increased over 30% year-to-year in a down market, as more aggressive price promotion drove greater strong branded unit growth than we had projected in our April guidance. This resulted in lower average unit revenue than we had anticipated.
For the quarter, the strong branded unit growth was driven by strong growth in all product segments, single-function printers, 3-in 1s and 4-in-1s.
In the business market segment in the second quarter, revenue was $734 million, up 3% year-to-year. Business segment operating income, excluding restructuring, was $149 million, down 8% year-to-year due to increased investment in research and development and demand generation.
During the quarter, we continued to see aggressive market pricing and promotion on laser hardware. Laser unit shipments for the quarter were up 5% year-to-year as double-digit growth in branded laser units was partially offset by declines in OEM unit sales.
Brand unit growth is driven by good year-to-year growth in low-end and work-group lasers and strong year-to-year growth in color lasers and laser MFPs.
Now let’s talk about the third quarter. As we look into the third quarter we expect the following factors to sequentially impact our consumer segment results. A continuation and the decline in inkjet supplies and mix shift to moderate these cartridges, and a sequentially negative APC/LCM impact. Continued aggressive pricing and promotion in inkjet hardware, a negative period impact from an increase in inkjet unit sequentially including some significant Black Friday deals shipping this year in the third quarter, and product cost impacts.
The combination of this negative impact is expected to result in a period loss for the consumer market segment in the third quarter. We also expect to see the usual seasonal decline in the business segment operating income in the third quarter. As a result, in the third quarter, we expect overall revenue to decline year-to-year in the low to mid single-digit range and GAAP earnings per share to be in the range of zero to $0.10 per share.
Now, as you look back at the second quarter, and then ahead to the third quarter, our business segment is performing about as expected while the consumer market segment is currently experiencing several problems. In our consumer segment we're in a difficult position. We're seeing continuing declines in our inkjet supplies and in OEM unit sales.
We need to grow brand unit sales, but this has become more expensive than we had anticipated. We need to drive our new initiative in wireless home printing and continue to invest in future products and technology and brand development.
Our focus going forward will be on improving product cost and price, on products, customers and countries that drive pages, and on making our operating expense spend as efficient as possible. We need to improve the affordability of our inkjet unit sales and find a better balance between unit sales and price.
Now, while these near-term results are currently disappointing, we continue to focus on the long-term growth and success of the company. With the launch of our new wireless inkjet initiative in 2007, we believe we're introducing a significant and compelling new area of opportunity in the Inkjet market to better attach printers to the growing sales of wireless notebooks and routers.
We are continuing our investment in new products and technology, which will provide a strong pipeline to future products. We are investing in improving the brand position and awareness of Lexmark and are encouraged with results of that initiative. And we continue to build our enterprise solution and services capabilities, and have seen success here with some of the world's major corporations.
Now, although these investments affect our results in the near-term, the positive impact from these investments is expected to come in the future.
I'll now turn it over to John Gamble for his more detailed comments on our financials.
Thank you, Paul, and good morning. Consistent with previous calls, I'll first discuss our results of the second quarter of 2007 relative to the prior year, and then relative to the first quarter of 2007. I'll then discuss selective changes on the balance sheet and certain items of cash flow. Finally, I'll finish with more detail regarding our guidance for the third quarter. I will call out the impact of restructuring related expense as we walk through the P&L. In the supplemental slide deck posted on our Investor Relations website we have included 2006 and 2007 details on the income statement line items impacted by the restructuring related activities.
Now, let me begin with the P&L. Total revenue for the quarter was $1.208 billion, down 2% compared to last year, down 4% sequentially from 1Q. Geographically for the second quarter, US revenue of $508 million declined about 4% year-to-year. Revenue and EMEA of $446 million declined about 1% year-to-year.
Remaining geographies grew about 3% versus a year ago. Laser and inkjet supplies revenue in the second quarter grew 1% year-to-year with good growth in laser supplies revenue being mostly offset by an ongoing decline in inkjet supplies revenue. Laser supplies came in above our expectation due to better supplies of AUR.
As Paul discussed, inkjet supplies were weaker than our model had indicated. The weakness is reflective of the lower branded unit sales from 2006 and the continuing weakness in OEM sales.
Laser and inkjet printer revenue in the second quarter declined 7% year-to-year. Laser hardware unit shipments grew 5% versus prior year. Laser average unit revenue declined approximately 10% year-to-year due to pricing and mix. Inkjet hardware unit shipments grew 3% year-to-year, which is a significant improvement from the 20% decline in 2006. Inkjet AURs declined 13% versus the prior year due to aggressive pricing, which offset positive mix.
Business segment revenue for the quarter of $734 million grew 3% from the same quarter in 2006 and declined about 1% sequentially from 1Q '07. The year-to-year increase was driven by increase supplies revenue partially offset by decline in hardware revenue. Conversely, the sequential decline in business segment revenue was driven by a decline in supplies revenue, partially offset by increase in hardware revenue.
Consumer segment revenue for the quarter was $474 million, down 8% compared to a year ago, and down 9% sequentially. The year-over-year and sequential decline was due to declines in both inkjet supplies and hardware revenue.
Gross profit margin for 2Q was 30.6%, excluding restructuring related charges of approximately $4.6 million; gross profit margin would have been 31.0%, down 430 basis points versus the prior year and down 270 basis points sequentially. The 430 basis point decline versus last year was principally due to a 590 basis-point reduction in product margins, the largest factor of which was a decline in inkjet hardware margins. This more than offset positive mix due to a lower mix of hardware relative to supplies.
Sequentially the 270 basis point decline is driven by a 190 basis point reduction in product margins, more than explained by the reduction in inkjet hardware margins, which was partially offset by a positive impact of APC/LCM in the quarter. The additional 80 basis point decline is due to mix due to a lower mix of supplies revenue, relative to hardware.
Operating expense for the quarter was $305 million. Restructuring related expense of approximately $0.6 million impacted of operating expense this quarter. Excluding this impact, operating expense was $304 million, an increase of $27 million year-to-year.
SG&A was $202 million, an increase of $18 million from 2006 driven by increased demand generation expense. R&D was $102 million, an increase of $9 million from 2006. Sequentially operating expense, excluding restructuring related cost, was up $3 million versus the first quarter. The operating expense to revenue ratio in 2Q was 25.2%.
Operating income in 2Q was $66 million, excluding the restructuring related expenses of approximately $5 million, operating income was $71 million, down $86 million from 2Q '06 and down $52 million sequentially from 1Q '07. As Paul discussed earlier, the weak 2Q results were driven by weakness in the consumer segment.
Compared to 2006, excluding restructuring-related activities, the business segment operating income in 2Q of $149 million was down $14 million versus last year, and down $5 million sequentially. The $14 million decrease versus 2Q '06 is due to higher operating expense, principally increased demand generation, and higher development spending.
The $5 million decrease sequentially is primarily due to a decline in supplies revenue. The consumer segment again, excluding restructuring related expenses, had operating income in 2Q '07 of $14 million, down $74 million versus last year and down $47 million sequentially.
As Paul discussed earlier, the $74 million decline versus last year is driven by weaker supplies revenue and an increased mix of moderate-use cartridges, reduced Inkjet hardware AUR reflecting aggressive pricing and promotion, increased operating expense and an increase in Inkjet hardware unit shipments. The $47 million sequential reduction was driven by weaker supplies revenue and increased mix of moderate-use cartridges, continuing hardware pricing pressure, increased Inkjet hardware unit sales and increased hardware costs.
Other expenses consisting primarily of costs related to centralize supply chain IT and other operating expenses, primarily G&A, were $93 million in 2Q, excluding restructuring related activities, a decrease of $1 million from 2Q '06 and about flat sequentially.
Operating income margin in 2Q was 5.4%,.excluding the restructuring related expenses our operating income margin was 5.9% a decline of 690 basis points from second quarter of 2006, and a decline of 390 basis points sequentially.
Concerning financing and non-operating costs, the interest and other was a net income of $11.2 million. Excluding an $8 million restructuring-related foreign exchange of pretax gain realized upon the substantial liquidation of the company's Scotland entity, financing and non-operating costs were a gain of $3.1 million, down about $0.5 million from 2006 and about flat sequentially.
The effective tax rate for 2Q was 16.4%, lower than the 26.5% rate we expected, primarily due to a one-time tax benefit of $5 million from the release of deferred tax assets. For the remainder of 2007, we expect the ongoing tax rate to be approximately 25%. This ongoing rate, excludes the impact of one-time tax benefits or losses, such as the $5 million benefit incurred this quarter.
Net earnings for the quarter were $64 million, excluding a net $2 million after-tax benefit from restructuring related activities, net earnings in 2Q '07 were $62 million. 2Q '06 net earnings were $77 million or $114 million excluding after-tax restructuring related charges.
GAAP earnings per share for the quarter were $0.67; excluding restructuring related activities EPS would have been $0.65 per share. This compares to 2Q '06 GAAP earnings per share of $0.74, or $1.09 excluding restructuring related activities.
Now moving to the balance sheet, cash flow from operations for the quarter was $124 million, down 18 million compared to 2Q '06 and up $37 million sequentially. Excluding restructuring related cash flows, cash flow from operations was $135 million this quarter a decrease of $20 million from 2Q '06 and an increase sequentially of $35 million from 1Q, '07.
Since the end of March accounts receivable declined $32 million, inventory increased $3 million, accounts payable increased $13 million and accrued liabilities declined $39 million, principally driven by a decline in taxes payable. For the quarter, capital spending was $43 million. Depreciation in the quarter was $43 million. Currency of the Euro accounted for the $1.35 compared to a $1.25 in 2Q '06.
Cash and marketable securities at the end of 2Q was $527 million, up $84 million since March. In 2Q we did not repurchase Lexmark shares. At quarter end we had $295 million of share repurchase authority outstanding of our $527 million of cash and marketable securities at quarter end. The significant majority were overseas and not available for share repurchase.
The restructuring actions that we announced in January of 2006 were principally complete in December of 2006 and as we have discussed on previous calls we will continue to have a relatively low level of impact relating to this in 2007.
In the second quarter we incurred a net $3 million benefit in pre-tax restructuring cost and related expenses comprised of approximately 4.6 million in cost of sales, 0.6 million in operating expense and a gain of $8 million in financing and non-operating costs. For 3Q '07 we expect restructuring cost and related expense to be about $0.05 per share.
Now from my forward-looking comments concerning 3Q, we expect third quarter revenue to be down in the low-to-mid single-digit range year-to-year. Supplies revenue is expected to be down in the low-to-mid single-digit range year-to-year. Again, we expect to continue to see good growth in laser supplies offset by a decline in inkjet supplies revenue.
GAAP EPS is expected to be break-even to $0.10 per share in 3Q, '07. Included in the GAAP EPS guidance is an estimated $0.05 per share in restructuring costs and a one-time tax benefit expected to more than offset impact of restructuring expense.
The one-time tax benefit will result in a lower effective tax rate in 3Q than the 25% ongoing rate referenced earlier as the expected rate for 2007. GAAP EPS in the third quarter of 2006 were $0.85 per share, or $0.95 excluding 3Q '06 restructuring related charges.
Our 3Q '07 guidance reflects continued good performance in the business segment. We continue to expect to see good laser supplies growth year-on-year, but sequentially we expect to see a seasonal decline in laser supplies and business segment operating income.
The expected week 3Q '07 operating results are largely driven by weakness in the consumer segment in which we expect to incur an operating loss. The sequential decline in operating income in the consumer segment is expected to be driven by lower supplies revenue, reflecting both seasonal weakness and supplies in the ongoing decline in inkjet supplies we have been discussing.
There will also be a sequentially negative APC/LCM impact reflecting the expected negative in period impact in 3Q '07, as compared to the benefit incurred in 2Q '07. We also expect continued aggressive hardware pricing and promotion, a sequential increase in inkjet unit sales and product cost impacts.
In items of our specific discussion of financial information, both the 2Q and 3Q data provided I am comparing to a non-GAAP and exclude the impact of restructuring related charges.
In the third quarter we expect gross margin percentage to be down versus the 31% we achieved in 2Q '07. This reflects the lower sequential profit generation expected in 3Q, '07 in the consumer segment. Operating expense is expected to be up slightly compared to the $304 million incurred in 2Q '07, as we continue our investments in both development and demand generation. Operating income margin in the third quarter is expected to be down significantly from the 5.9% achieved in the second quarter of 2007.
The effective tax rate for 2007, as I referenced earlier, is expected to be approximately 25%. In 3Q '07, the ongoing effective tax rate is also expected to be approximately 25%. However, the onetime tax benefit in the quarter that I referenced earlier is expected to result in a tax rate in 3Q below this level. We continue to project full year 2000 capital spending to be approximately $235 million and full year depreciation to be approximately $160 million.
With that, we'll go ahead and open it up for questions.
(Operator Instructions). Our first question is coming from Laura Conigliaro with Goldman Sachs. Please go ahead.
Brain Mansfield - Goldman Sachs
This is Brian Mansfield for Laura. My question is, with revenue down low-to-mid single-digit for the September quarter, can you take us once again through why such a profitability shortfall in Q3 and how long this will continue and specifically can you continue to grow hardware units at the current rate considering the price erosions that we have seen in this quarter and a little bit continue in the September quarter, and if so do you anticipate to be able to drive inkjet supplies growth to begin to recover these investments?
Brian, the impacts relative to profitability were the ones that we called out during the remarks. Obviously we are expecting to see a continuing decline in inkjet supplies in the third quarter from the second quarter level. We talked about an APC/LCM impact. In the quarter we talked about expected aggressive pricing and promotion, continuation. We also had an impact from increased units sequentially, and we had an impact from product cost.
So these are the major factors. These are clearly more margin issues, and mix issues, than just revenue issues, per say. But those are the major factors. Relative to the hardware we're clearly not happy where we are in the consumer market segment in terms of profitability certainly in the third quarter. We feel that we're in the difficult situation because we have these head win in terms of OEM units declining and supplies revenue declining.
Clearly we need to sell more branded hardware but this is turning out to be more expensive than what we had anticipated. We've launched a new wireless home printing initiative, so we need to drive that and need to make investments in R&D and development.
So our focus is, we want to work on the hardware unit placements to make that more affordable and we also looking for a better balance between units, unit sales and price. So that's our focus. And we're working cost and price so we're looking at prioritizing units as we go forward, so obviously these are some of the key factors that we'll be rolling out through third quarter and into the fourth quarter.
Relative to supplies, we certainly do believe that the products that we are selling will be driving future supplies. The issue around supplies fundamentally is the erosion in the install base. For us to ultimately turn that, we need to get the hardware units going more aggressively which is difficult with the OEM decline. At some point we'll be passed that we believe but certainly right now that's an issue for us. And we need to drive branded unit growth and our focus grow is going to be on wireless initiative as we go forward in time.
Brain Mansfield - Goldman Sachs
Thank you. Your next question is coming from Toni Sacconaghi with Sanford Bernstein. Please go ahead.
Eric Garfunkel - Sanford Bernstein
Good morning. This is Eric Garfunkel calling in for Tony. My question is, your OpEx continues to increase significantly year-over-year as a percent of sales up nearly 300 basis points this quarter. Should we take this is the new required level of spending needed to compete, or as you improve unit growth and performance do you plan on cutting it and going forward or is this something that you hope to grow into?
Well, I think the level of spending in general is being driven by two things and is the increase is being driven by the R&D investments and by the demand generation investments. The majority of these investments are being made in the business market segment. So from that perspective of we view those as necessary investments including we expect those investments to continue.
Over on the consumer market side, the investments are being driven by a couple of things. Clearly we feel we need to continue to invest in brand development and we need to continue to invest in R&D. What we will be looking for there as we go forward in time to make that spend as efficient as we possibly can and try to optimize that. So I think overall, what you would expect in the near term is that this level of spending is what we believe to be required. We're looking to make it more efficient. Obviously, longer term we're looking to drive our revenue up. And make this a better situation that what we have.
Eric Garfunkel - Sanford Bernstein
All right. Thank you.
Thank you. Your next question is coming from Richard Gardner with Citigroup, please go ahead.
Richard Gardner - Citigroup
Thank you. Paul, you talk about growing your consumer business more cost effectively. I'm wondering if you have any specific initiatives or ideas of how you can achieve that, and I was wondering if you would acknowledge that a big part of your problem in inkjet is lagging printhead technology, and given that your competitors are spending five to 10 times as much on inkjet R&D annually as you are. I'm wondering, how you can catch up at this point cost effectively, and as you say, possibly spend, as much as, you need to spend on R&D to get back to where you would like to be in the consumer segment. And if that's impossible, why not just make some tough decisions about that business?
Richard, relative to the growing cost effectively, clearly our focus there is on cost and price. We've seen some very aggressive pricing in the marketplace; we had to go aggressively in the second quarter. Obviously, we drove a lot of units off of that with over 30% growth on the branded side compared to a market that was down, certainly in the first couple months of the quarter down 5% in the US, down about 2% in Western Europe.
So, from our standpoint, we feel we have products and technology that we can grow. The issue fundamentally is that's gotten more expensive and what we need to do is, we need to go improve on cost and price. And as we do that, we're going to be very focused on prioritizing the products; we really focused on the products to customers in the country said that drive pages. That's what we're trying to do.
Relative to printhead technology, I would tell you that clearly we're focused on improving our technology that is in the products. The point you make about the competition spending a lot more than Lexmark, those are correct. But that's not a new situation for Lexmark, since Lexmark started back in 1991, we've always been facing significantly greater investments from the competition than what we've been able to afford.
And the way that we have survived and the way that we have succeeded and competed is we focus. Right, we don't try to do everything that the competition is doing. So, if you take a look at what Hewlett-Packard are spending, they are in a lot more segments. In wireless printing they are lot more segments in inkjet, they are doing a lot of things with Inkjet that Lexmark is not doing. We are obviously not working in the plotter in the wide format arena. We are obviously not focused up in the light production area, where Inkjet is going with HP.
We're focused in the consumer segment. So this is a much more, narrow segment of the market. We do believe that we're investing at a rate that will drive the technology appropriately for what it is we're trying to do in the marketplace. Relative to that how we see the Inkjet business obviously we're very disappointed with the results that we have here. We're not happy with where we are relative to the profitability. But we do believe long-term that Inkjet can be a profitable contributor to Lexmark. It has been in the past. We have some significant strength in this segment relative to our technology relative to our past market. And we believe that we can improve this and that's what our focus is as we go forward.
Richard Gardner - Citigroup
As a follow-up, Paul, could you just give us a sense of where these cost improvements in Inkjet could come from? Because as you say it does appear that you need to invest significantly more to catch up in Inkjet technology. By the way, I understand that Hewlett-Packard is going after a much broader swath of the Inkjet market but they're leveraging the same Inkjet printer technology across all of the segments, which should give them even more of a cost advantage over time. So could you address those issues? Thank you.
Relative to the cost improvements we're very focused on product costs. And product costs always come both on the box as well as on the supply side. So we think there is opportunity is for us to improve there. We're also focused on price and promotion. We certainly work aggressively in the second quarter we think that there is some opportunities for us to do a little less of that. So that, that may mean a trail off in some units but that's part of the balance between price and unit sales. So, we do think there are some opportunities.
Again, I would tell you that, I understand the points about Hewlett-Packard and what they're spending and the leverage that they believe they're getting across the line, but these arguments are exactly the same, that have been there for Lexmark since we started. And the reality is, we know that by focusing, we can drive success in the market. We know that scaleable technologies from consumer all the way up to light production, I mean, the reality is the cost base to excel where we are is not necessarily the cost base that allows you to scale the technology all the way across.
This has always been a issue, was focused versus being a broad provider. We do believe that is the advantage Lexmark brings to the table. But the key is we do have to focus. So that is where we are as we go forward.
Thank you, your next question is from Shannon Cross from Cross Research, please go ahead.
Shannon Cross - Cross Research
Hi good morning, just want to talk a little bit about what is going on in the inkjet side, I know you guys had been through this a million times with all of the aspect just everything for a minute and products that you are bringing now right now you have Wi-Fi capability and you are seeing pricing pressure on that. I assume you are going to have to recoup some of the cost associated with putting Wi-Fi and what have you. So, do you anticipate alternately getting a sufficient life time margin on these new products?
Or just sort of on the inkjet shipments share you're putting out there in general? When you walked away from the 20% last year, you said you were walking away from ones that, wouldn't generate sufficient usage. Are you seeing anything that would lead you to believe that, given what's out there on the market right now, you'll getting acceptable profit over the lifetime?
Well, Shannon, there is a lot of questions rolling into one. I think the term --let me try to address some of those. Clearly when we did the action in the 2006 we were looking at lifetime profitability and we were showing products that were driving acceptable level of lifetime profitability.
I think one thing that's important for everyone to recognize is that's a point in time and as price point move and cost points move, and units of supplies, usage by segments, those evolve overtime, the situations can change. I would say that that was a point in time where it little bit different point in time, because certainly price points have moved from where we were.
That said our focus is still the same as it was in 2006, we took the action. We're looking at lifetime profitability and we're looking for an adequate return from the investment we make in the upfront loss. So our focus is, with everything that we sell is that's the criteria that we have, and that's what we're looking to achieve.
Now as we look at the 2007 products, I think you're quite right to point out that we've put a significant additional function in these products, the things such as Wi-Fi capability and certainly we've improved the technology. It is important that we get the cost recovered through price. So one of the reasons certainly that we're calling up by the costs, as we look forward into the third quarter and beyond is, because we have additional cost and it is important that we get that price.
So as the pricing and promotion expenses have continued to occur, as pricing promotion has gotten more aggressive to the extent that we can't get all the price we hope to get, and honestly we're going to be under pressure, because of the additional cost that is in there.
So what we want to do is, we do want to go off and work on cost on those products. We want to continue to focus on price. But we need to go aggressively and select the places where we are trying to drive by wireless initiative and where we do believe we can drive significant pages. So that will continue.
And you're right. We need to be ever vigilant that as we do this that we're still driving a good return on the products that we are investing in when we placing in. That is the focus that we have.
Shannon Cross - Cross Research
Okay. Thank you. And then one follow-up question, with regard to your laser business are you seeing any impact from the IBM-RICO transaction or is everything still steady state?
Well, we can't comment on any specific customer. Obviously what we're seeing on the laser side as we are seeing a decline in OEM unit sales. I would tell you the decline in the second quarter was more significant from the year-to-year decline that we saw in the first quarter. But again that's not specific to any customer that's the statement about the overall category of OEM unit sales.
Thank you. Our next question is coming from Jeff Embersits with Shareholder Value Management. Please go ahead.
Jeff Embersits - Shareholder Value Management
Could you talk a little bit about your ability to track the install base both from the inkjet and laser perspective? And what you think the life expectancies are out in the field because obviously in forecasting supplies you have to be at a track of certain amount of that in it can be pretty hard once they're out the gate?
Yeah, I think tracking install base is a very challenging thing because certainly we can't see the install base. All we can see is essentially what Lexmark sells. When we take a look at our models, I mean, fundamentally, we're making estimates what we believe install base is and we start with fundamental assumptions based of here is what we sold, here is what rough life expectancies would look like, here is that we think we continue to be out there. The reality is that all we can see is the supplies orders that we get as we go forward in time.
So, what's mixed in there is a number of factors like what the real install base is, is also mixed in with what the real usage is which is also mixed in as to what the real royalty is what percent of that supplies business is how much amount really capturing. And fundamentally we can't distinguish that. That's all rolled together. And obviously in our models we try to distinguish it statistically, but the reality is that we don't know. So as we take a look at the laser business, what we see is, we see good supplies growth, we see that continuing.
We know that we're growing that install base. We know that we're getting a better mix of color and multi-function devices in there and we continue to very aggressively do the cartridge return program, collect up empties, participate in remanufacturing, and so, we see all of those dynamics going on. Over on the Inkjet side, what we're seeing is a decline and we believe that decline is being driven by the install base, but in the end we can't really know the difference between loss of install base, versus loss of usage, versus loss of loyalty on the supplies. So it is possible all those things are in there.
We believe the primary factor is the install base but it is only possible that the other factors could be there. As we go forward in time, we're very focused on, end products, customers and countries that drive pages. We're very focused on how we can participate in remanufacturing market, and this is the return program cartridge initiative we started in inkjet, to collect up those empties to participate in remanufacturing. But in the end, from a model perspective, we do our best with it. Currently in the second quarter we came in under the model. As to whether that's, lifetime, I mean, just a rough rule of thumb we think three years in terms of jet, 5 years in terms of lasers, the reality is on the model there was a curve, right?
And the curve is not just the straight line or just a blip over three years. It really is a--the usage over time is what we try to estimate goes up, and then it goes down. And, again, those things are very hard to estimate. And when the numbers don't come in exactly right, is it because that usage curve is not right or is it because the lifetime assumption wasn't right? Is because the install base got replaced more rapidly than you thought? We just don't know. But we certainly have estimates thing. On the Inkjet side we believe the primary factor is install base erosion most likely, by sooner replacement than what we have anticipated historically.
Jeff Embersits - Shareholder Value Management
Thank you. Your next question is coming from Richard Farmer with Merrill Lynch. Please go ahead.
Richard Farmer - Merrill Lynch
Thanks, Paul. Clarification, if I could, on the factors that you look for the affecting the third quarter margins in the inkjet business. I'm wondering if you can give us a sense of some of the relative magnitude you talked about, the inkjet supplies revenue declining, moderate use cartridges, negative LCM/ACP being sequentially negative aggressive pricing the higher inkjet unit sales and also some product costs, which of those is sort of the largest and second largest in causing your margins to decline? And maybe which one is the smallest?
And then related to that, which one of those factors do you think is the most likely to be reversible fairly quickly maybe LCM/ACP comes to mind, but I guess which of factors are going to precisely think for a number of quarters, versus those that might turnaround relatively quickly? Thanks.
Richard, the order that we gave the factors is that is the order we believe in terms of magnitude. Obviously, we're estimating what we think, we're going to do in the third quarter, but that is our belief given our current estimates of what the magnitude would be.
Currently, as we look at these factors, the supplies decline is not a, this quarter down. We see a decline in the inkjet supplies. We think it is being driven by a reduction in the install base. For us to turn that around, we have to grow the units that difficult with the OEM units coming down as aggressively as they are. We can't tell from the numbers we just gave today, to extent of the branded units grew over 30%. And this is our market that down 2 to 5% in the quarter.
We grew over 30% in branded units and we still need 3% increasing units, because of decline that we're seeing on the OEM side. So, I think that this is going to be an ongoing problem for a while. Ultimately, clearly we need to be growing the branded units and seeing a lot less decline over the OEM side and that's certainly the focus. I think pricing is something that's there in the market, and it's a very competitive market. The market was weaker in the second quarter than it was in the first quarter; from everything we can see, this tends to drive more aggressive pricing in the market.
And the cost point we talked about earlier, we've added additional function of cost in the new products, which makes price all the more important for us, and as pricing gets more aggressive, cost problems are price problems and price problems are cost problems. Right? So I think supplies price and costs, these are issues that will be with us for a while and this is why we are focused on these issues. Ultimately, we want to get to a place where the unit sales are more affordable which means we have to improve on cost and price. And, we clearly want to be able to drive more branded units, so we can attack the supplies issue that we have in the business.
Richard Farmer - Merrill Lynch
Just as a follow on the LCM/ACP specifically, is that something that is particularly negative in your forecast for the third quarter, but it is unlikely to persist and could even reverse out the other way going forward?
Well, APC/LCM tends to move up and down in periods during the year based on inventory movements during the year. So, it happens to be negative in the third quarter because it's negative in period, and it was positive in the second quarter. So, therefore sequentially we end up having a larger impact than the end period impact stand alone. But in terms of longer term, APC/LCM generally is going to move with the movements in Lexmark-owned inventory and with the general level of loss on the hardware that is in our inventory.
Richard, I would tell you my view of APC/LCM, is that this is not fundamental to the business. This is a result of the fact that we take losses on the Inkjet products and to the extent that more come in the inventory, we're taking advanced losses in quarters before we actually move the units out. So this moves up and down it affects our results but it's not a fundamental issue in the business. The fundamental issues are place hardware drives supplies; this is really not a factor in that.
Thank you, your next question is coming from Bill Fearnley with FTN Midwest. Please go ahead.
Matt Whittaker - FTN Midwest
Yes. This is [Matt Whittaker] on for Bill this morning. In your call two weeks ago, you had an unbreakable PC bundles where customers take a Lexmark printer because they have no choice, depended that's not using as the bad thing and there are breakable, I think we call net to zero bundles might be a better option. I was wondering if you saw more of this happening in 2Q than you did before and also if you had any specific plans to move to these net to zero bundles?
Matt, our focus since 2006 has been to avoid these unbreakable bundles where the customer has no choice. They get something for free, and very often they use don't use it. So even though we are doing some bundling after, in the market, all these bundles are breakable. Now these bundles number 1 from a Lexmark perspective of net the zero. The retailer may choose to do that, but they're certainly not net to zero from a Lexmark perspective and they're breakable. So, we feel even terms of the changes we've made there that we are driving good business with that. Obviously, as we go forward in time, as I indicated, our focus is going to be to find the right balance between pricing and unit sales, and going to be putting, obviously a priority on the wireless products and on products that drive for more pages.
Matt Whittaker - FTN Midwest
Okay. That you thank.
Thank you, our final question is coming from Ben Reitzes with UBS, please go ahead.
Jennifer Thorwart - UBS
Yes, hi. This is Jennifer Thorwart calling for Ben. I was wondering if you can give us some indications on the end user demand comments, just wondering if you can talk exiting the quarter was it as weak as it was during the quarter, was there any up tick, give us may be an idea of what you are expecting in the third quarter if your assumptions assume that market goes back, since I am wondering about the demand level. And, also, if you might is there any end users concerns in the laser business, or is all just Inkjet.
I look at the inkjet market. In the first quarter, we believed the market was up about 2%, and actually as that flowed through the quarter, I would say that was much more front-end loaded, certainly there was a Vista impact, I think, in terms of inkjet unit sales in the first quarter, sales much stronger in January, February, by the time we got to March, it was down such that the total quarter came to plus two.
We've only seen data for the first couple of months in the second quarter, and primarily the data of our US retail channel and Western Europe, but with that indicated US retail channel down by 5% year-to-year in the first couple of months and Western Europe down about 2% in the retail channel in the first couple of months.
So I would say overall the inkjet market has been, over the last couple of years has been a roughly flat and down market. We certainly expect that to continue, and I think that the slight up in the first quarter, we just remnant of the Vista announcement that happened at the beginning of the quarter.
So overall, end user demand is about what it has been. So I don't view that as a fundamental change going on, it's flat to down. One of the things we are trying to do with our wireless initiative, as we are trying to drive a much better attach rate of inkjet products on to notebooks and on to wireless routers, because these are high growth categories. These are categories growing in excess of 20% per year.
The reason the inkjet category is flat to down is because historically all the attachment has been the desktops and desktops sales are pretty weak. So, that's the whole thrust of our initiative. This is why the retailers are excited about our wireless initiative, because they see this as an opportunity to drive growth in the category and attach to something that they're already focused on which is a growth category for them.
So that's kind of the thrust as we go forward. So we hope to see the impact from this initiative. Obviously, we're trying to create a new category here and we're trying to do some new things and that always takes sometime to develop, but we think from the reaction we have seen, certainly from customers and from retailers, we think there is a significant opportunity here.
Over on the laser side, I would say that end user demand looks pretty good. We have not seen second quarter market information. I see first quarter market information looks pretty good, overall laser units were up about 16% on year-to-year basis good growth in mono in the low teens good growth in color and the low twenties good growth in laser MFPs will be in the 25 to 30% range.
We would expect that to continue. As we went through the quarter, we did see lots of opportunity in the laser market. We certainly saw some aggressive pricing and promotion in the laser market, as well. Certainly in large account, certainly in small medium business, certainly on the low end of the line both mono and color saw some aggressive pricing going on. Bu,t overall the market looked good on the laser side and we see opportunities on the Inkjet side.
Jennifer Thorwart - UBS
Great. Thanks, Paul.
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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