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Lexmark International Inc. (NYSE:LXK)

Q1 2007 Earnings Call

April 24, 2007 8:30 am ET

Executives

John Morgan - Director of IR

Paul Curlander - Chairman & CEO

John Gamble - EVP & CFO

Analysts

Tony Sacconaghi - Sanford Bernstein

Philip Olsen - UBS

Richard Farmer - Merrill Lynch

Laura Conigliaro - Goldman Sachs

Bill Shope - J.P. Morgan

Richard Gardner - Citigroup

Ben Reitzes - UBS

Katie Huberty - Morgan Stanley

Robert Semple - Credit Suisse

Shannon Cross - Cross Research

Bill Hand - Bear Stearns

Bill Fearnley - FTN Midwest

Chris Whitmore - Deutsche Bank

TRANSCRIPT SPONSOR
Wall Street Breakfast

Operator

Welcome to the Lexmark International First Quarter 2007 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, April 24th, 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

Good morning, and thank you for joining us today.

With me for Lexmark's first quarter 2007 earnings conference call, our Lexmark Chairman and CEO, Paul Curlander; and Lexmark 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 question.

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 will find today's earnings release, as well as the supplemental slide deck for the first quarter, which includes the reconciliations of GAAP and non-GAAP financial information.

Also on our IR website, you can access our upcoming events page, which lists the investor conferences we'll be attending this quarter, including the Merrill Lynch Tech Gathering on May 1st, the J.P. Morgan Annual Technology Conference on May 23rd, and the Sanford C. Bernstein Strategic Decisions Conference on May 31st.

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. Lexmark undertakes no obligation to update any forward-looking statements.

With that, I'll turn it over to Paul.

Paul Curlander

Thank you, John. Well, today we're announcing our first quarter results. While these results were in line with the guidance ranges we provided on our January call, we view this as a mixed quarter for Lexmark.

Among the factors affecting our results year-to-year were some very strong positives, some challenges and some investments that we believe are necessary to continue to strengthen our competitive position and to position us for long-term growth.

On the positive side, highlights for the quarter include strong branded unit growth in the key focus segments of color lasers, laser all-in-ones and inkjet all-in-ones. Total branded hardware revenue, which is the key focus area for Lexmark in 2007 was up year-to-year for the fourth straight quarter and continued to improve.

Good revenue growth in our business market segment in both core hardware and supplies revenue. Branded inkjet units were up year-to-year, starting to recover after unit declines in 2006, and in the first four months of this year, we continued our progress on our core strategic initiatives, particularly around new product introductions that strengthen our product position in key segments in both the laser and inkjet market.

Some of the challenges in the quarter include OEM hardware sales that continue to be weak for us and are more than offsetting the positive progress we're making in branded hardware revenue growth.

Inkjet supplies revenue that was down year-to-year reflecting the hardware declines in prior periods and offsetting the good growth in laser supplies. Pricing that was fairly aggressive in both the laser and the inkjet market and an availability issue with our low and mono lasers that is now resolved, but impacted us in first quarter.

During the quarter, we also stepped up our investments. First, we continued an increase year-to-year our investment and brand development with our going-to-work advertising campaign that we believe is helping our brand awareness and consideration.

We increased year-to-year our investment in R&D, focused on the key growth segments. We've seen a significant impact from our increased R&D investments in a steady stream of new product announcements and a significant strengthening of our product line.

Given the strength of the product line, we are now increasing our investment in demand generation in all customer segments. And while these investments negatively impact results in the current quarter, we believe we'll see the benefit from these in the future.

Now let's turn to the first quarter results. First quarter revenue was $1.261 billion, down 1% year-to-year and at the high end of the guidance range. Earnings per share were $0.95 in the quarter. On an operational basis excluding the $0.01 per share of net restructuring related charges, earnings per share would have been $0.96.

Hardware revenue for the quarter was down 3% year-to-year as our growth in laser hardware revenue was more than offset by a decline in inkjet hardware revenue. For the quarter, supplies revenue was about flat year-to-year, with good growth in laser supplies offset by decline in inkjet supply sales.

For the first quarter, supplies revenue was better than expected due to stronger laser supplies sales. This laser supplies over achievement was driven by stronger than expected end user sales and some increase in the estimated channel inventory. Inkjet supplies revenue was about on our expectation.

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 in 2006 to discontinue low profit inkjet sales.

Our current expectation is for second quarter 2007 supplies revenue to be flat to down year-to-year in the low single digit range and to be down quarter-to-quarter reflecting seasonality and some expected laser channel inventory shrinkage, somewhat commensurate with the increase in the first quarter.

And in the consumer market in the first quarter, our revenue was $523 million, down 11% year-to-year. Consumer segment operating income was $64 million. Excluding restructuring related impacts, consumer segment operating income in first quarter would have been $61 million, down 36% year-to-year, largely driven by year-to-year decline in inkjet supplies revenue and increased R&D and demand generation expenses.

During the quarter, we started to lap year-to-year the discontinuation of our low profit inkjet sales that started during the first quarter of 2006. For the quarter, inkjet unit shipments declined 10% year-to-year, an improvement from the 20% unit decline we saw in 2006, with growth in branded inkjet units more than offset by a decline in OEM unit sales. Our branded inkjet units were up year-to-year in the period driven by strong growth in branded inkjet all-in-ones.

Now, last week we started the introduction of our 2007 inkjet product line. For the year we will introduce 12 new models, of which eight have wireless capability, six models with integrated wireless and two models with the wireless option. When our announcements are complete, Lexmark will have the broadest and most affordable range of wireless inkjet printers in the market.

The reason that this is important is that unit growth in the inkjet market has flattened with very little to no growth last year and similar expectations for 2007. However, growth in notebooks and wireless routers for the home are very strong.

Our survey of customer's show that the majority of users have a strong desire for wireless printing at home. However, because of the high price of existing wireless products and the complexity of use, customers had been slow to adopt wireless printing with wireless printers representing less than 5% of total inkjet unit sales. In fact, the average selling price of wireless models in 2006 was about $300.

We intend to change that, with wireless printers that are easy to install, easy to use and are affordable with prices starting at just $79. We believe that affordable wireless printing has the opportunity to grow the inkjet market and satisfy the strong demand that is being created by growth in the mobility categories.

Now, last week we introduced three of our eight new wireless models, the Z1420 wireless color print with an estimated street price of about $79, the X3550 color all-in-one with wireless as an option, at an estimated street price of about $79, and the X4550 wireless all-in-one with an estimated street price of about $129.

And in the business market segment in the first quarter, revenue was $737 million, up 7% year-to-year. Business segment operating income was $154 million, down 1% year-to-year due to the increase investment in both R&D and demand generation.

In the first quarter, laser unit shipments declined 6%, largely due to the availability constraint on our low-end mono laser line that has now been resolved. However, despite this disruption, laser hardware revenue was up year-to-year due to strong growth in color lasers and laser MFPs.

Now, this morning, we announced several new families of color laser and laser MFP products. This includes the X500n family of low-end color MFPs and the X780 and X940 families of work group color MFPs.

These new products will be a strong addition to our color laser line and fill some gaps for us in one of the highest growth segments in the market. You can see from our press releases, these products are already beginning to win industry recognition in the pre-announcement review cycle.

Now, as we look forward to the second 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 in my earlier supplies guidance. We expect second quarter earnings per share to be in the range of $0.82 to $0.92 reflecting the quarter-to-quarter seasonal decline in supplies revenue, and the aggressive pricing environment.

Now, overall, we continue to make good progress in evolving our business in order to position Lexmark for long-term growth. This evolution started in 2003, when we began to uplift R&D with a focus on core technology investments in the key growth segments.

The impact of this investment is currently visible in our product line today with the improved strength in our low end mono laser line, color laser line, mono laser MFPs and now the newly announced color laser MFPs and wireless inkjet models. It is also visible in the number of industry awards we continue to receive on these products.

The second step in our evolution was the 2006 restructuring where we improved our inkjet sales portfolio by discontinuing the sales we believe did not return an acceptable profit over life and improved our cost and expense structure to help us partially offset new investments and the price declines in the market.

We also stepped up our brand development campaign that we had started in late 2004. The third step is beginning this year, as we now increase our focus on branded hardware growth and increase our investment in demand generation to drive hardware sales.

Now, clearly, the ongoing decline in OEM unit sales and inkjet supply sales are negatively impacting our financial results. But long-term, the key to success is to drive branded hardware growth.

With our increasing investment in R&D, the strengthening of our product line, including the new color laser MFP and wireless inkjet lines, our focus on building the Lexmark brand and our initial investments in demand generation, we continue to strengthen our competitive position and improve our ability to pursue the growth opportunities in the distributed output market.

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

John Gamble

Thank you, Paul, and good morning. Consistent with previous calls, I'll first discuss our results of the first quarter of 2007 relative to the prior year, then relative to the fourth quarter of 2006. 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 second 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 quarterly details on the income statement line items impacted by the restructuring related charges.

Now, let me begin with the P&L. Total revenue for the quarter was $1.261 billion, down 1% compared to last year, and down 8% sequentially from 4Q and at the high-end of the range that we provided in January. Geographically for the first quarter, U.S. revenue of $545 million declined about 5% year-to-year. Revenue in EMEA of $482 million was up about 4% year-to-year.

The remaining geographies were down about 1% versus a year ago. Laser and inkjet supplies revenue in the first quarter was about flat year-to-year, with good growth in laser supplies revenue being offset by a decline in inkjet supplies revenue as anticipated. As Paul indicated, laser supplies came in above our expectation due to higher end user sales and some estimated increase in channel inventory.

Laser and inkjet printer revenue in the first quarter was down 3% year-to-year. Laser hardware unit shipments were down 6% versus prior year. Laser unit shipments and revenue were both negatively impacted by limited availability of our low-end mono lasers in the quarter. The availability issue was resolved prior to the end of the quarter, but did impact sales in 1Q '07.

Laser average unit revenue increased approximately 11% year-to-year, due to improved mix of laser MFPs and color lasers. Inkjet units declined 10% year-to-year, which is a significant improvement from the full year 20% decline of 2006. During 1Q '07, branded unit shipments increased versus the prior year, while OEM shipments were down significantly.

The branded inkjet unit growth was driven by strong growth in inkjet all-in-ones. Inkjet AURs declined 5% versus the prior year due to price declines. Business segment revenue for the quarter of $737 million was up 7% from the same quarter in 2006 and down 4% sequentially from 4Q '06. The year-to-year increase was driven by increased supplies revenue and increased hardware revenue.

Laser hardware revenue was up in the period, driven by strong growth in color laser and laser MFPs. The sequential decline was driven by a decline in hardware revenue. Consumer segment revenue for the quarter was $523 million, down 11% compared to a year ago and down 12% sequentially. The year-over-year and sequential decline was due to the declines in both inkjet hardware and supplies revenue.

Gross profit margin for 1Q was 33.5%, excluding restructuring related charges of approximately $1 million. Gross profit margin would have been 33.7%, up 60 basis points versus prior year and up 260 basis points sequentially. The 60 basis point improvement versus last year was principally due to a 140 basis point improvement in mix driven by less inkjet hardware, partially offset by lower product margins.

Sequentially, the 260 basis point improvement is driven by 610-basis improvement in mix driven by less inkjet hardware, offset by lower product margins and the lack of the APCLCM benefit we saw in 4Q '06. Operating expense for the quarter was $302 million. Restructuring related expense of approximately $1 million impacted operating expense this quarter.

Excluding this impact, operating expense was $301 million, an increase of $39 million year-to-year. SG&A was $201 million, an increase of $26 million from 2006, driven by branding and demand generation. R&D was $100 million, an increase of $13 million from 2006. Sequentially, operating expense excluding restructuring related costs was down $2 million versus the fourth quarter. The operating expense-to-revenue ratio in 1Q was 23.9%.

Excluding the restructuring related costs the operating expense-to-revenue ratio was also 23.9%. This is an increase of 330 basis points from 2006 and an increase of 180 basis points sequentially. The 330 basis increase from prior year was driven by increased spending. The 180 basis point increase compared to 4Q '06 was primarily driven by lower revenue in 1Q '07.

Operating income in 1Q was $121 million. Excluding the restructuring related expenses of approximately $2 million, operating income was $123 million, down $37 million from 1Q '06 and up $1 million sequentially from 4Q. Compared to 2006, excluding restructuring related activities, the business segment operating income in 1Q of $154 million was down $1 million versus last year and down $11 million sequentially.

The consumer segment again excluding restructuring related expenses had operating income of 1-- in 1Q '07 of $61 million, down $35 million versus last year and up $8 million sequentially. Other expenses consisting primarily of costs related to centralized supply chain, IT and other operating expenses, primarily G&A were $92 million in 1Q, excluding restructuring related activities, an increase of $1 million from 1Q '06 and a decrease of $3 million sequentially.

Operating income margin in 1Q was 9.6%. Excluding the restructuring related expenses our operating income margin was 9.8%, a decline of 280 basis points from the first quarter of 2006 and an improvement of 90 basis points sequentially. Concerning financing and non-operating costs, the interest and other was a net income of $3.2 million, down $2.3 million from 2006 and down $0.5 million sequentially.

The effective tax rate for 1Q was 25.7%, slightly lower than the 27% rate we had forecast. For 2007, we expect the tax rate to be approximately 26.5%. Net earnings for the quarter were $92 million. Excluding after-tax restructuring related costs of approximately $2 million. Net earnings in 1Q '07 were $94 million.

1Q '06 net earnings were $86 million or $113 million excluding after-tax restructuring related charges. GAAP earnings per share for the quarter were $0.95, excluding restructuring related expenses, EPS was $0.96 per share.

Although supplies revenue did exceed our expectations in the quarter, offsetting factors including more aggressive hardware pricing in both laser and inkjet than we had expected, as well as the settlement of a patent dispute in the quarter, resulted in earnings being in line with a $0.93 to $1.03 range we indicated in the January earnings call.

In summary, excluding restructuring, although our 1Q EPS was down versus 4Q '06, operating income in each period was essentially flat. 4Q '06 net income and EPS were higher than 1Q '07 due to tax benefits that were generated in 4Q '06 that we discussed in January.

Again, excluding restructuring, operating income and margin was down in 1Q '07 versus 1Q '06 due to higher operating expense, reflecting increased investment in development and increased investment in demand generation. Gross profit dollars were essentially flat in 1Q '06 versus 1Q '07.

Now moving to the balance sheet and cash flow items, cash flow from operations for the quarter was $87 million, a sequential decrease of $56 million and a decline of $133 million from last year, excluding restructuring related cash outflows, cash flow from operation was $99 million this quarter, a decrease of $123 million from 1Q '06.

The decrease of $123 million versus 1Q '06 was primarily driven by lower cash flow generation from working capital, primarily receivables. Receivables collection performance remained strong in 1Q '07 with DSO below 40 days.

The strong cash generation from receivables in 1Q '06 not repeated in 1Q '07 was primarily a reflection of the high receivables balances at year-end 2005 that were liquidated in 1Q '06. The lower cash flow in 1Q '07 was also due to lower operating earnings in 1Q '07.

Since the end of December, accounts receivable increased $17 million. Inventory declined $25 million, reflecting reductions in both hardware and supplies inventories. Accounts payables declined $26 million, and accrued liabilities declined $20 million.

For the quarter, capital was $49 million. Depreciation in the quarter was $41 million, and currency of the Euro was accounted for at 131 compared to 120 at in 1Q '06. Cash and marketable securities at the end of 1Q was $443 million, down $108 million since December.

In 1Q, we repurchased 2.7 million shares, or $165 million at an average price of $61.06. At quarter end we had $295 million of share repurchase authority outstanding. Of our $443 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 discussed on the January call, we will continue to have a relatively low level of impact relating to this in 2007.

In the first quarter, we incurred a net $2 million in pretax restructuring costs and related expenses, approximately $1 million in cost of sales with the remaining $1 million impacting operating expenses, this is lower than we had forecast, primarily reflecting the sale of our Rosyth, Scotland facility that we closed in 2006 as part of the restructuring plan.

For 2Q '07 we expect restructuring costs and related expense to be net zero, as approximately $0.05 per share of project costs are offset by the expected gains from the liquidation of our Rosyth legal entity.

For 3Q '07 and 4Q '07 restructuring related expenses are not expected to exceed $0.05 per share in any given quarter. We will identify these costs for you each quarter. Now for my forward looking comments concerning 2Q.

We expect second quarter revenue to be down in the low-to-mid single-digit range year-to-year. As we mentioned last quarter, although we continue to make progress in branded hardware units and revenue and expect that to continue in 2Q '07, we continue to expect weaker OEM hardware unit sales in 2Q '07 versus last year.

Supplies revenue is expected to be flat to slightly down year-to-year, again, we expect to continue to see good growth in laser supplies offset by a decline in inkjet supplies. We expect EPS to be in the range of $0.82 to $0.92 per share. Restructuring related expense is expected to be net zero in 2Q '07.

EPS in the second quarter of 2006 were $0.74, or $1.09 excluding 2Q 2006 restructuring related charges. Comparing our 2Q '07 guidance versus 1Q '07, we expect income to be down primarily reflecting seasonally lower supplies revenue and aggressive hardware pricing environment.

Versus 2Q '06, we expect income to be down, reflecting increased operating expense due to increased investment in demand generation and development, as well as hardware price reductions.

In terms of our specific discussion of financial information, both the 2006 and the 2007 data provided that I am comparing to are non-GAAP and exclude the impact of restructuring and related charges. In the second quarter, we expect gross margin percentage to be down versus the 33.7% we achieved in 1Q '07.

Operating expense is expected to be in line with the $301 million incurred in 1Q '07 as we continue our investments in both development and demand generation. Operating income margin in the second quarter is expected to be down from last year's 12.8% and from the 9.8% achieved in the first quarter of 2007.

We continue to project operating margins will be in the range of 8% to 10%. The effective tax rate in 2Q '07 is expected to be approximately 26.5%. We project the full year tax rate to be approximately 26.5%.

We continue to project full year 2007 capital spending to be approximately $235 million and full year depreciation 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 Tony Sacconaghi with Sanford Bernstein. Please go ahead.

Tony Sacconaghi - Sanford Bernstein

Yes, thank you. I just wanted to probe the investments in brand development and demand generation a little further, how long do you think you have to sustain these investments and how much of it is discretionary, i.e., advertising and promotion, that you could actually pull back?

And I think what would be helpful for us to understand that is, can you comment on where head count went year-over-year, and can you comment on advertising and promotion year-over-year?

Paul Curlander

Well, Tony, if we look at the year-to-year SG&A movement, I would tell you that about 2/3 of it is media and people, certainly more media than people in there. The rest of it is a long list of items of what you might call discretionary kinds of things.

I think from our perspective, it's very important that we step up these investments. We really feel that we've brought the product line along to a point where we have now filled in all the key gaps. We think that we're very well positioned against the competition.

We've completed the, the change on the inkjet portfolio by getting rid of the low profit sales from last year and we think with the launch of our new wireless line on the inkjet side, we think with the strength of our product line and services set on the laser side, that now's the time.

So, we think we've got the right mix of discretionary and fixed and, as John indicated, we've kind of stepped up and we're going to be about flat quarter-to-quarter.

Tony Sacconaghi - Sanford Bernstein

If I could just follow up, Paul, you had a year-over-year positive impact from your restructuring initiative. So if SG&A was up $26 million, X the restructuring initiative, it was actually up closer to $40 million.

So are you saying 2/3 of that $40 million incremental is media and people? And again, can you try and answer the question about whether head count is up or down versus last year?

Paul Curlander

Well, I think relative to the year-to-year bridge on the OpEx we definitely are getting an improvement from the restructuring, that restructuring improvement was split between cost of goods sold, as well as OpEx.

So I think the OpEx is if you look at the $80 million plus savings for the year, net that back to one quarter, I think there's a much smaller number you may be thinking relative to the impact in the first quarter.

I think that as we go forward in time, the overall head count increase, we prefer not to talk about that, Tony, just relative to competitive issues, but it was not the bigger piece of the SG&A increase on a year-to-year basis.

Operator

Thank you. Our next question is coming from Philip Olsen with UBS. Please go ahead.

Philip Olsen - UBS

Yeah, thanks for taking our question, actually, a quick one. In terms of kind of priorities for free cash flow over the balance of this year. If you could maybe just articulate how you envision spending cash flow?

And as it pertains to the cash you made a comment, that the majority of the cash is held overseas, does that then restrain your ability to pursue additional share repurchases?

And then finally how do you think about addressing the refinancing of the 2008 bond maturity, is that something we just think you should pay out of cash on hand? Or would you look to refinance that in the debt market? Thanks.

John Gamble

Okay. In terms of cash flow, and it sounds like specifically around repurchases, right. So we've talked about this before, right? Effectively what we have done historically is we've repurchased shares out of cash available in the U.S., and as cash is now in the U.S. available now is at a relatively low level, then repurchases, historically would have been done out of that cash available or the cash generated in the U.S.

We don't forecast the activity, and so at this point we can't really go into more detail in terms of what we do going forward. But that's been our historic practice. We also have historically, we've specifically indicated we wouldn't necessarily add debt to do that, although it's something that we certainly revisit, and we revisit our entire purchase plans frequently with the Board, and we do that annually.

So that's something we do look at frequently. Your last question was around the refinancing, the 2008 debt. Not something we're really at this point going to talk about. It's $150 million, and as we get into 2008, we'll make decisions as to how we're going to specifically do that.

Philip Olsen - UBS

Okay. Thank you.

Operator

Thank you. Our next question is coming from Richard Farmer with Merrill Lynch. Please go ahead.

Richard Farmer - Merrill Lynch

Thanks. Paul, two questions please. First, on the inkjet supplies decline, you mentioned the effect of the declines in the prior period hardware sales, is that really the primary explanation?

Are there any other factors that you could provide color on, anything related to ink usage per install device or a mix of cartridge yields or any other factors there?

And then secondarily, on hardware pricing. Can you quantify more specifically, what you described, as I think fairly aggressive pricing in any rough percentage decline terms or how much worse was that relative to your expectations, which I believe included some anticipation of price competition, and in your outlook, what are you assuming in pricing going forward? Thanks.

Paul Curlander

Okay, Richard, relative to the inkjet supplies decline, I think there's a number of things going on there, I think clearly one of the major factors is the install base decline, and this is due to the reductions in inkjet units. Certainly 2006 was a big factor, but you have to look back to declines in the branded units in years before that as well.

Currently we're also continuing to see an impact on the mix in price. We haven't talked about that maybe in a few quarters, but that's certainly out there the mix between the standard yield cartridges, and the high yield cartridges, the mix between brand and OEM continues to have an impact.

And certainly we're very cognizant that loyalty and use of third party remands maybe a factor in here as well. We think the dominant factor certainly is the install base, I would also list the mix and price as an issue here as well, and loyalty, we're always looking at. On the hardware pricing, let me kind of characterize that in terms of the average unit revenues.

On the laser side, we indicated the average unit revenue was up year-to-year 11%. I would tell you there was a huge mix effect on that because of the availability issue we had on the low ends.

So we got a lot less low end products, we also had very strong sales on the high end, on the color laser, the color laser MFP. So the pricing impact is visible in there but only because the mix is actually much bigger than this plus 11%.

We're seeing very aggressive pricing; particularly in enterprise bids around the world, these things are being aggressively bid on by all the competitors, we're seeing a lot of aggressive pricing and promotion in small and medium business, obviously, low end mono lasers, color lasers continue to be aggressively priced in the marketplace.

On the inkjet side the average unit revenue declined 5% and again to characterized that we had a huge mix improvement between single function all-in-ones in the quarter. On a year-to-year basis we had strong growth in branded all-in-ones, we continue to see a significant decline in the single function.

Obviously the mix between brand an OEM played a role in here as well, but a lesser role than the mix between single function and all-in-ones, and that decline was pulled down off of a positive mix shift, was pulled down to a minus five.

If you look quantitively on the inkjet all-in-ones, on the three-in-one category, which is really our highest volume category now after the movements we've had over the last five quarters in inkjet. We're probably looking at a 30% year-to-year decline in the average unit revenue in that category. So a significant impacts out there in the market.

Richard Farmer - Merrill Lynch

Okay. Thanks, that's helpful.

Operator

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

Laura Conigliaro - Goldman Sachs

Yeah, just a couple things, really about your channel inventories, you talked about your higher DSOs. Can you give us more color on what's going on as far as channel inventory build, and what your expectations are in the June quarter?

And then just a follow-up clarification, which is that given the difference in the state of your branded business and your OEM business. Can you update us on the percent of your business approximately that is branded versus what it was, say a year ago?

Paul Curlander

Okay, Laura, on the second question, I don't think there's a significant movement in the percent of OEM in our business versus a year ago that would be a revenue statement looking at the total company.

One of the things that you need differentiate apart, as I say that is that usually when we talk about OEM weaknesses we're focused on hardware unit declines on a year-to-year basis, obviously, the supplies from OEM may be moving a slightly different direction.

On the channel inventory side, let me just focus in on the supplies channel inventory, because that's what we mentioned in the remarks. What we saw on laser supplies, it was really a very strong quarter, and first quarter compared to our expectations, which is good news because that follows the quarter and fourth quarter, we had very strong results versus our expectations. In both the fourth quarter, and the first quarter we saw more end user demand than we would have predicted from our models.

So that's also a good thing, I think that in the first quarter that we also saw some build in channel inventory in our estimated channel inventory, which is something we would preferred not to see, but apparently it did occur as we look at it after the fact. As we look at the inkjet side, we saw, again, a bad one expectation for inkjet.

As we look at channel inventory estimates after the fact we see some slight build there, not as much as what we see on the laser side. We would expect in the second quarter to see some shrinkage particularly in the laser channel inventory now, that's very hard to call, because we don't control that inventory.

But we just think that what went up in the first quarter could very possibly come out in the second quarter, and we've kind of put that into our outlooks as we go forward. It was not a huge amount, I mean, we're not talking multi-weeks or even a week in inventory, but it's not insignificant, so we mentioned it.

Operator

Thank you. Our next question is coming from Bill Shope with J.P. Morgan. Please go ahead.

Bill Shope - J.P. Morgan

Okay, great. Thanks. I guess my first question is on the laser unit weakness. If the mono product shortage was the key reason for that decline we saw this last quarter should we expect positive laser unit growth in 2Q?

And then my next question is a clarification. I thought I heard you mention a patent dispute issue that impacted profits during the quarter. But I didn't see that in the release. Can you give us some color on that and maybe quantify it?

Paul Curlander

Well, let me just mention the patent dispute, and we can't quantify it for you for numerous reasons relative to the agreement. But basically, we had a lawsuit with IP Innovations that we settled during the quarter.

Like we encounter with many different patent disputes, whenever we do a settlement. It's a business decision as to what it costs us to go forward versus what it costs us to come to a resolution and what's the best conclusion for Lexmark.

In this case, settlement, we thought, was the right answer, and we went ahead and did that, obviously an impact in the quarter. Relative to the laser shortage, clearly the biggest volume segment that we have in the laser market is low-end mono lasers.

As I look at our estimates to the amount that that we think we lost in the quarter because of disruption in supply, that was a difference between having negative versus taking us positive. We certainly would expect to see a bounce back in low-end mono lasers, as we go into the second quarter. We certainly would expect to see continued strong growth in color lasers and laser MFPs.

And I'm certainly hoping to see laser unit growth to be there on the branded side in the second quarter. I am a little concerned about how quickly we'll see the momentum build back in the low-end mono after the disruption that we've had in the category.

And it's also a very aggressive price category with a lot of competitors. So we'll see how that plays out, but we would expect to see it bounce back there, as well as continued strength on the branded side in both the color laser and laser MFPs.

Bill Shope - J.P. Morgan

Okay. Thank you.

Operator

Thank you. Our next question is coming from Richard Gardner with Citigroup. Please go ahead.

Richard Gardner - Citigroup

Thank you all. I have a couple of questions. First of all, it looked like based on our model that hardware gross margins were probably down roughly 500 basis points year-over-year and maybe 800 basis points to 1000 basis points quarter-over-quarter.

Despite the fact that you are seeing a positive mix shift within hardware toward, I would think better margin products with the exception of color laser, which I realize is very much racer blade razor.

So, can you talk about the relative impact of APCLCM and the aggressive hardware-pricing environment on the margins in hardware? And can you also give us some sense of whether declines in supplies margins contributed to, to what we saw in the gross margin line? Thank you.

Paul Curlander

So, in terms of APCLCM, APCLCM was a small impact specifically in the first quarter, but as we talked about in January, there was a benefit to APCLCM in the fourth quarter. So, quarter-over-quarter, because we lack that favorable benefit in the fourth quarter of '06, it was a negative impact on us. It was a negative impact on us if you're comparing margins quarter-to-quarter.

Richard Gardner - Citigroup

Was that a more significant impact in the pricing environment, or was pricing more significant, John?

John Gamble

I think pricing was an impact to us as we came from the fourth quarter into the first quarter. I also think, your question on supplies margins, we did see some erosion on supplies margins, a lot of it around the price and mix in the inkjet supplies that we mentioned a little bit earlier in the call. On a year-to-year basis, I don't believe we saw much change in the supplies margin.

Richard Gardner - Citigroup

Okay, so, when you say supplies margins were down, you're talking just primarily on a quarter-to-quarter basis?

John Gamble

Yes, sequentially. Sequentially, in terms of the mix, mix and price impact, standard yield versus high yield, OEM versus branded.

Operator

Thank you. Our next question is coming from Ben Reitzes with UBS. Please go ahead.

Ben Reitzes - UBS

Good morning. Thank you. Could you just talk a little bit more about the OEM drag, I know you don't like to cover this, Paul. But, it's so significant it seems to your results and the OEM drag in the quarter, but then you also have some issues with the IBM relationship and what happened there.

I mean is there any way we can just get any color from you on when the OEM declines just stopped being a drag and then I have a follow-up?

Paul Curlander

Well. Ben, I think it's a good question. Because, I mean the reality is what's going on is the progress we're making on the branded side is being covered up by the decline that we're seeing on the OEM side.

Clearly, we have a number of OEM customers, clearly, I can't talk about any of the OEM customers. I think that obviously, investors probably know who the bigger ones are. The reality is that OEM as a whole, it was a weak 2006 with hardware declines. What's a little frustrating as we come into 2007, we're seeing those declines continue and actually increase as we, certainly as we look into the second quarter.

We think that'll be even weaker year-to-year than what we saw in the first quarter. I think that the way to think about this is that, with OEM, this is what happens to you in the business. You cycle up, you cycle down. Hopefully, we'll cycle up at some point, but that may or may not happen. At the rate at which we're seeing declines, it certainly starts to compound pretty quickly as you go from year-to-year to year-to-year.

I think the key issue for us is to continue to drive on the branded side. Obviously, looking back at 2006 we had a good year branded side, on the lasers. Given that we walked away from 20% of the inkjet side, we also had a good year in the part that we weren't walking away from and we expect that to start to show here as we move through the year in 2007.

So, we feel pretty good about the branded side. Obviously, inkjet OEM is a big factor here, but as you pointed out the laser side has some drag as well on a year-to-year basis from what we had.

Ben Reitzes - UBS

And then just with regard to the patent dispute, I just wanted to ask in a different way, is it the fact it's not called out mean it's not material to the, to perhaps your margin or the cash flow, which was a little weak in the quarter. But, I assume that you didn't call it out, meaning that it wasn't material to, in terms of cash flow hit or a margin hit in the quarter, or is that not the case?

John Gamble

Well, it certainly impacted margins and it certainly was a cash flow impact. It wasn't a major impact, but there certainly was an impact in the period.

Operator

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

Katie Huberty - Morgan Stanley

Thanks. Good morning. Just quickly to follow up on the OEM business; did the mono laser disruption impact OEM relationships or just the branded business?

Paul Curlander

The major impact was on the branded side. We work hard to keep our OEM customers whole whenever we have any type of availability disruptions so, we feel pretty good about what we're able to do with the OEM customers.

Katie Huberty - Morgan Stanley

And then, just quickly on the inkjet side of the business, it appears you're adding the wireless capability for relatively low incremental costs. Is it fair to think of the new inkjet printers as lower gross margin, but with the hopes of incremental supplies usage longer term?

Paul Curlander

Well, we obviously never comment on the gross margins as of part of the product line. But, I would tell you we're certainly trying to add it with a minor amount of incremental price. Cost as the volume grows over time, we're looking to get those costs down.

We do believe that wireless will drive incremental usage in the marketplace. Certainly, some of the experiences in the tests that we've done have indicated that there can be more usage driven off of a wireless device, but obviously we'll have to see that as we go forward in time. But that's our hope.

Operator

Thank you. Our next question is coming from Robert Semple with Credit Suisse. Please go ahead.

Robert Semple - Credit Suisse

Sure. Thanks. Question on the OpEx, obviously, we know what's happening in the current quarter going forward, but how should we be thinking about OpEx growth for the balance of the year?

It's going to grow kind of mid teens this quarter versus negative revs, and just can you kind of think about or let us know what your thoughts are how that trends throughout the balance of the year?

John Gamble

Well, we don't really give specific guidance beyond the second quarter, but if you do look at fourth quarter to first quarter to second quarter, the OpEx levels have been relatively stable, right, if you take a look across those periods.

Robert Semple - Credit Suisse

Okay. And if you exclude the OEM business, do you think you gain to maintain or loss share in your branded inkjet business in the first quarter?

Paul Curlander

Well, first quarter is a little hard to know, because we haven't seen the market data. Let me answer the question a little bit more generally and then give you some thoughts about the quarter.

As I look back at 2006, you look at the data from IBC, which would say that the inkjet market was about flat. It would say that the mono laser market was up about 8% year-to-year, color laser was up about 15%, laser MFPs up 25% to 30%.

As I look across those laser numbers, the 8% in mono, the 15% in color, the 25% to 30% laser MFPs, Lexmark grew much faster than that. So, we gained laser share on the branded side across those categories in 2006.

On the inkjet side, I would tell you that obviously, since we were down 20% year-to-year on units and units were about flat to slightly down on the market, we lost share. We believe that we lost about four points of share year-to-year, but I would tell you a couple of interesting things about that.

First, as you look at the split between OEM and branded, we think three of those four points of share loss were on the OEM side. We think there was only one point of the share loss on the branded side, and this reflects the growth we had in the other piece of the business and the sales we did not discontinue.

So, we view that, we view that to be, to be good news, as we also had on the branded side good growth last year. Actually, yes, very good growth last year in the inkjet all-in-ones, so we may have come very close to holding market share on inkjet all-in-ones on a year-to-year basis. Currently we lost branded inkjet share on single functions because of the discontinuation of bundles.

As we look at first quarter, it's hard to know exactly what the market did. We have some preliminary data out of people like MBD for January and February in the U.S. indicating sellout was up 14%. That doesn't cover the whole market. We think when you roll the whole market in you're going to get a lower growth number than that.

Preliminary data from the weekly reports in March indicates that maybe March was down 7%. So, again, a partial view of the market would say maybe up mid-to-high single-digit. But, we think when everything's in, you're going to be looking at a much lower growth number in the U.S. than the first quarter. Obviously, there was a little bit of a vista effect in retail in the first couple months.

As we look at that, we think that on the branded side, it's very possible we held market share in the first quarter. We clearly think we lost market share on the OEM side in inkjet.

As we look at lasers, clearly mono laser was a little bit problematic for us in the first quarter. The market data is kind of mixed. There's some data out there from, from MPD that indicates that maybe the first quarter was a little stronger than the fourth quarter.

There's data that we've seen from U.S. distributor reports, and these are both U.S. statements, that indicates that the first quarter was weaker than the fourth quarter. It's hard for us to know, I would say with the exception of the mono laser issue we had with the low-end monos, we had strong growth year-to-year in both color laser and laser MFPs.

I would expect that we gain share in color laser and laser MFPs on the branded side. I would expect that low-end mono laser we probably lost share because of disruption, but again, we don't have that market data.

Operator

Thank you, our next question is coming from Shannon Cross with Cross Research; please go ahead.

Shannon Cross - Cross Research

Good morning, I had a question with regard to inkjet cartridges. Not just sort of the mix that impacted I guess the margins, as well as, pricing in the most recent quarter. But as we look forward to some of your rebate options that you're doing.

I'm just curious as we, how we should think about it because from what I understand the rebate cartridges. What the 23, 24, 28 and 29 will be sold at a what about a 4% discount to sort of where things are right now and sorry $4 discount relative to where things are right now.

And therefore, as these start to hit the market, what should we think about sort of ASPs and margins and net on those products. Obviously long-term would benefit from the after market standpoint. But what's the near term impact?

Paul Curlander

Well, Shannon I think you touched on all the relevant points. I think to it, I think that with the launch of the return cartridges in our new line of inkjet products. Obviously, we're very focused on working just like we have on the laser side to get returns back to Lexmark, so that we can then take those returns and start to get more into the remanufacturing business.

I think it's important to recognize, and I think you're on this point that we are giving customers an option. Right so we'll have the lower price cartridges that have the restriction, in terms of the patent license and then we'll have the higher price cartridges that have no restriction. If anybody wants to buy those, so that mix as we go forward in time.

We're obviously going start driving a mix more towards probably the lower price if the experience is similar to what we've seen on the laser side, so that'll be some near term change from a mix perspective.

But longer term, we certainly believe that as we get cartridges back as we can get more into the after market reman business, that this will be a good thing for Lexmark and allow us to start to compete with those third party offerings.

Shannon Cross - Cross Research

Okay. And then a follow-up because you say as you get more into the reman business. Would we expect to see maybe a two-tiered pricing strategy for you over time where, perhaps you would sell a remanned cartridge for even lower than the returned pricing, or the rebate pricing?

Paul Curlander

It's hard to say what you might see from us over time, I think it's, on the laser side what you see us doing is obviously we're selling remans into large accounts at prices below our return cartridge pricing.

So there's no question we're doing that today, on the inkjet side. It certainly is possible we might get there; we also are very interested in private label deals as well. So, I think both of those are possibilities; we obviously need to do a lot of work to get those returns up. So we can start to get that volume flowing.

Operator

Thank you. Our next question is coming from Bill Hand with Bear Stearns; please go ahead.

Bill Hand - Bear Stearns

Thanks Paul. If end user demand on the laser side has exceeded your model for two quarters now. Why aren't you more positive on the potential growth there particularly in light of what you've seen around color and MFP; and then just another quick question, just any thoughts on mem jet and how disruptive that might be to the market?

Paul Curlander

Well, on the color laser side, on the laser supply side. I think it's a great indicator of the momentum that we've built driving our laser units. Particularly on the branded unit side over the last three or four years, and we're delighted to see the stuff, see the end user demand exceeding what we have in our models.

I think that color is certainly is a big factor in that certainly pushing us up; I think our services business also helps us with that, clearly in the second quarter. We're looking at some potential shrinkage in the channel. We take these overages we crank those into the model, so our outlooks for the second quarter certainly reflect the fact that we had stronger end user demand than the last two quarters.

I would say that we're cautiously optimistic that maybe we'll see some more as we go forward. But we think the model should have taken into account those adjustments from the last two quarters. And we're going to see a little bit of shrinkage all that said, we're expecting to have good growth in our laser supplies in the second quarter.

So nothing we've said should take away from that, that we've had good growth in our laser supplies all through 2006; certainly very strong in the fourth quarter. Certainly very strong here in first quarter, and we expect to have good growth in the second quarter as well.

Bill Hand - Bear Stearns

Just to follow-up. Any thoughts on mem jet.

Paul Curlander

Well mem jet. There's not a lot I can say about that, the Silver Brook technology has been around for a long time. I think clearly here recently they've said some things that look like there a little different from some of the things that we've seen from them historically.

I would tell you that we certainly go out and look at everything that's in the market to understand what it is and. But we never talk very much about what we think after we take a look at it.

I really don't see much impact to Lexmark from mem jet, really kind of for two reasons, one is their they have not commercialized the technology and that's a nontrivial thing. But that may just be a timing thing, who knows when they might get that done.

Secondly, I have a hard time believing from what we've seen that this is going to, this is going to compete in the price range where Lexmark competes today. It just looks like higher end stuff, from what it is that we do in the market; so this is why it's not very high on our list of potential impacts to us in the marketplace.

Operator

Thank you; our next question is coming from Bill Fearnley with FTN Midwest. Please go ahead.

Bill Fearnley - FTN Midwest

Yes good morning, two questions if I could on the pricing side, when you talk about price aggressiveness. Is it product pricing or is it rebates and bundles and discounts that's putting the most pressure on pricing; and then specifically in the laser hardware-pricing trend.

Any updates to I think it was Paul's comments at the Analysts day regarding the razors and blades movement in the business model on the laser side; if you could help us out on pricing that would be helpful. Thanks.

Paul Curlander

Okay, well. Bill, relative, when I talk about pricing I really roll in everything, and so, it's movement in the price itself. But it's also promotions that are done, bundles per se. We've kind of changed our bundle policy somewhat. So that's maybe a little less of a factor for us, but on the promotion side. It's really pretty aggressive out there.

And you can see it; all you have to do is take a look in the Sunday circulars out at retail, you see huge promotions going on a regular basis every week. And this is becoming just kind of the usual cycle but right now we see the market as particularly aggressive in terms of promotions, family ads, as well as, individual product promotions.

As well as people moving through end of life stuff that's out there from prior generations, so a lot of it going on. A lot of it I think due to the fact that the inkjet market didn't have any unit growth in 2006. And people have capacity and so this is just a cycle that you start to see.

Over on the laser side, I think the issue again. We have a pricing issues out there as to what's going with low end mono laser, color laser and enterprise bids, very aggressive across all those things; but the point I think you're on is that we see a movement in the laser model because historically lasers have been different than inkjet where people have made money on the hardware. As well as, making money on the supplies.

And what we see certainly with the color lasers. And I would say to some extent with the low-end mono lasers is we see people moving more towards the inkjet model; certainly, the color lasers are there; we think some models within the low end mono range certainly as you get down sub $150, you start to see that as well.

And so, this is having an impact in the business model over on the laser side, over the life of the product this is not a problem because certainly these products continue to be very profitable and the business overall continues to be profitable.

But clearly to the extent that you get negative hardware margins in the quarter that you sell these things. You see negative impacts by selling more, more hardware, and we're obviously very focused on trying to sell more hardware.

Bill Fearnley - FTN Midwest

Any particular competitors you wanted to call out here, you've done that in the past, are you seeing new entrance into new categories putting the most pressure on the pricing. Or is it the incumbents that you see on a more on a regular basis.

Paul Curlander

I think most the action is with the incumbents. I think that some of the people who you might put in the new entering category. They're in, so they're kind of there and I think, over on the inkjet side we're certainly looking across HP, Brother and Cannon in addition to Epson.

But you also have to go over on the laser side look beyond just HP, and be looking at people like Konika, Minolta and Epson and Samsung there because there's a lot of impact from them as well.

Operator

Thank you. Our final question will be coming from Chris Whitmore with Deutsche Bank; please go ahead.

Chris Whitmore - Deutsche Bank

Thanks; to follow-up on that last question. Wanted to ask about your shelf space at retail. Can you give us an update as to what your shelf space did during the course of the quarter, and related to that. Are you seeing any impact from Kodak's entrance in the three-in-one and four -in-one space on that shelf space in overall pricing to the channel. Thanks a lot.

Paul Curlander

Okay, well, I think relative to Kodak, there's not a lot we can say about it there, they're right now only at Best Buy as far as we know; we've not lost any shelf space at Best Buy as a result of their entry. So, I would say there's no impact to us our models continue to be there and continue to sell, I think shelf space at retail for us has been an interesting story over the last four to five quarters.

And I think, it's turning into a positive story for us, last year as we walked away from the low profit inkjet sales. We saw a drop in our shelf space as some of the products fell off the shelf, and that was certainly an impact to us; as we went through the year, we've been getting shelf space back in different locations in both the CES and LSS, which have been helpful to us.

And as we ended the year, we really were, had recoveries throughout most of the shelf space that we had lost from the discontinuation of low profit sales, it wasn't all in the same place. But we had overall I think had recovered those number of SKUs.

Now as we look forward in 2007, we really think that this wireless launch is going to have significant impact on our shelf space. With the commitments that we have from retailers we're going to see an improvement in their shelf space from the spring to the fall of this year as we roll out the rest of the line; and it's 15% to 20% improvement in retail shelf space from where we are right now in the U.S.

And we're going to see improvements in all categories mass, CES and LSS. So, we think we're building a good story here on retail shelf space.

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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Source: Lexmark International Q1 2007 Earnings Call Transcript
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