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Lexmark International Inc. (NYSE:LXK)

Barclays Capital Global Technology Conference Transcript

May 22, 2012 9:00 AM ET

Executives

John Gamble – Chief Financial Officer

Analysts

Ben Reitzes – Barclays Capital

Ben Reitzes – Barclays Capital

Good morning, everybody. As people filing in. So I'm Ben Reitzes, the IT hardware analyst here at Barclays. Welcome to our conference. And I'm delighted today to have the management of Lexmark International here with us.

This is a company I covered, I don't know, probably up to 15 years, at least 14. And we're delighted to have John Gamble, the CFO. He has been the CFO of Lexmark for six years and we kind of know you very well, and we are delighted to have you with us. We're going to ask you a series of questions. I think you have statements to read.

John Gamble

Yeah.

Ben Reitzes – Barclays Capital

And while you are doing that, I'll check my BlackBerry. No, I’m just kidding.

John Gamble

No problem. Okay.

Ben Reitzes – Barclays Capital

Go ahead and read that and…

John Gamble

Thanks for having us. We're very happy to be here and I’ll just read the Safe Harbor. Here we go.

Ben Reitzes – Barclays Capital

Okay. Thanks a lot.

John Gamble

Contents of this presentation that are not statements of historical facts are forward-looking statements that involve risks and uncertainties that are discussed in the Safe Harbor section of our earnings releases and SEC filings. Actual results may differ materially from such statements.

Lexmark undertakes no obligations to update any forward-looking statements. The presentation contains non-GAAP financial measures unless otherwise noted. That’s it. Yeah. Thank you.

Ben Reitzes – Barclays Capital

All right. Thanks John. So let’s dive right into it. In the latest quarter you did a $1.05 in earnings and you’ve guided roughly for a $1.95 to $1.05 for the second quarter. So your guidance for the year, I think the midpoint is $4.80, and there is significant second half improvement after this quarter. Can you talk about the big drivers that allow you to get that extra, let’s call it, $0.65 to $0.70 in earnings in the back half vis-à-vis the first half?

John Gamble

Sure. Absolutely. So, if you, yeah, there is really three main factors that will drive the movement, probably a little less than a quarter of the improvement is related to some non-operational factors.

So we’re expecting the U.S. earning tax credit to come in, which will give us the tax benefit in the second half of the year as it occurs, that’s for buying back shares. So that’s probably a little bit less than a quarter of the benefit.

The ISS division, the printing division, the largest portion of the company, we expect to drive over half of the benefit. A big chunk of that is driven by cost, right, we announced the restructuring three or four months ago. A big -- a significant portion of that restructuring will be executed by midyear. So we should get nice benefits from that in the second half relative to the first half.

And then, also that we had effects from Thailand in the first half of 2012. And we should not obviously we had those effects again in the second half and plus we should get some insurance recovery again some of the cost we incurred in the first half and the second half, and that’s a cost benefit that you will see, it shows up on the cost line for the P&L.

And then in terms of revenue, we are expecting a strong half, second half in terms of our large workgroup placements. We’ve done very well at MPS for the past several years and I mean, we’re expecting a very good second half in large workgroup, which drives profit but also drives some supplies. And we think that will push probably a little more than half of the benefit.

And then the remaining benefit a little less than quarter is really around Perceptive Software and kind of other but we had a loss in the first quarter is about $8 million in Perceptive. They performed very well. They had 41% revenue growth, almost 20% organic revenue growth, excluding all acquisitions.

That actually was a little less than we expected and since we’ve been investing ahead of their revenue growth in order to try to drive the integrations with our MPS business and drive our MPS business even faster which we’ll talk about in a minute.

We ended up incurring some losses in the first quarter. We expect to run that this year at some -- in remaining period at around break-even. It could be slightly negative, slightly positive. But certainly the loss in the first quarter was more than we expected and the absence of that loss in the second half is a big chunk of our total improvement that you will see second half versus first and those are really big pieces.

Ben Reitzes – Barclays Capital

I’m going to jump around a little here on the order though, you mentioned that the MFP segment is going to -- the workgroup MFP will do well, in the latest quarter, you have a legacy supplies, which were the three printer giveaways kind of you getting away from on the inkjet side in the legacy supplies and you also have within your core business, core inkjet that actually, you try to sell with the workgroup lasers, in that business had a weak…

John Gamble

Yeah.

Ben Reitzes – Barclays Capital

… first quarter. So could you explain the dynamics and how the MFP will offset that in the second half or do you expect that that inkjet business in the core actually starts to kind of limit the legacy?

John Gamble

Sure. So if you take a look at our total sales in general, large workgroup now is about over 75% of our total hardware revenue and small workgroup which includes the inkjet that you’re just referring to, which are in our core is now under 25% of the total.

So we did have a weaker, a relative period in the first half of 2012 relative to the first -- in the first quarter of 2012 relative to the first quarter of 2011. A lot of that was driven by the fact that we’ve pretty much exited retail so -- for hardware.

So as we exited consumer and we’re not exiting retail channels, pretty heavily for our hardware, even our inkjet hardware that’s resulting in some year-on-year negative relative performance in hardware revenue. The small workgroup area which includes those business inkjets, as well as our low end lasers continues to be a core for us.

It continues to be something that’s important in our portfolio. We’re continuing to refresh those products. We’ve actually just launched. What we think is a true business inkjet. The new 5500 series that we’ve launched, that we did -- it’s a very robust product, it has very good print speeds for color, as well as mono. We have it now out and over 300 large accounts testing it.

And we are pretty excited that this is a product that could very well have very good application in enterprise, and media and business accounts as what we believe inkjet can deliver which is low cost color.

And the reason we keep investing in inkjet, it’s a lower cost color delivering platform for that small workgroup category of devices. And we believe the product that we’ve launched has a real opportunity. It has large ink capacity that has large print swaps, that has good print speed. It’s very robust. So we’ll see, right.

But, again, inkjet is one of ink platforms of Lexmark’s sales and the core of the company is really focused on large workgroup and is really focussed on management services, and then focused on software and solutions to expand our MPS business and to build the software business as well.

Ben Reitzes – Barclays Capital

Just one last question around the earnings trajectory is, you mentioned, channel inventories for inkjet and laser supplies, all supplies in the first quarter. How confident are you that that will be over this quarter and not be at headwind in the second half as well?

John Gamble

Well, it’s -- our expectation is, is the bulk of it should come out in one quarter, but that’s simply our expectation that the channel, since the channel was we believe purchasing ahead of price increases which were occurring in the market that they would likely allow that channel inventory to come down in one period.

Admittedly, we don’t -- it's hard for us to predict exactly what the channel will do. It would not be a surprise to see some of that linger into the second half, but it’s difficult for us to be specific or know for sure exactly how it will occur. We assume the bulk of it should occur in the second quarter though.

Ben Reitzes – Barclays Capital

Okay. Now, let’s talk about some thing you might be a little more excited to talk about manage your acquisition strategy and how it (inaudible) your MPS strategy, Lexmark’s try to differentiate itself through your focus on MPS and then by layering on software acquisitions. You haven’t been acquisitive in the past up until last few years really…

John Gamble

Yeah.

Ben Reitzes – Barclays Capital

… and maybe you can talk about your MPS strategy and how these acquisitions fit in and what acquisitions you’re particularly excited about?

John Gamble

Sure. Absolutely. So, management services, Lexmark has a long tradition of being in management services. This has been -- the last two years have been extremely strong for us in MPS. We have grown at over 20% per year, probably about three times the market rate.

And we’ve gotten a tremendous number of industry recognitions and industry awards around our MPS service, right. We now are in the Leader Quadrant from Forrester, IDC and Gartner in MPS as well as smart MFPs.

And what we really think that this is a recognition of the investments we’ve made over really a 10-year periods. So, everyone knows we’ve been investing heavily in hardware and we think we offer the best hardware, both color and mono in terms of printers and MFPs in the industry and it’s really around the investment and the ability of them to deliver solutions.

And enabling those MFP devices to be managed well, so that we can drive the cost of the infrastructure down, which is [stable state]. But also so that we can help you deliver solutions off of that platform to improve your workflow, so we can use the scanning capabilities to deliver high-performing workflow integrate well into your back-end systems.

We’ve also invested heavily over the past 10 years in having an IT based globally consistent, global single-instance process to manage a global fleet of devices. And we think we’re really the only company in the world that can do that, and we think that’s why we do so well in large enterprise bids.

That’s why we’ve won so many large customers in the past two years because our ability to deliver seamlessly, globally, consistently, not only in deployments but also in data collection, data capture and analytics -- and providing analytics back to customers because our processes and systems worldwide are completely consistent and completely global.

But what really differentiates us still beyond what we think is, differentiated delivery, ability and management capability is our focus on solutions, and that’s really where the acquisitions strategy comes in.

Lexmark has invested in buying five significant software acquisitions to us over the past two years that we believe will drive a strong software business, but also we believe is very additive to our MPS business.

We’ve acquired Perceptive Software, which is electronic content management company, but that’s really focused on delivering solutions into core verticals, much like Lexmark deliver solutions into core verticals and MPS, very strong in healthcare, very strong in higher education and then very strong in back office processing, payables, HR receivables.

We’ve added business process management capabilities with the acquisition of Pallas Athena in October, and importantly, in February and March of this year, we added intelligent capture capability with the acquisition of Brainware, and we added enterprise and federated search capability with the acquisition of ISYS.

And what all this allows us do is provide highly integrated solutions to our customers to help them improve their core processes and we can integrate those software solutions back into the MFP, so that we can then execute a full end-to-end solution right from scan, right through the processing, right through the integration into ERP.

In terms of software, if your customer that doesn’t happen to use Lexmark hardware, we can integrate into that hardware as well, into your -- and whatever legacy hardware you have as well. But we think we have truly differentiated technology now.

For example, Brainware, we believe offers the best technology in the industry in terms of capturing information off of unstructured data, off of scan, off of e-mail, off of anything e-mail, they are a leader in processing, payables and financial transactions, and it’s truly core enterprise software. ISYS as well enterprise software that enables enterprise wide search.

So as you look forward and you are working as a Lexmark customer, what you can envision and what we can deliver to an extent and we’ll be able to deliver to a great extend going forward, because you’re working in the process and you are using Lexmark software, which you’ll be able to do it, Perceptive Software as we brand it, which will be able to do is the software, we’ll understand where you are in your process.

Search your repositories for any information that’s relevant to you and presented to you before you ask. So that we can very quickly help you improve your processing and capabilities, and we can do that on your PC, we can do it on a tablet, we can do it all the way back into the screen on the MFP.

So, what we are focused on is delivering solutions and we think delivering those solutions allows us to drive MPS, as customers look to improve their ability to take cost out of their whole enterprise, not just their print infrastructure. But it also allows us to win new customers that aren’t looking for print infrastructure, that are looking for someone who can deliver solutions.

And what ties it all together for us is our industry focus we’ve had for 20 years at Lexmark. We’ve had it at Perceptive and that we have deep deep domain expertise in financial services and healthcare, in banking and insurance, in retail that we can apply now into software, as well as hardware -- as well as hardware and software-based solutions. So we are quite excited about the future back there.

Ben Reitzes – Barclays Capital

You may just talked about the profitability though again.

John Gamble

Sure.

Ben Reitzes – Barclays Capital

You mentioned it quickly in the beginning, but Perceptive lost money in the first quarter. And then turning that to profitability, does add significant fleet to our bottom line in my opinion on a sequential basis, if you are able to turn it around. So can you just talk about your plans for…?

John Gamble

Absolutely. So our expectation is that our software business, so Perceptive and its family of acquisitions will be profitable next year, 2013. We have -- and if you look at them today, on a gross margin basis, gross profit basis, they deliver software type performance. What’s been happening is, we’ve been investing ahead of the revenue curve as we try to grow them faster and you’ve seen the strong growth over the past three quarters.

We’ve been investing both and expanding their sales channel outside the United States, and also advancing their technology, so that we can not only deliver more solutions but ensuring that the acquisitions that we’ve done have a consistent technology base, so we can deliver seamless solutions.

So when we acquired the companies, we knew we are going to head in this direction, so it’s not a surprise to us that we’ve haven’t seen profitability today. But we feel confident we’ll see profitability pardon me in 2013.

Ben Reitzes – Barclays Capital

But you’ve got to exit this year I think it’s in the black given that trajectory.

John Gamble

Yeah. We said in the second half, we should be operating break-even plus or minus little bit, yeah.

Ben Reitzes – Barclays Capital

Okay. I wanted to ask you about the printer industry in general. There is some concerns out there that it’s not a growth sector. MPS is a very interesting strategy, but lot of MPS deals, you actually take out printers and consolidate printers, and then obviously there is a threat of tablets and smartphones, maybe on the inkjet side more than laser, but some would argue it infiltrate lasers. How do you view the printer industry and in particularly your then exposure to that and what is the growth rate of the sector?

John Gamble

So, if you take a look at the part of the broader imaging industry that we addressed. This is excluding software and I will cover that briefly in a second. But if you look at the broader imaging industry we address, it’s probably in the neighborhood of $80 billion. That includes both consumer and business up through enterprise.

And within that industry that’s probably an industry in total that’s probably flat. Some would say, slightly declining flat, maybe up a little bit, but it’s a flat business and it’s been impacted by a lot of the headwinds you just discussed, right. So, the exact impact of tablets and smartphones yet to be seen, but likely we will have some impact on the industry as time moves forward.

If you take a look within that -- within those segments, consumer certainly the weakest of that $80 billion industry. And then within enterprise business -- and enterprise where Lexmark plays, because we effectively at this point existed consumer, what we think is growing the strongest, right, is really management print services and then anything which drives extended solutions capability into the customer base.

So, of the overall opportunity in the market, we think focusing ourselves in business and then enterprise, and then forcing -- focusing ourselves on management print services puts us in the best opportunity to take advantage of whatever growth dynamics exists in that industry as we look forward.

What we are doing as a company though is really focusing heavily on solutions, right and that’s really the focus of the software acquisitions because it allows us now to access the market that is in the neighborhood of $5 billion to $10 billion and growing it 10% to 12% a year, and as well as to hopefully allow us to outperform the business enterprise segment in the imaging market because of the fact that we can offer extended solutions as I’ve just discussed.

So what we believe we should be able to do overtime is outperform the business and enterprise segment of the imaging market giving us an opportunity there for some performance.

And then really to significantly expand and grow the solutions portion of our business, including software to allow us to grow that business faster than it’s market rates and then also to allow us attach to MPS to improve the performance of our overall imaging business.

Ben Reitzes – Barclays Capital

I wanted to ask you a little bit about the cash policy of the company. Since Paul Rooke has taken over Paul Curl, you’ve kind of done a very shareholder friendly pie chart where you are doing some buybacks, doing some dividend and then reinvesting in acquisitions. So, if you just kind of go through that pie chart for us and your strategy, and the rationale for just raising the dividend, and then perhaps view into that your buyback strategy?

John Gamble

Sure. So what we’ve indicated is that we intend to return over 50% of our worldwide free cash flow to shareholders on average on an annual basis, and that would be through a combination of dividend and share repurchases.

And then with remainder of the free cash flow available to us for acquisitions or other activities. Obviously that’s the things on any given year could move around a little bit in terms of the total amount of free cash flow distributed, but we would expect 50% -- over 50% on average to be distributed to shareholders.

Basically what we did when we initiated it, was we put a dividend in place that we thought was substantial and showed out commitment to shareholders. And then we continue to buyback program that we’ve started in 2011 to again show our commitment to shareholders.

We increased it recently. Basically, what it did was, it got us to the point -- we’re about half of the free cash flow. We are returning this to dividend and probably the other half is something that we’re returning to share buybacks.

We think that leaves plenty of cash available to us for acquisitions plus given that -- given our leverage profile and the fact that we have about a $1 billion in cash and only about $650 million in debt. But we think we have sufficient liquidity as well as debt capacity to the extent that there were acquisitions that made more sense to us to execute that might that…

Ben Reitzes – Barclays Capital

You mean 25% royalties?

John Gamble

Yeah. You’re right of the 50%, yeah, 25% of the total. I’m not trying to suggest about the policy. I’m just saying that’s the current state, where we are right now about half of that is going back to dividends.

Ben Reitzes – Barclays Capital

What does that mean in terms of buyback for the rest of the year?

John Gamble

We didn’t forecast. What we just simply did $30 million in the first quarter. We just announced, we did about $25 million in the second quarter. What we indicated, I think when we launched the strategy was that we would try to be somewhat consistent in our purchases during the year so that we could -- may be could have -- our view is to where we were heading. So we have been fairly consistent in the first two quarters.

Ben Reitzes – Barclays Capital

If you -- your guidance that costs $4.80 per share this year and the free cash flow pretty commensurate with net income do you think? Or is it below or is there anything structural that makes it below?

John Gamble

Yeah. Our goal is to be about at 100% of free cash flow – I’m sorry -- of non-GAAP free cash flow -- non-GAAP, about 100% of non-GAAP net income in free cash flow. This year we think we’re at 90% to 100%. There is a little bit of restructuring this year that may drive us a little bit below that. So that’s our goal. Our goal is to operate it about -- at about 100% of net -- non-GAAP net income in terms of free cash flow.

Ben Reitzes – Barclays Capital

And then -- I just wanted to ask you about a strategic question. You made this difficult decision of exiting the consumer inkjet and legacy inkjet is basically Dell bundle, the giveaways, the old PC bundles that was maybe, Lexmark, over 10 years ago in inkjet. And now for legacy, now the core part of inkjet how slow, you said that might turn this in new products. But how will Lexmark continually reevaluate portfolio and do you think that you committed this part of inkjet the core part of inkjets for the long term?

John Gamble

So we evaluate the portfolio on a very consistent basis. And if you take a look at Lexmark right now, our eight core platforms that we sell in imaging, inkjet is one. It’s a technology that we think that we invest in because we think it does deliver color to our businesses at a lower cost point than lasers. And that’s why we continue to invest the product that we’ve just launched, we’re excited about. We think it’s a product that has real opportunity in the market.

But as we do with every platform we continue to reevaluate. We’re continuing investment in our platform. And we expect each of our platforms to perform. So that’s kind of where we are. We do expect this platform to perform.

But in terms of the technology base, we do believe that inkjet does have a play in business. And we think we provided a product right now that should give us an opportunity to plan business. So we will see how we’re doing.

Ben Reitzes – Barclays Capital

And then, I’ll turnover to some questions to clarify something about the growth rate that we talked about long-term growth for Lexmark. You had been growing your core business almost on a double-digit rate and then I think it’s gone in mid singles, is that about right as of last quarter?

John Gamble

If you take at -- if you take a look at last year, a new currency adjust last year, which was a couple points of hardware currency last year and then the first quarter there is a couple of points of negative currency. So let’s -- when you said doing that math, we’re running at a core growth rate of 3%, 4%, 5% first quarter as well as last year on a currency adjusted base and supplies in the core, I’m sorry, there is growing a lot faster but than that right.

The supplies is the biggest portion of our core, obviously biggest portion of our sales. But I think right now, where we are, is we are operating at kind of currency adjustment in neighborhood of 5% last year, currency adjusted probably in the neighborhood of 3% to 4% in the first quarter.

Second quarter is certainly weaker. Currency is very negative in the first quarter, which I know you adjust for currency first -- second quarter of last year was an extremely strong quarter for Lexmark with over 14% margins probably stronger than we normally see.

So but long term operating in the -- what we are currently operating in that low single-digit 3%, 4%, 5% type of range last year and we’re seeing that in the first quarter. So that’s probably not an unreasonable -- a reasonable place for us to execute in terms of core given the market we talked about it earlier, where it’s a market that’s kind of flat.

Ben Reitzes – Barclays Capital

Right. Okay. So, with the legacy business declining in a 30 plus percent range and then eventually going away, if the long-term growth for Lexmark more like this core growth rate or is it too hard to say?

John Gamble

No. We haven’t given a long-term rate. But you’re right, core is -- the core is growing. We should expect it to continue to grow as we continue to add more software assets. And if you come to higher percentage of our company that has a higher growth rate and that should help our overall core growth rate we think substantially. And we intend to invest how they are thinking to be the case.

And our legacy is declining very rapidly by the end of this year. We’re expecting to be in the neighborhood, I think, it’s 6% of total sales. And so getting to the point where the legacy decline is fairly small and manageable. And the core growth rate to start to come true as the growth rate for the company.

But what’s going to allow us to grow the core really is our successful solutions and our success in software. The success in software and solutions go right each growth but also we think drive the MPS growth because that’s really are differentiation.

Ben Reitzes – Barclays Capital

And we have time for few questions, right here.

Question-and-Answer Session

Unidentified Analyst

(Inaudible)

Ben Reitzes – Barclays Capital

Question was around inkjet, are there any inkjet in consumer corporate that are -- inkjet assets that are interesting in the consumer appropriate?

John Gamble

I think the date where really our strategy is been around is extending our solutions portfolio, and extending the part of that portfolio that really adds to management services, as well as drive the ECM, BPM assets which we’ve acquired. So that’s really our focus, right now.

Ben Reitzes – Barclays Capital

Maybe time for one more quick one? Later.

Unidentified Analyst

Could you talk about HP and how much concern is in the market or that you’re seeing in the market that HP to become private investor or let’s probably the HP to spill over to price capability in the market or generally how HP comes up competitively?

John Gamble

The question was specific HP, but it sounds like generally about competition, right. So if you take a look at where we really compete, like I said over 75% of our hardware sales are in high-end hardware, our Large Workgroup Hardware.

And the competition there is really quite varied, right. And for Lexmark when we are in Large MPS deals since our focus is so heavily on solutions and so heavily on software related solutions to extend the power of the fleet. But at the end of the day, when we’re competing in a large opportunity probably the company we compete most against is Xerox.

Xerox delivers solutions in a very different way, be it through an outsourcing model as opposed to in the neighborhood models through a software. But at the end of day that’s the type of customer that we end up competing for more aggressively because it’s a customers that’s really looking at solutions and higher value added out of the MPS engagement over the entire platform engagement as opposed to just a hardware sale.

So for us, what we need to do is to continue to do really good in MPS and be very good at solutions and continue offer the best management capability globally around MPS. And to do that we think we compete well and that’s why we have been growing at three times the industry rate in MPS for the past several years.

That’s how we gain share in large -- we gain a point of share here basically in large workgroup. So that’s really what we think we need to do to be successful in the industry and if we do that then we think we think it will be very well against anybody.

Ben Reitzes – Barclays Capital

John, thanks a lot.

John Gamble

Yeah.

Ben Reitzes – Barclays Capital

John, thanks a lot. We head to the break out right away. Thank you very much everyone.

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