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Lexmark International, Inc. (NYSE:LXK)

Q4 2007 Earnings Call

January 29, 2008 8:30 am ET

Executives

John Morgan - Director, Investor Relations

Paul J. Curlander - Chairman of the Board, Chief Executive Officer

John W. Gamble Jr. - Chief Financial Officer, Executive Vice President

Analysts

Shannon Cross - Cross Research

Min Park - Goldman Sachs

Eric C. Garfunkel - Sanford C. Bernstein

Analyst for Ben Reitzes - UBS

Analyst for Kathryn Huberty - Morgan Stanley

Bill Hand - Bear Stearns

Matthew Whittaker - FTN Midwest

Ananda Baruah - Bank of America

Ben Bollin - Cleveland Research

Peter J. Grondin - OSS Capital Management

Philip Oleson - UBS

Operator

Thank you for standing by and welcome to the Lexmark International fourth quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn the call over to John Morgan, Lexmark's Director of Investor Relations. Please go ahead, John.

John Morgan

Thanks for joining us today. With me for Lexmark's fourth quarter 2007 earnings conference call are Chairman and CEO Paul Curlander and Executive Vice President and CFO John Gamble. After their prepared remarks, we will open the call for questions as time permits. So that we can get to everyone, we are asking you to please limit yourself to one question and, if needed, one follow-up.

Later today, a replay of this call will be available on our investor relations website located at http://investor.lexmark.com. Also on the site, you’ll find today’s earnings release and the fourth quarter supplemental slide deck posted in the upper right hand corner of the home page. The slide deck includes 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 release 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 J. Curlander

Thank you, John. Today we’re announcing fourth quarter financial results that reflect the strategy we started to implement in the latter part of 2007 and that we described to investors in October. Revenue for the quarter was $1.310 billion, down 4% year to year and in line with our October 23rd guidance. Earnings per share in the fourth quarter were $1.04 and were significantly better than our guidance.

Excluding restructuring and related charges, earnings per share in the fourth quarter would have been $1.29, up 23% year to year. This earnings per share overachievement was primarily due to lower than expected inkjet hardware units but with better price and mix, and to an under-run in expected operating expenses.

During the fourth quarter 2007, we incurred $0.25 per share in restructuring and related charges. Our overall restructuring plan is on track and in the fourth quarter we completed the previously announced closure of one of our inkjet production facilities in Mexico. We continue to expect the total program cost of $90 million and annualized savings of $60 million after program completion at year-end 2008.

Fourth quarter 2007 cash from operating activities was $212 million.

Hardware revenue for the quarter was down 17% year to year, primarily driven by unit declines in lower usage product segments associated with our strategy change in the consumer market.

Supplies revenue was up 3% year to year, driven by good, laser supplies growth and exceeded our expectations due to the stronger than expected growth in end user demand for laser supplies. Inkjet supplies revenue was down year to year and came in about as expected.

Supplies sales during the quarter were also aided by an expected expansion of OEM supplies distribution. As we look ahead, we expect continued good growth in laser supplies and see the potential for continued erosion in inkjet end user demand.

In the first quarter of 2008, we do not expect the same supplies boost from OEM distribution expansion as we saw in the fourth quarter of 2007. Our current expectation for supplies in the first quarter is that continued growth in laser supplies will be more than offset by a decline in inkjet supplies.

During the fourth quarter, we continued the shift of our consumer strategy to focus on devices, customers, and countries that drive a higher page usage. As a result, our consumer segment revenue was $509 million, down 15% year to year and consumer segment operating income excluding restructuring was $46 million, down 12% year to year but up significantly from the third quarter of 2007.

Now, this strategic shift is having a significant near-term effect on units as we are prioritizing specific markets and channels relative to supplies generation and lifetime profitability. For the lowest priority markets, we have reduced or eliminated retail sales. In addition, we are working to minimize unit sales in all countries that do not generate an acceptable profit over life.

As we look back at 2007, we estimate that about 30% of our 2007 inkjet volume will not be anniversaried in 2008 due to these initiatives. As a result, we would expect inkjet unit sales to be off significantly year to year through 2008.

Now for the fourth quarter, inkjet unit sales were down 40% year to year and were less than expected. Although we were consciously less aggressive on pricing and promotion, the overall retail market demand in the fourth quarter was weaker and more price aggressive than expected.

For the quarter, inkjet average unit revenue was up 12% year to year, reflecting the strategy to grow high-end units, which drive stronger usage while reducing entry level units.

Now, a key focus area for Lexmark is wireless inkjet. In 2007, we believe this was the fastest growing segment in the market and in the U.S., wireless units increased from about 2% of market units in 2006 to about 7% of market units in 2007, accounting for about 15% of the 2007 inkjet market revenue in hardware.

Now, in December, Lexmark had a 30% market share in wireless inkjet units in the U.S. retail channel, up from our September share of 19%, and we achieved an even higher share position in some European countries.

Now earlier in January, we launched our Lexmark professional series inkjet line. This is a set of products targeting higher usage customers and that highlight some of Lexmark's key small office/home office features, such as automatic document feed, two-sided printing, and wireless.

This set of products also features high yield cartridges and a new warranty program that includes lifetime phone support, a dedicated priority phone line, and next business day replacement.

Now in the business market segment in the fourth quarter, revenue was a record $800 million, up 4% year to year and operating income excluding restructuring was $176 million, up 7% year to year. Laser units in the quarter were down 5% year to year as strong growth in laser multi-function devices was more than offset by declines in low-end, single function devices.

Laser sales were impacted primarily by unit declines in low-end lasers as we held back on chasing the aggressive market pricing in segments that have low usage. However, from a market perspective, we also saw some weakness in enterprise purchases. Despite this weakness, in the fourth quarter we continued to see growth in our branded workgroup unit sales.

Now for the fourth quarter and the full year, we had strong growth in our laser multi-function units. Earlier this month we announced another new color laser multi-function, the Lexmark X560N. This is a sub-$1,000 business class laser multi-function with color print speed of 20 pages per minute and mono-print speed of 31 pages per minute, and is configurable as either a desktop device or with optional additional paper input that converts it into a floor-standing unit. The X560N features the highest capacity toner cartridges in its class, which provides an attractive price per page and a lower supplies replacement intervention rate.

Now let’s talk about the first quarter of 2008. As we look forward, we will continue our inkjet strategy transition, significantly impacting our year to year inkjet units. We also expect some continued softness in overall market demand in both the business and consumer segments.

As a result, we expect first quarter revenue to decline in the mid- to high-single-digit range year to year and we expect earnings per share to be in the range of $0.80 to $0.90, excluding restructuring and related charges.

While our near term results are not where we would like them to be, we continue to focus on the long-term growth and success of the company and the creation of shareholder value.

We are continuing our investments in our business market segment and new products and technology. This is producing a steady stream of new product introductions, as well as an industry leading number of product awards. We are continuing our investment in the expansion of our managed print services and industry sales initiatives and are seeing success with some of the world’s largest corporations. We also made a significant investment in our enterprise sales force in 2007 to improve our coverage and expand the reach of our solutions and services proposition.

The focus of all of these business market investments is to drive workgroup laser growth and page generation. As we look back at 2007, we drove double-digit growth in our branded workgroup laser units and growth in our laser supplies that exceeded our plans and expectations.

On the consumer side, we’re driving a significant change in our market strategy. Although we are seeing near-term impacts in our units, we believe that with these changes, we will be much better positioned for the future. This strategy shift will increase our focus on higher priced, higher usage devices, customers, and countries, and will accelerate our investments to better meet the needs of these customers and product segments.

Our initiative in wireless inkjets is a part of this strategic shift and although wireless is a small part of the overall inkjet market, we believe it’s the fastest growing part of the market and we’ve already captured some significant market share.

We also are continuing to implement a restructuring of our business to lower our costs and better allow us to fund these strategic initiatives.

In closing, we continue to have a strong financial position and produce a good cash flow. In 2007, we generated $564 million in net cash from operating activities.

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

John W. Gamble Jr.

Thank you, Paul and good morning. Consistent with previous calls, I’ll first discuss our results of the fourth quarter of 2007 relative to the prior year, then relative to the third quarter of 2007. Next I’ll indicate our full year results. I’ll then discuss selected changes on the balance sheet and certain items of cash flow. Finally, I’ll finish with more detail regarding our guidance for the first quarter. I will call out the impact of restructuring related expense as we walk through the P&L. In the supplemental slide deck posted on our investor relations website, we have included 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 $1.31 billion, down 4% compared to last year, up 10% sequentially from 3Q, and in line with the guidance we provided in October. As Paul mentioned, laser and inkjet supplies revenue came in above our expectation while laser and inkjet hardware revenue came in less than we expected.

Full year 2007 revenue was $4.97 billion, down 3% compared to 2006. Geographically for the fourth quarter, U.S. revenue of $561 million declined about 3% year to year. Revenue of $475 million in Europe declined about 7% year to year. The remaining geographies declined about 3% versus a year ago.

Geographically for the full year of 2007, revenue in the U.S. declined approximately 5% and Europe and the remaining geographies each declined about 1%. For both 4Q07 and the full year of 2007, revenue declines in all regions were due to declines in the consumer business segment.

In 2007, Dell represented about 15% of revenue. They were the only customer at 10% or more of revenue in 2007. Laser and inkjet supplies revenue in the fourth quarter grew 3% year to year and 1% for the full year of 2007, with good growth in laser supplies revenue in both periods being mostly offset by an ongoing decline in inkjet supplies.

As Paul mentioned, in 4Q07 our supplies revenue also benefited from the expansion of OEM supplies distribution. Supplies growth in 4Q07 was stronger than we had expected due to stronger laser supplies end user demand.

Laser and inkjet printer revenue in the fourth quarter declined 17% year to year and declined 10% for the full year of 2007 compared to 2006.

Laser hardware unit shipments declined 5% in the fourth quarter versus the prior year. In the quarter, we had strong growth in MFPs as well as growth in branded workgroup printers. The decline in the quarter was due to lower sales of low-end mono and color printers, where we chose not to pursue aggressively priced transactions.

Full year 2007 laser hardware shipments of 2.1 million units declined 3% year to year. Again for the year, we had strong growth in MFPs and branded workgroup printers. The decline in the year was again due to lower sales of low-end printers.

Laser average unit revenue was up 2% year to year in the fourth quarter, driven by positive mix of MFP and branded workgroup lasers, partially offset by price and full year 2007 laser AUR was up about 1% compared to 2006.

Inkjet hardware unit shipments declined 40% year to year in the fourth quarter, driven primarily by the company’s previously announced strategy to aggressively shift its focus to geographic regions, market segments, and customers with higher page generation. Although the reduction was greater than the 30% we had expected for the quarter, we did see unit growth in higher end segments versus 4Q06.

Inkjet hardware shipments of 12.1 million for full year 2007 declined 18% year to year. Inkjet AURs increased 12% versus the prior year, primarily reflecting an improved mix shift towards the higher end segments. Full year 2007 inkjet AUR declined 3% compared to 2006.

Business segment revenue for the quarter of $800 million was a record, as Paul referenced earlier, and grew 4% from the same quarter in 2006 and grew 10% sequentially from 3Q07. Full year 2007 revenue grew 5% compared to 2006. The year to year growth in the fourth quarter and for the full year was driven by strong supplies revenue growth, partially offset by a decline in hardware revenue.

The sequential increase in business segment revenue in 4Q07 was driven by growth in both hardware and supplies revenue.

Consumer segment revenue for the quarter was $509 million, down 15% compared to a year ago and up 9% sequentially. Full year 2007 revenue declined 12% compared to 2006. The fourth quarter and full year 2007 decline compared to 2006 was due to declines in both inkjet hardware and supplies revenue. The sequential increase in 4Q07 was driven by higher supplies revenue.

Gross profit margin for 4Q was 33.4%. Excluding restructuring related charges of approximately $7 million, gross profit margin would have been 34.0%, up 290 basis points versus the prior year and up 580 basis points sequentially. The 290 basis point fourth quarter increase versus last year was principally due to a 590 basis point increase in product mix, the largest factors of which were the impact from the decline in inkjet hardware shipments and the increase in laser supplies. This was partially offset by a 300 basis point decline in product margins, the majority of which was in inkjet hardware.

Sequentially, the 580 basis point increase was driven by a 430 basis point increase in product margins, the largest factors of which were improved hardware margins and a positive impact from LCM APC in the quarter as compared to the negative impact we saw in 3Q. In addition, there was a 150 basis point improvement in mix, primarily due to less low-end inkjet hardware.

Gross profit margin for the year was 31.4%. Excluding restructuring related charges of approximately $17 million, gross profit margin for 2007 would have been 31.8%, down 120 basis points from 2006. The 120 basis point decline was due to a 420 basis point reduction in product margins, the largest factor of which is a decline in hardware margins, principally inkjet. This was partially offset by a 300 basis point improvement in product mix, primarily driven by less inkjet hardware.

Operating expense for the quarter was $324 million. Restructuring related expense of approximately $23 million impacted operating expense this quarter. Excluding this impact, operating expense was $301 million, a reduction of $3 million year to year. SG&A in the quarter was $200 million, a reduction of $6 million from 2006, reflecting lower G&A expense, partially offset by growth in investment and demand generation.

R&D in the quarter was $100 million, an increase of $4 million from 2006. Sequentially, operating expense excluding restructuring related expenses was about flat versus the third quarter. For the full year of 2007 compared to 2006, excluding restructuring related expenses of $35 million and $83 million respectively, operating expense grew $87 million. SG&A increased $54 million, driven by increased investments in demand generation, principally sales resources and promotion, which were partially offset by lower G&A. Development increased $33 million.

The operating expense to revenue ratio excluding restructuring related expenses was 23.0% in 4Q and 24.3% for the year. Operating income in 4Q was $114 million. Excluding total restructuring and related costs and expenses of $30 million, operating income was $144 million, up $22 million from 4Q06 and up $109 million sequentially from 3Q07.

Full year 2007 operating income was $321 million. Excluding total restructuring and related costs and expenses of approximately $52 million, operating income was $373 million, down $195 million compared to 2006.

Excluding restructuring related activities, business segment operating income in 4Q07 of $176 million was up $11 million versus last year and up $31 million sequentially. Full year 2007 business segment operating income of $624 million declined $12 million compared to 2006. The increase versus 4Q06 is due to higher gross profit, reflecting increased supplies revenue and hardware margins, partially offset by higher operating expense, principally increased marketing and sales and product development.

The sequential increase was due to higher gross profit, reflecting increased supplies in hardware revenue partially offset by higher R&D investment.

The decline in full year 2007 business segment operating income is due to higher operating expense, reflecting higher marketing and sales and product development investments, partially offset by increased gross profit, reflecting increased supplies revenue.

Again, excluding restructuring related expenses, consumer segment operating income in 4Q07 of $46 million was down $6 million versus last year and up $62 million sequentially compared to the $16 million operating loss in 3Q07. Full year 2007 consumer segment operating income of $106 million declined $198 million compared to 2006.

The $6 million decline in 4Q07 versus last year was driven by a decline in supplies revenue, partially offset by a favorable product mix shift reflecting less hardware. The $62 million sequential increase is driven by increased supplies revenue, increased hardware gross profit margin and dollars, and a favorable LCM APC impact.

The decline in full year 2007 consumer segment operating income was driven by lower supplies revenue, lower product margins, and increased operating expenses.

Other expenses, consisting primarily of costs related to centralized supply chain, IT, and other operating expenses, primarily G&A, were $78 million in 4Q07 excluding restructuring related activities, a reduction of $18 million and $16 million from 4Q06 and 3Q07 respectively. The majority of the reduction from both periods was due to lower operating expense, principally reflecting lower G&A.

Full year 2007 other expenses were $356 million, a reduction of $15 million compared to 2006, the majority of which was again lower operating expense, principally lower G&A.

Operating income margin in 4Q was 8.7%. Excluding the restructuring related expenses, operating income margin was 11.0%, an increase of 210 basis points from the fourth quarter of 2006 and an increase of 810 basis points sequentially. Full year 2007 operating income margin was 6.5%. Excluding restructuring related expenses, 2007 operating income margin was 7.5%, down 360 basis points versus 2006.

Concerning financing and non-operating costs, the net interest and other generated income of $7.4 million, up about $3.8 million from 2006. Sequentially, the interest and other was about $0.9 million.

Full year 2007 interest and other generated income of $20.2 million, an increase of $3.4 million compared to 2006.

In 4Q07, we had an effective tax rate of 18.5% versus the 20% rate we had estimated. For all of 2007, our tax rate was 13.9%.

Net earnings for the quarter were $99 million. Excluding the $24 million after-tax cost from restructuring related activities, net earnings in 4Q07 were $123 million. 4Q06 net earnings were $90 million, or $104 million excluding after-tax restructuring related expenses.

GAAP earnings per share for the quarter were $1.04. Excluding restructuring related activities, EPS would have been $1.29 per share. This compares to 4Q06 GAAP earnings per share of $0.91, or $1.05 excluding restructuring related activities. GAAP earnings per share for the full year were $3.14. Excluding restructuring related activities, EPS would have been $3.50 per share. This compares to full year 2006 GAAP earnings per share of $3.27, or $4.12 excluding restructuring related activities.

Earnings per share for 4Q07, excluding restructuring related activities, of $1.29 per share were significantly higher than the guidance we provided in October, while total revenue was approximately in line with our guidance. This significantly higher EPS was driven by lower inkjet hardware unit sales, improved hardware price and mix, reflecting our actions to focus on more profitable and higher usage placements, and lower operating expense, primarily SG&A.

Now moving to the balance sheet and cash flow items, cash flow from operations for the quarter was $212 million, up $69 million compared to 4Q06 and up $69 million sequentially. Excluding restructuring related cash out-flows, cash flow from operations was $226 million this quarter, an increase of $48 million from 4Q06 and an increase sequentially of $78 million from 3Q07.

Full year 2007 cash flow from operations was $564 million, down $107 million compared to 2006.

Since the end of September, accounts receivable increased $5 million, inventory increased $5 million, accounts payable increased $3 million, and accrued liabilities increased $38 million.

For the quarter, capital spending was $52 million and for the full year of 2007 was $183 million. This is lower than our guidance expectation. Depreciation in the quarter was $58 million and totaled $192 million in 2007.

Currency of the Euro was accounted for at $1.446 compared to $1.288 in 4Q 2006.

Cash and marketable securities at the end of 4Q was $796 million, up $157 million since September.

In 4Q, we did not repurchase Lexmark shares. At quarter end, we had $295 million of share repurchase authority outstanding. Of our $796 million of cash and marketable securities at quarter end, the significant majority were overseas and not available for share repurchase.

Now let me move to restructuring -- in 4Q07, total restructuring and related costs and expenses were $30 million. Of this amount, $28 million related to the restructuring we announced in October 2007. The remaining $2 million was related to the ongoing project related costs from our 2006 actions that we discussed with you throughout 2007.

4Q07 total restructuring and related costs and expenses of $30 million exceeded our guidance of $20 million, as some of the severance costs we had expected to be incurred in 2008 were incurred in 4Q07. This does not reflect an increase in total costs, just an acceleration of the timing of the recognition of these severance costs.

During the quarter, we made good progress on the restructuring actions and completed the closure of one of our inkjet manufacturing facilities in Mexico as expected. Savings in 4Q07 were less than $3 million.

Regarding the restructuring we announced in October 2007, we continue to expect the overall program parameters, costs, and benefits to be the same as we announced in October. The actions we are taking are expected to transfer or eliminate approximately 1,650 positions by the end of 2008, with the impacted positions being primarily in manufacturing, with the remaining impacted positions being principally in supply chain, service delivery, G&A, and marketing and sales support functions. The total cost of implementing these actions is expected to be approximately $90 million, of which $34 million was incurred in 2007 with the remainder expected to be predominantly incurred in 2008. The total cash cost of the restructuring is still expected to be $75 million, of which approximately $60 million will be incurred in 2008.

We continue to expect 2008 savings to be about $40 million, of which approximately 50% will benefit cost of sales and 50% will benefit operating expense.

Annualized full year savings from restructuring in 2009 are expected to be about $60 million.

In 1Q08, restructuring and related costs and expenses due to the restructuring actions are expected to be approximately $18 million. This amount is related to the 2007 restructuring program as the 2006 actions that we discussed with you throughout 2007 are now principally complete. Savings in 1Q08 are expected to be about $5 million.

Now for my forward-looking comments concerning 1Q08. We expect first quarter revenue to be down in the mid- to high-single-digit range year over year, reflecting our continued implementation of our inkjet strategy, significantly reducing our inkjet units versus 1Q07. We also expect some continued softness in overall market demand impacting both the business and consumer segments.

Total supplies revenue is expected to be down versus 1Q07 as expected continued growth in laser supplies is more than offset by a reduction in inkjet supplies revenue.

GAAP EPS is expected to be $0.66 to $0.76 in 1Q08. GAAP EPS includes expected restructuring charges of $0.14 per share. Non-GAAP EPS, which excludes restructuring and related costs and expenses, is expected to be $0.80 to $0.90. GAAP EPS in the first quarter of 2007 were $0.95 per share, which includes restructuring charges of $0.01 per share. Non-GAAP EPS in 1Q07 were $0.96 per share.

EPS excluding restructuring related costs and expenses, is expected to be down in 1Q08 versus the $1.29 achieved in 4Q07, despite lower inkjet hardware unit volume, primarily due to lower supplies revenue in 1Q08. The reduction in supplies revenue in 1Q08 versus 4Q07 differs from our historic seasonal pattern, primarily due to the increased supplies revenue we achieved in 4Q07, which included the impact of the expansion of OEM distribution. This resulted in increased supplies purchases in 4Q07, which we do not expect to recur in 1Q08.

In terms of our specific discussion of financial information, both the 4Q and 1Q data provided that I am comparing to are non-GAAP and exclude the impact of restructuring related charges.

In the first quarter, we expect gross margin percentage to be up versus the 34% we achieved in 4Q07. Operating expense is expected to be up compared to the $301 million incurred in 4Q07, primarily driven by increased R&D.

Operating income margin in the first quarter is expected to be below the 11% achieved in the fourth quarter of 2007. For 1Q 2008 and the full year, we expect our ongoing effective tax rate to be about 26% before any discrete items. If the U.S. R&D tax credit is extended, we expect our effective tax rate in 2008 to reduce to below 24% before any discrete events.

We project full year 2008 capital spending to be approximately $225 million and we expect full year depreciation to be approximately $180 million. This includes approximately $10 million of accelerated depreciation related to our restructuring activities.

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 Shannon Cross with Cross Research. Please go ahead.

Shannon Cross - Cross Research

Could you just give us some clarity on exactly what went on with the Staples channel? I’m assuming that’s what you are indicating when you talk about an OEM. Just in terms of magnitude, you know, if any of it will carry over in the first quarter and any more clarity you can give us, Paul, on the increased usage you also talked about on the laser side. Thanks.

Paul J. Curlander

Relative to the OEM expansion, obviously we can’t talk about details, some of it which I think may be obvious out in the marketplace but it’s not appropriate for us to talk about it.

What I would say is that there were two pieces to the OEM expansion. One piece, from a supplies perspective, was around an increase in channel inventory, which is a one-time thing because whenever you go into additional supplies distribution, what happens is you get an increase in channel inventory and that is a fairly stable thing. It’s not to be confused with increases that may come out the next quarter, so it’s kind of a one-time build and the one-time benefits you get. And so that was there and that was in the fourth quarter and we’re not expecting that to be repeated in the first quarter, unless the OEM would do more channel expansion. But right now, we are expecting that not to be repeated.

The other piece is incremental sales out that you get from a channel expansion and we would expect that incremental sales out to continue as we go forward in time because when supplies are more available, you pick up additional business.

So in terms of rough magnitude, if we just focus on that one-time benefit, which was the channel expansion of inventory, which would be a kind of stable thing, that was really a couple of points on a year to year growth rate in supplies was roughly the magnitude of that.

Over on the laser supplies, what I would tell you is that we saw a very strong end user demand and what’s going on there is really the result of a strategy that we’ve been driving to focus on our workgroup laser units and as we continue to focus on that and grow our workgroup laser units, we’re seeing good growth in our laser supplies. Also, we have a lot of initiatives going on in supplies around large account win-backs to make sure that we are capturing the supplies and we actually sell hardware into enterprise accounts. We’re very focused on our laser cartridge collection program. Of course we are doing remanufacturing of laser supplies and we continue to expand our distribution of our remanufactured laser supplies.

So all these things help us from a laser supply standpoint and for the year, we saw very good growth in laser supplies. That continued into the fourth quarter. We expect that to continue to be the story as we go forward in time.

Shannon Cross - Cross Research

Even with the down 5% on the -- you know, you said down like a 3% for 2007, so relatively stable laser business -- you expect workgroup to continue to be a greater percentage of your sales -- is that the indication?

Paul J. Curlander

Well, clearly we saw a mix shift as we went through the year and we saw a mix shift in the fourth quarter. And this is the part that is driving supplies. From a units perspective, as we indicated in the remarks, what we are not doing is we are not chasing down the entry level units to prices that aren’t justified by the page generation of those units. So by nature of those with a lower page generating units that we’re not getting, clearly that’s impacting the units number. The mix though is improving, the workgroup continues to grow for us and that’s the key focus of driving pages and supplies growth.

Operator

Thank you. Your next question is coming from Min Park of Goldman Sachs. Please go ahead.

Min Park - Goldman Sachs

Thank you. You noted that your inkjet hardware volumes came in even lower than you expected in the December quarter, down around 40% from last year, yet your revenue targets for the next quarter suggests an accelerating revenue decline on a year-over-year basis. Are you expecting to exit even more market segments or regions the next year? And is it fair to expect the more aggressive retreat from the consumer leading to 40% like unit declines for the next three quarters?

Paul J. Curlander

Well, let me just focus on the revenue guidance for the first quarter for a second. Honestly, a mid- to high-single-digit decline is more than what we saw in the fourth quarter on a year to year basis. A couple of factors on that; probably one of the primary factors is that the supplies guidance that we just gave is quite a bit lower from what we saw in the fourth quarter, some of which was aided by the OEM expansion. So instead of being up 3% year to year on supplies, we’re talking about being down on a year to year basis. So that’s one of the major factors. Also, we do see some weakness in the markets in both business and consumer.

Relative to the inkjet hardware, we haven’t given any forward-looking guidance and we don’t intend to give forward-looking guidance. We’ve made a backward looking statement about units that we will not anniversary from 2007. That’s about 30% of the 2007 units.

As we go forward in time, the prioritization by market and the exiting and reduction in specific markets, most of that, if not all of that occurred in the fourth quarter, so we really are pretty well through that.

As we go forward in time, we’ll see the impact from the units that are not being anniversaried and we’ll see whatever impact we get from the strategy that we’re following, which is we’re not going to aggressively chase down the low-end units to levels where are not going to make money on those products. We’re going to continue to focus on the high-end units and obviously it depends on what the overall market demand is as well.

So we tried to roll all that up into the guidance range that we’ve given for revenue.

Min Park - Goldman Sachs

And just one follow-up; now that you are above your previous long-term operating margin target range of 8% to 10%, are you ready to provide a longer term margin target again, or at least reestablish that range?

Paul J. Curlander

No, our plan is to only provide guidance for the next quarter. That’s the plan we’re on and we do not intend to give any longer term guidance.

Operator

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

Eric C. Garfunkel - Sanford C. Bernstein

It’s Eric Garfunkel calling in for Toni. Paul, your laser business delivered 4% revenue growth on a tough compare and in arguably a tougher environment and profitability was the highest in the last six quarters, so I have two questions on the laser business. First, was there anything unique about Q4 that drove the improved profitability? And second, do you believe that you can again deliver 5% revenue growth in the business in 2008, while at least maintaining the profitability you saw last quarter?

Paul J. Curlander

Well, if we take a look at the profitability in the business market segment in Q4, clearly on a year to year basis this was driven by the improved supplies growth, which is being driven by the focus we have on the workgroup lasers and all the initiatives around services and solutions and all the things we talked about on supplies.

This is what drove the revenue growth. This is what drove the increase in profitability and that profitability off the supplies was offset by investments we are making in demand generation, all around expansion of sales coverage, as well as investments we are making in R&D around improving the product line, which we hope will further drive the workgroup products.

So we’ve not given specific guidance beyond the first quarter. We’ve not given any specific guidance on the business market segment but clearly we feel good about the growth in workgroup units that we saw during 2007. We feel good about the supplies off of that. We feel good about ongoing supplies. The only thing that we have said is that we did see some softness in the market in the fourth quarter, so we obviously have some concerns about overall market demand as we go into 2008. But other than that, we feel very good about the business where it is and we continue to invest.

Eric C. Garfunkel - Sanford C. Bernstein

Thank you.

Operator

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

Analyst for Ben Reitzes - UBS

This is Jennifer calling in for Ben. Just one question; Paul, could you clarify and give us some more color -- I know you stated a couple of times about weakness in the business in consumer markets. Could you give us any color for what that demand is like internationally? And if the enterprise weakness that you cited was throughout 4Q or if it was more towards the end of the quarter?

Paul J. Curlander

Well, let me talk about consumer markets first and then we’ll talk about the business market. The consumer market, if we look at -- let me just focus on the U.S. retail channel for the moment. Through the first three quarters, we saw units about flat to slightly up in the U.S. retail market. If you look at the NPD data for the fourth quarter, what we see is units down about 9% year to year. So obviously a weakening from what we’ve seen in the first three quarters and I would also tell you that as we went between Thanksgiving and Christmas, we saw even weaker numbers than minus 9% on a year to year basis, so really a pretty weak finish on the consumer market in the U.S.

We also saw some weakness in the European markets as well. The U.K. year to year in December revenue growth in the retail market was not that strong. France also was down on a year to year basis. So we do see some signs on some weakness as we went through the quarter.

On the enterprise side, versus our expectations, I think the main thing that we saw was some sliding of enterprise business to the right, particularly out of Europe. We saw that. Against expectations in the U.S., that wasn’t as much of an issue but in the U.S. we also see some weakness certainly in some of our industries, like financial services and the retail industry.

So again, it’s hard to project what that’s going to be in 2008 or the first quarter of 2008. We just noted that we did see some weakening there in the fourth quarter and it was beyond just the U.S.

Operator

Thank you. Our next question is coming from Kathryn Huberty of Morgan Stanley. Please go ahead.

Analyst for Kathryn Huberty - Morgan Stanley

Hi, this is Alice for Katy. Could you explain to us why inventories and payables are up year over year, with revenue being down? Is that a build ahead of the January product launch or a back-end loaded quarter?

Paul J. Curlander

Well, on the payables, what I would tell you is that Lexmark is driving a conscious effort to continue to improve our cash cycle. One of the initiatives there is to continue to work with our suppliers to increase the number of payable days and we continue to have success with that initiative.

Over on the inventory side, a couple of things; one is from a supplies perspective on a year to year basis, we’ve made some shifts in our supplies production strategy and our supplies distribution strategy. Also, as we’ve gone through closing supplies facility, these are all things that tend to cause us to carry some additional supplies inventory, so we have that certainly on a year to year basis as well. So those are kind of the factors that we saw.

Operator

Thank you. Our next question is coming from Bill Hand of Bear Stearns. Please go ahead.

Bill Hand - Bear Stearns

Paul, can you refresh us of your thinking on the printing business model in times of economic weakness? I’m thinking more around the supplies business. Do you see a noticeable change in the usage per device or does it stay roughly constant?

In addition to that, is there any noticeable pattern that you see in terms of extended device lifecycles, which could have a positive impact on your profitability?

Paul J. Curlander

I think those are good questions, Bill. A couple of things; first, what we have seen historically, and if I think back to the early part of this decade when the market slowed down considerably, what we tend to see is impacts on the hardware side but the supplies side tends to continue. So we would expect even if the market weakens that we would continue to see good growth in terms of supplies usage and generation.

What we also have been seeing, and we would expect to see, is that as you extend the life of certainly enterprise devices, this again hurts you on the hardware sales side but it’s a big positive over on the supply side. If we look at our models over the last -- certainly over the last year or two, we are starting to see a little bit of that out there in the marketplace as well and that’s a plus in terms of driving more workgroup laser usage.

So I think that the overall printing business model is one that is very resilient in terms of economic slowdown in general because the supplies continue, but you do see some impact on the hardware.

Bill Hand - Bear Stearns

Just a quick follow-up, just on the OEM business; you noted the impact of the supplies expansion but did you see any noticeable impact in terms of your retail shelf space and/or impact on your branded growth from Dell and Staples and such?

Paul J. Curlander

Well, let me talk for a second about hardware. It’s hard for us to comment on Dell and specific initiatives that they may be driving. The only thing I would tell you is that we have in [existence there] and from our experience with Compaq that says it is possible to co-exist in the retail channel with a partner who is selling inkjet products.

What I would also tell you is that our focus is to drive, you know, our primary strategy is drive the branded sales. We do the OEM only to the extent that it is incremental and makes financial sense and that’s certainly how we would view the business with Dell. And beyond that, we really can’t comment on it.

Operator

Thank you. Our next question is coming from Matthew Whittaker of FTN Midwest. Please go ahead.

Matthew Whittaker - FTN Midwest

You’ve talked about aggressiveness in pricing in the inkjet segment and low-end lasers. I’m wondering if you are seeing anyone or anything in specific causing this. Do you see this 4Q07 also throughout the year and what do you expect in the next few quarters?

Paul J. Curlander

I think we clearly see aggressiveness across the board. We see it in every segment, from consumer to small and medium business to the enterprise side. I think that all the competitors are kind of in the middle of it.

If you look at things like low-end lasers, obviously you’ve seen people like Samsung play very aggressively there, [inaudible] has played very aggressively there. If you focus on the inkjet side, certainly in the U.S. retail market we saw Epson be very aggressive during the fourth quarter. When you get into the enterprise side, we see all the competitors being very aggressive. Certainly HP is doing it, certainly Xerox is doing it. So a lot of aggressiveness in all the segments coming from all the different competitors.

Matthew Whittaker - FTN Midwest

Okay. And also, I was wondering if you could give any more color on the decrease or I guess increase in other operating income. It was a 78 this quarter. It’s historically been around low- to mid-90s. I know you said it was mostly lower OpEx, but any other color you can give?

John W. Gamble Jr.

No, it was lower OpEx as we indicated, and generally around G&A. But in terms of specifics, we did have some lower compensation expense, incentive compensation expense in the fourth quarter than normal. But other than that, that was it.

Operator

Thank you. Our next question is coming from Ananda Baruah of Bank of America. Please go ahead.

Ananda Baruah - Bank of America

I just wanted to clarify -- in your guidance, it sounds like you said you expect gross margin to be up sequentially in the March quarter. Is that right?

Paul J. Curlander

Yes, that’s what we indicated.

Ananda Baruah - Bank of America

Okay, and then just a follow-up off of that, I guess relative to how gross margin has been the last so many quarters, and certainly on a sustainable basis, this quarter was a big stronger. I guess given that you are not expecting the supplies benefit to the same degree in the March quarter, how should we think about your gross margin levels as we go forward here? It sounds like you guys are pulling back on the inkjet units and so despite the supplies coming back in, maybe a little bit in the first quarter, we can expect at least for the time being maybe a new normal kind of gross margin.

Paul J. Curlander

Well, relative to guidance, we’ve given everything that we normally would say and it’s kind of hard for us to talk in detail about exactly what’s going to happen in the first quarter and beyond. But if we look back on this issue, say between third quarter and fourth quarter, we saw a couple of things in there.

One of the things we saw was an improvement in product margin and gross profit margin, and basically that was being driven by mix improvements as well as the strategy we are on to focus on the high-end consumer units and to de-emphasize and actually eliminate some of the low-end consumer units.

So we did see a sequential improvement in gross profit margins in the business. We saw improved mix as we went from third quarter to fourth quarter. So these are some significant factors that are playing in there.

Beyond that, what you really get into then is just the mix that happens in the quarter between supplies and hardware and the mix that happens between the business market segment and the consumer market segment, so it’s a lot of moving parts that can give you different results just based on how those factors come in.

Ananda Baruah - Bank of America

Okay, and what was the reason for the lower than expected OpEx this quarter?

Paul J. Curlander

Well, we had an under-run versus expectation. I think the primary factor was in G&A expenses, as John talked about a few minutes ago.

Ananda Baruah - Bank of America

Okay, and should we expect -- I guess you are saying you expect OpEx to be up sequentially, so it sounds like that was more of an anomaly and we can expect you to get back to whatever your internal expectations are going forward?

Paul J. Curlander

Well, we obviously haven’t given a lot of guidance relative to OpEx as we go forward in time but I think what we have said is that R&D expense is -- we continue to make investments in R&D so we would expect that to be up.

Also, we’re focused on our restructuring and G&A is one of the areas we are trying to take down, so this is the extent of the guidance that we’ve given on operating expenses.

Operator

Thank you. Our next question is coming from Ben Bollin of Cleveland Research. Please go ahead.

Ben Bollin - Cleveland Research

Good morning. First question, when you look at your services strategy, how significant has this become, either year on year, as a percentage of revenue? And what type of feedback are you receiving from enterprise customers that are really looking at that?

Paul J. Curlander

Well, in terms of the overall numbers, the services numbers are still small as a relative percentage of the total corporate revenue. But what I would tell you is that in terms of Lexmark's proposition to enterprise customers, in terms of our strategy and approach to selling, it is a major factor. That doesn’t mean that every customer buys services. In fact, only a small percentage actually do but it’s a key point of how we are trying to transform the way people look at output in the enterprise environment.

And what we see is that when customers really look at this, so when we actually have them come in and look at the details, what does it take to manage an enterprise, distributed fleet where you are talking 20,000 devices that could be spread over multiple continents over a lot of different countries, what does it really take to do something like that? How do you optimize that and how do you, in an ongoing manner, optimize that?

When customers really look at that and look at the investments that Lexmark has made in terms of our tools and infrastructure to accomplish that, we win. This is what we see. We win.

And when customers do not look at that, or when customers look at it very superficially, then there’s lots of people out there saying the same words and people get confused. But when they look at track record in terms of what have people actually done and accomplished, as well as the toolset and infrastructure they really have to go do what people are talking about on a global basis in a distributed environment, this is our strength. This is where we win and we showed some of these tools at our analyst meeting in November in New York city.

Ben Bollin - Cleveland Research

And my second question -- how will executive compensation be determined in 2008? What are the metrics that you are looking to base that on -- market share, profitability? What are some of the items you are looking at internally?

Paul J. Curlander

Well, we haven’t set our executive compensation for 2008 but in general, we focus with a number of factors that are described in our proxy, relative to how we go at executive compensation, so clearly what we are trying to do is drive pay versus performance. We’re trying to put pay at risk.

For executives, we are trying to ensure that we also have a competitive and attractive package so that we can retain the talent that we have in the company.

Key elements that we typically have are the base salary component. There’s an annual incentive which is driven off of a number of different factors but historically it has been revenue, operating income, and cash cycle that have been three of the key ones. Don’t know exactly for 2008 but that’s what we have used historically.

There’s also long-term incentive compensation, and that can be either equity or cash based off the long-term performance of the company. Again, off key metrics such as revenue, operating income, cash cycle and in some cases, market share as well.

Operator

Thank you. Our next question is coming from Peter Grondin with OSS. Please go ahead.

Peter J. Grondin - OSS Capital Management

I just had a question -- I want to understand if I’m thinking about the currency situation correctly. You said that Europe was down 7% year over year revenue wise, and then you gave some numbers, Paul, about the peg for the exchange rate and my math is about 12.2% benefit. So was Europe down almost 20% year over year on a smooth basis?

Paul J. Curlander

No. I think the way to think about it, and what we described in the comments is that if you take a look at Europe, our business segment was up and it actually grew and the weakness was around the consumer business. And as we’ve implemented our strategy, I think the consumer business was impacted somewhat more than the other regions as we implemented our strategy and that’s what drove the revenue down.

But in terms of trying to do the direct math that you are doing with foreign exchange on the revenue, it doesn’t quite directly apply.

Peter J. Grondin - OSS Capital Management

Okay. And what about contribution to operating margin from the currency situation?

Paul J. Curlander

It certainly was positive in the year but it’s not something we specifically disclose.

Operator

Thank you. Our final question will be coming from Philip Oleson of UBS. Please go ahead.

Philip Oleson - UBS

Specifically on the balance sheet, do you have a breakdown of the amount of cash that’s currently held within the U.S. and the cash that’s offshore? I guess specifically trying to get a sense of your ability to access that cash either to fund share repurchases or to address your upcoming public debt maturity?

Paul J. Curlander

Certainly we do. It’s not something we specifically disclose but as we indicated in our comments, the significant majority of it is overseas. It’s predominantly overseas.

Philip Oleson - UBS

Then can you maybe, to the second part of the question then, as you look at the upcoming May maturity of your $150 million bond deal, and to the extent that you wanted to reengage in share repurchases, what would be your plan to meet those funding needs.

Paul J. Curlander

Again, that’s not something that we specifically disclose. At this point, we haven’t disclosed our intent regarding the bond and I think as we get closer obviously it will become clearer but at this point, we haven’t disclosed our specific intent regarding the bond. In terms of repurchases, we don’t disclose our forward repurchase plans. We’ve indicated that we have historically repurchased out of cash available in the U.S. and haven’t intended to leverage in order to do that, and that’s the extent of the discussion we’ve had on the topic.

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 Q4 2007 Earnings Call Transcript

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