Lexmark Q1 2008 Earnings Call Transcript

Lexmark International, Inc. (LXK)

Q1 2008 Earnings Call

April 22, 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

Jeff Fidacaro - Merrill Lynch

Bill Hand - Bear Stearns

Toni Sacconaghi - Sanford C. Bernstein

Caroline Sabbagha - Lehman Brothers

Richard Gardner - Citigroup

Shannon Cross - Cross Research

Min Park - Goldman Sachs

Kathryn Huberty - Morgan Stanley

Bill Fearnley - FTN Midwest Research

Ananda Baruah - Bank of America

Chris Whitmore - Deutsche Bank

Ben Bollin - Cleveland Research

Presentation

Operator

Thank you for standing by and welcome to the Lexmark International first quarter 2008 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

Good morning and thanks for joining us today. With me for Lexmark's first quarter 2008 earnings conference call are Chairman and CEO Paul Curlander and Executive Vice President and CFO, John Gamble. After their prepared remarks, we’ll open the call for your questions as time permits. So that we get to everyone, we’re 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.

Currently in the upper right hand corner of this website you’ll find today’s earnings release as well as the supplemental slide deck for the first quarter, which includes the reconciliations of GAAP and non-GAAP financial information.

Also on your website, you can access our upcoming events page which lists the investor conferences we’ll be attending this quarter, including the Merrill Lynch technology conference on May 7th, the J.P. Morgan annual technology conference on May 21st, and the Sanford C. Bernstein strategic decisions conference on May 29th.

As a reminder, any of today’s remarks that are not statements of historical fact are forward-looking statements and involve certain risks and uncertainties that are disclosed in the Safe Harbor section of our earnings releases and SEC filings. Actual results may differ materially from such statements and Lexmark undertakes no obligation to update any forward-looking statements.

With that, I’ll turn it over to Paul.

Paul J. Curlander

Thank you, John. Today we are announcing first quarter financial results that reflect the strategy we started to implement in the latter part of 2007. Revenue for the quarter was $1.18 billion, down 7% year to year and in line with our January 29th guidance. Earnings per share in the first quarter were $1.07 and were significantly better than our guidance. Excluding restructuring and related charges, earnings per share in the first quarter would have been $1.16, up 21% year to year. Now this earnings per share overachievement was primarily due to better-than-expected operating income, driven by lower inkjet hardware units and a better product mix.

First quarter 2008 cash from operating activities was $178 million, up from $87 million in the first quarter of 2007 and for the quarter, our restructuring program that we announced in October 2007 continues to be on track.

Hardware revenue for the quarter was down 18% year to year, primarily driven by unit declines, particularly in inkjet units. Supplies revenue was down 2% year to year but came in about as expected, with good growth in laser supplies being more than offset by a decline in inkjet supplies.

Year to year, supplies performance is lower than we saw in the fourth quarter of 2007 but you may recall that supplies sales in the fourth quarter were aided by an 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 and user demand.

In the second quarter of 2008, our current expectation is for supplies revenue to be about flat year to year as continued growth in laser supplies will be approximately offset by a decline in inkjet supplies.

Now during the first 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 down 17% year to year and was $434 million. Our consumer segment operating income excluding restructuring was $80 million, up 31% year to year.

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 the unit sales in all countries that do not generate an acceptable profit over life. As a result, we would expect inkjet unit sales to be off significantly year to year through 2008.

For the first quarter, inkjet unit sales were down 42% year to year and were less than expected. The shortfall versus expectation came primarily in Europe where our inkjet hardware sales were disrupted by a distribution center fire that we previously disclosed in the February 8-K filing and by a shortfall in worldwide OEM unit sales. In the U.S., the retail market was weaker than expected with our U.S. unit sales being further impacted by some loss of shelf space during the quarter.

Overall, the inkjet market continues to be very price aggressive. Despite this aggressive pricing, for the quarter our inkjet average unit revenue was up 15% year to year, reflecting the strategy to prioritize high-end units which drives stronger usage while reducing entry level units.

Now during the first quarter, we introduced our new home and student inkjet line with prices ranging from $79 to $129. This home and student line features a new industrial design, two new wireless products and the world’s first all-in-one with a front laptop port for quick and easy access.

Also during the first quarter, we introduced our new professional series of inkjets with business class features such as wireless connectivity, two-sided printing, high yield ink cartridges, and enhanced product support. Recently three products from our professional series received Editor’s Choice awards from Better Buys for Business.

And in the business market segment in the first quarter, revenue was $741 million, up 1% year to year. Operating income excluding restructuring was $144 million, down 7% year to year due to increased investment in demand generation and R&D. Laser units in the quarter were down 8% year to year.

Now as we look at our business market segment, our focus is on growing workgroup class devices in both enterprise and small and medium business accounts and on holding the line on the low-end by not chasing entry level devices with low page usage.

Business segment revenue for the quarter was up slightly year to year with continued good growth in supply sales. However, revenue in the quarter was negatively impacted by weakness in the U.S. enterprise hardware sales, particularly in the government, retail, and financial services segments.

Overall our business segment revenue grew year to year in all geographies except the U.S. However, pricing was aggressive in all geographies and in all segments.

Last year we greatly expanded our presence in the color laser MFP segment. As a result, in the first quarter of 2008 we saw strong double-digit growth in our color laser MFPs. During the first quarter, we added the Lexmark X560N color laser MFP to the line as we continued to receive industry recognition and awards for our color laser and color laser MFP products.

Now let’s talk about the second quarter of 2008. As we look forward, we will be continuing 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 second quarter 2008 revenue to decline in the mid-single-digit range year to year and we expect earnings per share to be in the range of $0.65 to $0.75, 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 these business market investments is to drive workgroup laser growth and page generation.

On the consumer side, we are driving a significant change in our market strategy and 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 increases 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.

This strategy is driving strong growth year to year in our wireless inkjet units and improvement in our inkjet average unit revenue despite an aggressive pricing environment. It is driving the introduction of new products such as our professional series and our home and student line and it is driving an increase in industry recognition and awards for our inkjet products.

Now we are also continuing to implement a restructuring of our business to lower our cost and better allow us to fund these strategic initiatives and in closing, we continue to have a strong financial position with a net cash balance at the end of the first quarter of over $725 million, and we continue to produce a good cash flow from operations.

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

John W. Gamble Jr.

Thank you, Paul and good morning. Consistent with previous calls, I’ll first discuss our results of the first quarter of 2008 relative to the prior year, then relative to the fourth quarter of 2007. Next I’ll 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 side 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 $1.18 billion, down 7% compared to last year, down 10% sequentially from 4Q, and in line with the guidance we provided in January.

Geographically for the first quarter, U.S. revenue of $488 million declined about 10% year to year. Revenue for $455 million in Europe declined about 6% year to year. The remaining geographies declined about 1% versus a year ago. The revenue declines in all geographies were primarily driven by revenue declines in the consumer market segment.

Laser and inkjet supplies revenue in the first quarter declined 2% year to year with good growth in laser supplies revenue being more than offset by an ongoing decline in inkjet supplies. Supplies growth in 1Q08 was in line with our expectations.

Laser and inkjet printer revenue in the first quarter declined 18% year to year. This hardware revenue decline was primarily driven by lower inkjet hardware revenue due to a 42% decline in inkjet units. Laser hardware revenue also declined, reflecting the general weakness in the U.S. market. Laser revenue in the quarter grew in all regions outside the U.S.

Laser hardware unit shipments declined 8% in the first quarter versus the prior year. Despite the decline in overall unit sales, color unit shipments were up double digits, driven by strong MFP growth due to our broader presence in the color MFP market.

Laser average unit revenue was flat year to year in the first quarter as the negative net impact of pricing and mix was offset by currency. Inkjet hardware unit shipments declined 42% year to year in the first 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.

Unit sales were less than expected due to a shortfall in Europe where we had a distribution center fire, as discussed in our 8-K on February 14th, a shortfall in OEM unit sales, and market weakness in the U.S.

Inkjet AURs increased to 15% versus the prior year despite price declines primarily due to improved mix reflecting a shift towards higher end segments and currency benefits. Business segment revenue for the quarter of $741 million grew approximately 1% from the same quarter in 2007 and declined 7% sequentially from the 4Q07 record revenue. The year to year growth in the first quarter was driven by good supplies revenue growth mostly offset by a decline in hardware revenue driven by market weakness in the U.S.

All other geographies saw laser revenue growth in the quarter. The sequential decline in business segment revenue in 1Q08 was driven by declines in both hardware and supplies revenue.

Consumer segment revenue for the quarter was $434 million, down 17% compared to a year ago and down 15% sequentially. The first quarter year to year and sequential decline was due to declines in both inkjet hardware and supplies revenue.

Gross profit margin for 1Q was 37.1%. Excluding restructuring related charges of approximately $5 million, gross profit margin would have been 37.5%, up 380 basis points versus the prior year and up 350 basis points sequentially.

The 380 basis point first quarter increase versus last year was principally due to a 430 basis point increase in product mix, the largest factors of which are the impact from the decline in inkjet hardware shipments and the increased laser supplies. This was partially offset by a 50 basis point decline in product margins.

Sequentially, the 350 basis point increase is driven by a 460 basis point increase in product mix, the largest factor of which was the impact from the decline in inkjet hardware shipments, as well as the relative percentage increase in laser supplies. This was partially offset by lower product margins.

Operating expense for the quarter was $313 million. Restructuring related expense of approximately $7 million impacted operating expense this quarter. Excluding this impact, operating expense was $306 million, an increase of $5 million year to year. SG&A in the quarter was $200 million, a decrease of $1 million from 2007. Included in 1Q08 OpEx is the $1 million deductible expense for the distribution center fire as described in our February 8-K filing. R&D in the quarter was $106 million, an increase of $6 million from 2007.

Sequentially versus 4Q, operating expense excluding restructuring related expenses increased $5 million. R&D expense increased $5 million sequentially with SG&A flat sequentially. The operating expense to revenue ratio excluding restructuring related expenses was 26% in 1Q.

Operating income in 1Q was $122 million. Excluding total restructuring and related costs and expenses of $13 million, operating income was $135 million, up $12 million from 1Q07 and down $9 million sequentially from 4Q07.

Excluding restructuring related activities, business segment operating income in 1Q08 of $144 million was down $11 million versus last year and down $32 million sequentially. The decrease versus 1Q07 is due to higher operating expense, principally increased marketing and sales, and product development, partially offset by higher gross profit, reflecting a more favorable product mix.

The sequential decrease was due to lower gross profit, reflecting decreased supplies in hardware revenue as well as higher demand generation and R&D investment. Again, excluding restructuring related expenses, consumer segment operating income in 1Q08 of $80 million was up $19 million versus last year and up $34 million sequentially. The $19 million increase in 1Q08 versus last year was driven by a favorable product mix shift reflecting less hardware, as well as timing and demand generation. The $34 million sequential increase was driven by a favorable product mix shift reflecting less hardware and timing of promotions and media spend.

As we announced on February 14th, we had a fire at our distribution center in Europe. The total of inventory write-off and other costs due to the fire were approximately $20 million, all of which, with the exception of a $1 million deductible, is expected to be covered by insurance. The impact on inkjet hardware unit shipments in the quarter was approximately 3% to 4% of worldwide shipments.

Other expenses, consisting primarily of costs related to centralized supply chain, IT, and other operating expenses, primarily G&A, were $89 million in 1Q08 excluding restructuring related activities, a decrease of $3 million from 1Q07 and an increase of $11 million from 4Q07. The $11 million increase from 4Q07 is due to the impacts of foreign exchange and increased incentive compensation accruals as 1Q08 reflects normalized IC accruals versus the low levels earnings earned in 2007.

Operating income margin in 1Q was 10.4%. Excluding restructuring related expenses, operating income margin was 11.5%, an increase of 170 basis points from the first quarter of 2007 and an increase of 50 basis points sequentially.

Concerning financing and non-operating costs, the net interest and other generated income of $6.2 million, up $3 million from 2007. Sequentially net interest and other was down $1.2 million.

In 1Q08, we had an effective tax rate of 20.8% versus the 26% rate we had estimated. The lower effective tax rate reflects a non-recurring tax benefit due to the settlement of a tax audit. We continue to anticipate our ongoing tax rate to be approximately 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 about 24% before any discrete items.

Net earnings for the quarter were $102 million. Excluding the $9 million after tax cost from restructuring related activities, net earnings in 1Q08 were $111 million. 1Q07 net earnings were $92 million, or $94 million excluding after tax restructuring related charges.

GAAP earnings per share for the quarter were $1.07. Excluding restructuring related activities, EPS would have been $1.16 per share. This compares to 1Q07 GAAP earnings per share of $0.95, or $0.96 excluding restructuring related activities.

Earnings per share for 1Q08 excluding restructuring related activities of $1.16 per share were significantly higher than the guidance we provided in January. This significantly higher EPS was driven by higher operating income reflecting lower inkjet hardware unit sales and better product mix.

Now moving to the balance sheet and cash flow items, cash flow from operations for the quarter was $178 million, up $91 million compared to 1Q07 and down $34 million sequentially. Excluding restructuring related cash outflows, cash flow from operations was $188 million this quarter, an increase of $89 million from 1Q07 and a decrease sequentially of $38 million from 4Q07.

Since the end of December, accounts receivable decreased $63 million, inventory decreased $31 million, accounts payable decreased $70 million, and accrued liabilities increased $16 million.

For the quarter, capital spending was $40 million, depreciation in the quarter was $51 million and includes $10 million of restructuring related accelerated depreciation.

Currency of the Euro was accounted for at $1.494 compared to $1.310 in 1Q 2007 and $1.449 in 4Q07.

Cash and current marketable securities at the end of 1Q was $879 million, up $83 million since December. In the quarter, we reclassified $59 million of auction rate securities from current to non-current assets. This action was taken due to the current disruption in the auction rate market.

In 1Q, we did not repurchase Lexmark shares. At quarter end, we had $295 million of share repurchase authority outstanding. Our $150 million bond matures in May and we expect to utilize our available U.S. cash to satisfy the maturity.

Now let me move to restructuring -- in 1Q08, total restructuring and related costs and expenses were $13 million. During the quarter, we continued to make good progress on the restructuring actions. Savings in 1Q08 were about $6 million and in line with our expectations.

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 2Q08, restructuring and related costs and expenses due to the restructuring actions are expected to be approximately $14 million. Savings in 2Q08 are expected to be about $8 million.

Now for my forward-looking comments concerning 2Q08. We expect second quarter revenue to be down in the mid-single-digit range year over year, reflecting our continued implementation of our inkjet strategy, significantly reducing our inkjet units versus 2Q07. We also expect some continued softness in overall market demand, impacting both the business and consumer segments.

Total supplies revenue is expected to be about flat versus 2Q07, as expected continued growth in laser supplies is offset by a reduction in inkjet supplies revenue.

GAAP EPS is expected to be $0.54 to $0.64 per share in 2Q08. GAAP EPS includes expected restructuring charges of $0.11 per share. Non-GAAP EPS, which excludes restructuring and related costs and expenses, is expected to be $0.65 to $0.75.

GAAP EPS in the second quarter of 2007 were $0.67, which includes a net restructuring benefit of $0.02 per share. Non-GAAP EPS in 2Q07 were $0.65.

Our guidance or 2Q08 EPS shows a significant sequential reduction from 1Q08, driven by a sequential reduction in inkjet supplies and increased sales of inkjet hardware, as well as associated demand generation expenses.

In terms of our specific discussion of financial information, both the 1Q and 2Q data provided that I am comparing to are non-GAAP and exclude the impact of restructuring related charges. In the second quarter, we expect gross margin percentage to be down versus the 37.5% we achieved in 1Q08. Operating expense is expected to be up compared to the $306 million incurred in 1Q08, primarily driven by increased demand generation and R&D investment.

Operating income margin in the second quarter is expected to be below the 11.5% achieved in the second quarter of 2008.

For 2Q 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 about 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 about $15 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) Our first question is coming from Jeff Fidacaro of Merrill Lynch. Please go ahead.

Jeff Fidacaro - Merrill Lynch

Good morning. I was wondering if you could just touch a little bit on the softness you see in the business demand, maybe across regions and verticals. I noticed especially in Europe you had a little bit of an offset by the distribution fire. I was just wondering if you could talk about regions and then if you could break it down between inkjet and laser.

Paul J. Curlander

The primary softness that we saw in the first quarter was in the U.S. and it was in the enterprise segment to begin with, and we saw some softness there certainly in the federal government, state and local government, retail, financial services. I would also tell you that the consumer market in the U.S. in the first quarter overall was pretty weak. As we look at the data that’s available to us out of January and February, we see things like the units, you know, total market units down about 11%, total market hardware revenue down about 14%. So pretty weak in the U.S., I would say both enterprise and consumer. SMB in the U.S. actually looked pretty good during the first quarter, so really just enterprise and consumer.

If we looked at Europe, we saw some selected softness in the business market primarily for us in the U.K. and Italy. In Italy, some of the government spending was a primary issue. The U.K., a very competitive market so it’s hard for us to say much beyond that, other than we saw some softness there.

In Europe, it’s very hard for us to comment on the consumer market. I think overall the consumer market, and inkjet has been somewhat flat over the last year. It probably was roughly that in the quarter. Our main issue in Europe was the disruption from the distribution center fire.

As we look in the other geographies, overall we see good business market demand across all the other geographies. We saw good hardware revenue growth across those geographies in the business segment.

On the consumer side, of course with our strategy, we are pulling back across all of our geographies so that’s impacting Lexmark uniquely. I wouldn’t say there was a market impact per se.

Jeff Fidacaro - Merrill Lynch

Thank you.

Operator

Thank you. Our next question is coming from Min Park of Goldman Sachs. Please go ahead. We’ll move on. Our next question is coming from Bill Hand of Bear Stearns. Please go ahead.

Bill Hand - Bear Stearns

Thanks. This question relates just to your ability to forecast the supplies trajectory. HP has talked about the hardware unit growth become less of a predictive factor for supplies growth, just given their ongoing mix shift towards the enterprise and graphic arts and such. Given a similar mix you are seeing at Lexmark just in terms of the shift toward higher value segments in both inkjet and laser, just interested in getting your thoughts on how investors could just better gauge the supplies growth opportunity if the absolute installed base number is becoming less of a predictive factor as much as the quality of that installed device.

Paul J. Curlander

Well I think relative to Lexmark, because we are a little bit different situation than HP as they are pushing much more into production type of printing. But for us, I think it is true to say that units are not all equal and as we move forward, currently units is important but also the mix of the units is very important and we think the best indicator of that probably is in the average unit revenue.

So to the extent that we are making progress on the average unit revenue, that’s primarily being driven by mix because we don’t see pricing going up in this segment at all. Obviously currency can help some geographies but really pricing is very aggressive across the market.

So mix is really I think being reflected through the average unit revenue number that is out there. So for us, I would say units and AUR.

Bill Hand - Bear Stearns

And Paul, just to follow-up; can you comment at all on the relative supplies intensity of some of the low-end devices you are exiting versus the higher-end inkjet devices that you are trying to get into?

Paul J. Curlander

Well, we’ve not quantified the difference between those but what I would tell you is that fundamentally, what we’re trying to do is we’re trying to ultimately generate more pages out of fewer units. I mean, that’s kind of the crux of what we’re trying to do. We do believe there is a significant difference between the low end and the high end of the line. We do think that there are more pages associated with wireless inkjets. We certainly know there’s more pages associated with the professional class devices, if we can get them placed through the right channels to the right customers. And so we are projecting that in our supplies model and we seem to be tracking -- certainly in the first quarter here we track pretty well against the supplies model in terms of our expectation.

So we think the key is to get rid of the units that really aren’t generating the pages that we are looking for and clearly we are doing a lot of that. We think the key is to grow the units that are going to drive these higher pages and in the first quarter, I think that clearly we had some impacts there in Europe with the distribution disruption that we had, and in the U.S. with a slower market and some shelf-space issues. But nonetheless, we think the strategy is a right one and we think that we will see more pages per unit. And we do believe we are seeing that as we continue to shift this mix.

Operator

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

Toni Sacconaghi - Sanford C. Bernstein

Thank you. Paul, I wanted to ask a little bit about your guidance. If I look objectively, every quarter in history, Q2 has had higher EPS than Q1 with the exception of last year which I think you would agree was unusual. But prior to that, every single quarter in history, Q2 EPS was higher than Q1. You are also providing I think the strongest supplies guidance you’ve provided in several quarters. You are going to have an incremental restructuring benefit as well, so I’m trying to understand why the guidance is down so dramatically relative to any kind of normal seasonal pattern we’ve seen before. Is this just conservatism? You’ve beaten by $0.28 or more in each of the last three quarters. Or are you seeing something incrementally worse or is there something dramatically changed about seasonality that explains this guidance? And I have a follow-up.

Paul J. Curlander

Okay, well, I would say a couple of things, Toni. I would say clearly we saw a lot more market weakness in the first quarter than what we had seen in 2007. So we saw a lot of weakness in U.S., both the enterprise and consumer. We saw some selected weakness in Europe, so certainly some of that plays into our factoring.

Secondly, most of the swing is coming out of the -- in fact, all of the swing is coming out of the consumer segment and basically what we see there is we see a decline in supplies sequentially, which if I go back and look at that seasonally, that’s not unusual for us to see that. We’ve seen some seasonal declines certainly over the last few years.

And what we are looking at here is we are looking to also drive some incremental inkjet units as we go from first quarter to second quarter, and then hopefully we would do better in Europe, just by losing the disruption that we had in the first quarter. We are also putting some additional demand generation around trying to restart some of that because we did have a discontinuity there.

So it’s really the combination I think of the market weakness that we see, the seasonal decline in inkjet supplies, and the increase in demand generation associated with that, and those are the factors. And we went through this pretty closely and this is our best view as we look at it right now.

Toni Sacconaghi - Sanford C. Bernstein

Paul, I appreciate that but wouldn’t the first two boost EPS? I mean, if you are seeing market weakness and you are guiding for supplies to actually be better than you’ve seen in the last few quarters on a year-over-year basis, the market weakness means hardware and lower hardware generally means improved profitability. And so I’m -- again, maybe your business is changing but typically that would mean higher EPS. So perhaps you can comment on that.

But the follow-up question, which I think is related to your answer, is why does OpEx keep going up so dramatically? It was up 280 basis points year over year. It’s up, you know, it’s 500 or 600 basis points above where it was historically and in your first page of your slide deck, you say you are taking actions to improve costs and expense. You are now three quarters into the restructuring initiative and you are calling for OpEx to be up even more again.

So when are these actions going to start to kick in? Are we ever going to see OpEx get better as a percentage of revenue and why haven’t you been able to strike a better balance between demand stimulation and OpEx over the last three quarters?

Paul J. Curlander

Well I’ll give you my thoughts on it and I’ll ask John to give his thoughts as well.

What’s driving the operating expense up primarily is what’s coming out of the business market segment and we are making investments there in R&D, as we continue to try and drive our market position in both color and laser and multi-function devices. We think we have more work to do there and that’s where a lot of this is coming.

On the market demand generation side, again primarily as we look at what’s been going on in OpEx, it’s been coming out of the business market segment. We did a significant increase in our enterprise sales force during 2007 and we are seeing that on a year to year basis.

Now obviously we didn’t see all of the demand generation results from that as we hit some market weakness and segment weakness here in the enterprise space, but that’s where the majority of the OpEx increase has been coming. And we think that we need to continue to do that.

Now as we go forward in time, clearly we -- and as you talk basis points, obviously revenue is factor here as well and we’ve been seeing less revenue than we would have liked to have seen. You know, as we go forward in time, we do expect to get impact out of the restructuring. I think currency is also playing a factor here that’s kind of counter to what we are trying to do on the restructuring side. But let me ask John to kind of give his thoughts.

John W. Gamble Jr.

No, I think those are the major points where we’ve indicated pretty consistently that in terms of dollars, again not in terms of percent, that we continue to invest in R&D and that that’s really where you are seeing the growth in our OpEx. And as we said this quarter, what you saw in SG&A, it was relatively flat or slightly down both sequentially and versus last year. And again, I think that’s driven by there were restructuring related activities that took out some of the support costs but we did make some investments in demand generation and we are certainly being impacted by currency and the fact that a fair amount of our SG&A expense is outside of the United States.

Operator

Thank you. Our next question is coming from Caroline Sabbagha with Lehman Brothers. Please go ahead.

Caroline Sabbagha - Lehman Brothers

Thanks. Just a question on supplies inventory -- where do you think channel inventories are now for supplies, both in inkjet and laser, relative to historical? And a follow-up on your forecast for supplies growth in the second quarter -- it seems like you are looking for improvement versus the first quarter, although you said in some comments that inkjet supplies are going to get worse. So what’s really leading to the improvement versus the trendline you saw in 1Q? Thank you.

Paul J. Curlander

Okay. On the supplies inventory, what we saw in the first quarter was some sequential increase in laser channel inventory but that was pretty much as we had expected and as we look at weeks of inventory, it was about flat as we went from fourth quarter to first quarter. So I mean overall with laser supplies that continue to increase and channel inventory levels move with that, but we feel that it looks pretty good and we’re not expecting to see shrinkage in the second quarter relative to laser channel inventory for supplies.

Over on the inkjet side, in the first quarter we saw shrinkage in inkjet channel inventories; not surprising because overall inkjet supplies revenue is declining. But as we look forward into the second quarter, we expect maybe a little bit more shrinkage but we also see some opportunity for some additional OEM supplies distribution expansion, which is going to be playing a factor there.

So when you look at the guidance that we’ve given for the second quarter and compare that to the first quarter, the second quarter we’re saying about flat for supplies, first quarter was down 2% on a year to year basis. The real difference is in terms of the laser supplies -- as we ended the first quarter, there was a little weakness that we saw coming out of Europe because of the timing of where Easter was on a year to year basis. Also a little bit out of Canada. We didn’t see some of the government buying that we typically see at the end of the fiscal year. Our belief is we’ll catch up in that in the second quarter, that that was not a miss, just a little bit of shift in terms of timing. So that’s going to help us.

And then this OEM supplies distribution is an opportunity to get some more revenue and we’ve projected some of that in our outlook for the second quarter. So that’s really the difference from being flat versus being down 2%.

Caroline Sabbagha - Lehman Brothers

Thank you very much.

Operator

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

Richard Gardner - Citigroup

Thank you. Paul, I was hoping you could give a little more color on the loss of retail shelf space that you referred to in the United States. And in particular, give us a sense of how significant and how transitory or permanent the loss of shelf space that you’ve apparently had at Best Buy is in the United States on the inkjet side? Thank you.

Paul J. Curlander

Richard, we can’t really talk about any specific retailers. What I can tell you is that similar to what we saw in 2006 when we pulled back in volume is that when you pull back, you lose shelf space and that’s certainly what we saw here.

I would also tell you that it’s probably a little bit more aggravated here in 2008 than what we saw in 2006 because the overall category has declined and retailers are just reducing the amount of shelf they are putting into the category overall, so those two factors were out there.

I think that this is a moving target. Currently we expected to get some reduction and we did see some. Clearly we’ve got some reduction in some areas, such as you mentioned that we wished we didn’t have. But I would tell you again that it’s a moving target and we continue to work to improve this. We have new products in process and we continue to work to get back in as we go forward in time. But certainly we have lost some shelf space in the U.S. here in the first quarter.

Richard Gardner - Citigroup

As a follow-up, could you talk about how quickly you might be able to get that shelf space back and how frequently these agreements are revisited?

Paul J. Curlander

Well, I think that it’s hard to project and certainly we wouldn’t project what we might think we could do in shelf space but most retailers reset at least twice a year, and then there is always opportunities around things like back to school and holiday that present some opportunities out there and certainly we go to work with that, along with -- you know, as we continue to advance our products and have new things to offer.

Richard Gardner - Citigroup

Thank you.

Operator

Thank you. Our next question is coming from Shannon Cross of Cross Research. Please go ahead.

Shannon Cross - Cross Research

Good morning. Could you just talk a little bit about the operating margin on the inkjet side, as well as perhaps on the laser side? Just some of the puts and takes that made the changes from a sequential basis as well as year over year. And on inkjet, were there any of the APCs or anything that played in there? Thanks.

John W. Gamble Jr.

In terms of APC LCM, it wasn’t really a -- there wasn’t significant impacts in either sequential or year over year. If they were meaningful, we would have called them out, and we’ve mentioned that in the past too, that that’s really what’s going on. In terms of the impact on margins, really what we would say is what we have said already in terms of the greatest impact on margins in the quarter was really the reduction of inkjet hardware and then also the improvements in product mix.

In terms of specifics for each segment, we really don’t get into the specifics of what moves the margins on each individual segment.

Shannon Cross - Cross Research

Okay, and then just one follow-up question; I’m curious with regard to your debt why you are not rolling the debt, since it is U.S. domestic cash, and going out and buying more stock, given where your shares are at. Why the decision to actually pay back the debt?

John W. Gamble Jr.

Again, our practice has been with excess U.S. cash, you know, we have been repurchasing shares and given that the debt is maturing, we’ve decided to repay the debt as we move forward. In terms of adding or replacing debt, which is maturing, again we look at that frequently and continue to look at that but at this point we haven’t moved forward to do anything in terms of replacing debt or putting on new debt to repurchase shares.

Shannon Cross - Cross Research

Okay but you -- just to clarify, you are actually going -- you’ve confirmed right now that you are going to repay the debt at this point in time?

John W. Gamble Jr.

As of right now, we’ve indicated we intend to repay the debt, yes.

Shannon Cross - Cross Research

Okay, thanks.

Operator

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

Min Park - Goldman Sachs

Thank you. In touching on the softness you noted in the U.S. business segment, could you tell us how much of the weakness is actually due to competition versus the elongating life cycle of your installed base? And if the latter, should we see gross margins hold up longer coming from the supplies hardware revenue mix going forward? Thank you.

Paul J. Curlander

What we are seeing in the U.S. enterprise space is really we believe a market slowdown in these segments. Clearly there’s a lot of competition everywhere we look but we are not seeing any increase in competitive losses. In fact, we continue to do very well in those segments in the enterprise space. So we feel very well-positioned competitively. We’re just not seeing the big opportunities that were sitting out there a year ago. And as we look into the second quarter, we think that’s going to continue certainly to be the case in the second quarter as well.

Min Park - Goldman Sachs

Thank you.

Operator

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

Kathryn Huberty - Morgan Stanley

Thanks. Good morning. I want to follow-up on the laser operating income. There’s a couple of positive factors that are clear in the numbers you provided. Laser supplies up year-on-year while hardware units declined. Also the AUR is flat even in what sounds like a competitive environment, and so why would operating income dollars be down year-on-year with both of those positive factors influencing the margins?

John W. Gamble Jr.

I think the largest increase is around operating expenses, as Paul discussed. Most of the investment in operating expense has been around the laser business, as Paul mentioned, and that’s been an impact on laser margins year-on-year.

Paul J. Curlander

Right and currency hit us there and obviously we had some offset by increased supplies year to year.

Kathryn Huberty - Morgan Stanley

Thanks.

Operator

Thank you. Our next question is coming from Bill Fearnley of FTN Midwest. Please go ahead.

Bill Fearnley - FTN Midwest Research

A couple of questions here; in terms of the gives and takes during the recent quarter on the shelf space initiatives, can you comment whether you are going to be losing ink shelf space here? The press reports in the local Lexington paper say that you are losing hardware shelf space at Best Buy but can you comment about the ink? And then in addition to the earlier question about the restructuring and the benefits, directionally can you give us some idea of how much you expect to save and put in your own pocket from the restructuring and how much from the restructuring do you expect to give in pricing and promotion to end users and also for investments in R&D and OpEx?

Paul J. Curlander

I’ll let John comment on the restructuring. In terms of shelf space, we’ve talked about hardware. On the supplies side, I’m not aware of losses of shelf space. There’s a lot of SKUs out there so it’s possible in some places it moves around a little bit from time to time. But overall, we don’t feel like we are losing ink cartridge shelf space out there. Certainly we saw a loss of hardware shelf space.

Bill Fearnley - FTN Midwest Research

So if you are losing hardware shelf space then at this large retailer, as reported in the local paper that your spokesman confirmed this morning, are you expecting to still have the Lexmark labeled supplies on the pegs in that same store-front, just losing the hardware placements then?

Paul J. Curlander

Well, I’m not aware of any Lexmark spokesman confirming anything this morning and certainly I don’t know exactly what article in the local paper you are focused on, but I would tell you that in terms of ink shelf space, we’re not aware of any material change in the shelf space in retail. On the hardware side, we have seen a loss.

Bill Fearnley - FTN Midwest Research

Okay. And then is your -- just quickly, Paul, on the supply chain, have you guys recovered after the fire now? Obviously you guys took a hit, so to speak, in the first quarter, but are you recovered now in the inkjet hardware to recover from the damaged inventory?

Paul J. Curlander

In terms of our operational capability in the second quarter in Europe, it looks pretty good. Our back order, we pretty much have brought that down to kind of the historical level of back order and that certainly was not the case all through the first quarter.

We are seeing some good demand in Europe on professional series and we are expediting that product is, so we are a little short there in the second quarter but overall, we are dramatically improved from where we were.

Bill Fearnley - FTN Midwest Research

If John could comment on the price -- the restructuring savings.

John W. Gamble Jr.

We indicated savings in ’08 about $40 million ongoing; beyond ’08, about $60 million. And in terms of how much goes to pricing, how much goes to hardware, how much goes to OpEx, I mean, that’s effectively kind of an operating income forecast which again we don’t do but at this point, I think we are certainly planning on achieving our restructuring savings but in terms of how it impacts the ongoing business operating income beyond one quarter, we don’t really give guidance.

Bill Fearnley - FTN Midwest Research

No feel directionally either, John?

John W. Gamble Jr.

Really beyond one quarter, we don’t really give guidance in terms of what the impact is going to be net net on the operating income.

Bill Fearnley - FTN Midwest Research

Okay. Thanks, guys.

Operator

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

Ananda Baruah - Bank of America

Just going back over to the business segment, should we think of your go-forward opportunity as being more small medium business focused or enterprise focused? And then inside of that, what do you tend to think of as being more important -- is it incumbency, product portfolio, services capabilities? And then just lastly, as we think about your services capabilities vis-à-vis some of your competitors out there, do you feel that you match up as well as they do from a document management perspective, infrastructure management and consolidation perspective in some of those key service areas that folks continue to talk about?

Paul J. Curlander

In the business segment, our focus in Lexmark historically has been enterprise focused. We are clearly trying to grow our SMB capabilities around the world but in general enterprise is the strength of the company.

We are seeing weakness in the U.S. enterprise segment but around the world, we continue to see good enterprise sales. So in the U.S., obviously we were down in the first quarter but if you look in every geography outside the U.S., we had hardware revenue growth in our business market segment. So again, U.S. weakness, we talked about some selected stuff in Europe but outside the U.S. is seeing growth.

In terms of what’s most important, I think all those factors you mentioned are important. I think being the incumbent in an account is very important. I think having a strong product portfolio is important and services is becoming of increasing importance, so all these things are important and it depends on the enterprise account we are dealing with which one is most impactful. Obviously as we deal with small and medium business, product portfolio is a key issue because that’s how a lot of decisions are made. Services doesn’t play as much there and from an incumbency standpoint, we don’t have a lot of incumbency in small and medium business, so for us that’s around product portfolio.

I think around services capability in enterprise accounts, I honestly think that Lexmark has the strongest capability in the market. We have built a world-class global infrastructure. We’ve made a lot of investments in that and when our customers really look at our ability to manage a distributed fleet compared to the competition, we win. When they really look, we win.

So we feel very well-positioned there. I think the issue for us is not as many customers as we’d like to see have interest in buying that way but we continue to see that interest growing and we continue to focus on it and, to the extent that that does grow, we view that as a strong positive for Lexmark going forward.

Ananda Baruah - Bank of America

Just a quick follow-up, if I could; have you guys seen over the last couple of years an increased focus from some of your enterprise customers on vendors who offer maybe a broader hardware portfolio than you guys do? And maybe seeing some consolidation that way?

Paul J. Curlander

We don’t see an extensive amount of that. Occasionally what you will see is somebody might be in one technology segment, maybe they are running a data center, maybe they are doing desktop support, and occasionally you see an effort to do a consolidation into other areas off of a base in the account like that. But the vast majority of customers do not look at it that way and don’t do that type of thing. They are really looking for who is the best provider in each area.

We see the majority of people focused specifically on output. They’ve been broadening output beyond just distributed devices to include departmental copiers and sometimes even copy centers or print centers that do internal kinds of jobs, so we see that type of consolidation but we compete in that pretty effectively.

But it’s seldom but occasionally we do see somebody try and go across IT categories.

Ananda Baruah - Bank of America

Okay, very helpful.

Operator

Thank you. Our next question is coming from Chris Whitmore of Deutsche Bank. Please go ahead.

Chris Whitmore - Deutsche Bank

Great, thanks. I wanted to come back to the shelf space issue. Can you tell us what percentage of 2007 unit sales were sold through the Best Buy channel?

Paul J. Curlander

No, we don’t break that out, Chris, I’m sorry.

Chris Whitmore - Deutsche Bank

Okay. Secondly, I’m just trying to understand why Best Buy decided to move away from Lexmark on its shelves. You know, you have Eastman Kodak on the shelves at Best Buy, who has been in the business -- in the inkjet business -- for under a year and you are losing shelf space to Kodak essentially. Help me understand why you lost that shelf space -- was it brand? Was it product functionality? Was it price performance? Any additional color there would be great. Thanks.

Paul J. Curlander

Okay. Well again, we can’t talk about any individual retailer but what I can tell you is, and again we saw this in 2006, when you pull back on volume, depending on how you do that and what retail you are looking at, you can become a less significant player in a retailer. What we are also seeing is we are seeing overall category reduction because the market has been declining.

I think it would be incorrect to say Lexmark loses shelf space to Kodak because I think the reality is that it’s Hewlett-Packard, Epson, and Canon who are driving the majority of sell-out units through these retail chains. So I think it’s really much more an issue of if the market slows down, there is some contraction that goes on. When we pull back, at the same time, you can potentially lose some relevance or some importance in selective retailers. These are some of the factors.

As to why any individual retailer makes a decision, certainly we wouldn’t speak for them. You would have to ask them. But I would also tell you that this is a moving target and we expected to take a hit, we did take a hit here, and now we go back to work and try to improve our shelf space position as we go forward in time, looking at when they do their channel resets, looking at back to school, looking at holiday and obviously focused on upcoming products that we have as we go forward in time. That’s the game plan and we certainly would hope to get some improvement as we go forward in time.

Chris Whitmore - Deutsche Bank

The second question relates to your optimism around laser supply sales. Total laser units were down 3% last year, down another 8% this quarter. It looks like your installed base is actually declining in laser. How sustainable -- and given the spending environment, how sustainable is that laser supplies growth as we go forward over the next several quarters? Thanks.

Paul J. Curlander

We feel very good about the laser pages that are out in front of us and the demand generation for pages in laser. And this is a little bit like the conversation we had a little while ago in the call, is that units isn’t always the best predictor. In some cases, you have to look at the mix of the units. And in 2007, yeah, from a units perspective, we saw some decline but again, this was our strategy, to hold the line on the low end and not chase entry level units down in price that don’t generate enough pages to ever make money over the life of the device.

The focus we are putting into the market is on driving work group lasers, which drive a lot more pages per unit. And in 2007, we saw double-digit growth in work group lasers. Globally we gained share in work group lasers and this is what’s driving the page growth that Lexmark sees.

So as we look out through 2008, we certainly see a good installed base of work group lasers, a good impact from the growth in the share gain that we had in 2007, and we would expect to see strong pages.

That said, we’d like to be selling more and obviously the weakness in the U.S. enterprise segment is not what we would like to see.

Operator

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

Ben Bollin - Cleveland Research

Good morning. I had a question regarding the demand generation activities you’ve been discussing. Could you give us an idea of some of the investments you are making and how you hope to increase the demand?

And then a second part, not really related, I believe there is a non-compete of a former executive expiring. Just curious if you’ve seen or anticipate any change in the landscape because of that. That’s it. Thank you.

Paul J. Curlander

Well, from a demand generation standpoint, the majority of the investments that we have made certainly over the last 12 months have been the business market segment and it’s been around increasing enterprise sales resource in the business market segment and our focus there is really two things. First, we are trying to go deeper into the accounts that Lexmark already has, but we are also trying to go broader and get more participation in the total market by calling on a wider set of accounts.

We continue to be very focused in the industry segments that we have historically talked about. Certainly things like financial services and retail have been good opportunities for us, but also federal government, state and local government, healthcare. These are all good targets for us. So that’s where the demand generation investments over the last 12 months have primarily gone.

Relative to non-competes and former executives, all I could tell you is that we don’t see any shortage of competition out there in the marketplace and there is no one person who is going to make a material difference in the competition we see from the major players in the market, be it an HP or an Epson or a Canon or a Xerox.

I think that there is a lot of competition out there for units and services. There’s a lot of competition for people and talent and certainly we see that on a daily basis coming from a lot of different directions. But again, I think any one individual is not a major factor.

Ben Bollin - Cleveland Research

Thank you.

Operator

Thank you. Our final question is a follow-up coming from Toni Sacconaghi of Sanford Bernstein. Please go ahead.

Toni Sacconaghi - Sanford C. Bernstein

Thank you. You had mentioned the opportunity for OEM supplies distribution in inkjet. Is there a commensurate expansion in OEM hardware that’s expected? And if not, why would you be having expanded OEM supplies distribution? Is this because there was a shortfall in OEM distribution or some other reason?

Paul J. Curlander

Well, Toni, it’s hard for us to talk in any detail about the OEM side, so I think about all we can say is that on the supply side, you know, we saw some in the fourth quarter. It had a positive impact in terms of the supplies that quarter. We saw a negligible effect in the first quarter and we expect to see some in the second quarter and we put that into the outlook.

In terms of OEM hardware, we’re not commenting on whether there’s expansion or not but what we would tell you on OEM is that it continued to decline on both the laser and the inkjet side and came in below expectations on the inkjet side, as John pointed out. And that’s about all I think we can say on OEM.

Toni Sacconaghi - Sanford C. Bernstein

And then can you comment -- there was some mention in terms of forces affecting gross margins about the timing of promotion in media spend and how that affected profitability by segment in the quarter. Can you comment specifically on what you were referring to there and how it did impact margins?

John W. Gamble Jr.

I think all we were referring to was the fact that media spend is expected I think to be higher in the second quarter as we promote more of the products that we introduced in inkjet worldwide, specifically around professional series as we continue to promote those products, both in the U.S. and Europe. And then other media spend generally.

Paul J. Curlander

Right, and that’s a flip from I think what we saw last year from a quarter perspective. I think that was it, Toni.

Toni Sacconaghi - Sanford C. Bernstein

Thank you.

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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