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Lexmark International (NYSE:LXK)

Q2 2012 Earnings Call

July 24, 2012 8:30 am ET

Executives

John Morgan

Paul A. Rooke - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

John W. Gamble - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Eric Garfunkel

Shannon S. Cross - Cross Research LLC

Alban Gashi - Crédit Suisse AG, Research Division

Kathryn L. Huberty - Morgan Stanley, Research Division

Ryan Jones - Barclays Capital, Research Division

Robert Schiffman - Crédit Suisse AG, Research Division

Operator

Thank you for standing by, and welcome to the Lexmark International Second Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded on Tuesday, July 24, 2012.

I would now like to turn the call over to John Morgan, Lexmark's Director of Investor Relations. Please go ahead, John.

John Morgan

Good morning, and thank you for joining us. Chairman and CEO, Paul Rooke; and EVP and CFO, John Gamble, are with me this morning. After their prepared remarks, we'll open the call for your questions as time permits. We ask that you please limit yourself to one question and one follow-up if needed, so that we can get to everyone.

Please note that Paul and John will be referring to specific earnings presentation slides by number. These slides were posted to our Investor Relations website located at investor.lexmark.com earlier this morning. Paul and John will be referring to non-GAAP measures during the presentation unless otherwise noted. Pursuant to the requirements of Regulation G, the company has provided reconciliations of GAAP to non-GAAP measures and a discussion of management's use of non-GAAP measures in the Supplemental Materials section of the earnings presentation slides.

Regarding our upcoming dividend schedule, Lexmark anticipates that the second -- I'm sorry, that the record date of its third quarter 2012 dividend will be August 31, with an anticipated payment date of September 14. Please note that future quarterly dividend payments are subject to board approval. We have also included our anticipated dividend schedule for the remainder of 2012 and 2013 in the Supplemental section of our earnings presentation.

Following the conclusion of this conference call, a complete replay will also be made available on our IR website. 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 A. Rooke

Thank you, John, and good morning to everyone. As John said, we'll be using a presentation slide deck and will refer to the slide numbers as we go to keep everyone on the same page. So let's begin.

Starting with Slide 4. Our second quarter financial results were less than we expected and reflected the impact of 2 dynamics since the first quarter. First, we saw larger-than-expected impacts from the changing currencies, particularly in the back half of the quarter. This accounted for roughly half of the revenue miss and more than all of the earnings per share miss versus our second quarter guidance in April.

Second, we saw weaker demand than expected, particularly in Europe, in the quarter. Because of the sudden nature of the decline in demand, including paid usage, we believe this change was driven more by belt-tightening dynamics due to economic uncertainty similar to late 2008, 2009 versus any new mobile or other secular trends.

We remain confident in our strategy and our competitive strength. In the second quarter, we saw continued growth in our Managed Print Services business with revenue up 12% for the first half, and we were recognized as a Managed Print Services leader by 2 additional research firms. We also saw strong double-digit growth in Perceptive Software revenue.

However, given the impact of the recent trends on our results, I think it's important to make clear that we are committed to improving our profitability while we also continue to invest in our strategic areas. We're currently monitoring and evaluating the ongoing impacts of currency shifts in a softer economic environment, and will make adjustments accordingly while continuing to invest in the higher usage Hardware and higher value Software segments to enable long-term growth in the quarter. As we've demonstrated before, we are capable of making adjustments as required to overcome tough challenges. And we remain committed to our long-term operating margin assumption of 11% to 13% despite this short-term setback.

Our focus is squarely on the needs of business customers. We are building and growing our solutions business through organic expansion and acquisitions, and we remain committed to our capital allocation framework, returning greater than 50% of our free cash flow to shareholders through dividends and share repurchases.

On Slide 5, you can see the second quarter financial highlights. Revenue for the second quarter was $921 million, down 12% year-to-year. Basically, there were 3 headwinds: First, currency had about a $50 million impact year-to-year, and as I mentioned before, it accounted for roughly half of the revenue miss versus our April guidance. Second, we saw weaker demand for Hardware and Supplies, and we believe the Hardware weakness was primarily driven by customers deferring decisions on large-account business. Supplies saw the expected drawdown in inventory, but also saw some usage softness driven by the economic environment. And third, the Legacy supplies declined as expected.

On the positive side, we saw continued revenue growth in our strategic focus areas. We had continued growth in Managed Print Services and large workgroup MFP units. And Perceptive Software revenue grew 88% for the quarter, driven by both strong organic growth and the 4 recent Software acquisitions.

Our operating income margin was 10.1% for the second quarter, a tough compare against a record margin last year. There are 2 dynamics to note here: First, we maintained a strong gross profit margin of 40.5%, an encouraging result in light of the strong currency headwinds as we continue shifting the mix of our business to higher value Hardware and Software. Second, operating expense came in lower than we expected and up year-to-year driven by the increased Software investments and acquisitions to drive future growth.

Earnings per share were $0.89 for the second quarter, below our guidance, the currency shift more than explaining the shortfall of the April guidance.

We generated $11 million of free cash flow, less than we expected. This results -- this result reflects good inventory performance, but more receivables and less payables than expected, and John will touch on this later.

Now looking at Supplies revenue on Slide 6. Our strategic focus is to build a more productive, higher-value install base in terms of pages and Supplies revenue. Here you see the percentage of our Supplies revenue split between that which is driven from our Core install base, the red bars, fed from the large and small workgroup project sales, and from our Legacy inkjet install base, the gray bars, representing the Supplies revenue, still flowing from our Legacy consumer inkjet install base. Now the percentages on the bars represent the year-to-year growth rates of the Core and Legacy Supplies revenue. We've also added the overall percentage impacts from currency, both positive and negative, by quarter at the bottom, so you can get a feel for the currency adjusted trend over time, particularly as it applies to the Core.

As you can see for the second quarter, the Core supplies revenue declined 10%. Currency adjusted, it's less negative but still negative. If you recall, last quarter, we indicated that we expected Core supplies revenue to be down year-to-year in the second quarter for 2 reasons: currency and a drawdown in channel inventory from the first quarter increase in Supplies channel inventory in advance of our early April price action.

Now the channel drawdown happened as expected, but we saw a stronger negative currency effect and weaker demand as customers tightened their grip on expenses. Since we don't have complete visibility into the channel and our end-user base, it's difficult to determine whether these trends are driven by reduction of shelf inventories or reductions in actual usage.

Having said that, we do believe they were some of both. Our Managed Print Services data indicate some reduced usage, more pronounced in Europe, as customers manage their expenses tighter. This is similar to the trend we saw in late 2008, 2009 with the economic downturn. We saw a reduced usage for a period of time and then a return to a more normal usage pattern. While we can't predict the future, we do believe the trend we're seeing is one of economic belt tightening, and our guidance reflects this for the rest of the year.

The Legacy Supplies revenue continued to decline in the second quarter as expected and represented 13% of our total Supplies revenue. So overall, in the second quarter, we had declines in both Core supplies and Legacy inkjet supplies revenue, resulting in a year-to-year Supplies revenue decline of 14% overall. And while we must deal with the currency shift, along with the channel and end-user dynamics, we remain focused on growing the Core, so as the Legacy segment naturally declines with time and becomes a smaller piece, the Core supplies growth will become more dominant and drive growth in overall Supplies revenue.

On Slide 7, you can see the year-to-year total revenue comparison through the second quarter with the revenue split between the Core, meaning our Core Hardware, Supplies, Software and Services, and Legacy, the older consumer Hardware and Supplies. The percentages on the bars represent the year-to-year growth rates. And again, we've added the percentage impacts from currency at the bottom for reference.

Here you see for the second quarter, the Core declined 9% and represented 91% of our business. The remaining consumer Legacy component is declining as expected and becoming a smaller piece of our total revenue.

Now within the Core, we saw a mixed set of results. First, we had good growth in Managed Print Services, Smart MFPs and Perceptive Software. Second, this growth was dampened by declines in Core Hardware other than Smart MFPs and Supplies. And as I just discussed, Core Supplies were affected by currency, channel dynamics and some usage.

The Core Hardware decline was driven by 3 factors: first, currency; second, large workgroup Hardware other than Smart MFPs declined as we saw weaker-than-expected demand with some customers deciding to defer their buying decisions; and third, small workgroup hardware decline driven by the execution of our planned exit from inkjet retail distribution.

Again, we are committed to growing the Core and we have work to do to restore Core growth given these headwinds. We believe by continuing to win large incremental install bases through our leadership in management services by displacing competitive A3 copiers with our leadership in Smart MFPs, and by growing our higher-value software offerings, we will grow the Core. While the headwinds are certainly greater than the tailwinds at this point in time, we believe we are focused on the right segments to drive profitable growth for Lexmark.

On Slide 8, you can see our unit share position in the high-usage A4 laser workgroup segment. For those not familiar with A4 laser workgroup designation, this simply refers to the market of laser printers and MFPs that are designed for letter and legal size documents in contrast to the larger A3 or 11 by 17 format typically designed into floor-standing copier devices. And these A4 laser workgroup devices are increasing displacing the larger copier devices due to their smaller size, lower cost and improved functionality. And according to IDC, for the last 4 quarters ending the first quarter of '12, Lexmark continue to grow share in this A4 laser workgroup segment, and this is important since these are higher-usage devices which drive Supplies revenue.

Moving to Slide 9. During the second quarter, Lexmark announced it was named an MPS or Managed Print Services leader by 2 more independent firms, Forrester and Quocirca. This follows the earlier announcement in the fourth quarter of 2011 regarding our MPS leadership positioning in the Gartner and IDC reports.

As further proof, our overall Managed Print Services revenue grew again this quarter, and within the last 24 months, we competed for and won 19 new Managed Print Services contracts with companies listed on either the Global 500 or Fortune 500 list, which represent incremental business to Lexmark. We continue to believe this is a clear indicator that our value proposition here is strong and continues to be relevant with these large discriminating customers.

On Slide 10, you can see 2 recent examples of our expanding Solutions capability. With our recent win at the Federal Aviation Administration, a multiyear win, valued at $21 million, Lexmark will provide a broad range of capabilities and optimizing over 900 FAA locations, bringing greater efficiency, end-user productivity and cost reductions to the FAA.

Also in the second quarter, Perceptive announced that the University of Kansas plans to expand the use of Perceptive Software solutions to a university-wide contract. This will also include the use of Brainware's award-winning Distiller software to streamline invoice processing.

On Slide 11, we are now creating and delivering broader, higher value, industry-specific solutions for our customers more than ever. While we have increased the breadth and depth of our technology portfolio with the recent acquisitions, the competitive advantage comes at how we integrate these together to provide differentiated, seamless industry-specific solutions that can help our customers capture, manage and access key, unstructured content that today they're either completely missing, processing manually or having difficulty accessing.

So starting from the left side, Lexmark can now capture this unstructured content, electronic or hard copy, from a smart MFP, a scanner, desktop or mobile device. And we are leveraging our MPS enterprise presence along with our new Brainware intelligent capture expertise to help our customers extend their smart MFPs to now scan, classify and extract key content from documents all automatically and deposit the content directly into a core system or process, reducing time and manual labor costs in the process. Lexmark's intelligent capture expertise can also be expanded to their growing mobile and electronic information flows to capture unstructured content easily.

And on the middle of the slide, we can also build solutions to manage this unstructured content that's been captured as well as their unstructured processes and then connect them to their existing core systems. And on the right of the slide, with our search and analytics capabilities for both content and process, we can now give customers the ability to unlock and visualize key content or process relationships they've never seen before. Think of Lexmark now being able to help customers manage the unmanaged, print assets, content or processes, and give them access to any content, structured or unstructured, only when they need it and only in the context of their core processes.

As a reminder, on Slide 12, Lexmark's overall capital allocation framework is to return more than 50% of free cash flow to shareholders on average through quarterly dividends and share repurchases while pursuing acquisitions that support the strengthening and growth of the company.

In the second quarter, Lexmark paid a dividend of $0.30 per share, totaling $21 million and repurchased $25 million of the company's shares. For the first half, this represents a total of $94 million return to shareholders, $39 million through dividends and $55 million through repurchases. And we're planning to continue this and repurchase more shares this quarter.

Looking ahead on Slide 13, you can see our third quarter full-year 2012 and long-term outlooks. For the third quarter, our outlook is for revenue to be down 9% to 11% year-to-year. We expect earnings per share for the third quarter, excluding restructuring and acquisition-related adjustments, to be in the range of $0.75 to $0.85.

For full year 2012, our outlook is for revenue to be down 8% to 10% year-to-year. We expect earnings per share for the full year, excluding restructuring and acquisition-related adjustments, to be in the range of $3.70 to $3.90.

Long term, our outlook is to grow revenue at or above the market with an operating margin in the range of 11% to 13%.

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

John W. Gamble

Thank you, Paul, and good morning. Let me begin with the P&L. The discussion that follows is on a non-GAAP basis and reflects non-GAAP adjustments unless otherwise noted. As a reminder, included in the earnings supplemental materials posted to the Investor Relations section of the lexmark.com website are reconciliations of GAAP and non-GAAP measures.

2Q '12 was a very challenging quarter. Our results were below our expectations, reflecting 2 primary factors: The dollar strengthened substantially during the quarter, negatively impacting revenue by approximately 2 percentage points relative to our expectations. Approximately 2/3 of the currency impact was in EMEA, with Latin America and Asia Pacific driving the remaining impact. And weakening economies globally impacted demand for both Hardware and Supplies. The impact was most pronounced in EMEA, but also evident in Latin America and Asia Pacific and, to a lesser extent, North America. For Hardware, we saw customers delay delivery schedules on committed purchases, as well as defer decisions on new transactions.

For Supplies, sales ran below our models, with the greatest impact in EMEA. This variance drove the remainder of the weakness in revenue versus our expectations. I will provide more detail on this later.

Supplies channel inventory did decline in the quarter, impacting year-on-year Supplies growth by about 2%. However, this decline was approximately as expected and did not impact our performance relative to expectations. In terms of operating income, the impact of the stronger dollar versus our expectation was approximately $0.15 a share. Although we did take cost expense and other actions during the quarter, the weakening demand environment mitigated this benefit.

We did have positives in key parts of our Core in the quarter. Managed Print Services continued to show growth despite the impacts described above, up about 8% in the quarter and 12% for the first half year-to-year. Perceptive Software grew 88% year-to-year, about 26% excluding acquisitions, much faster than the market and consistent with our expectation. Integration of our most recent acquisitions of Brainware, ISYS and Nolij are proceeding well, with performance ahead of our expectations.

Turning to Slide 15. Total revenue for the second quarter was $921 million, down 12% compared to last year, down 7% sequentially from 1Q 2012 and below the guidance we provided in April. Core revenue declined 9%. Legacy revenue declined 35% year-to-year and represented only 9% of total Lexmark revenue in Q2 2012.

By the end of 2012, we expect Legacy revenue to represent less than 6% of total Lexmark revenue. Currency negatively impacted revenue over 4% year-to-year and 1% sequentially. Total Core revenue was negatively impacted by over 4% year-to-year due to currency and approximately 2% year-to-year due to declines in first-tier channel inventories.

Excluding these impacts, Core revenue decline was about 3%. I will discuss these and other factors in more detail in our discussion of Supplies revenue.

ISS segment revenue in 2Q 2012 of $875 million was down 14% versus 2Q 2011, down 9% sequentially. Despite continued growth in MPS revenue, overall Supplies and Hardware revenue declined. I will cover this in more detail shortly.

Perceptive Software revenue in 2Q 2012 was $46 million, up 88% year-to-year and up 55% sequentially. Excluding revenue from acquisitions completed over the last 4 quarters, growth was 26% year-to-year. Perceptive's revenue reflects growth in both North America and internationally and was in line with our expectations. We remain very positive about Perceptive and the opportunity to deliver new industry products and solutions through the combination of Brainware's capture technology, ISYS' search technology and Perceptive process and content management technologies. We continue to expect revenue growth to accelerate in 3Q versus the growth generated in the first half of 2012.

As shown on Slide 16, geographically, for the second quarter, U.S. revenue of $394 million declined approximately 11% year-to-year. EMEA revenue of $332 million declined about 13%, and the remaining geographies had combined revenue of $195 million and declined about 13%. The declines in all regions reflects the weakened demand environment. As we have reference in the past, Legacy consumer inkjet revenue was greatest in the U.S., driving much of that decline. The decline in EMEA, Latin America and Asia Pacific also reflect the impact of the stronger dollar.

As shown on Slide 17, Hardware revenue in the second quarter declined 17% year-to-year with Core Hardware revenue down 16%. Large workgroup hardware revenue, which in 2Q 2012 represented about 75% of total hardware revenue, was now down 9% year-to-year, driven by a 6% decline in units.

Large workgroup hardware AUR declined 3%. We did continue to see strong performance in both large workgroup MFPs and large workgroup color, which grew low-double and mid-single digits, respectively.

Small workgroup hardware revenue, which in 2Q 2012 represented 25% of total hardware revenue, declined 32% year-to-year, driven by a 53% decline in units. Small workgroup hardware AUR increased 45%. The decline in small workgroup revenue included a 60% decline in inkjet hardware revenue, driven by our exit from the retail channel.

Supplies revenue in the second quarter was down 14% versus 2Q 2011. Core Supplies revenue declined 10% year-to-year. This is much weaker than expected and much weaker than the Core Supplies growth we have seen consistently over the last several quarters. Core Supplies growth year-to-year was negatively impacted by the following factors: Currency negatively impacted Core Supplies growth by about 5%. As expected, first-tier channel inventory contracted in the quarter, negatively impacting Core Supplies revenue growth by about 3%. This is approximately consistent with our expectations. Excluding FX and channel movements, Core Supplies were down approximately 2% year-to-year. And finally, a weakening demand environment, particularly in EMEA, which has resulted in Supplies demand running well below our historical models.

This change in Supplies demand was sudden, and, based on our analysis of input from our channel partners as well as end-user data from our MPS customers, was driven by the following factors: the sudden nature of the change as well as input from our channel partners suggest that a reduction in second-tier channel inventory and pantry stock is a significant contributor to the decline in Supplies demand in 2Q; and an analysis of usage data from our MPS customers does show a pronounced reduction in usage in the current period.

As these impacts were sudden, we, at this point, do not have evidence that they are the result of a longer-term trend in printing behavior. In fact, as Paul indicated earlier, they appear similar to, although less severe, than the impacts we saw in late 2008 and 2009, when Supplies demand also ran below our models. As we know, late in 2009 and 2010, as economic conditions stabilized, we saw a recovery in Supplies demand. At this point, we certainly do not know if that will be the case again. And as we have said consistently, we have a very limited view into our channel.

Legacy Supplies declined 34% or $45 million in 2Q 2012 versus 2Q 2011. Legacy Supplies represented only 13% of total Supplies revenue in 2Q 2012 versus 17% in 2Q 2011. By the end of 2012, we expect Legacy Supplies to represent less than 10% of total Supplies.

In 2Q 2012, Software and Other revenue was up 26% year-to-year, driven by the 88% growth in Perceptive Software.

As shown on Slide 18, gross profit margin for 2Q was 40.5%, up 50 basis points versus 2Q 2011 and up 110 basis points sequentially. This is a continuation of the trend in increased gross margins as we grow our Software business. The year-to-year increase was driven by 340 basis points of positive mix, largely offset by 290 basis points of lower product margins. The 340 basis points of positive mix was principally driven by less Hardware, principally inkjet, and more Software. The 290 basis points of lower product margins were primarily due to the unfavorable movements in currency discussed earlier.

The sequential increase in gross margin of 110 basis points was driven by positive product margins of 350 basis points, principally in Hardware and Software, partially offset by 240 basis points of unfavorable mix. The 240 basis points of unfavorable mix was due to a higher relative percentage of Hardware versus Supplies.

In 2Q 2010, as expected, we did not incur significant costs, net of insurance recoveries, related to the Thailand floods. As we indicated previously, we expect the majority of all costs incurred related to the Thailand floods to be covered by insurance, net of deductible amounts.

Turning to Slide 19. Operating expense for the quarter of $280 million was slightly better than our expectations and up $10 million versus 2Q 2011 and down $2 million sequentially. The year-to-year increase was driven by ongoing Perceptive investments, including the acquisitions completed over the last 4 quarters.

As expected, overall R&D declined slightly versus 1Q 2012, resulting in the sequential decrease in OpEx. As shown on Slide 20, operating income for the second quarter of 2012 was $93 million, down $55 million versus 2Q 2011 and down $16 million sequentially.

ISS segment operating income in 2Q 2012 of $165 million was weaker than expected, down $52 million versus last year and down $23 million sequentially. The weaker-than-expected operating income reflects the negative currency and weaker Supplies demand that I referenced earlier.

Perceptive segment operating income in 2Q 2012 was negative $2 million, consistent with our expectation of significant improvement versus 1Q '12. We continue to expect Perceptive to operate at breakeven or slightly better over second half '12.

All other operating income of negative $70 million was in line with our expectations and down slightly from 2Q 2011. Operating income margin in 2Q '12 was 10.1%, down 410 basis points from 2Q 2011 and down 90 basis points sequentially, primarily reflecting the ISS operating income decline.

Now turning to Slide 21. Net earnings for the quarter were $64 million or $0.89 per share, compared to 2Q 2011 net earnings of $109 million or $1.36 per share. Our effective tax rate in 2Q 2012 was approximately 25%, and in line with expectations.

In summary, 2Q '12 was a challenging quarter. The decline in 2Q '12 revenue and operating income versus 2Q '11 reflects 3 main items: the over 4% negative impact of foreign currency or approximately $50 million on revenue; the reduction in Legacy revenue of approximately $45 million; and a weakened demand environment, particularly in EMEA, including the impact of the reduction in first-tier Supplies distributor channel inventory.

Despite this very difficult quarter, we did continue to make good progress in the strategic areas of MPS and Software as we continued growth in both areas. Please note that my comments on the balance sheet, cash flow and cash conversion cycle are based on GAAP results and refer to Slide 22.

Cash and marketable securities at the end of 2Q 2012 was $916 million, down $34 million from March 31, 2012. This reduction reflects $46 million in cash returned to shareholders, $25 million through share repurchases and $21 million through dividends during Q2.

June 30, 2012, U.S. cash and marketable securities balances were $79 million. Total debt at the end of 2Q 2012 was $650 million, with $350 million maturing in 2013 and the remainder in 2018.

Cash flow from operations for the quarter was $49 million compared to $94 million in 2Q 2011. Free cash flow was $11 million, below the $60 million generated in 2Q 2011. This free cash flow is disappointing and was a result of lower net income as well as increased working capital of $26 million.

During the quarter, we saw good inventory performance, down $23 million. Payables declined $44 million, but this was consistent with expectations as inventory declined and production levels declined, reflecting our lower unit shipments. Working capital increased, however, as receivables did not decline with lower revenue levels. This was driven by 2 main factors. Early payments by customers declined in the period. This generally occurred outside the U.S., including EMEA, and we believe is likely a reflection of weak economic conditions in those regions and the timing and mix of revenue.

Overall, our receivables, delinquencies and losses remain very low. We are addressing our processes in second half '12 to address the 2 factors impacting 2Q '12 results and to bring cash flow back toward the level of performance we have traditionally delivered. Our goal remains to generate free cash flow equal to 90% to 100% of non-GAAP net income.

Depreciation and amortization for the quarter was $57 million, approximately $11 million of which is accelerated depreciation related to restructuring and amortization of acquisition-related intangible assets. Capital expenditures were $38 million.

Now turning to Slide 23. In 2Q 2012, we continued the execution of our capital return framework of returning more than 50% of free cash flow on average to shareholders through a combination of dividends and share repurchases. In 2Q 2012, we returned $46 million. At quarter end, we had approximately $186 million of share repurchase authority remaining under the share repurchase program, which has no expiration date.

Since the beginning of 2011, we have returned 123% of free cash flow to shareholders in the form of dividends and share repurchases. Of this, dividend payments represented approximately 19% of free cash flow.

In the Investor Relations slide deck, we have provided estimated dates for dividend declaration and payment for 2012 and '13. Shares outstanding at 6/30/2012 were 70.305 million. Average shares outstanding for use in calculating diluted EPS for 2Q 2012 were 71.492 million.

Non-GAAP adjustments for the second quarter of 2012, consisting of restructuring and acquisition-related costs and expenses, were $33 million on a pretax basis or $0.34 per share. This was slightly higher than the $0.30 per share we had estimated. As you will remember, at our earnings release in April, we had not completed the purchase accounting for all acquisitions. This has now been completed, and integration costs and completion of purchase accounting resulted in the increase in non-GAAP adjustments.

Please refer to Slide 24 for my forward-looking comments for 3Q 2012. We expect third quarter revenue to be down 9% to 11% year-to-year. This guidance is equivalent to sequential revenue performance of flat to up 2%, with this range being consistent with normal sequential trends. We are assuming the economic conditions we saw in the second quarter will continue throughout the remainder of 2012. This outlook includes a year-to-year negative currency impact to revenue of approximately 4 percentage points, a reduction in Legacy revenue, impacting total revenue growth by approximately 4 percentage points, and assumed reduction in first-tier Supplies channel inventory and the continuation of the demand softness we saw in 2Q '12. Due to these negative impacts and despite continued growth in strategic focus areas of MPS and Software, we expect Core revenue will decline in 3Q 2012 and for the full year 2012.

GAAP EPS in 3Q 2012 is expected to be $0.52 to $0.62 per share. GAAP EPS in 3Q 2011 was $0.86 per share. In 3Q 2012, non-GAAP adjustments made up of restructuring and acquisition-related costs and expenses are expected to be $22 million. This includes restructuring costs of $0.07 per share and $0.16 per share of acquisition-related cost and expense.

Non-GAAP EPS is expected to be $0.75 to $0.85 per share. Non-GAAP EPS in 3Q 2011 was $0.95. The decline in non-GAAP EPS versus 3Q 2011 is more than explained by the negative impact of currency and lower Supplies revenue from the ongoing decline in Legacy Supplies. We are also expecting a continuation of the reduction in first-tier Supplies channel inventories and of the weaker demand we saw in 2Q '12. Partially offsetting this decline are lower losses related to the placement of inkjet hardware, lower shares outstanding, reduced operating expense and improved performance at Perceptive.

In the third quarter, we expect the gross profit margin percentage to be consistent with 3Q 2011. Operating expense is expected to be below the $280 million incurred in 2Q 2012. Operating income margin in the third quarter is expected to be down from the 10.4% level achieved in the third quarter of 2011.

We expect the effective tax rate for 3Q 2012 to be about 25%. As we indicated during the last 2 earnings calls, the tax rate of 25% reflects approximately 2 percentage points of increased tax rate due to the expiration of the U.S. R&E tax credit. Our planning assumption is that Congress will pass the U.S. R&E tax credit by the end of 2012, resulting in a full-year tax rate of approximately 23%. Our guidance is based on foreign exchange rates as of June 30, 2012. At these rates, the currency impact on revenue in 3Q 2012 versus 3Q 2011 is negative 4% and is negligible versus 2Q 2012. At these rates, the currency impact on revenue in second half 2012 versus second half 2011 is expected to be negative 3%.

Our expectation for the 2012 calendar year are shown on Slide 25. We expect revenue to decline 8% to 10% in 2012 versus 2011. The decline versus 2011 includes a negative 3% impact of currency. Legacy revenue, all Supplies in 2012, is expected to decline 35% to 40% from the approximately $510 million in Legacy revenue we had in 2011. This results in a minus 4% to minus 5% impact on total revenue in 2012 year-to-year.

The impact of Legacy declines combined with currency represents an approximately 7% impact on revenue in 2012 year-to-year. Core revenue is expected to decline slightly greater than the impact of currency, reflecting our expectation that the weak demand environment we saw at the end of 2Q '12 will continue through the remainder of 2012.

We continue to expect to see good growth in the strategic segments of MPS and Software and unit growth in large workgroup Hardware. Overall, by the end of 2012, Legacy revenue should decline to be less than 6% of total revenue. We expect operating income margin to be in the 9% to 10% range, below what we previously indicated. EPS is expected to be in the range of $3.70 to $3.90 a share. The decline on our full-year guidance on revenue and operating income is driven by the significant weakening of foreign currencies and weakened demand environment expected for the remainder of 2012.

As Paul indicated, as we look forward, we remain focused on delivering Core revenue growth and operating margins in the range of 11% to 13% as well as to returning over 50% of free cash flow to shareholders through dividends and share repurchases.

In terms of revenue, accelerating the growth of our software solutions capabilities, which both accelerates the growth of our Software business and enables continued increased share gains and high-usage large workgroup devices and MPS, will, we believe, allow us to deliver Core growth as currencies and markets stabilize. This shift should also continue to support strong gross margins.

In addition, as Paul indicated, we are currently determining the actions needed to focus our investments in these core growth areas and adjust our cost structure to reflect current market conditions and improve performance in the near term.

For the calendar year 2012, we expect free cash flow to be approximately 90% to 100% of non-GAAP net income; capital spending is expected to be approximately $185 million; and depreciation and amortization is expected to be approximately $240 million, of which approximately $46 million is accelerated depreciation related to restructuring and amortization of acquisition-related intangible assets. We anticipate pension funding of approximately $40 million in 2012, with $15 million in the remainder of 2012.

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 the line of Toni Sacconaghi of Sanford Bernstein.

Eric Garfunkel

This is Eric Garfunkel, dialing in for Toni. If we look at your updated guidance for FY '12, it's about $1 lower than you had previously stated. Can you just help us understand the relative impacts of currency, the macro environment and more specifically, also assumptions around changes in Supplies inventory and Supplies usage? And then I have one follow-up.

Paul A. Rooke

Eric, it is a more significant drop certainly in our full-year guidance there, primarily currency and this weakening demand environment that we're seeing are the primary factors. Certainly, we continue to have the Legacy headwind that declines as well. But back to the economic demand impact, what we're seeing -- a couple of things. We're seeing it in our channel, where the channel gets a little more nervous about taking on inventories, particularly in fluctuating currency environments. As we mentioned, we're seeing it in our end-user demand as well, which is some data -- which is a subset of our install base in our Managed Print Services business, but nonetheless an indicator of end-user usage. And we saw a decline there as we went through the quarter, so those are the big factors in adjusting our demand. As we mentioned, we've gone back in history and looked at this and we saw similar impacts back in the late '08, '09 time frame. And whether this is a repeat of that, we don't know. We're not here to predict in the future, but all I can say is that we've seen the change and reflecting it in our guidance here for the remainder of the year, and we'll see as we go whether it returns to the normal patterns as it did before.

John W. Gamble

And in terms of relative magnitude, the currency and demand impact are kind of equal, about 50-50.

Eric Garfunkel

Okay. And then my follow-up was just if I look at your guidance just based on spot rates of June 30, but it looks like the dollar has strengthened by about 4% versus the euro since then. And that seems to be a similar change that occurred in Q2 versus when you had set your guidance as of the March 30 spot rates, and that was a $0.15 EPS impact. So at current spot rates, how confident are you guys in your current EPS targets for both Q3 and the fiscal year?

John W. Gamble

Yes. So obviously, we've seen the movements in currency rates. And so at this point, we think we're in a position to be able to deliver the guidance we indicated.

Operator

Your next question is coming from the line of Shannon Cross of Cross Research.

Shannon S. Cross - Cross Research LLC

I have one and then a follow-up. The -- could you talk a little bit more in detail on linearity in the quarter? I mean, clearly you said, it got worse. I'm just kind of curious from a geographic standpoint, sort of what you've heard in the U.S. versus Europe and were these from conversations with the channel and the customer? Just -- if you can give any more detail on sort of what people are telling you as they look forward in the third quarter.

Paul A. Rooke

I'd say, Shannon, geographically, as we mentioned, it was more pronounced in Europe. Although we did see weakness across the other geos, but certainly more in Europe. The back end was worse than the front end, and I'll leave it at that. But on the channel and the whole Supplies usage piece, I mean, we don't have full visibility into our channel or end users, so -- but we do obviously interact with our channel folks. And they -- I think as -- in some of these geographies, there is more nervousness during uncertain economic times, and so they tend to pull back on the inventories they hold. And the end user data, like you say, is a subset of our total install base, but yet an indicator that we felt was strong enough to reflect it in our guidance.

Shannon S. Cross - Cross Research LLC

Okay. And then, John, can you talk a little bit about -- you said you're going to work on targeting the receivables in the second half. Can you give some specifics in terms of what you're doing there, because clearly, with $55 million of free cash flow in the first half, you're going to have to see a pretty substantial increase in the second half to meet your targets. So any more details on specifics on what you're doing on working capital would be great.

John W. Gamble

Sure. So, I mean, the focus is -- as we said, inventory performance was good and we'll continue to work inventory. We think we can make some continued performance improvements in inventory. Payables, payables should naturally improve, right, because the -- we did obviously reduce production levels as we saw weaker performance in the second quarter. So we should see the cash benefit of the lower production levels that we had in the second quarter and the third quarter, so that should happen naturally. Receivables is the place that requires the most work, and there it's really a focus of certainly on collections, but more than that, since collections performance really hasn't been -- has been okay, it's really around the overall revenue cycle and cash collection cycle, starting right from billing processes all the way through collection processes. And we're just going to see what we can do to accelerate each of the pieces of those activities, especially as it relates to a Services business and a Software business.

Operator

Your next question is coming from the line of Ananda Baruah of Brean Murray.

Unknown Analyst

This is Matt [ph] for Ananda. I have a question and a follow-up. The first question is, what is the market growth for your Core market? And are you holding share?

Paul A. Rooke

Matt [ph], certainly, if you look at the market, last year, the Imaging market was down. This year is shaping up, I think, to be another down year. And time will tell what happens as we go into 2013, but what we're assuming right now is it'll be more of the same. It's hard to predict these economic cycles, but nonetheless it's a stagnating environment out there and so we think it's prudent to plan for that. So that's our assumption, is that it's certainly a flat-to-down at best market out there right now.

Unknown Analyst

And the follow-up was, we understand that the Europe [indiscernible] softest relative to what you're expecting, but other geos were similarly soft. What do you think is happening? And if the U.S. economy significantly slows down, how soft can you see the U.S. getting?

Paul A. Rooke

Yes. Well, Europe was more pronounced in the softness. We did see it across the other geos, so it's not just a -- only a Europe problem. It's hard to predict the future of what's going to happen, but we have, as you can tell in our guidance here, reflected the softer environment going forward through the end of the year.

Operator

Your next question will come in from Alban Gashi of Crédit Suisse.

Alban Gashi - Crédit Suisse AG, Research Division

I just have a quick question. Sort of on longer term, you reiterated your operating margin expectations of 11% to 13%. Sort of what do you need from a revenue perspective in that area? And then what's your willingness to continue restructuring cost cutting to sort of get there longer term?

Paul A. Rooke

Yes. Like I said, we've had a setback here certainly with the headwinds of currency and weaker economic environment. And we thought it was important to reinforce our commitment to our long-term margin there of 11% to 13%. Now our -- to get back to the 11% to 13% is all about first growing the core. So we're very focused on growing our workgroup MFPs, the Smart MFPs, as we refer to them, growing our Managed Print Services business, growing our Software business. In all 3 of those, you saw growth here, even in a very tough quarter, continued to grow for us. Now the Legacy piece of it will continue to decline. We expect here it's going to be about 6% here by the -- of our revenue by the end of the year. And certainly by 2015, it's going to be less than $50 million, so that will naturally take its course. We do expect to improve our profitability in the Software business as we go forward, so that'll contribute to profit. And then, as you mentioned, cost and expense, actions we've taken before, we're quite capable of overcoming these types of challenges, but we don't have anything definitive to say today about that. But rest assured, we've done it in the past and we're looking at all aspects of our business currently.

Alban Gashi - Crédit Suisse AG, Research Division

Okay, great. And as quick follow-up on your offshore cash. It's been building up -- I think it's over $800 million currently, how do you think of the use of cash, the offshore cash particularly?

John W. Gamble

So in terms of our cash, so what we're focused on, as Paul said, is obviously, we do have a return policy to shareholders, of returning over 50% of cash to shareholders. And we think we've done a very good job of exceeding that since we really initiated it in 2011. In terms of the geographic distribution of cash, we continue to look toward acquisitions to strengthen the -- our software and services businesses, and we'll continue to do that as a go forward in the context of our capital return philosophy that we talked about earlier.

Operator

Your next question is coming from the line of Katy Huberty of Morgan Stanley.

Kathryn L. Huberty - Morgan Stanley, Research Division

I understand your focus is more on quality than quantity of an install base, but the 44% drop in Core Hardware units has to be at least somewhat of a disappointment. So can you talk about what actions you plan to take to reaccelerate growth in Core Hardware? And then I have a follow-up.

Paul A. Rooke

Katy, the Core Hardware, on the surface, certainly isn't going the direction we wanted, but you have to kind of peel it, peel it back. The large workgroup piece we are growing, particularly the MFP segment, the color segment, which are the key ones for us in terms of generating page usage and certainly revenue per page with the use of color. We saw similar trends in our small workgroup laser as well, and these are both in line with what we're seeing out in the marketplace. The negative that we saw was more pronounced in the small workgroup, which is really our exit of the inkjet SOHO product line that we had through our retail channel. So that's an action we're taking to exit that piece and move on, shift our business to the higher-value, higher-growth segments as we discussed. So that's it, kind of walking through the various pieces, and certainly, we're focused on growing those key strategic areas, particularly in the workgroup lasers.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. And then as a follow-up, how would you characterize the Supplies inventory adjustments that you expect in the third quarter relative to what you saw in the second quarter? Do you expect the adjustments to be greater or less than in 2Q? And do you have any visibility into fourth quarter inventory trends at this point?

John W. Gamble

It's hard to be really specific by quarter in terms of what the first-tier Supplies channel will do, but just generally speaking, I think in the remainder of 2012, we're expecting adjustments that are similar in size to the ones we saw in the second quarter of 2012. So in the second half, an adjustment in total, similar in size to what we saw in the second quarter.

Operator

Your next question is coming from the line of Ben Reitzes of Barclays.

Ryan Jones - Barclays Capital, Research Division

This is Ryan, in for Ben. I just wanted to get some color on when Perceptive Software starts to contribute to EBIT and kind of what level of profitability you're thinking it could contribute.

Paul A. Rooke

As you saw, it's growing quite nicely, and we were pleased with the 88% and 26% organic growth for Perceptive. We are, as we've said in the past, running it at more or less a breakeven. It varies by quarter, obviously, but -- as we're investing to grow it. But we do expect, as we move into 2013 and beyond, that it'll start to contribute to our overall profitability.

Ryan Jones - Barclays Capital, Research Division

Okay. And then for a follow-up question, I was curious about what level of unit consolidation you're currently seeing in your MPS deals.

Paul A. Rooke

Are you referring to the amount of install bases when we do an MPS deal, how much we reduce them?

Ryan Jones - Barclays Capital, Research Division

Yes, that's exactly it.

Paul A. Rooke

Yes, okay. Well, obviously, it depends on the customer. I mean, some customers are more or less efficient than others. So if it's a new customer just entering into the Managed Print space, I mean, you can see a 20% to 30% reductions in the amount of printers, because typically what you find is a lot of distributed small devices spread all over the place, and so the first job is to rationalize those and consolidate them, as you point out. Now, if you're engaging with a customer who has already kind of done that, then it'd be less obviously. So it really varies depending on the customer and their stage of efficiency in their printing infrastructure.

Operator

Your next question is coming from the line of Robert Schiffman of Crédit Suisse.

Robert Schiffman - Crédit Suisse AG, Research Division

On Slide 22, you mentioned maintaining investment-grade ratings, but you didn't mention it in your comments. I was wondering if the rating agencies indicated that they would potentially take you down to a BB. Would you be willing to change your shareholder return policies, i.e. how important is the IG ratings?

Paul A. Rooke

So we currently believe, given the performance that we expect to deliver, that we can maintain our investment-grade ratings as well as execute our capital return philosophy. So that's our goal and that's what we believe we can do, and that's what we're headed toward.

Operator

Your next question is coming from the line of Brian Alexander of Raymond James.

Unknown Analyst

This is Jeff [ph] in for Brian. Just going back to the revenue guidance really quick, the down 9% to 11% equates to roughly a sequential increase of flat to up 2%. And I believe that you said in your comments that your revenue guidance is assuming a 3% headwind from FX, and we know that the currency markets have kind of moved against that already. What gives you the confidence that you can grow revenues in local currency, especially given what sounds like pretty negative linearity in the quarter and these inventory adjustments?

Paul A. Rooke

Yes. So sequentially, Jeff, as you pointed out, it indicates kind of a flat to up, which is in line with the historical trends that we've seen. We do expect to see the Core improve here sequentially. We are expecting a stronger Hardware quarter here in the third quarter. We're seeing some good growth in our large workgroup, particularly in North America, with some of the deals that we have planned to execute here in the third quarter. So that's quite encouraging for us. Supplies, I think, will be more flattish sequentially. And then we do continue to expect to see the Software piece grow. As you saw the growth here in the second quarter, we expect to see strong growth in the third quarter as well. So I think the combination of the Hardware and the Software pieces sequentially here contributing to the Core growth to achieve what we've laid out.

Unknown Analyst

Okay, great. And you kind of touched upon my next question, which was the U.S. -- we saw a pretty negative decline, negative 11% in the -- compare that to EMEA, which was down 13% and had the negative FX headwind. It was just kind of surprising to us that the U.S. was actually, in local currency, appeared to be a lot weaker. And I know that you said that part of that was due to the Core or the Legacy business winding down, but it was just a lot more than what we had expected. Can you just give us some color on that?

Paul A. Rooke

Yes, I mean, that is the trend. I mean, the Legacy is a -- clearly the bigger factor there in the U.S. And when you net that out, then the U.S. would show better performance obviously against the European situation.

Operator

Our final question will be coming from the line of Shannon Cross of Cross Research.

Shannon S. Cross - Cross Research LLC

Just one follow-up. Can you talk a little bit about your thoughts on the inkjet business in general? I mean, clearly it's been a lot of under pressure. I mean, is this still a core technology for you? Just any more color you can give, given you've moved out off so many of the different retail channels and the units are down so much.

Paul A. Rooke

Shannon, as you point out, I mean, we've exited the consumer market. We're pulling out of the retail distribution of our SOHO platform. And so what we're doing is moving it up, as you've seen with the OfficeEdge platform, it's squarely focused on those workgroup segments, if you will, in business, and so it's really becoming a very targeted technology for us, and that's the way we viewed it. It's one of many technologies that we have in our portfolio to apply to various markets in addition to our mono laser, color laser, mono, color MFP technologies.

Shannon S. Cross - Cross Research LLC

What happens to the retail distribution of supplies though? How are your retail partners thinking about distributing your inkjet supplies given they won't be carrying your printers anymore?

Paul A. Rooke

Typically, a lot of it gets moved through the office superstores, and they're quite happy moving supplies even without the hardware being there. It's a profitable business for them, and it brings customers into their store. And so that traffic obviously is important to the retailer, so we don't see a problem there.

Operator

With that, I would like to turn it back over to Paul Rooke, Lexmark's Chairman and CEO, for closing remarks. Please go ahead, Paul.

Paul A. Rooke

In closing, while our second quarter financial results were impacted by currency and economic headwinds, we remain confident in our strategy, committed to improving profitability and focused on delivering value for our shareholders. We believe the investments we're making in our high-usage Hardware and high-value software technologies to bring new and differentiated solutions and services to market will drive long-term growth in our core, sustain margins and drive long-term value for Lexmark and our shareholders.

We've faced tough challenges before and overcome them. We'll continue to monitor this difficult demand environment and make adjustments accordingly as we move throughout the second half of the year. With that, I'll turn it back over to the operator to close out the call.

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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