Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

John Morgan - Director of Investor Relations

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

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

Analysts

Min Park - Goldman Sachs

Tony Sacconaghi - Sanford Bernstein

Shannon Cross - Cross Research

Mark Moskowitz - J.P. Morgan

Kathryn Huberty - Morgan Stanley

Bill Fearnley - FTN Midwest Research

Ananda Baruah - Banc of America Securities

Benjamin Bollin - Cleveland Research Company

Jeff Fidacaro - Merrill Lynch

Chris Whitmore - Deutsche Bank Securities

Lexmark International, Inc. (LXK) Q2 2008 Earnings Call July 22, 2008 8:30 AM ET

Operator

Thank you for standing by and welcome to the Lexmark International second 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

Okay. Good morning and thank you for joining us today. With me for Lexmark's second quarter 2008 earnings conference call are Lexmark's Chairman and CEO Paul Curlander and John Gamble, Lexmark's Executive Vice President and Chief Financial Officer. 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, if needed, one follow up so that we can get to everyone's question.

Later today a replay of this call will be available on our Investor Relations website located at http://investor.Lexmark.com. Currently on the homepage of this website you'll find today's earnings release as well as the supplemental slide deck for the second quarter, which includes the reconciliations of GAAP and non-GAAP financial information. You'll also find details on upcoming events, which includes our participation at the Citigroup 15th Annual Global Technology Conference on September 4th.

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.

Now before I turn it over to Paul, as many of you know we reached out to both top shareholders and sell-side analysts recently to better understand views on the company's guidance practices. I want to thank those that took the time to provide input on this. The significant majority of our shareholders responding to the survey indicated that they would like the company to continue offering quarterly earnings guidance. The majority of the sell-side analysts responding agreed. Currently our plan is to continue to offer quarterly earnings guidance. We continue to look at this, and we are, of course, open to additional input. Please don't hesitate to contact me with your thoughts on this.

Now with that, I'll turn it over to Paul.

Paul J. Curlander

Thank you, John.

Well, today we're announcing second quarter financial results that continue to reflect the strategy we began implementing in the latter part of 2007. Revenue for the quarter was $1.140 billion, down 6% year-to-year and about in line with our April 22nd guidance.

Earnings per share in the second quarter were $0.89 and were significantly better than our guidance. Excluding restructuring and related charges, earnings per share in the second quarter would have been $0.96, up 48% yeartoyear. This earnings per share overachievement was primarily driven by lower than expected sales of inkjet units.

Second quarter 2008 net cash from operating activities was $135 million, up from $124 million in the second quarter of 2007.

During the quarter we retired $150 million in short-term debt and then issued $650 million in long-term debt for a net increase of $500 million, effectively increasing our cash balance in the United States.

Also during the quarter we repurchased about 4.5 million shares of Lexmark stock with a total expenditure of $158 million.

For the quarter, our restructuring program that we announced in October 2007 continued to be on track. In addition, today we are announcing a plan to further consolidate our inkjet supplies manufacturing capacity. This plan includes the closing of our inkjet supplies facility in Chihuahua, Mexico by year end 2008. Now this is expected to impact about 650 positions, with most of these positions being moved to a lower-cost country. We estimate that this action will result in a total pre-tax cost of approximately $24 million, of which $8 million is cash, and an annualized savings of $9 million beginning in 2009.

Hardware revenue for the second quarter was down 19% year-to-year, primarily driven by unit declines, particularly in inkjet units.

Supplies revenue was about flat year-to-year in the second quarter but came in about as expected, with strong growth in laser supplies being offset by a decline in inkjet supplies. For the first half of 2008 Supplies revenue was down 1% year-to-year. 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 third quarter of 2008, our current expectation for Supplies revenue is a low single-digit decline year-to-year, about in line with the first half of 2008 results.

During the second quarter we continued to shift our consumer strategy to focus on devices, customers and countries that drive a higher paid usage. As a result, our Consumer segment revenue was $376 million, down 21% year-to-year, and Consumer segment operating income excluding restructuring was $27 million, up 98% year-to-year. For the second quarter, inkjet unit sales were down 49% year-to-year and were less than expected. The shortfall versus expectation came primarily in the U.S. and Europe as we continue to implement our change in consumer strategy.

Unit sales are being further impacted by market weakness and aggressive competitive price promotion activities while we have consciously been less aggressive on price and promotions than we were in the first half of 2007. In the U.S. our unit sales are also being impacted by our reduced shelf space versus last year.

For the quarter, inkjet average unit revenues were up 24% year-to-year, reflecting the strategy to prioritize high-end units which driver stronger usage while reducing entry level units. This increase in average unit revenue reflects strong year-to-year growth in our wireless inkjet sales, however the inkjet market continues to be very price aggressive, which is putting downward pressure on our average unit revenues.

Now as we look back at the second quarter, while we are not satisfied with the level of inkjet unit sales, this is just one part of a broad set of initiatives we're executing to shift the consumer strategy and turn this business around. We're shifting our marketing focus and targeted customer segments and are working to fully understand the needs and application requirements of the heavier-usage segments of student and professional users. We're shifting our investment in R&D to better design products and technology that will be attractive to these segments, and you're starting to see us deliver these targeted new products.

Interestingly, we're already getting industry recognition and winning awards as we improve the look and the capability of our inkjets, and we expect this to get even stronger as we continue to advance our technology. We're reengineering our supply chain to reduce costs, eliminate touches between the factory and the customers. We're working on our supplies to lower our costs and consolidate our manufacturing capacity, but we're also working to improve our supplies technology, increase the customer value and to improve our win rate in the aftermarket. In addition, the Consumer segment leadership team today is very different from the first half of 2007, with changes in eight of the top 10 leadership positions.

Now as part of this ongoing transition, we announced yesterday the introduction of three new members of our Home and Student Series and three new members of our Professional Series of inkjet products, with prices ranging from $99 to $199, the focus of these new announcements is to appeal to higher-usage customers. For example, all the new products feature our new industrial design and automatic document feeds, three of the new models feature twosided printing capability, and five of the new models include wireless connectivity. All the new Professional Series products feature high-yield ink cartridges and a five-year warranty with lifetime priority phone support. We expect these products to be coming onto retail shelves in September.

Already this year, three members of our Inkjet Professional Series have received editor's choice awards from Better Buys for Business, and in the second quarter the high-end of the Professional Series, the X9575, was recognized with awards from BERTL, a leading independent test laboratory, and from Computer Build Magazine.

Now in the Business market segment in the second quarter revenue was $763 million, up 4% year-to-year. Operating income excluding restructuring was $157 million, up 5% year-to-year, driven by strong growth and record revenue in laser supplies, however Hardware revenue was down as laser units in the quarter declined 12% year-to-year.

As was the case in the first quarter, this laser unit decline was due to declines in our low-end laser units as we hold the line on price and are not chasing entry level devices with low page usage and was due to workgroup unit decline in our North American Enterprise sales, particularly in the Government, Retail and Financial Services segments due to the current weak market conditions. However outside North America we had growth in branded workgroup laser units and every region other than North America grew their laser Hardware revenue year-to-year in the quarter.

Now despite this market weakness in the North American enterprise segments, we believe our laser product line and value propositions continue to be very strong. In fact, during the second quarter our Laser MFPs grew at a double-digit rate driven by strong growth in color laser multi-function devices and our managed print services revenue grew at a strong double-digit rate, including growth in North America as we continued to win enterprise services deals such as the win at Washington Mutual that we highlighted in our earnings release.

Let's talk about the third 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 and continued aggressive pricing. As a result, we expect third quarter 2008 revenue to decline in the mid to high single-digit range year-to-year, and we expect earnings per share to be in the range of $0.53 to $0.63 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 in new products and technology. This is producing a steady stream of new product introductions as well as a steady stream of product awards and industry recognition for our laser products.

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 enterprises, such as Washington Mutual. 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 propositions. The focus of all these Business market investments is to drive workgroup laser growth and page generation.

On the Consumer side, we're driving a significant change in our market strategy. Although we're seeing significant 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 price points and higher usage devices and the 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, an improvement in our average unit revenue despite an aggressive pricing environment, the introduction of new products such as our Professional Series and our Home and Student Series, and an increasing amount of industry recognition and awards for our inkjet products. We are also continuing to implement a restructuring of our business to lower our costs and better allow us to fund these strategic initiatives.

Now in closing, we continue to have a strong financial position with net cash at the end of the second quarter of 2008 - and by this I mean our cash balance minus debt - of about $680 million, and we continue to produce a good cash flow from operations.

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

John W. Gamble Jr.

Thank you, Paul, and good morning. Consistent with previous calls, I'll first discuss our results of the second quarter of 2008 relative to the prior year, then relative to the first quarter of 2008. 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 third quarter. I will call out the impact of restructuring related expense as we walk through the P&L. In the supplemental slide deck posted on our Investor Relations website we have included details on the income statement line items impacted by the restructuring related activities. Now let me begin with the P&L.

Total revenue for the quarter was $1.14 billion, down 6% compared to last year, down 3% sequentially from 1Q and in line with but at the lower end of the guidance range we provided in April.

Geographically for the second quarter, U.S. revenue of $432 million declined about 15% year-to-year. Revenue of $455 million in Europe grew about 2% year-to-year. The remaining geographies declined about 1% versus a year ago. The revenue decline in the U.S. was driven primarily by a decline in Consumer segment revenue as well as a decline in Business segment revenue reflecting weak U.S. demand.

Laser and inkjet Supplies revenue in the second quarter was flat year-to-year, with record results in laser supplies revenue being mostly offset by an ongoing decline in inkjet supplies. Supplies revenue in Q2 '08 was in line with our guidance.

Laser and inkjet Printer revenue in the second quarter declined 19% year-to-year. This Hardware revenue decline was primarily driven by lower inkjet Hardware revenue due to a 49% decline in inkjet units. Laser Hardware revenue also declined, reflecting the continued weakness in the North American market. Laser revenue in the quarter grew in all regions outside North America.

Laser Hardware unit shipments declined 12% in the second quarter versus the prior year. Despite the decline in overall unit sales, we saw strong growth in MFP unit shipments driven by our broader presence in the color MFP market.

Laser average unit revenue was up 4% year-to-year in the second quarter as the negative impact of pricing was offset by currency and favorable product mix.

Inkjet hardware unit shipments declined 49% year-to-year in the second quarter. A decline due to our previously announced strategy to aggressively shift focus to geographic regions, market segments and customers with higher page generation was expected. Inkjet unit sales in 2Q '08 were weaker than expected as the unit sales are being impacted by aggressive competitive pricing and promotion activity as well as overall weakness in the U.S. and European markets. U.S. inkjet sales also continued to be impacted by weaker U.S. shelf space versus last year.

Inkjet AURs increased 24% versus the prior year despite price declines primarily due to significantly improved mix reflecting a shift towards higher-end segments as well as currency benefits. The mix shift is consistent with our strategy. Please note the 24% increase in AUR is versus a 2Q '07 AUR which was the quarterly low point for 2007. And, as I mentioned earlier, the inkjet market is very aggressive in terms of both price and promotion, and this is putting downward pressure on our AURs.

Business segment revenue for the quarter of $763 million grew approximately 4% from the same quarter in 2007 and grew 3% sequentially from 1Q '08. The year-to-year growth in the second quarter was driven by Supplies revenue, partially offset by a decline in Hardware revenue. Hardware revenue decline was due to weakness in the North American market. All regions outside North America saw business segment revenue growth in the quarter. This sequential growth in Business segment revenue in 2Q '08 was driven by growth in both Hardware and Supplies revenue.

Consumer segment revenue for the quarter was $376 million, down 21% compared to a year ago and down 13% sequentially. The second quarter year-to-year decline was driven by both inkjet Hardware and Supplies revenue. The sequential decline was driven by both inkjet Supplies and Hardware revenue.

Gross profit margin for 2Q was 36.6%. Excluding restructuring related charges of approximately $4 million, gross profit margin would have been 37%, up 600 basis points versus the prior year and down 50 basis points sequentially. The 600 basis point second quarter increase versus last year was principally due to a 610 basis point increase in product mix, the largest factor of which were the impact from the decline in inkjet hardware shipments and the increased laser supplies. Sequentially, the 50 basis point decline is driven by a 70 basis point decrease in product margins, reflecting weaker Hardware margins partially offset primarily by a positive impact of APCLCM in the quarter.

Operating expense for the quarter was $316 million. Restructuring related expense of approximately $4 million impacted operating expense this quarter. Excluding this impact, operating expense was $312 million, an increase of $8 million year-to-year.

SG&A in the quarter was $209 million, an increase of $7 million, as increased marketing and sales spending was partially offset by lower G&A. The increase in marketing and sales expense in the quarter was demand generation investment, including media.

R&D in the quarter was $103 million, an increase of $1 million from 2007.

The impact of currency on operating expense versus 2007 was an increase of over $10 million.

Sequentially versus 1Q, operating expense excluding restructuring related expenses increased $6 million. SG&A increased $9 million, as increases in marketing and sales expense were partially offset by lower G&A. The increase in marketing and sales expense was higher demand generation, including media.

R&D expense decreased $3 million sequentially.

The operating expense to revenue ratio excluding restructuring related expenses was 27.4% in 2Q.

Operating income in 2Q was $101 million. Excluding total restructuring and related costs and expenses of $9 million, operating income was $110 million, up $39 million from 2Q '07 and down $25 million sequentially from 1Q '08.

Excluding restructuring related activities, Business segment operating income in 2Q '08 of $157 million was up $7 million versus last year and up $13 million sequentially. The increase versus 2Q '07 is due to higher gross profit, reflecting a more favorable product mix offset partially by increased marketing and sales and product development. The sequential increase was due to higher gross profit, reflecting Supplies growth partially offset by higher demand generation.

Again, excluding restructuring related expenses, Consumer segment operating income in 2Q '08 of $27 million was up $14 million versus last year and down $53 million sequentially. The $14 million increase in 2Q '08 versus last year reflects favorable product mix reflecting less hardware partially offset by less supplies. The $53 million sequential decline is driven by less supplies as well as increased demand generation.

Other expenses, consisting primarily of costs related to centralized supply chain, IT and other expenses, primarily G&A, were $74 million in 2Q '08 excluding restructuring related activities, a decline of $18 million from 2Q '07, reflecting lower operating expenses and no negative transaction effect of foreign exchange. Sequentially, the decline of $15 million reflects lower operating expenses and no negative transaction effect of foreign exchange.

Operating income margin in 2Q was 8.9%. Excluding the restructuring related expenses, operating income margin was 9.6%, an increase of 370 basis points from the second quarter of 2007 and a decrease of 190 basis points sequentially.

Concerning financing and non-operating costs, the net interest and other generated income of $2.7 million and was down approximately $8.5 million from 2007.

2Q '07 included an $8 million restructuring related foreign exchange pre-tax gain realized upon the liquidation of the company's Scotland entity. Adjusting for this one-time event, 2Q '08 was down approximately $0.4 million from the normalized year-to-year gain of $3.1 million in financing and other non-operating costs. Sequentially, net interest and other was down approximately $3.5 million.

During the quarter total debt increased by $500 million as we closed on $650 million in financing on May 22nd and repaid a maturing $150 million bond on May 15th.

In 2Q '08 we had an effective tax rate of 19.2% versus the 26% rate we had estimated. The lower effective tax rate reflects a $5.1 million nonrecurring tax benefit. We now anticipate our ongoing tax rate to be approximately 25% before any discrete events. This is slightly lower than our previous expectation of 26%. If the U.S. R&D tax credit is extended, we expect our effective tax rate in 2008 to reduce to about 23.5% before any discrete events.

Net earnings for the quarter were $84 million. Excluding the $7 million after-tax cost from restructuring related activities, net earnings in 2Q '08 were $90 million. 2Q '07 net earnings were $64 million or $62 million excluding after-tax restructuring related charges.

GAAP earnings per share for the quarter were $0.89. Excluding restructuring related activities, EPS would have been $0.96 per share. This compares to 2Q '07 GAAP earnings per share of $0.67 or $0.65 excluding restructuring related activities.

Earnings per share for 2Q '08 of $0.96 excluding restructuring related activities of $0.07 were significantly higher than the guidance of $0.65 to $0.75 per share we provided in April. Our revenue guidance for 2Q '08 was for mid single-digit decline, and we performed at the lower end of the range due to weaker inkjet hardware units and revenue. The significantly higher EPS was primarily driven by higher operating income reflecting lower losses on this lower than expected level of inkjet hardware units and revenue. In addition, there was a onetime nonrecurring tax benefit in the quarter of $0.05 per share.

Now moving to the balance sheet and cash flow items, cash flow from operations for the quarter was $135 million, up $12 million compared to 2Q '07 and down $42 million sequentially. Excluding restructuring related cash outflows, cash flow from operations was $143 million this quarter, an increase of $9 million from 2Q '07 and a decrease sequentially of $45 million from 1Q '08.

At the end of March accounts receivable decreased $40 million, inventory decreased $6 million, accounts payable decreased $5 million, and accrued liabilities decreased $48 million, primarily driven by a decline in taxes payable.

For the quarter, capital spending was $53 million. Depreciation in the quarter was $45 million and includes $2 million of restructuring related accelerated depreciation.

Currency of the Euro was accounted for at $1.56 compared to $1.35 in 2Q '07 and $1.49 in 1Q '08.

Cash and current marketable securities at the end of 2Q was $1.328 billion, up $448 million since March.

Total debt at the end of 2Q '08 was $650 million, an increase of $500 million since March.

In 2Q we repurchased 4.5 million Lexmark shares for $158 million at an average price of $34.85. At quarter end we had $887 million of share repurchase authority outstanding.

Now let me move to restructuring. As Paul discussed, we are announcing today the closure of an additional inkjet supplies manufacturing facility, our Chihuahua, Mexico supplies assembly facility. The focus of the plan is the further consolidation of our inkjet supplies manufacturing operations to reduce our fixed manufacturing costs and take advantage of lower cost manufacturing facilities. The closure referenced is expected to occur by year end.

The actions that we are taking are expected to transfer or eliminate approximately 650 positions by the end of 2008. We project the pre-tax cost of implementing these action to be approximately $24 million, of which $16 million is noncash, primarily accelerated depreciation, and $8 million is cash, primarily equipment relocation and employee severance. In 2Q 2008, $3 million of pre-tax expense was incurred. A total of $20 million of pre-tax restructuring and related expense is estimated to be incurred in 2008, of which $8 million will be incurred in 3Q '08. Annual savings for this program are expected to be $9 million beginning in 2009.

In 2Q '08, total restructuring and related costs and expenses, including the new facility closure in Chihuahua, were $9 million, of which $3 million was for the Chihuahua closure program announced today. During the quarter, we continued to make good progress on restructuring actions. Savings in 2Q '08 were about $9 million. Annualized full year savings for the 2007 and 2008 restructuring announcements are expected to be about $70 million in 2009.

Regarding the restructuring we announced in October 2007, we continue to expect the overall program parameters, costs and benefits to be the same as previously discussed. For brevity, let me refer you to the supplemental slide deck for the details of that plan.

As pointed out last quarter, movements in foreign exchange may result in changes in the cost and benefits of both the 2007 and 2008 restructuring actions.

From this point forward, restructuring comments and guidance will combine the existing 2007 and newly announced 2008 actions. In 3Q '08, restructuring and related costs and expenses due to restructuring actions are expected to be approximately $32 million. Savings in 3Q '08 are expected to be about $16 million.

Now for my forward-looking comments concerning 3Q '08. We expect third quarter revenue to be down in the mid to high single digit range year-over-year reflecting our continued implementation of our inkjet strategy, significantly reducing our inkjet hardware units and revenue versus 3Q '07.

Total Supplies revenue is expected to be down low single digit versus 3Q '07 as expected continued good growth in laser supplies is offset by a reduction in inkjet supplies revenue.

GAAP EPS is expected to be $0.25 to $0.35 in 3Q '08. GAAP EPS includes expected restructuring charges of $0.28 per share. Non-GAAP EPS, which excludes restructuring and related costs and expenses, is expect to be $0.53 to $0.63. GAAP EPS in the third quarter of 2007 were $0.48, which includes restructuring charges of $0.12. Non-GAAP EPS in 3Q '07 were $0.60. Please note, as we discussed in some detail at the time, 3Q '07 net income and EPS were positively impacted by the net tax benefit of $18 million recorded in 3Q '07 which included nonrecurring benefits and a reduction in the full year effective tax rate.

Our guidance for 3Q '08 EPS shows a significant sequential reduction from 2Q '08 driven by increased sales of inkjet hardware and a sequential seasonal reduction in laser supplies. Year-over-year, we continue to expect good growth in laser supplies.

In terms of our specific discussion of financial information, both the 2Q and 3Q data provided that I am comparing to are non-GAAP and exclude the impact of restructuring related charges.

In the third quarter we expect gross margin percentage to be down versus the 37% we achieved in 2Q '08. Operating expense is expected to be down compared to the $312 million incurred in 2Q '08.

As we look at operating expense for all of 2008, we expect 2008 operating expense to be somewhat higher than 2007. Overall, increases in Business segment R&D and marketing and sales and the impact of currency will more than offset reductions in operating expense in the Consumer segment and reductions in G&A and from restructuring. Currency impacts for the first half of 2008 alone have acted to increase operating expense by almost $20 million. Restructuring savings in 2008 in operating expense are expected to exceed $20 million or one-half of the total $40plus million of 2008 savings. In 2009, restructuring savings will increase to over $30plus million in operating expense.

Total R&D is expected to be up in 2008 as we increase R&D in the Business segment focused on color and MFP technology and products and solutions and services to allow us to continue to strengthen our ability to grow high page generating workgroup placements.

Total SG&A in 2008 is expected to be flat to up slightly with 2007. Marketing and sales will be up in 2008, again driven by the Business segment, where Lexmark invested in incremental direct sales resources and other demand generation again focused on expanding our workgroup coverage and placements. Consumer segment M&S will be down as we rationalize the Consumer business, focusing on high page generating customers and regions. Total G&A and other support costs will be down year-on-year as we continue to focus on reducing costs in support areas.

Operating income in the third quarter is expected to be below the 9.6% achieved in the second quarter of 2008.

For 3Q 2008 and the full year, we expect our ongoing effective tax rate to be about 25% 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 23.5% before any discrete events.

We project full year 2008 capital spending to be approximately $225 million, and we expect full year depreciation of approximately $200 million, which includes the accelerated depreciation from the 2008 restructuring program announced today. This includes approximately $30 million of total accelerated depreciation related to all restructuring activities.

With that we'll go ahead an open it up for questions.

Questions-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Min Park - Goldman Sachs.

Min Park - Goldman Sachs

You noted that Lexmark saw another quarter of healthy supplies growth from your Laser segment. Can you tell us if this growth is driven by higher usage within your installed base or were you impacted by fluctuation in channel inventory? And if you can give us a sense of what your overall supplies channel inventories look like right now, that'd be helpful.

Paul J. Curlander

As we look at the second quarter, we saw strong growth in laser supplies. There was a slight growth in channel inventory, but I don't think that was the major factor. I think we had strong end user demand. Some of this occurred because of the - we talked last time about the unusual timing of Easter into the first quarter. We saw an impact in Europe, where we had less ordering right at the end of the first quarter and some of that rolled over into the second quarter. So for the first half overall, we're about where we expected to be but a little more supplies ended up in the second quarter than the first quarter. But again, overall end user demand was good on the laser supplies.

Channel inventories, as I indicated, the laser supplies were up slightly as we went from the first quarter to the second quarter. Inkjet channel inventory supplies were down as we went from first quarter to second quarter. Overall, as we look at the channel inventory, from our perspective, you know, we're not expecting to see much material movement in the third quarter on channel inventory. Sometimes we get surprised by that but, overall, to us it looks about right.

Operator

Your next question comes from Tony Sacconaghi - Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

You bought back about 5% of your shares outstanding this quarter. Can you comment on what your ending diluted share count was, and then can you comment on ultimately what established that level of buybacks and whether it's reasonable to continue to expect buybacks at a similar level in the second half of the year?

John W. Gamble Jr.

Sure. In terms of the second part of your question, you know, Tony, you know what we did in the last quarter and certainly we did execute the borrowing and increased our debt by $500 million, effectively increasing our U.S. cash. Our policy continues to be to repurchase with excess U.S. cash. However, in terms of giving specific forecasts about the pace or specific levels of repurchases in a period, we really don't do that.

In terms of the absolute level of diluted shares at the end of the quarter, I believe it was about 90 million, but we'll check to make sure that was correct.

Tony Sacconaghi - Sanford Bernstein

And then if I could just follow up on the previous question around supplies, it sounded like you were maybe a little bit disappointed in inkjet supplies. My sense is they were down double-digits year-over-year. It sounded like you were pretty happy with laser supplies, up double, by my calculations up double-digits year-over-year. You mentioned that there was going to be no changes in - you didn't expect big changes in, material changes, in channel inventory going forward. Do you expect the forces of the business to dramatically change the supplies growth rates for laser or inkjet materially in the second half of the year versus the first half of the year?

Paul J. Curlander

Well, Tony, I think as we look at the second quarter, currently we continue to be happy with the laser supplies revenue growth. We did have strong growth in the second quarter. On the inkjet side, obviously we had expected a decline in the inkjet supplies. Overall, our Supplies revenue came in just about where we expected, about flat on a year-to-year basis.

You know, I think as we go forward in time we think that certainly in the third quarter, which is the only guidance that we've given, we expect it to be somewhat similar to what we've seen in the first half, all right? We expect to see good growth in laser supplies. We expect to see ongoing declines in inkjet supplies. We expect the overall growth rate to be in line with what we see in the first half, which is slightly down on a year-to-year basis.

So that's pretty much how we see it right now.

Operator

Your next question comes from Shannon Cross - Cross Research.

Shannon Cross - Cross Research

I was just curious. Could you talk a bit about, you know, your overall philosophy for the inkjet business? Obviously you just launched six new products. You are shutting down inkjet capacity. But how are you looking at that business? How are you thinking about investment in that business? And, you know, if you can talk a bit also about what you're seeing from a pricing standpoint because it seems as if, you know, pricing for inkjet hardware is getting pretty aggressive.

Paul J. Curlander

Well, I think our philosophy on it is in line with what we've articulated over the last several quarters. You know, we're focused on shifting the business to basically get after the units that drive a higher usage. So, I mean, I think the way to think about this as we're thinking about a smaller business, a smaller number of units but units that drive much more pages per placement than what we've seen in the past. And we're talking about ultimately trying to get to some significant multiples of pages per placement from where we've been in the past.

You know, I think as we continue along what you can see is results of the set of initiatives we're driving in a broad set of areas. What you're starting to see clearly is the impact from our shift in target to go after the heavier usage customers, particularly the students and the professional customer. You can see it in the product set that we just announced yesterday, you know, expanding our Home and Student Series as well as the Professional Series. And continue to bring more features and better industrial design, better look and feel to the products.

And as I pointed out earlier, what's interesting to me is just as we improve the look and feel of the products as well as put some additional feature function into it, we're already again starting to win product awards. And this is before we've really done any significant advancement in our technology, which we're working on in R&D. So we've shifted the R&D to basically get after some additional technology things, and obviously those types of things are in the pipeline for us as we go forward. So from an investment perspective, we're looking to make investments in these new segments.

On the capacity side, I mean, I think the thing to understand about the inkjet supplies capacity is a couple things. As we look back to when we first built these facilities, our capacity and productivity has increased dramatically and we're able to get significantly more production out of these facilities than what we had envisioned when we first constructed them. So as we've ramped up inkjet supplies, in the end we've built fewer facilities than what we would have thought at the beginning of that ramp up mainly because of the increase in productivity.

We continue to drive efficiency and productivity in these facilities, and as inkjet supplies decline what we see is the ability to get by with fewer facilities than where we were. So obviously in January 2007 we were sitting with five inkjet supplies facilities. In January 2008 we're at four. In January 2009 we'll be at three. So really this is all about increasing productivity and efficiency in the facilities.

Now as we look forward in time obviously we're focused on the time when we get to where we're growing our hardware units and growing our Supplies revenue. What we're looking to do there is continue to drive productivity and efficiency in the future supplies design, so we're looking for more efficiency there. We're also potentially looking to do much more leveraging of outsourcing on some elements of the supplies as well as go forward in time.

Shannon Cross - Cross Research

So [break in audio] clarify that you're not shutting down inkjet because - you know, you're not shutting down the inkjet cartridge facility and that's sort of a step in closing the overall business. You're still very focused on inkjet.

Paul J. Curlander

Oh, yes, we're still very focused. It's just increasing productivity and efficiency and helping us take some cost out while still maintaining the capacity that we need to drive the business. And, as I say, in the future we think the inkjet supplies will be more efficient, and we may change the sourcing structure a little bit so we won't need those facilities.

You mentioned pricing. Pricing is very aggressive in the second quarter. Clearly, we saw the market weaken more in the second quarter. In the U.S., the overall revenue decline year-to-year in the market was about the same, but the big change for us really was in Europe. We saw the Europe market weaken quite a bit more in the second quarter, and whenever that happens you see a lot of aggressive competitive price promotional activities and we certainly saw that in the second quarter.

Operator

Your next question comes from Mark Moskowitz - J.P. Morgan.

Mark Moskowitz - J.P. Morgan

A clarification first. I heard the commentary on the 3Q gross margin, but I may have missed it. Did you comment on the full year gross margin directional trend?

John W. Gamble Jr.

No, we did not. We just gave a 3Q outlook.

Mark Moskowitz - J.P. Morgan

Can you give us a sense, given that you did provide OPEX and other operational parameters, what is kind of the swing factor or gating factor to that full year gross margin? Are you anticipating maybe more downward pressure because of the pricing you just addressed with Shannon's question?

John W. Gamble Jr.

In terms of gross margin, the major factors obviously that impact our gross margin are the same factors that impact it every period, right, which is generally mix around supplies versus inkjet hardware and then to a degree laser hardware.

But in terms of giving specific direction on those individual items or on gross margin beyond the third quarter, we're just not going to do that yet.

Mark Moskowitz - J.P. Morgan

And then John or Paul, my question is regarding the managed print services business. Can you talk about the context there in terms of how much the laser supplies growth is really driven by managed print services in terms of increasing traction right now and how sustainable is that going forward?

Paul J. Curlander

Well, the managed print services business for us overall is still a small portion of the total business market segment revenue, but it's a fast growing piece. We saw strong growth in that revenue in the second quarter. Obviously, as we count that revenue, we count hardware. We also count supplies. And, you know, as we go forward we continue to see supplies, you know, the percent of supplies that's in the managed print services increase. Again, it's a small overall percentage still of what we do.

What we like about the managed print services business is first of all it allows us to really leverage Lexmark's strengths and differentiation versus the competition. So it moves us away from just a focus on hardware, because we think we have better hardware and obviously we're winning awards on our hardware, but for many customers it's hard to differentiate on hardware alone.

When we move over to services we have a very strong differentiation, how we're really helping our customers to print less, to consolidate equipment, and we've invested in a set of infrastructure that we think is second to none in terms of global enterprise class capability to actually manage an ongoing fleet of distributed devices. And when our customers really take a look at our capabilities and the references that we have, we win. And this is what we're seeing in the managed print services side.

Now not every customer is interested in that. It tends to be a little bit longer sales cycle, obviously, than just selling hardware. But this is the focus that we have, and as we go forward we would expect to see growing percentages of both hardware and supplies roll into that business.

But what's great about it is typically you're signing a longer-term contract with the customers and you're locking up the supplies versus just selling hardware where then you're subject to third-party aftermarket remand potentially moving into those devices.

John W. Gamble Jr.

Print less also allows us to significantly help our customers around sustainability and to really support our customer base in having them achieve their goals and sustainability, which we think is a real advantage for us.

Operator

Your next question comes from Kathryn Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

A couple of follow ups from prior questions. First on managed print services, can you talk about what the operating margin or operating profit over a managed print services deal is versus a typical laser hardware sale over its life? How do the margins compare between the two?

Paul J. Curlander

You know, [Katy], we don't break that out. What I would tell you, though, is that the managed print services deals tend to be enterprise deals. And what you see is enterprise is very aggressive price competition because every deal is bid with all the major manufacturers. I mean, we also see HP, Xerox, Rico, so these are aggressive deals. You know, the value really is in capturing the supplies, which are somewhat at risk when you just sell the hardware. But we don't break out the margin for that separately than the overall Business market segment.

Kathryn Huberty - Morgan Stanley

And then on the inkjet business, what will the inkjet cartridge capacity be once you shut down this additional Mexico facility versus, say, 18 months ago?

Paul J. Curlander

Well, we've never disclosed our inkjet cartridge capacity. Obviously, what we've seen is a decline of inkjet supplies versus 18 months ago. What I would say is that with this consolidation we're not really doing a reduction in our capacity. We're doing an improvement in efficiency and productivity among our facilities to generate the number of cartridges that we see that we need this year and in the future.

Operator

Your next question comes from Bill Fearnley - FTN Midwest Research.

Bill Fearnley - FTN Midwest Research

Any updates here, guys, on the gives and takes during the recent quarter and the rest of the year on shelf space gain or losses for hardware? And then as a follow up, any decreases in supply shelf space or inventory levels in stores that you're seeing as inkjet unit growth continues to decline? So it's a shelf space and inventory level question.

Paul J. Curlander

Okay, Bill, I mentioned earlier that we did see a reduction in inkjet supplies channel inventory during the quarter. That's not overly unusual versus what we've seen historically as we go from second quarter to third quarter. Third quarter tends to be, certainly the early part of third quarter, the summer, tends to be a very slow time in terms of inkjet supplies.

It's also not unusual what we've seen historically in times of slowing consumer demand for some of the major chains in the U.S. to pull back on some of their inventory because they're very aggressive on how they manage themselves when they see any slowdown in consumer spending. So we did see that decline but, again, we don't really think that's unusual from a supplies standpoint, and we continue to see our supplies in the stores. We're not seeing any reduction in shelf space on supplies. And obviously, we're very focused on keeping everybody in stock as we go through back-to-school season.

On the hardware shelf space, I would say there's no material net changes from where we were at the end of the first quarter. I mean, obviously in the second quarter we saw full quarter impact of the reduction in shelf space. I think it was a little more partial in the first quarter.

The only thing I would highlight is that we've now launched our Professional Series with OfficeMax. Maybe some of you saw the national ad that OfficeMax ran on the Professional Series in Sunday circulars. So we have a little bit more shelf space there and obviously a focus on the high end units that we're looking to get, and we're starting some of our promotional campaigns and marketing of the Professional Series with OfficeMax. That would be the only thing I would highlight, but overall not a material net change

We always get some puts and takes, but not much. And we continue to work to try to improve. We're not happy with where we are with the U.S. shelf space.

Bill Fearnley - FTN Midwest Research

And then just quickly as a follow up on the pricing from a competitive standpoint, are you seeing that it's from a few competitors or are you seeing it as an overall market trend? You had mentioned a couple of times, Paul, that the pricing and promotional environment was getting more difficult. Is it a few competitors? Can you give any additional color there?

Paul J. Curlander

Yes, I mean, on the inkjet side we're seeing it from essentially everybody. When the market slows down, this is what tends to happen. You know, on the laser side what I highlighted was that we see the enterprise deals always very aggressive because they're bid, but I would tell you, the SMB market has been very promotional, very price aggressive as overall market demand has weakened, certainly in North America.

Operator

Your next question comes from Ananda Baruah - Banc of America Securities.

Ananda Baruah - Banc of America Securities

I guess you spoke at a higher level about seeing some incremental softness both in the U.S. and Europe, and I was just wondering if you could maybe speak more specifically in both U.S. and Europe and in Consumer and maybe SMB and Enterprise, how things have changed incrementally from a demand perspective last quarter versus this quarter? I believe on last quarter's call you began to talk of seeing some initial softness in Europe. So just interested in how things have sort of progressed in each parts of the business as you've moved through this quarter.

Paul J. Curlander

Okay. In the U.S., you know, I would say that overall we're seeing - the major impact to us is weakness in the Consumer market and weakness in the North American Enterprise market, and we've highlighted the Financial Services, Government, and the Retail sectors.

But as I look first quarter to second quarter I think the U.S. was weak. I think it continues to be weak. You know, you see a few things in the second quarter. You know, for the overall market in inkjet the unit decline was not as much, you know, it was probably 9% or 10% in the first quarter; probably much less than that in the second quarter, perhaps impacted by tax rebates. But the overall revenue decline - so the prices came down much more aggressively  overall revenue decline was not that different between the first and second quarter in the U.S. So in terms of hardware revenue, the impact's really very similar in the U.S. I think the weakness in the Enterprise market, probably somewhat the same in the U.S. in the second quarter.

Probably the biggest change we saw quarter-to-quarter was in Europe. We saw some significant weakening in European Consumer market. We're not seeing as much yet in the Enterprise market although in selected countries  I think we highlighted the U.K. last time - we certainly see weakness in the Enterprise demand as well. But Consumer weakness across the four majors in Europe eroded pretty significantly first to second quarter, so we're seeing some definite Consumer weakness there.

Operator

Your next question comes from Benjamin Bollin - Cleveland Research Company.

Benjamin Bollin - Cleveland Research Company

Could you tell us why the shared expense line item was down in the quarter, and then any internal initiatives you have that you're evaluating to perhaps continue that trend or how you see that developing through year end?

John W. Gamble Jr.

I assume you're referring to the other expense segment.

Benjamin Bollin - Cleveland Research Company

Correct.

John W. Gamble Jr.

And reportable segments? Yes. And it was, as we mentioned in the comments, two things. Operating expenses were generally lower, and then the negative impact of foreign exchange that rolls through that column was lower in the quarter than it was in prior quarters. So those were the two major effects that reduce that in period.

Benjamin Bollin - Cleveland Research Company

Could you talk a little bit about how you see that developing going forward? Are there any specific initiatives or things you're targeting to further improve that going beyond the next quarter?

John W. Gamble Jr.

So a lot of that column is support costs, right? So what we've been talking about on an ongoing basis is our targets to reduce G&A and overall support costs. Some of the support costs are obviously in the divisions as well, but that is an area where we're continue to focus on reductions in support costs, G&A in general, and trying to have that continue to reduce over time. Not giving a specific number for next quarter, but over time the goal is to continue to drive that down.

Paul J. Curlander

Right. This was the primary target of the restructuring that we did in October 2007, and as John pointed out earlier, as the savings move from the $40 million savings this year to the $60 million from the 2007 restructuring next year, we expect to see more OPEX savings next year than this year. A lot of that is in this support area, G&A, corporate services expense line items.

Benjamin Bollin - Cleveland Research Company

And then if you look at your Enterprise customers, any idea on what percentage of those customers are using the print services model, and is there any concern that over time that degrades the cash flow of that business because you are in essence teaching them how to print less?

Paul J. Curlander

Well, I think that right now it's a small percentage of customers who are actually doing the managed print services. But it is a growing percent, and we continue to see more customers becoming interested as they see other companies and they talk with other people in their industry or in other industries that are doing this.

You know, the whole thrust around printing less is fundamentally our view that in the services business you have to be giving customers value and ongoing value to be an ongoing service provider. And, you know, Lexmark is a Fortune 500 company. We engage service providers. We do outsourcing of some of our services. And just like we do everywhere in our business, we want to take cost and expense out next year versus this year. We expect our service provider to come to the table just like one of our employees and help us take expense out.

So the whole thrust around printing less is to help our customers upfront optimize their environment and usually that is a significant consolidation of equipment. But then beyond that we need to manage the environment because most of them are [in exchange] to keep it optimized, and we significant opportunity for people to print less. And this is part of the cost savings we're looking to bring to our customer, and that's a pretty different attack than many of our competitors are taking. They're looking to move pages much more than take pages out.

Obviously, from our perspective we're looking to grow our business, all for gaining more customers and gaining a bigger percentage of people's enterprises because a lot of times when you win a deal for a large enterprise you're really just winning a piece of the enterprise and there's still opportunity yet to be gained throughout the enterprise.

So this is how we think about it, and this is the value proposition we're driving with our customers. And from an environmental perspective, what we find is this is a significant piece of the carbon footprint, associated with printing is around paper and paper usage.

Operator

Your next question comes from Jeff Fidacaro - Merrill Lynch.

Jeff Fidacaro - Merrill Lynch

I was wondering if you could talk a bit about your strategy for the SMB market and the spending outlook there. You know, that market tends to be a little bit lower end laser or higher end inkjet. And just talk about your positioning and sort of what you see as far as spending trends in this market.

Paul J. Curlander

Well, we see opportunity in small and medium business. We think it's not as weak, certainly, as the Enterprise marketplace in North America right now.

Our position in the SMB market is not as strong as we'd like to see it, and our strategy is really around how can we leverage Lexmark's strengths that we utilize on the Enterprise side and use that to go after small and medium business.

You look at SMB today, in general it is a very price promotional environment and it is a price-only strategy for most customers. And hardware's kind of viewed as a commodity type of thing. If you look at us in the Enterprise, we have strong differentiation in terms of our industry solutions in the major industry segments that we focus in. We have strong differentiation around out managed print services. So really our strategy there is to leverage some of those Enterprise strengths over into the small and medium business market.

Now to date we're very early in those initiatives, but you can see some of the things that we've announced over the last year in terms of the industry specific MFPs, things like the Education Station, the Legal Partner, the Clinical Assistant, you know, focused at education and the legal industry and the healthcare industry specifically. These were all focused towards the SMB market so that our resellers could sell industry specific solutions as their value add versus just trying to take pricing down.

We've announced other things such as our Lexmark Fleet Manager Program, where we take some of our Enterprise tools while managing distributed fleets to make that available to our partners in small and medium business.

So these are the kinds of initiatives and strategy that we're trying to drive. We also do promotional activities, but again, it's hard to differentiate on just promotional as.

Jeff Fidacaro - Merrill Lynch

If I could ask as a quick follow up, when you take a look at [inaudible] IT spending environment's getting a little tighter. Do you see the useful life of the hardware actually changing at your customers? And I'm talking about Enterprise and SMB.

Paul J. Curlander

Yes, this is one of the strengths of our business model is that when the economic environment slows down people do extend the useful life of the products, and what happens is we'll get more supplies on the installed base that's already out there. So that's just one of the aspects of the business model, that you may slow down in hardware sales but on the supplies side you continue to drive supplies off that installed base. So that's just a plus to the model.

Operator

Your next question comes from Chris Whitmore - Deutsche Bank Securities.

Chris Whitmore - Deutsche Bank Securities

Can you comment on the sustainability of supplies growth given the double-digit declines in units you've seen year-to-date and the resulting pressure on your installed base? And in addition, are you seeing any evidence that enterprises are cutting back on printed pages or even color usage in response to budgetary constraints?

Paul J. Curlander

Well, from a supplies perspective what we expect to see going forward is we expect to see good growth continuing in our laser supplies. This really is driven by the workgroup placements that we have done over the last several years. We had very strong 2007 workgroup placements.

You know, as we sit here right now in 2008 we've seen impact in North America because of the weak market certainly in some of these big industries that we focus in.

But I would tell you is that we do see some rays of light here. First I would tell you that all the decline in our workgroup space comes in North America, so outside North America our branded workgroup units actually grew in the second quarter. We saw laser hardware revenue growth in every region except North America, so we continue to get growth there. The managed print services results were much stronger in second quarter, and we think we're going to continue with that. And that included growth in North America, so we think that's going to be a plus. And we're seeing some strengthening in the managed print services funnel, sales funnel opportunities as we go forward in time.

So clearly we need to get back to where we're growing, the workgroup laser units, but we think this is an economic cycle that we're in, particularly in North America. Overall, though, we expect to see ongoing continued good growth.

And I think in terms of enterprises, and it's not just this year, over the last several years we've seen more and more companies interested in printing less, in cutting costs. We've seen more companies interested in controlling the cost of color printing and reducing the amount of color printing and controlling who prints and how they print it. And so we're very actively engaged with our customers, and we were before 2008, in helping them control color printing expenses as well as reduce pages for their current employee base.

Operator

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Lexmark International, Inc. Q2 2008 Earnings Call Transcript
This Transcript
All Transcripts