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Lexmark International, Inc. (LXK)

Q1 2006 Earnings Conference Call

April 25, 2006, 8:30 a.m. EST

Executives

John Morgan - Director, Investor Relations

Paul Curlander - Chairman and Chief Executive Officer

John Gamble - Executive Vice President and Chief Financial Officer

Analysts

Rebecca Runkle - Morgan Stanley

Ben Reitzes - UBS

Toni Sacconaghi - Sanford Bernstein

Laura Conigliaro - Goldman Sachs

Cindy Shaw - Moors & Cabot

Richard Gardner - Citigroup

Kevin Hunt - Thomas Weisel Partners

Keith Bachman - Banc of America

Shannon Cross - Cross Research

Bill Fearnley - FTN Midwest Securities

Chris Whitmore - Deutsche Bank

Bill Shope - J.P. Morgan

Richard Farmer - Merrill Lynch

Richard Chu - SG Cowen

Presentation

Operator

Thank you for standing by. And welcome to the Lexmark International First Quarter 2006 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 for Lexmark’s first quarter 2006 earnings conference call. With me today are Lexmark’s Chairman and CEO, Paul Curlander and Lexmark’s CFO, John Gamble. After Paul’s and John’s prepared remarks, we will open the call for your questions as time permits. Following the conclusion of this conference call, a complete replay will be made available from our investor relations website located http://investor.lexmark.com. Currently, on the upper right hand corner of this website, you can access a supplemental information slide that we hope you all find helpful.

And as a reminder, any of today’s remarks that are not statements of historical facts are forward-looking statements and involves 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 will turn it over to Paul.

Paul Curlander, Chairman and Chief Executive Officer

Thank you John. Well today, we are announcing first quarter results, that exceeded our expectations despite the year-to-year decline in revenue. Given the circumstances, this was a good quarter for the Lexmark. In the first quarter, we executed good expense control reduction. We made good progress with our planned restructuring initiatives. We had solid unit sales performance in our key branded segments and we continue to make progress on our core strategic initiatives.

First quarter revenue of $1.275 billion was down 6% year-to-year but exceeded our guidance due to stronger than expected supply sales. Overall, supplies revenue for the quarter grew 3% year-to-year compared to the flat results we were expecting as sales of both inkjet and laser supplies were above expectation. Overall, hardware revenue for the quarter was down 18% year-to-year as a decline in inkjet unit shipments year-to-year price declines and a mix shift to low-end lasers were only partially offset by increased unit shipments of laser hardware. Earnings per share of $0.78 significantly exceeded our expectations. On an operational basis, excluding the $0.31 in restructuring related charges and the $0.06 pension curtailment benefit, earnings per share would have been a first quarter record of $1.03. Earnings per share were better than expected due to the higher gross profit driven by stronger supply sales and a more benign consumer pricing environment and lower operating expenses.

Lexmark’s financial position continues to be strong. Net cash from operating activities in the first quarter was $220 million. For the quarter, supplies revenue grew 3% as laser supplies grew faster than this and inkjet supplies were about flat year-to-year. Our estimates indicate that negative impacts from year-to-year channel inventory changes were less than expected in the quarter. Overall, we believe end-user demand for laser supplies were about inline with our expectations. For inkjet supplies, we believe end-user demand came in slightly above our expectations. However, as we look ahead through 2006, we see the potential for some erosion in inkjet and user supplies demand due to the softer OEM sales we’re experiencing and the reduction in the inkjet volume due to our walk in the way from the low profitability business as we discussed in January. Currently for the second for the second quarter of 2006, we expect supplies revenue year-to-year to be flat to low single digit growth.

Now in the consumer segment, in the first quarter, revenue was $587 million down 7% year-to-year. Consumer segment operating income was 65 million. Excluding restructuring related charges and the pension curtailment benefit, consumer segment operating income in the first quarter would have been $96 million, up 22% year-to-year. Now for the quarter, inkjet unit shipments were down 18% year-to-year with growth in all-in-ones is being more than offset by declines in branded single function and OEM sales. However, our branded sales were down much less than 18% indicating that we are seeing good growth in the more profitable segments, such as three-in-one, all-in-ones and four-in-one inkjet that we are trying to penetrate.

Now for the quarter, hardware price declines were fairly modest sequentially. However, year-to-year price declines continue to be significant. In the consumer segment, we are also working on a hardware component storage that potentially could impact second half results. We are actively working to improve this and it’s such, it’s difficult to estimate right now what if any impact it could have.

In the business market segment, revenue was $688 million, down 5% year-to-year. Business market segment operating income was $148 million. On excluding restructuring related charges and pension curtailment benefits, business segment operating income would have been $155 million, down 13% year-to-year as the business market segment was negatively impacted by price declines and exchanges.

During the quarter, laser unit shipments were up 7% year-to-year, a strong growth in branded low-end mono lasers, branded color lasers and branded workgroup MFPs being partially offset by declines in both OEM sales and branded mono workgroup printers. Now during the quarter, we continue to make progress in our core strategic initiatives. Our investments in product development are evident in our new product announcements that are strengthening our presence in key growth segments as well as winning industry awards. For example, during the first quarter our new family of workgroup mono laser MFPs, were recognized with Editor’s Choice Awards as industry leading devices by Better Buys for Business.

Now although just announced in the first quarter of 2006, we are already seeing strong demand for these multifunction products in the segment that is growing rapidly but where we have had little presence. Although in mono lasers the E240, E340 and E342n, won Editor’s Choice Awards during the first quarter from Better Buys for Business. Our C522 and entry color laser which has been a strong addition to our color laser line won PC magazine Editors’ Choice award. Our X8350 four-in-one would significantly strengthens our offerings in this key integral segment was recognized by Better Buys for Business within Editors’ Choice Award.

During the first quarter of 2006, we announced the Lexmark E120n mono laser which is our smallest monochrome laser in both size and price and this product strengthens our current award winning low-end mono line within entry level model.

Now today, we are introducing three new inkjet all-in-ones that deliver industry leading value and ease-of-use for the home printing market. And overall, our strategy continues to be centered on three core strategic initiatives: first, to expand the number in penetration of product segments in which we participate including low-end mono lasers and color lasers, laser MFP’s for our inkjet all-in-ones and inkjet four-in-ones, secondly, to expand our penetration in the key market segments including enterprise solutions and services, small and medium business and part of the retail channel where we are under represented. And third, we want to continue to build Lexmark’s brand awareness and brand position.

Now, as we look forward to the second quarter, we expect revenue to decline in the low to mid-single digit range as we continue to be impacted by significant year-to-year price declines and reductions in inkjet unit sales. We expect earnings per share to be in the range of $0.70 to $0.80, excluding the impact of restructuring related charges and sequentially, we expect second quarter earnings per share to be lower due to slower inkjet supply sales and increased operating expenses primarily in R&D and brand development.

Now as we look to the longer term, the distributed output market is growing, and represents Lexmark with a number of attractive growth opportunities in segments where we are currently under represented. We have unique strength in this market and continue to strengthen our competitive positions to investments in R&D and branding and we have a strong financial position with a strong balance sheet and good cash flow.

Now these things coupled with the strength in our recent product introductions, the pipeline of the products on the way, the steps we are taking to focus on more profitable opportunities in inkjet and to restructure our operations makes us optimistic about the longer term. Now with that, I will turn the call over to John Gamble, for his more detailed remarks on the financials.

John Gamble

Thanks Paul, and good morning. Consistent with previous calls, I will first discuss our results of the first quarter relative to the prior year, then relative to the fourth quarter of 2005. I will also discuss selected changes on the balance sheet and certain items of cash flow. Finally, I will finish with more detail regarding our guidance for the second quarter.

Our first quarter 2006, results include pretax restructuring charges and expenses of $50 million and pension curtailment benefit of $10 million both of which we discussed with you on the January earnings call. This met $40 million expense increased cost of sales by $19 million and our operating expenses by $21 million. I’ll call out the impact of these items separately as we walk through the P&L. Please note; in the supplemental slide deck posted to our website we have included details on the income statement line items impacted by the two items referenced above as well as the 9.7 million of FAS 123R stock based compensation expense incurred in the quarter.

Now let me start with the P&L. Total revenue for the quarter was $1.275 billion, down 6% from last year and down 7% sequentially from 4Q. This quarter’s revenue was higher than expected primarily due to greater than anticipated supply sales. Geographically for the first quarter, US revenue of 574 million declined 8% year-to-year, revenue in EMEA of $465 million declined 9% year-to-year, the remaining geographies were up 6% versus a year ago with particularly strong performance in Latin America.

Laser and inkjet printer revenue in the first quarter was down 18% from 2005, as Paul indicated earlier inkjet hardware shipments declined 18% and laser unit shipments were up 7% year-to-year in the first quarter. Inkjet hardware average unit revenue was about flat year-to-year reflecting price reductions offset by a favorable mix to more AIOs. Laser hardware AUR was down about 25% reflecting the impact of pricing and unfavorable mix. Laser and inkjet supply revenues in the first quarter was up 3% from 2005.

Business segment revenue for the quarter was $688 million down 5% from 2005 and down 1% sequentially from 4Q. The year-over-year decline was driven by lower hardware revenue. Consumer segment revenue for the quarter was $587 million down 7% compared to a year ago and down 13% sequentially. The year-over-year decline was due primarily to lower hardware revenue. The sequential decline was also driven by lower hardware revenue. Gross profit margin for 1Q was 31.7%, excluding the impact of $19 million of restructuring cost gross profit was 33.1% approximately flat from 2005 then up 480 basis points sequentially. The flat margin versus last year is principally due to 380 basis point improvement mix, mostly from a decrease in the percentage of inkjet hardware offset by hardware margin declines in both inkjet and lasers. The 480 basis point sequential improvement was principally driven by an 820 basis point improvement in mix, mostly from a decrease in the percentage of inkjet hardware offset by product margin erosion. Cost of sales included $1 million of FAS 123R expense in the quarter. In the quarter, there were no new products transition to supply our managed inventory agreements.

Operating expense for the quarter was $283 million, restructuring expense and curtailment gains of $21 million impacted operating expense this quarter. Excluding this impact, operating expense was $262 million, a decrease of $24 million year-to-year. SG&A was a $175 million, a decrease of $28 million from 2005 and R&D was $87 million, an increase of $5 million from 2005. This year’s operating expense also includes $9 million of FAS 123R stock based compensation expense with $2 million and $7 million impacting R&D and SG&A expense respectively.

The SG&A reduction of $28 million reflects lower marketing spend restructuring savings and last year’s adjustments for Spain, partially offset by the FAS 123R expense referenced above. Sequentially, operating expense excluding restructuring cost and curtailment gains decreased $9 million versus the fourth quarter due to $13 million reduction in SG&A expense. The SG&A reduction reflects reduced marketing spend partially offset by $9 million of FAS 123R expense referenced earlier. The operating expense to revenue ratio in 1Q was 22.2%, excluding the restructuring cost and pension curtailment benefit, the operating expense ratio was 20.6%, a decline of 40 basis points from 2005 and an increase of 70 basis points sequentially. As mentioned earlier, the decrease from prior year was driven by reductions in SG&A, offset by our continued investment in Research and Development. Sequentially, the 70 basis point increases due to the addition of equity based compensation expense in ’06.

Operating income was $120.5 million, excluding the net restructuring expenses and pension curtailment benefit of $40 million operating income was $160.3 million flat from 2005 and up $45 million sequentially. Compared to 2005, the business segment operating income of $155 million was down $22 million versus last year while the consumer segment operating income of $96 million was up $17 million versus last year. Please note: all FAS 123R expense of $9.7 million is recorded in other expenses and does not impact business or consumer segment reported results. Other expenses consisting primarily of cost related to centralize supply chain, IT and other operating expenses primarily G&A were $91 million, a decrease of 4 million from 2005.

Operating income margin was 9.5%. Excluding the restructuring expenses and pension curtailment benefit, our operating income margin was 12.6%, an improvement of 70 basis points from first quarter 2005 and an improvement of 420 basis points sequentially. The improvement from prior year was primarily attributable to our improvement in operating expense. The increase sequentially was primarily attributable to gross profit improvement due to lower sales of inkjet printers.

Concerning financing and non-operating costs, the interest in other was a net income of $5.5 million, an increase of $1.8 million from 2005 and an increase of $1 million sequentially from 4Q. The tax rate for 1Q was 31.6%, higher than the 29% expected, reflecting the expiration of the US Research and Experimentation Credit that has not been extended by Congress to-date. Our 29% expected tax rate for 2006 assumes that these are in credits, will be extended for 2006. The tax rate in 1Q’05 was 25% which included a one-time benefit of approximately 2 points.

Net income for the quarter was $86 million. Without after-tax restructuring costs and pension curtailment gains of $27 million, net income was $113 million, down $10 million from last year. Net income in 2005 was $124 million. GAAP earnings per share for the quarter were $0.78. GAAP EPS in 1Q’05 was $0.96. Excluding the restructuring expenses and pension curtailment, the 1Q’06 expense was $1.03, up from $0.96 last year and significantly stronger than the $0.60 to $0.70 range we indicated in the January earnings call. This improvement was primarily due to higher gross profits, due to strong supply sales and more benign consumer hardware pricing environment and lower operating expenses.

Now moving to the balance sheet, cash flow from operations for the quarter was quite strong at $220 million, a sequential increase of $7 million. Accounts receivable decreased 67 million from December, inventory decreased 10 million in the quarter, accounts payable decreased 19 million since the end of December and accrued liabilities increased 9 million since the end of December.

For the quarter, capital spending was $47 million, depreciation was $62 million and currency of the euro was accounted for, at $1.20 compared to $1.31 in 1Q’05. Cash and marketable securities at the end of 1Q was $0.8 billion, down $123 million since December. Cash decreased due to share repurchases of $300 million that occurred in the quarter. In 1Q, we repurchased 6.4 million shares at an average price of $47.22. At quarter end, we had $1.03 billion of share repurchase authority outstanding. The restructuring actions that we announced in January are proceeding according to plan. We still expect the total implementation cost to be $130 million or $80 million in cash costs and again we expect to incur all of this in 2006 with $50 million impact in cost of sales and $80 million impact in operating expense.

We still anticipate $15 million in savings in 2006 and an annual, and on an annual basis going forward in 2007 and beyond, we expect approximately $80 million annually in savings, approximately 70% of which will benefit cost of sales and 30% operating expense.

In the first quarter, as indicated previously, we incurred $50 million in pretax restructuring costs and related expenses and $10 million in curtailment gains. Savings in the quarter from restructuring including their curtailment gain were approximately $15 million. In the second quarter, approximately 40 million of the 130 million total cost of the restructuring will be incurred. Approximately 15 million will be in cost of sales with the remaining estimated $25 million, impacting operating expenses. The second quarter savings is estimated to be approximately $10 million.

Now for my forward-looking comments concerning 2Q. Before getting into our detailed guidance, I would like briefly address the sequential trend in our earnings in 2Q. As Paul mentioned, we expect EPS in the second quarter to be $0.70 to $0.80 excluding the impact of restructuring charges. This reflects reduced supply sales sequentially and increases in operating expenses in 2Q, primarily in the business segment reflecting both increased R&D as we continue to increase our focus on both color and multifunction product and increase marketing and sales expense.

Now for our detailed guidance. We expect second quarter revenue to be down on a percentage basis in the low to mid-single digits versus both 2Q 2005 and 1Q’06. We expect EPS to be in the range of $0.70 to $0.80 per share excluding the $0.26 per share impact of the cost of the restructuring. GAAP EPS which includes these restructuring expenses is expected to be $0.44 to $0.54. Included in our guidance, is the FAS 123R expense estimated at $9 million with $0.05 per share impact. GAAP EPS in the second quarter of 2005 was $0.64 or $1.06 excluding at $0.42 charge for approvals repatriate $684 million under the American Jobs Creation Act.

In the second quarter, we expect the gross profit margin percentage, excluding the impact of the restructuring costs discussed earlier, to be lower than last year’s 34.6% due to product margin erosion and slightly lower sequentially than the 33.1% we achieved in 1Q. The operating expense to revenue ratio, excluding restructuring expense in the second quarter is expected to be slightly higher than last year’s 29.9% as our SG&A reductions mostly offset the impact of higher development spending and option expenses. Versus the first quarter of 2006, operating expense to revenue ratio, excluding the restructuring expense will be higher than the 20.6% as I discussed earlier.

Operating income margin in the second quarter, excluding the cost of the restructuring actions is expected to be down from last year’s 13.7%. Versus the first quarter of 2006, operating margin excluding the cost of the restructuring actions is also expected to be down from the 12.6% we achieved this quarter. Despite our strong 1Q operating margin, we still believe that our operating margin once we have completed our restructuring will be in the range of 8% to 10%.

The effective tax rate in 2Q ‘06 is expected to be 31.7%, and for the full year of 2006 is expected to 29%. Capital spending for 2006 is expected to be approximately $230 million. And depreciation is expected to be approximately $160 million. For the full year, we still expect the pretax impact of FAS 123R to be approximately $37 million. With that, we will go ahead and open it up for questions.

Question and Answer Session

Operator

Thank you. (Operator instructions).

Your first question is coming from Rebecca Runkle of Morgan Stanley.

Rebecca Runkle - Morgan Stanley

Good morning can you hear me?

Paul Curlander

Yes we can.

Rebecca Runkle - Morgan Stanley

Okay great thanks. Some clarification on the guidance, I appreciate all the details. But if I go back and look historically over the last 9 years, every year in the second quarter gross margin has been up year, quarter-to-quarter; Op margin has been up quarter-to-quarter with the exception of one year. And as I look at your sales commentary or margin commentary, and look at all the plusses and minuses that, the down sequential gross margin, the down sequential Op margin just looks extremely conservative and not all that realistic, given the business model, and, what we are seeing historically, so is there something in there that’s causing you a guide down that would be different from what we’ve seen historically or different from your sales commentary?

Paul Curlander

Well Rebecca I think, as we look at the second quarter, what we are seeing is compared to the first quarter; we are expecting to see less inkjet supply sales. And we are expecting to see step up in operating expense. Other than that, things look fairly similar to us between the quarters. I think historically, we have seen a lot of things similar between the quarters. So that’s the difficulty we have as we look at the, at the second quarter we realize the $0.70 to $0.80 is quite a bit under a $1.03, we understand that is not necessarily historical trend we’ve seen, but as we look it where we sit right now today, we are seeing less inkjet supply sales in the second quarter and we are seeing greater operating expense which is bridging that gap between the $1.03 and $0.70 to $0.80.

Rebecca Runkle - Morgan Stanley

So on the OpEx side, it sounds like a lot of the variance quarter-to-quarter has to do with the, relatively large pull back in marketing expenses during the first quarter and then commentary about, revisiting brand development in the second quarter, could you quantify that in a manner whatsoever and just talk to what your strategy is on brand development going forward?

Paul Curlander

Well basically what we are looking at as we go sequentially from the first quarter to second quarter is, we are looking at, at the ongoing investments that we’ve talked about really over the last 12 months in R&D and brand development. What’s going on in R&D is, we are consistently stepping up over spending, we’re focusing on these key growth segments where we want to improve our position and those growth segments haven’t changed from what we’ve talked about before. And, so you are going to consistently see that step up as we go quarter-to quarter, some quarters would be more than others just depending on what’s happening specifically and we are seeing that projected step up first to second quarter. In terms of brand development, we intend to continue to spend, a little bit what’s happening to us here in 2006 is the quarterly mix is little bit different than what we saw in 2005. So, in first quarter of 2005, we spend a lot more than what we did in, in ‘06 and that helped us year-to-year in operating expense. And I think converse to here in the second quarter, we intend to spend more in 2006 than we did in 2005, so we’re kind of seeing a year-to-year impact as well as the sequential impact in that area. But we intend to continue to spend on both these initiatives and our intent has not changed on that in the last 12 months.

Operator

Thank you our next question is coming from Ben Reitzes with UBS. Please go ahead.

Ben Reitzes - UBS

Yeah, good morning, thanks. Two questions, Paul, can you clarify with regard to your inkjet supply comments sequentially, are you seeing orders go down right now sequentially or you just, is your model and your internal planning saying it should be down, are you seeing it fall off dramatically right now to cause that guidance?

Paul Curlander

Well, we have always seen, historically between the first and second quarter some reductions in inkjet supply sales Ben and actually what we are projecting this year is very similar to the reduction we saw in inkjet supplies from first to second quarter in 2005. So, I think this is really is just a little bit of a seasonal effect.

Ben Reitzes - UBS

Okay and then with regard to laser printers and also inkjet, when do you think that OEM decline stop being a drag on revenue, do you have any ideas we look out throughout the year maybe without being as per, you don’t have to be completely precise than I don’t like to comment on this, but is there certain quarter out there where it stops being dragging and actually be benign or even contribute to grow?

Paul Curlander

You know Ben, I don’t have the answer; it’s very hard to project what OEM sales are going to be because we don’t drive those sales; our OEM customers drive those sales. The only, only, I think, I could point out you is that, it was the fourth quarter of ’05 where we saw OEMs decline on a year-to-year basis, but other than that, its hard to project. What I would tell you is that we are focused on driving the branded side of the business and we have a pretty good quarter, in the first quarter all things considered certainly on the laser side, we had a good first quarter in branded, low-end mono, color, laser, all-in-ones is a very good story for us. On the inkjet side, things were tougher because we are walking away from business. But even there, we saw growth in all-in-ones and we felt like we’re doing pretty well. But on the OEM side, it’s really hard to give any guidance on that.

Ben Reitzes - UBS

Thanks a lot Paul.

Paul Curlander

Thanks.

Operator

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

Toni Sacconaghi - Sanford Bernstein

Hi, yes thank you, I have a couple of questions. Paul, I wanted to revisit the guidance question, your gross margin guidance is, tends to be down only slightly sequentially implying that the OpEx is going to be the significant delta, given that you are going to get at least 5 million in incremental restructuring saving sequentially, it implies that your OpEx might be going up 20 million or 25 million which seems like an enormous boost actually maybe even a bit more because your share count is coming down so dramatically, is that really the kind of OpEx investments that you are looking to be making and given that R&D stepped up this quarter, my senses to that really is an SG&A statement, and does that really the order of magnitude and does that consistent with the kind of cost control that you are trying to put in place in the company?

Paul Curlander

Well I am not sure how you interpreted this slightly down on gross margin, but I would tell you that the, of the factors the inkjet supplies is a bigger factor in our outlook than the operating expense. So the numbers you are quoting there on OpEx are little bit bigger than what we were thinking about.

Toni Sacconaghi - Sanford Bernstein

Okay, in terms of the supplies growth you have mentioned that there was less of an impact on supplies due to channel inventory adjustments this quarter, can you clarify those comments where, was there, from your perspective, any drive down in channel inventory this quarter or was there any bills in channel inventory this quarter, overall, and supplies are in either side of the business?

Paul Curlander

Let me, let me start my response with that by qualification, Tony, as you know, we don’t know what the channel inventory is, we have estimates but we don’t know, we get, we get reporting out of the first tier another 100%, we don’t get any reporting out of the second tier, so its hard for us to know but we do, we do estimates. With that qualification, relative to our estimates, we saw last year-to-year impact than what we thought, we currently thought that we would see more year-to-year impact which is why we project a flat supplies year-to-year and we didn’t see that in fact, we saw quite a bit less than that. So that’s really the main reason why we popped up from flat to the plus 3%. On the laser side, that was pretty much all a bit on the inkjet side, we came in little bit, our estimate is, we came a little bit better on the end-user demand from what we’ve thought, so that’s kind of what we saw.

Operator

Thank you our next question is coming from Laura Conigliaro with Goldman Sachs. Please go ahead.

Laura Conigliaro - Goldman Sachs

Yes thank you. First of all, you touched on a hardware component shortage or some kind in second half, can you discuss that forward in more full, in fuller terms. Secondly, can you give us the factors again that would close the gap between operating margins that you just reported and the operating margins that you are talking about, the 8% to 10% operating margins, that you are talking about in the future was the very, very sizable difference. So what, in some kind of priority order, are the things that you think would be the contributive to that.

Paul Curlander

Let me start with the second one first and let me ask John Gamble also to give us his thoughts. Relative to the margin, as we, as we look at the 12.6%, I would probably make a couple of comments on it, about the quarter that’s a little bit unusual and may not necessarily be sustainable on the long-term. First thing is, we’re walking away form a lot inkjet business and as we walk away from inkjet business that obviously helps us in the near term in terms of profitability. That’s not our long-term goal, our long-term goal is not to be down 18% year-to-year we’d like to be up 18% year-to-year. And so, when you look into ’06 that kind of fuses some away that I think is not representive of where we are thinking about long-term. Second, the second thing we saw in the quarter was really a surprisingly benign price environment; it was very different than what we saw, certainly off through 2005, different than what we expect to see even we look forward in 2006. So I think those two things were somewhat, somewhat unusual you know as…

Laura Conigliaro - Goldman Sachs

Can I just follow up can I follow up on that and that is…

Paul Curlander

Sure.

Laura Conigliaro - Goldman Sachs

Did you mean that you put those things in order, yes, you are walking away form lot of inkjet business but by your own choice, a lot of that inkjet business is coming in an area that you really don’t want to be as involved and whereas the inkjet business that you are proportionally more involved in, is more of a contributor on the consumable side. So again, I don’t quite understand sort of the disconnect, the size of the disconnect between the longer term goals and the just reported numbers?

Paul Curlander

Well I think, I think where the, the one thing to think about in the inkjet side is that the business that we walk away from, its a profitability over a life discussion a lot of that has to do with the consumables usage we expect to get. So that’s not necessary to say that the, that the margin on the business is any better or worse than the business we continue, it’s a statement about the profit over life not being as good for the consumables usage, maybe not being as good. So these are the factors, as we look at the financials, these are the factors. The other thing that we have to look as we go forward in time is we do expect prices to come down. And as prices come down, we have to get cost down, it depends on the rate of prices coming down, the rates that we can get cost out. This is also a risk as to what we see in the operating income as, and when we roll these things together, we still think 8% to 10% is the right margin range that people should be thinking about for Lexmark right now, certainly in the foreseeable future. Fairly, we did much better than that in the first quarter, but I’ve given you my thought just to why I think that’s not necessarily sustainable, and the fact I think we are not going to see that in the second quarter but John do you think it’s going to go?

John Gamble

All right, I think the only thing I can really add is again, as we talk about the second quarter, we are expecting to see operating margins to move back toward that range. So given, given that, that’s the case, right the things that are driving that as we indicated earlier with the, with the lower supply sales and the increased operating expenses and the increased investments. So again, that’s what’s driving is their in the near-term and as Paul said that’s what people should be thinking about us in the near-term.

Paul Curlander

All right and of course, we are committed to continue our investment. Relative to the hardware components shortage a question were, first let me be clear that we do not expect that to be an impact in the second quarter, we’re, we don’t have a lot more say about than what I’ve already said, we do have a component shortage that could potentially impact the second half, we are actively working on that component, it’s a hardware component, so it’s not a supplies issue, it’s the hardware issue. And, as such, it’s hard for us to predict what impact if any of that’s going to have. We intend to put a statement to that effect in our 10-Q. So, I brought it up today because we don’t want anybody to be surprised if that’s going to show. But we are actively working on that. So, the timing isn’t really right to know what that impact is and our intent would be to update everyone when we do the second quarter earnings release in July.

Operator

Thank you, our next question is coming from Cindy Shaw with Moors & Cabot. Please go ahead.

Cindy Shaw - Moors & Cabot

Thank you, over the last couple of quarter, you’ve been really reevaluating demand for supplies more on the ink side than the toner, but really on both and wanted to come back and revisit, now that its been a little better than expected, is there been any change to your model what’s you’ve been updating every quarter?

Paul Curlander

Well, I think that our view of the inkjet supplies has moved pretty dramatically over the last 12 months. And certainly the growth rates that we are seeing have moved pretty dramatically over the last 12 months, what we saw in the first quarter was essentially inkjet supplies flat year-to-year, that I think is given that, we didn’t have a lot of year-over-year change in channel inventory, I think is fairly representive of what we believe is the end-user situation in terms of demand, even though it came in above, a little bit above of what we expect and that’s not too far off. As we look forward in time, if you see the potential for more erosion there, because currently our OEM sales are softening, in fact down, year-to-year in the fourth quarter, down year-to-year in the first quarter and we are walking away from business which in the near-term will have a supplies, end-user supplies demand effect. So, that’s kind of how we see the inkjet supply end-user demand situation right now.

Cindy Shaw - Moors & Cabot

When you look at the ink sales, there is about 20% of that, you know, you did last year, you won’t be repeating that you are walking away from and also basically you’d met, mentioned OEM, have you got a sense for how much supplies demand is driven by, say branded versus OEM, how much might have been driven if any by the business you walked away from. Or was that just to manage to sell an inkjet cartridge when the printer went out the door?

Paul Curlander

No, I mean we have estimates certainly on branded versus OEM and what I would tell you is that that the fact that we are at minus 18% with branded declines much less than minus 80% is really a very positive statement. Because what that says is, in the segment that we are focusing on the segment that we want to grow strategically, we are getting growth there. And so as longer coming in below that, the hurdle rate of what we are walking away from on the average that’s the good thing for us, and we saw that. On the, relative to the near-term impact of walking away from some of the business we knew that when we decided to do it, but we did for the long-term benefit and once we get to the transition period which we will experience pretty much through 2006, what we then would expect to see is growth in these focus segment the three-in-ones, the four-in-ones which should drive a good usage for us. And this is what we need to do, to start to, to get those units up and growing and get that supplies moving back in the positive direction. Similarly over on the laser side, the growth rate certainly is better than what we are seeing on the inkjet side, but that we’d like it to be much better. And the key there is we got to get the hardware units up and moving particularly in color laser which will drive a lot of supply particularly in things like laser all-in-one, the products we announced in the first quarter. These will consume a lot of supplies and so long term this is the game plan and to go drive that those segments, that have usage and really see that if we can turn supplies situation around.

Operator

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

Richard Gardner - Citigroup

Okay, thank you very much. Couple of questions, first of all, in past quarters, Paul you’ve made reference to weaker than expected corporate laser demand, I think especially in Europe. And was just hoping you could give us an update on how you see demand in that particular segment. And then secondly, I was hoping that you could just give us, now your read on channel inventory levels for both hardware and supplies and both year-over-year on sequential trends, for that inventory level? Thank you.

Paul Curlander

Richie let me, let me just say a few words about channel inventory levels, obviously we don’t know what those channel inventory levels are we have estimates and as such it really is typical for us to give any comment on what’s going on with this channel inventory levels. Relative to laser demand, what I would say is that in Europe, I think the demand is okay. I think there is opportunity there for us in Europe. As we look forward we see, we see some good deals, we see some good demand, we’ve had a tremendous response in Europe on our new laser multifunction devices, which is great because overall workgroup mono lasers has been a pretty week category in the market around the world and to the extent that we can drive more all-in-ones that will just drive more usage and would be a tremendous help to us going forward. What I would also tell you in the first quarters, you probably saw some weak demand in US maybe weaker than we had expected there, as we look at the sellout from our distributors in the US, the total market not just the Lexmark’s statement, the total market mono was certainly weaker than what we had expected to see overall color was up but not as strong as certainly what we have seen to the quarters in 2005. So, I would say demand in Europe was looking okay, they’re pretty good, I’d say demand in US was little weak in the first quarters certainly we hope the market will do a little bit better as we go forward through the year and we currently expect that.

Richard Gardner - Citigroup

Paul you mentioned earlier that, you thought that inkjet supplies inventory levels were pretty flat year-over-year, can you just give us maybe a more qualitative assessment of what you think inventory levels are doing?

Paul Curlander

What I said about to the inkjet, what I said about the channel inventory levels overall, that year-to-year, we didn’t see a great change in our, from an estimate standpoint, we didn’t see a great change in the first quarter, its very difficult to talk directionally about what’s going to happen with channel inventory levels, currently we thought in the first quarter that there would be significant negative impact to us, we didn’t see a significant negative impact to us, so my conclusion is, its just very hard for us to call exactly how these things are going to move. So, I think as we look forward in time, we always have the risk to be making channel inventory movements, but the reality is that as we indicated in the near-term, we are expecting supplies revenue growth to be flat to low single digit.

Operator

Thank you, our next question is coming from Kevin Hunt with Thomas Weisel Partners. Please go ahead.

Kevin Hunt - Thomas Weisel Partners

All right thanks, I just want to follow up on that, so you’ve seen that the supplies growth are flat to low single digits for the remainder of this year is going to, I guess, I’m hearing that, I was wondering if you can comment then on the hardware side, when you might expect to actually get back to seeing some year-over-year growth, and then I have a follow up.

Paul Curlander

Okay, Kevin I am, I didn’t mean to imply anything beyond the second quarter, what I meant, when I said flat to low single digit was just the second quarter, we’ve not given any guidance for supplies beyond the second quarter. Relative to hardware, we obviously had growth in laser units that we certainly would hope and except to have growth in laser units as we go forward through the year. On the inkjet side, it is going to be tough and we’re walking away from about 20% of the business that’s going to be present in every quarter of this year. So, I think the key thing to look for there is on the branded side to the extent that branded is coming in with decline less than that 20% and in the first quarter we certainly did that. That’s the positive thing that indicates growth in the strategic segment that we want to focus on, once we get through this transition. But on the inkjet side overall, we could expect to see some negative unit numbers year-to-year certainly throughout all four quarters of 2006.

Kevin Hunt - Thomas Weisel Partners

Okay then, my follow up is you kind of indicated at the beginning that you are happy with this quarter’s performance. But the order what are you kind of saying is that these are sort of, perhaps one-time exercised benefits that rolls this quarter. I mean, can you maybe summarize if you are happy with the outlook based on what you did this quarter?

Paul Curlander

Yeah I think, I think this was the good quarter for us and when I say that I’m certainly not focused on any one-time transitional thing that occurred during the quarter, the fact that I’m focused on the fundamental that occurred during the quarter. The things that I point to, that I think very significant are that we have been investing in segments such as low-end mono laser, color laser, laser all-in-one, inkjet three-in-ones and four-in-ones. And in this quarter, in the first quarter, we saw strong growth in low-end mono lasers, strong growth in color lasers, strong growth in laser all-in-ones. We saw good growth in inkjet all-in-ones. And this is due to the investments we have made to the products we have announced and the performance of those products in the marketplace. The other thing I would point out to here in the first quarter, relative to the first four months of the year, is that we are doing, selling very significant in terms of our product development our product announcements. We are filling in gaps in the product line, in gross segments where we have not had products before. The laser all-in-one announcement is a very significant for us. And some of the awards we won on that, I think they are indicative to the strength of the products that we’d launched there and we are seeing strong demand on those products just from the moment that we have announced them. We’ve also pointed out new products that are very recent in the product line, things like the E120, the entry mono laser; we’ve not had an entry mono laser in the product line before that’s a strong growth segment that’s an opportunity for us. The X8350, we’ve not had a strong entry in the inkjet four-in-one market which is strong growth market. That’s a very strong product force. That’s winning awards. So, these are the things that I point to, I feel very good about in terms of the quarter, clearly, we also feel very good that we are executing the restructuring plan, that we laid out, I mean, we got a lot of things going on, a lot of things we are trying to do, and that’s executing pretty much according to schedule. We feel very good about the cash flow. That went on; I mean we are working very hard in our cash cycle on working on, basically receivables and on payables and these are things that we are seeing some impact, and these are strategic things that we are working on. So, as we look at this we feel very good about the quarter from those aspects, obviously, we are not happy about overall revenue being down year-to-year, we are not happy about the inkjet units being down 18% year-to-year, these are things, we are working to correct as we go forward and obviously supplies growth of 3% is in where we would like to be in long-term.

Operator

Thank you, our next question is coming from Keith Bachman of Banc of America. Please go ahead.

Keith Bachman - Banc of America

Hi, thanks for the question. I have a couple ones if I could, I want to go back to the long-term margin description that you gave Paul, is the impact to get back to or go lower, I should say to 8% to 10% versus what you did this quarter. Is that more coming from gross margins or OpEx if you could give some colors on what’s the greater impact in any characterization I have some follow ups please?

Paul Curlander

Well, as we look at the sequential movement of margin or certain sequential movement of operating income we are going to see an impact in gross profit because of the reduce sales of inkjet supplies that we are expecting between first and second quarter and we are going to see an impact from the operating expense because of the step up in R&D and in the brand spend that we are going to do in the second quarter, I would say the bigger of those two factors is on the gross profit side than on the OpEx side.

Keith Bachman - Banc of America

Okay, Paul in the same commentary you’ve suggested that inkjet hardware units being down 20% this quarter, I think you’ve said that would continue for the year. Doesn’t that suggest though that you are going to get a margin, positive margin impact through the year?

Paul Curlander

Well, remember what we are trying to do, we are walking away from 20% of the inkjet unit. So basically, if you walk away from 20% and the other 80% were just flat year-to-year then we would expect to see, kind of a minus 20% every quarter it would vary a little bit by quarter, but on the average it will be minus 20%. So, what we are trying to do is we are trying to grow that other 80%. So we can grow the other 80%, if we could grow let’s say 10%, then overall we would be seeing a minus 10% on inkjet units year-to-year we would view that to be a great result, and clearly that would not necessarily be favorable, as favorable every quarter as what we saw in the first quarter. So, we are trying to drive that inkjet decline to be less, then what it is by focusing on the segments that we want to grow, and in the near-term that’s a negative, that’s negative versus what we saw in the first quarter.

Operator

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

Shannon Cross - Cross Research

Hi good morning.

Paul Curlander

Good morning.

Shannon Cross - Cross Research

A question for you in terms of the year-over-year 18% decline in inkjet hardware, I’m curious you’d said you’re in a walk away from 20, do you think that’s pretty much encompasses what you wanted to walk away from, or is there a big chunk there that’s OEM and therefore there is more to go on your side.

Paul Curlander

Well, in the 20% there was branded as well as OEM that we would like to discontinue. As we take a look at the minus 18% branded was stronger than that OEM was, was weaker than that. So, I think the way to interpret that is on the branded side, since we are pretty crisp about the business we didn’t want to do again that the business we do want to do is getting more growth than just being flat year-to-year, we’re also getting growth in those segment and we saw a growth in all-in-ones in the first quarter. On the OEM side, in aggregate, right, we have more than one OEM partner, in aggregate, that’s coming down more than 18% which sales we are not seeing all the growth we’d like to see in the segments that we would like to grow. That’s, that’s basically how I think you should interpret that.

Shannon Cross - Cross Research

Okay and then when we look at the revenue growth by geography, can you just talk a little bit about profitability by geography, in terms of gross profit and operating margin or operating income contribution, if International is growing in emerging markets, or those the same level of profit dollars that you see out of the US and Europe, given the more of, I guess emerging market potentially lower, I guess, level of products that they would purchase?

Paul Curlander

Yeah.

John Gamble

Yeah, unfortunately we don’t break that level of detail out. So we do release revenue, but that’s it.

Shannon Cross - Cross Research

Okay and then my last question is in terms of maybe in, I think Paul you mentioned, you were looking at moving more into retail or different segments of retail that you are not in right now. Is that trying to regain shelf space that maybe you, you’ve lost or moved away from over the past couple of years or can you be any more specific, in terms of were you are targeting?

Paul Curlander

Yeah, I mean, clearly we’re not, we’re not happy with where we are shelf space certainly in the US; let me just focus US for a moment. As we, as we moved away from, from the bundles here in the first part of the first quarter, we end up loosing little bit shelf space and we had expected that, I think the good news is we did retain some shelf space certainly with those customers and that where we’ve been doing the bundles. We would like to get some of that shelf space back as we go forward in time, we are obviously not happy with that shelf space in the OSS channel, we are not that happy with our shelf space in the club channel, right now, so these are all places where we would like to do better than we are in terms of inkjet shelf space.

Operator

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

Bill Fearnley - FTN Midwest Securities

Yes good morning. Quick question for you on the effect of supplier manage inventory benefit here in the first quarter or what you would perceive in the second quarter. Was there any benefit, can you qualify it?

John Gamble

Again, we didn’t have any, any new product transition, so this is specific SMI benefit would not have been material in the period.

Bill Fearnley - FTN Midwest Securities

Okay and then also a follow up on the component question is it laser or inkjet component and is it an industry wide or is it most Lexmark specific particular to a, particular product design or design that you guys have?

Paul Curlander

Yeah, Bill it’s an inkjet product and I haven’t done a lot of research to understand how much might be industry wide. But I can certainly say Lexmark has this issue.

Operator

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

Chris Whitmore - Deutsche Bank

Thanks couple of questions for you guys. Can you provide some color on percentage of inkjets sold in the quarter that were single function versus multifunction, and that similar type of question for supply sales in the quarter?

Paul Curlander

Well, I am not sure we can break out supplies between single function and multifunction. But, relative to the hardware, what we could say is that, for the quarter, the units were down 18% year-to-year single function units were down year-to-year, all-in-one units were up year-to-year. And that’s the level of detail we give.

Chris Whitmore - Deutsche Bank

Okay and following up on the strategy that accepts the low-end single function segment, when do you expect the full grant of the follow through on supplies to impact the P&L? Is that a second half event or do you think 2Q will be the worse of it?

Paul Curlander

Chris, let me clarify that we are not looking to accept the low end single function segment. There is certain business that we were doing which didn’t dry up the hurdle level profitability over the life of the product that we were looking for, certainly a lot of that was in bundles that utilize single function printers. But standalone single function sales at the low-end are very profitable for us. So, we are not looking to exit that segment or walk away from that. Relative to the supplies impact it’s a little hard to predict how you will see that roll over, over time obviously to the extent that this business is coming down about 20%. We’ve expect to see impacts in every quarter from that relative to the near-term supplies.

Operator

Thank you. Our next question is coming from Bill Shope with J.P. Morgan. Please go ahead.

Bill Shope - J.P. Morgan

Okay great thanks. In terms of pricing you said during the quarter, can you tell us was that, largely due to your own conservative actions or is that certainly that industry-wide phenomenon that shows more rational behavior throughout the quarter. I mean, then second, I thought to keep asking about the component shortage, but can you tell us that is it a new product or an existing product?

Paul Curlander

Bill, relative to the components, sure, it’s really isn’t much more we can say than what we’ve said and we will look to give an update in the next earnings release in July. Relative to pricing; let me clarify one thing on pricing. Even though we are focused on exiting some business doesn’t give the return that we are looking for overtime. We are not the giant from the marketplace and we are very active and we are very aggressive in the market, and we would intend to be very aggressive and certainly would react anybody’s pricing moves that we would see in the market, if we think that’s the right thing for Lexmark to do. So, we continue to be as focused as we were doing during 2005 and being competitive in the marketplace. So we talked about pricing, that really was a market phenomenon, I mean, obviously to the extent that Lexmark has indicated that we’ve seen pricing impacts and that we would drive into some business, who knows what impact that has in the thinking of our competition, hard for us to say, but I would say across the board that the pricing in the market was pretty benign in the quarter, but we don’t have to show, expect that to continue to as we go forward in time.

Operator

Thank you, our next question is coming from Richard Farmer of Merrill Lynch. Please go ahead.

Richard Farmer - Merrill Lynch

Thank you, Paul I apologize for asking you to clarify follow up on a question that you have touched upon in a couple of different instances, all right, do you think there is an aspect for the question that you have not answered directly, specifically with supplies channel inventory, I heard you say, you saw last year-over-year impact than what you’ve expected, but sequentially either in terms of weeks or in terms of absolute dollars or in terms of impact on sequential growth, what was the change in supplies channel inventory up, down or flat for laser supplies and inkjet supplies in the channel?

Paul Curlander

Yeah, Richard we haven’t quantified that and we don’t intend to quantify that and again these are estimates we have inside Lexmark, as indicated, we don’t have the fact this is not data Lexmark has, we have partial reporting from the first tier, we have no reporting from the second tier, we have estimates and I really don’t think, as a company we should begin enough quantifications from things that are, is not data inside the company. So I can just tell you that, that we saw less impact in our estimates, than what we had expected to see, hopefully that’s fairly accurate directionally, but beyond that, I think we can only talk about the supplies we actually solved which were up 3% year-to-year, which was better than the flat which is what we are expecting.

Richard Farmer - Merrill Lynch

Okay.

Operator

Thank you, our next question is coming from Richard Chu with Cowen. Please go ahead.

Richard Chu - SG Cowen

Thank you, good mornings Paul.

Paul Curlander

Good morning.

Richard Chu - SG Cowen

The, historically, I think the perception that we have is at the business model for laser is a little bit less backend loaded than in ink, you’ve commented that AUR user down 25% on laser this quarter due to mix in price, I wonder if you could comment on whether those are the changes that were offset by laser hardware comps these on declines or whether they are structural model changes that are going on in the business model for laser.

Paul Curlander

Yeah Richard I think, I think that there are some structural things and we’ve talked about some of these before but let me, let me kind of revisit them, the reality is that the extend that we see a transition from mono to color, color laser pricing is very, very aggressive. Color laser is much closer to an inkjet model than to the historic laser model, currently in terms of upfront hardware margins and recovering in supplies over time. So part of what we are seeing is that to the extent that we grow color, you are seeing the shift in the business from mono and laser from what it has been historically. The other thing, I think we are seeing is that historically Lexmark has been more heavily loaded to work replaces then other people in the market and to extent that starts to even out more towards low-end lasers, we also see a little bit of a shift currently in that business model also. So, I think that there are something that are changing there that are contributing to the 25% and that is both price and pricing has been very aggressive in color laser year-to-year. It’s been very aggressive in work replaces year-to-year and also in low-end mono lasers. So that’s there, but then the mix shift that we are seeing from the high-end to low-end mono lasers is some thing that’s also impacting us and you can see that in the results we’re reporting.

Richard Chu - SG Cowen

Is it due to, to improve from that that laser gross margins on a hardware side are eroding where the inkjet margins were relatively, relatively stable, on hardware, albeit a lot?

Paul Curlander

I would necessarily assume that. I think on laser side, certainly I think we’re seeing impact on inkjet side on a year-to-year basis, we’re also seeing impact on the margins. You can’t bring down prices 25% to 30%, you can’t get that much cost out. So you’re going to see, you’re going to see an impact and with the pricing that went on in 2005 and obviously we are looking at same profitable year versus the first quarter of last year then that’s what you are seeing.

Operator

Thank you. At this time I would like to turn the floor back to John Morgan for any closing remarks.

John Morgan

Okay that will do from here thanks for joining us today.

Operator

Thank you that does conclude today’s teleconference. You may disconnect your line at this time and have a good day.

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Source: Lexmark International, Inc. Q1 2006 Earnings Conference Call Transcript (LXK)
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