Lexmark: Strong Free Cash Flow Generator With Catalysts In Place

| About: Lexmark International, (LXK)
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Lexmark International, Inc. (NYSE:LXK)

Executive Summary

Lexmark International, Inc. ("Lexmark", "LXK" or the "Company") is a leading printing and imaging solutions supplier and enterprise content management provider. In FY2012, the Company derived 96% of revenue from its ISS segment, and 4% from Perceptive Software. The Company generated $3.6B in revenue and $563MM in EBITDA for TTM 6/30/2013, respectively.

Lexmark currently trades at an undemanding multiple of 3.2x EV/EBITDA, for a Company with a leading market share, highly cash generative business along with a catalyst in place as the Company is slowly going private through share repurchases. Why does this opportunity exist? It exists as the bear case against LXK is evident with a 20% short interest, as the shorts tend to perceive Lexmark as a "old-tech" highly commoditized printing business, which is in secular decline. However, peeling back the onion reveals a Company that is well positioned within a growing corporate printing niche, managed print services (although affected by overall capital spending, is not declining at the rate compared with consumer printing), as well as a roll-up document-focused software platform with healthy long-term growth prospects.

The following attributes make Lexmark an attractive long-term investment at current prices:

  • Aggressive Return of Capital: Lexmark's Management team have executed on their commitment to return at least 50% of free cash flow to shareholders, as the Company has returned more than $600MM in share repurchases and dividends since the second half of 2011. The cannibalization of the Company has been evident by the Company's aggressive share repurchases, especially in times of ultra-depressed valuations, for which shares outstanding have decreased from 126.2MM shares in FY2002 to 65.7MM shares as of 6/30/13. Further, Management has also initiated a dividend on top of the repurchase program.
  • Leading Market Position: Lexmark has a leading market share in large work group printers, estimated at 17%, which represents a 300 bps increase since 2010. Additionally, according to industry analysts at Gartner and IDC, the Company is a market leader in managed print services and multi-functional laser printers, two growth areas within the industry.
  • "Right-Sizing" the Business: Management has taken critical steps to "right size" its business, such as divesting its business inkjet business to Funai earlier this year for $100MM, in addition to a projected savings of $85MM annually, and has shrunk its workforce in order to focus solely on the corporate space/MPS and software business.
  • Strong Financial Profile and Creditworthiness: The Company has a strong financial position, with a net cash position of $281.6MM, and debt/EBITDA of 1.2x. Importantly, Lexmark has managed to maintain free cash flow generation over the past five years, generating a trough FCF of $160MM FY2009. Financially, as evidenced by its successful recent capital markets access, the Company has many levers it could pull, such as using its excess debt capacity to take on an extra turn of leverage for a mass tender offer/share repurchase.
  • Attractive Valuation Below Private Market Value: At the current price of ~$33.2 per share and a ultra low multiple of 3.2x EV/EBITDA, LXK trades below its conservatively estimated sum of the parts value of ~$42, which represents a base case upside of 27% from current prices. Additionally, our base case valuation is supported by a basic LBO analysis, which easily supports a take out of the Company in the ~$40 per share range (with no consideration for operating income generated from the software biz).
  • Growth Opportunities: The Company has significant growth opportunities within the ECM/BPM software space, estimated at $8B per year with a near-term growth rate of 12%, and the managed print services market, which is highly value-additive for corporate clients and is an un-penetrated space.

Overall, the Company is undervalued given its low valuation, free cash flow generation, solid market share and gradual cannibalization of shares. At current prices, the Company offers conservative upside potential of 27%+ and upside as high as 50%+.

Company Overview

Lexmark International, Inc. provides businesses of all sizes with a broad range of printing and imaging products, software, solutions, and services. Since separating from IBM (NYSE:IBM) in 1991, LXK's product line has expanded to include laser printers and multifunctional devices, as well as associated supplies, software, solutions and services.

LXK's strategic vision centers around helping clients manage, capture and access content. The core initiatives include solutions/services growth and laser/multifunctional expansion. In order to execute on the task, the Company acquired Perceptive Software, Inc., a leading provider of ECM/BPM software and document workflow solutions, in the second quarter of 2010 and acquired Pallas Athena, a leading provider of business process management, document output management and process mining and discovery software in the fourth quarter of 2011. The acquisitions build upon and strengthen LXK's industry workflow solutions and managed print services capabilities and allow the Company to compete in the faster growing ECM, BPM and document-process automation software solutions markets. The acquisitions support LXK's strategy of exiting the inkjet and consumer printer market to focus on higher margin software, managed print services and laser printers.

Historically, LXK has relied solely on the annuity-like razor/blade model which led to intense price competition among manufacturers. The Company; acknowledging the change, has now focused on switching to a more consultative approach focused on functionality and pages through managed print services/multifunctional printers and specialized industry solutions while still obtaining the lucrative, high margined supplies revenue.

FY2012 Revenue Overview

Imaging Solutions & Supplies ($3.4B TTM 6.30/13 Revenue/$659.0MM TTM 6/30/13 Adj. Operating Income)

The ISS segment primarily consists of the Company's printer and supplies portfolios. Given the Company's recent business inkjet exit and prior exit of the consumer inkjet, LXK is primarily focused on mono and multifunctional laser printers. LXK distributes hardware and supplies through their internal sales teams and channel partners. The company has specialized teams primarily focused on financial services, retail, manufacturing, education, government and healthcare.

The primarily growth driver for the ISS segment beyond MPS has derived from the adoption of multifunctional laser printers "MFP." While consumer pages and business inkjet have declined, MFP pages have steadily increased, growing 37% for 2008, 21% in 2009, 15% for 2010 and for 2011 recorded double digit gains in developing regions and high single digit gains within developed regions. Further, according to IDC, MFPs are projected to grow and gain market share within the EMEA and Latin America, at growth rates projected over 15% year-over-year, while inkjet is projected to decline roughly 16% year-over-year.

Although core revenue growth is masked by the Company's decision to exit the inkjet segment, Lexmark continues to make positive strides within the MPS and MFP space, which has been affected by weakened corporate spending and uncertainty within Europe. Even with these headwinds, LXK continues to grow their franchise in the MPS space at a rapid clip, growing 7% in 2012 and 12% year-over-year/6% sequentially. Additionally, LXK's Large Workgroup A4 printers continue to gain market share, growing from 14% in FY2010 to 17% as of TTM 6/30/13.

Perceptive Software ($185.2MM TTM 6/30/12 revenue)

Over the past few years, Lexmark's Management has focused on building out its software platform as a growth driver and essential component when rolling out its MPS services. The strategy is essentially focused on ingraining LXK products further into its customers' business operations. LXK's first acquisition in the space was in 2010, when the Company acquired Perceptive Software, which specializes in enterprises content management software "ECM." Perceptive describes itself as providing "content in context." Perceptive focuses on taking information in any number of ways, and make it accessible in a company's workflow. With the addition of Perceptive, LXK has been able to lever the platform for bolt on acquisitions over the past two years.

LXK's software division has exhibited strong year-over-year revenue growth; growing 34% (15% organic) for the TTM period. Not only has the segment experienced strong sales growth (organic and acquired), the segment has a steady share of recurring revenues, with maintenance revenues totaling 40% of total Perceptive sales. As management has spent significant sums on acquisitions and integration of the platform, the software segment has only recently turned the corner on profitability, reaching operating income positive for Q2 2013 and is expected to be operating income accretive by year end. Once stabilized, Lexmark's management is targeting operating margins typical for software companies, at ~30%. On current TTM revenues, this would equate to ~56.0MM in sticky operating income. Overall, the ECM/BPM industry is currently estimated at $8B per year and is expected to grow at a 12% CAGR over the next couple years.

Free Cash Flow Analysis

Per the above chart, LXK has demonstrated the ability to consistently generate free cash flow over an economic cycle. This is further supported as the Company managed to stay free cash flow positive in FY2009, in which free cash troughed at $160MM. The increase in free cash flow from FYE09-FYE10, demonstrates the ability LXK has to shift gears and take advantage of certain conditions.

Credit Metrics

Industry

Managed Print Services

LXK's strategy is tied directly to the managed print services industry and its trends. According to Gartner, managed print services is described as "a service offered by an external provider to optimize or manage a company's document output to certain objectives, such as driving down costs, improving efficiency and productivity, and keeping information secure. In a MPS set up, the service provider takes primary responsibility for meeting the customer's office printing needs, including the printing equipment, the supplies, the service and overall management of the printer fleet". In simple terms, LXK manages companies' printing by choosing the most efficient printer setups and shipping more toner as needed.

Currently a little less than half of total expenditures within corporate printing (includes hardware, supplies and services) is spent on MPS spending versus the traditional purchasing model. According to Photizo, MPS is projected to overtake spending on the purchase of equipment by the end of 2013 and obtain over 60% of a $130B estimated market by 2015. While companies have been looking at various ways to cut capex, MPS has been a natural benefactor given a 30% decline in average costs once implemented. Given the benefits, industry analysts are projecting the market to grow at a 20% CAGR. Further, the Asia Pacific and Latin American markets are expected to grow by more than double the expected rates.

Lexmark, which was recognized as an industry leader within the MPS realm has utilized MPS to build "sticky" relationships within corporate clients by offering print set ups that cut their customers' costs combined with various BPM and other document focused software. This is clearly evident with the Company's near 100% renewal rate, and consistent stream of new customer wins. Additionally, Lexmark's MPS offering allows for the perfect cross-sale platform to grow and sell its BPO/software offerings.

Competition

Given LXK's shift on focusing on multi-functional printers/managed printing services and their document management software, LXK mainly competes with Xerox (NYSE:XRX) and to a lesser extent HP (NYSE:HPQ). To get a feel of the current environment, I feel it is best to hear it from XRX; in its 1Q12 analyst call, CEO Ursula Burns noted:

"I would speak about two companies outside of the other group. So the other group is Canon (NYSE:CAJ), Ricoh (OTCPK:RICOY), KM [Konica Minolta] (OTCPK:KNCAY), the normal technology people, technology hardware providers, and they are still infants in document outsourcing. They're really not large players. They are trying to get together solutions and offer them, but we really don't compete actively against them. The places that we -- the competitors that we compete actively against are HP, Lexmark and us. Those are the 3 people who are in this document outsourcing business, today, as mature players. I'll break out HP, of those 3, as behind both Lexmark and Xerox."

"Yes, we have strength in the tech sector, in the telecom sector and in banking. I think Lexmark kind of does legal fairly well, and they do some financial fairly well. So we have to -- they're going to try to catch us in the places that we're good, and we're going to definitely try to catch them in the places that they are good. So I think the market is still very wide open, which is the good thing"

Porter's Five Forces Analysis

Risk

Severity

Mitigant

Threat of New Entrants

Moderate

  • The threat of new entrants tends to be lower, given the maturation of the space, along with technological infrastructure (patents) and customer relationships/ brand recognition needed to succeed. Entrants will most likely enter the space through an acquisition (Funai's purchase of LXK's inkjet assets for example)

Threat of Substitute Products

Moderate

  • Within the Consumer and small business space, tablets could potentially steal greater market share; however, Lexmark has exited this segment.
  • Within the Corporate space, Companies continue to print massive amount of documents daily. Within the financial services industry for instances, physical documents are a must have and are often required.

Bargaining Power of Suppliers

Low

  • Lexmark can source its raw materials from multiple suppliers.

Bargaining Power of Customers

Moderate

  • Pricing, functionality, reliability and service tends to be large factors in swaying corporate purchasers. Lexmark has a leading brand name, along with dedicated industry verticals.

Rivalry

High

  • Rivalry is high, however Lexmark is an industry recognized leader in the MPS and MFP space, along with Xerox.
  • Once printers are installed, it creates an embedded base of machines, which leads to a steady annuity like revenue stream.

Intrinsic Valuation

Given the two distinct segments that make up Lexmark, a sum-of-the-parts "SOTP" valuation is used to determine the intrinsic value for Lexmark.

Sum of the Parts Valuation

Under a simple SOTP valuation, we take adjusted TTM ISS operating income (defined as ISS EBIT less corporate expenses plus certain onetime charges) along with valuing software division at 1x revenues (which is conservative given growth exhibited and considering prices paid historically for software companies with high gross margins) along with net cash and we get a fair idea what the Company is potentially worth.

Under a downside scenario of 4x operating income, the equity value is pegged at $30.3 per share. This downside case is slightly below this week's share price; however, it has rapidly fluctuated. Further, if we believe LXK's profitable printing division is worth at least 6x operating income, our estimated value increases to $41.87 (27% upside) for our base case. As demonstrated below in our LBO analysis, we feel 6x operating income is conservative given a financial/strategic buyer could potentially pay more in a change of control scenario.

LBO Transaction/ Resource Conversion

Given Management's commitment to return at least 50% of free cash flow per year to shareholders in the form of dividends and buybacks, LXK is cannibalizing itself and slowly going private. LXK would benefit from a going private transaction as it will allow management to focus on the business instead of meeting the Street's relatively short-term focused goals. Furthermore, given that capital raised for private equity firms is at an all-time high along with many banks being asset starved, LXK would be an attractive candidate for a buyout given its leverage profile and cash flows.

The LBO scenario above assumes the following:

  • Company is taken private at $40 per share or roughly $2.5B, representing a 4.60x EBITDA multiple.
  • Company is financed with 25% equity or $645MM outlay and the rest in debt capital mix of Term Loan B & High Yield Bond debt at ~3.5x.
  • After a 8% decline year-over-year from FYE12-FYE13, revenues stabilize and grow 2% thereafter.
  • EBITDA margins stay consistent at 15%, which is in line with the historic norm.
  • Cash tax rate of 25%, D&A of $225MM.
  • No consideration is given for margin or operating income increase from the software segment.

Not only would LXK be attractive for a financial buyer, strategic buyers could easily find value in LXK's product portfolio. We have seen in the past five years consolidation within hardware companies given the synergies and economies of scale that could be achieved. I wouldn't be surprised if we see an acquirer from Japan/Asia given the cash they are dropping presently in the market. Finally, an Activist/Control investor could unlock value given the company is clearly cheap on an absolute basis and has the potential to add significant debt capacity. Similarly, the Company could proceed with a leveraged recapitalization with the proceeds used for a bulk share repurchase/ tender offer.

Catalysts to Value Realization

Catalyst

Description

Share Buybacks/Dividends

  • Lexmark trades at a materially discount (~27%) to its conservatively estimated base case valuation of $42 per share. At current prices, buybacks will be accretive to intrinsic value.
  • Management has a clear plan on capital allocation, spending over 50% of their yearly free cash flow on share repurchases and buybacks. Since the second half of 2011, the Company has spent $480MM on share repurchases.

MPS Penetration and Software Business Profitability

  • The Company's managed print service offering has experienced strong growth, which has been masked by the Company's run-off inkjet segment. Importantly, given the consultative nature, MPS tends to create sticky relationships which leads to annuity-like revenues.
  • The software business' profitability has been skewed by its aggressive roll up strategy. The segment has experienced strong organic growth (15% in the last quarter) and once the segment reaches normalized operating margins, the segment should rerate in line with its peers.

Attractive Valuation

  • LXK currently trades at 3.2x EV/EBITDA, an undemanding multiple for a FCF generative business.
  • Lexmark also trades below its conservatively estimated sum-of-the-parts value, estimated at $41 per share, which is further supported by a simple LBO analysis.

Buyout by a Financial or Strategic Acquirer

  • Given its low price, Lexmark has the debt capacity to support a takeover of the Company by both financial and strategic acquirers.

Risks & Mitigants

Risk

Impact

Mitigant

Mismanagement of the Balance Sheet

Weakened Balance Sheet Could lead to BK and/or a loss of market share.

  • Lexmark has maintained a net cash position of $281MM.
  • Management has kept to their capital allocation framework, returning over 50% of their annual free cash flow in the form of share repurchases and dividends.
  • Lexmark has comfortably met all covenant/debt obligations, with no net debt, even considering the large sums spent on building out the Perceptive platform.

Discontinuation of Capital Return Program

Potential Misuse of Capital

  • Management kept their word over the past two years and have continued to return capital, which has been their hallmark.
  • With a net cash position, we believe the Company will be able to execute on its software growth strategy and still continue its repurchase program.

Threat of Secular Decline

Decline in EV, Strategic Position and Financial Strength

  • Lexmark focuses on the corporate space, specifically MPS and MFP, which have strong long-term growth trends.
  • Management have exited the commoditized inkjet and consumer businesses, which have been margin positive.

Loss of Investment Grade Status

Cost of Future Funding will Increase

  • Lexmark should be able to maintain its investment grade status through its consistent EBITDA/FCF generation and net cash position. Further, the Company has no funding requirements for the next three years.

Conclusion

Given the depressed valuation that plagues Lexmark, we believe that the concerns are mostly exaggerated, leading to mispricing and volatility within the sector, offering a conservatively estimated upside of 27% for LXK. The Company's Management have proven that they are not asleep at the wheel and have strategically exited unattractive segments, while investing in growth (multifunctional laser printers/MPS/document management software) and prudently returning free cash flow to shareholders. We do admit that it is highly challenging in determining the pace of change within the tech world, henceforth at its current price it would be prudent to initiate a well-sized position or add LXK to a basket of cheap old-tech names (i.e. Intel, Tellabs,etc.).

Disclosure: I am long LXK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.