Lexmark: It Comes Down To Trusting Management

| About: Lexmark International, (LXK)

Summary

Lexmark reported 2015 second quarter earnings on July 21st. Results were mixed compared to analysts' average estimates. But, compared to management's previous guidance, the quarter was a solid beat.

However, news in the report resulted in question marks about the second half of 2015 and the share price dropped over 20%.

As Lexmark continues its path of transformation to a solutions provider and continues to integrate recent acquisitions, the decision to invest comes down to trusting management's guidance.

Lexmark (NYSE:LXK), a content, process and output management solutions provider, announced 2015 second quarter earnings on July 21st. Shareholders knew to expect a drop in both revenue and earnings per share year-over-year. Lexmark has been purposely transitioning from a reliance on hardware revenue and diversifying into providing software solutions. Compared to 2014 second quarter revenue of $894 million and EPS of $0.99, Lexmark earned $891 million in revenue and $0.97 in earnings per share (all amounts non-GAAP). The results were mixed compared to analysts' average expectations of $896 million for revenue and $0.82 for EPS.

Rather than focusing on year-over-year results during the transformation, Lexmark set key goals that can better be used to measure progress. In March 2015, Lexmark announced it would acquire Kofax, a business process management solutions provider. The transaction closed May 21st. For the full year of 2015, this acquisition will propel Lexmark beyond one of its key goals set for 2016 - generate $500 million in annual revenue in its Enterprise Software segment. The key goal, still left to achieve, is to drive its operating income margin in the segment to 25%.

In the 2015 first quarter, the Enterprise Software segment delivered operating income margin of 8.89%. It is not reasonable to expect the Kofax acquisition to be fully integrated in just one quarter. Yet for the 2015 second quarter, the operating income margin did swell to 20% resulting in a first half rate of 16%. In the second quarter earnings call, Lexmark CEO, Mr. Paul Rooke, shared the outlook for the remainder of the year:

"And we expect operating margin expansion to continue as we go under the full benefit of 2014 cost savings, optimize pricing, realize the cost and expense synergies from integrating ReadSoft and Kofax and drive continued revenue growth."

Relative to the acquisition of Kofax as well as the 2014 acquisition of ReadSoft, Lexmark announced it would be eliminating 500 positions worldwide in a restructuring effort. Regional facilities will be consolidated. Positions will be eliminated in general and administrative, marketing and development areas. Also, positions will be shifted to low-cost countries. By 2017, Lexmark expects to derive $65 million in savings from the actions.

While the results specific to Lexmark's goals are quite encouraging, the market did not respond favorably to the company's report. Shares closed the day down $9.57, over 20%. Such a reaction warrants a deeper look into the report. Headlines highlight the second quarter revenue miss and an adjustment to the full-year profit forecast.

Lexmark revenue is derived from several sources - the sale of hardware and supplies, MPS (managed print services), software licenses, maintenance and subscriptions. Annuity revenue (recurring revenue), the most attractive type of revenue which includes printer supplies, extended warranties, MPS, software maintenance and software subscriptions, grew 2% in the quarter and now contributes almost 70% of Lexmark's total revenue. Of the annuity revenue, Lexmark considers the MPS and Enterprise Software revenue "higher value" meaning it delivers higher margins. The company has tripled its MPS and Enterprise Software revenue from just over $500 million in 2010 to over $1.5 billion currently.

It's difficult to find horrifying news in the story above. But, the reality is Lexmark was impacted in the second quarter by two distinct situations. Like most companies operating in the global marketplace, Lexmark took a hit based on the strong U.S. dollar. On a constant currency basis, the company would have delivered a quarterly revenue increase of 7%. But, analysts' estimates were, most likely, set with the knowledge of a currency impact considered. Thus, to analysts, the miss was still a miss. However, it is probably important here to mention that the miss was strictly against analysts' estimates. The company had guided for a revenue drop year-over-year of 2% to 4%. Against its own guidance, Lexmark beat by 2.75%. At a -3% midpoint, the company was guiding at $867 million but delivered $891 million. Number to number, currency impact included, the year-over-year decrease was less than 1% at just 0.3%.

The second situation addressed in the results was an inventory optimization to the laser supply channel in the EMEA (Europe, Middle East and Africa). Revenue from laser printer supplies was down 10% year-over-year (3% on a constant currency basis). Lexmark strives to keep 6 to 10 weeks of laser printer supplies in its channel inventory. The inventory in the EMEA channel is above the high end of that range. Lexmark is decreasing its full-year revenue by $50 million as a result of reducing laser supply sales to the EMEA. The $50 million adjustment is expected to hit third quarter earnings per share.

However, for the full year, even with the $50 million adjustment, Lexmark guided revenue higher. It now expects a year-over-year change in the range of a 1% decrease to a 1% increase. This compares to first quarter guidance of a year-over-year decrease of 3% to 5%. Before the report, analysts' average estimate for full-year revenue was $3.72 billion, just barely under the 2014 results of $3.728 billion. This also falls right at the midpoint of Lexmark's second quarter guidance range of $3.69 billion to $3.77 billion. So, even though Lexmark guided full-year revenue higher, analysts were already expecting it.

Looking toward the bottom line, Lexmark's guidance for third quarter EPS was the shocker. As mentioned above, the laser supply channel optimization is expected to impact the third quarter. Lexmark guided EPS for the quarter in a range of $0.51 to $0.61. This compares to analysts' average estimate of $0.89. Lexmark guided full-year EPS in the second quarter at $3.55 to $3.75. This range was 1.4% lower than first quarter guidance of $3.60 to $3.80. Before the report, for the full year, analysts were expecting EPS of $3.68 which does still fit in Lexmark's range. It could be argued, however, that at the midpoint, the company's guidance was just 0.8% lower than the analysts' average.

Two other key points for shareholders from the earnings report and call were not likely to be the culprit for the sharp decline. As was already announced, the company has paused its share buy-back program in order to direct cash toward paying down the debt incurred to acquire Kofax. With the focus on paying down debt and restructuring the organization to further integrate Kofax and ReadSoft, management confirmed the company would not be in an M&A mindset for the next 18 months.

So far, it's still difficult to justify more than a 20% drop in the share price. Analysts' questions during the conference call do shed some light though. The two positive contributors to the second quarter earnings were the Kofax contribution and a resolution of a German copyright levy and litigation. Between the two, $0.19 and $0.23, respectively, were added to the bottom line. For the full year, Kofax is expected to contribute $0.39 to the bottom line. The litigation contribution will remain consistent at $0.23 for the full year. When analysts back these amounts out, concerns arise when the remainder is compared to the previous year. Management confirmed the laser supply channel optimization is the primary reason for the impact. They detailed how the situation arose:

"So, on the channel inventory and what we communicated was that our model range was 6 to 10 weeks of channel inventory. The actions that we took in the second quarter actually took every region down, North America, Latin America and Asia Pacific, either below or near the low end of that 6 to 10-week inventory range. Europe, however, or EMEA, however, is above that range. And what's happened in that region, and from a model perspective what's happened, is that we had last year, starting in third quarter, we had the euro move from roughly a $1.35, maybe $1.37 at the time, it moved all the way down below $1.10. It bounced back recently, but, it moved below a $1.10. Now, in response to that, Lexmark, as well as the entire market, moved to harmonize prices. So, there were Lexmark increases in fourth quarter, first quarter, second quarter with many of our competitors actually moving right along with us in the marketplace to harmonize pricing. The reaction of that cause in the channel was it caused the channel to try to get ahead of those price increases. And so, our models didn't incorporate that reaction. And so, when we took inventory sell in laser supplies down in the second quarter, we expected that inventory to decrease correspondingly which it did in all the other regions with the exception of EMEA. So, because EMEA didn't go down, obviously it went down but not as much as we expected, obviously, we kind of did a deep dive into that region to understand the dynamics behind that and that's when we determined that we needed to take the second half action."

With that explanation and the guidance for third quarter EPS in a range of $0.51 to $0.61 and for full year EPS in a range of $3.55 to $3.75, the concern, naturally, migrates to the implications for the fourth quarter. Year-to-date, the first half EPS equates to $1.80. Using the midpoints of $0.56 for the third quarter and $3.65 for the full year, fourth quarter EPS would have to be $1.29 ($3.65-$1.80-$0.56). The comparison of $1.29 in one quarter to $1.80 in the first half of the year depicts quite a build. The comparison of $1.29 in the sequential quarter to a quarter delivering just $0.56 is frightening. And, analysts did not bypass the opportunity to make Lexmark management justify the claim:

"But, we back into Q4, it's around $1.30 based on the full year outlook and that's well above the street. And it implies earnings, obviously, are going to more than double sequentially. So, what gives you the confidence in that Q4 outlook and what are the main sequential drivers that would take you from $0.55 to a $1.30?"

Lexmark's CFO, David Reeder, justified the guidance highlighting the following revenue expectations:

  • Lexmark revenue, historically, increases around $100 million in the fourth quarter (and has by as much as $110 million to $120 million)

  • the third quarter is usually Kofax's weakest revenue quarter and its fourth quarter usually improves sequentially

  • the majority of the channel optimization revenue action is going to happen in the third quarter.

The combination of the three means the company expects "some pretty nice lift sequentially third quarter to fourth quarter on revenue". But, delivering to the bottom line leads squarely back to the one key goal Lexmark has not yet met - margins - even if it is set based on exiting 2016. Mr. Reeder, continued:

"And then, when you think about how that impacts gross margin, we've got a software business that has 70 points plus of gross margin. And so as that revenue from the Enterprise Software business as a larger percentage of the total mix, you get that fall through not only at the gross margin line, but all the way down to the operating income line."

By the end of 2015, Lexmark expects operating income margins for the Enterprise Software segment to improve from approximately 5% at year-end 2014 to approximately 15%. For the company as a whole, Lexmark wants to achieve operating income margins of 11% to 13%.

Validating management's observations, Lexmark's revenue increased $115 million and $111 million from the third quarter to the fourth quarter in 2013 and 2014 respectively. The company projected third quarter revenue to be down 1% to up 1% which equates to $911.8 million to $930.2 million. Adding $100 million to that projection results in an estimate for the fourth quarter of $1.01 billion to $1.03 billion for the fourth quarter. Using the midpoint estimates for the third and fourth quarters, as a double-check, these estimates support the full-year revenue projection of $3.69 billion to $3.77 billion by meeting the low-end of the range.

For Kofax, the period ending September 30th was historically the first quarter of its fiscal year. For the periods ending September 30th in 2013 and 2014, Kofax' revenues totaled $65.6 million and $68.5 million respectively. And, as stated by Lexmark's management, the revenue from those quarters were the lowest of the year. By comparison, the quarters ending December 31st in 2013 and 2014 totaled revenue of $74.1 million and $79.8 million respectively which represented increases of 13% and 16%. As a final comparison, the quarters ending June 30th of 2013 and 2014 produced revenue of $78.2 million and $79.5 million respectively. Even though Kofax only added to Lexmark revenue for 40 days of the same quarter in 2015, the addition was $48 million. The chart below depicts a possible trendline for 2015 relative to Kofax' historical performance.

Finally, laser supplies in the third and fourth quarters of 2013 and 2014 are compared to a possible scenario for 2015 in the next chart:

As Lexmark continues to exit the inkjet business and revenue dwindles from that source, this impact added to the laser supply channel optimization impact easily offset the contribution of Kofax in the third quarter. But, a return to normalcy and continued improvement in the fourth quarter is not unreasonable. In the 2014 fourth quarter, the company earned $1.11 in non-GAAP EPS. The table below derives the fourth quarter assumptions based on actual data and available projections:

 

Q1

Q2

Q3

Q4

Full-Year Orig

Full-Year Current

2014 Actual

$0.92

$0.99

$1.05

$1.11

$4.04

$4.04

Operational Performance

$0.24

$0.17

-$0.03

$0.21

$0.61

$0.59

Kofax Contribution

 

$0.19

 

$0.20

 

$0.39

Currency Impact

-$0.36

-$0.42

-$0.40

-$0.16

-$0.90

-$1.34

Non-operational

$0.01

$0.04

-$0.06

-$0.02

-$0.05

-$0.03

2015 Actual

$0.81

$0.97

       

2015 Guidance

$0.75

$0.80

$0.56

$1.34

$3.70

$3.65

The curious number in the table above is the currency impact derived for the fourth quarter based on year-to-date actuals and projections for the third quarter and full year. However, an explanation is found in the earnings call:

"The remainder of the savings (from the restructuring) will come from the other actions we are taking to offset the ongoing currency impacts."

At the closing price on July 21st of $37.75, Lexmark's multiple based on the midpoint of current year guidance is just 10.34. It also places the dividend yield at 3.8% based on a dividend rate of $1.44 annually. The drop in share price offers Lexmark shareholders a chance to reinvest assuming they have developed a trust in Lexmark management. Potential investors may want to add weight in their decision criteria that considers Lexmark's performance compared to management guidance so far in 2015. At this point, it's come down to deciding whether one trusts management.

 

Disclosure: I am/we are 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.

Additional disclosure: I plan to review LXK with my investment club in August.

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Tagged: , Computer Based Systems, Earnings
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