LexMark (LXK) Developing Case Study

LexMark: Value or Value Trap?

I read the news today, oh boy!

LEXINGTON, Ky., July 12, 2012, Today LexMark announced that second quarter 2012 financial results will be lower than expected.  (Editor: Read analysts need to cover their asses!)

Based on a preliminary analysis of second quarter financial results, the company currently expects second quarter revenue to decline about 12 percent year over year. (Holy #$^&!). This compares to the guidance that the company previously provided in April for the second quarter of an expected revenue decline between 7 to 9 percent year over year. (Editor: Analysts are saying, “What the $%^&! …why didn’t the company tell me?) GAAP earnings per share are now expected to be in the range of $0.53 to $0.55, or $0.87 to $0.89, excluding approximately $0.34 for restructuring-related and acquisition-related adjustments. This compares to the GAAP earnings per share guidance that the company previously provided for the second quarter of $0.65 to $0.75, or $0.95 to $1.05, excluding approximately $0.30 per share for restructuring-related and acquisition-related adjustments.This revised second quarter outlook reflects a weaker than expected demand environment, particularly in Europe (Editor: Who Knew?! What a surprise), and a larger than expected impact from unfavorable changes in currency exchange rates. The weaker demand environment prevented the company from overcoming this currency shift.Looking ahead, the company expects these same factors to impact the second half of 2012 and will provide an update on its full year 2012 outlook on the company’s upcoming earnings conference call scheduled for Tuesday, July 24, 2012.

No conference call will be held in conjunction with this revised financial outlook and the company will have no further comment on this until its upcoming second quarter earnings release.

Analyst Downgrades………..will be announced. (Editor: The horse has left the barn).

5 PM update:

(LXK -16.3%) closes at multi-year lows thanks to an ugly Q2 warning. Goldman (Sell) is taking a hammer to its 2013 and 2014 estimates, declaring the headwinds to Lexmark’s high-margin printing supplies business to be worse than feared. Though no full-year guidance revision was provided, Brean Murray thinks 2012 EPS could be around $4, compared with prior guidance of $4.70-$4.90 – that still gives Lexmark a forward P/E of just 5. HPQ -1.9%. XRX -1.8%.

Upcoming Second Quarter Earnings Conference Call Information

The company will be hosting a conference call with securities analysts on Tuesday, July 24, 2012 at 8:30 a.m. (EDT). A live broadcast and a complete replay of this call can be accessed from Lexmark’s investor relations website at http://investor.lexmark.com .

This Post is to establish a basis for a case study in the future

This post is NOT a recommendation to do what I do (buy LXK today at $20.71) because you may be doing this:http://www.youtube.com/watch?v=go9uekKOcKM.

and here is why I might have a reason to buy: LXK_VL_July 6 12.

In a year or so I can refer back to this dated post. I want to be on record to improve the learning experience and build the case study. Next will the upcoming earnings report in late July. The history, valuation, financial strength, declining business can be discussed later, but for now, this is an attempt to take advantage of Mr. Market. Not everything works out, but we make our way.

Remember to be careful when fools rush in………….Better, perhaps, to follow them to the heart of the American Dream:http://www.youtube.com/watch?v=u_9tZ3aPCFo&feature=relmfu

Have a Great Weekend!

24 responses to “LexMark (LXK) Developing Case Study

  1. John,

    I was looking at LXK in April when it was around $35 per share. At the time I wasnt comfortable buying it and I havent revisited it since but I must say that today’s price move makes it considerably more attractive. I’ve pasted the contents of an email that I wrote to a friend on the company in April below that offers my thoughts on the company at the time:

    What interested me initially is their track record of returns on capital and returns on equity are high (especially net of cash) despite the fact that LXK is in a commodity business. This indicates some type of competitive advantage. Although I haven’t cleared identified what it is or if its sustainable, they’re clearly doing something right. They’ve also halved their share count in the last ten years and have authorization to buy back another $600mm of shares (like 25% of current market cap at current price) and pay a 3% div (50% is target payout ratio). The company is a cash juggernaut.

    The company is at the tail end of phasing out their consumer (legacy) segment, which is currently 10% of revenue and next year is supposed to be 6% of revenue (I understand that they sold their last consumer printer this year, so the rest will be a tapering off of legacy supply revenues). Revenues have declined for the past 5 or 6 years and are now roughly flat. So, effectively, the decrease in sales from the legacy business is masking growth in the business hardware segment (in $ terms that is, unit sales are more or less flat YoY) and, most importantly, in the high margin business supplies segment. The good news is that as the declining revenue stream eventually peters out, you are left with only a growing one, although the growth is modest. The question is then, will this revenue stream continue to grow and for how long?

    The company is now focused on multi-functional printers (MFPs) which are the most workflow intensive (basically the awesome copier, scanner, printer, stapler that is in every office). Because of the amount of workflow, these use up the most supplies per unit and therefore provide the most profitability to LXK over the lifecycle of the printer. Then you have the smaller periphery office printers which are much less profitable but necessary nonetheless.

    The street’s consensus view and the stock price implies that eventually all businesses are moving to tablet based readers and ECM solutions (LXK has made some acquisitions to boost competence in this space but I don’t assign any value to them being better at this than anybody else in the space and it could prove a waste of money) and that printers will die a slow death. Maybe this happens, but I think its plausible that it takes quite some time. Personally, I can’t imagine an office environment where I’m not printing a sh*tload, but I prefer hard copies rather than reading on screens. Also, do you think the current “recession light” environment of companies cost cutting through reducing print supply usage and forgoing printer purchases is permanent? I imagine that at 8.5% unemployment companies print a lot less than 5% unemployment.

    Bottom line is that I haven’t convinced myself that it’s not a value trap yet but at 2.6x EBITDA and with cash being returned at such a rapid pace to shareholders through buybacks and dividends, even if the top line never grows again you might make a little money. If they do achieve some growth in the next few years, I imagine the upside is pretty substantial as it would likely result in both EPS growth and margin expansion.

  2. Just to get a better understanding..was this company already on your ‘watchlist’ or did the new low popped up on your screen after which you did a quick scan of fundamentals and decided to build an initial position?

    • I have been stalking this for the past few years. The combination of earnings warnings, analysts panic (with the world economy in slow down, how can people be surprised at sales/earnings decline) and a long price decline of a few years without meaningful harm in their business (still generating alot of free cash (but they are making acquisitions to grow and transition so true “free cash flow” may be overstated) and a good balance sheet-(discuss val. Later) tells me that the SELLERS are not the strong side of this transaction in the LONG-TERM.

      But I may be the FOOL. We will see………

      HPQ is a mess and XRX is a so/so business. No doubt tablets and the amount of info that changes will reduce printing but not eliminate it. The question is what will they do with their free cash flow. I hope it goes to the investors while he mgt. focuses on the strengths off the business. There are no guarantees.

      I wanted to build a case study in realtime to the future. Perhaps the experience will be more like biking through Central Park Naked.

  3. Last question…I was also wondering whether your view incorporates a view on the declining ‘printing’ business. It seems objective data from enterprises show that there isn’t that much of a decline in printing / servicing them. Everybody sees however more and more other devices popping up (my company uses Ipads now for a lot of customer contact..whereas before they were printing a lot of documentation.

    You could however also just assume almost zero growth or even decline and look at cash-flow, buy back shares, balance sheet, current service revenue/margins/profit, …

    (Related..it has different divisions and it also is in a different market cap range but Baupost also initialized a HPQ position a couple of quarters ago..and also some other ‘value’ people see value in Xerox)

    Now back to independent thinking!

  4. 6 months ago I would have jumped on just about any EV/EBIT < 4, especially one with high ROCs. Been reading too much Greenwald lately though. I don't trust that future EBIT will look like the current. Is there market share stability & barriers to entry in printers, or is it just like PCs?

    Get ready for a Greenwald cut-and-paste:
    "Even when market share is stable and profitability is high, a close look at the business may fail to spot any clearly identifiable cost, customer captivity, or economies of scale advantages. The likely explanation for this discrepancy is either that the market share and profitability figures are temporary, or that they are the consequence of good management—operational effectiveness—that can be emulated by any sufficiently focused entrant. Identifying the sources of competitive advantages should help predict their likely sustainability…"

    Kahn, Judd; Greenwald, Bruce C. (2005-08-18). Competition Demystified: A Radically Simplified Approach to Business Strategy (Kindle Locations 973-978). Penguin Group. Kindle Edition.

    • Lumilog:

      Your best post ever. You hit the nail on the head. The investment at this price will fail/struggle if the future cash flows are in permanent decline greater than the cash flows that can be returned to shareholders through asset conversion (sale), dividends, and shrinking the company. This ain’t Coke.

      • I think my concerns are somewhat similar, although I’m thinking specifically about whether the enterprise market will look like today in the future. I used to work for a company that made christmas lights, and even they would take about the greater margins in commercial/enterprise sales over those to consumers. You can even look at insurers and some are trying to move into the commercial sector. HP has discussed the enterprise market as having better margins too, which is where Dell is better than HP. So we have christmas lighting, computing, and insurance companies all talking about the benefits of enterprise business – increased attention on an area may drive increased price competition leading to lower profitability, unless there are enough barriers to entry. (I would argue there are barriers to entry for _anything_ in life, even if it’s just the attitude of not being lazy that is needed, but the part that matters is that they’re large enough to keep people out)

  5. I have not been able to determine a sustainable competitive advantage for the company as of yet. In fact, I think LXK’s high ROC relates to selling more large “all-in-one” printers to business customers that then purchase more supplies (ink cartridges, paper, etc.) from the company. Its similar to a razor/razor blade model. All the margin is in the sale of the razor blades, or in the case, the printer supplies. “All-in-one” printers use up more supplies per unit than smaller printers and LXK, wisely, seems to be focused on pushing this business segment. LXK’s competitors (Xerox, HPQ, Canon) do not have the same high ROC’s but I believe this is probably do to these companies being larger and having other business segments that produce lower returns and therefore drag down their overall ROC. They likely achieve comparable ROC’s in the sales of larger printers and supplies as LXK does. However, one has to tip their hat to LXK’s management for playing to their strengths and consistently returning capital to shareholders.

    Does anybody have any good methods/resources regarding the valuation of declining businesses? With technology killing business models at a tremendous rate, developing a strong competence in investing in these situations could prove to be a profitable endeavor. This is a good example of a business that would be great to own outright. Then you could pocket the cash flows and reinvest them elsewhere (a la Buffett). But I think it’s worth considerably less from my position as a non-control investor. Any thoughts on how to think about these situations from a value perspective would be much appreciated.

    • I agree quite a bit with you on this one – with a declining business, there may be a lot of cash that can be siphoned off if it’s managed well, but I don’t think it’s the norm to see this occur. The challenge is that there are probably very few managers who are okay coming in and firing employees for 5-6 years in a row, liquidating assets, and in general, winding down the company. If they’re good enough to do this well, they’re probably going to have opportunities to make a company even more money on the way up. This means that you’re already going to be starting with individuals who aren’t the absolute best. Further… for any manager, wouldn’t a turn around count for a lot more? If they save a business from going under, that will do wonders for their next hiring, and the downside is limited, because they’ll still collect a paycheck.

      When I ran my business, I always knew that if I managed it well, there was a lot of cash that could be released on the way down. I would use up the assets, decrease function to whatever provided the greatest NPV without damaging my own personal reputation & future engagement ability, etc.

      This is likely going to be a bit easier, like you said, if you own the business outright. Henry Singleton, at times, invested far less in R&D within his companies than others, and I am betting that many of his investments generated far superior returns under his ownership than they would have as a public company. As a public firm, it would be far easier to make guesses that prove R&D to be value generating and thus consume all the FCF available and pile it into R&D, investments, etc. With Singleton guiding the major activities, he was able to control that and actually realize value where others would not typically be able to.

      Sometimes, I get the feeling that a lot of tech-focused companies have a shorter life-span than they are projected to have. The valuations that investment bankers put out will have a terminal value after year 10, but in reality, the company might only be around 7 years as a public firm, or whatever it is. Great technology doesn’t create a great business – just great products. I have no issue with this, but investments in products and businesses are very different – I won’t value a product based firm the same way I would a great business.

  6. It seems at least a lot of sell-side, past holders of the shares and people on this blog do not hold a positive view with regard to Lexmark as a company..most mentioned elements seem to be :
    – is printing a declining business?
    – how sustainable is the cash-flow if you do not account for take-overs?
    – will management continue to do good capital allocation towards shareholders?
    – is the high margin income from servicing sustainable?
    – …

    After that, you could probably compare quality versus valuation (return coming from among others cash flow going back to shareholders), and see whether it fits your profile.

    I think you can tick the at least the sentiment box if that would be part of your checklist.

  7. Sorry if this is obvious but LXK traded as low as $16/sh in 2009. They made 1.86 in Diluted EPS so traded ~8 or 9 PE when sentiment was about as bearish as one gets. So at 5x it seems like your getting a good price CURRENTLY. The company has large European exposure and stated it hit on currency. PG and PM said something similar and have rebounded nicely. The real question remains, is this RIMM or COKE? That’s a harder question as LXK isn’t the market leader. I don’t care if my printer is Xerox, Canon, or even RIMM as long as it works! So I can’t see much of a competitive advantage from where I sit. That being said, a Euro isn’t collapsing into anarchy bounce seems like a reasonable trade, an investment seems more difficult to ascertain without some more in depth industry knowledge imho.Will be watching this one to see how it plays out, earnings call on 7.24

    • Thanks NN:

      Yes, there is a declining business with a transition going on. We will get to a further analysis down the road. Of course, this is for a CASE STUDY and not a STOCK Recommendation. And even if it were how you categorize and weight the position (this is not a heavy weighting 5% to 25%, but much less than that because it is more of a special situation. And one or two quarters but two years is what it might take to see how they do. I am confident enough in the balance sheet that the decline won’t be due to a forced liquidation or bankruptcy (and LXK is making $$–for now).

      The first part was to focus on horrific news. Note the amount of trade over the last two days (probably a big volume day on Monday 1/5 of the float) as people throw in the towel (but someone is buying). There are always two sides.

      I have posted on PZN, MDC, ORI. But I wanted to go step-by-step more precisely. Let a little time pass/dust settle before the next part.

      But here is what a Hedge Fund Friend sent me by email:

      What an IDIOT. You posted a dinosaur in a tar pit. LXK is toast, done, gone, finished, kaput. Don’t you get it. This has no franchise, printing is in a freefall, they have no competitive advantage. Management owns less than 1% of the stock so they don’t care. This is a ride straight to Hell. When I saw your post, it gave me added confidence to short more because I have suckers like you taking the newbies off a cliff. So when will you puke out your loss? Next week below $20 or do you wait until agony hits and you sell at $15 or knowing you–$10.

      I hope you die slowly.

      Twist in the wind.



      Other email I will not post due to obscenities. Women and children may read these posts.

  8. Out of curiosity…I was wondering how you deal with your investment afterwards? I assume you focused initially on the fundamentals and sentiment. However…

    – did you set a timeframe in advance?
    – do you look at the price movements at all now? does it influence you that the stock remains quite flattish while the stock market is going lower?
    – do you have a ‘fair value’ for Lexmark?
    – do you look at analyst estimate changes at all?
    – do you have a stop-loss or a plan b ? do you know what you will do if nothing fundamental happens and the stocks goes 20% lower?

    I’m not expecting an elaborate answer on the questions..but I’m just trying to learn here how your selling proces works…

    • Dear PT:

      I don’t watch the stock during the day, but I am not surprised to see declines after XRX reported. My main concern is if the transition procedes and management is aggressive on repurchasing shares near their stated book value.

      I think the market is paying a lot for certainty like Kimberly Clark and CLorox and not much for cyclical names.

      No stop loss, just sell if management reverses course or I find a much more compelling opportunity–lock in the loss and go into another area. Or I hold for a few years. This will require a few quarters to navigate, I believe. The best is if I gain more conviction and the price declines more so I buy more. But this is not that situation currently. The business is suffering a storm while transitioning but it has the balance sheet and return of capital to give me patience. We will see.

  9. I found this paragraph in a sell-side report of today..I guess it reflects the view of the sell-side:

    Shares of Lexmark have been under pressure much of 2012, but we think the size of the cut to the 2012 EPS guidance and the prospects of another downward reset or two stand to reduce investor sponsorship. We recommend that investors stand clear of printing-related stocks until the macroeconomic uncertainty subsides, given the segment’s low stature in IT budgets.

    We expect the challenged fundamentals to overshadow Lexmark’s shareholder-focused activities of increased dividend and ongoing share repurchases.

  10. The market is really overlooking Lexmark’s capital allocation policy, which has been very good. It really seems that the sell side is just focusing on a big “what if” scenario that tablets etc. are going to completely kill printing in the corporate world…(while they are printing hundreds of pages a day) and the near term economic headwinds, which have affected many other companies and were pretty much expected.

    What I am worried about:

    1) If Lexmark loses IG status, what will it do to there $350 million debt refinancing?
    2) Acquisitions going forward.. so far it looks like their software moves have been alright.
    3) Something like $800 million is overseas, which they might possibly need tap to buy back debt and shares.
    4) Management stops returning capital…best time ever for them to buy back shares.
    5) A take under. It looks like LXK could be a very decent buy out target, especially at these prices.

    • In general, sell-side mostly looks at :
      – income statement
      – forecasting revenue numbers based on their industry view
      – putting a multiple on the EPS estimates
      – …

      They often do not focus that much on :
      – balance sheet
      – capital allocation versus operating mentality of management
      – the business model / franchise / entry barriers / … of the company
      – …

      So, I guess sell-side will keep on focusing on the what-if scenario’s, especially with regard to technology..

  11. I haven’t forgotten about reviewing Lexmark.
    The question becomes what is the price value
    relationship? Buy more, hold tight or redeploy
    capital elsewhere.

    Since the company is not under balance
    sheet threat, I would be suspicious that
    value declined as much as price. I will
    revisit this with a post when I finish other work.

    Another opportunity to learn and build character.

  12. Saw this trade go off, fyi

    Lexmark (LXK) trades 4,000 September $18/$17 bull risk reversals at zero cost. Sell the 17 put to finance the 18 call.

  13. Can I recommend a case study in TSN. Crushed today and trading below book value…

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