Company Summary

They are a producer of printers, printer peripheries and software used in the printing industry (through the acquisition of Perceptive Software last year). The

company split the industry broadly into Inkjet and Laserjet, with further subdivisions (for example Laser is further split into Monochrome and Colour).

Generally the Laserjet market seems to be growing a little bit faster that Inkjet, I think reflecting some cannibalization (for example Laserjet printing in

colour has gotten cheaper in recent years, making it more attractive). The actual reporting segments as of Q111 are ISS (where they lump together

hardware and supplies) and then Perceptive Software, which is the acquired business. Before the acquisition they provided a revenue split by Hardware and

Supplies, and additionally told us the shipping split between Inkjet and Laserjet, but unhelpfully they seem to have discontinued this split. They have never

given the margin split by Hardware and Supplies, I think because the margins they make in Supplies are extortionately high and they do not want to attract

attention from the media, customers or regulators.

The company have stated that the strategy is to target the higher growth areas such as Laserjet and then office products rather than consumer products

within Inkjet, though there has been some skepticism as to whether this will actually deliver growth above the market rate (a stated longer term goal at the

CMD) as it is believed that these higher growth areas will simply converge to market growth rates once the cannibalization is complete.

The $90bn a year market is characterized by a fairly high degree of producer concentration, (for example HP, Canon and Epson account for about 85% of

global inkjet hardware sales) but in spite of this, price competition on the hardware tends to be intense. The reason for the level of competition is that the

gross margins on the supplies tend to be very high - on average I have read that it tends to be around 60%, though I am told that for the cartridges for

the high end printers it can be as high as 90%. The margins are high because the manufacturers build their printers in such a way that the printer only

accepts cartridges produced by the company that made the printer (the printer and the cartridge are fitted with a chip) - thus once a company has shipped the

unit, it effectively has monopoly supplier power over the peripheries and can price accordingly. Over the years, a number of potential entrants into the supply

market have attempted to attack this monopoly power, but to date the incumbents have been successful in pursuing legal remedies to protect their intellectual

property. Given the high degree of visibility that the company that ships the printer has on the revenue and gross profit stream from the supplies over the life

of the printer once it has been shipped, they can of course afford to be quite aggressive in the pricing of the hardware and make a fairly accurate NPV

calculation over the entire contract. The company state in their annual report that they have observed strong price competition and expect this to continue.

Competition can get weaker or stronger from quarter to quarter but I have not observed and recurring seasonal pattern - the company state that it can

be due to transient issues, for example one player carrying a particularly high inventory level.

Aside from the qualitative comments that the company make on competition, I have tried to make an estimate on level of profit that the company achieves

on the hardware, assuming the 60% gross margin I have seen quoted on supplies is accurate - I find that over the cycle, the hardware is probably about

breakeven (though it has become marginally profitable in recent quarters, I estimate), further highlighting the degree of competition:

Lexmark In More Detail

The Lion's share of the revenue ($2,915m of the group $4,200 in 2010) comes from the lucrative supplies business, while in 2010 I estimate that supplies

probably generated about $1,750m of gross profit, Hardware generated about $60m of gross profit and there were about $290m of unallocated costs. Clearly,

maintaining an installed base of high quality units that generate a lot of print pages and guarantee supply revenue is the name of the game, and the company

talks a lot about this in their strategy presentations. From reading the transcript of the CMD, many of the questions focused upon why the company appeared

to report a bad quarter in the volumes they shipped, even in the higher growth units that they claim to be focusing on - the management answered the

question fairly convincingly I think, saying that price competition was quite strong and they stepped away from certain contracts - but I actually think the

analysts might have been asking the wrong question. The company unfortunately do not give quarterly data on volumes shipped - this is only available yearly,

but if we interpolate the data we have, we can get a rough feel for the pattern of shipments in the last few years.

Here we see shipments of the less profitable legacy Inkjet units calling precipitously from 2005 onwards. Moreover, if we assume that the average printer lasts

for about 3.5 years before being replaced (the company states that the legacy printers are dropping out of the revenue mix at a rate of about 30% per annum)

then from here we can make a roughestimate of what is happening with the installed base:

The company argue that this sales focus is the right strategy as the higher priced printers generate more printed pages per device, which require more ink

and in turn more supplies revenue - this argument is borne out by the divisional data - using the estimate we made of the installed base and then the quarterly

services divisional revenue, we can make anestimate of the revenue generated per installed device

Given the visibility on the revenue stream from supplies, I think that the trend observed will likely continue as the mix improves. The company talks about

"legacy" supply revenues declining at about 30% annualized going forward, so the units generating less revenue per unit should drop out of the mix quite

quickly. The sell side seems to have looked at this number and been concerned that it implies that the core revenues need to grow 10% just to offset the

decline in legacy. The concern is understandable but would I would note that the mix of legacy revenues will drop markedly over the next year or so, and

given the supplies revenue per unit trend we are seeing, and given the high gross margin on these supplies, the actual profit outlook for the company is

quite attractive. The drop through from gross margin to EBIT to operating cash flow to free cash flow is not that hard to model - SG&A has risen steadily from

about 20% of sales in Q105 up to about 28% in Q409, before falling sharply to 26% by Q310 and staying around that level ever since - the reason for the

decline recently is the fall in R&D as the cycle comes to an end. Operating cash flow has been at least equal to EBIT in 26 of the last 30 quarters, while free

cash flow has averaged 83% of EBIT since 2005, punctuated by a couple of negative quarters during the downturn:

Looking at the dollar amount of free cash flow generated over time, the quality of the annuity provided by the high margin service revenues is again readily

apparent:

Despite the attractive cash generation, the sell side seems focused on where the quarterly numbers come in - I have noticed that they tend to be quite

inaccurate in terms of forecasting this and the shares tend to react quite strongly either way to this on the day of numbers - the stock has moved 10% on

the day of results 6 times since the start of 2008 - up more than 10% three times and down more than 10% three times. I think that this represents both

a risk and an opportunity - of course there is the risk of losing 10% on the day of results and being forced out of the position, but part of the investment

case is that hopefully over the case of a year or so this will even out and the market will be forced to focus on the strong cash generation and reward the

stock. I have included a copy of the EBIT surprise rates and subsequent stock reaction on the day for reference

The quality of the balance sheet makes the case more attractive, in my view. The company's gross debt stands at around $650m and cash on hand is

$309m, but the company also holds some $960m in marketable securities which, if one considers them to be equivalent to cash, gives net cash of about

$620m. Delevering the free cash flow, I arrive at a trailing EV free cash flow yield of 20%, rising to an incredible 47% by 2012 year end. The 47% is

clearly a standout - either the market believes that the company is not viable as a going concern or they will do something stupid with their cash. It is

likely that they make acquisitions - the company state as much, saying that their first priority is using the cash to grow the business, while the second is

stock buybacks. I would note that the company has a track record of being shareholder friendly, having bought back on average $195m of stock per

quarter from Q204 to Q107, then initiating another buyback of $550m of stock from Q208 to Q408. While acquisitions are more likely, the two are not

mutually exclusive, and one would hope that were the company to do deals, they would be earnings accretive at some point - given that the current

forward earnings multiple is below 7x, this might even be beneficial to the shares. At the very least I would hope that the net cash and the prospective

cash generation would ensure quite limited downside, at least.

Valuation

The main valuation tool I have used is prospective EV free cash flow yield - I have used a target EV free cash flow yield of 15%, which I think is reasonably

conservative. Given my forecasts of cash generation going forward, I have mapped out the following path for the shares:

Clearly a fair value of $49 by 2012 year end is an attractive target, implying around 90% upside. To give some sense on the range the stock has

historically traded on, I have compiled a history of the trailing EV free cash flow yield going back to 2003. The analysis is of course complicated by the

financial crisis, as the trailing yield rose sharply in anticipation of poor results and disappearing free cash flow, but prior to this the stocked seemed

to trade on a a trailing yield of between 5% and 15% - since then it has been 15%-20%, so the overall range I would use is 5%-20%. Given my EV free

cash flow estimate of $445m by Q412, that would imply a bear case EV of $2.2bn - if I then assume all the cash generated between now and then is

used on acquisitions, it would still imply a fair value above $35/share. If I assume that the margin cannot be sustained, and falls back to the average

level since 2003 (well below guidance, consensus and the 12m average) then free cash flow would probably fall to about $215m - even then, if I use a

20% yield, the shares would be worth about $21.50, so the downside might be capped at 26%. My alternative valuation approach was an economic

value added approach. Making all the relevant adjustments, I found that despite the shrinking top line, the company

actually has a very good track record in terms of beating its cost of capital:

Note On Earnings

I forecast $3.85 of earnings this year and $3.92 next year, implying forward P/E's of 7.5x and 7.3x, respectively, against consensus

of $4.30 and $4.20, respectively. I am slightly below consensus on the top line, so the difference arises on the margins - I have not

seen a detailed justification from the sell side on why margins should compress so much but hopefully I have provided justification for my estimates.

The company have provided guidance as follows:

Given the margin achieved in Q1 of 10.9% GAAP, 11.9% non-GAAP, the company appears to have some work to do to get to 12.3% for the full year -

they say that the bulk will come from a slight mix improvement, along with the phasing out of some one-off costs. The one-offs were in the $15m-$20m

range in Q1 and were related to the streamlining of some non-manufacturing operations which did not go to plan - the company said at their CMD that

they are dealing with this and that the effect will be zero by Q112. Obviously we have to take the company at face value on this, but I would note than

consensus expects 11.7% for the full year, so is not giving them much in the way of credit for this. I think that the risk is that the transparency on how

they get to their guidance is not great - for example the non-GAAP margin that they quote is not arrived at by just adding the restructuring charge back

to EBIT - there are some other factors in there that must be in SG&A - from piecing together what they said at the CMD and then comparing the GAAP

and non-GAAP numbers in the press release, I can surmise that most of the difference must be the non-manufacturing costs, but it is not a transparent

calculation to do and I think there is always the risk that they disappoint the market again at some point this year.

Consensus

There are two stale buyers of the stock, nine hold recommendations and then four sells - I think most analysts have given up on the stock a little bit

as the strategy is taking a long time to execute and in the meantime the quarterly earnings are proving to be disastrously difficult to forecast with any

kind of accuracy.

What Can Go Wrong?

1. The company could use all of its cash to make acquisitions in an attempt to try to bring growth to the business. The recent deal, Perceptive

Software, involved the acquisition of a company that does not generate its cost of capital currently as the focus is on growing the business - if they

continue to do this, while there might not be tremendous downside, it could be a bit like RR Donnelley, where it is hard to see why the stock would

rerate

2. It is hard to see all that much structural growth given that people print less, use tablets more, etc

3. The top line has been in terminal decline driven by the falling installed base - if management strategy to stabilize this does not bear fruit then again

it might be hard to see the stock making much progress.

4. They have stated explicitly that the aim is to grow the business, so acquisitions are more likely that shareholder friendly moves

5. If somebody were able to successfully challenge the intellectual property on the supplies business then there would be meaningful downside to

the stock given how profitable this part of the business is

6. It could stay cheap for an extended period given investors in the sector have quite attractive growth stories like Apple to focus on, along with

bellwethers like Microsoft that are equally cheap (and indeed have been cheap for a decade).

7. They have some underfunding on their defined benefit pension scheme - but given the size (less than $200m) I don't think it can do that much

damage.

Would be interested to know what others think on this one - I guess my main concerns are management refuse to be shareholder friendly with the

cash they should generate, some more one-offs that torpedo one of the next sets of quarterly earnings, the image of the industry as one in structural

decline, and the subsequent inability of the stock to ever rerate. But yeah - would be interested in any pushback.