Lexmark - Stabilization or Decline?

The recent Lexmark earnings call signaled some gradual but significant shifts in the market and in their own position in the industry. On the positive side (if you can call it that), the announced results did not precipitate any drastic market reactions. Also positive was a somewhat more satisfactory operating income number ($74.6M), the best result since the middle of last year.

But while the operating result was positive and better than the last two quarters, it was well below the average historic result, which had been typically well in the range of the three-digit millions.  Also, their quarterly revenue ($944.1M) dipped below $1B for the first time in over 20 quarters.

Lexmark management defended the results as positive and healthy. Viewed as a product of the strategic shift away from unprofitable consumer business, that is correct in a limited sense. But the idea of that strategy was to compensate with healthy mid-range and corporate installations, and that hope has not come to pass.

The imaging industry is indeed healthy and can be enormously profitable, but only if you capture and maintain installations and drive ongoing output volumes.  But with hardware sales declining 30%, you will not maintain your MIF (machines in field), and even improving print volumes will not deliver the level of revenue and margins required to drive future business. This development is certainly not (yet) a death spiral, but it is a serious warning sign.

One also has to wonder about certain cost allotments. Lexmark has only two main business divisions, the laser ("Printing Solutions and Services") and inkjet ("Imaging Solutions") product groups. We can debate the sense or nonsense of these naming conventions in another space. In a somewhat murky accounting exercise, the operating incomes for both divisions were reported as strong positives: $93M for PS&SD and $52M for ISD. But that total is then reduced by $71M for "other" operations. Since these "other" activities account for an amount greater than one of the major business divisions, it seems like it might have been better to allot those costs directly to the respective operating areas. But depending on how those activities/costs are are parsed out, these might limit (or even eliminate) that division's positive result.

Analysts are also learning to track these key drivers, especially print volume developments. Many of the questions addressed different aspects of that issue: inventory buildup in danger of going chronic, increased threats from third party supplies, reasons for weak supplies demand, cost implications from underutilized production facilities.  These analysts know that this is what drives the future business, and they obviously feel the softness that Lexmark is now exposed to.

Invitation to Say . . . What?

Lexmark held an investor / analyst day at the New York Stock Exchange recently and took the opportunity to say . . . nothing special. Considering the cost and effort of bringing this key audience together, and considering the exceptional circumstances in the economy and in the imaging industry, it was nearly breathtaking how little substantial or new was shared.

Any outlook for future revenue or earnings was studiously avoided, maybe for good reason. Xerox recently revised their Q1 outlook downward and was immediately rewarded with a stern round of agency downgrades and a thrashing in the stock market (although the stock price has since recovered). Such a severe reaction may not have expected , and Lexmark management, who previously may or may not have been prepared to make a similar statement, refused to be drawn on the topic. 

Other statements? More cost cutting and restructuring, but that announcement is not necessarily newsworthy these days. The amount ($75M) is substantial, but one pointed question about how much of that actually benefits the bottom line remained unanswered. 

Some statements were vague or even contradictory: core investments will include R&D, but no focus was provided for which product or business area will benefit, and overall R&D spending will be reduced. Even portfolio-challenged Kodak provided more guidance on where their core investments will be targeted, but they also ignited a discussion by revealing their direction. So maybe again Lexmark thought better of providing too much (any?) detail.

Other topics highlighted:

• The divisions have been renamed - old news, confusing terminology.
• Pullback from unprofitable product lines and regions - old news.
• New products - always welcome, but these are all improvements in the current space.
• Reliance on internally developed technology - commendable but severely limiting.
• "Print less, save more" - a remarkable statement for a printing company.

One statement that did stand out was the clear demarcation to the world of copiers/MFPs, with the newest model positioned as the "copier killer." The presentation included tape on the floor depicting the size and service access areas of the competing products, obviously stressing how monstrous the competing products are. So while other companies are expanding their approaches and product portfolios to embrace all corners of the customer organizations, Lexmark has clearly stated that this is not an area of interest for them. Especially with a renewed focus on managed print services and a declared focus on high-volume and high-value installations, it is notable that an entire category of relevant products will not be pursued.

Several pointed questions surrounding the future of the inkjet business were also artfully dodged, leaving the audience with no clear outlook. Margins are at an unacceptable level but will improve, installations are dropping but will stabilize, higher volumes will improve results but no expected usage patterns were provided. And (again) the statement that inkjet will now successfully enter the business market. But the questions of how, why and why now were also left open.

So maybe the event and accompanying statements made sense for the hosts. But many of the guests were left wondering what the real message was.

You Never Know . . .

Today's headlines regarding Xerox:

"Xerox slashes earnings target on weak economy"

"S&P revises Xerox outlook to negative on lowered guidance"

"Xerox shares down 7% in early trading"

On the one side, this development should come as no surprise. Poor results will be punished, by ratings agencies and by the market.  On the other side (and this could sound a bit bizarre), is there a hint of a "return to normalcy" in these headlines?  

It was not that long ago that reduced or negative earnings hardly raised an eyebrow in the market. And now this reaction - why this time so severe?  You never know  . . . But the aberration was then, not now.

The market sensitivity to this announcement may catch Xerox management unprepared, as they might have expected a more casual overall response. They may have assumed a higher tolerance for further negative news, but obviously such developments were not baked into the current expectations. 

This was most definitely not the case, so what is the issue? The markets will not be so forgiving, maybe because there is proof that some individual companies can indeed perform well through the difficult times.  Or there is a stronger expectation that the leading companies in key sectors should now be able to deliver more acceptable results after market and internal adjustments.

So if the "market of expectations" has bottomed out, the results will have to follow a more positive curve, or those companies will suffer the consequences more severely than they have recently. The first quarter will be a key indicator for the future direction of the market.

New Report Details Industry Trends and Outlook

Woodford Group publishes its Imaging Industry Margin Index Report on a quarterly basis.  The newest edition, the twentieth in the series, is available now for purchase. This newest report, reflecting results up to Q4 2008, reveals a resilient industry with steady performance in spite of strong economic headwinds. Especially notable are the year's cumulative results, which are as strong as past years:

This cut of the data obviously includes the stronger quarters from earlier in the year, although by common agreement we were already in a recession then as well. This steady result is a product of the basic business dynamics: printing and imaging is vitally important to daily business life and delivers a solid, profitable annuity stream.

We do of course see strong differentiation in the individual quarters, and each company shows distinct trend lines on their own and relative to the industry as a whole. Not all will be equally prepared for the present and future challenges, but well-positioned imaging companies will survive better than leading companies in other sectors, and they will emerge from the current difficulties with new products and application areas to drive future growth.

For more information, or to order the report, please visit the Woodford Group website or click here.

The Mixed Bag of Imaging and Other Business Areas

Here is an interesting illustration of the imaging industry relative to other IT sectors: taken from Epson's recent earnings call, we can see where they can earn the most - printing.  The Information Equipment group is the printer business, and this distinct dynamic is visible in other companies with mixed product areas as well. Even HP, despite a slight disdain for the IPG group currently, shows a similar trend, especially when comparing their other hardware business ares. The obvious implication is that a stronger concentration on imaging products would be good for the overall business, which is indeed true as long as the right user and volume segments are targeted. But this is not an automatic recipe for success. Low end product focus does not deliver similar results, and as we know several companies are struggling to escape that segment. Which begs the question why Lexmark is evidently redoubling its efforts in the consumer channel, proudly announcing their renewed commitment to no less than six consumer-oriented stores.  This is an expensive and questionable undertaking, while other segments show more promise for volume and profit.

Lexmark downgrade - are we/they to be concerned?

From Marketwatch:  Standard & Poor's said late Wednesday it downgraded the corporate credit and senior unsecured debt ratings on Lexmark International Inc. to BBB- from BBB. The outlook is stable. "The downgrade reflects our belief that total revenue and profitability will remain pressured as Lexmark works through a strategic business mix shift toward higher usage and more profitable product sales in its consumer segment," said Philip Schrank, an S&P credit analyst, in a statement.

Let's just look at the elements of this short statement:

• Total revenue and profitability will remain pressured - that pressure will definitely remain, as the trend towards broader offerings leads to more exposure for those companies who focus on specific segments. If you are a pure-play company like Lexmark, you have to be ideally positioned to leverage your products and be investing to expand and reposition your technology base. The fulfillment of these prerequisites is questionable at best in this case.
  
• Strategic business mix shift - it is fair to say that some shift has taken place, but only within the long-suffering inkjet business area, which has not changed the overall outcome significantly. A shift of more consequence would involve a seismic innovation effort to develop significant new products or a serious reconsideration of the long-term purpose and viability of the inkjet business area.
  
• Higher usage and more profitable product sales in its consumer segment - this target, at least at the level of achieving acceptable unit placements, is practically a contradiction in terms. Kodak is attacking the same "high-volume consumer" space, promising 5-6 million placements annually within two years, others (most notably HP and Epson) are waiting with "shovel-ready" products and pricing models that can exploit the same space, and there is still the possibility that Memjet partners will be entering the market within a year. So that space, while never all that big, is going to be more crowded than ever.
  

Lexmark has a great technology base and product line-up, but the biggest questions remain: how to expand the overall product portfolio, and what to do ultimately with the ink jet business. Until those issues are resolved, their financial outlook will remain questionable.