Lexmark's Brighter Picture


By Megan Graham-Hackett At its annual analyst meeting on Nov. 9 in Cincinnati, Lexmark International (LXK

; ranked 4 STARS (accumulate); recent price: $83) discussed its strategy for future revenue growth. It also fielded questions dealing with concerns about the growth of its ink-cartridge business. Although the meeting helped shed new light on Lexmark's strategy, at S&P we haven't changed our outlook on the stock or our earnings estimates.

Lexmark listed three revenue-growth opportunities: low-end mono laser, color laser, and photo printers. The focus on the low-end mono laser business reflects a shift in customer demand toward that market segment. In the area of color, Lexmark concedes it's not where it needs to be as far as technology is concerned. And, finally, in photo printers, it admitted to being late to enter this market, having originally seen the photo-printing as a function instead of a separate category.

SPENDING PLANS. Our belief is that Lexmark is no longer able to compete just on price, as its competitors have improved their cost structures in the past few years, and that it can't rely on market-share gains in its traditional inkjet- and laser-printer segments. Therefore, we believe Lexmark must target new areas to sustain revenue growth in the maturing printer market.

Along with these strategic areas come new investments. In the area of color, it's increasing research and development (R&D) investments and spending on advertising and branding to better position itself in photo printers (Lexmark says R&D investments for this segment occurred late in 2003). The branding effort, which carries the tagline "uncomplicated," also is being used for Lexmark's business customers.

The strategy is to have a services-led approach and help corporations reduce the cost of their paper-based processes by printing less. Lexmark wants to introduce an electronic method that actually causes a company to reduce printing and cut logistics costs for shipping documents around a company. The idea is that Lexmark would offset the negative impact to printer demand and supplies by becoming a "trusted" partner of a client, which enables Lexmark to penetrate that account and perhaps keep it from using a competitor such as Xerox (XRX).

NEW MARKETS. Lexmark thinks it has a unique market position and competitive advantages to help differentiate itself from rivals also pursuing services business. In the end, these investments are expected to take operating margins down to the 11% to 13% band that it has typically talked about in its business model, after creeping up to 14% this year.

Lexmark believes that its strategy to enter new markets should help increase its installed base, and that its entry into photo printers can boost sales of its consumables, since photo printers typically use more ink cartridges than traditional inkjets. However, Lexmark is also battling countervailing trends, such as bundled printers, which typically show lower usage.

Another factor affecting the ink-cartridges business model is its introduction of standard-yield cartridges. These cartridges contain less ink and sell for about $20 each, vs. the more typical $30 cartridge. Lexmark concedes that standard-yield cartridges carry a lower gross margin, but the idea is to sell more of them. This hurt third-quarter results, according to the company. However, the negative gross margin impact was offset by better hardware margins as Lexmark wrung costs out, and as its hardware prices didn't fall as much as in the past.

At S&P, we haven't changed our earnings estimates or valuation model for Lexmark based on the analyst meeting. We continue to see earnings per share of $4.21, including a tax benefit, in 2004 and $4.58 in 2005.

BETTER BRANDING. Lexmark didn't quantify the investment increase for 2005 to tap new growth areas, but it did say areas such as R&D will not likely have a payoff until three years out. We believe Lexmark's new photo printers are competitive, and we agree with its strategy to gear up its branding message to get the word out. Some of these investments arguably should have occurred earlier, in our opinion, but Lexmark is conservative, and the market, as well as the economy, has showed mixed signals as far as growth.

While it has some $1.5 billion in cash and marketable securities and acquisitions are a possibility, we believe Lexmark will continue to focus on share buybacks as its primary avenue to return value to shareholders. With a return-on-equity of 31% in 2003, share buybacks are a compelling use of cash, in our opinion.

Lexmark shares currently trade at an attractive price-earnings-to-growth multiple (using five-year EPS growth) vs. its peer group, in our opinion. Our 12-month target price is $109, based on our discounted cash-flow model. We believe the shares are attractive given our view of its solid balance sheet, strong cash-flow growth, and stable business model, reflecting its increasing installed base and photo-printer opportunity, which we think should yield stronger sales of its ink cartridges in the future. Once the market begins to witness this growth, we believe the shares will outperform the S&P 500-stock index.

Note: Megan Graham-Hackett has no stock ownership or financial interest in any of the companies in her coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Graham-Hackett follows computer hardware stocks for Standard & Poor's Equity Research


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