Consider Lexmark International (LXK), a manufacturer of a full range of personal and enterprise printers and scanners, as well as software for document workflow and content management solutions. I wrote about LXK back in March, noting how the company had made changes providing for higher payouts in the event of a takeover (sometimes signalling an impending takeover!):
In June, Deutsche Bank issued a report of top LBO candidates that included LXK (and several other companies I’ve discussed on this site!). Though a takeover has not (yet) materialized, I believe LXK presents a compelling opportunity.
The company has recently taken actions which could indicate that it believes it might be a takeover candidate in the near future. In November, the company amended its employment agreements with senior executives, specifically ensuring continued employment and benefits in the case of a change in control, and providing for a nice bonus if terminated without good cause following a change in control. Read the full details here.
Let’s start with the company’s revenues and margins.
Lexmark International - Revenue and Margins, 1994 - 2Q 2011
Two things are worth noting here. First, the company’s revenues have declined precipitously over the last three years. Second, At the same time, the company’s gross margins have increased dramatically (480bp since 2007). Why? I believe this is largely the result of the company’s change in strategy, moving away from lower margin consumer printers toward higher usage business customers that will make use of LXK’s associated services and software. I like this strategy, as the company pointed out in several consecutive 10-Ks that the lower-end consumer division was experiencing extreme pricing pressure, and lower inkjet supplies and OEM unit sales. Here’s what the company said about the strategy in its 2009 (trough revenues) 10-K:
So essentially the company is saying that revenues (from consumers) may decline faster than the company can grow its business customers, but in the long-run, this will be for the company’s benefit as margins will be stronger and more sustainable.
Lexmark’s inkjet strategy shift that began in 2007 to transition to higher usage customers and products, and reduce sales of low-end/low-price inkjet hardware, continued to impact the Company’s inkjet unit sales and supplies revenue. The objective of this transition is to move to a smaller installed base of higher page generating units. However, in the near term, the Company sees the potential for continued erosion in end-user inkjet supplies demand due to the reduction in inkjet hardware unit sales during this transition period. In addition, the Company has experienced weakness in its OEM business over the last several years, which the Company believes could result in lower OEM inkjet and laser supplies demand.
Ok, now let’s take a look at the company’s stewardship of shareholder capital.
Lexmark International - Returns, 1995 - 2Q 2011
Only once in the last sixteen years did the company’s returns on equity dip into single digits. In short, the company’s returns have been stellar, and consistently so.
Before I get a dozen emails asking me what the difference is between ROIC and ROCE, let me clarify (Feel free to skip if you don’t care!). Both are measuring largely the same thing, but the difference has to do with how cash is treated. For my calculations, I use the following definitions:
Capital Employed = Total Assets – Current Liabilities This is essentially stripping out working capital from total assets.
ROCE = Net Income / Average Capital Employed
Invested Capital = Book Value of Equity + Book Value of Debt – Cash
NOPAT = EBIT * (1 – tax rate)
ROIC = NOPAT / Average Invested Capital
Ok, now that this is settled, we see that there is a big disparity in the above graph between the company’s ROIC and ROCE. Why? CASH. LXK has accumulated a ridiculous amount of cash.
Lexmark International - Capital Structure, 1995 - 2Q 2011
As you can see, the company’s cash (and marketable securities) balance has been increasing steadily since 2006. In fact, as of 2Q 2011, the company has Cash + Marketable Securities of $1.352 billion, which is approximately 50% of its current (7/27) market cap, or 26% net of debt.
Before we move on, take a look at that chart once more. Notice the massive decline in cash from 2004 to 2005? And then again into 2006? That’s not the result of ill-conceived acquisitions. That’s the company buying back shares, directly returning capital to shareholders. In fact, the company has returned $4.159 billion to shareholders since 1996. That’s 1.55x the current market cap, in cash returned.
Speaking of cash, let’s look at the company’s free cash flows.
Lexmark International - Free Cash Flows, 1994 - 1Q 2011
The company’s free cash flows follow fairly closely with the company’s revenues, which suggests a fairly stable relationship (further reinforced by the company’s relatively stable net profit margin and the FCF/NI ratio here, which should be familiar to readers of Financial Shenanigans (read my in-depth multi-part review here)).
Let’s put these free cash flows in perspective. At its trough in 2009 (the depths of the recession when enterprise customers were putting a hold on all discretionary IT spending!), the company generated $160 million in free cash flows. Using this as a starting assumption, we first have an apparent 5.9% free cash flow yield. However, if you assume the position of an acquirer, and reduce the purchase price by the cash on hand (let’s assume this is an LBO, and you are going to assume the current debt), you are really dealing with an 11.9% FCF yield. In the worst case. The company has (and I believe will again) generated far higher free cash flows than this over the last decade. Is it any wonder that the company is making it onto lists of “Top LBO Candidates”? If I could, I’d do an LBO on the company myself. For now, I’ll have to be satisfied with my equity stake.
Before we get to valuation, let’s round out this discussion by taking a look at the company’s cash conversion cycle (which, as I’ve mentioned many times on this site, helps identify several financial shenanigans):
Lexmark International - Cash Conversion Cycle, 1995 - 2Q 2011
There’s not much to complain about here! The cash conversion cycle is coming down, but predominantly due to increasing days’ payables. This isn’t sustainable, so I would expect the company’s CCC to increase again, but likely not to pre-2003 levels.
Ok, now for valuation. In completing my valuations, I aim to be vaguely right rather than precisely wrong, and so I treat my valuations as a ballpark, and I try to triangulate with a few different valuation metrics. So, I use a variety of scenarios and calculated both residual income values and earnings power values. Under my extreme bearish scenarios, the company is overvalued (as expected), but by an amount that I feel comfortable risking given the upside identified in my neutral and bullish scenarios. In other words, I believe LXK has a sufficient margin of safety. While I patiently wait for LXK to move up to what I believe its intrinsic value is, the company may begin buying back shares again (the company stopped given the uncertainty in the markets, and has approximately $491 million left under its Board authorization), and there always exists the potential for an LBO shop or other strategic acquirer stepping in. Hopefully someone wakes up to the value at LXK sooner, rather than later!
What do you think about LXK?
Author Disclosure: Long LXK
Talk to Frank about Lexmark International