One of the challenges with non-stop economic news/noise is that it can be difficult to focus on the fundamental underpinnings of individual companies. While the broad economic outlook is admittedly poor, some stocks seem to have derisked significantly and carry valuations across a number of metrics that would suggest significant undervaluation. Lexmark International (“LXK”) seems to be a company that gets no respect based on its current valuation. As this analysis will illustrate, LXK could easily be worth $55/per share or 75+% above current prices. LXK is a printer company focused on office imaging and enterprise content management (ECM) markets. The company’s key products are laser printers, inkjet printers, multi-function devices, dot matrix printers and associated supplies, solutions and services, and ECM software solutions and services. The short/bear case is primarily centered around a secular decline in printer demand around along with current weak corporate spending. LXK also has a rapidly declining consumer printer segment which the company readily acknowledges. LXK has actually been attempting to accelerate the phase-out of this lower margin business so it becomes a smaller contributor to its operations. Since Q1 2010, LXK’s legacy consumer segment has been accounting for a smaller portion of LXK’s overall business in each subsequent quarter. Through Q3 2011, the corporate focused hardware/supplies and software segments account for 89% of LXK’s revenue with the negative growth legacy consumer segment just 11% of total revenues. The corporate and software segments have also been growing, in some cases near 10% year over year. What investors should note is that just under two years ago, the corporate and software segments were 77% of total revenues with legacy 23%. As the legacy segment continues to roll off, LXK’s operating performance should experience less of a drag from this segment. I believe that the market and sellside may be overlooking this key aspect of LXK, allowing a significant valuation discrepancy to arise. The following points can provide further evidence that valuation for LXK may have bottomed.
LXK is cheap on an absolute basis: LXK has a market capitalization of ~$2.4B and enterprise value (“EV”) of ~$1.8B. The company is on track to generate roughly $700MM in EBITDA (inclusive of an estimated $25MM in stock compensation) leading to an EV/EBITDA multiple of 2.6x. On an LTM basis LXK is trading at 2.8x EV/LTM EBITDA. LXK’s capital expenditures are running below its annual depreciation and amortization but LXK does have a relatively small pension contribution it makes. The combination of the pension contribution and capex net out against LXK’s D&A which results in an EV/EBIT multiple of roughly 3.8x LTM EBIT. LXK also looks dirt cheap on a Price to Free Cash Flow basis as Table I below illustrates. With a market capitalization of ~$2.4B, LXK’s P/FCF ratio is just 6.6x 2011 expected free cash flow or 15% FCF yield.
TABLE I: 2011 ESTIMATED LXK FREE CASH FLOW ($MM)
LXK is cheap against comparable companies:LXK’s upside can get very interesting when compared to its peer group. The threats to LXK’s business are homogenous to most printing, imaging, and document management companies such as Xerox International (“XRX”) and Canon Inc (“CAJ”). Nonetheless, LXK carries valuation metrics that are well below those carried by XRX and CAJ, its two closest peers. Hewlett-Packard (“HPQ”) was excluded primarily because its valuation encompasses a number of distinct business segments. While the printer division is a key competitor of LXK, HPQ also has enterprise storage and service offerings, PCs, and mobile software, making it difficult to characterize as a true comparable.
TABLE II: LXX COMPS
LXK trades at a significant discount to its peers but is this discount justified? Often times a company can carry a discount to peers because it has poor operating metrics or capital structure issues relative to the broader peer group. However, when comparing LXK’s operating and capital structure metrics relative to XRX and CAJ, an even stronger case for LXK enjoying a higher share price could be made.
TABLE III: LXK VERSUS PEERS (LTM)
LXK’s operating metrics are similar to industry behemoth CAJ while simply blowing away XRX. While CAJ has the strongest balance sheet, LXK is a very strong credit, with Net Debt/LTM EBITDA at just 0.9x while XRX has much more, albeit still moderate, leverage. In terms of capital efficiency, LXK leads both LXK and CAJ. So despite operating metrics that are clearly within the broader cohort and capital allocation superior to its competition, LXK trades at a heavy discount to peers. While XRX has been somewhat of a hedge fund “hotel” of late, it appears that LXK offers the best value to investors. Readers should also note that LXK has also recently instituted a dividend of $1/share which equates to a roughly 3% yield.
Relative to peers, LXK offers better or comparable operating metrics, better or comparable capital structure, vastly superior capital return metrics as illustrated by strong ROA and ROE figures, and a dividend that is above the broader S&P 500 dividend yield. It’s hard to see how LXK does not deserve valuation metrics closer to its peer group as a result. Table IV outlines what LXK’s valuation range would be using the metrics of its key peers (green line denotes LXK current price).
TABLE IV: LXK VALUATION BASED ON COMPS
What is interesting is that LXK analysts expect that the company will experience substantial declines in revenue and EPS in 2012 while its peers are expected to experience growth. This leads to forward valuations, particularly on an P/forward EPS basis that can understate LXK’s valuation. This is because while the forward valuation metric itself may look similar to a peer like XRX, it is not truly reflective because analysts are expecting XRX’s EPS to grow while projecting a decline in LXK’s 2012 EPS. This is what leads to a lower range for the P/2012 EPS and P/2011 EPS metrics. While XRX has entered into other market segments via its acquisition of ACS, the main business, as with CAJ, still faces the same challenges as LXK.
Further, LXK has also made moves into other higher end areas of document processing and is experiencing top line growth in 2011 following an 8% sales growth year in 2010. In fact these strategic moves are what has in part contributed to LXK’s gross margins improving by roughly 500 basis points relative to its historical gross margins and operating margins above what was achieved in 2005 when revenues were nearly 25% higher. This indicates that if analysts are overly pessimistic regarding LXK’s future prospects, the company’s valuation is even cheaper on a forward basis. As previously stated, as the legacy business continues to roll off, more robust top line growth and more importantly higher operating margins should be achievable. It appears that analysts may be ignoring this. In fact, an even modest long-term top line growth of rate of just ~2.5% can make LXK a very attractive leveraged buyout candidate, supporting a $55+ valuation for LXK.
TABLE V: LBO ANALYSIS
Table V assumes modest 2.5% annual top line growth with margins comparable to what is achieved in 2011. Considering that 2011 is a challenging year, the analysis could be deemed conservative. LBO firms are known for aggressive cost cutting and it would not be a surprise to see operating expenses reigned in or capex reduced to boost free cash flow. The LBO analysis assumes a deal occurs at year end 2011 and that the deal is structured comparable to a Term Loan B and high yield debt offering with an average interest rate of 10%. With the cash flow metrics LXK exhibits and leverage of just 3.8x at deal close, the interest rate could also be too high as well. What this means is that the overall analysis from deal structure to projections could be very conservative. Nonetheless, these conservative assumptions lead to very attractive IRRs for a LBO shop. Assuming an exit at year end 2015, a sponsor’s IRR, assuming LXK could be sold via an IPO or to a strategic buyer, would range from 27% to 48%. This assumes that the sponsor does nothing with the excess cash flow and smart LBO firms generally use excess cash to either execute dividend recapitalizations, acquire complementary businesses that could boost value, or pay down expensive debt. In Table V, I simply let the excess cash accrue. Yet despite these conservative assumptions, an offering takeout price of $55 or just 5.4x EV/2011 estimated EBITDA yields an extremely attractive return profile to a financial sponsor. LXK could also be of value to HPQ, CAJ, or XRX and be a relatively minor acquisition given its smaller size compared to these larger firms.
Whenever analyzing a company, my main goal before investing in it is to absolutely bury the bull thesis and be fully aware of the short thesis. I have analyzed the short/bear case for LXK and while there are clearly near-term threats due to challenges at the corporate order level, the current valuation appears to discount a number of these challenges. Even modest assumptions regarding the future of LXK, particularly as its legacy consumer business becomes less of a drag to it, suggest that a share price well above $50 is reasonable. While $50 is ~60+% above current levels, investors should focus mainly on valuation. At $55/share, LXK would be trading at just 5.3x EV/EBITDA, comparable to CAJ yet still below the EV/EBITDA valuation XRX commands. In addition, LXK boasts better operating metrics, capital structure, and a more aggressive strategy for returning cash to shareholders via buybacks ($125MM in 2011) and a 3% dividend yield.
LXK’s management and board should also realize that they have a fiduciary duty to maximize shareholder value. With the stock declining by nearly 70% since 2004, the LXK board and management should consider selling the company to a party that can allow existing shareholders to realize a valuation LXK warrants. A share offer 50-80% above current share prices likely presents a return to investors far greater than successfully executing new corporate strategies which could also potentially destroy shareholder value.
DISCLOSURE: AUTHOR MANAGES A HEDGE FUND AND MANAGED ACCOUNTS LONG LXK.
About the author:
Amit Chokshi is the founder and owner of Kinnaras and affiliated companies and is responsible for security analysis, selection, portfolio management, and Firm operations. Prior to founding Kinnaras, he worked as an associate at the Royal Bank of Scotland ("RBS") in the firm's Corporate Advisory Services group, which provided corporate finance and mergers and acquisition ("M&A") services to the firm's clients with a particular emphasis on private equity firms. Amit also worked at Morgan Stanley and received a B.S. in Finance from Bryant University and an MBA from Emory University. In addition to passing the NASD Series 7, 63, and 65 exams, Amit is also a CFA Charterholder and on the Board of the Stamford CFA Society. Amit has appeared on Bloomberg Radio and has also been quoted in various publications regarding Firm-specific holdings.