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Printing Money - Lexmark International, Inc.

July 29, 2009 | About:
Thesis:

Lexmark issues debt that yields less than 7% to buy back equity yielding more than 20%. This policy is sustainable and will in time force up the share price to at least twice the current level.

FCF yield & Earnings yield > 20%

The company:

Lexmark International, Inc. (LXK) is a vertically integrated developer, manufacturer and supplier of printing and imaging solutions. Lexmark's product line includes laser printers, inkjet printers, multifunction devices and associated supplies and services.

Manufacturers such as Lexmark and Hewlett Packard use the razor/blades approach to sales, selling the printer as cheap as possible and making up for it as customers buy high-margin replacement toner and ink.

The Company sees continued erosion in end-user inkjet supplies demand due to the reduction in inkjet hardware unit sales and is executing a strategy focused on higher-usage segments of the market (SOHO).

According to IDC www.idc.com :

The inkjet market remained the dominant segment in 4Q08, with 22.8 million units shipped, but it was also hit the hardest with –18% year-over-year growth.

Monochrome laser was the second largest technology segment with 7.2 million units shipped and year-over-year shipment growth of –17.3%.

Color laser shipments, the third largest segment, was essentially flat year over year and was the only segment not to experience a decline in the quarter.

Lexmark is the fifth worldwide market player overall, it lost two points in total market share (4.7%). The strongest growth for Lexmark was the global Laser MFP segment where its shipments grew 20% year over year.


Debt capacity:

With 200m (a record low) of net income under:

- recession conditions

- an (allmost record) high capex of 245m

Lexmark should be able to service 1B of long-term (interest bearing) debt.

Long-term debt now stands at 600m. The company should be able to sell 400m of additional debt.

Lexmark currently has 800m of cash and cash equivalents on it's balance sheet...... meaning the company could spend ~1.2B on it's policy of aggresively buying back shares without cutting back on it's currently high capex.

From the 10q: "As of March 31, 2009, there was approximately $0.5 billion of share repurchase authority remaining."

With a market cap of 1.1B, Lexmark is able to sustain it's policy of buying back shares till the very last share. If by so doing the equity yield should rise above the yield of it's debt, it would be in the interest of shareholders to change the policy and buy back debt or return excess cash to shareholders in the form of dividend.

For the FCF yield of the equity to come near that of the debt, the stock price must triple.

Specific Risks:

1) Lexmark's strategy of gaining market share in the Laser MFP segment could fail.

2) Lexmark could spend it's cash on a dumb acquisition

As to the first risk, this could conceivably be dealt with by shorting the bonds.

Catalysts:

1) Lexmark announces an accelerated buy back program.

2) A takeover bid by Dell or any other strategic buyer.

Any and all questions and comments welcome as usual.

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


Rating: 2.4/5 (10 votes)

Comments

fk
Fk - 5 years ago
Batbeer,

Hewlett packard has the ticker HPQ, not HP. Do you have a position in LXK or its bond? I'll try to look through their 10k before asking any further questions...
hschacht
Hschacht - 5 years ago
Good article... I wrote about Lexmark on www.lonelyvalue.com last month. Company has $700+ million in cash and is dirt cheap. Even after accounting for a sizable pension liability. Company should generate $150 to $200 million in fcf this year against a market cap that is barely over $1 billion. Very glad to see someone else mention the DELL connection. I own some LXK. Hope Batbeer does too. Anyone can write passionately, but I prefer when conviction is followed by actual cash. Way to go!
hschacht
Hschacht - 5 years ago
Third Avenue owns 2+ million shares!
batbeer2
Batbeer2 premium member - 5 years ago
>> Hewlett packard has the ticker HPQ, not HP.

Sorry for the typo. I can't fix it now.... gurufocus ?

- edit - Thank you gurufocus for changing the ticker.

>> Do you have a position in LXK or its bond? I'll try to look through their 10k before asking any further questions...

I am long the stock.
Sivaram
Sivaram - 5 years ago
What did they do with the $500m or so debt that they issued in the last few years? Long term debt seems to have jumped from around $150m to $600m+ in 2008. Did they buy back shares?
batbeer2
Batbeer2 premium member - 5 years ago
That jump are the bonds they sold in two tranches in 2008 at ~6.5%. Line #1 of the OP.

At that time ~750m + 50m of cash was "earmarked" by the board to buy back shares. ~300m of this "earmarked" cash has now been spent leaving 500m.

Two additional items of interest:

- The company has ~300m of unused credit; validating my estimate.

- The bonds have a provision where the rate is raised if and when S&P or Moodys downgrades them to junk. I don't know the terms. Does anyone here have access to this information ?


From http://www.bloomberg.com/apps/news?pid=conewsstory&refer=conews&tkr=LXK:US&sid=akoRkQvACCek on May 20 2008

..... The notes are split into two tranches of five- and ten-year notes, respectively. The five-year notes, which are in the amount of $350 million, will have an effective yield to maturity of 5.939 percent and will mature June 1, 2013. The ten-year notes, which are in the amount of $300 million, will have an effective yield to maturity of 6.687 percent and will mature June 1, 2018. The offering is subject to customary closing conditions and is expected to close on May 22, 2008. As previously disclosed, the company intends to use the net proceeds from the offering for general corporate purposes, including to fund share repurchases, repay debt, finance acquisitions, finance capital expenditures and operating expenses and invest in any subsidiaries.

The company also announced today that its board of directors authorized on May 20, 2008 the repurchase of an additional $750 million of its Class A Common Stock.....
Sivaram
Sivaram - 5 years ago
Batbeer2: " The bonds have a provision where the coupon is upped if and when S&P or Moodys downgrades them to junk. I don't know the terms. Does anyone here have access to this information ?"

Just searched for it... Here is the SEC filing for the bonds:

http://www.sec.gov/Archives/edgar/data/1001288/000095015208004175/l31345de424b2.htm

The details are likely in the prospectus (I haven't read it)...

Lexmark is close to junk so I think one should look at the worst case and see what the worst case rate may be...
batbeer2
Batbeer2 premium member - 5 years ago
AHA !

I have learnt something; thank you.
batbeer2
Batbeer2 premium member - 5 years ago
Now I know. Worst case scenario, the rate is still less than 8.5%. Interestingly if ever these bonds are rated high, the provision is "killed".

From the prospectus:

"In addition, the interest rate on the notes of that series will permanently cease to be subject to any adjustment described above (notwithstanding any subsequent decrease in the ratings by either or both rating agencies) if the notes of that series become rated A3 and A- or higher by Moody’s and S&P, respectively (or one of these ratings if the notes of that series are only rated by one rating agency). "
hschacht
Hschacht - 5 years ago
They do need revenue to stabilize for any of this debt for equity trade to be sustainable or even worthwhile long-term. Financial engineering aside, sustained free cash flow of this level will make the stock go higher. The company does not have endless debt capacity. Let's not forget the implied debt of $400+ million in pension liabilities.
batbeer2
Batbeer2 premium member - 5 years ago
>> ... sustained free cash flow of this level will make the stock go higher.

Fair point. Although my thesis does not depend on it, I'm more positive than most about the future of LXK. The last time the company was spending this much on capex, they subsequently caused HP a lot of trouble in the inkjet home user market.

This does not guarantee they will succeed again, but this is the same management team and they are making progress in the SOHO laserjet department. In this space, they are growing 20% in an otherwise flat market......

IMO the company has a rational strategy and the cash to back it up. Home printing is a bad business to be in. Most poeple I know have stopped printing photos at home - that is what uses up ink -. SOHO multifunctional laserjets are a better business.

Even if the strategy fails and net earnings drop to ~100m; on 40m shares that is still

> $2 a share. Now I don't see how LXK could fail to buy back another 40m shares with 500m of cash marked for this purpose. Never mind the additional reserves.

You say financial engineering, I say arbitrage.

A senior issue cannot be worth, intrinsically, any more than a common stock would be worth if it occupied the position of that senior issue. , Ben Graham.

So.... either the bond is mispriced or the stock is.
Sivaram
Sivaram - 5 years ago
This is an interesting pick you have there BatBeer. I looked at it deeper... It's my type of stock. Definitely contrarian... one of the few stocks trading near its low for the year (this actually means something given how all junk stocks are at least 30% off their lows for the year.) In fact, it's trading at its 10-year low... vast majority of analysts have a hold or strong sell opinion

All this can only mean one thing: either it's a value trap or it has great investment potential.

It certainly fits the notion of a value trap when you consider its industry. Printers are oh-so-yesterday and even if you look at multi-function ones, it's probably a tough, declining, industry (just guessing; haven't done any research)... one needs to be sure that this doesn't turn into a Kodak (EK)...

Have you done any qualtiative or industry-oriented research? How does Lexmark's products compare against someone like Canon or Xerox?


I requested the investor kit so hopefully I'll get them soon. Thanks for bringing it to my attention. If I get interested, I'll post my thoughts on my blog and let you know about it...
hschacht
Hschacht - 5 years ago
Batbeer, Just to be clear, I agree with you. And I own the stock.

This is not pure arbitrage. It is financial engineering (better than most), but we are talking about the same thing. Basically as long as LXK stays profitable, hopefully at this level, it is woefully undervalued.

If profitability continues to drop without ceasing, the company is a value trap as Sivaram mentions.

There are not many printer platforms left. If anyone wants to compete with HP, then they have to make a run at XRX or LXK. Sad to say, but LXK has the better balance sheet. And it is much smaller.
batbeer2
Batbeer2 premium member - 5 years ago
>> Batbeer, Just to be clear, I agree with you. And I own the stock.

I know; just sharing my thoughts; others may be following this thread ;-)

>> Have you done any qualtiative or industry-oriented research?

Not enough; last year, HP and Canon did well with laser MFPs. HP buys it's laserjet technology from Canon by the way. I believe Xerox is more focussed on the larger printers. It does have "me too" workgroup MFPs, but IMO they are marginal in this niche.

This year Lexmark is hitting back with printers that are comparable to HP at roughly half the price. This has allways been Lexmarks thing.... more printer for less money.

I will dig into the qualitative aspects some more.
hschacht
Hschacht - 5 years ago
XRX is very focused on color printers and new solid ink technology. Customers base is skewed more towards businesses, but not all of their printers are huge.
Sivaram
Sivaram - 5 years ago
Do either of you, being Lexmark bulls, know why the Street is so bearish on it? The numbers don't look that terrible so I'm just wondering what you guys see that the market doesn't. The stock has completely fallen off a cliff for some reason.

I notice that the operating margin has declined significantly so I wonder if the market is re-pricing the company as a low-growth one going forward.
Evan
Evan - 5 years ago
Buffett bought some, then sold out a few months later. The reason? As far as I could tell, Dell was the only thing that changed. LXK makes its highest margins off of it's corporate contracts. Dell decided to get into the printing business to compete directly with LXK. What happens when a toy car faces off with a steamroller? Well...
hschacht
Hschacht - 5 years ago
I've clearly stated what I see in LXK. The market either sees something I don't OR it is missing something. Lexmark is clearly in a poor competitive position relative to behemoths like HP, but it does have value. The market is re-pricing LXK for death, not low-growth. Lexmark hasn't been priced for growth (high or low) for several years now.

Dell is the logical buyer of Lexmark. And LXK is far from unprofitable. As such it has value. The market disagrees. Why ask why? ;-)
batbeer2
Batbeer2 premium member - 5 years ago
If I had to make a bear case....

Lexmarks inkjet sales have dropped hard; the installed base of inkjets has been the cash cow for 5 years. That is very bad for future cash flow from cartridges etc. MFP laser sales have not picked up the slack.

So.... what we have is a sharp decline in what used to be Lexmarks profitable cash cow and a strategy that remains to be proven. Old Lexmark is dying fast.

Also, Lexmark has been buying back shares for a decade now. With the stock down so much, one could argue they consistently overpaid for all the stock they bought back.

- edit -

And an underfunded pension plan. http://seekingalpha.com/article/139039-beware-of-lexmark-s-pension-troubles

All of which IMO do not alter my thesis.
batbeer2
Batbeer2 premium member - 4 years ago
Todays market cap of 2.3B renders the original thesis invalid.
batbeer2
Batbeer2 premium member - 4 years ago
Lexmark drops 20% today. http://investor.lexmark.com/phoenix.zhtml?c=92369&p=irol-newsArticle&ID=1487032&highlight=

WASHINGTON (MarketWatch)

Shares of Lexmark International Inc. LXK sank as much as 9% in premarket trades Tuesday after the maker of printers reported lower than expected sales in the third quarter and said its chief executive would retire in early 2011.

Although Lexmark posted sharply higher profit, the company fell short of Wall Street's forecast of $1.04 billion in quarterly revenue. The company appears to have lost some market share to Hewlett Packard in the printer market, according to several analyst reports. Lexmark stock traded at $43.80 in premarket action, down from $47.72 at the close of Monday trading.


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