Thursday, August 13, 2009 12 comments ++[ CLICK TO COMMENT ]++

A look at Lexmark's 10 year financial history

This might be a landmine but whatever it is, I'm really attracted to Lexmark (LXK). I have been researching it and thinking about it a lot in the last few weeks. I thought I would write up my preliminary thoughts on its 10 year financials.

I'm just a newbie when it comes to financial statment analysis so if someone has ideas, tips, or corrections, let me know. The more ideas I get, the better off I'll be so even if it's a criticism, go ahead.

The following image summarizes the 10 year financial history of Lexmark. I extracted it from a Morningstar analyst report. I deleted items I either don't look at or felt didn't matter much for Lexmark. A lot of the stocks I look at don't have reports and I usually get the information from the sources I mentioned before.

I highlighted some preliminary thoughts I have from simply looking at the 10 year history.



Although I don't think in this order, let me go down the highlighted items from top to bottom.

Revenue

The scariest thing about Lexmark is its continuously falling revenue. For most companies, especially manufacturers, falling revenue is dangerous because small changes can have huge impact on profit. You can quickly go from a positive profit to a large loss, simply from a small decline in sales. This is generally because (i) companies are slow to adjust to declining sales (i.e. they don't cut costs, change product mix, etc, fast enough), and (ii) companies have fixed costs. The bigger the fixed cost, the more dangerous falling sales are. Cylicals with very high fixed costs quickly go from large profits to large losses when sales fall (usually during recessions.) One just needs to look at automobile manufacturers (e.g. Toyota), building material suppliers (e.g. USG), or forestry companies.

Lexmark's sales started declining before the economy started slowing so this is largely a company-specific issue. In fact, the so-called boom, say from 2004 to 2007, completely missed Lexmark. There is good and bad news in this. The bad news is that the declining sales portend to serious problems. It isn't just the economic environment, and it isn't just a one year or two year problem; it has been going on for at least 4 years now. The good news is that Lexmark's stock is probably unhinged from the broad market. If Lexmark can fix whatever its problems are, it can easily outperform even if the economy doesn't recover.

In its earnings call, Lexmark indicated that it expects declining sales—up to -20% in some areas—for most of this year. The first and second quarters saw huge declines and Lexmark said it expects a similar outcome for the third quarter. Part of the decline is supposedly because it is altering its product mix. It is supposedly exiting low-usage printers (mostly the low-end consumer segment) and trying to focus on high-usage printers. It supposedly introduced many new printers last year and will introduce many more later this year. So the fourth quarter is a big mystery for now.

One of the things I like about Lexmark is that it is supposedly spending a lot of money on R&D. It was criticized in the past for not spending enough on products and it decided to spend more. You can see this with its rising R&D in the last few years (not shown on graphic) even though sales and profits fell. Short-term investors may not be happy with this but I think it can be benefitial in the long-run—if their new products are actually better.

I think Lexmark needs to keep its sales above $3.5 billion. It can temporarily drop below this but if it keeps falling, it is not a good sign. On top of declining profits, such a sale decline will indicate that it is losing market share. In some markets it has the #4 or #5 spot and if falls much further below, it will become irrelevant in terms of branding. I'm not a brand expert but that's just my personal opinion. You probably can't even get some retailers to carry you if you drop out of the top 5.

If you want to be superbearish, I think one should probably assume a sales of $3 billion. That would be a conservative estimate for valuation purposes.

Operating Margin

Operating margins have deteriorated significantly. They used to be 10%+ but seem to be heading toward 5% right now.

Shares & Book Value Per Share

In hindsight Lexmark wasted billions but... just about the only positive thing leftover from the last 4 years is a reduced share count. Lexmark bought back a ton of shares (admittedly at much higher prices :( ) and reduced its share count from around 132 million in 2004 to 84 million right now. That's a huge decline. Lexmark did issue debt last year to buyback shares but they haven't used up all the money, and their debt is manageable.

All that share buying has kept book value per share, as well as EPS, pretty respectable. EPS and BV per share would have seen very large declines if the share count didn't decline.

What to take from the share buyback business? Well, management seems to realize that the share count matters a lot. But they are not very good capital allocators and are more akin to robots blindly buying back shares.

Going forward, assuming earnings stabilize and the debt situation remains manageable, blindly buying shares would be a really good thing. Stock does not look expensive (more on this in the P/E and P/BV section below).

Even if profits don't improve in the future, as long as they don't decrease, there is huge room to create shareholder wealth. I suspect the company will create more money from financial engineering, such as buying back shares or selling land or whatever is feasible, than from the business itself. Newbies may have a hard time grasping that but it's true (read up on some of Martin Whitman's shareholder letters if you are interested.) In America, a huge chunk of the shareholder wealth is created by corporate events and better allocation of corporate resources, than from the business itself! A sizeable chunk of the wealth created by Warren Buffett is simply from re-allocating resources better. A classic example is his handling of Washington Post. A lot of people keep mentioning Warren Buffett in the same breath as Coca-Cola but that investment is a joke compared to something like Washington Post. If Edward Lampert somehow ends up creating wealth for Sears shareholders, I'm pretty sure it won't be from the business per se.

Free Cash Flow

Lexmark's cash flows have declined quite a bit. From a peak of $704 million in 2002, they have declined to $264 in 2008. It's not clear in this picture (it helps to read the full annual reports or read a more detailed 10 year history) but some of the FCF decline is due to increased R&D spending so it's not as bad as it seems. For technology companies, spending on R&D shows up as an expense and subtracts from operating cash flow, but it can actually be a positive thing. You may actually be building a moat even though it doesn't show up anymore. Unfortunately, Lexmark is headed downhill and it's not clear if the R&D was wasted but I'm just pointing out that the FCF may look lower than it is. For instance, Lexmark can cut R&D by $100 million and it would simply be back to the 2004 levels, when sales were higher.

The question is whether FCF has permanently fallen below $300m. It will likely post a bad numbers this year but how about after that? I am going to be conservative and assume normalized FCF is around $200m. At $200m FCF, Lexmark is trading around 6x FCF.

A lot of value investors seem to ignore earnings but I like looking at that as well. In Lexmark's case, earnings are somewhat similar to FCF so it doesn't matter very much. In 2008, it posted a profit of $240m vs FCF of $264m; in 2007, it was $301m vs $382m; and so on. A conservative normalized earnings is probably around $200m, which pegs the P/E at roughly 6x.

Return on Equity

What attracts me to Lexmark is its high ROE. Even after all the struggles and declining sales & profits, its ROE is still over 15%. Some, such as David Einhorn, have suggested that ROE is somewhat misleading for technology companies but I still think it is a meaningful metric (in any case, Lexmark is a manufacturer.)

You can get a sense of Lexmark's glory days by looking at its ROE. It was over 30% in the early 2000's. Wow. That's very high, even for a technology company. But that's the past. It's moat, however small it used to be, has completely evaporated.


Profit Margin

Similar to the operating margin, the profit margin has declined considerably. Lexmark is probably entering the no-moat, now pricing power, commodity-type business zone. Hopefully it can avoid that fate. There are countless companies producing computer peripherals that are poor investments. Lexmark was pretty good a decade ago but its fate is in a precarious state right now.

One of the complications is that Lexmark's margins can be artifically boosted by declining sales. This is because the printers are sold at a loss or close to a loss, while the ink cartridges have high margins. Declining printer sales will actually boost margins in the short term, while hurting the company in the long run (less printers means less future cartridge customers.) If the annual reports and SEC filings break down sales by hardware vs supplies, we can get a sense of whether the margins have been artifically boosted in the last few years. If those numbers are not publicly made available, it's hard to say if the true margin is the reported 5.3%or something much lower.

P/E & P/BV Ratios

You can see how Lexmark went from a growth stock sporting P/E multiples over 20, to a distressed stock with a current P/E near 6.5 (stock rallied in the last few weeks and the P/E is around 10 right now.) Price to book value went from 7—over 17 in the dot-com days—to 1.4 now (1.6 today afte the recent rally).

Unless you were a wild optimist, it is fair to say that Lexmark has permanently changed. It is highly unlikely for the market to place a 20x P/E multiple on it. Sure, if it introduces a revolutionary product that cannot be easily duplicated, it may, but otherwise forget about it. I would go with the simplistic Graham suggestion of 8.5x for zero-growth to 10x.

A Quick Valuation Estimate

Based on the 10 year financials, I estimate the value of Lexmark as follows:

Using mostly conservative measures,

Low growth: Market cap = P/E * Earnings = 10 * $200m = $2 billion
Zero growth: Market cap = 8.5 * $200m = $1.7 billion


Current market cap = $1.4 billion

So Lexmark is trading around 30% below the low growth estimate, and 18% below the zero growth estimate.

I think $200m in profits is reasonable although there is a risk it can fall much lower. If you are far more bearish, Lexmark still looks overvalued. For instance, if you assume sales drop all the way down to $3 billion, and apply a 3% profit margin, you end up with earnings of $90 million (as opposed to the $200m I used.) If you use a 4% profit margin, you end up with $120m in profits. Applying a 10x P/E, you end up with a market cap between $900m and $1.2 billion. Lexmark is still trading above these values right now. So it all comes down to how much further its sales and profits can fall. If one is quite concerned and think sales may drop to $3 billion, then they should probably wait until early next year (until 4Q09 numbers are released) and see how bad 2008 turns out to be. Since this year is likely to be one of the worst, it may provide a rough idea of the bottom (assuming there is a bottom ;) ).

More Work Needed

More work needs to be done to see if Lexmark should be discounted further. It has pension liabilities and I need to figure out if this is worth worrying about. I also need to figure out if I need to place a much lower P/E multiple because of its brand strength, overseas performance, and so on. One can also boost the value after doing more research. For instance, if one thought it has a good chance of earning a lot in emerging markets then that may be something valuable (unfortunately, my preliminarly impression is that it has practically no overseas presence worth talking about, except in Europe.)

I also want to a get sense of the macroeconmic environment for printer companies. Is printer usage dropping? What's the impact of rising electronic document usage? And so on.

Since this is a contrarian bet—not only is it one of the few trading near its 52-wk low, it is also one of the most heavily shorted stocks out there—I would also want to be confident that I am right and the short sellers are wrong. Last time I went against the short sellers, it was with Ambac and I ended up with a specular loss :(


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12 Response to A look at Lexmark's 10 year financial history

Harsh Nahar
August 14, 2009 at 12:21 AM

In your analysis you are missing a key point, what are the drivers? You mention that sales growth with continue to slow are they are moving from low end to high end printers. High end printers, though profitable, is a highly competitive market. HP & Cannon are leaders. I havnt seen any office which uses a lexmark technology. Lexmark is not considered professional grade printers. I dont know whether it true but changing that perception is going to be monstorus. ANother thing. These companies make money in refills and cartridges not on printers. HP has been working extremely hard to avoid counterfeits and have had limited success as well. I havnt seen any such effort from lexmark.  I honestly think there is no revenue driver for this company. They had a partnership with dell a few years ago. Dont know what the status is know.

Other thing that you consider as a distress company investor is valuation. Just becuase its at a 52 week low, does not mean its cheap. There is a reason why its at a 52 week low. And current valuation, dont have enough downside protection.

I think there are better opportunities to put your money to work. This is a dead investment, at best.

IMHO,
Harsh

MrParkerBohn
August 14, 2009 at 7:42 AM

Keep in mind that I am also a newbie, but I'm going to question your assumptions.

Without digging into Lexmark at all, I question the idea that a zero-growth company is worth 8.5 times earnings.

Let's say we have on one hand:

A)  A non-profitable company that merely breaks even, year after year.

B)  A profitable company that reinvests all its earnings (paying no dividends), and achieves zero growth in earnings year after year.

Both cases are essentially the same. 
Neither A nor B throws off any cash to the investor.
Neither A nor B grows in value from one year to the next.

In both cases, "owner earnings" appear to me to be zero.
http://en.wikipedia.org/wiki/Owner_earnings

Please note that I have no opinion on Lexmark and this reply is more on the philosphy or methodolgy of investing valuation.

Guest
August 14, 2009 at 10:16 AM

in your analysis, u may see the company being undervalued... but remember what buffett said... always bet on <span>great companies at sensible prices rather than mediocre businesses at bargain prices</span> since when a company is going down, there are always more problems coming out...  it will be an easy pass for me, there are so many great companies trading a great value out there right now... look at URBN, FFH, LUK...

Sivaram Velauthapillai
August 14, 2009 at 12:01 PM

Thanks for the comments everyone. I appreciate all the feedback; it  sharpens my thinking :)  To address some points...


Harsh,

I haven't seen much of the Lexmark brand either. But I should note that Lexmark mostly sells to businesses. Something like 60% or 70% of its revenue comes from businesses (small businesses and medium sized busiensses.) The other thing to note is that it was never the #1 or #2 brand (except for short periods) even in its glory days. Companies like Xerox, Canon, Epson, and HP had bigger market share if my understanding is correct. I don't have much knowledge of the distant but that's my impression: it was never a leading company.

I think you do raise a very major issue about fake, clone, and no-name ink cartridges. Third party ink refills are also a big threat. I read a little into it and need to do more homework on this issue. It's really hard to say how much of an impact any of this is having. I'll spend more time trying to figure this out. This is an industry-wide issue and isn't Lexmark-specific.


Harsh: "I honestly think there is no revenue driver for this company"

I don't think one needs to worry that much about a revenue driver per se. If I were to invest, it would be with an assumption of very low, or even zero, growth. That's why I'm applying a low P/E (between 8.5 and 10) to this.

What matters is revenue and profit stabilization. Even if sales don't improve, as long as it is producing around $200m in free cash flow, I'm cool with that.  (do note that it has unfunded pension liabilities and other issues that I am ignoring with this $200m FCF thought.)

The question is, can it maintain its profitability? It has been declining for years and if it continues, the stock will continuously decline (it'll end up as a value trap.)

Harsh: " Just becuase its at a 52 week low, does not mean its cheap. There is a reason why its at a 52 week low. And current valuation, dont have enough downside protection.  "

Good point about 52wk low--you can't just blindly use that. I find it attractive based on earnings (i.e. P/E). But you are absolutely right in pointing out how the downside is uncertain. That's one of the problems with this company and it's one thing that one should seriously think about.

Sivaram Velauthapillai
August 14, 2009 at 12:18 PM

You are right. There are many companies that seem to have high sales and profits but don't create much shareholder wealth.

The clean way is to calculate owner earnings. People like me just use free cash flow as a proxy for that. FCF is close to Buffett's owner earnings. As long as FCF is positive and sizeable, it's creating shareholder wealth.

The next step is to make sure that management isn't destroying the free cash that is being generated. It's tough to say right now but at least they are not spending more than they generate (i.e. don't have negative cash flow.)

Lexmark does not fit scenario A or B so we are ok on that front. However, if profits (or FCF) keeps declining, then it may turn into A or B. It'll be a poor investment at that point.



As for the 8.5x P/E multiple, that's a really tough one to justify. It's simply my own opinion. I don't think there is a perfect multiple to use. It depends on your opportunity cost, what you feel a business with those characteristics are worth, and so forth (if you expecting to sell it to another investor or a buyout group then it may also depend on what you think buyers would value it at.)

I started using 8.5 after Benjamin Graham suggested it in The Intelligent Investor (scroll to the middle of my book summary for the formula). Graham's formula is:

value = current_(normal)_earnings x [8.5 + 2 x expected_annual_growth_rate]

It's very simplistic and simply be thought of as a guide rather than anything precise. If you set growth rate to zero, you get 8.5 in that formula above.

I think 8.5x is not too high for Lexmark because it does have some brand recognition and has historically had strong ROE, high profits, etc. If this were a microcap or a small-cap then I can an even lower multiple being used.

Sivaram Velauthapillai
August 14, 2009 at 12:52 PM

Thanks for the your suggestions...

As for Buffett's opinion, well, maybe I'm just not skilled enough, but I haven't found any great company at reasonable prices. Even at the market bottom back in October or March, I didn't find anything I liked.

I agree with your thinking and would prefer to invest in a great company at reasonable prices than a poor business at great prices. But it's easier said than done. I would argue that most of what people perceive as reasonable price isn't so. Most companies are overvalued--now, and before, and probably most of the time. Average investors make most of their money from positive macro environment than from their picks.


Having said that, I don't follow Buffett's strategies all the time. Buffett does not generally invest in turnaround situations but I do. I also engage in a strategy that Benjamin Graham suggested in The Intelligent Investor, of buying 'relatively unpopular large companies' (you can read a summary I did a long tiem ago here.)

Lexmark isn't quite a large company so it doesn't fit the 'relatively unpopular large company' startegy perfectly but it's somewhat close. It did used to have a market cap over $10 billion. So that's my strategy. It isn't exactly Buffettesque.

Sivaram Velauthapillai
August 14, 2009 at 12:53 PM

Guest: " look at URBN, FFH, LUK..."

I know a lot of people love FFH and LUK but they are not my type of stocks. FFH and LUK are black boxes! I don't think anyone knows what's in them. To see what I mean, consider FFH. How many knew that FFH made bets on a credit bust with the potential for a large pay-off? I'll bet not many. No one talks about how they never knew it because it was a positive outcome; but imagine if there was something negative. Similarly, LUK's book value seems to have collapsed 50% in the last year. Maybe it's irrational pricing--I don't follow the company so don't know--but how many would have known it was vulnerable such steep erosion in book value?

Having said that, I respect the guys running those companies. They are probably some of the best. But one cannot be certain. Anyone investing in FFH or LUK are investing largely due to management--is that right? If so, it's definitely not for me because I can't evaluate management properly.

Note that I'm not arguing these are bad investments; all I'm saying is that it's not my investing style and I doubt many know what those companies are exposed to.
 


As for URBN, that's interesting... I'm extremely careful with retailers since my macro view--and almost everyone else's--calls for weak retail sales for at least 10 years.

On a P/E basis, it looks expensive (trailing and forward p/e over 20)... but it is one of the few retailers whose earnings have held up during the tough times. So that's a big bonus. Operating margin, profit margin, ROE, look good. No debt!

I like your pick. It looks expensive to me--maybe you bought it before the huge rally recently--but business fundamentals look strong. I haven't looked at many retailers but this is one of the strongest comapneis (from a financial point of view) that I have seen in the consumer discretionary space.

Jae Jun
August 15, 2009 at 4:47 AM

Hey <span>Sivaram</span>

Always enjoy people going through financial statements. It takes a lot of time to go through it and probably 2-3 times longer just to do the image and write about it.

First a purely numbers point of view and some points I came up after runnning my own numbers quickly.

- ignore deferred taxes in the FCF formula and you'll get lower numbers but it is all positive from 1999-2008.
- looking at the correlation between capex and sales over 5 years, the company has 0 growth. If LXK decided to pursue growth it would destroy value as their ROC would be less than the growth rate.
- decreasing margins but same inventory turnover means less profits
- management seems to be effective in using its capital though. Able to return median of 19c off every $1 it invests.
- steady FCF/sales over the past 4 years confirms that the company is not growing or doing anything about it
- DCF intrinsic value: $29 or $35 when I adjust the FCF to ignore one time effects.
- Graham Formula of $27

Seems to be cheap but my guess is that there is a high chance of the intrinsic value decreasing to meet price rather than vice versa.

Sivaram
August 15, 2009 at 9:37 PM

Thanks for the analysis Jae. I appreciate you taking the time to go through the numbers.


Jae: "looking at the correlation between capex and sales over 5 years, the company has 0 growth. If LXK decided to pursue growth it would destroy value as their ROC would be less than the growth rate.  "

Can you detail how you are coming to that conclusion? Sales and profits are declining; and capex has gone up. But how do you know that increasing capex (an idea I really don't think Lexmark should pursue) will lead to capital destruction? Are you simply extrapolating the change in sales based on past capex increases?



This doesn't matter here that much but how do you factor in debt into your analysis? Do you just ignore companies that you deem risky based on debt or do you factor that in somehow? I'm curious because your estimate of DCF probably will not account for the risk posed by debt (unless you use a higher discount rate or something.) So do you seek a higher margin of safety? (I use P/Es and in terms of that, I just use a lower P/E. For instance, I would probably never buying anything at a P/E above 10 for a company in Lexmark's condition.)


Thanks for the comments...

Sivaram
August 15, 2009 at 9:39 PM

Jae: "Seems to be cheap but my guess is that there is a high chance of the intrinsic value decreasing to meet price rather than vice versa."


BTW, that's a great comment! You have basically described a value trap and that's a huge risk here. Just like the last 4 years, the company can continue to dwindle into nothing...

Jae Jun
August 16, 2009 at 4:18 AM

I meant 0 growth as in a company that is not growing or losing value based on cash not sales.

My reason for stating that increase in capex will lead to value destruction is simply that the ROC must exceed cost of capital for growth to be worthwhile.

LXK looks to be doing a good job in its current state of keeping everything running smoothly but I'm not too sure about its ability to operate under growth.

And yes Im simply looking at how capex has affect sales yoy.

DCF doesn't take into account debt which is why I look at it separately.
I dont like overleverage companies myself but I always make sure that even if they have a huge debt sum, their operating cash flows is able to pay it off.

I don't ignore companies just because of its debt but I do use an extroadinarily high MOS and discount rate. It's the distressed situations that have earned me big returns so far.

Jae Jun
August 16, 2009 at 4:19 AM

KO was also value trap for the longest time if you take away the dividends. :)

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