Saturday, August 1, 2009 3 comments ++[ CLICK TO COMMENT ]++

Preliminary look at Lexmark (LXK)

I came across an interesting contrarian stock, Lexmark (LXK). Thanks to commentator BatBeer2 at GuruFocus for bringing it to my attention (BatBeer suggests levering up the firm, by issuing debt and buying back shares, but I don't think that's a good idea right now.) Lexmark, once upon a time a division of IBM, is a printer company that has fallen off a cliff. But like most stocks in such situations, it hasn't hit the ground so one can never be sure if you are attempting to catch a falling knife. I would peg this as a very high risk opportunity.

Here are some quick numbers from Yahoo! Finance:

Lexmark International (LXK)

Market cap: $1.13 billion
Enterprise value: $976m

Debt: $648m (but has cash greater than this)
(has under-funded pension obligations)

ROE: 11.6% (depressed; historically 25%+ but not sure if it can regain it)

Operating margin: 6.7% (10-yr avg close to 10% but may not hit those numbers again)
Profit margin: 3.2% (10-yr avg over 6% but may not hit those numbers again)

P/Sales: 0.28
P/BV: 1.25 (prior 10-yr range: 2.6 to 17.7)
P/FCF: negative (free cash flow of around $200m looks reasonable)

P/E (ttm): 9 (10-yr avg close to 20)
P/E (forward): 8

Like most tech stocks, Lexmark was likely overvalued in the late 90's so one should probably pretend its history from 1998 to 2001 happened in a parallel universe—the infamous dot-com universe. Because the company is distressed, all valuations are near 10-year (and possibly all-time) lows.

The Street definitely does not like the stock. It is one of the few trading near an yearly low, which is also a 10+ year low. This is quite contrarian given how nearly all the junk stocks have rallied 30% to 50% off their lows this year. Around 17% of float has been sold short as well.

I just started looking at it so don't know how attractive it is. I requested the investor kit and hopefully they'll send it to me.

Does anyone have any thoughts on it?

Quick Look

Warren Buffett says he never looks at price charts until he analyzes the financials because it biases his opinion. I break that rule all the time; I see no way around for the time being :( The following log chart from shows the history of Lexmark, along with the P/E ratio and dividend yield (I'm not sure if the yield info is incorrect.)

The stock has collapsed almost 80% from its peak in 2004. Assuming the price chart is not misleading (i.e. decline wasn't due to special dividends or spin-offs of assets), it is a massive drop. To see how large this drop is, consider the fact that Lexmark has dropped more than the nearly-insolvent Bank of America since 2003.

Lexmark's P/E ratio used to be closer to 20 in the last 10 years but is now below 10. What was once a growth stock is no more. If you go with the very simplistic suggestion of Benjamin Graham, zero-growth companies should have a P/E around 8.5, which is where Lexmark trades.

Investment Strategy

I think an investment should be made on the basis of:

(i) Lexmark turning around its operations, or
(ii) Company slowly dying off (i.e. zero growth while producing positive cash flow, kind of like Sears)

The more conservative approach is to assume that it does not go back to its glory days (2nd option.) Instead, it does not grow, or possibly grows very slowly. If cash flow stays positive, this may be sufficient. I need to look at the financials and take a quick look at the industry before I decide whether this is feasible—or whether it's even worth investing in this at all.

Potential Value Trap

Lexmark has characteristics of a value trap. I just did a quick Google search, as well as search on SeekingAlpha, and I see corposes all over the place, most of them value investors. Berkshire Hathaway (but likely not due to Buffett) had a small stake a few years ago, before selling out, possibly at a loss (I don't know.)

One of the dangerous things about Lexmark is that their revenues are falling. As many would know, manufacturers, due to their high fixed costs, are leveraged to sales and I'm not sure how sensitive Lexmark is to declining sales. Companies ranging from Owens Corning, to USG, to Kodak, have seen massive collapse with small changes in sales. The danger is that Lexmark may see a quick reversal in their profits. The following chart from GuruFocus plots the 10 year revenue:

[??? chart doesn't show up properly (I'm trying to fix it :( ) ???]

Revenue has been declining for the last 4 years, which means either, Lexmark is losing market share, or the industry is shrinking. Without doing more research it's hard to say.

The difficulty for anyone considering an investment is to separate the company-specific issues from the industry-specific problems. Like all industries, the severe recession has hurt printer companies. You can see how hard these companies have been hit by looking at the fall in 1st quarter (2009) revenues:

Although Lexmark is suffering terribly, so are the market leaders. The question is whether Lexmark can maintain, or gain, market share while the competitors weaken. Analysts seem to suggest that Lexmark is one of the weaker players that is losing market positioning. If the market is mis-reading Lexmark, it presents an opportunity but I'm not sure about that yet.

Earnings per share does not paint a pretty picture:

[??? chart doesn't show up properly (I'm trying to fix it :( ) ???]

The EPS looks far better than the underlying business fundamentals because the company was buying back shares for many years. If it weren't for the buybacks, you would see a spectacular 50%+ collapse in earnings from 2004 to 2008.

It seems management has done a good job reducing expenses as revenues have fallen over the years. But it'll get more and more difficult as they cut more and more. They need to stabilize revenue, which is one of the goals under the restructuring plan they have been implementing.

That's It For Now

I haven't read through the annual report so I can't say much more. I think it may be worthwhile waiting to see how the 3rd quarter numbers are. I don't know how true this is of the other printer companies but one interesting thing that investor BatBeer2 pointed out was that Lexmark was spending heavily on product development in the last year. Indeed, if you look at the 10 year financial statements, R&D hit an all-time high of $423 million in 2008. This was probably by pure coincidence—I doubt they would have introduced so many new products if they saw the severe recession on the horizon—but, as I remarked in the blog entry, Should corporations tighten belts during recessions?, some of the greatest successed have occurred when a company expanded during a recession, while competitors were re-trenching. The Lexmark situation isn't quite like the battle between Kellogg and Post over the cereal business during the Great Depression, but I'm sure it feels like a depression to Lexmark employees and shareholders.


3 Response to Preliminary look at Lexmark (LXK)

Ross Greenspan
August 1, 2009 at 1:58 PM

There are better opportunities than investing in a market-lagger in a manufacuturing industry with a commodity-like product. Does Lexmark have any competitive advantage in printing? Strong brand recognition versus HP or Xerox? No and No, it appears.

As an alternative, take a look at CYNO. Shares have been battered and were a net-net until this week, company announced 10% buy-back, ramping up international distribution of their product, brand recognition.

Trust your gut on Lexmark. There are even better value *traps* than this one.

Sivaram Velauthapillai
August 1, 2009 at 8:01 PM

Thanks for the mention about CYNO. I took a very quick look and it's outside my circle of competence so I'm going to skip it (I usually skip anything to do with healthcare, even cosmetic services like CYNO).

But just quickly glancing at CYNO, it's certainly a different type of business. Although LXK may not have a moat, what attracts me is their consistently positive profits and cash flow. Things are declining and maybe the worst is still to come (who knows?) but at least it has a decent record. In contrast, CYNO, like most micrcaps or smallcaps, has been unprofitable in the past and its history is too short.

It's hard to tell if CYNO is very cyclical or not. Are the relatively high earnings in 2007 and 2008 a peak, or are they reasonable? The average earnings in the last 5 years is around $6m and that pegs the P/E ratio at 20; or if you use enterprise value and discount for the cash on the books, it's more like a p/e of 6.

Some company like LXK may be declining but it does produce $4 billion of sales. In contrast, many micraps like CYNO, depend on higher sales in the future and/or better management of capital.

BTW, if you like microcaps, take a look at MGIC. I have been tracking it for months and you may find it worth investigating. I haven't done much research onf MGIC yet so don't take it as a recommendation or anything...

August 6, 2009 at 8:32 AM

you need to look at their pension plan liabilities as well.

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