Lowell's

What to look for in Lexmark's earnings release

Lexmark reports its second-quarter earnings tomorrow.  Since we've written about the decline and fall of Lexmark and the recent rise in its stock price, we thought we'd tell you what to look for tomorrow to determine Lexmark's health.

Under its current management, Lexmark has been very conservative in its earnings guidance (what it hopes to earn in the near future).  This conservatism has historically created two notable dynamics around earnings announcements:

• The vast majority of Lexmark's earnings announcements have exceeded analysts' expectations, primarily because management guided those expectations lower.  This is the epitome of "under-promise and over-deliver".
• Because the future guidance has been so low - with management essentially saying "we don't expect to make much money in the future" - the stock market's reaction has been overwhelmingly negative, driving Lexmark's stock price down the day earnings are released.

Update 7/21/2009: Lexmark announced earnings (before restructuring charges) that were 55 cents, while analysts projected 60 cents per share.  Lexmark management also provided lower 3Q guidance.  By both missing 2Q expectations and giving lower 3Q guidance, Lexmark was down over 20% in early trading, approaching 12-year lows.

So, tomorrow, don't be surprised if Lexmark beats Wall Street's expectations for the second quarter, and yet the stock price falls because of very conservative guidance.

But these regular dynamics around Lexmark's reporting dates tell us little about the true health of the company.  Here's what to really look for tomorrow:

• Failing to meet expectations.  If Lexmark fails to meet already-conservative expectations, it is a sign that earnings are deteriorating even faster than Lexmark's management anticipated.  It is also a possible sign that Lexmark is entering the death spiral we talked about here.

Update 7/21/2009: As mentioned above, Lexmark missed expectations by 5 cents (nearly 10%).

• Continued / accelerating declines in supplies, especially in PS&SD.  The majority of Lexmark's revenues (and the vast majority of its profits) come from its supplies business.  In other words, Lexmark makes much more from toner and ink than it does from the printers that use them.

Lexmark's inkjet division (Imaging Solutions Division, or ISD) has seen continuous erosion in its supplies sales, which implies that the installed base of Lexmark inkjet printers is shrinking.  Because of the upside-down economics of the printer business, a decline in supplies business can rob the division of its ability to fund future growth, and signal the impending doom for that business. 

If the Printing Solutions and Services Division (PS&SD - ISD's larger sibling) continues to lose supplies sales - a trend which started within the last year - then Lexmark's decline will be even more pronounced.  Without the supplies-driven profit to 1) maintain its existing business structure and 2) invest in future growth, the company will continue to spiral downward with little prospect for pulling out.

Update 7/21/2009: Overall supplies sales dropped by 18%, and dropped in both PS&SD and ISD (both major divisions).  This is a very troubling sign that Lexmark is entering the death spiral we've written about previously.

• Additional restructuring.  Over the past few years, Lexmark has announced a series of "restructuring" efforts: Closing plants, reducing headcount, shifting resources, reducing costs.  Unfortunately, those efforts have done little to stem the bleeding at Lexmark.  If they announce similar moves tomorrow, it is a sign that management is still flailing and failing.

Update 7/21/2009: No additional restructuring was announced this morning.

It is tough to gauge the health of a company from a single quarter of earnings, and tomorrow will be no different.  But if some (or all) of these items find their way into Lexmark's earnings report, it will be another nail in Lexmark's coffin, and will be troubling confirmation of the continuing failure of Lexmark's executive team.

Update 7/21/2009: Second quarter earnings indicate that Lexmark is continuing the long, downward slide that we have seen over the past 5 years.  As they have 1) invested in ways that don't promote real growth at the company, and 2) made continual strategic missteps, Lexmark's management has slowly bled economic vitality from the company, and robbed it of its ability to invest in the future.

Why has Lexmark's stock price jumped?

Since we chronicled the implosion of Lexmark on June 25th, Lexmark's stock has seen a remarkable run-up in its stock price.  In less than 4 weeks, the stock has moved up over 22%: from just over $15 a share to $18.61 at Friday's close.

So does the run-up prove we were wrong on our assessment of the failures of Lexmark executives?

No.

While a 20% increase in a single month seems impressive, Lexmark needs to turn in a 1000% increase to overcome the failures of the past 5 years.  And even after the gains of the past month, Lexmark's market value is still down almost 90% from where it was five years ago.

But such an aggressive jump in price still begs the question: Why has Lexmark's stock price jumped?  The question is especially interesting given that there has been no significant news coming from the company.

There are three plausible explanations for such a run-up in stock price:

1. Earnings Surprise.  Lexmark announces its earnings on Tuesday.  It is possible that some traders believe that Lexmark will have higher profits and better future prospects than are currently expected by Wall Street analysts.  In the past couple of weeks, there has been a heavy increase in options calls - bets that the stock price will rise.  This could be in anticipation of much-better-than-expected earnings.
2. Takeover Speculation.  As we mentioned in the Implosion post, Lexmark's ability to generate cash has led to the company being seen as a potential takeover candidate, with Dell, Xerox, and Lenovo frequently cited as potential suitors.  Lexmark takeover rumors pop up occasionally, with the last batch in late 2007.  Traders could be speculating that such a takeover would include a "buyout premium" - a buyout price well above the current trading price to help "seal the deal".  This could also explain the unusually high activity in options calls.   
3. "Window Dressing".  Over the past five years, Lexmark executives have bought back the company's stock on a massive scale.  The $3.2 billion of stock buybacks have been a catastrophic failure - losing over 70% - which destroyed Lexmark's mountain of cash.  In our last Lexmark post, we talked about how such buybacks could boost stock price while simultaneously insulating the company's failed management from takeovers.  Lexmark's management could be buying back stock as a form of "window dressing" to improve their stock price in advance of Tuesday's earnings announcement.

So which of these explanations is most likely?  A chart of Lexmark's stock price (below, from Google Finance) shows that almost all of the recent increase came in July, with a conspicuous jump in price on July 1st.  July volumes have also been nearly 50% higher than average.  The July 1st pop in price was the first significant move up after drifting downward throughout June.

Why would the price jump on that date, and continue to increase through July?

July 1st is the first day of the third quarter.  More importantly, it is also the first day after the second quarter, and second quarter financials will be reported on Tuesday morning. 

The timing and volume of the surge in Lexmark's stock price make us suspect that Lexmark's management has been buying back even more of the company's stock - the "window dressing" explanation above.  By buying back stock beginning July 1st, they could improve stock price while not having to report buybacks until September (and not having to include those purchases in Tuesday's report).  If management is buying back a lot of stock, that could also account for the increase in options calls as traders try to feed off of the temporary boost in stock price.

The recent run-up in stock price is probably not due to improved business fundamentals at Lexmark.  All outward signs show that those fundamentals are deteriorating.  Instead, our bet is that Lexmark's stock price has risen because of share buybacks, a traditional crutch for Lexmark's management.

And, historically, buybacks have been a failed long-term strategy for Lexmark.

Update 7/21/2009: After Lexmark's earnings announcement this morning, Lexmark stock has given up all of the gains from the past month.  If Lexmark's management did buy back stock early in July, it would fit the long-term pattern of failed buybacks.

Implosion: The Decline and Fall of Lexmark

I have written a great deal about the failure of CentrePointe, the downtown Lexington development which has failed to produce promised jobs and economic contributions to our city.  It has left a scar in the middle of our city which has persisted for the better part of a year.  It has exposed just how flawed Lexington's planning and economic development processes are.

As much as I have commented on CentrePointe, however, it is primarily a failure of omission, of delivery.  There is a far larger and more important story about a failure which has actively destroyed jobs and economic contribution in our city.

It is a story of the colossal mismanagement of one of Lexington's biggest employers.  It is a story of the destruction of shareholder value and the bleeding of high-tech jobs in Lexington.  It is a story about how a $12 billion company became a $1.2 billion company in just 5 years.  It is a story of wasted opportunity.

It is a story which serves as a damning indictment of the failed executives who have presided over this corporate implosion.

This is a story of the decline and fall of Lexmark International.

About 5 years ago, Lexmark had a market value of over $12 billion, and its stock was over $95 a share.  As of this writing, it is worth less than $1.2 billion, and its stock is struggling to stay above $15 a share.  What happened?

Through a series of misinvestments and strategic blunders, Lexmark's executive management has simultaneously squandered a huge pile of cash, strangled most of their inkjet division, and destroyed some $11 billion in shareholder value. 

In this post, we'll explore a big strategic mistake which is leading to the downfall of Lexmark's inkjet division.  Then, we'll look at how management has failed to invest properly for the Lexmark's future.  But in order to understand the true extent of this failure we need to start with how a printer company makes money.

Business Model
Essentially, a printer business has two major components: 1) Printers and 2) Supplies for printers.  (Lexmark has also been trying for years to expand a services business for corporate customers, but we'll keep it simple here.)  Lexmark has two major divisions: the Printing Solutions and Services Division (or PS&SD) which focuses on enterprises and uses more-expensive laser-based technology; and the Imaging Solutions Division (ISD - formerly known as the Consumer Printer Division, or CPD), traditionally a more consumer-oriented division which mainly uses cheaper inkjet technology.

The printers are relatively expensive to buy, but are narrowly profitable or even unprofitable - especially with inexpensive 'low end' inkjet printers - for their makers.  Printer sales can be fairly volatile - up one quarter, down the next.  All of the active printers that a manufacturer has in the market are considered the 'installed base' of printers. 

Compared to printer costs, supplies tend to be relatively inexpensive.  Even though they cost less to customers, they offer a high profit percentage for their makers.  Supplies sales also tend to be much more stable and reliable, because supplies are generated from multiple years of sales of printers.  In other words, supplies are not generally subject to excessive swings like printers are.

Most of the printer industry tries to offset each high-dollar, low-margin printer with several low-dollar, high-margin supplies sold over the life of that printer.  The initial printer sale yields little profit (or a loss - as Lexmark has admitted they lose money on many of their inkjet printers), while supplies sales from that printer help (eventually) drive high profits. 

This business model is often called a razors-and-blades model for its similarity to how Gillette made enormous profits: Sell the razors for as little as possible, and make it up with profits from blades.

As the installed base of printers ramps up, more and more of the company's revenues (and, of course, profits) come from supplies sales.  Eventually, the more stable and reliable supplies business will outpace the more volatile printer business.  Over the past 5 years, supplies have accounted for between 60 and 70% of Lexmark's revenues. 

Upside-Down Economics
In order to get access to the market, most inkjet products are sold through major retailers like Walmart, Best Buy, and Staples.  These retailers wield enormous influence over printer manufacturers. 

Retailers are driven to maximize the profitability of their limited shelf space.  If a product isn't creating enough selling "velocity" for a given space, then the retailer will discontinue, or "de-list" it.  And because manufacturers are in a blind competition with one another for shelf space, de-listing poses an enormous threat to future supplies sales.  Lexmark's competition for retail shelf space is intimidating: it includes market-leader Hewlett-Packard (HP), as well as Canon, Epson, Brother, and Kodak.

To ensure continued access to the retailer's customers (and to the future supplies sales), manufacturers often feel compelled to sweeten the pot for retailers when their selling velocity isn't high enough.  Most often, this comes in the form of price cuts for printers. 

Lexmark was in the vanguard of the low-priced printer movement, offering the same (or more) functionality for lower prices than the competition.  For a few years, this was Lexmark's main competitive edge in the inkjet market.  But in 2003, HP - who had almost always used its market leadership to demand premium prices - changed its strategy and began to match Lexmark's pricing.

Over time, the printer industry kept giving more and more ground in this Faustian bargain with retailers, driving printer prices lower and lower, until they ultimately lost money on many of the printers they sold in order to get access to profitable supplies sales. 

But when a company loses money on its initial printer sale, funny things start to happen to the business model.  If it grows too fast, then the losses from printers can drain the profits from supplies: In other words, building the business for long term profit can require the sacrificing of profitability in the short term.  Conversely, if printer sales drop dramatically, then the business can appear enormously profitable: Management can enhance short-term profit even while destroying long-term business fundamentals.

These upside-down economics can be difficult to manage, especially during strategic shifts: it is expensive and uncomfortable to change, but it is also expensive and uncomfortable to remain in place.  In the case of Lexmark's inkjet-focused ISD, Lexmark executives failed to manage those economics - to the detriment of the ISD business.

Strategic Blunders
For several years, Lexmark executives have signaled their intent to get "higher-usage customers" for ISD.  The premise of these announcements was that Lexmark would sell fewer printers, but that they wouldn't lose (as much) money on printers and would simultaneously gain enormously-profitable customers who used lots of supplies. 

HP has traditionally been very strong among small businesses and other high-usage customers, and Lexmark was attempting to crack into that market.  Repositioning to get higher-usage customers would also be a marked departure from Lexmark's history (and its brand image) of cheap, low-end inkjet products.

Trouble is, the executives never identified any sustainably differentiated qualities in their high-end products which would tempt customers to leave the vaunted HP brand for the Lexmark label.  To date, Lexmark's products are "me-too" products: the same basic functions, features, and performance as the products offered by other printer manufacturers.  The few differentiated features that Lexmark has introduced (wireless printing, for example) have been quickly matched by rivals.

And it isn't clear that Lexmark has, in fact, gained higher-usage customers with the few printers it has managed to sell.  Spot-checking product prices in stores and online, it is common to see Lexmark's "high-end" inkjet products at nearly half the price of competitive products from HP.  This is a clear signal that Lexmark's products aren't getting the velocity of HP's products, and that retailers are extracting price concessions as a result.  Further, as these high-performance, heavily-featured products drop in price, two other upside-down dynamics kick in:

• The magnitude of losses for high-end products might be greater than the losses for low-end products.
• The lower prices likely appeal to the same lower-usage consumers which Lexmark is attempting to avoid

An example: a feature-laden product designed for the, say, $200 price point might lose even more money when repriced to $149 than a sibling product which was designed for $49 and reduced to $29.  And that bigger financial hole might be even harder to get out of if Lexmark "wins" customers who don't print frequently.

So, how did this "repositioning" strategy play out?

With new ISD leadership in 2008, Lexmark began to aggressively abandon low-end printers in the pursuit of the high end of the printer market.  Almost immediately, Lexmark's retail presence was dramatically reduced as it was de-listed at or kicked out of retailer after retailer, ending up with a significant presence only at Walmart and Circuit City - not the kinds of retailers where higher-usage customers would be expected.  Perhaps feeling the sting of being locked out of so many retailers, a more flexible Lexmark began regaining listings earlier this year. 

By the end of 2008, the damage was done: Lexmark lost almost half of the printers sold in 2007.  2008 revenues were down 22% from 2007, while profits were up 47% in the same period.  Remember when we said that a dramatic drop in printer sales usually creates a temporary boost in profits?  Well, in this case, Lexmark's supplies revenue and profit - usually the most stable part of a printing business - have also been dropping, which is a particularly worrisome trend.  This implies significant deterioration in Lexmark's cash cow - its installed base of printers.

In the past 5 years, the attempts to move to the high end have has disastrous effects: Since 2004, ISD has lost two-thirds of its printer sales and 40% of its revenues.  Profits in the division have dropped by nearly 60%.  And the prospects for the future are not good.

Death Spiral
When the most stable generator of cash (supplies) starts drying up, it can put a printing company in a kind of death spiral.  Because of its leveraged, upside-down economics, the company can no longer fund the aggressive growth initiatives which could help pull it out of the downward spiral.

Will the move to higher-usage printers pull Lexmark out of the death spiral?  No.  As we outline above, Lexmark has failed to offer truly differentiated products with a compelling business model, and it appears that the aggressive move upmarket may actually speed the division's demise. 

What's even more troubling are the warning signs of a similar death spiral in Lexmark's larger, more-business-focused PS&SD.  While not as volatile as ISD, the same patterns are emerging to point toward flat or falling supplies revenue: declining overall revenue, declining printer sales, and what appears to be a shrinking installed base.  Once both divisions have entered the spiral, it will be difficult for Lexmark to maintain long-term viability.

Cash Burn
For years, Lexmark's executives have touted the company's amazing ability to generate cash from its supplies-heavy business model.  But how have they deployed that cash for investors' and the company's benefit?  They haven't.  It is another troubling example of the mismanagement of the company.

At a recent meeting with analysts, Lexmark executives crowed about returning $3.2 billion to shareholders through stock buybacks.  As we delve into the effects of those buybacks, we have to wonder what they were so proud of...

With a buyback, management essentially tells shareholders, "We've determined that the best investment we can make is in our own company, so we're going to buy back our own stock."  After a buyback, since there are fewer shares on the market, each remaining share owns a bigger chunk of the company. 

Normally, a buyback is a great thing for long-term shareholders.  Because each share owns a bigger chunk of the company, the share's price usually goes up.  And a buyback usually acts as a signal from management that they believe in their company's health and prosperity.

But sometimes, buybacks are used by management as a weak attempt to prop up the share price of a flagging company.  Buybacks are especially worrisome when they are the primary use of cash by technology companies: Executives are signaling to shareholders that they can find no innovative technology more worthy of investment than simply plowing that cash back into the company's stock.  As a result of depriving technology development and acquisition, a buyback company's technology often falls far behind that of competitors.

In Lexmark's case, the buybacks have backfired.  Over the past 5 years, management has used $3.2 billion to buy back some 59 million shares of Lexmark stock at an average price of approximately $54 a share.  At $15 a share, that $3.2 billion investment is now worth about $900 million - a loss of over 70%. 

But it is worse than that.  The 59 million shares Lexmark's executives repurchased represent about 45% of the shares they started with in 2004.  So each share should have nearly doubled in value.  Without the buybacks, Lexmark's share price would likely be around $8, instead of $15.    All in all, Lexmark's value has dropped by a scandalous 90%.

In 2004, Lexmark was sitting on $1.5 billion in cash and securities.  By 2008, Lexmark had burned through that cash (and other cash it had generated since 2004) through share buybacks.  So, it took on a $650 million long-term loan, and began using that to continue purchasing new shares. 

Rather than deploying this arsenal of cash to fund growth with significant new technologies (which might have helped to differentiate their products - see discussion above), Lexmark invested in its failing status quo.  And, by any measure, that investment failed.  Miserably.

Is this executive incompetence?  Perhaps.

But there is another, equally-distressing, explanation for why Lexmark's management engaged in this failed buyback strategy on such a massive scale: They were protecting themselves.

When a company builds a large mountain of cash, it becomes an attractive takeover target.  In Lexmark's case, this is especially true, because it has also had (until recently) a reliable stream of cash from its supplies business coupled with a depressed stock price.  A private equity firm would look at buying the firm and using the cash and future profits to finance the acquisition.  In 2005, one of the industry's best analysts (Toni Sacconaghi, now with Bernstein Research) suggested that Lexmark was ripe for precisely such a scenario.  

By buying back almost half of Lexmark's outstanding stock, executives could solve multiple 'problems' at the same time:

• They reduced their cash holdings, thereby reducing their attractiveness as a takeover target;
• They could potentially buy out dissatisfied shareholders (further reducing takeover potential); and,
• They could prop up their flagging stock price, with the hopes of deferring shareholder judgment on their failures.

All in all, such a strategy would have allowed Lexmark's executives and board to maintain and concentrate control of the company.  In the process, however, they have failed their shareholders, their employees, and the communities in which they live and work (especially Lexington).  

Incompetence.  Or self-interest.  Neither explanation is satisfactory.  And both are deeply troubling.

A call for change
CEO Paul Curlander, ISD President Paul Rooke, and PS&SD President Marty Canning have all been with Lexmark for over a decade.  They presided over the destruction of 90% of Lexmark's market value.  They have marshaled failed (and failing) business strategies.  They have continually pursued failed financial strategies through stock buy-backs.  They have destroyed some 600 mostly-local US jobs.

By every meaningful business measure, they have failed.

It is time for Lexmark's board to act decisively.  Lexmark needs a vibrant new strategy 1) to survive and 2) to grow profitably.  The current standard-bearers are clearly not up to the task.  My hope is that the board can bring in new executive management who can articulate and execute that strategy. 

As a Lexington business owner, I want and need Lexmark to thrive.  Lexmark's current leaders have failed its shareholders, its employees, and our community.  It is time for meaningful change at Lexmark.

* * *

A few disclosures are in order: 

• As a former Lexmark employee, I'm prohibited from using knowledge and insights I gained while I was employed by the company.  I'm not allowed, for instance, to talk about how board meetings are orchestrated.  I also can't use the insights I may have gained in meetings with current and former executives at Lexmark.  I can't talk about the specific products, internal strategies, and personalities which might have led to the failures which I document here. 
• As a result, this story is stitched together entirely from studying publicly-available financial statements, presentations to analysts, and other public releases from the company and others.
• I have not owned Lexmark stock for over 1 year.
• I have friends, family, and customers who still work at Lexmark.  This in no way reflects their views, or conversations I may have had with them.  I did not consult with any of them before writing this.  These observations are mine and mine alone.
• Finally, this critique is aimed squarely at Lexmark's executive management.  The failures I document here are theirs, not the failures of Lexmark's smart and creative rank-and-file employees.