Lexmark Falls as Profit Picture Fades

Shares fell Monday after the printer maker said results have been hurt by heavy discounting amid tough competition

The earnings warning that Lexmark International (LXK) issued on July 9 for the second and third quarters had investors concerned that the black ink in the company's bottom line could turn to red before too long. The stock traded 6.6% lower at $46.16 on July 9.

The laser and inkjet printer manufacturer slashed its earnings forecast for the second quarter by more than 30% to between 57 and 62 cents a share, which excludes seven cents in restructuring and tax benefits, on a 2% decline in revenue from a year ago. Lexmark cited a shortfall in operating income in its consumer market business stemming mostly from lower-than-expected revenue from inkjet supplies, lower average unit revenue for hardware due to promotional costs and discounted prices, and greater-than-expected sales growth for branded inkjets.

The Lexington (Ky.) company previously projected earnings of 82 to 92 cents a share in the second quarter with no restructuring charges. It will report earnings on July 24.

Lexmark also warned that its third-quarter results would drop to between zero and 10 cents a share, hampered by the same factors as in the second quarter.

That's an unusually weak forecast compared with the 95-cent-per-share profit the company posted in the first quarter of the year, says equities analyst Tom Carpenter at Hilliard Lyons. He said it makes him wonder whether Lexmark is factoring in something other than just pricing pressure.

"They have a lot more unit growth in the third and fourth quarters on the inkjet side due to back to school, so it seems like something is going on behind the scenes to get to [earnings] of zero to 10 cents," Carpenter said.

Lexmark might be making allowance for the potential cost of settling a patent infringement lawsuit with Static Control ahead of an adverse court ruling, Carpenter said. Static Control makes a chip that helps ink cartridge remanufacturers get around safeguards that Lexmark has built into its printers to prevent use of the replacement cartridges sold by remanufacturers. Even though Lexmark is the plaintiff, in ruling against the company, the judge could decide to impose penalties on Lexmark, Carpenter speculated.

The competitive environment for printers has become much more intense over the past five years as Epsom and Canon (CAJ) have stepped up their marketing efforts and new players like Eastman Kodak (EK) have entered the market.

The 30% growth in sales for branded units from the second quarter of 2006 is positive for Lexmark, but whereas the weaker hardware unit growth boosted last year's profits, the recovery in growth is now putting substantial pressure on margins, JP Morgan Securities said in a research note on July 9. And that shift could continue throughout 2007, it added.

Lexmark and other hardware manufacturers tend to lose money on sales of inkjet printers, making it up over time by selling replacement cartridges. In recent years, however, the replacement business has been under attack from remanufacturers and kiosks in stores offering to resell cartridges at sharply discounted prices.

"So the industry is less attractive than it was five years ago. Lexmark is fighting to adapt," through deals with Dell Inc. (DELL), among other things, Carpenter said. "It's still searching for a cohesive strategy in a much more competitive industry." Carpenter has had a neutral rating on the stock for quite a while.

In a research note on July 7, Standard & Poor's said Lexmark would be under greater pressure to discount prices due to updated products being offered by competitors, which would hinder the company's overall growth rate. (Standard & Poor's, like BusinessWeek, is owned by McGraw-Hill Companies [MHP]).

Standard & Poor's also predicted Lexmark's operating margins would narrow this year, hurt by the company's business mix as it focuses more on the small- to mid-size business market.

Nothwithstanding product innovations over the past year and an ability to expand its branded products and laser printer businesses, the company "faces considerable challenges from Hewlett-Packard," Standard & Poor's said.

The excess margin that Hewlett-Packard (HPQ is generating in its supplies business is giving it room to slash prices for inkjet and laser printers to unusually aggressive levels, according to the J.P. Morgan note.

The declines in Lexmark's installed base will eventually bottom, but the pricing environment and its smaller scale versus its peers "suggest it may be challenging for the company to rebuild its [market] share in high-usage segments," JP Morgan said, adding that the stock price could continue to fall.

The prospect of a takeover is doing more than anything else to support Lexmark's stock price at the moment, but the company has some contractual agreements that could stand in the way of a takeover, Standard & Poor's said.

Carpenter doesn't own Lexmark shares, but as of May 31, Hilliard Lyons and/or its affiliates owned more than 1% of Lexmark's common stock. Hilliard Lyons doesn't do investment banking with the company. JP Morgan does and seeks to do investment banking with the companies it covers.

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