The following is a reprint of my December 12, 2007 RealMoney column
Printer manufacturer Lexmark, Inc. (LXK) started out this year at $73 and hasn’t looked back. Unfortunately, its motion has all been to the downside. Now less than half the stock it used to be, is it time to consider a nibble?
The stock is certainly cheap enough. Not only is it trading at a mere 12x expected earnings, $6.60 of the $34.50 current valuation is literally cash in the bank.
Over the last 12 months, Lexmark has brought in cash from operating activities totaling nearly $500 million and used less than $200 million for capital expenditures, resulting in free cash flow of $309 million and a FCF/Enterprise value yield of 11% – a very juicy premium to the current Treasury yield.
Of course, any juicy reward is bound to come with some risks, so let’s take a good hard look at those.
Even before Hewlett Packard’s (HPQ - Annual Report) recent resurgence, Lexmark was a distant runner-up in the printer business. Lexmark countered this position by forging an alliance with Dell (DELL) under which Lexmark makes all of the Dell-branded inkjet printers and half of their laser printers. Unfortunately for Lexmark, they inked that deal just in time for Dell to start its own tailspin.
Then, even if Hewlett Packard were to falter there are plenty of other competitors in the wings. First there are the traditional rivals like Seiko Epson (SEKE.Y) and Canon (CAJ), and Brother (BRTHY). Then, converging technologies have made competitors out of Ricoh (RICOY), Xerox (XRX), Samsung, and Kyocera Mita (KYO).
Everyone knows that obsolescence is a key risk for technology companies, and Lexmark is currently feeling the pain of the industry’s ongoing shift from inkjet to laser technology. I’ll let Lexmark explain it themselves (courtesy of the latest 10Q filing:)
Lexmark believes it is experiencing shrinkage in its installed base of inkjet products and an associated decline in end-user demand for inkjet supplies. The Company sees the potential for continued erosion in end-user inkjet supplies demand due to the reduction in inkjet hardware unit sales reflecting the Company’s decision to focus on more profitable printer placements, a mix shift between cartridges resulting in a higher percentage of moderate use cartridges and the weakness the Company is experiencing in its OEM business. Additionally, Lexmark expects to see continued declines in OEM unit sales, aggressive pricing and promotion activities in the inkjet and laser markets….
As the Company analyzes the situation, it sees the following:
- Some of its unit sales are not generating adequate lifetime profitability due to lower prices, higher costs and supplies usage below its model.
- Some markets and channels are on the low-end of the supplies generation distribution curve.
- Its business is too skewed to the low-end versus the market, resulting in lower supplies generation per unit.
Cheap Enough?If the risks haven’t sent you running for the hills, you are probably wondering whether the current share price is cheap enough to justify taking those risks. With the prospects for a decline in sales, earnings and cash flow being more than a distinct possibility, any price paid is going to have to be justified for a declining business.
The traditional valuation model says that value is equal to the cash flow in the coming year, divided by the difference between the company’s cost of capital and its growth rate. The 11% free cash flow yield I calculated above is a version of this model, and it provides the denominator in the equation: lexmark’s return, less its growth rate, should equal 11%.
Since the growth rate is negative, the return will be something less than 11%. If the current declines of approximately 3%, the implied return works out to 8%. That probably doesn’t sound like a huge payoff for many investors, but it is still a nice premium to Treasuries. Depending on the outlook for the rest of the market, value investors might find it worth a shot.