An Analysis Of Lexmark

In 2005, Berkshire Hathaway bought about a million shares of Lexmark I havenÂ’t followed this story closely, but I assume the stock was purchased by Lou Simpson rather than Warren Buffett I have only two reasons for believing this: the total purchase was small relative to BerkshireÂ’s investable assets and the Lexmark purchase is typical of SimpsonÂ’s investment philosophy (or at least, what little I can glean about his investment philosophy from his past purchases) Regardless of who actually makes the purchases, a new Berkshire holding always draws a lot of commentary

The commentary on Lexmark has been almost uniformly negative Even many value investors have a very dim view of Lexmark at these prices Now, I am not a contrarian investor Psychology and sentiment do not enter into my considerations at all IÂ’ve bought stocks trading near five year lows, and IÂ’ve bought stocks trading near five year highs I just try to be rational IÂ’m not afraid to agree with the consensus, if itÂ’s an accurate representation of reality Here, it isnÂ’t The model of Lexmark that has emerged in my mind over the past few weeks bears little resemblance to the Lexmark IÂ’ve seen described elsewhere

Most of the negative comments about Lexmark have focused on the consumer segment Yet, more than 75% of LexmarkÂ’s profits come from the business segment The business segment is LexmarkÂ’s franchise There, the company has managed to build a moat, not a very wide moat, but a moat nonetheless Lexmark is the only focused, integrated printing company of any consequence It understands its business customersÂ’ needs, and provides specially tailored solutions that none of its competitors can offer Worldwide, some very large companies use LexmarkÂ’s products for some very specialized tasks Among these are retailers, banks, and pharmacies Lexmark has complete control of their product including the printing technology itself and the software used to manage its printers (ie, to interface with the userÂ’s computer) Businesses that care about getting these specialized tasks done right (and getting them done cheap) use Lexmark

Even Lexmark’s competitors have to concede the fact that Lexmark knows printing better than anyone else Lexmark is the only company that develops its own ink – jet, monochrome, and color laser technologies It is a vertically integrated printer business like no other The two competitors most often mentioned as threats to Lexmark are HP and Dell While everyone will suffer from deep price cuts; I think it’s HP and Dell who should be scared

Lexmark has the much stronger competitive position For years to come, it will be launching the best printing products for high ink consumption tasks Lexmark hasnÂ’t been focused on competing directly with these companies in the consumer segment; thatÂ’s going to change because of the emerging photo printing market

Lexmark isnÂ’t interested in selling hardware ItÂ’s interested in selling ink Now that there is real demand emerging for high quality printing within the home, Lexmark is going to start going after the consumer market Over the next few years, Lexmark will be selling more printers in this segment A few years after that, the company will see strong recurring revenues from ink sales

Generic ink cartridges are the biggest threat to the high margin printing business However, I believe, of all the players in this industry, Lexmark will be the least affected Its highest margin sales are its most insulated sales Its lowest margin sales, in its least dominant businesses, are where generic ink will hurt the most

There is also some concern that Dell could always move away from using Lexmark printers Let them From what I can see, sales to Dell will not be a particularly significant high free cash flow margin business ThereÂ’s no benefit to the Lexmark brand either That brand is going to become stronger over the next decade, because the quality is already there Lexmark simply hasnÂ’t been that visible to consumers The Dell deal doesnÂ’t help build the Lexmark brand Honestly, I wouldnÂ’t be terribly troubled if LexmarkÂ’s sales to Dell dropped to zero tomorrow Such an occurrence would not materially affect my valuation of Lexmark

As far as I can tell, Lexmark’s management is excellent They understand the printer business better than anyone (they also happen to understand the science of printing better than anyone – CEO Paul Curlander has a PhD in electrical engineering from MIT) Lexmark’s management also sees highly profitable opportunities in printing long – term, despite a very competitive situation short – term I agree with that assessment

Within the printer business, there is a real danger of ferocious price competition However, I do not believe there is a real danger of prolonged ferocious price competition Lexmark is the company best positioned to weather the storm It will generate tons of free cash flow, none of which has to be siphoned off to other lines of businesses, as it does at all of Lexmark’s competitors Lexmark’s high free cash flow margin recurring revenue stream will supply it with more than enough ammunition to outlast its competitors They may be deep pocketed, but eventually, they will have to answer to Wall Street Long – term, they can’t compete with Lexmark It will take them some time to realize that But, Lexmark has the time

ThatÂ’s my assessment of Lexmark on qualitative grounds How does the stock look quantitatively?

The stock is selling for about 15 times earnings and 10 times cash flow Right now, a dollar of Lexmark’s stock buys you a dollar of sales I think that’s a bargain Not many companies of this caliber sell at a price – to – sales ratio of one

For the last ten years, Lexmark’s return on equity has not fallen below 20% During the same period, the company’s return on assets never fell below 10% The free cash flow margin has generally been in the 5 – 10% range

I wouldn’t be surprised to see Lexmark’s ROE and free cash flow fall substantially in the next few years However, long – term, I believe a return on equity of 15 – 20% and a free cash flow margin of 8 – 10% are sustainable In fact, if I was forced to pick an exact ROE that Lexmark could sustain I would pick 20% But, I would also caution you not to expect that for the next five years or so

The important estimate is the 8 – 10% free cash flow margin That’s the best way to value Lexmark At one times sales, you have an 8 – 10% yield, if you think sales can be sustained If you think sales can grow, you have to factor that into your analysis At present, a discount rate of 8% seems appropriate

I never do a discounted free cash flow analysis on this blog, because I feel the variables that go into are something you have to decide on for yourself I donÂ’t want to slap an exact figure on the value of a company, because I donÂ’t want to suggest that kind of precision But here, you can clearly see how IÂ’d value Lexmark I gave you what I think LexmarkÂ’s free cash flow margin will be (8-10%), you know what LexmarkÂ’s sales are ($54 billion), and I gave you the discount rate I thought was most appropriate (8%) The only necessary variable I havenÂ’t provided is a sales growth estimate, and IÂ’m not going to provide that, because I donÂ’t want you to think it has anything to do with the next five years

It doesnÂ’t IÂ’m looking at this company well beyond that point, and I like what I see Lexmark will strengthen its brand (with consumers), and people will still be printing So, yes, I am projecting revenue growth for Lexmark; and yes, it is enough to suggest Lexmark is worth substantially more than $55 billion

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Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at Gannon on Investing

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