By
Amit
Chokshi
:
One of the challenges with non-stop economic news/noise is that
it can be difficult to focus on the fundamental underpinnings of
individual companies. While the broad economic outlook is
admittedly poor, some stocks seem to have derisked significantly
and carry valuations across a number of metrics that would suggest
significant undervaluation. Lexmark International (
LXK
) seems to be a company that gets no respect based on its current
valuation. As this analysis will illustrate, LXK could easily be
worth $55/per share or 75+% above current prices.
LXK is a printer company focused on office imaging and
enterprise content management ((ECM)) markets. The company's key
products are laser printers, inkjet printers, multi-function
devices, dot matrix printers and associated supplies, solutions and
services, and ECM software solutions and services. The short/bear
case is primarily centered around a secular decline in printer
demand around along with current weak corporate spending. LXK also
has a rapidly declining consumer printer segment which the company
readily acknowledges. LXK has actually been attempting to
accelerate the phase-out of this lower margin business so it
becomes a smaller contributor to its operations.
Since Q1 2010, LXK's legacy consumer segment has been accounting
for a smaller portion of LXK's overall business in each subsequent
quarter. Through Q3 2011, the corporate focused hardware/supplies
and software segments account for 89% of LXK's revenue with the
negative growth legacy consumer segment just 11% of total revenues.
The corporate and software segments have also been growing, in some
cases near 10% year over year. What investors should note is that
just under two years ago, the corporate and software segments were
77% of total revenues with legacy 23%.
As the legacy segment continues to roll off, LXK's operating
performance should experience less of a drag from this segment. I
believe that the market and sellside may be overlooking this key
aspect of LXK, allowing a significant valuation discrepancy to
arise. The following points can provide further evidence that
valuation for LXK may have bottomed.
LXK is cheap on an absolute basis:
LXK has a market capitalization of ~$2.4B and enterprise value
("EV") of ~$1.8B. The company is on track to generate roughly
$700MM in EBITDA (inclusive of an estimated $25MM in stock
compensation) leading to an EV/EBITDA multiple of 2.6x. On an LTM
basis LXK is trading at 2.8x EV/LTM EBITDA. LXK's capital
expenditures are running below its annual depreciation and
amortization but LXK does have a relatively small pension
contribution it makes. The combination of the pension contribution
and capex net out against LXK's D&A which results in an EV/EBIT
multiple of roughly 3.8x LTM EBIT. LXK also looks dirt cheap on a
Price to Free Cash Flow basis as Table I below illustrates. With a
market capitalization of ~$2.4B, LXK's P/FCF ratio is just 6.6x
2011 expected free cash flow or 15% FCF yield.
TABLE I: 2011 ESTIMATED LXK FREE CASH FLOW ($MM)
LXK is cheap against comparable companies:
LXK's upside can get very interesting when compared to its peer
group. The threats to LXK's business are homogenous to most
printing, imaging, and document management companies such as Xerox
International (
XRX
) and Canon Inc (
CAJ
). Nonetheless, LXK carries valuation metrics that are well below
those carried by XRX and CAJ, its two closest peers.
Hewlett-Packard (
HPQ
) was excluded primarily because its valuation encompasses a number
of distinct business segments. While the printer division is a key
competitor of LXK, HPQ also has enterprise storage and service
offerings, PCs, and mobile software, making it difficult to
characterize as a true comparable.
TABLE II: LXX COMPS
click to enlarge
LXK trades at a significant discount to its peers but is this
discount justified? Often times a company can carry a discount to
peers because it has poor operating metrics or capital structure
issues relative to the broader peer group. However, when comparing
LXK's operating and capital structure metrics relative to XRX and
CAJ, an even stronger case for LXK enjoying a higher share price
could be made.
TABLE III: LXK VERSUS PEERS (
LTM
)
LXK's operating metrics are similar to industry behemoth CAJ
while simply blowing away XRX. While CAJ has the strongest balance
sheet, LXK is a very strong credit, with Net Debt/LTM EBITDA at
just 0.9x while XRX has much more, albeit still moderate, leverage.
In terms of capital efficiency, LXK leads both LXK and CAJ. So
despite operating metrics that are clearly within the broader
cohort and capital allocation superior to its competition, LXK
trades at a heavy discount to peers. While XRX has been somewhat of
a hedge fund "hotel" of late, it appears that LXK offers the best
value to investors. Readers should also note that LXK has also
recently instituted a dividend of $1/share which equates to a
roughly 3% yield.
Relative to peers, LXK offers better or comparable operating
metrics, better or comparable capital structure, vastly superior
capital return metrics as illustrated by strong ROA and ROE
figures, and a dividend that is above the broader S&P 500
dividend yield. It's hard to see how LXK does not deserve valuation
metrics closer to its peer group as a result. Table IV outlines
what LXK's valuation range would be using the metrics of its key
peers (green line denotes LXK current price).
TABLE IV: LXK VALUATION BASED ON COMPS
What is interesting is that LXK analysts expect that the company
will experience substantial declines in revenue and EPS in 2012
while its peers are expected to experience growth. This leads to
forward valuations, particularly on an P/forward EPS basis that can
understate LXK's valuation. This is because while the forward
valuation metric itself may look similar to a peer like XRX, it is
not truly reflective because analysts are expecting XRX's EPS to
grow while projecting a decline in LXK's 2012 EPS. This is what
leads to a lower range for the P/2012 EPS and P/2011 EPS metrics.
While XRX has entered into other market segments via its
acquisition of ACS, the main business, as with CAJ, still faces the
same challenges as LXK.
Further, LXK has also made moves into other higher end areas of
document processing and is experiencing top line growth in 2011
following an 8% sales growth year in 2010. In fact these strategic
moves are what has in part contributed to LXK's gross margins
improving by roughly 500 basis points relative to its historical
gross margins and operating margins above what was achieved in 2005
when revenues were nearly 25% higher.
This indicates that if analysts are overly pessimistic regarding
LXK's future prospects, the company's valuation is even cheaper on
a forward basis. As previously stated, as the legacy business
continues to roll off, more robust top line growth and more
importantly higher operating margins should be achievable. It
appears that analysts may be ignoring this. In fact, an even modest
long-term top line growth of rate of just ~2.5% can make LXK a very
attractive leveraged buyout candidate, supporting a $55+ valuation
for LXK.
TABLE V: LBO ANALYSIS
Table V assumes modest 2.5% annual top line growth with margins
comparable to what is achieved in 2011. Considering that 2011 is a
challenging year, the analysis could be deemed conservative. LBO
firms are known for aggressive cost cutting and it would not be a
surprise to see operating expenses reigned in or capex reduced to
boost free cash flow. The LBO analysis assumes a deal occurs at
year end 2011 and that the deal is structured comparable to a Term
Loan B and high yield debt offering with an average interest rate
of 10%.
With the cash flow metrics LXK exhibits and leverage of just
3.8x at deal close, the interest rate could also be too high as
well. What this means is that the overall analysis from deal
structure to projections could be very conservative. Nonetheless,
these conservative assumptions lead to very attractive IRRs for a
LBO shop. Assuming an exit at year end 2015, a sponsor's IRR,
assuming LXK could be sold via an IPO or to a strategic buyer,
would range from 27% to 48%. This assumes that the sponsor does
nothing with the excess cash flow and smart LBO firms generally use
excess cash to either execute dividend recapitalizations, acquire
complementary businesses that could boost value, or pay down
expensive debt.
In Table V, I simply let the excess cash accrue. Yet, despite
these conservative assumptions, an offering takeout price of $55 or
just 5.4x EV/2011 estimated EBITDA yields an extremely attractive
return profile to a financial sponsor. LXK could also be of value
to HPQ, CAJ, or XRX and be a relatively minor acquisition given its
smaller size compared to these larger firms.
Whenever analyzing a company, my main goal before investing in
it is to absolutely bury the bull thesis and be fully aware of the
short thesis. I have analyzed the short/bear case for LXK and while
there are clearly near-term threats due to challenges at the
corporate order level, the current valuation appears to discount a
number of these challenges. Even modest assumptions regarding the
future of LXK, particularly as its legacy consumer business becomes
less of a drag to it, suggest that a share price well above $50 is
reasonable.
While $50 is ~60+% above current levels, investors should focus
mainly on valuation. At $55/share, LXK would be trading at just
5.3x EV/EBITDA, comparable to CAJ yet still below the EV/EBITDA
valuation XRX commands. In addition, LXK boasts better operating
metrics, capital structure, and a more aggressive strategy for
returning cash to shareholders via buybacks ($125MM in 2011) and a
3% dividend yield.
LXK's management and board should also realize that they have a
fiduciary duty to maximize shareholder value. With the stock
declining by nearly 70% since 2004, the LXK board and management
should consider selling the company to a party that can allow
existing shareholders to realize a valuation LXK warrants. A share
offer 50-80% above current share prices likely presents a return to
investors far greater than successfully executing new corporate
strategies which could also potentially destroy shareholder
value.
Disclosure:
Author manages a hedge fund and managed accounts long LXK.
See also
Widows And Orphans Tied For Second Place In 10-Year
Total Returns
on seekingalpha.com