Lexmark Treated Like Junk as IBM Gets Upgrade: Corporate Finance

Credit-market investors are treating
Lexmark International Inc. (LXK) (LXK) like a junk-bond issuer as the maker
of laser and inkjet printers for businesses struggles to sell
its equipment in an increasingly paperless world.

Lexmark’s bonds and credit-default swaps tied to its debt
imply the market perceives a credit rating of Ba1, according to
Moody’s Corp.’s capital markets research group, compared with
its actual rating at Moody’s Investors Service of Baa3. The
swaps have surged to the highest level since 2009, according to
prices compiled by Bloomberg.

The perception of creditworthiness (LXK) of Lexmark, spun off in
1991 by International Business Machines Corp. (IBM) (IBM), which Standard
Poor’s upgraded to AA- from A+ on May 30, is deteriorating as
investors grow leery of its prospects. The Lexington, Kentucky-
based company is trying to become a provider of corporate
printer services and document management, a strategy that hasn’t
paid off as the decline in its traditional business (LXK) outweighs
contributions from new areas.

“Lexmark is in a mature-to-declining industry with a
weakening position, which is pressuring profitability,” said
Joel Levington, managing director of corporate credit at
Brookfield Investment Management Inc. in New York. “I
personally do not believe the business is worthy of investment-
grade status.”

Default Swaps

Credit markets agree. Swaps on the company’s debt have
surged since April, adding 92 basis points to 338 basis points
today, Bloomberg prices show. That means investors would pay
$338,000 annually to protect $10 million of Lexmark’s debt.

The contracts have jumped 149 basis points since June 1,
2011. Credit swaps, which typically fall as investor confidence
improves and rise as it deteriorates, pay the buyer face value
if a borrower fails to meet its obligations, less the value of
the defaulted debt.

Lexmark’s $300 million of 6.65 percent bonds due June 2018,
which traded as high as 115 cents on the dollar in April, have
fallen to 112.1 cents on the dollar where they yield 4.34
percent, according to Trace, the bond-price reporting system of
the Financial Industry Regulatory Authority.

That’s closer to the 4.46 percent Bloomberg Fair Market
yield for seven-year, BB rated industrial bonds than the 3.19
percent on BBB- debt of that maturity.

Free Cash

The bonds’ implied Baa3 grade matched the Moody’s rating
through May 24. SP rates the debt BBB-, Bloomberg data show.

The company, which has sold printers to consumers through
retailers such as Wal-Mart Stores Inc., Best Buy Co. and Target
Corp., is trying to develop a managed print services business,
contracts under which it provides all the printing needs of a
corporation or government agency. That strategy made for a
“mixed” year in 2011 for Lexmark, according to Toni Sacconaghi, an analyst at Sanford C. Bernstein Co.

“While the company has developed a healthy and growing
managed print services business and begun to diversify into
software, its inkjet business has continued to struggle and its
financial results have been undermined by continued decline in
its legacy supplies business,” Sacconaghi said on a conference
call from the Sanford C. Bernstein Strategic Decisions
Conference on May 31.

“It’s a bit of a headwind we’re fighting as far as getting
overall growth,” Chief Executive Officer Paul Rooke said in a
telephone interview. “We’ve come a long way from where we

Lexmark’s leverage (LXK), as measured by the ratio of its debt to
earnings before interest, taxes, depreciation and amortization
was 0.98 times at the end of the first quarter, down from 1.47
times at the end of June 2009, Bloomberg data show.

Cash Dwindles

Cash and marketable securities fell $200 million from the
end of 2011 to $949 million (LXK) because of acquisitions. The company
has about $650 million of long-term debt, with $350 million
maturing in 2013 and the rest in 2018, Bloomberg data (LXK) show.
Lexmark’s revenue is expected (LXK) to fall to $4 billion in 2012 and
$3.9 billion next year from $4.17 billion in 2011, according to
the average estimate of nine analysts surveyed by Bloomberg.

Lexmark was the printer division of IBM until 1991, when it
sold the unit for $1.5 billion to Clayton Dubilier Rice LLC,
according to Hoover’s Inc. Clayton Dubilier sold it to the
public at $20 a share in 1995, valuing the company at $1.78
billion, Bloomberg data show.

IBM, which has been emphasizing software and services over
hardware, was upgraded at SP because of its shift to these
“more stable and higher margin” businesses, SP’s analyst
Martha Toll-Reed said in a report.

Returning Cash

Lexmark plans to return more than half of free cash flow (LXK) to
shareholders through dividends and share repurchases, Rooke said
in a conference call from the Sanford C. Bernstein Strategic
Decisions Conference with analysts on May 31.

Lexmark gave $268 million back to shareholders last year
via stock purchases and dividends, more than its $234.5 million
of free cash flow (LXK), and in the first quarter this year
repurchased $30 million of shares and paid a dividend of 25
cents a share, or about $18 million.

Free cash not destined for shareholder rewards will be used
to “invest for growth, both organically and with a focus on
acquisitions to drive long-term shareholder value,” Rooke said
on the conference call.

‘Strategic Shift’

The company’s shares dropped 6.5 percent on April 24 to
$30.44 after it reported quarterly adjusted earnings of 84 cents
a share, lower than the $1.08 average analyst estimate in a
Bloomberg survey (LXK). The stock has erased 24 percent (LXK) of its market
capitalization this year, closing at $24.98 on June 1.

“Lexmark is in the midst of a strategic shift to higher
usage workgroup printers and more profitable supplies sales,
but, in our opinion, the company remains vulnerable to economic
cycles and pricing pressure,” Toll-Reed and Philip Schrank,
another SP analyst, wrote in an April 30 note affirming the
company’s BBB- rating and “stable” outlook.

The analysts wrote the outlook would be “negative” if
Lexmark’s profitability (LXK) consistently declines or if its
financial policies become more aggressive, “with sustained
leverage in excess of the low” 2 times areas.

Business outside the U.S. accounted for 57.9 percent of
Lexmark’s revenue last year, with 37 percent coming from Europe,
the Middle East and Africa, Bloomberg data (LXK) show.

Hewlett-Packard Co., the world’s largest personal-computer
maker, is consolidating its PC and printer business, and the
Palo Alto, California-based company will look to reclaim market
share Lexmark gained, according to Mark Moskowitz, a San
Francisco-based analyst at JPMorgan Chase Co.

As global growth slows as consumers and governments cut
spending to stem Europe’s sovereign debt crisis, competition
will heat up, he said.

“In an environment where we could be setting up for
another macro tailspin, you can bet for sure that printing is
going back to the bottom rung,” Moskowitz said in a telephone
interview. “Within six to nine months, you’re going to hear
about a bloodbath in printing.”

To contact the reporter on this story:
Mary Childs in New York at

To contact the editor responsible for this story:
Alan Goldstein at

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