Lexmark (NYSE:LXK): Added to Top Pick Live list at Citigroup; target to $52 - new Street high

Citigroup is making a big call on Lexmark (NYSE:LXK) adding the stock to their Top Picks Live list with a whopping $52 price target (prev. $41).

Firm notes that LXK moves to CIRA's conviction Buy list for three reasons. First, they do not believe 2010 consensus EPS ests reflect 1) the margin leverage associated with a cyclical improvement in laser printer/supplies demand, 2) the margin benefit assoc with the ramp of the new inkjet architecture intro’d in 9/09, or 3) mgmt’s plans to reduce op ex by a further 3-5% this year. Second, the shares are extremely inexpensive on both P/E (<6X FY10 operating EPS excl $6 in net cash) and DCF. Third, the shares are not widely owned; indeed, the current short interest represents more than 4 days of avg daily volume.

Cyclical and Structural Margin Boosters — In addition to a cyclical rebound in laser margins during 2010, there are several structural margin boosters. First, the co’s new inkjet architecture, intro’d in Sept 2009, reduces lifetime manufacturing cost for LXK while giving the co access to higher-usage customers. Second, LXK continues to move R&D and back-office to lower cost locations.

These factors drive Citi's revised 2010 EPS of $4.01 (+23% yoy) and 2011 EPS of $4.62 (+15% yoy), both of which are well above consensus. Moreover, they consider their estimates conservative on a number of fronts. For example, they are modeling inkjet operating margins down yoy in both FY10 and FY11 despite the cost benefits associated with the move to an entirely new architecture (specifically, a 4-5X reduction in print head costs over the life of the printer). In addition, Citi is not modeling laser margins back to past-cycle-peak through 2012.

Per Figure 1 below, LXK’s first yoy hardware growth in 4Q09 since 1Q05 bodes well for further share price appreciation as hardware placements lead to highly profitable supplies’ revenue in the future. LXK’s share price and hardware yoy revenue growth are highly correlated (correlation 0.82).


Second, Citi considers valuation very compelling, even after Tuesday’s (Feb. 2) 12% rise.
- LXK shares currently trade at 7.5X Citigroup's FY10 EPS estimate, just two multiple points above last year’s all-time low and well below the peers and the market. Excluding net cash from the share price and interest income from EPS, the shares trade at less than 6X Citi's FY10 EPS estimate.

- Free cash flow yield was an impressive 9% in FY09 and their modeling suggests a yield of 15% in FY10. A DCF analysis assuming 0% perpetual growth in FY12 free cash flow suggests a $70-80 fair value one year from now.

Finally, LXK shares are not widely owned, but they are widely shorted.
- By Citi's count, ten of the largest U.S.-based mutual funds were not top twenty holders of LXK shares as of September 30, 2009. Value fund representation within the top twenty is also surprisingly low. They expect this to change in coming quarters as it becomes clear that there is not only cyclical, but also structural improvement in margins underway.

- Shorter-term, the current short interest in LXK shares represents a more than 4 days of average trading volume. As a result, upside to 1H10 EPS could drive a significant short squeeze.

Citi is raising their FY10 revenue and non-GAAP EPS estimates to $4.1B (+6% yoy) and $4.01 (+23% yoy) from $3.9B and $3.28.

They are raising their FY11 revenue and non-GAAP EPS estimates to $4.4B (+7% yoy) and $4.62 (+15% yoy) from $4.1B and $3.94.

Firm is also introducing their FY12 revenue estimate of $4.7B (+6% yoy) and non-GAAP EPS estimate of $5.07 (+10% yoy).

Notablecalls: Wow - Lexmark (LXK) has come back to life! Citigroup's $52 price target is the new Street high with their EPS estimates for 2010-2010 towering consensus.

Lexmark has gone through major restructuring over the past couple years, pushing down the cost base which is enabling them to post strong bottom line numbers.

It also looks like the product line is getting a boost in the n-t.

Note how Citigroup hints LXK may be worth $70-80 per share in couple of years. This is bound to attract buyers. Short interest stands at 10% which isn't too big but still meaningful.

I think LXK can really explode when it gets past the $31 level.