Wednesday, July 14, 2010

Lexmark International (NYSE:LXK): Move to Underweight on Stiffer Competition, Weaker Inventory Growth, FX Pain - Morgan Stanley

Morgan Stanley is out with a rather significant negative call on Lexmark International (NYSE:LXK) downgrading the printer manufacturer to Underweight from Equal-Weight (no price target).

Morgan Stanley's meetings with printer competitors and proprietary channel data tell them the Street underestimates these 2H10 risks for Lexmark: 1) increased competition in laser printers as HP’s component constraints ease; 2) reduced growth benefits from inventory restocking; and 3) earnings risk from the recent depreciation of the EUR against the USD. Firm lowers their CY10 EPS estimates to 19% below consensus to consider these risks and expect LXK shares to underperform any near-term rebound in technology hardware stocks.

Believe Lexmark was a large beneficiary of HP’s laser component shortages earlier in the year. According to IDC, Lexmark’s laser printer value share was 8% in C1Q10, growing 30% Y/Y from 6% a year ago. In the same quarter, HP held 32% share, down from 37% a year ago. Following their checks in Asia, MSCO expects HP’s laser printer constraints to ease by July, allowing HP to reclaim laser market share from pent up demand starting in C3Q10. As a result, they are lowering their 2010 revenue growth estimate for Lexmark from 5%, which is already below consensus of 6%, to 3% excluding the Perceptive Software acquisition, and lowering laser printer revenue growth from 15% to 12% (11% at constant currency).

Checks with Wal-Mart revealed that some stores have stopped selling Lexmark inkjets over the last one to two months, but the stores expect to continue to carry cartridges. The decreased shelf space at Wal-Mart is not a surprise, given Lexmark’s strategic shift to target higher volume inkjet users in SOHO and SMB through office superstores. However, an exit from Wal-Mart stores could accelerate the decline of Lexmark’s inkjet installed base and result in lower ink cartridge inventory in the U.S., putting further pressure on Lexmark to execute its laser growth strategy. Even though Lexmark de-emphasized low-end inkjet over the past three years, the inkjet segment still accounted for 32% of revenue and ~22% of operating income in 2009, by MSCO estimates.

Morgan Stanley's June channel survey also suggested that the shift in business from Lexmark to HP might be underway. The survey showed that resellers expect Lexmark to lose share and HP to gain share in C2Q. In addition, 40% of printer resellers expect sequential growth in their business with HP in C2Q, compared to 35% of resellers last quarter. In contrast, the number of resellers expecting to increase their business with Lexmark fell from 40% in C1Q to 26% in C2Q.

Firm lowers their 2010 EPS estimate to $3.41 (19% below consensus) from $4.01, to account for increasing competition in laser printers as HP’s component constraints ease and earnings risk from the recent depreciation of the EUR against the USD. Their 2010 revenue estimate only falls to $4,055 million from $4,063 million as they model $61 million of revenue from the Perceptive Software acquisition, completed on June 7. Notably, they already assumed no inventory restocking benefit in their original estimates, therefore requiring no further changes to their model.

For C2Q10, MSCO EPS estimate falls to $0.82 from $0.96 (consensus at $0.95), on the back of lower gross and operating margins. They model gross margins of 34.8% versus consensus of 37% and operating margin of 9.3% versus consensus of 10.6% mainly due to foreign currency headwinds. Lexmark does not hedge P&L impacts and has limited natural hedges in Europe.

Notablecalls: This is a fairly fundamental call on MSCO's part. I would not be surprised to see the stock trade down markedly in reaction as most other tier-1 firms have been extremely positive on the name.

What bothers me in respect to this call is the ranting about competition and lack of shelf space at WMT while most of the EPS estimate cut comes from currency adjustments.

Nonetheless MSCO has dug up new and interesting info which is why I expect this call to drive the stock down in the n-t.

$33.50 anyone?

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