Below the Radar: Lexmark Takes Aim Again at the Low-End Printer Market - TheStreet

In a market as volatile as this one, many fund managers are looking for solid earnings growth, and they're finding it in some of the most mundane areas.

Laser and inkjet printers, and the toners and cartridges that go with them, have continued to sell well. They are a play on technology that some fund managers like, especially because of the steady and highly profitable revenue stream that replacement toners and cartridges bring in.



, a manufacturer of printers and cartridges, is attracting many fund managers' attention because of the predictability of its replacement-cartridge revenue stream and its competitiveness in the low-end printer market. It has delivered a strong 40.7% average annualized return over the past five years and is up 33.6% year to date. With a trailing

price-to-earnings ratio of 27, Lexmark's stock is not exactly cheap, but analysts are expecting 15.5% annual growth in earnings over the next five years, according to


Looking to Make a Comeback
After a rough 2000, Lexmark's stock is up almost 34% so far this year


The company's printer sales split just about evenly between two markets, consumers and businesses, with consumers purchasing primarily inkjet printers and businesses primarily laser printers, says Tim King, a Lexmark spokesperson. King won't reveal what portion of the company's revenue comes from printer and cartridge sales, but


estimates that cartridges generate about 40% of Lexmark's revenue and 70% of its profits.

Steady Revenue Stream

Fund managers and analysts say they like Lexmark's cartridge business because it provides steady, high-margin revenue.

"While we are actually quite cautious on technology for a number of reasons due to the weakened economy and overspending in technology in recent years, we like Lexmark because of the predictability of its earnings," says John Rutledge, portfolio manager of the


Evergreen Technology fund, which has 6.76% of its $5 million in assets invested in Lexmark.

Paul Wick, portfolio manager of the

(SLMCX) - Get Report

Seligman Communications & Information fund, which has 2.14% of its $4.1 billion in assets invested in Lexmark, concurs. "We own the stock because of the predictability of the company's overall revenues and earnings, given the consumables-oriented nature of the business," Wick says.

According to Rutledge, printer cartridges probably cost less than $1 to make, while Lexmark charges about $20 for black-and-white cartridges and $30 for color cartridges.

And even though the expectation of becoming a paperless society has long existed, paper use has actually


due to the growing trend of printing Web pages and emails. What's more, printers are taking business from copier machines as more people send and print emails rather than mailing hard copies, says Ken Weilerstein, a senior analyst at

Gartner Group

(another bonus: image-rich Web pages use lots of ink).

Holding Off H-P

As for its printer manufacturing business, Lexmark is currently the second-largest maker of laser and inkjet printers with 15% of the market, up from just 6% in 1997, according to Gartner. Printer giant



is the largest, with a 47% share of the market.

Making Its Mark
Lexmark's share of the combined inkjet and laser printer market has been increasing steadily, while H-P's has been dipping slightly

Source: Gartner Group

Although H-P recently began

competing more aggressively in the under-$100 inkjet market that is Lexmark's sweet spot, analysts and fund managers believe that Lexmark can continue to compete successfully against H-P, primarily because it specializes in printers, while H-P does not.

"What distinguishes Lexmark is their focus on printing and proprietary technology, whereas H-P's printing hardware technology in many cases is developed by other companies, including


," says Jay Ritter, an analyst at Morningstar.

With this proprietary technology, Lexmark can generate better margins on its printers than H-P, says Joseph Correnti, who follows the stock as director of research at Chicago brokerage firm

Wayne Hummer Investments

. Lexmark's operating margins in the first quarter of the year were 11.8%, while those in H-P's printing division were just 8.2%.

Practically Printing Money
Though declining some recently, Lexmark's operating margins have been extremely healthy due to its profitable cartridge business and its proprietary printing technology

Source: Company reports

Also, because Lexmark's technology is all its own, it has more flexibility in pricing and is frequently able to underbid Hewlett-Packard, which must rely to some extent on what Canon charges. A final advantage of Lexmark's specialization is that some of H-P's competitors in the PC market, such as


, prefer to partner with Lexmark for printers. Lexmark also has sales teams dedicated to a number of vertical markets, including pharmacies, hospitals, banks, automotive manufacturers, law firms and utilities. Given its niche in the low-end market, Ritter thinks Lexmark should be able to at least maintain its current market share.

A Difficult 2000

Although Lexmark's stock has delivered big gains over the past five years, 2000 was a very difficult year for a number of reasons. During this time, the company's stock declined 51% and earnings fell 10% to $3.8 billion.

First, a number of companies that had bought printers in 1999 ahead of Y2K didn't need them in 2000. Second, Lexmark built a new manufacturing plant to double its capacity, enabling it to deliver printers faster. But now the office superstore distributors selling Lexmark printers no longer need to place orders one or two quarters ahead of time; they worked through their back inventory rather than placing new orders, which hurt Lexmark sales considerably in the short term. Lastly, the weak euro hurt profits, as a third of Lexmark's revenue comes from Europe.

Not all analysts are certain that Lexmark can continue to compete so nimbly against Hewlett-Packard, however. Some, including Gibboney Huske of

Credit Suisse First Boston

, expect Hewlett-Packard to compete fiercely on price. "We continue to believe that the full impact of H-P's move into the sub-$100 segment has yet to be felt and remain cautious about the short-term pricing and market-share volatility that could follow," she says.

And while Lexmark has a steady replacement-cartridge revenue stream, its printer sales aren't immune from the economic slowdown, says Wayne Hummer's Correnti.

Nonetheless, Lexmark has dominated the under-$100 inkjet market with a brand name well known among an established base of consumers, and "the company has done a good job of dealing with competitive situations in the past," says Morningstar's Ritter.