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LXK > SEC Filings for LXK > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for LEXMARK INTERNATIONAL INC /KY/

Form 10-K for LEXMARK INTERNATIONAL INC /KY/


3-Mar-2014

Annual Report


Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto presented under Part II, Item 8 of this Form 10-K.

OVERVIEW

Products and Segments

Lexmark makes it easier for businesses of all sizes to improve their business processes by enabling them to capture, manage and access critical unstructured business information in the context of their business processes while speeding the movement and management of information between the paper and digital worlds. Since its inception in 1991, Lexmark has become a leading developer, manufacturer and supplier of printing, imaging, device management, MPS, document workflow and, more recently, business process and content management solutions. The Company operates in the office printing and imaging, ECM, BPM, DOM, intelligent data capture and search software markets. Lexmark's products include laser printers and multifunction devices, dot matrix printers and the associated supplies/solutions/services, as well as ECM, BPM, DOM, intelligent data capture, search and web-based document imaging and workflow software solutions and services.

The Company is primarily managed along two segments: ISS and Perceptive Software.

ISS offers a broad portfolio of monochrome and color laser printers and laser MFPs, as well as supplies, software applications, software solutions and MPS to help businesses efficiently capture, manage and access information. Laser based products within the distributed printing market primarily serve business customers. ISS employs large-account sales and marketing teams whose mission is to generate demand for its business printing solutions and services, primarily among large corporations, small and medium businesses, as well as the public sector. These sales and marketing teams primarily focus on industries such as financial services, retail, manufacturing, education, government and health care. ISS distributes and fulfills its products to business customers primarily through its well-established distributor and reseller network. The ISS distributor and reseller network includes IT Resellers, Direct Marketing Resellers, and Copier Dealers. ISS also sells its products through numerous alliances and OEM arrangements.

Perceptive Software offers a complete suite of ECM, BPM, DOM, intelligent data capture, search software and medical imaging VNA software products and solutions. The ECM and BPM software and services markets primarily serve business customers. Perceptive Software uses a direct to market sales and broad lead generation approach, employing internal sales and marketing teams that are segmented by industry sector - specifically healthcare, education, public sector/government, and cross industry, which includes areas such as retail, banking, insurance and manufacturing. Perceptive Software also offers a direct channel partner program that allows authorized third-party resellers to market and sell Perceptive Software products and solutions to a distributed market. Perceptive Software has two general forms of software agreements with its customers, perpetual licenses and subscription services.

Refer to Part II, Item 8, Note 20 of the Notes to Consolidated Financial Statements for additional information regarding the Company's reportable segments, which is incorporated herein by reference.

Key Messages

2013

Lexmark is focused on driving long-term performance by strategically investing in technology, hardware and software products and solutions to secure high value product installations and capture profitable supplies, software maintenance and service annuities in document-intensive industries and business processes in distributed environments. The Company continues the transition to a solutions company as it shifts from a hardware-centric company to a solutions company providing end-to-end solutions that allow customers to bridge the paper and digital worlds and the unstructured and structured content/process worlds. Lexmark provides comprehensive capabilities to allow customers to manage their print and MFP environment, including MPS. The Company also continues to build its capabilities to help customers capture, manage and access unstructured content, in any form, through both organic investment and acquisitions.

The Company continues a strategic focus on growing its MPS offerings and the placement of high-end hardware. The Company also continues the strategic focus on expansion in solutions and software capabilities, to both strengthen its MPS offerings and grow its non-printing related software solutions business focused in the ECM, BPM and DOM markets. These strategic focus areas are intended to increase our penetration in the business segment. The business segment tends to have higher page generating and more software intensive application requirements, which drive increasing levels of supplies and software maintenance and support revenue.


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In order to support these strategic focus areas, and to allow Lexmark to participate in the growing market to manage unstructured data and processes, and to further strengthen the Company's products, content/business process management solutions and MPS, the Company acquired Brainware, Nolij, ISYS and Acuo Technologies in 2012, and Twistage, Access Via, Saperion and Pacsgear in 2013. These acquisitions are included in the Perceptive Software segment.

While focusing on core strategic initiatives, Lexmark has taken actions over the last few years to improve its cost and expense structure. As a result of restructuring initiatives, significant changes have been implemented, from the consolidation and reduction of the manufacturing and support infrastructure and the increased use of shared service centers in low-cost countries, to the exit of inkjet technology. In 2012, the Company announced restructuring actions including exiting the development and manufacturing of its remaining inkjet hardware. In the second quarter of 2013, the Company and Funai Electric Co., Ltd. ("Funai") entered into a Master Inkjet Sale Agreement of the Company's inkjet-related technology and assets to Funai for total cash consideration of $100 million. Included in the sale were one of the Company's subsidiaries, certain intellectual property and other assets of the Company. The Company will continue to provide service, support and aftermarket supplies for its current inkjet installed base. The sale closed in the second quarter of 2013. With this announcement, Lexmark has focused its printing and MFP development activities solely in laser- based technologies.

During the fourth quarter of 2013, the Company changed its accounting policy for pension and other postretirement benefit plan asset and actuarial gains and losses. Under the new accounting policy, these gains and losses will be recognized in net periodic benefit cost in the year in which they occur rather than amortized over time. In addition, in the fourth quarter of 2013, Lexmark changed its method of allocating the elements of net periodic pension and other postretirement plan benefit cost to reporting segments. Results for all periods presented in this Annual Report on Form 10-K reflect the retrospective application of the accounting policy and segment allocation changes. Refer to

Part II, Item 8, Notes 2 and 20 of the Notes to Consolidated Financial
Statements for additional information.

The Company remains committed on its stated capital allocation framework of returning, on average, more than 50 percent of free cash flow to its shareholders through dividends and share repurchases while pursuing acquisitions and organic investments that support the strengthening and growth of the Company.

Lexmark's 2013 revenue was down 3% YTY, primarily due to the decline in inkjet revenue related to the decision to exit inkjet technology. Operating income increased 114% YTY primarily driven by cost and expense reductions executed in 2012 and 2013 related to the Company's 2012 Restructuring actions, a $69.2 million, net pre-tax divestiture-related benefit ($73.5 million gain on sale offset partially by $4.3 million of divestiture-related costs), and a pension and other postretirement benefit plan asset and actuarial net gain of $83.0 million.

As in 2013, the Company is focused in 2014 on revenue and profit growth from the strategic imaging and software segments of the business, particularly MPS offerings and Perceptive Software. While this growth will be dampened by the remaining Inkjet Exit headwind in 2014, this headwind will decline over time.

Refer to the section entitled "RESULTS OF OPERATIONS" that follows for a further discussion of the Company's results of operations.

Trends and Opportunities

Lexmark serves both the distributed printing and imaging, and content and process management markets with a focus on business customers. Lexmark's enterprise content and process management platform supports traditional business content as well as rich media and medical image content, and includes enterprise search, intelligent capture, DOM, and business process and case management. Lexmark's healthcare offering includes an industry leading, standards based and highly secure, content repository and VNA that integrates all patient unstructured information across the enterprise to enable easy access through an EMR system along with workflow automation and information sharing within and between facilities. Lexmark management believes the total relevant market opportunity of these markets combined in 2013 was approximately $80 billion. Lexmark management believes that the total relevant distributed laser printing and imaging market opportunity was approximately $70 billion in 2013, including printing hardware, supplies and related services. This opportunity includes printers and multifunction devices as well as a declining base of copiers and fax machines that are increasingly being integrated into multifunction devices. Based on industry information, Lexmark management believes that the overall distributed printing market declined slightly in 2013. The distributed printing industry is expected to experience flat to low single digit declining revenue overall over the next few years but, continued growth is expected in MPS, multifunction products ("MFPs"), and color lasers which are all areas of focus for Lexmark. MPS and fleet solutions are expected to continue to experience double digit annual revenue growth rates over the next few years and the relevant content and process management software markets that Lexmark participates in, are projected to grow approximately 10% annually over the next few years, both based on industry analyst estimates. In 2013, the total relevant content and process management software market was approximately $10 billion, excluding related professional services. However, management believes the total addressable market is significantly larger due to relatively low penetration of content and process management software solutions worldwide.


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Market trends driving long-term growth include:

Continued adoption of color and graphics output in business;

Advancements in electronic movement of information, driving a continued shift in pages away from centralized commercial printing and document scanning to distributed printing and mobile capture by end users when and where it is convenient to do so;

Continued convergence between printers, scanners, copiers and fax machines into single, integrated multifunction and all-in-one devices;

Increasing ability of multi-function printing devices and mobile devices to integrate into business process workflow solutions and enterprise content management systems;

Continued digitization of information and the electronic distribution of information, driving the explosive growth of unstructured digital information, such as office documents, emails, web pages, images, video and audio files;

Customer desire to have a third party manage their output environment;

Ongoing emphasis on improving business process efficiency and driving costs out of the organization by better managing enterprise content and associated processes;

Increasing need to capture, manage and access content from any location or any device, including mobile access and mobile workflow participation, while ensuring content security; and

Growing desire to unify structured data in business systems with unstructured digital content to make the unstructured content more valuable and actionable within business functions.

Increasing need in the healthcare industry to unify structured patient data, that is now typically stored in an EMR system, with unstructured content, that includes medical imaging studies and other patient documents and content such as lab reports, to enable easy unified access by clinical staff and referring physicians, across the healthcare continuum to improve clinical and business outcomes.

As a result of these market trends, Lexmark has growth opportunities in monochrome and color laser printers and MFPs, MPS, as well as fleet management, ECM, BPM, DOM, intelligent data capture, search and medical imaging vendor neutral archive software products and solutions.

Color and MFP devices continue to represent a more significant portion of the laser market. The Company's management believes that these trends will continue. Industry pricing pressure is partially offset by the tendency of customers to purchase higher value color and MFP devices and optional paper handling and finishing features. Customers are also purchasing connected smart MFPs and document and process management software solutions and services to optimize their document-related processes and infrastructure in order to improve productivity and cost.

While profit margins on printers and MFPs have been negatively affected by competitive pricing pressure, supplies sales are higher margin and recurring. In general, as the printing and imaging market matures and printer and copier-based product markets continue to converge, the Company's management expects competitive pressures to continue.

Lexmark's dot matrix printers include mature products that require little ongoing investment. The Company expects that the market for these products will continue to decline, and has implemented a strategy to continue to offer high-quality products while managing cost to maximize cash flow and profit.

The content and process management software and services markets serve business customers. These markets include solutions for capturing all types of unstructured information such as hardcopy, photographs, emails, images, video, audio and faxes as well as intelligent indexing, archiving and routing of this information to streamline and automate process workflows while managing changes to both content and processes and automating governance and compliance policies. These solutions help companies leverage the value of their unstructured content by connecting it with existing enterprise applications and making it available in context within processes so that businesses can make better and faster decisions to enhance growth, improve productivity, lower costs and improve customer satisfaction. These markets also include solutions that help businesses understand existing processes, design and manage new processes, and enable the assembly of content into meaningful communications internally and with their customers and partners.


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Management sees growth opportunities in large/global enterprises with a distributed workforce, in organizations that are seeking to optimize their content-related infrastructure and reduce costs, and in functional areas where workers rely on mobile devices for productivity.

The demand for ECM solutions is strong in developed and emerging markets alike, representing a considerable growth opportunity for Perceptive Software. Lexmark's products are already installed in geographies around the world, and management believes this global customer base serves as an impetus for additional installations for Perceptive Software outside of North America. Customers continue to purchase ECM solutions that result in greater efficiency and productivity in their various lines of business and back office operations.

Business systems such as enterprise resource planning ("ERP"), EMR, and customer relationship management ("CRM") systems represent a mature market and remain vital applications but do not satisfy an organization's enterprise content management needs. The Company expects organizations to continue to look to ECM and BPM solutions to complete their enterprise information infrastructure, increasing the value of their core business system investments and leading to gains in efficiency.

Challenges and Risks

In recent years, Lexmark and its principal competitors, many of which have significantly greater financial, marketing and/or technological resources than the Company, have regularly lowered prices on printers and are expected to continue to do so. Other challenges and risks faced by Lexmark include:

New product announcements by ISS' principal competitors can have, and in the past, have had, a material impact on the Company's financial results.

The Company's future operating results may be adversely affected by the Company's exit from future hardware development and manufacturing of inkjet printers if the consumption of inkjet aftermarket supplies used in the Company's legacy inkjet installed base is less than expected.

With the convergence of traditional printer and copier markets, major laser competitors now include traditional copier companies

The Company expects competition will continue to intensify as the ECM and BPM markets consolidate. The Company sees other competitors and the potential for new entrants into the ECM and BPM markets possibly having an impact on the Company's strategy to expand in these markets.

Lexmark expects that as it competes with larger competitors, the Company may attract more frequent challenges, both legal and commercial, including claims of possible intellectual property infringement.

Refill, remanufactured, clones, counterfeits and other compatible alternatives for some of ISS' toner and ink cartridges are available and compete with ISS' supplies business. However, these alternatives may result in inconsistent quality and reliability. As the installed base of laser and inkjet products matures, the Company expects competitive supplies activity to increase.

Historically, the Company has not experienced significant supplies pricing pressure, but if supplies pricing was to come under significant pressure, the Company's financial results could be materially adversely affected.

Global economic uncertainty and difficulties in the financial markets could impact the Company's future operating results.

Changes in printing behavior driven by adoption of electronic processes and/or use of mobile devices such as tablets and smart phones by businesses could result in a reduction in printing, which could adversely impact consumption of supplies.

Refer to the sections entitled "Competition - ISS" and "Competition - Perceptive Software" in Item 1, which are incorporated herein by reference, for a further discussion of major uncertainties faced by the industry and the Company. Additionally, refer to the section entitled "Risk Factors" in Item 1A, which is incorporated herein by reference, for a further discussion of factors that could impact the Company's operating results.

Strategy and Initiatives

Lexmark's strategy is based on a business model of investing in technology to develop and sell printing and imaging and content and process management solutions, including printers, multifunction devices and software solutions with the objective of growing its installed base of hardware devices and software installations, which drives recurring printing supplies sales and software subscription,


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maintenance and services revenue. The Company's management believes that Lexmark has the following strengths related to this business model:

Lexmark is highly focused on delivering printing, imaging, and content and process management software solutions and services for specific industries and business processes in distributed work environments.

Lexmark internally develops both monochrome and color laser printing technology

Lexmark, through Perceptive Software, also internally develops content and process management software that includes DOM, intelligent capture, search, rich content management, and healthcare specific medical imaging and VNA software products as well as corresponding industry tailored solutions to help companies manage the lifecycle of their content and business processes all in the context of their existing enterprise applications.

Lexmark has leveraged its technological capabilities and its commitment to flexibility and responsiveness to build strong relationships with large-account customers and channel partners.

Lexmark's strategy involves the following core strategic initiatives:

Invest in technology, hardware and software products and solutions to secure high value product installations and capture profitable supplies, software subscription, and maintenance and service annuities in document-intensive industries and business processes;

Target and capture business customers, markets and channels that drive higher page generation and supplies usage; and

Advance and grow the Company's ECM and BPM business worldwide.

Refer to the section entitled "Strategy" in Item 1, which is incorporated herein by reference, for a further discussion of the Company's strategies and initiatives.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Lexmark's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, as well as disclosures regarding contingencies. Lexmark bases its estimates on historical experience, market conditions, and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Refer to Part II, Item 8, Note 2 of the Notes to Consolidated Financial Statements for the summary of significant accounting policies. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the financial statements. The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition

Revenue recognition may be impacted by the Company's ability to estimate sales incentives and expected returns.

For customer programs and incentives, Lexmark records estimated reductions to revenue at the time of sale for customer programs and incentive offerings including special pricing agreements, promotions and other volume-based incentives. Estimated reductions in revenue are based upon historical trends and other known factors at the time of sale. Lexmark also records estimated reductions to revenue for price protection, which it provides to substantially all of its distributor and reseller customers. The amount of price protection is limited based on the amount of dealers' and resellers' inventory on hand (including in-transit inventory) as of the date of the price change. If market conditions were to decline, Lexmark may take actions to increase customer incentive offerings or reduce prices, possibly resulting in an incremental reduction of revenue at the time the incentive is offered.

The Company also records estimated reductions to revenue at the time of sale related to its customers' right to return product. Estimated reductions in revenue are based upon historical trends of actual product returns as well as the Company's assessment of its products in the channel. Provisions for specific returns from large customers are also recorded as necessary.


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Multiple Element Arrangements

The Company also enters into multiple element agreements with customers which may involve the provisions of hardware and/or software, supplies, customized services such as installation, maintenance, and enhanced warranty services, and separately priced maintenance services. These bundled arrangements typically involve capital or operating leases, or upfront purchases of hardware or software products with services and supplies provided per contract terms or as needed.

The Company uses its best estimate of selling price ("BESP") when allocating the transaction price for many of its product and service deliverables as permitted under the accounting guidance for multiple element arrangements when sufficient vendor specific objective evidence ("VSOE") and third party evidence do not exist. BESP for the Company's product deliverables is determined by utilizing a weighted average price approach which starts with a review of historical stand-alone sales data. Prior sales are grouped by product and key data points utilized such as the average unit price and the weighted average price in order to incorporate the frequency of each product sold at any given price. Due to the large number of product offerings, products are then grouped into common product categories (families) incorporating similarities in function and use and a BESP discount is determined by common product category. This discount is then applied to product list price to arrive at a product BESP. Best estimate of selling price for the Company's service deliverables is determined by utilizing a cost plus margin approach as the Company does not typically sell its services on a stand-alone basis. The Company generally uses third party suppliers to provide the services component of its multiple element arrangements, thus the cost of services is generally that which is invoiced to the Company, but may also include cost estimates based on parts, labor, overhead and estimates of the number of service actions to be performed. A margin is applied to the cost of services in order to determine a best estimate of selling price, and is primarily based on consideration of internal factors such as margin objectives and pricing practices as well as competitor pricing strategies.

For multiple element agreements that include software deliverables accounted for under the industry-specific revenue recognition guidance, relative selling price must be determined by VSOE, which is based on company specific stand-alone sales data or renewal rates. For software arrangements, the Company typically uses the residual method to allocate arrangement consideration as permitted under the industry-specific revenue recognition guidance.

Multiple element arrangements and software and related services represent a . . .

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