Shares of Lexmark International Inc. (LXK) moved up 2.6% on Jul 22, following better-than-expected second quarter 2014 results. Moreover, a year-over-year increase in the top line and an encouraging fiscal 2014 earnings guidance supported the upside.

Lexmark posted non-GAAP second-quarter 2014 earnings per share (EPS) of 99 cents per share, beating the Zacks Consensus Estimate of 92 cents per share. Non-GAAP earnings (excluding restructuring-related charges & project costs, acquisition and divestiture-related adjustments and, actuarial gain on pension plan) surpassed the company’s guided range of 85 cents–95cents per share. However, earnings per share decreased 5.8% from the year-ago quarter due to higher tax rate.

Revenues

Lexmark reported second-quarter non-GAAP revenues (excluding acquisition and divestiture-related adjustments) of $893.8 million which not only increased 0.5% from the year-ago quarter but also came ahead of the Zacks Consensus Estimate of $864.0 million.

On a GAAP basis, revenues came in at $891.8 million, up 0.6% from the year-ago quarter. The year-over-year increases were primarily attributed to higher revenues from Laser and Perceptive Software, which more than offset a decline in Inkjet Exit revenues.

On a year-over-year basis, Hardware revenues grew 7.0% primarily attributed to 9.0% growth in workgroup hardware revenues. On the other hand, both Supplies revenues and Software and other revenues decreased 1.0% each from the year-ago quarter. However, total Laser supplies revenues increased 5.0% on a year-over-year basis.

Revenues from the Imaging Solutions and Services (ISS) segment increased marginally on a year-over-year basis to $830.0 million. Within ISS, revenues from Managed Print Services (MPS.V) grew 14.0%, while non-MPS revenues increased 2.0% on a year-over-year basis. However, Lexmark witnessed a 33.0% decline in Inkjet Exit revenue.

Perceptive Software revenues (excluding acquisition-related adjustments) grew 3.0% year over year to $64.0 million driven by higher software and subscription revenue (up 89.0% and 39.0%, respectively).

Operating Results

Non-GAAP gross margin in the quarter was 40.9%, up 36 basis points (bps) from the year-ago quarter primarily due to strength in the laser business.

Non-GAAP operating income came in at $97.8 million, relatively flat year over year, primarily due to efficient cost management and strong laser business, which offset the decline in inkjet exit revenues. Operating margin decreased 4 bps to 10.9% from the year-ago quarter primarily due to higher operating expense as a percentage of revenue (up 43 bps year over year). Total non-GAAP operating expense increased 1.7% from the year-ago quarter to $266.8 million.

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Non-GAAP net income was $62.5 million or 99 cents per share compared with $67.1 million or $1.06 per share in the year-ago quarter. Non-GAAP net income excludes restructuring-related charges & project costs, acquisition and divestiture-related adjustments and, actuarial gain on pension plan.

Balance Sheet & Cash Flow

Lexmark exited the quarter with $1.03 billion in cash, cash equivalents and marketable securities compared with $985.2 million in the previous quarter. Trade receivables were $403.1 million and inventories were $286.4 million. The company’s long-term debt balance was $699.7 million, flat sequentially.

The company generated $102.0 million in cash from operations, up significantly from $10.0 million in the previous quarter. Free cash flow was 76.0 million. Capital expenditure totaled $26.0 million compared with $44.0 million in the previous quarter.

Lexmark paid dividends of $22.0 million (an increase of 20.0%) and repurchased shares worth $19.0 million during the quarter.

Guidance

For the third-quarter, management expects revenues to be in the range of flat to down 2.0% year over year. Revenues excluding the Inkjet Exit are expected to be up year over year. The weak guidance reflects the negative impact from the exit of the Inkjet business.

Non-GAAP earnings are expected in the range of 85-95 cents (mid-point 90 cents). The Zacks Consensus Estimate is pegged at $1.15 per share.

Management expects Laser supplies to be roughly flat on a year-over-year basis. Moreover, revenues from Perceptive Software and MPS are expected to show constant growth. It also affirmed its view to return 50.0% of free cash flow to shareholders through share buybacks and dividends. Management also expects the effective tax rate for fiscal 2014 to be approximately 29.0%.

Moreover, Lexmark expects gross margin to decrease marginally on a year-over-year basis. Operating expense is expected to be up sequentially while operating margin is expected to be down on a year-over-year basis.

For fiscal 2014, Lexmark expects revenues to be in the range of flat to down 2.0% (previous guidance 2.0% to 4.0%) year over year, primarily due to the shift to high margin solutions business.

Non-GAAP earnings are expected in the range of $3.95–$4.15 per share (previous guidance $3.80 to $4.00). The Zacks Consensus Estimate is pegged at $4.00 per share. For the long term, the company expects operating margin in the range of 11.0% to 13.0%.

Our Take

Lexmark’s second-quarter results were better-than-expected wherein both the top and bottom lines beat the Zacks Consensus Estimate. Moreover, revenues increased on a year-over-year basis primarily attributed to strong growth in Laser and Perceptive Software business.

Guidance for the third quarter was tepid, reflecting the Inkjet exit, the shift to high margin solutions business and macro uncertainty. However, the company provided an encouraging 2014 earnings guidance. Though synergies from acquisitions and renewed focus on the software space could set it back on the growth path, their impact on results could still take some time to materialize.

Nonetheless, we see the Inkjet exit as a positive. Lexmark will now be able to focus more on MPS and the software business where growth prospects are better. Moreover, Lexmark is doing really well in the MPS market and is winning deals continuously.

Lexmark’s recent bid for ReadSoft also bodes well as it will strengthen its position in the European business process management market. We believe that ReadSoft provides Lexmark the perfect footing to expand its business process solutions business.

Though restructuring and share buyback plans could boost share prices in the near term, the overall outlook for the printing industry remains bearish. Demand for printers is slowing down due to increasing usage of digital content through mobile devices.

We see good growth prospects for Lexmark in the software sector although the company is also trying to expand its hardware solutions business. But the overall macro uncertainty could have an effect on product demand. Lexmark has a strong market position, but reduced demand for traditional printing hardware has impacted pricing in the computer peripherals market.

Though constant pricing pressure from competitors such as Canon Inc. (CAJ), Xerox Corp. (XRX) and Hewlett-Packard Co. (HPQ) and a high debt burden remain concerns, we expect Lexmark to turn the tables with an increased focus on software and services.

Currently, Lexmark has a Zacks Rank #1 (Strong Buy).

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