An Analysis Of Lexmark
In 2005, Berkshire Hathaway bought about a million shares of Lexmark. I havenít followed this story closely, but I assume the stock was purchased by Lou Simpson rather than Warren Buffett. I have only two reasons for believing this: the total purchase was small relative to Berkshireís investable assets and the Lexmark purchase is typical of Simpsonís investment philosophy (or at least, what little I can glean about his investment philosophy from his past purchases). Regardless of who actually makes the purchases, a new Berkshire holding always draws a lot of commentary. The commentary on Lexmark has been almost uniformly negative. Even many value investors have a very dim view of Lexmark at these prices.
Now, I am not a contrarian investor. Psychology and sentiment do not enter into my considerations at all. Iíve bought stocks trading near five year lows, and Iíve bought stocks trading near five year highs. I just try to be rational. Iím not afraid to agree with the consensus, if itís an accurate representation of reality.
Here, it isnít. The model of Lexmark that has emerged in my mind over the past few weeks bears little resemblance to the Lexmark Iíve seen described elsewhere. Most of the negative comments about Lexmark have focused on the consumer segment. Yet, more than 75% of Lexmarkís profits come from the business segment. The business segment is Lexmarkís franchise. There, the company has managed to build a moat, not a very wide moat, but a moat nonetheless. Lexmark is the only focused, integrated printing company of any consequence. It understands its business customersí needs, and provides specially tailored solutions that none of its competitors can offer. Worldwide, some very large companies use Lexmarkís products for some very specialized tasks. Among these are retailers, banks, and pharmacies.
Lexmark has complete control of their product including the printing technology itself and the software used to manage its printers (i., to interface with the userís computer). Businesses that care about getting these specialized tasks done right (and getting them done cheap) use Lexmark. Even Lexmarkís competitors have to concede the fact that Lexmark knows printing better than anyone else. Lexmark is the only company that develops its own ink Ė jet, monochrome, and color laser technologies. It is a vertically integrated printer business like no other. The two competitors most often mentioned as threats to Lexmark are HP and Dell. While everyone will suffer from deep price cuts; I think itís HP and Dell who should be scared. Lexmark has the much stronger competitive position.
For years to come, it will be launching the best printing products for high ink consumption tasks. Lexmark hasnít been focused on competing directly with these companies in the consumer segment; thatís going to change because of the emerging photo printing market. Lexmark isnít interested in selling hardware. Itís interested in selling ink. Now that there is real demand emerging for high quality printing within the home, Lexmark is going to start going after the consumer market. Over the next few years, Lexmark will be selling more printers in this segment. A few years after that, the company will see strong recurring revenues from ink sales. Generic ink cartridges are the biggest threat to the high margin printing business. However, I believe, of all the players in this industry, Lexmark will be the least affected. Its highest margin sales are its most insulated sales.
Its lowest margin sales, in its least dominant businesses, are where generic ink will hurt the most. There is also some concern that Dell could always move away from using Lexmark printers. Let them. From what I can see, sales to Dell will not be a particularly significant high free cash flow margin business. Thereís no benefit to the Lexmark brand either. That brand is going to become stronger over the next decade, because the quality is already there. Lexmark simply hasnít been that visible to consumers. The Dell deal doesnít help build the Lexmark brand. Honestly, I wouldnít be terribly troubled if Lexmarkís sales to Dell dropped to zero tomorrow.
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