Fitch: Lexmark International's 'BBB-' IDR Unaffected by Kofax Acquisition

NEW YORK--()--Fitch Ratings believes the ratings for Lexmark International, Inc. (Lexmark) are unaffected by the proposed acquisition of Kofax Limited (Kofax). A full list of current ratings follows at the end of this release.

Lexmark announced it will acquire Kofax for approximately $1 billion, net of cash acquired. Kofax provides capture technology and technology to stream line business processes. Fitch believes the acquisition will strengthen Lexmark's competitive position in its Managed Print Services (MPS) and software solutions businesses which are expected to grow at double-digit rates over the intermediate term.

The acquisition will add nearly $300 million of annual revenue and expand Lexmark's mix of software revenues to 20% of total and increases recurring maintenance cash flows. The deal also modestly reduces the company's reliance on printing.

Kofax's EBITDA margin (approximately 10%) is less than Lexmark's 12% EBITDA margin as of Dec. 31, 2014, however, Fitch expects the acquisition will provide opportunities for scale, SG&A synergies, and cross-selling to Lexmark's software business. Kofax's business is also predictable due to the recurring nature of maintenance services and software license subscriptions.

The $1 billion transaction will be funded through offshore cash, borrowings under the company's undrawn securitization facility and undrawn revolving credit facility (RCF). The acquisition is expected to close in the second quarter of 2015 pending shareholder and regulatory approval.

Pro forma for the acquisition, Fitch estimates total leverage (total debt to operating EBITDA) was 1.7x, versus a pre-acquisition 1.5x, as of Dec. 31, 2014. Fitch expects Lexmark will maintain total leverage below 2x over the intermediate term.

KEY RATING DRIVERS

The ratings and Outlook reflect Lexmark's:

--Consistent free cash flow (FCF) from recurring revenue: Fitch expects pro forma FCF of $150 million to $250 million annually supported by annuity revenue that represents approximately 70% of total revenue. The growth of annuity revenue provides a more predictable revenue stream that reduces volatility in an economic downturn.

Annuity revenue consists of laser print supplies, extended warranty contracts, and subscriptions and maintenance for both Imaging Solutions and Services (ISS) and Perceptive Software (PSW). Fitch expects Lexmark's revenue to become more predictable as MPS and PSW constitute a larger percentage of total revenue.

--Stable Share of Target Print Market: Lexmark's unit share of the large enterprise workgroup laser (A4) market has remained relatively stable over the last three years, fluctuating between 16%-17%. Large workgroup printers account for a smaller share of units relative to small workgroup, but generate significantly greater print page volumes and associated demand for high margin supplies.

--Fitch expects Lexmark's EBITDA margin will exceed 18% over the intermediate term driven by a revenue mix shift to more profitable MPS contracts, operating profit margin expansion in its PSW business, and cost reduction activities, partially offset by continuing declines in high margin inkjet supplies.

Lexmark has the second largest share of the large enterprise MPS market behind Xerox Corp. and growth continues to exceed the overall market, supported by an exceptionally strong contract renewal rate. MPS contracts provide greater visibility into supplies demand, drive high margin supplies growth through the consolidation of competitors' single-function printers with Lexmark's A4 multifunction printers and enable cross-selling opportunities for PSW.

PSW is unprofitable on a GAAP basis. Fitch expects PSW's operating margin to expand following the Kofax acquisition. Further, PSW margin improvement is expected as the business scales through organic and inorganic means. Fitch believes PSW may ultimately reduce the company's reliance on printed page volume and associated risk of digitization in the long term.

--Solid Credit Metrics: Lexmark maintains conservative financial policies and strong credit protection metrics, however, there is risk that additional debt financed acquisitions may increase leverage as Lexmark seeks to gain scale in software.

--Moderating Impact of Inkjet Exit: The negative financial impact from the inkjet exit continues to moderate as inkjet is expected to represent less than 4% of total revenue in 2015 compared with 21% in 2011. The declining revenue contribution reflects MPS and PSW growth, as well as significant declines in inkjet supplies revenue.

Fitch expects inkjet revenue to decline approximately 40% in 2015, but total organic revenue excluding inkjet is forecast to be flat to slightly negative.

--Customer and Geographic Diversification: Lexmark is well diversified geographically and no single customer represents more than 10% of revenue.

Rating concerns center on:

--Reliance on Printing Industry: Printing supplies represents approximately 66% of Lexmark's revenue and an even greater percentage of operating profit, given the high profit margin on supplies. Reliance on printing volumes makes Lexmark vulnerable to long-term digitization, mitigated by the company's focus on the enterprise print market rather than consumer, strong market position in MPS and projected double-digit market growth in content and process management software through 2017. Lexmark's laser supplies revenue increased 5% in the LTM ended December 31, 2014, supported by strong growth in MPS.

--Moderately Acquisitive: Fitch expects Lexmark will continue to aggressively pursue acquisitions to expand its portfolio of software offerings and to gain scale necessary to strengthen the profitability of its PSW business.

--Majority of Cash Offshore: Lexmark may increase debt to fund U.S.-based acquisitions or return cash to shareholders, given only $58 million of the company's $234 million of pro forma cash and cash equivalents were based in the U.S. as of Dec. 31, 2014.

--Intense Competition: The print industry is intensely competitive, resulting in the commoditization of printing hardware which drives consistent equipment pricing pressure.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for the issuer include:

--Organic revenue growth flat to slightly negative over the intermediate term excluding the inkjet business.

--Domestic cash remains sufficient, although domestic acquisitions and shareholder returns could result in incremental debt issuance.

--Annual FCF of $150 million to $250 million excluding potential restructuring related to the Kofax integration or other acquisitions.

--Increased recurring revenue from higher mix of MPS and software solutions.

--Continued acquisition activity as Lexmark acquires software capabilities and reduces its reliance on printing.

--More than 50% of FCF used for dividends and share repurchases.

RATING SENSITIVITIES

The ratings may be upgraded in the event of:

--Significant diversification that reduces the company's dependency on print volumes and associated supplies revenues, given the long-term secular headwinds from digitization.

--If PSW achieves both scale and high operating margin.

The ratings may be downgraded in the event of:

--Secular weakness in printing demand leads to sustained declines in the installed base and supplies revenue.

--If management shifts to more aggressive fiscal policies. Sustained leverage (total debt/operating EBITDA) above 3.5x may result in negative rating actions.

Lexmark's total pro forma liquidity was approximately $900 million as of Dec. 31, 2014, consisting of $234 million cash (vast majority offshore) and available borrowing capacity of $500 million under an undrawn committed revolving credit facility (RCF) due February 2019 and $125 million under an undrawn secured trade receivables facility expiring October 2016.

Furthermore, liquidity is supported by Lexmark's consistent FCF, which Fitch projects will be between $150 million and $250 million annually through 2017. Lexmark will likely return the vast majority of FCF generated in the U.S. to shareholders via share repurchases and dividends, likely necessitating borrowing for U.S. acquisitions.

Lexmark's defined benefit pension plans were underfunded by $165 million (81% funded) at year-end 2014, from $115 million underfunded (85% funded) in 2013. Fitch believes Lexmark has ample liquidity to satisfy its legally mandated pension funding requirements. The company expects to contribute $15 million to its pension and other post-retirement plans in 2015 compared with $34 million in 2014.

Fitch estimates pro forma leverage was approximately 1.7x and interest coverage (operating EBITDA/total interest expense) was 14.5x. Lexmark has ample financial flexibility at the 'BBB-' rating given the company's strong and consistent FCF relative to its outstanding borrowings.

Lexmark's debt consisted of the following at Dec. 31, 2014:

--$300 million of 6.650% senior notes due June 2018; and

--$400 million of 5.125% senior notes due May 2020

Fitch continues to rate Lexmark as follows:

--Issuer Default Rating (IDR) 'BBB-';

--Senior unsecured revolving credit facility (RCF) 'BBB-'; and

--Senior unsecured debt 'BBB-'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (May 28, 2014).

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

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Contacts

Fitch Ratings
Primary Analyst
William Dickson
Associate Director
+1 212-908-0808
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Jason Pompeii
Senior Director
+1 312-368-3210
or
Committee Chairperson
Stephen Brown
Senior Director
+1 312-368-3139
or
Media Relations, New York
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
William Dickson
Associate Director
+1 212-908-0808
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Jason Pompeii
Senior Director
+1 312-368-3210
or
Committee Chairperson
Stephen Brown
Senior Director
+1 312-368-3139
or
Media Relations, New York
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com