Fitch Affirms Lexmark International's Ratings at 'BBB-'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed the ratings for Lexmark International, Inc. (Lexmark), including the long-term Issuer Default Rating (IDR) at 'BBB-'. The Rating Outlook is Stable.

Today's rating actions affect 1.2 billion of total debt, including the undrawn portion of Lexmark's $500 million revolving credit facility (RCF). A full list of current ratings follows at the end of this press release.

KEY RATING DRIVERS

The ratings and Outlook reflect Lexmark's:

--Opportunities following the Kofax acquisition to realize cross-selling opportunities, and capture SG&A synergies while building scale within Lexmark's Enterprise Software business. The recurring revenue characteristics of Kofax's maintenance services and software license subscriptions business will strengthen Lexmark's overall operating profile.

Fitch believes the acquisition will strengthen Lexmark's competitive position in its Managed Print Services (MPS) and Enterprise Software businesses which are expected to grow at double-digit rates over the intermediate term. The deal also modestly reduces the company's reliance on printing.

--Fitch expects pre-dividend FCF of $100 million to $200 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 Enterprise Software (ESW). Fitch expects Lexmark's revenue to become more predictable as MPS and ESW constitute a larger percentage of total revenue.

--While acknowledging secular challenges facing the 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 16% over the intermediate term driven operating profit margin expansion in its ESW business due to scaling. Fitch expects ISS margin to improve over the intermediate term due to a mix shift to higher value MPS contracts 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 ESW.

--Fitch expects ESW will generate positive operating margin in 2016 following the Kofax acquisition and other scaling activities. ESW may ultimately reduce the company's reliance on printed page volume and associated risk of digitization in the long term.

--Lexmark maintains conservative financial policies and strong credit protection metrics, but there is risk that additional debt financed acquisitions may increase leverage as Lexmark seeks to gain scale in software. Fitch estimates that total debt to EBITDA (pro forma for the Kofax acquisition) was 2.4x as of June 30, 2014 and will drop below 2x over the medium term due to increased profitability and credit facility repayment.

--The negative financial impact from the inkjet exit continues to moderate as inkjet is expected to represent less than 5% of total revenue in 2015 compared with 21% in 2011. The declining revenue contribution reflects MPS and ESW growth, as well as significant declines in inkjet supplies revenue. Fitch expects inkjet revenue to decline approximately 40% in 2015.

Rating concerns center on:

--Printing supplies represented approximately 66% of Lexmark's 2014 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, as print volumes are expected to decline in the low to mid-single digits during the rating horizon.

Lexmark's exposure to print is mitigated somewhat 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 decreased 1.3% in the LTM ended June 30, 2015, primarily due to currency headwinds and inventory channel optimization.

--Fitch expects Lexmark will continue to aggressively pursue acquisitions over the intermediate term to expand its portfolio of software offerings and to gain scale necessary to strengthen the profitability of its ESW business.

--Lack of U.S. based cash may cause Lexmark to increase debt to fund U.S.-based acquisitions or return cash to shareholders, given only $20 million of the company's $144 million of cash and cash equivalents were based in the U.S. as of June 30, 2015.

--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:

--Positive constant currency organic revenue growth 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 $100 million to $200 million through 2017;

--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.

RATING SENSITIVITIES

The ratings may be upgraded if:

--ESW's operating income mix exceeds 35% while maintaining stable ISS revenue and profitability. Greater diversification reduces the company's dependency on print volumes and associated supplies revenues, given the long-term secular headwinds from digitization.

The ratings may be downgraded if:

--Secular weakness in demand for printing supplies persists, which is not offset by the growing Enterprise Software business, resulting in expectations for negative annual FCF over a sustained period.

--Negative rating actions are more likely to coincide with discretionary actions of Lexmark's management including, but not limited to, the company adopting a more aggressive financial strategy or event-driven merger and acquisition activity that drives leverage beyond Fitch's 3.0x threshold in the absence of a creditable de-leveraging plan.

Lexmark's total liquidity was approximately $400 million as of June 30, 2015, consisting of $144 million of cash ($124 million offshore, $220 million of available borrowing capacity under a $500 million committed RCF due February 2019, and $37 million of available under a $125 million secured trade receivables facility expiring October 2016.

Furthermore, liquidity is supported by Lexmark's FCF, which Fitch projects will be between $100 million and $200 million annually through 2017. Lexmark will likely pause share repurchases temporally to repay the credit facilities associated with the Kofax acquisition after which Fitch expects more than 50% of pre-dividend FCF will be used for dividends and share repurchases.

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.

Lexmark's debt consisted of the following at June 30, 2015:

--$280 million under the senior RCF due February 2019;

--$88 million under the trade receivables facility due October 2016;

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

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

Fitch affirms Lexmark's ratings as follows:

--IDR at 'BBB-';

--Senior unsecured RCF at 'BBB-';

--Senior unsecured debt at 'BBB-'.

The Rating Outlook is Stable.

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

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=989607

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=989607

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings, Inc.
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
David Peterson
Senior Director
+1-312-368-3177
or
Media Relaitons
Alyssa Castelli, +1-212-908-0540
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings, Inc.
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
David Peterson
Senior Director
+1-312-368-3177
or
Media Relaitons
Alyssa Castelli, +1-212-908-0540
alyssa.castelli@fitchratings.com