Fitch Places Lexmark's Ratings on Negative Watch

NEW YORK--()--Fitch Ratings has placed Lexmark International Inc. (Lexmark) on Rating Watch Negative (RWN) following the announced acquisition of Lexmark by a consortium of companies led by Chinese firm Apex Technology Co., Ltd. and PAG Asia Capital for $40.50 per share in an all cash transaction with an enterprise value of approximately $3.6 billion net of cash. A full list of rating actions follows at the end of this release.

The Rating Watch Negative reflects the uncertainty of Lexmark's capital structure and financial policy following the close of the transaction as well as the uncertainty related to the transaction ultimately receiving required regulatory approval and closing. The Rating Watch Negative will be resolved as final details of Lexmark's post-close capital structure are disclosed. The ratings will be downgraded if Fitch determines that the company's financial policy will increase leverage beyond Fitch's 3.0x threshold for the current rating in the absence of a creditable de-leveraging plan.

Fitch expects the transaction will be financed through a combination of equity contributions and debt financing. The consortium of investors is expected to contribute approximately $2.32 billion of equity for the transaction. Meanwhile the consortium has received lender commitments to provide two tranches of term loans totalling approximately $1.6 billion. Lexmark's existing senior unsecured debt contains change of control provisions and will likely be redeemed upon close of the transaction. The extent to which the existing debt, including the accounts receivable facility (which does not have a change of control provision) remains outstanding adds to the uncertainty of the final capital structure.

The transaction is the result of a review of strategic alternatives undertaken by Lexmark's board of directors, with the assistance of outside advisors. Upon the close of the transaction, Lexmark's common stock will cease to be publicly traded on the New York Stock Exchange.

The merger should be completed in the second half of 2016. Lexmark's break-up fee is $95 million. The consortium's break-up fee is $150 million. The consortium expects to retain Lexmark's management team and employees to ensure stability and continuity of the business and operations.

The closing of the merger is subject to the approval of Lexmark's shareholders and receipt of customary regulatory approvals including: (1) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, (2) the receipt of certain foreign antitrust/competition approvals, (3) review of the transaction by the Committee on Foreign Investment in the United States (CFIUS), (4) certain approvals by PRC governmental authorities. Lexmark does not anticipate any significant hurdles from regulatory reviews.

Apex is a Chinese company that is listed on the Shenzhen Stock Exchange. Apex makes inkjet and laser cartridge components. Zhuhai Seine Technology Co., Ltd. owns 68.7% of APEX shares and has given its approval of the acquisition.

KEY RATING DRIVERS

Strong FCF: Fitch expects pre-dividend free cash flow (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.

Reliance on Printing Supplies: Printing supplies represented approximately 60% of Lexmark's 2015 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.

Lack of U.S. Based Cash: Cash location may cause Lexmark to increase debt to fund U.S.-based acquisitions or return cash to shareholders, given only $50 million of the company's $158 million of cash and cash equivalents were based in the U.S. as of Dec. 31, 2015.

MPS Market Share: 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.

ESW Profitability: 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.

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

KEY ASSUMPTIONS

--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

Future developments that may, individually or collectively, lead to negative rating action include:

--Lexmark's new ownership structure results in significant changes to Lexmark's current financial, operating, or strategic profiles; or

--i) 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; ii) 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.

Positive: 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.

LIQUIDITY

Lexmark's total liquidity was approximately $419 million as of Dec, 31, 2015, consisting of $158 million of cash ($108 million offshore), $212 million of available borrowing capacity under a $500 million committed Revolving Credit Facility (RCF) due February 2019, and $49 million of available under a $125 million secured trade receivables facility expiring October 2017. Fitch believes Lexmark's RCF will fall under the change of control provision and be replaced with a similar facility.

Furthermore, liquidity is supported by Lexmark's FCF, which Fitch projects will be between $100 million and $200 million annually through 2017.

Lexmark's defined benefit pension plans were underfunded by $157 million at year-end 2015, from $165 million underfunded in 2014. Fitch believes Lexmark has ample liquidity to satisfy its legally mandated pension funding requirements. The company expects to contribute $9 million to its pension and other post-retirement plans in 2016 compared with $15 million in 2015.

FULL LIST OF RATING ACTIONS

The following ratings have been placed on Rating Watch Negative

Lexmark International Inc.

--Long-term IDR 'BBB-';

--Senior unsecured RCF 'BBB-';

--Senior unsecured debt 'BBB-'.

Additional information is available on 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

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1003073

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Contacts

Fitch Ratings
Primary Analyst
Matthew Hankin, CFA, +1-646-582-4985
Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Jason Pompeii, +1-312-368-3210
Senior Director
or
Committee Chairperson
Philip W. Smyth, +1-212-908-0531
Senior Director
or
Media Relations
Alyssa Castelli, New York, +1-212-908-0540
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Matthew Hankin, CFA, +1-646-582-4985
Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Jason Pompeii, +1-312-368-3210
Senior Director
or
Committee Chairperson
Philip W. Smyth, +1-212-908-0531
Senior Director
or
Media Relations
Alyssa Castelli, New York, +1-212-908-0540
alyssa.castelli@fitchratings.com