Gannon On Investing

This completes a day of posting follow ups on companies I had previously discussed. I hope you didn’t mind these quick little reviews. I promise to bring you something new very soon.

Guru Focus is reporting Berkshire Hathaway tripled its stake in Lexmark International (LXK) during the fourth quarter of 2005. Berkshire increased its holdings from one million shares in the third quarter to three million shares in the fourth quarter.

As I mentioned in my earlier post on Lexmark, I believe the shares were purchased by Geico’s Lou Simpson. Lexmark shares currently trade at $46.79; so, the market value of Berkshire’s position is likely less than $150 million. That's a rather small amount relative to Berkshire’s total common stock holdings.

Lexmark looks like a typical Lou Simpson purchase. However, I have not seen confirmation that this is a Lou Simpson purchase. If anyone has more information on the matter, please comment below or send me an email.

The important question is not who’s buying Lexmark; it’s whether you should be buying Lexmark. I think the answer to that question is yes.

Lexmark has a price – to – earnings ratio of 16, a price – to – sales ratio of 1.04, and a price – to – book value ratio of 3.49. If we knew nothing about the stock, we would probably say the price – to – earnings ratio doesn’t suggest Lexmark is anything special, the price – to – sales ratio hints at a bargain (but only hints), and the price – to – book value suggests the stock is most definitely not underpriced.

Of course, we do know something about Lexmark. We know the company’s free cash flow margin has usually been extraordinary. In 1996 and 2001, Lexmark had a (just barely) negative free cash flow margin. In every other year, Lexmark’s free cash flow margin has been truly remarkable. From 1997 – 2000, the company’s free cash flow margin ranged from 4.71% to 8.24%. From 2002 – 2004 the free cash flow margin ranged from 10.86% to 16.16%. So, we know Lexmark is a special business (or was a special business).

Even over the last twelve months, Lexmark’s free cash flow margin has been much greater than that of the average business. But, we can’t evaluate the company by using the free cash flow margin alone.

For much of the 90s, Lexmark had an average revenue growth rate in the high single digits or low double digits. However, during this past year, revenue has declined for the first time in a long time. What does this mean?

The explanation usually given is that competition has increased in the consumer printer market. HP, Dell, and Canon are the most frequently cited competitors. Will these worthy competitors crush Lexmark?

I doubt it. Lexmark’s expertise in printing is unsurpassed. Only about 50% of Lexmark’s sales and 25% of its profits come from the consumer segment. The Lexmark brand is not well – known to consumers, and those who do know it don’t particularly like it. Now, I’m not an expert on printers. But, having read what bad things people have to say about Lexmark printers and what good things they have to say about Dell printers, I think it’s safe to say brands play a large role in people’s perception of the quality of their printer. For a lot of these people, a Lexmark built printer with the Dell name on it becomes a different printer.

Lexmark has the weakest brand in the printer business. It also has the strongest technical position. The company can provide good hardware and excellent interfaces. It will do more of both in the years ahead.

There is an opportunity here for Lexmark to build a strong brand in the printer business. That’s a nice bonus, because even if I didn’t think Lexmark had the strongest technical position of any printer company, the stock is still cheap.

Lexmark has a great balance sheet. The company has only $1.9 billion in total liabilities and about $2 billion in current assets (ex –other). Lexmark has nearly a billion dollars in cash and short – term investments.

Finally, when it comes to the price, you can see why I think the Journal Register Company (JRC) isn’t your best bet. Lexmark’s enterprise value – to – revenue ratio is just under 1, and its enterprise value – to – EBITDA ratio is just under 7. Compare that to the numbers for JRC; then, ask yourself which company you’d rather own.

Lexmark continues to generate lots of free cash flow. Management has responded aggressively to the company’s problems. The company has launched new products and is undergoing a restructuring.

I would say now is an ideal time to make a long term investment in a good company selling at a very good price. You will have to stomach a lot of bad news, but that’s not too much to ask, is it?

Related Reading

On Lexmark

Lexmark (LXK)

Information Week

Lexmark Rolls Out Multifunction Devices

Guru Focus

Warren Buffett Triples Lexmark, Sold Shaw Communications, Reveals Holdings in Wells Fargo