Armonk did not leave Lexmark out in the cold when it spun out the Lexington, KY-based printer-maker in 1991. It provided a critical asset for the start-up entity: IBM’s laser printing technology. With this sizable and proven technology cachet, Lexmark created a direct sales force and penetrated the enterprise market—whose appetite for laser printers, IBM’s own sales force had underestimated—through vertical industries. The company developed focused printing solutions, notably in the retail pharmacy and branch banking spaces, creating flash memory programs for printing oft-repeated forms.

After six years in the laser market, Lexmark entered inkjet printing in 1997 through a low-cost model. Abandoning the technology of the time, Lexmark used the PC as the raster engine (which translates images into code for printing) for its inkjet printers, thereby eliminating a costly component of the contemporary printer and enabling Lexmark to come out with a sub-$100 unit. Lexmark quickly gained market share as retailers were able to bundle these new machines with the first generation of sub-$1,000 PCs introduced by HP and Compaq.

Finding a Sustainable Growth Model
Accelerate to 2003. The worldwide printer and supplies market has grown to $97.6 billion, according to IDC. However, the analyst firm sees only limited market growth and declining average sales prices on hardware through 2006, with the engine for market growth coming from replacement supplies. Gone are the days of Lexmark’s explosive growth across the inkjet market, where the company carved out over 10% market share in a mere five years. The printer market has truly reached a maturity stage, with four major players (HP, Epson, Canon, Lexmark) controlling over 90% of the inkjet market and HP clearly holding the dominant position within the laser space.

Like the rest of the industry, Lexmark has seen its revenue model shift towards replacement cartridges as the dominant source of income. During 2002, over 53% of Lexmark’s $4.3 billion revenue stream came from high-margin replacement ink and toner cartridges, with analysts estimating that figure to increase to 55.4% in 2003. However, while more customers generally translate into more ink sold, Lexmark is not seeing an increase in new customers and an expansion of its flow-through printing base. Therefore, keeping these replacement figures high will be a challenge.

Analysts have noted that Lexmark is struggling to maintain market share vs. its primary competitors, particularly HP. The company remains focused on the SMB, SOHO and consumer markets, where price is often the determining purchase factor. However, with the advent of low-cost, multi-function inkjet devices, and the continuing commoditization within the dominant inkjet category, price pressure is rampant throughout all segments of the market, but most particularly in these retail and consumer areas. Therefore, Lexmark is seeing limited gross margins in hardware and is attempting to make-up revenues by cementing their high margins in replacements.

Benjamin Reitzes of UBS Warburg estimates that Lexmark lost over 4.4% of the U.S. monochrome laser market between 2001 and 2002, and that its inkjet market share in the U.S. retail market had declined 5.7% during the same period. (These figures could be somewhat overstated by Reitzes, as he did not include sales through Lexmark strongholds Dell and Wal-Mart as part of his report.) The company has maintained solid showings in Europe and Asia, which account for close to 45% of its corporate revenues, but these markets are decidedly smaller than the American market.

For companies throughout the printing sector, finding new ways to buttress the bottom line is going to be critical to long-term survival. And that is where Lexmark’s singular focus on printing could be a significant hindrance. "Increasing services and solutions opportunities are going to be critical for printer makers to maintain revenue streams and market share," says IDC analyst Dan Corsetti. "HP, Canon, and Xerox are the best for providing these solutions."

These three vendors offer two things that Lexmark does not: A diversified product base that enables them to enter enterprises through mature and highly cultivated channel relationships, and expansive and experienced services teams that can provide end-to-end solutions for a variety of business settings. Lexmark, meanwhile, continues to be seen merely as the hardware maker and ink supplier, with only 9% of 2002 revenues coming from non-hardware or ink sources.

Cue the Evil Empire Theme Music
With Lexmark pushed into a corner, and trying desperately to continue its growth pattern, it recently turned to a long-time ally in hopes of finding fertile new ground. Lexmark has long been a supplier of printers to Dell, but Dell had a mediocre attach rate for printers. Round Rock, always on the lookout for new revenue streams, saw Lexmark’s pool of replacement ink revenues and the companies quickly forged a plan to work more closely together.

Starting in 2003, Lexmark will supply Dell-branded printers for sale through their direct market channel. Analysts also speculate that Dell will also receive replacement supplies at some kind of discount from Lexmark, with estimates as high as a 30% discount. Lexmark sees Dell’s sales model as a new way to reach business and consumer customers with hardware and increase their replacement supply base. Dell sees a way to staunch the flow of ink revenues to HP and other competitors. However, significant barriers stand in the way.

First, Lexmark is initially going to take an earnings hit, as it will be supplying these Dell-branded printers to Round Rock at or below its manufacturing cost. Second, Dell will have to aggressively improve the attached rate of its printer efforts, which has led to speculation that it will initially give away (or sharply discount) the new printers with PC purchases. Third, Dell must overcome the consumer’s predisposition to go to a retail outlet when they need a new printing cartridge, and convince them instead to wait for UPS. Finally, if Dell sees early traction in their printer efforts, they could simply cut Lexmark loose, partner with an Asian supplier, and compete head-to-head.

Low Cost = Low Quality?
While it attempts to deal with the increasingly intense competition across the printer industry, Lexmark is also finding it difficult to maintain its course as the low-cost hardware and cartridge provider. While its proprietary intellectual property enables it to maintain low development costs, the company’s outsourcing of assembly and manufacturing operations throughout Asia could be costing it from a quality perspective.

The most recent PC Magazine Reader Survey saw Lexmark’s overall grade for quality and satisfaction drop from a "B" to a "D+", the lowest grade the company had ever received. Users gave Lexmark’s inkjet printers a "C," while the company’s laser devices (the original cornerstone of the business) received the survey’s worst-possible "E" grade. Lexmark also had worse-than-average scores on overall satisfaction and overall product reliability. In trying to cut corners, Lexmark may be cutting loose current customers, who rewarded HP with the first "A+" grade ever awarded in the Survey.

Buckle Up
With new "partner" Dell on board, Lexmark is hoping that it can power out of its gradual descent. While the company tries to adjust its payload and fuel mix, however, the skies are becoming more crowded and the headwinds are getting stronger. What remains to be seen is whether the Bluegrass Boys can handle these unfriendly skies.