On May 11, The Wall Street Journal published an article headlined “Lexmark Considered Inversion Before Kofax Deal” that took David Reeder aback.
The story presented the facts accurately, according to Reeder, the CFO of Lexmark, a company that makes printers and develops content-management software. What surprised him was the piece’s emphasis on what he sees as the firm’s routine consideration of a tax inversion rather than on the operational features of his company’s acquisition of Kofax, he says.
To Reeder, who joined the company in January, mulling an inversion was a mere “check the box” procedure done to assure shareholders that the firm made sure that it had examined all the alternatives to the eventual billion-dollar deal. Indeed, Lexmark similarly looked at the possibility of repatriating its offshore cash, on which it would be taxed a maximum rate of about 35%, and doing a share repurchase with it, he says.
More important to Reeder was how much the addition of Kofax could boost Lexmark’s shareholder value and operating margins. “I’m very much an operational CFO. My background’s in engineering, and I’ve spent a lot of time building factories, moving production[, and] managing supply chains,” says Reeder, who holds a bachelor’s degree in chemical engineering from the University of Arkansas to go along with an MBA from Southern Methodist University.
“I’m not a huge fan of what you might call ‘financial engineering,’” he adds, referring to the quest for capital via such moves as inversions. Examining these alternatives is “something you have to do because it’s part of the position [of CFO]. But it’s not anything that I would consider my forté,” he says.
The finance chief acknowledges that the company had fulfilled its “fiduciary responsibility” to its shareholders by going through the process of calculating the benefits of other uses of its offshore cash before using it to buy Kofax, an Irvine, Calif. company attached to a Bermuda-based holding company. Under the merger agreement announced March 24, Lexmark will use “its non-U.S. cash on hand and its existing credit facility programs” to buy Kofax for about $1 billion.
As part of the firm’s assessment of how to get the most value from its offshore cash, Lexmark looked at the possibility of doing an inversion, the finance chief acknowledged.
In an inversion, a U.S.-based multinational typically merges with an offshore partner and replaces its U.S.-based parent company with a new foreign holding company domiciled in a low-tax country. Inversions enable such companies to invest some of their offshore cash in their U.S. operations without having to pay the federal taxes they would be hit with if they were domiciled here.
But inversions have acquired an anti-patriotic taint here and — worse — have been threatened with punitive action by Congress and the Obama administration. Further, “there are a lot of bad things associated with an inversion — you have to go to a shareholder vote, it slows down your close time, and the structures aren’t as clean as they might have been,” notes Reeder.
In any event, doing an inversion or a repatriation rather than an acquisition did not make sense in strictly financial terms, according to Reeder. Because Lexmark could use its offshore cash to pay Kofax’s foreign holding company directly — and thus not be taxed on cash it would otherwise have needed to repatriate — there was no reason to do an inversion in tandem with the merger, the CFO says.
“The biggest reason you do an inversion is so you can bring that money back. But we’re spending our foreign cash [on a foreign-domiciled firm], so we’re not left with a big cash pile anymore. The overarching reason as to why you would do that is even gone,” Reeder says.
As a second alternative to the acquisition, Lexmark ran the numbers on the possibility of repatriating its foreign cash, paying the maximum federal tax rate on it of about 35%, and using the remainder to repurchase a portion of it shares, according to Reeder
While that would boost the firm’s earnings per share by about the same amount as the merger would through 2016, the EPS value of the merger would beat that of a buyback every year thereafter, he says.
Asked if the idea of the acquisition stemmed from a review by Lexmark of what to do with its overseas cash, Reeder says that “the question was not what do with our overseas cash. The question was how could we increase the value of our business, and Kofax, which is a great asset, became available on the market.”
It was the availability of Kofax that spurred the financial analysis, the finance chief adds, not the other way around. “And what the analysis showed was that it’s better to increase your future cash generation and operating income — to create real value … than just artificially reducing the EPS” by decreasing the number of shares via a buyback, he says.
Tacking on Kofax, with its $300 million a year in sales, to Perceptive Software, Lexmark’s existing software unit, will spawn a $700 million software operation for Lexmark, which has been looking to become a much more digitized company.
By nearly doubling the revenues of Lexmark’s software division, the acquisition of Kofax is bound to boost the operating margin of the merged unit. For the firm as a whole, and for Reeder as a professional, that will be a most desirable outcome.
In fact, Lexmark wants to achieve a target operating margin of 25% for the merged division by the end of 2016 to match the typical 25% to 35% margins of the software units of its competitors, according to the CFO, who says that operating margin is the metric that’s he’s personally most driven to increase.
Currently, Lexmark’s software division is running an operating margin of a little more than 10%, according to Reeder. To put that into perspective, he notes, the unit recorded a negative operating margin for the first half of 2014, lifting it to about 5% for the entire year. “It was the first time the division had an operating margin that was positive,” he says.
Once the merger is complete, however, the operations-minded finance chief acknowledges that he will face a bigger operational challenge: “How do you take 15 points of operating margin out of the [merged division] to make it look more normal versus the rest of the software industry?”