XEROX CORP XRX
February 27, 2012 - 1:58pm EST by
murman
2012 2013
Price: 8.38 EPS $1.12 $1.23
Shares Out. (in M): 1,340 P/E 7.5x 6.8x
Market Cap (in $M): 11,229 P/FCF 7.5x 5.6x
Net Debt (in $M): 8,410 EBIT 2,211 2,200
TEV ($): 19,639 TEV/EBIT 8.8x 8.8x

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  • Share Repurchase

Description

At first glance Xerox stock appears to be a good short candidate.

  • Stock has gone nowhere since, forever.  But Xerox was not your typical overvalued blue chip of the 1990s (i.e. Wal-Mart, Microsoft, J&J) that had a high valuation but tripled earnings since.   It was very pricey in late 90s, but its revenue per share and earnings per share are down significantly since.  On the surface it smells a little bit like another nifty fifty has been (i.e. Kodak or Polaroid) that is yet go out of business.
  • Printing is so last century, we don’t read paper newspapers anymore.  We are becoming paperless society.
  • It has plenty of debt $8.6 billion for $11 billion market cap.
  • Declining margins in business process outsourcing business

Negative optics of horrible fundamental and stock performance since late 90s created attractive valuation and thus an opportunity. 

  • Revenues are very predictable - 80% of revenues come from annuity stream. 
  • Only 50% of revenues is directly related to printing and copying:
    • Selling copiers is only 20% of its revenues,
    • Copier related supplies (i.e. toner and parts) and service– a predictable annuity stream - about 30% of total revenues.
  • Death of printing and copying have been greatly exaggerated, overall printing revenues have been and should continue to be about flat.  Black and white printing is in a slow very low single digit decline, however, color which is about 20% of all printing is growing fast and it is about four times more expensive (b&w page costs about 1cent, color 4cents). 
  • Document outsourcing – 15% of total revenues, is very healthy and growing business (revenues up 8% in Q42011).  Companies outsource all of their printer/copier related services to Xerox, they save money and Xerox gets an opportunity to sell their product to them in the future. 
  • 30% of revenue comes from print-unrelated, business process outsourcing business – Affiliated Computer Services (ACS) XRX acquired in early 2010.  ACS acquisition (if you ignore the fact that XRX issued very cheap stock to buy a fairly valued asset) actually ended up being all it was hyped up to be – very synergistic (the most  overused adjective). Xerox helped  ACS to go international.  ACS gave XRX access to ACS domestic customers, and resulted in 300 new deals in 2011.  Integration has not been an issue.  CEO of ACS is running ACS segment.
  • ACS business process outsourcing is actually a very good and sticky business.  As a headline risk it exposed to a lot of local governments, but most of the work ACS does for local governments either generates revenues (gives traffic tickets, collects taxes) or provides important non-discretionary services (processes unemployment benefits, administers Medicare etc…)
  • 2011 saw a lot of external headwinds for XRX that will not be there in 2012 and beyond:
    • The Japanese tsunami constrained supply. XRX had to fly parts and equipment from Japan, pressuring cost of goods sold.  This should be a one-off type of event.
    • The Japanese yen is up 50% over the last 3 years.  XRX buys $2 billion worth of parts from Japan.  There is no logical reason for the yen to remain strong against the dollar in the long run; quite the opposite.  Japan has debt-to-GDP over 230, and is very dependent on the health of the Chinese and European economies (especially Chinese).
    • Declining interest rates resulted in a lower pension-discount rate and forced the company to contribute $200mm to pension assets.  Pensions will turn from a headwind into a tailwind over the year, for several reasons: first, XRX closed its defined-benefit plan in 2011; and second, though interest rates may decline further, in the longer run they’ll likely rise. 
    • Weak Europe  – in Q4 2011 copier sales were down 4% in constant currency.  This happened for two reasons: weakness in Europe (20% of sales), where sales declined in double digits.  This will remain a headwind until it is not.   The good news: installed base of copiers grew 8%, mainly driven by US and Emerging markets; the bad news: this growth was driven by lower-end copiers made for high-end segment,  this was responsible for lower revenue growth, despite higher unit growth.

 

  • Services was a great growth driver.  New contract signings are up in double digits, which is a true testament that Xerox is offering a product and service customers want and that the ACS acquisition is bearing fruit.   While new contracts should have similar profitability to existing business in the long run, at first they come at lower margins, as they require up-front investment and it takes time for them to get to scale.  XRX’s success in signing new contracts is working against its near-term profitability, but in the longer run it will increase XRX’s earnings power.  
  • Debt – not a problem
    • Xerox has $8.6 billion of debt outstanding.  As of Q4 2011 XRX paid off all debt it issued to buy ACS.  Though $8.6 billion seems like a large number, it is not.  $6 billion of it is finance debt that is tied to equipment sales and is leveraged 7 to 1 – a very reasonable number (14% reserve).  $2.6 billion is XRX’s corporate debt.  Considering that XRX free cash flow is around of $2 billion, XRX can pay off all of its corporate debt in a bit over a year.  Management wants to keep it at this level.  
  • Valuation
    • XRX has 1,340 million shares out.
    • Market cap at $8.30 stock price is $11.2 billion.
    • Management guides for 2012 operating cash flows of $2-2.3 billion, capex $500, free cash flows $1.5-1.8 billion.  But this also includes a $200 million contribution to pensions – a short-term issue that will reverse itself as interest rates rise, and a $200 million impact from new contracts.  Therefore, free cash flow past 2012 should be around $400mm higher, or $1.9-2.2 billion (I am not factoring in any growth from services). 
    • XRX is trading at about 5.5 times free cash flows 
  • Capital allocation
    • Though I understand the logic of the ACS acquisition – Xerox wanted to increase recurrence of revenues and diversify away from its copier business –XRX shareholders paid dearly for it (share count went up 60%).  However, since then management has been very clear about its future capital-allocation decisions:
      • Pay off debt for ACS acquisition – done!
      • Dividend to common shareholders $300mm
      • Share buyback $0.9-$1.1 billion
      • Small tuck-in acquisitions $0.3-$0.4 billion in total
    • So far management has kept its promise, and I have no reason to believe that they’ll do something stupid and buy another whale.  The urgency to diversify away from printing is gone.  The CFO has been (almost) swearing on his mother’s grave (don’t know if his mother is dead or alive) that stock repurchase is a very high priority for XRX, so no big acquisitions.    

Catalyst

  • A combination of an insanely cheap stock valuation and sizable repurchase program should create a lot of value over time.  Depending on where the stock price is this year (hopefully lower), XRX will be able to buy 8-10% of its shares outstanding. 
  • Its service business revenues should continue to grow 5-10% a year, assuming the copier business is flat.  Overall, revenue should grow at low single digits.  Profit margins will likely rise over time:
    • Management believes it still has plenty of costs to cut.
    • Japanese yen will turn from headwind into tailwind (i.e., decline vs. the dollar) in some not-so-distant future.
    • Newly signed contracts mature and help margins. 
  • Overall we may get mid-teens earnings growth and a 2% dividend (which will rise as share count declines), while paying 5-6 times free cash flows for a company with very stable, highly predictable cash flows. 
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