Buy Xerox


Xerox LogoXerox (XRX)
just reported their third quarter results. Due to a challenging macro environment and government budgetary pressures, operating margins decreased 1 percentage to 8.6% and this had a negative impact on profits. Investors were not impressed and sent the stock down 7.8% to $6.48. However, the lower stock price is an opportunity to buy shares at a very cheap level.

Business

Xerox has three business segments that generate almost $23 billion in yearly revenue:

  • ServicesServices has three offerings: Business Process Outsourcing (“BPO”), Information Technology Outsourcing (“ITO”) and Document Outsourcing (“DO”). Services allow customers to run day-to-day business operations. It contributes over 50% of revenue and is the companies revenue growth driver.
  • Technology. Technology “includes the sale of products and supplies, as well as the associated technical service and financing of those products.” It contributes over 40% of revenue, and the company is focused on maintaing revenue while improving margins.
  • Other.The Other segment “primarily includes revenue from paper sales, wide-format systems, and GIS network integration solutions and electronic presentation systems.” It contributes about 6% of revenue is not profitable.

83% of the companies revenue are recurring (“Annuity”). “Annuity includes revenues from services, maintenance, supplies, rentals and financing.” The other 17% come from one time equipment sales. 

Valuation

Bullish case for Xerox:

  • In a challenging year, the company is on traget for $2 to $2.3 billion operating cash flow and $1.5 to $1.8 billion of free cash flow (FCF). The current market capitalization of the company is $8.3 billion. They are trading at around a price/FCF ratio of 5. If they trade at a ratio of 8, there could be 60% upside to the stock.
  • The company is returning money to shareholders. $1 billion will be used to buy back shares in 2012. $300 million be used for dividends. The company has a 2.5% dividend yield.
  • The company can still improve profitability by cutting costs.
  • 83% of revenues are recurring and company is focused on growing the services division which has more of the recurring revenue.
  • The company is targeting 15% earnings growth over the next coming years.

Risks

  • In a very competitive industry. In services division, competition comes from Accenture (ACN), Aon (AON), Computer Sciences Corporation (CSC), Convergys (CVG), Dell (DELL), Genpact (G), Hewlett-Packard (HPQ), IBM (IBM) and Teletech. In technology division, competition comes from Canon (CAJ), Hewlett-Packard (HPQ), Kodak, Konica Minolta, Lexmark (LXK) and Ricoh (RICOY).
  • Revenue and margins are down this year even though the company spent $200 million on acquisitions. This can be partly blamed on the economy. A lot of the aforementioned competitors like IBM have lower revenue, but unlike Xerox they have  been able to make it up by cutting costs. Xerox is not the strongest of the competitors, but in a stable economy they should be able to at least maintain revenue and margins. 
  • $9 billion debt load. However, this debt load should come down to $8 billion by the year end and over $6 billion is backed by finance receivables. 
  • There is no catalysts for a higher stock price. 

David Einhorn

One investor who agrees is David Einhorn of Greenlight Capital. Here are his comments earlier this year. 

“XRX is a document management provider that entered business process outsourcing when it acquired Affiliated Computer Services (ACS) in February 2010. The combination allows XRX to sell more value-added services to its current customers and apply XRX’s technology to deliver ACS’s services more cheaply. This is our second investment in XRX since the acquisition. The first time, we bought with the stock price around $9.35, and sold with a modest gain over concerns about XRX’s Japanese exposure after the earthquake. That issue appeared fully discounted by the market during the fourth quarter when we re-established a position at $7.61 per share, which is less than 8x estimated 2012 earnings. In the first nine months of 2011, XRX signed a significant amount of new multi-year outsourcing services contracts. XRX has been aggressively cutting costs within the legacy ACS organization. Over the long-term, XRX is expecting over 6% revenue growth and 10-15% adjusted EPS growth. XRX expects to spend $1.0-$1.4 billion on share repurchases in 2012, which should make a good dent in the share count given its current equity capitalization of $11 billion. XRX shares ended the year at $7.96 each.”

Since these comments, Greenlight has added to their posistion. As of June 30th, 2012, they held 26 million shares. Greenlight will report their next quarterly holdings in the middle of November. 

Conclusion

Xerox trades at a cheap price/FCF ratio of 5. They should be able to at least maintain that FCF over the coming years. If so, they should trade at least at a price/FCF level of 8. This would mean a 60% upside in the stock price.

Disclosure: I am long XRX