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

8.75% From Lehigh Gas Partners

Lehigh Gas Partners LPLehigh Gas Partners LP (LGP) announced pricing terms for its upcoming IPO. It expects to sell 6 million common units at a price range of $19 to $21. The underwriters will be granted a 30-day option to purchase up to an additional 900,000 common units.

 

Business

Lehigh does exactly what Susser Petroleum (SUSP) does. (See our article here.) They generate income from “the wholesale distribution of motor fuels primarily by charging a per gallon margin that is either a fixed mark-up per gallon or a variable rate mark-up per gallon.” They also own and rent out gas stations. As of June 30, 2012, it owned 182 sites.

Spin-off

Lehigh Gas Partners Ownership

Details of the spin-off:

  • 6 million common units are offered at the price range of $19-$21 or 6.9 million common units if the underwriters exercise their option to purchase additional common units in full.
  • If the underwriters don’t exercise the option, the .9 million additional units will go to the Topper Group.
  • Regardless of what happens with the underwriters, there will be “7,525,000 common units representing a 50.0% limited partner interest in us and 7,525,000 subordinated units representing a 50.0% limited partner interest in us.”

Cash Distribution

The common units and subordinated units differ on the priority of receiving dividends. The partnership will distribute cash each quarter in the following manner:
  • first, to the holders of common units, until each common unit has received a minimum quarterly distribution of $0.4375 plus any arrearages from prior quarters;”
  • second, to the holders of subordinated units, until each subordinated unit has received a minimum quarterly distribution of $0.4375; and”
  • third, to all unitholders, pro rata, until each unit has received a distribution of $0.5031.”

“If cash distributions to our unitholders exceed $0.5031 per unit in any quarter, our unitholders and our general partner will receive distributions according to the following percentage allocations:”

  • above $0.5031 up to $0.5469 – 85% unit holders, 15% general partner
  • above $0.5469 up to $0.6563 – 75% unit holders, 25% general partner
  • above $0.6563 – 50% unit holders, 50% general partner

Conversion of subordinated units

“The subordination period will end on the first business day after we have earned and paid at least:

  1. $1.75 (the minimum quarterly distribution on an annualized basis) on each outstanding common unit and subordinated unit for each of three consecutive, non-overlapping four quarter periods ending on or after December 31, 2015 or 
  2. $2.6250 (150.0% of the annualized minimum quarterly distribution) on each outstanding common unit and subordinated unit and the related distribution on the incentive distribution rights for a four-quarter period ending on or after December 31, 2013, in each case provided there are no arrearages on our common units at that time.

When the subordination period ends, all subordinated units will convert into common units on a one-for-one basis, and all common units thereafter will no longer be entitled to arrearages.”

 Analysis

This IPO is an exact copy of the Susser Petroleum IPO. The fact that Susser is now trading at $25 should be an indication that this IPO will price at high end of range and it will pop during trading. At $20/share and $1.75 dividend, the yield will be 8.75%. At $21/share, it will be $8.3%. The dividend should be very safe because common units have rights over subordinated units.

Based on their 2013 projections, the dividend could go above $1.75. Couple things that concerned me in the filing:

  • Based on their 2013 projections, their rental income is negative (free cash flow is positive because of depreciation).
  • LGO, an entity managed by Joseph V. Topper, Jr, the Chief Executive Officer and the Chairman of the board of directors of our general partner, is leasing or sub-leasing 182 sites from the company at an aggregate initial annual rent of 3.8 million. That is $20,0000 per site. This seems really low because each site is worth around $1 million. Yearly maintenance for each site is probably around $20,000.
Either way, I expect this to trade similar to SUSP, around $25/share. Especially, since the SeaDrill Partners IPO priced at the high end of range at $22.
 
    

Buy Dean Foods

Dean Foods LogoAs I mentioned yesterday, Dean Foods (DF) shot up 13% on the announced terms of its spin-off of WhiteWave Foods (WWAV). Based on the initial pricing for the IPO, Dean is still undervalued. 

 

Business

Dean operates three separate business segments:

  • “Fresh Dairy Direct is one of the nation’s largest processors and direct-to-store distributors of fluid milk marketed under more than 50 local and regional dairy brands and private labels. Fresh Dairy Direct also distributes ice cream, cultured products, juices, teas, bottled water and other products.”
  • “Morningstar Foods is a leading warehouse delivery dairy business that produces and sells traditional and specialty items, including cultured dairy products, ice cream mixes, coffee creamers, aerosol whipped toppings, traditional and value-added milks, and blended iced beverages to retailers and foodservice providers nationwide.”
  • WhiteWave-Alpro develops, manufactures, markets and sells a variety of nationally branded dairy and dairy-related products, such as Horizon Organic milk and other dairy products, International Delight coffee creamers and LAND O LAKES creamers and fluid dairy products, and Silk plant-based beverages, such as soy, almond and coconut milks, and cultured soy products. WhiteWave-Alpro also offers branded plant-based beverages, such as soy, almond and hazelnut drinks, and food products in Europe and markets its products under the Alproand Provamel brands.”

Spin-off

Dean is spinning-off its fastest growing unit, WhiteWave. It is expected to raise up to $320 million by selling 20 million Class A shares at about $14 to $16 each. The underwriters also have an option to purchase up to an additional 3 million Class A shares after the spin-off. Dean will still own 150 million Class B shares after the spin-off. The expected pricing date is October 25th.

Class A and Class B are exactly the same except:

  • Class A has 1 vote per share. Class B has 10 vote per share.
  • Class B also can or will be converted into Class A shares under certain circumstances.

After the spin-off, Dean will control WhiteWave because of its majority ownership and the fact it owns all the Class B shares.

Valuation

The value case for Dean Foods is pretty simple. The market capitalization for all of Dean is $3.13 billion. Based on the price range of $14 to $16 for WhiteWave, the range for its valuation is $2.38 billion to $2.72 billion.  That means the rest of Dean is worth between $410 million to $750 million.

Even though the rest of Dean is having trouble growing revenue and maintaing margins, it still makes over 50% of net income. Dean’s 2012 net income will be around $200 million. If we allocate allocate around $95 million of it to WhiteWave, the rest of Dean will make up the other $105 million. After the spin-off, the rest of Dean would be worth at a P/E of 3.9 to 7.1. 

WhiteWave

WhiteWave has been growing thanks to its brands and its focus on healthy foods such as organic milk and plant based milks. Consumers are moving towards a healthier lifestyle and that includes healthy foods.

Revenue for 9 months in 2012 increased 13% from $1.45 billion to $1.65 billion. Operating income has grown at more than 17% from $132 million to $155 million.

The company had pro forma earnings of $.49/share in 2011. If WhiteWave’s earns around $.57 for 2012, it will trade with a P/E range of 24 to 28 based on the IPO price range. 

Although, I would be hesitant to invest in WhiteWave at this type of valuation, it is somewhat in line with other health food competitors such as Hain Celestial Group, Inc. (HAIN), which trades at 25 times June 2013 earnings. It should be noted that Hain has a higher revenue and income growth rate, but their fiscal year ends in June 2013 where WhiteWave’s ends in December 2012. 

Rest of Dean

I went back and worth between valuing the rest of Dean separately or together. Initially, I valued it separately, but it became too complex because:

  • After the spin-off, Dean will have about $2.5 billion in debt. Assigning different amount of debt to each company has an impact on the valuation.
  • Dean does report operating income for each of the segments, but it has “Corporate and Other Expenses” of around $200 million for the whole company. Assigning different amount of expenses to each company has an impact on the valuation.

So, instead I’m going to make it real simple. As aforementioned, the rest of the company should have over $105 million in net income in 2012 if you back out WhiteWale. However the net income does not take into account:

  • Increasing free cash flow for rest of Dean. In 2012, the rest of Dean is decreasing capital expenditure. Based on management’s 2012 projections their depreciation expense will exceed their capital expenditure by $60 million. That’s $60 million extra in cash.
  • Private sale of Morningstar. In late September, the company was put up for sale by Dean to increase shareholder value. A lot of analysts said that it could fetch $1 billion in a private sale. Morningstar’s business is better than Fresh Dairy Direct’s because customers are less likely to switch from a branded coffee creamer as opposed to a branded milk. However, the market is mature and it is still highly dependent on the cost of raw milk and bulk cream. So, a $1 billion price is hard to fathom. It will have $120 million in operating earnings in 2012. If you factor in some interest expense, taxes and other expenses, net income would probably drop down to $70 million. I could see it going for 12 times that or $840 million. Private equity would still have room to load it with debt and flip it for a profit.
  • Although Fresh Dairy Direct makes up a majority of revenue (over 70%) and is a declining business, it is still profitable (over $400 million in operating earnings expected in 2012) and management is focused on cutting cost to increase profitability. 
Conservatively the rest of Dean’s free cash flow will exceed $150 million in 2012. 8 to 10 times that amount gives a valuation of $1.2 to $1.5 billion.
 
Conclusion
 
So, that gives us a valuation range of $3.58 billion to $4.22 billion or $20/share to $23/share. Of course, the final pricing and even post IPO pricing of WhiteWave has a huge effect on the valuation, but currently it is undervalued.
 
I should note one thing I am scared about is the Fresh Dairy Direct business, but the fact that management is focused on increasing shareholder value gives me some reassurance.
 
Nice to have the stock up $1 from when I recommended it yesterday!
 
Disclosure: I am long DF.

Dean Foods Spin-off

Dean Foods (DF) announced its WhiteWave-Alpro division has filed to spin-off into a separate company called WhiteWave. The IPO is expected to raise up to $320 million by selling 20 million Class A shares at about $14 to $16 each. Dean will still own 150 million Class B shares after the spin-off.

Dean is spinning-off WhiteWave to unlock the value of the company. WhiteWave has experienced strong growth over the last 5 years, but it has been hidden underneath Dean. WhiteWave makes Silk soy milk, Land O’Lakes and Horizon Organic.

I did a quick read of the filing, and it seems like Dean is undervalued even though it is up 13% today. 

I have initiated a position at $16.97, but will do more due diligence today and break down the analysis tomorrow.

Disclosure: I am long Dean Foods (DF)