Shares of Xerox (XRX) surged higher following Q4 2012 earnings, closing Monday at $8.23. Year to date the stock is up 20%. The company is a deep value play, driven to low multiples by concern that it may not be able to achieve growth going forward. Taking advantage of the low prices and strong cash flow, buybacks have been ongoing. This article updates on growth and buybacks, then digresses into a discussion of R&D.
Xerox operates in two segments - Technology (the copier business) and Services. Services encompasses the ACS (Affiliated Computer Services) acquisition, and includes ITO (information Technology Outsourcing), BPO (Business Process Outsourcing) and DO (Document Outsourcing). The question is, can growth in Services (52% of revenue) overcome declining sales in Technology (48%)?
Mathematically, if trends observed comparing 2011 to 2012 continue, the answer is yes. A simple projection using a 6% increase for Services and an 8% decrease for Technology going forward goes positive in two years and reaches 3% within 9 years. Using constant currency results of a 7% increase and a 6% decrease, growth is 1% next year and hits 3% in 6 years.
During the conference call, management said that for 2013, Technology would be down mid single digits (but with improving trends from 2012), while Services is expected to be up mid to high single digits. Combining that with the generally optimistic tone of the presentation and Q&A, I look for XRX to develop low single digit revenue increases over the next several years.
Xerox expects to generate $2.1 to 2.4 billion of annual cash flow for 2013, and to spend at least $400 million of that on buybacks. To the extent that buybacks are completed at prices less than intrinsic value, shareholders will be better off.
For 2012, the company spent $1.05 billion to buy back 146 million shares at an average cost of $7.19, less than current share prices. Shares of common stock outstanding decreased 9% during the year.
I think the buybacks are constructive if conducted at prices less than 12X forward guidance, providing growth in revenue and earnings materializes as Services continues its strong performance.
Highly regarded CFO Luca Maestri will be leaving to join Apple (AAPL). He was associated with the heavy buyback activity, and one analyst questioned the impact of his departure in that regard. Not surprisingly, CEO Ursula Burns remarked that buybacks will continue to be part of a balanced capital allocation.
$400 million of buybacks in 2013 is less than $1.05 billion in 2012. As such, buybacks are no longer a primary driver of share price appreciation. However, if the company has other, more productive uses for its generous cash flow, that's good news. The dividend is to be increased by 35%, and $400 million of debt retired. $500 million is earmarked for acquisitions to support Services growth.
After leaving the dividend unchanged at 4.3 cents quarterly since 2007, Xerox plans to increase it by 35% in April this year.
Dividends have received increased market recognition lately. It will be a positive for long-term share price appreciation if increases are made on a regular basis in the future.
Xerox has a tarnished reputation, an aura of faded majesty, on R&D. It's easy to point out the products that originated in their research facilities but were successfully commercialized by others. From a 2007 article in Fortune:
The story of how Xerox's Palo Alto Research Center in the 1970s failed to capitalize fully on two of the most critical elements of the personal computer - the graphical user interface and the mouse - has become legend. In 2000, then-CEO Paul Allaire admitted that the company's business model didn't work anymore - a conclusion Wall Street had already reached. A year later Xerox's innovation ranking among its peers plunged to tenth (i.e., last) on Fortune's annual list of America's Most Admired Companies.
Let's take a look at what's happening today.
As detailed in a recent press release, Xerox received 1,215 US patents in 2012. Overall, patents were up 17%.
Addressing the issue of relevance to the increasingly important Services business, the company cites patents that were issued in that area:
Recently issued patents in the services space include US Patent 8,315,946, which describes the e-Childcare solution that enables Human Services agencies to subsidize child care services while reducing fraud, paperwork, and payment processing overhead to save taxpayer money. US Patent 8,234,237 describes a workflow management system that notes when data is missing from a scanned document, and returns the document to the workflow when the data is provided. US Patent 8,195,474 describes a system that scans the databases of a large number of print servers to create a profile of the customer's needs, generating a list of the most useful marketing portals for the account. US Patent 8,190,469 describes elements of the software that runs the PocketPEOTM handheld parking citation device.
From an article on CTO Sophie Vandebroek published in the MIT Technology Review:
In order to improve on this process, she said Xerox has chief innovation officers in each of its business lines who are responsible for pulling innovations out of the labs. She also said that two-thirds of the budget for Xerox's research labs comes from the company's business groups, which acts as an incentivizing force.
ACS Acquisition in Retrospect
Hewlett-Packard's (HPQ) ill-conceived acquisitions of Autonomy and EDS have retrospectively cast a shadow over the whole idea of hardware companies buying software or services operations. In support of the bull case on Xerox, their acquisition of ACS was much better thought out and implemented.
ACS when acquired in February 2010 had revenues of $6.5 billion and had grown 7.9% annually for the past 5 years. The Xerox Services segment now has $11.5 billion of revenue and can be expected to grow 7% annually. ACS was acquired at a price of $63.11 per share, somewhat less than my fair value estimate of $67. ACS CEO Lynn Blodgett was retained and continues to run the Services segment.
In contrast, EDS was dead in the water when acquired by HPQ. The Autonomy deal was done at 10X sales, twice any realistic valuation, and allegations of fraud have since surfaced. Relationships with former Autonomy CEO Mike Lynch are hostile.
Based on the premise that Xerox can grow revenue at 2% annually, and EPS at a somewhat higher rate, I apply a P/E of 12 to estimated GAAP earnings of $1 and arrive at a target price and fair value of $12 per share.
Strategy and Tactics
Buying at today's prices, patient investors have a realistic expectation of receiving increased dividend income and eventual share price appreciation.
It's important to monitor segment revenue growth and margins quarterly, since the mildly bullish thesis here relies on a resumption of growth and improving margins in the Service business.
For investors who use options, the pricing on the deep in the money LEAPS is attractive. I'm long the January 2014 3.0 calls and short a lesser number of July 2013 8.0 calls.