Robert Olstein's Free Cash Flow Numbers for Xerox are Highly Misleading (XRX)

TheStreet.com's Weighing Options With Robert Olstein included some comments on Xerox (XRX) that had us a little puzzled. Our regular readers will recognize some of what we have to say from previous articles.

One stock in our fund which I’d like to talk about is Xerox. Xerox is a company we identified early as paying down a lot of debt. Plus they have a good leader in [Chairman and CEO] Anne Mulcahy and great free cash flow.

The key to Xerox’s success is that they transformed their business from black-and-white copiers to digitization and color. The margins are much higher now. And now the free cash flow yield is north of 10%. Now that the margins are higher, we think the free cash flow of this company is probably in the area of $1.25 a share. We think it is worth around $19 to $20, yet the market is focusing on the fact that there is excess depreciation instead of the tremendous transformation taking place.

We didn’t see much to argue with at first. Xerox has been paying down debt, and while we still see it as early goings, Anne Mulcahy is doing about as good a job as could be expected with the hand she was dealt. But the free cash flow yield part got us.

We always thought of free cash flow as being cash from operations less capital expenditures. If a company uses acquisitions as part of its growth strategy, we usually count them as part of capital expenditures.

Another way would be to look at the free cash flow available to equity holders, which takes into account changes in debt. If this is done, the reductions in debt actually reduce free cash flow to equity in the year the debt is repaid because that is money that could otherwise be given to equity owners.

On the other hand, not having the interest expense and future obligation increases future free cash flow to equity. Either way, the CFFO-CapEx formula is the base number.

Over the past three years, here is Xerox’ free cash flow:

Source: Xerox 10K for the period ending December 31, 2005.

As plain as day, and despite rising net income, cash from operations has fallen, taking free cash flow with it. (Note: Our capex number includes both the property and equipment line and the capitalized software line, but this adjustment makes little overall difference). Well, to be fair Olstein didn’t say that free cash flow was rising - he said the free cash flow yield was 10 percent.

The free cash flow yield is calculated by dividing free cash flow by enterprise value. Xerox has an enterprise value of $19 billion and free cash flow of $1.2 billion, resulting in a yield of 6.3 percent.

It appears that Olstein is calculating the free cash flow yield based on market cap rather than enterprise value. This doesn’t make any sense, because the debt holders have first claim on the cash flow. The alternative measure, using free cash flow to equity over market cap, would have to take into account any changes in the debt level. Since, as Olstein points out, Xerox has been paying off debt, the paydowns should be deducted from the free cash flow number.

Last year Xerox paid off $2.5 billion in debt, leaving it with a free cash flow to equity of negative $1 billion. In each of the last three years, debt reduction has more than equalled free cash flow. So by no appropriate measure does Xerox have a 10 percent free cash flow yield. Furthermore, unless they reverse the declines, it won’t be long before there is no free cash flow by any measure.

The article continues:

You can judge a good leader by how they manage their finances. This was a problem company. They had a bad leader, they had bad accounting, and they had a huge debt load. But all of a sudden you see debt coming down and other good things. And you can see it in the financial statements. We judge management via the financial statements. We pay attention to how they act, not what they say. We look to see if they are conservative and if they care about free cash flow.

We can’t argue with that.

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