Xerox Valuation: Growth Already Factored In

The last few years have been tough for Xerox Corp. (XRX), with the office-equipment maker lagging industry averages for sales and earnings growth. There were bright signs for the company on Monday as the company reported better-than-expected quarterly earnings, and its shares climbed nearly 2 percent in morning trading. Analysts are also optimistic about Xerox. A quick analysis, however, suggests those looking for big gains in the stock price may be disappointed as the good news has already been factored in.

Over the last five years, and in the trailing 12-month [TTM] period and most recent quarter [MRQ] prior to the latest announcement, revenue and earnings per share [EPS] growth have significantly fallen short of the averages for the office equipment industry.

Taking into consideration its recent performance, Xerox appears to be priced at a discount to the office equipment industry on the basis of key valuation metrics, including price to earnings (P/E) and P/Sales.

The company's 2 percent increase in revenue to $3.84 billion in the quarter ended September not only beat the consensus estimate of $3.81 billion but also marked a solid improvement from the trends above. The relatively favorable news is even more pronounced at the earnings level. As indicated above, EPS had been contracting. But the company's actual EPS of 23 cents in the latest quarter not only surpassed the consensus of 22 cents according to analysts in a Reuters poll, but also marked a 28 percent year-over-year increase.

Yet, the news from the latest earnings announcement wasn't all positive. Much of the top-line gain came from sales of color printers and related items and services, but total equipment-sale revenue slipped 1 percent amid competitive pricing pressure. According to the company, the product mix hurt profit margins. The gross profit narrowed 1.1 percentage points from the year-earlier period to 40.2 percent. As indicated below, this is also narrower than the company's five-year average. (Results below are based on available information prior to the latest earnings announcement.)

Nonetheless, Xerox expects EPS in the range of 33 cents to 37 cents in the final three months of this year. Analysts are optimistic on the company's performance, with the consensus average at the top end of this range. Moreover, analysts look for further revenue and EPS gains down the road. They expect revenue to approach $15.9 billion this year and rise to nearly $16.3 billion in 2007. EPS is expected to hit $1.03 this year and climb to $1.16 in 2007. Further, analysts believe that Xerox can grow its earnings at an average annual clip of about 9.6 percent going forward.

Based on EPS estimates for 2006 and 2007, Xerox is priced at forward P/E ratios of roughly 15.8 and 14.1, respectively. Dividing these P/E ratios by the expected long-term EPS growth rate yields PEG ratios. Typically, more-conservative value-oriented investors prefer to focus on companies with PEG readings below 1.00, but numbers below 2.00 are often still reasonable. Xerox has PEG ratios of about 1.6 for 2006 and 1.5 for 2007.

Our back-of-the envelope analysis of Xerox, which takes into consideration its historical performance along with analyst estimates, indicates that the company can grow its earnings at an average annual clip of about 8.3 percent, which is slightly slower than what analysts expect. But, it is also close to the 8.6 percent EPS growth that our analysis suggests is required to justify the current stock price.

At the time of publication, Erik Dellith did not own shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

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