A Tech Turnaround Worth Owning?

| About: Xerox Corporation (XRX)


This "old" tech stock is much cheaper than Apple, but is it a value trap.

It's slowly transitioning into an outsourcing company, and could be a buyout candidate.

Barron's notes that it trades at only 6.6x EV/EBITDA, while its outsourcing peer, Accenture, trades at 9.7x.

The majority of the tech world has been enamored by Apple (NASDAQ:AAPL) for the last half decade or so. However, a few companies could offer more upside than the iPhone maker. To find these stocks, investors have to look for stocks that are unloved and out of favor. One of the best areas is turnaround stocks.

Turnarounds by "old" tech stocks are possible; Hewlett-Packard (NYSE:HPQ) is doing a pretty good job, with shares up over 50% during the last twelve months.

Xerox (NYSE:XRX) is another potential turnaround stock worth looking at, with the ultimate question being, is Xerox a value trap?

For starters, Xerox trades at a P/E ratio of 10.8, based on next year's earnings estimates. Compare that to Apple's 13.5. Xerox also trades very cheaply on a price-to-free cash flow basis. Its P/FCF ratio is only 7.4, while Apple trades at 16.

Shares have been showing signs of life over the last twelve months as it keeps plugging away with its turnaround strategy. The stock is up nearly 40% over the last year.

We're seeing marked improvement in its margins in the document technology business (includes supplies and hardware). Meanwhile, the services business is still seeing margin pressure. Despite the fact that margins are better in the document tech business, its revenues are in decline. The services business is where investors should be focused, as this segment will offset the decline in document technology.

Xerox's ultimate plan is to move away from being a document-based company to one that is a high-margin outsourcing company.

Xerox recently hired an IBM executive of 35 years to run its service business. This puts a renewed focus on the services business. The services segment accounted for 55% of revenues last year. That number should hit 66% (of total revenues) over the long term.

Per an earnings call earlier this year, Xerox noted that it still plans on boosting margins by 50 basis points this year. The majority of that will come during the second half of the year. The easiest way for Xerox to boost margins in the services segment is to penetrate its current customer base deeper by offering more valued-added services.

Over four years ago, Atlantic Investment Management was touting Xerox as a takeover target. Shares are still trading just around where they were back then. Atlantic was hopeful that IBM, HP or even Dell would buy Xerox. This didn't happen, and Atlantic no longer owns the stock, but with a market cap of $15 billion, it's not unreasonable that Xerox won't still be bought out.

Barron's recently featured Xerox as one of its top 10 ways to play the M&A boom. The newspaper pointed out that Xerox is a beneficiary of technological change, rather than a victim of it, given the company gets 55% of revenues from outsourcing services. But it also noted that at "a 2014 EV/EBITDA ratio of 6.6, Xerox is priced more like copier rival Canon, at 5.5, than outsourcing giant Accenture, at 9.7."

Xerox is a cash flow generating machine, and it plans to step up its share repurchases in an effort to reward shareholders. Xerox's free cash flow margin is over 15%, while Apple's is 6.4%. Assuming Xerox should trade in line with its five-year average P/E of 14, the upside is to $15, or around 20%. Longer term, it could trade closer to the industry average P/E ratio of 16.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.