Xerox: The Power of Free Cash Flow

 |  About: Xerox Corporation (XRX)
by: Tom Armistead

Xerox (NYSE:XRX) is just plain cheap based on free cash flow. The acquisition of ACS (Affiliated Computer Services), which had good cash flow characteristics, was done at a fair price; and moderately favorable conditions in the Office Imaging Industry will permit the company to put on the next growth ring. At recent prices in the $10 area, patient value investors will be rewarded.

I was long ACS when Xerox announced the acquisition in September 2009, and booked a nice profit. The deal was worth $63.11 per share, somewhat under my estimate of fair value, which stood at $67. ACS had some debt, but tended to report earnings that were about half of cash flow, implying considerable financial strength. I bought XRX on the dip induced by the news, on the grounds it was trading at 8.5 X 5 year average EPS, but closed the position shortly thereafter. According to my notes: "I didn't think XRX was the sort of thing I would buy on purpose so I closed out the trade."

The bullish case for Xerox has been capably presented here on Seeking Alpha a number of times, most recently by Bret Jensen, and earlier this year by Common Cents and Frank Constantino. Rather than doing a complete writeup, this article focuses on a discussion of free cash flow, which I believe is critical to an understanding of profit potential for this value candidate.

Investor Conference

Key executives presented at the Xerox Corporation 2011 Investor Conference on 5/10/2011. The following slide is taken from a presentation by CFO Luca Maestri - (click chart to expand):

Click to enlarge

The company projects free cash flow at $10 billion over the next 5 years. Much of that is expected to be returned to shareholders, as dividends and buybacks.

Discounted Cash Flow Valuation

Averaging the company's projections for free cash flow for 2011, and 2012, I arrive at $1.47 per share. WACC (weighted average cost of capital) is the crucial issue. 80% of Xerox's debt is incurred at a 7 to 1 leverage ratio to finance customer purchases on leases or notes with an average maturity of 4 years. Xerox's bonds maturing in 3-5 years trade to yield a little over 3%. Bonds maturing 10 years and over are trading to yield something over 6%. Long term debt to equity was 36.2% as of 12/31/2010.

At a $10.20 share price when I did the computations, the free cash flow yield is 14.4%. Giving that 2/3 weight, and doing the other 1/3 at 6%, WACC works out to 11.6%. Using $1.47 free cash flow per share, increasing that 4% annually for 5 years, and 1% thereafter, I apply a WACC of 11.6% and arrive at a value of $15.82.

Here's something to consider. The company is buying back shares. Maestri projects 65 million (4.6%) for 2011, and 100 million (7.4%) for 2012. The company has no need to access the equity markets, and capital for the most common purpose can be raised at 3.25% to 6%, depending on duration. Maturities will be well matched, as mentioned above. Under the circumstances, a conventional DCF computation may understate value, as it overstates cost of capital.

I personally think that the DCF valuation method employs circular reasoning - if the market applies a low P/E, DCF simply validates the current price - the cost of capital is high because the stock is cheap. If Xerox wants to lend a customer some money so he can buy a photocopy machine, it can borrow the funds at 3.25% to 6%. That's its cost of capital.

The cost of equity capital is irrelevant. Xerox is buying back its own shares, paying less than they're worth. As will be demonstrated later, if the company continues to buy back shares and P/FCF remains constant, share prices will increase 7.5% annually. That's not cost of capital, it's return on capital.

The Market Doesn't Recognize Value

The main argument against these shares is the market won't pay for them. Xerox is old tech, a buggy whip manufacturer. Ten years ago it was overweight and out of date. The company was operating at a loss, and long term debt as a percentage of capitalization stood at 82.5%. Xerox's iconic stature was lost, never to be regained. Xerox as a term for a photocopy is right up there with Ameche as slang for a telephone.

Two arguments can be made. The first asserts that labeling Xerox as a manufacturer of copy machines over-simplifies and under-rates the business. The second relies on the power of cash flow, judiciously applied.

Buyback Ad Infinitum

Confronted with a large buyback situation, when combined with a low price, it is sometimes instructive to ask the question, what if this goes on for some indefinite period of time into the future? Holding free cash flow, cash flow expended on buying back shares, and P/FCF constant, Xerox's current program would increase share prices by 7.5% per year. Add a 1.7% dividend, and the total return is not bad.

Applying increases to free cash flow of 4% for five years, and 1% thereafter, share prices would increase 11.8% per year for 5 years, and 8.4% thereafter. Add the dividend, and total return is impressive.

If share prices go down temporarily, absent a change in outlook, the situation becomes more attractive. If share prices go up, to the point where future returns don't look as good, the investor can liquidate his position at a profit.

Strategy and Tactics

If the buybacks proceed along the lines projected, the process will apply pressure that should force share prices up toward a target of $16, as developed by the DCF calculation. Lacking any immediate catalyst, it's difficult to predict when the move will occur. Because XRX is a low prestige stock, there is no reason to anticipate that moves will be large or rapid. Patience is required.

For dividend investors, the dividend at 1.7% is not that large, although the company demonstrably has the resources to raise it. There is a reasonable expectation that share prices and dividends will increase over time. Looking at the long term, free cash flow yield is 14.7% and the company has stated the intention of returning a large part of it to shareholders.


XRX is optionable, to include LEAPS. There is sizable open interest, and the options trade in penny increments with narrow spreads. Implied volatility checks in at 28.4%, with beta at 1.6.

Looking at the options chain, there is large open interest for the Jan 2012 and 2013 10.0 calls, which are quoted at .95/.98 and 1.71/1.76 respectively. An investor who buys the shares at yesterday's close of $9.98 and sells the Jan 2012 10.0 call at .96 stands to earn 14.7% annualized if called away at expiration.

Buying at $9.98 and selling the Jan 2013 10.0 call at $1.73 yields 10.5% annualized if called away at expiration. I left the dividend out of the computation, reasoning that at some point the possibility of early exercise for the dividend will arise.

There is also quite a bit of open interest on the July 2011 9.0 and 10.0 puts. My guess is that they have been sold by investors who don't mind owning the shares at that price and are looking to collect premium while they wait. Selling either the October 9.0 and 10.0 puts looks good to me. I'm short the July 9.0 puts, sold back in March.

Under the circumstances, Xerox is attractive for investors who are looking for yield and are comfortable selling either covered calls or cash-secured puts.

Disclosure: I'm long XRX Jan 2012 7.5 calls and short XRX Jul 9.0 puts