Over the years, Xerox (NYSE:XRX) has built a strong brand name and become synonymous with printing solutions. The firm expanded by acquisitions into a variety of other segments and now offers technology, services, software, and IT outsourcing support, in addition to its flagship unit. The problem is that for the last three decades, shareholder value has gone nowhere. In the last twelve months, the stock is down 27.9%, and net debt now stands at 73.9% of market value. Where to go from here?
The stock trades at a respective PE and forward PE ratio of 11.1 and 7 - an extreme discount to peers - and is in the position to be a takeover target. In the foreseeable future, the firm will struggle more from macro headwinds than its competitors will. When there is a decline in IT, poor demand in business printing follows - and hence Xerox has a major issue at hand.
The best step forward for shareholders may very well be a takeover by a competitor that is exposed to higher-margin segments and can unlock revenue synergies. Although Xerox's acquisition of Affiliated Computer Services (ACS) was hailed as a step towards greater profitability, it has yet to materialize meaningful synergies. Management has indicated that operating margins will increase into 2012, but softer than anticipated gross margins should give pause. As the firm shifts over to ACS-services, this will become more of an issue, especially given increasing competition.
At the recent third quarter earnings call, CEO Ursula Burns spent a good amount of time discussing "transform[ative]" strategy:
To set the stage, here is a year-to-date review of the strategy that is transforming our business. First, accelerating our Services business, growing it faster by diversifying our offerings and expanding globally. Through the third quarter, revenue from Services is up 6%. Backed by a very positive pipeline, we've been especially pleased with the new contracts we've signed this year. Our new business signings are up 7% year-to-date.
Second, we're a services-led technology-driven company, which means maintaining our leadership in document technology is a top priority. We continue to hold our #1 equipment revenue market share position, and we've already launched 21 new products this year. And we are competitively advantaged through the breadth of our portfolio, our multiple sales channels and through our innovative workflow and managed print solutions.
Third, we're managing our business with a disciplined focus on operational excellence. Our productivity initiatives this year have helped offset the challenges from the Japan natural disaster and other macro dynamics.
An acquisition can accomplish all three priorities in one fell swoop. Possible suitors include DELL (NASDAQ:DELL), which has $7.4B worth of net cash, IBM (NYSE:IBM), and Hewlett Packard (NYSE:HPQ). Many rumors for why a buyout would occur have been speculated, but the important aspect to stress is that these companies can provide a tremendous global footprint and cross-selling opportunities for Xerox. Xerox remains attractive to them as a value and synergistic play.
As I highlighted earlier, Dell is suffering from stagnating growth and has too little expenditures on R&D; an acquisition could compensate for years of inaction. Should a tender offer ever present itself, Xerox would likely view it as a stop-gap measure - but nevertheless a measure - to decelerating volumes. With value levers limited at the present moment and the path forward unclear, a buyout would inject vitality in a struggling business.
Even without a takeover, I still believe that Xerox represents an attractive value play. Consensus estimates for EPS are that it will increase by 14.9% to $1.08 and then by 8.3% and 16.2% more in the following years. Of the 10 revisions, 8 have gone up. Assuming a multiple of 11 - below the peer median level - and a conservative 2012 EPS estimate of $1.13, the rough intrinsic value of the stock is $12.43. That represents more than a 50% margin of safety and more than justifies the high volatility of the stock, as represented by its beta of 1.6. Given the potential of a takeover, the upside is huge, thus providing for favorable risk asymmetry.