In an earlier article here, I argued that Xerox (NYSE:XRX) is an ideal takeover target for major tech companies. According to IDC analyst Alexander Motsenigos: "[t]he big band acquisitions seem to be happening right now." To expand into the domain of IT services, Hewlett-Packard (NYSE:HPQ) recently purchased EDS for $13.9B while DELL purchased Perot Systems for $3.9B. I find that while Xerox would be accretive to both companies in the long term, short term pressures would make successful integration, admittedly, a bit of a juggling act.
More likely, Xerox will be bought out for IBM - the largest of the three. Its strong fundamentals, international exposure, and large customer reach would yield meaningful revenue and cost synergies from an acquisition. The company has net debt of $18.8B, which represents 8.8% of market value and is manageable. Another possible suitor is Dell with its $5.6B worth of net cash. The company's fundamentals have floundered of late and an undervalued addition to Perot Systems could catalyze value. HP, on the other hand, has net debt of $22.6B, which represents 44.6% of market value. Hewlett-Packard's new CEO, Meg Whitman, is focused on simplifying the business, cutting costs, cleaning the balance sheet, and has explicitly stated reservations about acquisitions. Analysts are further noting that management is aiming for M&A activity no greater than $1B in 2012. That means Xerox, worth $19.5B by enterprise value, would not be on the table.
Xerox remains, in my view, one of the more attractive investments in technology. At the third-quarter earnings call, Xerox's CEO, Ursula Burns, noted favorable developments:
"In the third quarter, we delivered adjusted EPS of $0.26. That's up 18% from a year ago. On a GAAP basis, earnings were $0.22 per share. This includes $0.04 related to the amortization of intangibles. Revenue was up 3%, reflecting growth in Services and aided by the strong euro. Technology revenue was up 1%, and Services revenue increased 6%. Supply constraints due to the natural disaster in Japan have eased considerably, and as we shared with you last quarter, we've been working very closely with our colleagues in Japan to accelerate production and ensure that we're meeting our customers' needs. We've made significant progress in reducing our backlog while meeting new demand, and I'm very confident that these challenges are now entirely behind us.
Operating margin of 9.6% was up 0.4 this quarter, and gross margin of 32.7% is down. As demand increases for our outsourcing services, we do see an impact on gross margin, which we continue to offset with cost reductions and operational improvements as you see in our improved SAG results, all of which helped deliver solid bottom line results".
2012 is gearing up to be an inflection point for the company, as investors are looking to see tangible results from the ACS buyout. 2011 suffered from a poor business mix and declining IT has yielded lower demand for printing. Compared with expectations, however, Xerox performed well during the last two quarters. Moreover, investors are irrationally fearing the comany's exposure to Europe, which will result in abnormal high risk-adjusted returns. Europe represents one fifth of Xerox's business - much lower than peers. Management also remains committed to returning free cash flow to shareholders with the highest dividend yield of the 4 tech companies discussed in this article. In addition, 70% of surplus cash in 2012 will be applied to share repurchases (about $1.2B).
Consensus estimates for Xerox's EPS are that it will grow by 14.9% to $1.08 in 2011 and then by 8.3% and 16.2% more in the following two years. Assuming a multiple of 11x and a conservative 2012 EPS of $1.13, the rough intrinsic value of the stock is $12.43, implying 54.2% upside. Accordingly, in my view, Xerox is a clear value play.
Consensus estimates for Hewlett-Packard's EPS are that it will decline by 16.4% to $4.08 in 2012 and then turnaround to grow by 9.6% and 8.9% in the following two years. Assuming a multiple of 10x and a conservative 2013 EPS of $4.34, the company has significant upside. Even still, the Street rates shares around a "hold" and 34 of the 35 revisions to estimates have been lowered for a net change of 11.2%.
Consensus estimates for Dell's EPS are that it will grow by 32.7% to $2.11 in 2011, decline by 4.3% in 2012, and then hold flat in 2013. Assuming a multiple of 9x and a conservative 2012 EPS of $1.95, the rough intrinsic value of the stock is $17.55, implying 19.4% upside.