To me, Xerox (XRX) simply meant to make a paper copy. Xerox happened to create a powerful brand that turned its name into a verb for a generic action: making duplicates. Just like Kleenex (KMB) did with tissues and Coke (KO) with sodas, Xerox developed deep brand and franchise value.
With the current share price around $8.30/share, the market appears to be valuing Xerox as if it were a relic of the past and discounting the real growth story at Xerox - its evolution towards a service oriented business process outsourcer. It's a sign of the times: a more digital world, means less need for paper copies, and therefore, a diminishing need for the capital intensive printers and copiers that Xerox is known for. So while the printer and copier business is stagnant, Xerox's business process outsourcing services are producing steady growth and profitability which I do not think the market is capturing in the share price.
Xerox Corporation engages in the development, manufacture, marketing, service, and finance of document equipment, software, solutions, and services worldwide. The company operates in three segments: Technology, Services, and Other. The Technology segment provides multifunction printers, copiers, digital printing presses, light production devices, and desktop monochrome and color printers for office users. The Services segment offers business process, information technology, and document outsourcing services. The Other segment primarily sells paper, wide-format systems, and GIS network integration solutions and electronic presentation systems. (Source: Yahoo Finance)
I was surprised to see how low the stock price for Xerox had become after reading some articles on Seeking Alpha, so I decided to do some more investigation because a low stock price does not necessarily make a stock a bargain. Only if that low stock price is less than the value of the proportional piece of the business that it represents does it make it a bargain. Here is what I found.
Joseph Schumpeter said it best:
This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull.
In short, capitalism and innovation create new industries, and destroy old ones. Xerox, at one time, was on the former side of the equation, by creating a new industry to increase office productivity. Its a bit ironic that Xerox now is blowing the gales of creative destruction for the printer and copier industry itself created as it moves towards competing in the digital age with the likes of IBM (IBM) and Accenture (ACN). It turns out, Xerox's real value proposition is increasing office efficiency whether its through document reproduction, or by taking over the back office operations of its clients.
In 2011, Xerox recorded net income of $1.3 billion, or $0.90 per diluted share on $22.6 billion in sales (if certain noncash and/or one time charges are excluded, an adjusted $1.08 earnings per share results). Breaking the sales figures down further, Xerox's Technology sales (i.e., printers and copiers) were down 1% year-over-year and made up 32% of total sales while Service revenues (i.e., business process outsourcing) were up 8% year-over-year and comprised about 66% of sales. The remaining sales generally come from leasing arrangements with customers, and are insignificant to this analysis. On the whole, sales were up 5% year-over-year in a very challenging 2011 due to macro level events.
So that begs the question, in a less challenging environment, how fast can Xerox grow? I anticipate an 8-10% growth in Service revenue is achievable, while a 3-4% increase in Technology sales appears conservative. Based on those growth rates and the breakdown of sales, Xerox as a whole could approach a 7% sales growth rate. Combine that steady growth with the cost cutting (read: job cutting) measures being carried out and shareholder friendly capital allocation (read: undervalued share buybacks and dividend payouts), and the ingredients for solid business performance surface, at least from the shareholder perspective at current price levels.
While Xerox's business prospects appear fairly robust and sustainable, what are some of the indicators that make its equity undervalued? Here are a few that I see:
- 2% dividend yield at current price levels. The payout ratio (i.e., dividends paid as a percentage of net income) was 20% in 2011, a sustainable yield. Dividends as a percentage of operating cash flow was a scant 13.5%.
- Xerox generated $2 billion in operating cash flow in 2011 and expects to generate $2 to $2.3 billion in operating cash flow in 2012.
- Xerox repurchased about 88 million shares for $700 million ($7.95/average cost per share) in 2011 and announced it expects to retire between $900 million - $1.1 billion in 2012. At current price levels, a $1 billion repurchase represents about 9% of outstanding equity. Combine that with the 2% dividend yield, and that's an implicit 11% return for shareholders in 2012 alone.
- $4.2 billion in services contract signings in Q4 2011, up 15% year-over-year, and a robust pipeline of business in its backlog.
- Management is actively monitoring expenses and restructuring the business as it moves further towards the service model. Moreover, management indicated that gross margin in 2011 was negatively impacted due to ramp up activities for large contracts. Therefore, gross margin will likely increase slightly in 2012, leading to greater profitability. I certainly don't mind a small hiccup in margins if it means more revenue growth in the future.
- Xerox is expanding and strengthening its services portfolio, including a recently announced collaboration with McAfee (a subsidiary of Intel (INTC)) to improve IT and data security. This should be a nice catalyst for Xerox as companies become more sensitive to how they manage and protect confidential data. The news sent shares north about 4.7% on Valentine's Day, a sweet gift to shareholders.
For a high school chemistry field trip, I visited a Xerox facility and observed engineers working on ink printer and color technology. At that time, Xerox was overvalued, and its primary printer and copier business was eroding. Some years later, it pains me that a number of those engineers are losing their jobs, but it reminds that Joseph Schumpeter's premise remains true: Creative destruction renders some jobs obsolete, but it will undoubtedly create new ones, in other modern, innovative industries. Likewise, creative destruction sometimes spawns investment opportunities when investors don't quite understand the turnaround story. Xerox now appears quite undervalued for patient value investors.