Xerox (XRX) was founded in 1906 in Rochester but it later relocated to Southern New England where its headquarters are today. The company is known for technological innovation with more than 10,000 active patents. However, its main business of printing has been in distress since the 1990s, caused by the internet and the digitalization of documents. Investors are skeptical about Xerox because it still relies on its printing business with over 40% of revenue generated by this segment in 2011. I think that there is little to be concerned about. Xerox is successfully transforming itself into a service oriented company after the Affiliated Computer Services acquisition in early 2010. The company strategy is to continue to acquire more service oriented competitors in the next few years. From a valuation standpoint, Xerox appears to be undervalued and the stock is a good long-term investment. Also, Xerox is led by a remarkably capable management team which should help the stock price increase.
Xerox is moving from a hardware company to a more service-based company. This transition reminds me of a similar move by IBM (IBM) about ten years ago which was successful. In the previous decade, IBM sold its computer hardware business (known today as Lenovo) and acquired PricewaterhouseCoopers' (its accountant) consulting business. In a similar way, a large part of Xerox's growth and transformation today is due to its acquisition of Affiliated Computer Services. This deal transformed Xerox overnight from a company with double digit declining revenues in 2009 to a company with 5% revenue growth in 2011. Xerox continues to acquire companies at a healthy pace. In 2011, it spent over $200 million in acquisitions. Xerox plans to spend $300 to $400 million on buying other companies, mostly in services, in 2012. This should provide a healthy level of cash flow and revenue growth for the company in the coming years.
Xerox stock has been recently trading around $8 per share and the company pays a quarterly dividend of $0.045 per share for an annualized yield of about 2.1%. The company has 1.35 billion shares outstanding, a market capitalization of $10.8 billion, and an enterprise value of $18.5 billion which includes cash of $1 billion and long-term debt of $7 billion. Recently, Xerox raised $1.1 billion through a senior notes offering. This increase in capital suggests that it is either going to acquire a big company or spend more on share repurchases. Currently, the company has an authorization to repurchase its own shares in the amount of $1.3 billion. It repurchased 87.9 million shares for an aggregate price of $701 million in 2011. Part of the repurchased shares are used to contribute to the company's defined contribution pension plan (16.6 million shares in 2011) and to offset the issuance of stock option awards. However, shareholders also benefit from share repurchases. Due to stock buy-backs there is usually more demand for the shares being repurchased. Also, as the amount of shares decreases the earnings per share rise.
I expect Xerox to earn $1.05 per share in 2012, which is higher than the company's estimate of $0.97 to $1.03. The main reasons for being so optimistic are that the U.S. Government extended the tax benefits under IRS Section 179 for purchases of new equipment into 2012. Second, the IMF recently increased its estimate for 2012 economic growth from 3.3% to 3.5%. And lastly, as companies try to simplify their operations they will increasingly take advantage of Xerox's service offerings. Thus, I estimate that the 2012 price to earnings ratio for Xerox is about 7.6 which compares favorably to its main competitor, Canon (CAJ), whose 2012 estimated price to earnings ratio is 17.7. Canon is slightly more profitable than Xerox. It has earnings before interest, taxes and depreciation and net income margins of 18% and 7%, respectively, compared to 13.5% and 5.2%, respectively, for Xerox. However, Canon has a greater exposure to consumer goods such as digital cameras and camcorders. I see demand for these products decreasing as cell phones and other smart devices offer digital cameras in ever rising quality. Also, in 2011 Canon's revenues decreased 4%, while Xerox's were up 5%. Assuming a more reasonable price to earnings ratio for Xerox of 10, the stock should trade above $10 per share. This is a rise of 25% from the current price level. While I cannot predict if and when this price target will be achieved, the dividend yield is secure. Being paid 2.1% tax-advantaged dividend on your capital per year at current historically low interest rates with the potential for significant capital appreciation is a good proposition.
Looking forward, I believe Xerox will be able to execute well on its strategy. The main reason is that it has a great management team that is being overseen by a capable board of directors. Xerox's board of directors includes such business leaders as Citigroup's former chairman and CEO (Charles Prince), Procter & Gamble's current chairman and CEO (Robert McDonald) and the Center for Adoption Policy's current executive director (Ann Reese) among others. Most importantly, Ursula Burns is the CEO who currently leads Xerox. Ursula Burns has steered Xerox successfully through the last couple of years transitioning the company to services. In her short tenure at the top spot, Ms. Burns has earned a number of recognitions including the 27th most powerful woman in the world in 2011 according to Forbes and the top twenty list of black female CEOs according to the Washington Post. In addition, Ursula Burns is on the White House Committee on Science, Technology and Math Education along with a former Intel CEO and a well-known female astronaut. Many companies' shares carry leadership discounts. The most striking example being a Xerox competitor, Hewlett-Packard (HPQ), which has involuntarily changed its leadership seven times in the past thirteen years. In the case of Xerox, there should be a leadership premium, mainly because of its CEO.
Overall, I think Xerox has good prospects and its stock at the current price offers an attractive valuation. Xerox is still going through restructuring and there are risks such as changing the company from a printing technology manufacturer to a comprehensive business services provider. I think a positive outcome, from which shareholders are well-positioned to benefit, is most likely and I recommend considering Xerox's shares.