In this article, I will run you through a DCF model on Xerox (XRX) and argue why the company could and should be taken over by either Dell (DELL) (see here for why), Hewlett Packard (HPQ) (see here for why) or other companies looking to expand operations in business process outsourcing ("BPO"). I find that Xerox is substantially undervalued and can close this discount by being acquired.
First, let's begin with an assumption about the top-line. Xerox finished FY2011 with $22.6B in revenue, which represented a 4.6% gain off of the preceding year. I model 7.4% per annum growth over the next half decade or so, which is fairly conservative considering that it is around 340 bps below what is expected for the S&P 500 over the same time period.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I model cost of goods sold as 65% of revenue versus 22% for SG&A, 3.5% for R&D, and 2.1% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I expect this figure to hover around 0.45% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $10.82, implying around 40% upside. This valuation is merited if the company hits free cash flow of nearly $2B in 2017. The market is pricing in a WACC of 11.5%, which is much too bearish (especially in light of the already conservative inputs going into this model.)
All of this falls within the context of the company needing greater momentum:
"In the first quarter, we delivered adjusted EPS of $0.23. On a GAAP basis, earnings were $0.19 per share. This includes $0.04 related to the amortization of intangibles. Earnings, which are flat from a year ago, are in line with our expectations and reflect the investments that we're making to grow our services business."
In my view, added momentum could close the discount to intrinsic value. This added momentum will come from being acquired by companies looking to expand operations in BPO. Xerox currently trades at a respective 8.8x and 6.3x past and forward earnings versus 8.7x and 7.5x for Dell and 8.8x and 5.6x for HP.
Both Dell and HP are viewed as old-fashioned and out-dated businesses that are at the very mature stages of the business game. However, technology has few barriers to entry and the market has failed to account for this in valuing Dell and HP (see the article links included above). By buying out Xerox, Dell and HP can cross-sell products while expanding Xerox services and businesses to a global audience. Note, however, that HP's CEO has specifically expressed a disinterest in acquiring companies as large as Xerox, at least within the next year.
Consensus estimates for Dell's EPS forecast are that it will stay flat at around $2.15 over the next three years. Assuming a multiple of 7.5x and a conservative 2013 EPS of $2.15, the stock is more or less fairly valued. This is a very low multiple and thus the stock is well positioned to gain with a beta of 1.4 in a full recovery.
HP requires even less of a multiple to be fairly valued.
Consensus estimates for HP's EPS forecast are that it will decline by 17.2% to $4.04 and then turnaround to grow by 9.2% and 7.5% in the following two years. Assuming a multiple of 12.5x and a conservative 2013 EPS of $4.37, the stock would more than double. I highly recommend a strategic investment in all three of these companies.