Xerox (XRX) operates in the business equipment industry. I think this stock is highly undervalued by up to 72% or even more. Below are my calculations using a FCFF model, multiples comparison and other interesting facts and threats.
Discounted Free Cash Flow Valuation
In this article I will run you through my DCF model. In particular I will be using free cash flow to the firm FCFF model to evaluate the stock. Feel free to share your opinion regarding the assumptions I made for this valuation.
Let's start with the top line. XRX recorded $22.63B in revenue in 2011, which represented 4.59% growth year/year. In 2012, however, I predict that the company will record modest growth from 2011 to $22.93B (+1.34%), and 2.27% growth in 2013. I predict 2% growth for the next four years.
Coming down to the cost side I predict COGS to be 64%, SG&A - 22% and EBIT margin 9-11% of the revenues for the projected period. Interest expense should stay at around 5.5% of the long-term debt. I forecast taxes to be 26% on average for the projected period.
Then I subtract increases in working capital and capital expenditures. I model working capital to increase 10% of the revenue increase per annum. Capital expenditures should be approximately 37% of net income.
This model uses WACC to discount FCFF backwards to find out the present value. Beta of this stock is 1.57. I project the WACC to be 10.73%.
To get the value of the firm we need to discount the projected FCFF by WACC and add the terminal value at the end of the five-year period by calculating a perpetuity with growth of 2% and 10.73% WACC.
I get the value of equity by subtracting the market value of debt and adding back current cash and marketable securities.
Equity value per share is $12.40, which means the stock is 72% undervalued.
XRX is also undervalued in terms of P/E (8.00) compared with the industry (13.99) and to one of the biggest direct competitors, Canon Inc. (CAJ), which P/E is 15.83. On the other hand, it is similarly valued in terms of P/E, as Hewlett-Packard (HPQ) - 7.71.
The situation is similar in terms of P/S. XRX has P/S ratio of 0.43, which is lower than the industry average 0.65 and CAJ - 1.12, but slightly higher than HPQ - 0.35.
The median analyst target price for XRX is $9, which shows more than 25% upside potential. In the last 30 days four analysts have increased the EPS revisions for the current year and two analysts for the next year.
More positive facts
- I projected the long-term growth of the company quite conservatively. Some brokers are forecasting up to 5.2% long-term growth, which of course would mean ever more upside for the stock.
- The company also has 2.4% trailing annual dividend yield and 2.3% forward looking dividend yield.
- Strong pricing power with 33-45% gross profit margins. It has been decreasing in the last years, however.
- Significant positive free cash flows in the last 10 years.
- Xerox operates in a highly competitive industry with quite low net profit margins.
- Moderate-high capital intensity with an average of 51% of the net profits spent on capital expenditures during the last 10 years.
Financial data taken from Yahoo Finance.