Over the last month, Pitney Bowes (PBI) has lost nearly a quarter of its value. Many investors are afraid of unstable revenue sources and weak fundamentals. With the market assessing the stock at only 6.7x past earnings, investors appear to believe there is little hope left for the struggling company.
However, a bear case DCF model tells a different story. In this article, I will run you through my DCF model on Pitney Bowes and triangulate the result with a review of the fundamentals against Xerox (XRX) and Hewlett-Packard (HPQ). I find that, even assuming for bearish cases, Pitney Bowes' current valuation is baseless.
First, let's begin with an assumption about the top-line. In FY2011, the company generated $5.3B in revenue, which represented a 2.7% decline off of the preceding year. I model a 2% per annum decline over the next half decade or so. In my view, this is an extremely bearish assumption, and, indeed, it falls well short of what the Street anticipates. But, for the sake of proving my point, I am factoring in the projection.
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 49.3% of revenue versus 32.5% for SG&A, 3% for R&D, and 2.8% for capex. Taxes are estimated at 15% 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 to capital to get free cash flow. I model this figure hovering around -2% 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 $20.73, implying 55.7%. Of course, the -2% per annum growth over the next half decade or so was much too conservative. If we assume that the company just grows at a per annum growth of 1% over this time period, the stock should double.
All of this falls within the context of better-than-feared fundamentals:
Our financial results and business developments during the quarter point to the progress that we're making against our long-term goals as well as some near-term stabilization in parts of our business. The benefits from our previous actions to improve productivity and reduce costs enabled us to increase our EBIT margins in 4 of our 7 business segments, which in turn enabled us to grow our overall EBIT despite a decline in revenue.
From a multiples perspective, Pitney Bowes is also dirt cheap. It trades at a respective 6.7x and 6.9x past and forward earnings. In my view, Xerox and HP are also attractive. Xerox trades at a respective 8.1x and 6x past and forward earnings versus 7.8x and 5x for HP.
In my belief, HP may be considering a takeover of Xerox within the next three years. CEO Meg Whitman, however, has stated that she is not looking for acquisitions of Xerox's size in the immediate term. As I describe here, HP's price-to-free cash flow ratio is stellar and significantly under-appreciated by the market. Acquiring a catalyst should drive attention back to the fundamentals and dissipate investor fatigue. Consensus estimates forecast HP's EPS falling to $4.74 in 2014, and the Street rates the stock around a "hold" (source: NASDAQ). Although the firm has struggled to remind investors about the vitality of its brand, technology has no barriers to innovation. Signs of any catalyst materializing, I believe will send the stock price skyward.
Consensus estimates forecast Xerox's EPS growing by 4.6% to $1.13 in 2012 and then by 8.8% and 8.9% in the following two years. Assuming a multiple of just 8x and a conservative 2013 EPS of $1.19, the stock would soar to $9.52 for 30.9% upside. Given the stock has 50% more volatility than the broader market, it is well positioned to close the discount to intrinsic value when the economy hits full employment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.