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Xerox (NYSE:XRX) was hammered on second-quarter earnings, primarily on weakening growth and reduced guidance. Shares closed the day at $6.70, resulting in a TTM P/E of 7.2. The company expects full-year 2012 GAAP earnings per share of 92 to 97 cents and full-year adjusted earnings per share of $1.07 to $1.12.

With second-quarter revenue down 1% year over year, the investor is faced with the awkward question: what is a no-growth situation worth? The company anticipates repurchasing between $0.9 and $1.1 billion worth of shares for the year, from its abundant cash flow. Can buybacks create value, in the absence of growth?

Overview

From the 10-K:

We organize our business around two segments: Services and Technology.

Our Services segment is comprised of business process outsourcing, information technology outsourcing and document outsourcing. The diversity of our offerings gives us a differentiated solution and delivers greater value to our customers.

Our Technology segment is comprised of our document technology and related supplies, technical service and equipment financing (that which is not related to document outsourcing contracts). Our strategic product groups within this segment include Entry, Mid-range and High-end products.

An Analogous Situation

Experience with P&C Insurer Chubb (NYSE:CB) illustrates the possibility of a positive outcome from a no-growth, heavy buyback scenario.

For the five years from 2006 to 2011, earnings decreased 7.9%, annualized. The P/E ranged from 6 to 14, averaging 8.5. Buybacks reduced share counts by an average 7.2% per year, while tangible book value increased 11.2% annually. Share prices, which tend to follow tangible book, seesawed with the market, but on average increased 4.4% annually.

Value creation, defined as the increase of tangible book value, plus dividends received, proceeded at 12.6% per year. I started in September 2009, using LEAPS as a substitute for share ownership, and achieved an IRR of 35% over a period of almost three years. Buy and hold for the same period would have generated an IRR of 12.8%.

There was much talk of headwinds: the soft market in commercial lines, the increased catastrophe risk, the declining interest rates, the dangers of asbestos and environmental liability, the exposure to Directors and Officers Liability raised by the financial crisis, etc. It kept a lid on P/E multiples, that's for sure. But the buybacks created value.

Valuing Growth/No Growth

Ben Graham proposed a formula: P/E = 8 + 2G, where G is growth. A company with a growth rate of 2% would command a P/E of 12, under that line of thinking. Graham's formula is accurate, but only at low-growth rates.

A regression analysis on modern data developed a Graham-style formula of P/E = 11.7 + 0.7G. I prefer this version for growth over 3.5%, and switch to it when projected growth exceeds that level.

Labeling XRX as a no-growth situation, and using the midpoint of GAAP guidance for 2012, $0.95 X 8 = $7.60, round to $8. On a long-term basis, and perhaps after a reset, I see growth of 3.5%. $0.95 X 14.2 = $13.

Buyback Ad Infinitum

My original hypothesis when opening a position in XRX relied on the idea that buybacks would continue indefinitely, with modest growth. Management expected to deliver about $10 billion of cash flow over a 5-year period, and absent better uses of the cash, could be expected to spend about $1 billion per year on buybacks.

The thinking was, that if Mr. Market would not pay up for the shares, buybacks would create value, along the lines described above for Chubb.

Putting the above assumptions into a spreadsheet, together with a variable growth assumption and a P/E dependent on growth, I experimented with various scenarios. I assumed that reported earnings would be 65% of cash flow, that 50% of cash flow would be used for buybacks, and that the initial cash flow would increase consistent with growth, if any. I allowed an estimate of average buyback price for the first year: thereafter, share prices (and buyback cost) reverted according to the valuation formula discussed above.

The results are very sensitive to the assumptions. At zero growth, if the market permits management to buy back shares at $6.70 for 1 year, reversion to a P/E of 8 will give a pop of 25% to 30% from that price.

If growth resumes at a rate of 3.5%, and buybacks continue for one year at the current price, reversion to a P/E of 14 would make this a doubler, or better, from where it lies.

Playing it from Where it Lies

After initiating a position at a price above $10, I reacted to a drop in share prices by doing a vertical call spread, long July 6 calls, short July 7s. That's the equivalent of selling a put at $7, and after the shares closed Friday at $6.70, I'm the proud owner of additional shares.

One possible strategy, and a common one among put sellers, would be to turn around and sell calls at 7 on the newly acquired shares.

However, buybacks are expected to be loaded toward the end of this year, based on cash flow considerations. If the share price stays down, value creation would be relatively rapid. With that in mind, now would not be a good time to give away the upside on this exposure.

XRX January 2014 3 Calls have a relatively low time cost associated with maintaining a position. Swapping my current holdings for the LEAPS, I can reduce the capital devoted to the situation and wait patiently to see how this plays out.

Dividend

Xerox dropped the dividend in February 2001 and restored it in December 2007 at 17 cents per year, paid quarterly, for a yield of 2.5% at Friday's closing price.

The payout ratio is 18%, and the dividend may be regarded as secure. Dividends take a back seat to acquisitions and buybacks. Given the history of dropping the dividend, and lack of a regular increase, the shares will not be attractive to dividend-oriented investors.

Thoughts on Growth

Xerox as presently constituted is the result of a large acquisition - ACS (American Computer Services) in 2010. That's the origin of the Services segment, where the company expects future growth to occur. I owned ACS at the time, attracted by a 5-year revenue growth rate of 9.7%.

Checking pro-forma results for the combination, as disclosed in the 10-K, 2009 revenue was $21,082 million, and advanced to $22,626 for 2011, for an annualized growth rate of 3.6%. Combined segment margins on the same basis increased from 7.2% to 9.2%.

Under the circumstances, it's not unrealistic to look for growth to resume at 3.5%, when the global economy stabilizes in a growth mode.

Debt

Xerox finances customer leases as a profitable way of supporting Technology sales. This activity is conducted with borrowed money. Assuming a 7:1 leverage ratio of debt to equity as compared with finance assets, the company distinguishes between financial debt and core debt.

On that basis, core debt is 29.6% of shareholder equity.

The ratio of earnings to fixed charges and preferred dividends stands at 2.67. General Electric (NYSE:GE), by way of comparison, reports a ratio of 2.04. Xerox limits its financing activities to what is directly supportive of its primary business, while GE has permitted finance to wander into other areas.

Miscellaneous Analytical Observations

Services margins have come under pressure, due to the cost of ramping for large new contracts. It's possible to think of the increased expense as an investment in future income. In any event, margins are expected to increase as revenue from the new contracts comes on line.

A slowdown or reversal in the Technology segment improves cash flow, since capital formerly devoted to financing the activity is returned to cash.

MIF (machines in the field) is increasing, and installations are still running strong. The MIF metric is indicative of the future annuity type supplies and service revenue from machine sales, and it bodes well for that stream of income.

The company provides a wealth of information on signings and sales pipeline. Investors who want to track progress can maintain spreadsheets on a continuing basis and form an impression of future potential.

The company regularly does small bolt-on or fold-in acquisitions. Given the cash flow available for the purposes, this strategy can reliably add to growth, or augment capabilities in selected areas of expertise.

R&D expenditures are approximately $700 million per year, or 3.1% of revenue. The expense has been declining, both in % and in absolute terms. The company has the ability to stay ahead of the curve in technology areas where it has a stake. As such, it may be able to gain share against weaker rivals.

The strategy of hardware companies moving into software or data services operations, whether by acquisition or internal growth, is very common. XRX was relatively early to the game, and paid a fair price for ACS. Hewlett-Packard (NYSE:HPQ) may have been excessively zealous in cutting expenses on its acquisition of EDS. Clearly it overpaid for Autonomy, and very possibly it mishandled integration. Computer Services Corporation (NYSE:CSC) is floundering. The caliber of competition suggests taking share is possible.

Source: Xerox: Slow - No Growth, Lots Of Buybacks