Key Investment Considerations
Xerox's (NYSE:XRX) dividend yield is above average, offering nearly a 3% yield at recent price levels. We prefer yields above 3% and generally don't include firms with yields below 2% in our dividend growth portfolio. Though Xerox's yield is high enough for consideration, there are a few things we'd like to cover about its dividend. Let's have a read.
• Xerox is focused on business process outsourcing, information technology outsourcing and managed print services and document management. The company has come a long way since patent attorney Chester Carlson first invented the xerography in 1938 -
the event that led to its formation. It is headquartered in Connecticut.
• Our fair value estimate is supported by Xerox's strong expected cash flow generation. Cash flow from operations is expected to be $1.7-$1.9 billion in 2015, while free cash flow is expected to hit the range of $1.3-$1.5 billion for the year. While robust, this is meaningfully lower than prior years.
• Xerox's financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health. The firm continues to use its free cash flow to pay down debt, but dividend obligations are limiting the pace at which it can delever.
• The company's revenue stream continues to face pressure, but management is as shareholder-friendly as ever. In 2014, for example, the firm returned $1.4 billion through share repurchases and dividends, a 40% increase from the previous year. Dividend-per-share increases have resumed.
• The firm's adjusted operating margin hit a near-term peak of 10% in 2011 and has since fallen, despite services segment revenue becoming a larger piece of the revenue pie. We're monitoring profitability closely.
After Xerox reinstated its dividend in 2008, the company resumed consistent dividend increases in 2013. Xerox's solid Dividend Cushion ratio is driven by our expectations for strong free cash flow generation, even though it has been under pressure as of late. Management has plans to increase the dividend and pay out roughly $300 million in 2015. Though the firm cut and eventually eliminated its dividend at the beginning of this century, management may have a better handle on maintaining a reasonable yield amid industry uncertainty compared to its peers. The stabilization of earnings per share in recent years is a positive for its dividend as well.
Though Xerox's free cash flow generation has been strong as of late, dividends have often taken a back seat to other capital allocation options. The firm only uses 20% of its free cash flows toward paying out its dividend - the majority of Xerox's cash flows are used for share repurchases and acquisitions. We like that management is not worried about maintaining a high dividend yield given its debt load, unlike some of its peers. The company's free cash flows have been dwindling compared to prior years as its business faces ongoing uncertainties. If cash flows continue to weaken, the firm's financial health could be at greater risk, and the dividend could become an afterthought.
We think the safety of Xerox's dividend is good. We measure the safety of the dividend in a unique but very straight forward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Xerox, this ratio is 2.4, revealing that on its current path the firm should be able to cover its future dividends and growth in them with net cash on hand and future free cash flow.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Xerox's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's five-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is greater than the sum of the next five years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the five-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the "blue bar" to the right is in the positive, the more durable a company's dividend, and the greater the "blue bar" to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ration Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Xerox's numerator is larger than its denominator, suggesting strong dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next five years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative five-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of Xerox's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate and a solid Dividend Cushion ratio. We characterize its future potential dividend growth as excellent, which is the case for Xerox.
Because capital preservation also is an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Xerox's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low. Please view our website for information regarding our valuation assumptions.
Wrapping Things Up
We love the strong cash flow generation expectations at Xerox, which drive the company's value and its dividend growth prospects. The fact that the company cut and suspended its dividend near the turn of this century may make investors wary of the dependability of its payout, but its Dividend Cushion ratio suggests the dividend in good shape. We wouldn't be surprised to see continued growth in the high-single digits in coming years, but weakening cash flows could pressure this notion. Though there's a lot to like about Xerox, we like companies in the Dividend Growth Newsletter portfolio even more.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.