On the surface Xerox Corp. (
) smells a lot like its Nifty 50 brethren,
once-hotter-than-the-sun-but-now-bankrupt Eastman Kodak Co.
(EKDKQ.PK) and Polaroid Corp. Its stock has gone nowhere since
forever. But Xerox was not your typical overvalued blue chip of the
1990s, like Cisco Systems (
), Johnson & Johnson (
) and Microsoft Corp. (
), whose earnings have tripled or quadrupled since then - the kind
of stocks I have advocated in this column. Xerox was very pricey in
the late '90s, but its revenue and earnings per share have since
declined. And to make matters worse, printing and copying is just
so analog, so last century. It is hard to get excited about a
company making equipment whose main trick is putting ink on paper.
However, all these negative optics have resulted in one
misunderstood company and a very mispriced stock.
Though we think of Xerox as a company that sells copiers, that
represents only 20 percent of its revenue. About one third of
revenue comes from selling toner and servicing copiers - a
beautiful, high-margin, annuitylike business. Look around your
desk, and you'll still see plenty of paper; the death of printing
and copying has been greatly exaggerated. It is very ungreen of us,
but we still copy and print.
Xerox's story gets better. About half of its revenue comes from
services. Xerox is a giant in the document-outsourcing business,
which provides about one sixth of its revenue. Corporate customers,
sick of paper cuts and spilled toner, realize that managing copiers
and printers is not their core competency, so they let Xerox take
care of that. This has been a very nicely growing business, up 6
percent in the fourth quarter.
About one third of Xerox's revenue comes from its
business-process-outsourcing service. Xerox got into this business
in 2010 when it bought Affiliated Computer Services. It paid fair
value for ACS, but it had to issue a lot of undervalued stock to
finance the purchase. ACS was touted as a transformative
acquisition for Xerox; unlike most such acquisitions, which often
destroy value, this one is turning out to be as good as Xerox's
management proclaimed it to be. Xerox helped ACS go international;
ACS gave Xerox access to its domestic customers. This acquisition
has resulted in several hundred new deals. The integration has gone
smoothly. The CEO of ACS is still running the business, and
new-contract signings are up by double digits.
Last year was not kind to Xerox. The company sources $2 billion
worth of parts from Japan each year and got hit hard by the
earthquake and tsunami, which created supply shortages. Xerox had
to fly copiers to its customers to make sure they got them on time;
its gross margins took it on the chin. In addition, the relentless
ascent of the Japanese yen - up 50 percent against the dollar in
three years - hurt Xerox's cost of goods sold. But tsunamis are
unlikely to become annual events, and the yen will probably decline
in the long run given that Japan is the most indebted nation in the
world, has one of the oldest populations and is very dependent on
the health of the shaky Chinese economy.
Declining interest rates resulted in a lower pension discount rate
and forced Xerox to contribute $200 million to pension assets. But
pensions will turn from a headwind into a tailwind in the future:
First, Xerox closed its defined benefit plan in 2011; second,
though interest rates may decline further, in the long run they'll
likely rise, boosting Xerox's cash flows.
At first blush, Xerox appears to have a very leveraged balance
sheet, laden with $8.6 billion of debt. However, $6 billion of it
is finance debt that is secured by equipment and leveraged 7-to-1
(if our banks had had this leverage, we would not have had a
financial crisis). Xerox has $2.6 billion in corporate debt, which
it can pay off in a little more than a year from its free cash
Because 80 percent of Xerox's revenue is an annuitylike stream, the
company is a cash machine, spitting out about $2 billion of free
cash flow a year. Management has been very specific on what it
intends to do with the cash: pay down debt, continue to pay a
dividend (the stock currently yields about 2 percent), spend about
$1 billion on stock buybacks and make a few small tuck-in
acquisitions. Xerox will be able to buy 8 to 10 percent of its
shares outstanding this year.
The company's service revenue should continue to grow 5 to 10
percent a year; assuming the copier business is flat, overall
revenue should grow in the low single digits. As profit margins
rise, Xerox should be able to grow earnings in the midteens without
doing much heavy lifting. The best part is that the current
valuation of less than six times free cash flow sets the bar very
low for this company. It needs to show proof of life (of which it
has plenty), not proof of growth.
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