On the surface Xerox Corp. smells a lot like its Nifty 50 brethren, once-hotter-than-the-sun-but-now-bankrupt Eastman Kodak Co. 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 flow.
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.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.