“Many shall be restored that are now fallen, and many shall fall that are now in honor.” (Security Analysis, 1940 second edition, preamble)
Who better than Xerox, perhaps one of the least understood American corporations in business today, to better illustrate this verse of Horace, Benjamin Graham’s favourite?
By Thomas Gouttman
Continuous profits and promising perspectives do not necessarily set the stage for depressed security prices. Although prosperous and competitive, the finest companies sometimes remain inexplicably left on the shelf by distrait or disillusioned investors.
The U.S. technology sector presents today an unequivocal embodiment of this incongruity, witnessing its most formidable cash machines being nonchalantly traded at historically low multiples.
In fact, the disenchantment of investors persists despite an industry offering various competitive conveniences - viz. annuity-like contracts, prohibitive switching costs, strong entry barriers serving foremost powerful innovation leaders - and a market in which demand never ceases growing.
Worldwide, the Xerox Corporation employs 140,000 people, weighs $23B in revenues and serves clients across 160 countries. The United States accounts for 64% of the revenues, Europe for 26% and the remaining world for 10%.
Once synonymous with copying and printing (“The Document Company”), Xerox’s mission has been meaningfully recalibrated into “making business a little simpler, a little less tedious and a little more productive” - a noble purpose with unquestionably large prospects.
Xerox works with companies, administrations, and governments. It is the world’s leader in business process and document management, a $600 billion market.
Its business is split into three divisions: (1) Services, which consists of business, IT and document outsourcing - and accounts for $11B in sales; (2) Technology, which encompasses products, hardware, supplies and technical maintenance - accounting for $10.3B in sales; and (3) Equipment, which comprises miscellaneous merchandises, such as paper and network integration devices - the smaller division, accounting for the $1.5B in sales remaining.
The company’s scope of activities is wide and the variety of its competences truly astounding: Finance, healthcare, human resources, commerce, industry, transport, IT, customer care… there are not many enterprises Xerox does not have an outsourcing solution for.
A la IBM, its offer is increasingly designed and marketed around the concept of “intelligent life,” for example by helping the city of Los Angeles to manage its parking capabilities in real-time or, on a more trivial note, by ensuring that traffic violators caught by red light cameras get their tickets well-delivered at home.
The company is evidently at the forefront of the world’s digitalization, as financial institutions, federal offices, hospitals and airlines, among others, are extensively outsourcing their bureaucracy (automating payments, processing claims, etc.) to Xerox’s care, gaining efficiency in their operations and symmetrically saving significant costs.
Innovation is, of course, indivisible of the company’ strategy. Last year, Fuji Xerox – perhaps one of the most successful joint-ventures in business history – claimed 1600 patents. It is less than Canon (2500 patents), but more than Hewlett Packard (1480 patents).
Despite its prodigious and fast-paced transformation into a services company, completed by the acquisition of ACS in 2010 which propped up the services sales from $3B to $11B overnight, it is stupefying how Xerox remains perceived by the public as an archaic printers and copiers manufacturer - a sort of dinosaur in business.
Yet this misconception omits the fact that within the past decade, Xerox has been deeply reconstructed by two amazing ladies.
Following Anne Mulcahy who rescued the company as it was flirting with bankruptcy in the early 2000s, the incredible Ursula Burns - once a little girl from the New York housing projects, now, according to Forbes, the ninth most powerful woman in the world - took up the reins and is now brilliantly leading the enterprise through its metamorphosis.
The public may not have kept in touch with the change, but Xerox has today little to do with what it was no earlier than a decade ago.
Like Ms. Burns enjoys saying herself: “we’re the company you encounter every day and never see.”
Xerox qualifies as a legitimate solid company based upon the following revenue record :
The fundamentals of the business are based on a clever annuity model that drives recurring revenue, enhances client retention and ensures intense cash generation – no less than 83% of sales directly stem from it.
Revenue from services has tripled since 2009 (from $3.5 to $10.8 billion), while revenues from technology and equipment have remained remarkably constant ($10.5 and $1.5 billion). The management expects its services business to expand by two-thirds of revenue in 2017.
The business’ normalized operating margin since 2002 stands at 7% (HP: 5.3%, Dell: 6.5%, Canon: 12%, IBM: 14%) and the normalized return on equity holds slightly above 10%.
The total capital expenditures of the past five years ($1.8B) make up for half of the total net earnings ($3.7B), which likely indicates a concrete, yet moderate competitive advantage in the conduct of commercial operations.
As of today, and notwithstanding its fairly tangible potential for growth, Xerox’s business is for sale at $8B despite generating a net income of $1.2B - a comfortable earnings yield of about 15%.
The eminently attractive feature about Xerox’s business is the consistent and sustainable earning power it demonstrates, as shown by the free cash flow per share record:
(FCF per share)
At the current price of $6.5 per share, the investor of today is buying a normalized, perennial and (relatively) secure annual free cash flow of $1.52 per share – a compelling return on cash of 22%, which aptly illustrates the beauty of the annuity-like business model.
Furthermore, another substantial attraction is the discount to reported book value, as a share of Xerox carries $9 of the latter; at the current price of $6.5 a share, one would consequently gets an immediate 27% margin of safety on the purchase.
However, given that goodwill and intangibles account for almost half of the asset base, the prudent investor shall not give too much credit to the apparent markdown .
Benjamin Graham claimed that the investor need not elaborate techniques of security analysis in order to find superior value opportunities; let us establish three simple – yet conservative – hypotheses of the investment attractiveness in Xerox’s equity.
(1) Short term, book value and FCF at zero growth / moderate
(book value per share) $9 + (FCF per share) $1.5 x 5 years = $16.5
The investor gets a $9.5 margin of safety when acquiring a share.
(2) Short term, book value and FCF both discounted by 25% / conservative
(book value per share) $6.75 + (FCF per share) $1.125 x 5 years = $12.4
The investor gets a $5.40 margin of safety when acquiring a share.
(3) Short term, book value and FCF both discounted by 50% / very conservative
(book value per share) $4.5 + (FCF per share) $0.75 x 5 years = $8.25
The investor gets a $1.25 margin of safety when acquiring a share.
Well-illustrated by the implausible valuation ratios (P/E:5, P/B:0.7, P/CF:4), and besides the dire straights the whole industry is going through, the undeniable cheapness of the Xerox’ stock can be explained by three chief factors:
First, it is obvious that among the public, a vast misconception in respect to the company’s activities remains. As Seth Klarman put it in Margin Of Safety, it is not uncommon, even for securities of renowned companies, to become inefficiently priced as a result of biases and misconceptions.
Investors typically fancy growth and enjoy exciting stories; they avoid situations that involve the stigma of obsolescence, often erroneously - who could predict Apple’s resurgence orNokia’s downfall?
Second, the business has experienced a slight margins and returns compression, since the profitability has been diluted by a growth essentially driven by acquisitions. For instance, it is likely that the firm did not show enough caution when it overpaid to take over ACS in 2010.
Following recent HP’s cataclysmic $8 billion write-off related to its acquisition of Autonomy, the surge of apprehension and defiance around the marketplace does not come as a surprise.
Third, at first glance the Xerox’s balance sheet reveals a considerable debt load of $9.6B which, once put in perspective with the $12B equity, could be sufficient to discourage even reckless speculators.
Yet appearances, as often, are deceiving. This reported debt must be divided between the $3.6B of “core debt” - actually owed by Xerox Corporation to its creditors - and the $6B of “financing debt,” viz. the payment facilities accorded by the company to its clients.
In fact, Xerox finances the customer leases as a profitable way to support sales and improve customer retention. This activity is conducted with borrowed money, which of course involves that the client pays back both the principal and a - moderate - interest rate. The lease terms usually range from three to five years, and in some cases go up to fifty years.
As a result, and considering how the client base of Xerox is widely diversified, the carried debt is evidently not an imminent threat to the company’s financial stability. Mostly when, even as such, its balance sheet is actually less leveraged (2.5) than HP’s (3.7) or IBM’s (5.50).
The sum of these considerations decidedly make a compelling case for a critical reappraisal of Xerox’s business value.
If both efficiency and profitability could very certainly be improved, the chief factors spooking investors away seem to be based on misconceptions, and therefore are not apt to justify the excessively depressed price of the stock.
Xerox’s management thinks no less, as it is currently drilling into its abundant free cash flow of $1.5B to pay $330 million in dividends and to finance a massive share buyback program initiated last year - $700M in 2011, $1.1B this year, and at least $400M next year.
In order to pay down its debt, pursue growth and fund its pension plan, management will presumably cut the program in 2014.
This shall not prevent the conservative investor from recognizing the quality opportunity standing out. At its present price of less than six times earnings, it does appear that no price is being paid for the tremendous earning power of the company.
(1) Business we understand well – CHECK
(2) Demonstrated consistent earning power – CHECK
(3) Tangible and durable competitive advantage – CHECK
(4) Attractive price and compelling margin of safety – CHECK
(5) Able management in place – CHECK
(3) is based on the company’s size, know-how, brand recognition and reputation.
BUY [suggested price frame: $5-$7].
The author owns shares of Xerox Corporation.
“The worth of a good analyst undoubtedly shows itself decisively over the years in the sum total results of his recommendations.”