"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?
November 12, 2012
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.
The disenchantment endures despite an industry set-up offering appreciable competitive fortunes – viz. annuity-like contracts, prohibitive switching costs, and strong entry barriers serving foremost powerful innovation leaders – coupled with a market in which demand never ceases growing.
Upon such rare occasions, attractive opportunities are likely to surface. In their disciplined pursuit of mispriced gambles, enterprising investors shall not miss the chance to seize these up.
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 a world leader in information technology, document management and business process outsourcing, a $600 billion market.
The company’s scope of activities is wide and the variety of its competences truly astounding. From finance to healthcare, there are not many industries Xerox does not have a tailored 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 promptly delivered.
The company is at the forefront of the world’s digitalization, since financial institutions, federal offices, hospitals and airlines, among others, extensively outsource their bureaucracy – such as automated payments, claims processing, archiving procedures, etc. – to Xerox’s care, gaining efficiency in their operations and symmetrically saving significant costs.
Engineered in its various research centres, including the notorious PARC in Palo Alto, and by its intelligent joint ventures around the world, for instance Fuji Xerox – perhaps one of the most successful partnership in business history – innovation remains, of course, indivisible of the corporate strategy. Xerox claimed 1600 patents last year, which is less than Canon (2500), but more than Hewlett Packard (1480).
Yet despite its prodigious and fast-paced transformation into an innovative services company – completed by the acquisition of ACS in 2010, which propped up the services sales from $3B to $11B overnight – it strikes as stupefying how Xerox keeps being perceived by the public as an archaic printers and copiers manufacturer.
This misconception dramatically omits the fact that within the past decade, the company has been deeply reconstructed by two amazing women.
Succeeding to Anne Mulcahy, who rescued the venerable as it was flirting with bankruptcy fifteen years ago, the incredible Ursula Burns – once a little girl from the projects; now, according to Forbes, the ninth most powerful woman in the world – took up the reins and is nowadays conducting the enterprise through its remarkable metamorphosis.
The public may not have kept in touch with the change, but Xerox has today little to compare with the business 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 the services business to expand by two-thirds of revenue in 2017.
The 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 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 of its stock 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.
Another substantial appeal is the discount to reported book value, as a share of Xerox carries $9 of the latter. At the current price, one would consequently gets an immediate 27% margin of safety on the purchase.
Since goodwill and intangibles account for almost half of the asset base, prudence entails neutrality in respect to this apparent markdown.
Benjamin Graham asserted that the investor need not elaborate techniques of security analysis in order to find superior value opportunities.
Hence, let us draft three simple – yet conservative – valuation hypotheses of the investment attractiveness in Xerox’s common 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 – a price-to-earnings of 5, a price-to-book of 0.7, and a price-to-cash flow of 4 – the undeniable cheapness of the stock appears motivated by three chief factors:
First, it is obvious that among the public, a vast confusion in respect to the company’s activities remains. As Seth Klarman remarked 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 or, by contrast, Nokia’s downfall?
Second, profitability has indeed been diluted by a growth essentially driven by acquisitions. As a result, the business experienced a compression of margins and returns over the past six years.
It also appears probable that Xerox paid a too dear price to acquire ACS in 2010. Following the Hewlett-Packard’s cataclysmic $8B write-off related to the acquisition of Autonomy, the surge of apprehension around the marketplace cannot come as a surprise.
Third, at first glance the company’s balance sheet reveals a considerable debt load of $9.6B which, once put in perspective with the equity of $12B, might be sufficient to discourage even an intrepid investor.
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 – quite gentle – interest. The lease terms usually range from three to five years, and in some cases go up to fifty years.
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), while its interest expense accounts for less than 1% of the revenue.
The sum of these considerations decidedly make a compelling case for a reappraisal of the Xerox’s common stock value, as none of the aforementioned reasons seems apt to justify the excessively depressed price per share.
The management thinks no less, as they are currently drilling into the abundant free cash flow of $1.5B to pay $330M 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 meet the credit obligations, pursue growth and fund the hefty pension plan, the program will presumably be cut in 2014.
This shall not prevent the prudent 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.
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