Why Xerox Should Recapitalize and Boost Its Dividend

[bmichaud]

I submitted an article over at Gurufocus outlining what I think Xerox management should do to boost per share value and close the valuation gap. Would love feedback from the board and/or for larger investors to get involved!

 

http://www.gurufocus.com/news/178110/why-xerox-should-recapitalize-and-boost-its-dividend

 

Right up front I want to disclose that I own Xerox and am thus talking my book. The investment thesis for Xerox is well known throughout the investment community, as the stock has shown up in several well known hedge fund portfolios and recently won the “Best Idea” contest at the Sohn Conference, so I will only briefly outline – the ACS acquisition transformed Xerox into a service company with stable, annuity-like revenue, it generates approximately $1.6 billion of free cash flow, it sells for less than 7.00 times FCF at current prices and is committed to repurchasing roughly $1 billion worth of stock per annum over the next several years. While the investment thesis is attractive on a stand-alone basis, I believe the “low-growth” nature of the business and the paltry dividend yield leave the stock in “equity mandate no-man’s land” with the potential for an extended period of “dead money”. “Growth” investors are uninspired and “value” investors receive little in the way of current yield – while the buyback yield is significant and certainly benefits from the current undervaluation, I believe a more balanced policy of returning capital will result in a higher multiple over time as an attractive and growing dividend attracts a long-term, stable shareholder base. In order to take advantage of the current undervaluation, transform the shareholder base and close the valuation gap, I would propose the following three-part plan. Allow me to explain.

 

In summary, I believe Xerox should 1) boost its “core” debt from 1.14 times to 2.00 times LTM EBITDA by issuing up to $2.7 billion of additional debt, 2) initiate a $2.7 billion Dutch tender offer at $7.50 per share in order to retire 360 million shares and 3) boost its dividend from $250 to $735 million per annum. The Dutch tender offer would immediately boost per share intrinsic value by more than 20%, the more balanced payout policy would transform the shareholder base and the 9.2% post-tender offer dividend yield would catalyze a closing of the valuation gap as yield-starved investors drive the yield down to 5% or less.

 

As of 1Q12, Xerox had total debt outstanding of $9.6 billion, or 3.04 times LTM EBITDA. $6 billion represents “financing” debt backed by high-quality financing receivables, while $3.6 billion is considered “core” debt. At 1.14 times LTM EBITDA, I believe Xerox is under-leveraged from a “core” debt perspective, a belief underscored by Xerox’s recent $500 million issuance of 5-year unsecured debt at a pre-tax cost of 2.95%. Issuing $2.7 billion of additional debt would bring the “core” debt ratio up to a modest 2.00 times LTM EBITDA.

 

I estimate 2012 free cash flow to equity holders to be approximately $1.6 billion, or $1.12 per share based on $2.2 billion of management-guided operating cash flow, $600 million of capital & acquisition spending and weighted-average, fully-diluted shares outstanding of 1.427 billion. Assuming a conservative 10 times fair value PE multiple, Xerox is currently worth approximately $11.20 per share. A $2.7 billion Dutch tender offer at $7.50 per share would reduce shares outstanding by 360 million shares, boosting per share FCF to $1.38 (assuming a 6% pre-tax cost of debt and a 20% tax rate). The post-tender offer fair value would thus rise to $13.80, more than 20% higher than the current estimated fair value.

 

Post-tender offer, the current annual dividend of $250 million would rise from $.18 to $.23 per share for a dividend yield of 3.1% (versus 2.3% pre-tender offer). With its annuity-like cash flow profile however, Xerox is more than capable of handling a 50% payout ratio, or an annual dividend rate of $.69 per share – at a post-tender offer price of $7.50, the dividend yield would rise to 9.2%. To say the least, I do not believe a 9.2% dividend would last long – perhaps a new, dividend-seeking investor base drives it down to 5%? The upside speaks for itself – a 5% yield means a $13.80 stock price, while a 4% yield means a $17.00 stock price.

 

While it is a neat exercise to measure potential “downside”, since stock prices are simply a reflection of the collective investor mood at a moment in time, and the general mood at the moment is supremely negative as a result of the developed world’s inability to get its fiscal house in order, I will not venture a guess as to how low Xerox’s stock price could fall in the event of a large-scale market decline. All I will say is that I am quite confident the risk of permanent impairment from current levels is sufficiently low to warrant a full position.

 

I do not have the capital to push for such a plan, but as Jeff Saut often says, “Good things happen to cheap stocks”. A prolonged period of stock price stagnation particularly in the face a robust buyback program will no doubt incite shareholder action.

[Hielko]

I think your argument for increasing the dividend is poor. A company shouldn't take actions just to support the stock price, but because it's going to increase value for share holders. If they are indeed as undervalued as you say it seems to me that cutting the dividend and using all cash flow to repurchase shares is a better allocation of capital.

[bmichaud]

I think your argument for increasing the dividend is poor. A company shouldn't take actions just to support the stock price, but because it's going to increase value for share holders. If they are indeed as undervalued as you say it seems to me that cutting the dividend and using all cash flow to repurchase shares is a better allocation of capital.

 

 

I'll refer to what I said:

 

while the buyback yield is significant and certainly benefits from the current undervaluation, I believe a more balanced policy of returning capital will result in a higher multiple over time as an attractive and growing dividend attracts a long-term, stable shareholder base.

 

I don't think a low-growth company such as XRX will be as highly rewarded over time by returning capital primarily via buybacks. A higher payout that grows on an absolute and per-share basis, IMO will warrant a higher multiple. Rarely does a company get rewarded like Autozone or Autonation for their buyback program....look at XOM, Best Buy, HPQ, NFLX. I think Seagate is a great model for XRX - they had a massive cash hoard and annual cash flows, so they did large BB program AND raised the dividend. One could argue the better option would have been straight buybacks - but a big fat dividend yield has a funny way of enticing investors, like it or not. Sitting around a table trying to convince portfolio managers that a buyback yield is just as good if not better than a dividend is VERY difficult. You put something in front of them with a 9% yield and keyboards would be SMOKING.

[Packer16]

I think the main reason the levering up thesis is a mistake is due to Xerox's lack of growth potential at the current reveue levels.  If you look at the growth area, services, it is growing with declining margins to the point in the last Q the overall profit dropped.  Its renewal rate on BPO contracts is only 86% which in my experience with software and other recurring revenue streams is on the low-end of others I have seen.  The equipment and other areas are in secular decline so levering up may create a problem longer term.  From what I have been hearing, ACS is running the business to maximize cash flow and is not investing to create LT cash flow.  This may be reflective in low renewal rate.  In these types of flat to declining markets more leverage could be deadly.  They also continue to lay-off and outsource to India local jobs here in Rochester, not a good sign.  Just some thoughts on why it is cheap and why leverage may make the situation worse (especially if the equipment or services hits a bump).

 

Packer     

[bmichaud]

If you look at the growth area, services, it is growing with declining margins to the point in the last Q the overall profit dropped. 

 

This was actually due to the ramping up of recent large contract signings.

 

Its renewal rate on BPO contracts is only 86% which in my experience with software and other recurring revenue streams is on the low-end of others I have seen.

 

Interesting. Wonder if the effect of declining equipment revenue has anything to do with this...

 

From what I have been hearing, ACS is running the business to maximize cash flow and is not investing to create LT cash flow.  This may be reflective in low renewal rate.

 

Haven't heard this. My understanding is Xerox is being quite aggressive in integrating both legacy Xerox product/service offerings with ACS as well as with tuck-in acquisitions.

 

 

Even taking on an extra $2.7B and raising the dividend, FCF available to pay down debt would be around $800MM per year, so the additional debt could be paid off relatively quickly. Don't forget that there is over $1 billion of cash currently on the balance sheet, which is not taken into account when I look at current leverage ratios.

 

[Packer16]

The increased cost appears to be replacing lost business (as the total revenue is flat).  Therfore, it may be a permanent cost of business.  I know from valuing the recurring revenue streams of these types of businesses that 86% is not a good retention rate.  If you look at the purchase accounting for ACS, the estimated retention rate acquistion was closer to 91% (implying a 11-yr expected life for customer relationships).  These guys do have increased cost at the start of projects with the hope they can make it up after the start and on renewals.  But if they are loosing 14% of the contracts per year, I would want to wait until my renewal rate is up into the low 90s before I lever up.  These types of buinesses have operational leverage.  So if they lose revenue, the hit to cash flow is higher.  This is just prudent.  If you are right and the renewal rate increases then they can lever up.  If it becomes a cost of business then this business might become a levered CSC type business with a declining business attached.  If the leverage is high enough it could tip over the ship. 

 

I don't think equipment sales are directly tied to BPO.  BPO is a service while equipment is selling hardware at times to support the service.   

 

I wasn't referring to integration.  I am sure they are integrating fine but some local suppliers who provide productivity solutions have stated that ACS does not provide these solutions to customers that Xerox has supplied to in the past and thus may not be provding the best of class to clients.  I also think the outsourcing to India of software development is an issue from a competitive perspective.  Are they outsource their core that will be copied by Indian firms and drive prices down further in the future.

 

Packer

[bmichaud]

The increased cost appears to be replacing lost business (as the total revenue is flat).  Therfore, it may be a permanent cost of business.  I know from valuing the recurring revenue streams of these types of businesses that 86% is not a good retention rate.  If you look at the purchase accounting for ACS, the estimated retention rate acquistion was closer to 91% (implying a 11-yr expected life for customer relationships).  These guys do have increased cost at the start of projects with the hope they can make it up after the start and on renewals.  But if they are loosing 14% of the contracts per year, I would want to wait until my renewal rate is up into the low 90s before I lever up.  These types of buinesses have operational leverage.  So if they lose revenue, the hit to cash flow is higher.  This is just prudent.  If you are right and the renewal rate increases then they can lever up.  If it becomes a cost of business then this business might become a levered CSC type business with a declining business attached.  If the leverage is high enough it could tip over the ship. 

 

I don't think equipment sales are directly tied to BPO.  BPO is a service while equipment is selling hardware at times to support the service.   

 

I wasn't referring to integration.  I am sure they are integrating fine but some local suppliers who provide productivity solutions have stated that ACS does not provide these solutions to customers that Xerox has supplied to in the past and thus may not be provding the best of class to clients.  I also think the outsourcing to India of software development is an issue from a competitive perspective.  Are they outsource their core that will be copied by Indian firms and drive prices down further in the future.

 

Packer

 

Is it a dying business? Kodak in 5 years? Not arguing, just curious what you think the outlook is...

 

What percentage of Xerox's contract base is up for renewal every year? 20%? Assuming a 15% loss rate, that means it has to fight to replace 3% of its revenue base on an annual basis. If it's 10%, then annual revenue decline is 1.5%. For a merely "good" business, this is not to be unexpected. Oil, cable and phone companies all have annual decline or churn rates that must be replaced at a particular cost - thus they are not valued at a 15 or 20 PE.

 

Put it this way - I'd much rather have Xerox at 2 times debt to EBITDA than a Kroger, Safeway, Glacier Media or Salem Communications.

[Packer16]

My outlook for the printing business is much like the print imaging business.  You have alot of legacy capacity and new technology makes the old machines obsolete in a few years.  My dad runs a digital printing shop and has carved out a niche but can't find much growth.  The large printers (Donnelly, Quebcor, etc.) are all in terminal decline.  The printing business is tied to print advertising/publishing which is is a terminal decline.  Newpapers may survive by providing content via a different medium (video/internet/mobile).  The reason I like Salem and Glacier is they have the content and will find another channel to provide it and they are not capital intensive.  I am not sure I can say the same for XRX.  The hardware business is a commodity in a declining market where they used make money on cosumables which can be provided by others for a lower cost.

 

As I remember BPO contracts are typically 3 to 5 years but you need to know the number of contracts up for renewal.  The only observation I was making is if the renewal is so high why is the revenue bearly budging and the margins declining (ie they have to spend a good amount to prevent revenue decline) and the fact that the rate appears to declining based upon ASC's purchase accounting.  The margins have been declining every year since they bought ACS.  CSC is an example of a firm that is having problems with its BPO business.  If XRXs business ends up like CSCs then in can to be priced at less than 3.0x EBITDA.  Implying a decline from today's 5x EBITDA.   

 

As to Safeway and  Kroger, I agree that they need to something similar to Wegmans or what JC Penney is attempting (making the stores an experience) to differentiate themselves or they will consumed by Walmart, Target or Costco. 

 

I am not saying XRX should no have purchased ASC.  They were dealt a bad hand (like Kodak and IBM at one point) and tried to compensate via a services business.  I think the big difference is IBM had an organic service business, XRX bought one and Kodak had none.  For IBM the service business was part of the customer purchase not as much so for XRX.

 

Packer

[bmichaud]

LTM EBITDA margin has improved every quarter since 12/31/2009 before dipping this latest quarter (the ACS purchase was consummated in early 2010), while gross profit margin has declined every quarter. Xerox said this specific phenomenon, i.e. higher operating margins/lower gross margins, was to be expected as a result of a shift in revenue mix to services from hardware. And FWIW, return on capital is materially higher than it was at 12/31/2009 despite lumpy quarter-to-quarter figures. Please see attached.

Xerox_Corp_NYSE_XRX_Financials_Ratios.xls

[Packer16]

You can see the impact of ACS, the ROIC peaking in Dec 2011 (including the ACS acquisition).  Since that peak, it has declined.  The service margin has declined however, see page 8 of attached presentation.  The difference must be from D&A.  I would expect ROIC to increase including ACS or they would not have any goodwill in the acquisition.  The trends since the acquisition have in my opinion have not been good. 

 

Packer

Xerox-First-Quarter-2012-Earnings-Presentations-Slides.pdf

[bmichaud]

Taking management at its word, the Services margin decline is due to new contract ramps, as those investments are required before revenue begins rolling in.

 

Bottom of page 12/top of 13 is a good discussion on Services margins. Again, taking management at its word, the renewal issue is due to "3 or 4 meaningful contracts" in the ITO division.

 

Xerox_Corp._Q4_2011_Earnings_Call_Jan_25_2012.pdf

[Packer16]

It will be interesting to see how thus plays out as management has one view and the market is pretty skeptical about it (as can be seen by the analysts questions and the current stock price). 

 

Packer

[FCharlie]

A couple of things that I notice from the small amount of time I've looked at this:

 

In the 10Q they say During the first quarter 2012 we repurchased 6.1 million shares for an aggregate cost of $50 million, including fees.Through May 1, 2012, we repurchased an additional 2.6 million shares at an aggregate cost of $20.9 million, including fees, for a cumulative total of 290.8 million shares at a cost of $3.7 billion, including fees.

 

It looks like the buybacks were mostly done at much higher prices, and the company was mostly out of the buyback market while the stock was at the lows.

 

Also, depreciation is much, much higher than capex. What is behind that?

 

Finally, a question....

 

What services does Xerox provide that a newbie to the stock might not realize?

 

Thanks for the idea, and by the way... In my opinion, while massive dividend increases may force the stock higher, I think the most responsible thing to do if your stock is truly undervalued is to consistently buy it in the market, day in, day out, year after year, while increasing the dividend every year... Philip Morris Intl. may be the best example of this I know of.

 

Earlier someone mentioned Safeway. Safeway, based on it's free cash flow, could pay out a 15% dividend yield and still have cash flow to repurchase 6% of it's shares annually at these prices. Of course with a 15% dividend the stock price would probably double, but I would rather see them do what they are doing, which is pay a 3.5% dividend and repurchase 10-20% of their shares annually. If the market doesn't give them credit, keep buying. Eventually the market will give them credit. There are examples in history of stable companies that are out of favor that repurchase stock at rates that would essentially take the company private in less than ten years. It doesn't last as long as the underlying business is okay. Eventually the stock will move up. Even AutoZone's stock didn't budge for years  when they first began buying. It took years and 40% fewer shares to really make it move. Safeway is now approaching 50% of shares retired in 4 1/2 years. The price hasn't budged. It will.

[bmichaud]

A couple of things that I notice from the small amount of time I've looked at this:

 

In the 10Q they say During the first quarter 2012 we repurchased 6.1 million shares for an aggregate cost of $50 million, including fees.Through May 1, 2012, we repurchased an additional 2.6 million shares at an aggregate cost of $20.9 million, including fees, for a cumulative total of 290.8 million shares at a cost of $3.7 billion, including fees.

 

It looks like the buybacks were mostly done at much higher prices, and the company was mostly out of the buyback market while the stock was at the lows.

 

Also, depreciation is much, much higher than capex. What is behind that?

 

Finally, a question....

 

What services does Xerox provide that a newbie to the stock might not realize?

 

Thanks for the idea, and by the way... In my opinion, while massive dividend increases may force the stock higher, I think the most responsible thing to do if your stock is truly undervalued is to consistently buy it in the market, day in, day out, year after year, while increasing the dividend every year... Philip Morris Intl. may be the best example of this I know of.

 

Earlier someone mentioned Safeway. Safeway, based on it's free cash flow, could pay out a 15% dividend yield and still have cash flow to repurchase 6% of it's shares annually at these prices. Of course with a 15% dividend the stock price would probably double, but I would rather see them do what they are doing, which is pay a 3.5% dividend and repurchase 10-20% of their shares annually. If the market doesn't give them credit, keep buying. Eventually the market will give them credit. There are examples in history of stable companies that are out of favor that repurchase stock at rates that would essentially take the company private in less than ten years. It doesn't last as long as the underlying business is okay. Eventually the stock will move up. Even AutoZone's stock didn't budge for years  when they first began buying. It took years and 40% fewer shares to really make it move. Safeway is now approaching 50% of shares retired in 4 1/2 years. The price hasn't budged. It will.

 

Good questions. They buyback stock primarily in the second half of the year due to timing of cash flow and D&A is higher CAPEX due to the depreciation of finance division equipment (the purchase of finance division equipment shows up as a change in working capital, not CAPEX). Regarding what they do, they provide primarily business outsourcing services - IT outsourcing, document outsourcing and business processes. So they administer the "EZ Pass" program for example, and recently won the California Medicaid program contract.

 

Xerox is not a high-growth business, or even a GDP growth business - so personally, I'd rather see the cash come back to me in the form of a dividend. I'm not a huge fan of muddle-through or declining business buyback back significant amounts of stock over time - think Yahoo!, Best Buy, Radio Shack, HPQ or even Exxon - I consider Xerox a muddle-through type of business that should take advantage of the current undervaluation via a Dutch tender, but going forward have a more balanced payout plan. Basically I think the risk to only buying back stock for the next five years is that the value won't get realized as a result of the lack of growth. I'd rather actually see my cash over the next five years and as oppose to leaving that value realization up to the whims of the market in five years.

[bmichaud]

Just rambling here, but if you think Xerox is potentially attractive to a larger entity that finds Xerox's scale and international presence attractive, I think boosting the stock price will help to mitigate the risk of a take-under.

 

So for example, people on this board were advocating for Winn-Dixie to buyback stock below book value....it ended up getting taken under BV. Had Winn boosted the dividend and attracted a more stable investor base, resulting in a higher stock price, perhaps its suitor would have paid a higher multiple. Just food for thought, no pun intended.

[spin]

FCharlie ::

"Also, depreciation is much, much higher than capex. What is behind that?"

 

The deperication of the operating leases mentioned previoulsy is a part of the difference you note.

 

This itemization and reconciliation between cash flow, income statement and balance sheet should help explain why the delta.

 

http://i49.tinypic.com/2mpg2z4.png

 

In summary for the prior 3 years, D&A on the following balance sheet items shake out at:

- PPE ~31%

- Equpment Leases ~34%

- Acquired intangiables ~26%

- Internal capatalized Software and customer costs ~9%

 

The ~26% expense on acquired intangibles is mainly due to the allocation assigend to 'customer base' from the ~6B ACS acquisition n 2010 and is amortized over 10 years.

 

The following anlaysis should show the D&A is reasionable to the investment spend -ie: no hidden cash flow bounty.

Acquisitions are backed out over this 3yr snapshot period due to the large lumpy ACS buy but should be added in over longer trend.

 

http://i47.tinypic.com/2yuhsnk.png

 

Spin

[bmichaud]

Thank you for the breakdown!

 

As the last table shows, the equipment on operating lease addition shows up as a deduction to CFO. So to be more technical, you would add $300 million to my $2.2B CFO and $600 million CAPEX numbers.