Description

Long XRX @ $10.03 / $10.5b market cap / $12.9b TEV

Summary Thesis:

Xerox (XRX) is a beaten up, left for dead stock with challenging end markets that is undergoing a spin of their services business, “Conduent”, which is trading at 3.1x CY’2018 PE / 1.0x EBIT / 1.1x FCF. I see 25% upside in a base case and 60% upside in a bull case within the next 6-12 months, with limited to no downside from current levels.

The crux of the thesis lies with the Conduent business which I think is significantly undervalued within XRX + there’s a lot of M&A opportunities that could accrete meaningful value from current levels. I would hedge out the printing business by being short HPQ.

Summary of Recent Events:

For a detailed overview of what the company does, please refer to XRX’s November 2014 Investor Conference presentation available on their website: http://phx.corporate-ir.net/phoenix.zhtml?c=104414&p=irol-EventDetails&EventId=5173245

The major changes since the 2014 analyst day have been 1) divestiture of their ITO business to Atos in December 2014 and 2) announcement of a spin of their services business (“Conduent”) in January 2016, a few months after Icahn took a 10% stake in XRX

I’ll also point people to their Q4’2015 earnings call, where they lay out the rationale for splitting their business into two: http://phx.corporate-ir.net/phoenix.zhtml?c=104414&p=irol-EventDetails&EventId=5214368

XRX is pursuing a spin of their services business (“Conduent”; 38% of LTM revenue / 17% of LTM earnings) to unlock value in what is a very poorly run Business Process Outsourcing company within a larger printing company. The simple thesis of earnings multiple expansion as the higher multiple services business becomes a larger part of the overall mix has been around for many years, but poor execution has meant this dream was never realized.  

What’s different today is that XRX will be spinning Conduent by year end, which means 1) greater focus by new mgmt. given standalone nature of business, 2) M&A environment is heating up and I think there are multiple ways to win on that front, 3) valuation discrepancy is the most severe it’s been, and 4) with Icahn on the board there’s increased confidence they won’t do anything value destructive.

A summary snapshot of my valuation framework is below, which shows the Conduent business currently trades at 3.1x CY’2018 PE / 1.0x EBIT / 1.1x FCF.

Note: capital structures for Conduent / XRX Printing have not been disclosed yet, but mgmt. has indicated they want to leave Conduent with as much financial flexibility as possible while leaving XRX Printing investment grade; I’ve assumed $1.5b cash to Conduent on top of what has been disclosed in the latest form 10-12b/a (implies XRX Printing leverage of <2.5x net leverage and Conduent net cash of $500m). Convertible Preferred stock accounted for on an as converted basis. Q2’16 LTM financials for Conduent are available in form 10-12b/a filed 8/15/16: https://www.sec.gov/cgi-bin/browse-edgar?company=conduent&owner=exclude&action=getcompany

My base case assumption is that the Conduent multiple will re-rate to 10x 2018 PE once management lays out their multi-year roadmap for the business. 10x is a 4x discount to pure-play BPO peers and I think sufficiently accounts for the relatively lower growth + execution risk associated with the plan. This yields 25% upside from current levels assuming XRX Printing trades at 10x 2018 EPS (I explain why I think 10x for Printing makes sense below).

XRX will be hosting an analyst day sometime in mid-November this year to lay out the long term roadmap for both Conduent and XRX Printing, at which point I think people will realize how undervalued Conduent is and the stock should re-rate.

As mentioned earlier, the crux of the thesis lies with the Conduent business while the Printing business can be hedged with HPQ, but I lay out my valuation framework for both businesses below.

WHAT IS THE PRINTING BUSINESS WORTH?

XRX Printing fundamentals are not good, with revenues expected to decline in the low single digits (PF for the Document Outsourcing business which will become part of the Document Technology business) and earnings protected through cost cuts. HPQ is also talking about entering the A3 copy market where XRX is the dominant player, so that’s another potential headwind going forward. Nevertheless, there are multiple ways to think about valuation for the XRX Printing business that should give comfort that it’s not going down much from this level.

Method 1: Dividend Yield

XRX has a stated capital allocation plan of >50% of FCF in dividends + buyback, although they’ve been doing closer to 100%. Taking management’s stated $1.3b in normalized FCF for total XRX (Q4’15 earnings call), subtracting out $300m in FCF from Conduent for CY’15 leaves $1,000m in normalized FCF for XRX Printing. Given that ~60% of those cash flows will be domestic (my estimate based on PF geographic revenue break down), XRX Printing can still return 50%+ of FCF to shareholders through normal course of operations. The current dividend costs ~$325m/year and would imply a 3.5% dividend yield on XRX Printing assuming a 10x CY’18 EPS; 9x would imply 3.9%. HPQ trades at a 3.2% dividend yield.

Discussions with IR have been high level given they are still ironing out the details, but XRX Printing could conceivably turn into a yield co. and payout 100% of their FCF in dividends, which @ 10x CY’18 PE would imply a 5.1% yield.

This analysis suggests a 9-11x PE range on XRX Printing is reasonable, would imply 3.9% - 3.2% dividend yield.

Method 2: HPQ Comp / PE multiple

XRX Printing is a better business than HPQ given that XRX has no PC exposure and it has higher enterprise exposure on the printing side. HPQ trades at 9.5x FY’17 EPS which is roughly CY’17 (FYE October) and I think XRX Printing will re-rate to above HPQ’s level once the standalone story is laid out + capital allocation strategy is made clear during analyst day. There is no compelling reason why XRX should trade at a discount to HPQ. This sets a minimum 9.5x PE with room to expand beyond that.

Method 3: Terminal Value

Traditional printing industry is in secular decline, but there’s still value for a declining asset, especially one tied more to enterprise end markets which tend to be stickier. Assuming a 10% discount rate, -2% perpetuity growth, $1,000m uFCF = $8.2b enterprise value / 10x CY’18 Printing PE.

Based on these methods, I think it’s fair to assume XRX Printing is worth 9.5x-10x, which implies that Conduent is significantly undervalued.

WHAT IS THE CONDUENT BUSINESS WORTH?

Conduent fundamentals have been challenged for the last several years; the dream has been to expand EBIT margins to low double digits while growing topline high singles. The reality has been challenged growth and contracting margins. The most recent quarter saw revenues decline due to lost business from actions taken to improve profitability in under-performing areas, lower level of project work in litigation services offering, and FX.

However, refocus on higher profitability contracts is a positive longer term and Conduent actually saw an improvement in their operating profit dollars and margins sequentially from Q1 to Q2’16 as a result of cost actions they’ve been taking. I’ve spent a lot of time with IR trying to understand the issues plaguing the business + where we are in the revenue declines / profitability growth curve and feel that 2016 is likely to be the trough year.

Revenues

The key revenue headwinds for Conduent are 1) discontinuation of the Health Enterprise (HE) contracts in Montana and California, and 2) run-off of their Student Loans business.

HE write-off: Conduent took a restructuring charge in Q3’15 as they decided to stop development of the HE platform in Montana and California since they weren’t able to run it profitably; it’s been a 100bps headwind per quarter and will lap in Q3’16.

Student Loan business: this contract has been in run-off for several years and has been a <50bps headwind to growth; the contract is not profitable this year (I estimate a $30m loss) but is expected to be breakeven in 2017.

Normalized for the above headwinds, 1h’16 growth was ~0% cc vs. reported -2%. As we move into 2h’16, revenue dollars should be roughly flat at Q2’16 levels.

Margins

Although revenues have been challenged, margins and profitability in Q2’16 have improved. Management has indicated that we are still in the early days of reaping the benefits from cost cutting actions.

The biggest problem segment (aside from the “other” bucket which includes the HE contracts + student loans) is Commercial Industries where margins have been steadily declining. The primary service offering that is struggling in Commercial Industries is their customer care offering which is currently unprofitable and has been the primary cause for the margin declines over the last few years; XRX brought in new leadership at the beginning of the year to address these problems and it’s likely they lay out a longer term remediation plan on the analyst day. Customer Care in BPO is generally an easy process to execute and with a fully focused management team it’s likely to be quickly addressed. However, I have not been able to diligence this problem in depth since the company is waiting for analyst day to provide more detail.

In summary, I think revenues will stabilize at Q2’16 levels while profit dollars continue to grow. I think 2017 will be a no growth year but a profit expansion year as some of the headwinds subside + cost actions taken continue rippling through (I only assume ~$160m of cost savings in 2017, which is <3% of their total cost base). 2018 should be the first normalized year where growth can return with continued margin expansion. I’ve laid out my assumptions + disclosed financials below.

Conduent will lay out a long term plan during their analyst day in mid-November and I think my cut at the model will probably prove conservative.

PF for the spin, Conduent will be the largest publicly traded pure-play BPO company, with a new CEO (Ashok Vemuri who used to be the CEO of iGate which sold to CAP) who actually has real services experience / understands how to offshore.

Turning to valuation, I think there are several ways to win.

Scenario 1: Normal multiple re-rating

If they lay out a long term story that shows $0.35-$0.40 in 2018 EPS with modest revenue growth, I’d expect investors to focus on 2018 valuation metrics with some haircut to the multiple. Assuming 10x PE on Conduent (comps trade at 14x), XRX stock is worth $12.50 today, 25% upside. Assuming a 14x multiple, the stock is worth $14 / 40% upside. This is the most straightforward case for the re-rating and it’s my base case.

Scenario 2: M&A

I think the odds of M&A are very high. There are several targets that would make sense and all of them would create significant shareholder value. The two highest probability candidates in my mind are Genpact and Syntel.

Genpact: is currently the largest publicly traded pure play BPO company with core BPO growth in the low double digits and mid teens EBIT margins. An RMT with Conduent would send G stock up 40%+ and the implied value of XRX shares would be $16 / 60% upside from today.

Bain Capital owns 28% of G + Icahn on the XRX board means if they think there’s value to be unlocked here, they will probably have discussions once the tax timing schedule permits. If a transaction takes place, I think it happens before year end.

Syntel: focuses on IT outsourcing and the general industry view is BPO + ITO is a more competitive offering for the purposes of vendor consolidation when bidding for new contracts. SYNT randomly announced a $15 special dividend (stock price is $41 and trades at 10x PF for the special dividend – I will write this up as a long in the next week) which makes the acquisition more digestible. I think a $3b price tag on SYNT is reasonable, which Conduent would have to lever up <3.5x on a PF basis to do; SYNT’s margins are 25%+ so the deal would be extremely accretive. Finally, SYNT would bring a lot of the offshoring capabilities / infrastructure and could accelerate Conduent’s offshoring efforts. Value to XRX shareholders would be ~$15 / 50% upside. I think a transaction is possible in December / January timeframe.

What’s the downside?

I think there is limited to no downside owning XRX @ $10.03. Assuming Conduent is unable to grow earnings from this level (i.e. has $0.18 earnings in 2018) and trades at 10x PE and the Printing business trades at 9x, that would imply a $9.80 XRX stock or 2% downside.

Key Risks / Pushback

This “new” strategy for XRX is the same as the old strategy they’ve been trying to execute for the last several years, so why buy into the same thesis that has burned investors in the past? The key differences are that 1) with the split, the mgmt. teams will be more focused on their respective businesses and their compensation packages will be tied to KPIs relevant to their respective industries, and 2) Icahn on the board means there will be a heightened level of focus on shareholder value creation relative to the past.

The bigger risk is around the printing business and if those revenue declines continue but are not offset through cost cuts. I don’t have any real mitigating points to this concern as the real upside lies in the value of the Conduent business and would hedge out the risk on the printing side by being short HPQ.

Catalyst

Analyst day in mid November 2016

Spin of Conduent by calendar year end

Potential M&A on the services side by year end / early next year