Description

Investment Overview/Background

Xerox operates two segments: Services and Document Technology. The Services segment is a broad designation that includes managed print services, consulting, managed IT, and government services. Document Technology includes the sale of products and supplies, mainly printers. The Document Technology business is declining in the mid-single digits on a constant currency basis and Services is growing in the low single digits, but has been promised to grow much better soon.

There are several parts to a short thesis of Xerox. First, margins will continue to contract as the higher margin document technology segment erodes. Second, these margins could be under even more pressure if a price war erupts. These two factors coupled with aggressive accounting tactics and failed promises lead me to believe shares of Xerox could fall by more than 40%, while upside is limited due to the stretched valuations of a declining business.

Management

Management of Xerox is one of the best paid teams in the industry despite delivering sub-par results for over a decade. In press releases and conference calls the company is focused on share buybacks, good acquisitions and growing adjusted EPS. These goals sound good on the surface and, in theory, align shareholders with management. Xerox’s team routinely changes the goal posts and massages accounting to get the maximum incentives despite failing to actual grow the business.  The inputs to management’s incentive comps can be seen in Table 1 below.

Table. 1 Incentive Comp Metrics for Management Source: Xerox proxy statements

There is a very clear shift to Adjusted EPS and constant currency revenue growth, while a move away from operating cash flow. Interestingly, the company sold large blocks of finance receivables in 2012/2013. These sales were booked through operating cash flow, providing a one-time boost to operating cash flow. These boosts allowed management to hit their incentive targets. Once these temporary boosts wore off (in 2014), operating cash flow was weighted less in incentive compensation. Xerox estimated that operating cash flow was $580 million higher in 2012 due to finance receivable sales.  In 2014, these sales were an estimated drag of $433 million. 

The decline in operating cash flow is more than management even reports. Xerox capitalizes a number of items that, in my opinion, should be expensed. For example, amortization of internal use software has kicked back $390 million to cash flow from operations since 2012.

Besides moving the goal posts, management seems to be engaged in near endless restructurings. Since 2005 Xerox has booked more than $1.4 billion for costs related to restructurings. Meanwhile employment has gone up and revenue per employee has steadily fallen.

Table 2. Restructuring of Xerox Source: Company Filings

While it is speculation on my behalf, it seems likely that there are a number of real costs embedded in the various charges that Xerox adds back to their adjusted numbers. Regardless of intent, it appears the company is in a state of perpetual restructuring and ignoring these costs is short-sighted.

Management has reported operating margins in excess of 9.0% in the last three years. However, on a pre-tax GAAP basis, margins have held steady at 6.3-6.2% and overall pre-tax profit has declined. The table below shows this trend.

Table 3. Pre-tax Profit to Operating Profit Source: 2014 10K

The near constant spend on acquisitions (allowing for amortization of intangibles), restructurings, and amortization of internally used software has allowed the company to report better numbers than reality would allow. Acquisitions, internal software, and restructurings are simply a cost of doing business for Xerox and management should report these as real costs.

Price War Looming?

None of the accounting shenigans are new though, nor are they significantly different from a vast majority of public companies. What makes Xerox an interesting short is the likelihood of history rhyming. Xerox is one of the few printer manufacturers not located in Japan. During periods of yen depreciation they are at a disadvantage to companies like Epson, Brother, and Canon, all of whom have manufacturing costs primarily set in yen. It seems logical to believe that if the yen depreciates, the Japanese competitors can drop prices while keeping yen based prices/margins the same.

During a Xerox earnings call on January 30, 2015, Ben Reitzes from Barclays (the only sell-side analyst that asks hard questions on the XRX calls) asked management if management was “seeing price competition from Japan based competitors”. Management responded that they “haven’t seen any meaningful change overall.” This statement was rather broad and at odds with Hewlett Packard’s assessment of the market only 25 days later.

“Aggressive pricing from our Japanese competitors in the printing business, given the weakness of the yen, was a continued challenge.” Meg Whitman Q1 2015 HPQ earnings call, Feb 24, 2015

And…

“The weaker yen helps the cost side of our business, but it allows to our Japanese competitors to price much more aggressively.” – Cathie Lesjak Q1 2015 HPQ call, Feb 24, 2015

Apparently, the pricing of printers became extremely aggressive over the course of 3.5 weeks. Interestingly enough, Ben Reitzes was not on the Q1 2015 Xerox earnings call. While it is speculation why he was not on the call, it seems odd that the only analyst to ask about the yen’s impact on previous calls was not asking questions when the yen actually impacted results.

I believe that management of Xerox is refusing to acknowledge the impact in any concrete terms, instead referring to pricing pressure as normal and within normal historical ranges. While this may be true, it’s hardly honest.  Looking at the Japanese competitors, most maintain that pricing is expected to be stable. Interestingly enough though, they all seem to expect plenty of unit growth. Epson expects a 4% YoY rise in printer revenue during 2015. Canon expects similar results with yen-based 2015 printer sales increasing by 2.5%, while local currency base sales decreasing by 6.2% (higher than Xerox’s estimated Document Technology revenue decline).

Investors can use history as a guide in this case. During 2001/2002 there was a price war following another period of yen depreciation. One media report summed it up:

“Certainly fierce price wars have erupted lately among printer vendors. Data compiled by NPD Intelect and augmented by Salomon Smith Barney show that average prices for retail inkjets from printer companies including HP, Xerox, Lexmark, Epson, and Canon, fell almost 9.6 percent during December, while black-and-white laser printer prices dropped 10.3 percent.” Sergio Non CNET Article Published Feb 8, 2002

After adjusting for the sale of the ITO business in Dec 2014, Document Technology generated segment margins of 11.1% in Q1 2015(which as explained in a previous segment, is goosed due to management one-offs). A 10% hit to prices would obviously have a compounding effect on operating margin and free cash flow. Longer-term, the prices would dent annuity revenue that is received from financing customer purchases. In other words, low prices may not show up 100% tomorrow but they will hurt far longer than management has let on.  

Valuation

There are several ways to determine that Xerox is overvalued. Given the perpetual nature of certain expenses, I believe that GAAP EPS does a decent job of approximating the profitability of the business. As a whole, the business is declining and there is little reason to place a premium multiple on the business. Management has guided for 2015 GAAP EPS of $0.77-$0.83. I believe a 7-10x EPS multiple is appropriate, and perhaps overly-optimistic for bulls, given the leverage profile, declining cash flows, and overall quality of business.

GAAP EPS target: $5.39-$8.30 - Midpoint of $6.84

Digging into the company to determine free cash flow is helpful as well. To further augment the thesis that Xerox is overvalued, the table below shows my estimate for free cash flow in 2015 based on internal estimates and management guidance.  

Table 4. FCF Calculation in Millions. Source: Author's estimates and company guidance

I believe the numbers above are conservative because they assume that several costs (impairment and restructurings) are added back as management prefers. Deducting these charges would reduce FCF by more than $100 million. As I stated earlier, I believe many of these charges are the cost of doing business for Xerox, but I will err on the side of caution. I did not add back share compensation because I believe this is simply regular compensation for management and the share repurchases are simply the cash component of that.

By my estimates, a true proxy for FCF/share in 2015 is $0.58-$0.78. This figure factors in share repurchases and acquisitions.  The Bull scenario is the only scenario where revenue grows and this seems unlikely. Applying a 7-12x multiple gives us a fair value range of:

FCF Valuation: $9.36-4.06 Midpoint of $6.71

In order to conclude that Xerox is fairly valued or undervalued, an investor would need to assume that the business deserves a very healthy multiple. On a GAAP EPS basis, Xerox is valued at 14x 2015 earnings, and 11.7x adjusted EPS. Management estimates that free cash flow in 2015 will come in at $1.3-$1.5 billion, or roughly $1.23-$1.42/share (after factoring in buybacks). This figure ignores numerous costs and continues to decline - even their provided guidance should be given a haircut and a lower multiple.

Finally, I included average acquisition(past 3 years) spend to show how much the company spends each year on purchasing other companies. The company expects to spend $900 million in 2015. I do not hold out much hope for these acquisitions. Margins have decreased, revenues have declined, and free cash flow continues to decline. By any tangible metric, past acquisitions have proven to be poor capital allocation decisions and simply mask the declining core business. The table below shows the acquired companies contributions to revenue.

Table 5. Revenue from Acquisitions Source: 2014 XRX Annual Report

In this declining business, where every dollar counts, acquisition spend is being used to help stabilize the business and report better optics. A true FCF figure would deduct acquisition spend to determine the actual FCF being generated by the core business.

To conclude the valuation segment, I believe there is limited upside to shares of Xerox and the potential for more than 40% downside. If a price war breaks out and erodes margins, my bearish scenario in Table 4 could be a reasonable value. Given the facts at hand, I believe shares of Xerox are worth $6.77, the mid-point of my base scenario and my GAAP EPS valuation.

Risks

Xerox is hardly the only company using aggressive accounting to hit metrics. The game can continue on for a lot longer than anyone believes. They may be able to cut costs quickly, thus declines can continue on for several years while profitability is maintained.

With HPQ spinning off a portion of their business, perhaps the urge to consolidate the business picks up. Activists seem to know everything these days. Given the size and global complexity, it seems unlikely that a large merger could take place, but with such loose credit flowing in the markets today, anything is possible.

Finally, the price war may never unfold in spectacular fashion if Japanese competitors decide to keep prices high, or if the yen rebounds. I believe Japan’s government is determined to weaken the yen over the long-term, but that is just an educated guess.

Conclusion

At current prices the market is not factoring in Xerox’s declining cash flows and sub-par capital allocation. Even worse, the company may face a price war in their most profitable division due to yen depreciation. Through the utilization of aggressive accounting tactics, constant one-off charges, and the perception of shareholder friendliness, Xerox bulls believe the company has turned the corner and will emerge as a services business. The promise for higher margins in the services division has proved elusive and ultimately, may be overstated. I believe shares of Xerox are worth $6.77, implying more than 40% downside from today’s price of $11.50. 

Catalyst

Price war 

Continued decline in earnings