Description

We believe that Xerox (XRX) is a short for several reason:

• Terminal declining industry and even losing share in that industry
• Levered capital structure with increasing cost of capital and hidden liabilities
• More expensive than appears due to overstated FCF from receivables financing
• Poor capital allocation / corporate governance with Icahn greenmail exit

Xerox has been written up multiple times on VIC so we will refer to those write-ups for the company history, detailed business description and corporate timeline including the buying of assets (ACS), the sale/spin of some of those same services assets (Conduent) and other background:

https://www.valueinvestorsclub.com/idea/XEROX_CORP/5196080552

https://www.valueinvestorsclub.com/idea/XEROX_CORP/5611604745

https://www.valueinvestorsclub.com/idea/XEROX_CORP/9267018582

https://www.valueinvestorsclub.com/idea/Xerox_Corporation/8694670737

Terminal declining industry and even losing share in that industry

Xerox today is rather simple:  they sell printers, copiers and ink ($6.5 billion in revenues) and they finance them ($400 million in revenues).  While the company does have a very rich technological history, this is about as boring and unfortunately secularly declining as you get.   As you can imagine, printers are not a growing industry, despite a COVID bump from work-from-home office set-ups:

Going forward, we think the digital shift away from paper/printers will accelerate drastically across different price points, as can be seen in CTO surveys and paper demand:

Even in this dismal market, Xerox is worse positioned than peers like Canon and Fujitsu that are growing modestly:

Levered capital structure with increasing cost of capital and hidden liabilities

Xerox is heavily levered with $4.0 billion in gross debt and convertible preferred stock outstanding, with most of the debt with interest rates that do not reflect its poor credit and today’s rate environment.  The company does allocate a large portion of its debt to its financing business, but as we will discuss later, the finance assets are likely to shrink while we do not believe there is sufficient FCF to pay down the debt and maintain the current dividend.

In addition, the company’s recent capital markets activity demonstrates its increasing cost of capital.  Xerox had two bonds coming due in 2024 and 2025 with 3.8% and 5% coupons and have to redeem these with new debt at 8.875% and 3.75% convertible debt with a strike price at $20.  The result is that the company has $20 million in additional interest expense while diluting shareholders and capping the equity upside.  We believe that this will continue with the 2028 and 2029 maturities, especially as the business continues to decline and FCF weakens on a normalized basis (more later)

More expensive than appears due to overstated FCF from receivables financing

The bull case on XRX has always been “its cheap” and “its not as bad as people think.”  We don’t think the stock is cheap on a normalized basis.  While the company is guiding to “free cash flow of at least $600 million” we believe this number is artificially high due to financing asset sales included in CFFO as part of its funding agreement with a private credit firm called HPS. 

https://www.news.xerox.com/news/xerox-announces-entry-into-forward-funding-solution-with-peac-solutions-to-drive-continued-growth-of-fittle-financing-business

We believe that this makes up something like $200 million or more of estimated FCF guidance for 2024.  It is a far greater number of actual CFFO / FCF in 2023 but we cannot estimate the exact amount in 2024 guidance because management does not explicitly highlight the figure.  Excluding this financing, we believe that the company cannot fund its $1/share dividend and this gets even worse as the core printing business declines further. 

Poor capital allocation / corporate governance with Icahn greenmail exit

Lastly, we think pretty poorly of management, though we acknowledge that part of their problem was the business they inherited.  Still, throughout the past two decades over different management teams, the company has continued bought the wrong assets too high, sold/spun them too low, mismanaged their capital market requirements and even when they were getting pushed around by Carl Icahn, bought his shares out in a debt financed greenmail transaction at $16 per share:

https://www.sec.gov/Archives/edgar/data/108772/000119312523244902/d546628dex991.htm

Now you can short XRX at a higher price ($17) then where Icahn exited ($15.84).

Additional detail:

Customer Financing (FITTLE)

We finance a large portion of our direct channel customer purchases of Xerox equipment through bundled lease agreements. We also provide lease financing to end-user customers who purchase Xerox equipment and solutions through our indirect channels. We compete with other third-party leasing companies and financial institutions with respect to the lease financing provided to these end-user customers. In both instances, financing facilitates customer acquisition of Xerox technology and enhances our value proposition, while providing Xerox a reasonable return on our investment in this business.

Because our lease contracts allow customers to pay for equipment over time rather than upfront upon installation, we maintain a certain level of debt to support our investment in these lease contracts. We fund our customer financing activity through a combination of cash generated from operations, cash on hand and proceeds from capital market offerings as well as secured borrowing arrangements and sales of receivables. At December 31, 2023, we had approximately $2.5 billion of finance receivables and $265 million of Equipment on operating leases, net, or Total Finance assets of approximately $2.8 billion. We maintain an assumed 7:1 leverage ratio of debt to equity as compared to our Finance assets, which results in approximately $2.4 billion of our $3.3 billion of debt being allocated to our financing business.

In December 2022, the Company entered into a finance receivables funding agreement with an affiliate of HPS Investment Partners (HPS) pursuant to which the Company agreed to offer for sale, and HPS agreed to purchase, certain eligible pools of finance receivables on a monthly basis in transactions structured as "true sales at law" and bankruptcy remote transfers. Accordingly, the receivables sold were derecognized from our financial statements and HPS does not have recourse back to the Company for uncollectible receivables. During the second quarter 2023, the finance receivables funding agreement with HPS was amended to expand the pools of finance receivables eligible for sale to include the sale of the underlying leased equipment to HPS. The effect of these transactions has accordingly reduced financing debt as funding for certain new finance receivable originations is through the direct sale to HPS.

Disclaimer:  I, my firm, or my firm’s clients may have a position (long or short) in the securities discussed herein and may change such position without further notice.  This is not a recommendation to buy or sell any security.

Catalyst

Dividend cut

Investor recognition of true FCF / finance asset sale impact to FCF

Further business deterioration