Xerox Shows Not All Growth Generates Value
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Xerox (NYSE: XRX), much like other large cap players in the business solutions industry, is a historically bulky corporation that has spent the past several years making meaningful, although rather under-the-radar, changes to its core operations. Similar to industry peers including Canon (NYSE: CAJ), HP (NYSE: HPQ), and IBM (NYSE: IBM), Xerox has spent a considerable amount of effort (and money, of course) in gradually shifting its top line’s reliance on increasingly commoditized business equipment sales. In their place, the corporation has infused higher margin and portfolio-diversifying service revenue streams, most of which are recurring in nature.
Despite the meaningful shift in business strategies and its impressive comeback from mid-recession 2009 lows – 2011 revenues were nearly 50% greater than the 2009 level – Xerox still sells at extremely conservative valuations. Investors locking in at current prices (around $7.60 per share) are paying a mere 6.2x next year’s average earnings estimates and 84% of the company’s patent-laden book.
Is the corporation a screaming buy, however? There’s several key reasons why Xerox, even at current valuations, is not the most attractive pick in the business solutions sector.
Growth Through Acquisition
The corporation’s shift into more service-oriented offerings was conducted, as one would expect, through a long-term series of inorganic business acquisition. Over the past five years (2007-2011), Xerox’s top line has grown more than 30% to $22.6 billion in 2011, and higher margin service work has made an increasing contribution to the total pie. Services, which have a ten-year gross margin average of more than 550 basis points greater than gross margins on business equipment sales, represented 66% of sales in 2011, which is up from 48% in 2007.
Despite the improvement in top line, however, the corporation is hardly any more profitable. In terms of Xerox’s return on core operating assets, the company’s profitability has been extremely diluted by acquisition-driven goodwill balance growth.
- 2011 Post Tax Operating Income: $1.18 billion
- Net Operating Assets Average (2010-2011) see footnote for methodology: $20.00 billion
- Return on Net Operating Assets: 9.5%
- 2007 Post Tax Operating Income: $1.04 billion
- Net Operating Asset Average (2006-2007): $13.82 billion
- Return on Net Operating Assets: 13.2%
Despite the similar post tax operating incomes generated in 2007 and 2011, the corporation’s acquisitions are continually diluting Xerox’s overall return. The likely driver behind the reduced profitability is that Xerox is paying too much for the acquisition-fueled growth. Such a mistake is easily made, especially when purchasing service-based companies that are patent holders and are loaded with intangible assets. In such cases, the purchase price is, well, whatever the acquirer is willing to pay to continue posting top line gains. Xerox has spent nearly half of the free cash it has generated over the past five years on acquisitions, and its goodwill balance has doubled 1.5x over the same period. Top line growth is one of the drivers of profitability, but is by no means the sole driver.
On a side note, Xerox actually calls these business purchases “tuck in” acquisitions, as if, unlike other serial acquirers, Xerox has the uncanny ability to purchase billions of dollars worth of smaller businesses every year and efficiently incorporate their operations with minimal waste. This is much easier said than done, and the corporation’s profitability – which essentially covers its cost of capital requirements – is adequate proof.
Bulging Debt Burden
Xerox does not have the most attractive balance sheet, and the continuous purchase of businesses to drive top line growth has placed an unattractively large debt burden on the corporation. Total debt (both short and long term borrowings) as well as the corporation’s underfunded pension obligations have surged more than 20% over the past 5 years to more than $12 billion in the most recent quarter.
The $4.2 billion in debt maturity between the four years ending 2015 will end up eating a significant portion of Xerox’s free cash flow generation – average free cash flow per year over the past five years has been around $1.7 billion. Total debt load, therefore, is unlikely to see meaningful decreases anytime soon. Likewise, with the added pressure of the corporation’s acquisition “responsibilities,” there is little room left for the more shareholder friendly share repurchases. The purchase of $700+ million of stock in 2011 may have been a good use of free cash, as Xerox market valuations are at depressed levels historically, yet when compared to total share dilution from new issuances over the past five years, the repurchase represents a very minor value creation activity.
Xerox, as have other peers in the business solutions industry, has made significant progress in shifting its operations towards more service-oriented – and therefore higher margin and portfolio diversifying – offerings, yet leaves investors very little to get excited about over the next several quarters. Although natural market forces may tend to elevate the corporation’s market valuation back to historic levels over the long run (current TTM P/E of 8.32x compares with historic average between Q1 2005 and Q4 2008 of 14.39x) there are no meaningful catalysts with a known time frame that will act to influence Xerox over the mid-term.
Continued top line growth, especially when at the expense of overall return on core operating assets, will not lead investors to pay more per each unit of Xerox earnings. Robust bottom line growth, which will require the corporation to become a much more efficient acquirer and halt its recurring restructuring charges, will be the natural driver behind stock appreciation – not P/E expansion. As such, Xerox stock will remain relatively dead money for the foreseeable future.
Net Operating Assets = (Total Assets – Financial Assets) – (Total Liabilities – Financial Liabilities). Return on Net Operating Assets = (Post Tax Operating Income/Average Net Operating Assets in Year)
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