There Are Better Alternatives to This Business Machines Company

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The name Xerox (NYSE: XRX) has become synonymous with the copier business, with many office workers using phrases such as “I need to go Xerox these reports,” regardless of what company actually manufactured that particular copier. Xerox currently trades at a seemingly low valuation, pays a nice dividend, and is one of the market leaders. Is Xerox one of the few remaining bargains in the markets, or is it a trap that should be avoided? Are any of the other major competitors a better investment?

Xerox in a nutshell

Xerox is a leading manufacturer of not only copiers, but printers, fax machines, and multifunction units as well. The company operates in more than 160 countries, but still derives the bulk of its revenue (64%) from the U.S. 

What I was surprised to find out during the course of researching Xerox was that only 42% of the company’s revenue comes from sales of their machines. The majority of Xerox’s revenue comes from its Services segment, which consists of business process outsourcing, document outsourcing, and information technology outsourcing. 

Looks cheap…

At just 8.3 times the current fiscal year’s expected earnings, Xerox looks to be very cheap. The company also pays a 2.5% dividend yield, which the company has never reduced since it began paying dividends in 2008. Xerox is also trading at a steep discount to its historical average P/E ratio, which is closer to 14 times earnings.

…but it’s not

Don’t be fooled by that quick glance at the number. The printing/copying business has many challenges ahead of it, such as low margins, low spending, and longer product lifespans. Xerox’s operating margins narrowed significantly in 2012 and are projected to do the same this year. While Xerox is anticipating its revenues to shift more towards services over the next few years, this aspect of the business comes with lower margins than selling equipment. 

When the recession hit a few years ago, most enterprises and governments (including the U.S. Government) drastically cut IT spending, and it is yet to fully recover. This is especially the case for the U.S. Government, who seems to be stuck in a constant “budget mess,” and has effectively frozen spending on new equipment, and who was (at one point) one of Xerox’s best customers.

This also is an example of my point of longer product lifespans as mentioned above. While many customers are using their copiers and printers longer than they were in the past due to financial concerns, some are holding on to their equipment for another reason entirely. Quite frankly, there seems to be a general lack of innovation over the past decade or so in the printing and copying business. The HP Photosmart printer sitting next to me is four years old and in my opinion at least, is not significantly different from the current model. 

Alternatives: Canon and Hewlett-Packard

Canon (NYSE: CAJ) may be a slightly better option due to its more diverse product portfolio and higher yield, but not by much. In addition to business machines, Canon makes one of the most successful lines of digital cameras and their accessories, which initially took a big hit sales-wise when smartphone use became widespread, but are starting to make a comeback due to innovation and evolution of their product lines. In other words, as long as their cameras are significantly better than those that are built into smartphones, Canon’s camera business will indeed be viable. So far they are succeeding…

Canon trades for a slightly higher P/E of 14 times current year earnings, but consider that Canon is a very well capitalized company with about $8 billion in cash and virtually no long-term debt. Compare this with Xerox, which has over $6 billion in net debt (cash minus debt), and it’s easy to understand why Canon might be a more viable long-term investment. In addition, Canon pays a significantly higher 4.27% dividend yield, and is trading well below its 52-week high right now.

Hewlett-Packard (NYSE: HPQ) is in the middle of a turnaround effort, which has been successful so far.  As a result, shares have more than doubled from their lows of late last year. HP is a leader in PCs as well as printers and copiers, and there is some concern amongst investors about the PC business losing market share to tablets in addition to the concerns about weak printer sales. HP is trading at just 6.9 times fiscal year 2013’s projected earnings, however the company’s earnings are expected to be flat for the next few years, as a true turnaround in the company’s enterprise, printing, and servers and storage technology are expected to take a few years to have any measurable effect on the company’s bottom line.

Conclusion

As far as long-term investments, HP could certainly end up producing the best returns for shareholders if their turnaround efforts are successful. However, at this stage in the game that is a big “if,” and I’m not sure if I want to gamble on it at this point, especially after the recent gains in share price. Xerox is a “stay away” as it possesses a lot of red flags such as very high debt load, declining margins, and flat to declining revenues. Canon looks like the best of the three right now, with an excellent balance sheet and their camera business, the only product line of all three companies that is currently experiencing true innovation and evolution.

 


Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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