Surprising Takeover Targets, Undervalued Stocks

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Office equipment producers have been in for a rough ride in 2012. At a time when the Dow Jones index is up 10.2%, Pitney Bowes (NYSE: PBI), Xerox (NYSE: XRX), and Hewlett-Packard (NYSE: HPQ) have lost 25%, 8%, and 35% of value, respectively. This has overly discounted the sector and will encourage takeover activity from suitors hunting for strong margins of safety.

Pitney Bowes & Xerox

Over the last 5 years, the equipment install base has been on an accelerated decline. If you adjust this base to not include production paints, the story becomes even worse. Magnified by slower growth and a weaker earnings profile, Pitney appears to be in a decidedly weak cyclical phase. Continued declines in first class mail, weak consumer confidence, and macro uncertainty add to the list of woes.

With that said the market has overblown these headwinds. Assuming a 2% per annum decline in revenue and 1.5% growth into perpetuity, consistent operating metrics, and a 10% discount rate, the stock's intrinsic value is $20.73. With the stock currently worth just short of $14, Pitney is substantially undervalued according to my calculation and thus attractive to a suitor looking to unlock value.

Like Pitney, Xerox is an ideal takeover target in the overly discounted office equipment space. I believe the stock is better positioned for a turnaround due to promising efficiency opportunities and operating leverage from services revenue. After the integration of ACS, Xerox will be focusing on meeting the pent-up demand after quarters of weak business. Net margins have trended upwards while the tax rate stays below the high 31.1% 2010 level. While growth in the legacy business has become a bore with expectations for a 4% decline this year, other segments, save ACS, aren't doing particularly better. This makes Xerox a perfect play to strip off underperforming assets to businesses who could better use them. I recommend buying off of this takeover speculation.

Hewlett-Packard

Like Pitney and Xerox, HP may some day be an ideal takeover. For now, however, there is too much uncertainty surrounding the PC business that suitors are, at best, "on the hold." That is not to say the stock is overvalued; in fact, I think just the opposite.

HP is a free cash flow machine. In my DCF model, I assume just 0.5% per annum EPS growth over the next six years and 1% into perpetuity, consistent operating metrics, and a 10% dividend yield. Based on these inputs, I find the intrinsic value of the stock is just north of $42. That makes HP a substantially undervalued stock. With $8.1 billion in FCF generated last year, HP trades at an extremely low multiple that warrants a significant market correction. Perhaps if the business sold off some of its assets and restructured operations, investors would become aware that the parts are much better than what the macro environment suggests.

Value investors would do well keeping in mind that HP was challenged by unusually low demand in PCs, severs, and printers. This, however, has already been expressed in the low PE multiple, which is well below historical levels. As the economy starts to pick up, investors will be more willing to back riskier firms. After the Autonomy acquisition, HP lacks the cash necessary to pursue accretive takeover activity like it could in the recent past. JPMorgan still forecasts free cash flow heading from $6.6 billion in 2012 to $6.7 billion in 2013, which means that shareholders can get all of what they paid for in less than 5 years. If you can run a profitable brand-name enterprise thereafter and collect the dividends, you have yourself a good investment. Accordingly, I recommend backing HP.


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