Don't Give Up On Office Stocks Just Yet
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When stocks crash, the easy decision to make is to get out. But sometimes buying when there's "blood on the Streets" can bring massive returns. In my view, investors would do well in this strategy if they diversify across several takeover/turnaround plays. In particular, they need to look at free cash flow and the growth trajectory. If there is a secular transition against the business fundamentals, avoid. If it's just in a cyclical decline, and especially if it still has a high FCF yield, buy. Below, I review several producers in the falling office market.
Pitney Bowes (NYSE: PBI): A Downside Story
The office equipment maker--producer of such goods and services as software, customer credit controls, and basic equipment--has been on a roll down the hill. It has gone down and down over the years--71.4% in the last 5 years and 41.2% in the year to date. It now trades at a respective 6x and 5.8x past and forward earnings while offering a 13.8% dividend yield. But analysts are expecting long-term growth erosion, so it looks like a "loser." In my view, it's either takeover or bust.
The company was recently downgraded by Moody's--putting it yet closer to the "junk" category. A weak global mailing environment, which is reflected in declining volume of traditional mail, has exposed the business's weak fundamentals. While I am optimistic about the company's partnership with eBay to provide global tracking and duty rates, this alone won't change the trajectory of the business. In the second quarter, management slightly beat expectations, with equipment sales "only" falling 7.4% y-o-y. And while the company anticipates the enterprise segment moderating its decline, the absence of shareholder repurchases is disconcerting. If management doesn't believe in the business, then who should be expected to? Well, the business is highly leveraged, so it has little options. There is $3.7 billion worth of debt and only $461 million worth of cash on the balance sheet. A leveraged recapitalization should not be pursued, because it is a deterrent against a takeover, which limits downside.
The shorts currently cover 29.5% of the float, so the market is placing a bet of "unconfidence" on the firm. As free cash flow declines, the company's ability to continue increasing its dividend, which it has for three decades, will become increasingly compromised. I strongly recommend avoiding this downside story.
While the office equipment industry is in a decline, it's obviously not going to implode. A more likely takeover target would be either Xerox or Staples. Both are valuable brand names that are being, in my view, overly depressed by the poor business environment. Xerox trades very attractively at 7.3x past earnings and 35% under book value, and provides compelling ways to pay off the debt from an acquisition. It generates substantial free cash flow, for one. For the twelve trailing months ending 3Q12, $1.7 billion was generated--a 20.7% yield! Second, the balance sheet, growth prospects ahead will be enough to cover.
While the decision to cut guidance yet again is disappointing, management still decided to hike the dividend 35% and the add $1 billion to the shear repurchase program. So, in terms of risk/reward, I would say the downside is dwarfed by reward.
But, of course, downside is pretty big, and these kind of investments are best when you invest in a basket of turnaround/takeover plays. That is why I also encourage an investment in Staples, which is cheap at 10.7x free cans flow plus a 3.7% dividend yield. Analysts forecast EPS growing by 8.9% over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $1.82. At a multiple of 13x, this translates to a future stock price of $23.66. Discounting backwards by 10% yields a price target of $14.69--around a 25% premium to the current market cap. Even, UBS, which rated the stock "neutral", upped its price target from $11 to $12. For this reason, I encourage buying shares.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Staples. Motley Fool newsletter services recommend Staples. 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!