This Stock Is No Bargain

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

In a world where hot stocks like Tesla get most of the attention, the dinosaurs of the stock market often get overlooked. People hear the name Xerox (NYSE: XRX), known for its ubiquitous photocopiers, which were all the rage 20-30 years ago, and they assume that the company is a dusty old has-been that should have gone bankrupt a long time ago. But here's what you see if you go to Xerox's website:

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It seems that Xerox hasn't simply been going down with the photocopying ship but has transformed itself into a services company. Here is what some of Xerox's services achieve for its customers:

  • Processes 900 million insurance claims per year
  • Manages benefits for over 11 million employees
  • Answers 1.6 million customer interactions per day
  • Collects 37 billion annual transit fares per year

Xerox is in the business of supporting other businesses, and this shift into services is paying off. In 2012 a full 52% of revenue came from services, while the rest came from the legacy copying and printing business. The company signed new contracts worth $2 billion in revenue in 2012 while winning 85% of those up for renewal, and Xerox believes that it can achieve considerable growth going forward.

It was easy to miss this shift since Xerox is considered by many to be a boring company, but it looks like some exciting things are happening. The legacy businesses are certainly in decline, but growth in services is picking up much of the slack. Total revenue did decline a bit in 2012, but services revenue increased by 6.4% year-over-year. What's more, 84% of the company's revenue is annuity based, which means that the company's results should be fairly stable going forward.

An improving picture

Xerox faced tough times in the early 2000's, with bankruptcy rumors swirling. Today the company is in a far better financial position, but the stock price is at about the same level, under $10 per share. It seems that the market is still pessimistic when it comes to Xerox, but is this justified? Is there any chance of a Xerox bankruptcy in the near future? To answer that question I'll calculate the Altman Z-Score.

The Altman Z-score is a formula that combines a series of ratios involving items from a company's financial statements and results in a single number. If this number is below 1.81 then the company is considered distressed and has a high likelihood of bankruptcy within two years' time. I won't go into the details here, but this is how the Z-score has changed over the past 5 years:

<table> <thead> <tr><th><strong>Year</strong></th><th><strong>Z-Score</strong></th></tr> </thead> <tbody> <tr> <td>2012</td> <td>1.78</td> </tr> <tr> <td>2011</td> <td>1.66</td> </tr> <tr> <td>2010</td> <td>1.05</td> </tr> <tr> <td>2009</td> <td>1.58</td> </tr> <tr> <td>2008</td> <td>1.67</td> </tr> </tbody> </table>

Xerox is just barely in the distressed zone, but its Z-score has been improving. So while Xerox's financial position is a bit tenuous the trend is in the right direction.

Significant debt

Xerox has quite a bit of debt on the books. At the end of Q1 total debt sat at $8.54 billion with an additional $3.77 billion in pension obligations, which I generally count as debt-like. The company does have about $1 billion in cash, putting the net debt at $11.31 billion. This works out to $8.84 per share of net debt.

Xerox has managed to greatly reduce its annual interest payments over the last few years. In 2010 Xerox paid $592 million in interest, while in 2012 that number has dropped to $198 million. This drop in interest expense is one of the reasons why the net income jumped so much between 2010 and 2012.

More profitable than it appears

Net income in 2012 was $1.195 billion, or $0.88 per share. But this number actually understates Xerox's true cash profits. A better number to look at is the owner earnings, a variation of the free cash flow. Owner earnings for 2012 came in at $1.88 billion, or $1.42 per share, significantly higher than net income.

The stock currently trades for about $9.80 per share, and adding to this the net debt the P/OE ratio sits at about 13. So Xerox is not an outrageous bargain, but it's certainly not expensive either.

I'll do a simple discounted cash flow calculation to estimate the fair value of Xerox. I'll assume that owner earnings grow at just 3% per year, a rate which may end up being optimistic given the declining legacy businesses or pessimistic given the growing service business. For a discount rate I'll use both 12% and 15% and use them to define a fair value range. Using the above parameters and adjusting for the net debt I arrive at a fair value range for a share of Xerox of $3.35 - $7.41.

Currently the stock is overvalued if earnings growth is only 3% going forward. Analysts expect earnings to grow at closer to 6% annually, so if I assume that rate for the next 10 years and 3% after that the fair value range grows to $5.88 - $11.15.

The best case scenario is that Xerox is fairly valued today, and depending on earnings growth the stock could very well be significantly overvalued. The massive level of debt is the real killer here.

Cheaper than the competition

Getting into the business outsourcing business has put Xerox in competition with companies like International Business Machines (NYSE: IBM) and Accenture (NYSE: ACN). IBM has had its own share of troubles recently. Revenue declined in 2012 and again in the first quarter of 2013, leading the company to announce in April that it would begin laying off some employees. These layoffs started in June and are expected to reduce the headcount by between six and eight thousand. In addition CEO Virgina Rometty delivered a company-wide reprimand to employees in the form of a five-minute video after poor first quarter earnings.

IBM also has significant debt and pension obligations, although relative to its market capitalization this debt level is lower than that of Xerox. IBM trades at an adjusted P/OE of about 15.4, higher than Xerox's 13. Of course, IBM doesn't have a shrinking legacy business that makes up half of its revenue weighing it down, so this higher multiple is likely justified.

Accenture saw strong revenue and earnings growth in 2012. Revenue grew by 8.9% while net income increased by 12.9%. The first quarter of 2013 continued this growth trend, and Accenture doesn't appear to be slowing down. Accenture has no debt and less than $1 billion in pension obligations, leaving it a significant net cash position. Accenture trades at an adjusted P/OE ratio of 16.5, higher than both IBM and Xerox. But the lack of debt and higher growth likely justify this premium.

The bottom line

Xerox is not a bargain like many people believe. The stock is at best fairly valued, and given that half of its revenue is from a declining business it's difficult to expect anything but very slow earnings growth going forward. The debt levels are extremely high, although interest payments have been reduced substantially over the last few years. When the stock was trading near $6 per share at the end of last year it was much more appealing, but close to $10 per share it's just not all that attractive.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Accenture. The Motley Fool owns shares of International Business Machines.. 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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