Xerox Holdings Corporation $XRX
My Investment Checklist
1. Is the company undervalued?
EV/EBIT: 25.75
EV/Sales: 0.79
Price/Book: 0.59
Xerox is objectively a gross stock; the core business is in secular decline, profitability has fallen off a cliff, and their CEO unfortunately passed away earlier this year. With that said, $XRX has never traded cheaper relative to assets and are likely to see margins improve with supply chains starting to ease. Moreover management believes they can grow their business low to mid-single digits with 7%+ operating margins long term. If this scenario comes to fruition, the stock is almost certainly mispriced today.
2. Can I easily explain what the company does?
Yes, the sell printers and offer services/software on their hardware. Xerox also has a financing business unit for related equipment and services.
3. Does the cash flow statement line up with income statement?
Yes, cashflows have been consistently higher than reported income:
Most of their excess cash went towards debt repayment, share repurchases, dividends paid out, and capital expenditures. These all seems like a sensible use of capital to me. With the stock down ~40% YTD it obviously would’ve been better to either pay down debt or build up their cash position. However $XRX was trading for less than 0.8X book value over that time, so I can’t fault management for buying back their stock at less than liquidation value (haters will disagree with me on this point).
4. Is the Balance Sheet Healthy?
Total Debt: $3.9B
Total Cash: 1.2B
Current Ratio: 1.2
Xerox’s balance sheet is a bit wonky due to their financing arm, FITTLE. I’m also by no means a banking analyst, but management is asserting to have a net cash position:
I’m inferring that this chart implies zero bad loans for FITTLE, which is an assumption I’m uncomfortable making. Nonetheless $XRX doesn’t hold an absurd amount debt and net interest payments last year only totaled $100M. This number will also be lower in 2023 as they’ve paid off a decent chunk of principle. On a forward basis, $XRX has nearly a 4.5X net interest coverage ratio, which is above average. Therefore the balance sheet is much better than it appears at surface level.
5. How profitable is the business?
Gross Margins: 32.2%
Operating Margins: 2.6%
Net Margins: (9.3)%
These numbers look disgusting, but $XRX if probably at or near trough earnings. For example, here’s what the business has done historically:
Those numbers don’t look too shabby, but I would be surprised if operating margins mean revert back to double digits. For instance, management is only forecasting a ~7.3% EBIT margin in 2023 and 2024. Nevertheless that’s more than a 2.7X jump in profitability, which unquestionably moves the needle. Moreover I don’t think this goal is unattainable as $XRX does have price increases set in place and margins should naturally improve with the easing of supply chains;
“Xavier Heiss (CFO)
Yes. Thanks, Jim. So yes, we see as in a lot of businesses, see a pressure of inflation. However, as we mentioned it, some of the erosion that we are seeing currently on our business is mainly related to supply chain. And the supply chain, if you look at the gross margins that we printed for this quarter, we have a gross margin, which is down 370 basis points this quarter versus last quarter. Otherwise, the number were roughly the same in quarter 1 with a sequential improvement, but 340 out of the 370 basis points come from supply chain.”
6. What is the company’s growth potential?
10-yr Revenue CAGR: (10.7)%
10-yr Operating Profit CAGR: (15.33)%
10-yr FCF CAGR: (12.78)%
Again, abysmal results here and not surprisingly the stock is lower today than it was in 2012. Nonetheless, these numbers probably look worse than they are due to 2021 being the end date used. In fact management believes they can grow low to mid-single digits:
Although it’s important to note that management is forecasting flattish growth for their core business and double-digit growth for their financing and software business units. Candidly, I think these assumptions are far too optimistic. Printer sales have been declining in almost a straight line for the last decade and software is a highly disruptable industry. The growth component is by far the most important element of Xerox’s investment thesis. If the company can grow from here it’s way too cheap, if not investors are likely to experience more pain.
7. Is management rewarding shareholders?
$XRX currently offers a 7.65% dividend and have historically been share cannibals. The company is also promising to return at least 50% of FCF back to shareholders annually. If you take management at their word, shareholders should receive ~$170M on net back in the following year. That works out to a ~7.5% net shareholder yield, which is well above market. Unfortunately that doesn’t seem too appealing if you’re of the mindset that $XRX is a melting ice cube.
8. How does the company stack up against their peers?
HP Inc $HPQ is the closest competitor to $XRX
$HPQ EV/Sales: 0.52
Operating Margins: 8.7%
10-yr Revenue CAGR: (6.7)%
$HPQ is cheaper, more profitable, and have experienced slower declines in revenues. $HPQ seems like the obvious choice. However if you’re betting on a recovery in the printer business, $XRX most likely offers higher upside potential.
9. What’s the counter argument?
The counter argument is that Xerox is in secular decline and margins will continue to erode as competitors fight for remaining market share.
I 100% buy into this thesis, it doesn’t take a genius to figure out that corporate America is increasingly going more paperless. Although I will say the market is almost certainly pricing this risk in with a 0.59X book valuation.
10. Is there something I think the market may be missing?
Mr. Market maybe too pessimistic regarding Xerox’s business quality. For starters $XRX has implemented price increases and their order backlog is up ~5% YOY. If the business had a serious demand problem management wouldn’t have raised prices and their backlog definitely wouldn’t be growing. Furthermore ~2/3 of their business is contracted out over several years. For this reason I would be surprised to see a massive drop off in sales.
Final Thoughts:
Xerox is an extremely difficult investment to think thru. My base case would assume revenues coming in flat over the next 5 years with a 0.8X EV/Sales exit multiple. This essentially means that investors will only get paid off the capital management returns back to them. In short this implies a ~7.5% expected return annually. For that reason it’s a pass, but a stock that should be fun to watch as the range of outcomes are extremely wide and my assumptions could prove to be too conservative.
***Disclosure: I have no position in the security mentioned above, nor do I have any plans to purchase within the next 72 hours. This article is intended for educational purposes only and in no way should be interpreted as investment advice