Financial News
Xerox Could be a Dark Horse in 2023
I doubt I’d surprise anyone if I said Xerox (NASDAQ: XRX) is currently in a state of disarray. The 116-year-old printing and document services giant has tried several times in recent years to revitalize its business with limited success.
On the surface, the Q3 FY ’22 results released in late October were dismal. As a result, the stock dropped 36% year to date as of the market close last week.
However, if you are concerned about a 2023 recession, you might be interested in the following points/comments from XRX’s Q3 FY ’22 Earnings Presentation:
Two-thirds of revenue is contracted for numerous years.
Many of XRX’s service offerings are anti-cyclical in nature. (As a reminder, post-sales revenue accounts for the majority of XRX’s main print business.)
“Consistent with the uncertain macro climate, we are beginning to witness lengthier project deployment periods and lower page volume pledges. We believe our company to be resilient if weaker macroeconomic conditions induce a major decline in enterprise IT spending.”
It’s a bit of a paradox to assume that the stock of a company that has been slowly dying could be a safe haven if the economy falls apart next year. However, even a failing firm can be valuable. Simply ask Carl Icahn…
Making Investments Like Carl Icahn
Carl Icahn, as you may know, has been picking up XRX shares for years now, and increased his stake in April by more than 2 million shares, boosting his ownership position to about 20%. What does he notice about the company?
The most straightforward explanation is that he sees an undervalued firm that has been mismanaged for a long period. He earlier stated that “Xerox was one of the worst-run companies I ever witnessed.”
Unsurprisingly, Icahn proxies fought their way into the XRX board, and Mr. Icahn has pushed management to maximize shareholder value. In 2016, he advocated for the spin-off of Conduent (CNDT), XRX’s outsourcing firm. (As of the market closing on December 23, CNDT had a market capitalization of less than $900 million.) He was said to have pushed for XRX’s unsolicited offer to take over HP in 2019. (HPQ). That endeavor failed, with HPQ management stating that a merger of the two companies made little sense.
But he clearly sees potential in the company, which is now helmed by new CEO Steve Bandrowczak following the unexpected death of XRX’s former CEO John Visentin.
Mr. Bandrowczak has his job cut out for him, as Xerox has revised their FY ’22 guidance downward following the announcement of Q3 FY ’22 results:
From a total revenue of $7.1 billion to a revenue range of $7.0 billion to $7.1 billion in actual currency,
FCF from $400 million to at least $125 million.
The declining trend is consistent with the larger “blow” that XRX sustained during the epidemic, from which they have yet to recoup.
Despite the company’s intra- and post-pandemic challenges, the reality is that XRX’s legacy printing and document services division continues to generate cash, with management remarking at the end of FY ’21 that “demand for [print] products and services remains high.” Furthermore, Xerox is undoubtedly still the market leader in printing and document management solutions after more than a century (albeit not without strong competition).
It’s simpler to appreciate Mr. Icahn’s interest in this setting. We have a company that has:
A consistent, if gradually dropping, revenue and earnings stream from its main operation that can be used to fund growth projects.
A position of leadership in a mission-critical niche – it will be a long time before printing is entirely obsolete.
A diverse customer base ranging from small businesses to major corporations, distributed across 160 countries.
He evidently believes, and has for a long time, that the intrinsic value of these attributes outweighs the monetary value of the organization. As a result, I believe there is a compelling case to be made for investing in Xerox right now:
1. Even in recessionary conditions, the print industry is projected to be resilient in 2023 (see introduction).
2. Management is attempting to unlock shareholder value by growing key businesses that can someday be spun-off, perhaps with a little shove from Mr. Icahn and other activist investors every now and again sarcastic> (more on this in a moment).
3. The stock, which is currently trading near its 52-week low, is likely undervaluing the company’s underlying value.
Thinking About It
Let us go over the three reasons from the previous part in further depth.
1. The print industry is expected to be resilient in 2023. “[Third-party] research projects the print technology and managed print services (MPS) industry to grow 1% through 2024, and we anticipate to do better,” Xerox stated in their Annual Report FY ’21. This view was reaffirmed in their 2022 Investor Day Presentation. Even if a recession occurs in the coming year, any impact on new equipment sales may be more than offset by increased customer spending on maintenance and other after-sales services, as many businesses return their personnel to the office. Furthermore, XRX’s performance in the latter half of the pandemic and throughout much of 2022 was marred by supply-chain issues. While management stated in their Q3 FY ’22 Earnings Presentation that supply-chain issues continue to impact the print business – and were partially responsible for the lower FY ’22 FCF guide mentioned earlier – perhaps there is some evidence that, at the very least, component and supply shortages will be less of an issue in 2023. Color ink shortages, for example, hampered color printer sales during the pandemic. XRX, on the other hand, had install growth across all sectors of its color printer business during Q3 FY ’22.
Granted, management hasn’t given specifics on when and if supply-chain difficulties would abate. However, they have not yet updated their FY ’23 – FY ’24 growth model, which would probably be influenced by ongoing supply-chain concerns.
Also worth noting is that XRX’s backlog increased significantly at the end of Q3, reaching $429M from $265M at the end of Q3 FY ’21. So, as the year comes to a close, the business appears to be in terrific health. Finally, as I mentioned in my previous article on Xerox, the post-sale component of the print business has a higher profit profile. It doesn’t require much capital investment, with management noting in their Annual Report FY ’19 that “…there [are] low annual capital expenditures (less than 2 percent of revenues) required to support [it and]…these factors result in stable gross margins and operating margins as well.” Figure 2 shows that XRX’s gross margin has been anything but constant, with the adjusted operating margin falling to 3.7% in Q3 FY ’22 from 4.2% in Q3 FY ’21. However, keep in mind that the pandemic put a particularly significant monkey wrench into the machinery of Xerox. Given the business’s history of countercyclical dynamics, as indicated in the introduction, and management’s efforts to get the core “back on track,” it’s not unrealistic to believe the print industry will thrive (relatively speaking) in 2023.
2. Management is aiming to increase shareholder value by establishing key businesses that can be spun off in the future.
Management appears to want to list specific growth businesses at the appropriate moment in the future, “a la” Conduent, with FITTLE and CareAR being two obvious possibilities. With XRX’s growth activities being in their early stages, it’s impossible to predict what the resulting value of these efforts will be for the shareholder. However, I believe it is important expressing the obvious that investments such as those in FITTLE and CareAR build on existing capabilities, implying less risk and a better likelihood of long-term success. Similarly, I’m excited by XRX’s IT services push in the SMB market, which leverages their existing contacts with smaller enterprises – a sector that is arguably underserved. And I wouldn’t be shocked if their IT services division gets rebranded in the near future, with the goal of eventually becoming self-contained. So, while nothing can be said with perfect confidence, I believe the signals clearly lead to a shareholder opportunity, based on management constructing key growth areas with money from the core printing business and then spinning them out at the appropriate moment.
3. The stock likely undervalues the company’s intrinsic value. As of the market close on December 23, Xerox had a market capitalization of $2.3 billion, and the stock is trading near its 52-week low.
CareAR, as noted in the previous point, was recently valued at $700 million. Considering that, as well as the qualitative justifications in the prior two points, the company appears to be undervalued in my opinion, despite its history of erratic performance and mismanagement. When the company’s forward P/S and P/B multiples are considered, it appears to be a steal.
Putting Everything Together
I mentioned earlier that XRX is a shambles. That is still my opinion. But, based on where shares are trading right now and in the context of my observations in the preceding sections, I believe the risk/reward equation skews in favor of the long Xerox investor heading into a recessionary 2023.
With the dividend yield currently nearing 7%, investors are being compensated handsomely for holding a company that can still produce shareholder value even while it steadily diminishes.
I had previously established a long position in Xerox after authoring my last article on the company in late 2020, with an average cost base of roughly $18/share. I chose to exit the position earlier this year when the stock was still trading above $20 per share. With Mr. Bandrowczak at the head and backing from Mr. Icahn and other activist owners, I’m hoping he will instill a sense of discipline that has long been lacking. XRX has a lot of potential opportunities for new growth, yet management has to be careful not to “boil the seas”. I plan to start a new position. On December 29, XRX goes ex-dividend.
Of course, with a company like Xerox, nothing is certain, and Wall Street’s attitude is definitely gloomy. However, the contrarian long play on the stock may work well in a potentially recessionary 2023, even though it shouldn’t.
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