Does the Dominance of Activist Investors Save Xerox?

Xerox is one of the leading imaging, printing, and data analytics provider. The company also serves customers ranging from small to global enterprises for printing, related workflows, and business processes. According to Xerox’s company filings, the company has only one reporting and operating segment – the design, development, and sale of document management systems and solutions. However, the company summarizes its total revenue as commercial, consumer hardware; and post-sale services, which provides outsourcing and managed print services. The company’s manufacturing and distribution facilities are located around the world. Xerox has primary manufacturing operations in Webster, NY, Dundalk, Ireland, Wilsonville, OR, Aubagne, France, and Venray, Netherlands. In 2017, approximately 40% of the company’s revenue was generated outside the US.

Overview

Xerox’s revenue is declining from USD 19,5 billion to USD 10,3 billion in the 2013-2017 period, which is approximately 14% annual revenue reduction. Currently, companies tend to use few printing devices and printed pages and more electronic documentation. Also, there is a fierce competition in the industry, which results in a reduction in hardware and copier spending each year. The company’s equity ownership indicates that less than 20% of major shareholders are funds and more than 50% of shareholders are institutions. Activist investors Carl Icahn and Darwin Deason, the first and third largest shareholders of Xerox, were against the deal with Fujifilm. These investors believe that the company need to focus on small- and mid-business areas and will be able to expand its market share. The activist investors think that simplifying the distribution channels will reduce expenses without losing customer base. These activists also mention that research and development activities in sustainable and profitable business models may create a new revenue stream. The company settled with activist investors and Xerox CEO Jeff Jacobson resigned from his role.

Keith Cozza, CEO of Icahn Enterprises, is appointed as the new Chairman of Xerox, and John Visentin is appointed as the Vice Chairman and new CEO of Xerox in June 2018. The company changed almost 70% of key employees and high turnover rate indicate Xerox’s attempt to maximize shareholder values with strategic alternatives.

While the company offers its customers “Managed Document Services”, a variety of printing optimization solutions, BrightHedge does not expect trend reversal growth for the company in the foreseeable future.

Activist investors believe that the company need to focus on small- and mid-business areas and will be able to expand its market share.

Investment Characteristics

The company’s gross profit increased from 30% range to 40% in the 2012-2017 period. However, the negative trend of revenue growth continues due to an elimination of paper in business environments, which reduce printing equipment usage. The company’s operating expenses are decreased by 8.9% in 2015-2017. The operating expense as a percentage of total revenue remains the same, which is 30%. Xerox’s return on equity fluctuates from -7.5% to 10% range, which is currently 3.3%. The company’s financial leverage increased from 2.8 to 3.2 in 2015-2017.

Xerox’s 5-year average revenue decline is approximately 14% annually. The company has multi-year projects with government entities, however, due to competition, Xerox may not able reverse the negative return on equity in near future. The printing industry and environment are evolving due to shifts in customer preferences in office printing, including mobile printing and expansion of entry products. The company’s future achievement is correlated with its ability to adapt to developing and competitive technologies. However, we need to consider market cannibalization in the industry. Market cannibalization is the negative influence of a new trend, which diminishes current demand and reduces sales and its volume. Electronic documentation and digital workflows make multifunction printers unnecessary in business processes, which results in low printer usage and demand for printing devices. Xerox expects that document management and consulting services are growth areas; however, BrightHedge thinks that there is fierce competition in hardware deals with printing sales and tight margins may press the company to reduce service and hardware prices.

The company’s EBITDA decreased by 7.3% in 2017 and showing a declining trend in the last 5 years. Xerox’s tax rate was 84% in 2017 due to deemed repatriation tax effect on financial statements.

The printing industry and environment are evolving due to shifts in customer preferences in office printing, including mobile printing and expansion of entry products.

Valuation

Our fair value estimate for Xerox is USD 30 per share. We expect that the company’s 5-year average negative growth rate will continue but with a decelerating rate. We estimate that Xerox’s EBITDA-to-Sales ratio will accelerate with the company’s cost reduction program in the next 10-year. According to the company’s long-term debt rates, we use approximately 6.5% pretax cost of debt. The company’s high beta rate affected our cost of equity calculation, and we estimated a 10% cost of equity. Our cost of capital expectation is more than 7.3% due to more than 50% weight of equity in our calculation. We compute enterprise value-to-EBIT multiple of 19 and enterprise value-to-sales multiple of 5.5. The company’s negative growth rates are related to weakening demand of printing hardware and competition in managed printing services. We model that the company’s managed print services will penetrate large, global clients and will focus on small and medium-sized clients with the help of activist investors. Thus, we expect that managed print services will limit the negative growth trend for foreseeable future.

Risks to consider

Printing environment and industry is evolving due to changes in customer preferences and new technologies. Market cannibalization results reduction in overall printing hardware and document spending. Portable devices create a possibility of printing alternatives. Xerox considers industry-oriented services as a growth area with different solutions for customers. Also, the company aims to capture small- and mid-size companies and increase its managed printing services. However, the market is intensely competitive with limited pricing power and requires retaining a high level of supplies.

Market cannibalization results reduction in overall printing hardware and document spending. Portable devices create a possibility of printing alternatives.

Other considerations

Most of the company management has recently changed in June 2018 and activist investors take control of the company’s board, after a failed deal with Fujifilm. The company’s key executive compensation level increased more than 5 times, which is mostly related to the stock awards to former executives. However, Xerox’s declining revenues and EBITDA levels are indicating that these compensation levels need to be reduced.

Conclusion

Xerox stock price as of July 2018
Source: Yahoo! Finance

In the last three years, the company’s lowest and highest stock prices are approximately USD 23 and USD 34 per share, respectively. The current price-to-earnings levels are higher than the company’s 5-year average and the industry average. Xerox’s current profitability levels result in a spike in the price-to-earnings ratio. The price-to-book and price-to-value levels are lower than the industry average due to the negative expectation of revenue growth and high level of competition in the industry. It will be interesting to see how the new management, especially, relatively young director Keith Cozza, 39, and talented activist investors will fix the reservations of BrightHedge about Xerox.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

Image Source: Xerox Website

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Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

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The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.