The imaging and printing industry is undergoing a period of profound transition, a transition driven by seemingly irreversible technological shifts in the principal business model which has served the industry for half a century. Among many, the changes include:
- The rise of digital displays as the primary tool for dispersal and viewing of information
- The slow erosion of paper as the principal means of conveying and storage of information
- The swift decline in the relevance of paper to daily business operations and as a primary marketing delivery vehicle
- The growth in concerns surrounding the environmental impact of using paper as a communications medium
- A shift in the focus of printing and imaging OEM business models toward reliance on software and related services and process management – essentially what and how their customers do what they do with the documents that are critical to their businesses — and away from simply enabling their customers to produce and capture those documents.
Many OEMs have tried migrating and merging their hardware and annuity supplies-based businesses toward document software, services, and process management, strengthening their competitive portfolio through cross-selling and integrating business process expertise with document technology and services – including MPS – with varying levels of success (though they all publicly claim to have succeeded). These OEMs, including Lexmark, HP, Xerox, and Canon, have sought that transformation through a mixture of home-grown services-led initiatives as well as acquisitions. In 2010, Xerox Corp. spent $6.4 billion to acquire Affiliated Computer Services Inc. (ACS), a Dallas-based provider of information technology services and business process outsourcing solutions. At the time of the acquisition, Xerox noted that about 20 percent of the combined company's installed base of customers used products and services from both suppliers.
However, like HP, Xerox announced its intentions to split itself up in 2016, in a spinoff move that would result in the creation (or recreation if you will) of two firms – one essentially constituting what was ACS (the company generally calls this unit Business Services or Business Process Outsourcing), and one representing the traditional imaging and copying/printing operations of the pre-merger Xerox (the company calls this unit Document Technology). As with HP, the split was necessitated by pressure applied by activist shareholders, in Xerox’s case Carl Icahn, alarmed by the diverging direction and business models of the traditional imaging and printing operations compared to the business services/software unit: The traditional imaging and printing operations were experiencing continued declines in revenues and profits as a result of the shrinking market need for paper-based documents, while the business services/software unit demonstrated ongoing and healthy revenue growth with smaller but serviceable margins.
A critical mitigating factor in the breakup of these companies, especially Xerox, appears to be their inability to successfully integrate the two sides of these operations – despite the apparent intersection points of producing documents and subsequently handling/processing them. The integration challenge lies in the diverse nature of the businesses – one an annuity model relying on supplies and maintenance revenues driven by page production metrics, the other a system and infrastructure process-based model which is heavily labor based. The best efforts of these companies to integrate these operations never resulted in delivering on the promise that management made – that the business synergy of merging these functions would enhance shareholder value. Maybe there is no good way to merge these varied activities, though we doubt that companies will quit trying to do so. Our opinion: oil and water don’t mix.
What fate awaits the two entities that will result from the Xerox breakup? Xerox has not announced a specific date for the divorce, saying only it expects to be complete by the end of the year, so the firm has a couple more reporting quarters remaining before the split. Initially, Wall Street reacted favorably to the pending dissolution: the company announced the split at the end of January, when the stock was hovering around $9 a share – but by mid-April, share values had risen to about $11.25, a 25 percent increase in only a few months, though far below the over $14 a share it warranted in late 2014 (which explains shareholder exasperation with Xerox management and the demand for a major change). But that upward trend collapsed on April 25 when Xerox announced its Q1 2016 results, which, to be blunt, drove the shareholders to flee in droves, as post-report share values plunged as much as 13.6 percent to well under $10.
What spooked investors so badly? In Xerox’s case, financial numbers that spoke clearly: more of the same.
- Every key metric — total revenues, annuity revenues, and equipment sales revenues — declined, and all have dropped for the sixth consecutive quarter.
- Services revenues grew 2 percent in constant currency, having grown in five of the last six quarters (the exception was flat).
- Document Technology revenues plunged 9 percent in constant currency, a slide that has persisted for the same last six quarters. That is a trend, folks.
- In 2016, Xerox expects to incur one-time separation costs of up to $250 million, and additional total restructuring and related costs of $300 million.
- Xerox missed analysts’ earnings estimates and lowered earnings projections for the full year
- The company announced plans to further restructure operations, “initiated to mitigate margin pressure,” in Document Technology, above significant cuts that the company had previously announced, and expects a total of $700 million in cuts in 2016.
- The company acknowledged weakness in unbundled supplies sales, which it attributed, in part, to lower hardware placements in previous quarters … but …
- While showing strong increases in color hardware placements, mono sales plunged substantially in every segment … which means future supplies sales for those segments will be weak also. CEO Ursula Burns commented in the analysts’ presentation “… we expect supplies revenue will continue to be pressured given the lower level of A4 equipment sales.”
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While the reported numbers were generally bad, savvy investors and industry observers probably noted what was not reported or said: just how, exactly, does the new “Document Technology” Xerox entity plan to reverse years of across-the-board eroding performance? Burns comments on the Document Technology unit were apparently unconvincing: “Through relentless cost discipline, this business generates strong and consistent cash flows that allow us to make strategic investments to generate, to penetrate higher growth markets such as Aqueous inkjet, high-end color printing, managed print services and workflow.” All sectors that are especially targeted by the new HP, well-armed with its page-wide array technology. Tough sledding ahead.
Unbundling the bundle
Xerox’s revenues from the business services group exceeded the print/copy-based operations in 2011 – a year after the ACS merger — a fact the company has touted ever since. The company’s task through the remainder of 2016 is to effectively sell the viability of the two independent entities created as a consequence of the dissolution; the Document Technology folks have a tough sell with the numbers they have been showing in a market environment where even stalwart blue chippers such as Canon are experiencing steep declines in printer and copier hardware and supplies sales (see Canon's Q1 results here).
Both of the new entities are possible acquisition candidates by larger players in the sectors they compete in. The new Xerox Document Technology unit, like HP Inc. and the printing group of Lexmark, is very strong in some print/copying/production printing categories, but has suffered from declining revenues every year since 2010 – from over $10B in 2010 to $7.9B in 2015. In late April, Xerox’s total market cap was slightly under $10B, leading one to speculate that the spinoff capitalization value of the print/copying/production unit may end up being under $5B or thereabouts. HP Inc., with printing and imaging revenues of over $23B and a clearly expressed interest in targeting production and commercial printing areas, would be one potential suitor. Besides the obvious print/imaging fit, Xerox has tremendous presence in the higher-end print area, especially in production and commercial printing segments, which complement HP’s office printing strengths (where Xerox is, frankly, weak and getting weaker), and are in line with HP’s expressed strategy to target those sectors with its PageWide array inkjet capabilities. Canon would also be another possible fit, a company with cash, an interest in gaining major leverage in its imaging business versus big rivals such as Ricoh, access to deep imaging technology assets (including inkjet) – especially in color, and a company whose largest OEM customer is "all in," trying to displace OEM-sourced laser engines with homemade PWA inkjets.
In a flat or declining market, consolidation is frequently the name of the game as suppliers try to consolidate customers and marketing costs while achieving better scale in product manufacturing and service. The new Xerox Document Technology unit could go it alone of course, though it will have to specifically answer how it now plans to reverse years of declining sales and profits when it obviously has been completely unable to do so to date.
We are betting the new Xerox Document Technology unit gets acquired. The surprise acquisition of Lexmark, including its software unit, by the consortium of Apex Technology and PAG Asia Capital, at a substantial share premium, suggests that some investors are willing to invest money in the stagnant printing and imaging business – obviously in the belief that they see value in the company and that better days must lie ahead. There could very well be other investors that make the same assessment of the new Xerox for the same or similar reasons. A reasonable argument could be made that the value of acquiring Xerox’s existing customer base alone is worth most of the $5 billion-ish it will take to buy it.
The new as-yet-unnamed Xerox business process outsourcing company has solid financials, shows consistent growth in a growing market, and could easily go it alone, or seek acquisitions to build its customer base and vertical industry expertise. It might also be an attractive acquisition target for a firm like the new Hewlett Packard Enterprise, part of which is a large-scale business process outsourcing entity, several times the size (over $20B) of the likely Xerox spinoff unit. Though business process and outsourcing is a growth sector, buying vertical industry expertise and key customers is a relatively cheap way to achieve scale in a labor intensive operation. There are plenty of other possible suitors, and our crystal ball is becoming cloudy now so we will have to wait and see like everybody else.