The ‘New’ Xerox Sheds Its Old Skin and Is on the Offensive — Pt. 1: Financials

On Aug. 1, the “new” Xerox (which looks a lot like the “old’ Xerox) announced its Q2 financial results, marking the second quarterly financial report since the company split itself in two on Jan. 1, spinning off its business process outsourcing operations into Conduent and reforming Xerox as a document print/copy and managed imaging services company.

Let’s look at the stock performance of the two companies since Jan. 1. Conduent (CNDT) opened on Jan. 1 at $14.85; as of Aug. 8, it stood at $16.22 – up a little over 9 percent.

To fairly look at Xerox (XRX), we have to digress. On May 23, Xerox announced that as a result of the spin-off of the company’s business process outsourcing business, its market capitalization was divided. So the company proposed a 4:1 reverse stock split at its annual shareholder’s meeting, a move that was approved. The company stated that the move was intended to increase the per-share trading price of its common stock as well as its liquidity, and facilitate its trading. For the company, this was a risky move; for many analysts on Wall Street a reverse stock split is the kiss of death, signaling a company that is desperate to boost its share prices through stock gyrations rather than by demonstrating strong company performance.

Why execute a reverse stock split (reducing the number of shares outstanding by 75 percent)? According to Investopedia, “A company performs a reverse stock split to increase its share price. The desire to increase the share price is usually driven by an underlying motivation to avoid being delisted from a major stock exchange, to avoid being removed from a stock index or to avoid the general negative impression of being a penny stock.” Was XRX actually in danger of NYSE de-listing? No way to know for sure, but the stock gymnastics were executed in June.

When we last took a detailed look at Xerox in November 2016, we noted the following:

As mentioned in our article, this table clearly demonstrates that as a common stock investment vehicle, Xerox has been, essentially, a complete bust in one of the strongest bull markets in history, increasing a mere 12.9 percent while the S&P 500 performance increased 169 percent over the same five-year period. Xerox shareholders would have been much better off simply buying shares in an S&P index fund. That kind of poor stock performance usually gets CEOs canned, and it came as no surprise that Xerox CEO Ursula Burns’ seven-year tenure ended effective the day of the split, replaced by Jeff Jacobson. It was this poor stock performance that led activist shareholder Carl Ichan to force the company to split in two in an effort to “unlock shareholder value” – in this case, a euphemism representing the propensity for the aggregate value of the stocks resulting from a split to increase over the value of the integrated stock prior to the split.

On Dec. 30, the last business day before the split, XRX listed at $34.92 (note: this value has been converted from the then-listed value, $8.73 per share, reflecting the 4:1 stock split). On Jan. 3 (first day of the new Xerox), XRX dropped to $27.56, representing the deduction in company valuation, and thus shareholder value, represented by the Conduent Inc. spinoff. On Jan. 3, Conduent shares were pegged by the market at $14.85. Now, with two independent financial quarters behind it, we again assess Xerox’s share performance:

Of course, share prices alone do not directly reflect the asset or market capitalization (total worth of the company, typically shown as the number of outstanding shares multiplied by the share price, equally the cash value of the firm). Further, share prices do not include cash dividends paid to shareholders from earnings – and Xerox pays dividends every quarter, pegged at about 3.3 percent of share value.

Voila! The reverse stock split achieved its goal – the combined value of the two independent companies exceeded the value of the combined and integrated firms. Of course, post-split share prices reflect investor confidence and belief in the future performance of each company, which leads to share price valuation. While neither company has performed spectacularly well since Jan. 3 in terms of their reported financial activity, the rising tide of the overall bull stock market likely pushed up the value of these boats. At the end of January, Marketwatch lauded Xerox as one of the 10 S&P 500 index stocks that rose the most (with dividends reinvested) through Jan. 30; XRX rose 21 percent from Jan. 3–Jan. 31.

Let’s assume Mr. Icahn is a bit happier than he was last fall (and so are you if you had XRX in your 401(k) portfolio).

Another factor in making an effort to increase the stock’s valuation – access to cheap capital. Think that isn’t important? As explained by Xerox EVP and CFO Bill Osbourn at the Goldman Sachs Technology and Internet Conference in February, the company needs to maintain its “investment grade” rating because that enables Xerox access to cheap capital for financing customer purchases and contracts, for what are often very expensive equipment installations. Financing delivers the highest profit margin percentages of any product or service in the entire Xerox portfolio – 56 percent-plus gross margins, on revenues of 150 million in the first half of FY 2017 $325 million in FY 2016, with little associated direct product cost or head count. (Often, a car dealer will earn more profit from the financing associated with a car sale than the direct sale of the vehicle itself.) As this article is being written, Xerox is still up about 15 percent over its Jan. 3 open price as a standalone company, an increase that exceeds its share performance over the previous five years and beat the S&P 500 over the same period.

A number of investment analysts have touted Xerox as a “value” stock in an inflated equities market, noting that the company’s share value has appreciated significantly in 2017, and that it is selling at less than 10 times earnings (including dividends) while many stocks have much higher price-to-earnings ratios. If the company can moderate or reverse its declining equipment installs and hardware revenue trend lines, Xerox shares will likely continue to look attractive to the denizens of Wall Street.

In less than a year, Xerox split itself into two companies, executed a 4:1 reverse stock split, increased the value of its shares more than the previous five years, and engineered the largest new product and services launch in the company’s history – not to mention internal reorganizations and trimming hundreds of millions of dollars out of its cost structure. No wonder investors are taking notice. Now, the company has to deliver on its plans to reinvigorate and stimulate its document-based businesses – in a period of unequaled and relentless competition and declining print volumes in the office document marketplace.

Q2 results: Continued revenue declines, but above consensus earnings

To some, Xerox’s Q2 results were disappointing as revenues tallied $2.57 billion, missing street estimates by $40 million and down a steep 8.1 percent year over year, though that equaled a less objectionable 6.1 percent decline in constant currency. Other observers were buoyed by strong expense controls and excellent cash flows however – Xerox beat earnings estimates, anticipated at 80 cents per share, by delivering EPS of 87 cents, driven by improvements in both operating and gross margins that squeezed $300 million out of operating costs and expenses. Cash was abundant, as the company generated $343 million from operations in Q2, up dramatically from $84 million in FY16, and ended the quarter with a $1.25 billion cash balance.

Despite the solid earnings performance, the company’s sales continued to decline as they have for several years consecutively. In an investor presentation early in 2017, Xerox said it plans to improve its revenue mix from “mature” market segments to “growth” segments by 3 percent annually looking out to 2021 – which is critical because in FY 2017, the company projects 58 percent of its revenues will be derived from mature market segments.

Some bright spots in Q2 were a turnaround in a long sales decline in entry A4 MFP installs, which the company says is the result of the following:

• A 24 percent increase in color installs in Q2 reflects demand for recently launched A4 products; four lower-end entry A4 devices were launched in February
• A 10 percent increase in entry A4 black-and-white MFP installs was helped by higher activity for low-end printers in developing markets.

Xerox explains it has another eight new A4 products that will be available during Q3, so this is an area where it expects to see continued progress in the second half of 2017 and into 2018.

The Q2 report revealed that midrange and high-end installs are down dramatically from 2016, including a 30 percent decline in high-end black and white and a 19 percent drop in midrange black and white in the first half. While color installs also dropped in both categories, high-end sales dropped and post-sale revenues have also been lagging. The company offered the following comments on that sour note:

• The Q2 midrange installs decline reflects mostly the transition to the new product portfolio, and Xerox says it expected Q2 revenue as a result to be the weakest of the year given the transition.
• Xerox believes its weak Q2 install results were not indicative of what it will see in the second half, and it has indicated that it expects installs/equipment revenue to ramp up in the second half.
• The firm notes that post-sale revenue does lag equipment installs. Xerox says, typically, it has devices out in the field for three to five years and, as such, one quarter’s install performance does not greatly change the number of devices in the field printing pages and generating revenues. Thus, Xerox expects post-sale trends to remain stable with the potential for improvement down the line as it executes on its announced strategic growth initiatives.
• Xerox says the high-end black-and-white systems decrease was consistent with overall market declines and a general shift over time to color, while the launch timing of the new products affected color systems.

When asked about revenue declines exhibited across all its major product categories, the company explains it expects to see overall revenue improvement build toward the end of Q3, and then more strongly in Q4 of 2017 and into 2018 – noting that it did, indeed, lay out a strategy at its most recent investor conference to weight its revenues over time to the growth areas of the market with an objective of having 50 percent of revenues from growth areas by 2020 (currently at 39 percent). This mix shift will result in gradual but steady improvement in the revenue trajectory.

The company points to these increasing areas to grow revenues:

• Large enterprise MPS: +2 percent CAGR
• A4 MFPs: +3 percent
• Production color: +5 percent
• SMB MPS: +7 percent
• Workflow automation: +13 percent

Notable on this list is SMB MPS, increasing at an annual 7 percent CAGR compared to large enterprise MPS at only 2 percent, which explains why Xerox has this sector prominently targeted for revenue gains. The challenge for the company is that more than 75 percent of the SMB market is serviced by indirect channels (according to Xerox), and the channel is where Xerox has had the biggest trouble penetrating dealerships or boosting its revenue shares in the dealerships it does do business with. Growing share in this arena is easier said than done for sure.

The company points to these areas of its business that are in decline:

• A3 MFPs: (5 percent) CAGR
• Centralized print services: (0 percent)
• Production mono: (11 percent)
• Single-function printers: (8 percent)

In Part 2 of this article, we take a closer look at Xerox’s position in the dealer channel and its plans for the future.

*Note: An earlier version of this article incorrectly quoted Conduent’s opening price on January 3, 2017. Conduent’s correct opening price was $14.85. This and subsequent errors have been corrected.