Portfolio Review: Xerox

Company: Xerox Corporation ($XRX)

Investment Thesis: (1) Xerox is increasingly a business services company. (2) The printer business (“Document Technology”) is an ex-growth cash cow and will continue to generate cash for a long time. (3) It is attractive priced in absolute terms and (4) has a shareholder-friendly strategy of returning capital through dividends and buybacks.

Investment Thesis Review:

(1) Services Business: The Services Segment grew revenues 3% in 2013 and now represents 55% of total revenues. Its contribution at the PBT level is even higher. Some of the increase in contribution is due to the fact that Document Technology shrank slightly, but so long as the overall profitability remains stable to slightly improving, the revenue quality of the overall business is improving, which is a positive.

Services Rev 2013
2009 – 2013 Services Segment Revenue

This segment is an attractive business composed of Business Process Outsourcing (59% of Services rev.), IT Outsourcing (13% of Services rev.) and Document Outsourcing (28% of Services rev.). These are long term contracts with high renewal rates (85-90%) and the Company has a strong pipeline of new opportunities. Document Outsourcing (managed printing services or “print as a service” if you want to be promotional) is probably a lower quality business, but the Company is incredibly well positioned here given its legacy. It is also worth noting that other outsourced printing companies such as VistaPrint trade at very rich multiples (11x LTM EBITDA and 30x LTM PE–although to be fair FY1 multiple look decent if they achieve the growth at 8.3x EBITDA and 14x PE)

(2) Document Technology: The Document Technology Segment shrank by 6% in 2013. and profitability fell to 966m (9% below 2012), almost as low as it was 2009. I am still of the view that the era of the “paperless office” is still a long way away, so I think this profit stream will continue to be sustainable for a long time. Certainly not a growing market, but it is a market that needs to be served and few serve it better than Xerox.

(3) Attractive Absolute Valuation:  Maybe the below will sound like a contradiction to what I previously wrote on the bias of the cost basis, but I think it is more about “knowing where you stand” than anything else. Here are some key valuation metrics for Xerox with the change in the metric since my last review of this position (11/4/13; which was when I bought the shares) in parenthesis.

EPS: $0.92 (+0.2%)

Price / LTM Earnings: 14.2x (+32%)

Price / FY1 Earnings: 12.0x (+27%)

EV / LTM EBITDA: 8.2x (+17%)

EV / FY1 EBITDA: 6.7x (+11%)

EV / Revenues: 1.1x (+20%)

EV / FY1 Revenues: 1.1x (+17%)

At first glance, it looks like the valuation part of the investment thesis is poorer across the board now–by about 20%. One the one hand this is a ‘nice problem to have’ and one that should hopefully be a recurring one for any value investor. On the other hand, it would be preferable for the near 30% price appreciation experienced to date to be a result of an improving business, rather than a richer valuation. In any event, the valuation remains attractive on an absolute basis. at A 12x forward PE, the implied earnings yield is over 8%. That is a very acceptable base case, and there is a lot of optionality here with valuation re-rating (there is a long way to go before getting to ‘market’ levels) and some growth in the long terms once the slow decline of the Document Technology business settles.

The dividend yield has now fallen below 2%, but I would not be surprised to see the Company raise its dividend at some point. The share repurchase has been aggressive, which is the right thing to do with a depressed valuation. It would be nice to see a shift in favor of more dividends and less repurchases if the valuation continues to increase at this rate.

(4) Shareholder-friendly Strategy: One of the first thing that attracted me to Xerox was that it had a decent dividend yield. I see that as a sign of sensible valuation (assuming its sustainable) and a shareholder-friendly management. Combined with the aggressive share repurchase program, it is very clear that the management has a strategy of returning capital to shareholders. The chart below compares cash flow from operations to the major uses of cash for the last 5 years.

Use of Cash
2009 – 2014 Cash from Operations and its Uses

With the exception of the large acquisition of Affiliated Computer Services (n.k.a. Xerox Business Services) the Company has had a moderate and disciplined M&A strategy. That acquisition bolstered the services business and seems to have been a good one.  They do enough M&A that I have not had the time to analyze each one specifically, but given the Company’s heritage, it seems like they are being appropriately opportunistic here. I like the optionality it creates

Other Considerations: The Company makes a lot out of their “Annuity-Based Business Model” (now 84% of revenues). I certainly like that about the business model in general–recurring revenues are a nice thing. It strikes me as a bit promotional, despite the fact that I think it is true. I wonder if it is a legacy of the printer business where selling the ink cartridges was always where all the money was made–one of the real classic “razor/razor blade” business models.

Conclusion: The original investment thesis still holds and this investment should stay in the portfolio (good! since it has only been 9 months). This is a nice business worth owning for the long term. Given current valuation and profitability I would expect it to generate an overall return of about 100% over the next 10 years (implied by 8% earnings yield, assuming a bit of degradation), which would be a good outcome.

In more general terms, I think this is a decent investment to hold in the event of a downturn. The printers business would surely suffer, but the services business should be resilient. Some concerns around the consumer financing (the Company lends people money to buy its products) to which most of the debt is related, but the balance sheet is strong and credits should be fairly safe.

 

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Absolute Valuations

I have heard money managers I respect talk about investing as a ‘comparative process’, meaning that you should look at the whole universe of opportunities and select the most attractive ones. While there is obviously merit to this, it is ultimately not how I go about things. For one I like the time and resources of an industrial money management operation to ‘consider the whole universe’, but I also think there is a powerful aspect of risk management in limiting yourself to investments which you see as attractively priced on an absolute basis.

Portfolio Review

I think one’s “cost basis” is one of the biggest biases affecting most investors. The way professional investors are remunerated perpetuates this, but it affects personal investors just the same. With that in mind, I want to review the holdings in my portfolio and make an assessment about the initial investment thesis and whether it still holds. Hopefully this can be a periodic exercise, and hopefully it can be done independent of the entry price/cost basis of each holding.

Everything Boom

Reading this article the other day got me thinking: Welcome to the Everything Boom, or Maybe the Everything Bubble

What to do in an overall low return environment? We can just go to cash and earn basically zero returns. Buying short duration treasuries will get you to the same place. 10 yr. yields at 2.6%, near its lowest ever–so you can get some ‘safe’ yield of 2.6% but not without bearing big interest rate/duration risk as the central banks tighten and raise rates. It is worth noting that you could have said the same thing 10 years ago: in 2004 with 10 year yields at 4%–lowest since the 60s–rates have nowhere to go but up right? they have been in steady decline since. Who is to say that we can’t get another 10 years of currency debasement and nominal 10-yr rates dropping to 1.5%? where does that leave real rates? Either way, the last 10 years were a good time for fixed income.
Equities are about as expensive as they were in 2007, and we can’t even argue about ‘normalized profits’ with profit margins higher than ever. The Price/Sales multiple of the S&P 500 stands at 1.77x–at the peak of the market in 2007 it was 1.52x. You have to go back to the crazy days of the tech bubble in 1999/2000 to see levels like we see today.
Real Estate is also expensive and getting bid up based on cheap financing. Furthermore, Real Estate is not an asset class that has delivered long term return, with the exception of the latest bubble. It is a good inflation hedge, and ‘buying low’ following crises has been a good strategy, but hard to argue you would be doing that now. Commercial real estate is arguably ‘cheap’ today, but you have to wonder if the structural demand for retail (especially low-middle end retail, like malls) is ever going to come back given how much shopping is done at home/online. Blame the weather all you want, but last Christmas season may have well-marked a turning point. Teenagers don’t hang out in malls any more (See: all teenage specialty retailers which are really struggling: Abercrombie (ANF), American Apparel (APP), Aeropostale (AEO), etc.). High end / ‘experience’ retail may be here to stay, but I think that kind of ‘fifth ave.’ retail is not cheap (not really sure if there is a good vehicle to invest in that specifically).
I am sitting here with 30% of my assets in cash and maybe that is the right thing to do. I have 37% of my assets in passive index funds (pretty much the S&P 500), and I guess I have to be OK with the possibility of losing 50% of this value over a year (As happened in 2008). The remaining 32% is in actively managed , which could lose significant value as well. In the long term it should beat just holding cash and we will never do well timing the markets.
Howard Marks said it best: “You can’t predict. You can prepare” or more specifically: “We may never know where we’re going, or when the tide will turn, but we had better have a good idea where we are.” So here I am trying to think of what is a sensible investment opportunity in this market, besides just buying defensive stocks (I am loaded up in consumer goods and dividend payers and also a little too much technology but mostly old names that look more like services/consumer companies like Xerox, IBM and–dare I say–Apple).

Purpose

I have taken an active role in managing my investments for some time now. I try to be structured and thoughtful about each decision, but have not kept detailed records of my thinking so far. I often write e-mails to friends and family outlining my thinking–I know these are of little interest to them, and ultimately I do it mostly for my own benefit. It is a nice thing about investing that you can openly shares your thoughts and ideas without jeopardizing any personal value they may have for you. It is with all that in mind that I opened this account.