Shares of document equipment and service provider Xerox (NYSE: XRX) have outperformed the market over the past year and also have done well over the past five years, after recovering from a revenue recognition scandal that nearly ruined the company.
In all fairness, peers such as Canon (NYSE: CAJ) and Hewlett-Packard (NYSE: HPQ) have performed much better than Xerox over the past few years, but Xerox has held up better than other document-oriented firms, including Pitney Bowes (NYSE: PBI) and Lexmark (NYSE: LXK). Xerox has also been able to string together five years of income growth and solid cash-flow generation along the way. The problem has been top-line expansion: Sales have fallen an average of 3.5% annually since 2001.
Fourth-quarter and year-end results released yesterday highlighted Xerox's struggles to get sales moving in the right direction. Sales grew 3% for the quarter and eked out a 1% increase for the year. Analysts remain concerned about anemic equipment sales -- they make up just less than 30% of total sales -- because they form the backbone of the company's annuity sales model, by way of providing steady post-sale service revenue and financing dollars if customers choose to lease equipment or pay for bundled packages that include equipment, supply, and service options.
On a more positive note, Xerox generates impressive operating and free cash flow. Operating cash flow has exceeded reported net income by 30% to 40% over the past two fiscal years, and the margin was even wider in 2003 and 2004. And low levels of annual capital expenditures mean that free cash flow also exceeds net income each year.
The shares have run up by almost 26% since hitting yearly lows last summer, yet they still trade at a reasonable 13.5 times 2006 earnings. The multiple is even more reasonable on a cash flow basis. Investors continue to warm to Xerox, but it may stay at current levels until sales growth increases.
A couple of other drawbacks I see are high debt levels, in part because of the financing side of the business, and underfunded pension and other benefits that are draining away more than $300 million in capex as management makes up for years of retirement underinvestment. It may take some more time for Xerox to recover fully from its past mistakes, but it is well on its way.
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Fool contributor Ryan Fuhrmann is long shares of Lexmark but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.
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