What to Expect When Xerox Reports Earnings

Xerox (NYSE: XRX  ) , a leading provider of business process and document management services, is set to report its fourth-quarter earnings on Jan. 24. The company is split into two segments: a growing services business and declining document technology business, with services now making up a little more than half of the company's total revenue. With opportunities to grow the services business in industries like health care, Xerox will continue to diversify away from its legacy copying and printing business going forward. Here's what to expect from Xerox's earnings report.

What analysts are expecting
Revenue is expected to fall by 4.7% in the fourth quarter and by 3.9% for the full year, although analysts anticipate a return to growth in 2014. In the third quarter, revenue was flat compared to 2012, with the services business growing by 3% and the document technology business shrinking by 4%. If analysts are correct, then both segments will likely shrink during the fourth quarter.

EPS is expected to decline by a penny to $0.29 for the quarter, with the full-year EPS rising by 9% to $1.09. This is in the middle of Xerox's prior guidance for the quarter, with tight lower and upper bounds meaning that a significant earnings surprise is unlikely. Margins will have to increase, with revenue declining to hit these EPS numbers, continuing the trend from the third quarter where the services operating margin rose by 0.5 percentage points and the document technology operating margin jumped by 1.3 percentage points.

Keep an eye on margins
The key to the Xerox story is maintaining high margins in the declining document technology business, while focusing on high-margin services. Hewlett-Packard (NYSE: HPQ  ) competes with Xerox in both segments, and the differences between the two companies says a lot about what Xerox is doing right. While HP's printing business enjoys a higher margin than Xerox, 17.7% compared to 12.1% in each companies' previous quarter, Xerox blows HP away when it comes to services.

Xerox's 9.9% services margin last quarter was more than twice HP's 4.4% services margin and more than triple HP's full-year 2.9% services margin. While HP generates about twice Xerox's services revenue, Xerox manages to generate greater profits.

Investors should keep an eye on margins in both segments. In document technology, there's the potential for Xerox to grow its margins, even as revenue declines. Last quarter, the margin increase was due to increased productivity and savings from restructuring, helped by a 92% increase in sales of Xerox's high-end color systems. In services, while Xerox has far higher margins than HP, this number has declined over the past few years and is now at the low-end of the company's target range. There's plenty of room to improve here as well, with Xerox targeting an increase of 0.5 percentage points in 2014.

Possible dividend increase
Xerox reinstated its dividend in 2008, but the financial crisis led to a stagnant payout over the next few years. The company finally boosted the dividend in 2013, increasing the annual payout by 35%, but there's still plenty of room for further increases. The payout ratio in 2012 was just 18.9%, and the company paid out between 15%-19% of its free cash flow as dividends in 2013, depending on the exact free cash flow result.

With four consecutive payments without a dividend increase, it could be time for Xerox to increase the payout again. Even a double-digit increase would still result in just a small portion of the free cash flow going toward dividends. With the company in a far more stable position than it was during the heart of the recession, I wouldn't be surprised to see a dividend increase at some point this year.

The bottom line
Xerox's fourth quarter will likely be weak, with declining revenue and earnings, but the next few years look better. With services slowly accounting for an increasing portion of Xerox's business and plenty of room to improve margins, 4%-5% annual earnings growth in the long-term doesn't seem out of the question.

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