Xerox Hits a Snag With Government Health Care

Xerox just got dealt a blow regarding a lucrative government health-care contract. What will this mean for the company's performance going forward and its role in public-sector health care?

Jun 10, 2014 at 5:00PM

Xerox (NYSE:XRX) has been around for three-quarters of a century. It's one of those stocks that you know is there but might not pay too much attention to, let alone consider it for your portfolio. But Xerox isn't just a copy-machine maker with limited growth. It has evolved with technology and is attempting to redefine its legacy toward more of a services-oriented business in information technology. So is it time to reconsider Xerox? Let's take a look.

Xerox still makes printers, and in fact in February strengthened its position in the high-end color printer market through its acquisition of France's Impika. But it's the higher-margin services business, not hardware, that is the future for Xerox, where the company generated more than half of its revenue in 2013. Xerox's plan is for services to comprise two-thirds of its revenue by 2017.

Xerox Services

Source: Xerox's 2013 annual report

Unfortunately for Xerox, those higher margins remain elusive. In the first quarter, Xerox's margin from the increasingly relevant services segment came in at 8.6%, representing a decline of 70 basis points versus the year-ago period and falling short of the company's 9.3% estimate.

Let's find out why.

Behind the scenes
Today's Xerox seems to be more under the radar, as company executives suggest you encounter its IT services in everything from toll roads to mortgage applications but never really know that it's there. One particular area of growth for Xerox is the health-care industry, both in the public and private sectors. As Xerox execs noted on the company's first-quarter earnings call:  

So I think health care, historically, government health care, historically, and on a go forward basis is -- will be very profitable and is very attractive, and we continue to expect it to be. -- Ursula Burns, Xerox chairman and CEO

Unfortunately, the company was dealt quite a blow from the government health-care sector in recent weeks. The state of Nevada decided to end its contract with Xerox for implementing the state's health-care exchange platform dubbed Health Link, putting the kibosh on a $72 million agreement amid a botched rollout that was commanding more time and resources than either side expected.

The deal had been a real coup for Xerox, which handles logistics -- not implementation -- for health-care exchanges for about a half a dozen U.S. states where things seem to be going smoothly. Government health care, particularly the health exchanges (but also the company's role in Medicaid Management Information Systems), is a growth area for Xerox given what the company characterizes as a "demographic tailwind" among the millennials. But if the Nevada failure is any indication, it could hurt the company's chances to implement health-exchange platforms for other states.

Incidentally, Xerox in part blamed the "implementation of the Nevada health care exchange" for its margin shortfall in its service segment. Xerox in the first quarter already lowered its full-year guidance for the services margin and earnings on account of government health-care costs. Now that the Nevada exchange is no longer in the picture, it will be interesting if Xerox revises its guidance yet again.

Shareholder value
For all of the headwinds that Xerox is facing in its high-stakes services business, the company has managed to produce steady cash flow that it is intent on returning to shareholders. In the first quarter, after repurchasing $275 million worth of shares, Xerox lifted its guidance for share repurchases for the remainder of the year to at least $700 million from previous guidance of a $500 million minimum. And at just 12 times forward earnings, the stock is relatively in line with the likes of International Business Machines (at 10.3) and Hewlett-Packard (at about 9.1).

Bottom line
It's tough to say whether Xerox will grow its services business at the rate that it projects, especially with the latest setback in Nevada. But if you believe in its growth story and are willing to wait, you will be rewarded with a 2% dividend yield (about the same as what HP is yielding) and share repurchases in the meantime. The Affordable Care Act rollout hasn't been seamless for any state, so Xerox isn't alone in its challenges.

The company recently brought IBM veteran Bob Zapfel on board as president of its services business. And as a 75 year-old company, Xerox has the benefit of history on its side. But things could get worse before they get better at Xerox, so if you're willing to jump in at these levels just be sure and buckle your seat belt.

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Gerelyn Terzo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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