Xerox (NYSE:XRX) sent a buyout offer to fellow print technology and data management veteran HP (NYSE:HPQ) a couple of weeks ago. HP's board of directors considered the offer and responded over the weekend with a literal "Dear John" letter.

So HP turned down Xerox's $33.5 billion acquisition bid, arguing that the offer provided poor value for HP's shareholders. It's not the end of the conversation between the two companies, however. HP would be happy to consider an offer from Xerox on better terms.

What would it take for Xerox to provide a deal that HP's board and shareholders would accept? Let's take a look.

The offer

HP included a copy of Xerox's official buyout bid, dated Nov. 5.

The bid was valued at $22 per HP share, structured as $17 in cash and 0.137 Xerox shares per HP stub. That's a 20% premium to HP's closing price on Nov. 5, valued at 6.9 times HP's trailing adjusted EBITDA profits. If completed as written, 52% of the combined company's shares would be in the hands of former Xerox owners while HP shareholders would have to settle for a 48% slice of the total pie.

Xerox proposed a governance structure that would be "customary for a combination of this type." The company did not offer any further details, but one might surmise that the new business would have more names from Xerox than from HP in both the boardroom and the executive suites.

"It's not me, it's you"

In a letter, cordially addressed to Xerox CEO John Visentin, HP listed the shortcomings of the proposed buyout offer:

  • We are already doing great and are in no need of some dramatic buyout exit, thank you very much.
  • Xerox's trailing sales fell 10% over the last six quarters, so maybe it's not the strongest potential merger partner in the world.
  • This deal structure relies on a massive amount of debt. Are you sure we can handle those huge interest payments in the long run?
  • Synergies between these fairly similar businesses could make it work, but we'd need to take a deep dive into that analysis before going any further.

The letter ended with an open invitation to discuss better merger structures and synergy estimates.

Xerox and HP by the numbers

I can see how HP would have a problem with giving control of more than half of the new company to Xerox's shareholders. Here's how the two companies compare today in terms of scale:

Metric

HP

Xerox

Trailing revenues

$59 billion

$9.2 billion

Market cap

$26 billion

$7.8 billion

Enterprise value

$30 billion

$13 billion

Total debt

$5.1 billion

$5.2 billion

Cash

$4.9 billion

$922 million

Data source: Yahoo! Finance, Nov. 17, 2019.

A smaller company is attempting to buy a larger rival and take control over the combined boardroom. That's not an easy sell.

Furthermore, HP's balance sheet keeps the total debt load close to the company's amount of cash on hand while Xerox enters the proposed deal with more than $5 billion in debt and less than $1 billion of cash reserves. That's before adding several billion of additional debt in order to finance the cash portion of the HP buyout. I can't blame HP's board members for rejecting that idea.

Woman standing in front of a wall with a picture of a large fish eating a smaller fish.

Image source: Getty Images.

How to make this merger work

If Xerox really wants this to happen, it needs to come back with a completely restructured offer.

  • Prove that the synergies that might be unlocked by this business combination could add shareholder value in the long run.
  • Throw more Xerox shares and less debt into the hybrid buyout price, allowing HP to set the tone of the new company with a majority vote in the combined boardroom.
  • Debt-powered buyouts with a huge cash payment end up being a massive transfer of wealth directly to the target company's shareholders, financed in large part by new debt papers. I'm sure that leading institutional HP holders don't mind that cash transfer, but they don't have the final say in these negotiations. The HP insiders who do run the show own just 0.23% of the company today.

These factors add up to a steep uphill climb for Xerox's deal wranglers. It would actually make more sense to turn the tables and let HP acquire Xerox instead. That would be a smaller deal, requiring much less debt and maybe none at all if it is structured as a stock swap.

I'm not saying that HP absolutely will launch a buyout bid in reverse, or that it would be the best idea since sliced bread to do so. It's just a more sensible way to structure this merger between two similar giants of the technology industry -- let the big fish eat the smaller one and retain a majority presence in the united boardroom.