Xerox (NYSE:XRX) recently raised its bid for HP (NYSE:HPQ) to $24 per share, consisting of $18.40 in cash and 0.149 shares of Xerox for each HP share. This marked the first time Xerox raised its bid since its unsolicited offer of $22 per share last November that included $17 in cash and 0.137 shares of Xerox.
HP rebuffed Xerox's initial offer, stating that it undervalued the company and wasn't in the best interests of its shareholders. It also accused activist investor Carl Icahn, who owns a larger stake in Xerox than HP, of engineering the deal for his own benefit.
Xerox is moving to replace HP's board with its own nominees and is launching a tender offer for investors who want to take the deal. It's unclear how this drama will play out, but I recently sold all my shares of HP at a slim profit for three simple reasons.
1. Xerox can't afford to give HP investors what they want
Xerox's initial offer was surprising since it's much smaller than HP. Many analysts questioned how Xerox, which ended last quarter with just $2.7 billion in cash and equivalents, could secure the funding for its initial offer of $33 billion.
But in early January, Xerox announced that it had secured $24 billion in funding from Citi, Mizuho, and Bank of America, which would give it enough liquidity to fulfill the cash portion of the offer. But doing so would significantly boost Xerox's long-term debt, which it reduced 24% annually to $3.2 billion last quarter.
Many HP investors, including myself, likely favor an all-cash offer in the mid-$20s without any shares of Xerox, which is also struggling with revenue declines across its printing businesses. However, Xerox's financials suggest it can't afford to significantly raise the cash portion of its bid and that all future offers might be funded in Xerox's stock.
As a result, Xerox's tender offer, which requires 80% of HP's investors to tender their shares, will likely fail. When that happens, Xerox could finally walk away and cause HP's stock to plunge back to the high teens.
2. HP's stock deserves to go lower without the deal
HP's personal systems business, which sells PCs and workstations, remains broadly stable -- thanks to enterprise upgrades to Windows 10 PCs and decent demand for its new 2-in-1 and gaming PCs.
However, its printing business, which generates most of its profits, is still spiraling out of control. Last quarter, HP's printing revenue fell 6% annually. Its hardware shipments fell 9%, with declines in both the commercial and consumer markets, due to tighter enterprise spending and lengthier upgrade cycles.
Revenues from its higher-margin printing supplies, which are sold on a razor-and-blade model, slid 7% as cheaper generic competitors pulled away its consumers. Losing those higher-margin revenues caused the printing unit's pre-tax profit, which accounted for 59% of its bottom line, to decline 8%.
HP's main strategy for reversing this decline is its Instant Ink subscription program, which automatically delivers refills for a monthly fee. But that generally isn't an economical solution for customers who only occasionally use their printers.
Wall Street currently expects HP's revenue to dip 1% next year as buybacks and cost-cutting measures boost its earnings by 2%. Before Xerox launched its hostile bid last November, HP was trading at about $18 after it announced the abrupt resignation of its CEO and offered a gloomy outlook for the fourth quarter. Not much changed during HP's fourth-quarter report later that month -- so the stock could plummet if Xerox abandons its bid.
3. Icahn wants to create a company with monstrous debt
Xerox claims that the combined company would generate "at least" $2 billion in synergies within the first 24 months and that merging the two printing businesses would create a more formidable player via economies of scale. However, the combined company would also be saddled with over $30 billion in long-term debt. That's troubling because Xerox isn't faring much better than HP. Analysts expect its revenue to decline 4% next year as its earnings -- also buoyed by buybacks -- rise 1%.
Merging two companies with non-existent organic revenue growth is risky, and cutting costs to boost its cash flows and earnings could cripple its ability to generate fresh top-line growth. That strategy will also barely dent its mountain of debt.
Instead, Icahn will likely direct Xerox to aggressively divest HP's assets to raise fresh cash for buybacks -- which would arguably dull its competitive edge against rivals like Lenovo.
Locking in some profits to avoid nastier losses
I might have sold my HP shares prematurely, since Xerox could still raise its bid by boosting the stock portion of its offer. However, I'd rather lock in some profits now and move on to other rebounding tech stocks instead of waiting for this fragile deal to collapse.