Two months ago, I announced my intention to create a portfolio composed of 10 companies that investors have unjustly cast aside. My goal in creating the One Person's Trash Is Another Person's Treasure portfolio is to highlight just how successful value investing and contrarian viewpoints can be, as well as uncover some great companies that have a good chance of turning their fortunes around. For a more thorough explanation of what I hope to accomplish and how I'll measure my success, I encourage you to visit my portfolio mission statement.
For reference, here are my previous nine selections:
For my 10th and final selection, I've chosen business service and information technology company Xerox (XRX +0.00%).
Why traders have given up on Xerox
It's actually pretty easy to understand why traders have given up on Xerox. Simply mention the name Xerox to any 20- or 30-something-year-old and carefully watch their face as they dream of dinosaurs like the T-Rex or pterodactyls.
Xerox has been associated with the now-commoditized printer and hardware business for so long that it's having a really difficult time disassociating itself in traders' eyes from these businesses. Honestly, what do you call a copy? I know I find myself saying "I'm going to make a Xerox of this" more often than "I'm going to make a copy."
Xerox has tried its best to transcend from just hardware sales, but the transition, and the sectorwide precedent, hasn't been easy. IBM (IBM +0.34%) is one of the few hardware companies to successfully transition from being just a hardware company and move into the information technology and cloud-computing space. In its full-year report released yesterday, IBM noted an 80% increase in cloud-computing revenue, but really saw its diversification shine overseas with BRIC country revenues -- Brazil, Russia, India, and China -- up 11%.
Hewlett-Packard (HPQ 1.74%) hasn't been as lucky, suffering through an identity crisis and now being forced to cut 27,000 jobs just to rein in costs. Not to mention it also took an $8.8 billion charge on its Autonomy purchase, which casts doubt on the effectiveness of HP's management team and its CEO Meg Whitman in evaluating... well, anything! Cloud revenue for HP did grow 39% in 2012, so it's doing what it can to make the transition like IBM, but with multiple overhauls going on at once in enterprise services, software, hardware, and even with regard to developing its Converged Cloud, I have to wonder if HP can keep its eye on the ball.
Inkjet printing specialist Lexmark International (LXK +0.00%) has been even slower to respond, moving slowly into enterprise printing. The consumer side of the business simply dried up as competition for sub $100 printers increased and ink consumption decreased as e-reader and mobile usage increased. Lexmark has found a temporary fix in providing all-in-one devices (printer/scanner/fax) for businesses which have significantly higher print and ink needs, however, it could just be a matter of time before the same thing happens on the enterprise side of the business as well. Not surprisingly, investors have generally seen sales tick lower since 2004.
Xerox's answer to expanding its business was the purchase of Affiliated Computer Services in 2009 for $5.5 billion. ACS' business is predominantly with enterprises and the government, but comes with lower margins that have not pleased investors.
Why investors should trust Xerox
Yet, the same distrust that's bestowed on Xerox with regard to its purchase of ACS is the precise reason why I feel investors should consider this a turnaround that's well under way.
The driving factor that has me excited about Xerox is ACS' long-term contracts with the government. About half of Xerox's revenue is now derived from its service operations that handle everything from toll booths to government-sponsored Medicaid and Medicare claims. In California, Xerox is handling all Medicaid claims and processed more than 90 million claims totaling $7.5 billion in just the first six months on the job. If you haven't noticed, this is a state and a sector that's about to see a major boom as the 2014 insurance mandate and Medicaid expansion under the Affordable Care Act are going to bring 16 million new persons under the fold of government-sponsored health care. Xerox is actually on the precipice of a boom in recurring revenue!
Xerox's management also understands that cost-cutting isn't optional, but taking care of shareholders is mandatory. If Xerox wants to be taken seriously, it needs to err on the side of caution with its spending -- something it made very clear last quarter -- and it'll need to consider boosting its dividend, which yields 2.3% but only pays out about 19% of its profit out as a dividend.
What you'd get here
Just like my argument with Dell and Staples, you're going to get a dirt cheap service company with strong cash flow, a decent dividend, and the chance to put big money in shareholders' pockets if they'll just give it a chance.
On a valuation basis, Xerox is very inexpensive at just 78% of book value, less than six times forward earnings, and less than five times cash flow. It does contend with quite a bit of net debt (about $8.5 billion), but record-low interest rates have given Xerox the perfect time to refinance and begin paying down its debt load. Excluding 2008, Xerox has produced between $1.2 billion and $2.2 billion in free cash flow over the past decade and has delivered a bottom-line profit every year.
Simply put, Xerox's business may be unexciting, but it's reliable thanks to an abundance of recurring revenue and long-term contracts. It's pretty hard to argue that there's much downside left in this stock.
Check back next week when I kick off this year-long experiment and see if my portfolio of value and contrarian plays can outpace the broad-based S&P 500.
