Shares of Xerox (XRX +0.00%) fell by nearly 10% last week after the company issued disappointing guidance. While EPS beat analyst estimates by a penny, revenue fell short and the full-year outlook left much to be desired. Xerox is transitioning into a services company, but its legacy document technology business is weighing down the company's performance. Is this a market overreaction, or were investors right to sell?
A mixed bag
Total revenue for the quarter was roughly flat, coming in at $5.3 billion. Services, which now make up 56% of the total revenue, grew by 3% year over year, with profit rising 9% on a margin of 9.9%. The legacy document technology business saw revenue decline by 4%, although profit rose by 7% thanks to good performance in the high-end market. A margin of 12.1% represents an improvement over both last quarter and the same period last year. The total operating margin for the company was 9.4%.
The document technology segment is in a perpetual decline, as the demand for printers and copiers is on the decline. But Xerox is a leader in this space, and that has allowed the company's margins to stay intact even with declining revenue. A focus on the high-end market led to an increase in profit, and at the worst, I would expect profit to decline at about the same rate as revenue. Xerox should be able to milk the business for years to come.
Services grew, but this growth has slowed down. The same period last year saw 6% revenue growth, double the current rate. It's important to remember, though, that one quarter does not make a trend. The state of the world economy likely has something to do with the slowdown, so I wouldn't be too worried.
In August, Xerox acquired CPAS Systems, a developer of pension administration and record-keeping software. Xerox has made a series of acquisitions in the past few years to bolster its services portfolio. As time goes on, the services segment will become increasingly important for the company.
Strengthening the balance sheet
Xerox is sitting on quite a bit of debt. At the end of last quarter, the company had $7.5 billion in debt, in addition to about $2.8 billion in pension obligations. The debt has been declining, though. Over the past year, the company has shaved nearly $2 billion off the total. Strong cash flow allows Xerox to reduce the debt while paying a modest 2.4% dividend and actively buying back shares, and the company expects to further reduce the debt by $400 million this year.
An expected, free cash flow of $1.6-$1.9 billion for the full year puts the total debt at just 4 times the high end of this guidance. So, while the debt compared to the market capitalization looks high, it's actually fairly reasonable compared to the company's cash flow. The balance sheet should continue to strengthen as the debt is further reduced, and the picture looks a lot better now than it did a year ago.
Earnings are greatly understated
Calculating net income involves the deduction of depreciation, and in 2012 Xerox recorded a $1.3 billion depreciation charge. But the company spends far less on capital expenditures, with just $513 million spent in 2012. This discrepancy appears to be due to the acquisition of Affiliated Computer Services in 2010, which caused a huge jump in depreciation in that year. The bottom line here is that net income greatly understates the real cash earnings of the company.
While Xerox has guided for $0.93-$0.95 in EPS for the full year, free cash flow per share will be closer to $1.50. This puts the current stock price at just 6.5 times this number. There is a lot of debt and pension obligations, but Xerox looks like a good value after the earnings-related decline.
One caveat: The SEC is currently investigating accounting practices at Affiliated Computer Services. What this will ultimately mean for Xerox is unclear at this point, but it's something to be aware of.
Investors are focusing on the wrong things
While investors are focusing on the declining document technology sales and weak EPS guidance, services continue to grow and EPS greatly understates the real profitability. Another tech company which was recently a victim of the same type of misguided focus is International Business Machines (IBM +0.00%). When IBM reported earnings, a rising profit and growing software and services business was overshadowed by a huge decline in revenue from hardware. Hardware profit turned into a loss, and investors headed for the exits.
But for IBM, hardware is becoming decreasingly important for the company. Total profit grew even as hardware fell into the red, and the future of the company depends on the success of its software and services business, not hardware. Investors focused on one piece of seemingly terrible news, but it turns out that it's just not very important.
Xerox is following in the footsteps of IBM, focusing on growing its services business as its legacy businesses decline. Xerox does have one thing going for it, though. Because it has competitive advantages in the document technology business, even as revenue declines, the company should be able to maintain fairly high profit margins. IBM's servers, on the other hand, are quickly being replaced by cloud-based systems, and profits have already dried up. You can read a more detailed article on IBM's earnings here.
The bottom line
Shares of Xerox are a lot cheaper than they look. Net income, which many investors take as gospel, understates the real earnings, and the company is a lot more profitable than it appears. Strong cash flow will allow the debt to be paid down, a decent dividend to be paid, and a substantial share buyback program to reduce the float. The legacy business continues to generate profits, and the services business is growing. The market clearly overreacted, and Xerox at less than $10 per share is a good deal.
