Friday, April 23, 2010

Xerox up on earnings, boosted guidance (XRX)

Xerox (XRX) shares are up 8.5% this morning, after earnings per share for the first quarter of 18cents beat expectations by 5cents. They guided for the full year to be at the "high-end" of the 75-85cent range, which is above Wall Street's estimate of 81cents.

AlphaNinja readers who joined me in buying shares on September 29th 2009 are enjoying a 48% gain, about triple the rise in the general market over the same period. The reason we jumped in was due to the sell-off in XRX shares when they announced the ACS deal:

AlphaNinja - (10:23am EDT) Iconic but lethargic printing and "services" firm Xerox (XRX) has agreed to purchase business process outsourcing (BPO) firm Affiliated Computer Systems (ACS) for $63 in cash and stock. The dual cash and stock nature of the deal is used to reduce the out-of-pocket cash expense for Xerox, and to incentivize ACS employees with a stake in their new firm. Xerox shares are off almost 17% on the news - a total overreaction, and I'm buying shares this morning.
The offer to ACS consists of $18.60 in cash and a 4.935shares of XRX for each ACS share they own -->> this amounted to $63 per share based on Friday's closing price for Xerox, but today the market is punishing Xerox, with shares trading all the way down to $7.55. Thanks to the stock nature of the deal, this reduces the offer to ACS shareholders to $55 from $63. Ouch.
Why is Xerox off so much? They're purchasing a company with double the profit margin, and for a pretty decent price. At the $64 offer price and considering ACS' cash balance, it looked to me that Xerox was paying a FCFY (Free Cash Flow Yield) of 11%. At this lower price based on where shares are now trading, it looks more like 13%. And this is before major cost-cutting (no I won't say "synergies"!) adds a point or more to that.
I'd say the biggest reason Xerox shares are off is worries about the ability to finance the deal, which was not mentioned much in the presentation slides this morning, nor in the press release. Xerox has a massive debt load, but they also generate massive cash flow, leading to a FCFY of almost 20% based on the current stock market value. Xerox is looking at a drop of 16% in revenue this year, and is picking up a company that is growing revenues at 7%. There's execution risk here, financing risk, etc., but the Xerox stock drop more than reflects the worries. I'd say Xerox shares will head higher, and should be bought on this news.

Some of the best opportunities I've had to buy companies is when the market trashes the stock on news of an acquisition. A great example is Western Digital (WDC), when they bought Komag in June 07. I didn't know a lot about WDC at the time, but what I did know was that they got Komag for a SONG...when management makes a shrewed acquisition it is at the least a good starting point to do some more due diligence and possibly entrust your capital to said management.

Anyway, moving on. In addition to good results from the acquired ACS outsourcing business, Xerox saw an uptick in businesses spending on higher-margin color products:

From the release:

“Our results reflect improving demand for Xerox’s document technology in developing markets and from small and mid-size businesses. In addition, total color revenue grew 11 percent in the quarter with customers increasingly choosing Xerox color multifunction printers as a cost-effective way to get more for less,” said Burns. “Equipment sales are still under pressure for large enterprises and the graphic communications market. However, we’re seeing an improving trend in enterprises’ use of their existing devices, contributing to our annuity stream and indicating some economic stability in corporate environments.
“Annuity revenue is also significantly strengthened by our growing services portfolio with business process outsourcing up 8 percent on a pro-forma basis in the first quarter. Xerox’s annuity is now 83 percent of total revenue,” added Burns. “We’re on track with cost and revenue synergies from the acquisition. This progress coupled with marketplace momentum for our document technology positions us well to deliver continued revenue growth, strong cash and earnings expansion throughout the year.”
There are a LOT of moving parts (one time charges, acquisition expenses, etc..) involved with the company's operating cash flow figure of $375million, but it will still lead to an impressive number for the full year. Xerox has huge "hidden" earnings thanks to large deprecation expenses, so Free Cash Flow Yield(FCFY) for the year should still be in the mid to upper teens. I'm going to wait until next quarter to get a clearer estimate of what the full year FCF will be, but suffice it to say that I think shares will finish the year closer to $20 than to $10...

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