Several folks have been asking about the latest teaser pick circulating from Tom Dyson for his Palm Beach Letter — I haven’t seen this one really widely promoted, but it has come up enough that I think we’ll probably see more of it. And it so happens that it teases a company I have owned before and find interesting, so we’re going to borrow this idea from Dyson today for our Idea of the Month for the Ides of March, and see what there is to like (or not like).
Here’s how the idea was teased — this particular pitch was in the S&A Digest, which is the daily newsletter Stansberry sends out to anyone who subscribes to any of their paid newsletters (Dyson worked at Stansberry, running the 12% Letter, before he left to start Palm Beach with Mark Ford … I don’t think this idea has been more widely pitched than that yet but I’m not sure):
“Our colleague Tom Dyson tells us he’s found ‘the next IBM.’
“Regular Digest readers will recall us mentioning the IT services giant from time to time. Extreme Value readers are up 7% since I (Dan) recommended it last August.
“I’m extremely picky about the quality of businesses that make it into the Extreme Value portfolio. But IBM’s 16% profit margins and $20 billion in annual cash flow allowed it to make it into the club.
“IBM is also a major holding of the world’s greatest investor, Warren Buffett. He owns more than 6% of the stock, a $13 billion stake. It’s a stock that can safely build your wealth over a long, long time. Thus, when I hear a claim of ‘the next IBM,’ I take notice…
“Tom tells us his brand-new issue of The Palm Beach Letter focuses on a stock he believes will generate safe 12% returns for investors for at least the next few years (and likely a lot more). IBM has built an extraordinary business over the past decade or so by reinventing itself. It’s gotten away from the low-margin business of selling hardware (like computers and printers) and into higher-margin businesses like software and IT services. Tom sees his new recommendation making the same smart moves.
“Tom’s new recommendation is cheap. It’s priced 10% below book value and trades at a little more than five times free cash flow. Last year, the company bought back 10% of its shares and raised its dividend more than 30%. And last year, it distributed 55% of its profits to shareholders through dividends and buybacks.
“One Wall Street guru has already taken notice and bought $177 million of the stock. Tom is urging readers to buy the company before the rest of Wall Street and the investing public catch on.”
So what is this “next IBM” stock? It’s longtime tech pioneer and current “thrown on the dustheap” dinosaur Xerox (XRX). And yes, I did own the stock for six months or so in late 2010 and early 2011 — I let myself be stop-loss’ed out of the shares when they fell in the Summer of 2011, and they’ve just recently recovered from that fall and started to rise again (well, OK, “started” is a loaded word that implies they’ll keep rising — but the stock has been climbing nicely in 2013 so far and is now around the price I sold for again).
To dot our i’s and cross our t’s, here’s why the stock is a match:
Xerox is moving out of hardware and into services — they’ve been doing this for a while, most conspicuously with the large takeover of Affiliated Computer Services (ACS) a few years back. They are quite aware of the rising “paperless” world and the commoditization of imaging technologies and they’ve been moving into higher-end document management and into tech services to keep profit margins and potential revenue growth alive.
The shares are indeed at about 90% of book value — though that’s partly because of large goodwill charges from the ACS acquisition (and other, smaller acquisitions over the years).
And they did announce a dividend raise last year, though it hasn’t yet been paid — they boosted the dividend by about 35% to 5.75 cents per quarter, which means that starting with the April quarterly payout the effective yield will be about 2.7% with the stock at $8.60. That’s part of what helped the stock to perk up over the last few months, along with the announcement of what a large share buyback they completed, even though their writedowns on restructuring were a bit higher than expected and margins were pressured. The lack of dividend growth was one of the reasons I was willing to sell XRX a couple years ago (as of December the dividend had been flat for five years), so this is a promising development.
And yes, a “Wall Street Guru” did buy in with a $177 million ownership stake — though that was David Einhorn’s Greenlight Capital, and Einhorn pretty publicly bought in to the Xerox story over a year ago. Greenlight’s stake is currently $177 million, which is a decent size for them but only 2% of the company — perhaps more of an endorsement for value-oriented and patient investors is that the Dodge & Cox funds own almost 10% of Xerox.
So I’m sure Dyson is teasing Xerox as the “next IBM” — but is it worth getting over my resistance and buying back in to this stock? That’s the question I’m considering now as Xerox continues to try to transform itself both as an investment (hopefully becoming a steady dividend growth company) and as a company (figuring out how to get growth from the services division without sacrificing margins — and continuing to rationalize their structure three years after that big acquisition). The big question, I guess, is whether you think Xerox is the next IBM … or the next Hewlett Packard.
Xerox is not expected to grow their revenues very much this year, they’re forecasting sales growth of roughly one percent — so that immediately turns off some people. But they do believe that they can further “rationalize” their cost structure — which probably means both getting rid of duplicative workforces in the services division and moving lower-end work to lower-cost countries, their workforce is very much a Europe and US workforce right now. Some of the writedowns that they took at the end of last year are presumably for layoffs and buyouts that are going to bear fruit in lower costs for 2013, and they expect operating cash flow to be a little bit less than 2012, in the range of $2.1 to $2.4 billion.
There are clearly both positive and negative developments for the company when it comes to the big picture global economy that drives their revenues — they have significant exposure to healthcare through supporting Medicaid programs and through building better integrated health monitoring systems that can work with the healthcare reform goals of treating patients instead of just performing fee-based procedures, which means they should see revenue increases as more and more people are put on Medicaid and on insurance in general … assuming they continue to win their fair share of bids to run state programs. They also continue to have that IBM-like mix of ongoing revenue that people like — multiyear contracts for support and process outsourcing that save governments and companies money or, like running the EZ-Pass toll systems along the East Coast, or red light cameras for cities that actually generate revenue, or simply helping companies with costs through outsourcing IT and business support systems to Xerox/ACS.
And all of the areas have strong competition, of course, from companies like, well, IBM (and many other smaller players in various sectors), which means they have to continually rationalize costs — they don’t have as strong a brand identity and as large an installed base in business outsourcing and IT outsourcing as they do in document processing and printing. But they do have a strong brand, and they have relationships with thousands of governments and companies around the world and a growing expertise in solving those customers’ problems.
But probably the biggest argument in favor of Xerox shares is the same one I made a couple years ago when I bought the stock: It’s really cheap. It’s partly cheap because they’re not growing the top line very fast, but there are a lot of companies who don’t grow the top line fast or consistently but who, like Xerox, generally have the capability of turning that into 5-10% earnings growth, and not many big companies that can show earnings growth are this cheap.
XRX trades at 92% of book value right now, which is very cheap — that’s not the same as tangible book value, since XRX carries a fair amount of debt and they have a huge goodwill entry on their balance sheet for the premium over book value that they paid for their acquisitions, but those have been valuable acquisitions both in helping to restructure the company and, perhaps more importantly, in bringing in more customers and more annuity-type business on long-term and consistently renewing services contracts.
And they do trade at a very low multiple to earnings and cash flow — Xerox generates a lot of cash, with free cash flow last year coming in at about $1.50 per share (that’s operating cash flow minus capital spending), which, because of non-cash charges like depreciation, is substantially more than their 88 cents in earnings per share last year. Either one is plenty, though, to cover their buybacks and their higher dividend — the dividend is not much more than a quarter of earnings, and even buybacks at the rate of a billion dollars a year are manageable on top of that without pressuring working capital or their ability to invest.
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The debt, too, is fairly high but not particularly a concern — they do carry about $12 billion in long-term debt and pension liabilities, but the debt portion of that (about $7.5 billion) is mostly tied to financing equipment, they use debt to cover the equipment leases they make with their customers, the large number of companies that choose to lease rather than purchase their copiers and printing equipment. So there are assets and annuity-like revenue streams that cover a substantial amount of that debt, and the debt maturities don’t look like they’re an issue — the debt doesn’t all mature in the same year. Their debt is investment grade, though near the bottom of investment grade, so it’s not terribly expensive and should, given their continued cash flow generation, be something they can roll over pretty easily as each maturity passes.
XRX may even be more cautious with debt than some companies because they were almost destroyed by it in 2002, when they faced a fraud lawsuit and a massive restatement of their earnings that drove the shares from $60 to $5 in the space of a few weeks, which was enough to almost crush the company itself, but in the aftermath it also made their debt level at the time look completely unsustainable. That history, by the way, may have something to do with the very slow recovery of XRX shares in the last decade — part of that’s because it took a long time to rebuild and refocus the business, but I think it’s also true that it has taken investor perceptions of Xerox a long time to evolve to keep up with the changes at the company.
I don’t think this is a short-term popper of a stock, by any means, but I do think they have an opportunity to close the valuation gap as their business steadies — if they can do better than their expected 1% sales growth over the next few years, and if they can continue to grow their recurring and service revenues businesses and manage expenses to raise earnings and cash flow, they should be able to slowly get a better valuation from investors.
They’re not going to catch up with IBM overnight (IBM took a long time to make their evolution from a hardware company to a services company, too, which I assume is a big part of Dyson’s comparison), but if they can close even half of the valuation gap with IBM over the next two or three years that would provide the opportunity for a substantial capital gain — IBM trades at a trailing PE of about 15, and XRX at about 10. If Xerox is able to get a trailing PE of 12 in 2015, and if analysts are correct in their pretty reasonable 5-10% or so earnings growth over the next two years getting them to $1.19 in earnings per share in 2014, then that’s a share price of $14.25 in two years. It’s certainly not guaranteed, but it’s feasible and, if the company continues to execute roughly as well as they’ve been doing, the downside in the stock is probably not much worse than $7.
They will probably not be buying back a billion dollars of stock this year like they did last year, but they probably could if conditions and cash flow warrant … and they are indicating that they’ll buy back at least $400 million of stock and retire half a billion in debt, so if they can manage to keep doing that at relatively low prices (average buyback price was near $7 last year), that will help give some growth boost to both earnings and cash flow per share and book value per share.
So … I haven’t bought shares of Xerox (again), but with their continued focus on growing their services and outsourcing businesses, and now that they’ve signaled a willingness to raise the dividend (and I don’t think they would have done the big attention-getting 35% raise if they weren’t intending to embark on a dividend growth policy) and followed through with close to $2 billion in stock buybacks over two years, I’m a bit more comfortable with this as a value pick now.
They will probably not show top line growth this year in a meaningful way unless they win an unexpected amount of medicaid and health insurance business in that evolving industry or unless the European economy jumps back to growth far more quickly than anyone expects, but they should be able keep improving profits gradually as businesses reinvest for growth and efficiency and governments outsource for both fee generation and cost containment. Services are already a bit over half of their business, so the diminished reliance on copying and printing equipment is well underway.
I’m putting Xerox on the watch list and will think about buying it personally if the shares stay below $9 or, preferably, dip a little bit in the months ahead — we can’t have a huge amount of confidence in the company’s new course just yet, since it’s quite new and they’re still wringing costs out and trying to prove that they can grow, but it’s that lack of confidence that makes the shares cheap.