In summary, I believe Xerox should 1) boost its “core” debt from 1.14 times to 2.00 times LTM EBITDA by issuing up to $2.7 billion of additional debt, 2) initiate a $2.7 billion Dutch tender offer at $7.50 per share in order to retire 360 million shares and 3) boost its dividend from $250 to $735 million per annum. The Dutch tender offer would immediately boost per share intrinsic value by more than 20%, the more balanced payout policy would transform the shareholder base and the 9.2% post-tender offer dividend yield would catalyze a closing of the valuation gap as yield-starved investors drive the yield down to 5% or less.
As of 1Q12, Xerox had total debt outstanding of $9.6 billion, or 3.04 times LTM EBITDA. $6 billion represents “financing” debt backed by high-quality financing receivables, while $3.6 billion is considered “core” debt. At 1.14 times LTM EBITDA, I believe Xerox is under-leveraged from a “core” debt perspective, a belief underscored by Xerox’s recent $500 million issuance of 5-year unsecured debt at a pre-tax cost of 2.95%. Issuing $2.7 billion of additional debt would bring the “core” debt ratio up to a modest 2.00 times LTM EBITDA.
I estimate 2012 free cash flow to equity holders to be approximately $1.6 billion, or $1.12 per share based on $2.2 billion of management-guided operating cash flow, $600 million of capital & acquisition spending and weighted-average, fully-diluted shares outstanding of 1.427 billion. Assuming a conservative 10 times fair value PE multiple, Xerox is currently worth approximately $11.20 per share. A $2.7 billion Dutch tender offer at $7.50 per share would reduce shares outstanding by 360 million shares, boosting per share FCF to $1.38 (assuming a 6% pre-tax cost of debt and a 20% tax rate). The post-tender offer fair value would thus rise to $13.80, more than 20% higher than the current estimated fair value.
Post-tender offer, the current annual dividend of $250 million would rise from $.18 to $.23 per share for a dividend yield of 3.1% (versus 2.3% pre-tender offer). With its annuity-like cash flow profile however, Xerox is more than capable of handling a 50% payout ratio, or an annual dividend rate of $.69 per share – at a post-tender offer price of $7.50, the dividend yield would rise to 9.2%. To say the least, I do not believe a 9.2% dividend would last long – perhaps a new, dividend-seeking investor base drives it down to 5%? The upside speaks for itself – a 5% yield means a $13.80 stock price, while a 4% yield means a $17.00 stock price.
While it is a neat exercise to measure potential “downside”, since stock prices are simply a reflection of the collective investor mood at a moment in time, and the general mood at the moment is supremely negative as a result of the developed world’s inability to get its fiscal house in order, I will not venture a guess as to how low Xerox’s stock price could fall in the event of a large-scale market decline. All I will say is that I am quite confident the risk of permanent impairment from current levels is sufficiently low to warrant a full position.
I do not have the capital to push for such a plan, but as Jeff Saut often says, “Good things happen to cheap stocks”. A prolonged period of stock price stagnation particularly in the face a robust buyback program will no doubt incite shareholder action.