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Why Xerox Should Recapitalize and Boost Its Dividend

May 25, 2012 | About:
Ben Michaud

Ben Michaud

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Right up front I want to disclose that I own Xerox and am thus talking my book. The investment thesis for Xerox is well known throughout the investment community, as the stock has shown up in several well known hedge fund portfolios and recently won the “Best Idea” contest at the Sohn Conference, so I will only briefly outline – the ACS acquisition transformed Xerox into a service company with stable, annuity-like revenue, it generates approximately $1.6 billion of free cash flow, it sells for less than 7.00 times FCF at current prices and is committed to repurchasing roughly $1 billion worth of stock per annum over the next several years. While the investment thesis is attractive on a stand-alone basis, I believe the “low-growth” nature of the business and the paltry dividend yield leave the stock in “equity mandate no-man’s land” with the potential for an extended period of “dead money”. “Growth” investors are uninspired and “value” investors receive little in the way of current yield – while the buyback yield is significant and certainly benefits from the current undervaluation, I believe a more balanced policy of returning capital will result in a higher multiple over time as an attractive and growing dividend attracts a long-term, stable shareholder base. In order to take advantage of the current undervaluation, transform the shareholder base and close the valuation gap, I would propose the following three-part plan. Allow me to explain.

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.



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