Xerox (XRX, Financial) is dealing with a shrinking top line as printers and copiers are not as popular as they once were. It posted its first annual loss in five years. The century-old company got the attention of activist investor and guru Carl Icahn (Trades, Portfolio). Icahn has taken a 7.1% stake in Xerox and is looking to acquire board seats. Xerox jumped on the news although it is having a terrible year.
Icahn’s involvement comes just 30 days or so after Xerox announced it is reviewing its business and considering strategic alternatives. It makes sense that Icahn would like to have a say in this strategic review.
Icahn commented on the filing:
The reporting persons acquired their positions in the shares in the belief that the shares were undervalued. The reporting persons intend to have discussions with representatives of the issuer's management and board of directors relating to improving operational performance and pursuing strategic alternatives, as well as the possibility of board representation.
Things are not as bleak as you might assume if you haven’t looked at Xerox for a while. The company has diversified and is not just active in the fast detoriorating printing market but actually generates 60% of revenue from noncopier/printer business. It operates three segments: document technology, business services and other (only a very small piece). Business services already represents the majority of revenue and is the company’s growth business that needs to offset the secular decline in print.
What strikes me as interesting is that this is another business Icahn invests in, with very strong cash flows. It trades at 21x earnings but just 7.7x free cash flow. Not just strong free cash flows but very dependable cash flows. Just like his investment in Cheniere Energy (LNG, Financial) the cash flows are almost annuitylike in nature. Xerox's competitive advantage, if it has any, is that of customer captivity. Once your enterprise is dependent on Xerox services and products, you are stuck. The cost of sticking with Xerox pales in comparison to the challenge a switch puts on your business. It would require retraining of personnel, key business systems may be endangered in the process, and all that to save an immaterial amount of costs.
This explains why about 90% of Xerox revenue is recurring in nature. So, even in this declining market Icahn knows he has some protection on the downside while the upside could be quite interesting if he is able to effect strategic change or other shareholder-friendly measures.
The one thing that scares me a little bit here is the firm’s $7.5 billion debt load of BBB credit with rating agencies having a negative outlook given the strategic review. Sure, with $1.7 billion of EBITDA, nearly $1 billion in cash and lots of recurring revenue, even a firm with a declining top line should be able to deal with it, but it does not leave an ideal amount of room for error.
Management is in the hands of Ursula Burns. She is a true company woman having climbed all the way up throughout the company, starting out as an intern. Her salary is heavily dependent on performance-tied stock-based awards. Criteria are mostly based on multiyear adjusted earnings per share, operating cash flow and revenue growth. Not the worst mix of criteria but not the best either. It is a positive that most of her compensation is based on long-term objectives and not on one-year peaks. It’s hard to objectively evaluate how she performed as CEO since her start in 2009. If you look at the firm's 2008 situation, it has noticeably improved but if you review the progress from 2009 onward it is less impressive. Especially ROEs and ROICs disappoint. To be fair it should be said the numbers were not that impressive before her tenure, and she is dealing with a secular decline in the company’s industry. Icahn is not going specifically after the CEO but instead is out to influence the strategic review and try to break the $10 billion company up in pieces more easily valued so they get assigned a higher multiple.
