CNDT - Xerox: A Contrarian Pick For 2023

Summary

• 116-year old XRX is probably among the least favorite choices for long investors heading into 2023.
• But, key aspects of their core printing business tend to be countercyclical and the majority of revenue is contracted for multiple years. In other words, the business is recession-resilient.
• I argue that the resilience of core operations, management’s push to unlock greater shareholder value, and a share price near the 52-week low make XRX a contrarian buy.
• With the dividend yield currently near 7%, investors are paid handsomely as new CEO Steve Bandrowczak works to stabilize the printing segment and push into strategic growth areas.

A 116-Year Old Mess That Can Make You Money in 2023

I think I would surprise precisely no one by suggesting that Xerox ( XRX ) is a bit of a mess right now. The 116 year-old printing and document services leader has tried to reinvigorate its business numerous times in recent years with little success.

Q3 FY ‘22 results announced back in late October were lousy on the surface. The stock took a hit as a result and is down ~(36%) year-to-date (“YTD”) as of the market close on December 23.

Notes:

• Data as of market close on December 23, 2022.

Yet, if you’re worried about a recession in 2023, you might be interested in the following points/comments taken from XRX’s Q3 FY ‘22 Earnings Presentation :

1. 2/3 of revenues are contracted for multiple years.

2. Many of XRX’s services offerings are countercyclical. (As a reminder, most of XRX’s core print business is post-sales revenue.)

3. “Consistent with the uncertain macro environment, we are beginning to see longer project deployment times and lower page volume commitments. However, if weakening macro conditions cause a significant reduction in enterprise IT spending, we expect our business to be resilient.”

It’s certainly a bit of a paradox to think that the stock of a company that has been slowly dying could be a place of refuge if there is a downturn next year. But even a declining business can have value. Just ask Carl Icahn…

Investing Like Carl Icahn

As you know, Carl Icahn has been scooping up shares for XRX for years now, and upped his stake back in April by more than 2M shares, bringing his ownership position to nearly 20%. What does he see in the company?

The simplest answer is that he sees an undervalued business that has been mismanaged for a long time. On that point, he previously expressed that ““Xerox was one of the worst-run companies I ever saw.”

Unsurprisingly, Icahn proxies have fought their way onto XRX’s board and Mr. Icahn has pushed management to unlock shareholder value. He pushed for the spin-off of Conduent ( CNDT ), XRX’s outsourcing business, in 2016. (CNDT had a market capitalization less than $900M as of the market close on December 23.) In 2019, he was rumored to have pushed for XRX’s unsolicited offer to takeover HP ( HPQ ). That effort failed with HPQ management suggesting a merger of the 2 firms didn’t make much sense.

But he obviously continues to see value in the business, which finds itself led by new CEO Steve Bandrowczak after the untimely passing of XRX’s former CEO John Visentin.

Mr. Bandrowczak has his work cut out for him with XRX revising their guidance for FY ‘22 downward following the release of Q3 FY ‘22 results:

• From total revenue of $7.1B to revenue in the range of $7.0B to $7.1B in actual currency,

• Free cash flow (“FCF”) from $400M to at least $125M.

The downward guide follows the broader ”hit” that XRX took during the pandemic, from which they are yet to recover.

Despite the firm’s intra-pandemic and post-pandemic struggles, the reality – as you likely know – is that XRX’s legacy printing and document services operation continued to churn out cash, with management noting at the end of FY ‘21 that “demand for [print] products and services remains strong.” Moreover, after more than a century, XRX arguably remains the leader in printing and document management solutions (albeit not without strong competition).

In this context, it’s easier to understand Mr. Icahn’s interest. Here we have a business that has:

• A reliable, if slowly declining, revenue and earnings stream from its core operation that can fund growth initiatives.

• A leadership position in a mission-critical niche – it’s going to be a long time before print disappears completely.

• A diversified customer base of small businesses to large enterprises spread across ~160 countries.

He obviously believes, and has believed for a long time, that the intrinsic value of these qualities exceeds the value that the market places on the firm. Accordingly, I think there is a clear argument to be made to invest in XRX right now:

1. The print business is likely to prove resilient in 2023 (see the introduction) even under recessionary conditions.

2. Management, presumably with a gentle nudge from Mr. Icahn and other activist investors every now and again <sarcasm>, is working to unlock shareholder value by growing strategic businesses that can be eventually spun-off (more on this in a moment).

3. The stock, currently trading near its 52-week low, probably undervalues the intrinsic value of the business.

Thinking It Through

Let us explore the 3 arguments from the previous section in more detail.

1. The print business is likely to prove resilient in 2023. XRX noted in their Annual Report FY ‘21 that “[third-party] research forecasts the print technology and managed print services ((MPS)) market to grow 1% through 2024, and we expect to do better.” They reiterated this assessment in their 2022 Investor Day Presentation . Even if a recession hits in the new year, any impact on new equipment sales may be more than offset by increased customer spending on maintenance and other post-sales services with many companies increasingly returning their employees to the office. Further, XRX’s performance during the latter part of the pandemic and through a good part of 2022 was characterized by supply-chain challenges. While management noted in their Q3 FY ‘22 Earnings Presentation that supply-chain issues continue to impact the print business – and were, in part, responsible for the lower FY ‘22 FCF guide mentioned earlier – maybe there is some evidence that, at least, component and supply shortages may be less of an issue in 2023. For example, color ink shortages impacted color printer sales throughout the pandemic. However, XRX enjoyed install growth across all segments of its color printer business during Q3 FY ‘22.

Granted, management hasn’t provided any clear guidance if and when supply-chain headwinds will subside. But, at the moment, they also haven’t modified their FY ‘23 - FY ‘24 growth algorithm which would be presumably impacted by persistent supply-chain issues.

Also note that XRX’s backlog demonstrated good growth at the end of Q3, at $429M versus $265M at the end of Q3 FY ‘21. So, the business would appear to be in good shape with the year coming to a close. Finally, as mentioned in my last article on XRX, the post-sale component of the print business, which basically encompasses everything except equipment sales, has a higher profit profile and doesn’t require much capital investment with management noting in their Annual Report FY ‘19 that “...there [are] low annual capital expenditures (less than 2 percent of revenues) required to support [it and]...these factors result in stable gross margins and operating margins as well as strong and stable cash flow generation.” We see from Figure 2 that XRX’s gross margin has been anything but stable and adjusted operating margin decreased to 3.7% in Q3 FY ‘22 versus 4.2% in Q3 FY ‘21. But, again, keep in mind that the pandemic threw a particularly large monkey wrench into XRX’s machinery. With the business historically exhibiting countercyclical dynamics as mentioned in the introduction, and with management working to get the core “back-on-track”, it’s not unreasonable to think the print business might actually thrive (relatively speaking) in 2023.

2. Management is working to unlock shareholder value by growing strategic businesses that can be eventually spun-off. If we consider where XRX is placing its bets at the moment, we might think of “modern” XRX as follows:

Notes:

• XRX’s current financial reporting structure is only composed of 2 reporting segments: Print & Other and FITTLE.

A brief description of each growth area in Figure 6 is as follows:

• Print & Other : Includes XRX’s core printing business, as well as a newer-push into IT services with particular aim at the small-to-medium business market (“SMB”). Undoubtedly, a significant portion of XRX’s thousands of clients around the world is very “sticky” – i.e. XRX is a trusted incumbent and not easily knocked out by competitors. These customers are fertile ground for XRX as they try to push more deeply into the very large digital and IT services market.

• FITTLE : XRX rebranded its equipment financing business as FITTLE earlier in 2022. As noted on the segment’s website, FITTLE currently serves 150,000+ customers around the world and has 700,000+ leases under management with a value exceeding $3B (both Xerox and non-Xerox equipment). The financing business exhibits stronger profitability compared to the traditional print business and is a reportable segment on track for sales of $600M+ in FY ‘22. Management is increasingly eager to capture a larger share of the office equipment and IT leasing market which they measure at $270B.

• CareAR : XRX, along with many other industrial players, is trying to reinvent the equipment services business using modern approaches, including augmented reality (“AR”) and digital twin technologies. As a separate company under XRX’s umbrella, it’s a logical play that builds on the company’s decades of equipment service experience. ServiceNow ( NOW ) invested in CareAR in late 2021 at a $700M post-investment valuation; and XRX estimates CareAR’s total addressable market (“TAM”) at $30B today, growing to $80B by 2028.

• PARC : XRX’s legendary Palo Alto Research Center, which counts the inventions of ethernet networking and the computer mouse among their numerous contributions to modern computing, is leading research in several areas including 3D printing, cleantech, and sensor technologies. While management noted in the Q3 FY ‘22 Earnings Presentation that “ongoing evaluation of investment priorities” led them to scale back research in certain areas, commercialization of PARC research remains an important focus to deliver value to shareholders.

It would certainly seem that management wishes to list certain growth businesses at the appropriate time in the future, “a la” Conduent, with FITTLE and CareAR as perhaps the two most conspicuous examples. With XRX’s growth initiatives still somewhat nascent, it’s impossible to determine, with any precision, what the resulting value of these efforts will be for the shareholder. However, I think it’s worth stating the obvious that investments, such as those in FITTLE and CareAR, build on existing strengths, which hints at less risk and a better chance of success over the long-term. Similarly, I’m encouraged by XRX’s IT services play in the SMB market as it takes advantage of their existing relationships with smaller businesses – a market arguably not as well served as it should be. And I wouldn’t be surprised to see their IT services business rebranded in the near-term, positioned to stand alone at some point down the road. So, while nothing on this point can be stated with absolute certainty, I think the signs clearly point to a shareholder opportunity, betting on management building key growth areas using funding from the core printing business, and then spinning them out at the appropriate time.

3. The stock probably undervalues the intrinsic value of the business. XRX had a market capitalization of ~$2.3B as of the market close on December 23; and the stock is trading close to its 52-week low.

As mentioned in the previous point, CareAR itself was valued at $700M not too long ago. Thinking about that, along with the qualitative arguments in the preceding two points, the business does seem – from my point-of-view – undervalued, even given its history of inconsistent performance and mismanagement. In further consideration of the company’s forward P/S and P/B multiples , it starts to look like a bargain.

Of course, the company’s P/S and P/B multiples don’t tell a complete story. And as hinted earlier, Q3 FY ‘22 results were not that great:

• Total revenue was basically flat at $1.75B versus $1.76B in the prior period.

• Adjusted operating margin decreased to 3.7% versus 4.2% in Q3 FY ‘21.

• Operating cash flow was ($8M) versus $100M in the prior period.

• GAAP EPS declined to ($2.48) versus $0.48 in Q3 FY ‘21.

But, bear in mind that:

• Total sales actually grew 4.7% in constant currency.

• As already mentioned, order backlog grew to $429M compared to $265M at the end of Q3 FY ‘21.

• GAAP EPS was impacted by a non-operating goodwill impairment charge of ($412M), or ($2.54)/share.

Granted, XRX investors would like to have seen a different result. But, perhaps the market has overreacted, creating an opportunity for new long positions.

Putting It All Together

I suggested at the outset that XRX is a mess. I still think that is true. But, I also think it’s true that the risk/reward equation skews in favor of the long XRX investor heading into a recessionary 2023, based on where shares are trading right now and in the context of my points in the preceding sections.

With the dividend yield near 7% at the moment, investors are paid handsomely to hold a firm that can still deliver shareholder value as it slowly declines.

I had previously initiated a long position in XRX back in late 2020 after writing my last article on the company, with an average cost basis around ~$18/share. I opted to exit the position earlier this year when shares were still trading above $20/share. With Mr. Bandrowczak taking the helm of the company, and with support from Mr. Icahn and other activist owners, I’m hoping he can introduce a discipline that has long been lacking. XRX has a lot of potential avenues for new growth; but management has to be careful not to “boil the ocean”. I intend to initiate a new position. XRX goes ex-dividend on December 29.

Of course, nothing can be certain with a firm like XRX and Wall Street sentiment is decidedly bearish . But, the contrarian long play on the stock might just be something that works well in a possibly-recessionary 2023 even though it shouldn’t.

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