DXC - Xerox: Beyond Macroeconomic Factors Fundamental Challenges Run Deep

2023-10-30 18:04:44 ET

Summary

• Xerox's third quarter results reveal underlying issues and challenges that paint a poor outlook for future growth.
• The company is facing challenges in maintaining revenue streams, particularly in post-sales and equipment sales.
• Xerox's attempt to pivot from a print-centric model to a technology and service provider raises concerns about future profitability and competitive positioning.

Summary

Following my previous coverage of Xerox Holdings ( XRX ), for which I recommended a sell rating due to my expectations, I see no sustainable solution that can reposition the business to grow in the long term. This post is to provide an update on my thoughts on the business and stock. I reiterate my sell rating for XRX, as its third quarter results were not merely disappointing but revealed profound underlying issues and challenges that paint a poor outlook for its future growth.

Investment thesis

XRX reported disappointing third quarter 2023 results . The revenue for the quarter was $1.65 billion, marking a decline of 5.7%, showing that the company faced challenges in maintaining its revenue stream. The primary driver for this downward trend was a significant drop in transactional and non-contractual post-sales revenue components. This indicates that the company is facing challenges in retaining or expanding its post-sales business. Furthermore, equipment revenue, which is a vital segment for XRX, also showed a modest decline compared to the previous year. Equipment sales for XRX in the third quarter were $386 million, which represented a decline of 1% year-over-year in actual currency or 2% in constant currency. One of the reasons cited for this decline was a reduction in equipment backlog from the prior quarter.

Geographically, the company faced challenges in both its primary regions. The decline in the European, Middle Eastern, and African [EMEA] region was more pronounced. This was attributed to a substantial reduction in the EMEA backlog in the prior quarter, coupled with a weakening macroeconomic outlook. In the Americas, while there was an increase in equipment revenue, it was overshadowed by a decline in post-sales revenue. This decline was partly due to lower sales of cyclical transactional items. Additionally, the company highlighted that there was a significant decline in low-margin paper sales, which was influenced by lower IT and device placements. In addition, the influx of Asian paper in the market was putting pressure on prices.

XRX's ambitious reinvention strategy, aimed at transforming its core business, underscores deeper issues within the company. Despite its legacy in the print industry, XRX is grappling with the challenges of digitalization and evolving client needs. Their attempt to pivot from a print-centric model to a technology and service provider suggests a reactive approach to industry shifts rather than proactive innovation. This strategic uncertainty, combined with the pressures of managing traditional print headwinds, raises concerns about the company's future profitability and competitive positioning.

Despite XRX's recognition in IDC Marketscape’s Worldwide Print Transformation Vendor Assessment, the company's push into digital services underscores a reactive attempt to stay relevant in a rapidly evolving industry. While they report growth in digital service signings, this shift away from their traditional print stronghold suggests a struggle to maintain their core business. The fact that digital services are replacing traditional print demand in renewed contracts further highlights the diminishing value of their legacy operations. XRX's efforts to adapt to the competitive landscape raise concerns about their long-term viability in an industry that's swiftly moving past traditional print solutions.

Valuation

My target price for XRX based on my model is $10.39. This valuation takes into account the anticipated decline in growth of negative 2% and negative 2.6% for FY23 and FY24. These growth rates are consistent with general market consensus. Several underlying factors contribute to this projected negative growth. Firstly, XRX's third quarter performance was less than satisfactory, with revenue declines stemming from weak equipment and post-service sales. Moreover, there's a concerning reduction in equipment backlog, which further supports its weak equipment demand outlook. From a geographical perspective, XRX's primary markets are also experiencing sales downturns.

In a bid to save the struggling business, the company is shifting away from its traditional print business. This shift signals that XRX is facing challenges in maintaining their core business. Lastly, the growing preference for digital services in renewed contracts further emphasizes the diminishing relevance of their traditional operations. Overall, the future prospects for XRX's traditional print industry appear bleak.

Peers include DXC Technology ( DXC ). DXC's forward earnings multiple is 5.43x, with a projected 1-year growth rate of negative 2% and an EBITDA margin of 15.25%. In contrast, XRX's forward earnings stand at 6.13x, with a 1-year expected growth rate of negative 3% and a notably lower EBITDA margin of 1.36%. Considering XRX's consistently weaker metrics compared to DXC, particularly its meager EBITDA margin, it's puzzling why XRX trades at a premium. Given the negative growth outlook and the numerous challenges XRX faces, as previously discussed, it's logical to expect XRX to trade below DXC. Adopting a conservative approach, I've applied a 10% discount to DXC's 5.43x forward earnings to XRX, and it implies a downside of 15%. Based on these insights, I maintain my sell rating on XRX.

Risk

One potential upside risk to my sell rating for XRX is the company's strategic transformation and diversification efforts. XRX's reinvention strategy, aimed at shifting from traditional print to more digital and technology-driven services, could yield better-than-expected results. If XRX successfully capitalizes on emerging trends, such as AI-powered document workflows or managed IT services, and gains significant market share in these areas, it could lead to a positive revenue shift and improved profitability. This successful transformation could challenge the prevailing negative sentiment and potentially drive the stock price higher, contrary to my sell rating.

Conclusion

In conclusion, XRX's third quarter 2023 results were underwhelming, with notable revenue declines and challenges in both equipment and post-sales revenue. Geographically, the company faced headwinds, particularly in the EMEA region, compounded by a weakening macroeconomic outlook. The company's invention strategy, aimed at navigating the digital transformation, seems more reactive than proactive, highlighting deeper issues within its core business in my view. Even as XRX ventures into digital services, it appears to be struggling to maintain its foundational print business, with digital services overshadowing traditional print in renewed contracts. This shift underscores the diminishing relevance of their legacy operations in a rapidly evolving industry. When compared to peers, XRX's metrics, especially its EBITDA margin, are weaker. Despite this, XRX trades at a premium, which is perplexing. Given the challenges XRX is facing, the company's uncertain strategic direction, and the risk of a potential double-digit downside, I maintain my sell rating for XRX.

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