XRX - Xerox Holdings: Secular Headwinds Are Going To Be Challenging For Growth

2023-05-01 12:32:00 ET

Summary

• XRX is facing strong secular headwinds due to the increasing adoption of digital solutions by companies, leading to process migration to the digital realm.
• Despite positive 1Q23 earnings results, the recent donation of PARC research suggests a commitment to short-term profitability at the expense of long-term growth.
• The business is overvalued at 9x forward earnings, and its historical multiple of 7x earnings is a fairer multiple.

Overview

Xerox Holdings (XRX) is a well-known name among the corporate world for its printers, scanners and related supplies. Due to the increasing digitalization of the world, I do not have a positive long-term outlook for XRX. In spite of the fact that I anticipate XRX to continue to benefit from tailwinds associated with return-to-work and the digestion of its backlog, I believe normalized volume growth will continue to be challenged because overall demand is in a secular decline, which is being accelerated by the pandemic. I believe that many companies' adoption of digital solutions has been accelerated thanks to Covid, and that this has resulted in a significant amount of process migration to the digital realm. Therefore, I am recommending a sell rating for XRX because I believe the company will have a hard time countering the secular headwinds, especially after the donation of PARC.

1Q23 earnings

Revenue increased by 3% over last year to $1.71 billion, but were down by 12% sequentially. The sales of both equipment and post-sales were lower than anticipated. Better-than-expected cost management contributed to higher-than-expected gross margins of 34.3%, while operating margins of 6.9% were also a surprise. Increased profitability resulted in a better-than-expected EPS of $0.49, compared to the consensus estimate of $0.23. I would say that this is a good set of results, for now. The company has reduced its backlog for the third consecutive quarter thanks to the positive effects of an increasing supply of available equipment. The order backlog has dropped by $67 million vs last quarter and $287 million since its highest point in 2Q22. The current backlog of $179 million is still much higher than the low $100 million that has been typical in the past. As I mentioned before, the covid and supply chain situation created a tailwind, but that wind is beginning to die down. Future growth will be slow once the backlog reaches a normal level. In fact, the management has already acknowledged this. Management is maintaining their forecast for annual revenue to be flat to down low single digits, which suggests that growth will moderate in the coming quarters as backlog normalizes. Importantly, I also think there is a good chance we see negative growths as the business faces a tough comparison last year. What is supporting the share price (stock was up on earnings day) and valuation (above average) is the updated margin guidance for FY23, in my opinion. Management now expects operating margins of 5% to 5.5% for the full year. While the improved margin forecast is encouraging, I am maintaining my sell rating because I expect businesses to reduce their reliance on printed materials as they become increasingly digitized. Better cost management and reduced growth reinvestments are likely behind the improvement in margin, further reducing XRX's ability to innovate and fight this secular down trend.

Palo Alto Research Center

The PARC donation is an example of management's commitment to short-term profitability and, by extension, the length of the company's growth runway. In order to devote all of its resources to developing innovative solutions for its own print, digital, and IT service offerings, XRX recently announced that it would be donating its PARC research facility to SRI International. While I applaud XRX's efforts to boost margins from the CY22 lows, I do not think it is a good idea for a company to donate PARC given the long-term secular headwinds to enterprise print growth that it faces. In my opinion, management is basically signaling to the market that it will double down on a declining market rather than innovate to increase its TAM with this move. The repercussions may not be apparent right now, but I think they will be in a year or two.

Valuation

I believe the business is not worth 9x forward earnings due to the strong secular headwind, reduced capability to drive innovation to expand TAM, and reduced backlog tailwind. Historically, XRX traded at about 7x earnings, which is a fairer multiple in my opinion. While I believe management is going to expense all efforts to improve margins to drive earnings (which is also reflected in consensus figures), I believe it is not enough to offset the mean reversion in multiples. It is crucial to note that if margins improvement did not materialize, the downside could be much more. My model indicates a 1-year downside of 18% based on FY25 consensus estimates.

Conclusion

Despite the positive 1Q23 earnings results, I maintain a sell rating for XRX due to the strong secular headwind, reduced innovation capability, and reduced backlog tailwind. The adoption of digital solutions by companies has accelerated, leading to a significant amount of process migration to the digital realm. Moreover, the recent donation of PARC research facility to SRI International by XRX management suggests a commitment to short-term profitability at the expense of long-term growth. While the updated margin guidance is encouraging, I do not believe it is enough to offset the mean reversion in multiples. Therefore, I believe XRX is overvalued at 9x forward earnings, and its historical multiple of 7x earnings is a fairer multiple. My model indicates a 1-year downside of 18% based on FY25 consensus estimates.

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