DGRS - Xerox Q2 Results Suggest The Beginning Of A Long-Sought Recovery

• Xerox Q2 revenue was up slightly, $40 million over consensus, but adjusted EPS was 13 cents per share. This is 11 cents below consensus.
• Xerox revenue was down 2.6% YoY, but up 1.1% in constant currency. Revenue in constant currency was down 22.7% in 2020 and 1.4% in 2021.
• Xerox management expects that price increases, improved supply chains, and the growth from digital services will lead to higher volume and cash flow.
• Xerox's stock price at $16 per share is less than half its $38 price five years ago and it sports a yield of almost 8%. It is a buy.

Xerox

My previous analyses of Xerox Holdings Corporation (XRX) recommended selling. I viewed their new products as overblown, which they were. However, their work with digital and information technology has built a base of business that competes on the basis of a system and not purely on copiers. They still have projects like 3D liquid metal printing which are innovative but are quite small. Much of the gross margin depends upon niches that give them shelter from a highly competitive printing market. However, even in the printing market, the pages printed are increasing, so their sales should increase along with higher revenue per copy. The table below illustrates the performance in the first half of 2022 compared to the full-year directives for revenue and cash flow.

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Table by author

Management expects that operating margins bottomed out in the first quarter at a negative 2/10 of a percent. In the second quarter, it rose to two percent. Management expects continued increases each quarter. The gross margin in the second quarter is 39.1%, a decline of 380 basis points year over year.

The bulk of that is in the supply chain, which has not delivered sufficiently to meet the customer demand. Xerox has cut back the number of products it manufactures. Xerox expects to improve supply chain deliveries and that higher prices will increase margins. Xerox's backlog is at $404 million. The bulk of that is equipment. In Q2, equipment sales were $366 million, or 21% of the total. Solving the supply chain problems will have an outsized impact on sales.

They also expect that the higher print volume experienced in the market will affect them. They will see both higher volume and higher prices per page. The IT and digital markets are growing very quickly. Robotic process automation such as invoice processing and other functions like that have seen about a 40% growth. Other IT service functions are up sharply.

They have separated their financing business from the printing business which supplies financing to both Xerox and non-Xerox customers. The finance business is small, representing about 8% of revenue in the second quarter but about half of their operating profit.

The cash flow in the second quarter declined by $40 million because of a cancellation of a contract with Fuji Xerox. Another factor behind the negative free cash flow was the growth of inventory to support the new businesses. Xerox does not have a target for profitability, but they do have a target for the free cash flow of $400 million. This is lower than 2021, but represents an aggressive recovery in the second half of 2022.

Risks and opportunities

Risks

Xerox looks upon inflation as a positive, believing that they are protected from labor cost increases. They expect labor productivity will increase more than inflation. That may be a vain hope.

The current temporary CEO was formally in charge of "You own It," the major cost reduction program that reduced costs by $1.8 billion over the last few years. He is targeting a cost reduction of $450 million in 2022. If that fails, then the cash flow and profitability objectives will not be met.

The return to the office should generate more copy volume which Xerox will get a share of, but the company can be hurt by the prospect of a recession.

Opportunities

Xerox has beaten the revenue projection over the last two years by 63%. It is very possible that revenue and operating margins will exceed expectations.

Conclusion

Xerox has seen revenue declines for the last decade, turning the company to flat revenue. This is a major achievement even if it is a flat revenue. In a 9% inflation environment, the market niche appears to be working. The company should have a strong base from which to grow. The new ventures are small, and the company is less than transparent about the profitability and revenue from these ventures.

With all of this and the risks, it is not a sure investment. But it is an investment that has the possibility of profit growth in a difficult market. It pays an almost 8% yield. For these reasons, Xerox is a buy.

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