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Xerox: Tarred With The Wrong Brush

Many shall be restored that are now fallen, and many shall fall that are now in honor.

In technology as elsewhere, continuous profits and promising perspectives do not always set the stage for depressed security prices. Investors fancy fast growth and exciting stories, trying – often erroneously – to avoid situations that involve the stigma of obsolescence.

So who better than Xerox, perhaps one of the most misperceived American corporations in business today, to better illustrate this verse of Horace, Benjamin Graham’s favorite?

Once synonymous with copying and printing (“the document company”), Xerox’s mission has been meaningfully recalibrated into “making business a little simpler, a little less tedious and a little more productive” – a noble purpose with unquestionably large prospects.

A world leader in information technology, document management and business process outsourcing – a $600 billion market – the company’s scope of activities is wide and well-diversified: from finance to healthcare, there are not many industries it does not have a tailored solution for.

Yet, despite its fast-paced transformation into a services company – completed by the acquisition of ACS in 2010, which propped up the services sales from $3B to $11B overnight – it strikes as stupefying how Xerox keeps being perceived as an archaic printers and copiers manufacturer.

The public may not have kept in touch with the change, but Xerox has today little to compare with the business it was no earlier than a decade ago. As CEO Ms. Burns enjoys saying:

We’re the company you encounter every day and never see.

The fundamentals of the business are based on a clever annuity model that drives recurring revenue, enhances client retention and ensures intense cash generation – no less than 83% of sales directly stem from it.

Accordingly, the eminently attractive feature of its stock is the consistent earning power it demonstrates, as shown by the following free cash-flow record:

(free cash-flow per share)

2002: $1,92
2003: $2,10
2004: $1,69
2005: $1,25
2006: $1,37
2007: $1,59
2008: $0,68
2009: $2,29
2010: $1,63
2011: $1,03
2012: $1,17

At the current price of $6,5 per share, the investor gets a compelling return on cash of 22%, plus a 25% discount on book value.

The considerable debt load of $9,6 billion must be divided between the $3,6 billion of “core debt” – actually owed by Xerox Corporation to its creditors – and the $6 billion of “financing debt,” i.e the payment facilities accorded by the company to its clients.

In effect, Xerox finances the customer leases as a profitable way to support sales and improve customer retention. This activity is conducted with borrowed money.

Benjamin Graham asserted towards the end of his career that the investor does not need elaborate techniques of security analysis in order to find superior value opportunities. At its present price of roughly five times cash earnings, it appears that no price is being paid for Xerox’s recurrent earning power.

Management think no less, as they just initiated a massive share buyback program.

(Long XRX at an average price of $6 a share.)

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