CASE STUDY on Xerox (XRX)

There is, finally, the supremely important problem of combating general fluctuations of economic activity and the recurrent waves of large-scale unemployment which accompany them.  This is, of course, one of the gravest and most pressing problems of our time.  But, though its solution will require much planning in the good sense, it does not — or at least need not — require that special kind of planning which according to its advocates is to replace the market.  Many economists hope, indeed, that the ultimate remedy may be found in the field of monetary policy, which would involve nothing incompatible even with nineteenth-century liberalism.  Others, it is true, believe that real success can be expected only from the skillful timing of public works undertaken on a very large-scale.  This might lead to much more serious restrictions of the competitive sphere, and, in experimenting in this direction, we shall have to carefully watch our step if we are to avoid making all economic activity progressively more dependent on the direction and volume of government expenditure. But his is neither the only nor, in my opinion, the most promising way of meeting the gravest threat to economic security.  In any case, the very necessary effort to secure protection against these fluctuations do not lead to the kind of planning which constitutes such a threat to our freedom.–Hayek’s The Road to Serfdom, pp.121-22.

CASE STUDY

Your boss drops XRX’s 10K, www.yousendit.com/download/M3BscHBNTkxTRTdyZHNUQw on your desk. Then he asks, Should we sell out of this position since the company’s market cap is about $11 to $12 billion with $9 billion of debt and an underfunded Pension Fund?

Is this company dangerously over leveraged? Yes or no and why? Please reply in 20 minutes or less. If you feel you can’t adequately answer, then what would you need to find out? State your reply in no more than a sentence or two.

Value-Line Tear Sheet on Xerox for Reference:
http://www.yousendit.com/download/M3BscHBNTkxPSHo0WjhUQw

Prize to be determined.

Long-Term Bonds

The cure (low interest rates) IS the disease: http://mises.org/daily/5164

If you own long-term government bonds then the question you have to ask yourself is……………………..http://www.youtube.com/watch?v=u0-oinyjsk0

Housekeeping

I will post the analysis of Coke/Pepsi Case Study this weekend. And we have one final installment on ROIC before burying that dead horse.

Have a good weekend!

24 responses to “CASE STUDY on Xerox (XRX)

  1. Wow that’s one huge report. You know, Damodaran did a research on correlation between performance and length of 10K, and there’s a serious inverse correlation. a 10K longer than 150 pages may well be an underperformer, not to mention a 510 page one.

    I’ve taken a quick look, and it seems that while the interest coverage now looks pretty good, a dive in earnings as they took in 2008 could finish the company.

    Regarding the pension liabilities- they already appear as liabilities, aren’t they? I think it’s safe to say the company will have to pay it over a long period of time, so I don’t see it as adding much risk. Am I mistaken?

  2. I think the long dated maturity of the debt provides some safety. According the Xerox, 83% of their revenue stream is annuity like – quickly taking 83% of their 2011 revenue of $22.6b, assuming a 10% operating margin which is far below the norm indicated by the Value Line sheet, subtracting another 7% interest cost on approx. $8.5b in debt (eyeballed wtd. avg of debt cost) and subtracting 35% for taxes (probably a bit high) leaves you with about $832m net income. Add back D&A of $1.2b (2011) and subtracting $450m for capex and internal software costs leaves $1.5b in cash flow. Take out another $240m for dividends and you’re still left with approx. $1.25b in cash flow to be put towards debt paydown/share repurchases/pension contributions

  3. Took 25 minutes from when I saw the post – you can dock my bonus somewhat for my 5 minutes overtime

  4. Is this company dangerously over leveraged?

    Yes – upcoming debt maturities and interest will consume pretty much all discretionary cash flow (net of dividend commitments, interest payments, working capital needs, and pension contributions) – this is based on last year’s numbers and working capital profile. This position has left the company vulnerable to a downturn in its end markets, in the event of which they will have to roll over some of the maturities and be possibly forced to pursue alternative measures (selling divisions, downsizing, or issuing equity) – not enough margin of safety for me…

  5. I take back my long-dated maturity statement. Lesson learned – Morningstar data is erroneous and not worth paying premium for

  6. It’s not dangerously overlevered; operating cash flows are sufficient to cover debt service and they are simultaneously paying down debt. Their pension assumptions seem conservative, which is leading to elevated obligations (declining discount rate assumptions YoY), which amplifies the underfundedness.

  7. No, the company is not dangerously over leveraged based on their historical performance, which shows their capacity to operate with high debt levels. They have EBI/Interest Expense ratio of 3.5 as of the report. However, it is not very safe leverage either.

    I would recommend to sell the position due to it being expensive on a quick FCF calculation using a required return of 10%. Weak balance sheet and lousy equity performance when one take into account that they are running at a debt/equity of 0.72

  8. No it’s not overleveraged at the moment (the water balloon is still not bursting).

    Its cash flow from operations minus capex (which seems rather small considering) would still enable it to borrow (using the professor’s 6% minimum instead of prime + 2, it still has sufficient debt coverage; though market cap is slightly more than total amount of bank refinancing) . It has 4bil in finance receivables due in a year (enough to cover the pension liabilities when due) plus a small cash position. With 1.9bil cash from operations (less capex) would enable it to pay off debt 7bil in 5 years – however this cash flow is decreasing rather quickly -so a longer term average should be used).

    • Another way to approach this problem is to look at what the debt is financing then ask if it is typical for the type of business or assets being financed. You can also step into the CFO’s shoes and think about what should the capital structure be or is the current CFO doing an OK job with the capital structure and use of free cash flow.

  9. Looking at the numbers through the eyes of the CFO would certainly provide a more realistic analysis of the business and industry.

    Thanks for making learning fun.

  10. Doesn’t seem to be a problem at the face of it. They are funding their Finance Assets with Debt. So they basically make stuff and sell it on installments and “pass through” a % of these installments as the interest on debt, which they took to make the stuff in the first place. “core debt” is only 2.6bn. Everything else is supporting the these finance assets. I have no idea whether the 8:1 leverage is good, bad or ugly. What if someone doesn’t pay … I’m guessing their equipment is the collateral. What’s the quality of this collateral?

    • Dear Rahul:

      You would need to compare their leverage with other firms in their category. If US Banks and Investment banks had this leverage, I doubt we would have had the financial crisis as severe as we did.

  11. No, it is not dangerously overlevered.

    In the footnotes of p. 124…
    “(1) Financing debt includes $5,567 million and $5,793 million as of December 31, 2011 and December 31, 2010, respectively, of debt associated with Total finance receivables, net and is the basis for our calculation of “Equipment financing interest” expense. The remainder of the financing debt is associated with Equipment on operating leases.”

    Thus, core debt is $2 bil, not $8.6 bil. ~$5.6 bil of debt is secured against $6.3 bil of financing assets. The remainder of financing debt (~$0.4 bil) is secured against ~$0.5 bil of equipment on operating leases.

    So, real debt is $2 bil + funding the pension (underfunded by ~$2 bil).

  12. The full debt amount does not accurately describe the capital structure of the firm. Core debt (minus receivables) stands at only ~2B. You should view this segment as a separate business as it’s debt load does not correspond to the rest of Xerox’s business.

    You can value Xerox’s core business using the ~2B, while taking the finance income and interest (applying a 7-1 leverage) to find the return for their financing segment.

    As to their pensions, 2011 10K states:

    “We used a weighted average expected rate of return on plan assets of 7.2% for 2011, 7.3% for 2010 and 7.4% for 2009…The weighted average expected rate of return on plan assets we will use in 2012 is 6.9%….The weighted average discount rate we used to measure our pension obligations as of December 31, 2011 and to calculate our 2012 expense
    was 4.7%, which is lower than the 5.2% that was used to calculate our 2011 expense. The weighted average discount rate we used to measure our retiree health obligation as of December 31, 2011 and to calculate our 2012 expense was 4.5%,which is lower than the 4.9% that was used to calculate our 2011 expense.”

    This is a long-term problem that will be paid off over time. If discount rates and ROA’s normalize, it should be a significantly smaller problem.

    BC

  13. Dear Bill C:

    Your analysis is good because you break apart the different segments of the business and debt. You get a date with:http://www.youtube.com/watch?v=I7GeNWl-yaY
    You will also receive the same prize as all the others who posted here.

    Good job.

  14. I’m giving my answer before reading everyone elses comments, so as not to be influenced. Skimming through Value Line, I notice that it is on a PE of 7.2. As Ben Graham might say, “significant if true”. Taking a look at their historical record, it seems pretty lacklustre, which probably explains it. Revenues are up, but revenues per share are down. Common stock outstanding has been rising.

    Net profit margins are increasing, long term debt is going down, shareholder equity is going up, which is a good sign. Return on total capital looks low, at 9%. It doesn’t seem a very interesting business. I notice that the return on capital is consistently below ROE, suggesting that they’re not very good capital allocators. Based purely on the numbers, it doesn’t look a very good business.

    Looking at the 10K, I notice a lot of waffly junk. “Implementing Agile Business Processes”, for example. 55% of their revenue comes from Business Processing Outsourcing. That seems like a pretty mundane activity with plenty of players in the field. “Although we encounter competition in all areas of our business, we are the leader or among the leaders in each of our principal business segments.” Yeah, whatever.

    What’s quite interesting is their mention of customer financing. They have a leverage of 7:1 debt to equity. So XRX want to be a bank, does it? Here’s a very interesting statement they make about risls: “The long-term viability and profitability of our customer financing activities is dependent, in part, on our ability to borrow and the cost of borrowing in the credit markets. ”

    Sticking my neck out time: despite the reduction in long-term debt, it still seems high, and the business look mediocre. So it doesn’t look like an attractive purchase, even at the low PE.

    Not I’m going to look at the comments to see if I got it right, or missed anything. Fingers crossed.

    • Dear Mcturra2000 your eyes don’t deceive you. XRX does have long-term service contracts which locks in some revenues, but the business does not seem to be a franchise. Returns are average. And, yes, they probably paid too much for their acquisition in 2010. So if the returns will be average then what might be the reproduction value for this company per share and how does it compare to today’s share price? Is there a margin of safety there? I don’t know whether this is really a great investment–I doubt it, but the goal was to get you to focus on the most important aspect of the balance sheet–the $8-$9 billion of debt and then the terms of the debt.

      If XRX were a bank, then it would be very conservatively financed. Many banks are leveraged 10 to 15 to 1. But XRX does have tranches of debt due each years, so access to the credit market is a clear risk that should raise your cost of capital for this company (lower the multiple).

      So the more companies you look at, the greater a feel you will acquire for good, bad, normal businesses. Practice, practice, and practice.

  15. Under the Contractual cash obligations and other section 10-k lists 5,799 as the total commitment for 2012. Wouldn’t this adversely affect the cash flow? Am i missing something obvious..

  16. John, can you sum up this issue? How should the debt in this company be approached? is it really only 2-4 billion?

    Where in the report do we see the pension fund is underfunded? is it on the balance sheet?

  17. No it is not over leveraged as majority of the debt is used to finance lease contracts for customers allowing them to pay for the equipment over time rather than at the date of installation. As at Dec 2011 Financing Debt is $6,033 million and core debt is $2,600 million.

  18. Dear Arden:

    I will post this evening. Thanks for your patience.

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