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  • KPB & Co Research

In the market turmoil that occurred last September to December, Xerox's stock declined significantly in part due to concerns regarding the US Federal Reserves plan to increase interest rates at a rapid pace, concerns around a trade war, and prohibitive government policies. The pace of decline in the stock accelerated after the company got hit with credit rating downgrades by Moody's and Fitch, and was placed on review for downgrade by S&P. After the company released its Q4-FY18 results, which show better than anticipated cash flows the stock retraced a significant portion of the original decline.

credit rating downgrade

In our view, the credit rating downgrade reflects pre-emptive actions taken by ratings agencies in consideration of the company's declining revenue base, which they believed will hamper the company's ability to repay debt. It also appears that the sudden rise in interest rate on account of the actions taken by the US Fed led to a sort of knee jerk reaction. However, while the decline in the revenues is a concern to us the company has more than enough cash on balance sheet to meet debt obligations, and is also generating US$1Bn + in free cashflows to cover future liabilities. According to Moody's:

The downgrades reflect uncertainty about the company's ability to stabilize and grow its revenue base over the next few years given the secular decline in copier and printing demand as well as intense global competition. Xerox reported seven consecutive quarters of year over year revenue declines on a constant currency basis since the spin-off of the business process outsourcing segment despite major product launches in 2017.

Moody's has not reviewed Xerox's operating or strategic plans for 2019 which are scheduled to be presented in early February 2019 at the company's Analyst Day event. However, Moody's expects organic revenues to continue on a flat to declining trajectory over the next 12 to 18 months in the absence of an unlikely fundamental change in the company's revenue mix or market share. Xerox's top line faces continuing erosion due to a secular decline in copier and printing demand in developed countries combined with new equipment and service offerings from competing providers, a few of whom have deeper financial pockets, more stable revenues, or better penetration in higher growth Asian or emerging markets.

Q4 of Fiscal 2018 Highlights CompanY's Free Cash Flow Strength

While as investors in the stock ourselves, we are not happy about continued revenue declines, we did not buy the stock on the expectation that there will be an immediate turn around in revenue. On the other hand, the companies strong free cashflow generative power and excess fat puts the company in a position to fetch a good acquisition premium. The company has been poorly operated for several decades and is in a market that will find a new equilibrium. The industry for printers and document management services has to shrink to reflect the new paradigm of more digital and less paper-based documents, but it would be unrealistic to expect that the industry is going away. The trends in the industry are more facilitative of industry consolidation, and Xerox is already somewhere near that track with a corporate takeover attempted earlier in 2018. The Q4 of fiscal 2018 reinforces the argument that the company free cash position is a unique strategic advantage. The company generated operating cashflow of US$450Mn in Q4 and over US$1.4Bn for the full year on account better cost control under the new CEO John Visentin. Under the new leadership, and under the watchful eyes of activist investor Carl Icahn, the company increased adjusted operating margin to 16% in the quarter, a trend that is expected to push 2019 margins to range 12.6 to 13.1%. On the company's investor day on February 5, 2019, the company will provide an update on their long term expectation.

A Sale of Company Is Still The best Strategy We Believe

We appreciate the importance of improving the operations of a business as it enhances the value of the company whether or not it is eventually sold. In our view, given the nature of events that unfolded in early 2018, and the declining sales trend of the entire industry, it is still in both parties (Xerox and Fujifilm ) to pursue a merger. Of course with the likes of Carl Icahn in a very influential position the issue of valuation will be a major point of contention. The last time we checked he is comfortable with a sale price of around US$38 to US$40 per share. If the new CEO is able to cut cost and push free cashflow higher the US$38 per share becomes increasingly realistic.

The recent recovery in the stock priced welcomed and reflects Xerox's continued free cashflow strength in spite of continued revenue declines. At this stage, the company has in excess of over US$1.08Bn in cash and equivalents sitting on the balance sheet, generates US$1.14Bn in operating free cashflow and has roughly US$5Bn in debt and so concerns about debt repayment capacity are overblown. The US$1Bn in additional share repurchase authorization (with US$ 300 expected in 2019) will likely put a floor on the stock for now while potential buyers look on.

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