Summary

Xerox Corp (NYSE: XRX), founded in 1906 was one of the great corporations that epitomises the American entrepreneurial and innovative spirit. Over time bureaucratic red tape and complacency led to it to give away the technologies that would come to define the backbone of the information age. The Ethernet, PDF, Bitmap, and the graphical user interface of computers are some of the technologies that should have had a Xerox label. Over its 110 years history, the company built up a cadre of intangible assets. It is no surprise therefore when activist investor Carl Icahn filed a Schedule 13D with the US SEC. Today, the stars are aligned for either change of control or a change in the management of the company.

Background

In early 2017, we discovered that Xerox had valuable hidden assets, and that it was in the process of spinning-off it business process outsourcing business unit, so we took a position in the company. These hidden assets, required a tectonic shift in business practices for them to lead to incremental cashflows to the enterprise, and additional value to shareholders. In our view, the price of Xerox was "fairly valued" from a probably weighted sense, as the probability of a tectonic shift occurring was tantamount to a coin flip, and we had a declining document management industry to contend with. Despite the potential for Xerox to reduce our internal rate of return, we thought that the management team had already committed to generating cost efficiencies in the face of pressure from Carl Icahn. These cost efficiencies were likely to improve the value of the business during our holding period, because they were enough to offset the persistent decline in revenues. Today Xerox sits 19% above our cost of acquisition, but we believe that there is potentially more value to be had.

In December 2017, it was announced that Jonathan Christodoro -- an Icahn Alumni -- resigned from the Xerox's Board of Directors, in order to allow Carl Icahn and his affiliates to submit nominations for directors at the 2018 Annual Meeting of Shareholders. According to the company:

In connection with Christodoro's resignation, the standstill agreement between the company and the Icahn Group entered into on June 27, 2016 was terminated, and Xerox received notice from the Icahn Group of its nomination of four director candidates to stand for election at the company's 2018 Annual Meeting.

Shortly after Christodoro's resignation, Icahn began to publicly demand that Xerox's CEO -- Jeff Jacobson -- should be replaced. At the time we calculated that the probability of a change of control (a tectonic shift) increased significantly, because any CEO would fight to save his/her job, and the only fight he could put up before the board meeting in May 2018 was to find a White knight (business) in shining armour. Little did we know that shareholders would get such a raw deal from the White knight (business).

In January 2018, Xerox announced that they reached an agreement to sell a 50.1% stake in Xerox to Fujifilm. Fujifilm, a Japanese Conglomerate (company), would first repurchase Xerox's stake in a joint venture with them (Xerox Asia), then would purchase a stake in Xerox (Rest of the World). The purchase consideration was supposed to be a cash dividend of $9.80 per share + 40.9% ownership of the combined entity -- Xerox (Asia + Rest of the World). The combined entity would incur somewhere near to US$2.5Bn in debt to fund the payment. It should also be noted that the assumed valuation of the 40.9% includes projected benefits from cost efficiencies that CEO Jeff Jacobson was to implement himself. Furthermore, Xerox's share in the Joint venture is being carried on its books at ~ US$7.8 per share. See Xerox's investor presentation below.





Fast forward to today and we are at a point in history where Xerox has become ground 0, for the "Battle of The Five Armies". We have a New York Supreme Court judge --Barry Ostrager -- looking out for the public's interest, Carl Icahn looking out for himself, Darwin Deason looking out for himself--and also a passive investor turned activist after getting ripped off by Xerox, Jeff Jacobson and the Xerox board looking out for their compensation, and finally Fujifilm looking out for itself. The others, including ourselves are spectators watching. We are a little cautious though when it comes to investment bankers as these spectators are prepared to sell any idea to any one for the right compensation. Lo and behold the probability of a tectonic shift in business practices has gotten significantly higher, and it is likely to be in our favour. With a higher probability of a change happening, the expected value of these hidden gems is now higher, and we think the market is not pricing-in these gems as such.

Hidden Assets

The simple answer is that these assets are off-balance sheet, intangible assets. The market is more concerned about the decline in the industry, rather than the potential for these intangible assets to become tangible i.e. cash, resulting in a lack of appreciation for the value they carry. What are these assets really? There are two: (1) the company's massive net operating loss carry forwards (net operating loss), and (2) the company's very productive research and development lab in California. According to the company's 10-K filing, as at December 31, 2017 the company had:

tax credit carryforwards of $646 (millions) available to offset future income taxes, of which $23 are available to carryforward indefinitely while the remaining $623 will expire 2018 through 2038 if not utilized. We also had net operating loss carryforwards for income tax purposes of $0.8 billion that will expire 2018 through 2038, if not utilized, and $1.8Bn available to offset future taxable income indefinitely.

In total the company has US$3.24 Billion in NOLs, which at an assumed marginal tax rate of 28% (state + local) are worth close to US$1Bn, approximately 12% of current market capitalisation. If the company is able to maintain an operating margin of between 10% to 11%, which management has committed to and is on track to achieve, we think the commons with consideration given to the net operating loss is worth close to US$45 per share. In selling the deal to shareholders , management pointed to an indicative value of close to US$45 dollars per share which only gives us further confidence in our estimates. The catch is that approximately 26.6% of the value is tied to corporate synergy to be generated from the combined entity, and 51% of the value is based on the 40% stake in the combined entity. In essence 62% of the value is subjected to tremendous uncertainty, and 26% may never happen. NOT A GOOD DEAL.

The other asset, Xerox's Palo Alto Research Center is even harder to conceptualise if you don't know the history of the company. It is also harder to monetise particularly in the short term and would definitely require a revolution in business practices to lead to incremental cash to the enterprise. Activist investor Carl Icahn produced an investor presentation in which he underscores the potential value add by outlining several of the products that achieved commercial success over the years (albeit not under Xerox's ownership). Examples of profitable inventions created at this business unit include: (1) Developed the Ethernet, (2) Built the First Graphical User Interface for computers, (2) Created Computer Generated Bitmap Images, and (3) Built the PDF file format.

Additionally, Icahn believes that Xerox with additional cost savings slated to occur in 2018E, could be worth between US$54 to US$64 (excl. a control premium), with assumed enterprise value to EBITDA multiples of 6.5X to 7.5X. In our view, this sort of valuation is on the very high end of what we would expect but is welcomed nonetheless. See more form Icahn's presentation below.





The value of the Paulo Alto research center, and its mismanagement is also evidenced by the words of one of the greatest inventors of our age -- Steve Jobs. See below an interview in which Steve Jobs explains how the company's reckless behaviour has led to a disaster for shareholders.

Steve Jobs on Xerox's Leadership

The Probability of a Change is High

It is clear to us that a tectonic shift (either a change of control or a change in management) is needed for shareholders to benefit. In our view, the stars are aligned for us to see real change shortly for a couple of reasons. 1) Based on recent Form 13F filings, institutional shareholders constitute roughly 86% of total voting shares. A significant portion of these investors are value investors, and hedge funds seeking to profit from a potential event driven special situation. The other institutional shareholders are mutual funds (State Street, Vanguard, BlackRock) who are more passive investors, but would surely be open to dialog given Xerox's notorious track record for destroying value. Already there are pension funds joining the class of shareholders that are taking legal action. Our guess is that most will not like the current deal arranged by Xerox's management. 2) The Icahn and Deason tag team already accounts for 15% of voting shares. Yesterday both men got board representation as 6 members of the board resigned in deal reached outside of court. Both men have also successfully removed the CEO, and, have committed to significant changes to the strategic direction of the company-- which we take to mean a sale (more on this later). 3) On Friday Judge Barry Ostrager of the Supreme Court of the State of New York, County, granted injunctions to block the proposed merger with Fujifilm, and re-open nominations for Darwin Deason to obtain board representation. The judge said the following:

The facts abduced at the evidentiary hearing clearly show that Jacobson, having been told on Nov. 10 that the Board was actively seeking a new CEO to replace him, was hopelessly conflicted during his negotiation of a strategic acquisition transaction that would result in a combined entity of which he would be CEO

This event represents a big win for shareholders as its gives tremendous leverage for a renegotiated deal. Already, spokespersons for both Xerox and Fujifilm have confirmed that talks have been reopened. At KPB & Co we have sourced and put together a set of documents which provide details on the Xerox Vs. Icahn-Deason legal case, Judge Barry Ostrager's ruling, the investment bank's valuation analysis, and Xerox's "indicative value" presentation to shareholders. We provide this for free see the links below:

The Path of Least Resistance is a Sale

In our minds, Xerox likely has one or two years maximum as an independent company. The fact of the matter is that most of the companies in the industry are experiencing declines in revenues, as the "save the trees" movement gathers steam, and as more people rely on digital devices as opposed to paper. As a result, the industry must consolidate to the point where the companies that remain independent have bigger economies of scale. This would allow remaining incumbents to slash cost faster than the decline in revenues, until revenues hit a new steady state. Additionally, net operating loss do expire worthless if not used, and they do go down in value with a decline in the marginal tax rate. This aspect of net operating loss makes it is very difficult for research analyst to place faith in net operating loss when doing company valuations. In a change of control scenario, the value of these net operating loss are often crystalized, as the acquirer typically pays for these upon acquisition.

Concluding Remarks

Xerox today is at the cross roads of significant change, with a number of parties at the table that has a say on which the direction the company takes. In light of recent developments, we think the tide is in favour of a more beneficial arrangement for shareholders. Activist investor Carl Icahn and Darwin Deason have teamed up to take on management, and thus far they appear to be winning. We think the company will eventually take the path of a sale to an incumbent at price somewhere around US$45 per share or higher. Nevertheless, in the activist investment game a "number of cards" can play, which leads to some degree of uncertainty.