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Standard & Poor's


05/04/15 10:00:04 AM



This week's Focus Stock of the Week is Xerox (XRX $11.55), which carries S&P Capital IQ's highest investment recommendation of 5-STARS, or Strong Buy.

We upgraded our opinion on the shares to Strong Buy from Buy earlier this year, after a notable decline in the share price. We see Xerox's fundamentals stabilizing and leading to improving margins while its stock buyback program is aiding earnings growth. Meanwhile the company has less exposure to international markets and the strong U.S. dollar than many peers (on a percentage of revenues basis). The stock trades at substantial P/E discounts to relevant S&P benchmarks and offers a 2.5% dividend yield.

Xerox provides business process solutions and document management solutions, specifically, services, technology and expertise to enable customers, ranging from small businesses to large global enterprises, to focus on their core businesses and operate more effectively.

Through its business process outsourcing, Xerox has expertise in managing transaction-intensive processes. These include enterprise support through multi-industry offerings for customer care, transaction processing, finance and accounting, and human resources, as well as industry-focused offerings in areas including health care, transportation, financial services, retail, and telecommunications.

Xerox's document technology products and solutions provide clients with an efficient and cost-effective printing and communications infrastructure. Related offerings help customers optimize their use of document systems and related document workflow and business processes.

For now, the company also offers IT solutions, employing data centers, help desks, and managed storage facilities. However, in December 2014, Xerox announced a plan to sell its IT outsourcing business to Atos SE, an international IT services company, for $1.1 billion. We see the transaction closing by June 2015.

When the deal was announced, the IT outsourcing business had 9,800 employees located across 380 offices and 21 data centers. Xerox identified $35 million of annualized cost-savings associated with the transaction.

Treating the IT outsourcing business as discontinued operations, the services segment accounted for 54% of revenues in 2014, and the document technology business contributed 43%.

In 2013, the IT outsourcing business accounted for 7% of total revenues.

Revenues declined 4% in 2013 and 8% in 2014. We project a drop of 4% for 2015, but a return to growth, albeit modest, of 1% in 2016. Xerox continues to deliver solid contract signings at the services segment, and we see solid market positioning but secular challenges related to the document technology segment.

After notable improvement in 2014, we see stable gross margins through 2016. We project that EBIT or operating margins will continue to trend higher through 2016, reflecting continuing efforts to cut costs and manage expenses, which we expect to be enhanced by the sale of the IT outsourcing unit.

Xerox bought back $1.1 billion in stock in 2014, and we see comparable activity in 2015. Accordingly, we see EPS of $1.03 for 2015 and $1.15 for 2016. XRX generated annual EPS of $1.03 to $1.09 in 2012 to 2014.

Although we see limited top-line growth, we see the stock as compellingly valued at 11.3X our 2015 EPS estimate and 10X our 2016 forecast. We also note a recent indicated dividend yield of 2.5%, following a 7% increase in the payout announced in January 2015.

We believe the IT outsourcing unit sale will enhance the company's focus and execution, as well as its margins and balance sheet. In fact, in 2015, we see the company pursuing M&A intended to contribute to growth.

As of March 2015, Xerox had $872 million in cash and short-term investments, $1.4 billion in long-term investments, $979 million as the current portion of long-term debt, and $6.3 billion in long-term debt. We note that total debt has declined every year since 2010. In 2009, the company had $9.9 billion in such obligations.

Year to date, XRX shares have notably underperformed the S&P 500 Technology Sector index, with the stock down 17% and the broader benchmark up around 4%.

We see the potential for XRX to notably outperform over the next 12 months, and our related target price is $14.

To account for Xerox's varied businesses, our target reflects P/E and P/E-to-growth comparisons to the S&P 1500 data processing & outsourced services sub-industry, IT consulting & other services sub-industry, and S&P 1500 technology hardware, storage & peripherals sub-industry.

Importantly, we think, only a third of Xerox's 2014 revenues were derived from outside the U.S. We see XRX's greater domestic orientation as relatively appealing, given the recent strength of the U.S. dollar and that the S&P 500 technology sector generated more than half of its revenues from international sources in 2013 (latest available), according S&P Dow Jones Indices, which operates independently from S&P Capital IQ.

Also, we believe it is possible, following the divestiture of the IT outsourcing unit, Xerox would consider splitting the company along its services and document management businesses to create additional value, especially given that other technology companies with two disparate primary units are pursuing such actions.

Risks to our recommendation and target price include the potential for continuing challenges related to printer offerings, perhaps in part due to competition or the shift to digital, issues associated with government health care contracts being completed, and disappointment in deploying new products and services.

S&P Capital IQ's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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