Taking Stock: Xerox Attempts To Copy Past Success

Better management of Xerox's balance sheet is driving a recovery.
Not so long ago, Xerox dominated its market, document imaging and related products, and the company's name replaced the word "copy" in America's lexicon. But Xerox fell on hard times and reached a level of slow-growth business maturity that made it a pariah for investors. Only recently have they begun to warm to Xerox again. Though the company remains a force in IT, the real question is whether it has changed enough to warrant renewed investor enthusiasm.

CEO Anne Mulcahy has the company moving in the right direction. She has brought in a strong CFO to help manage the balance sheet and control costs. The company is focusing on product development and increasing its services offerings.

Revenue from production equipment, accounting for 35% of total revenue, is projected to grow by just 2% per year but was down 5% year over year in the third quarter. Within this segment, color production equipment is expected to be the fastest growing line; during the third quarter, a weak monochrome market offset strength in color sales. Production operating margins are around 12%. The office business market (43% of revenue) depends on sales of multifunction devices. Sales in the third quarter were down 2% year over year with operating margins of 7% driven by cost-cutting efforts. Document outsourcing revenue is included for both markets.

While Xerox is trying to improve the profitability of its business segments, the company's top management has focused much of its attention recently on managing its cash flow and balance sheet. At the most recent analyst meeting, the company highlighted how it plans to make it through 2004 without having to issue any new equity or debt. This will help reassure investors that the company won't have to make an equity offering. It didn't hurt that Xerox confirmed 2003 earnings-per-share forecasts of 50 cents to 55 cents, with the potential to reach earnings per share of about $1 to $1.10 by 2005. The company's goal is to get revenue to grow at about 5% per year with gross margins greater than 40%.

Xerox isn't out of the woods yet. Third-quarter revenue was $3.8 billion, down 6% year over year. Product revenue is expected to grow slightly as new products are offered, but overall revenue is expected to continue declining in 2003, with tough competition from Canon, Ricoh, and others. The decline is due mostly to the company's after-sale businesses (such as services, supplies, and financing), which make up about 65% of Xerox's revenue. Competition will keep Xerox from raising prices, helping suppress any significant margin expansion other than cost-cutting efforts. Any strategy that tries to expand the services and solutions side of the business will involve more strategic business partnerships. This, too, isn't without substantial risk.

The other big issue remains share price. The recent enthusiasm for the equity markets has driven share prices upward--beyond rational levels, in some cases. At present, the stock is aggressively priced at about $8.50. My fair value is closer to $4 to $5. If Xerox can get the top line growing again, then the value could rise to about $9, around the current level. It seems to me that the present stock price reflects projected success. This may be too presumptuous.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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