Xerox: Reiterate Sell Rating As Business Is Still Fundamentally Challenged

Summary

Following my coverage of Xerox Holdings (NASDAQ:XRX), for which I recommended a sell rating as I could not see how the business could survive over the long term given its existing state previously, this post is to provide an update on my thoughts on the business and stock. I continue to recommend a sell rating for XRX despite the surge in share price. The business is still facing strong revenue headwinds, and management has not specifically laid out any strategies to turn this around. While the reinvention program should drive margin growth, I think the burden of proof is high, and I am not convinced that XRX can pull this off based on the current conditions.

Investment thesis

XRX 4Q23 results saw $1.765 billion in revenue, down 9.1% on a reported basis and 10.6% on a constant current basis [CC]. 4Q23 revenue performance showed no signs of improvement again, as revenue fell for the second straight quarter on a CC basis. At the current pace, it seems like XRX will not be able to reach pre-pandemic revenue levels anytime soon. Using 4Q23 run rate revenue of ~$7 billion, it is still down by 22% vs. FY19 revenue of ~$9 billion. Gross margin also saw y/y compression of around ~130 bps (from 34.78% in 4Q22 to 33.6% in 4Q23). Consequently, adj EBIT was down 46% vs. 4Q22, coming in at only $96 million. This performance ultimately led to XRX reporting an adj. EPS of $0.42, down 52%, and missing consensus expectations of $0.52.

The major takeaway for XRX was that management has launched a reinvention program in which they intend to transform XRX’s organizational structure and cost structure to position for higher earnings despite weak revenue trends. Using this restructuring program as a springboard for margin expansion, management guided FY24 revenue decline guidance of -3% to -5% CC but is expecting an adj. EBIT margin of 7.5%. This 7.5% EBIT margin guidance is huge because consensus was expecting flattish margins ahead. I must say, this was great guidance given by management to drive a very positive stock sentiment (stock went from $16 to $19). However, I believe this is not solving the core issue that XRX is facing. The fact is, XRX is still a business that is in a declining industry, and management literally guided for a 3% to 5% decline in revenues y/y in 2024. Some might argue that the decline is driven by a combination of headwinds from lapping backlog tailwinds in 2023 as well as exits from non-strategic businesses. However, I don’t think this is the case. If we look at XRX performance before COVID, sales were down almost every quarter, and if management had anything up their sleeve to solve this structural headwind, they would have done so back then. In my opinion, the headwind (fewer people using paper) is just going to continue snowballing from here as more work becomes digital. In fact, I had argued that the rise of AI further diminishes the use of paper as data has to be digital before businesses can leverage the use of AI, which means fewer reasons for businesses to use paper.

As such, I think the burden of proof is really high on XRX management to show that revenue can trend better in order to convince the market that the business is not in a permanent decline mode. Regarding the restructuring program, which is expected to reduce costs by $300 million, I wonder if it can be done as easily as it sounds. On an absolute basis, $300 million is ~80% of FY23 adj EBIT or ~16% of FY23 operating cost base. These are huge figures that make me wonder if it is even possible. I am sure that XRX can achieve at least 30% of this target saving, as it will be from the reduction in force [RIF] announced in January, in which XRX intends to lay off 15% of employees, resulting in more than $100 million in cost savings, but it is the remaining 70% that is puzzling. This 70% is expected to be driven by operating model simplification and geographic realignment of investments. My experience with businesses doing such restructuring is that it takes a lot of time, effort, and cost to do so. Remember that XRX is laying off people while doing this, so resources are getting stretched. Also, this guidance also meant that XRX will see its opex as a percentage of revenue fall to its lowest ever when topline is expected to fall (operating deleverage kick in). I am not sure how any investor can be easily comfortable with this huge guide.

Even the capital return policy is not as great as I expected it to be, given that XRX now has more cash. Management guided FY24 FCF to be >$600 million, which implies a decrease of 8% vs. FY23 and an adj. EBIT to FCF conversion of 70–80%. Priorities are now set to first pay dividends (~5% yield, not great for a declining business), second to pay down debt, and third to reinvest for growth. This sequence means that share buyback programs are not within the list of priorities. Remember that share buyback has been a major drive for EPS growth (share count reduced from 216 million in FY19 to 122 million in FY23). Now that that leg of the capital return story is gone, I think the equity story is a lot less attractive.

Valuation

Because of the surge in share price, I think any potential upside from this restructuring program is basically priced in already. In my model set up above, using consensus current estimates (which reflect management guidance that I find overly bullish) and a current forward PE of 8x, the implied share price is around $20, or 3% upside. I don’t think there is an argument to be made that XRX should trade at a higher multiple because the business is still facing strong secular headwinds (revenue is still declining). For my own assumptions (bottom model), I expect XRX to continue experiencing revenue declines of the same magnitude in FY24 and FY25, with margins expanding modestly, mainly due to the RIF action. As XRX fails to show major improvement in margins and revenue continues to fall, I believe the current optimism embedded in the stock will go away, leading to a huge devaluation in multiples, falling to 5x forward PE, which had happened before in FY20 and FY16.

Conclusion

I reiterate my sell rating on XRX stock despite the recent surge in share price. 4Q23 results continues to show that the business is facing revenue headwinds with no signs of improvement. The guided decline in revenue for 2024 further supports my skepticism. While management’s reinvention program aims for margin growth, I find the burden of proof high, making it hard to be convinced at this point. Additionally, the capital return policy prioritizing dividends and debt repayment over share buybacks makes the equity story a lot less attractive. Notably, considering the current share price surge, I believe any upside from the restructuring program is already factored in.