Why Xerox (NYSE: XRX) Needs to Recapitalize

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Ben Michaud
Firm: H.M. Payson & Co. Portland, ME.
Firm Type: Hedge Fund.

Recommendation: Long Xerox (NYSE: XRX)
Timeframe: Uncited
Current Price: $7.00
Target Price: $11.20

Quick Thesis:
Right up front I want to disclose that I own Xerox and am thus talking my book. The long thesis for Xerox has been well-established within the investment community, so I will not spend time going through it in detail here - my goal is to make a compelling case for a recapitalization and a dividend increase.

The ACS acquisition transformed Xerox into a service company with stable, annuity-like revenue, it generates approximately $1.6 billion of free cash flow, it sells for less than 7.00 times FCF at current prices and is committed to repurchasing roughly $1 billion worth of stock per annum over the next several years.

While the investment thesis is attractive on a stand-alone basis, I believe the “low-growth” nature of the business and the paltry dividend yield leave the stock in “equity mandate no-man’s land” with the potential for an extended period of “dead money”. “Growth” investors are uninspired and “value” investors receive little in the way of current yield – while the buyback yield is significant and certainly benefits from the current undervaluation, I believe a more balanced policy of returning capital will result in a higher multiple over time as an attractive and growing dividend attracts a long-term, stable shareholder base.

In order to take advantage of the current undervaluation, transform the shareholder base and close the valuation gap, I would propose the following three-part plan:

In summary, I believe Xerox should
1) boost its “core” debt from 1.14 times to 2.00 times LTM EBITDA by issuing up to $2.7 billion of additional debt;
2) initiate a $2.7 billion Dutch tender offer at $7.50 per share in order to retire 360 million shares and;
3) boost its dividend from $250 to $735 million per annum. The Dutch tender offer would immediately boost per share intrinsic value by more than 20%, the more balanced payout policy would transform the shareholder base and the 9.2% post-tender offer dividend yield would catalyze a closing of the valuation gap as yield-starved investors drive the yield down to 5% or less.

Post-tender offer, the current annual dividend of $250 million would rise from $.18 to $.23 per share for a dividend yield of 3.1% (versus 2.3% pre-tender offer). With its annuity-like cash flow profile however, Xerox is more than capable of handling a 50% payout ratio, or an annual dividend rate of $.69 per share – at a post-tender offer price of $7.50, the dividend yield would rise to 9.2%. To say the least, I do not believe a 9.2% dividend would last long – perhaps a new, dividend-seeking investor base drives it down to 5%? The upside speaks for itself – a 5% yield means a $13.80 stock price, while a 4% yield means a $17.00 stock price.

I do not have the capital to push for such a plan, but as Jeff Saut often says, “Good things happen to cheap stocks”. A prolonged period of stock price stagnation particularly in the face a robust buyback program will no doubt incite shareholder action.

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