An Investment Idea Worth Copying

 | Mar 22, 2012 | 1:30 PM EDT
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Very few investors today think to look as Xerox (XRX) as in investment opportunity. Instead, the consensus is that Xerox will go the way of other once mighty computer and technology that got caught in the crossfire of a rapid tech revolution. Just think Eastman Kodak. With all the advancement in technology today, the business of selling copiers seems like a business destined to die slowly.

Against that backdrop, Xerox shares have become incredibly cheap and terribly mispriced. The valuation currently implies a belief that Xerox has no sustainable growth drivers when in fact, that assertion is way off the mark.

Copiers are not going anywhere. No matter how many emails we send or .pdf files we create, we still need paper documents for contracts, presentations, transcripts, and the like. Show me a law firm, college campus, or office and you are likely to find a copier furiously at work. To be sure, the sale of copiers is not a growth business for Xerox today, but the annuity stream that Xerox gets from servicing and supplying such machines is a cash cow, high margin business that isn't going anywhere anytime soon.

In fact, Xerox is no longer really a seller of copiers and printers, but a document management outsourcing business. The company gets 33% of its revenues from equipment sales with the rest coming from supplies sales and service revenue. This transformation was made possible when Xerox acquired Affiliated Computer Services in 2010. As the largest business outsourcing company in the U.S., the acquisition is turning out to be a brilliant move. Xerox's services division revenues are growing by 7% a year and Xerox can now cross-sell all its products to hundreds of new customers.

Despite all of this, Xerox shares currently trade for around $8 or less than 7x forward earnings. The seemingly low multiple confers a survival bias -- many investors view Xerox as a dying business when the reality is much different. That belief is sending investment capital looking at the Ciscos (CSCO) and Intels (INTC) of the world. That leaves Xerox trading at market cap of $11 billion. The balance sheet looks highly levered with $8.6 billion in debt yet most of that debt, around $6 billion is finance debt secured by equipment. The remaining corporate debt of $2.6 billion could be eliminated in less than two years with the $2 billion in free cash flow that Xerox pumps out each year.

Since the majority of Xerox's sales come from the annuity-like supply-and-outsourcing business, the company will continue to generate tons of cash flow. The company is using that cash flow to boost the dividend, currently a 2% yield, and buying back shares. In the next year, Xerox could potentially be buying back 10% of the company. When you factor in the corporate debt, Xerox is actually changing hands for less than 7x free cash flow. The ACS acquisition will keep the company's top line growing by single digits (assuming no growth in the copier business).

Priced as if doomsday is inevitable, Xerox is a mispriced stock that will not only survive, but will also thrive going forward. A solid growing dividend, tons of free cash flow, share buybacks, and respectable growth will most likely attract investors over the years to come.

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