Financial Ratio Analysis for Xerox

Xerox Corporation is company in the field of technology and services, which is currently developing, manufacturing, marketing, and financing a whole range of document equipment, software, integrated solutions and services. They have a global network, with branches in more than 130 countries all over the world. In America, its products are distributed through divisions, subsidiaries and third-party distributors. In the rest of the world (Europe, Africa, Asia), Xerox is represented by Xerox Limited and by other companies wherewith Xerox has concluded distribution agreements. Xerox’s customer pool is very diverse, both from a geographical and a demographical point-of-view, and ranges from low-end users, such as small and middle market businesses to high-end, high quality users like graphic arts shops, governmental entities, educational institutions and large corporate accounts.

The marketing strategy for Xerox currently concentrates on the new tendencies on the market: color and digital products. These products have saved the company from collapse in one of its darkest hours: the period between 2000 and 2001. In the past two years, Xerox has introduced on the market more than 40 new products, which are all digital. The production process focuses now on digital multifunction devices and production printers, which provide, according to the company’s management team, increased future post-sale revenue. The profit margins for this kind of revenue are certainly higher, and the fact that the number of units in services has increased contributes heavily to corporate proceeds. Every $1 of equipment sold shall generate another $3 of post-sale revenue in the following years.

For instance, one of its products, the iGen3 digital production printing press has proved quite popular and successful, as it allows users to print full-color marketing material at an incredibly price in low quantities. The consumables and service for this machine is worth a lot for the company, as every unit should provide a consistent and continuous post-sale revenue. The technology employed on the machine is very advanced, so the iGen3 will probably represent a powerful advantage on the market for Xerox.

Another very profitable business that Xerox is conducting is providing complete document-management services. Its competitors often supply only the hardware, overlooking the integration of systems and services. Outsourcing is yet again a great way to cut back on expenses, so many customers prefer to leave someone else handle the job of buying the equipment and handling document-management. Several clients have entered into long-term service agreements with Xerox, impressed by the company’s ability to solve problems relating to printing, facilities management and procurement.

The rising trends make the printer-business a very competitive environment and a difficult place to live in. The market is constantly pushed-up by insistent Japanese companies and by Hewlett-Packard’s HPQ entry into the office sector of the market.

However, Xerox has installed itself as one of the leaders of the pack; its color and digital production represents an advantage that should give the company enough time to expand and further diversify its installed base, which is very important for future high-margin revenues. If all goes well for Xerox, the company might even conquer back its position as the top player in the office industry.

Valuation

Valuation Ratios

Stock

Industry

S&P 500

Stock’s 5Yr Average*

Price/Earnings

Price/Book

Price/Sales

Price/Cash Flow

Dividend Yield %

Price/Cash Flow uses a three-year average.

Xerox’s stock has a forward earnings yield of 5.59%, which is the annual return the stocks would generate if its profits stayed fixed and it paid out all of its earnings to shareholders, as dividends. Although this is a normal value, when compared with the earnings yields of similar stocks in its industry, the value is extremely healthy in absolute terms. Decent returns for investors may be generated only by realizing moderate growth in earnings or a higher valuation by the market. A high yield may be explained sometimes by the sharp drop of stock prices for that particular company. A method to verify whether a company has a high quality of stock earnings is to compare the price/cash flow ratio with the stock’s forward price/earnings ratio, which should stay in approximately in the same range.

The fair value of the share may be estimated at about $15. Important post-sale revenues should be produced by re-supplying the installed base of high-end equipment, which means that the company should have a rising profit of about 4-5% per year in the next few years. Gross margins should show a slight increase, resulting from the larger quantities of sold high-margin equipment, although the pricing pressure on the consumers should not be more than moderate.

Morningstar Financial analysts expect “operating margins — stripped of any pension and leasing business distortion — to grow to about 9.6% by 2008” as they “see selling, general, and administrative expenses slightly decreasing as a percentage of sales. The leasing business is worth just under $2 per share in our model. Our fair value is sensitive to margin assumptions. If Xerox weren’t able to realize the 300 basis points of margin expansion we have built in, our fair value would fall to $8 per share.”

Profitability

Margins (% of Sales)

TTM

Revenue

COGS

Gross Margin

SG&A

R&D

Operating Margin

Net Int Inc. & Other

EBT Margin

Profitability

TTM

Tax Rate

Net Margin

Asset Turnover

Average)

Return on Assets

Financial Leverage (Average)

Return on Equity

The last five years were not very favorable for most companies in the office equipment industry, as the majority of players on the market recorded very low returns on assets. Xerox has posted results that are average for its industry. The company’s net profit margins, which are another very important profitability measure, haven’t been very impressive but not so bad either compared with similar companies in the industry.

Xerox generated Returns on Invested Capital of about 6% in 2003, which is double that of 2002. Better operating margins and asset turns should provide Xerox with a fair chance of returning its cost of capital next year.

Financial Health

Balance Sheet Items (in % Terms)

Cash & Short-Term Investments

Accts Rec

Inventory

Other Current Assets

Total Current Assets

Net PP&E

Intangibles

Other Long-Term Assets

Total Assets

Accts Payable

Short-Term Debt

Taxes Payable

Accrued Liabilities

Other Short-Term Liabilities

Total Current Liabilities

Long-Term Debt

Other Long-Term Liabilities

Total Liabilities

Total Stockholders’ Equity

Total Liabilities & Equity

Liquidity/Financial Health

Current Ratio

Quick Ratio

Financial Leverage

Debt/Equity

The analysis of Xerox’s stock’s debt/total capitalization ratio reveals that the company has a lot more debt than most of its industry competitors. This is not a problem by itself, as long as the company is able to service its debt, but it is something worth considering. Investors should note that, judging by Xerox’s cash flow from operations and current cash balance, the company should have enough money to service its debt, at least for the moment.

The company’s financial health is getting better. Earnings before interest and taxes managed to cover non-finance interest cost two times last year, and adjusted cash flow was enough to cover it more than five times.

Growth

Revenue Growth

Year over Year

3-Year Average

5-Year Average

10-Year Average

Operating Income

Year over Year

3-Year Average

5-Year Average

10-Year Average

EPS

Year over Year

3-Year Average

5-Year Average

10-Year Average

It is no news that the majority of stocks in the office equipment industry have experienced both declining revenue and earnings the past few years, and Xerox is no exception. The company’s stock has also witnessed declining revenue growth over the past three years.

Restructuring Xerox implied selling several non-core businesses during the process. AS a consequence, growth has been negative for the past years. Growth in equipment sales came back to normal in 2003, and overall revenue growth is expected to return by next year.

Management

The person behind Xerox’s revival is Anne Mulcahy, a 27-year company veteran, who took over in the spring of 2000 from Rick Thoman, who succeeded Paul Allaire in April 1999. Mulcahy proved her value by steering the company back to the right track, under incredibly tough conditions during the years 2000-2002. For achieving that performance, she is now receiving important amounts of money and securities. In 2003, her income meant some $3 million in cash, $2 million in restricted stock and 935,000 options. The board has nine members, with one new independent member from the summer of last year, but its composition is very similar to the one that presided over management’s accounting scandal from some time ago. 4.2% of shares are outstanding in 2003, so option issuance is not to be taken into consideration, at least according to Morningstar Financial Analysts.

Strategic Plans and Initiatives

Xerox’s company report mentions the management’s intention to work with other companies toward the common goal of standard implementation. Such an initiative involved Adobe; a brief description of the issue and declarations of the persons involved may be found below.

Adobe Systems and Xerox have announced an initiative to jointly support and help promote the adoption on a large scale of new print industry standards for information workflow technologies, both static and variable.

The standards in question are Adobe Portable Document Format (PDF), JDF (Job Definition Format) job ticketing, Adobe PostScript, Extensible Markup Language (XML), and different variable information workflow technologies.

Gil Hatch, president of the Production Systems Group at Xerox Corporation said that: “Together, Xerox and Adobe have led the transition to desktop publishing and digital printing, Industry standards are critically important in variable information and print-on-demand production workflows and in taking these businesses to the next level of growth and profit potential. We will work together to develop solutions that enable creators, producers and all other participants in the print value chain to capture the rich opportunities available through digital technologies.”

Also, representatives of Adobe (Jim Heeger, senior vice president of Creative Professional Products) have presented their view: “Adobe and Xerox share a heritage and a set of demanding customers who require great products and a set of robust industry standard print technologies they can build their businesses around. The integration of Adobe software across a range of Xerox Freeflow products will help our customers as they move to more efficient print workflows based on Adobe PDF and emerging standards such as JDF.”

This initiative must be based on a healthy financial situation for both companies. As far as Xerox is concerned, the analysis of its current status would suggest that it has enough resources, both financial and technical to support this new partnership. Xerox is focused not only on providing clients with hardware solutions, but also with implementing those solutions. That is way Xerox is a perfect partner for Adobe in this deal. Xerox’s growth from previous years, as well as good financial ratios should make an investor draw the conclusion that Xerox uses its resources correctly and that it can sustain its development, at least in regard to this particular initiative.

According to Morningstar Financial Analysts, on a bullish market, Xerox presents itself as follows:

1. Xerox has a strong brand, quality products, and a large salesforce. These attributes have earned the firm the leading share in several important product categories, such as color printers for the office, digital copiers, and digital printing and publishing systems.

2. Production printing is on the verge of a revolution, with digital equipment set to make share gains. With its iGen3 digital production press, Xerox is the best-positioned player.

3. Xerox’s strategy is paying off. Two thirds of second-quarter equipment sales came from products launched in the past two years. Further, the company’s target areas — office digital, production digital, and services — now represent 73% of total revenue.

4. Revenue from color — a subset of office and production digital — increased 17% in the second quarter, and now represents 25% of total revenue. ”

According to the same analysts, the bears on the market should see the following situation:

1. Post-sale revenue — the company’s most profitable business — had an unexpectedly tough second quarter, decreasing 4%. This is below management’s expectations due to softness in Latin America.

2. Sales in conventional light-lens equipment are contracting rapidly. Higher-end equipment sales will not be able to offset this decline until 2005, creating a no-growth environment for yet a few more quarters.

3. Hewlett-Packard’s recent announcement that it will enter the high-end copier market introduces yet another rival to an already highly competitive arena.

4. In 2002 the Securities and Exchange Commission slapped a large fine on Xerox for revenue-recognition and other accounting improprieties. Although Xerox has restated its financials and settled with the SEC, there is still litigation risk.”

Bibliography

1. Morningstar Financial Analysts www.morningstar.com

2. Reuters Financial Analysts www.investor.reuters.com

“Adobe and Xerox Announce Strategic Initiative to Promote Print Production Workflow Standards” Company Release www.adobe.com/aboutadobe/pressroom/ressreleases/pdfs/200309/093003XEROX.pdf

Morningstar Financial Analysts www.morningstar.com

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