XRX: Xerox and the Spirit of Honest Debate

In response to our somewhat heated reaction to Xerox’ (XRX) earnings report, a Xerox employee submitted a comment outlining the Xerox perspective. Since the company appears to be interested in fostering an honest debate, we encourage investors to consider their side of the story as well as our own. Of course, Xerox has presented their side in press releases, conference calls and investor conferences already, but there is certainly no harm in seeing it again here. So we present the comment, along with our response, as this article.

Warning: This is a long article. For those who lack the patience to read it all, our key points are:

  1. Xerox should insist that analysts and First Call base their estimates on Generally Accepted Accounting Principles, rather than adjusting them for “one-time” charges that occur every year.
  2. Whether due to price competition or slower unit sales, we don’t believe the negative constant-currency growth in equipment revenue says good things about the company’s future prospects.
  3. Enough with the light-lens to digital transformation story, already. We’ve been waiting for the growth businesses to offset the declining businesses for four years and are beginning to doubt it will ever happen.
  4. Key financial metrics have been flat to declining for several years.
  5. The company appears to be wasting money on share repurchases, because the share count keeps going up despite $1.5 billion in share buybacks.

Enough of the summary, here’s the beef.Xerox: When assessing Xerox’s financial performance, it’s important to understand these key facts. Here’s the view from Xerox:- First Call estimate for Xerox’s Q4 earnings was 37 cents. That number did not include restructuring. While Xerox provided guidance on restructuring for Q4, analysts posted an adjusted EPS number that excluded any impact from restructuring. Compared to First Call and Xerox’s own Q4 guidance, Xerox did exceed expectations for the quarter at 38 cents adjusted EPS.

Stock Market Beat: In the earnings release for the third quarter, management gave the following guidance:

Xerox expects fourth-quarter 2006 earnings in the range of 21-24 cents per share, including restructuring charges of about 13 cents per share. Excluding restructuring, Xerox expects fourth-quarter adjusted EPS of 34-37 cents per share.

Right away we see two discrepancies: First, since Xerox guided toward the amount of the charge, the company was implicitly asking analysts and First Call to treat it as special. Given that Xerox has had restructuring charges in nine of the last ten years they are clearly anything but special, unique, unusual or uncommon. Why not insist that both analysts and first call include them and earn our plaudits as an example for others to follow? Second, the restructuring charge was $0.03 higher than expected, which resulted in “adjusted” earnings beating estimates while GAAP earnings were at the low end of the range. Did the analyst estimates incorporate the full $0.16 charge or the $0.13 for which they were guided? It brings to mind Warren Buffett’s admonition in the 1982 (we have long memories and access to search engines) letter to Berkshire Hathaway shareholders:

It was only a few years ago that we told you that the operating earnings/equity capital percentage, with proper allowance for a few other variables, was the most important yardstick of single-year managerial performance. While we still believe this to be the case with the vast majority of companies, we believe its utility in our own case has greatly diminished. You should be suspicious of such an assertion. Yardsticks seldom are discarded while yielding favorable readings. But when results deteriorate, most managers favor disposition of the yardstick rather than disposition of the manager.

To managers faced with such deterioration, a more flexible measurement system often suggests itself: just shoot the arrow of business performance into a blank canvas and then carefully draw the bullseye around the implanted arrow.

Given that Xerox’ bubble-era accounting practices landed the company a case study in the book, surely you are aware of Howard Schilit’s Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition (aff. link). Shenanigan number 7 is “Shifting Future Expenses to the Current Period as a Special Charge.” One way to do so is to inflate the amount included in a special charge, as Xerox appears to have done in this period.

Or consider the value investor’s bible, Graham and Dodd’s Security Analysis. They say:

The correct technique [for analysts adjusting for restructuring charges] is to place each gain or loss in the year or years in which it is believed to have occurred.”

Or how about White, Sondhi and Fried’s The Analysis and Use of Financial Statements, which has been a key part of the curriculum for the CFA Exam for many years. They have this to say:

If we ignore nonrecurring items, we permit companies to sweep their mistakes under the rug. The purpose of analysis is to understand, not to forgive…. Restructuring provisions require special scrutiny. Such provisions often contain both noncash writeoffs and provisions for future expenditures. The former indicate that prior-year income was overstated; the latter increase future-year income (that will no longer include those costs) and forecast future cash flows. Repeated writedowns suggest that depreciation is inadequate and the firm’s quality of earnings is low.

And here is a reference from Financial Statement Analysis: A Global Perspective by Robinson, Munter and Grant, presented in a study of Motorola’s financial statemtents:

Motorola had similar problems in years prior to 1999. The continuing nature of these charges is somewhat disturbing. One would hope that the restructuring is effective and that these charges would cease in the future, but the analyst must be careful when these expenditures occur continuiously.

The point of all these references is not to show how many books about financial analysis we have read, but to illustrate that there is a clear consensus that restructuring charges, particularly when they occur frequently, should not be ignored. In fact, they are “suspicious,” “disturbing” and indicate that “the firm’s quality of earnings is low.”

If investors don’t believe the restructuring charges should count against the current period, they should adjust them to show the charges as operating expenses in a different year than when the charges were taken. However, since there are charges in pretty much every year, there doesn’t seem to be much point. We think Generally Accepted Accounting Principles (GAAP) does that job quite well and no adjustments are necessary.

Xerox: - About 70 percent of Xerox’s total revenue comes from post-sale — the annuity stream from supplies (toner, ink) and service for Xerox products. To boost the annuity stream, Xerox is focused on increasing the installs of its products, especially color multifunction printers and digital color presses. Considering the price pressures in the industry, it’s not unusual to see dips in equipment sale revenue. Xerox is increasing the placement of products and broadening its product portfolio. Many of the products are sold at lower prices but Xerox continues to maintain margins in its range of 40-41 percent. For example, Xerox installed 35 percent more color multifunction devices and 74 percent more color publishing presses in 2006.

Stock Market Beat: We are aware that the more machines that are installed the more post-sale revenue Xerox can expect in the future. In fact, here is how Xerox describes the process in their 2005 10K:

Our business model is an annuity model, based on increasing equipment sales and installations in order to increase the number of machines in the field (“MIF”) that will produce pages and generate post sale and financing revenue streams. We sell the majority of our equipment through sales-type leases that are recorded as equipment sale revenue. Equipment sales represented 29% of our 2005 total revenue. Post sale and financing revenue includes equipment maintenance and consumable supplies, among other elements. We expect this large, recurring revenue stream to approximate three times the equipment sale revenue over the
life of a lease.

It is that last part that leads us to say we are concerned about a 4% decline in equipment sales revenue on a constant currency basis. “Approximately three times” a smaller number is less than “approximately three times” a larger number, so we think the weak equipment sales number should be regarded as a negative. ‘Nuff said.
Xerox: - Xerox is seeing rapid declines in revenue from its older black-and-white light lens (analog) business as it accelerates customers’ transition to all digital devices. This transition takes time and does have an impact on the company’s annuity revenue. In Q4, the drag from light lens cost the company 2 percent of post-sale growth. For the full year and without the impact from currency, Xerox grew post-sale 2 percent. As the impact from light lens diminshes and as the flow through from the placement of color products picks up, Xerox expects to see steady growth in its annuity stream, which boosts total revenue.

Stock Market Beat: Yes, this transition takes time. In fact, in the 2002 annual report, Xerox made the following statement:

The remainder of the decline was due to a mix of economic weakness, continued competitive pressures and market transition from light-lens to digital technology. This resulted in continued declines in older light-lens products, as customers continue to transition to new digital technology, only modestly offset by growth in production color, monochrome digital multifunction, and color printers, reflecting the success of our new products in these key areas.

We believe, four years later, investors have the right to know exactly when this transition will be complete and Xerox will see said steady growth in its annuity stream.

Xerox: - All the key metrics: color, services, post sale and install activity are trending in the right direction.

Stock Market Beat: We consider the key metrics to be sales, operating income, and cash flow from operations. Here’s a look at how those have been trending:

xeroxsales.jpg

Sales declined dramatically early in the decade and have since been flat as a pancake.

xeroxopinc.jpg

Operating income started out negative, floated at a miserable two percent of sales for three years, climbed to an almost respectable number in 2004 and have been declining since.
xeroxcffo.jpg

The trend in cash flow from operations resembles… a lumpy pancake.

So color us unimpressed with the key metrics.

Xerox: - Xerox grew earnings by 17 percent – and has committed to earnings expansion of another 10-15 percent in 2007.

Stock Market Beat: See point 1 and Chart 2 above. Using Generally Accepted Accounting Principles, operating income was down 2.7% in 2006, although that was an improvement from the 14% decline in 2005. Since the company’s commitment to earnings expansion apparently requires investors to ignore “one-time” charges that occur every year, we think the company is painting bullseyes ex post facto.

Xerox: - The company generated $1.6 billion in operating cash flow in 2006. And, it returned to investment grade last year.

Stock Market Beat: We know. We mentioned the cash flow improvement as a positive in our original article, and had a whole special article talking about the debt upgrade. But one year does not a trend make. What we see now are lumps in our pancake.

Xerox: - Since launching its stock buyback program in October 2005, it has repurchased about 100 million shares, totaling $1.5 billion of the $2 billion program.

Stock Market Beat: Then why has the share count risen from 931 million to 946 million? Could it be that the share repurchases are simply offsetting generous option grants? It sounds to us like $1.5 billion has gone down the drain.
Xerox: We believe the facts tell a positive story about the company’s long-term value.

Stock Market Beat: We hope the company has a positive long-term value.

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3 Comments on “XRX: Xerox and the Spirit of Honest Debate”

  1. [...] Further elaboration was provided in a subsequent post: Stock Market Beat: In the earnings release for the third quarter, management gave the following guidance: [...]

  2. [...] Our response: Xerox guided to first-quarter 2007 earnings between $0.21 and $0.23, right in line with the 22-cent consensus. We’re sure they will report at least $0.22. The real surprise would be if they did it on an unadjusted basis. [...]

  3. [...] On to Sealab 2021, as all the HB episodes have been watched. Bill Trent takes Xerox to task for misleading investors on earnings in XRX: Xerox and the Spirit of Honest Debate. [...]

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