Printer manufacturer Lexmark, Inc. (LXK) started out this year at $73 and hasn’t looked back. Unfortunately, its motion has all been to the downside. Now less than half the stock it used to be, is it time to consider a nibble?

The stock is certainly cheap enough. Not only is it trading at a mere 12x expected earnings, $6.60 of the $34.50 current valuation is literally cash in the bank.

Over the last 12 months, Lexmark has brought in cash from operating activities totaling nearly $500 million and used less than $200 million for capital expenditures, resulting in free cash flow of $309 million and a FCF/Enterprise value yield of 11% – a very juicy premium to the current Treasury yield.

Of course, any juicy reward is bound to come with some risks, so let’s take a good hard look at those.

Second Fiddle

Even before Hewlett Packard’s (HPQ - Annual Report) recent resurgence, Lexmark was a distant runner-up in the printer business. Lexmark countered this position by forging an alliance with Dell (DELL) under which Lexmark makes all of the Dell-branded inkjet printers and half of their laser printers. Unfortunately for Lexmark, they inked that deal just in time for Dell to start its own tailspin.

Then, even if Hewlett Packard were to falter there are plenty of other competitors in the wings. First there are the traditional rivals like Seiko Epson (SEKE.Y) and Canon (CAJ), and Brother (BRTHY). Then, converging technologies have made competitors out of Ricoh (RICOY), Xerox (XRX), Samsung, and Kyocera Mita (KYO).

Declining Business

Everyone knows that obsolescence is a key risk for technology companies, and Lexmark is currently feeling the pain of the industry’s ongoing shift from inkjet to laser technology. I’ll let Lexmark explain it themselves (courtesy of the latest 10Q filing:)

Lexmark believes it is experiencing shrinkage in its installed base of inkjet products and an associated decline in end-user demand for inkjet supplies. The Company sees the potential for continued erosion in end-user inkjet supplies demand due to the reduction in inkjet hardware unit sales reflecting the Company’s decision to focus on more profitable printer placements, a mix shift between cartridges resulting in a higher percentage of moderate use cartridges and the weakness the Company is experiencing in its OEM business. Additionally, Lexmark expects to see continued declines in OEM unit sales, aggressive pricing and promotion activities in the inkjet and laser markets….

As the Company analyzes the situation, it sees the following:

• Some of its unit sales are not generating adequate lifetime profitability due to lower prices, higher costs and supplies usage below its model.
• Some markets and channels are on the low-end of the supplies generation distribution curve.
• Its business is too skewed to the low-end versus the market, resulting in lower supplies generation per unit.

Cheap Enough?If the risks haven’t sent you running for the hills, you are probably wondering whether the current share price is cheap enough to justify taking those risks. With the prospects for a decline in sales, earnings and cash flow being more than a distinct possibility, any price paid is going to have to be justified for a declining business.

The traditional valuation model says that value is equal to the cash flow in the coming year, divided by the difference between the company’s cost of capital and its growth rate. The 11% free cash flow yield I calculated above is a version of this model, and it provides the denominator in the equation: lexmark’s return, less its growth rate, should equal 11%.

Since the growth rate is negative, the return will be something less than 11%. If the current declines of approximately 3%, the implied return works out to 8%. That probably doesn’t sound like a huge payoff for many investors, but it is still a nice premium to Treasuries. Depending on the outlook for the rest of the market, value investors might find it worth a shot.

Our balanced product momentum across our core technologies and advanced technologies continues to be the best I have seen in a number of quarters….
Let me approach it from a broad perspective. First is what we are seeing is the importance of balance on a global basis. I have been in this business for 30 years — Jim, I think you have been there that long or maybe a hair longer. It’s the strongest global economy I have been a part of.

(Excerpt from full CSCO conference call transcript)

It was funny that nobody challenged him on this, as anyone who has been in the business for long must surely remember Chambers’ comments in 2000. According to a CIO Magazine case study called “What Went Wrong at Cisco:”

Xilinx’s Wall Street warning came two months before Cisco Chief Strategy Officer Mike Volpi told The Wall Street Journal in November, “We haven’t seen any sign of a slowdown.” Volpi told The Journal that Cisco hadn’t changed its internal plans since the beginning of its fiscal year in August. “We have guided [Wall Street] accurately, and we can execute to plan.”
On Dec. 4, CEO Chambers crowed to analysts, “I have never been more optimistic about the future of our industry as a whole or of Cisco.”
Eleven days later, CIO Solvik says, the company saw the problem for the first time.

In case you were wondering, Xilinx (XLNX) lowered its guidance in June, then missed the lower estimate. However, they didn’t pin the blame on Cisco. On their call, they said:

During last quarters’ call, we forecasted that all geographies extension plan would be up sequentially. Japan was down sequentially as planned, but so was Europe, which turned out to be surprise. This quarter our top 10 European accounts, which represent 45% of total European sales were up 16%, but the main remaining channel accounts were down 19%. The weakness was mainly in the distribution channel across a few end markets including industrial, audio and video broadcast and data processing.

(Excerpt from full XLNX conference call transcript)

Turning to some other companies, EMC (EMC - Annual Report) is certainly having no trouble.

Looking quickly at the IT spending outlook for 2007, we see a positive environment in all major geographies and we believe there is opportunity for us to beat our annual financial targets for revenue, earnings per share and cash flow. EMC’s positive results and momentum are obviously only possible because customers are embracing our strategy, our leading products, our services and our solution sets at each of our four businesses — storage, content management and archiving, RSA security and VMware.

(Excerpt from full EMC conference call transcript)

Other tech companies aren’t so lucky. Sun (a href="http://stockmarketbeat.com/blog1/category/tech/sunw/">SUNW - Annual Report) said:

Sun’s total revenues for the fourth quarter of fiscal year 2007 were $3.835 billion, an increase of 0.2% as compared with $3.828 billion in revenue reported for the fourth quarter of fiscal year 2006.

(Excerpt from full SUNW conference call transcript)

The largest technology distributor, Ingram Micro (IM) had a mixed quarter – overall sales were reasonably strong but currency fluctuations played a big role:

On a regional basis, North America sales where $3.3 billion, essentially, flat versus the prior year or 40% of total revenues. As we described at last quarter warranty sales on behalf of our vendors are now recognized as net fees rather than gross revenues in cost of sales as reported in the prior year period. We saw a negative impact on year-over-year sales comparisons of approximately 5%. European sales were $2.78 billion or 34% of total revenues, an increase of 16% versus a year ago. The translation impact of relatively strong European currencies contributed an 8 percentage point positive impact on comparisons to the prior year.

Asia pacific sales were $1.76 billion, an increase of 31% over the prior year and 22% of our total sales. Finally Latin America sales were up 4% versus last year to $344 million representing 4% of our total sales.

(Excerpt from full IM conference call transcript)

Much like the software conference calls, the outlook appears reasonably positive. However, I’m not ready to break out the champagne and say were past the tech spending doldrums. Results are mixed, the financial sector is very important to tech spending, and Cisco’s forecasting track record doesn’t help my confidence level. While I’d love to see tech spending improve, I’ll have to see it to believe it.

Disclosure: Author is long IShares MSCI Japan Index (EWJ) at time of publication.

Well, as it turns out they didn’t ask investors to ignore a bunch of stuff. Unfortunately, however, the report still didn’t strike me as being particularly strong. I’ll run down a few of my observations.

Total revenue of $4.2 billion grew 6 percent in the quarter. Post-sale and financing revenue – Xerox’s annuity streams that represent more than 70 percent of total revenue – increased 7 percent. Both total revenue and post-sale revenue included a currency benefit of 2 percentage points as well as the benefit from Xerox’s acquisition of Global Imaging Systems, which was completed in early May.

So… 4% growth excluding the currency benefit and $100-$200 million from Global Imaging, the sales looked about flat. With Global Imaging having clocked in $1 billion in sales last year, it should be expected to boost sales by 6.25% in its first full quarter as a Xerox subsidiary, or slightly more than half that in the partial quarter just completed. Xerox is spending billions of dollars on acquisitions not to grow but to stay in place.

A fundamental measure of Xerox’s business is increasing the number of Xerox systems installed in customers’ workplaces. This install activity generates sales of supplies and services that are expected to drive gains in post-sale revenue.

They keep saying that. I’m still waiting for them to prove it. For example, during the second quarter, install activity increased 54 percent for the company’s color multifunction devices that print, copy, fax and scan. But revenue from color grew 12 percent in the second quarter and now represents 38 percent of Xerox’s total revenue, up 4 points from the second quarter of 2006. Why isn’t the sales keeping up with the install rate? Shouldn’t all those installs be generating post-sale revenue by now?

Gross margins were 40.3 percent, a less than one point decline from second quarter of 2006.

I don’t need to add anything there.

Xerox expects third-quarter 2007 earnings in the range of 24-26 cents per share. The company increased its range of earnings expectations for full-year 2007 to $1.16 – $1.18.

After beating in the current quarter, the high end of the guidance range for the rest of the year only matches consensus. That is the equivalent of cutting guidance in the coming quarters.

With sales up just 7% (including all the aforementioned benefits) accounts receivable and inventories are up 11% year to date. Some of that increase, however, may be seasonal.

Cash flow from operations were up for the quarter and year-to-date, but only because the company contributed less to its underfunded pension plan than it did last year. Excluding pension contributions (which are discretionary) the cash flow would have been down.

Long story short, there is nothing to shout about with Xerox’s earnings.

EconomicData

The Earnings Calendar is as busy as it can get. Some of the names I’ll be watching:

Monday

• Altera (ALTR) – Xilinx (XLNX)  filed an awful report. Can Altera do any better? Consensus is $0.19 EPS on sales of $314 million.
• Hexcel (HXL) – This Small Cap Watch List (Track at Marketocracy) member was seeing rising estimates until last month, when they were cut from $0.20 to the current $0.17.
• Steel Dynamics (STLD - Annual Report) – The Mid Cap Watch List (Track at Marketocracy) member is expected to earn $1.04 on sales of $948 million.
• Texas Instruments (TXN - Annual Report) – expected to earn $0.42 on $3.45 billion in sales.

Tuesday

• CH Robinson (CHRW - Annual Report) – estimates have been rising and now stand at $0.47, but Landstar (LSTR - Annual Report) disappointed.
• CDW Corporation (CDWC) – stellar monthly sales reports have kept estimates rising. They now stand at $0.97.
• EMC Corporation (EMC - Annual Report) – The big news is still the VMWare IPO, but it is also a decent look at enterprise tech spend.
• Laboratory Corporation of America (LH) – The Mid Cap and Large Cap Watch List (Track at Marketocracy) member has been seeing positive earnings revisions and is now expected to earn $1.09 on $1.03 billion in revenue.
• Lexmark (LXK) preannounced and will probably offer poor guidance.
• Linear Technology (LLTC) – expected to earn $0.35 on $267 million in sales.
• Norsk Hydro (NHY) – The Large Cap Watch List (Track at Marketocracy) member has no analyst coverage right now.
• Plantronics (PLT) – my covered call position is now being cashed out so I’ve no skin in this one. But it is often volatile.
• United Parcel Services (UPS) is a great read on the health of the economy. Expectations are $1.03 on $12.23 billion in revenue.

Wednesday

• Arkansas Best (ABFS) – after Landstar’s (LSTR - Annual Report) weak quarter I’m expecting a poor showing. Estimates have come down to $0.67, but may not have come down enough.
• Colgate Palmolive (CL) – Large Cap Watch List (Track at Marketocracy) member unlikely to surprise much. Consensus is $0.83 on $3.31 billion.
• Corning (GLW - Annual Report) – is LCD supply/demand back in balance?
• Freeport McMoRan Copper & Gold (FCX - Annual Report) -Another Large Cap Watch List (Track at Marketocracy) member with dramatic positive earnings revisions, now standing at $2.71.
• Graco (GGG) is another Large Cap Watch List (Track at Marketocracy) member. Estimates have been coming down and are now at $0.61.
• MEMC Electronic Materials (WFR) – Is polysilicon supply catching up to demand for this Large Cap Watch List (Track at Marketocracy) member?
• Xerox (XRX) – can they make the numbers without asking investors to ignore a bunch of stuff? I don’t doubt they will earn $0.27 as expected but wonder how they’ll get there.

Thursday

• Federated Investors (FII) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.54.
• Ingram Micro (IM) is on the Small Cap Watch List (Track at Marketocracy) and expected to earn $0.36.
• KLA-Tencor (KLAC) – I know the semiconductor equipment fundamentals stink. I want to know how much and whether it is priced in.
• NII Holdings (NIHD) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.49.
• Western Digital (WDC) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.36.

Disclosure: William Trent has a long position in SMH.

Leo Apotheker

Let me maybe try to answer your two questions on Germany and the U.S. Let me start with the U.S. first. We did not see any material change in the spending environment in the U.S. It was as expected, not better, not worse — steady as it goes. We have no reason to believe that that will change.

(Excerpt from the full SAP conference call transcript)

Heather Bellini – UBS

Thank you and congratulations on a very good quarter. Safra, I was wondering if you could help us out with two questions. One, what do you think was behind the strength in new license sales this past quarter? How much of it do you think was related to changes in execution that you put in place post the November results?

The second thing would be many have been nervous about enterprise spending trends, given some of the missteps from some of the big software companies over the past few quarters. Can you give us your view on the macro environment right now? Thank you.

Safra A. Catz

Sure, and you know, Charles, you should add in on the first — on either question, actually. The reality is that the anomaly is not this quarter at all. It is really last quarter, and as we told you, we had a blockbuster Q4 in ’06 and Q1 was again fantastic. Q2, I think you basically saw that we felt we had some execution issues out in the field, really focused mostly around North America. Charles and Keith put in place — basically everyone is focusing back on what they need to be doing and they are really just back on track.

Today is not really the announcement of the anomaly. It was really last quarter when we talked about what went down in Q2. Charles, do you want to comment on that part?

Charles E. Phillips

Yes, and that is what we felt last quarter, what we said is that our destiny was in our control and the guys focused, did a great job and came through around the world, but North America especially.

(Excerpt from the full ORCL conference call transcript)

Anne Mulcahy

I think we would not highlight any difference or change in terms of enterprise spending that we certainly are aware of in Q1. We look at pipelines and activity and feel that there is a level of consistency that we are seeing with regard to our enterprise accounts. So I know that that has become a subject of certainly debate, but I don’t think we would share the view that there is any noticeable slowdown right now on the enterprise side in the US.

(Excerpt from full XRX conference call transcript)

Mark Loughridge

Well, you know, if you look at it, I am not going to make an economic forecast here. If you look at the U.S., however, we did see weakness, predominantly at the end of the quarter, in our enterprise space.

(Excerpt from full IBM conference call transcript)

It looks like the voting so far runs 3:1 in favor of “no slowdown.”

Xerox Corporation (XRX) announced today first-quarter 2007 earnings per share of 24 cents.The company’s earnings include a 2-cent charge to reflect its share of a restructuring charge recorded by Fuji Xerox Co., Ltd. This previously announced restructuring was initially expected to be a 3-cent charge to Xerox’s first-quarter earnings.

Total revenue of $3.8 billion grew 4 percent in the first quarter. Post-sale and financing revenue – Xerox’s annuity streams that represent more than 70 percent of total revenue – increased 6 percent. This growth was largely driven by a 7 percent increase in post-sale revenue from digital systems. Both total revenue and post-sale revenue included a currency benefit of 3 percentage points.

When we issued our earnings preview, we said: Xerox (XRX) – Consensus expects $0.20 on $3.82 billion this quarter and $0.27 on $4.09 next. The estimates have come down but are at the high end of revised guidance.

The new official guidance, which included the charge, was $0.18-$0.20. Since the charge was $0.02 instead of $0.03 it should have been $0.19-$0.21. Estimates properly came down after the guidance revision, so the earnings including the charge are the ones that matter. And on these, Xerox beat by $0.03. Guidance for next quarter was in line:

Xerox expects second-quarter 2007 earnings in the range of 26-28 cents per share.

What is amazing to us is how much glowing coverage the company received for mediocre 4% growth that was itself primarily due to currency effects rather than operational success. For example, “InPlay: Xerox beats by $0.05, ex items; guides in-line for Q2;” or even more laughably “[$$] Xerox’s Net Income Rises 17%, Boosted By Strong Sales.” Boosted by Strong Euro, they should say.

Still, the stock looks to rally on the news, which tells us management is good at managing expectations, anyway. Moving to the nitty gritty:

A fundamental measure of Xerox’s business is increasing the number of Xerox systems installed in customers’ workplaces. This install activity generates sales of supplies and services that are expected to drive gains in post-sale revenue. As Xerox accelerated activity in key markets during the first quarter, the continued impact of pricing declines put pressure on equipment sales, which were down 2 percent including a 2 point benefit from currency.

They are trying to say they are willing to lose money selling the razor in order to sell more blades. However, until they can produce overall growth in excess of nominal GDP we remain thoroughly unconvinced of the strategy.

• Monday’s retail sales report (Consensus 0.6%, 0.9% less autos)
• CPI on Tuesday (Consensus 0.2% core, 0.6% headline)
• Housing Starts on Tuesday (Consensus 1.49 million, SA)

Earnings season is quite active this week as well.

Tuesday

• IBM (IBM - Annual Report) – Consensus expects $1.21 on $21.86 billion in revenue and next-quarter guidance of $1.46 on $23.04 billion. Given that these numbers represent sales growth of 5.8% and 5.2%, respectively, it would be a near-disaster if they miss.
• Intel (INTC - Annual Report) – Consensus wants $0.22 on $9 billion this quarter and $0.22 on $8.9 billion next. We think that next quarter sales figure, which represents 10.8% year/year growth, is too optimistic.
• Linear Technology (LLTC) – Consensus wants $0.32 on $254 million this quarter and $0.34 on $263 million next.
• Yahoo! (YHOO) – Consensus expects $0.11 on $1.21 billion this quarter and $0.13 on 1.28 billion next.

Wednesday

• Motorola (MOT - Annual Report) – Consensus expects $0.02 on $9.3 billion this quarter and $0.08 on $10 billion next. They already preannounced, so the guidance is the important bit. Numbers have come down dramatically but may have further yet to go.

Thursday

• Armor Holdings (AH) – Consensus wants $1.11 on $841 million this quarter and $0.92 on $775 next. There may well be a guidance beat since the numbers expect a significant growth slowdown year/year.
• Advanced Micro Devices (AMD - Annual Report) – Expected to lose $0.46 on $1.34 billion in sales this quarter and $0.36 on $1.35 billion next. Given how disastrous the current outlook is, we may be getting near the bottom for estimates. Valuation, however, remains questionable. We hate negative P/E multiples.
• Google (GOOG - Annual Report) – Consensus expects $3.30 on $2.5 billion in revenue this quarter and $3.41 on $2.63 billion next. The Double-click acquisition may help next quarter. Without it, the estimates seem more realistic (less room for upside surprise) than they have been recently.
• Landstar (LSTR - Annual Report) – Consensus expects $0.40 on $590 million this quarter and $0.54 on $656 million next. We think they will beat.
• Nokia (NOK) – Consensus expects $0.32 on $13.1 billion this quarter, $0.34 on $13.9 billion next. We take the under.

Friday

• SAP (SAP - Annual Report) – Consensus expects $0.36 on $2.93 billion this quarter and $0.44 on $3.17 billion next. Both seem on the high side.
• Xerox (XRX)  – Consensus expects $0.20 on $3.82 billion this quarter and $0.27 on $4.09 next. The estimates have come down but are at the high end of revised guidance.

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.

Money News:- Xerox Cuts Outlook on Restructuring – AOL Money & Finance

Xerox Corp. late Monday slashed its profit outlook for the first quarter because the copy machine maker said a partner company will record accounting charges as part of a plan to cut costs.The Stamford, Conn.-based company has a 25 percent stake in Fuji Xerox Co., a partnership that markets Xerox products in Japan and other countries in the Pacific Rim.

Xerox said in a Securities and Exchange Commission filing late Monday Fuji Xerox plans to record accounting charges against earnings as part of a restructuring program to rein in costs and become more productive and competitive.

While Xerox reiterated its outlook for the year of $1.12 to $1.16 per share, the company cut its first-quarter profit target by 3 cents per share to a range of 18 cents to 20 cents per share.

We applaud Xerox for actually taking the numbers down to reflect this new charge. We hope they also insist that analysts do the same thing when reporting their estimates to First Call. However, our guess is that when it comes time for the earnings report all eyes will be on the number excluding this charge.

Speaking of this charge, Xerox’ participation in the Fuji Xerox JV is accounted for using what is known as the equity method. According to the company’s latest 10K, “Equity in net income of unconsolidated affiliates of $114 million, principally related to our 25% share of Fuji Xerox income, which increased by $16 million in 2006 as compared to 2005, primarily due to improved operational performance.” In both 2005 and 2006 the Fuji Xerox venture contributed nearly 10% of the net income reported by Xerox, without muddying up the “revenue” or “expense” lines.

It is a simple adjustment, however, to see how net margin would be affected by looking at only the operations for which Xerox fully reports results. All that is needed is to subtract “equity in net income of unconsolidated affiliates” from net income, which we do in the table below.

As expected, net margin is lower when you take out portions that are treated as 100% profit (all costs are off the financial statements.) There is also a smaller improvement in margin (130 basis points rather than the 140 reported) in 2006, but a larger one in 2005 when adjusted numbers are used. In addition, the growth in net income is higher in both periods when using the adjusted number. Overall, this analysis tells us that the company’s non-JV business was starting in worse condition that was apparent, but showed more significant improvement relative to taking the numbers at face value.
By understanding how the accounting requirements as well as any management discretion used when applying them, investors can piece together more of the puzzle.

Disclosure: Author is long IShares MSCI Japan Index (EWJ) at time of publication.

Is it Xerox?

Is it Fidelity National Information Services?

Is it Ceradyne?

Or maybe Finisar?

The comment box is open.

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:

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

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.

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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