Would a Fuji Xerox merger with Xerox make a difference?

If there was one thing we all had a pretty good idea that something was imminent, it was the likelihood of a significant change at Xerox. The pressure from activist investors Carl Icahn and Darwin Deason (who, between them, hold more than 15% of the shares) and their dissatisfaction with the leadership and strategic direction being taken at Xerox all but guaranteed a shakeup.

In this, the first of a multi-part series on the recent developments, we'll present our analysis of the immediate outlook for the proposed New Xerox. Then, in the subsequent parts of the series, we'll give our view of some of the challenges we think the management team will have to overcome if they're to make a success of the combination.

The Fuji Xerox Deal

The Fuji Xerox deal to acquire Xerox was announced on January 31 and is expected to close in mid-2018, subject to the shareholder vote required to approve the transaction.

At the time of the announcement, management disclosed a target for $1.25B of synergistic savings to be achieved by 2020. These savings are to be extracted from the following three cost/expense centers:

1. Cost of Goods Sold: $650M
2. R&D: $200M
3. Other SG&A Expenses: $400M

In the following table are six sets of financial statements relating to the Fuji/Xerox deal and with Hewlett-Packard included for benchmarking purposes. We'll examine these and the underlying assumptions for the Fuji Xerox projections below.

Source: http://quotes.wsj.com

February 12, 2018, Exchange Rate: US dollar to Japanese Yen: 1:108.8 (Note: in the deal PowerPoint published by Xerox & Fuji, an exchange rate of 1:114 was used. This accounts for the difference between the $18B pro forma sales in the Fuji document and the $18.7B in our analysis)

1. Hewlett Packard (2017 year-ending October 31, 2017)

In the trailing 12 months leading up to October 31, 2017, Hewlett Packard increased its top line by over 8% to $52.2B and 3.5% in the 24 months since 2015. Although Hewlett Packard does have a more diversified product offering than Xerox, apart from its emerging presence in the industrial 3D printing market, just like Xerox, the remainder of its revenue stream is mostly from mature categories such as PCs, laptops, printers, and supplies.

With the printer and supplies market declining at 5% or more per year, HP is increasing its market share organically and through acquisitions, such as that which was accomplished with the Samsung printer business.

2. Xerox (2017 year-ending December 31, 2017)

At the end of January 2018, as news of the merger was released, Xerox announced its full-year and Q4 2017 earnings. At $10.26B, two thousand seventeen sales were down almost 5% in 2016 and cumulatively down over 10% in the two years since the 2015 reporting period. With consolidated net income of just over $600M (before a Q4 2017 charge of $400M to account for recent changes in US tax law), earnings were similar to the prior year despite the 5% decline in the top line.

While HP has increased sales 3.5% over the last two years, sales at Xerox have decreased by over 10%.

3. Fujifilm (2017 Trailing four quarters ending December 31, 2017)

In US dollars, sales revenue at Fujifilm has been essentially flat since 2014 and was shy of $22.5B for the trailing four quarters ending December 31, 2017. However, operating profits have increased by over 60% to $1.62B during the same four-year time frame, or 7% of sales.

At the end of January 2018, Fujifilm (parent and 75% owner of Fuji Xerox) reported a 30% drop in operating profit at its document solutions operations (which includes Fuji Xerox) and announced they would be cutting 10,000 jobs or more than 20% of the overall workforce.

4. Fuji Xerox (2017 estimates from public disclosures)

The 75% Fujifilm-controlled Fuji Xerox joint venture accounts for 46% of Fujifilm's total revenues and the same percentage of operating profits. Therefore, out of total sales of $22.5B and net income of $1.62B, the Fuji Xerox sales are in the region of $10B and net income of around $730M. However, $1.7B of the Fuji Xerox sales are to Xerox and must be eliminated when creating a pro forma for the consolidated business.

5. The New Xerox Pro Forma (combining Xerox and Fuji Xerox)

Combining Xerox's $10.26B in sales and $581M in net income with Fuji Xerox's trailing 12 months sales of just over $8.2B (after eliminating the inter-company business with Xerox) and net income of $731M, it results in a new entity with a combined sales total of just under $19B and net income of around $1.3B, or 7% of sales.

6. The New Xerox Pro Forma (combining Xerox and Fuji Xerox and factoring synergies)

The difference between the pro forma in scenarios #5 and #6 is the incorporation of $1.25B in savings projected by management to be in place by 2020. These synergistic cost savings make quite a difference to the financial outlook for the combined entities, increasing net income to nearly $2.2B or 12% of sales. Based on the same price-to-earnings (P/E) ratio as today (13), this projects a share price of over $55, an increase of nearly 85% from the current price and generating a market capitalization of $28.5B!

Should the New Xerox achieve this level of performance then, with less than 40% of HP's current sales, they will generate 85% as much profit!

Is there more to the story?

So ... it all looks fine so far, but there is one big problem. We can't just assume the top line will stay in the $18 to $19 billion range over the three years it takes to implement the $1.2B in expense reductions.

We know sales at Xerox have been declining at around 5% per year. Still, we don't know much about the historical performance at Fuji Xerox because Fujifilm doesn't provide a breakdown in its historical financial reporting. However, the disclosure of a 30% drop in operating profits at the Document Solutions business is a strong indicator that performance issues also underlie the simultaneous announcement of a planned reduction of 10,000 (20%) of the workforce.

In light of these circumstances, it's not unreasonable to assume sales at Fuji Xerox are also likely to retreat in line with the overall market contraction of around 5% per year. So, unless Xerox can win market share or develop revenue from new products, sales in 2020 will be down 15% compared to where they are today. This means that instead of $18.8B in sales, they will only have $16B. As seen in the table below, this dramatically affects the financial outlook.

For comparison purposes, we've included scenario #6 in this table. Remember, this is the projection associated with maintaining the top line at $18.8B and accomplishing $1.25B in synergistic expense reductions by 2020.

7. The New Xerox Pro Forma (with reduced sales)

A contraction of 5% per year on the consolidated top line would result in sales of $16B in 2020. Assuming COGs are also reduced in direct proportion to the reduction in sales, then the gross margin would remain at 44%. However, despite $1.25B in savings, net income would be 40% lower at $1.3B or 8% of sales.

Should this transpire, it would be difficult to imagine investors continuing to value the company at 13x earnings, so expecting the P/E ratio to fall is not unreasonable. For our model, we've assumed it would drop from 13x to 8x.

Should the 15% decrease in the top line occur alongside a reduction in the P/E ratio (as expected), it would result in a share price of around $20 and a market capitalization of $10B. This would be 40% lower than the theoretical $17B market capitalization we've calculated the New Xerox will be starting life at!

8. The New Xerox Pro Forma (with reduced sales and additional cost reductions)

This final scenario demonstrates that should a 15% contraction of the top line occur over the 2018-2020 time frame, the targeted $1.2B of cost savings appears inadequate to protect shareholders' interests.

In this scenario of a reduced top line, the required cost savings would need to be twice the announced target of $1.25B and closer to $2.5B to achieve the same profitability as the stable top-line scenario.

Almost 50% of the $1.25B of cost reductions identified by the company will be extracted from the cost of goods sold. These savings will be achieved through one-time events such as consolidating manufacturing into single plants in the most cost-effective locations.

If it were necessary for a second round of cost reductions because of a decrease in sales, it's doubtful much would be left to come out of the cost of goods sold. This means the additional $1.25B of savings would have to go entirely from a reduction in SG&A expenses.

Even if this were possible, it would be difficult to imagine investors valuing the shares at 13x earnings with a top line continuing to decrease at 5% yearly. Regardless of how good a job management was doing to cut costs, investors would look elsewhere for more attractive investment opportunities knowing, in the longer term, managing can't keep reducing costs at a sufficient rate to maintain the earnings per share.

Of course, we can't predict the actual P/E ratio. Still, even if management could cut costs at twice the rate of the plan they have communicated, it's not unreasonable to expect the P/E ratio to still fall from its current level of 13. In our model for this scenario, we've assumed it would fall to 10 resulting in a share price in the $40 range and a market capitalization of around $21B.

Although this would be an improvement compared to the likely opening position, unless a believable growth strategy is in place, the decline would continue beyond 2020.


1. Based on what we currently know, it's not unrealistic to think the New Xerox will experience a 5% per year reduction in sales.

2. It's not unreasonable to believe the plan for reducing costs by $1.25B by 2020 is possible.

3. It's probably unrealistic to anticipate management could cut costs by $2.5B by 2020.

We have to ask, what (if anything) does this deal bring to the table that the old Fuji Xerox joint venture didn't already (at least in theory) provide? Apart from additional scale and the combination of geographical markets under a collaborative management team, it's difficult to see any transformational benefits directly from the merger.

The bottom line is for Xerox to be an attractive investment, the top line must be stabilized. This means Xerox must take market share from their competitors, and they must introduce products for new, growing markets.

On its own, we don't see the combination of Xerox and Fuji Xerox will do anything to favorably impact the top line.

What the merger may bring is time. As the two entities are combined and the cost synergies are implemented, management may buy some time to introduce new strategies and products for the growth necessary to satisfy investors.

Xerox has struggled for years with its business transformation strategy. As Eastman Kodak worked with the rapid change from analog to digital, so has Xerox. Adapting slowly to the change in business conditions and reduced demand for printing equipment and printed documents, Xerox has failed to create a clear path to a growth strategy.

In Part 2, we'll explore some of the challenges we expect the New Xerox management team to face in their efforts to increase sales revenue. Sign up for our blog below to ensure you don't miss the next installment.

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