Xerox Holdings: Hitting FY24 Guide Seems Unlikely (NASDAQ:XRX)

Summary

Following my coverage of Xerox Holdings (NASDAQ:XRX) in January 2023, in which I recommended a sell rating as the business is still being challenged fundamentally and facing strong growth headwinds, this post is to provide an update on my thoughts on the business and stock. I reiterate my sell rating for XRX, as I expect it to miss its FY24 guidance. Even if XRX were to achieve its FY24 guidance, I don’t see any fundamental changes to the bearish view that its core business (print) is not seeing a positive turnaround (FY24 guidance still implies negative growth).

Investment thesis

On April 23, 2024, XRX announced its 1Q24 earnings, which saw its lowest quarterly revenue since 2Q20, which it attributed to a disruption in the business from operational restructuring (Project Reinvention) this quarter. Revenues declined by 12% to $1.502 billion vs. consensus of $1.534 billion. Gross margins also declined to 31.9% vs. consensus expectations of 33.7%. This combination drove the EBIT margin down to 2.2%, missing estimates by 310 bps. Consequently, XRX saw EPS of $0.06, a major miss compared to the consensus of $0.35. That said, management maintained its FY24 guidance for a 3 to 5% constant currency revenue decline and an adj. EBIT margin of at least 7.5% with an FCF of at least $600 million.

I am surprised that management reiterated guidance after the poor 1Q24 performance, as it implies a steeper ramp in revenue and margin expansion for the remaining 3 quarters, which I have little confidence that they can achieve. Hence, I reiterate my sell rating.

Starting with the revenue guide. 1Q24 performance was horrendous, with little signs of any underlying turnaround as equipment revenue fell 26% Y/Y, supplies fell 13% Y/Y, and services, maintenance, and rentals fell 7% Y/Y. Although management attributed the decline to the tough comp last year and the organization disruption (lesser sales reps to drive sales), and believes these disruptions are over. In my opinion, this does not change the outlook for the core business at all. I believe investment in print and related IT services is not going to be the top priority of businesses in the near-term, and there are two reasons I say this: (1) Businesses have continued to lay off employees in 2024, which means there are lesser workloads; (2) The fact that they are laying off employees meant that they are still tight on budget, as such, any available budget is likely to go to more important areas like AI (for cost savings and productivity). I also note that 2Q is typically a seasonally stronger quarter, so there should not be too much surprise that April is going to see a better quarter. Therefore, I am not inclined to believe that the double-digit growth in March (and spillover into April) is a sustainable trend for the rest of the year. Also, even if XRX were to hit management’s revenue guide, this does not change my bearish view on the core business (less demand for print as more workload shifts online), as it still implies negative growth for the rest of the year.

As for the at least 7.5% EBIT margin guide, I also have doubts about whether this is achievable. I do give management credit for driving up EBIT margin from the low of 2022 through streamlining the business cost line and ramping up on Project Reinvention. However, given the scale of this exercise, I find it hard to believe that it can be completed in just one quarter, and there are definitely knock-on impacts that do not surface in the P&L directly. For instance, cutting the number of sales reps but still gunning for sequential growth improvement implies more workload on existing staff. Unless XRX has developed a magic formula in 1Q24 to drive up productivity (which begs the question of why they have not done so in the past), sales team productivity is going to be reduced. Another good example is the $36 million one-time inventory charge for terminating a manufacturing agreement that resulted in gross margin declining by 240bps. From a cadence standpoint, this guide implies that XRX achieves at least a 9.3% margin for the rest of the year. If we look back at the past 3 years, XRX has never seen its EBIT margin go to 9% except for 4Q20 and 4Q22. Moreover, XRX has been in restructuring mode (incurring restructuring charges) for almost every year over the past decade. It begs the question of how much more major restructuring management can do to achieve a major decline in cost structure. Lastly, a major part of margin expansion was the decline in R&D expenditure (from ~4.5% of revenue in FY21 to 3.3% in 1Q24), which drove 140bps of expansion since FY21. Cutting R&D is a fast way of driving up margins, but it comes at the cost of future growth. But with just 3.3% of revenue being invested in R&D, I wonder how much more they can cut at this point.

All in all, I think XRX is going to miss both its revenue and EBIT margin guidance, leading it to miss its FCF guide as well.

Valuation

My target price for the XRX based on my model is $11. My model assumptions are that revenue will decline by 6% (100bps below guidance) and earnings margins will be flat for FY24. For my revenue growth assumption, I do think y/y growth will be better than 1Q24 before 3/4Q23 are going to be easy comps. Assuming the same 2-year stack growth for the rest of FY24, it implies -6% growth. For my earnings margin assumption, I gave the benefit of doubt that management can still find areas to streamline the cost structure. However, I assume flattish margins against FY23, as I expect any margin expansion to be netted off by the knock-on impact of the cost of restructuring. As this plays out, I expect valuation to go down further as the market gets disappointed by the miss in guidance. I assumed XRX to trade at 5x forward earnings (the low where it traded during COVID and in 2016).

Risk

Project Reinvention could drive much more margin upside than I believed if management is willing to further cut R&D and sales and marketing expenditures. This could stir up positive momentum in the stock sentiment as XRX will report very positive headline numbers and hit their FY24 guidance.

Conclusion

In conclusion, my rating for XRX as I expect it to miss its FY24 guidance. Top-line growth guidance seems unlikely because businesses are still in cost cutting mode, hence, unlikely to invest in print and related IT services. As for EBIT margin guide, credit to management for streamlining costs, but I question if they can pull off such a dramatic improvement in just one quarter. There are bound to be hidden costs associated with these cuts, like a less productive sales force due to reduced staffing. All in all, XRX missing guidance is likely to drive valuation further downwards.