Should Investors Copy Carl Icahn’s Xerox Strategy?

Activist investor Carl Icahn, one of the most high-profile money managers in the world, recently revealed a massive investment in Xerox (NYSE: XRX). The move raised some eyebrows in the financial world, as Xerox is a struggling company that has fallen on hard times. Its stock price has lost 25% of its value year-to-date.

In a regulatory filing, Icahn disclosed a 7.1% stake in Xerox, making him the company’s second-largest shareholder. In doing so, Icahn must be seeing something the market doesn’t see.

Xerox strategyXerox Struggles to Adapt

Xerox built its business on its namesake printers and copiers. It should be fairly obvious that in the digital age, in which consumers and businesses are going online, these products aren’t selling like they used to. One of the major growth areas in technology right now is cloud storage, which effectively renders printers and copiers obsolete.

Last quarter, Xerox reported its first quarterly loss in the past five years. Over the first nine months of the year, total revenue is down 8% year-over-year. One of the hardest-hit areas of the company is not surprisingly equipment sales, which fell 11% last quarter.

In response, Xerox management has reiterated its commitment to major cost cuts. But cost-cutting can only take a company so far.

Xerox operates two main business segments. It has a consumer franchise which operates the printers and copiers. But it also has an information technology services segment, which provides business process outsourcing.

The latter business is still performing well, and it is likely the focus of Icahn’s Xerox strategy.

Icahn Says Xerox Is Undervalued

Icahn stated that his interest in Xerox is based on his belief that the stock is undervalued. It’s true that Xerox trades for about 10 times forward earnings, which is a significant discount to the S&P 500 forward multiple. However, given the deterioration in the company’s fundamentals, its valuation multiple could continue to contract if earnings keep falling.

Icahn has become famous by taking investment positions in struggling companies, then capturing board seats and pursuing significant shake-ups. In this case, Icahn once again stated his intention to claim a board seat.

It’s likely Icahn will push the company to consider a wide range of strategic options like a spinoff or outright sale. Among the initiatives Icahn could pursue include a sale of the company’s joint venture Fuji Xerox, or a spinoff of the documents business from the IT services business.

Indeed, a large financial transaction of this nature could create value for shareholders. But the benefits will likely be short-term. More importantly, the long-term trajectory of the core business seems to be in a downtrend.

Revenue Jam

In 2010, Xerox generated $19.6 billion of revenue. Last year, revenue clocked in at $19.5 billion. The fact that the company has suffered declining revenue over that five-year period – during a significant economic recovery – is a major concern.

The market was excited by the news of Icahn’s investment and sent shares up 10% after it was announced. But the stock has since given up the Icahn-related gains. Icahn sees potential in Xerox, and will likely urge the company to split itself up or sell off certain businesses. However, whether retail investors should buy the stock to piggyback on Icahn is a different question.

Xerox has a fundamental problem, which Icahn alone won’t be able to fix. The structural change taking place in the technology industry has caught the company off guard. The world is increasingly embracing computing performed on mobile devices and smartphones. As a result, there is much less demand for printers and copiers than there used to be.

Xerox has seen business conditions deteriorate over the past several years. Its revenue and earnings have been stuck in a prolonged decline, and there are few signs of that reversing, with or without Icahn. Because of this, investors should avoid Xerox.

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Published by Wyatt Investment Research at