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While many investors were watching the election, companies were beginning to close out earnings season with some of the best news we’ve seen in more than a year.
According to FactSet, with 98% of the companies in the S&P 500 having reported earnings for the third quarter, the earnings growth rate is 3.2%. This marks the end of a five-quarter earnings recession that seemed to be the primary reason the stock market has gone virtually nowhere for so long.
In the long term, price changes are highly correlated with earnings, and there was quite a bit of good news this earnings season.
Seventy-two percent of companies reporting so far have beaten expectations, exceeding the five-year average of 67%. Companies also beat estimates at a better-than-average rate, with earnings coming in 6.3% above expectations compared with an average 4.4% over the past five years.
When companies deliver upside surprises, analysts tend to increase their estimates to catch up to the companies’ performance. Upgrades typically push stock prices up, and as long as earnings continue to beat expectations, a virtuous cycle can unfold where stock prices trend higher.
Looking ahead, analysts expect earnings growth of 3.3% for the fourth quarter and 11.4% for full-year 2017.
As investors, we should follow earnings reports just as much as, if not more than, we follow short-term price action. In the long run, earnings growth has pushed stock prices up, and with earnings expected to grow in the next year, investors should be bullish.
One company I think will be among the winners in the coming months is longtime laggard Xerox (NYSE: XRX).
The stock has been a market laggard for more than 15 years, but management is finally addressing problems and reorganizing the company, which will unlock shareholder value.
In January, Xerox announced plans to separate into two independent, public companies. The separation is on track to be completed by year end and “will create two industry-leading companies in order to maximize returns to shareholders and align the businesses to current market dynamics.”
I believe this is an innovative approach that will allow Xerox to finally be recognized in the market.
The first of these two companies will keep the Xerox name and continue to focus on document management. This will include the most familiar part of the current company, including the copier division. In 2015, this segment generated approximately $11 billion in revenue.
The second company, which will focus on business process outsourcing, will be called Conduent. In 2015, this segment brought in approximately $7 billion in revenue. This will be a pure play consulting business. Conduent’s expertise is in areas such as health care, transportation solutions, customer care and digital payments. The company provides back-end processing of transactions for many of these industries.
Transportation services could be a significant growth area in the next few years. As traffic congestion grows, cities are increasingly considering variable toll roads, smart parking solutions and intelligent transit systems. Conduent has solutions in each of these areas.
For example, Conduent is responsible for implementing E-ZPass. This electronic toll collection system allows commuters with E-ZPass tags (linked to a personal payment account) to whiz through toll booths without fishing for correct change. The company processes more than $2.3 billion from these transactions per year via 1,800-plus installed tolling lanes in a number of major states, including New York, New Jersey, Georgia and California.
The large base of installed equipment and expertise are a form of an economic moat. Potential competitors will need to convince transit authorities they can do a better job, and the risks involved with transferring contracts are often too high for authorities to accept. Conduent has the same advantage in health care, where it is integrated into many states’ Medicaid systems.
Such contracts provide steady revenue, with management estimating 90% of the company’s revenue comes from these annuity-like payments.
The board of directors set the separation date for Dec. 31. On that day, Xerox shareholders will receive one share of Conduent common stock for every five shares of Xerox common stock they hold as of the close of business on Dec. 15, the record date for the distribution. So, every 100 shares of XRX will translate to 100 shares of the new XRX and 20 shares of Conduent.
In announcing the deal, management noted, “As standalone companies, both companies will offer distinct and compelling investment propositions with differentiated financial profiles, growth drivers and business prospects.” This is important for understanding the potential of the two companies.
As a consultant, Conduent can be expected to trade in line with peers such as Booz Allen Hamilton (NYSE: BAH) in the business services industry. Stocks in this industry have traded with an average price-to-sales (P/S) ratio of 1.2 over the past five years. Xerox will be a computer peripheral company like Canon (NYSE: CAJ), and stocks in that industry have a five-year average P/S ratio of 1.3.
XRX’s current P/S ratio is 0.55. Using last year’s sales, the blended ratio for the two companies would be 1.26. If shares of each company continue to maintain that ratio after the separation, their combined value could gain 130% over time.
Another thing that adds to XRX’s investment appeal is its higher-than-average yield. The current dividend of $0.31 a year throws off a yield of 3.3% at current prices. Once the separation is completed, there is no plan for Conduent to pay a dividend, but XRX shares are likely to continue paying investors at the current rate.
Buying XRX here and holding on for capital gains and income certainly looks to be a good strategy. But if you’re interested, I recently told a small group of traders how they could skim an extra $40 off XRX for every 100 shares they purchased by intercepting lost deposits made by other traders.
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