Stuart Shaw, CFA

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”
John D. Rockefeller

Dividends are real cash in our pockets that we can use to reinvest or spend as we please. They are a clear reflection of management’s confidence in the future of their business.

That’s why Xerox caught my attention when the company announced on November 19, 2007 that it would be reinstating its dividend. Shareholders will be paid their first quarterly dividend in six years on January 31, 2008 amounting to 4.25 cents a share.

I did a quick study using the Company Stock Risk Profile Fast Track. Xerox failed 3 out of 10 categories, so I took a closer look.

Xerox lost money in 2000 and 2001 stemming from both operating and financial problems that surfaced in 1999. Subsequent concerns about the company’s liquidity led to credit ratings downgrades. The stock price reached a low of $3.75 a share in December 2000. Anne Mulcahy was appointed the new Chief Executive Officer the following year.

Ms. Mulcahy set out to turn the company around by cutting costs, redirecting the business to color printing and away from traditional copiers, focusing on cash, strengthening customer relationships, and maintaining research and development to produce new products.

Let’s look at the results:

1. Moody’s upgraded the company’s senior unsecured debt in November 2006 with a positive outlook. Fitch did the same in December 2007 with a stable outlook.
2. Revenues began growing in 2007 after being essentially flat since 2002. Revenues posted increases of 7.2% in the nine months and 11.9% in the third quarter. Post equipment sale and financing revenue are an attractive captive component. Management refers to this as the company’s annuity stream, which accounts for more than 70% of total revenues. In addition, research and development is paying off as two-thirds of equipment sales are coming from products launched in the past two years.
3. Profitability has been improving. Operating profit margins (before taxes and non-operating items) expanded from 8.6% in 2002 to 9.6% in 2006 and 10.3% in the latest 12-months.
4. Cash flow is healthy. The company is projecting cash flow from operations of $1.6 billion this year, up from an estimated $1.5 billion in 2007, and $1.4 billion in 2006.
5. Earnings are growing. Adjusted for tax benefits and other one - time items, earnings per share increased 16.7% to $1.05 in 2006. Reported earnings beat the Street’s consensus estimates for the last four quarters. Management is forecasting double - digit earnings growth going forward, averaging 12% through 2009.

Although the fundamentals are moving in the right direction, I would like to see a stronger balance sheet. Long-term debt as a percentage of total capital, at 49.4% at the end of last year’s third quarter, is on the high side of my comfort level. Cash on hand ended the third quarter at $848 million, which is down from $1.5 billion at the end of 2006 and $1.3 billion a year earlier.

What does management think? Ms. Mulcahy offered the following advice to CEO’s in a Wall Street Journal interview last November: “….don’t rush to reinstate the dividend until your recovery is rock-solid.” She backed up her confidence about Xerox’s prospects by adding 10,000 shares to her existing holdings last August. Lawrence Zimmerman, Chief Financial Officer, also purchased 10,000 shares, and Ursula Burns, President, bought 5,000 shares.

What does the Street think? Ten analysts are covering Xerox. Five analysts rate the stock hold, and one analyst is carrying an underperform rating. There’s ample room for expanded coverage and ratings upgrades. One analyst upgraded the stock from sell to hold last October, and another initiated coverage with a buy rating last November.

Xerox has a Medium Risk Company Stock Risk Profile rating. Having failed 19 of the 50 categories, the stock missed being rated Low Risk by two categories. Valuation was a standout variable with the stock failing only two of the 12 valuation categories.

Those who recognized Xerox’s turnaround early and had the fortitude to buy and hold made a lot of money. While it may look like the easy money has been made, and maybe so, the company’s improving fundamentals still have yet to be fully reflected in the stock price.

The economy is doing well….right? Gross domestic product grew at a healthy 3.9% annual rate in the third quarter, following an equally strong 3.8% reported for the second quarter. The bright spots were consumer spending, business investment and exports. According to the payroll report, 166,000 net jobs were created in October, well ahead of the 93,000 expected. Wages gained .6% in September. The economy is growing; people are working and making money. Well, sort of….

Housing keeps going down. The GDP report included a 20.1% drop in housing investment on top of an 11.8% decline in the second quarter. September housing starts and existing home sales were down 30.8% and 19.1%, respectively, from a year ago.

Roiling the credit markets, the subprime – mortgage crisis has taken no prisoners. The heads of Merrill Lynch and Citigroup were forced to resign after those financial institutions sustained huge write-offs. And it is not over yet for the financial services industry.

The Dow is up about 4% year-to-date (11/19/07). Among the best performing Dow Jones U.S. industry groups in the last three months were economically sensitive basic materials (+12.1%), heavy construction (+25.6%) and computer hardware (+11.7%), which would seem to be forecasting a growing economy. Maybe, but….

Homebuilding stocks have been mauled. The Dow Jones home construction industry index has fallen 54% year-to-date and 23% in the last three months, making it the worst performing sector this year. Housing is integral to our economy, so these stocks may be telling us a recession is up ahead.

Wait! Starbucks reported a 1% drop in transactions in the U.S. for the September quarter. Could this mean we are in recession now?

No wonder investors are nervous. Uncertainty breeds difficult markets and high volatility, a market environment that I expect to persist, at least in the near-term.

I’m always interested in the downtrodden, the rubble pile as I call it. Homebuilding stocks are at the bottom of the heap.

I put together this list of major homebuilders: Centex (CTX), D.R. Horton (DHI), Pulte Homes (PHM), Toll Brothers (TOL), Lennar (LEN), M.D.C. Holdings (MDC), The Ryland Group (RYL), and Kb Home (KBH). I used the Company Stock Risk Profile Fast Track™ to do a quick study. Here’s what I found:

Cash on the balance sheets of this group of companies has plummeted. However, I was surprised that cash balances held up at Kb Home, Toll Brothers and M.D.C. Holdings.

Long-term debt to total capital averaged 32.7% for the group. M.D.C. was able to pay down all of its long-term debt. Excluding M.D.C., the average was 37.4%, within a range of 36.8% for Pulte to 51.7% for Centex.

Free cash flow has been highly erratic, even when the industry was doing well. Last year half of these companies posted negative free cash flow, and three were negative so far this year.

Reported earnings have been disappointing the Street. Trying to catch up, analysts have been adjusting their estimates sharply lower.

Deficit earnings, both reported and projected, negated using earnings based valuation methods. So I turned to book value, and found that the group is selling for an average price / book value of .77 within a range of .61 for Lennar to .97 for Kb Home.

I was intrigued to find high insider ownership at seven companies, ranging from 11% of outstanding shares at Ryland to 23% at M.D.C. Holdings.

Street analysts are carrying 85 ratings for these eight stocks. Forty-two are rated hold and 13 sell.

All eight stocks failed Fast Track™, and I would not be buying homebuilding stocks now. The only positive I found for the group, which is important, is that managements’ interests are aligned with those of shareholders. Otherwise: (1) Debt is too high, particularly for this phase of the homebuilding cycle. (2) Cash flow is not stable. (3) Price / book values appear to be reasonable, but book values are vulnerable as long as home and land values continue to decline. (4) Because of the lack of any solid fundamental underpinnings, I would need the Street to be a lot more negative to begin to pique my interest.