Xerox Is Still Sinking Toward Rock Bottom

Editor's note: This week, we introduce Glenn Curtis as a columnist for RealMoney.com. Curtis formerly was a senior equity analyst at worldlyinvestor.com; at InsiderTrader.com, a financial Web site purchased by Edgar Online; and at Cantone Research, a New Jersey-based brokerage firm dedicated to researching small-capitalization investment opportunities for its retail and institutional client base. As always, please let us know what you think.

Xerox (XRX Quote - Cramer on XRX - Stock Picks) is cheap. But I still wouldn't touch it with a 10-foot pole.

Hold your horses. Before you start sending me hate mail, I'll concede that I'm impressed with GE Capital's willingness to provide Xerox with more than $430 million in financing earlier this year. I'm also impressed with management's plan to jettison assets in order to improve liquidity.

But I am not convinced that Xerox has what it takes to survive.

Face it. This is a tough business and Xerox is going to have serious trouble maintaining a decent gross margin. I know, I know, the optimists are quick to point out that the company recently inked a $310 million megadeal to provide Kinko's with a slew of state-of-the-art high-speed printers. And there is some indication that the agreement could be expanded upon as early as next year. But so what? Xerox generates north of $18 billion in annualized revenue. This agreement, and its deal flow, is small potatoes by comparison.

Then there are the accounting issues. Xerox used a $100 million reserve, which was intended to cover costs associated with a 1998 acquisition, to offset unrelated expenses in 1998 and 1999. According to the Securities and Exchange Commission, that's a big no-no.

To remedy the situation, Xerox restated earnings for the past three years. Unfortunately, these adjustments reduced the company's tangible net worth by more than $75 million and reduced its cash position to about $2 billion -- well shy of the $3.1 billion figure management had quoted at the end of the first quarter.

But the worst might be yet to come. Word has it the SEC is investigating accusations that the company improperly accounted for lease revenues over a period of several years. The theory is that management made aggressive assumptions about future lease payments and interest rates in Latin America and Mexico. The company declined to comment on the matter. If proven true, some say Xerox may have to restate earnings once again to the tune of several hundred million dollars. Put simply, this could irreparably damage shareholder confidence.

As a result of the lingering uncertainty, smart money players have been reluctant to pick up shares. In fact, both Smith Barney Asset Management and Deutsche Asset Management were net sellers in the first quarter, reducing their total holdings by 20% and 3.5% respectively in the period. And although other well-respected firms, including Putnam Investment Management and Brandes Investment Partners, bought stock, Xerox remains a very small percentage of their overall holdings -- less than 1.6%. Not a good sign.

Then there are the insiders. Logically, if the stock were such a bargain, I'd expect to see officers and directors clamoring for it. Yet even if you include the company's profit sharing, deferred compensation and options programs, officers and directors own fewer than 16 million shares, or 2.4% of the outstanding stock. That level of ownership speaks volumes considering that the management team at Hewlett-Packard (HWP Quote - Cramer on HWP - Stock Picks) owns roughly 18.8% of its outstanding shares. Remember, these are the same guys who, on average, are paying themselves (according to the proxy statement) a base salary of between $425,000 and $975,000 each year. That's pathetic. Seriously folks, you have to ask yourselves why you should be buying the stock if insiders aren't ponying up their own money. (Company officials declined comment, pointing me to the proxy.)

Last, I am concerned that there are a lack of appreciable catalysts on the horizon. Other big names in the industry, including Hewlett-Packard and Lexmark (LXK Quote - Cramer on LXK - Stock Picks), are taking it on the chin. And the feel is that stiffening competition and the sluggish demand for PC-related products will continue to pinch margins going forward.

For the record, I contacted representatives at Xerox and questioned them specifically about the company's turnaround plans, as well as any future SEC actions. They simply referred me to the 8-K and 10-K, which were filed May 31 and June 7 respectively.

After reviewing these documents, I am left with more questions than answers. The company was (understandably) more interested in discussing what went wrong, rather than offering viable solutions. Of course, I am encouraged that the company has been able to work through much of its lower-margin inventory and by management's ability to trim the selling, general and administrative expense lines, but there is still a long, long way to go.

The bottom line is that although Xerox is trading near its five-year low, there are both macroeconomic and company-specific factors leading me to believe that the downside risk in the stock far outweighs the upside potential. So do yourself a favor; don't bottom-fish. Wait for the dust to settle before jumping on this one.