Printers Were Hard Hit By The Pandemic

The COVID-19 pandemic brought a shock to the printing industry. Digital transformation projects accelerated and digital tools for the hybrid work environment proliferated. While S&P Global Ratings expects printing vendors to recover somewhat as offices reopen, the effects of the pandemic will be long-lasting. We recognize the structural shifts have different levels of penetration. Still, it is clear that the pandemic creates an additional and permanent downshift for printing demand in the future.

U.S.-based Xerox Holdings Corp.'s (BB/Stable/--) roadblocks during 2020 and the routes it might take to recover are a harbinger of further changes within the printing industry as a whole, given Xerox's significance in it. We expect hardware sales declines will pressure Xerox's profits and revenue streams. At the same time, we expect Xerox will move forward with its digital transformation plan and organic investments, and evaluate newer strategies.

The Effects Of COVID-19 Linger Over Demand

The pandemic accelerated the adoption of digital workflow tools and caused further structural changes within the printing industry. In the near-term we expect printing vendors will continue to support clients' digital transformation through managed print and cloud services and integration of digital workflow tools, though industry growth will remain challenged as the software industry is disrupting the traditional printing industry and will continue to grow. More important, we believe some of the digital workflows stand to cannibalize core printing activity, clouding the recovery path to pre-COVID-19 levels for printer industry demand. We expect many enterprises, particularly those in highly regulated industries, will continue to use some legacy processes such as print, scan, and fax. However, the rapid adoption of digital tools and workflows will reduce the need to print hard copies longer-term.

Newer digital workflows such as electronic signature and digital document management are fast growing. While the transition will be gradual, we believe the trend of digital and cloud document management in traditionally print intensive processes will dampen longer-term hard copy usage. This is illustrated by the momentum in fast growing enterprise document management software companies such as Docusign Inc. and Box Inc. that enable higher work productivity in a hybrid work environment.

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Hybrid Work Is Here To Stay

We expect printing vendors will contend with lower office occupancy rates over the longer-term in addition to weaker printing demand as hybrid work environments gain momentum. While this transition will unfold over a number of years partly due to long-term lease agreements, office space demand is unlikely to recover to pre-COVID-19 levels for a long time. Additionally, the recent rise in COVID-19 cases (and variants) and further lockdowns and containment measures could delay the return to offices, extending the work from home (WFH) arrangements. We recognize there will be varying degrees of global penetration--for example, in some major U.S. cities office occupancy rates reached 20% during the peak of the pandemic--but what's certain is tenants will evaluate their office footprints longer-term and balance the benefits of in-person collaboration and WFH arrangements.

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Industry Trends Are Unlikely To Reverse Any Time Soon

We see potential for further downside rating risk given significant enterprise exposure among printing vendors. We expect industry profitability will have suffered as equipment sales declined and higher-margin supplies and services waned amidst the pandemic. In response to longer-term decline, vendors have focused on penetrating small-/midsize business (SMB) managed services, investing in adjacent software offerings and innovating in emerging areas. While these strategies could position vendors for some growth longer-term, investment returns and meaningful revenues might take longer to realize.

S&P Global Ratings has taken rating actions on printer vendors as the pandemic pressured their operating performance, notably office equipment segments that experienced lower business activity (see table 1). Meanwhile, HP Inc. (BBB/Stable/A-2) saw increased at-home printing demand for consumer low-end equipment and outsized growth in its personal systems business. While some vendors such as HP and Canon Inc. experienced some unit growth, we don't expect that trend will materially affect overall printer hardware demand longer-term given that at-home printing has lower penetration and printing volumes.

Industry headwinds will affect vendors differently. For example, while we expect Fujifilm Holdings Corp.'s (AA-/Stable/A-1+) mature office document business, which focuses on Asia, will experience weaker demand because of the pandemic, the impact is relatively small in the Asia-Pacific regions where the company operates. Additionally, demand for office equipment in the region will experience some growth, in our view. Global print vendors such as Canon Inc. (A/Negative/A-1), Ricoh Co. Ltd. (BBB+/Negative/A-2), and Xerox will also face greater printing pressures, particularly across western countries that experienced a surge in COVID-19 cases while East Asia was largely unaffected. This dynamic could produce an uneven recovery path.

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Xerox As A Case Study

Our rating on Xerox has been on a downward trend though our rating outlook is stable. While Xerox has meaningful contractual revenue streams, it experienced persistent revenue declines over the past several years and severe erosion during the pandemic. Revenue declines accelerated in the fourth quarter of 2020, mainly a result of the resurgence of COVID-19 cases in the U.S. and Europe, but also as a result of a slower-than-expected vaccine rollout, which complicates the return to offices, a major driver of business improvement.

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Under a status quo scenario, Xerox's retained cash alleviates rating pressure as it could allow for investment in growth areas, which we would view positively. In addition, we view its cost reduction efforts favorably. Xerox will have reduced gross costs of approximately $1.8 billion over 2018-2021. On the other hand, while these cost cuts provide for operational flexibility, they could hurt the company's longer-term prospects, causing it to fall behind technologically in emerging areas. Incremental organic investments are unlikely to drive meaningful revenue and cash flow growth. A path to a lower rating could entail evidence of a weakened competitive position, greater market share losses to newer technologies, and unsuccessful investments in more speculative emerging areas. We could also lower the rating if cash flow and liquidity deteriorate, causing adjusted leverage to rise above 2.5x.

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The company maintains a systematic shareholder return program and dividends targeting at least 50% of free cash flow over time. The company guided free cash flow of at least $500 million in 2021, though it could increase returns using excess cash balance of about $1.5 billion (total cash balance of $2.6 billion at Dec. 31, 2020). During its covenant modification period Xerox must maintain a $1 billion minimum unrestricted cash balance that is required under the credit agreement. The modification period ends Dec. 31, 2021, or earlier at the company's election. While the company has taken a more shareholder-friendly stance, increasing cash returns would not achieve its primary objective to restore profitable long-term growth.

While Xerox is considering tuck-in acquisitions and strategic transactions, it is also exploring standing up new separate entities spanning innovation, software, and financing. The company could structure these businesses at the holding company level and target them at emerging growth areas--such as digital packaging and print, 3D technology, artificial intelligence (AI) workflow, Internet of Things (IoT), and software. This could expand addressable markets by $20 billion-$30 billion, though Xerox's revenues from these areas are minimal now.

We envision more acquisitions in these areas given the market fragmentation and abundant subscale players. Considering growth challenges in the core enterprise print business and greater competitive pressures, we believe partnerships and mergers and acquisitions (M&A) will allow the company to accelerate and scale these newer initiatives.

We view this path to be preferable to shareholder returns from a credit risk perspective, but recognize that it comes with potential business disruptions. We view business diversification from M&A positively, though a significant acquisition that depletes cash and causes adjusted leverage to exceed 2.5x would pressure ratings.

Will a bid for Xerox emerge from larger print vendors?

This is a major unanswered question. Xerox anticipates further industry consolidation(1), and current management and activist investors have pushed for a merger. Icahn Capital LP has increased its ownership over time, currently owning 14.5%.

While we avoid speculation, a bid for Xerox should not come as a surprise considering it has significant cash and maintained low leverage. The company's stock is hovering around all-time lows, making a transaction more feasible for a larger competitor to merge. If a large-scale merger transpires, we could see potential rating upside for Xerox by virtue of the higher ratings of potential suitors (see Table 5), and these companies could, in turn, see rating pressures considering the high business execution risk. Additionally, we do not expect significant refinancing needs for Xerox's outstanding bonds because a merger at this point would not trigger a change in control or a put for the existing bonds considering a downgrade to non-investment grade is a condition in the documentation.

It is possible for Xerox to reengage with HP Inc. considering their recent courtship. HP's past refusal was not related to the merits of combining them but rather the significant debt leveraging that would have reduced operational flexibility. Furthermore, HP and Xerox already have a commercial relationship through sourcing arrangements for certain printer, toner, and ink products as well as a partner reseller in the SMB market. HP could also benefit from Xerox's printer technologies where it currently partners with Canon. From Xerox's perspective, a combination could offer scale benefits, geographic market expansion, broader product and customer offerings, and enhanced cash flow and resources to invest in emerging growth areas.

Xerox and FUJIFILM were close to merging in 2018 until Icahn and other investors got involved, and we believe several more obstacles now stand in the way. First, while the two companies will continue to have supply arrangements, Xerox has taken steps to distance itself from the long-standing Fuji Xerox joint venture (JV) and monetized its 25% then-stake in the JV. Second, with its technology agreement with FUJIFILM expiring in March 2021, Xerox could expand sales into territories that had previously been closed to it (and the reverse is true for FUJIFILM with respect to U.S. and Europe markets). Third, FUJIFILM is strategically focused on its health care business and is unlikely to double-down on Xerox's challenged enterprise printer markets. Lastly, Icahn remains a significant investor in Xerox at 14.5%.

How do we calculate Xerox's leverage metrics?

Xerox's customer financing operations, Xerox Financing Services (finco), is a distinct business line. We calculate Xerox's corporate leverage (S&P Global Ratings-adjusted) to include the separation of the finco from the corporate business. We assess the asset quality and standards of the finco's portfolio and determine an appropriate debt-to-equity ratio (7:1) based on company disclosures and historical loss rate track record. We derive the finco's revenues and EBITDA using a revenue factor and approximate operating expenses based on appropriate funding costs equivalent to interest expense. These figures are deconsolidated from reported figures.

We apply our captive finance methodology when certain conditions are met, including our expectation that the finco will generate 70% or more of its receivables from the parent's goods and services (see table 3). This is notable because Xerox recently announced that it will explore financing for third-party products. We will monitor how this new strategy evolves.

In 2019 the company explored the sale of finco. A sale would have had implications for the rating if the company did not use the proceeds to repay debt--it would lose the earnings assets and the debt funding would remain with the company.

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(1) "Xerox Says Printer Industry Consolidation 'Long Overdue'," Barrons, Nov. 7, 2019