HP Shareholders See 'A Lot Of Risk' In Xerox Takeover: Analyst

A recent revenue decline at Xerox is one of the issues HP shareholders have found troubling, according to a Morgan Stanley research note.

Xerox's hostile takeover bid for HP Inc. is facing major challenges when it comes to persuading HP shareholders to accept the deal, according to a research note from Morgan Stanley analyst Katy Huberty.

HP shareholders see the proposed $32 billion deal as risky and not lucrative enough, according to the Monday note, issued ahead of Xerox’s fourth-quarter 2019 earnings on Tuesday.

[Related: HP Vs. Xerox: 4 Key Financial Metrics In The Takeover Fight]

Following repeated rejections of the takeover offer by HP's board of directors, Xerox last week disclosed plans to nominate a new slate of HP board members that would be amenable to combining the printer and copier giants.

Xerox CEO John Visentin has also said his company has been engaging directly with HP shareholders around the deal. "HP shareholders have told us they believe our acquisition proposal will bring tremendous value," he said in a Xerox news release last week.

However, according to Huberty's note, many HP shareholders actually see significant risks in merging with Xerox, including the company's declining revenue. Xerox generated revenue of $9.23 billion during the four latest quarters it has reported (ending with the third quarter of 2019). That was down 8 percent from the prior four quarters, when Xerox’s revenue reached $10.04 billion.

Xerox appears to be "unlikely to return to revenue growth" by calendar year 2021, Huberty noted.

"Our bottom up analysis of Xerox's end-markets suggests that a near-term return to growth is unlikely, as growth investments in new and adjacent markets are unlikely to offset market declines and share losses in Xerox's core end markets," she wrote.

And regardless of concerns about revenue, HP shareholders want to see a larger payout than what Xerox is proposing, Huberty wrote.

"Does the math for a Xerox deal for HP work at $22 per share? The short answer is, probably not," she wrote. "At $22/share, we do not believe Xerox's offer seems rich enough to persuade HP's board or shareholder base into accepting the deal."

Among other things, that offer is below where HP shares were trading a year ago--at $23.84--and well below the company's $26.41 share price in late 2018, Huberty wrote.

"It's also important to note that HPQ shareholders would receive 77% of the deal consideration in cash, meaning the upside participation from HP shareholders in the NewCo will be limited by the amount of cash offered in the deal, making the deal less attractive than if it were more heavily weighted towards stock," she wrote.

"In our conversations with HP investors over the last few months we've heard fairly consistent messaging: 1) it feels like there is a lot of risk in combining with a company whose revenue base is shrinking, whose management team is still relatively new, and whose balance sheet is not investment grade quality, and therefore the offer would have to be higher than $22 to offset the potential risks, and 2) but at the right price, one that HP cannot achieve in the near-to-medium term on its own, investors appear to be willing to engage with Xerox," Huberty wrote.

Xerox declined to comment on Monday. CRN has reached out to HP for comment.

An offer of $26 per share for HP would have a "greater likelihood of success,” Huberty wrote.

"That being said we think Xerox faces risks on both sides of the coin in pursuing a deal for HP. In the event Xerox closes a deal for HP, the complexity of absorbing a company 4x as large raises the risk of integration issues, which the market is likely to penalize given Xerox's high debt levels (5.4x net leverage post-deal) post-close," she wrote. "Conversely, not pursuing a deal means Xerox would have to rely on organic means to stabilize revenue, a risk unto itself."

In its statement last week, HP sought to make a distinction between activist investor Carl Icahn--who owns a 4.24 percent stake in HP--and the company's other shareholders. Icahn also owns 10.6 percent of Xerox shares, and he was central to the installation of Visentin, a longtime loyalist, as CEO of Xerox in 2018.

"We believe that Xerox’s proposal and nominations are being driven by Carl Icahn, and his large ownership position in Xerox means that his interests are not aligned with those of other HP shareholders," HP said in the statement. "Due to Mr. Icahn’s ownership position, he would disproportionately benefit from an acquisition of HP by Xerox at a price that undervalues HP."

HP said it has not yet announced a date for its 2020 annual meeting, where the board of directors will be chosen.