EARNINGS ANALYSIS: Xerox Reduces 2026 AOI and FCF Guidance on Cost Pressures, Uptiers $174M of Notes Due 2028 at a Discount; Bonds Slide

Credit Research: Anton Gorbounov, CFA

Relevant Documents:
Earnings Presentation
Transcript
Other Financial Supplementals
Exchange 8-K

This morning, Xerox held a conference call to discuss its third-quarter results, which exceeded consensus expectations for adjusted operating income, or AOI, and EBITDA, according to Quartr. However, much of the focus was on the significant downgrade to the company’s full-year outlook and management’s expectations for continued headwinds in 2027. The reduction in guidance was driven by the continued increases in memory and oil prices; a mix shift toward entry-level devices, which carry a lower equipment margin; general print market weakness; and execution challenges in IT services.

The company also disclosed the details of a non-pro-rata uptier exchange of $174 million of its notes due 2028, matching Octus’ earlier reporting.

As of 3 p.m. ET, Xerox Holdings’ common stock was down more than 39% on the day, and its entire debt capital structure appears to be selling off, with its liquid unsecured bonds down 8 to 14 points, the first lien notes down over 6 points, and the non-cooperation-agreement term loan down almost 13 points on the day, according to data from S&P IHS. The co-op loan appears to be quoted up on the day, according to S&P.

Capital Structure: Exchanges $174M of 2028s for New 1Ls and Equity at Premium to Market Price, Capturing $54M of Discount

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Concurrent with its earnings release, earlier today, Xerox agreed to exchange approximately $174 million of its senior unsecured notes due 2028 held by members of an ad hoc group with significant holdings in the company’s secured debt for a combination of new first lien notes due 2030 and equity, though noteholders that cannot hold equity can receive all of their consideration in the form of new notes.

The stated exchange ratio is 75 cents of par, comprising 69 cents of new first lien notes and 6 cents of equity at an agreed discount to market. The effective value of the package at this morning’s prices is approximately 56 cents, as shown below. This is approximately 15 points higher than the current market price of the 2028s, which are quoted in the 40.5 to 41 context. The exchange allowed the company to capture approximately $54 million of discount. Both tranches appear to be down materially.

As disclosed in the exchange 8-K, the company also amended its first lien credit agreement limiting future debt issuances at its IPCo joint venture to refinancing transactions, while permitting the issuance of the new first lien notes for the aforementioned exchange. The consenting creditors also agreed to release the company from certain claims related to the IPCo transaction.

The company also retired approximately $8 million of its convertible notes due 2030 through its warrant program, the first disclosed use since it was put in place in January. On the call, the company disclosed that it had repurchased another $4 million of bonds through the program subsequent to quarter-end.

The company also announced it suspended the dividends on its common and preferred stock, which would result in approximately $28 million of annual cash savings beginning in the first quarter of 2027.

The company said it now expects to exit the year with gross leverage of 5.6x and net leverage of 4.7x, up from its prior guidance of 4.9x and 3.9x, respectively. The company further highlighted that this expectation does not reflect any potential future debt repurchases.

Q3’26: Better Print Cadence Driven by Entry-Level Devices; IT Affected by Sales Force Rebuild
Xerox recorded a 4.7% year-over-year decrease in revenue for the quarter, and its AOI almost doubled as synergies and cost savings continue to take hold. The decline in its print and other segment moderated from last quarter’s rate as the company recorded its first quarter of year-over-year equipment revenue growth in three years.

CEO Louie Pastor attributed the better print cadence to new model launches and a mix shift toward entry-level models. In the quarter, sales of entry-level models actually outpaced sales of mid-range printers, which Xerox has historically focused on.

On the other hand, the IT services segment registered meaningful declines in revenue, bookings and AOI. Pastor attributed this to a slower-than-expected ramp-up of the company’s sales force, as well as tighter customer and vendor terms stemming from Xerox’s credit profile.

Free cash flow for the third quarter, using the company’s preferred definition, was a modest inflow of $7 million. The company also recorded a $14 million outflow in its financing cash flows related to the factored tariff receivable amortization. Notably, the company recorded its first net finance receivable outflow since the third-party factoring program was put in place in 2023. Consistent with its prior practice, the company did not quantify the split between sales to third parties and on-balance-sheet funding in its initial filings.

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Guidance: Sharp Decline in AOI, FCF Expectations Driven by Higher Input Costs
Most of the earnings call focused on a significant downgrade to the company’s full-year profitability and free cash flow outlook. Pastor highlighted four key drivers of this change:

• Higher input prices, particularly for memory and oil. Pastor noted that memory costs accounted for 2% of the cost of a machine before 2026 and said that it is currently 10% and expected to increase to 15% in 2027. Other cost factors affected service margins as well.
   
• The aforementioned mix shift toward entry-level devices, which have similar full-cycle profitability as mid-range machines once services are factored in but are sold at negative equipment gross margins that are 30% lower than mid-range machines.
   
• Generally weaker print market outlook, which is expected to affect volumes and, thus, profitability, and
   
• The IT services underperformance.
   

The company downgraded its AOI guidance by approximately $120 million at the midpoint, with roughly half attributable to higher input costs. Free cash flow guidance decreased by $175 million, with additional headwinds from lower-than-forecast finance receivables sales and tariff receivable receipts slipping into 2027. Because the tariff receivable was factored in the second quarter but the factoring was recorded as a financing transaction (rather than a true sale), the timing of receipts affects the company-defined free cash flow metric but not its actual cash receipts, which from the tariff refund will be zero going forward.

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On the basis of the updated guidance, the company expects to record $64 million of AOI in the fourth quarter, down nearly 50% sequentially and down 38% year over year. At its midpoint, the updated guidance implies a fourth-quarter margin of 3.2%, the lowest rate for the year. This is in sharp contrast to the typical seasonal cadence, which usually sees the year’s highest margins recorded in the fourth quarter. The sequential decrease is consistent with the expectations of input cost pressures being heavily weighted toward the fourth quarter as well as the typically higher level of equipment sales, which now carry a lower margin due to mix shift, in the quarter.

The lowered free cash flow expectations remain heavily weighted toward the end of the year, with the full-year guidance implying a $222 million inflow for the fourth quarter at the midpoint. This is directionally consistent with prior years’ seasonality.

Looking out to 2027, management expects cost pressures to have a more pronounced full-year impact; it also expects the overall market pressure and the mix shift toward entry devices to continue. The company said that it expects to be able to offset some of these pressures through the full-year normalization of the implemented Lexmark synergies ($100 million incremental impact) as well as pricing actions, though the latter are dependent on the market. It said that it plans to pursue additional cost rationalization actions as well, highlighting the opportunity to drive down service cost through better preventative maintenance and remote capabilities.