If HP and Xerox Really Want a Merger, Why Not Consider It in Reverse?

If HP acquired Xerox you would still have two value companies combined, but if Xerox takes on this much debt to do a deal, you would just have a relatively low price-to-earnings ratio and a massively bloated balance sheet.

Fitch Ratings had already downgraded Xerox’s long-term and senior unsecured ratings by one notch to BB back in March of this year. Fitch Ratings issued a note on Friday warning about significant debt funding to get this deal done, and it noted disruption and secular change in their industries:

Xerox’s confirmed buyout offer for HP could provide strategic benefits for both companies due to challenging secular trends in commercial printing and personal computers, but any potential transaction would likely require significant debt funding given HP’s large size, says Fitch Ratings. HP is more than three times larger on an enterprise value basis. Rating implications would depend on deal structure, assumed revenue and cost synergies, intermediate-term leverage expectations, financial policy and the business risk profile of the combined entity.

Consolidation in declining markets is not unusual, particularly when emerging technology disrupts traditional business models. Therefore, M&A event risk is elevated in sectors experiencing disruption and secular change as companies look to transform business models and remain competitive. Transactions are often leveraging with long-term value creation that is uncertain. Rarely do smaller entities acquire larger companies but, if financing is available, it is not inconceivable, as evidenced by Dell’s purchase of EMC in 2015. Xerox is expected to receive $2.3 billion of proceeds from the sale of its 25% stake in it Fuji Xerox JV and, according to media reports, has an informal funding commitment for the potential HP acquisition.

Assuming Xerox offered $17 per share in cash and $5 per share in stock, as reported by the media, incremental debt financing could be about $20 billion and pro forma core leverage between 3.4x and 4.2x, depending on synergy capture. HP and Xerox have relatively low stand-alone leverage of around 1.5x and 1.8x, respectively, but have different revenue growth, profitability and FCF prospects. HP is solidly investment grade while Xerox is speculative grade. Investor appetite for such a sizable debt issuance in a secularly challenged industry is an open question.

HP’s confirmation statement earlier in the week said:

As reviewed at HP’s most recent Securities Analyst Meeting, we have great confidence in our multi-year strategy and our ability to position the company for continued success in an evolving industry, particularly given the multiple levers available to drive value creation.

Against this backdrop, we have had conversations with Xerox Holdings Corporation (NYSE: XRX) from time to time about a potential business combination. We have considered, among other things, what would be required to merit a transaction. Most recently, we received a proposal transmitted yesterday.

We have a record of taking action if there is a better path forward and will continue to act with deliberation, discipline and an eye towards what is in the best interest of all our shareholders.

By combining two dinosaurs, there might be a new species called the HProx.