Deason Sues to Replace Xerox Board; New Joint Deason-Icahn Letter

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Neither rain, nor snow, nor a severe storm in the Northeast appears likely to stem the ongoing battle between activist investors Darwin Deason and Carl Icahn versus Xerox leadership, with the two investors again publishing a letter arguing against the proposed merger of Xerox with Fuji Xerox, and Deason filing a lawsuit in an attempt to replace the Xerox board of directors.

This is the sixth letter that activist investor Icahn has published arguing that the proposed Xerox merger with Fuji Xerox must be stopped, and the fourth letter Icahn has published jointly with Deason. Together, the two hold about 15 percent of Xerox stock.

This time the two argue that Xerox never disclosed the “crown-jewel lockup buried for 17 years in the Fuji Xerox joint venture agreements until more than six weeks after the original nomination deadline on December 11, 2017.” (Editor’s Note: Xerox stated last month that the two had access to all information regarding the joint Fuji Xerox venture for some time).

The letter also states that, in light of the Xerox’s board denial of Deason’s request to nominate members to the Xerox board, Deason has filed a lawsuit in the Supreme Court of the State of New York “to ensure that Xerox shareholders have the right to nominate a full slate of directors at Xerox’s 2018 annual meeting.”

The letter argues that the Xerox board “has exhibited a clear pattern of failure. Time and again they have failed to understand and deal with important terms in the principal agreements binding the company, failing over and over again to disclose the material terms of those agreements, including the crown-jewel lockup. Similarly, they failed to adequately resolve or respond to the massive accounting scandal at Fuji Xerox, and now, they have once again failed shareholders by playing tactical games with the nomination deadline for the 2018 election of directors. Denying a clearly justified request by Xerox’s third largest shareholder to waive the nomination deadline is nothing more than an attempt to avoid showing any modicum of responsibility for the company’s shocking lack of material disclosure and failure to comply with law. The principal question for Xerox shareholders faced with this pattern of concealment and legal maneuvering is this: Do we think things will get better when Fuji takes 50.1% control of our company? Can we actually expect things to improve when we are in a completely captive, minority position, represented by former Xerox directors who engineered this entire entrenchment scheme?”

Icahn and Deason again argue that Xerox shareholders “need to take back control of our company” and that “there is absolutely no reason Xerox shareholders should trust Fuji. Fuji is still reeling from a massive unresolved accounting scandal at its controlled subsidiary, and, from what we can tell, Fuji will still be able to compete with the combined company post-closing. Why would we ever accept being a minority shareholder in a company controlled by a competitor? It’s absurd.”

The letter goes on to question Xerox calculations about the proposed transaction, stating:

“Further, while the Board’s “Comparison of Value Components” analysis correctly includes a pro forma 49.9% ownership interest in the Fuji Xerox joint venture (not an overstated 62.4% ownership interest, as we previously stated), the Board’s underlying valuation methodology is clearly aggressive and overtly inconsistent, which leads to a predicted $45 per share valuation that we believe is outrageously misleading. The primary problem is that the Board admittedly uses a higher multiple (7.5x) when valuing Fuji Xerox (a business that, according to Xerox’s recent 10-K, includes “entities for which audited financial statements have not yet been provided”) and the purported synergies (which they admit may never even be achieved) than the multiple market analysts assign to stand-alone Xerox (6.0x). The purported justification for this lofty multiple is Fuji Xerox’s “exposure to growth markets”, but that overly simplistic reasoning conveniently ignores one obvious fact – Fuji Xerox has declining revenue growth and operating profit margin, which means it must be losing share. As Barclays wrote in a recent analyst report about the Board’s inconsistent valuation methodology, “exposure to growing end markets alone does not substitute for a lack of efficient execution in [Fuji Xerox]’s operations, especially to a wide margin such as a 7.5x valuation for [Fuji Xerox] and only a 6.0x EV/EBITDA valuation for Xerox.”

There are numerous additional problems and inconsistencies in the Board’s valuation analysis. For instance, there’s no marketability discount factored into the analysis as a result of Xerox shareholders becoming minority owners in the combined company. That is a striking omission considering Xerox itself acknowledges in its recent 10-K that Fuji’s “concentrated control…might harm the market price of [the] Common Stock.” But the relevant valuation slide ends with perhaps the Board’s most disingenuous statement, which implies that there could be additional “multiple expansion over time” that was not included. The truth is that multiple contraction, especially for the Fuji Xerox business that the Board values at a lofty 7.5x projected 2018 EBITDA, is much more likely. As we all know, companies rarely acquire businesses at a higher multiple than their own and begin trading up to the acquisition’s multiple. Rather, the best a shareholder can realistically hope for is a blended multiple. Given that Fuji Xerox operates in what Fuji itself describes as an “increasingly severe” competitive environment, has historically lacked efficient execution and will now be led by a management team that has never displayed a capacity to generate revenue growth, even a blended multiple seems like a pipe dream to us. This is particularly true in light of the massive, ongoing accounting scandal at Fuji Xerox, which Xerox acknowledges in its recent 10-K may result in liabilities and government investigations that could have a “material adverse effect” on the company.

Shareholders should not be surprised that the Board’s analysis, though not mathematically wrong in the manner we previously stated, is misleading and self-serving. The proposed Fuji scheme is exceedingly complex, which makes the consideration to be received inherently difficult to value and easy to manipulate. And since we’re dealing with a Board and company that have historically lacked transparency (for example, not disclosing the joint venture agreements – which they now claim permanently prevent (for all intents and purposes) anyone other than Fuji from ever buying Xerox – from shareholders for the last 17 years), we should not assume that they are conducting themselves in good faith with our best interests in mind. Rather, they are doing what they have always done – burying their heads in the sand and hoping things above ground are better than they actually are.

Hope is not a strategy. We cannot just hope for multiple expansion. We cannot just hope for synergies. We cannot just hope that the massive Fuji Xerox accounting scandal will not result in substantial additional liabilities for Xerox. We cannot just hope that Fuji that will treat us fairly once they are in control of our company. We cannot just hope that combining two companies that have both historically lacked the ability to successfully integrate acquisitions or efficiently operate their businesses will magically unlock additional value.

We need a strategy that is grounded in reality, not wishful thinking. In the coming weeks, that is exactly what we will lay out for your consideration.”

Our Take

This is probably going to go on for some time – until the Xerox shareholder meeting in May 2018, at which time Xerox shareholders will vote on the merger.

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