Old Industrials Profit From New Products

In the past few years, these four industrial companies have invested heavily in research to transform their traditional products (telephones, copiers and cash registers) to take advantage of new digital technologies. While this spending has cut into their earnings, it has helped them expand sales to their current customers, and enter new markets.

We have a high opinion of all four, particularly since their products and services help cut their customers’ costs. But only three are buys right now.

XEROX CORP. $15 (New York symbol XRX; Conservative Growth Portfolio, Manufacturing & Industry sector; WSSF Rating: Average) is one of the world’s leading makers of printers, copiers and document publishing equipment. Overseas markets account for about half of its sales and profits.

In the three months ended June 30, 2006, Xerox’s earnings fell 35.0%, to $0.26 a share (total $260 million) from $0.40 a share ($423 million) a year earlier. However, the year-earlier quarter included a non-recurring net gain of $213 million. Sales rose 1.5%, to $3.98 billion from $3.92 billion.

The company spends around 5% of its annual revenue of around $16.00 a share on research. It has to write off these costs immediately, which hurts its earnings. But this spending has helped Xerox become the largest maker of black-and-white publishing systems in the United States and Europe.

Xerox is devoting most of its research to new color printing technologies, which generate higher profits than traditional black-and-white systems. Strong sales of its color printers have also spurred demand for document publishing software, maintenance services and ink supplies. In fact, Xerox now gets about 75% of its revenue from service contracts.

Xerox now expects to receive a tax refund of between $400 million and $450 million by the end of 2006. It will not get cash, but will likely receive credits that it can use to cut its future tax bills. That should help offset the impact of Xerox’s new restructuring plan, which will cost $175 million.

The company is using its improving earnings and cash flow to buy back stock. It recently wrapped up a $1 billion buyback program, and authorized a new $500 million program. That should provide support for the stock, which now trades at 14.6 times its likely 2006 profit of $1.03 a share.

Xerox is a buy.

NCR CORP. $34 (New York symbol NCR; Aggressive Growth Portfolio, Manufacturing & Industry sector; WSSF Rating: Average) is a leading maker of automated teller machines (ATMs), cash registers and bar code scanners. It also provides customers with maintenance services and supplies such as paper and ink.

NCR’s fastest growing business is its Teradata division, which helps businesses capture and analyze data such as customer buying habits. Identifying trends helps Teradata clients improve customer satisfaction, and expand sales. Teradata accounts for 25% of NCR’s revenue, but 60% of its profit.

Thanks to an 11% rise in revenue at Teradata, NCR’s overall revenue in the three months ended June 30, 2006 rose 4.1%, to $1.53 billion from $1.47 billion a year earlier. Net income fell 37.3%, to $0.42 a share (total $78 million) from $0.67 a share ($127 million).

However, if you disregard a tax refund and other one-time items, NCR earned $0.37 a share in the year-earlier quarter, which means per-share income actually rose 13.5%. The benefits of a restructuring plan also contributed to the improved earnings.

NCR spends roughly 4% of its revenue of $32 a share on research, which makes it seem less profitable than it really is. This spending should pay off in the next few years as banks replace older ATMs with new models that speed up the check-clearing process. Demand from retailers for self-serve checkout systems is also rising strongly.

The company has $747 million ($4.15 a share) in cash, and just $305 million in long-term debt (14% of stockholders’ equity). NCR is using its cash to buy back stock. It spent $98 million on buybacks in the most recent quarter, and is still authorized to repurchase a further $353 million.

The stock fell to $8.50 in 2003, but climbed to a new peak of $44 in April 2006. It now trades at 18.3 times its likely 2006 profit of $1.86 a share.

NCR is a buy.

AVAYA INC. $10 (New York symbol AV; Aggressive Growth Portfolio, Manufacturing & Industry sector; WSSF Rating: Average) is a leading maker of telecommunication equipment for large businesses and government agencies. This gear helps its clients efficiently manage their voice, data and Internet traffic.

The company gets roughly half of its revenue selling equipment, and the other half from maintenance and other services. That cuts the company’s exposure to the increasingly competitive telecom industry.

At the 2006 FIFA World Cup soccer tournament in Germany, Avaya installed the largest voice and data network ever built. The U.S. Army recently selected Avaya, as part of a group, to overhaul communications at its bases around the world.

High profile deals like these further enhance Avaya’s already strong reputation, and should help it win more contracts.

The company is now focusing on cutting costs, particularly in Europe, which accounts for 30% of its total revenue. This led to restructuring charges which cut its profits in its third fiscal quarter ended June 30, 2006, to $0.10 a share (total $44 million) from $0.40 a share ($194 million) a year earlier. However, the year-earlier quarter included a $123 million tax gain. Revenue rose 4.8%, to $1.3 billion from $1.24 billion.

The lower earnings surprised investors, and caused the stock to fall 10%. It now trades at 20.8 times the $0.48 a share it will probably earn in fiscal 2006.

Avaya spends around 9% of its revenue of $11 a share on research, mostly on new products that use VoIP (Voice over Internet Protocol) technology to make phone calls over the Internet. These products should spur strong growth for years to come.

The company is debt free and has $822 million ($1.80 a share) in cash, which improves its long-term chances of success. But Avaya’s stock will likely make little progress until its earnings improve.

Avaya is a hold.

MTS SYSTEMS CORP. $34 (Nasdaq symbol MTSC; Aggressive Growth Portfolio, Manufacturing & Industry sector; WSSF Rating: Average) makes equipment that manufacturers use to test the mechanical behavior of materials, machines and structures.

In its third fiscal quarter ended July 1, 2006, earnings from continuing operations fell 6.3%, to $0.45 a share (total $8.5 million) from $0.48 a share ($9.9 million) a year earlier. Sales grew 1.3%, to $95.9 million from $94.7 million.

Although MTS sold more equipment, it received fewer orders for custom-made equipment, which generate higher profits for it than its regular products.

MTS spent $4.8 million (5.0% of revenue) on research in the latest quarter, up 43.3% from $3.35 million (3.5% of revenue) a year earlier.

One area that MTS hopes will spur its future growth is nanotechnology, which is the science of manipulating materials on a molecular scale.

Although nanotechnology accounts for just 2% of its total revenue, its use is spreading. Some customers may prefer to buy this new equipment from a supplier they are familiar with like MTS, instead taking on a new supplier.

The stock has moved down from the $48 peak it hit in May. It now trades at 18.1 times its forecast earnings of $1.88 a share. The $0.40 dividend yields 1.2%.

MTS gets about half of its revenue from the American automotive industry, and investors fear that slowing car sales will force carmakers to cut spending on new testing equipment. But MTS’s products and services pay for themselves many times over, which offsets this risk. Rising sales to overseas manufacturers also cut MTS’s risk.

MTS has $115.3 million ($6.35 a share) in cash, and just $14.5 million in long-term debt (9% of equity), so it can easily survive any short-term slowdown.

MTS Systems is a buy.