Xerox CEO Ursula Burns has made a bold bid for services company ACS. Photo: Xerox.

Xerox's new CEO bets big on services. Can she convince investors she made the right move?

Ursula Burns calls less than 30 minutes after the markets close on the most tumultuous trading day in Xerox (XRX) history, and she sounds, well, energized. Not quite 100 days into the CEO job, on Monday she launched the biggest acquisition bid in the company's history and survived a 15% drop in its stock price on record volume. And she's still standing.

"I was positively surprised that it wasn't as bad as it could be," she says, adding that she's ready to continue explaining the deal to Wall Street. "Exciting times."

Investors are understandably less sanguine than Burns. Her $5.7 billion cash and stock offer for outsourcing giant Affiliated Computer Services (ACS) would put $3 billion in debt onto the books, and more than double Xerox's employee headcount from 54,00 to 128,000. This, when investors had been expecting nice, safe stock buybacks.

Burns, a plainspoken New York native known for her engineering savvy and her operational discipline, isn't interested in playing it safe. In her move to grab ACS, she is embracing the same forces that drove Hewlett-Packard (HPQ) to purchase EDS for $13.9 billion last year, and Dell (DELL) to offer $3.9 billion for Perot Systems (PER) just last week.

In a maturing enterprise technology market, customers increasingly want to outsource the purchase and management of complicated systems, and to offload administrative tasks. By purchasing ACS, Xerox can offer to handle more tasks for its customers, and earn profits while putting its products to work. It helps that ACS has 10% profit margins, and grew revenue at about 6% this past year. The deal is expected to close in early 2010.

From copiers to services

Though investors aren't yet buying it – Burns will have to convince them – this move probably makes sense for Xerox. ACS would transform the company from a seller of printing equipment and print services with $16 billion in revenues into a $22 billion specialist in gathering, analyzing and sharing information. Without a bold services move, Xerox faces stagnating revenue in its core product business as it matures.

Dallas-based ACS specializes in business process outsourcing, the paper-intensive, back-office work like payroll and benefits, auto and mortgage loan processing and Medicaid claims. Burns believes that with ACS in the Xerox portfolio, her sales team could expand its business to Europe, where Xerox's brand is strong and ACS has almost no presence today. And Xerox could boost ACS margins by offering its technology to eliminate paper and automate more processes.

"ACS has got a services portfolio in state and local government that, at this point in the maturity scheme of things, cannot be replicated," says Jefferies & Co. analyst Joseph Vafi, who covers ACS. "At this valuation, the deal is a success for Xerox even without much synergy. Obviously Xerox needs to sell the deal a little more to their investor base, which wasn't looking for a big acquisition."

Though it blindsided Wall Street, this deal arguably looks downright sweet for Xerox – compared, say, to Dell's plan to buy Perot Systems. Dell is paying 29 times estimated 2010 earnings for Perot, while Xerox would get ACS for about 14 times its estimated 2010 earnings. Plus, many of the information analysis problems ACS tackles every day are precisely the ones Xerox scientists are trying to solve. For example, ACS, which runs the E-ZPass electronic toll collection system in some areas on the East Coast, could use Xerox character recognition technology to digitally read the license plates of toll lane violators and issue them tickets.

A deal too rich for investors?

In fact, the deal might be a little too sweet. Even before Xerox shares took their beating on Monday, Burns was offering a relatively modest 33.6% premium over ACS's Friday closing price. Some analysts suggested to Fortune that she might have to raise the bid to make up for the stock shrinkage and satisfy ACS shareholders.

Then again, flamboyant ACS founder and Chairman Darwin Deason, who holds super-voting class B shares in the company, may have the only opinion that ultimately matters. Xerox plans to pay him $300 million in convertible preferred stock for those class B ACS shares, on top of the even bigger payout he would get for his stake on the company. He, not surprisingly, supports the deal.

Burns says she isn't too worried about other companies swooping in to snatch ACS from Xerox. "We have a fair price on the table. ACS has been in and out of deals over the past couple of years – if somebody wanted to come in, I think they would have come in already."

Now her challenge will be convincing a skeptical Wall Street that this deal is good for everyone. Day one didn't go so well – she had to rush the news out to keep it from breaking in the press, and short sellers and arbs jumped into the fray, a combination that drove Xerox trading volumes to more than 25 times the normal level.

Over the next days and weeks, her message to investors will be to take a deep breath and take a fresh look at ACS. "If you asked us to stay in the print and copy infrastructure business, you would sell us only because we'd have very little future," she says. "We're actually scaling our services business and scaling our BPO in a very effective way to respond to changes in the marketplace."

Related:

See Ursula Burns on Fortune's 50 Most Powerful Women list.

Why Xerox CEO Burns is buying big

The Interact S605, Lexmark's new high-end home office inkjet, comes with a touchscreen. Image: Lexmark

In this era of Kindle books, text messages and Facebook photos, printed information is taking it on the chin – and perhaps no company has been hit harder than Lexmark. The Kentucky-based printer company is one of the worst performing stocks in the hardware sector this year, down about 30%.

But Lexmark (LXK) CEO Paul Curlander hopes a new line of printers will help him climb off the canvas.

The eight new machines for small and medium-sized businesses, which Lexmark is launching today, sport eco-friendly features designed to conserve paper and ink. Some have touchscreens. And they should get more attention than usual, thanks to expanded distribution deals Lexmark signed earlier this year with retailers like Staples (SPLS), Office Depot (ODP) and OfficeMax (OMX).

“We’re trying to make inkjet a bigger piece of the business market,” Curlander tells Fortune. “We want to move down from the enterprise space into small and medium business, and get device prices down into the $199 to $399 range.”

Even with these fresh products, Curlander is in for a bruising battle. Last year Lexmark’s nemesis, printing giant Hewlett-Packard (HPQ), shipped about six times more inkjet printers, and nine times more laser printers.

Under the unique economics of the printing business, that size difference can be particularly significant. Companies like HP and Lexmark often sell printers at a loss, expecting to make profits later from sales of ink and toner.

So Lexmark’s market share disadvantage hurts more than just its pride; lower volumes make it tougher for the company to keep costs low on money-losing hardware, and to later milk those customers for profitable ink sales.

In part because of those economics, Lexmark’s business has suffered over the past few years. Sales shrank from $5.1 billion in 2006 to $4.5 billion in 2008, and its share has continued to slip this year; industry leader HP’s sales rose from $26.8 billion to $29.4 billion over a similar period.

Now Lexmark has a comeback strategy that’s focused not on the low-end consumer market but on businesses, who are likely to buy color laser printers and multi-function inkjets that fax and copy as well as print. Those customers, the thinking goes, are more likely to bring in healthy ink sales down the road.

Most on Wall Street are not convinced that Lexmark's strategy will work. Bank of America has an underperform rating on the stock, saying it’s too soon to tell whether Lexmark’s strategy has legs. Deutsche Bank has a hold, saying it’s skeptical that Lexmark can grab market share without simply slashing prices.

Still, Curlander sounds upbeat. The company has survived thus far by cutting expenses in proportion to declining revenues, and it has held on to niche customers like pharmacies and bank branches, where its printers are popular.

Now Curlander is talking up Lexmark's push into managed print services, industry lingo for consulting on how businesses can get their printing done with less waste and less money.

He waves off the observation that Lexmark isn't alone on the services bandwagon; HP and Xerox (XRX) are saying many of the same things about helping customers print less. "We're actually doing it," he says. "I'm not convinced they are."

One of the things Lexmark does have going for it, ironically, is that investors have punished the stock rather mercilessly of late  – enough that a few investors are banking on a rebound. Among the Lexmark bulls is respected Bernstein Research analyst A.M. Sacconaghi, who has an outperform rating on the stock.

His bullish case: Lexmark's sales have actually held up pretty well considering the overall doldrums in the printing market, which Sacconaghi believes are due more to the battered global economy than to an Internet-fueled decline in printing.

Lexmark’s failure to hedge against currency fluctuations makes its cash flows look worse than they are. Its laser business is healthy. And in early August, Lexmark stock was at $16.70 – so cheap that investors were valuing its still-sizable inkjet business at basically zero.

Others might be starting to come around on Lexmark; the stock is up 13% since Sacconaghi made that case in a note last month. Even so, Sacconaghi has a lofty price target of $25 on the stock – which means if Curlander wants to prove his supporters right, these new printers had better be good. (AMZN)

For the second time in as many years, Apple Inc. (AAPL) is No. 1 on Fortune Magazine's list of the World's Most Admired Companies.

"It's been a rocky year for Apple," writes Alyssa Abkowitz. "CEO Steve Jobs' health made headlines, and critics said Cupertino wasn't being open enough about it. But customers remained loyal to the brand that made white ear buds cool. As much of the computer industry struggled, Apple shipped 22.7 million iPods during its first quarter (up 3 percent from last year), 2.5 million Macs (up 9 percent), and 4.4 million iPhones. No wonder Apple tops our Most Admired list for the second year in a row." (link)

In the nine key attributes used to rank the companies, Apple got top marks (1 out of 12) for innovation, people management and quality of products/services. It got lower marks (5 out of 12) for social responsibility and global competitiveness.

Curiously, when judged by its peers (i.e. other companies in the computer industry), Apple came in No. 2 after Xerox (XRX) and above Hewlett-Packard (HPQ).

In the broader list of most admired companies in any industry — judged by companies both inside and outside the computer field — HP came in No. 30 and Xerox didn't make the cut.

To see the full list, click here.

When is great not good enough? When you're Hewlett-Packard's printing group.

A few years ago, the $28 billion business, headed by veteran Vyomesh Joshi, was the goose that kept laying golden eggs. It supplied most of the company's profit while the PC group lost money and the corporate technology group struggled. Now new leadership and smart acquisitions have fixed the PC and corporate businesses, and printer sales are showing signs of weakness.

Though the printers and ink have so far pulled in a healthy $2.4 billion in profit this year for HP (HPQ), the growth rate is slowing. To cut costs, Joshi last week announced a reorganization that trims the printer group from five divisions to three. The consumer hardware and ink businesses will be collapsed into one unit, laser printers and other enterprise operations will be collapsed into another, and graphics will be the last.

But while HP's printing shakeup may keep profits healthy for now, it won't bring new money in the door. The only quick way to do that would be to reverse a troublesome trend: Consumers, who make up the bulk of HP printer sales, are no longer bingeing on ink. HP had hoped that its advances in its printer technology would inspire more folks to avoid professional photo finishers, but that hasn't really happened. And since HP is already the biggest company in inkjet printers, it can't grow much by simply stealing customers from rivals.

In a twisted way, HP brought this on itself. A big part of the reason why the printing group is seen as troubled now is that investors have high expectations after it delivered reliable sales growth for so many years. Especially in the last decade, as home PCs became as common as televisions, HP played a big role in establishing the printer as a must-have accessory for producing everyday fare like book reports, letters and photos. Now it's easy to see that printing isn't as necessary to the PC experience as it used to be, with online social networks like Facebook and MySpace based largely on sharing information electronically, not printing it. But as printing sales growth slows, investors still expect the division to make up for it somehow.

For growth, HP is looking to markets like large businesses and commercial print shops, where rivals like Xerox (XRX) have more experience. (See HP's printer challenge.) The good news about those: they print a lot. The bad news: it won’t be as easy for HP to turn big profits. So to fund those efforts, HP is mercilessly cutting costs from its older, slower-growth printer businesses. Joshi has already jettisoned the digital camera business and outsourced much of manufacturing for black and white laser printers, and he's still looking for more cost savings.

All of which makes sense – but is HP cutting too much, too fast? Under CEO Mark Hurd, the business groups have adopted a disciplined approach to innovation where each group funds tomorrow's hit by cutting costs out of yesterday's – a tactic few investors would argue with. But the downside is, innovation can't be plugged into a spreadsheet, or put on a schedule. Just look at Apple's (AAPL) computer business – it achieved only anemic growth for years, until a boost from the iPod, retail stores, and a switch to Intel (INTC) chips recently put the shine back on the brand, but Apple continued to invest in it.

So far, analysts say there's no indication that HP is slicing too far. Which is good – because I've heard you want to be careful with a golden goose.

HP CEO Mark Hurd is taking a risk by bidding for troubled services player EDS. Image: HP

Hewlett-Packard CEO Mark Hurd has built a world-class reputation as a cost-cutting turnaround artist, and he's risking it all with a smart bid for technology services giant Electronic Data Systems.

HP (HPQ) announced Tuesday that it would pay $13.9 billion in cash for Texas-based EDS (EDS), which manages technology projects for a range of large clients. If HP does it right, buying EDS is the business equivalent of a triple-play. In one fell swoop HP is more than doubling the revenue of its services arm, mounting a more serious threat to IBM (IBM), and shutting down a distribution channel for other competitors.

Strategically, the deal makes sense. Hurd is in the midst of expanding HP beyond its base providing lower-margin hardware like PCs and printers. Instead, he wants HP to grow more profitable businesses such as "services," – industry parlance for helping customers to buy and manage technology gear. (In a Super Bowl commercial eight years ago, EDS memorably compared this tech management challenge to herding cats.)

Still, Hurd's play for EDS is a gamble. It will raise questions on Wall Street about the efficiency expert's ability to close a mega-deal. Hurd and his team will also face the daunting task of deciding whom to keep among EDS's 140,000 employees, how to get the troubled company into shape (it's trading far below its $22 billion annual revenues), and how to manage the acquisition without losing ground to rivals. So far, investors are taking a wait-and-see approach. After news of the deal talks broke Monday, HP's stock dropped just 5 percent to close at $46.83, a relatively small hit given the size of the deal. EDS stock rose 28 percent to $24.13 per share on Monday.

In a humorous Super Bowl commercial years ago, EDS compared the technology services business to herding cats. If an acquisition goes through, HP could have a similarly tough task integrating EDS.

Hurd has plenty of reason to believe HP can do the deal smoothly. Under the leadership of Chief Strategy Officer Shane Robison, HP has recently snatched up prizes like Mercury Interactive and Opsware. And even though those two companies were bigger than HP's existing software business, it managed to successfully integrate them. HP has also worked on getting into tip-top shape operationally, tightening up its IT systems and its performance management policies. That should make a large acquisition easier to digest.

Perhaps more important, the EDS acquisition would mark a homecoming of sorts for HP Services head John W. McCain, who would likely lead the combined EDS/HP Services. [UPDATE: HP has said EDS will remain a standalone organization, based in Plano and led by Ronald Rittenmeyer.] Earlier in his career, McCain spent 16 years at EDS and rose to the ranks of president of e.Solutions. As a veteran of EDS culture and practices, he's sure to have opinions about how HP could get the most value from the company. McCain might also know how to position EDS's workforce to sell more HP equipment and less from competitors such as Dell (DELL), Xerox (XRX) and Sun Microsystems (JAVA), without alienating the customer base.

The EDS buyout is expected to close later this year and is subject to EDS shareholder and regulatory approval.

HP has now postponed its official earnings announcement until next Tuesday, May 20, after the close of trading. The company released a preliminary earnings statement today for its second fiscal quarter saying that sales came in at $28.3 billion and non-GAAP profits at 87 cents per share,  both beating Wall Street's average estimates. The company also raised its revenue and profit guidance higher for the year. HP now says revenue will be between $114.2 billion and $114.4 billion, at least $200 million higher than the previous range. Non-GAAP diluted earnings per share will be $3.54 to $3.58, just above the previous range.

Xerox technology chief Sophie Vandebroek is placing bets on technologies to spur growth. Image: Xerox

Xerox (XRX) PARC has come a long way. A generation ago, the Palo Alto Research Center famously developed many of the technologies that led to modern PCs from folks like Apple (AAPL) and Dell (DELL), but never got them beyond the lab. Today the unit is determined to get its inventions out of the lab, even if it means sacrificing secrecy.

To underscore that point, the company's normally secretive Silicon Valley researchers and their colleagues from around the world held an open house this week to show off surprising projects they're developing. Among them: A blood scanner that uses a twist on laser printing technology to spot rogue cells, a type of paper that can be erased by ultraviolet light and reused, and a new hybrid plastic that's partly made of corn and grass.

I sat down with Chief Technology Officer Sophie Vandebroek after the demonstrations to talk about how she manages the tough trade-offs in Xerox's technology development –- building versus buying, managing risk and partnering up with other companies. Here's as edited transcript of our conversation.

Companies that I've talked to in Silicon Valley are all talking about "technology transfer" — how to get ideas out of the lab and into products. A lot of it seems to come down to minimizing the risk associated with spending R&D dollars, making sure they don't go to waste.

If you do research, in the explore phase, they won't all become commercial successes.

Right, right, by nature. So PARC is now doing more consulting work, and that's kind of a risk hedge — you know you're going to get paid for that. Why is that model better than the models that a lot of other folks are adopting, and how can you be sure you're taking big enough risks to get a big payoff down the road?

When a project doesn't have risk, I don't want to do it in research. It goes into the business groups directly. A corporation has research centers to make sure that we do the most risky projects. Whether it's the smart document technologies, or some of the clean tech opportunities, or even reusable paper, if they succeed there's potentially a great reward. So there's a portfolio of smaller projects that are high risk, but also high return if they're really successful. So on a yearly basis, and sometimes even faster if we have breakthroughs, we will grow some of these projects into what we call incubation programs. We scale them up as much as ten times, to make sure that we invest enough.

But often the really big, game-changing research projects don't fit well into a formula, because either they don't fit into an existing business that you have.

Yeah, that's more challenging.

So I imagine a big part of your job, in positioning Xerox to be successful in the next decade, is making sure there's a good chance that you've got one or two of those. What do you do with those projects that might be a threat to the way the organization runs today?

There are those projects. What we do then is we find an open innovation partner. We have to go to market either with a partner, or do what PARC has done several times and incubate a new company. We can also look for a startup, where we can contribute some of our intellectual property to that startup in return for equity in the company.

If you're going to radically grow your business, it's going to come either from risky projects or acquisitions. So are you more involved in the merger and acquisition process now than a CTO might have been five years ago?

I would say for sure. Definitely.

Why is that important?

I'm involved in two different ways. One way is, we see this company, it looks really great, can you assess the technology? Just kind of asking my advice. Hand in hand with that would be looking at our research and saying, OK, which partners are still missing? So what do we recommend to the business teams either as partners in the go-to-market solution, or are there some technology elements we might be interested in acquiring so we can do something disruptive? We're always scoping out the technology landscape to see what other smaller companies are doing that could make them acquisition targets, and what are large companies doing that could make them partners.