DXC Technology ($DXC) — Initiation (3/18/20)

Price: $10 Market Cap: $2.6bn Valuation: 2.9x PE / 8.4% dividend yield Category: GENERAL

Background

For starters, this stock has been absolutely annihilated over the past year from $90+ to $10 today. Down almost 90%!!

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Let’s get the basics out of the way… this is a $10 stock x 256m shares = $2.6bn market cap. There is $6.4bn in net debt as of 12/31/19. EBITDA was $2.8bn for the past 12 months so 2.2x leverage and 3.2x EV/EBITDA.

DXC is an IT services business that came about from the 2017 merger of HP’s Enterprise segment and Computer Science Corp (CSC). They did $21bn in FY18 sales, then $20bn in FY19, and looking like $19bn in FY20. In their own words and graphics, here’s what the company says they do:

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IT Outsourcing isn’t a phenomenal business (just ask IBM). Both HP and CSC had been struggling with revenue growth for years prior to their merger. Some areas of this business are growing nicely like cloud, security, data, and analytics.

The overall profile looks awfully similar to IBM — GBS and GTS have good overlap with DXC’s core offerings:

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Why is it down so much?

Mistake #1 — Results are down (the past) — Former beloved CEO Mike Lawrie had set some lofty goals after merging the HP business.

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After performance deteriorated, those lofty goals were rescinded and Mike stepped down as CEO. FY19 saw revenue declining but earnings increase.

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…so far in FY20, revenue is declining and earnings are falling off a cliff! (Down 34% through 9 months of FY20):

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Underinvestment in the business, loss of profitable customers, etc. FY20 guidance calls for ~$5.25 in EPS so call it a 37% decline in earnings when the full year is over…

Mistake #2 — More near term pain coming (the future) — The Q3 call indicated some tough pills to be swallowed over the next few quarters. Q4 cash flow will see a few large outflows and opex “reinvestment” will cause margin compression in FY21

Snippets from the call:

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Mistake #3 — ITO is a business in secular decline — If you look at the below chart which breaks down the various pieces of the business, ITO declined 16% YoY in 3Q20! And ITO is >1/3 of total remaining revenue.

Excluding the businesses that are up for sale, you have 60% of revenue in growth-mode and the other 40% declining >10% per year — that equates to ~2% revenue growth per year.

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Mistake #4 — Asset sale and business update — This announcement was both a positive and a negative. Sold some assets for $5bn but the proceeds will only go to debt payments (no buybacks). Also, FY22 guidance was withdrawn. DXC laid out a pretty reasonable 2.5-year plan that looked like it offered some great upside for the stock. Unfortunately, with coronavirus and market turmoil, that plan was withdrawn until more clarity pops up. I’ll cover this later but it certainly deals a blow to investor confidence.

So why is it interesting?

Positive #1 — Asset Sales = Debt Free

There are 3 business units on the block — Health, BPS, Workplace / Mobility. These business units amount to roughly 25% of total revenue. Good news, the first (Health) has already been sold!

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The goal is for new-DXC to offer a soup-to-nuts IT offering for businesses and these assets had no place in that. Healthcare was really a standalone business unit which made it easy to sell. The others are smaller and have minimal fit. These divestitures are a great move in that they also offload 7%+ in annual revenue declines.

DXC is hoping to sell these 3 businesses for a total of $5bn in after-tax proceeds. The first (healthcare) was just announced at $5bn gross / $3.5bn net proceeds. Not a bad start!

This is a huge sum considering the current market cap is only $2.6bn and total debt of $6.4bn… could leave the company with a nearly debt-free balance sheet.

Positive #2 — RemainCo = Some Valuable Gems

Of the $15bn in remaining revenue, it’s hard to say what the quality of that business will look like. Remember from the colorful chart above displaying the breakdown of the business?

We have at least $3.5bn in revenue growing 10%+ per year with 1.5x book-to-bill ratios (Data & Analytics and Cloud & Security).

A good example of this value is a recent acquisition, Luxoft…

Luxoft — DXC acquired this business in mid-2019 for $2bn. This business alone was growing ($900m in revenue at closing), high-margin, and generated $100m+ in free cash flow. Highly likely it is still worth at or more than the $2bn paid for it…

IBM — The best comp for DXC is probably IBM… A mix of growth and decline in the portfolio, overlapping service offerings, but a much worse balance sheet. IBM carries $63bn in gross debt and $8.8bn in cash for ~$54bn in net debt, trailing operating cash flow was just shy of $15bn so call it 3.6x leverage… After asset sales, I get roughly $2bn in net debt for close to 1x debt to op cash flow.

On a price to cash flow basis you have IBM trading at 6.4x and DXC at 2.2x…

Positive #3 — The 2.5 Year Outlook = Cheap!

This slide came from the 2Q20 earnings call. New CEO came in, evaluated the businesses, and laid out this plan along with the announced divestitures:

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Sadly, this outlook was withdrawn until the coronavirus and market disruption settles down. Along with the announcement to focus on debt reduction.

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FY20 guidance was left in place so call it $3.25-3.50 in GAAP EPS or 3x PE as of today (!!)… Once the balance sheet is cleaned up, DXC should be able to focus exclusively on improving revenue / earnings over the next few years.

The positive here is that cash conversion levels at 80-85% of earnings should remain possible. And earnings should bottom out in FY21. Restructuring costs are coming down as seen by the ramp in GAAP earnings. And the focus on debt reduction should leave the company well-capitalized coming out of this downturn.

Let’s review the checklist so far…

  • Selling assets — check
  • Clean balance sheet — check
  • Positive cash flow — check
  • RemainCo growth — uncertain (?)

So what happens over the next few years?

In FY21, DXC should wrap up the sale of the $5bn in after-tax proceeds. Here’s a look at my take on the 2.5 year outlook…

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A few quick comments around some assumptions:

  • I’ve reflected the asset sales starting day 1 on FY21 — this may not be the case but will give a sense for the RemainCo standalone — the longer these units are held, the more additional cash they should contribute to the picture…
  • I’m using GAAP EPS in FY21+ — this includes any cash costs for restructuring, separation, integration, etc.
  • Assumes 80% (low end) cash conversion from earnings
  • Assumes capex / sales is increasing each year (>3%)

These “good biz / bad biz” situations are really difficult to predict when it comes to finding that crossover point that leads to overall growth… If current trends continue, that could take until FY23 to happen:

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The picture I’m painting seems pretty draconian. Maybe reasonable given the uncertainty (though I’d think these businesses are less impacted by oil/coronavirus). My FY22 estimate for GAAP EPS is only $3.50 relative to the $5.25+ that management originally guided. And at 80% cash conversion gets you $2.80 in FCF per share.

So with my haircuts and discounts all over the place, I still get a debt-free stock trading at 3.5x FCF and eventual revenue / earnings growth..

The X Factor here is in how management will deploy cash each year. There is plenty of it, the dividend is a given, but beyond that will determine how much value can be created…

Valuation

Here’s an overly simplistic look at DXC valuation relative to IBM, Accenture, and Capgemini:

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With IBM trading at 8x FCF and a more levered balance sheet, I don’t see why DXC couldn’t trade at least at that level… At 8x $2.80 in FCF = $22.40 stock price (+120% from here)… Accenture has some overlap but is not a perfect comparisons given their better growth profile. DXC will look more like Capgemini once the asset sales are completed.

Remember that you’re also collecting $0.84 a share in dividends each year which gives you an added 8.4% dividend. That costs DXC $215m per year which would leave something like $500-600m per year for buybacks, M&A, or debt paydown. DXC could easily add another $0.75+ per share to FCF if they devoted $250m per year to buybacks through FY23. At the same 8x multiple that gives you another 50% upside. Or they could hang on to that cash and have a decent-sized net cash position.

Long story short, new management is taking a dumpster fire of a situation and quickly turning it into a low-risk cash machine. Simplify the story, improve the balance sheet, and start showing earnings growth and the stock should do fine…