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Expanded Purchase Recommendation: February 2017
The Turnaround Letter recommended this mid-cap tech stock pick in February 2017:
Conduent, recently spun off from Xerox, is a technology services company that helps organizations operate more efficiently and effectively. Its $6.6 billion in revenues come from a diversified base of business, public sector and healthcare clients, including 76 of the Fortune 100. With an 86% contract renewal rate, Conduent’s business is relatively stable.
Conduent joined Xerox in 2009 in a $6.4 billion acquisition that was intended to produce faster revenue and profit growth. However, the combined company struggled to produce much of either, and both metrics are now declining. It appears that Xerox tried to force-fit a cross-selling strategy at the expense of each segment’s underlying strengths. Under pressure from activist Carl Icahn and other investors, Xerox decided to reverse the 2009 acquisition by spinning off Conduent.
We like the spin-off. It provides two very appealing fundamental improvements: new leadership and more focus. Ashok Vemuri, the new CEO, brings impressive leadership, operating and shareholder value capabilities. Vemuri will re-focus the company exclusively on technology services. Initial efforts will emphasize stabilizing revenues, then on growth by providing new services and pursuing higher-margin opportunities. Early priorities include tightening the organization, which likely became mis-aligned under the former Xerox structure. Management is targeting $700 million of cost savings. Other initiatives including modernizing its technology platform and fixing problems in the student loan and healthcare segments. Carl Icahn controls three of the eight board seats, which should keep pressure on the new management team. Cash operating profits (Ebitda) are reasonably healthy at about 9.9% of revenues. The debt will be manageable. The overall valuation of 7x EV/Ebitda is attractive and at a meaningful discount to its peers. We think Conduent has a bright future. We recommend buying Conduent up to 20.
At its most basic level, the Conduent story is one of revenue growth and margin expansion, bolstered by deleveraging. If the management can restore the first component, execute on the second and remained disciplined on the third, Conduent’s stock should produce strong gains.
FAILED MERGER (or, 1+1 = 1.5)
When Conduent’s predecessor Affiliated Computer Systems (“ACS”) joined Xerox in a $6.4 billion merger in 2009, it was described by Xerox’s management as “a game-changer for Xerox… helps us expand our business and benefit from stronger revenue and earnings growth.” The company explained further: “by combining Xerox’s strengths in document technology with ACS’s expertise in managing and automating work processes, we’re creating a new class of solution provider.”
Over the following seven years, the combined company not only struggled to produce any growth at all, but revenues and operating profits were considerably lower by 2015 compared to 2010 (the first full year after the combination):
For Conduent2, by 2015, results were actually declining:
- Source: Xerox Corporation. Xerox divested its Information Technology Outsourcing (ITO) business in June 2015, and divested other smaller operations. The above reported results reflect the company’s reclassification of these divested units as discontinued operations and thus are excluded.
- Source: Conduent. Results for Xerox Business Services.
Clearly, the combination was not working. Xerox had plenty of difficulties dealing with the slow but steady decline in the demand for paper-related hardware like copiers and printers. The company couldn’t figure out how to effectively integrate its acquired services businesses. Efforts to force-fit the integration appear to have made both the hardware and services businesses worse.
BRIGHTER FUTURE AS A SERVICES-ONLY COMPANY
We like the new Conduent. It provides two very appealing fundamental improvements: new leadership and more focus.
Ashok Vemuri heads the company as CEO, bringing impressive capabilities. His experience in leading and building technology services companies looks like a good fit for the kinds of changes that Conduent needs to reach its potential.
Vemuri joined Xerox in 2016 as CEO of Xerox Business Services, after building tech services firm IGATE Corporation and then selling it to consulting giant Capgemini. He also gained valuable experience with senior leadership roles during his 14 years at global IT consulting firm Infosys, including membership on Infosys’ board. His early experience as an investment banker at Deutsche Bank and Bank of America provides a critical shareholder value perspective.
Brian Webb-Walsh is the new Chief Financial Officer (CFO), stepping up from his former role as CFO of Xerox Business Services, the previous name for Conduent’s operations under Xerox. He held a variety of senior financial roles since joining Xerox in 1997. While he has no direct experience as a public company CFO, he appears fully capable and is surrounded by senior executives with extensive public company experience.
Jeffrey Friedel joined in September 2016 as Chief of Staff. He is a long-time Vemuri lieutenant, having served with him at IGATE and Infosys in legal, regulatory and general counsel roles. Carol Kline joined in August 2016 as the new Chief Information Officer, overseeing the company’s technology infrastructure. Previously she was an advisor to private equity firm TPG Global and the Chief Information Officer of TeleTech, a competitor in the BPO industry. We anticipate that additional senior leadership with strong operating experience will join the company over the coming quarters.
New board of directors
The board is completely new, with no carry-overs from Xerox except for the CEO (who joined in 2016 in preparation for the spin-off). This should provide a fresh and focused perspective for setting Conduent’s direction and priorities.
Activist investor Carl Icahn controls three of the eight board seats and owns a 9.8% stake. While we have no insight into his long-term intentions, his presence should keep pressure on the new management team to improve execution and results.
Independent from the hardware-focused Xerox, the new management will re-focus the company exclusively on technology services. Hardware and services businesses have very different business models, sales processes, expense priorities, skill sets, cultures and capital allocation priorities. A core component of the new company is to redirect all aspects of the business away from the hardware-centric approach under Xerox to a services orientation. We believe this shift will yield impressive improvements in efficiency and productivity.
RESTORE REVENUE GROWTH
In returning Conduent to revenue growth, the new leadership will focus on two primary strategies: investing in its talent, its go-to-market capabilities and its technology.
- Invest in talent and go-to-market capabilities
Conduent’s revenue-producing processes fell behind during its Xerox days. With Xerox’s near-constant reorganizations, pressure on cost-control and different priorities, the sales force and talent base need fresh attention and funding. The company will be increasing its sales force, currently at about 300 (too small for a company the size of Conduent). The sales force will also be re-aligned to improve their coverage and accountability.
Conduent’s talent base needs deep expertise in current business process practices and in next-generation capabilities. Whereas hardware is an equipment-centric business, services are people-centric: training and motivating the talent base is critical for retention, innovation and basic execution of work. This was lacking under Xerox.
- Differentiate through innovation
Similarly, Xerox Business Services under-invested in technology. Older technologies can become commoditized quickly, so Conduent is re-investing in its technology platform to allow newer services that create more value for customers. Newer technologies that analyze all the data that its processes gather, automating more processes to reduce labor costs and increase speed, and allowing more personalization at the end-user level should produce more revenues and higher margins. Additionally, the company will work to better leverage their technology from one client to the next, and across their internal business segments. There appears to have been little sharing of ideas and technology platforms within the former Xerox Business Services.
Other drivers of revenue growth
Management anticipates acquisitions of about $200 million a year starting in 2018, as cash flow accumulates to a sufficient level. Acquisition activity has been on hold during the spin-off process. The acquisitions are likely to boost the revenue growth rate by 1%-3%.
Revenue growth in 2017-2018 will likely be constrained by several profit improvement measures: unprofitable contracts will be exited, some contracts will be repriced/lost, some operations and verticals may be sold or closed down if they are not deemed strategically important. Also, the company indicated it might exit many of the 42 countries where it has clients, refocusing instead on the United States and Europe. While reducing revenues, these measures should have a positive effect on margins.
Conduent’s Ebitda margin of about 10% significantly lags the industry average of 15-16% and the 16%+ achieved by ACS prior to the Xerox merger. Management’s goal is to expand margins back to this mid-teens level. Management has stated they will not pursue revenue growth just to grow – that they want profitable growth that meets their targets.
- Implement strategic cost transformation
Conduent launched a three-year $700 million cost transformation program last year. This program is critical to helping the company boost its margins and to fund its transition to an independent company that has the resources to invest in future growth. Of the $700 million, the company has already achieved the first $170 million in savings. Over the next few years, about $50-$60 million will fund the higher costs from being independent (systems, compliance, etc.). About half the remaining $470 million will be re-invested back into talent, sales, technology and other initiatives. The balance, about $235 million, is expected to flow to the bottom line. For perspective, on a $6.6 billion revenue base, this equates to 3.5 percentage points of margin improvement.
- Address legacy margin pressures
Within the Commercial Industries segment, the call center operations contain many unprofitable contracts. Management will be renegotiating pricing, culling some relationships, reducing their call center footprint and aggressively addressing personnel problems. The Health Enterprise business will no longer be adding clients and will re-focus on serving the existing clients while improving their profitability to Conduent. The troubled Student Loan servicing business will eventually decline to insignificance over the next five years. Management’s goal is to move these operations collectively to break-even over the next four years or so.
Another, more subtle margin improvement initiative
As a contract-driven company, much of Conduent’s future profits are built-in during the pre-contract bidding stage. There is a direct link between the rigor and quality of this scoping stage and future profitability. Well-scoped projects produce healthy margins and satisfied clients. Poorly scoped projects create the opposite. We believe that the pricing and planning stages were poorly executed under Xerox given the hardware-centric and likely bureaucratic Xerox processes. We expect this pre-contract effort to improve.
The company will focus on high-return, high-margin new business, with an emphasis on more business with current clients. Management has outlined its timeline to revenue growth and margin expansion:
- Revenues will decline by about 5% in 2017 compared to 2016
- Return to revenue growth by the end of 2018
- Expand Ebitda (dollars) by at least 5% in 2017 and by at least 10% in 2018.
The transition to independent public company presents Conduent with several challenges to successfully executing its plans. We believe the company and its new leadership are fully capable of meeting these challenges. Four of the largest include the following:
- Highly competitive market:
- Technology services is a crowded market with many larger, better-capitalized companies and small low-cost competitors. These pressures could constrain its revenue and margin opportunities.
- Free cash flow is initially constrained, particularly by high interest expenses:
- Nearly 70-80% of Ebitda goes to pay interest expenses, capital expenditures, taxes and cash payments related to restructurings. While servicing the debt is not a concern given the company’s stable cash flows, with only 20-30% of Ebitda available for growth or reserves, its financial flexibility is somewhat limited. However, if Conduent can expand its margins, refinance its debt and use its assets more efficiently, the $200 million/year in free cash flow could increase considerably.
- Cultural independence doesn’t always translate into cultural improvement:
- After seven years as part of Xerox, with its relentless focus on low costs and its hardware-centric mindset, changing Conduent’s culture to a more entrepreneurial services company has its challenges. While we expect the people-intensive company to become re-energized, we anticipate disruptions as management re-aligns the company’s processes.
- Volatility from Health Enterprise and Student Loan businesses
- These businesses represent less than 5% of Conduent’s revenues and are in wind-down mode, but they are unprofitable and produce volatility in its revenues and profits. While we think these have a small negative value within Conduent, they produce a risk to Conduent’s efforts to create a stable revenue and profit stream.
Conduent will make its first report as an independent company on February 22 with 4Q16 and full-year 2016 results. Management’s current guidance for 4Q16 is:
- total revenues expected to decline (year-over-year) at a similar rate to 3Q16 (-5.4%)
- segment profit and Adjusted Ebitda margins to improve sequentially and year-over-year.
We like management teams to provide annual revenue and earning guidance. While the guidance sets tangible markers for measuring results, perhaps more usefully it reveals management’s priorities in their selection of which numbers are important to them.
Conduent’s current valuation looks attractive. On an EV/Ebitda basis, the company trades at a low absolute multiple and a healthy discount relative to its peers1. We would anticipate that Conduent’s shares would have little difficulty trading at least in-line with its peers.
Conduent’s valuation on Ebitda
Its P/E multiple of 20.2x on 2017 earnings is above the 15.1x average of its peers and 17.1x for the S&P500 Index. While higher on an absolute and relative basis than we prefer, much of this premium is likely due to the company under-earning at the operating level and its high level of expensive debt. We expect this multiple to decline over time as earnings improve. We are applying our standard end-of-transition valuation methodology to Conduent. Our estimates for the primary value drivers (revenues, Ebitda margin, net cash position and Ebitda multiple) in the endgame scenario are outlined below:
 Peers include: Atento (ATTO), CSC Corporation (CSC), Convergys Corporation (CVG), Genpact Ltd (G), Maximus (MMS), Sykes Enterprises (SYKE), TeleTech Holdings (TTEC) and WNS Global Services (WNS).
- Revenues – We are assuming that revenues decline 4.5% in 2017, followed by a 1% increase in 2018 and a 3.7% increase in 2019, for a zero net growth rate from 2016-2019. We are assuming $200 million in acquisitions.
- Ebitda margin – We estimate an increase of 2.1 percentage points, or 210 basis points, to 12.0%, by 2019, from improved operating efficiency and incremental margins on new revenues. Peer margins average 14.6%, increasing the likelihood of Conduent reaching our estimate. Our assumption is consistent with management’s Ebitda growth timeline yet we acknowledge that our margin target is conservative.
- Ebitda multiple – Our end-scenario multiple of 7.0x is below the 7.8x average peer multiple on forward Ebitda. If the transition is on track to be successful, we would anticipate Conduent reaching the target multiple on 2019 Ebitda during 2019 or perhaps before. If the transition is not successful, we see little downside to the shares below 7.0x as long as Conduent does not accumulate excessive debt or make poor acquisitions.
- Cash balance and incremental cash flow – We are assuming free cash flow over the next three years accumulates to an additional $400 million in cash balances through 2019, net of $200 million in acquisitions.
- Gross debt – While our model indicates no debt paydown, we are implicitly assuming that some of the incremental cash flow is used to repay debt. From a valuation perspective we are indifferent to a cash build-up versus a debt paydown, although from a Conduent shareholder perspective we greatly prefer at last some of the debt to be paid down. This directly reduces their high interest costs, increases their operating flexibility, requires a current-market test for any new debt issues and reduces the urge to use cash for ill-conceived acquisitions.
- Shares outstanding – For modeling purposes we are assuming the number of shares outstanding remains flat. As the company has no previous public shares, we are assuming zero equity-based compensation initially. However, it is almost certain that the company will provide equity-based compensation in future quarters. We anticipate updating our model to reflect this.
Sources of value creation
Compared to the current $14.96 share price, the increase to the $20.06 target price (we rounded down to $20 for the actual target price) represents $5.10/share of value creation. For Conduent, the primary opportunity is to expand its Ebitda margin. This represents 99% of the potential value creation. With the streamlined and more highly-focused operations, its $700 million cost-savings program and other initiatives (with $170 million already achieved), the company appears to have a high likelihood of achieving this self-help target. Our 12.0% margin assumption is below the peer average of 14.6%, indicating that our assumption is reasonably attainable even considering any business mix and models differences for the peer companies.
We like that the accumulation of cash contributes 39% of the upside. This is our preferred source as it is very tangible, easily trackable and often escapes the market’s attention. However, we recognize the risk that management could spend this cash on over-priced or unwise acquisitions.
Revenue growth has no effect on value creation, given our assumption that revenue growth is flat over the period. We recognize the possibility that revenue growth could be faster than assumed. However, continued revenue decay would exert pressure on management’s strategy and likely weaken their ability to expand Ebitda margins. The -31% of value creation (reduction) from a change in the Ebitda multiple is based on the assumption that the company’s valuation remains below average. We recognize that the multiple on 2017 Ebitda is 7.1x, making this assumption conservative.
A brief note on Ebitda
We typically use the EV/Ebitda multiple to value most companies. It not only explicitly focuses on the value of the operating company regardless of the capital structure, but it also separately values any unrelated assets and liabilities. The approach is widely used in private equity transactions, which increasingly drive public equity valuations. An additional merit of EV/Ebitda is that it allows useful comparisons of similar companies even if they have different capital structures.
In a straightforward business, the Enterprise Value (“EV”) is the value of the equity (market cap) plus any debt, less cash. It is the value of the operating business (the “enterprise”). If the company was acquired, the buyer would pay for the entire enterprise, not just the equity. Debts may be paid off immediately or carried over to the buyer, but one way or another the buyer would be obligated to cover them.
We compare the enterprise value to the cash operating profits of the business (earnings before interest, taxes, depreciation and amortization, or “Ebitda”) to produce the EV/Ebitda multiple. The principal shortcoming of Ebitda is its exclusion of taxes and capital expenditures. These costs are accounted for subjectively in assigning the multiple – admittedly a form of art. Interest costs are also excluded, as they are not operating costs but rather financing costs associated with capitalizing the business.
Affiliated Computer Services, or ACS, was founded in Dallas in 1988 by Darwin Deason. The company initially focused on bank data processing, then expanded into a wide range of other industries. ACS completed an initial public offering in 1994, and by 1996 was producing nearly $400 million in revenues. Growth continued at a quick pace from both organic and acquisitions sources. ACS became a Fortune 500 company and joined the S&P500 Index with $3.8 billion in revenues in 2003. By 2009, its 74,000 employee were producing $6.5 billion in revenues growing at a 10% rate over the prior 5 years. The Ebitda margin in 2009 was 16.6%.
Its soon-to-be parent company Xerox, led by CEO Anne Mulcahy (from 2001 to mid-2009), was completing its remarkable transition from black and white analog printing to color digital printing. Mulcahy had initially focused on keeping Xerox out of bankruptcy in the early 2000’s as it staggered under a heavy debt load and shrinking profits. With the transition complete and Xerox turning its attention to growth, Mulcahy retired in 2009.
Mulcahy was succeeded by Ursula Burns, then Xerox’s President, who soon announced the $6.4 billion acquisition of ACS in September 2009. The deal was intended to produce faster revenue and profit growth by cross-selling: ACS brought considerable technology services expertise while Xerox brought a large base of hardware customers.
The December 31, 2016 closing price for Xerox shares was $8.73. At the open of trading on January 3, Xerox shareholders held $8.73 of value but in two different securities: “New” Xerox shares worth $5.75 each, and Conduent shares worth $2.98. As Conduent has only 1/5 the number of shares that Xerox has, the $2.98 in value became a $14.90/share CNDT price.
As a business process outsourcing (BPO) company, Conduent provides services that compliment or replace back office functions including customer care (call centers), transaction processing and transportation-related services. The company estimates that the global market for its services is $260 billion, growing at a 4-6% rate over the next three years. The healthcare industry, a primary focus for Conduent, is estimated to grow at a faster 8% annual rate over this period.
Across the economy, companies and governments look to reduce their fixed costs and capital intensity. BPO solutions allow these enterprises to offload their non-critical back-office functions yet benefit from the greater technological innovation and operating leverage that companies like Conduent can provide. Conduent looks to grow by expanding its services to existing customers, gaining customers in its existing markets and penetrating new industries.
Conduent’s revenue stream is highly recurring. BPO services generally are within an organization’s core back-office operations. While its transaction-driven volumes can be cyclical, Conduent’s customers tend to be in less-cyclical industries, including healthcare and the public sector. Contracts are typically for three to five years and Conduent has an 85-90% win rate on renewals. The company’s client base includes 76 of the Fortune 100 companies such as General Motors, Procter & Gamble and Delta Airlines as well as over 500 government entities. Nineteen of the top 20 managed U.S. healthcare plans are clients as are five of the 10 largest global banks.
Its revenues have a low client concentration. The largest client is only 4% of revenues and the top 20 clients produce only about 20% of total revenues. Conduent organizes its business into four segments1:
1. Source: Conduent
Commercial Industries (44% of revenues)
The company provides both standardized and customized services to customers in a broad range of industries. Services include customer care (call centers), payments processing, human resource management and finance and accounting services. Revenues fell 1.9% in 2015 which accelerated to a 6.1% decline for the first three quarters of 2016. Segment margins of 2.2% are substantially below the company average of 6.1%, much of this due to weak call center contracts. An early priority of Conduent is addressing this call center problem.
Public Sector (26% of revenues)
This segment serves the U.S. federal, state and local and foreign governments, and provides BPO services for transportation operations. Transportation services include revenue-generating activities like electronic toll collection, automated parking and mass transit fare collection. Revenues returned to growth in the first three quarters of 2016, at 0.5%, reversing a 2.3% decline in 2015. Segment margins of 12.6% are the highest in the company.
Healthcare (26% of revenues)
The Healthcare segment provides business process services to healthcare providers, payers, employers, pharmaceutical and life science companies and government agencies. Services emphasize improving the patient care experience, lowering total costs and enabling better long-term health outcomes. Healthcare is one of the fastest growing markets for BPO services, and Conduent has a leadership position.
In 2015, the company began a more concerted effort to focus on higher-margin growth segments like medical and pharmacy benefits management and fraud/abuse detection, while de-emphasizing Medicare and other unattractive segments. Revenues fell 1.2% for the first three quarters of 2016, reversing a 0.4% increase in 2015. Segment margins are strong at 8.8%, driven by cost and productivity improvements.
Other (4% of revenues)
This segment could be seen as a holding tank for major problem operations that Conduent is looking to exit. Optically it also removes these operations from the other three segments to highlight their strengths. The two major operations in the segment are the Health Enterprise/Medicaid business (which will no longer be accepting new clients) and the Student Loan servicing business (which is in run-off). The segment also includes non-allocated corporate expenses as well as inter-segment eliminations. Revenues from this segment will continue to decline. The losses are likely to drag on overall Conduent profits until 2020 when the company believes they will return to break-even.
Global revenue mix
Conduent has a global business, but 78% of its revenues are generated by clients in the United States. About 12% of revenues are produced in Europe with 10% coming from the rest of the world.
The company has a global workforce of approximately 93,700. We expect this number to decrease over the near term, and then gradually increase as the company moves to a growth orientation. Revenues of $70,400 per employee are generally comparable to its peers but remarkably low for an American company where the median personal income is roughly $45,000. Conduent’s employee base in lower wage countries allows it (and its peers) to produce good profits despite this low level of revenues/employee. Nearly 50% of employees are outside the U.S., with 41% in Asia Pacific, Latin America and the Caribbean.
Conduent’s property portfolio includes 513 leased and eight owned properties, primarily in Kentucky, New Jersey, California, Mexico, Guatemala, the Philippines, Jamaica, Romania and India. Its total space is 12.2 million square feet with an annual operating cost of approximately $294 million. We expect that over the next three years the company will dispose or sublease some of these properties as part of its restructuring plans. We don’t expect these changes to have a significant financial impact although they will tighten Conduent’s operations.
Conduent has a simple capital structure with a single class of common stock. Current shares outstanding are 202.9 million, which resulted directly from the 1:5 spin-off ratio as Xerox had 1.0 million shares outstanding. Xerox does not hold any shares. The company has 120,000 shares of Series A Convertible Perpetual Preferred Stock outstanding. The notes carry an expensive 8.0% annual coupon, or approximately $10 million/year. Each share is convertible at the option of the holder into 44.9438 common shares, or a total of 5.39 million common shares, of Conduent. The shares have a carrying value of $140 million.
These preferred shares were exchanged from Xerox Series B Preferred Shares by ACS founder Darwin Deason, who remained one of the largest shareholders in Xerox upon completion of the spin-off. We currently are assuming that these shares remain in Deason’s hands for the long term. We anticipate Conduent will provide further details on its stock-based compensation program with its upcoming 4Q16 report and inaugural 10-K and proxy filings. In its S-8 filing, dated December 29, 2016, the company disclosed that it authorized 25.0 million shares for its stock incentive plan. These shares represent the maximum amount of shares that may be awarded, and it could be 5-10 years before this total has been issued. For our analysis, we are initially assuming no dilution from stock awards. As information is disclosed we will update our models.
Debt and liquidity
Conduent’s debt structure is similarly straight-forward. To fund an approximately $1.8 billion cash transfer to Xerox, the company raised $1.96 billion in four tranches of debt:
With only a moderate amount of cash ($225 million), we consider Conduent’s debt load at the upper end of “reasonable” at 3.0x estimated Ebitda of $655 million. Even for a company like Conduent, with a highly-recurring revenue stream and moderate cyclicality, we support management’s intent to work down its debt load. The company has stated its target leverage (net of cash) ratio is 2.5x Ebitda, lower than its 2.7x net debt ratio at the spin-off.
The debt is expensive: the weighted average interest rate on the outstanding debt is 6.2%. Conduent anticipates spending $150 million a year on cash interest expenses. This is nearly a quarter of its Ebitda – a sizeable drain on cash flow. We would expect one of the 2017 priorities to be refinancing this debt at lower rates.
Note: Debts indicated pay interest at a rate that changes with Libor, the short-term London Interbank Offering Rate. Currently, the one-month Libor rate is 0.77%
- Interest rate is Libor + 225 basis points, or 0.77% + 2.25% = 3.02%
- Interest rate is Libor + 550 basis points, or 0.77% + 5.50% = 6.37%
- Interest rate is Libor + 225 basis points. Credit facility has a $750 million capacity
At 6.5 years average maturity, the debt structure provides Conduent with plenty of time to stabilize and improve its operations.
Off-balance sheet arrangements and derivatives
Conduent uses forward contracts to hedge its foreign currency exposures, but apparently has no other significant off-balance-sheet arrangements, variable interest entities or other similar obligations or liabilities aside from leases.
Based on its recent SEC filings, Conduent shows a $150 million “Pension and other benefit liabilities” obligation on its September 30, 2016 balance sheet. We anticipate more complete disclosure with its upcoming 10-K release.
BOARD, GOVERNANCE AND ESG PRACTICES
Board of Directors
Conduent’s board is new. Overall, we like the board’s structure and composition. At nine, it has a nearly ideal size, and only one member (Conduent CEO Vemuri) is part of the company’s management team. The age range of 33 years (a senior Icahn associate) to 71 years (former CEO of accounting firm Deloitte Touche Tohmatsu) is excellent.
Three members are employed by Carl Icahn, which provide him a great deal of influence if not control of the board. Two members are women with a great deal of business experience and two other members provide racial diversity. Professional experience among the directors is somewhat heavily focused on business strategy and finance. While one member is CEO of an electronic payments company (which is somewhat closely related to Conduent’s payments-related businesses) we would ideally have preferred a board with more operational experience in technology services. We acknowledge the issue that perhaps most other companies in the industry could be seen as competitors.
Conduent’s website states prominently that it “aims to be a role model in ethical behavior and business practices, nurturing a culture of integrity, openness and inclusion.” In reviewing its governance documents, we would anticipate that the board will have strong governance practices. However, this bears watching.
The most significant issue for Conduent’s board is its ability to work effectively together. As it is completely new, this ability is unproven. However, most of the members have significant board experience elsewhere. While board dynamics cannot realistically be predicted in advance, we do not anticipate any significant issues.
While difficult to directly quantify the impact of strong Environmental, Social and Governance (ESG) practices, we believe these matter to relevancy, sustainability and quality, which drive long-term revenues, profits and valuation. Increasingly, solid ESG practices indicate well-run companies, and the lack of attention to ESG issues may indicate other unseen shortcomings.
We have essentially no information on Conduent’s ESG practices. GMI (a subsidiary of MSCI, Inc.), a leading provider of ESG risk scores, rates Conduent’s former parent Xerox as having an overall ESG rating of “Average” for all three subcategories of Environmental, Social and Governance quality. Relative to its technology peers, Xerox was in the top 50-percentile for Environmental and Social quality, but in the bottom quartile for its Governance. Despite its lack of disclosure at this early stage in its corporate existence, we would expect a Conduent ESG score comparable to that of Xerox.
Independent auditor PricewaterhouseCoopers LLP gave an unqualified opinion on former parent Xerox’s financial statements for past two calendar years (2015 and 2014). The auditor also gave Xerox an unqualified opinion on its internal controls over its financial reporting in their report dated February 19, 2016. We anticipate no issues with Conduent’s financial reporting or internal controls.
Business Process Outsourcing Business of Xerox Corporation
Condensed Combined Statements of Income (Loss) (Unaudited)
Business Process Outsourcing Business of Xerox Corporation
Condensed Combined Balance Sheets (Unaudited)
Business Process Outsourcing Business of Xerox Corporation
Condensed Combined Statements of Cash Flows (Unaudited)
While we believe the turnaround will be successful and that the stock market will reward the shares with a significantly higher price, it is not without risks. Identifying the risks helps guide our focus as well as gauge the company’s progress. We see the following risks as significant to a successful investment:
Operating risks (risks relating to the company’s operating performance):
- CEO Vemuri may not be successful in leading the transition to growth and wider margins.
- Competition may erode Conduent’s revenues and margins.
- Government policies may change and result in cancelled contracts.
- Conduent could make poorly chosen or overpriced acquisitions, or have difficulty with integrating its acquisitions.
Financial risks (risks relating to the company’s financial condition):
- A sharp reduction in cash flow, a significant increase in new borrowings or interest rates or overpriced or poorly executed acquisitions could reduce the company’s ability to make timely cash interest or principal payments or adequately refinance maturing debt. These could trigger debt covenants, reduce its ratings below investment grade and potentially risk a default.
Economic risks (risks related to broad economic conditions):
- A major economic slowdown.
- A significantly weaker U.S. currency would increase the dollar cost of overseas wages.
- Rising interest rates would raise the company’s cost of servicing its debt.
Market risk (risks related to public securities markets):
- Investors may lose confidence in the magnitude or timing of a successful turnaround.
- Stock market may fail to assign the estimated target multiple on the company’s profits.
- Capital market changes could impair the company’s abilities to obtain financing.
Sovereign and regulatory risk (risks from actions by governments):
- Geopolitical events and other related circumstances.
- Increase in trade barriers including tariffs and/or quotas.
- Trump Administration uncertainty: In addition to its generally uncertain policies, a border adjustment tax or immigration restrictions could have significantly negative effect on the company.
- Changes to U.S. and foreign country laws, regulations and policies.
This report uses sources which we believe to be reliable. However, we cannot guarantee its entire accuracy. New Generation Research and related companies and their employees may at times hold positions in any of the securities mentioned herein.
Sources include: company news releases, 10-K, proxy and other regulatory filings and website; Bloomberg; Schwab research; Fidelity research; GMI/MSCI; Fortune, The Wall Street Journal; Wikipedia; web.archive.org; fundinguniverse.com; Current Population Survey 2015, U.S. Census Bureau; The Turnaround Letter analysis and other sources.