Description

CNDT Investment Recommendation – 7/25/17

Long CNDT Summary Thesis – Recommend long Conduent (“CNDT”) at the current price of $16.50 – our price target of $26 represents nearly 60% upside.  CNDT is a classic “multiple ways to win” spinoff situation. First, the company is deeply undervalued even on today’s operating metrics when considering the significant unappreciated hidden gems within CNDT’s portfolio. Second, the company is executing an operational revamp to exit unprofitable pre-spinoff legacy contracts and businesses inherited from Xerox, which should drive meaningful margin improvement. Third, FCF generation and likely deployment into tuck-in M&A, as well as upside from corporate cost reductions represent additional sources of value.  

Part of what makes the Conduent story truly exciting is two gems in their portfolio that if traded standalone would account for ~60% of the company’s current enterprise value: (i) Conduent’s Transportation sub-segment which includes their Electronic Tolling business (“Tolling”) and shares what is essentially a duopoly market with TransCore (unit of Roper, NYSE:ROP), and (ii) BenefitWallet, a fast-growing Health Savings Account (“HSA”) provider. Applying market multiples to these two assets implies the remaining Conduent assets trade at a >50% discount to fair value. TransCore’s parent ROP trades at 17x ‘18E EV / EBITDA, and BenefitWallet’s publicly traded comparable HealthEquity (“HQY”) trades at ~10.4x ‘18 EV/sales.  Assuming Transportation is worth 12x EBITDA (a 30% discount to ROP) and BenefitWallet is worth 8x sales (a 23% discount to HQY), the current price values CNDT’s remaining business at 3.8x EBITDA. Implicitly, Transportation and BenefitWallet account for only ~30% of EBITDA while representing ~60% of EV. Moreover, Icahn’s 9.5% ownership of CNDT and board representation makes SOTP value realization more likely.

CNDT’s core business has had challenging revenue trends and industry-trailing margins. However, this is largely due to mismanagement under XRX. These challenges are more than priced in at today’s 7x EBITDA valuation, which is below low-quality call center operators at ~8x ‘18E EBITDA. This valuation also gives no credit for the potential success of an operational turnaround that is currently being implemented by CEO Ashok Vemuri, who, according to our third-party checks is fully capable of improving the business. Vemuri is a proven value-creator, having previously led iGate Corp for the two years preceding the company’s acquisition in 2015 by Capgemini.  Prior to that, he was a business head for many years at Indian outsourcer Infosys Ltd. His $5mm incentive stock compensation dwarfs his $1mm annual salary, excluding potential cash bonuses.

Finally, CNDT has fundamental and structural catalyst events.  First, there is upside to EBITDA estimates as management has guided to $210mm of gross cost reductions in ‘17E and an additional $270mm in ‘18E, a total of $480mm, while guiding for EBITDA to increase only to $750mm in ‘18 from $635mm in ‘16. Essentially, guidance implies that management will reinvest 75% of the cost savings back into the business on an ongoing basis, seemingly a very conservative assumption. Management also recently announced a portfolio streamlining review to determine which businesses they will keep and which they will exit.  This review will be concluded by the end of the summer, and could potentially result in new means to highlight CNDT’s higher-value businesses.

Company Background - CNDT is an outsourced service provider, comprised of the businesses of the former Affiliated Computer Services (“ACS”) prior to being acquired by XRX for $6.4B in ‘09.  CNDT’s portfolio of >200 businesses handle non-core functions such as call center outsourcing, HR services (benefits administration, payroll, compensation consulting), transaction processing, etc.  

XRX’ thesis in buying ACS was similar to HP’s ‘08 acquisition of EDS and IBM’s ‘02 acquisition of PWC Consulting – that leveraging ACS’ services offering into XRX’ mostly product offering (enterprise hardware and software) would make both the product and services stickier. Also, XRX would sell its document technology products into ACS’ customer base, particularly ACS’ strong presence in state & local governments. Ultimately, none of the anticipated revenue synergies materialized, and ACS was mismanaged – EBITDA margins fell from 12.7% in 2013 to 9.8% in 2016 and dollars fell by nearly 30% over the same period. Furthermore, as Xerox managed ACS for growth, there were few risk guardrails built around the contracting process which ultimately led to a portfolio of mediocre accounts.  

By 2015, it was clear that none of the reasons for the deal were going to materialize.  In November of that year, Carl Icahn disclosed an 8.1% stake in Xerox, and shortly thereafter CEO Ursula Burns announced a strategic review culminating in an agreement with Icahn that XRX would spin off CNDT, undoing the ACS transaction. XRX appointed a new management team for CNDT in mid-July 2016 and completed the spinoff in early January 2017. Icahn continues to own 9.5% of CNDT and has 3 seats on the board.  

CNDT’s Commercial segment, which we estimate comprises ~60% of core CNDT EBITDA, has EBITDA margins of only 8%, in contrast to commercial outsourcing peers Convergys, Teletech and Sykes at ~13% EBITDA margins, demonstrating just how much cost can be trimmed from this business. CEO Ashok Vemuri has promised he can turn around this business by walking away from underperforming contracts and eliminating legacy costs.

In contrast to its underperforming Commercial segment, Conduent’s Public segment (excluding the Transportation business described above) which accounts for the remaining 40% of core EBITDA, has retained its industry-leading EBITDA margins. The Public segment margins of ~15% are ~500 bps higher than government services competitors Booz Allen Hamilton, Leidos, SAIC and CSRA, at an average of ~10%. This premium to the peers reflects CNDT’s success in signing long term contracts structured with a per-transaction focus rather than the cost-plus contracting more typical in the industry. This is largely a result of CNDT’s historical focus on leveraging its technology in a “platform-as-a-service” model vs. the peers’ labor-based model. Although the business does see some pricing compression on contract renewals, per our diligence this is an industry-wide phenomenon for all government IT services companies due to pressure on federal and state budgets and the need to win new business.  

Our Variant Perception – Conduent’s Hidden Gems

CNDT’s two high-multiple businesses – Transportation and BenefitWallet – are together worth ~60% of CNDT’s EV  

Transportation – $2.4B valuation @ 12x EBITDA (45% of total EV)

• CNDT’s Tolling business, which accounts for ~70% of its Transportation segment, processes transactions, billing and maintenance for EZ-Pass-type toll collection systems. Per our diligence, Tolling is the 2nd largest player in the US and essentially has a duopoly with Roper’s TransCore unit – the two have a combined 85-90% share of the market, roughly split evenly, with similar EBITDA margins (greater than 25%). This business is structurally different than core Conduent, which has EBITDA margins of ~11%. Tolling is underpinned by intellectual property that was developed to allow the company to sync up disparate tolling systems employed across state roads, and also to allow payments across state lines. Their system is fully automated for crediting and debiting accounts based on RFID reader technology. In addition, CNDT has IP related to license plate recognition technology and GPS recognition technology, as well as red light / speeding cameras. The business benefits from the increasing trend toward electronic tolling vs. cash tolling and increased camera-based traffic law enforcement.

• To date, CNDT has not disclosed much about its Tolling business which is a like-for-like comp to Roper’s.  Roper trades at 17x ‘18E EV / EBITDA.  Based on our diligence we believe ~70% of CNDT’s Transportation sub-segment (~14% of total CNDT revenue, or $870mm) consists of its Tolling business, so the exercise is to determine how close to a ROP multiple to place on the Transportation sub-segment.  

• Per ROP’s M&A presentation for TransCore in 2004, we know that TransCore had roughly 60% of the market.  This suggests two things: (i) that CNDT has maintained or gained market share in the space, and (ii) that the electronic tolling market has grown at MSD growth rates, similar to ROP’s overall ~6% expected revenue growth rate.  At that time, the business generated roughly 20% EBITDA margins, while the RF Technology segment at Roper (in which TransCore is reported) today generates 31% operating margins and TransCore is the largest contributor to that segment. The RF segment includes some software businesses, which likely has higher margins vs. the core tolling business.  Since the RF technology segment generates similar margins to ROP’s overall margin at 31.2% and its MSD growth profile approximates ROP’s, this suggests the segment is likely worth near ROP’s consolidated multiple.

• Our diligence suggests CNDT’s Tolling business’ EBITDA margins are roughly 25% – vs. TransCore’s at <31%.  Assuming TransCore would trade at a 16x multiple vs. ROP’s 17x, and discounting the 16x by 25% for (i) conservatism, (ii) slightly lower margins, and (iii) the fact that Tolling represents ~70% of the total CNDT Transportation sub-segment, we arrive at a 12x multiple for CNDT’s Transportation business implying a $2.4B valuation, ~45% of CNDT’s current EV.

BenefitWallet – $1B valuation @ 8x revenue (18% of total EV)

• BenefitWallet, a top-5 player in the fast growing Health Savings Account (“HSA”) industry, grew accounts at a 29% CAGR from ‘13 to ‘16 according to industry research from Devenir.  BenefitWallet grew 60% faster than the overall HSA industry, where accounts increased 18% during the same period. Devenir estimates the number of HSA accounts will continue to grow at a high-teens CAGR through 2018E as high-deductible healthcare plans become more commonplace.

• BenefitWallet’s public comparable HQY is trading at 10.4x ‘18E sales – the high multiple reflects the significant growth runway in the HSA administration market and HQY’s best-in-class technology. Per our conversation with Aon, BenefitWallet is perceived as a solid product that offers good capabilities – it has not fallen behind despite XRX ownership, though HQY has the best-in-class platform and technology integration. Still, BenefitWallet is a superior product to those offered by PAYX, ADP and other share donors. We attempted to implement our own HSA solution through both BenefitWallet and HQY and came away impressed with the BenefitWallet offering.

• We believe BenefitWallet generates roughly $120mm of revenue.  Because CNDT is not a non-bank custodian certified by the Treasury Department, it can’t collect float income, which is a potential upside opportunity.  HQY generates nearly 30% of topline from collecting float income.  Per our diligence, HQY received its Treasury approval in 2006, roughly 3 years after the company was founded and 2 years after the initial application.  In addition, the DoT website denotes that several entities have received approvals each of the last several years.  This suggests that receiving approval is not an insurmountable regulatory barrier and presents an opportunity for either CNDT, or a synergy for HQY were it to acquire BenefitWallet.  The only reason that we can theorize as to why XRX never applied for non-bank custodian approval is that BenefitWallet was not front of mind for XRX due to its relative size.  

• As it is unclear if CNDT collects float income, we give them credit for half the market rate of 1.5-1.7% of assets under administration of $2.1bn, or roughly $17mm.  We find it hard to believe that CNDT would receive no float income when giving Bank of New York (its custodian) such a significant deposit, and therefore we assume they collect this $17mm from BoNY in some other form.  

• If CNDT filed for and received Treasury approval, revenue would increase by an additional $17 million to ~$137mm, 15% more revenue than our valuation assumes.  

• Although the Street has started to realize the value of BenefitWallet, our variant view is based on our estimate of the business’ revenue generation, and we are only including 50% of their float income potential. Our diligence suggests the business is worth at least 8x revenue of ~$120mm – a ~25% discount to HQY’s 10.6x revenue – this reflects BenefitWallet’s slightly slower historical account growth (29% CAGR vs. HQY at 38% from ‘13A-‘16A per Devenir) and its lack of float income.

• Looking at valuation per account, HQY’s current EV is roughly $1,000 per year-end 2016 account.  Applying a ~25% discount to this – in-line with our discount to HQY’s sales multiple or $750 per account – to BenefitWallet’s 1.9mm accounts results in an EV of ~$1.4bn, 50% above the value in our SOTP analysis.  

Potential Events / Value Realization

• As part of the outcome of the business/contract review which is currently ongoing, it is possible that CNDT will improve disclosure around its higher-multiple businesses and/or start talking about ways, structural or otherwise to crystallize this value.

• Vemuri’s historical track record of selling iGate to CapGemini after two years as CEO suggests that Icahn’s ultimate endgame could be making a streamlined CNDT more compelling to a potential acquirer.

Stating/Debating the Bear Case

Street believes CNDT is a portfolio of mediocre businesses with poor economic characteristics – near-term performance has exhibited pricing declines suggesting increasing commoditization of its core competencies; moreover, the business has sub-optimal capital returns and has underperformed the BPO market.  

• The BPO market is growing at 6% while CNDT’s overall revenue has been declining – down 2.3% in 2015 and down 4.2% in 2016

• Street is worried that management’s guidance for cost reductions won’t be enough to overcome continued topline headwinds

We believe management will execute on its operational turnaround:

• Street concerns reflect “chronically failed” execution at XRX and applying that prism to analyze CNDT’s turnaround.  For example, the January ’17 MS initiation voiced significant concern around the ability to achieve the cost savings, in the context of historical performance.  Further, its lack of technology leadership and capital structure inhibits investment in growth areas that bode poorly for a turnaround.  

• Robert Zapfel, the former CEO of Xerox Business Services, was hired in 2014 to turn around that business and failed.

• Weak bookings growth presages poor topline outlook – the 1Q ’17 revenue guide-down stoked these concerns further.

• Margin expansion from cost cuts is at risk from scheduled price-downs, reinvestments, and public company costs.

• Despite appearing challenging, we believe CDNT’s CEO will successfully execute an operational turnaround:

• Unlike XRX, CNDT management is competent – our third-party checks on the CEO came back extremely positive.  

• The thesis on RemainCo, which consists of call centers, HR outsourcing, transaction and payment processing for commercial and public customers amongst other offerings, is one of operational turnaround.  Vemuri is a well-respected CEO in the industry, but Street reflects concerns that he doesn’t have a meaningful amount of experience in the gritty details of fixing a broken business.  

• We believe an operational turnaround is doable:  

• During the investor day in December 2016, the company articulated a new strategy to fix the business:

• Take $480mm of costs out net of stand-up and business-as-usual cost pressures and reinvest some portion

• As a part of this, to improve the “Other” segment which consists of the HE contracts and their student loan business

• Their target was to be breakeven by YE 2018 – they’re already there – op income was ($1mm) in 1Q ’17 – their guidance implies a material worsening of near-term trends which seems conservative.  This also contradicts bears who argue that the operational turnaround is tough – it’s already showing up in the numbers.

• Layoffs already happening per Glassdoor.

• Exit unprofitable contracts – either sell more profitable work into the same customer, or just walk away – per the investor day call, customers are working with CNDT about 40% of the time.

• Per our diligence, top 100 clients represent 67% of revenue and remaining 2,900-3,000 clients are the rest – the smaller clients are $25-100k accounts and don’t generate profitability when overhead is layered on – this seems pretty straightforward.

• Management expects the problem contracts to be resolved by the end of 2018 – average contract length is 3 years and they started the exit process a year ago.

• Improve business development function.  To this end, they’ve turned over 50 of their 300 salespeople and plan to hire 60 more in the next several quarters

• Automation is a threat, but also an opportunity.  Conduent can leverage both internally developed and third-party software to automate internal functions and reduce labor needs, driving the potential for margin expansion.

• Unlike other BPOs, the model is more platform and technology-dependent – 80% of topline is from transaction-based pricing while for both public and private-sector comps are predominantly labor-based models.

• We believe CNDT has yet to implement their automation or AI or analytics offerings to all the client base, presenting an opportunity.

• CNDT’s topline miss in 1Q was driven entirely by an acceleration of walking away from unprofitable contracts – this is a positive given their strategy.  Any turnaround will also face near-term disruption, which presents an opportunity for longer-term oriented shareholders

• They don’t use backlog to track their business.  Concern is that this hiding something – per management, they are working on improving disclosure.

• Pricing pressure is normal course for BPO

• Street thinks core Conduent is not a good business, as it doesn’t have pricing power and capital returns are mediocre.  Pricing pressure is a structural industry-wide phenomenon, however – virtually all BPO businesses (serving both private sector and government clients) suffer from comparable price-downs upon renewal.  Despite this, public call center peers trade at ~8x EV / EBITDA while government services peers trade at 10.7x.

• All BPO companies sign new business in order to offset structural pricing pressure – as a result CNDT is already reshaping its sales organization to improve signings, which is already bearing fruit in the 1Q results – CEO is incentivized to drive new business growth (see below section for compensation details).

• At the same time, the market perceives core Conduent as suffering from the risk of technological disruption, as next-gen automation software is driving less need for people-based outsourcing services.  Based on our research, the automation and chatbot technology that’s currently being deployed is designed to assist human callers rather than supplant them.  Real replacement is likely years away even with optimistic assumptions around the evolution of natural language processing.  

• Strong recurring revenue

• Despite pricing pressure, both the remaining public and private sector outsourcing businesses have favorable economic characteristics

• 90% recurring revenue with 86% renewal rates

• 3-year contracts at commercial and 5-year at public (CNDT’s public sector contract lengths are at industry-standard levels)

• 80% of contracts are transaction-based, whereas public comps are disproportionately cost-plus – this creates the opportunity for higher margins and operating leverage as the business ultimately returns to growth

Management quality and incentive structure:

CEO

Ashok Vemuri joined Xerox Business Services in mid-2016 to replace the previous business unit head for underperformance.  Before this, he was CEO of iGate – he joined iGate in April 2013.  At iGate, Vemuri took over after its previous CEO was fired for non-performance related issues.  The strategy was several-fold:

• Exit areas and businesses that can’t be scaled up – eg. ME, LatAm, Africa

• Scale up solutions that can scale and exit those that can’t – during a October ’13 WFC conference Vemuri called out 18 solutions that iGate wasn’t making money selling and said he wanted to eliminate solutions that weren’t working

• Shed non-strategic accounts and ensure new account openings are done with more stringent qualifications

• Invest to grow capabilities (mobile and analytics) and add labor capacity – running at 84% utilization not sustainable

• Create core competencies in technology and processes and verticalize the business

As is clear, the first three parts of the strategic transformation is identical to his plan for CNDT.  Importantly, iGate was sold to CapGemini within 2 years of Ashok’s joining, in April 2015.  CapGemini cited its customer relationships, 98% retention rates and recent transformation as the reasons behind the acquisition.  

Ashok’s compensation is heavily weighted to his LTIP, with a base salary of $1mm and LTP of $5mm – half performance shares and half restricted stock units (per 2016 proxy).  There are 3 components to executive comp – the 2017 Annual Performance Incentive Plan (APIP), the 2017 Executive Long-Term Incentive Plan (ELTIP) and the Strategic Initiative Grant (SIG) – per 8-K filed 3/29:   

2017 APIP – 60% Adj. EBITDA, 30% CC revenue decline, 10% revenue productivity per employee

2017 ELTIP – 50% of award based on performance shares and 50% RSU from continued service.  Metrics for performance shares are Adj. EBT (25%), FCF (25%).  

2017 SIG – Received performance shares based on certain metrics – 50% performance and 50% service.  Performance elements are service line penetration (12.5%) to cross-sell to top 40 commercial clients, new business signings growth (12.5%), cost transformation (25%, half of RE and G&A and half information technology)

CFO - Brian Webb-Walsh is an XRX lifer, having spent the last 20 years at the Company in a variety of corporate finance roles.  Despite a lack of public company experience, he’s done a respectable job of explaining results and articulating the story.  

Catalyst

Upside to near-term EBITDA estimates from higher drop-through driven by cost savings

Strategic review update - mid-August 2017 in conjunction with CDNT's 2Q earnings release

Improvement of disclosure around CNDT's higher-multiple businesses

Formal announcement of plan to separate lower-multiple from higher-multiple businesses