Description

Recommendation: Long Conduent (NYSE: CNDT) - $26 PT / ~ 80% Upside

Situation Overview

Xerox recently completed the spin-off of Conduent, its Business Process Outsourcing (BPO) unit. Xerox (XRX) stock was up ~20% after the completion of the spin-off, indicating the market is more interested in the Xerox classic business than Conduent. Recent sell-side research reports indicate that many investors are wary of investing in Conduent due to the perception of the business as one with shrinking revenues and weak margins, as well as overblown political concerns (potential implementation of the Border Adjustment Tax). It is worth noting that ~ 130mm shares of Conduent have traded since trading of the stock began, which is very substantial relative to the total float of 203mm shares (likely indicating many holders of XRX have decided to sell the shares they received).

Thesis

The recent spin-off of Conduent presents a compelling opportunity to invest in a business that has been under-managed as part of Xerox, has substantial margin upside potential, has demonstrated robustness through the economic cycle, is trading at a compelling valuation, is being led by a proven operator in the space (CEO Ashok Vemuri was hired last summer to lead the company), and is a likely acquisition target once margins have been fixed and revenue stabilizes.

Industry Overview

The BPO industry is a $250 BN global market, growing at ~ 6% annually. The main justification for a company outsourcing a given process in its value chain is that it wants to focus on its core competencies and the economic activities that engender its “secret sauce”, as these are the largest drivers of its economic returns and competitive advantage. The growing trend toward business process outsourcing is driven by the increasing competitiveness of the global economy and the trend away from full vertical integration of the value chain; many businesses are electing to let a BPO firm handle parts of the value chain that they are not most suited to performing. BPO firms are usually contracted over a period of years by a firm to serve as a partner in the value chain; contracts are typically structured such that BPO firms must cut costs every year of the contract in order to maintain the same margin of profitability on the deal.

The BPO industry has a reputation for being a commoditized industry, which is not entirely accurate; the industry encompasses a spectrum of services, some of which are highly commoditized, others of which are more differentiated. One of the best examples of a commoditized BPO service is call centers (uniform output of talking to customers and most players use outsourced labor in low-cost countries like India). For the most part, the more difficult and mission critical a service BPO firms provide, the less commoditized that service. An example of a mission critical service is healthcare processing (e.g., claims processing, member administration, etc.); this service is critical as failure to properly process claims and botched customer administration can be highly detrimental to healthcare franchises and potentially trigger large fines. The primary justification of the BPO industry’s existence is twofold: scale in low-skill, labor-intensive functions such as customer service centers to generate adequate returns on capital in those economic activities, and the expertise to perform mission critical processes that companies do not want to manage themselves (i.e., intellectual knowledgebase of how to effectively deliver certain parts of the value chain). Another large portion of growth in the BPO industry is services provided to the government; as the scope and scale of services provided by the government grows, the government is inclined to let BPO firms handle services related to the actual administration of those services (e.g., administering EBT cards, claims processing for Medicare / Medicaid, etc.).

Conduent’s History

Conduent is largely comprised of the assets Xerox acquired from Affiliated Computer Services (ACS) in a ~ $8.3 BN deal (total EV) completed in 2010. ACS was essentially a portfolio of different business process outsourcing units, many of which were acquired steadily over time. The table below illustrates the key reporting segments of the business at the time of the sale.

The ACS business Xerox acquired was fairly robust, having demonstrated a 17% CAGR of revenues since 1998, as well as revenue growth in 2008 and 2009 during the recession. The business remained profitable through the recession, given many of the services it provides are mission critical and many of the government services it administers relate to social safety net programs which are larger in scale during bad economic times.

The Xerox acquisition of ACS never really made much sense from Xerox’s perspective given there was not much overlap between the offerings of the two businesses, and the potential synergies were not very high from a cost perspective, aside from potential G&A cost-cuts.  The integration of ACS with Xerox was almost non-existent; the businesses were essentially run separately. In 2014, Xerox sold the Information Technology Outsourcing (ITO) segment of the business to Atos for $1.05BN, at a multiple of ~.8x Sales / ~ 9.8x Operating Profit (sales of ~ $1.3BN and operating profit of ~ $107mm at time of acquisition).

Conduent Today

Today, Conduent has ~ $6.6 BN of revenues, with ~ $630mm of Pro Forma, Adjusted EBITDA. Conduent has four main segments: commercial (44% of 2015 Revenues, 2.4% Segment Margin), public sector (26% of 2015 Revenues, 11.6% Segment Margin), healthcare (26% of 2015 Revenues, 9.0% Segment Margin), and other (4% of 2015 Revenues, producing losses). The commercial sector is highly competitive, and Conduent’s margin has decreased substantially since ACS was initially acquired by Xerox. Examples of the kinds of services Conduent provides include: Ezpass toll-processing, healthcare claims processing, and finance & accounting functions, among many others. The healthcare segment is a potential source of growth given secular tailwinds in the industry and continued regulatory shifts which drive additional spending. The commercial segment is also a source of growth as Conduent is aiming to increase its existing customer penetration (aiming to increase customer service penetration ratio from 1.1-1.2 to 1.7-1.9). Conduent has showed declining top-line in 2016, but in reality this was a result of exiting contracts that were unprofitable. The overall BPO industry is growing at a rate several points higher than GDP growth and Conduent has substantial opportunity to gain market share given it is only ~ 3% of the total market. Additionally, Conduent has a successful track record of doing small, bolt-on acquisitions which is an additional source of potential market share gains. A comparison of Conduent today with the historical ACS business can be seen in the table below.

The table above illustrates that today the business has substantially lower margins. There are a number of reasons driving that trend, but one noteworthy explanation is that the Conduent business was run sub-optimally at Xerox. It seems clear that the integration of Conduent with Xerox was unsuccessful, and the hoped-for synergies never materialized (see quote below); the business thus had the drawbacks of being part of a large conglomerate (i.e., slower to make strategy and capital allocation decisions) without any of the resulting benefits.

“And I would just add from a back office, finance, and HR and payroll systems, the good news is we never integrated with Xerox. So, we have our own systems. So, that's one piece of good news. But we do have multiple systems and we need to consolidate going forward. So, that is an opportunity we'll be focused on.” – Alan Katz, SVP of IR, Conduent – 12/5/16

The table above also shows that Xerox likely was underinvesting in the business when comparing Conduent’s current capex run-rate with that of ACS. While the cost of building software has declined substantially over the past few years, and Conduent no longer owns the ITO segment, it still seems like Conduent would benefit from investing more in capex to support growth in the business and to increase the durability of current contracts.

Conduent’s average contract length is ~ 3 years for commercial contracts and ~ 5 years for government contracts. These contracts can be viewed largely as annuities given the very high renewal rate (~ 86%). A typical contract consists of Conduent partnering with a client and agreeing to perform a specific function for them. As mentioned above, the contracts generally necessitate that Conduent increase its efficiency each year in order to maintain profitability. This presents a risk as the capital is deployed at the outset of the contract, so execution is key to ensure a given contract meets return thresholds. The unprofitable or marginally profitable contracts that have plagued Conduent of late can probably be traced back to poor or aggressive estimates when initially negotiating the contracts.

Conduent today is focused on transactional-based services as well as services where it can successfully leverage its broad technology platform (~ 80% of Conduent’s revenues are from transaction-based processing). The real value-add in the BPO industry is intellectual and functional know-how, as well as the ability to execute on promised services. This is precisely what Conduent is focused on with its current suite of services.

“Technology is a commodity. I can buy technology every other day at half the price I paid the day before yesterday. The technology product isn’t going to give you any differentiation. What gives you differentiation is what you do with that technology. If I understand processes and have functional and domain knowledge, then I can actually leverage that technology and literally make it jump through hoops to provide me the answer or the outcome that the business really needs.” – Ashok Vemuri, 1/3/17 Fortune Interview

The benefit of focusing on these types of services is that there is substantial operating leverage; once the infrastructure to perform the service is set-up, there is capacity to process growing volumes resulting in the potential for higher margins over time. This is more attractive than labor-intensive services which require a scaled-up employee base as volumes scale. An additional potential opportunity for growth is Conduent’s ability to more productively use the data generated as part of the services it provides for its customers. As Conduent invests more in its technology, there is the potential for the company to drive valuable insights for its clients using the data generated through the transactions it administers. This would help differentiate Conduent’s product offerings from competitors and drive pricing power.

Turnaround Opportunity / Margin Upside

The performance of the Conduent business while at Xerox can be categorized as mediocre at best. Nevertheless, the business franchise does not seem to have been impaired as a result of the poor execution these past few years. The recently hired CEO, Ashok Vemuri, has a proven track-record of executing in similar capacities. Ashok successfully ran iGate; he improved the performance of the business and ultimately helped sell it to Capgemini, resulting in a robust return for shareholders.

In the 12/5/16 investor meeting, Ashok highlighted 5 core reasons why he sees Conduent as an attractive investment today: 1) leader in a large and growing industry 2) diversified and large client base 3) long-term, predictable, annuity-like contracts 4) margin improvement potential 5) “disciplined capital allocation strategy targeted towards high-return and low-risk opportunities to enhance shareholder value”. Ashok has already been driving margin increases by cutting loss-producing contracts, and trimming G&A spending. There is reason to believe that G&A costs were bloated under the Xerox structure. With more visibility and flexibility as a standalone company, it is likely G&A costs can be cut substantially. Adjusted EBITDA Margins have already increased ~50bps YoY as of 3Q16. Additionally, Ashok noted in the 12/5/16 presentation:

“Now, let's look more closely at what we are doing to improve margins. Earlier this year, we began a three-year strategic cost transformation program to deliver $700 million cumulative cost savings through 2018. These focus initiatives currently underway are from across the business, from automation to supply chain and performance management. So far, we've made significant progress on this program, and we are set to launch Conduent with the most optimized cost structure possible.”

~170mm of the $700mm in cost savings mentioned in the quote above are necessary to maintain margins at current contracts (the remainder is incremental to current margins). Another driver of margin upside is reducing run-off businesses that are producing losses, as well as improving customer call center margins. The CEO is focused on renegotiating terms of low-margin contracts by engaging with customers in a collaborative manner, and running-off the run-off segment as quickly as contracts and customer relationships permit. The removal of the losses from the other segment alone would result in margin improvement of ~ 150bps. The table below summarizes the margin improvement opportunity; it is noteworthy that the margin opportunity is ~ $575mm or ~ 90% of the business’s current Adjusted EBITDA of ~ $630mm. The margin improvements will take some time to execute, but it is likely that a large portion of them can be executed by the end of 2018.

Activist Engagement

The original decision to spin-off Conduent is due in part to pressure put on Xerox by Carl Icahn to drive shareholder return. Post-spin, three members of Icahn’s team will be on Conduent’s Board of Directors. Additionally, Icahn owns ~ 10% of Conduent post-spin. This should help hold the management team accountable for executing on the core initiatives to improve the business’s performance and for driving shareholder value. The fact that Icahn is enlisting three members of his team to join the Conduent board indicates he may view Conduent as the more attractive vehicle post-spin, as compared to the market which seems to favor XRX. Additionally, the Icahn board members would likely be supportive of a potential sale of the business once the turnaround has been executed.

Financials Overview / Valuation

The main drivers of Conduent’s valuation over the next few years will be: 1) management execution on cost-cutting / margin improvement initiatives and successful termination of the run-off segment 2) the extent to which management can drive organic revenue growth at attractive margins. If management is successful on these two fronts, the valuation being ascribed to Conduent today by the market will prove to be far below the business’s intrinsic value. Sell-side analysts have noted they view Conduent as a “show-me story” and are inclined to ascribe a discount to the peer-set until the execution risk has been eliminated. While some discount to the peer-set is to be expected given the potential execution risk, the discount being placed by sell-side analysts is far too draconian and does not reflect the underlying business fundamentals. The tables below illustrate financial projections, as well as a summary valuation based on EV / EBITDA multiples of 2018 Normalized EBITDA. While there is no perfect peer set for Conduent given fundamental business differences, many companies that would be classified as Conduent’s peers trade in the 6-9x EV / EBITDA range. Given Conduent has execution risk and below-peer margins, it will likely trade at the lower portion of that range until management is able to demonstrate progress on improving the business’s performance. That being said, Conduent is also a potential acquisition candidate given there has been some recent consolidation in the space (e.g., HPE merger with CSC), and given scale is becoming increasingly important in the industry (as technology becomes an increasingly important part of the value proposition). I think Conduent is worth ~ $26 / share (~ 80% upside from current levels), with potential additional upside.

For the sake of conservatism, I have not modeled in any potential benefit from the proposed corporate tax reform dropping rates to ~ 20%. It is also worth noting that Xerox originally acquired the business for total consideration of ~ $8.3 BN in 2010 (total EV / ~ $7.3BN when adjusted for sale of ITO business in 2014); while they likely overpaid and have since sold the ITO business, the present EV of ~ 5.0 BN presents a healthy margin of safety relative to that price (somewhat warranted given weaker margins, and worse revenue prospects, but the business has not deteriorated that much fundamentally). Another sanity check on valuation is that Atos paid ~ .8x EV / Sales for the ITO business that was originally part of Conduent, and Conduent is presently trading at ~ .75x EV / Sales. This is notable because ITO businesses are weaker businesses than pure BPO businesses because IT outsourcing is in many respects a race to the bottom from a cost perspective and is increasingly being commoditized (as opposed to BPO where you can differentiate on institutional know-how and execution prowess). One additional data point on Conduent’s valuation is that in agreeing to exchange Xerox preferred stock for Conduent preferred stock, Darwin Deason (founder of ACS and large equity owner prior to Xerox acquisition of ACS), accepted Conduent preferred stock with a conversion price of $22.25 / share (note: for the sake of simplicity, I’m not assuming the conversion of the preferred in stock at my target price given the target price is relatively close to the conversion price).

[1] Note: EV calculation assumes ~ $100mm of debt paydown / cash generation in 2017 and 2018; this is likely a conservative estimate, but given the uncertainty around potential acquisitions and capex / restructuring spending, this seems reasonable.

Risks

• Given the nature of the BPO business, there is risk of litigation and / or write-off’s resulting from poor execution on a contract or a dispute with a customer; this can be seen with the current litigation outstanding with Texas related to Medicaid services provided, as well as the health enterprise charge taken in 2015 as a result of being unable to successfully execute on a contract

• Since Conduent’s BPO business is composed of so many different service offerings and encompasses many distinct contracts, the only way to get comfortable with this risk is to have confidence in the management team’s execution ability; Ashok’s exemplary business record certainly warrants this.

• Border Adjustment Tax

  • While I expect there to be a lot of continued chatter about potential a potential Border Adjustment Tax and other similar plans, I have confidence in the durability and resiliency of the business, despite the heightened political uncertainty

  • It seems that Trump may be in favor of simpler trade policies, although it is possible that he favors a plan that is punitive for companies that are large importers

• As part of a tax reform proposal being contemplated by Republicans, the Border Adjustment Tax would eliminate the tax-deductibility of input costs that are imported (i.e., any COGS item that is imported would no longer be tax deductible).

• President-Elect Trump recently was quoted on the BAT:

• “Anytime I hear border adjustment, I don’t love it,” Mr. Trump said in an interview with The Wall Street Journal on Friday. “Because usually it means we’re going to get adjusted into a bad deal. That’s what happens.” – WSJ, 1/16/2017

• While this could have a big impact, some economists believe the dollar would strengthen by a large enough amount to offset most of the impact

• ~ 50% of Conduent’s employees are based outside of the United States, and employees represent a substantial cost for the company, so a BAT would likely have a negative first-order impact of reducing after-tax income

• As part of the tax reform proposal, the corporate tax rate would be reduced to 20%, which would offset to a certain extent any impact of the BAT

• The potential BAT may not have nearly as big an impact on Conduent as some fear: 1) there may be a structural solution Conduent can execute to blunt the impact of a BAT (i.e., a large strengthening of the dollar could provide justification from a transfer pricing perpsective to pay less for Conduent’s imported costs) 2) the BAT may only be focused on “hard goods” industries that involve physical manufacturing given Trump’s emphasis on manufacturing goods in the U.S. (i.e., intellectual-type goods being exluded from the BAT)

• It is also possible that to the extent the BAT impacts all companies that utilize offshoring, industry pricing will offset this to some extent

• An additional mitigant of any potential BAT impact is that Icahn is substantially invested in the company; he has a close relationship with Trump and would likely be able to voice concern about how punitive a BAT would be on the BPO industry

• Execution Risk

• If the management team is unable to deliver on most of the cost cuts and margin improvements promised, today’s valuation will likely prove to be a fair assessment of intrinsic value

• It is possible that the nature of the business has changed since Xerox originally acquired it and that the mix has shifted to a lower margin from a structural standpoint

• I view it as likely that the margin upside being promised by the management team is achievable; it is unlikely Ashok would have accepted the CEO job after doing his diligence if he didn’t believe that that was the case

• Many of Conduent’s peers have substantially higher margins; it seems likely that Conduent can conceivably close at least part of this gap

• Revenue growth

• If Conduent is unable to demonstrate a stabilization of revenues at the minimum, or some organic revenue growth, the valuation may contract as it may be viewed as a melting-iceberg business (much of this concern is already priced in given many view it as something close to that)

• Accounting risk – given Conduent is essentially a portfolio of different BPO services, including a number of acquisitions over the years, there is the potential for accounting risks or write-downs to intangible assets

• Given there were no major problems while the business was a part of Xerox for six years after the acquistion of ACS, this does not seem likely to be a problem

• Additionally, Xerox successfully sold the ITO business to a shopisticated buyer, indicating that Atos was comfortable with the financials / controls / processes / etc.

Exhibits

Exhibit 1: Slide summarizing ACS business from 2009 Xerox presentation: Xerox to Acquire Affiliated Computer Services

Exhibit 2: Slide summarizing CNDT key segments from 12/5/16 Investor Presentation

Exhibit 3: Precedent Transactions Analysis Performed by Citigroup for Xerox Acquisition of ACS, September 2009

Catalyst

• Execution on margin upside potential; several quarters of margin increases should drive meaningful increase in street valuation / improvement of street perception of the business

• New business wins; will validate the thesis that there is substantial growth potential for the business at attractive margins

• Bolt-on acquisitions; Conduent has a long track record of successful bolt-on acquisitions. These drive steady revenue growth and help Conduent enter new end-markets

• Continued debt paydown and deleveraging over time

• While leverage is not necessarily high post-spin, some sell-side analysts seem concerned so a lower leverage level would likely improve valuation

• There should also be an opportunity for the company to replace its unsecured 10.5% notes – 10.5% is much too high relative to Conduent’s underlying financials and the current credit environment (likely had to settle for 10.5% given the business hadn’t spun-out yet and they had no full year financials as an independent company)

• Would give the market more confidence in the credit strength of the business. It is worth noting that the bonds are trading at ~112% of par or ~9% YTM.

• Acquisition of Conduent by large competitor or large conglomerate looking to enter the space; natural acquirers could include HPE-CSC or other similar players in the services space. Additionally, a large conglomerate such as IBM could acquire the company to become a bigger player in the BPO space. Another potential acquirer is Infosys; Ashok worked at Infosys for a number of years and Conduent could potentially be a good fit or Infosys. This would likely not occur until Conduent is able to demonstrate margin improvement and revenue growth / stabilization.

• Release of 2016 10-k – will be the first full-year of financials post-spin