Xerox (NYSE:XRX), in an effort to reduce its debt amidst consecutive years of declining revenues, completed its spinoff of Conduent (NYSE:CNDT) in January 2017. The process took about one year, as the spinoff was announced on January 29th, 2016. The spinoff is due partly to Carl Icahn, who took roughly an 8% stake in November 2015, and pushed for three seats on the board in conjunction with a separation of the company. Since the spinoff was announced, XRX shares have not performed well. Below is a chart from the announcement to the day before the spinoff. XRX shares are represented by the shaded area and the S&P 500 is represented by the blue SPY trend line. Xerox shares were down over 10% versus a 15% increase in the S&P 500 over the same time frame:
As part of the spinoff, Xerox received a payment of $1,905 million from Conduent, while the company raised approximately $2,250 million in debt. But now that the spinoff is completed, what will happen to the business process outsourcing company that is now Conduent? First, by analyzing the company's pro-forma financials and investor presentation, Conduent will continue to show weakness in revenues related to its legacy Health Enterprise and Student Loan business - both generating losses for the company. Second, relating to the investor presentation in December 2016, Conduent management expects revenues to trend downward to the tune of 3-5% through 2017. This downward trend will be compounded by low margins, restructuring expenses, and an inability to generate new business contracts. As a result, while current CNDT prices reflect an EV/EBITDA multiple of 11.3x, historically, per the pro forma 2015 financials, the shares should trade closer to 9x EV/EBITDA, implying significant downside to the stock. A pro forma model will be presented by referencing the pro forma financials, the December 2016 investor presentation, and past reports in order to build a short case for CNDT, followed by possible counterpoints to shorting the stock.
Building the Financials
The index to financial statements section of the Form 10 (pro forma) contains audited financials for the BPO business (Conduent) as part of Xerox for 2014 and 2015. But before getting into the numbers, let us first define Enterprise Value as
The tables presented (below) contain total revenues, total costs and expenses, earnings before taxes, D&A expense, interest expense, taxes, net income, and relevant balance sheet items for calculating Enterprise Value. In each CNDT table, I keep the number of shares and share price static at 202.67 million and $15, respectively. You'll discover varying EV/EBITDA multiples for CNDT, against a backdrop of declining revenues, which demonstrates high uncertainty surrounding current valuations. Table 1 below shows financials for Conduent as a part of Xerox for 2014-2015, from the balance sheet and income statement:
Because Conduent was still operating as a part of Xerox in 2014 and 2015, there are no interest expenses and no preferred stock. Both of these figures will change as we work toward 2016 and the pro forma financials. It is noteworthy that Conduent's total revenues declined by $276 million (a 3.9% decline), while the costs and expenses increased by $308 million (a 4.4% increase), both of which contributed to a substantial loss in 2015 and an outrageously high EV/EBITDA multiple. It is a mixed bag here in terms of valuation, and it is clear that Conduent has not escaped the revenue decline experienced by parent Xerox. To gain a better perspective, we need to move on to the pro forma numbers.
As part of the spinoff, Conduent issued $140 million in preferred stock and ~$2.25 billion in debt. Both appear on the pro forma balance sheet. Below is Table 2, showing EV and EBITDA resulting from the pro forma financials, first released last year. Note that the necessary balance sheet items (short-term debt, long-term debt, preferred stock, and cash), are dated back to the balance sheet for the six months ended June 30th, 2016, while the income figures are dated to the end of 2015. In addition, no pro forma cash flows are provided here; as a result, we will assume a $600 million D&A expense - the same figure from the 2015 CNDT table above (as part of XRX):
The revenues for 2015 are unchanged from the first table presented. However, the costs and expenses are about $76 million more (the interest expense included), and EBITDA is almost four times greater at $95 million. The tax benefit is approximately $32 million higher, and the resulting net loss of $390 million is $24 million less than previously stated. The changes in Enterprise Value are understandable due to the increase in debt. But otherwise, it seems that once the spinoff occurs, there is a definite possibility for error in Conduent's financials. While this may be due in part to my adding back a $600 million D&A expense, the addition is not unreasonable to assume because the same figure was presented in the index to financial statements of the Form 10. Just what kind of impact the financials will have on the stock price remains to be seen and we will know more when Conduent reports later this month. For now, the EV/EBITDA multiple obtained in Table 2 is still very much fallible.
There is yet one more scenario to consider. Conduent reported its 2016 Q3 financials (once again as part of Xerox) on November 11th, 2016, and also conducted an investor presentation on December 5th, where CEO Ashok Vemuri and CFO Brian Walsh outlined their strategy for Conduent over the next few years. But before getting to the presentation, investors were able to see the numbers in Table 3 by referencing the 2016 Q3 press release. In order to estimate full year 2016 numbers, I multiplied the Q3 numbers for revenues, expenses, D&A, and the benefit from income taxes by 1.33. It is a crude, but feasible estimate. The balance sheet items will remain as they did in the press release. The pro forma interest expense, long-term debt, preferred stock, and cash and cash equivalents are absent from the Q3 press release. Therefore, in order to form the final model, we will account for these figures accordingly in the last column:
The ~$141 million interest expense, ~$2,250 million debt raise, $140 million in preferred stock, and $410 million in cash and cash equivalents have been added to the model, resulting in a change in EV/EBITDA multiple from 6.68x to 11.3x for Conduent. Needless to say, with this mixed information, the current valuation is quite possibly unfounded. How can we move back and forth from financial to financial with a difference of ~$2 billion? At $15.00 per share, is the 11.3x multiple a justified valuation?
One logical step might be to look at Xerox's historical multiples using the same analytical lens. Using the parent's 2014, 2015, and 2016 financials (as reported in the 2015 10-K and 2016 Q4 press release), we are able to extrapolate EV/EBITDA multiples for XRX, shown in Table 4:
The price per share is drawn from the last trading day of each year, while the shares outstanding are sourced from the financial statements. Taking the average EV/EBITDA of XRX over the three years results in a value of 9.15x. Recall that Conduent operated under the umbrella of Xerox during the entire three years presented. That said, is there a reason to believe that Conduent, after the spinoff, deserves a valuation of 11.3x EV/EBITDA?
The December Investor Presentation
From slide 5 of the investor presentation, management highlighted $6.6 billion in revenues and $630 million in pro forma adjusted EBITDA, excluding the impact of the suffering Health Enterprises segment of the business, which resulted in a $116 million reduction in revenues and a pre-tax charge of $389 million in Q3 2015:
I will pair this information with slide 35, which shows the pro forma numbers for the last 12 months on the rightmost column:
The above slide puts Conduent's last 12 months revenue at $6,624 million, and EBITDA at $552 million (pre-tax income of -$137 million, plus $551 million D&A and $138 million in interest expense). Note that the presentation shows adjusted EBITDA at $630 million by adding back restructuring and other expenses. For our model, only D&A and interest charges were added back. The D&A and interest expense line items in the slide above are close to my 2016 estimates from Table 3, but I believe revenues will come in below the $6.6 billion reported on the presentation slides. In order to justify the decline in revenues, I will reference minute 22:30 of the conference call, where management guided to an approximate 3-5% revenue decline due to unprofitable Customer Care Services, Student Loans, and Health Enterprises. Below is the transcript of the CFO's commentary:
So, on slide 19, let's start with our historical results. As you can see, revenue has declined since 2014, and through Q3 year-to-date, revenue was down a little over 3%, and in the most recent quarter, revenue was down 5.4%. The 2016 decline is primarily driven by a few distinct factors. First, our Student Loan business is in run-off. Second, we have purposely exited some unprofitable contracts, primarily in customer care. We've also seen lower volumes from some of our clients and we've had no M&A investment in 2016 due to separation, which is atypical for our business.
And lastly, we have not signed enough new business to offset these other factors. However, as you heard from Ashok, we can overcome these issues and we have a clear plan to address them. On the positive side, I'll note that adjusted EBITDA and margins have stabilized in the past quarter as we've made progress in our strategic transformation program, which I will talk about a bit more later.
We've also provided more detail on a segment basis in the appendix, but I'll note here that the Healthcare and Public Sector margins have showed margin improvement year-to-date and our Commercial Industry segment started to stabilize, reflecting the benefits of our Strategic Transformation program.
Overall, the company's segment profit was up 7%, Q3 year-to-date compared to the prior period driving a 50- basis-point margin expansion. I'm encouraged that we're on the right track here. As you can see, we expect revenue to continue to decline in Q4 at a similar rate of decline, as we saw in Q3. A number of the factors I mentioned including exiting non-profitable contracts and the run-off of the Student Loan business will continue.
So, moving to slide 22, we'll talk about our financial performance outlook. Let's spend a minute and discuss the long-term prospects of the company in a bit more context. This should also help in how you're modeling the company and how the strategic initiatives will translate the top- and bottom-line growth.
First, I'll note that we expect revenue declines in 2017 to be similar to the declines we saw in 2016, as a result of the factors I mentioned earlier. However, we expect to stabilize in 2018 with growth potential later in the year. And by 2019, we expect to see adjusted growth - we expect to see revenue growth accelerating.
Adjusted EBITDA is expected to expand in both 2017 and 2018 by greater than 5% and 10% respectively. Beyond 2019, we expect continued growth in adjusted EBITDA, as we grow the business. We will be focused on reinvestment to create shareholder value. This will be reinvestment with enhanced focus to capture market growth opportunities by increasing the size of our sales force, investing in platforms and technology and looking at M&A, which will be somewhat limited in 2017, as we build our cash balance, but cash spend on M&A should increase to historical levels of around $200 million per year by 2018 and beyond.
(Source: Investor presentation transcript pp. 6-8)
Management is guiding Q4 revenues down to the tune of 3-5%. Assuming about $1,627 million in revenues per quarter, then a 3-5% revenue decline could result in a decrease of anywhere from $48 million to $81 million. Similarly, the decline is expected to continue in 2017. This should have a marked impact on share prices. From the tables above, we know that total costs and expenses are basically ~100% of revenues, if not worse. Therefore, any revenue decline will flow straight through to EBITDA. Compounded with no M&A investment in 2016, which is "atypical" for the business, there's just not going to be much revenue generation, and even less room for error.
Because the process is early on, and the spinoff is so recent, there is reason to believe that the accounting differences and prospective revenue declines are not factored into analysts' models - creating a hazardous mix of underperformance and uncertain information.
Here's where the EV/EBITDA multiple comes in: should Conduent report continued revenue declines and smaller margins, resulting in part from the Healthcare Enterprise and Student Loan segments, shares could trade down to a more conservative multiple of say, 9.15x (about what XRX traded at when Conduent was a part of the company). A multiple of 9.15x, assuming EBITDA of $552 million (as stated in slide 35 above), implies a share price of ~$15.30, right about where shares trade currently. I believe this price lies at the high-end of the EV/EBITDA model shown in Table 3, and requires revenues of $6,621 million, keeping costs and expenses steady at $6,764 million, D&A at $555 million, interest at $141 million, and all balance sheet items the same.
Suppose instead that we assume $6,509 million in 2016 revenues, about 1.5% lower than the $6,600 million management referred to both in the investor presentation and the pro forma Form 10. Then consequently, using the $440 million in EBITDA forecasted by the model (again, see Table 3), share prices would need to fall to $10.30 in order to match a 9.15x EV/EBITDA multiple. Any further revenue declines in the vicinity of 3-5% annually would result in a much sharper decline in share price. To demonstrate, Table 5 below represents the same model used in Table 3, but shows a matrix of various share prices for EV/EBITDA multiples of 8.0x, 9.0x, 10.0x, and 11.0x, combined with possible revenue declines anywhere between 0% and 5%. The table implies that any downward trend in revenues results in significant share price depreciation:
I will interject one more quote from management, which occurred in the Q&A session of the investor presentation, when an analyst pressed for more information regarding revenue outlook and the prospect of no revenue growth until the second half of 2018. Below is CFO Brian Walsh's commentary:
I would just add that if you look at the revenue decline this year, about half of it would be what I would consider self-inflicted. So, decisions around the Other segment to deemphasize, were to let it run off, and then contract exits. And then the other half would be not enough new business signings to offset the pressures.
Looking at M&A, typically we spend a couple of hundred million on average in M&A a year, which gives 1 point to 3 points of uplift on the revenue growth rate. We haven't done any M&A this year because of separation. And we think it's going to be relatively small next year just because we need to generate free cash flow to afford it.
And then the organic investments, which come from the transformation program and need to be funded by the transformation program. But investing in the sales force, modernizing our offerings that will take time to make the investment because, we have to be able to afford it, and then it will take some time to pay back. But the good news is, we operate in an industry that's growing 6%. So, there is the opportunity. We have a plan to capture it.
The other thing that's important to note is on margins. Our third quarter year-to-date margin is 9.4% adjusted EBITDA margin. Our competitors run north of 15%. So, we have a lot of headroom on both revenue and margin to drive improvements, and we have the plans to do that (pp. 13 of the transcript)
While management remains optimistic in the long term, over the short term, there are more headwinds from the revenue side, M&A side (or lack thereof), and margin side, which outweigh the positives of the overall business processes industry. In addition, the company employs about 94,000 employees in more than 40 countries, and 50% of the labor force is outside the United States. Given the oncoming protectionist economic policies for the United States, the question is whether that will that have an effect on international companies like Conduent that have so many employees internationally?
Revenue Counterpoint. Indeed, with the business processes industry growing at 6% annually, there are opportunities for growth. But given that management does not expect revenue growth until 2018, this risk is mitigated and a share price decline will likely happen in the short term. Because of the multiple differences in the financials presented by Xerox and Conduent, there is reason to believe that revenue declines are not baked into the current stock price.
Management Counterpoint. CEO Ashok Vemuri, although very new to the company, has a commendable history when it comes to returning value to shareholders. Mr. Vemuri previously served as the CEO at iGATE, and sold the company to Capgemini for $4 billion in 2015. While a Conduent sale would be disastrous to a short position, currently, the priority of management is to orchestrate a transition that will take about 12-24 months. Nevertheless, Mr. Vemuri is highly capable, and solid management execution can make any stock price rise.
Valuation Counterpoint. While the EV/EBITDA multiple demonstrates that CNDT is overvalued relative to XRX and past practice, from the perspective of a Price/Sales ratio, CNDT trades at 0.4x P/S. Morningstar reports an industry average of 2.1x. Although there may not be many comparable BPO companies on the Morningstar list of Cyclical peers, the low price/sales ratio implies there is room for share price appreciation.
Analyst Coverage Point-Counterpoint. Yahoo Finance reports three analyst estimates for 2016 Q4 revenue and earnings, with average estimates at $1.64 billion in revenues and $0.25 per share in earnings. While the revenue estimates are not far outside my own estimates, the earnings will almost certainly be negative in upcoming quarterly reports. On a similar note, because so few analysts have coverage on the company, there is reason to believe that there could be a wide miss when CNDT reports.
Disclosure: I am/we are short CNDT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.