Diebold Nixdorf's Turnaround Is Gathering Pace

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About: Diebold Nixdorf, Incorporated (DBD)
by: Shareholders Unite
Summary

The bulls are firmly in charge at Diebold Nixdorf, betting that their DB Now cost-cutting efforts can produce positive cash flow.

If so, that would set in motion a self-reinforcing loop where deleveraging drives further cash flow improvements.

We're not there yet, but the prospects have significantly improved from half a year ago, and company executives are fully on board with considerable insider purchases.

Investors have had lots to cheer about with Diebold Nixdorf (DBD), and depending on the timing, they sit on wins that could be multiples:

The company embarked on a cost-cutting exercise under the name of DN Now initiative which is expected to realize $400M of gross savings through the year 2021.

These are going well, which has been cheered by investors, but you also see that the Q1 results were not so well received and the shares gave back some of the spectacular gains since December last year.

First, as usual, we start with a longer-term perspective:

Chart Data by YCharts

This makes it instantly clear that there is still significant operational work to be done, but that's what the DN Now initiative is actually targeting.

DN Now

A little overview, from the earnings deck:

Where do we stand? Here are the main measures and results:

  • Roughly 1,400 employees have been let go through March 31 with exit dates known for 95% of the remaining 300 employees. This should cut cost by $100M this year and $130M next year.
  • With respect to the simplification of their ATM product portfolio and manufacturing footprint, the company has relocated the production of certain ATM products to lower cost facilities.
  • Net working capital was reduced from 24% of revenue in Q1 2018 to 19.1% in Q1 2019, a pretty impressive improvement.
  • The company closed several unprofitable businesses (one not surprisingly in Venezuela, another in Europe) and divested their program management IT consulting business in Europe, as well as their Dutch cash-in-transit business. They received $10M for these in Q1 and the plan is to divest around 5% of revenues.
  • There are office closures as well as other cost SG&A cutting measures (see slide directly below). The proceeds (expected to be $20M annualized) are used to reduce debt.

With respect to service modernization, management noted the steps that have been taken (Q1CC):

"Our key actions include automating incident reporting and response, standardizing our contract terms and other processes, which enable the company to realize scale benefits, and upgrading older customer hardware and software, which typically generates higher volume service calls. On the prior earnings call, we introduced three key performance metrics to help track our progress."

These metrics are:

  • The trailing 12-month service renewal rate
  • The contract base of ATMs
  • Gross service margins

These delivered improvements, from the earnings deck:

Overall, management is confident in achieving gross savings of $160M in 2019.

Q1 Results

The market greeted the Q1 results with a considerable selloff on the revenue and substantial earnings miss, but there are also positives (the 54% improvement in operating profit comes to mind).

From the earnings deck:

The company suffered from a fairly massive 6.5% currency headwind, producing a $66M hit to revenues in the quarter due to the rising dollar against the Brazilian real, the euro and the British pound.

In constant currency, product revenue increased by 15%, driven mostly by a 52% rise in the Americas Banking segment due to upgrades to Windows 10.

Service revenue declined by 3% as management focused on more profitable contracts. While forex headwinds dented revenues significantly, the effect on operating profit is much smaller, just $4M in the quarter. Operating profit increased substantially (54%) to $27M y/y.

Guidance

Guidance has been unchanged from the Q4CC:

Management expects profitability to increase during the year as the DB Now initiative gains traction. If they could leave the year generating free cash flow, this would give a boost to the required refinancing needs in 2020.

Margins

Chart Data by YCharts

The DN Now initiative is starting to pay off with a recovery in margins. Gross margins of both products and services rose, and operating profits increased from $20M last year to $34M in Q1.

But operating profits were negatively impacted by 120 bps ($13M) of one-off factors listed below (from the earnings deck):

SG&A was declining as a percentage of revenue, but that progress stalled in Q1 (at 17.7% it was unchanged from a year ago) to one-off factors (Q1CC):

"...include normalized compensation expenses, unfavorable mark-to-market entries resulting from legacy Wincor options, which are linked to the Diebold Nixdorf share price and other benefits in the first quarter of 2018, which did not recur. Collectively, these factors accounted for about $13 million or 120 basis points of headwinds versus the prior year."

Cash

Working capital has been on the decline, but free cash flow took a hit in the quarter:

Management does guide free cash flow at break-even for the year, which would be a significant turnaround:

Chart Data by YCharts

The improvement of cash flow is supposed to come from (Q1CC):

"Net working capital cash flow of approximately $100 million; net interest expense of approximately $190 million; restructuring payments of approximately $130 million; and approximately $80 million of capital expenditures, $60 million of cash taxes, and $40 million of other cash uses."

The company does have a substantial amount of debt ($1.8B):

There are big maturities coming due in 2020, but management doesn't see significant or immediate opportunities to refinance cheaper. Creating these opportunities will have to come from improving EBITDA and free cash flow.

This is not something you see every day, from Finviz:

Usually we see a sea of red in these tables, so executives are voting with their wallet which should give the investor considerable confidence in the company.

Valuation

Chart Data by YCharts

Obviously on a sales basis, the shares are still fairly cheap, even for the type of business it is. More interesting is perhaps that we're still at the historical low end of that valuation metric, despite the dramatic rise in the share price this year.

This year's earnings are going to be break-even (EPS of -$0.01), but analyst are much more positive on next year's earnings which they estimate at $0.95. That would make the shares fairly cheap.

Discussion and conclusion

We agree with the reasoning, but not the conclusion of fellow SA contributor Olsny Freitas, who argued that the DB Now initiative was "grossly insufficient" for achieving a meaningful turnaround and depended crucially on working capital improvements.

Of course, since he wrote his article, management has identified at least $150M in additional savings so they have turbo-charged DB Now and things no longer look as bleak. Working capital improvements were pretty substantial (Q1CC):

"...we continue to aggressively manage our net working capital investment and we reduced this metric as a percentage of trailing 12-month sales from 24% in the year-ago period to 19.1% in the first quarter of 2019. Our progress is due to better collections, improved payment processes, and inventory management.

In fact, our first-quarter collections represent the best start to the year since the combination. Our working capital improvement was a key reason why the company was able to reduce its free cash flow use in the quarter by $91 million versus the prior year period."

Where we agree is that cash flow is crucial, as the asset sales haven't made much difference in terms of yielding significant cash to pay off debt. That is, without positive cash flow there is no chance of deleveraging.

On a 12-month rolling basis, cash flow is still negative, but DB Now is going to gain traction during the second half and the currency headwinds aren't likely to continue, at least not to the same amount.

Management argues free cash flow will be break-even this year and it looks like they will have a shot at that. If they manage that, this means that cash flow will turn positive by the end of the year (given that it's still negative now), and if they can maintain that momentum, it will greatly help with the refinancing of the debt next year.

With respect to this, it is encouraging that investors, as well as management, are voting with their wallets, given the dramatic price increases in the shares and the insider buys.

In the above scenario, there is the perspective that they can refinance at reasonable rates, rather than the much higher rates their senior notes were trading when Olsny Freitas was writing his article (December last year).

If they can manage this, the shares are also likely to be a good buy still, so we'll keep a keen eye on the cash flow development. The DB Now initiative should proceed more or less as planned as these are under management control.

We're not immediate buyers of the shares here, much of the easy money has been gained already and the road to positive cash flow is not a given, even if we expect it to arrive.

But if it becomes clear they will achieve positive cash flow, there is still significant upside in the shares as a self-reinforcing loop will kick in where deleveraging drives further cash flow improvements.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.