What To Do After DXC Technology Falls By More Than 30%

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About: DXC Technology Company (DXC)
by: Chris Lau
Summary

DXC stock fell hard after the company lowered its full-year guidance.

The pace of cost-cutting did not match the rate of revenue decline.

Valuations now align with lowered expectations ahead.

The post-earnings performance in shares of DXC Technology (DXC) is nothing short of unexpected. DXC fell by one-third and to all-time lows when it cut its full-year guidance. The single-digit P/E and dividend yield of 2.5% is not a selling point for value investors. Should shareholders continue holding DXC? For DIY value investors who waited for a better entry point, is now the time to buy?

DXC reported first-quarter non-GAAP earnings of $1.74 despite revenue falling 7.4% to $4.89 billion. Delays in a few deals sent the book-to-bill ratio to 0.9 times. Digital revenue came in even stronger, growing 35% Y/Y and lifting the book-to-bill to 3 times. Management is confident that the Luxoft acquisition will strengthen its digital offerings. It strengthened its relationship with Microsoft (MSFT) through a joint Microsoft Azure digital transformation practice together with DXC. A partnership with Alphabet's (GOOG) Google Cloud will further broaden the pair's digital solution offerings.

DXC Technology (NYSE:<a href='https://seekingalpha.com/symbol/DXC' title='DXC Technology Company'>DXC</a>)

These partnership developments failed to impress investors and run contrary to DXC's lowered outlook. The company now forecasts revenue in the range of $20.2-20.7 billion, below the previous $20.7-21.2 billion. EPS will be $7.00-7.75, sharply lower than the previous guidance of $7.75-8.50. Growth of its cloud infrastructure, up 36% Y/Y, may not be enough to offset the slowing traditional infrastructure business. DXC blamed high client workload costs from legacy environments hurting the outlook. Such stranded costs are taking longer to work through than DXC previously expected.

Staff automation initiatives are also taking longer to implement. The Bionix automation program, which reduces headcount. To get a better view on what is pulling DXC's quarter lower, look at the non-GAAP to GAAP reconciliation in the first quarter:

Source: DXC Technology

Restructuring and transaction, separation, and integration-related costs hurt earnings and may continue to do so for the rest of the year. Investors, who saved a-third of its market cap following the earnings report, lost patience. With the growth momentum behind it and near-term integration headwinds ahead, holding DXC stock is riskier than ever.

Value investors who waited for the discount may look at DXC differently. At its new discounted price, the stock more reasonably reflects the risks ahead.

Headwinds

DXC touted a number of partnerships with fast-growing firms like Salesforce (CRM), ServiceNow (NOW), and SAP (SAP). Yet, these connections are not helping the share price. DXC must prove that the book-to-bill ratio will rise. It must also demonstrate that Luxoft, along with the 13,000-person workforce, will bring in digital strategy and engineering services orders from customers. DXC forecast Luxoft bringing in $700 million in revenue during the last three quarters of the fiscal year.

Delays in the headcount reduction during the Q1 period is troubling. Although DXC cut 3,900 staff in the quarter, those who are still working at the company will not have the drive to work efficiently and productively. Exiting the high-cost and complex countries will take longer than thought, hurting near-term results. Although the $250 million to $300 million cost savings is below the original target of $400 million, DXC will eventually get there. Reducing the middle management layers is expected:

We have additional opportunities to extract greater efficiencies from our middle-management layers, including the number of managers as well as their location mix. In [the] supply chain, we're in the process of renegotiating several large software contracts as well as driving additional vendor consolidation to achieve incremental savings.

Source: SA Transcript

DXC's share buyback worth $400 million now looks ill-timed. Still, with $1.9 billion in cash and cash equivalents on hand, the company is positioned to opportunistically buy back shares. This might set a bottom in the $33-35 range.

Opportunity

DXC realized the pace of the infrastructure cost reductions did not keep up with the impact of the move to the cloud. And because it has an impact on volume metrics, the infrastructure business will lag. Cost cuts over the next three quarters should meet management targets. DXC's revenue drop took $0.25 out of the EPS guidance cut of $0.75. And once costs are aligned, the $0.50 in EPS will return in the future.

You Takeaway

Progress in the cost-cuts should stabilize the DXC share price, though analysts may downgrade the stock after the fact. Expect the re-acceleration of revenue growth taking longer. Investors willing to hold the stock for at least two to three years may get rewarded as the Luxoft acquisition pays off.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DXC over 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.