Unisys: Q4 Slight Miss, Pressing A Reset Button In 2020

Summary

• Q4 figures are below our and market expectations as Service segment is softer than expected.
• 2020 is a transition year which is reflected in mild guidance - on par with our expectations.
• 2021 is expected to be a strong year with high single-digit growth and improving profitability.
• Softer results and overall stock market sell-off drag the stock price down, presenting a good buying opportunity.

Unisys (NYSE:UIS) has released its Q4 financial figures on February 25. The results slightly missed our and market expectations; however, with no major surprises.

Following the results, the stock plummeted - 5.4% while subsequently closing at -3.8% and in line with the major indices (NASDAQ -3.6%; NYSE - 3.1%) as the market was suffering from increasing pressures of COVID-19. Given the similar magnitude of the stock and the market decline, we believe it's fair to assume a muted stock reaction explained by the release of financial figures.

Overall, in the conference call, the management sounded rather conservative pointing out that 2019 was an abnormal strong year for Unisys with 2020 being softer. Sales growth should be rather flattish (midpoint) which is in line with our expectations and beating the market consensus, which expected a -4% decline. The management expects a mild margin decline, we reckon explained by the sale of the US business, which operates at above group-average margin levels, while core business ("Enterprise") margins should stay roughly flat.

As mentioned in our last article, we see 2020 as a transition year and working toward increasing backlog levels, which saw a considerable decline in 2019 to $4.3b (-10% y/y). Overall, we continue to see Unisys as an attractive buying opportunity backed by new customer wins, improving operating metrics and solid growth prospects, as the sale of US Fed business frees up financial resources.

In the conference call, the management explicitly mentioned no material impact from COVID -19 outbreak with revenue share in China accounting for less than 5% and no expansion expected.

The company will host Investors Day on April 29, where it presents a new strategy, financial performance and financial implications of US Fed business sale.

Chart 1: Sharp stock increase following the sale announcement

Data by YCharts

Q4 sales miss on softer Services growth

Missing our expectations, Unisys saw its Q4 sales declining by -2% (non-GAAP) as growth in the Services segment wasn't as pronounced, +1.9%, as expected +5.2%. On par with our expectations, the Technology segment was the main growth spoiler, posting a sharp decline of -19.9% (non-GAAP) and slightly ahead of our -21.9% estimate.

Overall, 2019 was an extraordinarily strong year for Unisys with 6.1% (non-GAAP) sales growth backed by strong +26.5% growth in the US Fed business and Public sector +7.3%, while other segments (e.g., commercial and financials) were rather sluggish.

For 2020, the management guides for -2% to +2% growth (excl. US Fed business) with flat growth at the mid-point. This is in line with our expectations, as we believe the company's main focus in 2020 is growing order backlog in its core Enterprise segment and participating in larger deals, with the newly unleashed financial freedom, following US Fed business sale.

In the conference call, the management highlighted softer growth dynamics in H1'20 given tough comparables and renewals schedule in the Technology portfolio tilted towards the end of the year.

Chart 2 Steeper Q4 growth decline amid softer Service salesSource: Image created by the author with data from Unisys

Sales miss in the Service segment

Sales growth of +1.9% wasn't as pronounced as originally expected +5.2%, explained by the mild decline in Application Services, -2.8%, and Business Process Outsourcing surprising us with a very steep decline of -10% vs. expected +8%. On the positive side, Cloud and Infrastructure solutions, which account for more than 60% of the segment's revenue, surprised us with +15% growth vs. expected +6.3%.

Overall, 2019 was a strong year for Service business with +6.7% growth - way ahead of last year's +2.8%, as Unisys was working through its large order backlog, in particular in the US Fed segment.

The company didn't provide any sales guidance on a segment basis. However, in the conference call, we have learned that JV (check usage business with iPSL; 51% share), which accounted for c. 6% or $145m in 2019 of the segment's revenue, is expected to decline to $105m in 2020 (with continued modest declines during contract duration until 2023) and burdening the overall revenue growth. However, we believe continued solid growth in InteliServe and CloudForte products will offset the negative JV impact with flat pro-forma revenue growth in 2020. Overall, we see the management's main focus on building up the order backlog, which saw a considerable decline to $4.3b or -10% y/y (incl. US Fed business) at the end of 2019. Including $200m in two delayed large projects, which the company closed in Q1'20, order backlog would be at $4.5b and in line with its expectations.

Chart 3 Cloud & Infrastructure saves the growth in Q4; however, not enough to offset the decline in other products

Source: Image created by the author with data from Unisys

Technology is slightly better; however, still in rapid decline amid tough comparables

Q4 sales dynamics were weak as expected with sales declining sharply by -19.9% vs. expected -21.9%. This steep sales drop was largely anticipated by us and the market, given that 2018 revenue was back-end loaded whereas 2019 was spread over the course of the year. This slightly better sales figure, translated into +2.7% overall growth for the full year vs. expected 2%.

Amid light renewal schedule of ClearPath Forward business and being partially offset by continued strong Stealth growth, albeit still low sales contribution, the management expects "technology revenue to be down high-single-digit percentage year-over-year" while subsequently rebounding in 2021 with a large license renewal schedule which will more than offset the robust 2020 sales decline. We adjust our estimates accordingly to reflect the expected growth dynamics. Overall, we expect to see +3.6% over the cycle growth driven by cross-selling activities with the Service segment as well as new products attracting new customers and renewals, which are highly predictable by the management.

Chart 4 Q4 was competing with strong comparables

Source: Image created by the author with data from Unisys

Flat margin amid unfavorable product mix

Profitability development in Q4 was disappointing for us with non-GAAP operating margin residing at 8.6% - below our and market estimates of 9.5% and 9.35%, respectively. The management mentioned unfavorable product mix in the Technology segment, with a higher share of third-party hardware sales. For the full year, the disparity between actual and expected margin wasn't as steep with non-GAAP operating margin at 9% vs. expected 9.2%.

As the company mentioned in its last conference call (no transcript available), convertible note exchange, restructuring costs, and fx impact, among others resulted in a negative (basic) EPS of -$0.31 vs. $1.48 last year, which we reckon were not included in the consensus figures.

The group's newly published guidance reads a non-GAAP operating margin of between 7.7% and 8.7% with a mid-point at 8.2% indicating a decline of 80bps compared to last year. However, the guidance excludes US Fed business profitability, and management didn't provide any insight into margins of its core Enterprise business to track the performance. Based on the known information, that US Fed business was already operating at its maximum margin levels and 2020 EV/EBITDA (adj.) valuation multiple of 10.5x, which SAIC paid, we calculate the margin of the US Fed business should be roughly between 11% and 13% and ahead of the group's average margin of 9%. This, in turn, suggests, that the 2020 Enterprise margin is flattish. In the conference call, the management mentioned an expected margin boost of between 75bps and 100bps in 2021, following the savings realization of c. $60m from the sale of US Fed business implying reverting to its pre-sale margin levels of up to 9.7%.

Conclusion

Overall, 2019 was the strongest year for Unisys, mainly driven by double-digit growth in the US Fed business and public sectors. Margin decline was anticipated and explained by unfavorable product mix in the Technology segment as well as transition costs. 2020 should be a transition year with the main focus in H1'20 the finalization of US Fed business sale; debt repayment, further investments in more efficient cost structures (i.e., automation, exit from low profitability countries) and service backlog expansion. In 2021, we expect to see solid high single-digit growth and moderate margin improvement with a subsequent multiples expansion (2020 EV/Sales 0.31; EV/EBIT 2.7x). We see H1'20 providing good buying opportunities.

Analyst’s 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.