Context of the article
Conduent Incorporated (NASDAQ:CNDT) is one of the small-cap turnaround stories that I've been deconstructing and writing about over the last 7 months; in my most recent article at the start of the year, when the stock was trading around the $4.5-$4.8 levels, I'd suggested that conservative investors could consider holding out till the $7 levels.
We've now exceeded that initial target zone, and at a time when both the Nasdaq Composite (^IXIC), and members of the small-cap IT space (PSCT) have only managed to deliver either negative returns, or mid-single-digit returns, CNDT has managed to trounce the competition, delivering returns of around 50%.
Source: Yahoo Finance
Considering the closure of the first target, and also the announcement of the company's recent Q1 results last week, it felt appropriate to review some of the goings-on at CNDT and try and get a sense of the outlook ahead. Here are some of the noteworthy developments since my last report.
Sequential progress across all three segments and Q2 may prove to be a sweet spot
Overall group revenue growth still continued to decline, coming in -2.2% lower on an annual basis in Q1-21 (mainly driven by the ongoing loss of business from legacy contracts in prior years before the new management took over), but it is a credit to the CNDT management that despite these difficult topline headwinds, they've managed to keep costs under control and engender additional efficiency through their shared services center.
It also helps that the high-margin government segment continues to flourish thereby aiding overall group margins. All in all, despite the annual revenue attrition, Q1 adjusted group EBITDA actually grew by 20% on an annual basis with margins gaining 210bps, and coming in at 11.2%.
Source: Prepared by the writer using data from CNDT's presentation
As you can see from the chart, it's also worth noting that revenue trends are actually improving on a sequential basis across all of CNDT's three divisions, and it looks like Q2 could prove to be something of a goldilocks scenario. Firstly, comps will be particularly weak in both CNDT's largest segment - Commercial (-12.2% in Q2-20) - and its smallest segment - Transportation (-14.9% in Q2-20). Management also mentioned that the negative COVID-19 impacts related to these two segments were dimming and they were also seeing a ramp-up in new business. For instance, in the commercial healthcare payer administration space, they've recently won a couple of deals and also have four other big implementations underway (Source: Q1 call).
In addition to that also don't underestimate the positive impact of a pickup in interest rates for CNDT's BenefitWallet offering (that appears under the commercial segment); for the uninitiated, BenefitWallet is part of CNDT's Health Savings Account (HSA) offerings whereby the company generates interest-related revenue from balance fees maintained with depository banks who hold cash deposited in various savings accounts. As of FY20, CNDT was managing around 1m active HSAs with an AUM of around $2.7bn (Source: 10K).
Then also note that we could see yet another strong quarter from the government segment on account of the COVID-19 volumes tied to the payment business before things start to ebb by the end of Q3.
Considering all this, I feel CNDT could surprise in Q2 although management was more conservative stating that revenues in Q2 would only be flat to slightly up, with EBITDA margins around 11% (which would also be in line with Q1).
New business wins dominated by the commercial segment
In my previous report, I did wonder how things would be beyond Q3 when the positive COVID-19 volume tied to the government segment would begin to fade. There's little doubt that some of the recent buoyancy in EBITDA margins may fade on account of this (the government segment margins are above group margins) but I also wanted to see some evidence of future strength in CNDT's commercial segment.
This is their largest segment (51% of Q1 revenue) and it's also the segment where they've tried to significantly revamp legacy systems and spend a lot of CAPEX to become more competitive with other peers that are seemingly ahead of the curve and who generally have better margin profiles. It looks as though there are some promising signs here.
Source: Q1 Presentation
It looks as though CNDT can still attract a sizeable chunk of new commercial clients; in Q1-21, the company saw new business TCV (Total contract revenue related to signed contracts) signings worth $356m; out of that, 62% came from the commercial segment alone. Management mentioned that these signings were across the board including customer engagement and healthcare. Potentially, with new sales leadership in the commercial health segment (more on that later) the growth prospects here do look encouraging.
TCV signings run rate slows, especially on renewals, and the average contract length declines
Whilst things in the commercial segment are looking up, what was disappointing to note is that the overall pace of new contract wins looks to be declining; if you look at the run rate of TCV signings (this is the estimated total future revenue from contracts signed during the year which include both new projects as well as expansion with existing clients) one can see that it peaked in Q2-20 at more than $1535m (conversely one could also maybe argue that Q2 level was off-the-charts and not sustainable) and since then there's been a sequential decline over the next three quarters. In Q3 and Q4-20 those numbers were still impressive at around $1200m on average per quarter, but in Q1-21 this pace has dropped quite significantly to only $629m.
Source: Q1 Presentation
Within this, the drop-off in the trend of renewal contracts (contracts with recurring services to existing clients) is particularly concerning, as this was one of the impressive facets of CNDT's results for much of 2020, and essentially reflected existing clients' confidence in the company's service offerings. In Q1-21 this came in only at $273m, significantly lower both on a sequential basis (Q4-20: $637m) and an annual basis (Q1-20: $515m).
Unfortunately, none of the analysts on the earnings call asked the CNDT management why this had happened, but as per the latest 10-Q report they only state that "there were fewer renewal opportunities in the quarter". No other clarification has been provided.
Now renewals are a hard business, and it is quite possible that as the economic environment is still not sufficiently resilient, companies may not be willing to pay high prices, and perhaps other competitors were able to offer more favorable pricing than CNDT, and maybe CNDT just decided not to compete at a certain price point. If this is the reality then I'd be okay with it, but if the lack of renewals isn't down to pricing and perhaps service quality, then this is quite disconcerting. I don't want to jump the gun on anything as yet until one has further clarity, but this is certainly something to be monitored and I'll wait to see how this develops in Q2-21.
Source: Q1 Presentation
The other distinctive aspect of the new wins was that the contract length seems to be much shorter (only around 2.4 years vs around 4-5 years for the last 4 quarters). This doesn't necessarily have to be a problem and could just be a function of the type of contracts CNDT is competing for; also, potentially if you expect the economic environment to improve and consequently client confidence to pick up, ideally you don't want to tie yourself down to long-tenured, low-priced contracts, and would rather have the opportunity to renew at more favorable terms, as frequently as possible. Let's see if this is a trend that will be kept up in the coming quarters.
Smooth CFO transition is welcome, and potentially new sales leadership for CNDT's commercial health business could transform the business
Alongside the Q1 results, CNDT also announced that their long-standing CFO - Brian Webb-Walsh - would be stepping down to pursue other opportunities (he will continue to be around until June 11th, 2021, to facilitate the transition). He's been at CNDT for over 24 years and served as CFO of not just CNDT (since 2016), but also as Xerox Services before CNDT's spin-off. Usually, when a long-standing C-suite member stands down, there's the risk of seeing some negative repercussions, but I believe in CNDT's case this has been/will be well-managed.
Firstly, Webb-Walsh's replacement - Stephen Wood - has a significant history with CNDT's current CEO - Clifford Skelton; the duo had previously worked together at Fiserv Inc (FISV) where Wood served in many finance and accounting leadership positions before finishing off as CFO of Fiserv Output Solutions until May 2020. So that certainly helps.
Secondly, even though CNDT claims that Webb-Walsh put in his papers only last week, I'd like to believe that this is something that had been brewing for a while now and they've taken good care to ensure sound succession planning; admittedly, this is pure speculation on my part but the reason I say this is because Stephen Wood was brought in to CNDT back in August-2020 itself and has been serving - first - as CNDT's Corporate Controller, and then later on as Principal Accounting Officer since Dec-20. All this suggests that he was being groomed for the big role.
In addition to the CFO change, the CNDT management also mentioned that they would be announcing a new leader for their commercial healthcare segment; the person is supposedly an external hire and someone who has good experience in leading sales verticals at some of CNDT's commercial health peers.
At the moment whilst CNDT has built good traction for its automation and digitization offerings for health claims and processing, it looks as though some of its BPO/BPS and customer experience management (CXM) service offerings are somewhat under deployed; a focused sales head with a proven track record could certainly help address this.
Closing thoughts
CNDT management sounded optimistic about the company's turnaround plan and are looking to pivot to growth mode possibly in H2-21. They're backing up their optimism by purchasing shares. Looking at the insider data one can see that after a gap of 8 months, some notable insiders including the CEO have started purchasing CNDT shares this year. So there's certainly an element of walking the talk.
Source: GuruFocus
Besides more investors are also noticing CNDT and are willing to pay a higher multiple than before. Since my previous article, there's been an upgrade in CNDT's FY21 EBITDA consensus expectations by 2.5% from $453m to $464m, whilst there's been an 11% expansion in the forward EV/EBITDA multiple to 6.1x. With regards to the target price, I'd previously set a target price of $10 based on a forward EV/EBITDA multiple of 7.5x (still lower than the peak 5-year average multiple of 8.5x seen in Feb 2019) as well as a technical resistance.
Source: Prepared by the writer using data from YCharts
Now, based on the Q1 results, I don't see any significant reason to upgrade or downgrade this multiple, but despite an improvement in consensus EBITDA by 2.5%, the overall target price has come down to around $9.2 because of two key reasons; one, the net debt (debt + preferred stock - cash) has gone up from $1,298m to $1,513m, and two, the weighted average share count has gone up from 209.2 to 212.25.
These are the two main reasons for the decline in the target price. Also, perhaps some caution is warranted because of the decline in the pace of renewals and a lack of clarity as to why this is so. Ultimately it may prove to be nothing serious but it is something to be monitored.
Going forward, we may potentially see the net debt figure go up some more as the company is looking to ramp up its CAPEX investments. In Q1 they did about $30m of CAPEX or 2.9% of revenue, but as per the FY21 guidance, they are looking to do around $170m for the year, which works out to more than 4% of the mid-point of their FY guidance of $4,050m-$4,150m (source: Q1 presentation).
Source: Trading View
On the charts, things still continue to move healthily, and the technical target of $10 still holds. The stock is witnessing strong bullish momentum and on the daily charts, it has been taking support around the 50DMA (bounced off the 50DMA 4 times since October 2020; notice the 4 blue ellipses).
Source: Trading View
On the weekly charts, the broad movement hasn't been particularly volatile nor has it been relentlessly exploding in one direction. Rather what we've seen over the past few months is one large move followed by some healthy base-forming, followed by yet another big move. This type of movement lends greater support to the broad uptrend which has been in place since August 2020.
In early March, we saw the stock hit my conservative target of $7 and since then it had been building a base until last week when it took off again in the shape of a large green candle. To sum up, my long thesis on CNDT still holds. Based on your risk appetite, one can start winding down your positions from anywhere between $9.2 and $10.