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Gina Zhang
Gina Zhang
Articles (30)  | Author's Website |

Back to the Future

Conduent has at least 50%-plus upside

Conduent (NYSE:CNDT) spun off from Xerox (NYSE:XRX) on Jan. 3. It was the business process outsourcing (BPO) business within the services segment of Xerox. It has $6.6 billion revenue, $630 million EBITDA and 94,000 employees in a market growing at 5% to 6% a year. According to Xerox, its BPO business, or Conduent, has No. 2 market share. This is confirmed by the leading IT research and advisory firm Gartner Inc.

Source: company presentation

Conduent has three business segments: commercial, health care and public sector. Note that about 10% of revenue is from government health care but categorized in the health care segment rather than the public sector segment. Therefore, in total, a bit over one-third of revenue is from the public sector. The public sector has the highest operating margin of 12%. The commercial segment has a low operating margin of 2%. Health care has an operating margin of 9%. By geography, Conduent has three-quarters of its revenue from the U.S.

Source: company presentation

Conduent is largely what was Affiliate Computer Services (ACS). Xerox bought ACS in 2010 for $6.4 billion or 33.6% premium over the market price of ACS at the time, assuming $2 billion debt. ACS was then combined with Xerox’s own $900 million BPO business. In 2015, Xerox sold the original ACS ITO business, which had $1.3 billion revenue in 2014 and $74 million earnings, for $930 million net of cash. ACS was founded in 1988.

Source: company filings

Carl Icahn (Trades, Portfolio) owns about 10% of Conduent due to owning about 10% of Xerox before spinoff. Icahn bought Xerox shares from fourth-quarter 2015 and pushed for the spinoff, which was announced in first-quarter 2016.

Why buy

As an independent entity with a new management, Conduent could restore its margins.

As we mentioned before, Conduent is largely the BPO business of ACS. Conduent has materially deteriorated since 2009.

Revenue growth stalled from 2013.

Source: company presentation

The margin came down, especially since 2014. Cash flow deteriorated even further. From ACS to pro forma Conduent, the workforce was 27% more with about the same amount of revenue and one-third less EBITDA. No wonder the market cap of Conduent was just a bit over half of what ACS was prior to the Xerox acquisition.

Source: company filings

Compared to its BPO peers, Conduent appears miserable in terms of profitability.

Management has identified $700 cost saving opportunities as below. If it could achieve half of that, the EBITDA could be in line with ACS’ in 2009.

Source: company presentation

The current CEO has opportunities to turn around operations and could seek a deal after fixing the margin problem. The current CEO of Conduent is Ashok Vemuri. He started his career as an investment banker at Deutsche Bank (NYSE:DB) and Bank of America (NYSE:BAC) before joining Infosys in 1999. He worked at Infosys (NYSE:INFY) for 14 years, mentored by the co-founder and former CEO Narayana Murthy, and was speculated by the press that he could be the next CEO. But he joined IT firm iGATE (FRA:MS4) in 2013. In 2015, he sold iGATE to Capgemini (XPAR:CAP) for $4 billion. He made $19 million from sales of iGATE stocks as a result.

From the financials of iGATE, we cannot tell how well iGATE has turned around operationally under Vemuri’s leadership. Although revenue and adjusted earnings were up from 2013 to 2015, the time period was just too short to make a confident judgment. Stock price did very well though. Note that Vemuri was appointed iGATE CEO on Sept. 16, 2015, when iGATE stock traded at $28. iGATE sold at about $48 in April 2015. Vemuri’s banking background and 14 years experience with Infosys should give him the edge on creating shareholder value through either operational turnaround or M&A.

Risks

Conduent has a large percentage of revenue coming from federal, state and local governments including Medicare and Medicaid. These are also contracts with higher margins. We don’t know where these programs would go with the Trump administration. But on the positive note, there would be more revenue opportunities for the same reason.

Turnaround takes time. The length for a commercial contract is three years and for government contracts is five years. Getting rid of unprofitable contracts takes time.

Conduent has relatively high leverage with $2 billion debt, which is not very different from what ACS had, but EBITDA is much smaller. Net debt/EBITDA is about 3x, but debt is due the earliest in 2021. We believe that the EBITDA is depressed. The balance sheet would get fixed when operations are turned around. The CEO has strengths in banking and broad experiences and connections gained from Infosys.

Valuation: Target price is $22

Currently, Conduent has an EV/EBITDA of 7.3x and a forward price-earnings (P/E) of 19x. Both are reasonable multiples on what we believe are depressed earnings.

In addition, cash earnings could be higher than net income. Due to the large difference between depreciation and amortization of $600 million and small cap ex of $200 million, the free cash flow should be much larger than net income. To put it in perspective, the difference of $400 million is $1.3 per share after tax compared to 2017 EPS estimate of 74 cents. Therefore, on the cash basis, current P/E could be more like 7x, everything else being equal. No other peer has the same large difference in D&A and cap ex.

If Conduent could largely restore ACS’ profitability, the company deserves to be $6.5 billion enterprise value ($4.8 billion market cap prior to Xerox acquisition plus $1.7 billion net debt), because the businesses are about the same. This translates to $4.6 billion market cap or $22 per share, or about 60%-plus upside from here. At $22, EV/sales is 1x and EV/EBITDA is 10x on current financials but only 6.5x on $900 normalized EBITDA. Just a side note. ACS’ $6.5 billion enterprise value used here was achieved in September 2009, just a few months after the stock market got to its lowest point. The market has materially rerated since then.

Disclosure: We are long Conduent.

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