The Long and Short
DXC turnaround story supported by strong credit profile
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
DXC Technology Company (DXC, Baa2/BBB-/BBB) has spent the past year reducing both costs and overall debt levels to preserve ratings and margins as it executes its turnaround strategy. Management has demonstrated good progress on its efforts over the past few quarters as bookings remain above 1.0x. As one of the widest trading credits in the technology space, DXC’s strong credit profile with net leverage below 1.0x provides for ratings stability as the company works to further stabilize the top line. Debt spreads could compress closer to similarly rated technology credits as margin expansion further improves its credit profile. A swap out of Marvel Technology (MRVL – Baa3/BBB-/BBB-) 2.45% 2028 bonds into DXC 2.375% 2028 notes provides for a pick-up of 30 bp (g-spread) while gaining a ratings notch at both Moody’s and Fitch.
DXC was in the market earlier this month and priced $1.35 billion of debt across two tranches, 1.8% notes due 9/15/26 and 2.375% notes due 9/15/2028. The deal was essentially leverage neutral for DXC as proceeds from the transaction will be used to repay higher coupon bonds within the company’s capital structure, including the 4.125% 2025 notes, the 4.75% 2027 notes and the 7.45% 2029 bonds. Additionally, the company issued EUR 1.35 billion in notes with proceeds earmarked to repay term loans.
Exhibit 1. BBB Technology 5- to 7-year curve
Source: Bloomberg TRACE; Amherst Pierpont Securities
Divestiture Proceeds Used for Debt Reduction
Over the past year, DXC has reduced debt by approximately $7.1 billion using proceeds from five recent divestitures. DXC’s total debt now stands at $4.9 billion (excluding leases) and net leverage has declined from 2.2x in fiscal 1Q20 to 0.9x currently. Net leverage below 1.0x is very solid for the current BBB ratings as MRVL’s pro forma net leverage is closer to 2.6x. In fact, some of DXC’s single A peers (including IBM – A2/A-) have net leverage over 1.0x and have maintained net leverage above the 1.0x mark for quite some time. Management has prioritized a strong balance sheet and its investment grade ratings and was targeting a total debt level of $5 billion, which they are now below. Furthermore, with the reduction of the debt level, interest expense had declined by roughly 50% from last year and the most recent debt refinancing will continue to push interest expense lower. Additionally, debt maturities are now very manageable and total roughly $700 million through fiscal 2024.
Exhibit 2. DXC Balance Sheet Improvements
Source: DXC 1Q21 Presentation; Amherst Pierpont Securities
Turnaround on Track
DXC’s most recent earnings highlighted how far management has come on its turnaround efforts as the company continues to post year-over-year improvement on revenue, margin and EPS trends. While DXC has struggled in the past to post sustainable organic revenue growth, it has made a dramatic improvement in the rate of decline. For the most recent quarter, DXC posted a 3.7% organic revenue decline which was a significant improvement from the 10.1% decline witnessed in the year ago-period. Management also reiterated guidance for the full fiscal year with organic revenues expected to be down in the 1%-2% range. Management believes it can achieve an organic growth rate in the 1%-3% range by March 2023.
Its cost optimization efforts helped DXC expand margins on both a sequential and year-over-year basis. Management has been focused on four cost levers which include contractor conversion, real estate, Global Innovation and Delivery Centers (GIDCs) and DXC Platform X. Contractors have and will continue to be replaced with DXC employees. The reduction in contractors has reduced head count needs and brought the contractor to employee ratio closer to industry standards. Real estate portfolio rationalization is part of the company’s modern workplace solution as DXC looks to reduce the total number of buildings within their portfolio. GIDCs have been scaled to simplify the company’s delivery footprint and nearly half of DXC’s delivery capacity now comes from the GIDCs. This has enabled the company to reduce its capacity at regional delivery centers. Finally, Platform X has been instrumental with the automation process as it can auto-detect and self-field incidents across the technology stack. That said, the adjusted EBIT margin expanded 50bps sequentially and 380bps yoy (to 8.0%) in the most recent quarter. Management has guided to an 8.0%-8.4% EBIT margin range for fiscal 2Q and reaffirmed its 8.2%-8.7% range for the current fiscal year. The margin improvement has also improved free cash flow generation which is expected to be roughly $500 million for the year, up from a slight outflow last year.
Book-to-Bill has also been above 1.0x for the past five consecutive quarters and has improved from the 0.9x witnessed in fiscal 2020, which is clear evidence that DXC can both compete and win in the IT Services market. In the most recent quarter, 57% of bookings were new work with the remainder being renewals. Management expects book-to-bill to remain above 1.0x in fiscal 2Q as they focus on cross selling to existing accounts while winning new business. Specific sales campaigns relating to Information Technology Outsourcing (ITO) and combining different cloud networks have resonated well and attracted new business.
Exhibit 3. Turnaround Trajectory
Source: DXC 1Q21 Presentation; Amherst Pierpont Securities
Stable Outlooks at All Three Agencies
All ratings and outlooks were affirmed when DXC brought its new deal with the agencies highlighting the leverage neutrality of the issuance. Additionally, they believe that management has done a good job demonstrating its commitment to an Investment Grade profile with gross adjusted leverage expected to fall below 2.0x. Not only did management direct 100% of divestiture proceeds towards debt reduction but both the dividend and share repurchases were suspended to direct more cash to deleveraging efforts. Leverage metrics are expected to improve over the ratings horizon as revenue stabilizes and margins continue to expand. Once the company reaches positive organic revenue growth, the agencies believe DXC will be better positioned to pursue revenue enhancing acquisitions while keeping leverage within the parameters of current ratings.
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