DXC Technology Company (DXC) — Q2 2018 Earnings Call Transcript

Thank you and good afternoon everyone. I am pleased you are joining us for DXC Technology’s second quarter fiscal 2018 earnings call. Our speakers on today’s call will be Mike Lawrie, our Chairman, President and Chief Executive Officer and Paul Saleh, our Chief Financial Officer. We have slides to our website at dxc.com/investorrelations, which will accompany our discussion today. Slide 2 explains that the discussion will include comparisons of our results for the second quarter of fiscal 2018 to our pro forma combined company results for the second quarter of fiscal 2017. The pro forma results are based on historical quarterly statements of operations of each of CSC and the legacy Enterprise Services business of HPE or HPES, giving effect to the merger as if it had been consummated on April 2, 2016. As a consequence of CSC and HPES having different fiscal year-end dates, the pro forma combined company results include the results of operations of CSC for the 3 and 6 months ending September 30, 2016, and of HPES for the 3 and 6 months ending July 31, 2016. Slide 3 informs our participants that DXC Technology’s presentation includes certain non-GAAP financial measures and certain further adjustments to these measures, which we believe provide useful information to our investors. In accordance with SEC rules, we have provided a reconciliation of these measures to their respective and most directly comparable GAAP measures. These reconciliations can be found in the tables included in today’s earnings release as well as in our supplemental slides. Both documents are available on the Investor Relations section of our website. On Slide 4, you will see that certain comments we make on the call will be forward-looking. These statements are subject to known and unknown risks and uncertainties, which could cause actual results to differ materially from those expressed on the call. A discussion of risks and uncertainties is included in our quarterly reports on Form 10-Q and other SEC filings. I would like to remind our listeners that DXC Technology assumes no obligation to update the information presented on the call, except as required by law. And now, I would like to introduce DXC Technology’s Chairman, President and CEO, Mike Lawrie. Mike?

Okay, thank you. Welcome, everyone. Thanks for your interest in DXC. As always, I have got four or five key messages. I will develop those in a little detail and then Paul will come on and then as always we will have an opportunity for some questions. So, first key message here is second quarter non-GAAP EPS was $1.93. This includes a cumulative benefit of $0.26 from the reclassification of leases, which I will cover in a moment. EBIT adjusted for restructuring, integration and amortization of intangibles was $876 million, including a cumulative benefit of $121 million from the lease reclassification. Adjusted EBIT margin was 14.2% or 12.3% excluding the lease reclassification. We generated $589 million of adjusted free cash flow in the quarter. Second point, revenue in the second quarter was $6.163 billion on a GAAP basis. Excluding the impact of purchase price accounting, GAAP revenue was down 2.7% year-over-year and grew 2.5% sequentially. In constant currency, revenue was down 3.5% year-over-year and was flat sequentially. Book-to-bill was 1.0x for the quarter. Third point, excluding the impact of purchase price accounting, our digital GAAP revenue grew 23% year-over-year and 15% sequentially. Industry IP and BPS GAAP revenue was relatively flat year-over-year driven by the completion of several large healthcare contracts last year. The 7.5% growth in the insurance business partially offsets the decline in healthcare. And sequentially, industry IP, BPS GAAP revenue grew 4%. And in the second quarter, our digital book-to-bill was 1.2x and our industry IP and BPS book-to-bill was also 1.2x. Fourth point, during the second quarter, we continued to achieve key merger integration milestones. We are executing our synergy plan and are on track to meet our targets of $1 billion of year one cost savings as well as $1.5 billion of run-rate cost savings exiting the year. We are also on track in the early stages of separating our U.S. Public Sector business and combining that company with Vencore Holding Corporation and KeyPoint Government Solutions. As discussed in our announcement on October 11, this will create a separate mission-focused independent publicly traded technology company to serve U.S. government clients. And then finally for fiscal 2018, we continue to target revenue of $24 billion to $24.5 billion in constant currency. We are increasing our fiscal 2018 target for non-GAAP EPS to a range of $7.25 to $7.75 reflecting the benefit from the reclassification of leases. On that basis, our adjusted free cash flow target will now be 90% of adjusted net income since net income will include the benefit of the lease conversion and corresponding asset adjustments.

Well, thank you Mike and greetings everyone. Before I review our second quarter results, I would like to take a moment to clarify the basis of our financial presentation. First, the pro forma results for second quarter of last year conformed to the same methodology we used in the first quarter. And as such, all references to the unaudited pro forma statement of operations for the prior year include the results of operations of CSC for the 3 and 6 months ended September 30, 2016 and of HPES for the 3 and 6 months ended July 31, 2016. Also prior year pro forma non-GAAP results assume a flat quarterly tax rate of 27.5%. In addition, fiscal ‘18 second quarter results reflect revenue adjustments for purchase price accounting, whereas the prior year pro forma does not. And lastly, non-GAAP results exclude restructuring, integration and amortization of intangibles consistent with CSC’s non-GAAP methods from prior years. And with that, I will now cover some items that are included in our GAAP results in the quarter. In the current quarter, we had restructuring costs of $192 million pre-tax or $0.50 per diluted share. These costs represent severance costs related to workforce optimization programs and expenses associated with facilities and data center rationalization. Also in the quarter, we had $66 million pre-tax or $0.15 per diluted share of integration and transaction costs. Year-to-date, restructuring, integration and transaction costs amounted to $572 million pre-tax or a $1.45 per diluted share, which is in line with the $1.3 billion spend envelope we laid out for fiscal ‘18. In the second quarter, amortization of acquired intangibles was $169 million pre-tax or $0.39 per diluted share. Excluding the impact of these special items, adjusted EBIT was $876 million or on a non-GAAP EPS of $1.93. Turning now to our second quarter results, revenue in the quarter was $6.163 billion on a GAAP basis. Purchase price accounting reduced revenue in the quarter by $22 million representing a write-down of deferred revenue. For the full fiscal year, the deferred revenue write-down for PPA is now expected to be $230 million, which is better than our prior estimate of $335 million. Excluding PPA, GAAP revenue was down 2.7% year-over-year and up 2.5% sequentially. In constant currency, revenue was down 3.5% and roughly flat sequentially. EBIT in the quarter was $876 million after adjusting for restructuring, integration and amortization of intangibles. Adjusted EBIT margin on that basis was 14.2%. Adjusted EBIT in the quarter included a cumulative benefit of $121 million or $0.26 of EPS from the reclassification of HPES operating leases to capitalized leases and a corresponding adjustment of those assets to fair value. In subsequent quarters, we expect a continued benefit of roughly $60 million per quarter or $0.13 EPS from this lease reclassification. Excluding the reclassification benefit in the quarter, adjusted EBIT would have been 12.3% compared with 6% in the prior year and 11.5% in the first quarter. This improvement in our margin reflects cost actions we are taking to optimize our workforce, extract greater supply chain efficiencies and rationalize our real estate footprint. In the quarter, we continued to rebalance our workforce. We reduced our labor base by about 4% in the quarter through a combination of automation, best shoring and pyramid correction. We will also continue to rebalance our skill mix, including the addition of almost 4,800 new employees and the ongoing retraining of the existing workforce. Also at the end of the quarter, our near shore and offshore labor mix was 54.5%. In supply chain, we are extracting greater procurement efficiencies. We completed renegotiations with key strategic suppliers, ensuring that we capture the benefits of our global scale, and we continue to consolidate our overall supplier base. In addition, we are implementing tighter procurement review practices across all of our regions. In real estate, we have rationalized 49 sites and eliminated 900,000 square feet of space during this quarter. This represented 5% total square footage reductions in our facilities footprint and on a year-to-date basis would reduce our facilities cost by roughly 9%. So, in total, we delivered $110 million of incremental cost take-outs in the quarter and are on track to meet our $1 billion in-year and $1.5 billion exit run-rate of synergies for fiscal ‘18.

Good afternoon. Thanks for taking my question. Good job on the quarter. I wanted to maybe start with revenue question came in a little bit better than our expectation, but can you maybe Mike help us with an update on your conversations with clients? Any update on the dialogue regarding customer to synergies, specifically some of larger customers like the UK government, the U.S. Navy etcetera and maybe just give us a sense of how your progress is going with up-selling existing clients to increase their contract size in exchange for cost synergies etcetera?

Yes, it was the – in terms of the UK we continue to see a runoff there. I am not sure I got this synergy, it’s more a reflection of some of the contracts concluding, but we still see pressure in the UK around some of the dis-synergies. On a global basis, I would say the revenue dis-synergies are pretty much tracking as we thought, I would say, probably a little bit less than what we had originally planned at the Investor Day. In terms of conversations with clients, I mean I got to tell you, we just had our global customer advisory board in London several weeks ago. We have got Americas Advisory Board going on this week in New York. I mean, the clarity of the messaging back to us is incredible. Every one of these clients is trying to figure out how they can improve their current IT operations. This is through automation, it’s through simplification. It’s a whole host of different things. And then we continue to encourage them to take those savings and invest in other digital platforms, whether it be the modernization of applications or new cloud native applications, the deployment of those, or cybersecurity platforms or analytics moving to a hybrid cloud environment. So, we have done several deals very similar to the one that we announced before. So, the messaging back from the clients and our messaging to the clients has not changed one bit; they like our scale, they like the breadth of our portfolio, the partnerships that we have are clearly differentiated. In many cases, we are showing up as one in front of those clients which they readily appreciate and simplifies their decision-making. So, I’d say the continued challenge we have, Jim, is to continue to attract and retain and retrain the talent necessary to capitalize on those opportunities. And that’s one of the reasons we put this digital transformation in place as we begin to pilot a different approach to some of these clients by helping build the methodologies and the tools and the process and procedures to help with a complete end-to-end digital transformation.

Thanks, guys. First question is just on overall growth. I mean, I guess USPS accelerated quite a bit and maybe I missed it on the call, but I didn’t hear any good explanation as to what drove the year-over-year acceleration there? And then really on top of that, I mean when we look at the GBS and GIS segment sequentially, revenue looks fairly stable at this point. Is there anything again that would – any seasonality or anything else or should we now start to expect that the majority of the revenue that you have been trying to address given the areas that you don’t think made sense from its global pricing. Is that coming closer to finalization now so that we can have more sequential stability, maybe start to show some of the new add-ons benefit your year-over-year over the next few quarters?

I would not draw that conclusion. I think there is still – there are many things in the second half of the year. We have got price-downs which is consistent with our season plan that needs to be factored. And so I would not get off the original sort of track that we have provided for you. What we are seeing is we are seeing moderation and some of the headwinds in the ITO business. And more importantly, we are seeing good growth in our digital offerings as we reported this quarter and we are seeing pretty good growth in our industry IP and BPS, particularly when you adjust for the runoff of some of these big healthcare contracts. I would jump to any conclusions here that there is a significant change over what we have already talked about. In the case of USPS, the USPS has a pretty significant backlog and as they hire more people and bring those people on, then they are able to build that revenue out, and that’s a partial explanation to why you saw a slight acceleration in the revenue.

Hi, guys. Paul, just want to follow-up on that, of the increase in the guidance to $0.75 it doesn’t look like that’s all lease reclassifications or is that all lease reclassification, just want to be clear there?

I think there is in total about $0.53 in the sense of reclassification – the reclassification on the full year basis, $0.26 of it came into the second quarter because there was a catch-up to the first half of the year and $0.13 per quarter. So if you add that it’s about $0.53 for the full year and then we have done a little bit better than given the synergies a little bit better than we had expected in the first half of the year.

Thanks for squeezing me in here guys. I wanted to ask about synergy realization on the labor side and first on the optimization of your labor footprint meaning moving in the right shoring more headcount. Can you talk about the challenges or points of friction in doing and doing that operational logistical political, how much runway is where are we out in the process, I know you talked about a pretty material move in the context of the merger. So, sort of an update on where we are and sort of also on how – what are the challenges you faced kind of accelerating that shift or at least tracking?

Yes, let me give you a couple of thoughts on that. One, I don’t really see the political so much. I think what you have to understand is that the labor dynamics around these digital transformation projects are much different than the labor dynamics around the outsourcing business. So when you talk about digital offerings and digital transformation with our partners, you do talk about much more client intimacy. These are projects that are often done locally sometimes with land and resource, but in any regard, they have really done very local. When we talk about right shoring, we don’t necessarily talk about offshoring. Probably the biggest hurdle we have when we do choose to move workload to a right sourcing location is just the transition. So, you go as you have to ramp up the skill some place else before the skills in the current place could be redeployed or optimized. I would also say that automation is clearly adding a different dimension. So rather than thinking about moving positions from point A to point B in many cases we can displace those and retrain those people around our digital profile. The other thing is as we rethink our labor strategies we are thinking much more about college graduates we are thinking about internships program, we are thinking about co-op programs. We are thinking about different training programs, because the mix of our business as it changes over the next 3 or 4 years will have an entirely different labor dynamic than what we have seen in the traditional businesses. So, it’s a combination of rethinking how you bring people in, that’s what our dynamic talent cloud is all about, it’s about retraining, it’s is about reskilling and it’s about a whole different approach to where we setup our locations. I have said before we are looking at creating some lower cost facilities in the United States and moving some of our workload there. So, it’s that mix of location that the type of businesses in the digital business requires more customer intimacy is it driven by productivity improvements and then that drives a whole reskilling, training and recruiting process. And that’s what makes this so exciting and I think so a dynamic as we move forward.