DXC Technology Company (DXC) — Q2 2022 Earnings Call Transcript

Thank you. Good afternoon, everyone. I'm pleased that you're joining us for DXC Technology's second quarter FY22 earnings call. Our speakers on the call today will be Mike Salvino, our President and CEO, and Ken Sharp, our Executive Vice President and CFO. This call is being webcast at dxc.com Investor Relations website, and the webcast includes slides that will accompany the presentation today. Today's presentation includes certain non-GAAP financial measures, which we believe provide useful information to our investors. In accordance with SEC rules, you will find a reconciliation of these measures to the most comparable GAAP measures in the table included in today's earnings call on the webcast slides. Certain comments we'll make on this call will be forward-looking statements. These are known and unseen risks and uncertainties which could cause actual results to differ materially from those expressed on the call. A discussion of these risks and uncertainties will be included in our annual report and Form 10-K and other SEC filings. And now I'd like to remind our listeners that DXC Technology assumes no obligation to update the information presented on this call, except as required by law. And with that, I'd like to introduce DXC Technology's President and CEO, Mike Salvino. Mike.

Thanks, John, and I appreciate everyone joining the call today, and I hope you and your families are doing well. Today's agenda will begin with an update on our Q2 performance, which shows hard evidence that we're delivering on our transformation journey and building the foundation to make DXC operationally efficient, sustainable, and ultimately grow. Next, I will provide you with additional insight into the operational work we are performing as we execute our transformation journey. Then I will hand the call over to Ken to share our Q2 financials, guidance, and more details of the financial results driven by our strong operational execution. Finally, I'll make some closing remarks before opening the call up for questions. Regarding our Q2 performance, our revenues were $4.03 billion. Our organic revenue growth continues to show progress as we improved from minus 3.7% in Q1 to minus 2.4% in Q2. Also, I was very pleased to see the GBS business segment grew for the second quarter in a row from positive 2% in Q1 to positive 3.4% in Q2. We also continue to improve new organic revenue of the GIS business segment from minus 9.1% in Q1 to minus 8% in Q2. Now, all of these results show our organic revenue is on the right trajectory. Our adjusted EBITDA margin was 8.6%, that was driven by the operational work that we're doing to optimize our business. This is the third straight quarter of both improving organic revenue growth and sequential margin expansion, and we expect both trends to continue in Q3. Book-to-bill for the quarter was 0.91, which came in below our goal of 1 due to the timing of a couple of deals. I'm happy to report that both deals are hybrid cloud and IPO deals and are now closed. We continue to attract a book-to-bill over one year-to-date. And we expect to be back above 1 in Q3. Our non-GAAP EPS was $0.90 in the quarter, which is up $0.41 as compared to $0.64 a year ago. Finally, we are encouraged by the strength of our Q2 free cash flow, which moved us into positive territory. On a year-to-date basis, we have now produced roughly $100 million in cash. Now, let me turn to the progress we're making on our transformation journey. The first step is to inspire and take care of our colleagues. We are executing a New People First strategy, and attracting and retaining talent is fundamental to enable our growth. We know our strategy is working. We saw a higher percentage of our employees complete our September employee engagement survey, and we're showing improved and stable engagement scores. These engagement scores give us confidence that we have a motivated workforce and we will be able to manage attrition, which we've seen an uptick. To offset this increase in attrition and demand, we hired and onboarded more colleagues than any other quarter since I became CEO. A key advantage of our hiring efforts is that we have implemented and are running a virtual first model. Hiring has been a focus for us and we will continue. While hiring improved, we left some open demand and project work unconverted, and we're focused on capturing this moving forward. Focused on the customers the second step of our transformation journey and continues to be the primary driver of our success in improving our organic revenue growth. A key metric that we manage is our Net Promoter Score, and we're seeing continued improvement. The last time we gave you our NPS score was during the Investor Day in June 2018, almost within the industry best practice range of 20 million to 30. Currently, our 12-month rolling NPS score is at the midpoint of our best practice range. This is the most positive our customers have been since I arrived. This improvement is due to our strong service delivery and gives us the ability to sell up the enterprise technology stack from our GIS business to our GBS business. Now let me remind you that the way we will get to grow is to deliver the GIS services that are critical for our customers and build trusted relationships. Once these trusted relationships are built, we can move our customers up the enterprise technology stack towards the services of our GBS business. This is exactly what we're doing in the organic revenue trajectory of GIS, GBS, and the overall business is great evidence that this strategy is working. Now let me turn to our cost optimization program. We continue to make progress in optimizing our costs in delivering for our customers without disruption. I mentioned at the beginning of this call that we are doing operational work to make DXC efficient, sustainable, and ultimately grow. I've already commented on some of the operational work we're doing like motivating our colleagues, hiring new talent, and implementing a virtual first model. In addition to this work, we're also improving the efficiency of our service delivery, implementing better IT tools, and actively managing our real estate footprint. Let me provide you with some additional color concerning the operational work we're doing with real estate. This quarter, we closed our Tyson facility and are moving to a much smaller footprint in the DC area, where our colleagues that need to come into a facility will share space versus having dedicated space. This work emphasizes our commitment to a virtual first model, reduces our carbon footprint, and represents our desire to maintain a much smaller real estate footprint. Ken will detail out the financial results of all of this operational work that simply put, this work is allowing us to improve margins from 8% in Q1 to 8.6% in Q2 and gives us the confidence to increase our margin and EPS guidance for FY22. Next season market is where we're focused on cross-selling for our existing customers and winning new work. As I previously mentioned, we had two significant deals slip into Q3 and are now signed. The great news about these deals is they were both hybrid clouds with long-standing customers. Specifically, we are helping these customers modernize their existing infrastructures and build new private cloud capabilities to run their mission-critical applications. In Q2, 59% of our bookings were new work, and 41% were renewals. The new work continues to increase due to our focus on another piece of our strategy, which is our Platinum customer channel. Taking our offerings through this channel is another key foundation piece for growth. We're now starting to see evidence that we are being successful taking Luxoft, which drives our analytics and engineering services, through our Platinum customer channel. The evidence is that analytics and engineering grew 17.3% in Q2, which is clearly helping us create growth in our GBS business segment. Now, let me give you an example of what the Platinum customer in the future looks like at DXC. We have a 14-year relationship with one of the world's largest specialty retailers. Now, before I arrived and implemented this strategy, our revenues were roughly $80 million per year, split 1/3 GBS and 2/3 GIS. By continuing to deliver our GIS services for this customer, we were offered the opportunity to sell our GBS services as a result. And we have increased the total revenue on this account by 13%, and the mix between GBS and GIS is now split 50-50 as we are now providing them analytics and engineering services. We're in the early innings of this strategy, but we feel confident that we can implement this approach to our other platinum customers, successfully delivering GIS services and growing GBS services. They have the same or more revenue at better margins. Now, let me turn the call over to Ken.

Thank you, Mike. Turning to our quarterly financial performance, as you can see, our progress continues. Our organic revenue improved to a decline of 2.4% or a 130 basis points improvement from Q1. This represents our third consecutive quarterly improvement. As you can see, we have come a long way from double-digit organic revenue declines in Q1 FY21, to low single-digit declines in FY22. Our adjusted EBIT margin continues to improve as well, delivering 8.6% in Q2, up 60 basis points as compared to the first quarter. Year-over-year, our adjusted EBITDA margins have expanded 240 basis points or 460 basis points excluding the disposed businesses. Our book-to-bill for Q2 was 0.91, below our goal of 1 due to timing and remains over one year-to-date. Further, we expect to deliver a book-to-bill of over one for Q3 and for the full year, non-GAAP diluted earnings per share was $0.90, up $0.06 from Q1 and a healthy 41% increase as compared to the prior year. Our earnings per share expanded due to increased margins, lower interest expense, and a lower tax rate. Moving to our segment results, our GBS segment continued its strong growth performance, posting its second quarter of positive organic revenue growth of 3.4%, an improvement from 2% in the first quarter. The GBS growth is a positive sign as we continue to deliver higher value for our customers. Our GBS business has higher margins and lower capital intensity, so as we grow this business, it has a more positive impact on margins and cash flow. Our GBS margin was 15.9%, up 150 basis points compared to the first quarter and up 180 basis points compared to the prior year. Our GIS segment, organic revenue declined 8%, a full 110 basis point improvement compared to the first quarter and improved 380 basis points compared to the decline from the prior year. GIS margins were 5.5%, an improvement of 390 basis points compared to the prior year. Turning to the enterprise technology stack, analytics and engineering revenue was $520 million, up 17.3%. Analytics and engineering book-to-bill was 0.95 and 1.13 year-to-date. We continue to see high demand in this area. The applications layer was up 1.5%, book-to-bill was 0.94 and 1.13 year-to-date. BPS, our smallest layer of the enterprise technology stack at $118 million of revenue was down 13.7%, book-to-bill was 0.69 and 0.91 year-to-date. Cloud and Security revenue was $521 million, down 1.5%. Book-to-bill was at 0.8 in the quarter and 0.82 year-to-date. IT Outsourcing revenue was $1.05 billion, down 9.6%. ITO book-to-bill was 0.81 and 0.92 year-to-date. We expect our ITO declines to continue to gradually moderate as we move through FY22. The two deals Mike mentioned earlier that slipped out of Q2 that were subsequently closed were in the ITO and Cloud and Security layers of our technology stack and order boosted our GIS book-to-bill for the quarter to over 1.1. Lastly, modern workplace revenues were $581 million, down 10.9% as compared to the prior year. This is an improvement from last quarter when modern workplace was down 19.7% year-over-year. Book-to-bill was 1.2 and 1.1 year-to-date. Next up, let me touch on our efforts to build our financial foundation. This quarter we made particularly strong progress on strengthening our balance sheet and solidifying our financial position, cash generation, and reducing restructuring and TSI expense. As Mike pointed out earlier, we've made measurable improvements driving our business to improve our financial foundation that will ultimately allow us to increase our deployable cash, affording us more opportunities to create value. We reduced our debt from $12 billion to $5.1 billion. The refinancing of all of our high-rate bonds during the quarter culminates our collective efforts to transform the business, improve its trajectory, and strengthen our balance sheet. There is no similar and clear way of seeing the impact that Mike and his team have made, improving the operations of the business than what was accomplished with our debt over the last year. Net interest expense has been reduced from $83 million in the first quarter of 21 to $45 million this quarter. With the full benefit of our refinancing, we anticipate interest expense to be reduced to approximately $33 million in Q3. We also continue to deliver on reducing restructuring TSI expense while increasing our margins. This not only improved our cash flow, but it also narrows the difference between GAAP and non-GAAP earnings. Finally, capital lease and asset financing is an area that was overused. In the last year or so, we've significantly curtailed new capital lease origins from $1.1 billion in FY20 and are on track to reduce the origins to approximately $500 million this year. These efforts to better manage this form of financing allowed us to reduce our debt and ultimately our capital lease cash outflows from $245 million in Q1 FY21 to $177 million this quarter. We expect further reductions in our quarterly cash outflows to around $150 million per quarter at the end of FY22 and further below that level going forward. We delivered these reductions while also better managing capital expenditures. Our capital expenditures were reduced from $225 million in Q1 FY21 to $159 million in Q2 FY22. Based on our reductions to capital lease origins, a more meaningful metric that demonstrates our progress is CapEx spend and capital lease origins as a percent of revenue. CapEx and capital lease origins as a percent of revenue were 10.2% for FY20, 8% for FY21, and now down to 5.3% for Q2 FY22, delivering 5.3% is a good step forward related to better managing our capital spend as it gets us in the peer range or be it at the top end and as a proof point of our improved operational rigor. Returning to our debt, I want to spend a minute on our recent refinancing. This chart shows how the refinancing further solidifies our financial position by extending maturities. We now have no bond maturities before FY26, lowering maturity towers and reducing annual interest expense and cash outflows by about $50 million a year. From our improved balance sheet, let's move to cash flow. Cash flow from operations totaled an inflow of $563 million. Free cash flow for the quarter was $404 million, up 33% compared to the prior year and moves us to positive free cash flow for the first half of FY22 of $100 million. The second quarter was impacted by previously disclosed cash tax payments related to business disposals, accelerated interest payments due to our refinancing, and the payment related to restructuring a vendor relationship to take greater control over our delivery. Further, as part of our strategy to focus on customers, we were able to better manage working capital in the quarter. As we look to the second half we expect the fourth quarter of free cash flow to be stronger. Our third quarter has two discrete non-recurring cash payments, including a $60 million payment associated with a legacy vendor that has a take-or-pay agreement and a $90 million payment associated with COVID relief legislation where we deferred certain tax payments and now have opted to accelerate the tax payments to utilize the tax deduction. Slide 18 shows our trended free cash flow profile. The negative cash flow over the last three quarters was due in large part to absorbing a number of non-recurring cash outflows of over $1.7 billion to put the business on a better trajectory, building our foundation. These cash outflows include $700 million tax payments associated with taxable gains on our divestitures, $500 million to normalize vendor payments, $332 million related to readying the U.S. state and local health and human services business for sale, $114 million to end an AR Securitization program, and $88 million to end a value destructive pay-to-pay agreement. So $1.7 billion headwinds put into perspective our $749 million trailing four quarters negative free cash flow. A key driver of improving cash flow is to continue to reduce our restructuring in TSI spend. Our restructuring in TSI efforts are highly focused and we believe our improving investment in the business, addressing our outsize cost structure in certain countries, and reducing our facilities footprint to align to our virtual model, we remain on track to reduce restructuring in TSI from an average of $900 million per year over the last four years to $550 million in FY22 and about $100 million in FY24. I would like to take a moment to update our capital deployment expectations from Investor Day. The Investor Day chart calls for 55% of our free cash flow to be used to pay debt and capital lease obligations. As a result of our progress, our cash outflows for debt and capital lease financing are now expected to be about 20% of our free cash flow. This leaves 80% of our expected free cash flow to invest in our business and we will repurchase our stock. I should note, we like the business we have and believe that we have the right level of investment in GBS and GIS. We believe our technology stack has critical mass and capability at each layer. We believe we will create more value by continuing to focus on driving the transformation journey across our business, improving the fundamentals, and continuing to build organic growth up the stack, ultimately delivering 1% to 3% organic growth in FY24. Related to acquisitions, our focus is to ensure our Platinum channel strategy will be fully vetted and proven out, so eventually, when we are acquisitive with tuck-in size acquisitions, we will have a clear path to deliver value. Related to our debt, we have a clear line of sight to achieving our targeted debt level of $5 billion near-term as we have scheduled debt repayments via our capital lease financing and commercial paper. Our preference is to maintain approximately $2.5 billion of cash on hand to fund an appropriate level of working capital. When we have cash in excess of $2.5 billion, we will determine how best to deploy the cash as we do not expect to leave significant levels of excess cash generating no meaningful returns on our balance sheet for an extended period of time. At this point in our journey, we favor share repurchases as our valuation is attractive. In Q2, we repurchased $83 million of our common stock, bringing the FY22 year-to-date repurchases to $150 million or 3.9 million shares. Our share repurchases are a disciplined approach to capital allocation and are expected to be self-funding using a rather simple formulaic approach of deploying cash in excess of $2.5 billion when we're at our target debt level of approximately $5 billion. We remain very focused on our investment-grade credit profile. Turning to our third quarter guidance, we expect revenue between $4.08 billion and $4.13 billion. If exchange rates were at the same level as when we gave guidance last quarter, our third quarter revenue guidance range would be $90 million higher. Organic revenue decline improved to down 1% to down 2.5%, adjusted EBIT margin of 8.6% to 8.9%, non-GAAP diluted earnings per share is expected to be in the range of $0.88 to $0.93 per share. We're pleased by our progress as we look to the second half of FY22, I would like to update our current fiscal year guidance based on the strengthening U.S. dollar. Our revenues are expected to be negatively impacted by approximately $200 million, which has been reflected in our revised guidance range of $16.4 billion to $16.6 billion. Reaffirming organic revenue growth at down 1% to down 2%, increasing adjusted EBIT to a range of 8.5% to 8.9%. Increasing non-GAAP diluted earnings per share to $3.62 to $3.72 per share and reaffirming free cash flow guidance of $500 million. We are reaffirming our guidance for FY24. This reflects our strong execution in driving forward on our transformation journey. Before I turn the call back to Mike, I want to reflect a moment. As I'm closing out on my first year at DXC, we are clear-eyed on the value we are driving with the transformation journey. We feel strongly there is more opportunity in front of us to continue to improve the business and the underlying economics. With that, I will now turn the call back over to Mike for his closing remarks.

Thanks, Ken. Let me leave you with the following key takeaways. We are building a foundation to make DXC operationally efficient, sustainable, and ultimately grow. By focusing on the operational work of motivating our colleagues and hiring new talent, moving to a virtual first model, making service delivery more efficient in implementing better IT tools, and reducing real estate, we're able to deliver better for our customers and gives us the ability to sell up the enterprise technology stack to GBS. The good news is the financial results Ken just took us through, reduce debt, shrinking restructuring, and TSI costs, increased margin and EPS, and stronger free cash flow are all sustainable as a result of the operational work we are doing. This gives us confidence that we will achieve our FY24 double-digit margin guidance. On growth, Q2 confirms that we're on the right trajectory for growth. Our focus on delivering and fixing the GIS business develops trusted relationships with our Platinum customers. We are negotiating our GBS offerings to our Platinum customers, selling up the enterprise technology stack. The evidence that this is working is in our organic revenue results of GIS, GBS, and the overall company. This also gives us confidence that we will achieve our FY24 guidance of 1% to 3% growth. In closing, I'm confident that by staying focused on our transformation journey and building the foundation, we will continue to deliver in the short term and ultimately deliver our long-term financial targets of margin, growth, and free cash flow. Operator, please open the call up for questions.

Hi, guys. Good afternoon. Just want to ask about the bookings in demand picture, I guess kind of a two-part question. Obviously, the bookings saw a little bit below 1 in the quarter, but you didn't have to change your organic growth for the fiscal year. And that might just have to be just due to a timing issue. Can you just explain that a little bit? And then secondly, there was some talk about it seemed like the demand was strong enough that if you had some more, you could have fulfilled even higher demand. So I just want to understand a little bit of, do you have the right amount of people? And I know you had a big quarter hiring, but just trying to fulfill the demand that you have. Thanks.

Thanks, Brian. So, look on Book-to-bill, the focus for us is around the year-to-date. We're over one. That gives us a lot of confidence, and like Ken said, total year, we should be over one. I don't see a problem in the demand, that's why I called out a couple of deals. If you look at a couple of deals, they were hybrid cloud and ITO deals. So when you look at our page 13, you would see that they would push that book-to-bill for GIS up around 1.1. So the deals are there, we're definitely winning in the market. The comment I made in terms of demand and projects is that when I talked about us getting additional, it was because we're delivering on GIS now, and the fact that it's there for us to take. I think we got to continue to be more aggressive. You guys know that ever since I've been here, I've been very customer-focused, and with that focus, I think we can do even more in the market. So that was the purpose for my comment. We do have the people; I called that out in terms of I think we're managing the attrition well, so our positioning and what we're doing in the market, Brian.

Got it, and then how do you do more? I mean, what is that going to take for you guys to fulfill that extra push to grow a little bit faster? Is there something there that you need to do, or is that just executing at a high level?

I think it's continuing to deliver and continuing to knock on the doors of our Platinum accounts. The reason I gave you guys the example of the Platinum accounts at the end of my prepared remarks is the fact that when we are delivering, we do get those opportunities. And we get those opportunities you are seeing that now we're growing GBS. So, the key green shoot in this whole organic revenue story is the fact that GBS now has grown for the second quarter in a row. Before I got here, that business had never grown. So I like what we're doing. I have confidence in terms of us being able to compete in the market, and so far so good.

Thanks so much. The slides are really helpful. I want to ask on GBS since you mentioned that the demand environment seems pretty good there, Mike. Do you see continued progress there on the revenue front? Can you bring that into the mid-single digits or higher? And on the margin front as well, with the high watermark of 15.9%, can you bring the margins up even higher from that level?

I mean, that progress engine is pretty special because when you look at the top of the stack, which is what we've been saying all along, let's make sure we deliver the critical applications in GIS to make sure we get those at-bats and then start selling through that Platinum channel. So when you look at GBS, I mean, analytics and engineering, I will tell you we can compete with anybody. That 17.3%, that's good work. The second thing is, I know it's small growth, but applications have grown for the second quarter in a row as well. Again, we're competing in the high-end work, and what we need to continue to do is make sure that we're also fixing the GIS business. What you're seeing there is that we got to continue to stay focused on Modern Workplace. Modern Workplace saw some really good results this quarter, going from 19.7 negative to now 10.9. Now, that business is going to continue to be lumpy because we're still seeing some runoffs. But the other thing I'm happy to report is when I look at the ITO business, remember all those customer run-offs we had because of non-delivery and so forth? For the most part, that stuff now is done, and we can start seeing good progress in ITO in the second half of the year.

Okay. That's encouraging here. My quick follow-up just maybe for Ken just on the, I know you did good work in reducing the capital lease obligations. On Slide 20, just want to clarify the excess cash allocation inside the circle there. That means after retaining the $2.5 billion in cash to run the business, I just want to make sure I understood that. Thanks.

Yes, that's correct Jianwu. So we'll keep $2.5 billion of cash on the balance sheet. And when we have excess cash, we'll look to deploy it.

Great. Thanks, guys. Just wanted to start on the organic growth side based on what you are guiding to for Q3. I know that implies there will be a ramp in Q4 to get to the full-year target, which is unchanged. Can you just talk to us a little bit about the visibility on that additional acceleration in the fourth quarter? I think you can probably get to positive territory in Q4 if I'm not mistaken. Thanks.

So Jason, look, the guide in Q3 is not only solid but also it winds us up directly for FY22. And when I look at our strategy in terms of the GIS business and the GBS business, look, that's going to get us there. What we're focused on with GIS, just to be specific, when you look at Page 12, we're looking to drive that to negative single-digits over time. Now I keep saying it's going to be lumpy this year, so it's going to sort of hang around the 8% range as we fix Modern Workplace. So that's sort of the bottom end of the equation when you're looking at organic growth. The top end of the equation is I've also been very clear that GBS is now growing, and it's going to continue to grow. So when I look at the business, that's how we're going to get to our minus 1 to minus 2 for the full year, and I would tell you the visibility on that is pretty good.