DXC Technology Company (DXC) — Q2 2023 Earnings Call Transcript

Thank you, and good afternoon, everybody. I'm pleased that you're joining us for DXC Technology's Second Quarter Fiscal Year 2023 Earnings Call. Our speakers on the call today will be Mike Salvino, our Chairman, President, and CEO; and Ken Sharp, our EVP and CFO. This call is being webcast at dxc.com/investorrelations, and the webcast includes slides that will accompany this discussion today. Today's presentation includes certain non-GAAP financial measures, which we believe provide useful information to our investors. In accordance with the SEC rules, we provide 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 and in the webcast slides. Certain comments we make on the call will be forward-looking. These statements are subject to known risks and uncertainties, which could cause actual results to differ materially from those expressed on the call. A discussion of these risks and uncertainties is included in the annual report in our Form 10-Q and other SEC filings. I'd now 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 with that, I'd like to introduce DXC Technology's Chairman, 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 overview of our Q2 results. Next, I will update you on the progress we are making on our transformation journey. Our Q2 results show that our transformation journey is back producing the kind of results that we've grown accustomed to. Ken will then discuss our financial results in more detail and provide our guidance. And finally, I will make some closing remarks before opening the call up for questions. Our Q2 results for organic revenue, adjusted EBIT margin, and non-GAAP EPS were all at the top end of our guidance. In Q2, revenue was $3.57 billion and organic revenue was negative 1.5%. Organic revenue is one of the best results that we've produced for a quarter since I've been at DXC. Our adjusted EBIT margin was 7.5%, a 50 basis point improvement compared to Q1 driven by our execution of our cost optimization efforts. Our non-GAAP EPS was $0.75. Our trailing 12-month book-to-bill was $1.04. And our Q2 book-to-bill was $0.83. I look at both of these numbers to see if we are driving the kind of new work to grow GBS and continue to shrink the negative revenue declines in GIS. The trailing 12-month book-to-bill of over one means that we are still on track with our plans. Overall, I'm pleased with how we have delivered in Q2, and, more importantly, we have our execution momentum back. Let me give you some additional color around our transformation journey. The first step is to inspire and take care of our colleagues. The good news is that our attrition remains well under control. Our growth in GBS demonstrates that we can recruit and retain top talent like engineers and software developers who create innovative solutions for our customers. These engineers and software developers are highly sought after in the market, and we're doing a great job of recruiting and retaining them. The reason for all this is my leadership team is focused on changing the culture of DXC. We're making sure we're taking care of our people, we're working together, and we know how to make a positive business impact for our customers. The next step is to focus on our customers. The key metric here is our net promoter score. Our most recent NPS score was 33, above the top end of the industry benchmark; it's clear that our customers value our services. The value that customers place on delivery has helped us stabilize our revenue. In Q2, we achieved sequential organic revenue growth as well as driving our yearly organic revenue to minus 1.5%. Our focus on delivering for our customers has enabled us to grow GBS for six consecutive quarters and shrink the negative organic revenue growth of GIS to minus 5.8% in Q2. This was a 140 basis point improvement over Q1 and the best organic revenue results for GIS since I've been at DXC. On our last earnings call, we committed to $500 million of cost takeout in FY 23, and I'm pleased to report that we're delivering. We've made progress on all five levers while taking care of our customers and colleagues. Our progress so far has allowed us to expand our margin from 7% in Q1 to 7.5% in Q2, and we are on track to hit our FY '23 margin goals. This is a testament to our leadership team. I mentioned on the last earnings call that my leadership team delivered a similar cost takeout plan in FY '21, and the team is delivering again, as I expected. In the area of GBS, we're implementing a new sales model. This model distinguishes between our two businesses of GBS and GIS, as we believe they require two different sales organizations. The GBS sales organization is focused on relationship selling. This means selling to our customer executives based on value, which we define as helping them increase revenue and decrease costs. In the automotive industry, our engineering team works with over 90% of all automotive manufacturers. Software development is increasingly important with the change to software-defined vehicles as it improves the in-car experience and connects the driver to the automotive manufacturer. An example of one of our relationships in this space is with CARIAD, the Volkswagen Group's in-house automotive software company. We have worked with them to develop a uniform, scalable software platform that will be adopted across vehicles for most of the Volkswagen Group's brands. Drivers will experience 24/7 connectivity, lower maintenance downtime, and higher residual values for their cars. As you can see, our distinct engineering work drives value for our customers. I firmly believe that our engineering and software development capabilities are some of the best-kept secrets, but we're gaining momentum changing this perception. In GIS, our sales organization is oriented toward RFP-focused selling, which is highly price competitive. We continue to implement a disciplined sales approach with the deals we are bringing into GIS. Our belief is we can be disciplined as customers are seeking us out against our competition because of our strong delivery reputation. We're beginning to see this disciplined sales approach pay off internally, which gives us confidence that we're on the right path with GIS. Overall, we continue to see demand in the market. With the new sales model for GBS and GIS, you will see us accelerating new work versus renewals. In this quarter, our new work was 63% of our total sales, one of the best new results yet. I want to comment on a press release we issued on October 4. We have been approached by a financial sponsor regarding a potential acquisition of DXC. Consistent with our fiduciary responsibility to maximize shareholder value, we have engaged in preliminary discussions and are sharing information. However, today no formal proposal has been received. Also, there are no assurances that any proposal will be received or determined as adequate by our board of directors. We do not intend to comment further on this matter. As you can see by our Q2 results, our leadership team remains focused on our transformation journey and delivering for our customers and colleagues. Now let me turn the call over to Ken.

Thank you, Mike. Turning to our progress, we continue to move forward on our key initiatives. Q2 organic revenue declined 1.5%, a 110 basis point improvement from the first quarter. Adjusted EBIT margin and non-GAAP diluted earnings per share were at the top end of our guidance range at 7.5% and $0.75 respectively. Free cash flow of $17 million leaves us a little better than breakeven free cash flow for the first six months of the year. We expect our FY '23 free cash flow will be back-end loaded, similar to last year. As you recall, we delivered over $700 million of free cash flow last year. Moving to slide 12 on a year-over-year basis, we have margin headwinds of about 130 basis points from lower pension income (70 basis points), exiting Russia (30 basis points), and FX (30 basis points). Second quarter gross margin declined 110 basis points compared to the prior year and is up 120 basis points sequentially. We anticipate our gross margin will improve in the third quarter as our cost optimization efforts gain traction. SG&A as a percent of sales decreased by 10 basis points driven by our cost optimization efforts. Depreciation was lower by 60 basis points. Other income decreased primarily due to lower non-cash pension income of about $30 million per quarter. As a result, adjusted EBIT margin declined 110 basis points compared to the prior year but is up 50 basis points sequentially. EPS was down $0.15 compared to the prior year and was impacted by $0.10 from FX headwinds, $0.09 from lower pension income, $0.08 due to a higher tax rate, and $0.04 from lower margins. These impacts were partially offset by $0.16 due to lower interest expense and a lower share count. The U.S. dollar has strengthened at an unprecedented level. Given the global nature of our business, let's put the FX headwinds for the full year and context compared to the prior year. Revenue is expected to be negatively impacted by $1.2 billion, a $200 million increase from our prior guidance. Adjusted EBIT is expected to be negatively impacted by $130 million and 25 basis points of margin. EPS is expected to be negatively impacted by $0.40. The FX impact to profit impacts cash flow by $100 million. About 60% of our debt is denominated in currencies other than U.S. dollars. FX reduced our debt by approximately $400 million since our refinancing. Specific to Q2 compared to the prior year quarter, FX impacted revenue by $300 million, adjusted EBIT margin by almost 30 basis points, EPS by $0.10, and free cash flow by approximately $30 million. Let's turn to our segment results. We continue to see improvement in the business mix as GBS becomes a larger portion of the business, which is our focus. Year-over-year, our GBS revenue mix increased 150 basis points to 48% of DXC's total revenue. GBS has consecutively grown for six quarters and is our higher value business with higher margins and lower capital intensity. GBS grew organically 3.4% driven by strong analytics and engineering growth. The GBS profit margin declined 320 basis points year-over-year and was up 80 basis points sequentially. GIS organic revenue improved to a decline of 5.8%. GIS profit margin increased 70 basis points year-over-year, though down 30 basis points sequentially. Turning to our financial foundation on slide 16, debt is down to $4.5 billion and below our target debt level of $5 billion. We recently entered into a $500 million term loan that is undrawn to provide us additional financial flexibility. We continue to tightly manage our restructuring and TSI expenses. These expenses totaled $57 million in the quarter or $92 million for the first half of the year. We expect to see an uptick in restructuring expenses in the second half of the year as we execute on our cost optimization efforts. You will note in our 10-Q we disclosed an $8 million reserve associated with a longstanding historical matter with the Securities and Exchange Commission. This matter relates primarily to disclosure associated with the company's transaction, separation, and integration costs included in its non-GAAP measures from the time of the merger. The reserve represents our best estimate of the potential settlement based on ongoing discussions with the SEC. I should note that under our leadership, we have substantially driven down the TSI expense while increasing the related disclosures of these expenses. Capital expenditures and capital lease originations as a percent of revenue were 6.2% in the quarter, up 100 basis points as compared to the prior year. We continue to examine our capital expenditures and capital leasing as our capital intensity presents a significant long-term opportunity to improve cash flow. Our $500 million portfolio shaping proceed goal is on track. As we previously disclosed, we have one regulatory approval remaining to divest our German banks for €300 million. As we continue to review our facility portfolio, we've identified additional underutilized offices and data centers that we expect to sell that will generate $250 million of incremental cash proceeds. Thus, facility sales have been gaining traction as we execute on our virtual model and make thoughtful decisions on asset returns. These facility sales may create losses on disposal that would impact our non-GAAP results. As our guidance does not include any estimate for these losses, we will be sure to break these out separately in the future to the extent they occur. Related to our $1 billion share repurchase, we did not repurchase any shares in the quarter due to interest received from a financial sponsor. As you know, we are halfway through the $1 billion share repurchase. Turning to our guidance for the third quarter, revenue of $3.55 billion to $3.58 billion, organic revenue growth at minus 1.5% to minus 2.5%. Adjusted EBIT margin is 8% to 8.5%, with non-GAAP diluted earnings per share of $0.80 to $0.85. Our FY '23 guidance includes revenue of $14.4 billion to $14.54 billion, reflecting a $200 million reduction due to FX. Organic revenue is expected to decline by minus 1% to minus 2%, with an adjusted EBIT margin in the range of 8% to 8.5%. We expect margins to improve through the second half of the year based on accelerating our cost optimization efforts. Non-GAAP diluted earnings per share are projected to be between $3.45 to $3.75. Free cash flow for the year is expected to be $700 million. Year to date, our free cash flow has been negatively impacted by lower customer bank deposits of about $100 million held in our German banks. Our guidance assumes customer bank deposits will increase by $100 million back to about $600 million. Services companies don't traditionally own banks, and it can create an unusual free cash flow movement as customer bank deposits change. We are reaffirming our FY '24 guidance. With that, let me turn the call back to Mike for his final thoughts.

Thanks, Ken. And let me leave you with a few key points. As our Q2 results demonstrate, we are delivering and expect to achieve our FY '23 goals. Also, I expect our execution momentum to continue. By focusing on our transformation journey, we have created the following repeatable drivers of our business. Due to our culture, we have the ability to recruit and retain top talent, like the example of engineers and software developers that I mentioned. Due to our ability to deliver for our customers, we have stabilized our revenue. Due to our experienced leadership team, we are executing on our cost optimization efforts and expanding margins. Our new sales model distinguishes between GBS and GIS and will help us accelerate new work versus renewals. Due to our financial foundation, we have created a quality company that is driving shareholder value. These repeatable drivers of our business allow my leadership team to now focus on the future versus the past and give us the confidence in achieving our FY '24 goals. With that, operator, please open the call up for questions.

Thanks, this is Zack Ajzenman on for Bryan. Good progress on the overall organic revenue front. Our first question was on the bookings number in the quarter, which was below one on the book-to-bill. I think last quarter the sub one result was explained by three to four conscious deal push-outs. So first off, did these deals close during Q2, and was the expectation above one this quarter? I'm just trying to better understand if the letter result was all due to the new sales model or was there something else here?

Look, here's where I'm at. I really like what we're doing with the new sales model. Like I said on the call, it totally enables us to accelerate the new work in GBS and be very disciplined with what we're doing in GIS. So when I think about the book-to-bill, this is what I've been starting to say now for probably two or three quarters; I'm looking at both the 12-month trailing along with in-quarter. If you look at what we did last quarter, our trailing 12-month was well over one. This quarter, we're at 0.83. And again, the trailing 12-month is definitely over one, and we expect to continue to drive revenue growth. In GIS, we have roughly a $9 billion backlog, and my point is I think I can afford and we can afford to be patient.

Got it, that's helpful. And then switching gears over to the macro; I didn't really hear anything in the way of macro incrementally weighing on performance. Could you comment on the nature of services that clients are leaning into or de-emphasizing here and how that can potentially impact segment performance? Just high-level thoughts on what you're hearing from clients amid the macro and digging a little deeper into potential segment applications, please.

The color I would give you is this. We continue to see the demand. When you look at GBS, which is the business that we're focused on for growth, I would have thought if the macroeconomic environment was going to hit us, it would have hit us in analytics and engineering. What you see with that is we've got a trailing 12-month book-to-bill over one. You also see growth of 14%. So I think that speaks to not only the quality of the people and what value we can deliver. In the GIS business, we have definitely seen a situation where the deals have gotten bigger. When you're talking about infrastructure and modern workplace, people want more cost savings. So that's making the deals bigger, like the deal I referenced. Yes, they are taking a little bit longer, but I don't think it's because of the macroeconomic conditions. I think it's more based on our disciplined approach to say we are going to do deals that are better than the deals we have today.

Thank you, guys. I appreciate all the commentary there. Just going back to the sales commentary with your new sales force, could you provide more granular detail regarding whether you are adding to the overall sales force or if you're swapping out certain parts of it? Clearly, I understand the relationship selling piece in GBS because that's where all your cross-sell is going to come. Can you talk Salesforce numbers, Salesforce targets, things like that? Any granular detail would help.

Let's talk GBS first. When I say relationship sellers, these are folks that I'm used to in my past. These folks will go out there; they know the automotive industry incredibly well. What they're doing is they're talking about what's going on in the industry, how we can provide value, and what we can do. Projects we've piloted will grow over time in the analytics and engineering space, and then you've got other pieces where we're sitting with a client sketching out what that project should look like. That's what I call relationship sales. That workforce is something Michael Corcoran and Ray have been adding to for probably now the last three to four months, and I expect that to continue. But it's important to find the right folks. In GIS, we’ve been very focused; it is a quota carrying workforce that focuses on RFPs. So here, I'm being very focused on whether you're hitting your quota and doing the kind of disciplined deals we want.

Yes, that's quite helpful. Just in terms of the book-to-bill; as we think of the pipeline, what's going to fill that book-to-bill coming in the coming quarters? Could you talk about the health of that pipeline and any decision-making that's being pushed out? Not because you're being disciplined, but because clients are being careful with what they want to do.

I would tell you that both GBS pipeline and the GIS pipeline are very healthy. The GBS pipeline is filled up with work we're piloting that we're now scaling. The GIS pipeline is reversed; we're seeing that pipeline grow based on the performance of our competition. If you're not delivering for your customers, you're never going to get new work. We're seeing in the industry in the GIS space that deals are coming to the market before their contract has expired, and they want to talk to us, which allows us to be disciplined. So I'm not worried about the pipeline. I'm not worried about the book-to-bill.

Hi, good afternoon, guys. Thanks for taking my question. I wanted to dig in on the free cash flow bridge. Ken, I know you kept the outlook intact at $700 million for this year or $1.5 billion again for next year. Can you just help us again bridge that outlook? Not only the back-end loaded aspect of this fiscal year, but also looking out into fiscal 2024, how you get from that $700 million to $1.5 billion? Thank you.

Yes, that's great, Lisa. Just a couple of things: We talked about this current year being back-end loaded, very consistent with last year. We generated $650 million of free cash flow in the back half of last year. So I think we feel pretty comfortable with that. We had a number of discrete cash outflows that happened in the first half of this year, about $500 million. When you look at the first half and second half, I mean, I would prefer not to have the seasonality of cash but have it be more linear. We're comfortable with the $700 million guide. Looking to FY '24, the improved margins are a big piece of the cash uplift, the reduction of restructuring in TSI, and then we continue to work through our CapEx and understand how we're signing new deals and making CapEx commitments. Our guidance assumes a customer bank deposits increase of $100 million back to about $600 million. We'll keep executing to get there.

Looking at last year's back-end loaded nature, we've got a team now that is a year smarter, making sure we have the collections. So if you combine that with what we've already done, that gives us a lot of comfort in terms of what we're going to do.

I do have a second question. I just had a question also on the revenue outlook. I mean you came in at the upper end of your range in 2Q and down 1.5% on an organic basis, as you highlighted, one of the best results you've had over the last few years, but left your revenue outlook impact for 3Q. So just wondering, do you see upside to that outlook for 3Q or just given the positive trajectory you saw this quarter?

We feel very comfortable about the guide, not only for Q3 but also for the entire FY '23. I like our momentum because I think everybody is seeing what we just printed with our execution momentum back. So I feel good about this.

I wanted to ask about the ITO business and would love to hear your comments on the underlying enablers of the lessened decline that you're seeing in that legacy ITO business. Any color on pricing, new logos, add-on work that might be contributing to that stabilization in ITO and also whether those enablers for ITO can be applied in the near future in the workplace business.

Look, we ran the playbook on that business. We scaled our global delivery network. So we're literally putting the right people in the right locations to make sure that work is done appropriately. Ken talked about the data center consolidation. The last piece is the disciplined sales approach. We're not going to take a deal that can't get better than what we're sitting on right now. That's our playbook. We think we can get significant increases in the workplace business, and that's where we're going.

Yes. The follow-up, I mean, you're getting a lot of questions about the book-to-bill and some macro uncertainty out there. So I guess my question is, you mentioned in your commentary that your new sales model seems to be working internally. Can you just elaborate on what you're seeing that's giving you encouragement internally with the revenue trajectory based on the new sales model?

What we're seeing internally is better deal economics, full stop. That means better terms, better margins, and better long-term outlook in terms of our delivery. That's what's happening in the market right now. We've been at it for 3 years, and I think we're in a very good spot with ITO and heading in the right direction with modern workplace. GBS is totally different; we don’t respond to just rote RFPs from procurement. We're dealing with senior executives at these clients. When you're right in the middle of dealing with the software that goes into the cockpit of the car, you're at the heart of what these automotive manufacturers are doing. It’s important to have these repeatable drivers because we can make this shift to focus on the future versus the past.

I was wondering if you could talk a little bit more about the conversations you're having with clients around pricing. You've mentioned in previous quarters making conscious decisions to push out projects without the right pricing. And it looks like the 3Q guide is around 75 bps above 2Q at the midpoint. So how quickly or to what extent do you think you can continue to pass on price increases, if at all, or if there's any additional leverage you have available to use?

For GBS, we've seen price increases, and that's just the market. We talked about how scarce those engineers and software developers are. Clients are willing to talk to us about price increases because of the value we're delivering. On GIS, we have to show clients how the deal they're sitting on is not priced appropriately. A lot of deals were done at a very price-competitive environment. We're going to continue to play that game because I believe it's working. We look at that 12-month trailing and we’re fine; that will help fuel the growth we need to hit our targets.

Just one quick follow-on. I know you mentioned macro, but from a geographical standpoint, is there anything specific to call out there? I know that with the Luxoft acquisition, there may have been some negative impact given what's happening in Eastern Europe. So just any thoughts there?

We stay very close to that situation. I think we've done a fantastic job taking care of our people. It's unfortunate what's happening with Ukraine, but we haven't seen increased costs in that region. Luxoft is a major piece of that A&E team, and you can see that business continue to grow along with a healthy book-to-bill.

You've got Jonathan on for James. I appreciate you taking the questions. The first one will be on the lengthening decision cycles that you talked about. Can you talk through which specific areas you may be seeing that in and how you're contemplating that in your outlook for the year?

The lengthening decision cycles are baked into the outlook, specifically in the GIS business. We're continuing to take a disciplined approach that's going to help us drive our margins, consolidate our data centers, and scale our global delivery network. It's all part of the guidance we've provided.

And on that point around global delivery scaling, could you dig into potential competition for talent and how you're thinking about wage inflation in the current environment?

The competition for talent is across the board, particularly in GBS. You can pay people whatever you want; if you don't have the right culture, those folks will not stay around. My team has been focused on creating a strong culture that has helped us take care of our people, especially during challenging times like COVID and the Russia/Ukraine situation. I appreciate everybody joining the call today. As you can see, our Q2 results show that we have our execution momentum back. We're focused on our transformation journey because we believe it's delivering for our customers and colleagues. Those repeatable drivers of our business allow my leadership team to focus on the future and give us confidence that we can hit our short-term and long-term goals. With that, Savannah, please close the call.