Summary

Conduent (CNDT: NYSE) is a significantly undervalued technology and business process outsourcing company. After years of mismanagement under Xerox's stewardship, Conduent was recently spun-off and a new CEO appointed who been aggressively restructuring the company. Activist shareholder Carl Icahn, who has been instrumental in the spin-off, currently has 4 board seats, and is highly incentivized to ensure that value accrue to all shareholders.

Conduent Incorporated (NYSE: CNDT) is one those businesses that activist investor Carl Icahn would say was "one of worst run in his 30 plus years of investing in stocks". The fact that Icahn says this about most of his activist investments doesn't take away from the degree of neglect that this business endured, for he invests when the enterprise can be made significantly more productive under his watch. Over the years, Icahn developed a track record of making billions from turning around broken companies. This bring us to why we are interested in this asset, but before we begin let's look into the history of the company.

Same Story, Different Name

The services offered by Conduent today are repacked services from those of Affiliated Computer Services, after Xerox's Business Process Outsourcing (BPO) business was spun out early this year. Affiliated Computer Services Inc. (ACS) was purchased by Xerox Incorporated in 2009. They provided information technology, and business process outsourcing services to corporations, government agencies, and not-for-profit organizations. ACS was incorporated by Darwin Deason in 1988, and by the time of its effective sale in September 2009, it operated in 100 countries, generated annual revenues of US$6.5Bn, and employed 74,000 people (revenue per employee of US$87,837). The company also had average EBITDA margins of 16.5%, and grew earnings per share by 14% CAGR over the preceding 3-years.

According to Xerox's 8-K filings, ACS was acquired in a cash and stock deal amounting to $63.11 per share (US$6.0Bn). ACS shareholders received US$18.6 per share in cash plus 4.935 Xerox shares for each ACS share they owned. Xerox assumed US$2.0Bn in debt, and issued $300Mn of convertible preferred stock to ACS' Class B shareholder -- Mr. Darwin Deason. Our calculations show that the deal was done at an implied EV/EBITDA multiple of 7.9X, which is quite low for this kind of business. Nevertheless, one can understand why this happened as one year earlier there was the great recession, and so valuation multiples would be low for most companies.

At the time of the purchase, Xerox had this to say:

Revenue growth synergies: Xerox will achieve significant incremental revenue growth by leveraging Xerox's strong global brand and established client relationships to scale ACS's business in Europe, Asia and South America. In addition, Xerox will integrate its intellectual property with ACS's services to create new solutions for end-to-end support of customers' work processes.

Cost reduction synergies: Xerox expects to achieve annualized cost synergies that will increase to the range of $300 million to $400 million in the first three years following the close of the transaction. The synergies are primarily based on expense reductions related to public company costs, procurement and using ACS's expertise in back-office operations to handle some of Xerox's internal functions.

Ursula Burns (CEO) on Conduent Acquisition--2009

As is the case with most acquisitions, a rationale that sounded perfectly logical and cheered on by investment bankers in the beginning, turned out to be an oversimplification of the challenges to come. By July 2015, Xerox sold the IT outsourcing segment of ACS to Atos for approximately US$850Mn. At the time, the rationale provided was that the IT outsourcing business was not aligned with the company's business process and document outsourcing expertise. Looking at Xerox's 10-K filings, we see revenues for the ITO business declining from US$1.3Bn in 2012 to a US$1.2Bn run rate by the time of its sale in July 2015. This mediocre performance certainly confirms that something was amiss, but it also reflects the significant underperformance that occurred under Xerox's stewardship. The performance of the reminder of ACS was also mediocre. After adjusting for the discontinued operations of the ITO business, we saw that revenues in the BPO segment flat lined for the 3 years leading up to 2015, while adjusted EBITDA margins and earnings deteriorated significantly. Revenue per employee-- a measure of worker productivity-- also deteriorated significantly. All of this happened while most other industry players were growing rapidly, and enjoying fat margins (more on this later).

In December 15th 2015, Icahn filed a 13D with the US SEC after amassing a 10% stake in Xerox. 13Ds typically indicate a shareholder's intention to exert control over a company. Over the ensuing months, Xerox announced a series of strategic changes that included, among other things, a spin-off of the BPO unit under the brand Conduent. The spin-off occurred in January 2017, and since then there has been a number of changes to the fundamentals of the business, changes that we believe have not been properly priced into the commons.






Improvement in Revenue Quality

A new CEO was hired -- Ashok Vemuri -- and he has begun to unravel the plethora of unprofitable contracts that were entered into prior to his appointment. It is quite puzzling to us that unprofitable contracts were taken on to pursue a revenue growth that never happened. Even more puzzling is that the CEO of ACS, when ACS was owned by the public, did not enjoy the same success when ACS became solely owned by Xerox. Anyway, while the rationalization of contracts has led to lower revenues in the short term, free cash flows and adjusted EBITDA have improved markedly. Mr. Vemuri has also sold assets that are not competitively positioned. The proceeds of these divestments are available to be re-invested in IT infrastructure, and automation. According to the CEO:

During the third quarter, we divested five businesses resulting in $56 million of proceeds which contributed to an improved cash position... These businesses generated $60 million in revenues and $5 million in adjusted EBITDA in the first three quarters of the year... proceeds from the sale we will use to grow the business, both organically and inorganically.

Ashok Vemuri (CEO) on Q3 FY-17 Conference Call

Based on news releases from Atos, we think 3 of these businesses: Pursuit Healthcare Advisors, Breakaway Group, and Healthcare Provider Consulting were sold to Atos Corp. While we are not comfortable with Atos still circling like a crow, we cannot ignore the improved margin profile and worker productivity that came along with the deals. On the Q3 of FY-17 conference call, Ashok also outlined that the company has identified other areas for further M&A:

In addition to the $80 million of our annualized revenue that we have already divested, we are evaluating an additional $250 million to $500 million of revenue for potential strategic actions in the fourth quarter. This extends our effort to right-size the company along a set of core services and capabilities that we intend to amplify going forward.

Ashok Vemuri (CEO) on Q3 FY-17 Conference Call

Cost Containment

Over the course of 2017, overheads declined materially as the company aggressively tackled inefficiencies across the business. According to data provided by the company, SG&A declined from a quarterly run rate of 10.9% of revenues in Q1 of FY-16 to 9.7% in Q3 of FY-17. Management also made comments to the effect that they are largely on track to meet FY-17E cost savings (US$200Mn or 3% of FY-17 revenue run rate of US$6.0Bn), with a sufficient pipeline of initiatives to meet FY-18E cost savings. On Q3 of FY-17 conference call Ashok Vemuri mentioned:

As we consolidate our footprint around the world, we are aggressively closing sites. In the third quarter we closed 24 locations and exited an additional 27 leases. We continue to make progress on overall expenses this quarter with SG&A as a percentage of revenue down to 9.7%, an improvement of 60 basis points compared with Q3 last year. An aggressive adoption of automation technologies combined with process standardization and more modern work models are combining to help us achieve these kinds of efficiencies.

Ashok Vemuri (CEO) on Q3 FY-17 Conference Call

Expectations Going Forward

With so many changes happening in the business, investors rightfully ask what is the right economic model to assume going forward, and how can we be sure that the transformation will be value accretive? First, as investors we are never sure of what the future entails, but the nature of Conduent's business, its industry, management, and history gives us a degree of comfort about our expectations in the midst of many unknowns.

Conduent's business today essentially does the same thing ACS did. It provides back office infrastructure, and front office client support to multiple industries globally. At the core of the company's value proposition is using scale to offer its clients efficiencies in the management of people, processes, and digital interactions with customers (See investor presentation). Few would argue against the idea that these services are deeply integrated in, and mission critical to the value chain of various industries across the global economy. Today, Conduent is organized under three segments: Commercial Industries, Public Sector, and Other, broadly reflecting the nature its clientele. The commercial segment accounts for 60% revenues and 7.5% of adjusted EBITDA, the public segment accounts for 35% of revenues and 15.3% of adjusted EBITDA, and the Other accounts for 5% of revenues and has a negative EBITDA contribution.



Acceleration in Growth

We think the company can re-accelerate revenues above its current US$6.0Bn run rate by FY-19. If we take management's presentation as accurate, at least those that have been filed with the US SEC, CNDT operates in a US$250Bn industry that is projected to grow at 6% CAGR for several years into the future. This growth provides room for "co-opetition" in the space for the time being. Add to this the fact that prior to Xerox's ownership, Conduent/ACS grew revenues by 16% CAGR in the 10-years ending in 2009, and earnings per share by 17%. Today most of the other incumbents in the industry have been growing at a decent clip. Genpact Ltd grew revenues by 6.4% CAGR, Exl Services holdings 17% -- albeit a portion of the growth is due to acquisitions--, and WNS holdings 6%. Convergys is the only outlier with 1% growth over the period. Furthermore, Conduent's products are deeply embedded in its customers' service offerings, leading to fairly high switching costs, and sticky customer relationships--annual client retention rate is above 85%. Contracts are 3 to 5 years in nature, and perhaps even more impressive is the pedigree of the company's clientele -- Fox, P&G, KOCK Industries, GM, RBC, and the list goes on. Most of these companies are dominant in their industries, and have a fairly reasonable growth profile.

Margin Improvement Drives Shareholder Value and Higher Multiples!

Going forward we expect the company to move to a healthier margin profile, as management executes on their cost savings plan and productivity initiatives. Earlier, we pointed to the improvement in SG&A margins to date, we believe there is more to come. The company's investor presentation pointed to US$700Mn (11% of FY-17 revenue run rate) in cumulative annual savings, of which close to US$300Mn have been realized. We think this cost saving projection is realistic for several reasons. 1) If realized, it would put the margin profile of the company slightly above where margins were pre-Xerox (10% operating margin, 16% EBITDA margin). 2) The cost savings would put the margin profile of the company closer to the current margin of its peers. 3) From a productivity standpoint, it is abundantly clear that the resources of the company have not been maximized. Revenue per worker was at US$87.8k just before the purchase, and by the time Xerox got to work it was US$66.7k. Today, we calculate--based on company filings-- that revenue per worker is close to 75k at FY-17 revenue run rate.

An important point to note here is that Conduent's direct peers have lower worker productivity levels than Conduent, yet they have better margins. The worker productivity range of peers lies between 19.7K to 35.8K, while Conduent's is at 66k. In our view, this highlights a couple of things. 1) Conduent has multiple types of businesses under its umbrella. The peer group used here are mostly pure play call center companies with most of their staff located in emerging markets--lower pay per head in us dollar terms and hence you can hire more without increasing cost significantly. Conduent, on the other hand, has a greater proportion of their staff located in developed countries. In our opinion, this cost structure does not only reflect worker location inefficiency, but also the people needs of the businesses they have. The company has businesses that are technology based -- require a few high skilled workers, and businesses that are people based -- require a large volume of moderately skilled personnel. 2) Our valuation will be conservative, as we have used "the lowest common multiple" to value the entire enterprise. Companies in the BPO space that are heavily automated typically have higher margins, higher worker productivity, and trade at higher multiples. Example of such companies include ADP, Paychex, Paycom, and Paylocity all with worker productivity levels that lies between 148k and 214k. If we are right in assuming that the company has many different types of businesses under its umbrella, they would have the option to spin-off the call center business, which could unlock additional value as the right multiples can be assigned to each business unit. If we are wrong and the company really has one type of business, then it means that the cost efficiencies that are being tackled should lead to Conduent having higher margins that its peers. Either way investors should be handsomely rewarded. This goes to the heart of our investment philosophy--we like to invest in businesses that have "strategic optionality".

Comparable Companies Data Stack

Shareholder Friendly Management Team

The newly appointed CEO has a track record of delivering value for shareholders in the BPO space. Ashok Vemuri is an Infosys alumni who at one point was touted as a potential successor to the original founders of the company. Mr. Vemuri is more known however, for what he accomplished at IGate, where under his watch the market value of the company went up by 3X within 2 years. At the time Mr. Vemuri was hired, IGate had huge debt, unsettled tax claims, crippling lawsuits, and the prior CEO had resigned under questionable circumstances.

In an interview with India times, Ashok Vemuri said:

In all my past stints, I've always believed in adding value, whether it is for employees or business models of a company, And I'm very happy now in that, in these past 16-20 months, I've added value for shareholders as well and market capitalization has gone up by three times.

Ashok Vemuri (CEO) on IGate Sale April 2015

At the board level, you have Carl Icahn who has three board seats and is well known in value investing circles as a value creator. Carl Icahn has a 10% stake in the company, and so has skin in the game. Darwin Deason who has a 6% stake in the company, we believe has significant skin in the game and would also love see "his baby" thrive.

Valuation

We think Conduent is today is being priced based on its historical financial position, which reflects legacy issues from Xerox's stewardship. Judging by what management has done thus far and the nature of Conduent's business, we think this valuation is overly conservative. Conduent's adjusted EBITDA and adjusted EBITDA margins are on track to hit US$750Mn, and 12.0% respectively by the end of FY-18. Currently, the worst performing company in the space -- Convergys trades at 7.6X NFY EBITDA, while Conduent trades at 7.2X. Over the years Convergys has grown 0%--negative after adjusting for inflation -- Debt service coverage ratio of 1.4X--slightly better than where we think Conduent will be in FY-18, and a 12.0% margin. Valuation sounds reasonable, right? Well what about the optionality, and what about the scale difference (Conduent is 2.1X the size of Convergys). As we mentioned before, Conduent is not only a call center business as Convergys is, but also has other businesses that deserve higher multiples. Using the "lowest common multiple" overlooks the additional value in the company. Nevertheless, we consider this our downside protection as we are more interested in long term value.

We think this business is worth at least US$46 per share, judging by how the better managed peers trade today. A lot has to happen for us to see this price obviously, as the better managed peers are registering better numbers today. The EBITDA margins of these companies ranges from 17% to 18%, Debt service coverage ratio from 0.5X to 3.1X, and growth from 6.2% to 17.2%. It will surely take some time for Conduent to get to this level of performance. If it does get to this level of performance, and we believe that it will, the company should be valued at 15.0X EBITDA. Using next fiscal year EBITDA, we get US$46 per share, but if we assume the company is going to improve, then in 3 - 4 years EBITDA will certainly be higher than what we have used here, so we are being conservative. Additionally, don't forget that we are using the "lowest common multiple".

Final Remarks

In summary, we think that Conduent is significantly undervalued, and that the patient investor will be handsomely rewarded for investing in this company. Though the business has underperformed under Xerox's stewardship, we believe that this poor performance is purely down to a company specific management and control issues. The industry on a whole is still healthy and is expected to grow in the years ahead. Within this context, we believe that activist investor Carl Icahn should be able to positively impact the company's bottom line and drive value for all shareholders.