DXC Technology Company (NYSE:DXC) Q3 2023 Earnings Call Transcript

DXC Technology Company (NYSE:DXC) Q3 2023 Earnings Call Transcript February 1, 2023

Operator: Ladies and gentlemen, thank you for standing by. My name is Brent, and I will be your conference operator today. At this time, I would like to welcome everyone to the DXC Technology Third Quarter Fiscal Year 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After speakers’ remarks, there will be a question-and-answer session. Thank you. It is now my pleasure to turn today’s call over to Mr. John Sweeney, Head of Marketing and Investor Relations. Sir, please go ahead.

John Sweeney: Thank you and good afternoon everybody. I’m pleased that you’re joining us for DXC Technology’s third 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, Investor Relations. 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. The reconciliations could be found in the tables 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 our quarterly report on our Form 10-K 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?

Mike Salvino: 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 strong Q3 results, where our execution drove record bookings along with margin, EPS and free cash flow that all exceeded expectations. Next, I will discuss our transformation journey and how it has helped us drive these strong results. Ken will then discuss our financial results in more detail and provide our updated guidance. And finally, I will make some closing remarks before opening the call up for questions. In Q3, revenues were $3.57 billion, and our organic revenue growth was negative 3.8%. This was a direct result of the weak bookings in the first half of the year.

However, our organic revenue grew for the second consecutive quarter sequentially, and it is notable that we have driven the same level of revenues in constant currency, excluding dispositions for all three quarters in FY 2023. Our adjusted EBIT increased from 7.5% in Q2 to 8.7% in Q3, highlighting the strong execution of our cost optimization efforts while not negatively impacting our customers. Our non-GAAP EPS increased to $0.95. Our book-to-bill of 1.34 is the strongest book-to-bill results since I’ve been CEO. This quarter we almost hit on all cylinders by having five out of our six offerings deliver a book-to-bill of over 1.0 Overall, Q3 showed strong execution and has created good momentum for us. So now let me give you some additional color around our transformation journey, which is at the core of how we are creating these results.

The first step is to inspire and take care of our colleagues. We are seeing improved attrition due to the way we are taking care of our colleagues and our efforts to change the culture at DXC. I am proud of how we are taking care of our roughly 4,000 colleagues in the Ukraine, and we continue to be impressed by their resiliency to take care of their families and our customers. Concerning COVID-19, we were just awarded the President Certificate of Commendation in Singapore. This prestigious honor has awarded the organizations that made exceptional efforts, which had a significant impact in Singapore’s fight against COVID-19. I want to thank the women and men of DXC, along with my leadership team for their continued execution. And as we look to 2024, we will continue to take care of our people and continue to adjust and add to my leadership team to deliver on our commitments.

The next step in our transformation journey is to focus on our customers. The key metric here is our Net Promoter Score. And our most recent NPS score was 27, near the top end of the industry benchmark. This solid customer delivery has driven sequential organic revenue growth in constant currency for two quarters in a row. The key thing I would like to highlight is that we have now delivered roughly the same level of revenue in constant currency, excluding dispositions for all three quarters in FY 2023, and you will hear from Ken that we are guiding to a fourth quarter at a similar organic level. Now this is a great accomplishment as we have been a company with declining revenues for the past several years. Also, you will see our strategy for GBS and GIS working.

In GBS, we continue to grow the business and expand margins. This is the seventh quarter of consecutive organic revenue growth. As a result, GBS continues to become a larger part of DXC, now accounting for approximately 49%, up from 48% in Q2, demonstrating that the business mix is trending towards the new tech of GBS. In GIS, we continue to stabilize revenue and expand margins. We are seeing our increased financial discipline and ITO payoff as the demand we saw in the market translated into strong bookings this quarter, which we expect to drive future revenues. So you can see we are executing on both parts of our growth strategy to accelerate growth in GBS and moderate the declines in GIS. This execution of our growth strategy is why we expect to drive flat to 1% organic revenue in FY 2024.

The third step is to optimize cost. Clearly, we are executing on our cost takeout numbers as we expanded our margins from 7.5% in Q2 to 8.7% in Q3. We continue to take a thoughtful approach to cost takeout by focusing on our entire organization, while delivering for our customers. This approach gives us confidence that we can continue our efforts for the remainder of FY2023 and into FY2024. The other piece of our cost optimization efforts is portfolio shaping. You will hear from Ken that we were able to generate approximately $375 million of cash from the sale of data centers in the quarter along with the German banks in early January. In the area of seize the market I am extremely pleased with our bookings this quarter. A record book-to-bill of 1.34x brought us back to over 1.0x on a year-to-date basis for FY2023, and this shows strong momentum as we are completing FY2023 and heading into FY2024.

In GBS, all three offerings delivered a book-to-bill of over 1.0x and we continue to see momentum in our engineering and software capabilities that we discussed last quarter. But this quarter we saw even greater success in applications. In GIS, our more discipline approach to deal making has paid off. In Q3, we signed over $800 million of ITO deals that were delayed from the first half of the year and signed two new logos by closing deals with SAP and Georg Fischer in Modern Workplace. Again, this shows good execution and momentum as these deals will create future revenue. It is clear that there is demand in the market for our offerings and we need to be patient because we are taking work from our competition at better economics. Our final step is our financial foundation where we generated $463 million of free cash flow this quarter.

Photo by Howard Bouchevereau on Unsplash

The execution in this area was outstanding and it gives us great momentum to hit our yearly guide for free cash flow. This free cash flow result, along with the cash we generated from portfolio shaping, including the sale of the German banks in January, totaled $840 million. We anticipate that we will use approximately $400 million to pay down our debt further, enhancing our investment grade profile, and we plan to repurchase approximately 400 million of DXC shares to complete our previously announced $1 billion share repurchase program. Now, before I turn the call over to Ken, I want to reiterate what we said in our October 4 press release. Management has been approached by a financial sponsor regarding a potential acquisition of the company.

Consistent with our fiduciary responsibility to maximize shareholder value the company is engaged in preliminary discussions and is sharing information. We do not have any further update on this situation today, and we will not be commenting on it further. Now let me turn the call over to Ken.

Ken Sharp: Thank you, Mike. Let me provide you a quick rundown of our Q3 performance. Q3 organic revenue declined 3.8%. Adjusted EBIT margin and non-GAAP diluted earnings per share were above the top end of our guidance range at 8.7% and $0.95 respectively. Free cash flow was $463 million in the quarter. The team is making great progress with what we expect will be two consecutive years of positive cash flow of at least $630 million. This is quite a turnaround from two years ago with over $650 million of negative free cash flow. Moving to our key financial metrics, third quarter gross margin declined 60 basis points on lower volumes. SG&A as a percent of sales increased 10 basis points. Depreciation was lower by 10 basis points.

Other income increased 60 basis points primarily due to asset sale gains of $24 million and FX hedging gain of $11 million, partially offset by lower pension income. As a result, adjusted EBIT margin was flat compared to prior year and up 120 basis points sequentially. EPS was up $0.03 compared to the prior year due to $0.08 from a lower share count, $0.06 from a lower tax rate, $0.02 from lower interest expense, these benefits were partially offset by $0.13 from lower revenue and FX. Let’s turn to our segment results. Our business mix continues to improve as our GBS revenue mix increased 110 basis points to 48.7% of DXC’s revenue. GBS grew 0.2% organically. The GBS profit margin declined 220 basis points year-over-year and was up 130 basis points sequentially.

GIS organic revenue declined 7.4%. GIS profit margin increased 190 basis points year-over-year and was up 50 basis points sequentially, benefiting 80 basis points from settling a commercial matter in the current quarter. Turning to our offerings, Analytics and Engineering continued with solid organic growth up 11.7%. Applications declined 6.8% on lower project revenue, coupled with a difficult prior year compare as Q3 was the strongest growth quarter in FY2022. Insurance Software & BPS is up 3%. Our Insurance Software business is about $550 million of annual revenue and grew approximately 7% in the quarter. Security was up 4.2%. Cloud Infrastructure & IT Outsourcing declined 5.4%. Modern Workplace was down 15.3%. We are encouraged by the recent new logo wins.

Let me tie the year-over-year organic revenue declines above with Mike’s earlier point on sequential quarterly revenue. I am pleased to note that we’ve delivered three quarters of revenues that are flat on a constant currency excluding divestitures basis. Further, we are guiding to a fourth quarter that is also going in a positive direction all while on the backdrop of very strong Q3 bookings, demonstrating our momentum. Turning to our financial foundation. Debt is $4.7 billion. We continue to tightly manage restructuring and TSI expenses. These expenses totaled $55 million in the quarter. And year-to-date, restructuring in TSI is $147 million, down $124 million from prior year. Capital expenditures and capital lease originations as a percent of revenue were 6.4% in the quarter, up 120 basis points as compared to prior year.

We continue to believe our capital intensity presents a long-term opportunity to improve cash flow. Free cash flow for the quarter was $463 million on January 3. We closed the sale of our German banks. Customer deposits were $70 million lower as compared to the start of the year, thus creating a free cash flow outflow. With the sale of our German banks for €300 million, we have substantially completed our $500 million portfolio shaping and asset proceeds goal. Last quarter, we announced a new $250 million asset sale proceeds goal. While selling these real estate assets will bring in real cash, we expect to incur a noncash loss that is not incorporated in our guidance. In Q3, we closed on four facility sales, yielding $56 million of cash proceeds and recognized a $16 million gain.

The combination of our Q3 free cash flow, sale of our German banks and our Q3 asset sales delivered $840 million in cash. To put a finer point on the $840 million of cash, it is over 12% of our market capitalization. We expect to deploy $400 million to repay a portion of our debt, and we’ll adjust our target debt level to $4.5 billion. With the bank sales, customer bank deposits are no longer part of our cash balance. Accordingly, we are reducing our target cash balance to $1.8 billion. As these new target levels, we have an additional $400 million available to repurchase our stock. Turning to our capital allocation on Slide 19. We repurchased approximately $600 million of our stock to date. With cash on hand, we feel good about our ability to deliver on our $1 billion share repurchase.

Our Q4 guidance. Organic revenue decline of minus 2.6% to minus 3.1%. Adjusted EBIT margin of 8.7% to 9.2%, and non-GAAP diluted earnings per share of $1 to $1.05. Turning to our FY2023 guidance. Organic revenue decline of minus $2.6 million to minus 2.7%. Adjusted EBIT margin of 8% to 8.1%. Non-GAAP diluted earnings per share of $3.45 to $3.50. As I mentioned earlier, our free cash flow was negatively impacted by $70 million due to lower customer bank deposits held in our German banks. Accordingly, free cash flow was adjusted to $630 million. As Mike and I reflected on our FY2024 guidance we gave almost two years ago, we envisioned a business that could grow with solid margins and good quality cash flow. We still envision that same business today.

Let me provide you some context on our original FY2024 guidance. At the time, organic revenue was declining double digits, and we guided to organic revenue growth of 1% to 3%. Adjusted EBIT margins were approximately 6%, including 190 basis points of noncash pension income, and we guided to a 10% to 11% margin. Free cash flow was negative $650 million, and we guided to $1.5 billion of free cash flow. Lastly, let us not forget the $900 million of annual reoccurring restructuring and TSI costs that we guided to $100 million, all while expanding margins. From our vantage point, we have come a long way over the last two years as the business is on a much stronger foundation. Let me take a minute to update you on our preliminary FY2024 expectations.

For organic revenue, we are working plans to drive the business to flat to 1% growth, adjusted EBIT margin to expand above FY2023 levels, but do not expect margins to exceed 9%. When we provided the FY2024 EBIT guidance, pension income was 65 basis points higher than where we are in FY2023. We are assuming pension income continues at a similar level and is a 65 basis point headwind from our original FY2024 guidance. Free cash flow to increase above FY2023 levels, but do not expect to exceed $900 million. When we set our FY2024 $1.5 billion free cash flow guidance, we had $900 million of capital lease payments. The capital lease payments are not part of free cash flow, but we’re a significant consumer of free cash flow, leaving $600 million of cash generation.

As we sit here today, we expect to originate about $200 million to $250 million of capital leases in FY2023. Our lower originations over the last couple of years has driven down the capital lease payments to about $400 million next year. We will refine our FY2024 guidance on our next earnings call once we complete our annual planning process. With that, let me turn the call back to Mike for his final thoughts.

Mike Salvino: Thanks, Ken, and let me leave you with a key takeaway. We will achieve our inflection point at the end of FY2023 and deliver the business we have always envisioned in FY2024, albeit with slightly lower guidance. As we exit FY2023, you can see that we have cleaned up many of the challenges from our past that Ken just outlined. Our clear execution of our transformation journey has built a quality company that you can depend on to deliver revenue that is not declining, change the mix of the revenue to the higher-value tech offerings of GBS, expand both margins and EPS, win new work in the market as our offerings are relevant and in demand, generate strong free cash flow, manage our debt and return cash to shareholders.

Now this is great execution, but we didn’t come here to DXC to fix the challenges. With the momentum that we’ve created in the business, we have confidence that we are poised to deliver the business we had envisioned in FY2024, as we can see the ability to drive revenue flat to 1% growth, expand both margins and EPS, rotate the revenue to the new tech of GBS and generate increased free cash flow. Getting this inflection point was no small task, and my management team and I are proud of the quality company we have created, along with being clear and excited about the future of DXC. And with that, operator, please open the call up for questions.

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Q&A Session

Operator: Your first question comes from the line of Bryan Bergin with Cowen. Your line is open.

Mike Salvino: Hey Bryan.

Bryan Bergin: Hey guys, how you are doing? Good afternoon. Thank you. Wanted to start on free cash flow. So Ken, just hoping to dig on the moving pieces here to make sure we understand this for 2023 and 2024. So can you first talk about some of the factors that drove the strong 3Q performance? Should we expect the continued lumpiness in free cash flow generation going forward? Or does that start to kind of smooth out? And then just to clarify on the last point you made there after capital leases, it sounds like the real net free cash flow difference in your fiscal 2024 post capital lease payments is about $100 million, given you’ve taken the number down. So a couple of combo questions are on free cash flow to start, please.

Ken Sharp: All right. Great, Bryan. And look, if I need to clarify, feel free to jump back in. Look, its great work from the team, right? We’ve been at this for a couple of years, right? If you wind the clock back, the business had negative free cash flow. We’ve done a lot of work. Probably the biggest, you look at it now two years in a row of positive cash flow over $600 million. So it’s really not lost on us, right? A lot of good work from a lot of people across the entire business. The biggest driver, right, if you had to just kind of look holistically at the business has been the focus on driving down the restructuring in TSI. So I think that’s been somewhere around $600 million swing, so year-to-year. So I think that’s a pretty big piece.

And then just this quarter, we had built up some AR. It’s a little bit hard to tell on the balance sheet but €“ because of FX movements and so forth. But we had built up some AR in the last couple of quarters and brought that back down this quarter to kind of a more normalized level. So really, the team has done a nice job just driving across the business. And then when you look to FY2024, I think the net is a good way of looking at it. The leasing was out of probably a little bit, it didn’t have the right economics from our perspective. So when we looked at it, and it also creates some, I would say, business oversight challenges. When you’re leasing a lot of assets, it’s not always as economic as you want it to be. So we went through a process of making sure that when you lease assets that it goes through kind of the right economics and has the right hurdles to it.

So when we did that, of course, we brought down the level of leasing pretty dramatically. I think everybody knows this, right, but it gets a little confusing on the cash flow statement. If you lease assets, they drop below free cash flow because they are financing purchase basically. If you buy them straight out, they go rate through CapEx. So as we squeeze down on the leasing, certainly that some of that capital ends up in the CapEx, which directly impacts free cash flow. So in that way, is certainly a good way to look at it. I mean, certainly, I think when you look longer-term, we’ve got opportunities to improve it. Our CapEx as a percent of revenue is higher than a lot of our peers, so I think that’s a place we need to continue to work on.