Xerox’s (XRX) CEO Ursula Burns on Q2 2014 Results – Earnings Call Transcript

Source: Seeking Alpha

 

Xerox Corporation (NYSE:XRX)

Q2 2014 Results Earnings Conference Call

July 25, 2014 10:00 AM ET

Executives

Ursula Burns – Chairman and CEO

Kathy Mikells – Executive Vice President and CFO

Jim Lesko – Vice President, Investor Relations

Bob Zapfel – EVP, President, Xerox Services

Jeff Jacobson – President, Document Technology

Analysts

Brian Essex – Morgan Stanley

Ben Reitzes – Barclays

Shannon Cross – Cross Research

Jim Suva – Citigroup

George Tong – Piper Jaffray

Keith Bachman – BMO Capital Markets

Tien-tsin Huang – JPMorgan

Ananda Baruah – Brean Capital

Bill Shope – Goldman Sachs

James Friedman – Susquehanna

Operator

Good morning. And welcome to the Xerox Corporation Second Quarter 2014 Earnings Release Conference Call hosted by Ursula Burns, Chairman of the Board and Chief Executive Officer. She is joined by Kathy Mikells, Executive Vice President and Chief Financial Officer.

During this call, Xerox executives will refer to slides that are available on the web at www.xerox.com/investor. At the request of Xerox Corporation, today’s conference call is being recorded. Other recording and/or rebroadcasting of this call are prohibited without the express permission of Xerox. After the presentation, there will be a question-and-answer session. (Operator Instructions)

During this conference call, Xerox executives will make comments that contain forward-looking statements, which by their nature address matters that are in the future and are uncertain. Actual future financial results may be materially different than those expressed herein.

At this time, I would like to turn the meeting over to Ms. Burns. Ms. Burns, you may begin.

Ursula Burns – Chairman and CEO

Good morning and thanks for joining our call. Today we are reporting second quarter 2014 earnings that continued to reflect the benefits of our diversified portfolio and strong cash flow. We remain focused on our priorities and we are making progress.

This quarter we saw a return to growth in Services and the business is well-positioned for sustained improvement. Services is now 57% of revenue and we are on track to reach our target of two-third by 2017. This important shift will drive overall revenue growth.

Our Document Technology business drove strong profits again this quarter and continues to be an important for us, generating cash and profits above expectation. We continue our initiatives to improve Services profitability. We are seeing good profitability improvement especially within areas like document outsourcing, our commercial BPO business and ITO businesses, including healthcare and international services.

We know that more need to be done especially in government healthcare, where we continue to stand-up a new Medicaid platform and deal with a couple of challenging contracts. So this remains a top priority.

And of course, both segments, Services and Technology we remained focused on our important stakeholder with the keen attention on supporting our customers, delivering value for our investors and making Xerox a great place to work for our people.

In the quarter we invested $227 million in acquisitions. Welcoming into Xerox the employees and customers of Smart Data Consulting and ISG Holdings. ISG is a leading provider of workers compensation software in the U.S.

This acquisition will expand our significant present in the healthcare payor and insurance BPO markets, and we continue to invest organically in areas where we see good market opportunity, such as in private health exchanges, we have a differentiated offering for large employers through Buck Consultants at Xerox.

We have a business that delivers strong cash flow. This gives us flexibility to not only invest for growth, but also build short and long-term shareholder value through a balanced approach to capital allocation that includes share repurchases and dividends.

To execute on our direction, we have a strong team. Jeff Jacobson was recently named the President of our Document Technology business, taking over from Armando Zagalo de Lima, who is retiring after 31 years at Xerox.

I want to thank Armando for everything that he has done for Xerox. He has put our document technology business on a solid foundation by transforming the organization to be more customer-focused, profitable and well-positioned to adapt to changes in the market.

Here to look our results and my perspective. As I mentioned earlier, there are bright spots and positive trends, but we still have work — more work to do. We reported adjusted EPS of $0.27, which is at the high-end of the range that we said.

In the quarter we saw improvement in Services revenue growth. Services revenue was up 2%, that’s up from flat growth last quarter and the business is trending well.

Document Technology revenue had higher declines in the quarter as expected given timing of last year’s product launches. It is in the range of expectations for the first half and we are very excited about upcoming product launches.

Our operating margin is up year-over-year, driven by strong margins in Document Technology, the result of continue good operational discipline and focused on productivity.

As anticipated, though, we did see margin decline in Services, due to the pressures that we are experiencing in government healthcare. We took a non-cash charge in the quarter and are making progress transitioning out of some challenging contracts. Kathy will provide you with more details in a few minutes.

We are continuing our activities to create shareholder value, using our strong cash flow, which is up over $150 million for the first half to repurchase shares at a steady pace, supporting a growing dividend and acquiring companies that enhance our Services capability.

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We have a talented and dedicated team and we are keeping our stakeholders at the center of all that we do. Our goal is to provide excellent product and services, and deliver the operational results that are expected of us.

With that, I will turn it over to Kathy. Then I will wrap up and we will open the call to your questions. Kathy?

Kathy Mikells – Executive Vice President and CFO

Thanks, Ursula, and good morning, everyone. Overall, we feel about our sequential program with the number of the themes from quarter one carrying through to quarter two. We continue to show operating profit growth, driven by strong margin expansion in Document Technology and we had good operational performance in the majority of our Services businesses.

As expected, the government healthcare business continues to pressure Services margin, as we invest in rolling out our Medicaid platform. Additionally, we took incremental non-cash impairment charges, driven by the transition out of the Nevada Health Insurance Exchange. I will cover all of these dynamics in much greater detail when I review segment performance.

First, I’d like to begin by walking through our earnings. Revenue in the quarter was down 2% at actual currency and down 2.5% in constant currency. Segment revenue trends were as expected, with Services revenue growth improving and Document Technology weaker as we face a challenging year-over-year compare due to last year’s product launch timing.

Gross margin of 30.8% was down 70 basis points year-over-year, driven by the Services margin decline, as well as the greater mix of Services. We again saw a significant improvement in both SAG and RD&E as we benefit from productivity initiative, as well as lower pension expense.

These improvements more than offset below our gross margin and resulted in operating margin expansion of 30 basis points year-over-year and 110 basis points sequentially, and enabled higher operating profit year-over-year.

Moving down to income statement, adjusted other net was $14 million higher year-over-year. The increase was split between OID, which was $9 million higher year-over-year, reflecting a real estate gain in the prior year and restructuring which is $38 million was $5 million higher year-over-year and in line with our guidance.

Adjusted tax rate of 27.7% was 360 basis points higher year-over-year and just above our guidance range of 25% to 27%. So, overall, there was a modest year-over-year headwind below operating profit. Adjusted EPS of $0.27 was flat year-over-year and at the high end of our guidance range of $0.25 to $0.27.

Looking at the first half, adjusted EPS of $0.54 was also flat year-over-year, operating profit grew 6% in the first half, despite the pressure we are seeing in our government healthcare business and when combined with lower share count more than offset higher restructuring costs, OID and a higher tax rate. So, all in all, I believe we are making progress, obviously, with more work yet to do.

With that, I will move to the Services segment slide to review those results in a little bit more detail. Services revenue growth once again improved sequentially and was up year-over-year 2% or 1% in constant currency, driven by a pick up in BPO which went from down 2% in Q1, so up 1% in Q2.

Good growth in commercial healthcare and internationally, and better inorganic contribution was partially offset by a negative 1 point impact from the continued June loan run-off, as well as headwinds from lower customer care volume. Trends in document outsourcing up 3% and ITO up 1% were largely consistent with prior period.

Turning to signings, signings were lower year-over-year especially renewal. The combination of a low renewal rate that was below target due to the Texas Medicaid law and the lower overall renewal opportunity resulted in renewal signings contract value down more than 35% in the quarter.

New business signs were better story, up double-digit sequentially, but down 4% year-over-year and flat on a trailing 12-month basis. It should be noted that we did see some contract shift to the second half and we had a couple of large contract awards that won’t be close until later this year.

New York Medicaid, for instance, is not in these numbers. Our new business pipeline remains healthy, up 4% year-over-year and we expect better signings result in the second half. Shifting the profitability, segment margin was 8.6% in the second quarter which was flat sequentially and down 160 basis points year-over-year.

A year-over-year decline was expected but we’re below our guidance of sequential margin improvement. The miss was due solely to the impairment charges we took in the quarter associated with our health insurance exchange platform including non-cash charges related to the Nevada contract.

We didn’t formally adjust out the $20 million net impairment charges, but if we exclude it, our segment margin would be 9.2%, which is in line with our expectation for continued sequential improvement.

So, we’re beginning to get closure on our Nevada HIX contract and will be working with the state to continue to support the 2014 annual release and comply with their decisions to transition to the federal exchange for the next year’s open enrollment.

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Turning to our Medicaid business, the second quarter performance was largely in line with our expectation as we continue to incur higher cost associated with launching our Medicaid platform and getting it to operational maturity. We’re making progress. We had positive references and we’re winning new business in the market. This is an area where we expect lower margins in the intermediate term as we drive improvements in our other implementation.

Within the rest of services, we’re seeing improved performance. I was very pleased with our margin performance in areas like commercial healthcare, document outsourcing and IPO. So our five-plank strategy and cost initiatives are driving improvements in many parts of the business and should continue to ramp as we move through the second half of the year.

Turning to Services guidance. On revenue, second half growth will be negatively impacted by the losses of the Texas Medicaid contract, which is worth roughly 1.5 points of revenue growth. The rest of BPO improved and will also benefit by greater in organic contribution. We now expect to exit the year with a lower single-digit growth rate.

On margin, our expectations are largely intact. We expect sequential improvement through the year putting aside non-cash impairment charges. The third quarter should coming in above 9.2% and we expect to exit the year comfortably above 10%. In terms of full year Services margin, we expect to come in at the lower end of the 9.4% to 9.8% range, reflecting the non-cash charges that we took in the second quarter.

I’ll now turn to Document Technology. Revenue in Document Technology was down 6% at actual currency and 7% at constant currency. This was higher than last quarter’s rate of decline and as we highlighted during our first quarter earnings call, this was anticipated given the timing of last year’s product launches. That impact drove the higher rate of decline for equipment revenue with annuity revenue showing a consistent 4% decline in both quarters.

Looking at the first half, Document Technology revenue was down 5% or 6% at constant currency, which is in line with expectations from mid-single digit decline and includes an approximate one point negative impact associated with our previous finance receivable transactions.

From a geographic perspective, trends were generally consistent with our last quarter with the U.S stable, Europe improving and developing markets still weak. Looking at our product group, activity levels were lower as we save the challenging ConnectKey compare and some large wins in the prior year on graphic communications.

In addition, the timing of this year’s product launches are more back half weighted, which we believe will position us well later in the second half and into 2015. Planned launches include the recently announced Versant’s entry production color product, extension of our ConnectKey platform within our mid range portfolio and into entry as well as a refresh of the number of entry desktop product.

Document Technology margin in the quarter was 14.4%, which was 360 basis points higher year-over-year and continues to run above our long-term expectations. Our strong profit performance reflects ongoing benefits from restructuring and cost initiatives.

In addition, transaction currency and lower pension expenses boosted our performance by 200 basis points. This quarter we also experienced more favorable mix and lower pricing impact. The strong margin performance resulted in operating profit growth of 25% despite a revenue decline. So overall it was a good quarter for Document Technology.

Looking towards the third quarter, we continue to expect Document Technology to have revenue down mid-single digit with good margins although below the first half as we invest in the launch of new products that I mentioned earlier and also expect to have a less favorable impact from mix and some of other variable factors.

With that, let’s turn to the cash flow. Cash flow from operations was strong at $325 million in the quarter following a good Q1 results. Through the first half, cash from operations was $611 million, which was $165 million higher year-over-year.

Underlying cash flow which excludes the impact from prior year finance receivable sales was $437 million in the second quarter and $846 million for the first half. It should be noted that the timing of operating cash flow generation was more balanced between Q1 and Q2 for the first half of this year versus last. And we’re continuing to work to smooth out our working capital flows.

The drivers of the higher year-over-year first half cash flow improvement include lower uses of cash for accounts receivable and inventory and higher cash earning. Partially, offsetting this positive is less contribution of cash flows from finance receivable, which reflects the negative impact of the prior-year finance receivable sales.

Moving down the cash flow statement, investing cash flows were $326 million used in the quarter. We spent $123 million on CapEx and $227 million on acquisition. We closed in May on ISG, which complements Xerox’s current business with the top 20 U.S. property, casualty and commercial health insurance company.

The acquisition pipeline continues to look good and our full year expectation to spend up to $500 million in 2014 is unchanged. Consistent with our portfolio management strategy, this quarter we divested truck load management solutions, a small non-core business within services transportation.

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Cash from financing with the use of $561 million in the quarter and included $299 million in net debt payment, $204 million in share repurchased, and $79 million in preferred and common stock dividends. Ramping up cash flow we had a good first half and our full year guidance remain at $1.8 billion to $2.0 billion of operating cash flow, with the more event distribution through the year.

Second half cash flow will be down year-over-year as the prior year included $384 million in proceeds from finance receivable sales in the third quarter and $270 million and $247 million in proceeds in the fourth quarter with no sales activities planned in 2014. That said second half underlying cash flow should be more consistent on a year-over-year basis.

Now I’ll walk through capital structure. We ended the quarter with $7.7 billion in debt and in line with our original guidance, we continue to expect to end the year with about 7.8 billion in total debt. Applying 7 to 1 leverage on customer financing assets, our allocated financing debt is $4.4 billion, leaving core debt of $3.3 billion.

We managed our core debt to maintain a leverage ratio consistent with our investment grade rating. Our financing debt has come down the past few years, driven by the finance receivable transactions as well as lower origination. So we feel good about our stable capital structure and if we move through the next slide, I’ll review where we’re at on share repurchases and dividends.

With a strong first half cash flow performance and relatively high beginning of the year cash position, we’ve been able to steadily repurchase shares during the first half for a total of $480 million or 42 million shares. We continue to view our shares as a good investment and anticipate doing at least $700 million in share repurchases for the year.

Our full year guidance for dividend payments remains $300 million in 2014 and reflects our current quarterly dividend of $6.25 per share. When combined with the share repurchases, we expect at least a $1 billion to be returned to shareholders this year.

Before I turn it back to Ursula, I just like to summarize our expectations for the third quarter and the full year.

We were once again pleased with the performance of Document Technology and for the third quarter we expect margins to be at the high end of our target range with mid-single digit revenue declines. Given the strong first half profit performance, we expect full year margins to be at least a point above our target range of 9% to 11%, and up a similar level year-over-year.

Within Services, we expect to make may further gains in the second half. The Texas Medicaid contract loss temporarily flows sequential revenue growth improvement and results in an exit revenue growth rate for Services in the low single digits. We feel good about delivering sequential margin improvement and exiting the year comfortably above 10%. And as I mentioned earlier, we expect full year Services margin to be at the lower end of our 9.4% to 9.8% range as a result of the non-cash charges that we took in the second quarter.

At consolidated level for the first quarter, we expect revenue to decline about two point and adjusted earnings per share of $0.25 to $0.27, which includes approximately $0.02 of restructuring. And for the full year, we’re narrowing our adjusted EPS guidance range to $1.09.to $1.13.

And with that, I’ll hand it back to you, Ursula.

Ursula Burns – Chairman and CEO

Thanks, Kathy. I want to get to your questions. So I’ll summarize quickly. Our second quarter shows progress, growing revenue in our Services business, operating profit in our technology business, and reaping the benefits of our strong cash flow. Our profits in Document Technology help offset the headwinds that we’re seeing in some of our Services businesses.

Our focus on implementing the Services strategy is showing positive results, and we are seeing good progress internationally and in areas like document outsourcing and commercial healthcare. Our strong cash flow allows us the flexibility to make strategic investments that will enhance opportunities in the future. Our 2014 priorities and focus are consistent.

In Services, improving growth through portfolio management and profitability by driving cost efficiencies through the business. In Document Technology, capitalizing on the most advantaged segments of the business to maintain our leadership positions in the industry while maintaining strong profitability. And we’ll continue to generate healthy cash flow to deliver shareholder value.

Thank you. And now I’ll turn you over to Jim.

Jim Lesko – Vice President, Investor Relations

Thanks, Ursula. Joining Ursula and Kathy today are Bob Zapfel, head of our services and Jeff Jacobson, head of our Document Technology business. Also let me point out that we had several supplemental slides at the end of our deck. They provide more financial detail to support today’s presentation and complement our prepared remarks.

For the Q&A, I ask participants to please limit follow-on and multipart questions, so we can get to everyone today. At the end of our Q&A session, I’ll turn it back to Ursula for closing comments. Operator, please open the line for questions now.

Question-and-Answer Session

 

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