DXC Technology is a B2B IT services company that provides information technology solutions. It provides enterprise-level services through a mix of fast growing, stagnant, and declining verticals. Its main competitors are Accenture, Cognizant Group, Infosys, and CGI Inc.
On March 9th, DXC entered into a purchase agreement to sell its Health and Human Services Business (“HHS”) to a private equity firm for $5B cash on a 3.5x TTM sales multiple. This happened just as the market was collapsing from the COVID lock-downs, leading to an extreme fade on a massive rally. Indeed, it seems the market has all but forgotten that DXC, a $4B market cap company, just closed a sale for $3.5B of after-tax cash proceeds. Perhaps it thinks the deal won’t go through, but the date of the deal and the following clause from the Purchase Agreement force us to think otherwise.
Additionally, for the past few years, DXC’s stock price has been on a steady fall because of a declining top-line. What a better time to reevaluate DXC than now given it is poised to see a significant decline in sales this year and then show growth on a lower base-revenue going forward?
The current picture looks like this. The company trades at 0.60x TTM EV/Sales, but only 0.46x pro-forma TTM sales. There are two paths the current valuation can take. Either the market continues to apply an already low 0.6x sales multiple on the pro-forma company or it truly believes a 0.46x multiple is deserved and it continues to apply that instead. I believe it will apply 0.60x on a go forward basis because the lower multiple would lead to negative equity value on next year’s revenue. The point of this exercise it show that DXC has basically hit rock bottom in terms of a multiple. 0.6x sales is already half DXC’s nearest competitor and much lower than the peer group’s 1.97x depressed median. Maybe 0.60x is deserved, but anything much lower would be mathematically improbable.
So, let’s assume 0.6x EV/Sales is DXC’s future. When you combine worst-case projected future cash flows and keep a distress-level multiple, you start to see the absurdity in the current market price.
Assume -50% revenue, margin contraction across the board, $1.5B in AR write-downs (40% of outstanding), and $400m in working capital additions for five years on a smaller business with currently break even working capital, and you still get positive IRR (5.77% over 5 years, much higher over 10). This shows the absurd margin of safety in this business in that there are still positive returns to be had even if the company were materially smaller in the future.
So, what happens if DXC aggressively buys back shares like it has consistently done over the past couple years? What happens if sales only fall 35% instead of 50%? This seems probable given that global IT spending is expected to fall only 8%. What happens if DXC doesn’t lose 40% of receivables from largely enterprise clients and doesn’t commit an additional several billion to working capital? What happens if DXC actually reduces its “non-recurring” restructuring costs? What happens if DXC commands a 1.0x sales multiple on a rebased revenue coming out of 2020/21? What happens if DXC is able to successfully sell the two additional divisions they want to, representing $3.5B in revenue, for something more than 0.6x sales? What happens if Luxoft, its recent high-growth acquisition comparable to EPAM Systems, commands an implied value greater than the zero it currently does? As you can see from the rough FCF build out above, the results quickly reach upwards of 20% IRR over a decade.
I think a lot of DXC’s selloff has to do with its immense debt burden and massive goodwill write down last year (excluded in the normalized model above). But, given that DXC raised an additional $500m in debt recently and doesn’t have any debt due until 2022, distress risk is remote. It is interesting to see new, unsecured bondholders give a highly levered company money at 4% interest during a crisis while the market assigns distress-level multiples to that company’s equity.
HHS Sale Sale Doesn’t Go Through
I think this possibility is remote, again looking at the timing of the deal (it happened in March) and the language in the Purchase Agreement shared earlier. Even if it doesn’t go through, I still believe there is no long-term impairment to the investment, though there may be significantly lower returns. Again, the margin of safety at this price is very real and is driving me into this investment in size.
I sold this position on 9/8 for a 30% gain.