|Shares Out. (in M):||203||P/E||17.0||11.3|
|Market Cap (in $M):||2,952||P/FCF||N/M||N/M|
|Net Debt (in $M):||1,875||EBIT||177||311|
Recommendation: Long Conduent (NYSE: CNDT) - $26 PT / ~ 80% Upside
Xerox recently completed the spin-off of Conduent, its Business Process Outsourcing (BPO) unit. Xerox (XRX) stock was up ~20% after the completion of the spin-off, indicating the market is more interested in the Xerox classic business than Conduent. Recent sell-side research reports indicate that many investors are wary of investing in Conduent due to the perception of the business as one with shrinking revenues and weak margins, as well as overblown political concerns (potential implementation of the Border Adjustment Tax). It is worth noting that ~ 130mm shares of Conduent have traded since trading of the stock began, which is very substantial relative to the total float of 203mm shares (likely indicating many holders of XRX have decided to sell the shares they received).
The recent spin-off of Conduent presents a compelling opportunity to invest in a business that has been under-managed as part of Xerox, has substantial margin upside potential, has demonstrated robustness through the economic cycle, is trading at a compelling valuation, is being led by a proven operator in the space (CEO Ashok Vemuri was hired last summer to lead the company), and is a likely acquisition target once margins have been fixed and revenue stabilizes.
The BPO industry is a $250 BN global market, growing at ~ 6% annually. The main justification for a company outsourcing a given process in its value chain is that it wants to focus on its core competencies and the economic activities that engender its “secret sauce”, as these are the largest drivers of its economic returns and competitive advantage. The growing trend toward business process outsourcing is driven by the increasing competitiveness of the global economy and the trend away from full vertical integration of the value chain; many businesses are electing to let a BPO firm handle parts of the value chain that they are not most suited to performing. BPO firms are usually contracted over a period of years by a firm to serve as a partner in the value chain; contracts are typically structured such that BPO firms must cut costs every year of the contract in order to maintain the same margin of profitability on the deal.
The BPO industry has a reputation for being a commoditized industry, which is not entirely accurate; the industry encompasses a spectrum of services, some of which are highly commoditized, others of which are more differentiated. One of the best examples of a commoditized BPO service is call centers (uniform output of talking to customers and most players use outsourced labor in low-cost countries like India). For the most part, the more difficult and mission critical a service BPO firms provide, the less commoditized that service. An example of a mission critical service is healthcare processing (e.g., claims processing, member administration, etc.); this service is critical as failure to properly process claims and botched customer administration can be highly detrimental to healthcare franchises and potentially trigger large fines. The primary justification of the BPO industry’s existence is twofold: scale in low-skill, labor-intensive functions such as customer service centers to generate adequate returns on capital in those economic activities, and the expertise to perform mission critical processes that companies do not want to manage themselves (i.e., intellectual knowledgebase of how to effectively deliver certain parts of the value chain). Another large portion of growth in the BPO industry is services provided to the government; as the scope and scale of services provided by the government grows, the government is inclined to let BPO firms handle services related to the actual administration of those services (e.g., administering EBT cards, claims processing for Medicare / Medicaid, etc.).
Conduent is largely comprised of the assets Xerox acquired from Affiliated Computer Services (ACS) in a ~ $8.3 BN deal (total EV) completed in 2010. ACS was essentially a portfolio of different business process outsourcing units, many of which were acquired steadily over time. The table below illustrates the key reporting segments of the business at the time of the sale.