Thesis: DXC was formed in a merger of HPE’s Enterprise Services (“HPES”) division and CSC. We believe the combination represents a unique opportunity to buy one of the world’s largest pure-play IT services companies for ~7x P/E. HPES was an overlooked segment within the much larger HPE conglomerate focused on legacy hardware (i.e. servers and data storage). The union of the bloated cost-structure within this segment and CSC CEO Mike Lawrie, who has had a phenomenal track record cutting costs at CSC already, creates a large margin improvement story with a few other levers for value creation that is being overlooked by the market. Additionally, we believe DXC may trade off over the next couple weeks due to technical selling by HPE shareholders who are given unwanted shares allowing for an attractive entry point. We believe DXC could be worth 11x 2020E EPS of $10/share for ~60% upside in 3 years (although the share price will likely rerate faster than that as Management executes on its plan). A spin or sale of the Company’s public sector business could lead to even further value creation.
DXC should be able to achieve at least 15-16% adj. EBIT margins once the acquisition is fully integrated, which would put the company at levels similar to peers including Accenture, IBM and CGI Group (14.9%, 15.0% and 15.2% EBIT margins respectively). DXC will have 8.5% EBIT margins post-merger closing, so closing this margin gap represents a 750bp opportunity.
At its analyst day on March 30, DXC laid out its FY18 and 3-yr outlook in addition to detailing its strategy for turning around rev growth, cost take out plans, and capital allocation priorities. DXC expects EPS of $6.50-$7 in FY18 growing at a CAGR of 20% to $9.25-$10 by 2020 driven by 700-800bps of EBIT margin expansion and share repurchases. DXC expects to turnaround the current revenue decline of -4% to -1% toward positive growth of 1-4% by FY2020 as headwinds in the core business (-4 to - 7% revenue decline) are offset by 25-30% growth in the Digital business, 7- 10% growth in key industries and BPS (faster than the three year industry CAGR of 4% till FY2020), and 1-2% from tuck-in acquisitions. The company expects FCF to adj. net income conversion of 100%+ and expects to generate ~$12bn in operating cash flow (OCF). DXC expects to return 30% to shareholders delivering $0.70 benefit to EPS over the next 3yrs.
DXC’s management team has a proven track record of exceeding synergy targets at CSC. The cost-cutting and margin expansion opportunity as DXC is simply a continuation of the story, and we expect management to consistently exceed synergy expectations as they have been doing with CSC since 2012. CEO Mike Lawrie and CFO Paul Saleh joined CSC in 2012, laying out an aggressive strategy to cut costs and find efficiencies in the business. At its Sept. 2012 analyst day CSC outlined a plan to achieve $2bn in gross synergies over 3-5 years – and CSC achieved this target in 3 years, beating synergy targets by 43%, 155% and 20% in FY13, 14, and 15 respectively.
DXC trades at a meaningful discount to IT Services peers even before cost synergies are realized. DXC trades at ~8.5x NTM P/E relative to peers trading between 12.5x and 18x NTM P/E. Notably, in 2012, CSC traded at 6x before cost synergies were realized, but then rerated to 13x as the management team executed on its cost-takeout plan.
Outside of the cost improvement story, we believe there is call optionality in DXC’s US Public Sector business. Management has stated that it intends to consider “all options” with respect to this segment. We believe the market is applying the same multiple to this business as the rest of DXC despite Government IT Services companies trading for ~3x higher EV/FCF multiples than traditional IT Services peers. A spin or sale of this business could lead to 5-15% incremental upside.
In summary, DXC Management has a great track record executing on cost-takeout and value creation while at CSC and materially exceeding guidance. Cutting costs of HPES will be a very similar playbook to what management has just executed on over the past 3 years and the magnitude of the margin improvement the Company has outlined squares with the margin profiles of peers. The management team has also laid out detailed guidance of the cost takeout, which we believe is low-hanging fruit and imminently achievable. The Company is cheap (~8.5x NTM P/E) on an absolute and relative basis even before any of the synergy opportunity is realized and there’s potential to create even further value through a sale/spin of the public sector business.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise do not hold a material investment in the issuer's securities.
Management execution on cost-takeout and revenue stabilization