DXC Technology Company (DXC) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the CSC Second Quarter 2013 Earnings Call. As a reminder, today's call is being recorded. For opening remarks and introductions, it is my pleasure to turn the call over to Mr. Steve Virostek. Please go ahead, sir.

Thank you, operator, and good morning, ladies and gentlemen. Welcome to CSC's second quarter 2013 earnings call and webcast. CSC issued our earnings release this morning, and I do hope you've had an opportunity to review that document. On the call with me today are Mike Lawrie, our Chief Executive Officer; and Paul Saleh, our Chief Financial Officer. As usual, this call is being webcast at csc.com, and we've also posted slides to our website, which will accompany our discussion. On Slide #2, you'll see there's a discussion of some of the matters that we discuss today will be forward-looking in nature. Please keep in mind that these forward-looking statements are subject to known and unknown risks and uncertainties, which could cause actual results to differ materially from those expressed on the call. A discussion of our risks and uncertainties is included in the Risk Factors section of our Form 10-K, 10-Q and other SEC filings. On Slide #3, we acknowledge that CSC's presentation includes certain non-GAAP financial measures, which we believe provide useful information to our investors. In accordance with SEC rules, we have provided a reconciliation of these metrics to their respective and most directly comparable GAAP metrics. These reconciliations can be found in the tables of today's earnings release and in an appendix to our Web slides. Both documents are available for your review with the Investor Relations section of the CSC website. Finally, I'd like to remind all listeners that CSC assumes no obligation to update the information presented on this conference call, except, of course, as required by law. And moving to Slide #4, I'm pleased to hand the call over to Mike Lawrie.

Okay. Thank you, Steve, and good morning. Hello to everyone on the call. Thanks for your interest in CSC. As you know, we issued our second quarter results earlier this morning, and I'm joined by Paul Saleh, and he and I will take you through those results and also provide a quick update on some of the other key initiatives that we're executing against to continue to drive improvement in CSC's financial performance. I really want to leave you with 4 key messages today, and then I'll develop each of those messages a little bit. But the first message is our solid Q2 results reflect continuing financial improvement, primarily driven by our cost takeout efforts and better contract management. The second message is we had strong commercial bookings in the quarter, but a lot of the uncertainty in the federal market was a drag on our total bookings and that certainly impacted our NPS bookings. The third message is our turnaround activities that we talked about in September when we were together are gathering pace, and we are beginning to see tangible results of this throughout the business. And as a result of that, we are raising our fiscal year 2013 EPS target to a range of $2.30 to $2.50 per share. And then the final message is, not dissimilar from what we talked about in September, we do see some market uncertainties, most notably around the federal government and sequestration and also continued macroeconomic headwinds, particularly in Europe, and we do have sort of the mid case reflected in the numbers and the targets that we've talked about. So let me just go into a little more detail on each of those, and then I'll turn the call over to Paul. In terms of our improved financial performance, we…

Yes. Thank you, Mike, and good morning, everyone. On this call, I'll comment on our quarterly results. I'll update you on our cost takeout program, and I will just give you some comment. I'll comment also on the revised targets for the year. On Slide 9, our second quarter results were reported as revenues of approximately $3.85 billion, represent a 3% decline year-over-year, but only a 1% decline in constant currency. Our operating income in the quarter was $298 million and included a workforce restructuring charge of $58 million. Operating margins, as Mike mentioned, were 7.7% in the quarter and were sequentially ahead of our first quarter margin of 4.6%, and that reflects the benefit of our cost takeout actions. Year-to-date margins of 6.2% are running at the high end of the range which we provided for the full year. Operating margins improved by 150 basis points year-over-year after adjusting for the U.S. claims settlement charges in the prior year. If you look at diluted EPS, our results were $0.83 per share in the quarter, which compares favorably with the prior year loss of $18.56. In the second quarter of last year, CSC's results included a goodwill impairment charge of $18.21 and a claims charge of $1.20, and those were partially offset by a tax settlement benefit of $0.72 per share. Adjusting for these items, EPS last year would have been $0.14. Speaking of taxes, our tax rate in the quarter was 31.7% and 34.8% for the first half of the year. And for the full year, we continue to expect of an effective tax rate to be in the range of 32% to 36%. Free cash flow was $237 million in the quarter, representing a year-over-year improvement of $505 million. Now let me turn to segment results, starting with…

Okay. Paul, thank you very much. Operator, we can now open this up to some questions.

[Operator Instructions] And our first question comes from Darrin Peller with Barclays.

Just, if you wouldn't mind, maybe a little more specifics around where exactly -- maybe building blocks to the $280 million you've done year-to-date. What we're trying to understand is -- first of all, is the $500 million to $600 million for the year, is that -- are you just ahead of plan and that's still going to be $500 million to $600 million for this year? Are we going to move into more of that $1 billion to $1.2 billion this year? Secondly, I know during the Investor Day, Mike, you had mentioned reinvesting, I think, it was around 75% of that 25% passing through. I know you again mentioned you'd see around $200 million to $250 million reinvested, but how much actually was reinvested in this quarter because based on the margin expansion, it looks like a lot of it passed through to the bottom line?

Yes, I -- let me answer the second question first. I mean, the biggest expense we had, reinvestment, if you will, in the second quarter was the restructuring charge of $58 million, if I remember correctly. So that was the biggest single investment, and that's obviously helping us then achieve an operating expense run rate lower than we had in the first quarter. I still think we're -- as Paul said, we're sort of at the high range here of the cost takeout for the full year, so I don't want to declare anything more than that. We are slightly ahead, but a lot of that is a result of some actions we took at the end of last fiscal year around the restructuring, particularly at the U.K. and Germany and the Nordics. And those teams did a great job executing that part, and we're seeing the benefits in our run rate now. I would also say we've made some good early gains in procurement as we've centralized procurement and got some standardized contracts in place and some standardized buying around the world. So you get sort of an initial blip in terms of cost reduction when you put that in place, and then that begins to moderate as you move forward and get to a more of a steady-state run rate. So I think Paul's called it right here. I think we're at the high end here of the cost takeout this fiscal year, and we're at the high end of the reinvestment. Most of that reinvestment has come around restructuring charges to date. We will be making some reinvestment, particularly in our systems, our financial systems. We are going to begin to invest in some go-to-market or demand generation activities, particularly sales people, as we see that demand pick up in areas like cloud and Cyber, for example, and even some geographic areas. So I think we've got this called pretty much the way we see it right now.

That's great. Just one quick follow-up on that point. From a contribution revenue, you said there is -- I didn't realize the restructuring included reinvestments in cloud and Cyber and some of the new growth areas, but that's good to know. From a contribution of revenue standpoint, can you just describe some specifics around early advances in your goals on reaching a higher percentage of revenue from those next-generation infrastructure, such as perhaps cloud and Cyber? Have you seen some early success?

Well, we have seen some early success. I mean, Paul and I worked pretty hard trying to put together, what I'd call, an economic model around cloud. There's a lot of -- I won't call it hype, but a lot of discussion around cloud. And what Paul and I want to get comfortable with is the economic model that supports cloud. Because the hypothesis here is that as we begin to deliver infrastructure services more as a service or from the cloud, we want to make sure there is an existence theorem that says we will get higher margins, higher contribution than we do from our existing infrastructure business. And we boil this down to 2 fundamental things: One is the capacity of the compute and storage facility in the cloud, and we understand that now. We understand where we break even. It is a geometric progression as you begin to get more capacity utilized. And then the second thing is the labor to support that compute capacity. It's very important that, that labor cost come from lower-cost areas around the world. And if you manage those 2 variables well, then there is an opportunity to have significant higher contribution to profit from the revenue associated with that. So where we are now is we are much more now in the mode of demand generation. So we're comfortable with the economic model. We've got a lot of this infrastructure in place. And now, it comes time to begin to sell. Gartner just put us in the leaders' quadrant for our cloud infrastructure offerings, so we're really going to begin to try to push the accelerator here on the demand generation side.

Our next question today comes from Edward Caso with Wells Fargo.

And my question is around the margin for the NPS group. It seems particularly high here. Are there any contract adjustments and so forth that may have helped the margin this quarter?

No, this is our seasonally high quarter for NPS. So it pretty much tracked with what we thought, maybe a tad better due to the fact that NPS also took cost and expense actions. So the combination of a seasonally high quarter, coupled with the fact that Dave Zolet and the team took some early cost and expense actions, mainly in the first quarter, gave us a slight bump. But I don't see anything materially different than the -- our goal here of trying to get to sort of 8% to 10% high-single digit margins for the NPS business.

Okay. Can you talk within the 3 categories, how much of your awards were for new business as opposed to recompete or renewal?

I don't have the exact number. On the commercial side, most of the business was new business, while there was quite a bit of renewal. Part of the Zurich Financial Services was a renewal, but there was also contract expansion there. Paul, do you have...

No, no.

The exact numbers on new? We can get that to you. It was more than half was new business. I just don't have the exact percentage. And that's something we watch pretty carefully because we obviously want to drive an expansion of our existing contracts in our existing client base.

Okay. Last question, do you -- the sequestration, is there any hedge in your guidance for that? Or are you just going to adjust if it happens?

We'll adjust to whatever happens. I mean, we just, to be honest with you, don't have a clue as to exactly what's going to happen. I suspect there will not be an immediate impact. Where we've seen an immediate impact is with the new contract signings, as I reported. I don't expect to see, at least in the third quarter, a major hit or change in our revenue projections. And then depending on how this gets resolved or not resolved, it could have some impact on our fourth quarter as we go into the next fiscal year. So we would update you at that point in time.

Yes. So to answer your questions about the bookings, 50% came in from existing -- around 50% came in from new versus recompete in the quarter. And for the first half of the year, it's 60% new and 40% recompete.

[Indiscernible]

Our next question today comes from Rod Bourgeois with Bernstein. Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division: I'm trying to quantify your year-over-year change in margins and free cash flow, while excluding extraordinary items in both the current period and in the year-ago period. So for instance, on the cash flow side -- I mean, your cash -- your free cash flow is up $505 million year-over-year. But it looks like maybe $110 million in the current period came from the NHS settlement payment, and then there was a $200-plus million, I guess, settlement negative item in the year-ago period. Is that the accurate way to look at the free cash flow, in which case the free cash flow is up about a little over $100 million year-over-year, is that the right way to look at it when you exclude extraordinary items on the free cash flow side?

Rod, that's exactly how we look at it. Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division: Okay. So on an operational basis, taking out the NHS settlement, you've got $100 million -- maybe a little over $100 million of year-over-year improvement. Is that -- what would you attribute that to? And are there onetime items contributing or detracting from that $100 million year-over-year change?

No. The thing that's been a positive to that has been the cost takeout and the expense actions and some reduced capital expenditure. So that's driven the positive side of it. On the negative side of it, we've had some ongoing payments associated with severance and restructuring programs that were announced in the first quarter, where we actually made the cash payments in the second quarter, but that all pretty balances out. I think the way you characterize it is how I think about it. From an operational standpoint, it's roughly $100 million improvement and the rest was NHS and the fact that we didn't have to make a repayment this quarter as we did in the previous quarter in 2012. Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division: Okay. And then just the same question on the margin side, can you help us quantify the year-over-year margin change if you exclude -- like in the year-ago period, it seems there would have been some accounting true-up items that hurt the year-ago period margins. I'm assuming you're not having that occur in the current period. Is there a way to give us a year-over-year margin change, excluding some of these lumpy items?

Yes. I think if you look at last year's operating income margins, they will be 4.8%. And this quarter, we said it was 7.7% and that included some restructuring that we have taken. And what Mike has alluded to is absolutely the case. It's improvement in the cost takeout. Combined in -- within it is the improvement in the focus accounts that are, again, contributing to a year-over-year improvement.

Yes. I think, Rod, there's no magic here. I mean, it is just on a -- I mean, we're trying to get some much clearer straightforward numbers as we wash through some of these additions and subtractions. But at the end of the day, it's pretty straightforward, our operational performance is improving. Our revenues are basically flat. So we're getting the improvement in margins and profitability and EPS primarily through an intense focus on our existing contracts and new contracts and the ongoing expense and restructuring actions that we are taking. It is no more complex than that. Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division: All right. And, Mike, just on the restructuring actions and I'll close on this.

Yes. Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division: In my view, this business needs restructuring pretty much every quarter just by the nature of the business. I'm assuming the restructuring you're incurring now is sort of an above normal level. But is it a lot above a normal level, or is it just a little bit above a normal level, if I'm sort of thinking about that the right way?

It's significantly above, significantly above. And we'll probably have some more restructuring as we finish out this year and do our delayering work. Yes, you always have some restructuring. You have contracts that expire and people go off of that, but we're fundamentally trying to get to a more streamlined organization. We have more overhead than we need in this company at every level, at our regional level, at our headquarters level and that is coming out. We have got -- I just don't think we need 13 layers of management between the client and me, and that's coming out. So that -- those actions do contribute to a higher restructuring run rate right now, and I don't see those things repeating unless we get sloppy in our discipline in the years ahead and build that overhead structure back in, which I've got no intention of doing because we're going to benchmark ourselves against the best-of-breed in our industry and stay on those benchmarks. So again, our -- the run rate on restructuring expenses is higher than I expected to be on an ongoing basis, but I do expect that higher-than-normal run rate on restructuring to continue for several more quarters as we clean up the business.

Our next question comes from Arvind Ramnani with BNP Paribas.

What I would really want to get an understanding of is, are you able to provide some details on how you're renegotiating existing contracts to improve contract profitability? And you can pick 1 or 2 examples, or you can just give us a broad set, whatever conversations you're having and how are you improving profitability so fast among your problem accounts.

Okay. Well, that's a great question. I talked a little bit about this in the past. One, the reason we're seeing a fair amount of improvement early on here is just flat-out discipline and focus. That's all it is, just focus. I'm on this stuff every other week. We've got a management system in place now. You ask questions. You put actions in place. You follow up to make sure those actions are taken. This is just good old-fashioned business 101 discipline, and that gives you a real bump. Now in order to make that sustainable, you then need to make systemic changes, and that revolves around our bid models. We've just rolled out a whole new delegation of authority throughout the business, so we understand at what levels of the business we're going to take what risks, and those are all more systemic changes to the model that will allow us a more consistent disciplined approach to contract management as we go forward. In terms of conversations with our clients, they range the gamut. Sometimes, we amend the contract for a little less revenue, but more profitability. Other times, we get an agreement to expand the scope or, in some cases, as we've gone through these contracts, we've found that we haven't billed all of the scope changes that we should have billed. So then we go to the customer and say, "Gee, we haven't billed these. We're going to bill them now." So those conversations run the gamut of the different levers that we have to improve profitability. But it's not just about improving profitability, it's about improving value, the value that we deliver to the client. So this isn't about, "Let me just go figure out how to make more money," this is about how do we add more value to our clients and in the process be more profitable. So that's the genesis of the discussion with the clients is what can we do to help them. And in helping our clients, we drive more profitability for our shareholders at the same time. So it's a two-way street.

Great. That's helpful. And having run an IT services company myself, I know the kind of stuff you are doing. It's pretty hard. But are there any accounts that you feel there's risk that the clients are really not open to renegotiating and there's a chance that these clients may say, "Okay, let's kind of close out the relationship?"

Sure, there are some that, that might be an outcome. You're absolutely right. And when you -- if you ran an IT services business, you know as well as I do nothing is status quo. Contracts that are in good shape one month can be problems the next month because you're always implementing things, you're doing things and that creates operational risk. And so this is -- nothing in this business is status quo. What you need to do is put a good disciplined process in place, so you have early warning to problems. And then you have to have a management team that is proactive, recognizes those early warning signals and then goes out and does something about it as opposed to just watching it happen. It's sort of like defensive driving, you need to proactively deal with these things. But the key thing is around trying to maintain client goodwill, doing what's right for them and, in turn, doing what's right for CSC. But, yes, I do expect some of these contracts will not be renegotiated favorably. That's just part of the business.

Great. That's really, really helpful. Just one quick question on the interest expense. Kind of, just looking at your debt schedule, do you get about $24 million, $25 million in interest expense for next quarter? Or is it...

No, that is not the case. I think interest expense in the next -- in this current quarter will be higher because of that onetime item of the redemption. Early redemption has a cost of about $19 million as I made -- as I clarified in my notes. And then in the fourth quarter, the interest expense comes down. And as a result of that, I think we'll benefit from the lower interest expense in the fourth quarter. It'll be benefiting to us in the second quarter. But net-net, you'll see interest expense up sequentially, then back down. And we'll...

And this is, I mean, not just -- again, I compliment Paul. This was a big cloud that was hanging over CSC, which was our debt maturity schedule. It just wasn't a great schedule. And now we've got that pretty well smoothed out. And then the other big cloud that we're able to get removed was the agreement with NHS this quarter. So those 2 things give us a little more certainty and a little more clear visibility as we go forward.

Our last question today comes from David Grossman with Stifel, Nicolaus. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Throughout the call, you've referenced a lot of moving pieces in the margin structure. So perhaps to simplify things, can you guys just maybe help us understand some of the specifics that will impact margins in the second half of the year, perhaps that we didn't see in the first half? I think you just mentioned the $19 million for refinancing and there were several other items noted, but perhaps you could just review those quickly, so we have an idea of what some of the items that are going to happen in the second half of the year that we didn't see in the margin structure in the first half?

Right. I think we -- let's take it in steps. So we said that our cost takeout is progressing well at the high end of the range. And so I would suspect that we'll have just a slight benefit from that in the second half of the year on a net basis. We will do better on our cost takeout net of the reinvestments that we are making. Some of the headwinds that we would have is there's some seasonality in our MSS business in the third quarter, then it kind of comes back in the fourth quarter. The other thing is our NHS new accounting. As I mentioned to you, this is going to be now accounted under service accounting. And as a result of that, if I were to look at the entire contribution from NHS in the first quarter, this is Lorenzo and non-Lorenzo part, that would be a -- we were slightly positive in the first half of the year. If we include again all of the business that we do with the NHS, in the second half of the year we will be operating closer to breakeven. And so when you net all of these things out, you get back to what we gave you as a guidance, which is, sequentially, third quarter would be a little weaker than it was in the second quarter, and then it will pick up again in the fourth quarter. And for the total year, we will be at the $2.30 to $2.50 range in EPS. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: All right. And given just your progress and where you stand going into the second half of the year, is there any reason that -- and I apologize, I know it's early, but any reason to think differently about fiscal '14?

No, I think it's too early to think about fiscal '14. I just -- I really want to see what happens here over the next 3 or 4 months, not only on our ability to continue to execute. As I said, this was a good incremental step here in the quarter, but 1 or 2 quarters doesn't make a trend. So I want to see us continue to execute. We're bringing a lot of new leaders into the company. That's positive, but we've got a lot of change that we're going through. So, one, I want to see our continued execution; and, two, I'm -- like any business leader right now, I'm trying to understand what's going to happen here, particularly in the U.S. with our federal business, that's very important and then the continued commercial business in Europe. And it's just too early to make a clear call on that for 2014. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Okay. All right. And just one other thing, Mike, then, is can you help us maybe understand a little bit better some of the changes that you've made in the demand creation engine? You've referenced a couple of things in terms of leadership changes, but can you give us any specifics? And also, should we expect the investments to ramp in that effort as this year progresses and we get into next year as the focus shifts from cost to revenue...

Sure, sure. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Or demand creation?

Sure. One, we are bringing in some outstanding sales leaders, I mean, real sales people. I mentioned Blake [ph], I mentioned Pete Espinosa, but we've got some others. These are proven sales leaders. They understand how to drive technology solutions into the marketplace. So we're trying to move from we respond to RFPs to we actually create demand for our offerings in the marketplace. So that's one, is that it starts with -- always starts with people and it starts with sales leaders. We are beginning to ramp up some of our sales people in cloud, for example. So I talked about the fact that Paul and I are reasonably comfortable with the economic model now under cloud. So we're beginning to go out and recruit people into our cloud offerings, likewise with Cyber, where we're seeing some success in demand and also with Big Data. The other area is cross-sell. I think I mentioned, when we were together in September, of all of our global 1,000 accounts, we only cross-sell into about 12% of those. So we're changing how we approach that because if you have a happy client that you're delivering value to, it's an easier place to go sell additional services and capability to. Zurich Financial Services would be an example of that. And then there's certain theaters, geographic regions that we see growth. We see good growth right now in the commercial sector in the United States. We see growth opportunities in parts of Asia. So we're going to target these investments in sales, in particular, in those areas where we see and are very comfortable with the trend line, and we have factored that into the projections that we have communicated today.

There are no additional questions or comments at this time.

Okay. Well, listen, again, thank you all for your interest in CSC and dialing in today. And I look forward to catching up again in the near future. Thank you.

And, ladies and gentlemen, that will conclude today's presentation. We appreciate your attendance. You may now disconnect.