CONDUENT Inc Q2 FY2021 Earnings Call

Greetings, and welcome to Conduent’s Second Quarter 2021 Earnings Results Conference Call. At this time all participants are in a listen-only mode. I will now like to turn the conference over to your host, Giles Goodburn, Vice President of Investor Relations. Thank you, you may begin.

Good evening, and welcome to Conduent’s Second Quarter 2021 Earnings Call. Joining me on today’s call is Cliff Skelton, Conduent’s CEO, and Steve Wood, Conduent’s CFO. Following our prepared remarks, we will take your questions. This call is also being webcast. A copy of the slides used during this call was filed with the SEC this afternoon. These slides as well as the detailed financial metrics package are available on the Investor Relations section of the Conduent website. During this call, Conduent executives may make comments that contain certain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 that, by their nature, address matters that are in the future and are uncertain. These statements reflect management’s current beliefs, assumptions and expectations as of today, August 5, 2021, and are subject to a number of factors that may cause actual results to differ materially from those statements. Information concerning these factors is included in Conduent’s annual report on Form 10-K filed with the SEC. We do not intend to update these forward-looking statements as a result of new information or future events or developments, except as required by law. The information presented today includes non-GAAP financial measures. Because these measures are not calculated in accordance with U.S. GAAP, they should be viewed in addition to and not as a substitute for the company’s reported results. For more information regarding definitions of our non-GAAP measures and how we use them as well as the limitations as to the usefulness for comparative purposes, please see our press release, which was issued this afternoon and furnished to the SEC on Form 8-K. And now, I’d like to turn the call over to Cliff for his prepared remarks. Cliff?

Thank you, Giles. Good afternoon, everyone. Welcome to Conduent’s Q2 earnings call. I really appreciate everybody being here today. Let me start by saying that Q2 was a very good quarter for us. It marks a milestone in our journey. If you think about the journey from two years ago, in 2019, when I said this was a fundamental and foundational turnaround, I think you’ll be quite pleased with what you’re about to hear today. Through the hard work of our 60,000 associates, we experienced strong performance in sales, operational excellence, profit and top-line, all of which took place during a pandemic as we all know. I’m going to talk today a little bit about why we’re winning and how improved quality is driving value. Then I’m going to turn it over to our new CFO Steve Wood to talk a little bit about the detailed financials. I’m also going to touch on the importance of and our confidence in refinancing our debt over the next few months. So if you please turn to Slide 4. I think you’ll see that Conduent’s revenue came in at $1.26 billion, up 1% year-over-year marking the first quarter of year-over-year revenue growth since the spin in January of 2017. Overall, that performance was driven in large part by Government Payments and a return to near pre-COVID Transportation volumes, project revenue and new business ramp. Meanwhile, adjusted EBITDA was $128 million equating to a 12.5% margin. That’s up 170 basis points year-over-year, driven by mix of revenue and good expense management. Regarding new business sales, Q2 was the strongest sales quarter since the spin at $775 million in total contract value. That’s up 24% compared to our previous high sales quarter of Q2 of 2020. New business ARR was also strong at $115 million, up 10% year-over-year. I’m going to talk about that here in just a minute. Finally, our net ARR activity metric for the trailing 12 months was $106 million. Now this is the third consecutive quarter of growth and I’ll talk more about that in a minute as well. Now, think of that for a minute: $106 million, the previous 12-month trailing was $87 million, the previous 12-month trailing before that was $60 million. So, we’re seeing quite impressive positive growth, which indicates that our new business sales are outpacing our losses. As we run through all those legacy losses, it’s quite an impressive forecast for the future. Also, on Slide 5, you can see that our sales were balanced across our three segments of Commercial, Government and Transportation. On a percentage of revenue basis our Government and Transportation sales performance stands out quite nicely. In the Transportation segment, we signed a 10-year $178 million deal with the UK Department of Transport’s Highways England. This contract marks a significant expansion for our towing business in the UK and Europe. In the past 12 months, we’ve secured three major towing deals, which gives us optimism for the future, and the pipeline continues to be quite strong, with opportunities on a global scale. The sales performance in Government was also quite strong, where we signed two major deals, one with the New Hampshire Department of Health and Human Services for Medicaid Services, and also with the State of Hawaii for Medicaid Claims Processing. In our Commercial business, our sales performance is improving, but it’s still lagging the great performance we saw in Government and Transportation. The good news is that we’ve had some very encouraging early awards already in Q3. We’re doing things like modifying our go-to-market approach, changing our account management and sales approach, upgrading talent, and we have a very serious focus on the healthcare industry. In the Commercial business, a high portion of those legacy losses remain and some of the remnants of the pandemic are also resonant. We’re now burning through those losses and we see the sales reversing in the near term. In aggregate, we’re very positive about our sales results, and we’re quite optimistic regarding the second half. Now, regarding the non-financials on Slide 6; our clients and others are recognizing our progress as well. GM named Conduent as Supplier of the Year in our category for performance across multiple product lines. This was a first-time award for us and separates us as one of the top performers among thousands of suppliers. Our Chief Information Officer was recognized with an American Business Award Gold Stevie for outstanding technology achievement in the category of leading through digital disruption. That’s all about enabling over 40,000 associates to work from home during the pandemic. And finally, I’m proud to represent the company by being recognized among the top CEOs for diversity by Comparably, one of the top 50 CEOs for large companies. This is really important, and I’m very proud of this for our company, because we’re trying to create a culture where all of our associates can be themselves and are empowered to deliver the very best for our clients. The bottom line is that we experienced a quarter of continued operational performance, great sales, and a set of strong financials. However, as you know, the journey is a continuing one. One earnings quarter alone will never represent the destination; it’s always one step along the way. However, we’ve said all along that we intend to tell you what we will do, and then perform against that commitment. This will be the eighth consecutive quarter where we’ve delivered on the commitments we made. So today, we’ll update our guidance for the remainder of the year. Steve is going to talk about that here in a minute, but we remain very optimistic. I want to reiterate that our debt refinancing remains a top priority for us in 2021. The markets remain attractive. And we would expect to refinance the debt in the next few months. Also in the quarter, our well-planned transition of Chief Financial Officers was seamless. Steve Wood has already made significant progress as CFO. I’m pleased to turn the call over to him to take you through some of the more detailed financials. Thank you all very much for listening. Steve?

Thanks, Cliff, and good afternoon, everyone. As we have done in the past, we are reporting both GAAP and non-GAAP numbers. The reconciliations are in our filings and in the appendix of the presentation. Let’s turn to Slide 8 to discuss the Q2 2021 results, starting with the P&L. As Cliff highlighted, we had a strong quarter in line with internal and external expectations with revenue above $1 billion, up 1% year-over-year. The trajectory of our revenue trend continues to be positive. Revenue growth was driven by increased stimulus-related volumes in our Government Payments business, increased volumes across the Transportation segment, and new business ramp partially offset by lost business from prior years. Adjusted EBITDA for the quarter was $128 million, up 16.4% year-over-year, while our adjusted EBITDA margin for the quarter was 12.5% up 170 basis points compared with Q2 2020. The increase in adjusted EBITDA was driven by a strong revenue mix, continued progress across our range of efficiency programs, and a one-time item that affected Q2 2020. This was partially offset by lost business from prior years. Let’s turn to Slide 9 to go over the segment results. For Q2, our Commercial segment revenue declined 3.3%; increased volumes and new business ramp were more than offset by lost business from prior years. Adjusted EBITDA increased 4% while the adjusted EBITDA margin of 10.7% was up 70 basis points year-over-year. This was driven by efficiency progress, as well as a one-time item that affected Q2 2020. Our Government segment revenues grew by 2.1% for the quarter. This was primarily driven by stimulus volumes in our Government Payments business, as well as the ramp of new business in both payments and healthcare, partially offset by lost business from prior years. Government segment adjusted EBITDA increased by 23% while adjusted EBITDA margins of 35% increased by 590 basis points. This margin improvement was due to the revenue mix and efficiency progress. Our Transportation segment achieved revenue growth across all business units. Revenue grew 12.1% compared to Q2 2020 primarily driven by increased volumes and new business ramp partially offset by lost business from prior years. Adjusted EBITDA was down 13.8% compared with Q2 2020, driven by some short-term cost savings that benefited Q2 2020 and revenue mix. Adjusted EBITDA margin for the quarter was 13.5% down 410 basis points year-over-year. For the quarter, our unallocated costs were $69 million, 4.5% higher than the same quarter last year, driven mainly by short-term cost savings that benefited Q2 2020. In the appendix, we’ve included the detail by segment of our year-over-year growth trends for the past six quarters. Our trends in the Commercial and Transportation segments are positioned to continue to improve moving forward as we lap the COVID-19 impacts, ramp new business and work through the remaining taper of the legacy losses. Our Government segment is currently benefiting from the federal support of pandemic SNAP, which, as we have said, will come down over time. Let’s now turn to Slide 10 to discuss the balance sheet and cash flow. Our balance sheet continues to remain healthy and we have a solid liquidity position. We ended the quarter with $403 million of cash on the balance sheet. As of quarter end, we had approximately $743 million of capacity under the revolver. Our net leverage ratio at the end of the quarter was two turns, in line with our target of two to two and a half turns. As you can see on the debt maturity table, our first major maturity is at the end of 2022. We repaid the remaining $34 million of senior secured notes due in 2024 on May 1 of this quarter. As Cliff mentioned in his remarks, refinancing is a top priority. And we see the markets still being attractive. We would expect to complete the refinancing in the next few months. Operating cash flow for the quarter was an inflow of $105 million and adjusted free cash flow was $62 million, an improvement of $24 million compared with Q2 2020. This was primarily driven by strong EBITDA performance and improved working capital. CapEx for the quarter was $41 million or 4% of revenue, an increase sequentially over Q1 and $71 million for the first half of 2021. As a reminder, we constrained CapEx in 2020 due to the pandemic. Now, let’s move to Slide 11 to discuss our outlook for Q3 and full year 2021. With two quarters left to go, and good momentum in our sales execution, we have increased our full year revenue guidance range to between $4.1 billion and $4.175 billion. We continue to get improved line of sight to both the timing and quantum of Government Payments volumes associated with the stimulus programs. As we stated before, stronger volumes in these programs could drive us towards being close to flat in 2021 year-over-year, as compared to 2020. As it relates to pandemic SNAP, we expect volume to remain strong in the third quarter, but will then taper in Q4 as those programs conclude. In terms of adjusted EBITDA, we have raised our guidance range, and now expect full year adjusted EBITDA margin in the range of 11.25% to 11.75%. Our adjusted EBITDA margin in the first half of 2021 was 11.8%, driven by the strong performance this quarter. Looking forward, we expect adjusted EBITDA margins to remain strong, but be slightly lower in Q3 and then to normalize as we transition into Q4. As a reminder, we have said previously we believe the normalized adjusted EBITDA margin for the business, excluding the impacts of the government stimulus volumes, will be range bound between 11% and 11.5% in the short term as we lap these stimulus effects and continue investments to grow top-line revenue and aid retention. We still expect to convert approximately 20% of full year adjusted EBITDA to adjusted free cash flow. Normalized for the expected CARES Act payment in December this year, this number would be approximately 25%. Normalizing both 2020 and 2021 would result in an approximate 900 basis points year-over-year improvement. We have not changed our outlook on our expected 2021 CapEx spend of $170 million, or our restructuring spend between $40 million and $45 million. Before I close, I want to thank our associates, shareholders and clients for their continued support, as well as my teammates who have helped me in my transition into this new role. We will now open up the lines for some questions. Operator?

Thank you. Our first question comes from Shannon Cross with Cross Research. Please state your question.

Thank you very much. I was wondering, can you talk a bit about Commercial and what’s going on there in terms of lost business versus growth and how we should think about margins given the shifting portfolio? I have a couple more questions after that. Thanks.

Yes, Shannon, let me start with Commercial. I think there are two parts to the Commercial story: one is sales and one is the net revenue. If you look at sales, some of this is timing; we’re envisioning a very strong Q3 on sales. On a relative basis, commercial sales lagged a little bit—the really strong Government and Transportation success overshadowed it. We see a lot of that coming back in Q3. On a net basis, though, that negative 3.3% you see on Commercial is significantly improved. If you look at the compares, prior and what we’re seeing there is that net ARR number that we measure across our different segments, and in aggregate, it’s still very positive on Commercial. It’s just a matter of running through the legacy losses. So it’s timing, and we just need a little more time to get that done. But let me just, let Steve add some color to it.

Yes, Shannon, the one other thing I’d add—and Cliff alluded to it when he talked about the net ARR activity metric—is that we’ve seen that sequentially increase on a trailing 12-month basis for the last three quarters. Cliff talked about that in his remarks. Within the Commercial segment, the Commercial contribution to that number has been positive and sequentially improving as well. So, if you think about the Commercial business, I like to think about the two primary hydraulics that are driving where that business is going right now. It’s the net ARR metric for the Commercial segment, which we’re starting to see sequential growth in. And then secondly, there’s the component of the legacy losses. Just a reminder about the legacy losses: we talked about those as being losses in 2019 and prior. We’re really starting now to get into what I call the thin end of the wedge of those legacy losses. We haven’t quantified them in terms of their overall number, but the number this year was more than twice as big as last year, the number next year is going to be half the size of this year, and the number in 2023 is going to be half the size of 2022. So we’ve now got both of the hydraulics—improved sales performance and improved retention—beginning to trend us in the right direction. As we move forward, that gives us increased confidence and line of sight to get that segment back onto a growth path. We just need a little more time.

Okay. And then with regard to the add-on business that you’re selling, what’s driving that? Do you think customers are increasing their programs? Or have you changed your sales comp structure or selling mechanisms to try to increase both revenue and reasonable incremental margin with those deals?

A lot of the add-on business, both the ARR and the non-recurring revenue, is project volume and add-ons to current engagements. A portion of it is also stimulus-related volume, but a lot of it is confidence-driven add-on work. It comes from an improved account management game plan, different leaders and upgraded talent. Frankly, growth in that add-on business is outpacing the growth in our global sales organization improvement, which itself is quite improved.

Okay. One last question: how much of this growth or improvement do you think is just the market growing overall versus better win rates for you? I’m wondering about share within your various business units. Thank you.

I wouldn’t attribute it to market growth overall. I would say it’s improved performance. We have a different sales model and we’re burning through legacy losses. We’re seeing marked improvement in Transportation from both retention and sales, evidenced by the Highways England deal. So, it’s better sales performance and better retention. Markets are modestly improving—3% to 4% in different places—but the picture is still affected by the pandemic. So I would not chalk this up to market growth alone.

Okay, thank you very much.

Our next question comes from Puneet Jain with JPMorgan. Please state your question.

Hey, thanks for taking my question. I have a follow-up to the prior question. Obviously, glad to see revenue guidance being flattish within the overall range. How much of it would stem from near-term benefits that may not continue into next year—like easy comps in Transportation and Government Payments—versus sales performance and improved competitiveness that could sustain beyond this year?

It’s a great question Puneet. It would be naïve to say there isn’t some tailwind from stimulus that will drop off. But it’s all of what you just said. We don’t know exactly where COVID and related volumes will settle. Here’s what we do know: the base business is doing well. In modeling, think about three areas: the base business (net of COVID and legacy losses where we’re pivoting the way we want), the burnoff of legacy losses—Steve described that as the thin end of the wedge—and finally where COVID/stimulus volumes land. That unpredictability makes it hard to allocate exact percentages of the 1% growth to any single driver, but the base business trends bode well for the long term.

Puneet, I agree with everything Cliff said. It’s a combination of factors. As we thought about guidance, we remain positive on sales performance—both new business and add-ons—and we are benefiting from some short-term tailwinds from stimulus. But it’s a mix of those dynamics that informed our guidance.

Understood. You’ve clearly benefited from improved sales execution. But the industry overall is investing heavily in automation and AI and some peers are pursuing acquisitions. How will you respond given balance sheet constraints? Maybe talk about your M&A strategy and how you’ll invest in technology tools to stay competitive.

We are investing in AI and machine learning and have several partnerships across automation and AI companies, specifically in our Commercial business. We’re investing in fraud automation tools that are starting to bear fruit, helping internal fraud management and enabling us to sell those capabilities externally. These investments are incremental rather than big-bang. Regarding M&A, we want to be planful and paced. We’re not looking for a large transformative deal in the near term. We will consider adjacent opportunities, partnerships and tuck-ins, but for now we’re focused on growing organically and showing that in our results. That doesn’t mean large M&A is off the table, but it’s not our near-term focus. Steve, you may want to add on the balance sheet perspective.

I don’t view the balance sheet as a constraint to do the things we need to do in the near term. As we allocate CapEx and other activities, we’re transitioning the CapEx mix toward investments that drive new business and strategic initiatives. We’ve secured foundational strength in the business and that quality has allowed us to sell more to existing clients. Over time, our capital allocation will enable further investments, and the balance sheet is capable of supporting those actions in the medium term.

That’s good to know. Thank you.

You bet. Thank you, Puneet.

Our next question comes from Bryan Bergin with Cowen. Please state your question.

Hi, yes, it’s actually Jerry on for Bryan. My first question: can you characterize clients' willingness to sign deals currently, and how that might have changed over the last three months? In terms of the pace of deal ramps, what are you seeing there?

I think the answer varies by segment and by industry. In the public sector, there are a lot of RFPs out there and the dynamic remains a reputation of quality, price and execution. That hasn’t changed and has been pretty consistent. In the Commercial space, propensity to buy is increasing; there was a dip in the heart of COVID, but overall the market and our ability to sell have been pretty consistent. So you’re seeing steady appetite to sign deals, with variations by sector.

Correct, and how that’s changed over the last three months?

Over the last three months, it’s been fairly consistent overall but varies by segment. Public sector RFP activity remains healthy. Commercial has improved as pandemic uncertainty has eased in some areas. Overall, we’re seeing improved deal flow and continued execution on ramps, but specific timing can vary by project and client.

Okay, great. And then in terms of international plans, which geographies do you think are underpenetrated and the most attractive opportunities currently?

If you think about the Transportation business specifically, that’s where we see the most international opportunity. We just won the towing deal in the UK and see towing expansion opportunities in Europe and South America. We also see some opportunities in our customer experience business internationally, but Transportation has the nearest-term international upside.

Got it. Thank you.

Thank you. There are no further questions at this time. I’ll turn it back to management for closing remarks.

Thank you. I really appreciate the questions today. With everything going on in the world and the unpredictability of COVID, I hope everybody stays well. I know many analysts have been very busy with a lot of other earnings. So thank you very much for taking the time out of your day to be with us. I hope everybody’s well. Thanks.

Thank you. This concludes today’s conference, all parties may disconnect. Have a great evening.