Xerox Holdings Corp Q4 FY2021 Earnings Call

Good morning, everyone. I'm David Beckel, Vice President and Head of Investor Relations at Xerox Holdings Corporation. Welcome to the Xerox Holdings Corporation fourth quarter 2021 earnings release conference call hosted by John Visentin, Vice Chairman and Chief Executive Officer. He is joined by Xavier Heiss, Chief Financial Officer. At the request of Xerox Holdings Corporation, today's conference call is being recorded. Other recording and/or rebroadcasting of this call are prohibited without the express permission of Xerox. During this call, Xerox executives will refer to slides that are available on the web at www.xerox.com/investor, and will make comments that contain forward-looking statements, which by their nature address matters that are in the future and are uncertain. Actual future financial results may be materially different than those expressed herein. At this time, I would like to turn the meeting over to Mr. Visentin. Mr. Visentin, you may begin.

Good morning, and thank you for joining our Q4 2021 earnings call. I hope everyone is safe and healthy. Summarizing results for the year, revenue of $7.04 billion grew slightly year-over-year in actual currency, but was down 1.4% in constant currency. Adjusted EPS of $1.51 was $0.10 higher year-over-year. Full year GAAP earnings of minus $2.50 reflects an after-tax noncash goodwill impairment charge of $750 million or $4.08 per share which is largely a reflection of the impact COVID-19 pandemic has had on our print business. We generated free cash flow of $561 million, $87 million greater than the prior year. Adjusted operating margin of 5.3% was lower year-over-year by 130 basis points due primarily to supply chain-related disruption and incremental investment in our new businesses. Our assumption entering the year was that in-office work would normalize following the winter wave of COVID-19 infections and the global rollout of effective vaccines. However, the Delta and Omicron variants of COVID-19 delayed the company's plans to return workers to the office, causing a reduction in expected post-sale revenue and profits. In the second half of the year, we experienced an unprecedented level of supply chain disruption, with conditions deteriorating throughout the final two quarters of the year. These disruptions resulted in revenue falling below expectations we laid out at the beginning of the year, with most of the shortfall comprised of high-margin mid-range devices and post-sale revenue. Supply chain disruptions also drove an increase to our backlog of equipment and IT hardware to nearly $350 million, which is approximately two and a half times higher than at the end of 2020. I am proud of the progress our team made this year, advancing initiatives that will set Xerox up for long-term growth in revenue and profits. We continue to streamline and optimize our operations and exceeded our target Project Own It savings of $375 million in 2021. We invested in and grew areas of our print and services business that will lay the foundation for long-term stabilization and growth, such as IT services, digital documents services, and hybrid workplace solutions. We stood up three new businesses, CareAR, XFS, and Innovation, and developed a blueprint for monetizing investments and innovation, as evidenced by the formation of our Eloque joint venture and the outside investment in CareAR we received from ServiceNow, valuing CareAR at $700 million on a post-money basis. We generated more than $500 million of free cash flow while investing significant amounts to expand our capabilities and grow our new business. Despite continued uncertainty, there are many reasons to be optimistic as we head into 2022. Demand for our equipment remains strong, as evidenced by our backlog, which stands at close to $350 million as of year-end. That is 31% higher than the prior quarter and is primarily comprised of high-margin office equipment. This suggests to us that companies are continuing to invest in printing equipment in anticipation of the return of workers to the office. We expect nearly all of this backlog to be installed, given previous quarters' timely clearing rates and limited risk of cancellation. But we do expect to carry an elevated backlog at least through the first half of the year. As the backlog clears, our equipment revenue mix will improve, driving gross margin higher. We continue to believe that a broader return of workers to the office in 2022 is a matter of when, not if, and for Xerox, the correlation between return-to-work trends, page volume, and post-sale revenues remain strong. This suggests employees print when they return to the office and clients continue to value printing services. Our breadth of product offerings, suite of digital document workflow solutions, and externally recognized security capabilities position us well to address evolving workplace needs going forward. At our Investor Day on February 23, we will share more detail about each business' strategy and their respective pathways to monetization.

Thank you, John, and good morning, everyone. As John mentioned, continued disruption to the global supply chain and new COVID-19 variants negatively affected our financial results in Q4. Revenue increased sequentially from Q3, but extensive high-margin product shortages and shipping delays due to the Omicron variant caused Q4 revenue to come in slightly below our expectations. Despite this setback in Q4, demand for our products and services remained strong, as evidenced by our increased backlog of roughly $350 million, which is close to 2.5 times the size of last year's fourth quarter backlog. Further, our hybrid workplace and digital solutions are driving new business wins, with page volume higher in Q4 than in any quarter since the beginning of the pandemic. These broader trends underpin our confidence to invest nearly $400 million in our stock this quarter while maintaining investment in strategic growth priorities, driving our expectation for revenue growth in 2022. Turning to profitability, as with Q3, higher supply chain costs, a less profitable mix of equipment, and lower margins on post-sale revenue drove our profitability lower year-over-year. Gross margin declined 330 basis points in the fourth quarter; 240 basis points of this decline is attributable to supply chain costs and capacity restrictions, including higher freight and shipping costs, and constrained availability of higher-margin A3 devices. 90 basis points of the decline relate to investments to support future growth and lower royalty revenue from Fujifilm's business innovation. We continue to expect supply chain disruption to pressure gross margin through at least the first half of 2022. Adjusted operating margin of 4.8% decreased 470 basis points year-over-year, reflecting lower gross profit as previously explained, lower government subsidies net of Project Own It savings, and costs associated with standing up new businesses. These headwinds were partially offset by lower selling costs, bad debt expenses, and compensation. RD&E was $75 million in the quarter or 4.2% of revenue, which was an increase of 30 basis points as a percentage of revenue year-over-year. Despite a difficult operating environment, we continued to invest in new businesses this quarter, particularly in 3D, cleantech, and IoT. We generated free cash flow of $182 million in Q4, down from $221 million in the prior year. Lower cash earnings, which included significant investment in our new businesses, were offset by working capital benefits from lower finance receivable originations due to lower equipment sales.

I will now hand it over to Xavier to cover our financial results.

Thank you, John, and good morning, everyone. As John mentioned, continued disruption to the global supply chain and new COVID-19 variants negatively affected our financial results in Q4. Revenue increased sequentially from Q3 but extensive high-margin product shortages and shipping delays due to the Omicron variant caused Q4 revenue to come in slightly below our expectations. Despite this setback in Q4, demand for our products and services remained strong, as evidenced by our increased backlog of roughly $350 million, which is close to 2.5 times the size of last year fourth quarter backlog. Further, our hybrid workplace and digital solutions are driving new business wins, and page volume was higher in Q4 of this year than any quarter since the beginning of the pandemic. These broader trends underpin our confidence to invest nearly $400 million in our stock this quarter while maintaining investment in strategic growth priorities; and this trend drives our expectation for revenue growth in 2022.

Turning to revenue, supply chain disruption and the spread of the Omicron variant in December resulted in equipment and post-sale revenue coming in slightly below expectations. However, the underlying fundamentals of our business remained strong. Equipment orders once again outpaced supplies, resulting in a cumulative backlog this quarter of equipment and IT hardware of nearly $350 million, a 31% increase over Q3 and nearly 2.5 times prior year levels. For context, our backlog is now approaching a full quarter worth of equipment and hardware sales. The quality of our backlog remains high, and we expect nearly all excess backlog to be realized as revenue as supply chain conditions normalize. Post-sales trends also continue to correlate well with return-to-work trends. Recent page volume momentum is an encouraging indicator about the future trajectory of post-sales revenue as workers return to offices, even in a hybrid model. In services, pandemic-related closures caused several large new business signings to fall into 2022, but renewal rates remained high, and full-year renewal rates were 2 points higher than the prior year. I will now hand it over to Xavier for the financial results.

I appreciate your question. So, we snapshot the trend from a revenue perspective to manage the growth on all existing businesses. And from a free cash flow standpoint, it is also monitoring the materially improving forecasts now because each of the new businesses is starting to take off. And we believe we're in a good place from a cash flow perspective.

Thank you, Xavier. I would now like to welcome our questions.

Certainly. Our first question comes from Ananda Baruah from Loop Capital. Please go ahead with your question.

Hey, good morning, guys. Happy New Year. Thanks for all the detail and for taking the questions. Just a couple, if I could. First, on the revenue growth, how are you guys thinking about based on what you see right now, kind of the normalized revenue growth of the business given the backlog, given that you're looking for revenue growth this year off of a big drop down in 2020, but then pretty stable 2020 and 2021? I would love to get your thoughts there. And then I have a quick follow-up.

Yes, Hi, Ananda, so good morning. For revenue, you should look at that with two angles. One is equipment, and as you have seen, that we suffered in quarter four from supply chain disruption, mainly driven by the lack of chips there. But you saw as well that our backlog equipment backlog, which is a strong backlog has increased by 31% over quarter three and also year-over-year. So we expect this backlog to resolve or to clear during the second half of the year. With the visibility we have on supply chain, we usually have around $100 million to $150 million of backlog of equipment. We expect, I would call that half of this backlog to be resolved, the remaining backlog to be resolved in the second half. Then post-sale is everything related to back to the office and employees using our solutions and using our equipment there. So good news Ananda, we mentioned this, and we commented here is that in Q4, since the beginning of the pandemic, we recorded the highest print volume on our equipment, particularly in October and November. However, December was a little bit softer due to the pandemic variant, but we feel encouraged with Omicron now being more behind us and the recovery we start seeing in quarter one, coming from various countries, not only in the U.S. but also in Europe.

And do you think, sort of the new business notwithstanding, do you guys think once you get through the backlog, the revenue decline profile of the core business could resume that to being similar to prior to the pandemic, or do you think it could look different?

Yes, Ananda. Good morning. When you think of the revenue backlog in our print business, what we've done is also invest in the IT services business, which wraps a lot of solutions and digital services around the product and we've seen a lot of good growth come from both those businesses. Our strategy moving forward is to win market share, which we have in the last few quarters, and continue to win in the spaces where we're strong. And then two, we will continue to wrap our services around security services, IT services, and NPS services around our product base, so that we can achieve sustainable growth going forward.

That's really helpful. I'll leave it there, I know there are a lot of questions. Thanks, guys.

Thank you, Ananda.

Thank you, Ananda.

Thank you. Your next question comes from the line of Shannon Cross from Cross Research. Your question please?

Hi, yes. Thank you very much for taking my question. I'm curious, I realize you're not giving EPS guidance, but as we look into early 2022, how should we think about operating margin trajectory? I know Xavier, you talked about it being up to the full year, I believe, on a year-over-year basis, but clearly, there's going to be pressure early on. So maybe if you can just give us some more color on how you're thinking about linearity during the year that would be helpful?

Yes. Hi Shannon, good morning. From an operating margin perspective, we expect improvement. As you know, the operating margin is highly driven by revenue mix. What we faced during 2021 and 2020, was a less favorable mix of post-sales revenue. We expect this post-sale revenue to improve next year with the hybrid environment and back to the office trends. At the same time, the backlog that we have currently from an equipment point of view mainly impacts the A3 equipment, which tends to generate higher margin. Assuming that the back-to-office trends improve during the second half of the year, and some of the backlog could also be resolved then, I am expecting a sequential improvement in quarters three and four for margin. We have provided guidance regarding the investments we are making. We continue to sustain investments while also increasing them to support the growth revenue businesses that we are currently building.

Okay, thank you. And then maybe, John, could you talk about the $200 million that you're investing in your growth businesses? Can you provide clarity on where those dollars are going? What milestones should we be watching within CareAR, 3D Print, the sensor business, and HVAC? I’m not sure exactly where you have focused most of your investment dollars. Thank you.

On Analyst Day, we'll detail that for you in February, Shannon. But suffice it to say that we're making investments in both R&D, go-to-market strategies, partnerships, and standing up these businesses so they can grow independently. XFS is an example, where in the past, they relied on Xerox products alone. Now, we are encouraging them to become a global payment solution business looking for OEM and third-party partners, which does require investment. We’ll provide metrics to help you assess the valuation of each segment at Analyst Day.

Okay. And finally, I saw an 8-K speech recently about some retention program for a change of control. Can you give us insights as to what drove that and specifics on the program?

We’re aligning with key employees who have been instrumental in establishing these businesses. We want to ensure that their compensation is aligned, which essentially means if there is an exit type of transaction, they would also be compensated. However, that compensation will depend on some level of monetization.

Thank you very much.

Thank you, Shannon.

Thank you. Our next question comes from the line of Erik Woodring from Morgan Stanley. Your question please?

Hi, this is Sabrina Hill on for Eric Woodring. Thanks for taking the question. I guess first, we're wondering how should we think about the pace of buybacks in 2022 given that dividends should account for nearly 50% of free cash flow in the year, so why not buy back more?

Good morning. We have a $500 million authorization for buybacks, and as we mentioned, we spent $388 million in 2021, so we have about $112 million left. We are using this buyback authority opportunistically to position the share price where it should be.

Okay, perfect. Just a follow-up on the $300 million of gross savings in 2022 from Project Own It: how should we think about those being concentrated?

Project Own It is a broad, systematic program that enables us to adjust our cost base as needed. We believe that our $300 million in savings will be distributed across the main cost lines of the P&L. It's mainly geared towards cost of goods sold and some impact on SAG expenses as well. We will detail this during Investor Day. For example, we have more than 500 robots running millions of transactions, which replace manual activities and provide better customer outcomes.

Great, thank you.

Thank you. Our next question comes from the line of Samik Chatterjee from JPMorgan. Your question please?

Good morning. John, you mentioned as you're planning for 2022 that the return to work is more a matter of when and not if. But there are concerns that an increasing number of professionals will work in hybrid setups as people return. I wanted to understand how you're planning to align both the equipment business and managed print business with the increase in hybrid work models and how that will grow your business with consumers in this setup?

Yes, we are well positioned in a hybrid environment where print will be done both in the office and at home. Furthermore, workflow solutions are critical for sharing information securely and ensuring it is printed in the right locations. Our solutions—like our cloud-based print solution and security solutions—are tailored to support hybrid work models. We also found that as clients return to the office, even in hybrid arrangements, a lot of printing is still done in the office. This gives us confidence in our backlog, signaling that clients are preparing for the future despite ongoing concerns related to variants.

Understood. Finally, looking at seasonality, the first quarter tends to show a low teens decline compared to the fourth quarter based on historical averages. How do you think about that context for 2022, with a backlog persisting alongside the expected delays due to new work arrangements in the first half?

You've rightly noted that in the first quarter, we're not anticipating significant supply chain improvements, although we expect some stabilization in the second half of the year. We continue to model a gradual return to the office and back to work trends, particularly in the second half of the year.

Thank you.

Thank you. Our next question comes from the line of Jim Suva from Citigroup. Your question please?

Thank you. In your prepared comments, you mentioned incremental investment of $200 million. I wasn't sure if that figure was for Xerox core or for PARC, or if it's a combination? I'm curious if the investment was planned or if it was new information communicated. I want to better understand if this pertains to getting closer to a go-to-market strategy with more initiatives in Xerox PARC, or if it expands the addressable market.

Hi Jim, good morning. Just to clarify, the $200 million is not incremental. We will be investing this amount to support our investments in the new businesses, such as Innovation and Software, now called CareAR. This amount represents roughly $70 million above what we were doing last year, or a 50% increase relative to 2021 levels. This illustrates our commitment to investing helping drive revenue growth and future monetization of these investments.

Okay, thank you. I appreciate it and look forward to hearing more from you next month.

Thank you, Jim.

Thank you, Jim.

This concludes the question-and-answer session of today's program. I would like to hand the program back to John Visentin for any further remarks.

Thank you, Operator. As you heard today, we are confident in our ability to deliver at least $7.1 billion of revenue in actual currency and $400 million of free cash flow in 2022 despite the continued uncertainty. That confidence stems from the strength of our team and a strategy we believe in. We look forward to sharing our three-year outlook and plans for driving long-term growth and results and shareholder value at our Investor Day. We hope to see you all there. Be safe and be well.

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.