Earnings Call Transcript - XRX Q4 2022

David Beckel, Vice President of Investor Relations

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 2022 Earnings Release Conference Call hosted by Steve Bandrowczak, Chief Executive Officer. He is joined by Xavier Heiss, Executive Vice President and 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’d like to turn the meeting over to Mr. Bandrowczak.

Steve Bandrowczak, CEO

Good morning and thank you for joining our Q4 2022 earnings call. One year ago, it would have been difficult to predict the number and severity of obstacles we and many other companies would face in 2022. Supply chain conditions were challenged entering this year. In February, Russia invaded Ukraine and the humanitarian tragedy that disrupted supply chains further and led to the effective shutdown of our operations in those markets. These and the aftereffects of the pandemic fueled an unprecedented level of inflation and currency dislocation. And Central Bank efforts to control inflation drove historic increases in interest rates. Finally, for Xerox, last year, we unexpectedly lost our dear friend and leader, John Visentin. I am proud to report that we managed through these challenges taking significant corrective actions to match supply with demand and lower costs to offset inflationary headwinds. For the year, revenue of $7.1 billion increased 1% in actual currency and 4.8% in constant currency. Our first year of constant currency revenue growth since our separation from Conduent. However, growth in revenues and cost savings were more than offset by broad-based inflationary pressure, resulting in a decline in operating profits and free cash flow. Still, we delivered revenue and free cash flow above the revised guidance levels given last quarter. Throughout the year, our company and our people remained resilient and never lost focus on what is most important: providing value to our clients. I couldn’t be more proud of the effort our team expended in the fourth quarter to deliver the highest level of quarterly equipment revenue since 2019, an accomplishment that was instrumental in driving full-year revenue and free cash flow above our revised guidance. We ended the year with momentum in our values and business performance. Sustainability has long been a top priority for Xerox, and our sustainability efforts are being recognized in the marketplace. Xerox was recently named one of the Global 100 most sustainable corporations in the world by Corporate Knights and received an A rating from the Climate Disclosure Project for climate transparencies, one of the leading evaluators of corporate environmental reporting efforts. Importantly, the progress we have made to improve the sustainability of our offerings is driving improvement at our clients’ own sustainability goals. And our ability to help clients manage their sustainability goals is increasingly a competitive differentiator in the marketplace. Turning to our performance. In Print and Managed Print Services, equipment revenue grew at the highest rate since before the pandemic due to improved product supply. Consumables, such as supplies and paper, grew again this quarter and contractual print services, our largest, most stable source of revenue, grew low single digits in constant currency, including contributions from recently acquired Go Inspire. In Q1, we plan to launch a series of customer experience applications to improve the setup, security, and productivity of equipment geared towards small and home office users. Included in these plans is the launch of CareAR Instruct, which provides augmented reality support for our A4 devices using digital twin technology. IT Services grew revenue double digits for the quarter and the year, including contributions from Powerland in Canada. Enabling that growth is the breadth of enterprise-class services we bring to mid-market clients. Xerox Automation, our robotics process automation solutions, once again grew signings meaningfully on a quarter-over-quarter basis. The automation group wins business by understanding at a deep level our clients’ business, industry, and needs and then use that knowledge to drive customer success through customized solutions. Increasingly, our team is integrating automation with other leading technologies such as object content recognition and machine learning to drive productivity enhancements. As an example, this quarter, our automation group won new business from an existing U.K. client by developing an end-to-end document workflow solution that combines multiple advanced technologies to extract, classify and process digitized information from scanned documents, saving the client significant time and money. Digital Services signings also grew double digits in the quarter and for the full year, and our offerings are resonating in the marketplace. In December, Xerox was named a Top Accounts Payable Solution Provider by CFO Tech Outlook in recognition of our ability to assist clients with digital transformation of their payables process. Our AP workflow optimization solution delivers a reduction in processing costs and improvement in working capital for our clients and is just one of many digital services we offer. In 2023, we will begin offering our suite of digital services to the mid-market, further augmenting the types of enterprise-class services and solution sets we can bring to mid-market clients. FITTLE grew originations this quarter more than 40% for both captive and non-captive leases, capping off a year where total originations grew at high single digits, including double-digit growth in non-captive leases. We recently announced an innovative funding solution for FITTLE, enabling a strategic shift in its business model to focus on being an asset-light best-in-class provider of leasing services and solutions. This funding agreement also allows for growth in FITTLE’s portfolio without the use of Xerox's balance sheet. Xavier will explain this funding solution in more detail. I will now touch on our priorities for 2023. Amid all the volatility and uncertainty in the marketplace, we at Xerox are focused on what we can control to drive growth in profits and shareholder value. Our three main priorities this year are customer success, profitability, and shareholder returns. Starting with customer success, we can deliver more value to our clients by making it easier to do business with Xerox. I have spent a lot of time since becoming Xerox CEO meeting with our clients and partners to discuss the ways we can extend our relationships through additional value-added digital services. And all too often I have heard, 'I didn’t know Xerox could do that.' To leverage this opportunity and drive revenue growth, we are taking a more holistic client-centric approach to improving customer outcomes by delivering essential products and services that are closely aligned with our clients’ needs. The current macro backdrop plays to our advantage in this regard as our IT and digital services are designed to increase productivity by reducing the cost and complexity associated with clients’ technology and document workflows. Further, it is apparent from our market research that Xerox has a clear path to win more business within the IT and digital service markets because of the trust we have built over time, providing value to our clients. We are confident our brand and client relationships can be leveraged to expand our penetration of wallet share, and we are confident in our ability to expand client TAM over time as we invest in and develop new types of digital services for a hybrid workplace and distributed workforce. An example of our ability to increase wallet share is the recent renewal and addition of services at a large telecom operator in Canada. This client, like many, is adapting to the complexities associated with a hybrid workplace. Leveraging our deep relationships across the company, we took a holistic approach to tailoring a set of print and digital services that will help them in the hybrid transition and improve overall productivity. We also included advanced analytics for print management, digital mail, to bring speed, security, and cost savings to their mail and carrier operations and advanced software solutions to streamline and enhance their production print operations. By leveraging our relationships and portfolio of offerings, we are able to drive customer success while growing our annual contract value by double-digit rate. Another priority for 2023 is the continued focus on profitability. Since 2018, Project Own It has been a cornerstone of our transformation efforts and a focal point for the optimization of our cost base. We reached our 2022 targeted gross cost savings of $450 million, bringing total savings since 2018 to more than $2 billion. Just as important as these savings, however, is the management operating system, the set of disciplines around measuring and monitoring business processes that was instilled in our organizational culture by Project Own It. We do not plan to provide annual savings targets going forward, but the behaviors engendered by the program will aid in our continuous effort to implement a more flexible cost base and operating model. Just as we will make it easier to do business with Xerox, we will make it easier to do business within Xerox by investing in processes that drive incremental organizational efficiencies and enable the types of collaboration required to offer holistic solutions to our clients. The current macroeconomic environment necessitates a greater focus and scrutiny on the profitability of our offerings and operating units. Accordingly, we have become more disciplined about where and how we do business, placing emphasis on metrics such as return on investment and the generation of profit, not just revenue dollars. This discipline has already been applied to our investments in R&D. In the past few months, we have taken actions to lower and in some cases redirect investments in R&D towards projects with more certain and near-term returns. We exited our joint venture Eloque and pared growth investments in 3D printing. Novity and Mojave, two successful businesses incubated at PARC were spun out, allowing these businesses the freedom and flexibility to attract external growth capital at their own pace. To be clear, investments in innovation remain a priority at Xerox, but will be more focused on projects and partnerships that augment our existing strengths and opportunities within print, IT, and digital services. Finally, we will continue to prioritize shareholder returns, a greater focus on customer success and profitability will naturally result in higher profits, but we also remain laser-focused on cash flow generation. Despite a strong finish to the year, free cash flow in 2022 fell below our initial expectations. 2022 was an anomaly, not a trend. Beyond expected improvements in profitability for 2023, we have already taken steps to improve our capacity to generate more free cash flow per profit dollars, such as FITTLE’s receivable funding agreement. We also remain focused on improving working capital and expect improvements in inventory efficiency in 2023 as supply chain conditions normalize. Each of these priorities, customer success, profitability, and shareholder returns will remain cornerstones of our long-term strategic plan. And each of these priorities are reflected in our full-year guidance, which calls for stable revenues amid a challenging and volatile economic environment and growth in adjusted operating income margin and free cash flow, the details of which Xavier will provide. To recap, '22 was a challenging year, one that tested the resolve of our employees and the strength of our business model. The lessons learned from overcoming these challenges will serve us well as we execute on our strategic priorities for the year. And these priorities will ultimately form the foundation of a long-term plan for delivering sustainable growth in profits. I will now hand over to Xavier.

Xavier Heiss, CFO

Thank you, Steve, and good morning, everyone. As Steve mentioned, 2022 was a challenging year on a number of fronts. Revenue and profitability were impacted by surging inflation, supply chain challenges, currency disruption, the war in Ukraine, higher interest rates and as a consequence, an uncertain and unpredictable macroeconomic environment. Encouragingly, we ended the year stronger with full-year revenue exceeding our initial guidance of at least $7.1 billion, despite more than $250 million of currency headwinds and more than $90 million headwinds from halting sales to Russia. Adjusting operating margin improved sequentially each quarter this year and grew 440 basis points year-over-year in Q4, due in large part to improved product availability. Full year free cash flow exceeded our revised guidance, and we put in place a funding solution at FITTLE that will improve future free cash flow generation while supporting FITTLE’s growth. Q4 revenue grew in actual and constant currency for the first time since Q2 of 2021 due to resilient demand for our product and services and improvements in product supplies and mix. Revenue growth of 9.2% at actual currency was negatively impacted by 470 basis points of currency headwind, notably the euro and British pound. Equipment revenue grew significantly, reaching its highest level since Q4 of 2019 due to an improvement in supply chain conditions. As a result, our backlog, including equipment on IT hardware, declined 43% sequentially to $246 million. Our backlog remains elevated, but it’s healthy. We expect backlog to decline through the first half of the year as supply chain conditions further normalize. Post-sale revenue grew mid-single digits in constant currency for the fourth consecutive quarter. Growth this quarter was driven by IT services, which includes the acquisition of Powerland and consumables. The resiliency of contractual print services revenue was observed again this quarter, aided by recent pricing action and the acquisition of Go Inspire. Turning to profitability. Profits were higher year-over-year, driven mainly by better equipment sales, improved product and geography mix and lower logistics costs, partially offset by higher bad debt expense. We expect profitability to improve further in 2023 as we realize the benefit of price and cost actions taken in 2022, further improvement in product availability, lower logistics costs and additional operating efficiency. Gross margin improved 190 basis points over the prior year quarter, mainly driven by a favorable shift in product and geography mix, lower supply chain-related costs and benefits associated with price and cost actions taken throughout the year, partially offset by ongoing product cost increases and the effect of recent acquisitions. OpEx, excluding bad debt expense, was lower year-over-year due to our focus on improved return on R&D investment and Project Own It actions. Adjusted operating margin of 9.2% increased 440 basis points year-over-year, driven by 300 basis points of supply chain-related cost improvement, 130 basis points from cost reductions action, and 100 basis points from the price increase on currency. Partially offsetting this benefit were higher bad debt expenses associated with the release of reserve in the prior year. Other expenses net were $7 million lower year-over-year due to a $39 million benefit from sales of non-core business assets, partially offset by an increase in non-service retirement-related costs and higher currency losses due to currency volatility in certain geographies. Fourth quarter adjusted tax rate was 21.8% compared to -8.8% last year. The increase was largely due to prior tax benefit for changes in the remeasurement of uncertain tax positions. Adjusted EPS of $0.89 in the fourth quarter was $0.55 higher than the prior year, driven by higher adjusted operating income, sales of non-core assets and a lower share count, partially offset by a higher tax rate. GAAP earnings per share of $0.74 was $4.71 higher, mainly due to a non-cash goodwill impairment charge of $750 million or $4.38 per share in the prior year. Let me now review revenue, cash flow and profitability in more detail. Turning to revenue. Equipment sales of $554 million in Q4 grew 49% year-over-year in constant currency or 44% in actual currency. Growth was driven by better availability of product across all categories and regions, particularly for higher-margin A3 devices in the Americas region. The sequential growth in equipment revenue mirrors the decline in equipment backlog, revealing resilient order activity amid an uncertain macroeconomic backdrop. We continue to see particular strength in demand for our A3 office machines. Equipment revenue growth outpaced installation this quarter due to favorable product mix and the benefit of recent pricing actions. Installation growth was strongest for higher-margin mid-range product and Color A4 multifunction equipment. Color A4 outperformed Black & White due to a stop in shipment of A4 mono products to Russia and supply shortage. Post-sales revenue of $1.39 billion grew 4.2% in constant currency year-over-year and declined 0.4% in actual currency. Post-sales growth in constant currency was driven by IT services, including benefits associated with the recent acquisition of Powerland in Canada and growth in consumables. Contractual print services revenue was resilient and grew low single digit year-over-year in constant currency, reflecting benefits of recent pricing action and the acquisition of Go Inspire. Notably, this important component of our annuity revenue grew modestly in 2022, despite a slower-than-expected return of employees to offices and ongoing macroeconomic concern. We believe we have now reached a normalized level for this revenue stream. Growth in post-sales revenue at constant currency was partially offset by lower financing revenue, reflecting a lower FITTLE receivable balance. Geographically, both regions grew in constant currency. The Americas region grew faster than EMEA due mainly to better product availability and mix as well as stronger growth in consumable sales. Let’s now review cash flow. Free cash flow was $168 million in Q4, lower year-over-year by $14 million. Operating cash flow was $186 million in Q4 compared to $198 million in the prior year. Working capital was a source of cash of $73 million this quarter, $120 million lower than the prior year, driven by higher accounts receivable on the use of cash to position inventories ahead of Q1, partially offset by higher account payables. Additionally, cash used to fund finance receivable and operating lease was $169 million in the quarter compared to a use of cash of $50 million in the prior year, reflecting improved equipment sales activity and FITTLE growth strategy. Positively offsetting this effect were higher operating income in the current quarter and favorable timing of other liability payments. Going forward, we expect FITTLE receivable funding agreement to result in finance receivable being a source of cash as new originations are increasingly funded by third-party financing partner while collection runoff of existing receivables continues. Investing activities were a source of cash of $17 million compared to a use of cash of $31 million in the prior year due in large part to an asset sale in the current quarter, partially offset by slightly higher CapEx, which mainly supported our investments in IT infrastructure. Financing activities consumed $67 million of cash this quarter, which is comprised of dividend payment on the early payment of a portion of our 2023 notes, netted by proceeds from finance receivable securitizations. During the quarter, we paid dividends totaling $43 million and did not repurchase any shares. Turning to profitability. Q4 adjusted operating profit margin grew substantially on a sequential year-over-year basis for the reasons previously discussed. Importantly, margin expanded sequentially each quarter this year as we took corrective measures to offset an unprecedented level of inflationary pressure and ongoing supply chain challenges. We successfully implemented price increases across our portfolio of products and services and took action to rein in costs, most notably, across areas of investment where the expected payback period extended across multiple years or was less certain. Many of these actions were reflected in the achievement of our targeted Project Own It savings of $450 million. As Steve noted, we will not be providing our targeted savings amount for 2023, but the principle of continuous improvement and operating efficiency instilled by Project Own It will play an important role in driving expected margin improvement in 2023 and beyond. Turning to segment. In Q4, FITTLE finance assets were $3.3 billion, up 7% sequentially in actual currency. FITTLE origination volume grew more than 40% year-over-year. Both non-captive channel origination, which includes third-party dealers and non-Xerox vendors and captive product origination grew more than 40%, a function of growth in new dealer relationships and third-party equipment origination as well as higher Xerox equipment for lease. FITTLE revenue declined 9.6% in Q4, mainly due to a reduction in operating lease revenue, which reflects lower equipment installed in prior periods. Segment profit was -$5 million, down $30 million year-over-year due to a reserve release of $12 million in the prior year quarter, lower net financing profit, higher intersegment commissions associated with higher Xerox origination, higher bad debt expenses, and strategic start-up costs on investment. Segment margin was -3.4% compared to positive 15.2% a year ago. Over time, we expect current and future receivable funding solutions to result in lower financing revenue and profit for FITTLE, which will be partially offset by growth in fee-based commission and servicing revenue. However, in 2023, we do not expect a material change in FITTLE revenue or profit as lower finance revenue will be offset by higher upfront commissions and lower bad debt expenses. Print and Other revenue grew 10.2% in Q4. Print and Other segment profit tripled over the prior year quarter, resulting in a 640-basis point expansion in segment profit margin year-over-year, driven by improved product supplies and mix and the benefit of price and cost actions taken throughout the year. I’d like to spend some time now to discuss how FITTLE's recent receivable funding arrangement is expecting to affect free cash flow for the year. The agreement Xerox and FITTLE signed with an affiliate of HPS Investment Partners contemplates sales of FITTLE lease receivable of around $600 million in 2023. This amount would have otherwise been funded by Xerox, so this reduction in our funding obligation will result in a direct benefit to operating cash flow. However, this benefit is expected to be partially offset by growth in our lease receivable portfolio. When considering the year-over-year change in free cash flow, the net receivable funding benefit will be additive to free cash flow. Additional agreement covering U.S. non-direct controlling receivables are not included in guidance but would further increase expected free cash flow for the year. Receivable funding agreements are expected to contribute to free cash flow for multiple years, but at a decreasing level due to the timing of prior lease receivable runoff. Turning to capital structure. We ended Q4 with $1.1 billion of cash, cash equivalents, and restricted cash. $2.9 billion of the $3.7 billion of our outstanding debt is allocated to the FITTLE lease portfolio. The remaining debt of around $800 million is attributable to the core business. Debt consists of senior unsecured bonds and finance asset securitization. We have a balanced bond maturity ladder over the next few years and expect to repay the remaining $300 million of debt maturing this year in March 2023. Finally, I will address guidance. We expect revenue to be flat to down low single digits in constant currency in 2023. As noted earlier, demand for our portfolio of products and services remain resilient, particularly for our most material and profitable A3 office devices. Contractual print services revenue, our largest contributor to post-sales revenue, is expected to remain steady. While we have not yet experienced a meaningful pullback in demand for our product or services due to macroeconomic pressure, our revenue outlook does account for a potential deterioration in macroeconomic conditions. If economic conditions were to degrade further, we believe the most likely effect will be delays in equipment purchases or service implementations, not cancellation or order reduction and difficulty implementing future price increases. Offsetting these risks are the annuity-like nature of our post-sell business and the counter-cyclicality of many of our IT and digital services for which demand is expected to increase even if IT budgets are rationalized. This year, we are reinstituting guidance for adjusted operating income margin. For the year, we expect adjusted operating income margin to be at least 4.7%, an 80-basis point increase over 2022 levels, driven by recent enacted and expected price and cost actions as well as lower logistics costs. We expect to generate at least $500 million of free cash flow, including the benefit of FITTLE receivable funding solution. Excluding the net benefit of the receivable funding solution, we expect free cash flow to be in the range of 90% to 100% of adjusted operating income. Finally, our policy of returning at least 50% of free cash flow to shareholders remains unchanged. While we do not provide quarterly guidance, I want to provide some color on the expected quarterly cadence of our results. First, on revenue, equipment sales growth is expected to be higher in the first half due to easier product-to-price comparisons. And at this time, we do not expect a significant deviation in the quarterly growth rate of post-sales revenue. For adjusted operating margin, we expect sequential improvement in margin after Q1 and year-over-year increases in margin in Q1 through Q3. The sequential improvement reflects normal seasonality, the clearing of the remaining backlog, and the cumulative effect of lower R&D spend, which is expected to benefit margin in the second half relative to the first half. Finally, free cash flow. The cash flow benefit of the receivable funding arrangements is expected to be realized throughout the year at roughly the same cadence as equipment sales revenue. We will now open the line for Q&A.

Operator, Operator

And our first question comes from Ananda Baruah from Loop Capital.

Ananda Baruah, Analyst

Starting with your comments about the guidance and what you're observing from customers, can you provide some insights into what you're hearing from enterprise customers? It seems like there has been some slowing in the enterprise sector, but it doesn’t appear that you are experiencing that yet. You mentioned earlier that equipment sales are a primary risk to your forecast, so any additional context on that would be appreciated. I have a quick follow-up after this.

Xavier Heiss, CFO

Ananda, Happy New Year to you as well. From a demand perspective, we are seeing strong interest from both our enterprise and SMB customers. Q4 has been a very successful quarter for us, primarily due to our ability to lessen equipment backlog, particularly with A3 equipment. At the same time, our order patterns remain robust. We continue to see demand for our products, and I want to highlight our services as well. As I mentioned earlier, equipment demand is strong, but when considering post-sales revenue, which includes contracted activities, some is related to print while some is not. In our forecast, we aim for a realistic and balanced approach. Realistic because the macroeconomic environment carries uncertainty, yet we remain confident and balanced regarding demand for both our equipment and solutions. I'm sure Steve will provide more insight into the current offerings driving this demand.

Steve Bandrowczak, CEO

Yes. I am Steve. So one of the things that we’re seeing, if you think about the macro environment with inflation and with the ability to be able to handle cost increases, all of our customers are dealing with those macro trends. And so as we think about customer success and really driving solutions specific to driving productivity for our customers, we think we have a great opportunity to expand inside of the existing customer base that we’re in today. Simple example: if you think about school districts and their challenge with administrators and teachers having to do more with less, how do we drive more productivity in workflows? Things like our equipment can do language translation, our equipment can grade papers, our equipment can do things like plagiarism checks on documents. So driving productivity, driving workflow inside of very specific verticals, we can actually help drive and penetrate and assist our customers with their macro trends. We believe we’ve got a great opportunity to play certainly in the small and mid-market space.

Operator, Operator

And our next question comes from the line of Erik Woodring from Morgan Stanley.

Erik Woodring, Analyst

Congratulations on the impressive results for the December quarter. Steve, I wanted to ask a broader question as we move into 2023. It seems that most enterprises and small businesses have established their hybrid work arrangements. I'm interested in what insights you've gained as hybrid work and remote work have become more common. How are enterprises and small businesses utilizing Xerox in this new environment? What has surprised you, and what was perhaps unexpected? I'd appreciate your thoughts on this, and I have a follow-up question as well.

Steve Bandrowczak, CEO

Yes. I think there are a couple of things, Erik. First of all, you’re right, companies are getting settled into this new hybrid environment, but it’s driving significant challenges in and around the security of documents and data security around how workflows happen in the company, how do you drive productivity? And so what we’re seeing is a great opportunity for a couple of things. One, to actually play in that space, right? We have been incredibly innovative through the years around how we drive workplace productivity. This is just a new area for us in terms of workplaces wherever an individual is. And so we see an opportunity to do a couple of things: one, with our products and solutions, workflow with our cloud solutions, AI solutions, and what we think we can do with augmented reality, we can actually help customers drive productivity, but more importantly, drive insights to the data that they have inside of those workflows. So we believe there’s a great opportunity for us to play in that space and really be the provider of choice to help customers in this new world, wherever their employees are, and drive productivity and insights to data. So that’s the first thing. Second, as you think about the macro headwinds that customers are facing, as I talked a little bit earlier to Ananda, we have an opportunity to drive some very specific workflow solutions. You heard me talk about what we’re doing in accounts payable. We can do things like drive productivity and help our end customers in their workflow, but very specific around verticals and very specifically around customer success. And so we think we can play in this area, and we have a great opportunity to expand our wallet share inside of customer accounts there.

Erik Woodring, Analyst

Thank you, Steve. Xavier, I have a question for you. It's great to see some margin expansion as we move into 2023. Could you help clarify the trade-off between gross margins and operating expenses this year, and how we should approach each? Additionally, what key factors would you need to see in 2023 to bring operating margins closer to the levels we saw in 2020 or 2021?

Xavier Heiss, CFO

Thank you, Erik. As you mentioned, Q4 was a critical period for us, and we successfully increased our margin during this time, which positively impacted our overall company margin for the year. The key elements necessary to achieve our goals for Q1 2023 are straightforward. First, we have implemented price increases to mitigate some of the cost inflation and to restore our margins. These price hikes were introduced in 2022, and we expect them to continue to be effective into 2023. Since a significant portion of our revenue is based on contractual agreements, these price increases will remain in effect for this year and subsequent years. Secondly, we anticipate improvements in our supply chain. The disruptions in 2021 and 2022 have been significant, particularly due to rising costs and instability. However, we are beginning to see these conditions normalize, even though container shipping costs have not yet returned to their pre-crisis levels. This improvement will also help enhance our gross margin. Lastly, we are focused on maintaining a flexible cost structure. This approach means we will be strategic about our investments, prioritizing high-return initiatives over longer-term projects, especially in an uncertain economic climate. While we might face some challenges, such as inflation costs and the ongoing benefit from the Fuji Xerox royalty, we're optimistic about our ability to expand our operating margin in 2023 through our strategies focused on pricing, supply chain improvements, and investment priorities.

Operator, Operator

And our next question comes from the line of Samik Chatterjee from JP Morgan.

Angela Jin, Analyst

This is Angela Jin on for Samik Chatterjee. Congrats on a strong quarter. So a question about backlog. So I saw that backlog came down about $183 million quarter-on-quarter, and equipment sales are up $164 million quarter-on-quarter. So can you just walk us through the gap there? Like, is the implication here that you’re seeing an uptick in cancellations or equipment order rates are dropping? And if you continue at this rate, will you reach pre-pandemic levels back within a quarter? So how should we think about sort of the cadence of backlog into the first quarter of 2023.

Xavier Heiss, CFO

Yes, Angela. The backlog situation is positive as it has been decreasing. We noticed a reduction in the backlog in Q3 and were pleased to see a 43% decline in Q4. This decline is mainly due to improvements in the supply chain and logistics, particularly with our high profit A3 equipment. This has led to a more normalized product mix and an improvement in overall gross margins, as these products also generate good post-sales revenue and profit. Regarding order patterns, we continue to see strong demand for the same products, especially our A3 offering, which is essential for customers in this hybrid working environment. The growth in equipment sales aligns with the backlog decline, which is consistent with our expectations. Looking ahead, we plan to clear the backlog in the first half of the year. Currently, our backlog is at 2.5 times what we would consider normal, and we anticipate resolving this backlog in Q1, with some effects carrying into Q2. If supply chain and manufacturing conditions remain stable, we expect operations to return to normal in the second half of the year.

Angela Jin, Analyst

Got it. That’s really helpful. And then for my follow-up, so just thinking about your free cash flow guide of at least $500 million, can you maybe dig in more into what portion of that is attributable to your core business versus FITTLE? It seems at some point right now that the core free cash flow is in the low 100s range unless there’s a plan to sort of very meaningfully ramp originations in 2023.

Xavier Heiss, CFO

Yes. Let's start with 2022. In that year, we identified that free cash flow was an anomaly for two reasons. The first reason is the reduced profitability we experienced in 2022. The second reason, which I refer to as good and bad cholesterol, is that FITTLE is growing. As FITTLE grows, it consumes cash, impacting our free cash flow. If I normalize this and project for 2023, I expect the normalized free cash flow, without considering any FITTLE movements, to be around 90% to 100% of adjusted operating profit. Additionally, we will benefit from what we call the forward flow agreement. This agreement allows us to secure funding from an external party for future receivables or originations from FITTLE, which means we won't need to use the Xerox balance sheet for that. This will balance out the runoff of our existing book on the Xerox balance sheet. It's important to reference the chart in the presentation for clarification. FITTLE is still growing concurrently, which influences the $600 million wave 1 we signed in Q4, offset by FITTLE's growth. Therefore, when we provide our guidance of $500 million, we account for normalized free cash flow without FITTLE, estimated between $300 million to $330 million. On top of that, we add approximately $200 million to arrive at the $500 million guidance we have shared.

Angela Jin, Analyst

All right. And if I could just squeeze in one last quick one. So equipment margins are up to 33%. So it drove a lot of upside in this quarter. It seems like the mix is more favorable than usual with A3 units being shipped and strong U.S. sales. So what is the sustainable level of equipment margins going forward?

Xavier Heiss, CFO

When I review the equipment margins over the year, I consider the entire year's pattern rather than just Q4. You're correct that the mix plays a significant role, but a major factor has also been our ability to implement price increases for customers. This has helped us maintain our margins while managing pricing effectively. We believe that with the price adjustments we've made and their anticipated impact in 2023, we should be able to sustain and mitigate some of the cost inflation we expect. The normalized margin is not far off from what you've observed. While Q4 may not fully represent the situation, we can provide further guidance on our margin outlook for the remainder of the year through our Investor Relations team if you're interested.

Operator, Operator

And our next question comes from the line of Shannon Cross from Credit Suisse.

Shannon Cross, Analyst

I’m wondering about just balance sheet cash requirements. As you’re shifting, obviously, your model on the financing side, but also as the business itself changes more to solutions and services, how should we think about what level of inventory over time? Because I would assume this will maybe become a little bit more of an inventory-light model as you move more away from just equipment? And then also just in terms of core cash needed to run the business because I’m trying to figure out what your excess cash is as you think about where maybe you’re going to be exiting 2023.

Xavier Heiss, CFO

Shannon, let's revisit what I just explained. I will clarify some points. You can view our guidance for free cash flow for next year in two ways: with FITTLE and without FITTLE. For the business without FITTLE, as we noted, 2022 was an unusual year for free cash flow due to margin pressures, particularly in the first half. Looking at the normalized free cash flow without FITTLE for next year, you can expect around 90% to 100% of adjusted operating profit, which translates to approximately $300 million to $330 million. The second part...

Shannon Cross, Analyst

Xavier, I wasn’t asking about cash flow. I was asking about actual cash. So just to be clear, so I understand the cash flow. I’m just saying what level of cash do you need to run the business? And then just off of your balance sheet because, obviously, you have to pay down some debt right now. But I’m wondering, like, if I think about your company right now, if you generate the $500 million in free cash flow next year, where do you think you need to be in terms of total cash coming out of 2023? So that will give us an idea of what excess cash you might use to deploy elsewhere.

Xavier Heiss, CFO

Yes. If your question pertains to capital allocation and our cash management, our priority remains straightforward and unchanged. We allocate 50% of free cash flow to shareholders, primarily through dividends. We have sustained our $1 dividend even during the COVID-19 period, which will continue to be a key method for returning cash to shareholders. To provide a figure, if we project $500 million in free cash flow, that translates to $250 million for dividends, which will be in the range of $140 million to $150 million. The flow of cash and free cash flow throughout the year will hinge on this funding, and if not related to FITTLE, it will proceed accordingly. We will share more insights in the next quarter regarding how we plan to utilize and return this cash to shareholders while also investing in the business to support the strategies Steve outlined, including investments in high yield, low time-of-return products like digital services, as well as our automation offerings and workflow automation for customers.

Shannon Cross, Analyst

Okay. And then I guess my question is basically, as you think about the debt maturities you have coming due and obviously, the near-term one will be paid with cash on hand. Is your idea to deleverage the balance sheet over time because you are shrinking the FITTLE business? Or do you anticipate utilizing the cash that you generate from FITTLE in other areas and keeping a higher level of leverage on the balance sheet going forward?

Xavier Heiss, CFO

So what we plan simply to do is to face our debt obligation. So we have a $300 million debt to pay in March, and we are on line and we plan to pay it based on the cash generated by the business. We are not planning at that time to add leverage or overall leverage of the balance sheet. And if you look at the debt ladder that we have in 2024 and 2025, I’ll say, quite clean. We think that we’ll be able to face this debt obligation. So I’m not specifically concerned about our ability to phase debt and how debt will take a prevalence versus other types of investments we plan to do.

Shannon Cross, Analyst

Okay. My last question is regarding your conversations with customers and the management services contracts you currently have. What are the discussions like regarding future page volumes and the size of equipment? Last quarter, you mentioned some customers were negotiating lower page volumes. Is that trend still ongoing, or are things starting to normalize as offices begin to reopen?

Xavier Heiss, CFO

Yes. Good question, Shannon. So what we see are currently and we commented that we believe we have reached a normalized position here. We don’t see a higher erosion around page volume. We see, as well, our ability to negotiate contracts with product minimums. And from a price point as well, we have had some data points showing that the price increases that we are passing to customers are sticking. So the way we look at this line, what we call contracted print revenue lines, the way we look at this line from a revenue next year is like a flattish type of line, which is good because this is not an accelerated decline. So return to the office has been, I would say, slow in some places, a little bit higher in certain geographies. But the way we look at it for the last three or four quarters, this line had been, I would call that like flattish, steady. So that’s the way we look at it for the next year.

Operator, Operator

And our final question today comes from the line of Jim Suva from Citi.

Jim Suva, Analyst

In your prepared comments, you mentioned about the Federal Reserve changing interest rates and all that. And then I have a follow-up. But can you just kind of give us some outlook about what we kind of should be modeling or thinking about for interest expense because now that you have your relationship with FITTLE and things like that, it gets a little more complicated, especially with interest rates swinging a lot? Is the Q4 number like a long-term number that we could use or can we kind of use the full year number and just divide it by four? There are just a lot of moving parts in your interest expense item.

Xavier Heiss, CFO

Jim, to understand the interest rate in relation to our core debt, it's important to note that our core debt is primarily based on a fixed interest rate. Therefore, none of the rates for our maturing debt are directly tied to the Fed rate increase or inflation. Additionally, we have been actively reducing our debt as you may have noticed. This year, we addressed a maturity of $1 billion due in March 2023 and took the opportunity to pay down approximately $300 million to $350 million in early March and December. We have about $300 million remaining, and we plan to fully address that. We have no concerns regarding our ability to manage cash payments. From an interest perspective, if you consider the charges we incurred in Q4, performing well means successfully managing our debt, and the FITTLE business does not factor directly into our interest calculations because it's reflected on the income side for interest. The forward flow agreement will change how interest from the FITTLE business is reported in the future. I would like to emphasize a key point regarding FITTLE. The forward flow agreement we've established is shifting its business model to an asset-light service model focused on lease business related to office and industry equipment, including Xerox. This transition allows FITTLE to expand beyond Xerox without negatively impacting our free cash flow. Furthermore, as you mentioned, it does not jeopardize our capacity to obtain competitive rates for FITTLE. We've partnered with a strong entity that has a solid balance sheet, which supports the growth of this business while preserving our adjusted cash flow.

Jim Suva, Analyst

Okay. And then my quick follow-up. On Page 12 of your earnings presentation, where you talk about the effect on free cash flow of your receivable funding arrangement. I know this year is kind of the inaugural year of this agreement with your financing partners and impacted the net positive funding benefit to your 2023 cash flow. Long term, should they kind of equal out, meaning the growth in the receivables, should they kind of equal out? Or should they kind of always be a net funding benefit like we’re seeing in the year 2023?

Xavier Heiss, CFO

So you’re right, Jim. The way to look at it is over time, and time will be four to five years, while the runoff of the existing portfolio, which has been funded by, let’s call that the Xerox balance sheet on FITTLE acquisition programs that we have in place. So this one-off will decline over that time, and it will be replaced by this funding agreement. This funding agreement is done outside of the Xerox balance sheet. So this benefit that we see, specifically 2023 and also in 2024, will erode over time. But it will be offset, not from a free cash flow point of view but in the P&L way of looking at Xerox. It will be offset by the fact that this agreement, as I mentioned, is a shift in the way FITTLE will work. It will be offset by commission that we are receiving every time we sell some of this future receivable to our partner. But also, we are still highly rewarded by the fact that we will have fees from this business and also some benefit of how we will service and manage this portfolio. So this is a change, this is a shift in the way the FITTLE business is being built. This is for the good, I would say, of Xerox because less use of Xerox balance sheet, while preserving the growth of FITTLE and being able to preserve the revenue on the profit related to this business.

Operator, Operator

This does conclude the question-and-answer session of today’s program. I’d like to hand the program back to Steve Bandrowczak for any further remarks.

Steve Bandrowczak, CEO

Thank you for listening to our earnings conference call this morning. We have turned the page on 2022. Macroeconomic conditions remain uncertain, but this past year has proven that at Xerox we can react and drive profitable results. I am confident we have the right team and strategy in place to deliver growth and profitability and shareholder returns in 2023 and beyond. Thank you for joining our call and have a great day.

Operator, Operator

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