Fitch Rates Xerox's $1B Unsecured Term Loan 'BBB-'

CHICAGO--()--Fitch Ratings has assigned a 'BBB-' rating to Xerox Corporation's (Xerox) $1 billion senior unsecured term loan. Pro forma for the term loan, Fitch rates $10.4 billion of total debt including the undrawn $2 billion revolving credit facility (RCF). Fitch's ratings on Xerox, including the Long-Term Issuer Default Rating (IDR) of 'BBB-', remain on Rating Watch Negative pending clarification on the ultimate corporate and capital structure of Xerox after it separates into two publicly traded companies (the separation). A full list of current ratings follows at the end of this release.

Xerox entered into the term loan, which will be drawn by April 1, 2016, with a syndicate of banks. The term loan expires on the earlier of 364 days or upon receipt of financing related to the separation. Xerox will use net proceeds from the term loan to meet near-term bond maturities and for general corporate purposes.

KEY RATING DRIVERS

The proposed separation effectively unwinds the 2010 acquisition of ACS, separating the business process outsourcing (BPO) businesses associated with the ACS deal from the legacy Xerox businesses, including the Document Technology (DT) segment and the Document Outsourcing (DO) portion of the Services segment. The legacy Xerox business accounts for roughly $11 billion (approximately 60% of the total) of Xerox's 2015 consolidated revenues, while the BPO businesses represent the remaining approximately $7 billion (approximately 40% of total).

The ratings reflect Fitch's belief that the separation reduces diversification, scale and top-line growth prospects even as DT continues to face significant long-term secular headwinds and BPO is in the midst of a multi-year restructuring. The ratings also reflect Fitch's belief that alternative scenarios (including a leveraging recapitalization, business sale, straight separation of the DT and Services segment, or nothing) would be less credit-friendly or would intensify event risk, were Xerox not to complete the separation.

Fitch's maintenance of the Negative Watch reflects the current lack of certainty as to which of the two public companies will constitute the Remainco, as well as the Remainco's ultimate structure and capitalization. Fitch believes legacy Xerox is more likely to be Remainco, given legacy Xerox could be capitalized with the majority of debt, including all financing business related debt, and modest share of core debt aimed at preserving an investment-grade rating.

Fitch anticipates resolving the Negative Watch upon formalization of Remainco's ultimate structure and capitalization. Were legacy Xerox to constitute the Remainco, the Negative Watch could be removed and ratings affirmed at 'BBB-' if Fitch believes the operating profile will strengthen from investments in DT markets that yield legitimate prospects for the resumption of top-line growth in the intermediate term.

Were the BPO businesses to constitute Remainco, Fitch believes the most likely resolution of the Negative Watch would be a downgrade to non-investment grade. While the BPO businesses have the operating profile of and could be capitalized for low investment grade, we do not believe there is meaningful strategic rationale. Also, given Carl Icahn will receive three board seats in connection with Xerox's conclusion of its strategic and capital allocation review and that ACS operated as non-investment grade prior to its acquisition by Xerox, Fitch does not view an investment-grade capital structure as likely.

Xerox announced it will separate into two public companies, driven by the company's belief that a greater focus on its unique markets and sets of customers will drive improved operating performance. Xerox did not disclose costs associated with the separation but Fitch believes these will be limited to unwinding currently shared general corporate, given the lack of market-facing, technology and revenue synergies that exist between legacy Xerox and BPO. The separation is subject to customary regulatory review and approvals and Xerox expects to complete the separation by the end of 2016.

In connection with the plan to separate, Xerox also reached an agreement with its largest shareholder, Carl Icahn, that will provide him with three seats on the Board of Directors of the BPO company. Fitch notes the agreement does not provide for any change to Xerox's current shareholder return policies prior to separation.

Finally, Xerox announced a plan that will reduce annual costs by $2.4 billion on a run-rate basis by the end of 2018. For the DT segment, restructuring is essential to maintain operating income margins in the 12% to 14% range within the context of secular revenue declines. For Services, cost reductions should drive contract renewals and underpin the segment's efforts to achieve and maintain industry-average operating income margin of more than 9%.

Fitch expects near-term operating results will remain challenged by significant currency headwinds and secular revenue declines in DT (mid-single digits) that have been exacerbated by lower demand in developing markets, consistent with the company's just announced full-year 2015 results. DO continues to grow in constant currency driven by increased outsourcing trends and the BPO businesses are poised to resume flat-to-normalized low single-digit constant currency growth following multiple years of contract portfolio refinement.

Fitch anticipates operating income margins will be flat-to-slightly higher, driven by productivity and improving performance in Services, which is structurally higher following the exit of unprofitable healthcare system builds. Xerox expects $1 billion to $1.2 billion of pre-dividend free cash flow (FCF) in 2016 and to use roughly half for shareholder returns, including $300 million of dividends. The remainder will be used for acquisitions and managing core leverage.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Xerox include:

--Low-single-digit negative revenue growth in constant currency, driven by low-single-digit growth in DO, flat-to-slightly up growth in BPO and mid-single digit negative growth in DT.

--Flat-to slightly up operating income margin, driven by restructuring and BPO's exit of healthcare system builds.

--Use of 50% of pre-dividend FCF for shareholder returns, including more than $300 million of dividends and the remaining for share repurchases.

--Modest acquisition activity with other cash used for some core debt reduction aimed at maintaining core leverage within 1.5x.

RATING SENSITIVITIES

Fitch believes negative rating actions could occur if the company provides further clarity on the ultimate capitalization and financial policies for Remainco that are not meaningfully more conservative than they are now, given the company's reduced diversification, scale and top-line growth prospects.

Fitch believes Xerox providing further clarity on the ultimate capitalization and financial policies for Remainco that are meaningfully more conservative than currently could result in affirmation of Remainco at 'BBB-'.

LIQUIDITY

Pro forma for net proceeds from the $1 billion term loan, Fitch believes Xerox's liquidity was solid at Dec. 31, 2015 and consists of:

--$2.4 billion of cash and cash equivalents; and

--An undrawn $2 billion RCF expiring March 2019.

Fitch's expectation for $1 billion of annual FCF also supports liquidity.

Pro forma for the $1 billion term loan, total debt, including 50% equity credit applied to the $349 million of convertible preferred stock, was $8.5 billion as of Dec. 31, 2015. Nearly half of total debt, or $3.9 billion, supported Xerox's financing business based on a debt-to-equity ratio of 7:1 for the financing assets. Xerox's net financing assets, consisting of receivables and equipment on operating leases, totaled $4.5 billion at Dec. 31, 2015, compared with $4.8 billion exiting the prior year.

FULL LIST OF RATING ACTIONS

Fitch rates the $1 billion senior unsecured 364-day term loan 'BBB-'.

Fitch currently rates Xerox:

--Long-term Issuer Default Rating (IDR) 'BBB-';

--Short-term IDR 'F3';

--Revolving credit facility 'BBB-';

--Senior unsecured debt 'BBB-';

--Commercial paper 'F3'.

The ratings are on Rating Watch Negative.

Date of Relevant Rating Committee: Jan. 29, 2016.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1000789

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Contacts

Fitch Ratings
Primary Analyst
Jason Pompeii
Senior Director
+1-312-368-3210
Fitch Ratings, Inc.
70 West Madison Street
Chicago, IL 60602
or
Secondary Analyst
Matthew Hankin
Director
+1-646-582-4985
or
Committee Chairperson
David Peterson
Senior Director
+1-312-368-3177
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Jason Pompeii
Senior Director
+1-312-368-3210
Fitch Ratings, Inc.
70 West Madison Street
Chicago, IL 60602
or
Secondary Analyst
Matthew Hankin
Director
+1-646-582-4985
or
Committee Chairperson
David Peterson
Senior Director
+1-312-368-3177
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com