Fitch Expects to Assign 'BB' IDR to Conduent; Outlook Stable

CHICAGO--()--Fitch Ratings expects to assign the following ratings to Conduent Incorporated (Conduent) following its separation from Xerox Corporation (Xerox):

--Long-Term Issuer Default Rating (IDR) 'BB';

--Senior unsecured debt 'BB/RR4';

--Senior secured term loans 'BB+/RR1';

--Senior secured revolving credit facility 'BB+/RR1'.

The expected Rating Outlook is Stable. Fitch's actions are expected to affect up to $3.1 billion of total debt, including an up to $750 million senior secured revolving credit facility.

In connection with the separation, Conduent will raise approximately $2.4 billion of new borrowings and transfer approximately $2 billion of net proceeds to Xerox, with the $400 million of remaining net proceeds being added to the balance sheet. Conduent will issue a mixture of senior secured term loans and senior unsecured notes, as well as enter into an up to $750 million senior secured revolving credit facility to support liquidity.

Fitch's expected ratings follow Conduent's disclosure on its expected capital structure, liquidity and cash transfer to Xerox prior to separation. Xerox will separate Conduent, which will be comprised of the Business Process Outsourcing (BPO) businesses within Xerox's Services segment (excluding the Document Outsourcing business that will remain at Xerox) through a spin-off transaction intended to be tax-free for Xerox shareholders for federal income tax purposes. The separation unwinds legacy Xerox's 2010 acquisition of Affiliated Computer Services Inc. (ACS) for $6 billion and is expected to be completed at the end of calendar 2016.

KEY RATING DRIVERS

Stabilizing Top Line: Fitch expects stabilizing operating performance in the near term with modest transitory headwinds pressuring revenue growth and profit margin expansion on track. Conduent's focus on turning around unprofitable contracts, customary price declines and lower volumes, particularly in commercial industries should constrain near-term revenue growth. However, Fitch expects the top line will stabilize in 2018 and should grow in-line (low single digits) with the market through the intermediate term.

Size and Diversification: Conduent is a global leader in BPO by revenue and number of employees with geographically mixed delivery platforms. Fitch believes Conduent is a market leader in certain industries and, given its scale, should consolidate share over time from smaller players without financial flexibility to support higher investment levels or capabilities to drive innovation. Fitch also believes Conduent's domain expertise across end markets should reduce operating volatility. Conduent has strong positions and is a market leader in transaction processing, customer care and human resource services, serving public sector, large enterprise and healthcare.

Recurring Revenue Streams: Fitch expects Conduent to continue benefitting from 90% recurring revenue from contracts with an average life of more than three years. Conduent's 86% contract renewal rates result in greater visibility, although contractual price step-downs for certain contracts require Conduent to reduce delivery costs through productivity gains, including automation and right shoring, to maintain consistent profitability.

Restructuring Led Profitability Growth: Fitch expects Conduent's strategic transformation initiatives, announced in connection with the separation transaction in January 2016, will result in stronger operating performance over the longer-term and begin driving profit margin expansion beginning in 2017. Fitch believes Conduent plans on achieving significant cost savings with a portion reinvested and remainder dropping to the bottom line. A portion of savings also should support standalone costs (dis-synergies).

Reasonably Conservative Financial Policies: Fitch expects financial policies will remain reasonably conservative for the rating through the intermediate-term. Fitch estimates total leverage (total debt to operating EBITDA) at separation will be approximately 3.8x, which assumes $2.4 billion of new debt and Fitch's estimate of roughly $625 million of pro forma operating EBITDA. Credit metrics should strengthen through the intermediate-term from a combination of voluntary debt reduction and restructuring driven profitability growth and Fitch expects Conduent to maintain total leverage below 3.0x over the longer-term. Fitch believes Conduent will prioritize organic investments and acquisitions rather than shareholder returns, given the company's focus on organic growth.

Modest FCF: Fitch expects annual FCF will remain modest, given investment intensity required to support growth. Fitch anticipates profit margin expansion will drive higher FCF over time, eventually exceeding Conduent's roughly $300 million of FCF in 2015. Fitch expects the company will use modest FCF to support organic investments and acquisitions, which could potentially be debt financed given a significant majority of Conduent's cash is located inside the U.S. and acquisitions may include offshore deals.

KEY ASSUMPTIONS

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

--Low-single digit negative constant currency organic revenue growth in 2016 and 2017, driven by Conduent's decision to exit unprofitable contracts, particularly Health Enterprise platforms for Montana and California, lower volume in commercial industries and customary price declines;

--Low single digit constant currency organic revenue growth through the intermediate-term from leveraging platforms across industries and tuck-in acquisitions;

--Increased investments to support next-generation software and automation technologies;

--Expectations for operating EBITDA margin expansion to double-digits and then low-teens through the forecast period from the realization of cost savings from strategic transformation initiatives and resumption of positive organic revenue growth; and

--FCF will be used for acquisitions or build available cash, with no shareholder returns through 2017.

RATING SENSITIVITIES

Positive rating actions could occur if Fitch expects:

--Sustained positive single-digit constant currency organic revenue growth; and

--Strengthening annual FCF ranging from $250 million to $500 million beyond the near-term, driven by resumption of positive revenue growth and sustainable profit margin expansion; and

--Total leverage below 3x from debt reduction and profitability growth.

Negative rating actions could occur if Fitch expects:

--Negative constant currency organic revenue growth beyond 2017, likely signalling an inability to penetrate growth markets and lower renewals for existing contracts;

--Pressured profitability that offset a meaningful portion of restructuring benefits resulting in operating EBITDA margins remaining in high single digits and pressured FCF ranging from break-even to $250 million; or

--Debt financed shareholder returns or acquisitions, indicating a shift in priority use of FCF and resulting in total leverage sustained above 3.5x.

LIQUIDITY

Fitch expects Conduent's liquidity profile will be adequate and supported by:

--$400 million of on balance sheet cash at separation; and

--An up to $750 million senior secured revolving credit facility, which will be undrawn at separation.

Fitch's expectation for $250 million to $500 million of annual FCF also supports liquidity. Fitch expects $2.4 billion of total debt at separation consisting of a mix of senior unsecured notes and senior secured term loans, as well as modest existing debt.

Date of Relevant Rating Committee: Sept. 30, 2016

Summary of Financial Statement Adjustments - No material adjustments have been made that have not been disclosed in public fillings of this issuer.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/site/re/879564

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012932

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Contacts

Fitch Ratings
Primary Analyst
Jason Pompeii
Senior Director
+1-312-368-3210
Fitch Ratings, Inc.
70 West Madison St.
Chicago, IL 60602
or
Secondary Analyst
Alen Lin
Senior Director
+1-312-368-5471
or
Committee Chairperson
David Peterson
Senior Director
+1-312-368-3177
or
Media Relations:
Alyssa Castelli, New York, +1 212-908-0540
Email: alyssa.castelli@fitchratings.com