CHICAGO--(BUSINESS WIRE)--Fitch Ratings has downgraded the ratings for Xerox Corporation, including the long-term Issuer Default Rating (IDR), to 'BBB-' from 'BBB' following the company's announcement it will separate into two publicly traded companies. Fitch maintains the Rating Watch Negative pending further details around the ultimate corporate and capital structure of the remaining company (Remainco). Fitch's actions affect $9.4 billion of total debt including the undrawn $2 billion revolving credit facility (RCF). A full list of ratings follows at the end of this release.
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 total) of Xerox's 2015 consolidated revenues, while the BPO businesses represent the remaining approximately $7 billion (approximately 40% of total).
The downgrade reflects Fitch's belief that the separation reduces diversification, scale and top line growth prospects even as DT continues facing significant long-term secular headwinds and BPO is amidst a multi-year restructuring. The downgrade also reflects 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 intensify event risk, were Xerox to not complete the separation.
Fitch's maintenance of the Watch Negative reflects the current lack of certainty around which of the two public companies will constitute 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 Watch Negative upon formalization of Remainco's ultimate structure and capitalization. Were legacy Xerox to constitute Remainco, the Watch Negative 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 Watch Negative 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, Fitch does 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 a greater focus on the 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.
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 to maintaining core leverage within 1.5x.
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 currently, 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-'.
Fitch believes Xerox's liquidity was solid at Dec. 31, 2015 and consists of:
--$1.4 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.
As of Dec. 31, 2015, total debt, including 50% equity credit applied to the $349 million of convertible preferred stock, was $7.5 billion. $3.9 billion, or more than half of total debt, 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 compared with $4.8 billion as of Dec. 31, 2014.
FULL LIST OF RATING ACTIONS
Fitch has downgraded Xerox Corporation's ratings as follows:
--Long-term Issuer Default Rating (IDR) to 'BBB-' from 'BBB';
--Short-term IDR to 'F3' from 'F2';
--Revolving credit facility (RCF) to 'BBB-' from 'BBB';
--Senior unsecured debt to 'BBB-' from 'BBB';
--Commercial paper (CP) 'F3' from 'F2'.
The ratings are maintained on Rating Watch Negative.
Date of Relevant Rating Committee: Jan. 29, 2016.
Additional information is available at 'www.fitchratings.com'.
Corporate Rating Methodology - Including Short-Term Ratings and Parent
and Subsidiary Linkage (pub. 17 Aug 2015)
Dodd-Frank Rating Information Disclosure Form