Fitch Downgrades DXC Technology to 'BBB'; Outlook Stable

(The following statement was released by the rating agency) Fitch Ratings-New York-10 June 2020: Fitch Ratings has downgraded DXC Technology and its subsidiaries' long-term and debt ratings by one notch to 'BBB'. Fitch has also affirmed DXC and its subsidiaries' short term ratings at 'F2'. The Rating Outlook is Stable. Fitch updated its expectations following DXC's fourth-quarter 2020 earnings call both due to the more pronounced revenue runoff and increased uncertainty due to the coronavirus, indicated by the company. Gross leverage was 4.8x at March 31, 2020, three-tenths higher than expected in April (pro forma to April's bond issuance and term loan repayments as well as the incremental revolver draw subsequent to quarter end; Fitch had previously assumed DXC would draw the entirety of its $4 billion revolver and affirmed DXC following its April issuance). Previously, Fitch saw the potential for DXC to return its gross leverage to 2.0x consistent with its 'BBB+' rating within roughly two years even while accounting for near-term impacts of the coronavirus. However, the agency now sees this as unlikely. This is due entirely to weaker expectations for FY21 - core revenue lower by about $600 million and importantly an operating EBITDA margin that is weaker by nearly 3 pts. If DXC is able to stabilize its revenue base (pro forma for planned divestitures), leverage is no longer expected to decline to 2x or below even while continuing to assume 2+ points of margin expansion from trough levels in FY21. This is despite directing $3.5 billion of after-tax expected divesture proceeds toward debt reduction, in addition to Fitch's assumption of any and all after tax proceeds for the other planned divestitures, consistent with the company's March announcement. In March, DXC's stated reason for directing proceeds toward debt reduction in order to maintain its investment-grade credit rating as a conservative measure in response to the concern over the macro environment due to the coronavirus and DXC's lack of performance to plan. The implication being that its go-forward business trajectory was precarious and suggesting the company's financial profile will continue to migrate to that consistent with the 'BBB' level or lower. At the time DXC withdrew its FY22 forecast estimates and that, in conjunction with DXC's recent deterioration in operating performance, particularly on the margin line, prompted Fitch to see significant risk to its previous operating expectations at the time of the Outlook revision to Negative in November. DXC had said it would provide FY21 targets on its annual earnings call in May, but it ultimately suspended guidance until it has better visibility into the coronavirus' impact on its business and progress on its FY21 transformation initiatives. Fitch said it would reassess its forecast and consider any potential rating implications based upon this input in addition to the overall macro environment. Fitch expected that DXC's business prospects would likely remain challenged and necessitate capability acquisition that together offset any debt reduction likely resulting in a downgrade to the 'BBB' level. While the company's further shift in financial policy to enhancing liquidity (e.g. suspending the dividend, extending its maturity profile and making a full precautionary draw of its revolver) ameliorate near-term concerns, Fitch now sees operating performance challenges as being deeper than previously expected. Although uncertain, based upon our current assumptions we see the ability for DXC to maintain its credit protection metrics consistent with the 'BBB' level, allowing for continued top line challenges. To the extent Fitch's expectations change due to more pronounced operational challenges, the agency could reassess the Outlook. Key Rating Drivers Strategy Execution: On its most recent earnings call, DXC's CEO said revenue run-off due to suboptimal delivery and weakening customer relationships resulted in a loss of $1 billion in revenue in FY2020. The company has continued to reiterate good progress improving its standing with customers. However, the company expects a further $1 billion revenue loss FY21 due to customer terminations and price-downs. The company seems to be shifting back to a cost optimization stance from a previous stated focus on increasing appropriate investment in execution in order to ameliorate revenue declines. While DXC does not have a high share of consulting revenue that would likely be more discretionary in a reduced IT spend environment, the fact that the company has not performed to its sales targets going into a more challenging environment suggests that the company is now weakly positioned entering FY21, largely confirming that Fitch's prior expectation that DXC cannot stabilize its revenues over the near term. Margin: Management had previously committed to an approximately 12% margin (adjusted EBIT, non-GAAP) in fiscal 2020 and earlier withdrew its 12%+ target by fiscal 2022. This compares with 15.8% in fiscal 2019 and the prior articulated target of 250bps to 350bps expansion by fiscal 2022. FY20 EBIT margin underperformed the company's previous commitment, coming in at 10.5%. While Fitch believes the higher margin U.S. state and local HHS is offset by the lower margin workplace/mobility business, it now appears certain that DXC's core business is experiencing a structural decline in margins. DXC's operating EBITDA margin has declined by about five points (unadjusted for Fitch's new finance lease treatment) since fiscal 2019. Fitch sees a further 100 basis points of unadjusted margin decline in FY21 before improving to pre-FY19 levels thereafter, reflecting the company's stated expectation to eliminate about $700 million of cost on an annualized basis with 4,500 people affected, or 3.5% of its workforce. DXC's CEO previously committed to executing cost reductions while shifting to refining the cost structure as opposed to being as aggressive in cost takeout and investing in appropriate staffing levels and capabilities needed to execute effectively, particularly within the ITO and applications business as the basis for gaining increased digital business. This plan may be difficult to implement in a more challenged revenue environment, and while DXC has a track record of cost containment, Fitch believes DXC may face structurally lower margins over the forecast horizon as a result. Leverage: Pro forma gross leverage was 4.8x at March 31, 2020, reflecting weaker margin performance, previous issuance to fund the $2 billion acquisition of Luxoft Holdings, Inc, and a $4 billion draw of the company's revolver. Fitch had previously expected DXC would reduce its leverage back to below its 2.0x leverage sensitivity by fiscal 2020 and now does not see this occurring over the rating horizon. DXC's commitment to directing toward debt repayment of approximately $5 billion of net proceeds from its announced business divestitures may only offset a structurally lower margin profile, which has been reduced considerably. Fitch now sees DXC's gross leverage exiting FY21 at approximately 3.1x, before stabilizing at between 2.3x and 2.4x. Financial Policy: In March, DXC stepped back from its November commitment to return $4.25 billion to shareholders, representing approximately 50% of its market cap at the time through dividends and share repurchases by fiscal 2022. Fitch had expected a greater proportion of proceeds to go toward acquisitions that enhance the company's growth profile. Based upon the expected second-quarter 2021 close for the HHS business and an ongoing sales process for the remaining assets, DXC will not have headroom to support a return to capability acquisitions while managing its gross leverage to 2x or below. At the 'BBB' rating level, DXC will have headroom to a 2.5x gross leverage sensitivity, again contingent upon operating performance of its remaining business, which remains a challenge. DXC has generally demonstrated discipline toward maintaining its leverage profile consistent with Fitch's rating sensitivity while managing operational challenges, acquisitions and spinoffs. ESG - Governance: DXC Technology has an ESG Relevance Score of 4 for Management Strategy due to the company's shortfall in execution of its strategy to achieve growth in its digital offerings that offsets legacy IT services offering declines, compounded by the decision to divest 25% of revenue providing reduced scale and flexibility, and is relevant to the rating in conjunction with other factors. Derivation Summary DXC Technology Company's rating reflects its position as the third-largest IT services company by gross revenues after International Business Machines (NYSE:IBM) Corp. (WD; formerly A/Negative) and Accenture plc (NYSE:ACN) (A+/Stable). DXC's mid-teens current operating EBITDA margin is comparable its IT services peer group, including Accenture plc, Perspecta Inc.'s (BB/Stable) and Conduent Incorporated (WD; formerly BB-/Negative). With the disposition of its U.S. public sector business and its additional planned divestitures, Fitch now views DXC's scale and industry and geographic diversification as being weaker than its more highly rated peers. However, Fitch does expect DXC to continue to benefit from next-generation IT capabilities akin to that of its larger, more highly rated peers Accenture plc and International Business Machines Corp, particularly as augmented by acquisitions, which have been a meaningful part of DXC's strategy as a combined entity. DXC's financial profile is now consistent with its 'BBB' rating, and it appears top line challenges and execution challenges have pressured credit protection metrics amid a continued effort to rebalance its business from legacy to digital offerings on a sustained. At the 'BBB' rating level DXC will have appropriate prospective headroom to Fitch's leverage sensitivity, although it possesses financial flexibility to respond to operational challenges, to a degree. Fitch assigned the higher of two available short-term rating options based on the following observations: --Fitch has determined the three-notch midpoint for DXC's 'Financial Flexibility' factor is 'bbb+', at the minimum required to achieve a higher short-term rating. DXC has very comfortable liquidity, consistent with an 'a' factor rating (Fitch believes DXC would not have to use external funding in the next 12 months even under the very unlikely event of a severe stress scenario whereby the company loses access to external funding). However, Fitch assesses DXC's Financial Discipline factor to be 'bbb' given its shift to maintaining diminished headroom in its credit protection metrics; --The 'Financial Structure' factor is 'bbb' consistent with DXC's leverage metrics, above the minimum required to achieve the higher short-term rating; --The Operating Environment factor (upper end of the rating band) is 'aa' given DXC's geographic orientation heavily weighted towards developed economies. No parent/subsidiary linkage is applicable, no Country Ceiling constraint was in effect for these ratings, and no Operating Environment influence was in effect for these ratings. Fitch adds its estimate of receivables factoring to total debt and adjusts working capital and cash flow from financing accordingly. Key Assumptions Fitch's Key Assumptions Within the Rating Case for the Issuer - Approximately 9% revenue decline in fiscal 2021 and core remaining revenue post-divestitures approximately 3% decline thereafter; - Assume all three announced business divestitures occur as announced with retention of Workplace & Mobility business being incremental to the current rating case; - Operating EBITDA margin of 13% (adjusted for Fitch's finance lease treatment) in fiscal 2021 and improving 2 points in FY22 to reflect cost restructuring and flat thereafter; - Repayment of $5 billion of gross debt and no further material increase in receivable sales debt outstanding; - Repayment of precautionary revolver draw in FY21; - $5 billion of net proceeds from divestitures, $50 million in annual tuck-in acquisitions, resumption of dividend in FY22 at approximately 10% of DXC's adjusted non-GAAP EBIT, and no share repurchases in fiscal 2021 and approximately $1 billion annually thereafter; - Large-scale M&A and further divestitures not contemplated. RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: - Sustained stabilization in revenue with path towards positive organic growth; - Post-dividend FCF margin sustained above 5%; - Gross leverage (operating EBITDA/total debt including receivables factoring) sustained below 2x. Factors that could, individually or collectively, lead to negative rating action/downgrade: - Gross leverage sustained above 2.5x; - Post-dividend FCF margin sustained below 3%; - Sustained negative revenue growth; - Shift to more aggressive financial policy. Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Adequate Liquidity: Fitch views DXC's liquidity as solid, supported by $6.2 billion in cash and cash equivalents, as of March 31, 2020 pro forma for DXC's 2.5 billion additional drawn on its revolving credit facility, subsequent to quarter end. The company's liquidity is further supported by Fitch's expectation for $600 million to $800 million in post-dividend FCF annually over the ratings horizon (Fitch now treats finance leases as operating expense including amortization of right-of-use assets, reducing EBITDA and FCF while adding back to financing activities). Manageable Maturities: DXC's maturities are well staggered. Fitch assumes DXC will repay maturities with net cash proceeds from its divestitures with now an anticipated $5 billion earmarked for debt reduction. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations DXC Technology has an ESG Relevance Score of 4 for Management Strategy due to the company's shortfall in execution of its strategy to achieve growth in its digital offerings that offsets legacy IT services offering declines, compounded by the decision to divest 25% of revenue providing reduced scale and flexibility, and is relevant to the rating in conjunction with other factors. Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3 - ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. DXC Capital Funding Limited; Short Term Issuer Default Rating; Affirmed; F2 ----senior unsecured; Short Term Rating; Affirmed; F2 DXC Technology Company; Long Term Issuer Default Rating; Downgrade; BBB; RO:Sta ; Short Term Issuer Default Rating; Affirmed; F2 ----senior unsecured; Long Term Rating; Downgrade; BBB DXC Technology Australia Pty Limited; Long Term Issuer Default Rating; Downgrade; BBB; RO:Sta ----senior unsecured; Long Term Rating; Downgrade; BBB Computer Sciences Corp (NYSE:DXC).; Long Term Issuer Default Rating; Downgrade; BBB; RO:Sta ----senior unsecured; Long Term Rating; Downgrade; BBB CSC Computer Sciences International Operations Limited; Long Term Issuer Default Rating; Downgrade; BBB; RO:Sta ----senior unsecured; Long Term Rating; Downgrade; BBB Contacts: Primary Rating Analyst Kevin McNeil, Director +1 646 582 4768 Fitch Ratings, Inc. 33 Whitehall Street New York 10004 Secondary Rating Analyst Jason Pompeii, Senior Director +1 312 368 3210 Committee Chairperson David Peterson, Senior Director +1 312 368 3177 Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: elizabeth.fogerty@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Parent and Subsidiary Rating Linkage (pub. 27 Sep 2019) (https://www.fitchratings.com/site/re/10089196) Sector Navigators: Addendum to the Corporate Rating Criteria (pub. 01 May 2020) (https://www.fitchratings.com/site/re/10120367) Short-Term Ratings Criteria (pub. 06 Mar 2020) (https://www.fitchratings.com/site/re/10112342) Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). 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