Fructivore Investments

DXC Technology Company is a provider of IT outsourcing services to other corporations, and it has been going through a rough patch over the last few years as shown by a dramatically declining share price. Investors have been holding out for a turnaround from the introduction of new management over this period, and perhaps at the moment they are seeing early signs of it. And in the meantime, the company’s free cash flow yield of 28% has brought it a lot of attention.

DXC offers a suite of offerings including IT outsourcing and consulting, data analysis, etc. The company was formed by the merger of Computer Sciences Corporation with HP Enterprise, and has spent the last few years whittling away at its noncore assets, which has made analyzing its year over year performance trends difficult, as has the fact that the company operates all over the world and apparently doesn’t bother to hedge the bulk of its currency exposure. However, the company has been kind enough to disclose “organic growth” of sales (or to be precise, “organic shrinkage”), and the trends on that appear to be leveling off. Moreover, as a result of this shrinkage, depreciation substantially exceeds new capital investments, making free cash flow significantly higher than earnings.

DXC operates in two sectors: Global Business Services and Global Infrastructure Services. GBS offers analytics and engineering to automate operations and analyze data, writing applications, and run insurance software and business process services in the form of bank cards, payment processing, etc. . GIS offers security, cloud infrastructure and IT outsourcing, and a modern workplace service.

For fiscal year 2023, Global Business services showed organic revenue growth of 2.4%, while Global Infrastructure Services showed organic revenue shrinkage of 7.2%, making a total revenue decline of 5.3% on a comparable basis. As stated before, divestitures and the strong dollar produces a larger overall revenue decline. At any rate, free cash flow from operations for the year came to $1.088 billion (the calculation is somewhat complicated by substantial swings in pension funded status, currency translation effects, and the inclusion of gains on divestments in “other income,” but I think I’ve sorted most of it out). This is an improvement on fiscal year 2022, where sales declined by 9.1% on a comparable basis, affecting both Global Business and Global Infrastructure, while free cash flows came to $490 million. I would also note that restructuring costs declined from $551 million in fiscal year 2021 to “only” $216 million in 2023 and are on course to be about $120 million in fiscal year 2024.

The share price has been declining for some time, but the first quarter of fiscal year 2024 (last August) severely disappointed the markets and drove the price down from $28 per share down to $20, where it lies today after drifting back up to $24 in the interim. In that quarter, organic revenue declined on a year over year basis by 3.6% and free cash flow from operations was $130 million as compared to $203 million the year before. However, $25 million of this difference was due to increases in contract onboarding costs and software (both of which DXC capitalizes somewhat aggressively in my opinion, but as I count them against free cash flow anyway it all comes out in the wash).

However, in the second quarter of fiscal year 2024, free cash flow for the quarter was $233 million versus $252 for the previous year, and in the third quarter, $276 million versus $164 million, making for $629 million year to date as compared to $619 for last year. Projecting this out to the entire year produces $838 million, which based on the company’s market cap and taking excess cash into account, comes to a free cash flow yield of 28% against an adjusted market cap of $3 billion. I should also point out that DXC recently won a lawsuit against Tata Consultancy for trade secret violations, with the jury recommending an award of $210 million, but that would have to be approved by a judge and presumably survive an appeal as well.

So, is that free cash flow yield attractive given DXC’s situation? Well, since sales declines seem to be flattening and restructuring costs are declining, we may say tentatively that DXC is approaching the size and configuration that the management has in mind. If we assume a terminal 5% decline in revenues, and that the company adjusts its operating and capital expenses accordingly, that works out to a multiple of 6 2/3, while a 28% free cash flow yield is a multiple of about 3.75, so there is apparently significant upside.

But on the other hand, there is the possibility that DXC could see a major exodus of clients which will make these past figures an unreliable guide to its earnings power, and it seems clear to me that DXC does not have the competitive moat that Warren Buffett looks for. That, combined with the ongoing declines, suggests that DXC could easily turn into a value trap despite its attractive free cash flow yield. In other words, there is not the asymmetry between the upside and the downside that makes for an attractive value play.

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Investing by grocca