Fitch Rates Xerox's Senior Notes Offering 'BBB'
Xerox will use net proceeds from the senior notes issuance for general corporate purposes, which may include debt reduction.
KEY RATING DRIVERS
Xerox's ratings and Stable Outlook reflect:
--Fitch's expectations for improving operating results in Services to offset revenue declines in Document Technology (DT), primarily black-and-white (B&W) high-end production printing.
--Substantial recurring revenue from long-term services contracts, rentals and financing, and supplies (more than 85%).
--Solid liquidity supported by \$1.1 billion of cash at Dec. 31, 2014 (pro forma for the new \$650 million senior notes issuance and \$1 billion maturity February 17, 2015), an undrawn \$2 billion RCF due 2019, staggered debt maturities and consistent annual free cash flow (FCF). Fitch believes FCF (post-dividends) will to exceed \$1.3 billion annually.
--Fitch expectations for an increasingly diversified revenue mix from faster growth in the Services segment and with declining exposure to the slower-growing print industry. Services accounts for 54% of Xerox's total revenue.
--Xerox's conservative financial policies. Fitch believes management remains committed to an investment grade rating and has a track record of reducing debt to offset declining financing assets, resulting in flat core leverage.
Fitch's credit concerns center on:
--Fitch expectations for ongoing revenue pressures in DT, which includes equipment and supplies bundled with DO contracts. Fitch forecasts mid-single digit revenue declines for DT through the intermediate term. Revenues fell 8.8% primarily from a year ago due to weakness in B&W. Benefits from restructuring resulting in higher DT operating margin will partially mitigate revenue declines. Operating profit margin will exceed 12.5% through the intermediate term, up from 10.8% in 2013.
--The aggregate \$2.6 billion underfunding of worldwide defined benefit (DB) pension plans as of year-end 2014, up from \$1.9 billion in the prior year. The lower funded status primarily reflects higher benefit obligations due to a 90- and 110-basis point decrease in the U.S. and non-U.S. discount rate, respectively. Total contributions are expected to be \$340 million in 2015 up from \$284 million in 2014.
--Pressured operating margin in the Services business, although stronger pro forma for the ITO business sale. Fitch expects operating margin to remain in the high-9% range through the near term but has greater confidence Xerox will reach and maintain 10% in the longer term, driven by higher BPO profit margin and greater contract bidding discipline.
Cost overruns related to government healthcare contracts and the continued run-off of certain higher margin business process outsourcing contracts, consisting of student loan processing and customer care (CC) volume with a telecom client post acquisition drove operating profit margin compression.
--Fitch's expectations for Services operating profit margin sustained below 9%;
--Sustained declines in DT more than offsetting growth in Services, resulting in a material decline in financial performance and credit metrics.
Positive rating actions are unlikely in the absence of:
--A significant reduction in the funding shortfall for Xerox's worldwide defined benefit pension plan;
--DT revenues levels stabilize with expectations for sustained operating profit margin near current levels; and
--Revenue growth and margin expansion in Services results in expectations for FCF margin approaching 10%.
Xerox's pro forma liquidity is solid, supported by \$1.1 billion of cash and an undrawn \$2 billion RCF that matures in March 2019. Fitch's expectation for more than \$1.5 billion of annual FCF also supports liquidity.
Pro forma for the senior notes issuance and \$1 billion maturity February 17, 2015, total debt with equity credit was \$7.6 billion on Dec. 31, 2014. Total debt consisted of approximately \$7.1 billion of senior unsecured debt and \$349 million of convertible preferred stock, to which Fitch assigns 50% equity credit. As of Dec. 31, 2014, \$4.2 billion, or 54%, 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 \$4.8 billion compared with \$5.1 billion in the prior year.
Xerox's nearest debt maturities include \$250 million of senior notes due June 1, 2015.
Fitch currently rates Xerox as follows:
--Long-term Issuer Default Rating (IDR) at 'BBB';
--Short-term IDR at 'F2';
--Revolving credit facility (RCF) at 'BBB';
--Senior unsecured debt at 'BBB';
--Commercial paper (CP) at 'F2'.
--IDR at 'BBB';
--Senior notes at 'BBB'.
The Rating Outlook is Stable.