Combining technical/momentum indicators with undervalued stocks can help you avoid value traps, and that’s exactly what the Valuentum Buying Index did with DXC Technology recently. The VBI helped us avoid a catastrophe.
By Callum Turcan
Shares of DXC Technology Inc (DXC) were shredded after its August 8 earnings report for the first quarter of FY2020 (period covers April 1 to June 30). Management issued out a guidance cut that signaled DXC Technology’s attempt to shift into new markets to offset weakness at its legacy businesses would be a steeper uphill climb than previously expected. The company sells a combination of legacy IT offerings (particularly in the realm of enterprise data application management) and more modern IT offerings that cater towards the internet of things (“IoT”), cloud computing, cybersecurity solutions, and more. Shares of DXC Technology yield 2.5% as of this writing.
Back in our July 9 piece covering DXC Technology, we noted that we liked its historical free cash flows and that the firm could support a nice dividend growth story if share buybacks were pared back. At the time, shares of DXC appeared very cheap relative to its future discounted free cash flows. However, we didn’t add DXC to our newsletter portfolios as its Valuentum Buying Index (“VBI”) stood at 3 in early-July 2019 and pressures on its top-line indicated the market was expecting additional pain in the short- to medium-term.
Please always keep in mind the holdings in our newsletter portfolios (such as the Best Ideas Newsletter and Dividend Growth Newsletter) represent our favorite investment ideas. We also particularly like stocks that register a VBI of 9 or 10, but generally after our newsletter holdings. When shares of equities are trading well below our fair value estimate, that alone doesn’t make those stocks good investment considerations. We ended the July article on DXC Technology on this note;
“DXC Technology is on our radar. We’re waiting for shares to turn higher [as its VBI rating was quite low].”
Down in the graphic below is a segment from DXC Technology’s 16-page Stock Report, which can be accessed here, that highlights why the VBI is so important when used in conjunction of our fair value estimate. We believe an appreciating equity is one that has a higher likelihood of price-to-fair-value convergence. This market action is picked up in the VBI, while the fundamental, cash-flow-derived fair value estimate does not consider this. Strong pricing momentum is a good indication that price-to-fair value convergence may occur (after all, the market has to eventually agree for us to be right). Such pricing momentum was absent in DXC Technology in July; hence, we stayed away from what turned into a value trap.
Image Shown: The VBI is a crucial part of Valuentum’s equity analysis and investment process. Fair Value Estimates alone don’t provide the full picture. Image Source: DXC Technology’s 16-page Stock Report
Additionally (from our previous note):
Please keep in mind that DXC Technology’s top-line has been coming under pressure, and we expect that to continue going forward to a lesser degree. During FY2019, DXC Technology reported that its revenue dropped by $1.0 billion from FY2018 levels, down 4.5% year-over-year. Global Business Services (“GBS”) sales were down 6.2% while Global Infrastructure Services (“GIS”) sales decreased by 3.3%, bringing total revenue down to $20.8 billion in FY2019. The company mentioned that its sales decline was due to weaker performance at its traditional application management & maintenance business and legacy infrastructure services. Foreign exchange movements reduced sales by 1.6% in FY2019, as the US dollar strengthened against the Euro and British Pound.
On the GBS side, the revenue slide is largely due to the shift towards the cloud (accelerated levels of cloud adoption across the globe are making application maintenance and management services, traditional offerings to support IT infrastructure, steadily irrelevant over time). On the GIS side, weaker sales were a product of the shift away from legacy infrastructure environments towards the cloud, however, rising cloud adoption helped drive demand for its own cloud infrastructure and digital workplace offerings.
At that time, management was still forecasting for $20.7 billion – $21.2 billion in total revenue in FY2020, implying the potential for modest top-line growth this fiscal year as DXC Technology generated $20.8 billion in revenue in FY2019. However, that’s no longer the case with DXC Technology, with the firm now targeting $20.2 billion-$20.7 billion in revenue in FY2020. Even at the top end of guidance, management thinks the decline in DXC Technology’s legacy businesses will offset growth elsewhere and continue to push company-wide revenue lower. In the first quarter of FY2020, revenues of $4.9 billion were down over 7% year-over-year. Its GAAP operating margin tanked by ~260 basis points year-over-year as its operating income dropped by 43%.
Shares of DXC Technology probably sold off due to investors beginning to factor in top-line pressures in their valuation models, which negatively impacts expected future free cash flows.
DXC Technology had $7.5 billion in net debt (inclusive of short-term debt) at the end of June 2019. While that isn’t unmanageable given the firm generated $1.5 billion in free cash flow in FY2019, its ability to adapt to the fast-changing IT landscape is hampered by its hefty debt burden. Its annual dividend commitment is relatively small at ~$0.2 billion but note share buybacks have represented a large part of DXC Technology’s total shareholder return strategy. Future free cash flows are enhanced by DXC Technology’s relatively capex-light business model.
It’s clear that past share buybacks (such as the $1.3 billion spent in FY2019) did not lead to meaningful shareholder value creation on a sustained basis. We would support DXC Technology deleveraging and allocating more free cash flow to its dividend policy, both of which are viable capital allocation strategies if the tech company significantly pares down share repurchases.
Concluding Thoughts
We will be taking another look at our model covering DXC Technology, but please note that as its VBI stands at 3, we aren’t interested in shares here. DXC Technology is no longer on our radar as things stand today. The market is signaling that there’s a lot of additional pain ahead of DXC Technology, and that sentiment was reinforced via management’s recent guidance cut.
IT Services Industry – Cognizant Technology Solutions Corporation (CTSH), DXC Technology Inc (DXC), Infosys Limited (INFS), Jack Henry & Associates Inc (JKHY), Wipro Limited (WIT)
—–
Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.
Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.