Rating Action Overview

• U.S.-based print technology and services company Xerox Holdings Corp. continues to face revenue growth, profit, and free cash flow headwinds amidst a difficult operating environment notwithstanding the ongoing recovery in office print activity.
• We expect a more uncertain business recovery given the current macroeconomic and inflationary environment that will pressure profit margins and constrain free operating cash flow generation relative to historical levels. Credit metrics will be weaker than expected with higher adjusted leverage of 1.9x-2.1x in 2022 versus our 2.5x downside trigger.
• We revised our outlook to negative from stable and affirmed all our ratings including our 'BB' issuer credit rating on Xerox.
• The negative outlook reflects our expectation for rising macroeconomic risks and ongoing supply chain challenges that create a more difficult operating environment for Xerox over the next 12 months. This will likely hurt enterprise IT demand and make it challenging to achieve financial guidance and FOCF growth despite some improvement in equipment sales and post-sale revenues as office activity continues to recover and as price and cost reduction actions are implemented.

Rating Action Rationale

We expect global economic growth uncertainty will pressure information technology (IT) spend and create a more challenging operating environment for Xerox. While enterprise IT spending has remained steady, we expect a more volatile operating environment and the potential for a recession in the U.S. and weaker economic conditions in the Eurozone. We forecast global IT spend to increase about 5% in 2022 but macroeconomic headwinds increase the risk for reductions in enterprise demand in the near-term and likely in 2023 depending on the severity of the downturn. Along with several other technology companies, Xerox noted that some enterprise customers have begun to slow or delay their projects, creating a more uncertain outlook for enterprise expenditures. We believe digital transformation projects essential to business processes will be prioritized, and spending cuts or deferrals in noncritical areas are very likely. Xerox may benefit from digitized workflow implementations, but we believe print hardware demand is vulnerable because unemployment could increase in 2023 and print volume improvement (which will be important in its recovery) may be slower than expected post-pandemic. About 75% of Xerox's revenue is driven by higher margin post-sale activity (services, supplies, and financing).

Xerox will focus on additional cost reductions in 2023 to help offset cash flow and profit pressures.  While some supply chain and component procurement challenges are easing, the persistent inflationary environment continues to weigh on profitability, especially for printer hardware. The company grew revenues (4.7% constant currency) in the third quarter of 2022, though profitability remains low. The company's S&P Global Ratings' adjusted EBITDA margin was about 7.8% at Sept. 30, 2022, which is an improvement from 6.9% in the second quarter, but remains well below of its historical 14%-15% range. We now expect adjusted EBITDA margin of 6.5%-7.5%, which is below our previous expectations for about 10% in 2023. Xerox expects its margins will improve through the remainder of 2022 and achieve expansion near its 200-basis-point target above 2021 levels as it takes action on prices and reduces costs.

The company targets $450 million in cost reduction in 2022 and further reductions in growth business investments to help offset more recent inflationary headwinds. While some margin pressure will abate as business conditions improve, further significant cost reductions may be difficult given the persistent revenue erosion and cost actions under Project Own It implemented in 2018. Additionally, many years of business restructuring and significant reductions in growth initiatives may undermine business innovation and future growth prospects.

We expect profit headwinds will also constrain cash flow generation and reduce credit metric cushion at the current rating level. The company's negative retained cash flow has reduced cash balances over the past several quarters, contributing to rising adjusted leverage. We expect the continuation of more shareholder friendly polices to support dividends of about $175 million annually, and acquisitions will lead to negative retained cash flow in 2022 and modestly positive cash flow in 2023. We expect adjusted leverage of 1.9x-2.1x in 2022 and may improve in 2023 depending on the prospects for margin expansion. Our adjusted leverage metrics include 100% cash netting.

Our rating reflects high business execution and event risks. Xerox has experienced many years of revenue erosion and financial target shortfalls because of the secular decline in physical print volume and unexpected macroeconomic events like the pandemic making it difficult to grow revenue and reach profit margin targets. We continue to expect high business execution risk with its longer-term revenue trajectory and evolving business strategies. We acknowledge the company's focus on restoring profitability and growing free operating cash flow generation in the near-term, but its path to sustained revenue growth is increasingly challenging. Considering uncertain longer-term growth prospects in the core enterprise printer business and greater competitive pressures, we believe partnerships and mergers and acquisitions (M&A) that allow the company to accelerate and scale other growth initiatives are higher-probability events. Additionally, we believe the company's underperformance over the years may prompt other business and financial strategies that we view as credit negative.

Outlook

The negative outlook reflects our expectation that rising macroeconomic risks and ongoing supply chain challenges will create a more uncertain operating environment for Xerox over the next 12 months. These headwinds will likely reduce enterprise IT demand and make it difficult to achieve financial guidance and FOCF growth despite better equipment sales and post-sale revenues as office activity recovers. The outlook also incorporates Xerox's long-term revenue erosion and underperformance because of the difficult environment, raising event risk that may pressure our rating.

Downside scenario

We could lower the rating if:

• The company is unable to offset profit pressures through cost cuts, other expense management and revenue growth strategies such that adjusted EBITDA margin improvement is unlikely to be sustained and adjusted leverage continues to rise toward 2.5x over the next 12 months; or
• FOCF remains low and does not grow toward $400 million.

Upside scenario

We could revise the outlook to stable if:

• Revenue growth (constant currency basis) consistently improves while margins continue to expand such that adjusted leverage trends back to the mid-1x area; and
• FOCF growth improves such that prospects for achievement of $400 million annually is likely in 2023.

Company Description

Xerox Holdings Corp. (parent company of Xerox Corp.) supplies multifunction printers and managed document services to enterprise customers in North America, EMEA, and Latin America. Xerox provides IT services to the small and midsize business (SMB) market, including PC and network infrastructure, communications technology, and network administration.

Our Base-Case Scenario

• Global GDP grows 3.2% in 2022 and 2.7% in 2023.
• U.S. GDP grows 1.6% in 2022 and 0.2% in 2023.
• Eurozone GDP grows 3.1% in 2022 and 0.3% in 2023.
• Adjusted revenues decline 2%-3% in 2022 amid a slower-than-expected recovery in print, foreign exchange headwinds, and the uncertain macroeconomic environment.
• Post-sale revenue grows in the low-single-digit percent and equipment sales decline 7%-9% in 2022.
• S&P Global Ratings'-adjusted EBITDA margins in the 6.5%-7.5% range over the next 12-24 months, still lower than pre-pandemic levels of 14%-15%, due to supply chain headwinds, lower print volume, and restructuring costs, partially offset by ongoing cost management, and somewhat stable post-sale margins.
• About $175 million of dividends annually.

Based on these assumptions we derive the following adjusted credit metrics:

• Adjusted leverage of 1.9x-2.1x; and
• Adjusted FOCF of about $155 million-$165 million (equivalent to reported FOCF of $80 million-$90 million).

Liquidity

We revised our assessment of Xerox's liquidity to adequate from strong because of credit agreement covenants that reduce its available cash balances and debt maturities in 2022 and 2023. We expect the company's liquidity sources will exceed its uses by about 1.25x over the next 12 months, and that its net sources will remain positive even if its EBITDA declines by 15%.

Principal liquidity sources:

• Available cash on hand of about $432 million (reduced by $500 million that is required to be maintained in accordance with its credit agreement);
• Full availability under its $500 million revolver expiring 2024; and
• Annual operating cash flow of about $135 million-$145 million in 2022 and $240 million-$260 million in 2023.

Principal liquidity uses:

• $650 million of senior notes due in 2023 (of which $350 million is required to be repaid by Dec. 15, 2022);
• Annual capital spending between $55 million and$60 million; and
• Annual dividends of about $175 million.

Covenants

The company's $500 million revolving credit agreement requires that it maintain: at least $500 million of cash on hand at quarter end; a total net leverage ratio of 5x at Dec. 31, 2022, stepping down to 4.25x at Dec. 31, 2023; and a minimum interest coverage ratio of 2.5x at Dec. 31, 2022, stepping up to 2.75x at Dec. 31, 2023.

The revolver also requires the company have no more than $300 million of senior notes due 2023 outstanding at Dec. 15, 2022.

Issue Ratings - Recovery Analysis

Key analytical factors

• Our '3' recovery rating on the company's unsecured debt is unchanged.
• Xerox's capital structure includes $1.5 billion of unsecured senior notes and $500 million secured revolver issued by Xerox Corp., and $1.5 billion of unsecured notes issued by Xerox Holdings Corp. and guaranteed by operating subsidiaries.
• We view the finance receivables securitization as senior to all debt and assume these debts are repaid as they become due through 2025.
• Our estimated gross enterprise value is reduced by total unfunded pension obligations.
• Our recovery analysis assumes a hypothetical default in 2027 due to print erosion and technological disruption that accelerate revenue declines and pressures profitability.

Simulated default assumptions

• Simulated year of default: 2027
• Implied enterprise value multiple: 6x
• Implied EBITDA at emergence: $450 million

Simplified waterfall

• Net enterprise value at default (after 5% administrative costs): $2.2 billion
• Collateral value available to unsecured creditors: $1.7 billion
• Total unsecured claims: $3.1 billion
• --Recovery expectations: 50%-70% (rounded estimate: 50%)

Note: All debt amounts include six months of prepetition interest.

Ratings Score Snapshot

Issuer Credit Rating: BB/Negative/--

Business risk: Fair

• Country risk: Low
• Industry risk: Moderately high
• Competitive position: Fair

Financial risk: Minimal

• Cash flow/leverage: Minimal

Anchor: bbb-

Modifiers

• Diversification/portfolio effect: Neutral (no impact)
• Capital structure: Neutral (no impact)
• Financial policy: Negative (-1 notch)
• Liquidity: Adequate (no impact)
• Management and governance: Fair (no impact
• Captive finance: Neutral (no impact)
• Comparable rating analysis: Negative (-1 notch)

ESG credit indicators: E-2, S-2, G-3

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• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
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