Xerox Services Q3 Results: Any Signs of Progress?

Xerox Services, now 57% of total Xerox Group revenues, is critical to the future of Xerox: it is its engine for future growth.We have been waiting for a better quarter for some time, but Q3 was not a stellar quarter for Xerox Services.

Revenues Flat and Signings Down, with ITO the weakest link

Xerox Services revenues in 2014 YTD are flat – and guidance for full year is more of the same. The impact of the Texas Medicaid loss is beginning to impact results.

• The strongest part in its portfolio currently is the BPO business (2% y/y growth this quarter) to $1.75bn.
• Its challenge is its smaller ITO business (down 3% to $389m), challenged both by loss of some recompetes and also slippages in new signings
• The Document Outsourcing business (28% of Xerox Services business) is essentially flat.

Anyone looking for an early indicator of the various initiatives that have been put in place to improve margins would be disappointed: Services margins were down 1.1 pts y/y to 8.9% (where Technology managed to improve margins by 1.9 pts y/y to 14.0% against a background of negative topline growth). While Services margins were up 0.3 pts sequentially, management admits this was below expectations (of at least 9.2%). Factors impacting Services margins this quarter included:

• Having to invest more than anticipated in the first platform implementation of its new MMIS at New York
• Costs related to the Nevada HIX. Overall costs across its government healthcare business are now approaching $100m this year
• Restructuring a few ITO contracts to improve profitability

Looking at the short term prospects:

• Signings were down 18% y/y, down 6% TTM.
• Renewal rate (BPO/ITO) in the quarter was 82%, below the target range of 85% to 90%. The BPO renewal rate was above 90%, albeit with less renewal activity, but ITO renewal rate was lower

But it is not all doom and gloom. Among the positives:

• Three large (each over $500m in TCV) deals that have been awarded and are taking longer than expected to get to signing stage (one is a renewal, two are being protested): this should help renewal rate and signings in Q4, if not pushed back further into 2015
• Pipeline is up 7% y/y
• The commercial healthcare business is seeing both revenue growth and margin improvement
• Parts of Europe are seeing revenue growth and margin improvement
• The HR and learning and litigation businesses did well

Xerox Services now expects in Q4:

• Topline growth to remain constrained as several large new deals that have been awarded are taking longer to get to contract and some new business decisions that have been deferred are also delaying the ramp of new work
• Margin to be between 9% and 10%. Margins in the government healthcare business will continue to be below the company level for a while

What is Xerox Services Doing to Drive Future Profitable Growth?

Q3 performance essentially continues a trend that has been evident at Xerox Services for some time… our interest in what the company is doing to address its issues.

Bob Zapfel has been in place as President of Xerox Services for several quarters now, and some of the initiatives to restore Services margin back to 10%+ and to kick-start profitable growth are now in place. There is no secret sauce to any of them – they are standard good practice in an IT and BPO services organization.

• Taking layers out of the legacy SBU management structure that served ACS well years ago (Xerox reckons it has some 2,500 SBUs)
• Consolidating management of the company’s contact center capabilities. Not only will this deliver scale benefits (better margins), but it should also enable the introduction of standardized best practices and methodologies and tooling (improved productivity, better delivery and better CSAT). This is a natural evolution
• Similarly, standardizing processing in the government healthcare business through creating a common platform for use by New Hampshire and New York
• Expanding the level of off/near/rural-shore delivery, something which the company has been talking about for years
• Realigning the go-to-market approach along target sectors. Again, this is a natural evolution, and builds upon what Xerox Services has also achieved in sectors such as transportation and U.S. state and local government: an intimate understanding of an industry, of its future dynamics and of client needs. This should also remove some GTM blocks that formerly existed (for example, the HRO business had no access to the federal sector)
• Portfolio management, including introducing more analytics-led offerings within its existing BPO offerings. In the commercial HC market, Xerox recently launched Juvo, a care performance platform that allows hospitals to analyze every aspect of the clinical cycle of care. And in parking management, Xerox’s Merge system uses analytics to optimize parking demand and meter pricing. This is where we will see the promise that was one of things that excited us back in 2010  - the application of Xerox innovation (leveraging PARCS) to the former ACS BPO portfolio
• With ITO, currently the weakest area of Xerox Services’ portfolio, Xerox is contending with both a margin contribution that is lower than it would like and lack of competitiveness. It says it is now being very selective in new pursuits. The focus in the short term will be on margin improvement rather than topline growth
• Increasing the global sales force
• What management refers to as “aggressive” sales training to improve conversion rates.

Acquisition activity has been below the $500m anticipated for 2014 ($25m in Q3, $306m YTD). The acquisition of Consilience Software (brings in a case management system) is perhaps typical of what we should expect to see from Xerox in 2015: niche acquisitions that bring in specific IP, typically with an analytics flavour, that can immediately bolt on to an existing sector offering.

Under Zapfel’s leadership, Xerox Services appears to be putting in place a range of initiatives that, although arguably should have been introduced before now. All of this is a three-year effort that will position it for much better health in the mid-term, perhaps as early as 2016.

We look forward to learning more at the investor meeting in November.