OREANDA-NEWS. Fitch Ratings has placed the ratings for Xerox Corporation (Xerox) on Rating Watch Negative following the company's announcement that it will review its business portfolio and capital allocation options. Fitch's actions affect $9.6 billion of total debt, including the undrawn $2 billion revolving credit facility (RCF). A full list of current ratings follows at the end of this release.

Xerox declined to provide additional details, including when the company expects to conclude the review. However, Fitch believes the examination will contemplate the potential sale of material businesses, separation of the services business or intensified shareholder returns, each of which likely would result in a one-notch downgrade. Fitch anticipates Xerox will manage core leverage (total debt to operating EBITDA excluding the financing business) to maintain investment grade ratings and, therefore, cheaper funding for the financing business.

Xerox announced the review in connection with reporting financial results for the quarter ended Sept. 30, 2015 and updating full year guidance - both slightly below Fitch's expectations. Slowing demand in developing markets for the Document Technology (DT) segment, weaker contract signings in the Services segment in recent quarters and Xerox's exit from new healthcare contracts more than offset growth in Document Outsourcing and Fitch expects these trends will continue, resulting in low- to mid-single digit negative constant currency revenue growth in 2015.

Profitability also will fall short of Fitch's 10% target for the year, driven by lower than anticipated revenues and realization of cost reductions. Nonetheless, Services operating profit margin continues to improve sequentially, and Fitch anticipates it should exceed 9% in 2016 from restructuring and an improving sales mix following the exit of unprofitable healthcare engagements. Profit margins in DT remain on track at 11%-13%, driven by cost cuts offsetting larger than anticipated revenue declines.

Fitch continues to expect free cash flow (FCF) of $1 billion to $1.5 billion for 2015 and through the intermediate term. Lower capital spending from weaker than anticipated revenue growth will partially offset cash charges related to exiting certain healthcare contracts. Xerox will use FCF in the current fourth quarter to reduce debt by $200 million, which will offset lower profitability and financing receivables and return core leverage below 1.5x from a Fitch estimated approximately 1.7x for the latest 12 months (LTM) ended Sept. 30, 2015.

KEY RATING DRIVERS

Xerox's ratings and Stable Outlook reflect:

--Fitch's expectations the Services business will improve in 2016 and begin offsetting revenue declines in 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 $804 million of cash at September 30, 2015, an undrawn $2 billion revolving credit facility (RCF) due 2019, staggered debt maturities and consistent annual free cash flow (FCF). Annual FCF should (post-dividends) range from $1 billion to $1.5 billion.

--Fitch expectations for an increasingly diversified sales mix from faster growing Services businesses and declining exposure to the slower-growing print industry. Services accounts for 57% of Xerox's total revenue in the latest 12 months (LTM) ended September 30, 2015 and should continue edging toward 60% in the near term.

--Xerox's conservative financial policies. Fitch believes management remains committed to managing core debt levels to maintain strong core credit metrics for the rating as the company works to resume healthy organic revenue growth. Xerox has a track record of reducing debt to offset declining financing assets, resulting in flat core leverage. Fitch expects core leverage (total non-financing related debt to core EBITDA, which excludes debt and profit related to financing activities) to remain below 1.5 times (x) over the intermediate term.

Fitch's credit concerns center on:

--Ongoing revenue pressures in DT, which Fitch forecasts will decline by mid-single digits through the intermediate term. Despite expectations for lower sales, profit margins for DT should continue expanding from higher mix of higher end equipment and the benefits from restructuring. Operating profit margin should remain in the 11%-13% range through the intermediate term, versus 10.8% in 2013 and 13.7% in 2014.

--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.

--Continued operating margin pressure in Services, although stronger following the ITO business sale. Higher than expected costs associated with government healthcare contracts, which caused Xerox to take an impairment in the second quarter and narrow focus on incremental contract opportunities, and increased investments should constrain meaningful operating profit margin expansion. Fitch expects operating margin to exceed 9% range in the near term, up from 7.7% for the first nine months of 2015.

KEY ASSUMPTIONS

--Low- to mid-single digits revenue declines for 2015, driven by lower Services contract signings in recent quarters, exit of healthcare contracts, and weaker than expected macroeconomic activity for DT.
--Services growth beyond 2015 will offset expectations for further declines in DT, on a constant currency basis.
--Operating EBIT margin of more than 10%, driven by strengthening profitability in DT from
Restructuring and gradually improving Services profitability.
--Cash pension contributions will range from $250 million to $500 million through the intermediate term.
--Xerox will use FCF for debt reduction and core debt will remain roughly flat, resulting in core leverage returning below 1.5x in the near term.
--The company will curtail share repurchases in the current quarter, given Xerox completed the 2015 budget for share repurchases in the first three quarters of 2015.

RATING SENSITIVITIES

Fitch believes the following could result in a one notch downgrade:
--Xerox separates/spins-off the Services business, given the long-term secular challenges facing the DT segment;
--Debt financed shareholder returns, resulting in Fitch's expectations the company will sustain core leverage above 1.5x.

Fitch believes the Negative Watch could be resolved and ratings stabilized at current levels if Xerox completes the strategic review without altering financial policies or selling businesses representing material profitability.

LIQUIDITY

Fitch believes Xerox's liquidity was solid at September 30, 2015 and consists of:

--$800 million of cash and cash equivalents;
--An undrawn $2 billion RCF expiring March 2019.

Fitch's expectation for $1 billion to $1.5 billion of annual FCF also supports liquidity.

As of Sept. 30, 2015, total debt, including 50% equity credit applied to the $349 million of convertible preferred stock, was $7.8 billion. $3.9 billion, or more than half 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 $4.5 billion compared with $4.8 billion as of Dec. 31, 2014.

FULL LIST OF RATING ACTIONS

Fitch currently rates Xerox as follows:

Xerox Corporation

--Long-term Issuer Default Rating (IDR) 'BBB';
--Short-term IDR 'F2';
--Revolving credit facility (RCF) 'BBB';
--Senior unsecured debt 'BBB';
--Commercial paper (CP) 'F2'.