Fitch Affirms Ratings, Outlook on Computer Sciences (CSC) Amid HP Enterprise Deal

Fitch Ratings has affirmed the ratings for Computer Sciences Corporation (NYSE: CSC), including the 'BBB' Long-Term Issuer Default Ratings (IDR), on its plan to merge with Hewlett Packard Enterprise's (HPE) information technology (IT) services segment, Enterprise Services (ES). Fitch's actions affect $5.1 billion of total debt, including the undrawn $2.5 billion revolving credit facility (RCF). The Rating Outlook is Stable. A full list of ratings follows at the end of this release.

The affirmation reflects Fitch's belief the merger of CSC and ES is modestly net credit positive, given meaningfully increased scale and diversification and significant merger related cost synergies, which should partially offset the addition of $18 billion of revenues with lower profit and cash flow margins.

CSC announced on May 24, 2016 its board approved a plan to merge the company with HPE's ES segment in a tax-free transaction. HPE first will spin off the ES segment to HPE's shareholders, excluding the small cloud management systems business. The subsequent merger of CSC and ES should deliver approximately $8.5 billion to HPE's shareholders, including a more than $4.5 billion equity stake in the combined company, $1.5 billion cash dividend, the retirement of $1.6 billion of HPE debt, the assumption of $300 million of Electronic Data Systems senior notes due 2029 and transfer of $600 million HPE net pension liabilities to CSC.

Fitch expects the combined company will fund the cash dividend and retirement of HPE debt with approximately $3.1 billion of incremental debt. Pro forma for the combination, Fitch estimates total leverage (total debt-to-operating EBITDA) will be 2.2x (1.7x including $1 billion of cost synergies), roughly flat from Fitch's estimates of total leverage on a standalone basis, as well as for fiscal 2016. Fitch notes CSC has been on track to deleverage over the intermediate term with FCF from elevated total leverage due to the partially debt-financed acquisitions of UXC and Xchanging. Over the longer term, Fitch expects CSC will maintain total leverage below 2x.

Pro forma for the merger, shareholders of CSC and HPE will each own 50% of the combined company. CSC expects to close the merger by March 2017, pending customary regulatory approvals.

KEY RATING DRIVERS

--Increased scale and diversification: Fitch expects increased scale and diversification as a result of the merger will smooth operating performance. The deal adds approximately $18 billion of revenue and creates the third-largest global IT services company with $26 billion in annual revenue. Fitch also expects CSC's strength in insurance, healthcare and financial services combined with ES's strength in pharma, transportation, travel and telecom, with minimal customer overlap, should reduce operating volatility.

--Significant cost reduction roadmap: Fitch expects the combined entity's significant cost reduction roadmap will drive pro forma blended profit margin expansion. CSC expects $1 billion of total cost synergies in year one and $1.5 billion of run-rate cost savings from synergies exiting year one. As a result, Fitch expects operating EBITDA margin will increase to the high-teens over the intermediate term from the mid-teens, pro forma for the combination, and a Fitch estimated 17% for fiscal 2016 on a standalone basis.

--Constrained top-line: Fitch expects organic constant currency revenue growth will remain constrained over the intermediate term, driven by secular shifts to the cloud from on-premise solutions and, to a lesser extent, a more cautious spending environment and customer rationalization initiatives. However, Fitch also expects significant revenue growth in next-generation service offerings (cloud, cyber and applications), which will be $3 billion on a combined basis, to remain robust and offset declines in legacy in the intermediate term, resulting in a low-single-digit long-term top-line CAGR.

--Meaningfully stronger FCF: Fitch expects the combination to result in meaningfully stronger annual FCF beyond the near term, driven by the addition of roughly $1.8 billion of operating EBITDA and anticipated $1 billion of total cost synergies in year one, and $1.5 billion of run-rate cost savings from synergies exiting year one. Fitch projects $1 billion to $2 billion of annual FCF through the forecast period, excluding cash payments related to cost synergies. Fitch expects the company will use FCF for debt reduction (term loan amortization), as well as tuck-in acquisitions and share repurchases.

--Ongoing acquisitions activity: Fitch believes CSC's ongoing acquisition activity will strengthen the company's operating profile over the longer term but present near-term integration risks. CSC closed the acquisitions of UXC and Xchanging during the fourth fiscal quarter ended April 1, 2016, and they should add next-generation capabilities and potential cost synergies in the back half of fiscal 2017. The merger with ES more than triples CSC's revenue base but we believe the integration of ES, UXC and Xchanging heighten execution risks over the intermediate term.

KEY ASSUMPTIONS

Fitch's key assumptions within the Rating Case for CSC include:
--CSC and ES merge at the beginning of FY2018.
--Flat to low-single-digit organic constant currency revenue growth in FY2017 and beyond.
--Operating EBITDA margin expands to 17% in fiscal 2017, to 19% in fiscal 2018 and more than 20% beyond, driven by the achievement of merger-related cost synergies.
--Restructuring costs to achieve synergies and integration costs are $1.5 billion in fiscal 2018 and $800 million in fiscal 2019.
--FCF used for debt reduction and, to a lesser extent, tuck-in acquisitions and share repurchases.
--Capex remains near 6.5% of revenues through fiscal 2017 then declines to approximately 5%.

RATING SENSITIVITIES

Positive rating actions could occur if Fitch expects:
--Sustained positive organic revenue growth, resulting from growth in next-generation services offsetting declines in legacy services; and
--Annual FCF of more than $5 billion through the cycle.

Negative rating action could occur if Fitch expects:
--Total leverage sustained above 2x from weaker than expected profitability;
--CSC does not expect positive organic revenue growth in the intermediate term or positive operating trends in the near term, indicating heightened investments in cloud-based solutions are not sufficiently competitive to offset declines in legacy offerings.

LIQUIDITY

Fitch believes CSC's liquidity was solid at April 1, 2016 and supported by:
--$1.2 billion of cash and investments;
-- $2.5 billion of available borrowing capacity under a revolving credit facility expiring 2020;
--$200 million of available capacity under a committed leasing facility for capital expenditures on IT equipment and associated software.

More than $500 million of annual FCF also supports liquidity.

Total debt was $2.6 billion at April 1, 2016.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

Computer Sciences Corp.
--Long-Term Issuer Default Rating (IDR) at 'BBB';
--Revolving Credit Facility at 'BBB';
--Senior Unsecured Term Loan at 'BBB';
--Senior Unsecured Debt at 'BBB';
--Short-Term IDR at 'F2'.

CSC Capital Funding Limited
--Commercial paper at 'F2'.

Fitch has assigned the following ratings:

CSC Capital Funding Limited
--Short-Term IDR at 'F2'.

CSC Computer Sciences UK Holdings Limited
--Long-term IDR at 'BBB';
--Senior Unsecured Term Loan at 'BBB'.

The Rating Outlook is Stable.

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