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Fitch Rates Xerox's Senior Unsecured Note Offering 'BBB'; Outlook Stable

Fitch Ratings has assigned a 'BBB' rating to Xerox Corp.'s (Xerox) proposed offering of senior unsecured notes. Net proceeds from the offering will be used for general corporate purposes. The Rating Outlook is Stable.

KEY RATING DRIVERS

Xerox's ratings and Stable Outlook reflect:

--Revenue growth in Services is expected to continue to offset revenue declines in Document Technology (DT), primarily black-and-white (B&W) high-end production printing.

--Substantial recurring revenue from long-term services contracts, rentals and financing, and supplies (85% of total revenue).

--Solid liquidity supported by $948 million of cash at Sept. 30. 2013, an undrawn $2 billion RCF due 2016, staggered debt maturities and consistent annual free cash flow (FCF). Fitch believes FCF (post-dividends) will continue to exceed $1.4 billion annually through 2016.

--A highly diverse revenue mix and declining exposure to the slow-growth print industry due to stronger growth in the Services business. Services accounts for 56% of Xerox's total revenue.

--Conservative financial policies. Management remains committed to remaining at investment grade and has established a track record of reducing debt to offset declining financing assets, thereby maintaining flat core leverage, which excludes debt associated with the financing business.

Fitch estimates Xerox's core leverage, including off-balance-sheet debt, will increase moderately to 1.8x at year-end 2013 from 1.7x in 2012 as declining on-balance-sheet debt is offset by greater securitizations of accounts and finance receivables. Annual core leverage is projected to remain in the range of 1.5x-1.7x thereafter through year-end 2016.

Fitch's credit concerns center on:

--Revenue pressures in DT, inclusive of equipment and supplies bundled with Document Outsourcing (DO) contracts, partially offset by tight expense control. DT revenue, including DO contracts, declined 3% year to date (YTD) due to declines in both B&W and color revenue. Operating profit for DT on a stand-alone basis declined 9.3% YTD to $667 million on a 5.9% decline in revenue, excluding one-time gains on sales of finance receivables.

--The aggregate $1.9 billion underfunding of worldwide defined benefit (DB) pension plans on a projected benefit obligation basis as of year-end 2012, up from $1.5 billion in the prior year. The lower funded status primarily reflects higher benefit obligations due to a 30- and 60-basis point decline in the U.S. and non-U.S. discount rate, respectively. Total contributions are expected to be $195 million in 2013 compared with $494 million in 2012. Fitch forecasts $250 million of cash pension contributions in 2014.

--Operating margin (OM) pressures in the Services business. The operating margin for Xerox's Services segment increased 30 basis points in the latest 12 months (LTM) ended Sept. 30, 2013 to 10.2% but remains at the lower end of the company's range of 10%-12% and 140 basis points below the corresponding period in 2011.

The lower margin reflects: i) start-up expenses on new contracts, including greater implementation expenses for a healthcare insurance exchange (HIX) platform deployed in Nevada and Medicaid Management Information System (MMIS) platform deployed in Alaska; ii) negative revenue mix as the lower-margin Information Technology Outsourcing (ITO) outperformed; iii) declining volume on certain higher margin business process outsourcing contracts, consisting of student loan processing and customer care (CC) volume with a telecom client post acquisition; and iv) typical price erosion following contract renewals.

Fitch anticipates Services profitability will strengthen in 2014 due to strong BPO signings in the YTD period (+53%) and decline in ITO signings (-36%), albeit the mix of new business versus renewals is undisclosed. ITO was Affiliated Computer Systems' lowest margin business historically. Margins will also benefit from the completion of the HIX and MMIS platforms, which can be leveraged across other states, restructuring actions, and increasing mix of offshore commercial delivery resources.

The key risk is the underestimation of costs, which could be an initial indicator of broader systemic issues with respect to Xerox's contract bid process. The desire to demonstrate revenue growth can lead to a compromised bid process, whereby the provider uses aggressive assumptions in order to secure new contracts. Clearly, Xerox's one challenging contract does not signify a trend, but the disclosure of additional problem contracts, if any, could indicate a broader issue.

--The print industry is intensely competitive, resulting in consistent equipment pricing pressure, particularly office products.

RATING SENSITIVITIES

Positive:

--Revenue growth and margin expansion in services strengthens Xerox's FCF and credit protection metrics;

--Significant reduction in the funding shortfall for Xerox's worldwide defined benefit pension plan.

Negative:

--An accelerated decline in DT more than offsets growth in services, resulting in a material decline in financial performance and credit metrics;

--A material increase in core debt to finance acquisitions and/or shareholder-friendly activities.

Xerox's liquidity is solid, supported by $948 million of cash at Sept. 30, 2013 and an undrawn $2 billion RCF that matures in December 2016 and requires compliance with two financial covenants, consisting of a minimum total interest coverage of 3x and maximum total leverage of 3.75x. In the LTM ended Sept. 30, 2013, Xerox generated $2.5 billion of reported FCF (post-dividends) before adjusting for accounts and finance receivables securitizations.

Total debt with equity credit was $7.7 billion on Sept. 30, 2013, primarily consisting of approximately $7.5 billion of senior unsecured debt and $349 million of convertible preferred stock, which Fitch assigns 50% equity credit. As of Sept. 30, 2012, $4.6 billion, or 59%, 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 $5.2 billion compared with $6.2 billion in the prior year.

Xerox's annual FCF is expected to exceed annual debt maturities through at least 2017 due to a highly staggered debt maturity schedule. Debt maturities in 2014-2018 are $1.1 billion, $1.3 billion, $971 million, $1 billion and $1 billion, respectively.

Fitch estimates total leverage (total debt/operating EBITDA) and core (non-financing) leverage were 2.5x and 1.1x at Sept. 30, 2013, respectively, compared with 3.1x and 1.5x in the year ago period. Total interest coverage (total operating EBITDA/interest expense) and core (non-financing) interest coverage was 7.6x and 11.6x at Sept. 30, 2013, respectively, compared with 7.1x and 12.1x in the year ago period. Fitch estimates gross debt, including off-balance-sheet debt, decreased to 3x as of Sept. 30, 2013 compared with 3.4x in the year-ago period.

Fitch currently rates Xerox and its wholly owned subsidiary, ACS as follows:

Xerox

--Long-term Issuer Default Rating (IDR) at 'BBB';

--Short-term IDR at 'F2';

--Revolving credit facility (RCF) at 'BBB';

--Senior unsecured debt at 'BBB';

--Commercial paper (CP) at 'F2'.

Affiliated Computer Services

--IDR at 'BBB';

--Senior notes at 'BBB'.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 5, 2013).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=810322

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

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