惠普 (HPQ) 2007 Q2 法說會逐字稿

Good afternoon.

Welcome to the EDS second quarter earnings conference call.

All participants are in listen-only mode.

(OPERATOR INSTRUCTIONS) Today's conference is being recorded.

If you have any objections you may disconnect at this time.

I would now like to turn the call over to Mr.

Dave Kost, Vice President Investor Relations.

Please go ahead, sir.

Thank you very much.

Hello, and welcome to our second quarter 2007 earnings call.

With me today on the call are our Chairman and CEO, Mike Jordan; President and COO Ron Rittenmeyer; and CFO Ron Vargo.

You should have received an e-mail from me with a copy of our press release as well as the presentation to be used on today's call.

We must apologize for the premature media distribution of our earnings press release by a Canadian affiliate of PR News Wire.

The presentation along with the webcast are available on our website and will be archived there over the next 30 days.

The information covered on today's call which is not historical in nature, including statements regarding financial guidance or future financial performance and the value of our new contract signings constitute forward-looking statements within the meaning of the Federal Securities laws.

These statements are subject to numerous risks and uncertainties, many of which are beyond our control which could cause actual results to differ materially from such statements..

For information concerning these risks and uncertainties, see the risk factors section of our most recent Form 10-K.

We disclaim any intention or obligation to update these forward-looking statements whether as a result of subsequent events or otherwise except as required by law.

In addition we refer you to the slides posted on EDS.com that accompany this call.

Among other information these slides and our earnings release present a reconciliation of the non-GAAP financial information to be discussed today and should be reviewed in connection with this discussion.

With that let me turn the call over to Mike.

Thanks, Dave.

Just a few comments.

First, I believe the second quarter was a pretty solid quarter for EDS.

We met or exceeded our revenue and EPS goals.

But more importantly, we made a lot of progress in the operating parts of our business and in our change program.

Our growth in applications and our continued productivity improvements have led us to believe that we can really accelerate those efforts greatly going forward, and Ron will take you through the details.

But we have a lot of ambition to carry that program forward and further improve margin.

You will note that we adjusted our free cash flow guidance downwards by about 9% to reflect some start-ups and -- resulting from 2006 signings, but we think if you look at this free cash flow in contrast to previous years where there was a lot of controversies, shall we say, about the quality of our free cash flow, this 900 to $1 billion represents, we think, the earning power of the business.

Clearly it includes the Verizon payments were a substitute for the profit we would have earned this year, but still we think that's reflective of the business as it exists.

Clearly, that's a hole we'll have to fill in 2008, but we have laid out our goal of achieving approximately the same level of free cash flow in '08 and '07, despite these negatives.

So let me turn it over to my partner in crime and successor here, Ron Rittenmeyer, to take you through the details.

Thanks, Mike, and good afternoon.

Let me take you now through our business highlights for the second quarter.

So turning to slide 4, our second quarter signings totaled 4.3 billion, primarily coming out of the Americas and EMEA, and I would say very balanced performance for the quarter.

Bear in mind that last year in this quarter we signed the $1.7 billion Kraft deal, so that makes it a bit of a tough comparison.

But (inaudible) to KarstadtQuelle in Germany, the application service line represented 43% of our bookings in the quarter.

We're very proud of that.

We're very pleased with the six deals we signed with TCB greater than 100 million and that 30% of our TCB was actually from new local clients.

We had the pipeline to sign more than 4.3 billion but three large deals did slip into Q3.

I just want to make the point as we said before that we're not going to allow the quarterly target to influence whether we sign a deal in a specific quarter if we don't think it's right to sign yet, so movement can and should be expected in these types of things.

But all in all we're off to a very good start in the second half.

In fact, one of those three deals that's slipped has already been signed.

Across the vertical markets, retail, government, financial services, we also saw very good strength.

So all in all, signings were very solid.

Next slide.

Slide five shows for the full year we continue to see line of sight to our target of a 1 book-to-bill ratio.

We also expect progress with new level of signings to continue the positive trend that we've already established.

We're further investing in our sales model both with an increase of sales people.

In fact, we've hired about 80 to 100 globally so far this year, as well as in ways we're going to market within each service line.

Our application sales activity is being enhanced to be more -- to more effectively sell and deliver that portfolio.

So net-net our full year TCB should be approximately 23 billion.

Again, deals may move a bit, but what's critical is our pipeline, which really remains solid.

In fact we have more than 50 qualified mega deals in the pipeline already for the second half of this year.

Looking into 2008, our pipeline is up over 20% with all service lines up versus second quarter of '06, and we have mega deals in our pipe -- even though we have mega deals in our pipeline, and always will, we also recognize the changing dynamics in the marketplace.

Smaller, unbundled deals, but what we've seen is a larger volume of deals.

So this really has resulted in reducing our dependencies on deals that are greater than 100 million.

Our pipeline has been adjusted to reflect that.

We're investing in sales, we're investing in offerings and industry practices to also reflect those changes which really gives us much greater flexibility and broader reach in the marketplace.

Let's talk a little bit about our growth initiatives on slide six.

A couple of examples of where we're seeing revenue that we expect to contribute to our growth engine in the future, in the BPO service line we've just launched the mid-range credit card platform to further secure our position with a leading credit card processor outside the U.S.

Outside the U.S.

we still see growth in this area that continues to be an area of opportunity.

In the HR outsourcing segment, accelerate HRO has released its new health and welfare and defined benefits administration platforms.

We've actually converted EDS to that system, same as will be done with our clients, and we've begun to generate interest in the marketplace.

We've signed several new clients to the platform and we're converting existing clients.

With regard to the next generation end-to-end platform in HRO, we've actually gone live with the first series of capabilities for a very large global client.

We're also converting EDS to the EHRO platform to further validate not only the capability but the size and the scale of that offering.

We will be client one in many of these to show our commitment.

So we're turning our focus now to building a pipeline of opportunities, based on these offerings.

I think those are a few good examples of the way we're expanding offerings and services to further enhance our growth.

Next slide.

We're very excited with applications.

Our second quarter revenue was 1.6 billion which is up 8% versus a year ago.

Application services accounted for 43% of our TCB in quarter two.

Looking ahead our pipeline for application services is up 20% versus second quarter of '06 and we expect this to continue.

We've consolidated the testing organization of EDS emphasis and Real Q.

Real Q, you will recall, is our recent acquisition, into a global group.

This group will be run as a practice.

It will significantly improve the quality and efficiency of our global application centers as well as provide some sales expansion.

We've also formally consolidated EDS India into emphasis, and that's a move that facilitates the more aggressive plans we have for India.

To maximize our opportunities and applications we have organized [Charlie Feld's] group to operate not just as the service line but as a business with full P&L responsibility within the regions.

Our strategy of developing applications that are designed to run is truly resonating with our client base and generating modernization opportunities.

For EDS this means starting the design and engineering with attention to running efficiently given security, privacy, network utilization, and infrastructure consideration, which all impact the ongoing cost of maintenance.

Ongoing cost to operate an application is the key part of our design and something that our clients are very excited about.

We're making progress organically but expect to make acquisitions to enhance our consulting and ops development capabilities.

All in all the applications service line is providing growth and margin expansion consistent with our overall mix strategy.

Slide eight.

Within our global service network we also created a competitively differentiated service that has resulted in a significant pipeline of sales activity for our network management services.

As you know, we developed our own secure network, so from an operational standpoint we're now managing one network versus six in our old network architecture and we have, in fact, shut down the majority, if not all of the old networks.

It has allowed us to shed the high cost of running multiple networks and carrying expensive spare parts.

From a sales perspective it is truly a hot commodity with clients and recognized as a strong offering.

The significant pipeline has been built as a validation of the value we offer.

Our SDA, service delivery automation, and BMT, business management transformation initiatives are part of what we call enterprise services.

They're the tools that are based on the standards that standardize work flow and also automate and change what we do, helping us deliver work more effectively and efficiently but really also helping our clients with improved performance and transparency.

And we're deploying those to clients as well as EDS are realizing the benefit.

In Best Shore, we're equally focused on improving with day to day services within our Best Shore service centers.

We have been consolidating resources into our leverage centers which mean fewer decentralized locations, improved leverage, resulting in improved service, improved costs.

We're also adding other locations to better balance our mix across the globe.

Slide nine.

Thank you.

As you can see on the bar graph we're now up to 38,000 employees in Best Shore locations.

Q2 was the highest quarter yet for our migration.

We have formally opened up our revamped facility in China and it's gotten off to a very positive start.

We're very excited about the partnership we've established with the Chinese Ministry of Commerce which should help us solidify our position in the Chinese IT market.

To put our resource count into perspective, when you exclude our employees who support government work approximately 34% of our workforce and now in lower cost locations.

That's a significant movement from two years ago.

It will continue.

We are going to continue to optimize our workforce and clearly we see it as a great opportunity.

Slide ten.

Quality remains one of our critical pillars.

We've talked about this many times.

Quality improvement is what we do every day, and it continues to be one of the vitally important responsibilities that each employee at EDS has an accountability.

Our severity one incidences continue to decrease significantly year-over-year as our zero outage mentality continues to take hold in the Company.

Q2 was a significant month from an improvement standpoint.

In the first half of '07 our severity one outages are down 60% with a 72% improvement in Q2.

Clearly our zero outage mentality is producing positive results and we're very proud of that as a company.

So to summarize our highlights we've had strong strength in our sales pipeline, gives us very, very solid confidence in our future revenue growth.

We're starting to see revenue generation from all of our initiatives.

Our apps business is making meaningful progress in growing the business while transforming the global resource mix.

Best Shore migrations continue to wrap up.

Global resourcing mix, excluding our government business, continues to show scale.

And as we look ahead we do see future opportunities and some challenges, but we're going to proactively address these challenges and continue our aggressive cost business restructuring alignment.

That means continued aggressive Best Shore alignment to further this resource mix change and more aggressive build out of our apps practice.

We're convinced that our offerings and value propositions will generate upside not only in revenue, but margin, and equally in cash flow.

And we're going to continue these actions through 2008.

During this we'll provide in our opinion a much better return in 2009 and we see much more available upside and consider these actions as prudent ways to go about building a better performing company.

At this point we need to build out some of the tactical elements of that plan.

As you know, that's the time of year we're in right now.

We'll provide a much more detailed road map later this year as we build out those specifics.

So with that, I'd like to pass it over to Ron Vargo for more details regarding our financial performance.

Great, thanks, Ron, and good afternoon.

I'll be covering results for the quarter and commenting on our third quarter full year guidance.

With slide 13, total revenues were $5.45 billion, up 5% on a year-over-year basis, and up 1% organically with the primary difference due to currency exchange rates.

Adjusted earnings were $0.27 a share, up 35%, and GAAP earnings $0.26 a share, up 30% versus the second quarter of 2006.

Free cash flow is positive $156 million, down 206 from last year's second quarter when we benefited from two large one-time client payments.

And finally total contract value signed was approximately 4.3 billion which was impacted by three large deals that slipped into the third quarter as Ron stated.

I'll provide a bit more color on these metrics in a moment.

First let me discuss our GAAP and adjusted earnings on slide 14.

Again, GAAP earnings were $0.26 a share, and we had $0.01 of adjustments from discontinued operations, mainly related to divested businesses, resulting in the adjusted earnings of $0.27 for the quarter at the high end of our expectations.

Now I'll take you to the income statement.

This slide contains summary level line information from our income statement, adjusted to exclude certain items.

As you know, the income statement and the other financials are provided with our earnings release as well.

Here we provide a walk in this deck, in the appendix to walk you from the GAAP income statement to the adjusted format, and that's on slide 28.

So a couple highlights on this income statement.

Revenue up 255 million.

Again, currency exchange rates, emphasis revenues and organic growth was partially offset by the 2006 divestiture of our European field services business.

Excluding Verizon revenues from both the second quarter of '06 and the second quarter of '07, revenue would have grown 7% or 4% on an organic basis.

Operating income was up 82 million, or 35%, due to contract performance improvement and productivity programs.

And our tax rate was 28.6%, benefiting from recently enacted Texas tax legislation that permitted a recovery of $13 million of deferred tax assets.

Contrasting that, though, in the second quarter of 2006 our tax rate included favorable changes to tax liabilities for contingencies that resulted in an effective rate in that quarter of only 15%.

As we look out for the full-year 2007 we're projecting a full-year tax rate of approximately 37% for the Company.

And finally, diluted shares outstanding were 541 million, and we continue to expect the full-year count for 2007 to be 545 million shares on a weighted average basis.

So in summary, it was a solid quarter.

High end of revenue and earnings per share expectations.

Now I'll update you on free cash flow on page -- slide 16.

Again, free cash flow -- free cash flow was $156 million in the quarter, and $148 million year to date for the first half of 2007.

Working capital movements and capital expenditures were key drivers of both our absolute first-half cash flow, and as well there were some material differences in these items between the first half of 2006 and the first half of 2007.

So let me discuss the changes in working capital movements on a year-over-year basis.

First, deferred revenue.

The impact of the two large client payments we received in 2006 second quarter, from Navy and another large government client, provided a significant difference in deferred revenue on a year-over-year basis.

Receivables, due primarily to an increase in day sales outstanding in the first half of '07, which I'll talk about in the next slide.

And an increase in deferred contract costs from 2007 over 2006, associated primarily with the ramping up of some of the large contracts we've signed over the last few years.

And these items were partially offset by lower tax payments and a higher provision for taxes.

Capital expenditures, net capital expenditures were up 89 million on a year-over-year basis.

Gross capital, which includes real estate leases, as well as hardware, software, and other capital, increased 321 million on a year-over-year basis.

And this was impacted significantly by a refinancing of our Tulsa data center, and other office space leases, including significant rentals for Best Shore office space.

In addition, we have conventionally reported our gross capital net of any asset sales or other asset proceeds.

On a year-over-year basis we had 114 million lower asset sales and other asset proceeds which affects the net capital expenditures.

Let's turn to the DSO.

Slide 17, on this slide I'll just update you on where we are on our receivables DSO.

We did make some improvement from second quarter to first quarter.

Our DSO declined by two days from 64 to 62 days.

But on a year-over-year basis, we are still impacted by certain contract term changes that took effect in the first quarter of 2007.

We're still confident in targeting a DSO at the end of 2007 in the mid-50s, and we think several factors will get us there over the next six months.

Process improvements addressing the timeliness of our invoicing process, reductions in outstanding past-due receivables, as well as certain payment structures that should result in higher fourth quarter collections as they did in fourth quarter of 2006.

Now for a summary of select balance sheet movements we'll turn to slide 18.

This slide highlights notable balance sheet movements between December 31, 2006 and June 30.

I'll only mention on this slide our shareholders' equity that increased by $319 million due to earnings and foreign exchange effects, partially offset by share repurchases during the year that combined with our debt staying essentially flat, up $10 million on a year-over-year basis, resulted in a debt to total capital ratio of 27%.

Now I'll turn to our financial guidance.

We are maintaining our full-year 2007 revenue and earnings per share guidance at 22 to 22.5 billion for revenues and $1.55 to $1.60 per share respectively for earnings.

We are revising our full-year 2007 free cash flow guidance to a range of 900 million to 1 billion, due primarily to higher investments in both capital and working capital, including deferred costs.

We are adjusting our full-year 2007 TCB guidance to approximately 23 billion from 23 billion plus.

For the third quarter, we expect revenue between 5.6 and 5.8 billion, and earnings in the $0.37 to $0.43 per share range.

The key earnings per share drivers in the quarter are expected to be, first, the income from recognizing the remainder of the Verizon contract payment.

As you'll recall we recognized a portion of that in the first quarter of 2007, and upon the removal of certain contingencies we expect to recognize a second portion of that in the third quarter.

We will also benefit from sequential revenue growth and continued momentum in our productivity and operational performance.

Offsetting these pluses will be a non cash German tax asset charge which we told you about in the first quarter call which will be approximately $0.07 a share and a step-up in our severance and Best Shore expenses as we drive forward with our workforce initiatives.

So in summary, we had a solid second quarter, with revenues and earnings significantly higher than last year, and we improved our operating margin to 4.3% in the quarter.

We began making progress on our DSOs and expect further improvement across the second half of 2007.

Cash flow was $156 million in the quarter, and expected to be 900 million to 1 billion for the full year, greater than the full year 2006 total, and we will continue to take aggressive actions into 2008 to manage our cost structure.

As a result, currently we would target free cash flow in 2008 to be roughly in line with our 2006 and 2007 levels and expect improved financial performance in 2009.

So with that let me pass it back to Ron Rittenmeyer.

Thank you, Ron.

Let me just summarize, then, before we move to questions.

We've had a solid quarter two business performance, significant year-over-year earnings improvement continuing our three-year trend.

We are confirming guidance for revenue and EPS in 2007, and we are adjusting our full-year 2007 free cash flow which both Mike and Ron spoke to.

We have line of sight, a very strong pipeline for our $23 billion forecast in bookings, and we really have continued commitment and conviction that as we go through 2007 with the improvements we're making in operational performance, for aggressive actions, we see that continuing past 2007, because we think that much opportunity does exist, and we believe that will be the pillar that will continue to further improve EDS's overall performance.

So with that I will turn it back to Dave Kost.

I'd like to open up the call for questions.

I would ask that you try to limit your questions to one per person.

Thank you.

We will now begin the question-and-answer session.

(OPERATOR INSTRUCTIONS) Our first question comes from Julie Santoriello with Morgan Stanley.

Ma'am, your line is open.

I wanted to ask you, in light of some of the additional cost moves that you're taking, can you talk about any change potentially in long-term margin targets?

Well, we don't have, at this point, I think, specific numbers to talk about in 2008.

I said we'd do that probably in the next quarter's call, when I think we've had a little more detail around this, but clearly we obviously know we have to -- this investment will result in a step-up of our performance so at this point I think I'd rather wait until third quarter to get into those types of details as we formalize this, but suffice it to say that we expect to have a step up, and that's what our direction will be.

Thank you.

And if you can just elaborate a little bit more on the three large contracts that were pushed out beyond the second quarter.

Can you talk a little bit about the circumstance around that and if this is something that you think is endemic in the industry right now?

Well, I don't know if it's endemic in the industry.

And I really, given the highest confidentiality on some of this I can't get into specifics but, I guess what I would say is that, when you're negotiating a deal and you get close to the end of that negotiation, as you bump up against the quarter, I mean, I was a customer, if it's obvious that you have a lever that you want to negotiate a little further with, you've got to decide whether or not that's a real lever and whether or not we're willing to do that, and I wouldn't say that it's an endemic issue, but it's something we have to be conscious of.

In some cases it's just because they haven't been able to get their Board approval in time.

In some cases it's because we still have one or two open points, but in the end, for example, one of the three already signed, in fact, signed three days after the quarter.

So it's just kind of the way it it happens and falls.

But I don't want us to be making a rash decision if, in fact, you know, just to get to a number.

But I am comfortable about the pipeline, and I think that's what's important.

Just an historical comment, as we looked at our 20 plus major problem contracts several years ago.

A very high percentage of them were signed in the last week of the quarter.

So haste makes waste, so we're pretty conscious of doing the right thing.

And not worrying about where it falls in the quarter.

And we have a tough governance process now, so there's a lot of oversight in that which makes us, I think, keep our objectivity.

Thank you, Julie.

Our next question comes from Rod Bourgeois with Bernstein.

We've nudged the free cash flow guidance down a little bit for this year.

We're planning to keep it flat in the 2008 time frame which means the allure in many respects for investors to be interested in EDS's stock has a lot to do with 2009.

I know it's extremely premature to ask this, but you are sort of advertising improved financial performance in '09.

Can you talk about what's behind the '09 financial performance improvement?

Do you have any sort of cash flow target that you're thinking about for the '09 time frame as I do think a lot of the -- particularly the value investors that look at your stock are going to want some idea on what the plan might be, at least a ballpark plan for the 2009 time frame at this point.

Can you say anything along those lines?

I don't think we can see anything that right now.

As Ron said, we are targeting to move our operating margin significantly above the '07 target, which we look to be on track to hit.

And the cash flow will obviously come with that.

we're just not far enough along in pinning down what's in '08 and what's going to slip into '09.

So we'll try to give you a little more color than this in the third quarter call when we present -- usually present our guidance for '08, but just say we're targeting a significant margin improvement going forward with obvious impact on free cash flow.

Okay.

And then just for Ron Rittenmeyer, as Ron assumes the CEO spot, I'm wondering if there's any messages that will be conveyed to the employees, to the customers, or even to investors in terms of strategic changes or operational philosophy changes or anything along those lines that will be communicated as Ron moves into the CEO role.

I'm wondering if there's anything along those lines that will be communicated.

This is Ron.

I think, Rod what I would say is that Mike and I have been pretty close, clearly the last six months we've been very close as we've worked through this transition.

So I think the messages you're hearing about improved performance, stepping it up a little bit more, being a little bit more aggressive, not even a little bit more aggressive.

A lot more aggressive, and more focused on some of the key measures there -- I think you're going to see that continue, and I don't see any significant change that I'd want to say today.

I think we're already on the trajectory, and that's where we're going to head.

Just a quick related question on the strategy.

It seems that a lot of the strategy that was outlined earlier this year somewhat hinges on the ability to acquire higher margin, higher growth businesses.

We haven't seen a lot in the way of acquisitions this year, and so can you give us any update on--?

Rod, just a quickie on that.

We've got probably seven, maybe eight active negotiations going on.

The first half of this year was a tough year for strategic investors for obvious reasons.

As we saw the private equity craze come in and scoop up stuff that had no business buying, in our minds, but we didn't chase stuff that was uneconomic, and in some respects, this crunch in the credit markets favors strategic investors, as was pointed out in the journal yesterday or the day before.

So we think the second half will be much more productive than the first half.

All right.

That makes sense.

Thanks, guys.

Thanks, Rod.

Our next question comes from Julio Quinteros with Goldman Sachs.

First of all, congratulations, Ron, on the new position here.

Clearly the track record on the operating side is pretty well established.

I guess I'm wondering more about the growth side of the equation here as we begin to look at 2008 and beyond with bookings now at the lower end of the trajectory here and expected to be down year over year in the double-digit range.

Just give us a sense beyond acquisitions where the sources you think are for real revenue growth in this model on an organic basis.

Again, I'd say, Julio, that our bookings I think are still pretty positive.

When I look at our -- you got to go back to 2006 and realize that you have the big GM recompete and the Navy recompete so those did somewhat skew the overall number.

When you look at it on a basis of year over year growth, continue to show pretty positive growth, we're reflective of that growth relative to the balance of capital and the investment required.

So I mean, there's got to be a balance between margins, free cash flow, and revenue.

We are really putting a lot of focus on applications.

I think that applications clearly from our standpoint have higher margin opportunities for us, less capital usage, things we've already talked about.

So we've seen that type of improvement.

When I compare it to last year it's up significantly.

We're investing in the practice area.

We're putting a lot of our focus on building out applications and things like the Real Q testing, the combination of India with emphasis in EDS now being finalized.

I believe the future of this company will skew more, we'll spend much more emphasis into the application side of the business.

And even though we say we're going to be less dependent on mega deals, the reality is there's still a lot of $100 million deals in the pipeline.

And those are good deals.

Now, we may have qualified 50 deals for the second half.

Doesn't mean we'll certainly win all of those.

Some of those will spill over to a future year, but having said that, I'm pretty comfortable that we have a very good line of sight, and that the growth will continue to be pretty positive.

So I'm not concerned about that, if that's what you're heading.

I think our strength in deals is still pretty good.

Our win rates continue to be very positive.

So overall I think our growth looks actually pretty solid.

Okay.

But you're not willing at this point to at least peg it to a number for certainly the out years?

Low single digits, high single digits?

It will follow with the rest of the guidance that we do.

Thank you.

Thanks, Julio.

Our next question comes from Jim Kissane with Bear Stearns.

Ron, can you elaborate on your requirements regarding the capital requirements going up?

It sounds like the business is getting more capital intensive again, but you're saying that your application services contracts are growing as a percentage of the total.

I'm just trying to reconcile the two things.

We'll go with Ron Vargo first, then Ron Rittenmeyer can chime in if he wants to, because I did talk about capital in the free cash flow statement.

I said that one of the drivers of taking our cash flow down for the year by $100 million was higher capital and working capital in 2007, and I don't think it's a dramatic shift, Jim, and I also pointed out the fact that we benefited historically from asset sales, and those are down year-over-year.

I think it's the combination of a little bit more intensive capital from some of the bigger and newer deals that we signed in deferred costs, a little bit of buildout of some of our Best Shore investments, and overall working capital that's driving the cash forecast down for the year.

Ron, do you want to add anything?

No, those are all correct, and as you -- even as you grow what we call capital light, which is continuing to be a focus, we still to have build seats out in India, and we still have to build seats out in some of these new locations.

So there are some up-front capital things that we have to deal with, it's a reality of the business.

Those should pay out to much greater returns going forward.

Ron, just the margins on the smaller unbundled deals that you've talked about versus the mega deals, and also can you comment on the margins on the HR BPO business?

Those margins are good, again, I think they're in line with certainly the -- some of those deals, those margins would be in line, probably better than IPO, less than applications, so somewhere in the middle there.

I don't want to give a specific number, obviously, for competitive reasons, but the margins are more than acceptable.

So they're good solid margins.

Including HR BPO?

Well, HR BPO, again, you've got two types of HR BPO.

You've got benefits admin.

business, which is a very good business, and you've got the larger HRO deals.

The larger HRO deals just like any large deal tend to be less, benefit admin.

tends to be better.

We have a healthy mix, the platform we've just released and we've converted a lot of people on is in the bed admin.

space.

Thanks, Ron.

George Price with Stifel Nicolaus your line is open.

Main point is, I wanted to drill down a little bit more on what's going on with free cash flow.

Ron Vargo, you mentioned, three things just now, right.

Capital needed for some of the bigger deals signed last year, building out a Best Shore, and then overall working capital.

Can you kind of disaggregate those and help us understand what each of those is -- what impact each of those is having on the free cash flow, the change in the free cash flow guidance, and then I'd add to that also, on the capital needed for some of the bigger deals signed last year, why is that -- why are we hearing about that only now when those deals were presumably things you had more visibility on?

Okay, George.

I don't think it's any one area that's causing a significant impact, so it's really more of a combination of things, including lower asset sales and slightly higher deferred costs.

So when I talk about the deals that we've signed over the past couple of years, I'd say those are more just slightly higher deferred costs that we're seeing, and then when you go to the Best Shoring activity, I think we are moving a significantly higher number of jobs offshore.

We're building out infrastructure in those countries.

We're outfitting those desks with hardware and software, and I think the combination of those things is causing a slightly higher amount of capital this year, but I would not say it's any one individual thing, and I'd say some of the best shoring has been happening over the last couple of quarters in increasing amounts, even increasing higher than we thought it would in terms of the number of jobs we've been Best Shoring.

Let me ask something more directly.

Is any of this cash being deployed to address execution issues on any of the contracts that you've signed over the last year or so?

No.

Let me make a couple comments on this.

Free cash flow number is always volatile because of timing issues on capital.

But as I tried to emphasize, if you take out the -- the one-time payments we had last year, this is significant improvement in free cash flow over the prior year.

And that's a little lower than we thought.

We got surprised by a couple of things, like India and the need for India stuff.

I think we're on a pretty solid trend of improving earnings and we'll also improve capital efficiency.

I think it would be a mistake to read some dire trend here.

In terms of the prior guidance that you've given, you've split it up between cash from ops, I think it was, Ron, last official guidance was 10% of revenue was cash from ops.

Then 5 to 5.5% CapEx.

Can you reclarify those?

Yes, George, our expectations are that CapEx would still come in at that 5 to 5.5% range for the year, probably more on the high end.

I think working capital with the accounts receivable deferred contract cost and other changes will probably be very much at the high end of the 1 to 2%.

So the combination of those two being up at the high end, along with our cash flow from earnings being kind of where we expected it to be is what drives us a little bit lower than the 4.5 to 5 for the full year, as a percent of revenues.

Okay.

Last one.

Below the operating margin line, you may have commend on it.

I may have missed it.

But just obviously you had the lower tax rate -- the operating income was actually pretty spot on to what we were expecting but the below the line negative impact was much larger.

Can you take apart that other income expense line below the line a little bit more?

Thanks.

Yes, briefly.

We had a little higher interest in "other" I think than we expected.

We have interest rate swaps on a significant amount of our debt, and some of those get marked to market every quarter.

With the interest rate movements in the second quarter, we had a pretty high provision for our swap in the second quarter.

That could very well reverse in this quarter if you see interest rates continue to be at very low levels.

So there's some volatility there, caused primarily by some of our interest rate swaps.

Thank you.

Adam Frisch with UBS your line is open.

Mr.

Frisch, your line is open.

Thanks, good afternoon.

George did a good job on free cash flow but I had a couple other questions there.

First, Ron Vargo, under EITF-0021, higher deferred costs are indicative of contracts that are a little bit maybe behind schedule, is that correct?

Not necessarily.

Several of these large contracts, Adam, have some significant construct and build portions to them, where the costs get put on the balance sheet.

And again I would kind of go back to Mike's comment around capital generally and deferred costs individually -- these are not rampant alarming changes, or problem contracts, for that matter.

Okay.

Investments supposedly peaked last year, and I'm assuming would theoretically be accretive to cash flow this year, just on the math of easier comps as well as the operational savings.

So why is that being cited as a reason for free cash flow weakness?

It's what we call investments outside of severance are not incremental.

They're more investments in rolling out -- hardware rolling out, say to our data centers and things like that.

I think the point is, there's nothing lurking under here besides kind of normal volatility.

But if they're less this year than they were last year, and the ones last year are saving you money, wouldn't that be accretive to '07 free cash flow?

I'm not sure where you're headed here, but--.

I guess where I'm headed is, to be blunt, investments were supposed to go down, last year was the peak, and why are they still like at equal or elevated levels, or why aren't the ones that you've made in the past year--?

We didn't say that, Adam.

I think maybe we're getting confused here around capital investments and sort of this terminology we used in the past around P&L investments.

Technology.

In our technology and our severance costs, which the combination of those are coming down on a year over year basis.

I'll take that off-line with you, Ron, maybe after the call.

The last question I had on free cash flow was the asset sales in the quarter that are about 23 million, first half 69.

Last year's first half was 183 according to your slide.

I think it was related to like building and land sales and stuff like that.

What was done in the quarter and in the first half of '07 so far?

What you're seeing -- the big change on a year-over-year basis is the runoff of the treatment of the Navy contract leases, which makes up the bulk of both of the numbers, and then the remainder is just some miscellaneous asset sales and there was nothing really significant to note in either period.

Then Mike Jordan, at the analyst day you basically said that given your current revenue mix, margins were close to if not at peak levels and to get you higher you would need to do some acquisitions to get you further up the value stack and so forth.

Is M&A part of that expansion story here, or can you do it organically?

No, actually it isn't.

It partially is supporting our applications, but basically I think we sort of changed our tactics.

We think even without a significant mix change we can drive our operating margins further, because we've just made so much progress on the cost side that we just think there's more opportunities, so when we said the 7 to 8% sort of pre compensation expense as kind of the target margin, we think we can push higher than that, and obviously applications mix and growing applications faster will help that, but it doesn't need a significant M&A to do that.

We're not counting on that.

Okay.

Then, promise, Dave, last question, for Ron Rittenmeyer.

Mega deals you said there were 50 in the pipeline.

Are those now being defined as deals greater than 100 million?

Greater than 100 million.

Thank you.

Thank you, Adam.

Tien-Tsin Huang, with JPMorgan, your line is open.

Just a follow-up question to Adam's questions on the mega deals.

How many are over a billion in PCV of the 50 that you talked about?

How many are over a billion?

Yes.

The only thing I really want to talk about, we have 50 over 100 million, and that's kind of the cut we'll make at this point.

There are deals in the pipeline that we would consider to be over a billion, not a significant number, but that's kind of what we talk about at this point.

Okay.

Then also on the acquisition pipeline are we still targeting 1 to 2 billion in spending there per year?

Yes.

I was curious, would you consider doing a single large deal there outside of the range if the right one came along?

If the right one came along, yes.

So we're not limited to--?

Depends on how large is large?

Depends on your financial capability.

But, yes, I mean, we're -- we think the market is improving for strategic acquisitions.

As I mentioned before, and -- we've got a lot of irons in the fire, and -- but we have a lot of parts of our business we want to strengthen through this.

So just stay tuned.

We think we'll get quite a bit done in the second half.

Is it fair to say that perhaps maybe BPO is sort of a higher priority on the acquisition side than applications given that applications is growing pretty well here given the Emphasis deal?

Well, we have more -- we're looking at improving specific capabilities and applications where we're short talent and industry orientation.

We have some of the other ones that we talked about, like healthcare still a high priority for us in addition.

Very good.

Ron, congrats on the CEO role, Mike, good luck.

Good luck.

Thank you, Tim.

Good luck.

David Grossman with Thomas Weisel Partners, your line is open.

Thanks.

You may have answered this in parts of other questions, but just in summary, can you, other than the Verizon contract, can you review what the primary plus and minuses are to free cash flow in 2008 and also help us understand whether your '07 and '08 guidance are you assuming you get to that mid-50s DSO target by the end of the year?

I'll start with the -- it is Ron Vargo.

I will start with the DSO number.

We would target to get down to the mid-50s by the end of this year.

So approximately the same as last year's ending number of 56 days.

And be able to hold or marginally improve that in the future.

I don't think there are significant pluses and minuses to talk about in '08 other than Verizon.

I think we're kind of just putting, if you will, some boundary around where we think the '08 cash flow will be, but it's really premature to really kind of go beyond that right now.

And as we told you we'd get back later in the early fourth quarter to talk more about our views of '08 and beyond.

And is '08, as I recall at one time it was going to be a refresh year for NMCI.

Is that still the case, or when you reupped that contract last year did that change?

It actually started this year and will continue next year.

Correct.

We're in it now.

We've got heavy spending now and next year.

There was a question on the tax rate.

Maybe I missed this.

You're assuming about 37% for the year.

Is that the right number going forward into '08, and I guess secondly, is the German contained of item that you talked about in the third quarter is that reflected in that 37% rate?

Yes, it is.

We had some pluses and minuses in the year.

This German item is a significant hit to the tax rate.

We're expecting it to the happen in the third quarter.

37% is the expectation this year.

On a going forward basis we would expect it to be closer to 35 or 36%.

Okay.

And I guess just one last question, just on the guidance for the year.

Is that with or -- should we assume that's with the discontinued operations and the adjusted EPS, or is that a GAAP number that you're guiding to?

We guide to adjusted earnings.

So not the GAAP number.

Okay.

Thank you, David.

Thank you, David.

Pat Burton with Citigroup, your line is open

This is [Nathan Rosoff] in for Pat Burton.

Wanted to turn the question to ask about the pipeline a bit and bookings numbers.

You mentioned that you were moving more towards the smaller contracts as being preferable to the larger ones.

Is that just due to market demand or are those contracts more preferable in your view?

Well, i's not necessarily preferable.

The market requirement, which we've seen more movement towards unbundled contracts and therefore smaller contracts what we've done is align our organization to be able to daily with those.

I think there's a balance of deals greater than 100 million and deals less than 100 million.

We don't want to be a corporation that is fully dependent on these mega-mega deals as carrying the business.

We signed a few this year.

KarstadtQuelle was a great example, it's a great deal, we love it, it's a great apps deal and it's a big one.

So those kinds of deals we're going to do every time but having said that we're not going to be dependent on only elephant hunting.

I think we have to have the capability of doing other things as well, so we've adjusted accordingly and so far it is playing out pretty well.

Given that we're about what, a third of the way to the full-year goal, is it the trend towards the smaller deals that's to slowing up the progression of bookings or is more just a seasonal trend towards the back half?

Well, again, I think if you compare where we are this year compared to last year, we signed 4.3 which is up 20%, ['06] included the Kraft deal and another large deal.

So when I look at net-net, I don't know if it's slowing down or not.

I feel like we've actually had a pretty good quarter and I would expect the 23 billion we're saying for the year is a good number.

I just wanted to adjust the bookings to say approximate to give myself some reflection of some of the deal slippage that I think occurs for the reasons we talked about earlier.

So it's no signal that the deals are not there.

The pipeline -- I think the most important point to realize is the pipeline, when I look at our overall pipeline, it's still up significantly year over year.

If those three deals that had slipped out of this quarter if those had come to fruition.

About how far -- how much would that have helped close the gap to the full year -- bookings expectation?

I don't want to quote numbers because we haven't signed, we've just signed one of those and announced it.

We haven't signed the others.

We announced the Bank of Australia, the CBA deal, and that's already been announced publicly.

The other two I can't talk about because they're just not signed is and it would be inappropriate to talk about numbers.

Understood.

Then just a last question on free cash for '08.

The question there is, is -- does the assumption that it will be, similar level to '07 include continued investment related to offshoring?

Or do you expect those investments to be completed this year?

No we expect offshoring, or Best Shoring as we call it to be an important part of the Company's strategy going forward as well.

To the extent that we're going to expand that we're going to continue investing in it.

It reduces our cost and gives us a much better quality and cost footprint.

I think it makes all the sense in the world to continue doing it.

Okay.

Thank you, guys.

Operator, we have time for one more question.

Thank you.

Our last question comes from Joe Vafi with Jefferies & Company.

Hi, gentlemen.

Good afternoon.

Maybe just one question on the Best Shoring strategy, if we look out five years from now, do you have a feel for what your -- where if you look at your delivery mix and headcount where you see the mix being in lower cost geographies versus maybe more traditional geographies and where we in that progression now.

This is Ron Rittenmeyer.

First of all, remember, we have a large government business, so some of this will be dependent on how much we grow government versus commercial.

Government is not going to be significantly Best Shored.

There may be some, but it won't be material.

So we're already 34% of our non government workforce Best Shored.

I think that will go up to a 50/50 mix going forward.

I also believe that you'll see a higher percentage on the application side, more around managed work compared to time and material work.

So the more we do managed work, the more we'll be moving that offshore.

So I don't know if that answers your question, but directionally, that's what I would say.

That's helpful.

As you move more of your -- as the geography and the delivery mix changes, if you had to change contracts should we be worried about revenue cannibalization in some of the traditional businesses here?

I think any time you move it, you have revenue cannibalization.

The key is can you provide the values when you move it you should be providing the value scenario that shows that reinvestment of that gives the client significantly more than what they had.

So I think, in the pure sense to your statement, yes, there's revenue cannibalization, but what we've also been successful doing is reapplying that savings that the client gets and fed it to the their bottom line.

They have actually reinvested it in more work.

So I actually think it's a greater opportunity to further solidify your position.

Thank you very much.

Thank you, Joe.

With that, operator, I'd like to thank everyone for joining us on the call today.

If there are still some questions in the queue, I'll be available afterwards.

Feel free to call my office and we can talk those through.