Maximus Inc (MMS) 2006 Q4 法說會逐字稿

Ladies and gentlemen, welcome to MAXIMUS's fourth quarter earnings conference call. [OPERATOR INSTRUCTIONS] The presentation is posted on the MAXIMUS web site under Investor Relations if you would like to follow along. At this time, I would like to turn the call over to Lisa Miles, Director of Investor Relations.

Good morning and thank you for joining us for our fourth quarter earnings conference call. On the call today is Rich Montoni, Chief Executive Officer and David Walker, Chief Financial Officer. Following our prepared remarks, we will open the call up for Q&A. Before we begin I would like to remind everyone that a number of statements being made today will be forward-looking in nature. Please remember that such statements are only predictions and actual events or results may differ materially as a result of risks we face, including those discussed in exhibit 99-1 of our SEC filings.

We encourage to you review the summary of these risks in our most recent 10-Q filed with the SEC on August 8, 2006. The Company does not assume any obligation to revise or update these forward-looking statements to reflect subsequent events or circumstances. And with that, I'll turn the call over to Dave.

Thanks, Lisa. Good morning. As outlined in this morning's press release, we reported our earnings for the quarter of $2 million, or $0.09 per share. These financial results reflect a decision to take a conservative revenue recognition approach on two signed software licenses that were delivered at the end of the quarter. This shifted $0.22 of our earnings from fiscal 2006 largely into fiscal 2007. The license revenue will be recognized ratably over the period of the contract instead of recognizing the license revenue up front. I realize this was unexpected, but the accounting standards in this area are sufficiently complex that the appropriate treatment could not be determined until earlier this week. I'll get into the specifics during the segment discussion, but if this revenue was not deferred we would have been in line with our previous full-year guidance of $0.31 to $0.41 per diluted share.

Summarizing the highlights of the quarter, this morning we reported fourth quarter revenue of $171.8 million and for the full fiscal year, revenue totaled $700.9 million. Net income for the quarter was $2 million, or $0.09 per share and for the full fiscal net income totaled $2.5 million, or $0.11 per diluted share. Before I jump into the segment details, I wanted to walk through a supplemental table included in this morning's press release. If you turn to the last page of our release, the supplemental table is entitled Base Operations Results. In an effort to provide clear visibility into our business, we believe it was important to provide details on a quarterly basis on our overall financial results for base operations, which we define to be our financial results excluding legal settlement expenses and the losses on the Texas project. We believe this is particularly important when addressing our expectations for fiscal 2007.

In terms of legal settlement expense during the fourth quarter we received approximately $0.03 per share related to an insurance claim reimbursement net of certain legal expenses. For the full year, legal settlement expense totaled $0.26 per diluted share. For the fourth quarter, the Texas project lost $0.36 per diluted share, and for the full fiscal year, the project lost $1.38 per diluted share. Excluding these charges, results for base operations would have been $0.42 per diluted share for the fourth quarter and $1.76 for the full fiscal year.

Let's move into the results by business segment starting with consulting. Consulting segment revenue was $26.1 million for the quarter and $102.8 million for the year. Operating income for the consulting segment totaled $5.2 million for the quarter for an EBIT margin of 19.8%. The segment ended the full year with $14.5 million of operating income for a full year EBIT margin of 14.1%. The consulting segment delivered solid results in the fourth quarter and full fiscal year. Margin expansion was primarily attributable to robust claiming from the financial services division.

Moving into the systems segment, the decision to recognize $10 million in license revenue ratably over the term of the contract impacted our results for fiscal 2006, but this will certainly provide benefits in fiscal year '07 as the majority of the deferred revenue will be recognized over the next 12 months. Systems revenue in the quarter totaled $30 million and for the full fiscal year totaled $127.2 million. Systems operating loss for the fourth quarter was $2 million with a full year operating loss of $0.9 million. The decreases in revenue and income were in part a result of the license revenue shift into next year.

Beyond the impact of the shift in license revenue, the segment benefited from growth in the asset solutions division, which offset softness in the Company's ERP business, which lost money for the year. The ERP division should return to profitability in the second half of fiscal 2007 as a complete selective project. On a go-forward basis, license revenue will continue to be an important part of our business and strategic direction. We're seeing strong demand for information technology and infrastructure solutions with our state and local clients, which Rich will talk about in greater detail later. Generally when our clients ask for integrated solutions rather than a single point product solution, the accounting requirement may be to recognize license revenue over the life of the contract. But these contracts also provide increased predictability and consistency of our financial results than recording license revenue up front.

Turning to the operations segment, fourth quarter and full year results from the segment were impacted principally by the loss on the Texas project. Revenue for the operations segment totaled $115.7 million for the fourth quarter and $470.9 million for fiscal 2006. This segment lost $2.9 million in the fourth quarter and $9.5 million for the full fiscal year. As previously noted, Texas results were the largest driver behind the segment's performance in the year. Full year results from the Texas project included $37.3 million in revenue and a loss of $49.4 million. On a quarterly basis, the results from Texas break down as follows. Q1 revenue of $5.8 million with a loss of 0.1 million; Q2 revenue totaled $9.7 million with a loss of $2.3 million. In Q3, revenue was $10.2 million with a loss of $34.3 million. That includes an impaired asset write-off of $17.1 million. In Q4, revenue totaled $11.5 million with the losses improving to $12.7 million.

In British Columbia, the total loss for the year ended September 30, 2006 was $4.6 million, while the current quarter results appear to be break-even, this is not yet reflective of ongoing operations. Rather, it is simply timing in the quarter of when costs are incurred and infrastructure development can be capitalized. We anticipate losing approximately $2.5 million on this contract in fiscal year '07, but we have specific initiatives underway that could improve on this forecast before year end. The British Columbia project continued to meet all service level requirements through the end of September and we continue to make progress. A couple of final notes on the P&L, other income was $1.7 million in the quarter, which primarily consists of investment income of $1.8 million with a small loss of $0.1 million related to foreign currency. The Company also received an insurance settlement net of legal expenses of $0.9 million in the quarter, which is recorded on the legal settlement line of the income statement. This related to the litigation that was settled in the third quarter.

And lastly, moving on to expenses for the quarter, while the losses in Texas have declined relative to last quarter, the contract continues to impact overall company margins. On a full-year basis, excluding the impact from both legal expenses and the Texas contract, pro forma operating income from the Company's base operations would have totaled $56 million with an operating margin in excess of 8%. Reflected in the 8% margin is stock option expenses of $4.4 million in 2006, or $0.12 per diluted share for the full year.

Moving on to balance sheet items, in the category of bookkeeping, we changed the balance sheet categorization for certain capitalized costs related to the BC contract. We reclassified approximately $6.5 million of net costs previously capitalized as deferred contract costs to BC-related software development costs. Our accounts receivable for the quarter totaled $201.1 million. We also have $2.7 million in long-term accounts receivable, which are classified within other assets on the balance sheet. DSO's increased in the quarter to 108 days, driven in part by the two software license billings in deferred revenue.

At September 30, we had approximately $12 million of license billings with no associated revenue in the quarter, which accounted for six days. The other major driver is receivables in Texas, which accounts for approximately five days. This is because client payments slow down through the prime contractor. MAXIMUS gets paid from the prime 45 days after payment from the client. During October, we had strong client payments, including $12.2 million from the license revenue billings discussed earlier, which by itself will improve DSO's by six days. This will certainly help DSO's in the first quarter. However, the first quarter does experience seasonality as a result of the various holidays, and we have traditionally had higher DSO's in the first quarter of any given year.

Turning our attention to cash, net cash provided from operating activities totaled $15.7 million for the fiscal year. For the quarter, cash from operations used $4.9 million, driven by a reduction of accounts payable of $10.9 million. We ended the quarter with cash, cash equivalents and marketable securities of $156.9 million, and with that, I'll turn the call over to Rich.

Good morning, everyone. Fiscal 2006, including this fourth quarter, was certainly challenging for MAXIMUS. Today we will focus on closing out this year and address our views on fiscal 2007. When I assumed the role of CEO in April, we set a strategy, a direction and a plan to focus on optimizing our current business. This included improving many of our internal practices and our organizational goals. In short, we wanted to better manage risks to increase profitability in the projects we have. I believe this plan is still appropriate today and we have made meaningful progress against this plan. We will continue these important initiatives into fiscal 2007. For the past several months we have directed our focus towards profit margin expansion, moved away from pure volume-driven sales, worked towards lowering risk profiles, divested non-core business practice areas, resolved certain legal overhangs.

I know that Texas is top of mind for many of you, so let's jump right into the details. The operating loss for the Texas integrated eligibility project was substantial, but it was in line with our previously disclosed expectations. We had stated we expected the pretax loss to be in the range of $45 to $50 million for the second half of fiscal 2006. This was in addition to the pretax loss of $2.4 million incurred in the first half of fiscal 2006. The pretax total loss on the project for the full year in fiscal 2006 was $49.4 million. We believe we have made significant operational progress on this project. The level of functionality and enrollment broker operations remains satisfactory.

Over the last several months, we have worked hard to manage the impact of several recent policy changes to the Chip program. While we have been meeting our key performance requirements under the contract, we have launched a program to drive required improvements within the Chip operations. As a result, we have dedicated resources working to improve service delivery on this key program. In the integrated eligibility operations, working closely with Accenture, we've made important progress against key measures of timeliness, accuracy and productivity. We established a model office environment to prove our business process and technology changes and to promote best practices to the production floor.

Overall, we are working a plan that includes a series of additional actions, these designed to improve the operational and financial aspects of the project. While the loss rate has lessened somewhat, we do expect losses to continue through Q1. Results thereafter will depend upon certain factors, many of which are controlled or dependent upon state or Accenture as the prime contractor. I'll get back to this point. The project was the subject of extensive political focus during the recent gubernatorial election in Texas. We continue to work with the prime contractor to improve the project and have entered into negotiations with that prime contractor regarding ongoing roles and responsibilities. It is our fundamental interest to be of remaining service to the project only where we are positioned to deliver a high level of quality service on a profitable basis.

Accordingly, the negotiations could result in MAXIMUS having a diminished role in certain elements of the program. We do not solely control the pace of negotiations, but we would hope to conclude a process by early January or sooner. In fact, we would like that resolution by December 15, 2006. I feel that this process is encouraging, but a disclaimer is appropriate. As you know, there can be no assurance that negotiations will be completed or on terms that are satisfactory to us. Also, there remains the possibility of liquidated damages and/or claims resulting in legal disputes between the parties. As a result of this, you can appreciate that forecasting the financial performance of the Texas project for fiscal 2007 within a tight range is not possible at this time. So a rather wide range is appropriate.

Given the current set of conditions, which will likely change, we estimate a pretax loss on this project for fiscal 2007 in the range of $20 million to $30 million. This estimate is based upon our latest results in planned operational improvements. The main factors that will influence the ultimate loss include any change from negotiations, the future rollout plan, the ability to achieve the planned operational improvements, systems enhancements, the possible assessment of liquidated or other damages and the level of cover costs. I would like to put the Texas issue at rest in order to enable us to return to operating within a more stable environment. As many of you know, this midterm election cycle was the most dramatic shakeup in the last 16 years. We don't think this will have an impact on our overall business or demand in the marketplace. While traditionally the Republicans say we're outsourcing, it's the Democrats who typically create the programs that MAXIMUS administers. The political landscape is vastly different than it was even a decade ago. Governments have even more compelling needs to use technology and new processes to serve the increasing caseloads and demand.

We do see earnings growth in the short-term fueled by profitability improvement in our base business. Market demand is very strong and we're pursuing new business and winning our share. However, our primary emphasis right now is on improving performance within our current book of business and reducing risks. Avoiding substantial losses in the future really begins with our approach to new business. In the last several months, we have applied more stringent criteria to our pursuit of new business and rebid opportunities. In more than a few instances we have passed on bidding potential jobs due to unfavorable margins or undefined project scope, which adds increased complexity and excessive risks. We have also pushed back on new work where we've had concerns over contract terms and conditions, most notably liability limits. We have also taken a much more aggressive posture to exiting businesses that are no longer areas of focus. These are essentially areas where we believe the potential does not exist for us to establish a meaningful leadership position or the market itself isn't growing quickly.

In October, we sold our corrections practice at a nominal gain and shut down a small student loan collections business within the operations segment. These two operations had combined operating losses of just over $1 million in fiscal 2006 and for us were not viewed as businesses where we had or could have competitive advantages. The divestitures free up important management resources to focus on areas of growth and better position fiscal 2007 by removing the associated losses. We will continue to maintain a divestiture mindset and will consider alternatives for additional non-core businesses that do not meet our criteria for market leadership and growth.

Let's address longer-term revenue and profit growth. MAXIMUS is an established leader with a strong brand name in the government solutions industry, and we are in an enviable position to pursue new business opportunities in this high demand environment. On a macro level, we see two significant drivers we believe serve as the platform for long-term sustainable growth. First, demographics are driving demand for health and healthcare reform, education, human services, and children's services. More people, more cases, more diversity, and more languages are leading to greater demand and an increased need to serve clients with services that fall well within our core competencies. These demographic changes also drive legislation, which create the funding for our services. The recent legislation around Medicare and the Deficit Reduction Act are examples of how we can help and benefit from legislative change.

Second, the looming government retirement bubble. In May, the Secretary of Labor cited statistics which noted that 60% of the federal work force will be eligible for retirement in the next 10 years. State governments are also concerned with worker retirement over the next decade. They are already running legacy systems in increasingly outdated languages that no longer are even taught in colleges. So the move towards outsourcing and DPO-type work is increasingly attractive to governments as they seek to cost effectively replace workers and systems.

Now let's take a look at growth drivers specific to our segments. Consulting segment, this segment is benefiting from an increased interest in program integrity. This is essentially centered on controlling fraud and abuse in major entitlement programs. In this area, we were awarded the downstate New York Medicaid compliance contract, which is a contracting vehicle through the New York Medicaid Inspector General's office. Under the same contracting office, we're also in final negotiations for the New York fraud and abuse reduction and detection contract.

Within the program integrity area, we also launched a project in Georgia under the administrative services organization, which will measure eligibility error rates driven by new federal legislation for payment error rate measurement. Additionally, under the Department of Housing and Urban Development, recent legislation has also driven new requirements and created new opportunities for MAXIMUS. We recently completed our first two cost allocation plans for public housing authorities. We see this as a potential growth area.

Moving into our enterprise systems segment, technology will certainly play a pivotal role in longer-term demand. New federal reporting requirements upgrading of outdated systems and changing demographics and key products including a new version of our SchoolMAX product, significant enhancements to our asset solutions products and to a lesser extent we've made some investments in our justice software. We have substantial value in our intellectual property within enterprise systems. In fiscal 2007 we plan to drive increased realization of this value by expanding the offering geographically and adding new sales channels, such as authorized software resellers or independent integrators. The two licenses deferred are good examples of this. We sold justice solutions license in Australia and we sold an educational systems license to IBM as part of our system integration for Puerto Rico.

In the operations segment we see major opportunities to grow this business as a result major opportunities to grow this business as a result of increased demand for business process outsourcing, with the significant need for subject matter expertise. In addition, governmental policies continue to evolve and as policies change, there's a fundamental need for governments to seek assistance in implementation. At MAXIMUS, we don't make new policies, but we translate new policies into action. With policy change comes new work. For example, in the area of Medicare reform, we are designated by CMS as a qualified independent contractor, or QIC, as well as a Medicare integrity drug contractor or MEDIC, and are currently working on a variety of projects in this area.

Additionally, the Deficit Reduction Act, which was enacted earlier this year and reauthorizes the TANF program provides states with additional flexibility to make reforms to their Medicaid programs. This legislation touches upon a number of key health and human service programs. Additionally, the added flexibility provided under the new DRA to innovate state Medicaid programs should be a catalyst for new opportunities across both of our operations and consulting segments. Specific to healthcare programs at the state level, Massachusetts is leading the way in innovative healthcare reform. Their universal healthcare initiative expands coverage to all Massachusetts residents. MAXIMUS is working in conjunction with the commonwealth to help them implement these new initiatives and to also leverage our existing infrastructure to provide these services in the most cost efficient way.

With that, let's move into rebids, new wins and pipelines. Let's wrap up fiscal '06 rebids and options. In fiscal '06 we were awarded or received contract extensions on 16 rebids and 14 option exercises for a total contract value of approximately $250 million. We lost one small rebid worth $4 million in fiscal '06, so all in all on, a total contract basis, we won 98% of our options in rebids. For fiscal '07, we have 10 rebids worth approximately $187 million. Most of our rebids happen later in the year, so the impact to '07 is only about $10 million. Additionally, we have 18 contracts up for option exercises in fiscal '07. The total contract value is approximately $95 million, with a fiscal 2007 impact of approximately $45 million. Moving on to fiscal '07 sales and pipeline, for the year ended September 30, 2006, we had new signed awards totaling $717 million and awarded unsigned contracts of $103 million. Compared to last year, new sales were down, largely because fiscal 2005 included $640 million for the wins in British Columbia and Texas. As noted in the press release, our pipeline remains robust at $1.1 billion with new opportunities at all stages of development.

Turning our focus to the Company's capitalization, during the quarter, the Company did not complete any share repurchases under its Board authorized program. MAXIMUS will maintain its cash reserves until there is additional certainty around the Texas matter. Until this uncertainty is resolved, our strong capitalization provides needed confidence to customers, perspective customers and surety providers. Management and the Board will continue to review its capitalization position. Moving into guidance, for fiscal 2007, the Company expects diluted earnings per share of $1.25 to $1.65. This consists of earnings of $2.10 to $2.20 from our recurring base business offset by a wide range of an estimated pretax loss on the Texas project. Revenue for fiscal 2007 is estimated to increase 5% to 10%, or to $735 to $770 million.

Let me break down the earnings guidance in greater detail because there are two main elements. The first is performance from base operations, which we view as recurring, and the second is the Texas project, which we plan to be nonrecurring. So let's start with base operations. Fiscal 2006 EPS base operations were at $1.76 per diluted share. We believe this represents the starting point for guidance in fiscal 2007. That said, we currently expect earnings per diluted share for base operations to be in the range of $2.10 to $2.20.

There are several factors to base operations. The license deferral has a silver lining benefit of $0.19 per share, which we expect to be realized in fiscal 2007 with the remainder coming in fiscal '08. However, I've decided to factor only half of this benefit into our guidance because I expect to see and in fact I prefer more ratable revenue recognition on licenses going forward. So there may be some offset from that. Secondly, this is a recent issue, and, frankly, I just want to take a cautious approach. Also, our efforts to expand operating margin by focusing on optimizing current operations in areas such as pricing, bidding, and project performance are a factor in base operations. We've also eliminated losses through the divestitures, which will provide benefit in fiscal '07 and we plan to continue to prudently manage costs.

Second element to overall company guidance is the Texas project. While we expect losses in fiscal 2007 on this project, we do not plan that such losses will be ongoing into future years. The point being that these loss impacts should best be viewed as fiscal 2007 events, but not beyond. So as I previously discussed, as the project sits today, we forecasted losing from 20 million to 30 million pretax in fiscal 2007, or $0.55 to $0.85 per diluted share. As I mentioned earlier, this could very well change. So in total, we see the full fiscal year shaping up to be in the range of $1.25 to $1.65 per diluted share for all of MAXIMUS. As to revenue, our view is that revenue growth is a means towards earnings growth. As you know, our primary focus in fiscal 2007 is to optimize our current book of business and the good news is we have much of it already in backlog. So high level growth, revenue growth is not essential to fiscal 2007 earnings growth.

Therefore, we are thinking it is appropriate to forecast revenue growth from 5% to 10%, or in the range of $735 to $770 million. But I want to be clear we believe higher revenue growth is possible, given the strong industry demands. Just to wrap up before we open the call to Q&A, fiscal 2006 was a challenging year, with changes in management and operational direction. Our financial results were disappointing, mostly due to losses from legal charges and the Texas project.

While it's been tough going, we know what challenges remain and we are moving forward with a plan to improve performance and capitalize on our many strengths. Our primary focus is to increase our earnings by better execution on projects and we are excited about the many of our new product offerings and position in the marketplace. We think that our base of operations are poised to deliver a much improved results in fiscal 2007. This, along with our focus to eliminate legacy overhang matters, we believe is a key step towards delivering to our shareholders the value they deserve and the value we believe firmly resides within MAXIMUS. With that, let's open it up for questions.

[OPERATOR INSTRUCTIONS] The first question comes from the line of Shlomo Rosenbaum with Stifel Nicolaus.

Hi, Rich, David, Lisa. I want you just to delve right into the Texas project and within the $20 to $30 million in losses, is that what's exactly-- I understand that's for the whole year, but can you just frame that around what you're expecting from the renegotiations? In other words, you expected losses in the first quarter and then what's supposed to go beyond there? If you can just talk about, you know, how we couch that and I'll sort of follow up after that?

Hey, Shlomo. Here's our thinking. It is a very fluid situation, and as I said in my comments, difficult forecast Texas for fiscal 2007. So what we've done is we have assumed the current level of operations and we have also given specific management actions in place to improve the operations which should improve the performance of the project.

Consequently, the numbers that we're giving you, the $20 to 30 million range is very much front ended. We expect that we'll lose approximately $10 million in the first quarter and that's a reduction from our current run rate as we disclosed because we're going to get full realization from some head count actions that were taken and then after that we expect that the efficiencies will start to kick in, some system resources would be relieved as we complete buildouts of improved functionality.

The reductions you're expecting going forward are, you know, if you continue on the project as it is or is that including some kind of expectation of being able to exit parts of this contract?

We have not factored in the results of any consequences from renegotiations. It's just not practical to do that at this time.

Okay. Now, when you were talking about liquidated damages, is that between you and Accenture? Is that what the potential is there? Is there some kind of, you know, box you can put around that or give us any more clarity on that?

It's not, not appropriate to put a box around it at this time. The way the situation works is our contract with Accenture is prime, so relative to Maximus, it would be the potential for the flowdown of any liquidated damages that the state might, and, again, that's the state's decision, and I can't represent them, pass down or attempt to pass down to Accenture, who would then, under contract terms, attempt to pass it down to MAXIMUS. So as you can appreciate under that context, it's not practical, again, to estimate any if and when on that circumstance.

I understand you don't want to get too far into it. From my reading of parts of I thought were around the contract, was there a $250 million maximum on that?

That's correct. Our limitation of liability I believe on the contract is $250 million.

Okay. Getting into British Columbia, could you just talk a little bit more about why the sort of break-even this quarter. What's going on in the next few quarters where you're going to incur some losses still?

Dave Walker's going to address that.

Yes, hey, good morning. You know, the revenue on that contract is a fee for service, which means it's straight line, so the timing of the expenses drive the profitability more than the revenue and sometimes you just get anomalies of when costs are incurred and when your operations people are working on software and things that are capitalized. While we broke even, we don't think that's indicative of operations yet. We haven't reached that status, but we're certainly striving towards that and we anticipate the loss to be more in line with 2.5 million next year and we've got a lot of specific actions in place that we think we can drive that down towards the back end of the year, so we're making progress.

So is the 2.5 million sort of breaking even in the middle of the year and then becoming profitable, or sort of-- how should I think about that in terms of going through the year?

It will be towards the tail end, so it, it's pretty much this next quarter should be at about where we're running now. We'll start to see some change around the middle part of the year and improvements towards the end.

Shlomo, I would also like to add, keep in mind the 2.5 million is before the impact of specific management actions that we've laid out to improve upon that.

You bet.

So, you know, management's expectation is to do better than that frankly.

Okay. Good. Thanks. Just a couple going over some of the other larger contracts up for recompete, Medi-CAL, what's the status of that rebid right now?

We expect it to be rebid and that will be the largest rebid in FY '07. That process will happen in FY '07. It will be an FY '08 revenue event.

And can you go over, just remind us again of what the revenue was in '06 for that?

One moment.

Yes, Shlomo, revenue from California HCO was roughly $45 million for fiscal 2006.

Okay, great. ERP, I'll squeeze one last one in, ERP has been weak for a few quarters. Can you go over what's going on over there and, your expectations going forward? Then I'll get off and let other people get in here.

Yes, you bet. You know, ERP has had a couple projects in wrap-up mode. It's taken us a tad longer, but we think we'll be out of them pretty nicely this quarter and we've actually had a couple very nice new projects starting up. So it's really just a couple projects that the costs have exceeded what our original estimate was and so we had to book some charges for them, and frankly, if ERP had been profitable systems would have been profitable so ...

Okay, thanks.

Yep.

[OPERATOR INSTRUCTIONS] The next question comes from the line of Matthew McKay with Jefferies & Co.

Great. Good morning, guys.

Good morning. [overlapping voices]

Good morning.

First question, just on Texas, is it just simply because you're breaking it out of the numbers and, there's a lot of talk about exiting businesses that you don't feel are going to be profitable, is there any possibility that you actually exit Texas all together?

Boy, it's really premature to say anything like that. It's always a possibility, but I'll tell you, in Texas, and this relates to our discussions in Texas in total, that you are aware we're in negotiations. They are intense. They are fluid, and we're going to advance them expeditiously. We hope they are successful. No guarantees, but we hope they are successful. And our goal is to continue to be involved in Texas where we continue to add value, where we continue to service the state of Texas in an appropriate fashion, and it can be profitable for MAXIMUS. Those are really the guidelines, and, you know, those are sort of our guiding negotiating points and positions. So we would like to operate within that framework. So if there's reduction in scope, we'll pursue that path if it accomplishes those guidelines.

Okay. That's helpful. And then shifting over to the license revenue, the $10 million, is-- just maybe step back for a second. How much of software revenue typically is recognized up front versus ratably in your current structure?

You know, I don't know the exact breakdown, but-- and we don't normally disclose it, but we occasionally get contracts where we have to book it ratably or as a percentage of completion, but by and large, most of our revenue from software is booked right up front.

Most is booked right up front. I will say things like LAUSD, which is a contract several years ago, because of the complexity and significant customization, we recognized that concurrent with the systems integration work. The larger they are, generally the more they are booked ratably on a percentage completion basis.

Okay. So then in terms of the shift to recognizing it up front to ratably here, is it, you know, more indicative of sort of a change in the type of work that you're doing, or is it a change in how you're writing contracts?

Actually I think there's several things in play here. You need be aware that we're very excited about the opportunities in our enterprise systems segment and those three areas where we have intellectual property, as I said in my call notes, we're going to push that real hard to get the value that I think really exists there. You know, I do think that we will continue to offer contracts that have a total solution. I do think because the solutions are getting more complicated as opposed to less complicated, it's going to draw us towards situations where ratable recognition is more appropriate versus the base simple install situations in the past.

So, for example, in these two situations, we were bundling in other third party technology provided services or technologies, like Oracle On Demand. That complicates the system, but we will expect that we're going to see more of those types of situations as customers want total solutions. I think the pendulum's swinging more towards ratable recognition and I would also reiterate that I think that has a great silver lining. I think we are taking one of the most unpredictable elements, profit elements, certainly from a profit perspective in our business model and we all know that we've had quarterly situations where we've had to deal with it, that we've all had quarterly situations where it's been very difficult to forecast with precision these licenses closing towards the end of the quarter. We take our perhaps most unpredictable element of our profit stream and make it one of the most predictable elements and I think that's a good thing.

Yes, I agree. And then does that change the software capitalization policies?

No, I don't think so. I think they are stand-alone. I think that's a separate view. There's separate guidance on this. This is revenue recognition as opposed to software capitalization.

That's right.

Okay, and then just sort of one last question. When does the focus of senior management shift away from, you know, sort of the legacy and internal issues, hopefully more towards the business development? Is that potentially December 15 when we, with the negotiations of Accenture, or is it something that's going to extend into, you know, further into next year?

Well, we've actually had -- continuing to advance our new services, new product offerings is something that we have been focused on. I do think we certainly will have additional opportunity to do that, and, you know, if we can remediate the Texas situation, that will be the number one driver to allowing us to refocus some of those energies.

Okay. Great. Thanks, guys.

Thanks.

[OPERATOR INSTRUCTIONS] The next question comes from the line of John Mahoney with BB&T Capital Markets.

Hi, guys. How are you doing?

Hi, John. [overlapping voices]

The $0.07 you mentioned for the software, the improvement, rather, in Q1--

Yes.

In Texas?

No. The--

You said you're going have a $10 million loss in the first quarter in Texas.

Oh, that's correct, that's correct.

I'm sorry. Yes, by my estimates, that's like $0.027 or something like that. Is that about right or what's the impact on the EPS basis? I know obviously you didn't give quarterly guidance, but could give us some feel for kind of seasonality consulting? As I understand that business is typically a little softer because of the holidays.

Yes, I think that's about $0.27 a share, $10 million in rough math, there's 365,000 pretax for $0.01, so that's about $0.27 in that quarter. And there is a little bit of softness and of course we do have this license situation that swings around, so that's our view. John, if I can take a little moment and just share with you a situation here to help you folks roll forward our '06 to '07, this is important point, so, if you bear with me, I would like to make that point with you. In particular, if I were to roll forward the fiscal '06 to the fiscal '07 estimates, what we've done -- if I were to take that mid range of 2.10 to 2.20, in the mid range of that is 2.15, to roll that forward from $1.76, which I do view as the fiscal '06 base operations on a GAAP basis, and we do have a schedule in the press release that gets you to that $1.76.

It's important you hook into that $1.76 to understand where it comes from, and management believes it's the right base number for fiscal '06 and start to grow that, our view in terms of providing EPS guidance for '07 is to start with that base, to take about half of the impact from the deferred revenue, which is about $0.10, okay, that gets to us a subtotal of $1.86. And then to get from the $1.86 to the $2.10, which is the base level, we expect the biggest driver, as I said in the call notes, is going to be improved project performance. And to help monetize that, I would say the big driver is going to be improving that operating income percentage and I think we can improve it from 1% to 1.5%, but even at the 1%, that's going to give us about $7.5 million, or $0.20 a share.

That gets us to 2.06, and then when I add back the benefit, or $0.03 a share from the two businesses that we divested, that gets me to 2.09, which we round to 2.10. To get to the upper end of our range from that 2.10, the biggest factor would be whether or not we can get not just 1% improvement in operating percentage, but rather 1.5%, so an additional 0.5%. Is that helpful?

That's helpful on the excluding Texas math. I was more looking at from the $0.09 you just made, the incremental $2.7 million improvement in Texas is equal to $0.07, so, that gets us to $0.07 plus $0.09 to $0.16, to $0.16. What other factors, just-- I know I'm taking a more short-term view, but the market doesn't want to be surprised often. In that December quarter, what other factors are going to affect you in the December quarter? My understanding is there is seasonality in consulting?

There is seasonality in consulting. Systems more obviously, license and project sales, less seasonal than consulting, and operations tends to be more steady. But there is vacation time, which when we have vacation time, it doesn't translate into profit so ... And we would be glad to drill down with you in terms of those factors offline as well.

Okay. Thank you.

But just the categorical factors. Okay? One other point, John, and I know you would be interested in this. When we forecast the revenue growth to be in the 5% to 10% range, you need to realize we had some revenue in there, as David said, I think about 10 million that related to prior businesses and we also had some one-time sales regarding voter equipment in '06 that won't occur in '07. So if you take a same-store sales or more organic revenue approach to it, you'll find that that revenue growth rate is more in the -- I think it's closer to 11%.

Okay. That's, that's fair. I have one more question. On the operations excluding Texas, it looks like the revenues went in the March quarter from 1.11 to 1.21 in June, and now down to 1.04 in September.

That was the voter registration going away. It wasn't the June number, John.

Okay. Thank you.

Thank you, folks.

The next question comes from the line of Jason Kupferberg with UBS.

Yes, sir.

Hey, guys.

Hi, Jason.

I was hoping you would give us more background on this latest round of Texas renegotiations. Who initiated the discussions and what's the process that is going on, and is the state involved at all in that, or is it solely between yourselves and Accenture?

Jason, we would like to do that. We know that folks are very anxious to know the details, but being in negotiations, and as I've said, they are intense, they are fluid, I have laid out kind of our benchmark that we plan to go forward with, but really given the nature of negotiations, it's really not appropriate to talk about such details, and I don't know that it is helpful to the process and I'm concerned it might not be in our best interest. We're going to have to limit it to that general and we'll certainly keep folks apprised of material developments as it relates to Texas.

Okay, and on the accounting change with the software revenues, I guess I'm just trying to understand here, you know, obviously it's applying two big sales you had specifically in the fourth quarter, but it sounds like you are making some projections in terms of how it's going to apply going forward, but obviously that will depend some on the mix of types of projects, whether they are stand-alone or integrated. So is this-- I mean are your auditors changing their approach here, or are you guys just adopting the accounting standard to what you see as a changing mix in your business? I'm a little confused on that.

Yes, that's a fair question. First off, you need to appreciate that it's a very, very complicated area of accounting, that the accounting treatment can change based upon perhaps sometimes very subtle differences in contract terms and conditions, facts and circumstances. So a lot of the accounting and there's three basic areas in the accounting methodologies that you can use, and we've used all three in the past and I expect we'll continue to use all three in the future. So we're not changing how we account for these contracts, but what is changing, think, is the mix of the terms and conditions in the contracts. So I anticipate that the nature of the terms and conditions will be such that we'll see more ratable recognition as opposed to up front recognition.

Okay.

So for example to give you an example, so you can understand it, if we simply sold a license stand-alone cost application, little to no customization, then the accounting for that is to recognize, subject to many, many conditions that we historically have met, to recognize that license up front. However, if we start to have more extensive customization or start to couple other software providers' licenses with that, which is a trend we're seeing, as we increase our install base, people are moving forward with adding additional applications. I think it's an industry trend and I think it's something we're seeing. That's good.

So as you add more complexity to these contracts, it's going to lean us more towards either percentage completion revenue recognition or ratable recognition. The other business thing I think is going to happen is I think as we go more towards on-demand accounting in some situations where we are the provider or the primary obligator of that on-demand accounting, that's going to put us in a situation of effectively pro rata or ratable recognition.

Okay, and for fiscal '07, you have put some bounds around Texas, which is helpful. Can you help us in terms of putting some bounds around where you see free cash flow and DSO coming in for the full fiscal year '07?

Dave Walker will talk to that.

Yes you bet. Our DSO's really should run in the high 90s range, so we usually vary between 95 and 100. And we would expect that normally to be true unless we have a large license that's billed and we don't have it recognized in revenue. That has an anomaly. In fact, the big bulge in receivables that we have, we've received the cash in October, so that's economically still a good thing. The free cash flow should be in the -- operating cash flow would be in the $25 to $30 million range and we tend to spend CapEx and software 15 to 18, in that range. Okay.

So free cash flow for the year could be, call it 10 to 12-ish?

Yes. [overlapping voices]

Okay. Thanks, guys.

The next question comes from the line of [Jamie Sullivan] with RBC Capital Markets.

Hi, good morning.

Good morning. [overlapping voices]

Just a quick question on Texas, on the revenue side. I know you said you're assuming kind of the existing operations with a range of losses. Should we assume that the revenue, the revenue should run at kind of where it is at the current level?

What do you have it at the current level? [overlapping voices] Maybe a little-- I think 37 is where we are, 37 to 40.

37 to 40 for '07?

Mm-hmm.

Okay, great. That's it for me. Thanks.

The next question comes from the line of Tom Meagher with FBR.

Yes, good morning. Rich, when you guys had your press release back in June, late June, I think it was, you talked about your divestiture plan that you had in place, but you also mentioned smaller acquisitions and strategic business combinations. I'm just wondering in light of the efforts you're having to put into clean up Texas, are those two options still on the table, or have you pretty much put them to bed right now and concentrating on getting Texas cleaned up?

You know, really concentrating on Texas is a primary number one to do in our global plan to optimize the current book of business and take care of these legacy overhang situations. That being said, we are still presented with M&A opportunities. We'll consider them, but they are more of a back burner secondary element than a primary element today.

Okay, and that same thing for the strategic business combination as well? [overlapping voices] Kind of being on the back burner, if you will?

Oh, no, I think the Board of Directors is obligated to consider whatever is appropriate to maximize shareholder value. So it's not appropriate for me to say that we have a process in place or don't have a process in place. That's a Board decision, but we're focused. Management is focused on the operations level and we think that's where our focus should be.

Okay. Thanks very much. I appreciate the detail.

Sure. Thanks, Tom.

Our last question comes from the line of Arnie Ursaner with CJS Securities.

Good morning. First question I have is regarding the December 15th date which you gave us, is there anything magical about that, anything specific that occurs at that point?

No, it's something we just like to, you know, you have to set a goal and we think it is a reasonable goal for us to march to.

Okay. Couple of other questions, regarding the whole IE space and obviously Texas was the first contract of what appears now clearly with hindsight to be a very challenging process, because you were-- because of your experience in Texas, are you eliminating additional IE work in the future, or-- just help us understand how you're thinking about taking on this complexity of work in the go-forward basis?

Yes, that's a great question, Arnie. I'm going to answer from two perspectives, one from an industry perspective and one from a MAXIMUS perspective. From an industry perspective, we believe eligibility is very important to the larger states. I think it is the concept which represents the need for states to improve their systems to better process, more efficiently process very important transactions within social programs. There is an interesting input article that addresses the state of the universe here, and it seems to be from an industry perspective that states will lean towards a go slower, go modular approach in these things.

As we all know, the larger the project, the faster the install, the more extensive the scope, the higher the risk. So the states themselves are very concerned about how do you do that. And Texas, you know, certainly is the most recent one with, with this initiative. So I think the states tend to compare notes and I think that's what's evolving and I would suggest you take a look at that input article. It's a very good one.

As it relates to MAXIMUS, we made this pretty clear I think back in June in our prior calls that we want to balance risks. We want to balance reward, and we believe we're very well positioned to add a lot of value in the integrated eligibility space, but it has to be on the right terms and conditions, so we're going to balance all of those factors. We expect and would very much like to be a player in integrated eligibility. We have got a customer base that's very interested in it and we have what we think is best of class capabilities in that regard, so ...

Well, to be more specific, in the backlog you have or the opportunities you are considering, is there other specific IE work embedded in that backlog, and if, so how can you give some sense of safety or security to your shareholders that we won't walk down another path where it could be quite costly?

I know there's a lot of discussions we continue to pulse those discussions. I don't believe it's a big number in our backlog today, Arnie. And again, I do want to emphasize that we are not going to chase revenue for the sake of revenue. We're going to manage our risks, so if we pursue this, I would very much like to pursue it on a modular basis, a slower go basis, a controlled risk basis. Not only very important for us and our business model, but it's as important to the states.

Okay. My final question is a financial one. Your SG&A as a percent of revenue was quite high this quarter relative to at least our expectations. Was there some number embedded in that, and to the extent again your focus seems to be on cost control, what should we expect on SG&A as a percent of sales going forward?

Yes, Arnie, our SG&A will move around depending on what we're doing, so we're involved in a lot of proposal activity. Things like that will drive it up. Year-over-year, our SG&A contains our stock option expense of about 4.4 million. So if you look at it year-over-year, it's going to look higher just simply because of the accounting differences. But it's really driven heavily by proposals, et cetera. We tend to focus on the bottom line because when those operational people are spending money on proposal, we tend to do better in the gross profit margin, so ...

Well, again, the 20% as a percent of sales was materially higher than our thought in the 17% range.

As a percentage of revenue?

Yes.

Yes, well, the revenue went down because there was less voter hardware going through, too. Right? Lower denominator.

Right.

Okay. That's my final question. Thank you.

Thank you, Arnie.

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