Unisys Corp (UIS) 2005 Q2 法說會逐字稿

Good day, everyone, and welcome to the second-quarter 2005 results conference call for Unisys Corporation.

Today's conference is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the call over to Mr. Jack McHale, Vice President of Investor Relations at Unisys Corporation.

Please go ahead, sir.

Well, thank you, operator.

Hello, everyone, and thank you for joining us this morning.

About an hour ago, we released our second-quarter 2005 financial results.

With us this morning to discuss our results are Unisys President and CEO, Joe McGrath, and our Chief Financial Officer, Janet Haugen.

Before we begin, I want to cover just a few housekeeping details.

First, today's conference call and the Q&A session are being webcast live at Unisys Investor Web site.

A replay of the webcast will be available on our Web site shortly after the conclusion of the live event.

Second, you can find our -- on our Investor Web site the earnings release and the associated spreadsheets, as well as the presentation slide we will be using this morning to guide the discussion.

These materials are available for viewing, as well as printing and downloading.

Third, today's presentation, which is complementary to the earnings press release, includes some non-GAAP financial measures.

Certain financial comparisons made in this call will be with and without the impact of pension accounting.

We believe that providing this non-GAAP information is meaningful to fully understand our operating performance because, while pension accounting is nonoperational in nature, it does impact our reported results.

On the Unisys Investor Web site, we have also provided a reconciliation of our reported results on a U.S.

GAAP basis, compared with our results excluding the impact of pension accounting.

Finally, I'd like to remind you that all forward-looking statements made in this conference call are subject to various risks and uncertainties that could cause actual results to differ materially from expectations.

These factors are discussed more fully in the earnings release and in the Company's periodic reports as filed with the SEC.

Copies of these SEC reports are available from the SEC and also from the Investor Web site.

Now, let me turn the call over to Joe.

Thanks, Jack.

Hello, everyone, and welcome to today's call.

To begin our discussion this morning, please turn to Slide 1 for an overview of our performance in the quarter.

As those of you who follow our company are aware, we are currently working through a transitional period in our business.

In particular, our results are being impacted by several challenging transformational outsourcing contracts and by weakness in our high-end enterprise server business.

We are also being impacted by significantly higher pension expense year-over-year.

Reflecting these factors, our second-quarter 2005 results overall came in as expected with services a bit stronger and technology somewhat weaker.

We reported a second-quarter 2005 GAAP loss of $0.08 per share.

This was an improvement over the $0.13 per share GAAP loss we reported in the first quarter.

Excluding pension expense, we reported a small profit in the quarter, which was within our targeted range.

Our Chief Financial Officer, Janet Haugen, will provide more details on our second-quarter results in her comments later.

But first, I would like to provide an update on the key initiatives we have been pursuing to drive improved results in the second half of the year and into 2006.

Please turn to Slide 2 for a strategic review of the business.

While the first half of 2005 was challenging for us financially, we made a good deal of progress during this transitional period in repositioning the business for future growth.

But before getting into some of the specifics of what we've accomplished, I would like first to step back and discuss our strategy in the marketplace.

The strategy we've been pursuing is to drive profitable growth by capturing selective value-added opportunities, both in services and in technology.

In services, we're focused on growth opportunities in four areas, in systems integration and consulting, particularly for our industry-leading Unisys 3D visible enterprise methodology and solutions -- in outsourcing, particularly in business process outsourcing and managed services, in infrastructure services work, and in enterprise and Homeland Security.

In technology, we're focusing on capturing growth opportunities for high-end, Intel-based ES7000 servers running Microsoft and Linux software.

In addition, we're focused on serving our ClearPath mainframe base by introducing new capabilities in that area.

We are now involved in an in-depth strategic planning process while continuing to focus our business on large dynamic markets that are expected to grow at above industry average rates in the coming years.

In the meantime, we need to improve our execution of this strategy, particularly in the area of sales and marketing.

When we talk to clients and potential clients, we find too often that they aren't aware of the full portfolio of Unisys solutions; they don't know what Unisys offers and stands for.

To compete and grow, we need to strengthen our sales and marketing skills.

We need better discipline and execution in going to market, identifying and winning value-added opportunities, and delivering our solutions to clients.

We also need to reduce our cost base to make us more competitive and efficient in the market.

Over the past six months, we've been working to enhance our execution of the Unisys strategy.

Our goal is to drive profitable growth, improve our margins and position the business for stronger results as we move toward 2006.

There are three areas in particular that we have been focusing our repositioning efforts.

You can see these three priorities summarized in Slide 3 of the presentation.

First, we have been rebuilding our sales and marketing efforts to drive stronger order and revenue growth.

Second, we have been working to lower our cost base through a series of short-term and longer-term actions.

Third, we've been addressing the operational issues of our challenging outsourcing operations and working to improve margins in this business.

I'd like to update you on where we stand in each of these three areas, now what we've reached the halfway point of the year.

Turning to Slide 4, the first priority has been to strengthen our sales and marketing efforts.

As I mentioned to you last quarter, we have slowed down our order growth in -- late in 2004 as we worked on correcting the issues in our outsourcing business.

In 2005, we have been putting in place aggressive new programs to drive stronger order and revenue growth.

This effort is being led by Peter Blackmore, our Executive Vice President of Worldwide Sales and Marketing, who joined us in February from Hewlett-Packard.

Under Peter's direction, we have been rebuilding our sales and marketing efforts with a goal of dramatically increasing our effectiveness and competitiveness in the market.

This is a broad-based multi-faceted effort that touches every aspect of our sales and marketing activities.

In the sales area, we've been strengthening our business development skills through high-impact training and recruiting world-class sales management and personnel from leading outside firms.

We are recruiting experienced sales executives to more effectively manage our large accounts and also drive business to new customers.

We've also made adjustments to our sales coverage model in our focused geographies and industries, and we are pursuing aggressive activity management to drive order growth.

We have strengthened our alliance program; we have a number of strategic alliances that, with the right focus, can deliver growth in the areas of services, outsourcing and technology.

For example, Microsoft, Oracle and EMC are all strategic partners of ours where we have established new growth programs.

We are also exploring more alliances with new partners.

In the marketing area, we have significantly enhanced our efforts to support our sales force.

We are conducting aggressive marketing programs to drive revenue and client wins in our focused areas, in outsourcing, security, in 3D-VE and consulting and infrastructure services and the ES7000.

To increase the effectiveness of our marketing efforts, we have also centralized our worldwide marketing programs.

We have combined our marketing and communication functions and recruited high-level marketing personnel from leading outside companies.

As part of our more aggressive marketing efforts, we plan to relaunch the Unisys brand.

We are planning a proactive campaign to expand awareness of Unisys and what we stand for in the marketplace.

Look for more details on this program in the fall.

We have much more work to do in driving these programs.

I am pleased, however, with the progress that we have been making.

After a slow order performance in the second half of 2004, we've seen a strong recovery of orders in the first half of 2005.

Please turn to Slide 5 for an overview of our orders.

As you may recall, we saw good order growth in the first quarter.

We continued that momentum in the second quarter.

We showed double-digit services order growth in the quarter against a strong order quarter a year ago.

In the first half of 2005, we achieved double-digit order growth in systems integration and consulting, infrastructure services, and the ES7000.

We also continued to close significant multi-year annuity-based services contracts.

During the second quarter, we received a three-year contract extension from the State of New Jersey valued at approximately $90 million to continue managing the state's Medicaid Administration Services.

Also in our outsourcing business, in early April, we received a five-year, $68 million order from a group of U.S. telecommunication companies to provide IT infrastructure outsourcing service.

We also won a number of smaller but significant outsourcing contracts from major clients in the quarter.

They include Cadbury Schweppes, Andersen Corporation, TeliaSonera and Mercuri Urval in Sweden, Tre-For in Denmark and CAN TV (ph) in Venezuela.

In our systems integration business, we won a strategic contract from China's Beijing Capital International airport to develop and integrate the core operational system for the airport's new international terminal, which is being built in preparation for the 2008 Olympic Games.

We expect our order momentum to continue in the second half, and we're looking for strong order performance in the third quarter.

Moving to Slide 6, we are also seeing good order activity for some of our significant, targeted programs.

For instance, one of our most important initiatives has been to drive growth in the Unisys 3D visible enterprise methodology and solutions. 3D-VE is an industry-leading approach that helps organizations model and to see the cause-and-effect relationships among their strategy, processes, applications and IT infrastructure.

It is a consultative-driven methodology that typically builds from workshops and leads into consultative assignments and from there to other services and technology opportunities.

We have been aggressively marketing our 3D-VE solutions in customer seminars, on our Web site, and in a new series of global corporate advertising that we launched in the second quarter.

Because 3D-VE is consultative-driven, we expect to see the results of these efforts first in our consulting business.

We were pleased to see substantial double-digit order growth for systems integration and consulting in the second quarter.

We are seeing strong interest in 3D-VE and our 3D-VE-based programs among clients and potential clients.

Overall, we are pursuing some 200 opportunities with a potential value in billions of dollars.

In our technology business, while we had a tough second quarter for our technology products, we continued to take actions to improve sales of our high-end servers.

As you know, the ES7000 is the growth platform in our technology business.

For the past several years, we have been steadily enhancing this platform with leading-edge capabilities.

Our goal is to keep the ES7000 in a leadership position in the Intel-based server market by continuing to expand the capabilities of the platform.

In the second quarter, we took another major step forward in this effort by launching the ES7000 real-time capacity series of products.

These are uniquely styled servers that offer the industry's first capacity on-demand capability for Intel servers running Windows and Linux.

This new technology allows clients to cost-effectively plan for peak levels of demand in their business.

Each new Unisys ES7000 RTC server is shipped with surplus capability, consisting of additional processors.

It's these extra processors -- these extra processors can be activated and paid for only when and if they are needed.

As a result, clients can build more flexible, responsive infrastructures, those that can be adapted quickly as their business requirements change.

After good growth in 2004, we continue to see solid growth in our ES7000 platform.

The ES7000 showed high single digit revenue growth and substantial double-digit order growth in the second quarter.

About 30% of the ES7000 systems shipped in the quarter went to new Unisys clients.

We also continue to launch innovative new products and solutions in our ClearPath family of mainframes.

A few weeks ago, we added new offerings to ClearPath, allowing these systems to run mainframe applications based on J2EE and JBoss open standards.

We also added an innovative pay-for-services pricing environment that allows customers to pay for computing power based on a predetermined business metric such as number of accounts or transactions.

This adds to the metering pay-per-use technology we announced last year, which has been very well-received among our clients.

More than a third of new ClearPath systems delivered today are used in a pay-per-use business environment.

As we drive these new programs, we look for improved sales of our technology products in the second half, particularly in the fourth quarter.

Moving to Slide 7, our second key area of focus has been to reduce our cost base.

During the second quarter, we essentially completed the cost reduction actions that were announced in late 2004.

These cost actions are aimed at reducing our annualized cost base by about $70 million by the end of 2005.

As part of our efforts to reduce costs and improve our margins and cost-competitiveness, we also continue to expand our use of low-cost offshore resources in our engagements.

As a global company, we're making use of lower-cost resources in locations across the globe.

Last quarter, I mentioned that we had recently opened a new global service center in Bangalore, India.

We are currently in the process of establishing another center in Budapest, Hungary that will support our European business.

In early 2006, we plan to open a support center in China.

These centers will support both internal Unisys and external client business work in applications development, help desk, outsourcing and other areas.

We are beginning to see some benefit from our cost-reduction actions.

We reduced our SG&A expense as a percentage of revenue by nearly 1.5 points, excluding pension expense, in the quarter.

We continue to target getting this SG&A expense ratio down below 17% of revenue by the end of 2005.

One final note on cost reduction -- we continue to expand our Six Sigma lean program.

This effort, which we launched earlier this year, is aimed at significantly enhancing quality, reducing costs and waste, and improving cycle times across the Company.

We are pursuing Six Sigma improvement programs in key areas company-wide, such as cross selling, chargeability, Accounts Receivable management, and sales delivery.

We also continue an aggressive training effort that is allowing us to expand Six Sigma into other geographical regions and individual business units.

We expect to see results from these efforts in 2006 and beyond.

In addition to sales and marketing and cost reduction, our third area of business focus has been to address the issues in our challenging outsourcing contracts that have been impacting our results.

Please turn to Slide 8 for an update on these initiatives.

You will recall that, as we've mentioned in the past, there are several challenging transformational outsourcing operations that have been impacting our results in recent months.

These contracts are in our business process outsourcing, or BPO business, where we've encountered some problems in transforming the operations, which resulted in higher-than-expected costs.

Over the past six months, we've been working proactively to address these problems.

We've been doing this in a variety of ways, including renegotiating terms of the contracts with customers, renegotiating labor contracts, hiring new personnel, and streamlining business processes.

While we are making progress in these areas, there are two large transformational BPO operations that are significantly impacting our margins and it is taking longer than we expected to work through these issues.

Both are multi-client utility operations where it's been more difficult than we anticipated to migrate clients to a standard, common platform.

In one of these operations, we've renegotiated the labor contract and added a new customer to the operation to drive higher volume.

This has provided some improvement to the business, but we are still pursuing other steps to improve the financial results of this operation.

The second operation is our check-processing utility in the UK, which is generating approximately 200 million in annual revenue.

This is structured as a joint venture between Unisys and our banking partners, and we are currently in discussions with our partners to possibly sell our ownership position in the joint venture and/or make other changes to service agreement.

We currently have approximately 235 million of outsourcing assets related to this operation.

While we believe that our ongoing discussions will result in the recovery of these assets, the final outcome of negotiations could differ from current expectations, which may impact our ability to recover the assets.

We are working aggressively to address the issues in these two challenging contracts.

We hope to resolve the issues by the end of the year, so we can enter 2006 in a significantly improved financial position for these operations.

Because it is taking longer than expected to work through the problems in these contracts, we are tempering our financial outlook for the second half of 2005.

While we continue to look out for a strong second half, particularly in the fourth quarter, we now look for earnings per share, excluding pension expense, of between $0.33 and $0.38 for 2005.

Janet will discuss our outlook in her remarks.

Let me reiterate that despite the issues we face in the BPO market, we are not stepping away from this market.

This is a high-growth area of the market which is expected to continue to grow at a rapid clip over the coming years.

What's more, this is an area where Unisys offers tremendous strength through our services and vertical industry expertise and solutions.

We are, however, modifying our approach to pursuing utility arrangements to ensure that any utility operation we establish can be based on a standard platform, which is critical to the feasibility of this utility approach.

Our check-processing utility in The Netherlands, which serves continental Europe, is successful using a standard platform approach.

It is profitable and growing.

In addition, our other outsourcing businesses continue to do well.

Our infrastructure managed services business grew very substantially in the second quarter, as we continue to book strong orders in that business.

Our datacenter, or ITO business, is also growing and profitable.

In fact, in its new 2005 evaluation of datacenter outsourcing service providers in North America, Gartner has listed Unisys in the "Leaders" quadrant.

So outsourcing remains a key growth area for Unisys and as we get these challenges behind us, we are confident we will return to profitable growth in this business.

Turning to Slide 9, in summary, while the second quarter was challenging, we continue to make progress in our strategic focus areas.

We delivered double-digit order growth overall.

We grew our services revenue and showed continued growth in our services orders.

We are making progress in reducing costs and expanding our use of low-cost resources.

We continue to make progress in our outsourcing business, and we're working aggressively to improve the challenging outsourcing contracts that are impacting our services margins.

We look to continue this progress in the second half and to show continued financial improvement.

Now, I will turn the call over to Janet Hogan for a review of our second-quarter results and our financial outlook going forward.

Janet?

Thank you, Joe.

Hello, everyone.

This morning, I will review our second-quarter results, including our cash flow performance, and I will also update our financial outlook for 2005.

To begin, please turn to Slide 10 for an overview of our orders in the quarter.

We had a strong order performance in the second quarter.

Overall, our orders showed double-digit growth in the quarter, compared to a year-ago level.

Both services and technology orders grew in the quarter; service orders were up double-digits, driven by substantial order gains for infrastructure services and systems integration and consulting.

Outsourcing orders, which can vary from quarter to quarter based on the timing of contract signings, were down in the second quarter but are up for the first half overall.

Technology orders showed high single-digit growth in the quarter.

This was driven by substantial order gains for the ES7000.

For a summary of our income statement results in the second quarter of 2005, please turn to Slide 11.

At the top line, we reported revenue of $1.44 billion, which was up 3% from the year-ago period.

This was driven by 7% growth in our services business, which more than offset a 13% revenue declined in technology.

At the bottom line, we reported a second-quarter loss of $27.1 million, or $0.08 per share, which was in line with our expectations for the quarter.

Our second-quarter 2005 results included $46 million of pre-tax pension expense, or $0.09 per share.

This compares to a pretax expense of $25 million, or $0.05 per share, of pre-tax pension expense in the year-ago quarter.

Excluding pension expense, we reported net income of $4.1 million, or $0.01 per share, in the quarter, in line with our expectations.

Please turn to Slide 12 for an overview of our second-quarter revenue by geography.

Our U.S. revenue increased 6% and represented 47% of our revenue in the quarter.

Within our U.S. business, we saw strong double-digit growth in our federal business.

Revenue from international regions was up 1% in the quarter and accounted for 53% of our revenue in the quarter.

Currency had a 3 percentage point positive impact on our revenue in the second quarter, reflecting weakness of the dollar against international currencies.

On a constant-currency basis, our overall revenue was up slightly and our international revenue was down 4%.

Moving now to revenue by business segment, as you can see in Slide 13, services revenue increased 7% in the second quarter and services represented 86% of total revenue in the quarter.

Our technology revenue declined more than expected in the second quarter as conditions in this market continue to be weak.

Technology revenue declined 13% in the quarter and accounted for 14% of our total revenue in the quarter.

Please turn to Slide 14 for more details of our revenue by business segment.

In our services segment, we saw growth in all areas except for core maintenance.

Our outsourcing business grew 13%, our project-based services, consulting and systems integration and infrastructure services, each grew 7% in the quarter.

Growth in these areas more than offset a 12% decline in core maintenance, which we had anticipated would be down low double digits for the year.

Turning to Slide 15, within technology, we saw revenue declines in both enterprise servers and specialized equipment.

Enterprise server revenue declined 10% in the quarter, while specialized technology sales declined 24%.

Within enterprise servers, ClearPath sales were down in the low double digits, while the ES7000 sales showed a high single-digit revenue increase.

We were encouraged by the good order growth for technology products in the quarter, primarily driven by order growth for our ES7000 servers.

As we look ahead to the second half, we expect our enterprise server sales to show growth, driven by growth in both ClearPath and ES7000 sales.

However, it's hard to call how the technology revenue will flow by quarter in the second half.

Moving onto expense trends and margins in the second quarter, SG&A expenses, excluding pension expense, represented 18% of revenue in the quarter, down from 19.3% in the year-ago quarter, as we benefit from our efforts to control and reduce expenses.

We expect to see more benefits from our cost reduction actions in SG&A in the second half of 2005.

R&D expenditures, also excluding pension expense, were down about $7 million or 11% in the quarter.

The decline reflects our ongoing efforts to leverage open-standard technology from our partners and streamline and improve efficiency within our development operations.

Slide 16 shows our operating margins in the current and year-ago quarters.

Our overall operating margins continue to be impacted by the challenging outsourcing contracts, weak enterprise server sales, and pension expense.

Excluding pension expense, we reported a second-quarter 2005 operating margin of negative 0.8% in the quarter, down from a positive 3.4% a year ago.

Slide 17 provides a comparison of our services operating margin in the quarter.

Excluding pension expense, we had a services operating margin of a negative 0.6% in the second quarter of 2005, compared to a positive 2.5% in the year-ago quarter.

On a sequential basis in 2005, our services operating margin in the second quarter, excluding pension expense, improved significantly from a negative 3.2% in the first quarter of 2005.

Looking ahead, we expect to see continued sequential improvement in services margins in the second half of the year.

This is based on our expectations for higher services revenue, lower expense levels, and improvements in outsourcing.

Moving to Slide 18, margins in our technology business in the quarter were impacted by lower sales of enterprise servers and by the mix within those sales.

The mix this quarter was not as rich with higher-end models and software as it was in the second quarter of 2004.

Excluding pension expense, we reported a negative 2.1% operating margin in the technology business in the second quarter.

This compares to a positive 6.7% operating margin in the second quarter of 2004.

We look for improved operating margins in the technology business in the second half, particularly in the fourth quarter.

Now, please turn to Slide 19 for our cash flow and balance sheet details.

We generated $64 million of cash from operations in the second quarter of 2005.

This was down from $108 million in the second quarter of 2004.

The decline was primarily due to lower income.

Capital expenditures in the second quarter of 2005 were $112 million, down from $114 million in the year-ago quarter.

About $76 million of our capital expenditures in the quarter were for revenue-generating assets.

After deducting capital expenditures, we used $48 million of cash in the second quarter of 2005, compared to a $6 million cash usage in the year-ago quarter.

A few other notes on cash flow and the balance sheet -- in the second quarter, we received, as anticipated, a $39 million income tax refund from the U.S.

Internal Revenue Service relating to a tax audit settlement from 2004.

Depreciation and amortization was $93 million in the second quarter of 2005.

Looking forward, our expectation for capital expenditures for the full year of 2005 continues to be in the 365 to $380 million range.

We expect depreciation and amortization to be in the 360 to $370 million range in 2005.

At the end of the second quarter, we had no borrowings against our revolving credit facility, and we ended with about $400 million of cash on hand.

Moving on, let me provide a quick update on the cost-reduction actions we announced in the third quarter of 2004.

In the second quarter, we essentially completed the plan for the 1400-position reduction.

The actions will require about $65 million of cash in 2005, but this cash usage is being offset by the proceeds from U.S. and international income tax refunds, as well as expected cost savings from taking the action.

Turning to Slide 20, I'd now like to update our financial outlook going forward.

With regard to our results, excluding pension expense, we look for continued sequential profit improvement in the third quarter of 2005.

Excluding pension expense, we expect third-quarter 2005 earnings per share to be about $0.04 to $0.06 positive.

We expect revenue to be up mid single digits versus a year ago.

Based on today's rates, currency should have around a 1 percentage point positive impact on our third-quarter 2005 revenue comparison.

We look to close the year with a very strong fourth quarter, particularly in our technology business.

However, based principally on the current status of negotiations of our challenging outsourcing operation, we are tempering our overall outlook for profitability for the full year of 2005.

We now look for full-year 2005 earnings per share of between $0.33 to $0.38, excluding pension expense, and we look for our revenue for the full year of 2005 to increase in the low single digits from 2004 level.

Although we have tempered our earnings forecast for the full year, we are still working aggressively to reach $50 million of free cash flow for the year.

Reaching this goal will depend upon the timing of contract signings and related prepayment.

Now, I'd like to turn the call back to Jack for questions.

Well, thank you, Janet and Joe.

Operator, we are now ready to open up.

Thank you, sir. (OPERATOR INSTRUCTIONS).

Ashwin Shirvaikar from Citigroup.

I have a two-part question.

Part one is, if Unisys remains sort of a two-part business, including technology and services, then both technology and services need to work.

So, could you tell us what it will take to stabilize ClearPath, which really is your highest-margin product?

Could you provide more information on the margin trends for ES7000?

Part two of the question is, in your view, should Unisys be a two-part business and should you be actively investigating sort of split of the Company?

Thank you, Ashwin.

Let me start with the first part of your question.

The reason we are a two-part business is we really believe that there is a high degree of synergy between both parts of our business.

Even though 30% of our ES7000 business is in new accounts, that means 60% are in current accounts and very often, especially with the ES7000, there's high synergy between systems integration outsourcing and so on.

For example, in our highly successful West Virginia Medicaid business, the core of that and the core of our price performance advantage and why we won it in the first place was the ES7000.

Let me come back more specifically to the two parts of your question.

Frankly, we have been disappointed by the softness of the ClearPath part of our business.

There have been enhancements that we recently introduced for both members of that family, the Libra extensions as well as the Dorado extensions.

We don't really see the payoff of those coming until the fourth quarter, as Janet said a few minutes ago, but we really think that you're going to see a real pick-up in aggressive growth in the fourth quarter.

There's a second program behind just the core enhancement of those products.

So, there's performance improvement and other things.

But for us, we also changed the quarter (ph) in opening these systems as part of something we call the ClearPath Modernization Program.

It's just now that we can run native J2EE on even the closed side of this, and we can run J2EE and .net on an open hybrid implementation of this.

I think you're going to see a real ramp up, again not starting until the fourth quarter, of the ClearPath business, and we believe we can stabilize that.

There's a long history of loyal customers from that business that we have leveraged into much broader relationships, and some of which are largest ongoing revenue streams that are now community-based that often exceed 100 million a year from a single client.

The second part is ES7000.

Even though we talked about high single-digit growth but double-digit order growth for the ES7000, what wasn't visible is we actually grew units by 60%.

So, we expect a good second half for the ES7000 as well, and a lot of that will be around the alliance programs we mentioned with Oracle and Microsoft and some of those partners.

So, we believe, in the second half, you're going to see some real recovery in both sides of that business, but for slightly different reasons in each of them.

Now, one of the things that we have not chosen to do -- consciously -- is to move downstream in this market.

We still have the largest share in what's called the Big Windows market for the ES7000, and we have resisted the temptation to move in the commodity margin business, the lower, four-way servers, which is today dominated by Dell.

So, we believe we've picked our segments wisely; we think we're making the right investments.

You'll start to see the payoff for that in the third quarter for the ES7000 but not until the fourth quarter for the ClearPath family.

On the services side, as you know and we've talked with you personally, the single biggest drag on services gross margins are those outsourcing contracts, specifically the two that we've just talked to you about.

You've heard, on the first one, we made improvements by adding new clients, renegotiating labor contracts, a whole series of actions.

It's still not where we need it to be and we will continually aggressively work that in the second half when we expect to see, by the beginning of 2006, some real improvement.

The biggest and the most challenging is the second one that we gave you a little more detail and color on today.

It's more complicated, and the reason the negotiations have taken us longer is it's a joint venture.

It's a multi-client joint venture with a very, very complex operating environment.

So, that's been the toughest challenge for us.

Frankly, Larry and I are personally working that one to fruition.

We have no higher priority between the two of us in the Company, because of its impact on gross margins in our services business.

When we resolve these two, when we resolve these two in the second half of the year, you'll see a tremendous uplift in services gross margin there.

It is far and away the single biggest drag we have.

So, let me look back to your original opening part of the question and how you closed it.

We still believe there's high synergy across these businesses.

We actually use even engineers from the R&D labs in the systems and technology group in designing complex multi-vendor, very complex systems integration and outsourcing projects.

So there is a high degree of synergy between these businesses, and we do not intend to manage them separately but rather take advantage of their combined synergistic effects.

Thank you, Joseph.

That's very helpful.

Jim Kissane from Bear Stearns.

Joe, based on what you know are the problem contracts and the new business that you're signing, what's a reasonable target for services operating margins?

You sort of intimated that the gross margins will be a lot higher once you get through the problem contracts, but if you include the new business that you're signing, give us a sense?

Thank you.

Yes, Jim, you know our long-term target has and always will be 10%.

Because of this, you know, we frankly have really pushed that goal a lot further out.

I think, if you look of the marketplace overall, with certain rare exceptions, you'd see most of the tier one companies in that 8 to 10% range.

We don't intend to change our goal, but we have a challenge on the way to get there.

You will see a real step change as we deal with these two big outsourcing contracts.

That's not to say that we don't have margin improvement opportunities in every other area, because we do.

Like every other major supplier in this business, we believe there's constant opportunities for taking costs out of our infrastructure.

When we say that, we don't just mean headquarters, SG&A; it's across our entire services business; it's about driving labor productivity, in terms of getting to higher levels of chargeability and expanded control.

Because of that, because of cost-out, labor productivity and streamlining, that's the reason this whole Six Sigma program became so critical to us.

People normally think of Six Sigma when they think of manufacturing process redesign or maybe supply chain redesign.

I think you're going to see this idea of Six Sigma become much more important in services industries because, as you've seen in the marketplace and some actions of some of our competitors, taking costs out and becoming a -- maybe not least cost but a low-cost provider, becomes extremely important.

Other elements that are critical to us is driving lower-cost labor streams.

We've talked previously about India.

This movement of both call centers and delivery to Hungary is an important piece of it; the movement to China is an important piece of it.

As you saw the last week or so, this drive to lower-cost labor, the lower-cost infrastructure, to being more lean and mean -- and again for us driven via Six Sigma -- is a never-ending battle and a race with no finish line.

Joe, if you just adjust for these two problem contracts, what would the services operating margins be?

Well, Jim, you know we haven't shared that with you in the past and we don't intend to today, but it will have a big impact.

But it's not the whole job, and there's other things that we have to do, some of which we just mentioned.

You know, the global sourcing phenomenon, you know, we have to move faster on and we have to get -- we already have a large portion of our total resources in low-cost countries, but we have to even get a higher percentage of them over time.

Janet, any sense what the pension expense will be in 2006?

Well, obviously, that's going to depend upon where the interest rates are at December 31 and how the markets perform through the second half of this year.

So we will not be providing guidance as to what the expense is for '06 until we get later into the year.

Jennifer Dugan with Merrill Lynch.

Yes, thanks.

I was wondering, could you tell us what's included in the other income this quarter?

Sure, Jenny, in the other income, which you know from following us can vary from quarter to quarter, the most significant item in there is the equity income from our joint venture and long-standing joint venture in Japan.

That has improved from the second quarter of last year 'til now, and that is the major driver in this link.

In both years, we do have FX gains.

FX gains, okay.

Secondarily, on the check-processing joint venture, could you go in a little bit more?

What's really the problem there?

It seems like initially the problem was getting these contracts set at kind of the rollout phase, but since you're considering selling it, it sounds like maybe the overall pricing related to that joint venture is not attractive to you.

Can you just tell us a little bit more about what's going wrong with the joint venture?

Yes.

What we tried to describe a little bit earlier was the core of the overall business model was about -- (technical difficulty) -- a utility, was about a single process and a single platform.

That's where we struggled.

Now, you'd have to look at almost the dynamics between multiple parties in this joint venture, their legacy systems in this evolution to one common system, one common platform.

That has been the single biggest barrier, and in this joint venture, although, you know, I think you can go figure out who's in it with us, there's three major partners and there's a total of ten different banks.

So, a very valuable lesson learned from us the hard way about this evolution to a common platform.

That's the reason that our similar system, frankly, in the Netherlands is so successful.

We did not vary from a common system, a common platform.

That's why other of our BPOs around the world, in Malaysia and other countries, are a common system, common platform.

This barrier has just been a phenomenal barrier, considering the complexity of the operation.

Three other joint venture partners had ten total banks.

That's a challenge, rather than pricing per se.

It was the economies -- or, sorry, the reductions we could get out of this common system; that was the struggle.

Going into the joint venture, all of the partners hadn't agreed to go to a single platform?

I'm going to be careful of how specific I am here, but that was the original vision.

That was what?

That was the original vision of the four original partners.

But that doesn't sound like that was actually spelled out in the contract?

Yes, we are in negotiations, so if I sound as though I'm treading softly, it's because we are in negotiations.

Cindy Shaw from Moors & Cabot.

Thanks, a couple of questions on the challenging contracts in the BPO sector -- it sounds like that your expenses are reducing related to those contracts on a sequential basis and getting better, even though we are expecting them to continue through the second half.

If you could confirm that and comment in terms of if you think those expenses might carry into next calendar year?

Then I had a couple of housekeeping questions.

Yes, the answer is we've made improvement, especially remember the first one that we talked about, but there are fairly substantial challenges that remain.

Frankly, taking the second, the bigger one that we talk about, that requires a serious renegotiation, so just by continuous cost improvement, that cannot get us to where we need to go.

We will have to negotiate our way through this and as you've heard from my response a second ago, Cindy, we can't give you the specifics of those negotiations but that's what will get us over the final step.

Can you comment at all if you think it sounds like there is potential then for that to carry into next calendar year?

You mean the negative?

Yes.

No, it's fully our intention to be out of this by the end of the year.

Oh, it is?

Okay.

Then the housekeeping questions -- if you could -- I would assume your free cash flow numbers changed along with your earnings guidance for the year.

If you could give us a bookings number for the second quarter?

Cindy, in my comments, I said that even though we tempered the outlook for profit for the second half of the year, we still are aggressively targeting for a 50 million free cash flow number.

Obviously, with the change in the guidance, that makes that more difficult to obtain but we are still aggressively going after that 50 million free cash flow.

It will depend upon the timing of the contract signings, how early we get them done in the second half, how skewed the technology is into the fourth quarter and prepayments from customers related to contract signings.

Was there anything in particular the changed that makes you think you can still hit the number?

We just believe that generating free cash flow has always been an emphasis from the management team, and we will continue to do our best to strive for that 50 million free cash flow.

I know you don't always give booking numbers.

Will you share one for the second quarter?

Well, just as we mentioned, the booking -- you're right, we do not give the bookings number, we just close the backlog on an annual basis.

But we did comment on the strong growth we had in orders in this quarter.

I think you can infer from that what that -- that we've seen an improvement in our backlog, because we were particularly pleased by the order growth.

Julie Santoriello with Morgan Stanley.

Good morning.

Joe, one more for you on the problem BPO contracts -- I will apologize for keeping this theme going here.

But what I'm wondering is, you know, in the past, when we've seen outsourcers with problem contracts, in several cases, they've ultimately ended up just exiting those contracts.

You've mentioned that maybe one of the alternatives is selling this position in the joint venture in check-processing.

Can you share with us your thoughts on that?

I mean does it -- at some point, does it become -- make more sense to just exit it and maybe take the hit on the revenue line but begin to see your operating margins improve that much sooner?

Yes, our objective in this is not necessarily to sell it, and maybe I wasn't clear in how I spoke before, but it's an and/or thing.

We believe we are in the right levels of negotiations with our partners here that they are prepared to make the changes on their side that will close this gap.

Now, it may end up in us selling our ownership share in this; it may end up just redesigning rates and tariffs and the change program.

But we are convinced, between us and ourselves, that, by the end of the year, we can successfully negotiate that.

That's not to say we will be completely out of this.

What that means is that we would be a service provider to this engagement but the operational ownership might change hands.

So, we wouldn't completely exit but we would be a subcontractor to the new entity if that was the direction that we took.

But I believe the negotiations are proceeding well and I'm cautiously enthusiastic about the final result.

Do you think ultimately, under a newly negotiated arrangement, you'd be able to get operating margins on that business close to the long-term target of 10%?

I wouldn't go that far.

Today, it's a real drag, and I think the real answer is just by reaching the conclusion that we're working with them, it will allow us, in a larger sense, to get to those because it is not -- is not such a drag on the existing business.

So even if we just closed that gap in a meaningful way, it will allow us to get inside of the range I discussed earlier -- goal, 10, you know, the acceptable range is that 8 to 10 range.

Okay.

If I recall correctly, about this time last year is when we first saw I think two other problem contracts arise.

Have you specifically been able to renegotiate those on good terms -- (multiple speakers) -- second half are not a drag?

Yes, and you know my disclaimer here.

We can never say that we will never see another problem again, as you see from other people in this segment.

That said, we've made great progress in getting what I will consider the vast majority of these things behind us.

The two key ones are the ones we felt we had an obligation to share with you, a combination of both our progress and our timetable with and the magnitude of the issue.

So, I think, with the exception of these two, our problems are largely behind us.

That's not to say that it could never happen again, but we've done a very rigorous root-cause analysis of why it's forced us to redesign how we do due diligence, how we ramp up these contracts, how we manage them, how we monitor them.

We learned some lessons in a very tough environment, but I believe those lessons are becoming institutionalized.

If you could just turn quickly to more the demand picture and the competitive picture, we heard from IBM the other day; they had a very good quarter in terms of bookings and outsourcing, and they pointed to a strong outlook.

It was quite a strong turnaround for them in the second quarter versus the first quarter.

I'm wondering I guess two things -- if you are seeing them more competitive in the marketplace, and if you are also seeing any kind of improvement in the pipeline?

Yes, in terms of our pipeline, normally, with the way we've shared it with you this, is that we always have at least 12 or more 100-plus - $100 million-plus contracts.

We have a very attractive pipeline going forward; there's quite a number of $100 million deals.

They are all in what we believe to be our sweet spot.

A fair number of those are in the public sector and fairly they are balanced around the world.

Very large or a fair number of them are in the federal business, a fair number of them are in state and local government around the United States; others are in federal government around the world.

The second largest chunk of those are in the financial-services sector, so we believe at least across those two sectors, we are pursuing a pretty aggressive pipeline.

You know we don't comment on competitors, but we see all the major players in these deals once they are over $100 million.

So, we believe, because of the ones we target, we are very careful in what we choose to chase and not chase.

We believe, especially with some of the sales and marketing initiatives we talked about earlier, you will continue to see our win rate hit rate go up.

So we're gaining momentum and confidence going forward that our sales and marketing improvements are really taking effect.

Great, thank you.

Just one more quick one on hardware -- the clients that we're seeing in the revenue and the server business, would you attribute any of that to the change among customers in terms of purchasing decisions?

Is pay-per-use demand one of the reasons why you're not seeing as much growth there as you might have expected?

That's a great question.

We will see, over time, some migration of what would be a traditional hardware business into a service business, frankly.

I think the real issue is there's been a softness across the board; it's not just us.

You can look at our competitors in this space out there, especially in what I will call the high end of the market.

Just look at a few of the other announced results over the last week or so, and you'd see that same softness at the very high end of proprietary.

Even at the high end, very high end of the Microsoft business, we're starting to see that come back -- or the ES7000 first in Q3.

We expect to have, despite the softness of the first two quarters and continued softness in the third quarter, a pretty strong ClearPath year that will largely be delivered in the fourth quarter.

These are kind of named accounts that we know and we know the timeframes and what it takes to make these things happen.

That does conclude today's teleconference.

We do appreciate your attendance.

You may disconnect at this time.