Unisys Corp (UIS) 2007 Q3 法說會逐字稿

(OPERATOR INSTRUCTIONS) Good day and welcome to the Unisys third quarter 2007 results conference call.

At this time, I would like to turn the call over to Jack McHale, Vice President of Investors Relations at Unisys Corporation.

Please go ahead, sir.

Thank you operator.

Hello everyone and thank you for joining us this morning.

Earlier this morning, Unisys released its third quarter 2007 financial results.

With us this morning to discuss the results are Unisys' CEO Joe McGrath and our CFO Janet Haugen.

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

First, today's conference call in the Q&A session are being webcast by the Unisys investors website.

This website, includes--- including the question-and-answer session is being recorded and will be available as a replay on our website shortly after the conclusion of the live event.

Second, you can find on our investor website, the earnings release as well as the presentation slide that we will be using this morning to guide the discussion.

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

Third, today's presentation, which is complimentary 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 retirement expense and restructuring charges.

In the presentation, we have provided a reconciliation of our reported results on a U.S.

GAAP basis compared with our results excluding the impact of these items.

Finally, I'd like to remind you that all forward-looking statements 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 the SEC reports are available from the SEC and also from the Unisys investor website.

Now let me turn the call to Joe.

Thanks, Jack.

Hello everyone and welcome to today's call.

To begin our discussion this morning, please turn to slide one.

Two years ago this month we announced an aggressive plan to fundamentally reposition Unisys in the marketplace and achieve a competitive profit level for this company.

We aimed high setting a goal of 8 to 10% operating profit margin excluding retirement expense.

Given where we were coming from, this would represent a huge leap forward.

Today, two years later, we can point to clear, strong and continuous progress.

In fact, as I'll show you in a few moments, we have increased our services operating profit to a level we haven't seen in nearly four years.

That's not where we want to be at, we still have challenges to work through and opportunities we plan to take advantage of.

But I am very encouraged by the transformation we're seeing in this company's profile and business model.

I'm proud of the work our people have done and the tenacity they have shown in stepping up to a big challenge.

We look to close out this year with a strong fourth quarter.

Our CFO, Janet Haugen, will go through the financial results in detail in a moment.

Please turn to slide two for financial highlights.

Starting with orders, our services orders showed single digit growth in the quarter and year-to-date.

Our services order growth in the quarter was driven by growth in out sourcing and infrastructured services while systems integration orders were down in the quarter following substantial gains in the second quarter.

Systems integration orders were up slightly through nine months.

At the top line, revenue was down slightly in the quarter as we continued to rationalize our portfolio.

Within our revenue base we continue to see a shift towards strategic programs while we de-emphasize lower value-added areas of the portfolio.

In our services business, which now represents 87% of our business, revenue was flat in the quarter.

We saw continued revenue growth in outsourcing which was offset by declines in infrastructure services and core maintenance.

We did see a positive sign in our systems integration and consulting revenue which was flat in the quarter following declines over the past year.

Technology revenue declined 9% driven primarily by a continued secular decline in the marine train revenue.

We expect a strong rebound in this business in the fourth quarter.

At the bottom line, we reported an operating profit of $44 million in the quarter.

This is an $87 million improvement from a $43 million operating loss a year ago.

Our tax expense more than doubled in the quarter and we also incurred $19.3 million in other expense compared with slight other income a year ago.

Including these items we reported a net loss of $31 million in the quarter.

This compared to a $77.5 million net loss a year ago which included a restructuring charge.

As we implement our repositioning program we continue to see significant improvement in our profitability.

Slide three shows how overall operating profit margins have progressed over the past two years.

This is on a GAAP basis including restructuring charges and retirement expense.

Slide four shows our operating margin progress on a non-GAAP basis excluding retirement, related expenses and restructuring charges.

As you can see on this slide, we improved our non-GAAP operating profit margin to 4.6% in the third quarter.

This is a 170 basis point improvement over the year ago quarter.

This year-over-year margin improvement is even higher in our services business.

Slide five shows our service operating profit margin over the 2006 to 2007 period on a GAAP basis.

Slide six shows our services operating margin progress on a non-GAAP basis excluding retirement expense.

As you can see, we increased our services operating profit margin to 5.3% in the third quarter.

This is the highest services operating profit margin that we've achieved in 15 quarters, going back to the fourth quarter of 2003.

We expect this improved services margin trend to continue in the fourth quarter.

We're also expecting a strong rebound in technology revenue and operating profit in the fourth quarter.

The combination should enable us to close out 2007 with continued year-over-year improvement in our overall operating margins in the fourth quarter.

We're achieving this margin progress despite two issues that have been weighing on operating profitability this year.

Those two issues are higher temporary contract labor cost and weakness in our systems integration and consulting business.

Please turn to slide seven for an update on these two issues.

As you recall, our use of third party temporary labor has increased in 2007 to hem maintain service delivery levels during the transitional period as we implement headcount reduction.

We continue to take actions to reduce our use of temporary contract labor, our largest use of contract labor is in our outsourcing business where we have seen the most growth and the most number of people working on client engagement.

We've worked through an extensive benchmark process and are now re-engineering processes in our outsourcing business and throughout our services operation.

This is proving to be somewhat more difficult than we thought and we're stepping up our efforts by placing more resources, including additional teams of six sigma lean experts to address it.

We did make some progress in the third quarter, taking out some of these increased contract labor costs.

We expect to take out an even larger amount of these temporary costs in the fourth quarter and we have targeted to then complete the effort in the first quarter of 2008.

So it's taking us an extra quarter or so, but as we get these costs out, we expect to see the benefits in our margins.

Regarding our systems integration and consulting business, we continue to work through disruptions in this business related to changes we've made in our repositioning program.

As I think you know, our systems integration and consulting business at Unisys is closely linked to creating high-end solutions for specific vertical industry markets such as banking, insurance, airline reservations and communication messaging.

Coming into the repositioning we had some powerful industry solutions, but they were fragmented and were often proprietary in nature.

We needed to refresh our portfolio solutions and move our clients to the next generation of technology.

This has been and continues to be a major reinvention process.

To refocus our solution set, we have de-emphasized many programs and narrowed our portfolio to about 20 key solutions that take advantage of the cost efficiencies of new technologies such as open source, Microsoft and real time infrastructure.

Slide eight shows our new, more focused road map for industry solutions in our systems integration and consulting business.

As you can see, we're focused on three industries, financial services, public sector, and commercial markets such as transportation and communication.

Horizontally across all three industries we're using our business blueprinting methodology as the foundation for building service oriented architecture-based solutions.

Also, across all three industries, we are focused on providing application services and enterprise security services given the growth opportunities and our capabilities in these areas.

We don't have time to go into all the specific programs, but let me focus on just one growth opportunity in each industry.

In financial services we see significant growth opportunities in the area of enterprise payment.

For example, a few years ago with the passage of the check 21 legislation in the United States, banks became free to accelerate their move from paper-based check payments to electronic images.

The reality was that many banks didn't move aggressively in this direction because of the sheer size of their payment operations and the cost and effort associated with moving to electronic images.

Now with the availability of lower cost, open source and Microsoft software and the advent of real time virtualized servers, the technology is here to allow banks to cost effectively make the shift to image-based processes.

To stay competitive, banks are increasingly adopting image-based solutions to reduce the cost of their payment operations and integrate electronic checks with the rest of their payment.

They are also rapidly adopting remote image capture at their teller locations to reduce float and get deposits more quickly into their payment streams.

We believe the market for electronic enterprise-wide payments will grow aggressively in the coming years and Unisys is a long time leader in the payment market, is well positioned to capitalize on this growth.

To capitalize on these opportunities, we've developed a comprehensive end-to-end suite of solutions for enterprise payment.

This includes the next generation electronic image exchange system based on advanced, open source, and Microsoft technology.

Last quarter we sold this solution to the Federal Reserve banks in the U.S.

and we see strong interest in the solution and other payment solutions among additional financial institutions worldwide.

As another example, in the public sector we see growth opportunities in the area of health and human services.

With the 2005 passage of the Deficit Reduction Act, state medicate programs need to reduce their spending on entitlement programs such as Medicaid and Medicare.

States are increasingly moving from legacy Medicaid processing systems to more cost effective platforms that can handle electronic and web-based transactions, integrate with systems from other agencies and more flexibly handle changes as they happen.

Unisys has built a new solution called [Health Path] built with a cost efficient Microsoft technology, the Health Path system is the only federally certified Medicaid management information system in the country, and it's made from commercial office shelf software.

The state of West Virginia is successfully using this solution and we are seeing strong interest in other states in moving from propriety legacy systems.

In our commercial industry, we see growth opportunities in the area of airline passenger reservation and communication messaging.

Airlines want to move from closed proprietary distribution systems to flexible platforms where they can open up access to their reservations and drive new revenue by integrating bookings information with customer loyalty system.

Telecommunications providers need new, more powerful platforms to offer new text, video, and entertainment services on messaging platforms.

Unisys has developed next generation solutions in both areas.

In airline reservations, Conair Systems recently went alive with the first phase of a new airline booking system based on our next generation air course solution which in their case, is built on Microsoft technology.

We're seeing interest among some of the other major players in this market.

In the area of communication messaging, we've developed a next generation messaging platform also based on a flexible modular architecture using open source technology.

During the third quarter, we signed a five-year multimillion dollar contract to help Sprint enhance its voice mail infrastructure.

We will develop a next-generation messaging platform that will provide Sprint the flexibility to deliver new enhanced services to its millions of customers.

We currently provide the communication messaging platform for a subset of the Sprint wireless network.

Again, we don't have the time this morning to go through all the growth areas that we're focused on in our systems integration and consulting business.

The point I want to leave you with is that Unisys is right in the center of some large shifting in growing markets.

We're making highly focused investments to build complex, value-added solutions for each of them.

As we begin to get traction in selling these solutions into these markets, we expect this too, to help drive improved growth and margins in our services business.

Turning to slide nine on the subject of growth, let me update you on progress we are making in our strategic growth program.

You'll recall I've used this slide in the past to depict the transition we're seeing within our business mix as we focus on new growth areas while de-emphasizing lower value-added areas of the portfolio.

As a reminder, our focus growth areas are out-sourcing enterprise security, open source, Microsoft solutions and real time infrastructure.

Revenue from these programs grew more than 10% in the third quarter and is up about 10% year-to-date.

We continue to look for revenue from our strategic growth areas to grow to about 70% of our total revenue in 2008 up from about 50% of our revenues in 2006.

Turning to slide 10.

Before I close, let me just say a few words about our ongoing cost reduction program.

Our primary focus so far in the repositioning program has been on addressing our profit model.

We are now turning more attention to driving top line growth.

I want to stress that we are not done in transforming our cost structure.

While I believe that we have the bulk of our restructuring behind us, we continue to explore ways to further streamline our cost and expenses.

As Janet will discuss in her remarks, we plan to take actions in the fourth quarter to further consolidate facilities.

As I mentioned earlier, we continue to drive initiatives to enhance the productivity of our services delivery work force and we continue to expand our lower cost offshore delivery resources.

At the end of the third quarter, we had about 3800 Unisys and vendor resources providing off-shore delivery services from India, China and Eastern Europe.

We continue to target, having about 20% of our work force, providing services from these offshore locations by the end of 2008.

Turning to slide 11.

In summary, this morning we made continued good progress in the third quarter in driving our repositioning program.

Our non-GAAP services operating margins grew to 5.3% in the third quarter, the highest level since 2003.

We expect services operating margin to continue to improve year-over-year in the fourth quarter.

Our technology non-GAAP operating margin was 4.9% in the third quarter due to seasonality in the business.

As we said back in July, we expect a stronger second half of 2007 driven by ClearPath.

There is no change to that and we expect strong technology operating margins in the fourth quarter.

Looking ahead, we continue to drive toward a goal of an 8 to 10% operating profit margin excluding retirement relating expense.

As I mentioned earlier, this was an aggressive goal.

And as we get closer to 2008, we are beginning to get more clarity on where we will likely end up, relative to this target.

We are still working on our plans for 2008, but our view at this point is that we expect to hit the 8 to 10% range for the second half of next year, rather than for the full year.

The 8 to 10% range remains our goal for the business and a level of profitability that we look to build on as we move beyond the repositioning program.

Thank you again for joining us this morning.

Now I'll turn the call over to Janet for discussion of our third quarter finance-- Janet?

Thank you, Joe, hello everyone.

This morning I'd like to provide more details on our third quarter 2007 financial results and I'll also discuss cash flow and our debt refinancing strategy.

To begin, please turn to slide 12.

At the top line we reported revenue of $1.39 billion for the third quarter of 2007.

This was down 1% from the year ago quarter.

Currency had a three percentage point positive impact on our revenue in the quarter.

Our third quarter results include $22.8 million of pretax retirement related expense compared with $47.5 million a year ago.

Our results in the third quarter of '06 included a pretax restructuring charge of $36.4 million.

We reported operating income of $43.6 million in the current quarter compared with an operating loss of $42.9 million a year ago.

You'll note that we had other expense of $19.3 million in the third quarter of 2007.

Other income expense can vary from quarter-to-quarter as you know and in this quarter included about $11 million related to the settlement of a very old (inaudible) item and approximately $6 million of foreign exchange losses.

Our tax expense also increased significantly in the quarter to $36.8 million from $16 million a year ago.

Our tax provision in the quarter includes a one-time adjustment of $9 million related to a tax law change in the U.K.

Our higher tax expense also reflects the improved profitability that we are seeing in certain international regions resulting from our repositioning actions.

Including other expense and tax expense, we reported a third quarter 2007 net loss of $31 million or $0.09 per share.

By comparison in the year ago quarter, we reported a net loss of $77.5 million or $.23 per share which included the restructuring charge.

, At the end of the presentation slides, we have provided supplemental slides showing details on restructuring charges and retirement related expense for the third quarters of 2007 and 2006.

Turning now to revenue, please turn to slide 13 for an overview of our third quarter revenue by geography.

Our U.S.

revenue represented 44% of our revenue in the quarter and declined 5%.

International revenue grew 2% in the quarter.

We saw growth in Latin America and Pacific-Asia regions partially offset by declines in Japan and Europe.

International revenue accounted for 56% of our overall revenue in the third quarter.

On a constant currency basis, international revenue declined 4% in the quarter.

Slide 14 shows our revenue by business segment.

Service revenue was flat in the quarter and represented 87% of our third quarter revenue.

Our technology revenue declined 9% and represented 13% of our revenue this quarter.

For more details on our services revenue, please turn to slide 15.

Within services, our out sourcing revenue grew 7% in the quarter.

And as Joe mentioned, our assistance integration and consulting revenue was flat in the quarter.

The growth in out sourcing was offset by a 12% decline in infrastructure services revenue and the continued secular decline in core maintenance revenue.

The decline in infrastructure services was due to weakness in network and design and consulting projects, as well as the shift of project-based infrastructure work to manage services-- I'm sorry, to manage out sourcing contracts.

We expect this trend to continue.

Turning to slide 16 in our technology business, revenue from enterprise servers declined 8% and represented 76% of our technology revenue in the quarter.

Within enterprise servers, revenue from ClearPath systems was down double digits in the quarter as expected.

As Joe mentioned, we expect strong ClearPath revenue in the fourth quarter.

Moving to expenses, we continue to drive our program to reduce expenses in line with our more focused business model.

And, our efforts to reduce operating expenses are yielding good results.

Slide 17 shows our operating expenses through 2006 and the first nine months of 2007.

This is on a GAAP basis including restructuring charges.

Operating expenses presented here include both SG&A and research and development expenses.

Slide 18 shows our operating expenses over the same period excluding restructuring charges in the retirement related expense.

As you can see on this non-GAAP basis, operating expenses declined from 22% of revenue in the first quarter of 2006 to 18.8% of revenue in the current quarter.

One area where we're doing a lot of work right now is consolidating facility space.

As I mentioned last quarter, we are working on opportunities here to further reduce our expenses given our headcount reduction and also the increasingly mobile nature of our services work force.

We expect to further make progress in that in this this quarter and we expect to take charge in the fourth quarter for further consolidation of space.

Moving onto segment margins, you may remember that Unisys has a long-standing policy to evaluate business segment performance on operating income exclusive of restructuring charges.

Therefore my comments on segment performance, exclude the third quarter 2006 restructuring charge.

As we continue to streamline our operations and implement other aspects of the repositioning, we are seeing benefits in our services margin.

Slide 19 shows margins for our services and technology segment in the third quarter.

On a non-GAAP basis, excluding retirement related expense, services growth margins improved 240 basis points from the third quarter of 2006.

Services operating margins improved 320 basis points to 5.3% from 2.1% a year ago.

Technology growth and operating margins declined in the quarter from a year ago reflecting lower sales of enterprise server products.

We expect stronger enterprise service sales and technology operating margins in the fourth quarter and we are also continuing to look for ways to further streamline our operations and reduce cost in the technology business.

Now please turn to slide 20 for an overview of our cash flow in the third quarter of 2007.

We generated $7 million of cash from operations in the quarter.

In the year ago quarter, we generated $27 million of cash flow from operations.

As you may remember, the year ago period included the collection of 1 -- I'm sorry -- of $112 million related to our royalty agreement with NUL.

Items in the quarter that helped to offset the decline were improvements in working capital management and lower restructuring cash payments.

In the quarter we used approximately $37 million of cash for restructuring payments compared to $71 million in the third quarter of 2006.

For the full year 2007, we expect between 150 and $160 million in restructuring cash payments.

Total capital expenditures in the third quarter of 2007 were $71 million compared to $60 million a year ago.

The increase reflects higher expenditures in the quarter on two out sourcing projects.

After deducting capital expenditures, we used $64 million of free cash in the quarter compared to free cash usage of $33 million in the year ago quarter.

Depreciation and amortization was $87 million in the third quarter of 2007 and we ended the quarter with a cash balance of $449 million.

Looking ahead for the full year of 2007, we continue to anticipate capital expenditures around $300 million and depreciation and amortization in the 360 to $375 million range.

One last comment regarding our debt refinancing plan.

We have been watching the debt market closely since the correction in July and August.

We are seeing improvement in the market.

Our goal is to complete a refinancing of the $200 million in 7 and 7/8 senior notes that are due in April of 2008, complete the financing by the end of the year.

We will continue to closely watch for the opportune time to enter the market.

That concludes my comments this morning and now I'd like to turn the call to Jack for

Thank you.

Janet, and thank you, Joe.

Operator, we'd now like to open the call up to questions from investors please.

Thank you.

[OPERATOR INSTRUCTIONS].

We'll take our first question from Julie Santoriello with Morgan Stanley.

Thank you, good morning.

Joe, on the change in the operating margin goal, it seems to have slipped a bit to the right here with the goals of 10% operating margin for the second half of '08 now.

Talk about just what's changed there in your mind?

Were there any other, some delays perhaps in some of the cost realization?

Are you spending more than you thought?

Is that the revenue is not cooperating?

Why--

Yeah, thanks, Julie.

The two main reasons are the reasons I covered earlier, but I'll give you more color now.

Frankly in this area of these temporary contractors, this has really been probably the single largest issue.

We would have liked to have made more progress at this point and we haven't, so we recently doubled our efforts.

We had about 25 black belts and master black belts focused on this and we've now doubled the number of people and the number of teams to over 50.

The target here is actually slightly more than 30 major basis processes primarily in our out sourcing business.

And, our real objective is an end-to-end process redesign between what they call in the out sourcing business, the independent service towers.

There's's one for call center, one for data center one for desk-side support.

And so, our objective is to eliminate idle time and drive up individual levels of productivity in call centers, (in audible) people and so on.

And this has emerged as my single highest priority.

Our target here is to get at least a $20 million quarterly reduction and so we've targeted that over the next two quarters.

So this sliding into Q1 is probably our single biggest issue of affecting the first half results versus the second.

And remember, although we've developed our strategic plan, we're kind of in the process of crystallizing our operating plan, we just wanted to set expectations straight on this.

And didn't want to be in a position where we surprised anyone.

Okay, related to that, what about the consolidation of facilities here that is going to be coming up in the fourth quarter?

Is that going to have an affect of actually helping margins a bit more in 2008?

Why are we seeing that sort of help to offset these other issues?

I'll defer to Janet on this since she's leading that project.

Good morning, Julie.

We have been working on consolidating our facilities throughout the change, throughout the time period that we've been in this transformation and we have continued to reduce our square footage under lease and operations as leases expire and we have the ability to enter into sublease.

So there isn't a major amount of facility, of new facility consolidations for which we could see savings in early 2008.

We have been gradually reducing down that expense as the work force has come down.

So there are opportunities and facilities not to the magnitude of which Joe is talking about in the contractor side.

Okay, thanks, Janet.

Continuing on with this, restructuring seems as though it's going to pretty high amount of restructuring in 07, you said 150 to $160 million.

Seems that will fall off dramatically in 2008.

Can you give us just a general estimate of kind of restructuring charges you think you might have to take in 2008?

Yeah, we're still on the fence for restructuring in 2008.

Here's why we're torn a bit, frankly.

In terms of the morale of our population, we've really held it pretty strong through this whole process, but it's clear that the largest part of our team wants to get this restructuring behind us.

So here's what we've been trying to do.

For all new jobs, we've been trying to get a fair portion of those offshore right from the beginning.

Remember, 1/3 of the people we restructured we actually moved to low coast countries like India, China and Hungary.

So we would like to do it as a normal course of business, part one.

And part two is, we have something we call a closed loop labor model.

Meaning, every time someone voluntarily leaves our company, we look at moving their jobs offshore or to a lower cost country or to what we call lower cost subsidiaries.

So will there be a need for some restructuring?

The answer is yes.

We want to minimize it; however, we want to be able to share with our team that the vast majority of this is behind us and we can manage the rest of the people out via this attrition management process.

Our most recent attrition numbers are about 15%.

Last year it was 12.

The fifteen is a little bit higher than the industry average.

We don't know the 2007 voluntary attrition rates, but we know last year they were 10.

So, at that rate, we belive we can make a lot of progress if we much more successfully manage on a proactive basis, attrition management.

Now you'll still see some things from us, but ideally they won't be major on a forward-looking basis.

Okay, thank you.

That's helpful.

And if I could get one more quick one for Janet.

Just on the $200 million debt that is coming due by the end of the year.

I know you're looking at several options which included perhaps an extension or paying it off in cash.

I just want to be clear.

Are you definitely planning on actually refinancing this in the fourth quarter and if so, what kind of rates do you think, would we be looking at here?

Julie, you're right to read into my comments that our expectation right now is to refinance that in the quarter.

The markets have started to improve from what we can see and from what we can tell from talking to the bankers so our expectation is to refinance it.

Obviously we don't think that the 7 and 7/8 is probably the environment we're going to see, but hopefully below 10.

Julie, let me make one last comment on restructuring.

I didn't mean to mislead you on the -- there'll be none.

What we're trying to do is stabilize our population.

There are some regions in the world that we still have challenges and so you might see some things from us there.

but on a broad basis around the world, we didn't intend to have any type of actions that have the size or the scale of actions you've seen in the past.

Don't be surprised if you see us do something that is more sharp shooting.

So but-- , but, we'd like to generally stabilize our overall employee

Okay, so-- so in essence, though the amount of restructuring taken in 2008 should be pretty well less than 150 to $160 million in '07.

Julie, you're talking about the cash requirement on restructuring?

The cash requirement was $198 million that we paid in 2006.

Right now, in 2007, we expect it to be 150 to 160, and based upon the actions that we've taken so far, as well as the fact that the majority of the facilities charge in the fourth quarter will be a non-cash item, there'll be minimum amount of cash for true-ups of the building before we exit.

Our expectation is that right now you'd be at $100 million or below in 2008 on cash expense standpoint.

Okay, thanks very much.

Great, thank you.

And we'll take our next question from Jason Kupferberg with UBS.

Hey guys, good morning, a question on the margins here.

So it seems like we continue to have some really divergent trends here.

On the one hand services looking pretty strong, best in fourth quarter of 2003, but the hardware margins obviously down pretty significantly on a year-over-year basis.

I know you expect it to come back in the fourth quarter, but it just seems like this is yet another example of hardware impacting the volatility of the quarterly P&L and I'm wondering, at this point, if you can really walk us through what the management team's rationale is for keeping the hardware business, especially now that you've made progress in getting services closer to more normalized margin levels.

First let me deal with it as a stand alone.

You're right.

We had a very tough comparative third quarter '06.

That's one of the real challenges of the business which you've identified.

We can tell how much will happen in the second half but as you just called out, it's very hard for us to call 3Q versus 4Q.

Last year there was a very successful 3Q.

This year we expect a very successful fourth quarter.

And so, it's very hard to manage that on a calendarized basis.

That said, you might be surprised some of the examples I gave you a second ago of the effectiveness of the technology in driving the out sourcing in the systems integration business.

I'll just replay a few of the illustrations I just gave you.

In the case of the Federal Reserve, we replaced or the target of our system is to replace a very, very large main frame application that has very high scalability, very high peak periods and so on.

and, in that we're replacing it with standard ES7,000s using open source and technology like VM wear.

Our systems integration team alone couldn't match these extremely high performance levels and peak periods of traditional enterprise servers on this much lower cost, better priced performance hardware platform.

And so, as we continue to work this hand-in-hand with the folks from the Fed Reserve, it was the technology people that tuned the databases, the operating systems and so on and actually dramatically exceeded their expectations for peak periods on a forward-looking business.

We found that to be true not just in the Fed Reserve but in airline reservation systems, there are a number of deals that are underway that we can't share with you, where they have some of the highest peak periods in the overall transaction processing business.

On an industry by industry basis, her it's banking, insurance, communications, and in that case, airline reservation systems, they have proved to be useful.

The second part of it is, that's now, as you yourself know fallen to only 12% of our overall business.

So it has less an impact, but you identified there was one here in the third quarter.

In the fourth quarter, although we haven't been explicit about exactly where all of those businesses land, you'll see that it will make a very big contribution.

So with that in mind, smaller part of the total, very helpful in helping our other course services businesses differentiate themselves from companies like [Exsensure] that can't do those things and at the end of the day they generate, as long as our costs are in line, which we believe they are now, it generates an awful lot of profit for our company, very profitable business.

Can you give some color on services margins?

The rate of your improvement did accelerate in the third quarter, can the magnitude of year-over-year improvement continue on that tread line in the fourth quarter '07 or do you naturally see a little bit of slow down in the pace of year-over-year?

First, let me just re-enforce where we landed.

The 5.3 at first, maybe doesn't jump out at you, but it actually is our best to support the quarter of 2003.

Our best operating-- results in operating margin services in the (inaudible) quarter.

We really believe it took a strong effort to get us there.

We believe, on a year-to-year basis, we can continue to have that improve and even though the bad news that we shared with you was we hadn't gotten all the contractors we wanted to, you can actually do the math of the flow through as we start to get them out.

It's continuous improvement through the fourth quarter and the first quarter of next year and start to really pay off in the second quarter of next year.

Okay and just finally on the services revenue growth year,, maybe a little bit less than we were expecting, coming in flat, little better than the past couple of quarters, now looking at the fourth quarter, I think you definitely have a higher base to try and grow off of, but you did still have respectable services order growth in the third quarter, despite a tougher comparer there.

So, can you give a sense of how the services revenue growth picture might look for the fourth quarter?

Looks like it would be tough to be in positive territory, but are you seeing any acceleration in the flow through or conversion of the order growth trends from the last six quarters and for P&L?

Yeah it depends on the business or segment within the services business.

Frankly the disappointment this quarter was actually our infrastructure services business, but I think you're speculation is right where you're going to start to see the impact of the prior order growth of the out sourcing business and the overall systems integration business start to come online.

But as you know, we, we try to avoid giving guidance in these areas.

Okay, thanks.

Thanks, Jason.

We'll take our next question from Ashwin Shirvaikar with Citigroup.

Hi Joe, hi Janet.

My question is going back to something that Jason asked, can you actually get rid of hardware and keep the highly profitable core maintenance services revenue stream?

Because that would I believe be smaller, it would still be very worthwhile if you could actually do that.

Here's an interesting thing and we've been hoping to actually keep the lid on an evolving strategy in that business going forward.

And, unfortunately, it's going to take a little bit longer of an explanation, but as we get out of the custom (inaudible) chip design business, we're on our ClearPath line, we eliminated one of the large, very fixed costs in R&D for that business, so that was part one.

In '08 and beyond, that will run on standard Intel hardware.

The second part was the partnership where we actually licensed intellectual property NEC to get out of the hardware design business.

You'll see those products start to come online, that next generation platform in the second half of 2008.

You may ask why I am I taking you through the chip business or the hardware business.

It's been our strategy for some time to evolve that business to a software services business.

So what's today a hardware business, we intend to involve to a software services business.

The reason I said we'd try to keep the lid on it is because we have a new president of that division, we recruited from the enterprise services division of Hewlett Packard and behind the scenes he is finalizing his strategy in the next phase of that evolution.

We weren't prepared to share it with you until the first quarter of next year, but we'd like to believe you'll see a very different profile of that business, as it evolves to primarily software and services and so, that's as much as I'd say here so you'd see a larger suite of software around the area of real time infrastructure, virtualization, those type of capabilities, that's the highest growth area of the hardware business.

That sounds counter intuitive.

Software is the highest area of hardware business, but it's true and the second part of it is, that services business is growing very aggressively for us.

As people move to this area of virtualization, that's a very high growth area for services.

You, yourselves, have seen what's happened to VM wear, the division of EMC, you can imagine what it's doing on the services side as well.

You're going to see a real, I'm reluctant to call it a shift, but a change for us here in terms of the expansion of the software services part of that and it will move closer to our more traditional services model.

Okay, I get shifting gears to bookings and revenues.

It was nice that you guys provided a nine-month sort of retrospective, that bookings are up slightly over last year.

If you annualize those bookings, which is probably a more useful metric to convert to revenue, annualized bookings, are they also up slightly?

So between annualized bookings being up slightly and currently giving you maybe a 3% benefit, maybe we could-- we could look for low single digits growth next year?

This is Janet, good morning.

We did provide that year-to-date nine-month number, we think with the way orders get booked that that nine-month number is pretty consistent with what we would expect to see on an annualized basis.

So your assumptions with regard to currency and how that would affect that number would appear valid and as we've said before, we are continuing to move the strategic portfolios forward and Joe mentioned that they, for year-to-date they're around 10% growth of the strategic portfolio offerings area, but from the overall services business, you're right that it's in the low single digits and with currency impact that should translate in the way you talked about with regard to 2008.

So as we-- as we have commented previously, we're trying to make sure we do this in a measured approach to make sure that we transition the revenue into the strategic program areas, and when we do that, we know that has a negative impact in some of the program areas that we have de-emphasized.

So as we go through this transition, we are encouraged by the services order growth year-to-date in the low single digits because that reflects a strong 10% growth in the strategic program offerings that are being offset by some of the programs that we've emphasized as part of the continuation of the transformation.

Got it.

And some clarification, I apologize if I missed this, but in terms of the tax that you paid this quarter and the other income, if you could go into some detail.

Sure.

Sure the, roughly $11 million relates to [Escheet] laws, which, in our case, I said were very old.

Goes back to the 1980s believe it or not.

This has been a--- this is not something that is an issue for us in the 90s or in the 2000s.

It's an old issue that's been outstanding that there have been a multi year audit going on and based upon the progression of that and how long the time has taken, we chose to settle this but this does go back to beginning in 1982, in the 80s time period.

1982.

Okay.

And the-- in terms of your expectations for tax rate, would it be more reasonable, more in line with pretax income and normal accrual rate of 35 to 40?

Is that a good expectation?

Ashwin, we won't get to that rate until we're in the situation that we're through the transformation generating pretax income on a consistent basis so that we can go back to tax affecting all of our operations.

When we had to write that deferred tax asset off and can no longer provide a-- a global provision based upon all of our pluses and minuses.

That's what causes a significant variation in the tax rate.

It's difficult for us to predict what's that tax rate is going to be in the nearer term horizons because it's a function of where the transactions occur.

But as we continue through the transformation, move to the point where we're generating pretax on a consistent basis and we've crossed the gap hurdle with regard to recognizing the deferred tax asset again, that will be the point in time where we can go back to a more normal tax rate.

Okay, got it.

Thank you.

Thanks, Ashwin.

And we'll take our next question from [Susan Chen] with Merrill Lynch.

Thank you.

Question for Janet.

For free cash flow, when can we see a positive free cash flow quarter especially given potential increase in CapEx from out sourcing contracts in 2008?

Good morning, Susan.

Let me just comment, on the out sourcing expenditures in the current quarter.

In my comments I mentioned that these outsourcing expenditures that occurred in the quarter, relate to two projects.

You should not expect that the current rate that we saw in the third quarter would be the ongoing rate for, to our CapEx and so don't conclude that the third quarter trend of that increase is something you would expect to see as you move into the fourth quarter and into next year.

These were two very specific contracts where we made a decision, based upon the return, to do higher than our normal, which is around 3 to 5%, roughly around 5% of contract value for CapEx, so that's a little bit of an anomaly.

That's why I called it out in my comments to be clear on that.

We have not given any guidance on free cash flow generally from a-- from an historical perspective and the seasonality of the business, the third quarter is probably our softest quarter with regard to free cash flow.

Fourth quarter is our strongest as we close out the quarter and close out the year.

We see no reason why that trend won't continue.

Thank you.

Thanks.

And we'll take our next question from [Jerome Land with Millcreek Capital]

Good morning.

Can you go into a little bit more detail on the decline in infrastructure and you referenced in your remarks, Joe, a trend, I'm sorry, maybe it was Janet, a trend that will continue, but I'm not certain that was the overall trend rather than a piece of that business.

Good morning, Jerome, in our infrastructure services business, there are three types of offerings that are included in there.

The first is our business where we support companies like Dell and EMC.

That business continues to move along, but-- but consistent with what else we're doing in the rest of the portfolio, we are turning down opportunities there if they do not meet our profit criteria or cash flow criteria.

So that has been moving along steadily.

The second area of that business is where we're doing shorter project-based work, whether it's network infrastructure work or shorter projects around the design of help desk and other, what Joe referred to as the powers of the offerings that we do.

In that area, we are seeing a shift towards more of that going from not being initial consulting projects, but going right into a multi year managed out sourcing environment.

So we have a little bit of a shift between this line and that line.

And then the last area that's in there is on occasion, as infra structures are built out, we, as part of the project, install hardware, Cisco routers, those type of switches and that type of, you know, hardware that is part of the solution, but not the critical portion of the solution and we're seeing a decrease in that.

So, which of these trends do you expect to continue and to what magnitude?

Right, so we expect to see the overall shift from that line into the infrastructure services area.

We expect to see-- so you've got three pieces in that, in that, in that line item, we expect to see, in the first area, what we refer to as TSM, third party service support, in the Dell EMC area, we expect that to continue, we're working on those relationships, but making sure we go after those deals that are attractive from a profit and cash flow perspective.

It's in the second two areas that we expect to see a decline in the area of the project-based work, we see a shift from this line into the growth we're seeing into out sourcing.

And then lastly, in the hardware area, we're seeing that decline as well.

So you have three components in there.

One that's relatively stable.

The second that's causing a shift between this line and into the out sourcing line and a third which a decline overall.

So it's kind of-- so you're not really growing and out sourcing in the matter that you know, the, slide 15 suggests if you want to corden off infrastructure.

You're kind of--

Jerome, I don't think-- I wouldn't conclude that step because in this infrastructure services area, these are short-term projects so we are growing in out sourcing and we are going from something that is a short-term project-based business into something that you can quickly get into a multi year annuity stream for the company.

And that is not all the reasons for the growth in out sourcing.

We're growing in the IT outsourcing area, we're growing in other areas of that business as well.

But it is a contributor to the growth.

Can you quantify the three contributors?

Or those three pieces of infrastructure?

We have not broken that line out by component.

The largest component is the third party service--- the service, maintenance and support area that I talked about.

It is the largest portion of that business and the other two are smaller.

So on the next quarter and in 2008, do you expect the trajectory of that business to overall stay the same, get better, get worse?

As I said-- as I said in my comments, we expect the-- we expect the trend in that to continue into the fourth quarter and into 2008.

And it is part of making sure that the revenue that we are getting has got the right economic benefit both in the profit and in the cash flow and so while it may mean a sure term foregoing of revenue, we believe it's better from an overall bottom line profitability and cash flow to do that.

Can you quantify the effective-- the short fall in systems integration consulting and in the use of temp labor in this quarter?

I don't know if we're going to call out the specifics of what was the GAAP.

If you're looking, when you're asked-- Jerome, when you're asking, there's two portions we talked about.

One is the systems integration against our expectations for the full year that has been the portfolio that has gone through the most amount of change and we did see that revenue go flat in this quarter.

So in this quarter, we were at the flat level.

That's an area of the business from a longer term perspective that we expect to grow.

So just to give you a sense you can see it on the financial statements where that revenue is and expectation as we fully implement the transformation, that should, as we move through 2008 continue to grow.

In the contractors area, I think Joe commented on the magnitude of that in his earlier comments of about $20 million.

Right, it's about $20 million and we expect to work that out over the next two quarters .

So that's $20 million on a quarterly run

Got it, thank you very much.

I want to ask you about guidance overall.

And this relates to disclosure and a lot of things we already asked about, but things like backlog and go forward guidance.

You're two years into the restructuring, give or take, or almost, you have a target out there for 2008, but as the target gets moved, I think it causes the market increased concern and uncertainty that we can't track your progress against it.

So, I'm wondering why this far along in the process you can't look at beginning to give guidance-- specific guidance.

That's a great question.

At the very beginning of this process we were strongly encouraged by our board not to do that.

Because, transformations of this magnitude-- size, never go on a straight line.

So, you end up disappointing people more than you end up fulfilling their expectations.

We committed to them we would revisit this issue of guidance in 2008.

We understand the challenges it presents to everyone that's on this call.

So we're going to go back to them to see at what rate they'd like to give guidance.

I will tell you, even in this particular quarter, for them, they believe until we really start to hit the targets that we've communicated with you, they have a fair amount of reluctance on this.

And so, it's not that we don't have engaging discussions every quarter on when we should begin giving guidance because of the challenges it presents in your creating your model.

We do understand that, but we have not gotten their support yet and we completely understand why in starting to give guidance on a forward-looking business.

But we'll continue to revisit it, and maybe you'll see that sometime in 2008.

Okay and I want to clarify why I asked that.

It's not about just creating the model and it's not about trading you on a quarter-to-quarter basis or making sure you hit quarterly numbers, it's about tracking a progress.

We make sure that we don't get into the second quarter calendar next year, you're releasing first quarter earnings, and we're looking at a hockey stick to get you to the target.

And moving it out again, 2009 not 2008.

There's more to it than just measuring progress moment to moment.

It's about being able to see whether you are in fact tracking towards that goal which today has been pushed out an extra six months.

I can tell you major investors have caused us a lot of consternation, I'm sure you can imagine.

It's very important to us that we understand whether or not you're making progress.

Don't disagree.

That's precisely the discussions, as I said, we have with our board and we'll continue to have.

And one last question if I can.

Do you have any comment on the DHS investigation, that was reported a few weeks ago in the Washington Post and elsewhere particularly as time has passed and you had more opportunity to speak with the authorities.

Here's what we said and let me reinforce it.

The facts and documentation we have contradict the claims that were made we have in that article.

We believe a proper investigation will show we acted in good faith.

And we really have provided the DHS with a credited and government certified security systems program.

And frankly, we're proud of the work.

Are there investigations going on?

There's some things that we're aware of, there's things that we're not aware of that were referenced in that article.

So we have reached out to the DHS inspector general's office and said we'd love to actively cooperate in anything and they haven't gotten back to us.

Okay, thank you.

Great.

We thank you all of you.

I'd like to reinforce that we do expect a strong fourth quarter as we said earlier and we expect services operating margin to continuously improve on a year-over-year basis on our way to the fourth quarter and a strong technology operating margin in the fourth quarter which is a reflection of what we believe is strong continued progress in our transformation program.

So thank you very much for joining us.

That does conclude today's conference.

Thank you for your participation and have a great day.