Convergys Corp. Q3 2008 Earnings Call Transcript

Convergys Corp. (CVG)

Q3 2008 Earnings Call

October 28, 2008 9:00 am ET

Executives

David Stein - VP of IR

Dave Dougherty - President and CEO

Earl Shanks - CFO

Analysts

Jason Kupferberg - UBS

Shaul Eyal - Oppenheimer & Co.

Ashwin Shirvaikar - Citigroup

Karl Keirstead - Kaufman Brothers

David Koning - Robert W. Baird

TC Robillard - Bank of America Securities

Peter Jacobson - Brean Murray, Carret & Co.

Scott Sutherland - Wedbush Morgan Securities Inc.

Dhruv Chopra - Morgan Stanley

Presentation

Operator

Good morning, and welcome to the Convergys third quarter earnings teleconference. (Operator Instructions).

I would now like to turn the conference over to Mr. David Stein, Vice President of Investor Relations. Sir, you may begin.

David Stein

Thank you, Shelly, and good morning. Welcome to Convergys' third quarter 2008 earnings call. This call is the property of Convergys. With me on the call today are Dave Dougherty, our President and Chief Executive Officer and Earl Shanks, our Chief Financial Officer. Dave will provide a summary of our operational results and Earl will follow up with financial performance and forward guidance. Then, we will open the call for your questions.

Today's discussion contains a number of forward-looking statements, including future financial results, operating projections and cost estimates that involve potential risks and uncertainty for Convergys. Future results could differ materially from those discussed. Please refer to Convergys' most recent new release and filings with the SEC for additional information, including risk factors. Currently we do not intend to revise or update any forward-looking statements made during the call.

Also during the call, we will discuss non-GAAP financial measures, including free cash flow and non-GAAP earnings per share. These non-GAAP financial measures should not be construed as being more important than comparable GAAP measures. Convergys' management believes free cash flow and non-GAAP earnings per share provide the users of the financial statements with a more comprehensive understanding of the company's underlying performance. A reconciliation of these non-GAAP measures is available on the Convergys website at www.convergys.com.

Now, I will turn the call over to Dave.

Dave Dougherty

Thank you, David, and good morning. Convergys third quarter results from ongoing operations were generally in line with expectations. However, we did have to take a significant charge related to our HR Management business, and results here are clearly not satisfactory.

Despite this, we took several steps during the quarter that we believe will lead to a stronger future and better financial performance for Convergys. In the face of a tough economy, we began to see the benefit of changes we have made in the Customer Management segment, reflected in sequential revenue and operating margin improvement.

We completed the acquisition of Intervoice to enhance our leadership in relationship management. We initiated and announced our valuation of the potential separation of our Information Management business, and we are taking a series of actions to reduce risk and improve the future earnings and cash flow of HR Management.

Let me talk more about HR Management. We are making progress in key outsourcing implementations, but the financial results, including the charge we took this quarter, are not acceptable. There has been an increase in the overall cost to implement and deliver these outsourcing contracts. This is due to a number of factors, including the complexity of global implementations and also actions taken by our clients that have contributed to project delays.

As a consequence, we are writing off $273 million of deferred implementation costs in the third quarter, as outlined in today's press release. Earl will discuss this in more detail in a few moments.

Clearly we have to take a very different approach to this business. We have already begun a series of actions to reduce the implementation risk and improve the future earnings and cash flow of an HR Management.

More specifically, here are some of the steps we are taking. First, our approach to all future HR outsourcing business will be dramatically different. We will not sign any new HR outsourcing business with significant implementation risk. With our prospects and partners, we are working to leverage our past learns and develop an implementation model that delivers value for the client while eliminating risk to our shareholders.

Second, we are evaluating all areas of HR Management to drive efficiency faster. We will do this through further automation, standardization and leverage of our offshore assets.

Third, as you know, we are in the middle of two significant global HR outsourcing implementations. We have begun discussions with these clients to potentially change the implementation approach going forward.

Let me emphasize again, all of the actions I just outlined are designed to reduce our risk and improve the future earnings and cash flow of this business. Notwithstanding the challenges at HR Management, we are pleased with the progress and customer management and are on course to achieve our margin guidance and Information Management for the year.

On a consolidated basis, revenues in the third quarter were in line with our expectations. Excluding the HR Management related charge, EPS was $0.29, which is in line with our guidance for the full year.

I will turn now to discuss some of the highlights in each of our business segments during the quarter.

Let's begin with Customer Management. As you know, we significantly strengthened the leadership team in Customer Management, including bringing in new talent from outside the organization. Collectively this team's depth of experience in contacts and our operations and technologies is outstanding. This new team is driving improvements across all areas of the business.

Let me give you three examples. First, they are relentlessly improving the quality of our service delivery to our clients' customers. We know this is critical to increasing our share of our clients' business over time. Second, they have introduced enhance tools and processes to drive daily improvements in revenue and profitability. Third, they are aligning our capacity footprint more closely with client demand and profit opportunities.

Let me elaborate on the quality of service delivery. We are taking a holistic view of quality of service that goes beyond customer satisfaction to look at all the metrics that ultimately impacts how our clients view the effectiveness of our agents. We have implemented a new approach to how our team leaders coach the agents and improve their quality of service.

We are using daily reporting to our leadership team regarding service quality metrics and a consistent methodology of stack ranking our agents on all measures that impact quality of service. The result of this focus has been an improvement in quality of service across most of our top 10 clients. There has also been an improvement in how our top 10 clients rank our performance versus competitors, and importantly, their own in-house operations.

Next, I want to talk about context and profitability. We have added tools and processes that are enhancing our ability to bring daily, even hourly, focus on cost drivers and cost management. This transformation is already having a positive impact on our contact centers. We have rolled out an improved scheduling approach that we believe will help us drive reductions and absenteeism and attrition in our sites.

Early results are encouraging as we have seen improvements in both as we move through the third quarter. We have implemented changes to our training programs that reduce training time, while improving service quality and agent retention at the same time. We have enhanced reporting tools at the site, team leader and agent level that provide real time visibility into agent productivity and quality.

Our site management has both responsibility and accountability for managing these metrics. With these tools we have gotten even better at managing key operating metrics such as channel time, first call resolution, line adherence and sales conversion rates. Of course, we have always focused on these metrics.

The real difference is the enhanced tools and processes we have introduced. These tools allow real-time reporting of exceptions to our leadership team so they can take real-time corrective action. The early results have been promising, as we are able to drive sequential improvements in both billing yield and agent productivity during the quarter.

On the capacity delivery side, we are making good progress providing capacity and delivery capability where our clients want it and where we can be profitable. We are in the process of ramping up 4,700 new seats in the Philippines that will come online through mid-2009. Demand for the Philippines remains strong, and to-date we have sold all of the 2,000 seats that will come online through the end of this year.

We continue to focus resources on building our home agent business, and our solution is gaining traction. Today, we have more than 1,500 full-time equivalent home agents handling calls.

We continue our planning to offer near shore bilingual services. In recent months, we have closed four sites with approximately 2,250 seats. The decision to close these sites was based on market labor and other factors that caused these sites to no longer be either saleable or profitable.

As a result of this new renewed emphasis on capabilities and capacity, as well as the quality improvements I mentioned earlier, we are making better progress closing new business and converting operational improvements into additional market share from existing clients.

For example, during the quarter, we announced program wins with existing and new clients in multiple verticals including healthcare, government, communications, financial services and manufacturing. We had year-over-year growth in technology, communications and other markets. We feel good about the level of new business captured in the quarter, and we see opportunity for growth with existing and new clients into 2009.

Contract signed in the third quarter had an estimated 2009 revenue value of $85 million. On the flip side, we are also seeing volume softness with some existing programs related to the economy particularly in financial services. Consistent with what we said last quarter, there has been some softening in client forecast for the fourth quarter as well, which is further evidence of the impact of the slowing economy.

Though we are not immune to the effects of the slowing global economy, we feel confident we can continue to improve operating performance, which, in the past, has led to share gains and growth over the long run.

Also in the third quarter, we closed the Intervoice acquisition. This provides an important foundation for our relationship management strategy. The integration of Intervoice is off to a strong start. There are a number of immediate and future benefits, which are taking shape.

As expected, our clients and industry analysts have welcomed our comprehensive array of integrated automated and live agent solutions. In fact, we already have our first client with the joint implementation of the combined, automated and live agent solution.

In addition, we have identified a substantial number of additional cross-sell opportunities that we are currently pursuing. We expect our differentiated live and automated capabilities to allow us to fully participate in our clients growing use of multi-channel automation and gain a larger share of spending.

We are also seeing early synergy by leveraging relationship management technologies to improve the efficiency of our agents, and also reduce overall corporate expense. We are forecasting more than 200 million in revenue from Intervoice next year, and we expect its standalone profit margin to increase.

Third quarter results in Customer Management reflect substantial increase in cost due to changes in foreign exchange rates compared to last year, and further investment in strengthening our relationship technology management consulting capability.

Let me now talk about Information Management. Information Management continues to transition from a predominantly data processing services provider to more of a pure-play software solutions provider. With the third quarter results, Information Management remains on track to meet 2008 guidance even in this challenging environment.

Since the beginning of the third quarter, we announced Infinys implementation at T-Home and Netsize. We also announced contracts with ZON TV in Portugal, AIS in Thailand, Cincinnati Bell and Cellular South. We completed the acquisition of Ceon to expand our product management functionality, and we announced the availability of Customer Service Manager, CSM 5.0, which has enhanced functionality to further improve our client's customers' experience.

Moving to HR Management. Despite the contract challenges and the related charge, we have met critical HR Management milestones. We began significant operations for one of the large HRO clients supporting about half of the total employee base with the full suite of HR services. These include payroll, HR administration, benefits, recruiting, compensation and learning services.

For another large client, we went live with a global HR portal and recruiting support in the United States. We are on track for the go-live of payroll, benefits administration, compensation and HR administrative services in early 2009. This will cover more than half of their employee base across all major regions of the world.

Furthermore, we have consistently met or exceeded our critical service level targets for ongoing operations, while expanding the number of critical service level metrics that we measure across the client portfolio.

Having discussed our third quarter results, let me now give an update on the potential separation of our Information Management business being evaluated by our board of directors and management team. We are making progress in the evaluation. In particular, we are assessing the impact of separation on client relationships, evaluating the impact of stand-alone cost structures, and reviewing tax and financial considerations.

We also recognize that the economic and financial environments are different from when we announced the evaluation. We are taking this into consideration as part of our review, and we will continue to act in the best interest of all stakeholders. We will provide an update on the potential separation with our announcement of fourth quarter results in January.

In summary, we are in a difficult economic environment as difficult as we have seen in quite sometime. Some providers in our space could be significantly challenged and have liquidity issues. Our focus is on continuing to be one of the leading players in our markets and emerging even stronger as the economy improves.

We are addressing our challenges, and we are investing and focusing on the areas of greatest potential for profitable growth. We are addressing the challenge in HR Management by taking a series of actions that will reduce our implementation risk and improve our future earnings and cash flow.

We are continuing to evaluate the separation of the Information Management business. We are making progress in Customer Management, and we are investing in our relationship management strategy to better serve the evolving needs of our clients, broaden our addressable market and position Convergys for continued market leadership. The completed acquisition of Intervoice is better positioning the company for growth.

As a single source provider, we are able to help clients drive more value from their relationships with customers and employees, which, in turn, we expect to drive growth in our revenues and earnings.

Despite the challenging macroenvironment and hurdles in HR Management, our unique blend of automated and live agent solutions and our scale sets us apart in the marketplace. We have a global capacity, a large and stable base of client relationships, and we feel good about providing jobs to 75,000 people around the world. Our future value creation opportunities are exciting.

We have the leadership position in relationship management and believe we have the right strategy for short-term and long-term success and we are confident about the future. Our entire team across the business segments is focused on doing what is in the best interest of the shareholders, our clients and our employees.

At this time, I will turn the call over to Earl, who will provide greater detail on our third quarter financial results and forward guidance. Earl?

Earl Shanks

Thank you, Dave, and good morning. Before I get into details of our third quarter financial results by segment, let me provide some additional detail on why we took the write-down of deferred charges related to our HR Management contracts. The $273 million charge includes $208 million of asset impairment and the expensing of $65 million of implementation cost for large HRO contract. Recall, we typically defer direct implementation costs and amortize them over the life of the contract.

On a quarterly basis, we assess the ability to recovery the capitalized implementation cost by considering items such as contract profitability. Based on the assessment done in the third quarter, two HR outsourcing contracts are no longer projected to be profitable over the contract term. As a result, the capitalized costs related to these contracts are impaired, and therefore, written down in the quarter.

Three factors contributed to the change in the profit expectations for these contracts. First, higher projected IT and operational labor cost due to solutions that are more complex than initially expected. This is due to demand for higher level of service center expertise, a need for additional technical support staff to support the transformed HR information systems and current wage inflation pressures.

Second, the magnitude and complexity of delivering third-party vendor support. Both higher costs and a higher than planned number of vendors are participating in this service which became evident when we went live with one of our large clients. This has increased the cost to serve significantly.

Third, our current estimate of our client's employee headcount for future year has declined for both of these HR outsourcing clients. This has negatively impacted revenue, and therefore profitability estimate.

Moving to the expense implementation cost of $65 million, in the quarter, the cost of implementing another large HRO client exceeded the amount recoverable at September 30 under the contract. In accordance with our accounting policy, implementation costs that exceed the term for convenience fees in the contract even for a profitable contract are expensed in the quarter, instead of capitalizing them in the balance sheet.

The write-down of deferred charges in the third quarter does not relate to future cash flow. Deterioration in the expected profitability of the contracts, as well as the charges recorded in the quarter, also triggered an impairment assessment of the HR Management-related goodwill. As a reminder, we normally test for goodwill impairment in the fourth quarter unless events change that causes us to do it earlier.

Testing requires a two-step process to determine if the impairment to goodwill is appropriate. The first step test is the fair value of the business is greater or less than the book value. We have determined the fair value of the HR Management business is less than the book value. As a result, a second step test is required which involves valuations of the assets and liabilities.

We will complete this step two test to determine the degree of goodwill impairment, if any, during the fourth quarter. At this point, we are not able to estimate the amount of a potential charge. Total goodwill in HR Management is approximately $135 million. Depending on the outcome of the step two test, results in the fourth quarter maybe impacted by potential goodwill impairment in the HR Management segment.

We are very disappointed by the charge. We are taking action to improve execution and financial performance in HR Management. We will not sign new HRO business with any significant implementation risk. We are streamlining existing operations and reducing service delivery costs, and we are in dialogue with our clients to restructure the contracts and modify the implementation approach.

Let me turn now to a review of third quarter financial results. For the quarter, consolidated Convergys revenues were $676 million. The net loss of a $140 million includes the $273 million charge. Excluding the HR Management related charge, EPS was $0.29. This non-GAAP result includes the impact of strong non-operating income, a lower tax rate and lower share count.

Turning to the segments, in the third quarter Customer Management revenues increased 4% to $483 million. This included $14 million of revenue from Intervoice. This quarter, we have seen a shift in our revenue mix from North America to the Philippines. That shift positively impacts margins but negatively impacts revenue.

Customer Management operating income in the third quarter was $23 million, compared with $40 million in the same period last year. Factors impacting the year-over-year decline include foreign exchange changes of about $12 million or a 250 basis point negative impact and investment in relationship management consulting, technology infrastructure and additional sales resources.

On a sequential basis, third quarter operating margin improved to 4.8% from 4.1% in the second quarter. We delivered this improvement based on the tight management priorities Dave talked about earlier, including improvements in quality, efficiency and capacity.

Moving to Information Management, revenues were $134 million in the third quarter. As expected, we saw softness in the third quarter given the impact of the Sprint migration and acceleration of license revenues into the second quarter, which we discussed in our last call. Declines in data processing and professional consulting services were partially offset by a one-time payment of $10 million from a North American client.

Information Management operating income was $17 million in the third quarter. This reflects the expected revenue decline with North American service bureau client, as well as lumpiness inherit in the more software-oriented solution mix. Operating income includes approximately $3 million from accelerated amortization of acquired assets and the impact of the $10 million payment from a North American client, of which I just spoke. Last year's results included restructuring charge of $3.4 million.

Moving to HR Management, HR Management revenues were $59 million. Revenue grew from the North American go-live with a large HRO client. This was more than offset by the completion of pass-through activity at the end of the second quarter that I referenced on our last earnings call. Excluding the deferred charges expensed in the quarter, HR Management operating loss improved slightly compared to the prior year.

Let me now turn to other items. Non-operating income was up $13 million in the quarter, compared with the prior year. Earnings from the cellular partnerships were $8 million in the quarter, an increase of $6 million over the prior year and down from $11 million in the second quarter. The sequential decline was a result of incremental cost that the partnership incurred related to the recent iPhone launch.

Other income of $10 million in the quarter, an increase of $8 million over the prior year was largely due to a $6 million gain on settlement of an interest rate hedge. The effective GAAP tax rate was a 39% tax benefit. This relatively high rate is due to the large charge we took in HR Management.

Our non-GAAP tax rate excluding the charge was 15% tax expense. This relatively low rate is due to the higher mix of low tax offshore income. DSO increased to 77 days in the quarter due to timing of project payment milestones in our international business and a large payment in the US which we received this month.

At the end of the quarter, we had cash of $136 million and we now have unused bank lines of $75 million. Free cash flow in the quarter was $4 million. Deferred charges net of implementation revenue received and amortization increased $40 million in the third quarter before the impact of the HR Management charge. There was a non-cash pension settlement charge of $6 million in the quarter. This was reflected in the segment results.

I will now move to a discussion of our forward financial guidance. It is not yet clear how the global financial crisis may affect our client's fourth quarter and 2009 business volume. As a result, our expectations for the fourth quarter of 2008 are as follows: Revenues in the range of $725 million to $745 million. Earnings of approximately $0.20 per diluted share. This includes an abnormally high effective tax rate in the range of 45%.

The third quarter charge is having an impact on the fourth quarter tax rate. If we had not taken the charge, the effective tax rate in the fourth quarter would be about 25%. The sequential operating improvement should be driven by continuing revenue growth and margin improvement.

As I mentioned a moment ago, we are currently conducting a review of potential goodwill impairment for HR Management. There is also potential for restructuring expenses in the fourth quarter to streamline the business.

With regard to 2009, taking into account the uncertainty in the current economic environment and the potential for a prolonged economic contraction, we are focused on delivering overall revenue and earnings improvement next year, excluding charges. Driving the year-over-year improvement next year will be overall margin improvement, lower year-over-year currency impacts and continued successful tax expense management. We will provide additional details on 2009 expectations on our fourth quarter call in January.

At this time, Shelly, please open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Jason Kupferberg with UBS.

Jason Kupferberg - UBS

Hi, good morning.

Dave Dougherty

Hi, Jason.

Jason Kupferberg - UBS

I wanted to talk about the outlook here in two dimensions. First of all, I know you mentioned that IM is on track to achieve its '08 goals. Can you comment on Customer Management and HR, excluding potential charges in Q4? How you are expecting the year to track versus your prior expectations, and do you have any comments around the full year free cash outlook?

I know you had been expecting a strong second half, and it doesn't look like third quarter really went in that direction. Are there any implications from a rating agency prospective with the free cash flow remains challenged?

Earl Shanks

Sure, I'd be happy to comment on all of that Jason. I think, in general, the businesses apart from the charge on bigger part have tracked against our expectations in the third quarter and, in general, are going to be in the range of the expectations that we laid out for each of the businesses that we laid out in July. I think the range for the second half of the year is going to be pretty consistent with that. So there is no real change with any of the businesses in that regard.

In terms of cash flow, you are right, the third quarter was less than we expected it to be. Significant contributor there was the additional cost we had in HR Management that will have some impact as well in the fourth quarter, so I am pessimistic about our ability to get to our previous cash flow guidance for the fourth quarter. I still think it will be positive and much stronger positive cash flow than what we saw in Q3, but probably not getting us to the full year numbers I would expect.

I think the good news from a cash flow standpoint as we look at it is the cost that we are incurring in HR Management, we think are peaking here in the second half of the year and we see a significant positive swing year-over-year from a cash flow standpoint in terms of what will be required for that business, and therefore the overall impact on our cash flow, and so therefore I am more encouraged about where cash flow will come out in 2009.

And as to the rating agency, certainly we've been having conversations with the rating agencies. They are quite aware of the pretty strong cash position we have and the very solid liquidity we have, and in the current market that's one of the first questions that they ask of every company that they call. We've got a very solid response to both of those. So I don't expect near-term changes from the rating agencies. Obviously, they made an adjustment because of the additional debt we took on for the Intervoice acquisition which was not much of a surprise.

Jason Kupferberg - UBS

Okay. And a follow-up in terms of your commitment to the HR Management business, sounds like you're starting to take some actions here, but things haven't been going as expected more recently. Can you comment on how you're thinking about the business strategically? Are you totally committed to fixing it, or is it possible that you also look for potential exit strategies?

Dave Dougherty

Jason, this is Dave. I want to emphasize my focus right now, the number one priority is doing the things that we talked about here in the call. I mean, we are taking a very different approach in terms of how we go to market and we're not going to take on any additional implementation risks, we're taken pretty dramatic actions to streamline the existing operation and then we've engaged discussions with the two large HRO/BPO clients that were doing the implementation right now.

I'm laser focused on that. Having said that, if somebody comes along and makes an offer for the business, we certainly would evaluate that, the management team and the board, but my focus right now is on fixing the business.

Jason Kupferberg - UBS

Okay. One last question on pension. I think last quarter or couple of quarters ago, you said you planned to clear about $15 million of cash into the plan this year. Obviously financial market returns has been pretty awful for pretty much everyone's pension plans. So any changes on those assumptions for this year and anyway to start thinking about the potential pension expense or cash contributions in '09?

Earl Shanks

We did, Jason, put $13 million into the plan in the third quarter, pretty consistent with our expectations. Certainly we've begun to think about '09, but there's enough volatility in the marketplace that I'm probably not at the point that I yet want to start predicting exactly what we'll put into it, given that I'm not smart enough to predict the ending market value that are underlying the plan. We'll remind you that we did freeze the plan from a benefit standpoint earlier this year, so it's the plan where the liability is essentially capped at this point.

Jason Kupferberg

Okay. Thanks for the comment.

Dave Dougherty

Thanks, Jason.

Operator

Thank you. Our next question comes from Shaul Eyal with Oppenheimer & Co.

Shaul Eyal - Oppenheimer & Co.

Thank you. Hi. Good morning.

Dave Dougherty

Hi, Shaul.

Shaul Eyal - Oppenheimer & Co.

Question on the CMG side. I recall you spoke about the volume of calls last quarter. I think you spoke about the automotive vertical that was a little weak. Can you provide us with some color as to the various breakdowns that you had seen this quarter from the CNG and as it relates to call volume, I would imagine maybe the financial sector could have been even a little better than you would have expected given the turmoil that we are experiencing?

Dave Dougherty

Well, let me start to add on. As you can see in our external report results and we did see declines in the financial services sectors. I guess to your point, they could have been worse. The good news for us is in my view we are not terribly have large exposure to financial services, and in some of the other vertical categories, almost 60% or so of our revenues of our revenues in Customer Management come from communications.

And you know quite frankly, communications companies continue to do pretty well. AT&T reported this week, Verizon reported this week, and you see continued strong growth in wireless subscribers and certainly that's good, that's a good thing to be attached to in the communications market right now, in my opinion.

Earl Shanks

The only thing I would add to that is certainly our words are fairly cautious as we look out in the year and into next year, and part of that is generally what we see on a call volume basis, and where that is going. We are not seeing horrible news there but certainly we are seeing news that causes us to be cautious in terms of where the call volumes are running, and it's probably a bit worse in that regard than it was in the second quarter call in terms of our caution around it because we work that.

Having said that, we are still within the range of the guidance that we provided in terms of the operating performance in the second quarter, so no significant shift there. I think that is probably as much as not because of the success we had and Dave touched on this in his comments of selling new business during the quarter.

Dave Dougherty

We feel very good about that.

Shaul Eyal - Oppenheimer & Co.

Now, that's fair enough. I have one final question on the Intervoice integration; how is that coming along relative to what you have seen as you started the process? Are you happy with what you are seeing so far even in this very, very difficult environment?

Dave Dougherty

Great question. We are extremely happy. It's off to a great start. As you can imagine, clients are looking for ways to do care in lower cost ways, and automation speech and IVR is perfect timing to be bringing that capability to market combine that with our other capabilities. So we've seen an awful lot of interest from clients.

I mentioned in the script one we've already kind of landed one new client that combines the value proposition of our automated and our live agent. And we're seeing what looks like very, very strong demand for that capability.

Earl Shanks

And, on the other side, Shaul, we are on track to take the cost out that we expected to take out. So, it's good news on the revenue side and good news on the cost side.

Shaul Eyal - Oppenheimer & Co.

Got it. Thank you very much.

Earl Shanks

Thanks.

Operator

Thank you. Our next question comes from Ashwin Shirvaikar with Citigroup. Your line is open.

Ashwin Shirvaikar - Citigroup

Hi.

Dave Dougherty

Hi, Ashwin.

Ashwin Shirvaikar - Citigroup

My first question is, does your new sort of HR Management guidance take into account that many of your existing clients have recently announced large layoffs and how do such layoffs in the client base affect the numbers?

Dave Dougherty

Well, certainly Ashwin, as you understand, the pricing in that business is generally per employee per year pricing. So, if we have a change in the number of employees and I touched on this, that we have had a change to the number of employees in the guidance that we provided, that will have an impact.

There are contractual floors though, in those contracts as well to provide us with some protection. I'm not sure, I've kept up on every single announcement regarding layoff, but we've tried to make those in, in general, and that's why I've touched on in the comment.

Ashwin Shirvaikar - Citigroup

Okay. And in that same business, other large vendors that have gone through the same process you are going through and they went through it a couple of years ago. It subsequently took them one to two years to sort of settle down that business. How are you confident that you take shorter time?

Dave Dougherty

Well, I think the actions we are taking I'd say are pretty severe, and we are being ruthless about the point of view we are taking in terms of winning new business, and we are not going to take on any additional implementation risks as we look at opportunities in the market, look to partners and others to provide that capability.

And as I've said in the prepared comments, we've begun negotiations and discussions with a couple of the large clients that we're in flight on the implementations; and our expectation is that we will look at them modifying some of the terms of our relationship going forward, and how we approach those implementations. Again, that is designed to reduce our risk and financial exposure.

Ashwin Shirvaikar - Citigroup

Those are the same actions, those other vendors took actually, it took them one to two years. But moving on, my question on Canadian currency, Canadian currency retracing its steps, so has your strategy or your tactics in Canada changed because of that?

Earl Shanks

Well, certainly in the short-term, at least once we get beyond the existing hedges that we've got in place, the change that this happened with Canadian currency is going to be very helpful to the near-term profitability that we have in that geography. So I would expect as we get into the later part of next year and particularly that that will help us with the next year's results.

The challenge in Canada has been labor availability in some locations as well, given the oil field development that's up there. I think it's a little early to tell how much impact the currency change is going to have and the change in value of oil is going to have on the labor market up there. So I think directionally we are still down a road that says our footprint in Canada is probably going to be significantly lower in total than it has been historically for us and we are down to about 13% of our labor force now in Canada.

So that shift is already happened so to speak. I think it's possible, Ashwin, that we'll stabilize at a level there or somewhat below there if the currency does stabilize, but certainly given the experience we had, I think we are cautious about counting on that currency to stabilize and the ability to be successful in that market until we really get more confidence around the currency to stable.

Ashwin Shirvaikar - Citigroup

Clearly it is very difficult to predict currency. My last question on DSOs. Any comment on DSO? Are you seeing clients maybe push out payments?

Earl Shanks

We are not seeing a significant challenge around that, Ashwin. I think what happened with us in the quarter was pretty much what we had expected and frankly what I've been trying to indicate externally for a couple of quarters. But I also expect an improvement in DSO here in the fourth quarter based on the timing of payments that we've got laid out from clients. So I should see an improvement this period based on the specifics of our client relationships.

Ashwin Shirvaikar - Citigroup

Okay. Thank you.

Operator

Thank you. Our next question comes from Karl Keirstead with Kaufman Brothers.

Karl Keirstead - Kaufman Brothers

Hi, good morning. I have got a few questions for Earl. Earl, just given the street sensitivity to balance sheet issues given these extraordinary credit markets. So I'm wondering if you could review the debt balance which post the Intervoice acquisition is now 650, and just could you talk a little bit about whether there are any required principal payments over the course of '09, any required funding events in order to pay this off? Are there any restrictive loan covenants that it would be good for us to know, a little bit of added color would be great?

Earl Shanks

Sure. I'll be happy to do that. I think in general, Karl, we don't have a lot of restricted loan covenants or anything like that that are particular issues that I'm worried about. I think, there are essentially two loan documents that are relevant. One is our revolving credit agreement about $400 million. It was renegotiated a couple of years ago and matures in 2011 and so, no short-term challenges with that one.

The other one is the bond deal we did now just about four years ago a five-year bond deal, so matures is December of next year about $250 million. And in terms of the things that we are funded at the moment, those are the two big liabilities that are funded.

When we look at the $250 million, the good news given our expectations about cash flows and our current cash position is that if the credit markets don't open again, we have the ability with our current cash and cash flows to fund the $250 million in its entirety at the end of next year and to repay that.

So, while it's something we are attentive to, it is something we think we have an answer under our control with regard to. We also have a couple of additional facilities in total about $75 million that are currently un-drawn besides the cash that was on the balance sheet at the end of the quarter. So, there is a fair number of liquidity cushions, I think on our balance sheet that I feel comfortable with.

Karl Keirstead - Kaufman Brothers

Okay. That color is terrific. One related follow-up. Obviously given the debt balance, the interest expense jumped a little bit in the third quarter to 5.5 million, but I don't think that included a full quarter with the added debt. Could you give us a little bit of color as we try to model where that interest expense total will go to in the coming quarters?

Earl Shanks

Yes. It will go up, a couple million dollars more probably in the fourth quarter.

Karl Keirstead - Kaufman Brothers

Okay. And then just a bit of a nip here. I think in your prepared comments early you mentioned that in the IMG unit there was a $10 million payment by a client. Did I infer correctly that that boosted your margins in the third quarter? And if it did, was it by the full $10 million, maybe you can add a little color?

Earl Shanks

Yes. We had a couple of unusual things in the quarter. That was one, the additional amortization of about $3 million was the other in the business, so net we had $6 million or $7 million flowing through on that.

Karl Keirstead - Kaufman Brothers

So it was $6 million, $7 million flowing right through the margins?

Earl Shanks

Yes.

Karl Keirstead - Kaufman Brothers

Okay, good. Thanks for the color.

Operator

Thank you. Our next question comes from David Koning with Robert W. Baird.

David Koning - Robert W. Baird

Yes. Hi, and a couple of other things. On IMG; if we look at it, the revenue was down about $28 million sequentially. Are we now at base, I guess, that is completely out?

AT&T and others a little loss, but I guess might still be coming. But are we pretty much at a base now if we take out that additional $10 million license fee and tend to go to $123 million? Is that a base now probably not going to get lower than that and grow from there?

Earl Shanks

Certainly that's an expectation that we have when we look even third quarter to fourth quarter, we expect to see the business grow between third quarter and fourth quarter in order to meet the guidance expectations, David, that I touched upon. The business has moved more to a license and software model, and so there's going to be more volatility quarter-to-quarter in that business than what we've seen in the past.

And as we talk about last quarter, we had some accelerated revenue into the second quarter, which came out in the third quarter. So this was pretty much as expected from our standpoint in terms of what was going to happen.

David Koning - Robert W. Baird

Okay. And then I guess on the margin side then, net it sounded like $6 million or $7 million of EBIT, additional EBIT kind of fell to the Q3 line. Without that margins would have been sub-10%. Is there something that will happen short-term that will push margins quickly back above 10% by Q4 already?

Earl Shanks

Well, I mean it always depends on the mix of revenue and projects that you got in the business. I mean we are also across the businesses looking for opportunities to squeeze cost. But the key driver for what happens to margins is what the particular mix is and given that particular mix we had this quarter, it was the margins were down a bit.

Dave Dougherty

We don't want to be down for the whole year.

David Koning - Robert W. Baird

Right, sure. Am I right that Intervoice was done, was it August once two months of revenue in the quarter?

Earl Shanks

One month, just one month.

David Koning - Robert W. Baird

Just one month. Okay. So you triple the $14 million and $40 million, $45 million of normalized revs per quarter.

Earl Shanks

That's roughly right.

David Koning - Robert W. Baird

Okay. So it sounds like it's a little bit below, was going a little over $200 million run rate, but sounds like it's a little lower than that, but it sounds like not outside of your expectation?

David Koning - Robert W. Baird

Not at all. I think it's pretty consistent with our expectations.

David Koning - Robert W. Baird

Okay. Thank you.

David Koning - Robert W. Baird

Thanks.

Operator

Thank you. Our next question comes from TC Robillard with Banc of America Securities.

TC Robillard - Bank of America Securities

Great. Thank you. Good morning, guys.

Dave Dougherty

Good day.

TC Robillard - Bank of America Securities

I just wanted to go back to the issues that you guys are addressing in the HR Management business. As we are looking forward, I know this is a quarter-to-quarter situation that you continue to evaluate, but how much more risk do we have that there are some accelerated implementation costs for some of your existing contracts that you have? You already addressed the two that you had issues with now.

You are not going to be taking on incremental risk going forward, but there is still a couple of years of contract signings that display some additional risk. I'm just trying to get as sense to, where we're looking for accelerated implementation cost over the next couple of quarters, or is this something that, you guys are just going to have to review quarter-by-quarter and if you have to take the charge, you take the charge?

Earl Shanks

Well, TC, I'd remind you that what we're talking about at this point is primarily two contracts. So it's not an unlimited number of contracts and it's not as some of our competitors had a whole series of contracts that they were trying to deal with meant to little hard to mange. It is something we will have to review every quarter. That's what the rules require. It is what we are of a practice of doing.

We don't currently expect that we will take more charges for implementation based on what we look at the timing of the payments from the clients that are contracted and the expected timing and what we're going to spend in terms of the implementation. But, that's something that we are going to have to really address pretty carefully over this quarter and the coming quarters in order to get to the right outcome in the business, which is why we are back to talking to the clients about potentially changing the approach to some of the implementations.

TC Robillard - Bank of America Securities

If you don't get the stability to change some of that approach, would you run at the same risk where there is greater IT infrastructure that's got to be in place? I mean, wage inflation aside, it sounds like as if this has gotten a lot more complex than you've guys had expected which leads me to believe that there are other contracts that you have that have been signed over the past couple of years that would also take this kind of risk. Maybe I can ask this in another way.

What are you guys getting your initial feedback from these initial conversations with your clients? I mean, are they receptive to this, or because of the environment we're in they're going to push back or they're just looking to save as much as they can save?

Earl Shanks

TC, let me touch on some of that and then Dave will touch on some of that later. I want to remind you that we've two big implementations in progress, and so I've got the other implementations done at this point, so I'm not going to get surprised out of the other implementations. So those are in an operating mode already. We in a different position in that regard. With that, I'll let Dave comment on where the conversations are…

Dave Dougherty

One of the clients, one of the contracts we are talking about the client is paying for the implementation is a fixed amount they are paying, but they are paying for the implementation. So it softens the blow a bit.

But the reactions we've gotten from the clients is their willingness to work with us and consider different approaches to implementing these projects on a go forward basis. So, I'm optimistic that hopefully, we'll get to a position with both of them that works for both of us.

TC Robillard - Bank of America Securities

Okay. I'm sorry. I don't mean to belabor this point here, but if the conversations you are currently having with these clients don't work in your favor, would you have additional charges to come through?

Earl Shanks

I think that's something, TC, we'll have to evaluate at the time and work through in detail, and it's probably not something I'm going to negotiate publicly with a client on a call like this one. So probably I've gone as far as I'm going to go in terms of discussing a specific client.

TC Robillard - Bank of America Securities

Okay, fair enough. On the currency issues with the Canadian dollar, can you remind me when you put the contract hedges in place, because of the strengthening of the dollar through the quarter. It looks as if you actually had an incrementally greater headwind. So were these hedges put on kind of late in the second quarter?

I'm trying to get a sense as to when you anniversary your hedges. If the dollar continues on its trend line of strengthening, it actually starts to become a significant benefit to your operating line.

Earl Shanks

With the Canadian dollar TC we hedge out, well in fact with all of our currencies we hedge our periods of time, which is as short as six months and as long as two or three years. With the Canadian dollar we have got hedges now that cover about half of next year. So it will be the second half of next year before we see the significant impact of current rates.

TC Robillard - Bank of America Securities

Got you. One last housekeeping question. You said the deferred charges, the balance at the end of the quarter, was up $40 million. Was that sequentially or year-over-year?

Earl Shanks

There was a $40 million increase in the quarter if you exclude out the impact of the charge.

TC Robillard - Bank of America Securities

Okay. Perfect. Thank you.

Operator

Thank you. Our next question comes from Peter Jacobson with Brean Murray.

Peter Jacobson - Brean Murray, Carret & Co.

Thanks. Good morning, everyone.

Dave Dougherty

Hi Peter.

Peter Jacobson - Brean Murray, Carret & Co.

Earl, regarding the '09 tax rate and fourth quarter you talked you are expecting 45% and 25% normalized, is there a suggested tax rate for '09 for modeling purposes at this point?

Earl Shanks

Not at this point, other than I expect to continue to be successful at managing the tax rate and staying away from the statutory rate of 35 and running at something that is meaningfully below that.

Peter Jacobson - Brean Murray, Carret & Co.

Okay. I think your words were something to the effect concerning HR, of not taking on significant implementation risks. It seems to me that that would have been a normal practice that you would have had over a period of years based on your experience with these projects. Can you give us an example of a significant risk that you have taken on that you would not be taking on in the future?

Dave Dougherty

Well this, maybe Peter, just to be clear, the implementations that we're doing for the two large customers we are talking about, we're doing the predominance of the work. Once the blueprint is finalized and the actual costing and everything else - we are doing that.

And the expectation on a go-forward basis would be that, we would not be doing that work and that we would turn to partners to have them handle those phases of the project. And that our expectation is that in those circumstances we would be the ongoing operator potentially. But again, we'd had no exposure to implementation risk. Earl, do you want to add anything?

Peter Jacobson - Brean Murray, Carret & Co.

Okay. That's all I had. Thank you.

Dave Dougherty

Thanks Peter.

Operator

Thank you. Our next question comes from Scott Sutherland with Wedbush Morgan Securities.

Scott Sutherland - Wedbush Morgan Securities Inc.

Great, thank you. Good morning.

Dave Dougherty

Good morning. How are you Scott?

Scott Sutherland - Wedbush Morgan Securities Inc.

I want to return to IMG margins. You mentioned in the prepared comments, we know that a large customer finished migration last quarter and that’s why it impacted the margins. And you also mentioned some lower licensing revenue in the quarter. Can you talk about the impact of each and kind of how you expect new margins to back up next year?

Earl Shanks

Scott, I'm not sure I completely follow your question. In general, the mix of revenue has a pretty direct impact on margins in this business, and to the extent that we drive license revenues up in the business, that's positive for margin and that's probably the biggest variable.

We had, as we talked about last quarter, accelerated some license revenue into the second quarter, and so that was good for the second quarter margins, but that would ordinarily have come out of the third quarter in terms of the timing we were expecting and client wanted to get it done in the second quarter, so we got it done. But that had a negative impact this quarter, as we see more license revenue sales in the business in coming quarters that will have a positive impact on margins in future quarters.

Scott Sutherland - Wedbush Morgan Securities Inc.

Yeah, subsequently the Sprint revenue that you were recognizing up to Q2, that's a pretty profitable stream that you now have lost?

Earl Shanks

The Sprint revenue was at pretty at kind of average margins.

Scott Sutherland - Wedbush Morgan Securities Inc.

Okay. Same question I had on Intervoice. How are you going to market with this? You have primarily done outsourcing and you could probably really run the managed services group pretty well, but how are you targeting doing the license and on-premise sales and are you doing the bill-and-operate transfer model? How do you expect to target the customers, to drive a hybrid model here?

Dave Dougherty

Well, the view we are taking, which is very consistent with your philosophy, of being flexible and doing what the client needs, and so they've offered both premise space and alternatives to that. We see on a go forward basis that we'll continue to do that and offer either alternative, and believe me, we have great value proposition with a hosted approach. But if the client wants to buy the technology and run it themselves, we certainly welcome those kind of opportunities as well and work with them to install it and modify the technology going forward. So we are kind of agnostic.

Earl Shanks

And on a more tactical level in terms of how we are approaching the market, there is 50 or 100 customers, of our customers that are an easy set to look at where we need to have a specific account plan that leverages both our capabilities and the Intervoice capabilities.

We have those specific account plans and as Dave talked about some of what's coming out of that is the cross-sell opportunities we see. We've also done significant cross-training of their sales force, of the Intervoice sales force, so they understand the historically Convergys products and how we market those products.

Now we can't take all of our products to all of their 5,000 customers, so it's a tiered approach to the customer sets to make all of this work with the kind of the top 50 or 100 customers, which are pretty obvious there is going to be specific account plans and then as you tier down the customer set, we'll have modified approaches in order to sell what's appropriate to each of the level of the customer.

Scott Sutherland - Wedbush Morgan Securities Inc.

My last question is for you Earl. What about stock comp? It looks like that $65 million of implementation cost was driven across multiple line items. Do you have the breakout from cost of sales and OpEx…?

Earl Shanks

$65 million is primarily in cost of sales and the stock comp was $2.9 million in the quarter.

Scott Sutherland - Wedbush Morgan Securities Inc.

Great, thank you.

David Stein

Operator, we have just time for one more question.

Operator

Thank you. Our final question comes from Dhruv Chopra with Morgan Stanley.

Dhruv Chopra - Morgan Stanley

Good morning gentlemen.

Dave Dougherty

Good morning.

Dhruv Chopra - Morgan Stanley

Given the cash flows the HRO restructuring and the December '09 debt maturity; how should we think about the share repurchase plans going forward?

Earl Shanks

Well, we have stopped doing our share repurchase plan near the end of the second quarter as we began to think about liquidity and the importance of liquidity in the near term. We are likely to reactivate that program when the financial markets open up again, because I want to make sure that we have adequate liquidity for the $250 million debt repayment in December of next year. And so we'll devote the cash to that purpose.

Dhruv Chopra - Morgan Stanley

Okay, great. And lastly, can you give us some broad trends that you might be seeing on the customer management side from customers? Are they still signing deals in the current environment, are they pushing out decisions?

Dave Dougherty

I've referenced earlier that I'm pretty encouraged by continued strength of our pipeline, the number of opportunities that are being added to the pipeline. We are converting the pipeline. Actually, our conversion rate is up a bit. So I'm feeling good about that. My concern and Earl touched on it earlier is just our existing base of business and clients forecast here for the fourth quarter. We are seeing a fair amount of be prudent and be very conservative.

So, we certainly have taken that approach as we looked at the total business. But, my perspective appears to be still fairly significant amount of demand and in this environment we're taking a view of being aggressive and being out there with our clients and trying to see if we can help in bigger ways. So we are trying to generate demand too, because we think there is a lot more we could be doing for clients In this environment clients may be interested in making moves that are bigger than potentially ones that they have considered in the past.

Dhruv Chopra - Morgan Stanley

Great. Thank you.

Dave Dougherty

Sure. Operator, I'd like to add that Earl and I will be available the rest of the day to answer any questions about third quarter results or the forward guidance that we have discussed. And thank you all for your participation today.

Operator

Thank you. This does conclude today's conference. You may disconnect at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!