Affiliated Computer Services, Inc. F1Q09 (Qtr End 09/30/08) Earnings Call Transcript

Affiliated Computer Services, Increase.(ACS)

F1Q09 (Qtr End 09/30/08) Earnings Call

October 30, 2008 4:30 pm ET

Executives

Jon Puckett - VP of IR

Lynn Blodgett - President and CEO

Tom Burlin - COO

Kevin Kyser - CFO

Analysts

Julio Quinteros - Goldman Sachs

James Kissane - Banc Of America Securities

Ashwin Shirvaikar - Citigroup

George Price - Stifel Nicolaus

Adam Frisch - UBS

David Grossman - Thomas Weisel Partners

Tien-Tsin Huang - JPMorgan

Moshe Katri - Cowen & Company

Bryan Keane - Credit Suisse

Bhavan Suri - William Blair & Company

Presentation

Operator

Welcome to the ACS first quarter fiscal year 2009 conference call. Today's call will consist of prepared statements by ACS followed by a question and answer period. All participants will be able to listen only until the question and answer begins. The call is webcast live on the company's website and available for replay purposes. If you have any objections, you may disconnect at this time. I would now like to turn the conference call over to Jon Puckett, Vice President of Investor Relations. Mr. Puckett, you may begin.

Jon Puckett

Thank you, Sara. Good afternoon, and thank you for joining us today to discuss our first quarter fiscal year 2009 results. Today on the call we have Lynn Blodgett, President and Chief Executive Officer, Tom Burlin, Chief Operations Officer, and Kevin Kyser, Chief Financial Officer.

As always, I must caution everyone that any statements on this call that are not historical facts may be considered forward-looking statements within the meanings of the Federal Securities Law. As you know forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed in or implied by these statements. Additional information concerning these factors is contained in the company's filings with the SEC. Copies are available from the SEC's website, from the ACS website, or from ACS investor relations. We have also provided a presentation on our website that we will refer to during our discussion.

We will reference certain non-generally accepted accounting principal financial measures, which we believe provides useful information for investors. We have posted both the presentation and the reconciliation of those measures to generally accepted accounting principles on the investor relations page of our website at www.acs-inc.com.

And finally we disclaim an intention, and undertake no obligation, to update or revise any forward-looking statement.

]I will now turn it over to Lynn Blodgett, who will provide a summary of the significant events during the quarter.

Lynn Blodgett

Thank you, John, and thanks to each of you for joining us today. Please turn to slide number three. It goes without saying that we are in the most uncertain economic times that any of us can remember. The news from the financial markets and main streets of the world are sobering to say the least.

In these uncertain times, I'm grateful that since the beginning our company has been built on a foundation that not only allows us to survive, but, in fact, allows us to thrive in difficult economic times.

These better off principles are: one, focus on services that are non-core, but essential to our client; two, win contracts with predictable recurring revenue streams; three, in government, focus on services that are either basic needs no matter what the economic environment such as Medicaid, or the activities that help government entities generate revenue or cut costs to address their budget challenges; and; four, build a diverse portfolio of services and customers in order to minimize risk from a particular sector or client.

Although none of us have seen the full effect of this economy, our first quarter results show that our model is solid and it works.

Revenue is the life blood of any company, and this quarter our internal revenue growth accelerated from 4% to 5%. Total revenue growth was a healthy 8%, excluding divestitures. Adjusted operating profits grew 9%, to $178 million, and adjusted operating margins increased 10 basis points, to 11.1%.

Finally adjusted earnings per share grew 16% over the prior year quarter, to $0.89. In nearly any economic environment these would be strong results, but to deliver these in the face of the storm that we are all weathering makes me very proud of our team and very confident in the defensive nature of our business model.

Kevin will provide much greater detail on our financial performance, as will Tom on operations, but let me focus on the key areas of sales, pipeline, bookings, and renewals. Bookings, which are the ultimate driver of revenue and growth, were strong at $203 million of annual recurring revenue, and resulted in a 40% increase in the trailing 12 months bookings on a year-over-year basis to $863 million.

This is the highest growth that we've seen in five years. Total contract value was $774 million. Turning to renewals, our renewal rate for the quarter was 76%, which is below our goal of 90%, primarily due to the non-renewal of the Georgia health partnership contract.

We included this loss in our renewal rates this quarter, as we received the final notification. However, remember that this will not impact our revenue until fiscal year 2011. We believe our renewal rates for the remainder of the year will approximate our goal of 90%.

Next, we finish the quarter with a new business pipeline of approximately $2 billion. I'm extremely pleased with our first quarter results. As we look at today's circumstances, we are very mindful of the challenges that our government and commercial clients and prospects face. The pressure to reduce costs, to do more with less, and to fill holes in budgets increases daily. I'm reminded of a statement that Churchill made, ”An optimist sees the opportunity in every difficulty.”

When discussing these conditions with our Chairman, Mr. Deason, board members, and other members of the executive management team, we determined that this is precisely the course that we should pursue. Here at ACS we have skills and capabilities that can help our clients and prospects with these demands in very substantial ways. Our services are needed more broadly by more organizations today than ever before.

Please turn to slide No. 5. In order to provide the greatest value to our customers and to strengthen our organization, we are taking the following actions. Number one, we are reducing our costs aggressively. Recall we are one of the first companies to leverage offshore production, and we have a proven global production model.

We ended fiscal 2008 with nearly 18,000 employees in our low cost offshore production locations, which represent 28% of our total workforce, but we are doing more to keep our cost structure competitive. We must take advantage of our ability to use talented offshore employees, and significantly expand our global production model in order to reduce our costs of service delivery and our internal administrative costs.

Our plan is to increase our offshore headcount in fiscal 2009 by approximately 4,200 employees, a 23% increase over our 2008 offshore headcount. To have a greater financial impact we will be moving a higher percentage of more complex, higher paying, jobs offshore, including management and application development roles.

Tom will provide more detail on our offshore plan later in our presentation, and Kevin will provide the financial details, but in short the plan that we are announcing today will require us to take a charge in the second quarter in the range of $14 million to $16 million, and to incur other transition costs related to this new offshore investment.

We anticipate our full payback on this investment will occur by the second quarter of fiscal year 2010. This is the right thing to do and the right time to do it. This investment will make us stronger, not only during this economic storm, but for years to come.

Number two, we must get our message out to more organizations more rapidly. This initiative will allow us to invest more in sales and sales-related activities. In FY ‘09 we've already added 47 salespeople and plan to add 91 more during the remainder of the fiscal year.

These additional resources will help us expand our existing sales pipeline and continue to stoke the fire of our sales engine that needs to continue to grow to achieve our aggressive sales target for fiscal 2009.

The third aspect of our plan is to create clients for life as we focus on strengthening our long-term client relationships. Some of our clients may be capital constrained, and we intend to make certain investments that are beneficial to both our clients and ACS. We have done this in the past and it has been very successful.

Let me give you an example from a conversation I had recently with the CEO and other key executives of one of our largest clients. We were discussing the growth in our relationship. They commented that many companies talked about being partners with them, but that ACS actually does it.

They remarked about the investments ACS made, and innovations that ACS brought to bear for their company, which are significantly improving their operation. Our stability affords us an opportunity to make these investments in our clients today, a time when our services are needed more than ever, and forge even stronger client relationships.

We're able to do this because of the internal investments that we have made in our broad service offering that we can leverage, including our innovative solutions, our technology platform, and our global production model.

Standing by our clients in these difficult times should expand the services we provide for these clients for years to come, creating clients for life.

Number four, we must continue to be disciplined with our use of cash. We typically generate free cash flow ranging from 6% to 8% of revenue. Our strong cash flow generation and disciplined use of cash has provided us with a strong balance sheet. It is this strong balance sheet that allows us to lay out an aggressive plan of action amidst this tumultuous economic environment and makes these investments that will help to drive our continued growth and profitability.

We will make these client investments while continuing to leverage our competency in acquisitions. During fiscal 2009 we expect to add vertical expertise and technology solutions to maintain our competitive edge. We have an active acquisition pipeline, and will remain conservative with our approach to valuations.

We are in unpredictable times that have created choppy waters around the world, but ACS has been, and will continue to be, a company that performs well in difficult times. Our proactive plan to take advantage of the disruptions caused by the economy will make us more competitive, and should ensure our future growth and success. I believe that we are well positioned for fiscal 2009 and beyond.

Now let me turn it over to Tom for an operations review.

Tom Burlin

Thanks, Lynn. Please turn to slide seven. I will provide some more detail in our signings. Total contract value basis trailing 12 month signings increased 15% over the prime trailing 12 month period to $3.3 billion. Our first quarter signings were driven by the government segment, which contributed 55% of the signings, and commercial comprised 45%. In our federal solutions business we leveraged our student loan processing solution and expertise to expand our relationship with the Department of Education.

In transportation, we expanded a significant photo enforcement relationship with a client, and leveraged the SmartBus solution that we acquired in the TMS acquisition. We expanded our services with clients, and cross sold our defined contribution record keeping service to a state client, leveraging our commercial total benefits outsourcing solution.

In commercial ITO we created several relationships with [major management services]. In business process solutions we leveraged our process expertise, signed new business, and expand client relationships.

From a service line perspective 87% of first quarter signings were BPO and 13% were ITO. I'd be pleased with the results in a normal environment, but I'm even more impressed with our sales teams given the uncertainty in the economy that occurred during this quarter.

If you please turn to slide eight, we renewed $304 million of annual recurring revenue, which represented total contract value of $1.1 billion. On a trailing 12-month basis we renewed $967 million of annual recurring revenue and $3.6 billion in total contract value. This represents 48% growth in renewal ARR, and 105% growth in renewal TCV over the previous trailing 12-month period.

Our first quarter total signings, new and renewed business, have a total contract value of $1.9 billion and a trailing 12-month total contract value of $6.9 billion. As Lynn already mentioned, our first quarter renewal rates of 76% were driven by the non-renewal of the Georgia Health partnership.

If you'll now turn to slide 9, I'll provide some more detail on pipeline. We're seeing pipeline strength in several areas across both segments. We believe we'll see more opportunities to help existing and [perpetual] clients improve their operational effectiveness, and drive cost savings to the bottom line.

We're pursuing numerous healthcare prospects in both commercial and government. We're excited about the opportunities to leverage our loan servicing platform in our commercial education business. We continue to see excellent prospects around the globe in transportation, and finally we see strength in S&A outsourcing and HR point solutions. We have also provided the split of our pipeline between segment and service line.

If you'll now turn to slide 11, I was pleased with our commercial results this quarter. On a year-over-year basis commercial total revenue grew 10%, excluding divestitures, with 6% internal revenue growth, which was driven by our communications and consumer goods vertical as we ramp new wireless customer care business.

In HR we saw increased activity in consulting, and grew our ACS learning business as we ramped new contracts. We believe our decision to leverage our point solutions is the right one, especially given today's environment, as clients are seeking faster return on their outsourcing decisions.

In S&A we saw good growth also due to new business ramp. Total revenue growth was positively impacted by our acquisition of Syan and [SDS], which provided our ITO business with additional global reach, and the acquisition of CompIQ, which broadened our service offerings in healthcare payer.

On a sequential basis, revenue was slightly down due to the impact of renewal pricing. Turning to profitability, year-over-year adjusted operating margins remained constant. Sequentially, adjusted operating margins decreased by 30 basis points, primarily due to renewal pricing and lower transaction volumes in certain parts of our business that are economically sensitive, like shipping, freight, and airline.

If you'll now turn to slide 13, I was pleased that revenue growth in our government segment rebounded from last quarter. On a year-over-year basis, despite the negative impact of the Florida MMIS contract, government total revenue grew 6% excluding divestitures, with 4% internal revenue growth.

Internal revenue growth was driven by the ramp of new business, primarily in electronic payment, and children and youth services. Government healthcare grew as we ramped new Medicaid business. Revenue growth was partially offset by volume declines in our electronic toll business, lower unclaimed property, and a non-renewal in our government IT business.

Total revenue growth year-over-year was positively impacted by our fiscal year 2008 acquisition of TMS and our transportation business.

Our ability to grow government business despite the backdrop of tightening state budgets gives me confidence in our business model, and it sheds its counter-cyclic nature.

On an adjusted basis government operating margins decreased a 110 basis points year-over-year and sequentially. The year-over-year decline was driven by lower volumes in our electronic toll business and the non-renewal of the Florida Medicaid contract, which was generating higher incremental margins than the new Medicaid business we are ramping.

This tradeoff in margins was the primary driver for the sequential margin decline, also. But over time we expect the margin profile in new business to improve as we ramp. It's important to note that due to reduction in overhead, consolidated operating margins increased 10 basis points sequentially and year-over-year.

If you'll turn to slide 14, I'll provide some additional information regarding our offshoring initiative. As you can see from the chart in this slide, we have steadily grown our offshore employee base over the past several years. We plan to significantly accelerate this growth with the offshoring initiative that we are announcing today.

Our target fiscal 2009 is to increase offshore employee base by more than 4,000. This is the largest annual increase in offshore headcount in our history. We're taking this step now for several reasons.

First, as Lynn discussed, to increase our investment in sales. Second, this initiative will allow us to accelerate our investments in innovation, which will lead to improvements in our existing solutions for the development of new solutions, which is key to differentiating us in the market. Third, this initiative will fundamentally reduce the labor component of our cost structure and improve our long-term operating margin, providing benefits to our shareholders in the form of better returns.

We've done a great job in moving base production level jobs offshore, but have decided to aggressively move more of our higher level jobs, like production managers, higher level back office functions, and the higher level development roles, to lower cost locations.

With this initiative we plan to expand our capacity in the Philippines, Mexico, Jamaica, and Guatemala. We will also create a new production center in Noida, India. This offshore expansion requires more significant upfront investment due to the higher complexity of work, which requires a greater degree of job training and [job sharing].

These actions will further strengthen and diversify our global delivery model. Kevin will cover the financial details of this initiative later in our presentation, but I think you'll agree this initiative is the right action to take and this is the time to do it.

In summary we delivered a strong quarter in a difficult environment. Our offshore initiative will benefit our operations for many years to come.

Let me turn it over to Kevin, and he’ll take you through the financials.

Kevin Kyser

Thanks, Tom. Please turn to slide 16, and let me spend a moment on our first quarter highlights. Revenue for the first quarter was $1.6 billion, and represented 8% total revenue growth excluding divestitures. Internal revenue growth accelerated to 5% this quarter. Consolidated adjusted operating margin was 11.1% for the quarter and was within our range of long-term margin expectations of 11% to 12%.

The year-to-year margin increase on a consolidated basis was primarily driven by lower corporate overhead expenses. On a sequential basis adjusted operating margins increased 10 basis points, primarily due to lower bonus accruals. Adjusted diluted earnings per share was 89 cents for the quarter, and grew 16% over the prior year due to growth in adjusted operating income, lower interest expense, and lower share count.

Please turn to slide 17. Recall that our first quarter is always our lowest cash-flow quarter of the fiscal year, due to the timing of our management incentive compensation payment.

The September quarter also had an extra payroll run, which negatively impacted cash flow. These two items represented about $100 million of cash disbursement in the quarter. For the quarter, we generated operating cash flow of $63 million, which was a $55 million improvement from the prior year quarter, driven by growth in earnings and better collections on accounts receivable.

Free cash flow for the first quarter was negative $11 million, but was a $56 million improvement over the prior year period, as CapEx remained flat on a year-over-year basis. We continue to expect free cash-flow for fiscal 2009 to be within the range of 6% to 8% of revenue. Given the current economic environment we will continue to be disciplined and prioritize our use of capital.

I have recapped our major balance sheet categories that had the most significant fluctuations from June on slide 18. As you can see, our cash balance was $435 million at the end of September. Accounts receivable increased $81 million for the quarter, due to lower sequential collections on AR.

On a year-over-year basis, DSOs decreased approximately one day. Accrued compensation decreased $91 million, primarily due to the timing of payroll cycles and the payment of our annual management bonuses related to fiscal 2008.

On slide 19, I provide the financial impact of our offshoring initiative that Tom and Lynn referenced earlier. Over the last several quarters, we have incurred costs to migrate lower level work offshore. However, this initiative we’re announcing today will be more comprehensive, include a higher skill level position, and take about 12 months to complete. We estimate that we will incur approximately $38 million to $42 million in severance and transition expenses over the next four quarters to move approximately 4,200 people.

For the second quarter, we currently estimate we will incur approximately $14 million to $16 million in severance and $7 million to $9 million in transition expense. As we reduce domestic positions, we will generate savings and while it will continue to be negative to the third quarter earnings, we should begin to see positive returns in our fourth quarter results.

We will take a substantial portion of the savings and invest in innovation and sales, and upon completion, we estimate the full annual run rate savings will be approximately $40 million after these investments. We should see the full benefit of the annual savings beginning in the second quarter of fiscal year 2010. We will update you quarterly on the progress of this program, as well as the costs and the savings.

Before we go to Q&A, let me provide some color around the second quarter. New business, which is the real driver of internal revenue growth, continues to ramp as we expected. We are seeing some downward pressure on our volumes as it relates to the services we provide to the transportation industry.

Considering this, we think internal growth for the second quarter will be in the range of 4% to 5%. Prior to the charge related to our offshore initiative, we expect operating margins will be similar to the first quarter. As you update your models and calculate year-over-year EPS growth, remember that in the second quarter of fiscal year 2008 we had a one-time $0.04 benefit to EPS, related to a tax refund

Also Q2 will be the first quarter in which we do not have the full benefit of the noncompete, which expires in November and will negatively impact EPS by a penny.

Our effective tax rate for the quarter is expected to be 37%. You will then need to adjust your model for the cost of our offshore initiative, which will negatively impact operating profit by $21 million to $25 million and reduce EPS by $0.13 to $0.16 in the second quarter.

For the fiscal year, based on what we know today, we expect internal growth will be toward the lower end of our original range. Prior to the cost of the offshore initiative, we are comfortable with current consensus EPS estimates of $3.82. We estimate that the cost of the offshore initiative will negatively impact full year EPS by a net $0.12 to $0.14. We would expect to see a positive benefit from our offshore plan beginning in the fourth quarter.

The first quarter results demonstrate the resiliency of our business model, and the actions we are embarking on will only make us stronger. I'm excited about the future and where we are headed.

That is all the prepared comments we have at this time. Let's open it up for questions. We have several on the line, so please hold your questions to one per caller. Operator, please

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the Q&A session. (Operator Instructions) Our first question comes from Julio Quinteros with Goldman Sachs. Your line is open.

Julio Quinteros - Goldman Sachs

Hi, can you hear me?

Lynn Blodgett

Yes.

Kevin Kyser

Hi, Julio.

Julio Quinteros - Goldman Sachs

I'll start on the offshore question and what I'm trying to understand is, as you think about the impact more from a revenue and a gross margin perspective as opposed to the benefits down the road, how do we think about that relative to the trend in organic growth? Obviously this headcount that you are going to put on is coming in. Mostly it comes in at a lower bill rating. Correct me if I'm wrong and it is something different.

Typically, on top of the expenses that you have to incur due to the transition, is some revenue deflation and drag also introduced into the model.

I’m trying to understand that and relate that back to the comments for fiscal year ‘09 lower-end organic revenue growth. Is that a part of that view or is this something more macro, and if you could parse what the drag is of the demand environment versus what might be the drag that's sort of self-inflicted as you move more people offshore?

Lynn Blodgett

Okay. Thanks, Julio. I'll start on this and then, Kevin, you can finish. The issue with the revenue growth in terms of us saying that we think it might be towards the lower end of range, that is only related to the fact that we're seeing pressure on the transportation-related volume and the issue of revenue cannibalization that you raise in terms of moving work offshore. Most of work that we're moving we have already moved the lower level jobs for that work offshore. So we don't expect a significant decline in revenue. There may be a little, but that's not what's creating that issue because we're moving work that's already -- the base work has already been moved. We're now just moving some of the expenses that we incur in servicing network. Kevin, if you'd like to add?

Kevin Kyser

I think that's right. Obviously we don't think this will cannibalize the revenue in any way. We get paid based upon the amount of work we output and produce and these folks are not -- these aren't really billable type folks. We're getting paid based upon the amount of work that we output.

Lynn Blodgett

I think the other thing, Julio, is that this initiative in terms of longer term impact on growth, that's a big part of why we're doing it. We want to be able to invest more in sales and work towards accelerating our internal growth rate in the long run. So…

Julio Quinteros - Goldman Sachs

Okay. That makes a lot of sense. Thank you.

Lynn Blodgett

Thank you Julio. Operator next question.

Operator

Thank you. James Kissane, Bank of America Securities. Your line is open.

James Kissane - Bank of America Securities

Yeah. Thanks and good job, guys.

Lynn Blodgett

Thank you. Jim.

James Kissane - Bank of America Securities

Just to follow upon the offshore issue. Is the competitive environment changing where you're seeing maybe some more pure low cost offshore competitors, which is maybe forcing your hand a little bit here or is this just too big of an opportunity for you?

Lynn Blodgett

Jim, the offshore competition isn't changing. You know, we've been facing pure play offshore firms now for a number of years. This is something that we're doing because we want to be proactive in building resources that we can spend as well as sales, as we mentioned, spend more money on innovation. As you move forward, the offshore aspect of things becomes less and less of a differentiator and your technology or solutions, those types of things become more of differentiator and we want to invest more there. So now this is being driven by increased offshore competition.

James Kissane - Bank of America Securities

Okay. Did the transportation business stabilize in the quarter for the revenue drag sequentially on the margin was more a drag year-over-year?

Tom Burlin

Jim, we did see that our volumes in our government transportation has leveled off where we traditionally saw about a 3% growth there; it flattened but the decline has certainly abated over the last three months. It is hard to tell with the change in the oil prices and the result in gas price reductions will do to drag miles, but generally we've seen it flatten across the industry.

Lynn Blodgett

This is not only the transportation business, our transportation sector that does Easy Pass and those things. This is our business that services transportation across commercial and government. So, we're seeing a decline in shipping activity, for example, and trucking activity. This is not solely related to the government sector.

James Kissane - Bank of America Securities

Got you. Okay. Thank you.

Lynn Blodgett

Thank you. Let's move to the next question, operator.

Operator

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

Ashwin Shirvaikar - Citigroup

Thanks. Can you hear me?

Lynn Blodgett

We hear you.

Ashwin Shirvaikar - Citigroup

Okay. To understand this from a tactical standpoint, are you changing your account management or sales force structure; if you move mid level management overseas, how do you handle that relationship going forward?

Lynn Blodgett

That's a very good question. The moves that we're making have very little to do with the account management and the account interface. We are talking about development-type positions that we are moving offshore, positions of supervisory middle management, with very little in terms of customer contact.

Ashwin Shirvaikar - Citigroup

Okay. A different question here. Going to the budget pressure problem that many states are facing, As the pressure continues, are you seeing any kind of change in your bookings pipeline, for example if you are in a pipeline, the nature of contracts changing maybe to more cost saving types or any changes there?

Tom Burlin

Great question. This is Tom. You know, first we're reminded that we had an improvement from a minus 2% growth to a plus 4% quarter-to-quarter. So we're seeing both new business and our base business reflected in volume growth there. As it relates to the future, I think we're uniquely positioned here. This is a counter cyclic nature. It's the reason that I'm excited about our opportunities here. Unlike most clients, our state clients are looking for things that save them money.

To give you an example. We have a client we're speaking with right now that mails out some $15 million -- 15 million cheques that are entitlement-based cheques that are unemployment or welfare based, and they spend some $26 million a year doing that. By moving to our EPC solution, our electronic payment card solution, we take that to zero. The state pays us nothing to do that. The recipients of those cheques pay some $85 million to cash those cheques. They pay nothing as they use their cards responsibly, they can do those transactions underneath the card at no cost.

The cards that we issue use standard retailer fees. So as those recipients go to retailers, we collect our fees like every credit card company in the nation does on standard fees. So it's a great solution for the state to cut money, the recipients to have better use of their dollars, the more secure. It's an FDIC-insured solution. It's got a regulation e-protection for fraud. These recipients of those cards receive a more secure, more timely and quite frankly, a more private use of their funds.

So as we talk to states about our opportunities, those are the kinds of things we're seeing, things that cut costs or generate revenue and we're seeing more of those come into our pipeline. So we're -- yes, we are seeing more of the same but a shift towards that model.

Ashwin Shirvaikar - Citigroup

Okay. Thank you for that example.

Lynn Blodgett

Okay. Let's go to the next question, please.

Operator

Thank you. Our next question is from George Price with Stifel Nicolaus. Your line is open.

George Price - Stifel Nicolaus

Sure. Thanks very much. A clarification before a question on offshore issues. You're talking about 3.82, you're comfortable with the 3.82 consensus number, that's 8% and that's excluding the offshore impact, correct?

Lynn Blodgett

Yes, that's right, George.

George Price - Stifel Nicolaus

And that's up -- as that’s up about 8%, not quite the 10% level previously discussed. Is there anything else driving what I'd classify as a revision, besides what you're seeing on the transportation volume side?

Kevin Kyser

And the only other thing would be the interest, right? I think the LIBOR, the changes in LIBOR over the last month would definitely have an impact on that, but we are comfortable with that 3.82 and that would be prior to this charge for the offshore initiative.

George Price - Stifel Nicolaus

But the interest impact, I mean those get reset on a monthly basis? Kevin, just remind me because LIBOR is coming back down.

Kevin Kyser

Sure. We have different tranches in our debt and they do reset on a 30-day basis typically. So I don't think -- I believe in one of your notes you might have quantified the annual impact at maybe $0.09 or $0.10. We're not seeing that it's going to be that drastic.

George Price - Stifel Nicolaus

All right. You still have LIBOR coming down.

Kevin Kyser

Lynn Blodgett

Sure.

So it was a brief spike. I'm not sure why there would be really any impact given it's only that we're talking about one month.

Kevin Kyser

Well, obviously LIBOR is higher than it was, even though it's come down LIBOR is higher than it was 30 days, 45 days ago. But I believe today LIBOR is at 2.8%. So it's still north of where it is. So we are very comfortable with the 3.82 prior to the charge.

George Price - Stifel Nicolaus

Okay. The main question I have which is related to offshore is in two parts. Why now, and why the magnitude of the action? I guess I'm still not kind of clear on that and why should we look to exclude that from the results? I mean I know it's sort of an unusual size, but this is the kind of transition that really virtually all companies in the space have had to go through. It's really a course of business, right?

Kevin Kyser

Oh, we totally agree with you, George. So let me address the latter and then Lynn can address the first part of your question. We are not suggesting that you add it back, take it out in any form or fashion. What we are trying to do is just we want to give you clarity around what it is, what's going on inside of the business related to this initiative. We're not suggesting in any way that you add it back.

George Price - Stifel Nicolaus

Okay.

Lynn Blodgett

I think in terms of the reason for the magnitude is if you look at our overall workforce, we're certainly not finished. In the long run we'll continue to move work offshore. We'll continue to implement our activity-based compensation. This is unusual in the sense that we are moving a higher number of higher cost employees and so the transition costs are higher and we just want to call that out. We think that it's the appropriate kind of magnitude in terms of the number of people. It's a push, it's a challenge for the organization, but it is not something that will be negative to the organization. So we think we've hit a good balance there.

George Price - Stifel Nicolaus

But on the "why now and why the magnitude part". You have been ahead of the curve for a long time in terms of global delivery. Why such a big push now?

Lynn Blodgett

I think that the reason that we're pushing now is we want to be able to be more aggressive in our sales activity. We want to be more aggressive in our investments in technology. We want to be able to have the resources available for our customers as we go through kind of these tough economic times. We want to be able to be solid in being able to make the appropriate investments and so on in innovation. As we said, to stand with the customers; so we think this is an initiative that we began implementing about the beginning of this quarter and so we think it's the right time. We think it's the right time organizationally. It positions us to be a stronger competitor, to be more innovative. And I think this is the right time.

Tom Burlin

If I might just add, it is going to help change the cost structure of the delivery model as Tom noted and obviously that will be beneficial to margins in fiscal ‘10.

George Price - Stifel Nicolaus

Thank you very much for taking the time.

Kevin Kyser

Oh, you bet, George.

Lynn Blodgett

Operator, let's move to the next question.

Operator

Thank you, Adam Frisch with UBS. Your line is open.

Adam Frisch - UBS

Okay. Thanks, for that clarity on the last question. The one that I had on sales where are you adding? What do you expected to impact future bookings rate? Does it mitigate the need at all in your minds to do M&A? Could you address those issues?

Lynn Blodgett

Yeah. We are driving all of our lines of business to improve their growth. That's the basic strategy that we have, but we're putting, additional emphasis in healthcare, in transportation, in transactional BPO, in a lot of the core services that clients need. We think our messages need to get out and so we're putting more emphasis in those lines. Tom, you want to add anything to that?

Tom Burlin

Yes. We've found that one of our best performing lines of business from a sales perspective, the most predictable, is that our business process outsourcing uses a commercial best practices sales approach. We're applying that sales approach across all of our business, including our government sectors and we're starting to see improvements in the pipeline and sort of the singles and doubles, Adam, that we can start to count on more consistently. And I think that will help us to not only raise the level of consistency, but also the amount of sales that we're able to close within a quarter.

Lynn Blodgett

I think the second part of your question, Adam, as far as M&A, M&A we do as a core competency of the company and we really view it as sales. Internal revenue generation is one initiative, adding to our technology and geographic reach and vertical solutions through M&A is something that we're going to continue to do and I really see them as independent.

Adam Frisch - UBS

Okay. So if you increase your sales to boost your bookings, the increased bookings bring on some margin pressures, you're taking out some costs to deal with that, so everything is phased. Ultimately this should result in better growth with a lower cost structure and maybe higher margins or at least ones at the higher end of the 11% to 12% range. Is that the formula behind everything?

Lynn Blodgett

Yeah. It's actually right and we're expecting as we were saying and in Kevin comment, we expect to see a margin increase that put us solid in the middle of our range. That's what we're trying to do and also accelerate bookings and growth as you outlined.

Adam Frisch - UBS

Okay. Last question I have on the bookings front. I think you commented on your last call of the first half of the year, you should have about $200 million or so in booking. Second of the half of the year you should be north of that, I think you said in the 225 to the 250 range. Are you seeing anything in the marketplace now anything in the macro stuff that we're trying to get through that would ultimately make you reconsider those assumptions?

Lynn Blodgett

No.

Adam Frisch - UBS

Okay, great. Thanks, guys, nice job.

Lynn Blodgett

Thank you. Let's move to the next question, please.

Operator

Thank you. David Grossman with Thomas Weisel. Your line is open.

David Grossman - Thomas Weisel Partners

Thank you. Other than transportation and land records, it sounds like you haven't seen many other volume changes over the last three months, particularly in the state and local business. So is it the strong bookings trends on or is it just the stability that’s giving you confidence that the low end of the internal growth target is still achievable?

Lynn Blodgett

I would say it's both. You know, our business is very diverse. If you look at how our revenue breaks down, there's just a wide swath of different industries. But the way -- one of the things that I think is helpful to understand is the way we contract. We structure our contracts that’s both beneficial for our clients as well as for us and we structure it -- it's transaction sensitive, but envision there is within a range there is what we refer to as a [debt band]. So volumes can move plus or minus, percentage of that 3%, 5%. It depends on what we negotiate and the volumes can move up or down and the revenue doesn't move. If they get outside of those bands, then that's where we start to get more revenue or less revenue. So there's some protection even inside our contracts beyond just the diverse nature of our business, but also the ramp of the bookings or the PTM growth I believe is 40% and then that then just provides additional cover.

Tom Burlin

Yeah, David. The fact that -- we've had strong bookings in the last year is definitely helping to drive this and then this initiative, We are doing this to be able to be more aggressive and to get to push bookings up and to counter anything, any negatives that we're in a interesting economic time. We are doing these things to be more aggressive in sales and to make sure that growth is there.

David Grossman - Thomas Weisel Partners

Right. Back to a question that Adam asked about the margins, so as you roll this through the balance of the year, are we to assume that the cost savings that come in, in the fourth quarter are offset by the investments that you outlined earlier?

Kevin Kyser

We won't fully recover the cumulative investment that we make in the fourth quarter, but you'll see a positive impact to margins and EPS from this initiative in the fourth quarter. You'll see the full run rate, David, of this initiative after 12 months. So it will be fully initiated in the second quarter of 2010.

David Grossman - Thomas Weisel Partners

Okay, got it. Thanks very much.

Kevin Kyser

You bet. Thank you.

Lynn Blodgett

Next question, please.

Operator

Tien-Tsin Huang with JPMorgan. Your line is open.

Tien-Tsin Huang - JPMorgan

Thanks. Sorry if I missed this, but what exactly is driving the softness in transportation again? With gas prices down it seems like the impact wouldn't be as large as what we saw a couple quarters ago?

Tom Burlin

Sure. Initially what we saw and again I'll talk about the government and I'll talk about the general transportation industry. What we saw initially was that with the spike of the gas prices that occurred several months ago we saw a precipitous drop in drive miles that resulted in not only lower tolls, but lower transactions associated with transportation whether it's violation process, parking, photo enforcement, et cetera, and that's on the fringes because as Kevin said, most of those contracts have a base revenue stream that's associated with the service and the maintenance of those devices and the incremental comes from the transaction base.

So we saw that decline last quarter that we’ve talked about. As I said, that component of our market seems to have leveled off. We have not seen further decline, nor have we seen increase. I can prognosticate about, why that's happening or what might happen but right now I can only state the facts that they've settled down. Across the rest of our market, though, we think about the industry that we serve, the airline industry, parking and the airports, the shippers and the small trucking industries that we supply, they're clearly seeing reduced rates.

Again we got to put this in perspective. I think one of the major shippers put a notice out that they were down about 4% in volume. So it's not horrific but again, that does affect some of the volume that we handle in their wayfaring and other types of things.

So there could still be some downward pressure in this industry and even if drive miles recover, it's not the only source of downward pressure. But again, I want to put this in perspective. It's the fringe, not the core that we're dealing with here.

Tien-Tsin Huang - JPMorgan

Got it. That's helpful. And taking one more, just your non-recurring business, how did that perform versus planned and what's the outlook with the macro environment ?

Lynn Blodgett

Our non-recurring business performed just fine during the quarter and we're not seeing - a lot of that business is, there is some consulting and obviously some hardware sales. We are not seeing that being impacted -- nothing that I've seen, would say that we're going to be negatively impacted there.

Tien-Tsin Huang - JPMorgan

Great. Thanks. Good quarter.

Lynn Blodgett

Thank you.

Kevin Kyser

Thank you. Let's move to the next question, please.

Operator

Thank you. Moche Katri with Cowen and Company. Your line is open.

Moshe Katri - Cowen & Company

Thanks. In terms of the impact from some of the cost savings, I think you've indicated on a run rate it's about $40 million, so that's about 50 basis point benefit to EBIT margin. Does that sound right?

Lynn Blodgett

Yeah, it does, Moshe

Moshe Katri - Cowen & Company

Okay. And then looking at some items on the income statement for the quarter, I think wage and benefits came in at 45.7% of sales. This is a level we haven't seen I think since fiscal '05. Is this in line with some of the costs, focus on costs that you are having and then should we expect these levels for the remainder of fiscal '09?

Kevin Kyser

You know, Moshe, that's a good question. Obviously the mix of -- I think what this couple of things you're seeing. You're definitely seeing a benefit from the piecemeal offshore work that we've been doing, not the initiative work kicking off, but the offshore work that we've been doing from quarter-to-quarter. So that's kicking in, but I think you're also -- it's a mixed shift in revenue as well. So we've probably got a little bit higher revenue with the lower labor component. Again, there are a wide variety of labor components in the different business services that we provide.

Lynn Blodgett

And, Moshe, I mean, I think that what you're seeing is we're working hard at reducing labor. It's our largest single cost. We're implementing our activity based compensation that has a direct impact on that. So this initiative is in addition to the cost improvement plans that we've had in place and they're pushing as part of just running a normal business.

Moshe Katri - Cowen & Company

So ideally what do you want that percentage to be in terms of percentage of revenues looking at this a year maybe two years from now?

Kevin Kyser

Well, today we're in the mid-40s. Obviously I'd want to see that go down a point or two. That would be ideal, but again, you know, Moshe I do -- you need to look at it over a longer term. I think from quarter-to-quarter it can fluctuate around a lot as you, you know as got bonus accruals. Bonus accruals get higher towards the end of the year and those kind of things, but you know what? I think we're going to make a good dent in the percentage as we move these 4,000 -- 4,200 people offshore.

Moshe Katri - Cowen & Company

Okay and then ultimately --

Lynn Blodgett

That initiative is as Kevin said, that's a couple -- give or take, that's a couple points.

Tom Burlin

And then to be, there is a lot of initiatives as Lynn said that we work on, but this is not the only thing and I wouldn't lay it all on our offshore activities. Certainly this will create a pool resource for us, but one of the greatest drivers we have is when we create solutions that are one to many and when we do that, those are our most successful solutions. So that's why it's so important that we invest in innovation. That can have a tenfold improvement on revenue to -- employee cost to revenue to labor if we can install a technology fix versus trying to use labor arbitrage or reduced ABC. So the focus again is on investing.

Moshe Katri - Cowen & Company

And then two more items on the income statement. Under operating expenses, what you call other, was it $10.3 million had a pretty big jump. Can you kind of explain that and then also next to the interest expense other items net also had a negative contribution to pretax income. That line actually has been positively impacting pretax income since fiscal '06. Can you kind of talk about that?

Lynn Blodgett

Sure. I'll talk about the latter. The negative on the other non-operating expense is the investments -- we have investments related to our deferred compensation plans and obviously during the first quarter those there were losses in the deferred comp plan. So that's what's going on in that line. As it relates to -- what was your other question?

Moshe Katri - Cowen & Company

Another item that's under operating expenses other had a pretty big jump?

Lynn Blodgett

Yeah. I think that is going to be during the first quarter I think – you’re talking about the $10 million?

Moshe Katri - Cowen & Company

That's right. It was up from six to 10.

Lynn Blodgett

Yeah. I think a lot of those are the -- we had a couple of clients that went bankrupt this quarter. Obviously they were smaller clients incurred about $2.5 million dollars of bad debt expense because of about three clients. We are very aware of the potential for further bankruptcies in our business, but the beauty of our business is that we built it and diversified it across many clients, many customers, and we are staying on top of the accounts receivable and making sure that we stay current. So hopefully we can mitigate that as we move through the year, but it's something we're definitely watching.

Moshe Katri - Cowen & Company

Any specific vertical, any specific trends that we should look at, about these clients?

Lynn Blodgett

Well, let me just tell you, one was in the retail space, restaurant space. One was in the trucking industry and one was a small -- we have a small exposure to the financial institution. So it was across three different verticals, but very, very small.

Moshe Katri - Cowen & Company

Okay. And then finally, maybe you can also go back and clarify the EPS impact from this new initiative for fiscal '09 and then maybe talk about the next two quarters?.

Kevin Kyser

I will be glad to. So if you look to second quarter I believe we'll record we're estimating, right now the Q2 impact will be $21million to $25 million. That would include severance and the transition expense and that would effectively I think, be about $0.13 to $0.16. Transition expense will continue to be incurred in the third, fourth and the first quarter of next year as we continue to move the work offshore. The transition expense will be negative to the third quarter. The fourth quarter would actually be the gains that we have from letting the domestic employees go will overcome the transition expense so that the fourth quarter will be positively impacted by this initiative and then for the full year we believe that the net, net detriment to EPS will be $0.12 to $0.14 cents. Just to repeat, as we said, we're very comfortable with the 3.82 that's consensus estimates today and that is prior to this $0.12 to $0.14 cents.

Moshe Katri - Cowen & Company

Thanks for the clarifications and a nice quarter.

Kevin Kyser

Thanks a lot.

Lynn Blodgett

Next question, please.

Operator

Thank you. Bryan Keane with Credit Suisse. Your line is open.

Bryan Keane - Credit Suisse

Hi, I got on a little bit late here, so just a couple of clarifications. Organic growth was 5% for the quarter. Then you're expecting it to go to four to five. Is this slight down tick in organic growth? I would have expected it to go up a little, is that due to just the transportation sector or anything else?

Lynn Blodgett

Yeah, I think obviously, there are the softness around the transportation industry, not only government, but also commercial I think are definitely one of the areas., We're tracking volumes very closely right now and we're just continuing to see some softness there and so we're estimating it could be 4% to 5%.

Bryan Keane - Credit Suisse

Okay. And then to get up to the 6% I think would be the low end of your overall organic growth range. You're expecting a back half acceleration in fiscal year '09 for organic growth. What would drive that?

Lynn Blodgett

Well, the continued ramping of new business from ’08 and the bookings that we experienced in the first quarter and the second quarter. Those started to kick in. Now we see about 30% roughly of that revenue in the first year. So, it's the combination of the ramp of the bookings in '08 and then the impact that you start to get from '09 bookings.

Bryan Keane - Credit Suisse

Okay. And then, Kevin, on the expense due to the move towards offshore, I guess I’d have thought that the third quarter we hopefully we would see a little bit of a benefit there, but it looks like that there is still transition expenses that are going to override the benefit.

Kevin Kyser

Yes. Let me help you understand what we're calling transition expenses. When we moved domestic heads offshore, obviously there is a shadowing period. There is a period, where we have duplicate individuals being trained for the work. So, we have to hire the foreign employee, have them on staff, train them, have them go through the normal company training and then have kind of on the job training for the specific tasks that they're going to take over. That's the transition expense. We're not moving the full 4,200 employees offshore today or in this quarter. They're staged over the next three to four quarters. So, that's why the transition expenses aren't fully offset in the third quarter, but we think they will be in the fourth quarter.

Bryan Keane - Credit Suisse

Okay. But can you quantify the Q3 transition expense? Is that $0.02 to $0.04 sounds like that?

Kevin Kyser

Probably towards the higher end of that range, but you're in the ballpark.

Bryan Keane - Credit Suisse

Okay. And then just last question. Lynn with these new initiatives especially, hopefully spurring sales growth. Does that change the outlook for organic growth going forward? I know six and seven was the goal this year. Does that mean we can hope for better organic growth going forward?

Lynn Blodgett

That's the reason we're doing it. So, as we pointed out, we tried to give what we think going to happen this year, but we would expect to see acceleration in our growth in 2010.

Bryan Keane - Credit Suisse

Okay, great. Congratulations.

Lynn Blodgett

Thank you very much, Bryan.

Kevin Kyser

Thank you, very much.

Jon Puckett

Let's move to the next question. This would be the last question.

Operator

Our final question comes from Bhavan Suri with William Blair & Company. Your line is open.

Bhavan Suri - William Blair & Company

Thanks. Thanks, guys. Good quarter especially on the bookings front.

Lynn Blodgett

Thanks.

Bhavan Suri - William Blair & Company

That's nice. I wanted to ask a couple quick questions on the pricing. We've talked about pricing being a little weaker a couple times now. Is that because of competition or is that something you guys have been doing because customers are little hesitant? Why is that a little more than we have anticipated?

Kevin Kyser

I think we're - if we conveyed the pricing is weaker, I think that's not accurate. I think we are in a competitive environment, but we haven't seen any particular shift in terms of downward pressure any more than that has been for the last several years. We need to constantly be driving down our costs because that's what our customers stand or expect. But we haven't -- I don't know, where we must get the marking data we haven't really seen any downward pressure on pricing.

Bhavan Suri - William Blair & Company

And so the annual renewal that you got a built in pricing reduction renewal, that's stay consistent to where you expected it?

Kevin Kyser

Yes.

Bhavan Suri - William Blair & Company

Okay, great, great. And then, another just question about the pipeline. Can you talk a little bit about the margin profile, the contracts signed and what those look like because it's great to see the execution, but with the government being a higher margin I was hoping that would offset some of the impacts of the offshore business. So, just a little color on that if possible?

Lynn Blodgett

Well, let me take that and Bhavan, are you talking about the new business that we’ve signed this quarter?

Bhavan Suri - William Blair & Company

No. Obviously that will impact in the future, but in the past some of the government bookings were higher and so I was just wondering how that was helping or not helping offset some of the margin issues?

Tom Burlin

Yes. This is Tom. This is a down fact -- obviously we discussed in our comments this quarter, we had the offset reduction from the loss of our Florida Medicaid contract and as we ramp our new Medicaid contracts, we've been very successful in that area. That revenue comes in at a lower margin progress as we ramp that.

The government and we've talked about this before as well. We've had a lot of wins in areas, where the ramps with our EPC, our Medicaid business tend to have longer ramp periods on average than our core business. So, as you look at that, it's probably taking a little bit longer for that to ramp and therefore, longer for those margins to creep up as we approach the operational phase, but I’d expect that we'll see benefit of that as we move forward.

Bhavan Suri - William Blair & Company

Okay, super. Thanks, guys.

Tom Burlin

Thank you.

Lynn Blodgett

What I'd like to do is just conclude. We appreciate everybody's participation. I think it's very important that people understand that from our viewpoint the business is very resilient. We think that this quarter is good evidence of that. We've got a great recurring revenue model given some of the issues that the overall economy is facing. We are very confident in the resiliency of our model and I want to conclude with this comment about this initiative. This initiative is the right thing for us to do. When we finish, the company will be fundamentally stronger. By doing this, we will be able to drive better growth. We will be investing more in sales and that will drive stronger growth in the long run. That means the company will be stronger.

The best thing we can do to help improve margins long-term is to grow and then to invest in solutions that are leveragable because that those contribute higher margins. As we have said, this initiative will result in better margins, a better margin profile. We will have a lower overall cost model. We will be able to be more competitive because our overall cost models will be more competitive and finally we will have more innovative solutions as we are able to make investments and things that will really differentiate us from our competition.

So, we are absolutely confident that doing this and doing it now and treating the resultant savings from this the way that we are treating them and investing them the way that we plan to do is the right thing to do in terms of building a much stronger company for the long-term and that is the reason that we are embarking on this initiative now. So, we appreciate everyone’s participation and thanks for everybody being here. Thank you.

Operator

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

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