Affiliated Computer Services, Inc. F2Q09 (Qtr End 12/31/08) Earnings Call Transcript

Executives

Jon Puckett – VP of IR

Lynn Blodgett – President & CEO

Tom Burlin – EVP & COO

Kevin Kyser – EVP & CFO

Analysts

Moshie Katri – Cowen & Company

Bhavan Suri – William Blair

Jason Kupferberg – UBS

Bryan Keane – Credit Suisse

James Friedman – Susquehanna

Julio Quinteros – Goldman Sachs

Ashwin Shirvaikar – Citigroup

George Price – Stifel Nicolaus

Affiliated Computer Services, Inc. (ACS) F2Q09 (Qtr End 12/31/08) Earnings Call Transcript January 29, 2009 4:30 AM ET

Operator

Good afternoon, and welcome to the ACS Second Quarter Fiscal Year 2009 Conference Call. Today's call will consist of a prepared statement by ACS followed by a question-and-answer period. All the participants will be able to listen-only until the questions and answer session begin. The call is webcast live on the company's Web site and available for replay purposes. If you have any objections you may disconnect at this time.

I would now like to turn the meeting over to Mr. Jon Puckett. Sir, you may begin.

Jon Puckett

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

As always I must caution everyone that any statements on this call that are not historical fact may be considered forward-looking statements within the meaning of the Federal Securities laws. 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 Web site, from the ACS Web site, or from Investor Relations.

We have provided a presentation on our Web site that we will refer to during our discussion. We will reference certain non-generally accepted accounting principle financial measures which we believe provide 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 Web site at www.acs-inc.com. And finally, we disclaim any intention to and undertake no obligation to update or revise any forward-looking statements.

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, Jon. And thanks for joining us today. Our performance again this quarter demonstrates our recession resistant model that the company was founded upon. The dedication of more than 70,000 employees and the support of our wonderful clients.

Let me give you the highlights of the quarter. Please turn to Slide #3. Revenue grew a total of 7% with 4% internal. Adjusted earnings per share was $0.85 which included $0.11 of expenses related to our global production initiative or project compete that we introduced last quarter. New business signings were $202 million in annual recurring revenue, an increase of 31% over the trailing 12-month period. This marks our fifth consecutive quarter of signings over 200 million.

Our pipeline continues to grow and reached a record 2.1 billion at December 31st and does not include deals we are currently pursuing that are over 100 million in value. Renewals were 94% as we executed our program called client for life. The total contract value of all signings which include new business, renewals, and nonrecurring revenue which is how many of our competitors report was 2.3 billion.

Finally, we had excellent cash collections and expense discipline and generated free cash flow of $154 million or 9.5% of revenue. I'm very proud of our team for producing these results.

Now let me give you my perspective on our market and some detail on how we're managing the company. Please turn to Slide #4. First, demand for our services. Our pipeline of 2.1 billion is a record. Last quarter, we indicated that we expect record bookings of 900 million for fiscal 2009.

To help accomplish this we've added 20 new sales people this quarter and we expect to continue adding new sales people for the remainder of the fiscal year. We expect bookings in the third quarter and fourth quarter to average $250 million per quarter but remember the bookings can be lumpy from quarter to quarter.

Second, margins. We have indicated that we will achieve margins in the lower part of our range of a 11% to 12%. Meeting our objectives requires that we maintain pricing discipline on new business and renewals and that we control expenses carefully. We are confident that we can reach our margin goals for the year.

Third, our ability to compete. To effectively compete, win new business and retain our existing clients, we must do several things. Number one, we must provide outstanding service to our value – and value to our clients. Evidence of this can be seen in our 94% renewal rate and over 400 million in year-to-date new business signings. Second, we must provide new and innovative solutions for our clients and prospects. For example, we're investing in our next generation TBO platform and continue to invest in technology that allows us to leverage our solutions across more clients. For example, investments in our commercial student loan platform have allowed us to win new business. Third, we must demonstrate our ability to reduce our costs day in and day out. Project compete is evident that we have the focus and that we can reduce our costs on an ongoing basis.

During the second quarter we expanded our global production resources by almost 2,000 positions, and we'll continue until we reach our target of 4,200. With this initiative complete, we estimate that our labor expense, our largest single component of expense, will still be 85% based in the United States, the UK, and Europe, and 15% in low-cost production locations.

In other words, unlike our offshore competitors whose model is typically the inverse of ours, we still have room for expense reduction by more fully utilizing our global delivery platform. Remember, that many of our domestic positions support government and commercial clients that require a domestic workforce which will always keep our percentage of domestic workforce higher than our offshore competitors.

Now, let me take a minute to discuss the people affected by this. These difficult moves are essential in order for ACS to remain competitive and healthy. However, it affects many dedicated ACS employees. During these unprecedented economic times the challenge of job loss is even greater as fewer opportunities for reemployment exist. We intend to provide additional financial assistance to these displaced ACS employees. And we believe that these additional expenses will not cause us to exceed our cost estimates for project compete.

Now returning to our action plan, we must generate cash adequate to support the needs of the company. Our strong cash generation for the quarter not only demonstrates our focus on collection, managing expenses and capital expenditures, but it is also a powerful indicator of client satisfaction. People don't pay unless you are delivering what they expect.

The final and most important area is growth, growth that is generated by new business signings, growth via acquisition, growth in profits, earnings per share and cash. In the last 24 months revenue has grown a total of 16%. New business signings have grown 36% based on annual recurring revenue. Earnings per share has grown 32%. We have grown because the services we provide are essential for our clients to operate their businesses and therefore are resistant to downdraft in the economy.

Over the past few weeks, I have read several articles in major publications either highlighting the performance of a particular company that has performed better in this economic downturn or outlining opinions from pundits about what constitutes best practices to not only weather these economic conditions but to emerge in a more competitive position.

These proactive methods include acting with a sense of urgency, aggressive cost control, comprehensive communication to employees, programs to provide unique and innovative cost savings to clients and prospects and careful preservation of cash in order to be able to take advantage of opportunities in this market.

I can say with confidence that ACS has long been a leader in these best practices. We began implementing several of these practices well before the experts proclaim them. For example, early on we asked our managers to identify creative and innovative ways that we can help our clients deal with this economy. Our leaders responded in force and in short order I had about 20 different opportunities on my desk that we began evaluating. And we're pursuing some of these today.

As investors and analysts, you can rest assured that we are managing the company carefully with particular focus in these areas. Our strong performance is not accidental, and is the result of our recession resistant model, the finest people in the industry, excellent service delivery, sales performance and financial and managerial discipline which is the hallmark of ACS. Thank you for the trust and confidence that you show in our great company.

Now I will turn it over to Tom Burlin for an operations review.

Tom Burlin

Thanks, Lynn. Please turn to Slide #6, and I will provide some more detail on our signing. In Q2 we signed $202 million of annual recurring revenue with a total contract value of $853 million. On a trailing 12-month basis total contract value increased to $3.4 billion representing a 34% growth over the prior period. Second quarter signings were driven by the commercial segment which contributed 54% of signing and government comprised 46%.

We continue to leverage our student loan processing solution with Department of Education. We also won new business in commercial education. In government healthcare and commercial healthcare payer we expanded existing relationships by providing incremental value-added services. Our communications and consumer goods vertical we continue to diversify our client base with new business.

From a service line perspective, 85% of second quarter signings were BPO and 15% were ITO. These are strong results and are indicative that our services are in great demand. Please turn to Slide #7 for an update on renewals. Our renewal rate for the second quarter rebounded to 94%. On a year-to-date basis, our renewal rate now stands at 86%.

In the second quarter we renewed $456 million in annual recurring revenue with a total contract value of $1.3 billion. On a trailing 12-month basis, we renewed $1.3 billion of annual recurring revenue and $3.9 billion in TCV. These results demonstrate the tremendous success we are having at the client level with our innovative solutions and the client for life program.

If we now turn to Slide #8, for some additional color on our record $2.1 billion pipeline. We are seeing increased demand for our services which is translating into an expanded pipeline. Our pipeline is strong in several areas across both segments. We're pursuing numerous government healthcare prospect.

We continue to see excellent opportunities around the globe in transportation. We are getting traction for our point solutions in HR and finally we're seeing several potential opportunities in our federal business as our non compete expired during the second quarter. On this slide we've also provided the split of our pipeline between segment and service line.

Please turn to Slide #9 for an operational update on our global production initiative or project compete. We made significant progress towards our goal of increasing our global production workforce. During the second quarter we added almost 2,000 global employees or 47% of our stated goal of 4,200.

Let me provide some color on our additions by geography, line of business, and job grade. First, when considering the geographic distribution, we followed our strategy of global diversification. This strategy has helped us hedge against political unrest, currency fluctuation, supply of qualified workers and wage inflation. Our most significant hires were in Mexico, India, Philippines, and Jamaica.

Second, the vast majority of our additions were within the commercial segment which hired 92% of all positions under project compete. The lines of business that added most to their global production were human capital management, ITO, commercial education and financial services, and communications and consumer goods.

By job grade, we hired experienced professionals, managers, and production staff that totaled 70% of all global additions under this initiative. The remaining hires were level one production. These hiring statistics are consistent with our goal of adding higher skill set jobs under project compete. We were able to make significant progress this quarter due to many hard working individuals around the globe and I appreciate their efforts. With their help I'm confident project compete will be successful.

Now let me cover the commercial segment results on Slide #11. Commercial internal revenue growth was 3% and total revenue growth was 7%. Internal growth was driven broadly across the business, in particular, we saw new business ramp in our healthcare payer vertical, our finance and accounting business and our communications and consumer goods vertical.

Internal growth was partially offset by rate reductions on renewals and our commercial, education and financial services business and in commercial ITO. Prior year acquisitions in commercial ITO and healthcare payer also contributed to total growth.

Excluding costs associated with the global production initiative, year-over-year and sequential adjusted operating margins increased primarily due to operational improvements and new business which overcame rate reductions on renewals.

If you please turn to Slide #12, I will give you a brief summary of our most recent acquisition in the commercial segment. During December we closed the acquisition of Grupo Multivoice, a South American based provider of outsourced customer care.

The acquisition of Multivoice further diversifies our communication in consumer goods vertical and enhances ACS's position as the go-to provider for outsourced customer care in the wireless telecommunications space. This acquisition also broadens our customer care capabilities adding thousands of Spanish speaking employees and expands our global presence into four significant South American countries. Argentina, Chile, Colombia and Peru, from which we can provide cost-effective BPO services to our existing multinational client and our new South American clients.

Similar to ACS, Multivoice has a strong base of recurring revenue which coupled with its talented leadership team and local market experience made this acquisition attractive. From a financial perspective Multivoice generated trailing 12-month revenue of approximately $40 million.

The purchase price was below our typical revenue multiple to mitigate currency risks associated with the acquisition South American operations. Multivoice generates above corporate average operating margins and should be modestly accretive. We're really excited about this acquisition and think it will be a great addition to ACS.

Now let's move to the government segment results on Slide #14. Government continued to improve its internal revenue growth to 5% this quarter despite the negative impact from Florida Medicaid on a year-over-year basis. Internal growth was primarily driven by the ramp of new Medicaid business and government healthcare, electronic payment services, including the US treasury debit card program, and education solutions from incremental FFEL loan volumes.

Internal revenue growth was impacted by our transportation business as we experienced lower year-over-year volumes in electronic toll and lower project work in public transportation.

Total revenue growth for government was 8% excluding divestitures and was positively impacted by the prior year acquisition of TMS in our transportation business. On an adjusted basis government operating margins decreased year-over-year primarily due to transportation. The ramp of new Medicaid business contributed to operating margins but to a lesser extent than a mature Medicaid contract that went to term.

Operating margins on new Medicaid business will continue to improve as it continues to ramp. Excluding costs associated with project compete, sequential adjusted operating margins increased due to the ramp of new Medicaid business, the ramp of electronic payment services, and operational improvements and eligibility. Given the backdrop of tight state and local budgets our government results reinforce the confidence I have in our business model and is recession resistant nature. I am pleased with our performance this quarter.

In summary, we delivered a strong quarter in a tough environment and our results reflect the resilient business model we build. Further we delivered good results while embarking on several internal initiatives that will serve to strengthen our business, improve our operations, and drive additional growth.

Now let me turn it over to Kevin to take you through the financials.

Kevin Kyser

Thanks, Tom. Please turn to Slide #16, and I will spend a moment on the financial highlights of our second quarter results. Second quarter revenue was $1.6 billion and represented 7% total revenue growth. Despite an unexpected one percentage point headwind from foreign currency during the quarter, we were able to deliver internal revenue growth of 4% within the range of our expectations. Consolidated adjusted operating margin of 10.7% for the quarter met our expectations.

Two significant items impacted our adjusted operating margins during the quarter. First, we incurred costs related to project compete that totaled approximately $17 million or 1.1 percentage points of margin. Second, we had a benefit in our operating expenses from our deferred compensation plan that totaled approximately 13 million or 0.8 percentage points of margin.

This benefit is offset with investment expense below the operating margin line in other non-operating expense. We typically don't break out the deferred compensation impact to operating margins because it has historically ranged from 0 to 30 basis points positive or negative in any quarter. However, because it had such a significant positive impact this quarter, we thought it would be helpful to highlight it for you.

On a year-over-year basis, the decline in consolidated adjusted operating margins was primarily driven by transportation volumes and rate reductions on renewals. On a sequential basis, operating margins were impacted by the costs related to project compete and the deferred compensation plan. The impact of which is noted on the slide.

Second quarter reported earnings per share was adjusted for cost related to the stock option investigation, buyout, divestitures, and the previously announced termination of our chairman's supplemental executive retirement plan or SERP. We believe excluding these items is consistent with our stated policy and provide some more meaningful representation of our operating performance. As a result, you can see on Slide #17 adjusted earnings per share was $0.85 for the quarter and included $0.11 of costs related to project compete.

Our EPS results were ahead of expectations due to lower costs related to project compete and foreign exchange and investment gains. Our effective tax rate on our non-GAAP results was 37.9% and slightly higher than our expectations.

When comparing the second quarter results to the prior year, let me remind you that the prior year earnings per share included a $0.04 tax benefit related to a refund that reduced our FIN 48 interest expense by 4 million and was the primary reason for our lower than normal adjusted effective tax rate of 32.6%. I am pleased with earnings per share for the quarter.

Let's move on to cash flow. Please turn to Slide #18. The second quarter of fiscal year 2009 was a terrific quarter with operating cash flow of $246 million or 15% of revenues driven by strong collections of accounts receivable and advanced payments of unearned revenue. In fact, we collected over $1.6 billion in cash during the second quarter, which was a record for us. Free cash flow for the second quarter was $154 million or 9.5% of revenues.

As we expected, CapEx increased about 80 basis points over the prior year, primarily related to new business ramp. Recall that the second quarter of last year was a record quarter of cash flow following a slow start in fiscal 2008. Additionally, when comparing the fiscal year-to-date results, we received a favorable ruling from the IRS in the second quarter of the prior year and were able to utilize certain refunds to reduce our estimated federal tax payments by $40 million in the prior year.

We continue to expect free cash flow for fiscal 2009 to be within the range of 6% to 8% of revenue. I have recapped major fluctuations in our balance sheet categories from September on Slide #19. Our cash balance at the end of December was $567 million, an increase of $132 million due to our strong cash flow results.

Accounts payable and other accrued liabilities increased $60 million due to the timing of payments to vendors. Accrued compensation increased $47 million due to the timing of payroll cycles and severance accruals related to project compete. Total unearned revenue increased $27 million due to the advanced payments from clients and the Multivoice acquisition.

Now, please turn to Slide #20 for a financial update on project compete. As Tom explained earlier we have made significant progress this quarter having hired approximately 2,000 employees under this project. This brings us to about 47% of our overall goal and we will continue to hire new global employees throughout the next few quarters. During the second quarter, we incurred $13 million in severance costs which was slightly below our expected range of $14 million to 16 million. And we still expect to incur our original estimates.

We expect the transition costs would be between 20 million to 22 million for the fiscal year and 7 million to 9 million during the second quarter. During the quarter we incurred approximately $4 million of transition costs which was also below our expected range due to the timing of global production hires within the quarter.

We continue to anticipate we will incur transaction costs over the next three quarters that are consistent with the original projections. In the third quarter, we expect to incur costs in the range of $10 million to $12 million related to project compete. After investing in sales and innovation, we are still comfortable that we will begin to achieve the full annual run rate savings of $40 million in the second quarter of fiscal 2010.

Before we go to Q and A let me provide some color for the third quarter. We expect internal revenue growth will be between 5% and 6%, plus acquired revenue of another two percentage points for a total of 7% to 8% total revenue growth.

Adjusted operating margins excluding project compete transition costs will be above 11%. Our effective tax rate is expected to be 37% and including the impact of project compete we expect adjusted earnings per share will be in the range of $0.92 to $0.95.

For the fiscal year we are targeting 5% to 6% internal revenue growth. The upper end of our range is within our original estimates from August. We reduced the lower end of our range by one point primarily due to a change in foreign currency rates and slower ramp of certain new business.

Adjusted operating margin should begin to accelerate as we close out the year and reach the middle of the 11% to 12% range in fiscal year '10. Our effective tax rate for fiscal year 2009 is expected to be between 37% and 37.5%.

Including the impact of project compete, we expect adjusted earnings per share for fiscal year 2009 to be between $3.70 and $3.75. That's all the prepared comments we have at this time. Let's open it up for questions. We have a lot of people on the line, so please hold your questions to one per caller. Operator, please begin the Q-and-A session.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Moshie Katri. Your line is open.

Moshie Katri – Cowen & Company

Hey, thanks. And nice quarter. Can you help us give us your views on cell cycles and project ramp, project funding by commercial public sector, BPO and ITO? And then you did – thanks for the transparency looking at the next quarter, but how should we think about organic growth by commercial and public sector for the next few quarters? Thanks.

Lynn Blodgett

Okay, Moshie, we are going to parse this one down to several answers. Kevin will take part, I will take part, Tom will take part. First of all in terms of the sales cycle, decision cycle and so on we're seeing – there are some customers who have hunkered down a little bit and there are a little bit – maybe a little bit more conservative, which is kind of – kind of understandable in other ways not. Yet most customers are still very anxious and in some cases more anxious to get the savings that they can achieve by entering into an agreement with us. And so on balance, we're seeing the cycle remain about the same.

In terms of the ramp, the businesses are ramping with one exception. Pretty much inline with what we would do traditionally. In other words, Medicaid tends to ramp a little bit slower. ITO contract ramps very quickly. The one exception to this is the contract that we have with the treasury that has ramped. We had mentioned we signed the last – third quarter last year, we had indicated that we thought it would be a slow ramp. It's actually ramping a little bit slower than even we thought, so that's having a bit of an impact. But with that exception, things are ramping pretty much as we would expect.

Kevin Kyser

And then, Moshie, from a segment line basis, obviously we've got the segments going in a different path this quarter sequentially commercial went from six to three, and government went from four to five. I really see, as we look out in the next several quarters I really see those moderating into the middle single digits in both areas. I would just add that obviously the six to three in commercial sequentially, we were filling some impacts from currency in the quarter, in the commercial side, more so than the government there.

And then the other point I would like just to make, Moshie is that, the internal revenue growth of while 5% we believe is good in the government, I think it's important to note that kind of our core state and local business is actually growing higher than that because recall, we've got soft volumes in our transportation area that would actually be bringing the transportation area below that average and obviously the core state and local business would have to be above that average. So I think that's a key point, because obviously that's where you see some pressures from the state and local budgets, and our services are some that help them, we're kind of seen as somewhat of an ally to the budget cycles that they are going through today.

Moshie Katri – Cowen & Company

So commercial should accelerate next quarter?

Kevin Kyser

Yes, I believe it will, unless we see another 20% reduction in the euro, or something like that. I don't think we're going to see the type of fluctuation in the foreign exchange rates, so and we've got some stuff ramping, so I believe it will.

Tom Burlin

And, Moshie, very specifically, if you recall back to the third quarter we had a record booking and included in that was a US Department of Treasury debit card program. That's the first time we've taken that service into the Federal government, particularly into this set of clients, the Social Security recipients. So we didn't have good metrics on how they would adapt the use of the cards, and we have very good metrics on the use in our state and local market. So we made some predictions. We did indicate then that we expected a slower ramp. It has been slower than we expected. However, ourselves, along with our clients and our partners, we've learned a lot about how to market to that community, and we've seen a good pickup in the recent months, and while we would like to see it continue to ramp and get back up to the rates we expected, it is a sound contract. We're very pleased with the contract otherwise.

Moshie Katri – Cowen & Company

Thanks. Nice quarter.

Tom Burlin

Thank you.

Lynn Blodgett

Operator, next question.

Operator

The next question comes from Bhavan Suri.

Bhavan Suri – William Blair

Hey, guys, nice quarter.

Lynn Blodgett

Hey, Bhavan, thanks.

Bhavan Suri – William Blair

Quick couple questions around pricing. I saw there was a little sort of rate reduction pressure especially on the commercial ITO side. I was wondering can you talk a little bit about pricing on renewals? Are customers pushing greater than usual for price concessions when contracts come up for renewal?

Lynn Blodgett

Great question, one that we're very focused on. When we had our investor day about a year ago we indicated that you could expect about a 10% discount on renewals, and we're running right in that area. We just happen to have a couple of deals that, as you pointed out in IT, in our commercial loan area that hit us this quarter, and it caused a little bit of pressure there. But overall, we're – our averages are running right where we have said they would be.

Bhavan Suri – William Blair

Great. And then just sticking with IT, we've talked about building the IT pipeline and things like that. I know you had some sales people. Two quick things. Could you provide some color about how those sales people are going to be focused? And B, sort of looking at the booking pipeline, again, IT seems to be sort of under that 20% number. How are things going with the ramp of IT business, color on sort of the business wins, anything along those lines?

Kevin Kyser

Yes. Again, a very good question, and in IT, we've seen an increase in our pipeline over the last quarter. We're still not where I would like it to be. I think we're adding sales people there. I talk to the group president almost every day and say who else did you hire today? Because this is not an issue of demand in the market. I mean, I know there's some areas that might say that IT is experiencing pressure, whatever. That's not the reason that our bookings have not been where we want them to be. It's that we need to continue to build that sales force and then execute. Our pipeline is building nicely. I'm much more comfortable. I'm never comfortable but I'm much more comfortable today with the pipeline than it was a quarter ago. So we're seeing deals in basic infrastructure. We're seeing deals, some of the project work as we've said, multiple times, some project work is a little softer because I think that most people are seeing that, but our overall deals that are our sweet spot, which are the infrastructure deals are fine and we're actually building it.

Lynn Blodgett

And Bhavan, you mentioned a little bit about the ramp of IT deals. One of the reasons we like IT is because it does have a quick revenue ramp cycle to it, and it's not a light switch, but it's the closest thing we have to one in our business. And those deals typically ramp quicker, and we haven't had a lot of that business come on, so we're looking forward to producing some wins in that area, and bringing on some new revenue streams in the IT business.

Kevin Kyser

It's not at all a market matter for us. It's a sales matter. We just have to build that force and close those deals.

Bhavan Suri – William Blair

Great. Thanks, guys.

Kevin Kyser

Thank you.

Lynn Blodgett

Next question, operator.

Operator

Yes, the next question comes from Jason Kupferberg.

Jason Kupferberg – UBS

Yes, hi, good afternoon, guys.

Kevin Kyser

Hi, Jason.

Jason Kupferberg – UBS

Two part question here, first on wage inflation, can you give us a sense of what you guys are planning for this year in India and some of your other key offshore regions? And second part is wanted to get a sense of whether or not clients are asking ACS to put more capital into outsourcing deals, especially in situations where the customer might be caught in the middle of the financial crisis.

Tom Burlin

Sure. This is Tom. Jason, it relates to salaries of course we're being very conservative in that area and into controlling our costs, one of our controllable costs. So we're trying to stay in tune to what we see coming at us in the economy and taking – being very cautious in that area. As it relates to the offshore, we're primarily focused, as I said, when we look at where we go, we try to go to areas that are second-tier cities where we have good access to a stable workforce that is not seeing as much pressure or little pressure from wage inflation, and we have directed the hiring of these people accordingly, so we study the geographies and directed our work forces, and that's why you see us not concentrated in one particular area. So we saw growth in Mexico, in Jamaica, in Malaysia, and in India. So we spread it out pretty good.

Kevin Kyser

Also, Tom, if I may add, the way we incent and pay our employees is – it's kind of a natural hedge against wage inflation, because in fact what we're doing is we're paying employees for the amount of work that they produce, and when an employee can produce a greater amount of work, they're getting a greater wage than someone who is earning an hourly – a wage on an hourly basis. So just our overall methodology for pay has a built-in hedge against wage inflation in addition to what Tom spoke about.

Lynn Blodgett

Also, the market certainly has – we're not seeing the same kind of upward pressure in any of the markets that was there, say a year ago. I think the impact of just the world economic circumstances has caused that.

Tom Burlin

And I think our employees are understanding and appreciative of that.

Jason Kupferberg – UBS

Then just on the part about capital and outsourcing deals, any more that you are being asked to do there?

Kevin Kyser

Yes, I have been telling folks and continue to see that our CapEx is continuing to pick up. It's not so much a factor of clients requiring more capital requirements. It's just the amount of new business we're signing in that that brings on the additional CapEx. So from a capital intensity perspective, I'm not seeing any clear trends. Now, with that as a backdrop, I will say there are one-off situations where we have discussions with clients, especially in this – in these times where we're talking about, hey, for the right deal, for the right metrics, for the right financial situation, we may take a little bit of our capital and invest and the deal might be a little heavy on the CapEx side. But those are one-off deals where we believe we can take advantage of a situation that's afforded us by this economy.

Jason Kupferberg – UBS

Okay. Thanks for the color.

Kevin Kyser

You bet.

Lynn Blodgett

Next question, please.

Operator

Next question comes from Bryan Keane.

Bryan Keane – Credit Suisse

Yes, hi. If you guys back out the one-time costs inside of commercial segment, it looks like the margins were up year-over-year, and that's probably the first time I've seen that in awhile. Can you just talk about you're getting a little bit of margin leverage in the commercial side. Can you just talk about where that's coming from?

Tom Burlin

Sure. Couple of areas. We're seeing ramp of new business in our commercial and consumer communications area where although we're seeing a shift between the various clients in there, that's a business that's still growing very healthy. It's growing above the average. As a result of that we're seeing better returns there. Also, our healthcare payer area is growing as well and our commercial student loan area has had some very good results. In all of those, as we especially in our areas of our, like commercial student loans, we've always talked about the one to many model that we have. So when we can add additional portfolios to a base business like commercial student loans, the incremental margins are very attractive and it has resulted in better margins in commercial. I would also say that given the team credit there is a tremendous amount of investment and innovation that's going on that is driving the cost of delivery down and some of that is passed on to our clients, which is helping us in our renewals and helping us win new business as well.

Bryan Keane – Credit Suisse

Okay. And just on the flip side of that, margins are a little lower on the government side, when you look at it on a year-over-year basis. Is that sustainable on the model or is this primarily due to I think the transportation solutions group has been hit due to volumes, but will that margin come back or is that the new steady state margin?

Tom Burlin

I think you've hit it right on the head. So the transportation market is down. Those incremental margins – the incremental volumes that we see there obviously they come at a steeper margin when we lose that. And in particular, transportation market tends to be outside of the general fund of most governments, and they operate almost as quasi independent businesses. So when they lose volume revenue they tend to go away from their discretionary project. So we're seeing softer projects. And those projects also tend to be above average in margin. So we're getting kind of a double hit in our transportation area and it's contributed significantly to the decline there. The margins in our core government business, our stable and growing slightly as we ramp some of that significant wins we had in the healthcare business. But I think a lot of it will depend on how quickly our transportation business rebounds back and when that happens. Otherwise, I'd say you can count on pretty stable margins.

Lynn Blodgett

Let me see if I can just add additional color to, Bryan. Obviously, some of the longer ramping contracts that we have are over in the government side, and when a contract is a slow ramp, typically we do have some upfront costs that we have to incur in terms of start-up, and that is – that's also contributing to the – little bit to the decline in margins, but I feel comfortable that a 17%, 18%, anywhere in this range is a good range for us to stay in and I think it will be fine.

Bryan Keane – Credit Suisse

Okay. And then just my final question, ACS came back in the Federal market. It sounds like the pipeline has picked up there. Can you just talk about what your expectations are? Do you think you will be able to sign meaningful deals to help the organic growth?

Kevin Kyser

Absolutely. We're very excited to be reengaged there, and we've had – Tom mentioned the deal with the Treasury that was the very important for us. We're very upbeat and I think we have reason for our pipeline is growing. We've been very good at our delivery in the Federal market space and we've got some good models there, some good references, and we're optimistic that we're going to see very strong growth out of the Federal piece.

Tom Burlin

I think you remember our strategy is pretty straightforward there. We call it planary aces. We're going to take what we do very well in our commercial market and apply that to the Federal market. And we got a solid strategy there. And we are working both with the large providers in the area and teaming with some of the eight A's and others that are in that mark. So we're very hopeful that market will grow.

Lynn Blodgett

I think, although relatively speaking, it is not a huge part of our pipeline. That pipeline is up 50%. So it's – we're seeing some nice pickup.

Bryan Keane – Credit Suisse

Congratulations on the solid execution.

Lynn Blodgett

Thank you very much.

Operator

The next question comes from James Friedman.

James Friedman – Susquehanna

Hi, thank you. Thanks for taking my question. Jamie Friedman at Susquehanna. I will just make it three, but I want to ask with regard to the sales force clearly 20 new sales heads is a strong positive investment in the company. I was wondering if you could share some context about that. Is that a lot or a little? How does that compared to historic, and where does that put your total headcount in terms of sales generation? Thank you.

Lynn Blodgett

You bet. Our target for the year when we talked about adding new sales people and sort of bumping up that rate was that we wanted to add about 100 new sales people this year. We're right about there. I think we're at 48 that we've added so far. And we will – we expect to continue to do that. And each of those, it depends on which market. If it's somebody in the Federal market, they are going to probably carry a bigger number, a bigger pipeline number and quota. If they are in one of our – some of our more niche businesses, the quota might be a little bit lower. So I can't give you a number per sales person, but that's a significant improvement for us, a significant increase.

James Friedman – Susquehanna

Thank you. I appreciate the color.

Lynn Blodgett

Thanks, Jamie.

Operator

Next question comes from Julio Quinteros.

Julio Quinteros – Goldman Sachs

Hi, guys, can you hear me?

Lynn Blodgett

Hi, Julio.

Julio Quinteros – Goldman Sachs

Okay, great. Real quickly can you just go back through – two quick things, one is just on the margin mix, the deferred compensation benefit there for the quarter, and then also if you could – can you just rehash the percentage mixes that you were targeting for sort of the onsite/offshore mix commentary that you provided there? Thanks.

Lynn Blodgett

Sure. Let me give you some background on the deferred compensation. This is a program that our employees are able to defer some of their current pay out of and defer it from taxes. That program has been with us for many, many years. Obviously it continues to grow. The performance in those funds, depending on where the employees choose their investments, the performance of those funds will rise and fall with the markets, obviously. Typically, the impact from that program has been it's pretty much zero to pretax profit, but it does fall, and from time to time it impacts wages and benefits, and it will also – the other side of it will impact other non-operating income.

But generally, that piece that affects wages and benefits has typically not impacted operating margins to a large degree. I think we said zero to 30 basis points, either positive or negative in any given quarter, and it's generally washed out in the year. We broke out the deferred – the benefit we saw inside of wages and benefits this quarter just simply because we felt like it was good transparency and we wanted you to see it and others to see it. We felt like it was the right thing to do, and it provided 80 basis points or I think about $13 million of benefit to the wages and benefit line. So that's really all that is. Again, it's offset in other non-operating and doesn't have an impact in terms of pretax profit.

Julio Quinteros – Goldman Sachs

Okay.

Lynn Blodgett

And then I think your question on the offshore/onshore mix –

Tom Burlin

Julio, are you looking for the mix of where we diversified or just the percentage of population?

Julio Quinteros – Goldman Sachs

Exactly. I think I missed some commentary that you guys making earlier about what target you expected to be at and towards the tail end that you guys obviously suggested that you wouldn't be obviously at the pure offshore model mix but just trying to get a sense of where you are now and where you plan to be, especially on the commercial.

Kevin Kyser

As it relates to the targets we established, we said we were about 47% there. We moved about 2,000 resources were added offshore. We intended to move to about 4,200 over the course of the whole program. And I think what you were referring to is in Lynn's comment he talked about the mix of our labor, and it was still at this point we're still about 85% of our labor costs are in the US, UK, and mainland Europe, and about 15% of that cost is in what you'd consider to be low-cost offshore locations.

Lynn Blodgett

And I think we wanted to point that out for two reasons. Number one, we have a very significant domestic presence, and we anticipate we will always have that. Our government and a lot of our commercial clients want the work done here, and we obviously support that 100%. And the other is that we – sometimes I think people think we've tapped out on what we can do utilizing global production, and we haven't. We've got a ways to go.

Julio Quinteros – Goldman Sachs

Just to be clear, then, when it is all said and done and you ramped up to the 4200 what would be the actual mix on the commercial side, I guess is probably what I'm – if you are going to have more impact, I'm guessing it's more on the commercial than the government side. So if you were to sort of isolate just commercial by itself, the 85 to 15 mix, what does that look like somewhere down the road?

Kevin Kyser

Well, I think that, where that would put us, and I'm just doing very rough math here, we would be at about 40% of our workforce by headcount would be located in the low cost production area as far as commercial is concerned. And the rest would be in the higher cost domestic locations, and we – we're going to continue to look at that, look at that workforce and be – we have to be aggressive in that regard, because we're facing people who have a higher percentage of their workforce offshore, and so we have to be careful, and we have to be aggressive, and we're going to continue to push. We're not going to stop. If your question is are we stopping at 4200, the answer is no. We will be vigilant and continuing to work with that because we have to be competitive.

Lynn Blodgett

We're also looking, Julio, at acquisition opportunities that will drive that up. So it will drive up the number internally, and then – we acquired the Multivoice acquisition this quarter, which I believe had about 6,000 employees in South America. That kind of new areas for us so we'll continue to do that. And then there are other deals in the pipeline that should impact the mix as well. So it's a combined effort from internal and acquisitions.

Julio Quinteros – Goldman Sachs

Great. Thanks, guys.

Kevin Kyser

Does that make sense?

Julio Quinteros – Goldman Sachs

Yes, definitely.

Lynn Blodgett

Operator, next question.

Operator

Next question comes from Ashwin.

Ashwin Shirvaikar – Citigroup

Hi, guys, nice quarter, particularly on the cash performance side of thing.

Kevin Kyser

Thank you, Ashwin.

Ashwin Shirvaikar – Citigroup

My question, my first one, is on the full year benefit of project compete in fiscal 2010 that – could you give us some parameters to think about that as you exit a phase of investment and get – start recouping some of the benefit? And then how much might you then turn around and give up off that benefit in terms of rate reductions and so on?

Kevin Kyser

Yes, I'd be glad to answer that. Our comments have not changed from last quarter. We continue to see about $40 million that we believe. Once this is fully instituted, we'll drop to the margin line about $40 million. Obviously that's not the total benefit from this move. We're going to take – Lynn as – Lynn and Tom have hired additional sales force this quarter. We'll continue to add to that, we're investing in sales, we're also investing in some innovation that provided we're seeing some good results early on. I believe that the costs that we've called out that $38 million to 42 million will continue, obviously next quarter we're looking at 10 to 12 and then it will – we'll have costs in the fourth quarter. We'll have some straggling costs in the first quarter of fiscal '10, and we ought to be done with the transition costs, done with the severance by – fully in Q2 fiscal year '10. That's when you will begin to see the $40 million annual run rate in that quarter.

Tom Burlin

Ashwin, I'd answer that, too. The idea that it's a discount that portion of that goes to cost reductions, actually, I really believe what our clients are asking for innovation, they're asking for us to come forward and find ways to make their businesses more competitive. And the way we keep ourselves from having a – we will ensure discount discussion with the clients, it's really doing there, talk to them about how we can enhance their business. So a good share of that money, every one of the group president is charged with having an innovation plan, an innovation fund, and they have to review that with Lynn and myself on a regular basis. And the purpose of this is not just to cause an increase in margin, that's benefit that our shareholders will certainly see, but to also create investment money for our groups to go back and spend money on improving our offerings to our clients and be able to sit down with our clients and not just renew our business but expand our business offerings and provide new innovative ideas to them to make them more competitive in the market.

Kevin Kyser

If we can help them fundamentally change something they're doing in their operation, the value to them is many times what they would see if all we offered them was some kind of discount. So what Tom says is absolutely true.

Ashwin Shirvaikar – Citigroup

Okay. And question about volumes. The transportation, Medicaid volumes, obviously down year-over-year, but have things become worse on a sequential basis, or is it sort of the continuation of sort of more of the same that will lap some time this summer?

Tom Burlin

Okay, you said transportation Medicaid. I want to make sure I separate, because Medicaid is a strong going. We've signed a lot of business there, and we're seeing both in the basic count and our new business, healthy growth in our Medicaid growth. So and that is a combination of new offerings and innovation we've made it a new platform and the response we're getting from our clients as well as increased volumes in those areas. So Medicaid is very strong part of our business. Transportation, in particular, as I said, they generate – usually generate their own revenue and fund their own projects and they're standalone outside of the general budget. So with the volumes down anywhere from 2% to 5% across the markets, they're not creating it, so we're seeing the revenues that would be generated there typically placed back into the business. That's not happening. Sequentially, we're seeing flat volumes, so we're not seeing continued decline but year-over-year they are not pared down. So they flattened out. It is difficult to predict. I think what we saw was initially, if you will recall, the high fuel prices before we saw the financial meltdown, we saw the high fuel prices that contributed to lower volumes, and then when fuel prices came down, I think the economic environment has caused the decline in both commercial and consumer travel. So it's hard to predict, Ashwin, but right now we're seeing pretty flat volumes sequentially.

Ashwin Shirvaikar – Citigroup

Okay. Kevin, one question for you. What is driving the lower level of deferred tax? Because that line did benefit your operating cash flow last year, and it isn't so much this year.

Kevin Kyser

Yes, I think one of the things – obviously, it actually is – it's impacted by the tax refund that I discussed earlier, and we, in the prior year we received a favorable ruling from the IRS on a position on one of our contracts that actually allowed us to pay less in our estimated tax payments last year versus this year. It's by the tune of about $40 million. That's the biggest impact. And it's simply a – from a cash flow statement and a balance sheet perspective it's simply a reclass between the deferreds and the income taxes payable. But it's really related to that favorable ruling last year that we were getting a benefit of.

Ashwin Shirvaikar – Citigroup

There's nothing else going on there?

Kevin Kyser

No, everything else is pretty much the same.

Ashwin Shirvaikar – Citigroup

Okay. Great. Thanks.

Kevin Kyser

Great, thanks, Ashwin.

Lynn Blodgett

Operator, let's move to the next question, and this will be the last question.

Operator

Thank you. And the last question comes from George Price.