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Executives

Jon Puckett Vice President, Investor Relations

Lynn Blodgett President and Chief Executive Officer

Tom Burlin Chief Operating Officer

Kevin Kyser Chief Financial Officer

Analysts

Bryan Keane Credit Suisse

David Grossman Thomas Weisel Partners

Moshe Katri Cowen & Company

James Kissane Bank of America

Jason Kupferberg UBS

Ashwin Shirvaikar Citigroup

James Friedman Susquehanna Financial Group

George Price Stifel Nicolaus

Eric Boyer Wachovia Capital Markets

Affiliated Computer Services, Inc. (ACS) F3Q09 Earnings Call April 30, 2009 4:30 PM ET

Operator

Good afternoon and welcome to the ACS third quarter fiscal year 2009 earnings conference call. Today's call will consist of prepared statements by ACS followed by a questionandanswer period. (Operator Instructions) 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, Investor Relations. Mr. Puckett, you may begin.

Jon Puckett

Thank you for joining us today to discuss our third quarter fiscal year 2009 results. Today on the call we have Lynn Blodgett, President and Chief Executive Officer; Tom Burlin, Chef Operating 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 forwardlooking statements within the meaning of the federal securities laws. As you know, forwardlooking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed in or imply 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've also provided a presentation on our website that we will refer to during our discussion. We will reference certain nonGenerally Accepted Accounting Principle financial measures, which we believe provide useful information for investors.

We've posted both the presentation and the reconciliation of those measures to Generally Accepted Accounting Principles on the investor relations page of our website at acsinc.com. Finally, we disclaim any intention to and undertake no obligation to update or revise any forwardlooking statements. I will now turn it over to Lynn Blodgett, who will provide a summary of the significant events during the quarter.

Lynn Blodgett

Will you please turn to slide number 3? I am very proud of ACS and our performance this quarter. At a time when most companies are seeing a slowdown in new business opportunities, we posted the highest booking quarter in our history at $342 million of annual recurring revenue. In an environment where our peer group showed revenue declines of midsingle digits, we grew 5%, excluding divestitures. Our adjusted margins increased to 11.3%; and finally, we posted the highest adjusted EPS in our history at $1.00.

ACS is a diverse organization, providing mission critical services across a broad spectrum of business and government organizations. By design, this defensive model of focusing on services that, for the most part, are nondiscretionary, fundamental, but noncore to our client operation, has allowed us to continue to grow revenue, profit, and bookings in the midst of these economic conditions. This quarter, again, demonstrated that ACS is recession resistant, although obviously we're not recession proof.

Our internal revenue growth was lower than we expected at 3%. Because of the importance of accelerating revenue growth to the longterm health of the company, I'd like to focus my initial comments in this area.

First, internal revenue was about $30 million lower than we'd hoped on total revenue of $1.6 billion or 2%. The shortfall came in two areas. First, transaction volume that was negatively affected by the economy. One of the areas that was affected was customer care that supports new subscribers of wireless services, which was down from expectation by about $3 million.

One year ago, this area handled about 14 million calls per quarter. This quarter, we had anticipated that we would handle an increase to 19 million calls, but instead received 18 million calls. In the overall scheme of things, pretty strong growth, but below what we expected.

Transactions were also impacted in the transportation area where tolls, violation processing, [inaudible] and shipping volumes were lighter by about $6 million.

The second area of our business that was most affected by the economy was that of onetime project work and consulting and was about $24 million below expectations. This was work broken up pretty evenly between government healthcare, transportation, and commercial HR consulting. While this is a significant amount, it was relatively small compared to others in our sector.

Now, let me give you some reasons why I am confident in our longterm growth. First, from the beginning, the ACS model was built on a foundation of recurring revenue, which today is 85%, as compared with about 60% for most of our competition. This is one of the reasons that our business is defensive and the primary reason that ACS showed 5% positive revenue growth, compared to an average 5% decline by our peers.

The second reason for my confidence in our longterm growth is growth in bookings. As I think you'll all agree, our bookings for the quarter of $342 million is outstanding and positions us well to reach our goal, our FY09 goal of $900 million, which should accelerate revenue growth in FY10.

The third reason is the ramp in our bookings. In earlier calls, we've discussed the fact that some of our bookings over the last 18 months have ramped slower than our historical average. In fact, had the treasury, MMIS, and FFEL bookings ramped at normal rates, they would have contributed nearly $80 million of additional revenue in FY09 or more than 1% additional internal growth. This revenue is not lost, but only delayed and should eventually contribute to internal growth in FY10.

This underscores that the type of booking impacts the revenue ramp schedule. Fortunately, the bookings we achieved in Q3 of FY09 are ramping ahead of our historical level; and, in fact, are expected to reach over 50% of full volume by the end of this quarter. These bookings alone should contribute 2% to 3% internal growth for FY10. Kevin will give more color on bookings, ramp, and growth rates in his presentation.

The fourth reason for my confidence in our longterm growth is the fact that discounts and pricing on renewals are in line with historical results. We are not seeing anything that is materially different from the formula we gave you in our investor conference from one year ago and, therefore, should not adversely affect growth beyond historical trends. I'm confident that we are doing what is necessary to insure strong longterm growth in all critical areas and that any shortfall in revenue is shortterm in nature.

I'm confident that we are well positioned, from a cost, service mix, and client relationship standpoint to see an uplift from modest improvements in the economic climate. My confidence is grounded in our exceptional bookings, our solid business model, the talent of 74,000 professionals who make up ACS, and in the fundamental actions we've taken and continue to take.

Please turn to slide number 4. In our first quarter conference call, we outlined a bold plan called Project Compete to substantially reduce our cost structure in order to do three things: Number one, increase operating margins 40 to 50 basis points and move margins to the midpoint of our range of 11% to 12%. Number two, free up money for significant investment in sales in order to dramatically improve booking. And three, to free up money for investment in technology and innovation in order to win more new business because we're more innovative than our competition.

Over the last two and a half quarters, we've executed our plan. The expense reduction program has been rolled out with precision and care and results are what we intended. Our operating costs have been reduced enough that we will begin to recoup our expenses associated with Project Compete in the fourth quarter and are now beginning the second part of the commitment we made with shareholders, which is improving operating margins and, therefore, returns.

We are on target to see consistent margins in the midpoint of our range in the second quarter of FY10. This initiative was not trivial. We've asked our people to tighten their belts, and they've done so extremely well. This also involved expanding our global delivery platform and the skills supported thereby. It included further implementation of our activitybased compensation program as well as delivering on our continuing cost optimization program.

I commend our team, from those who I work with daytoday to every supervisor and person working in the production position. This has truly been a team effort, and I would be proud to fight in a foxhole alongside with any of them.

Next came the need to build our sales force and harvest results quickly. Our sales organizations have stepped up to the challenge we gave them; and I think the results speak for themselves.

In summary, ACS has performed well in one of the most difficult economic environments of the past 75 years. We delivered strong EPS growth, demonstrated effective cost control as manifested in both margin improvement and EPS performance. Finally, we've positioned the company for revenue and profit growth with record bookings. I am confident that ACS will continue to deliver strong results that will accelerate in the future. Now, let me turn it over to Tom Burlin for an operations update.

Tom Burlin

If you now please turn to slide number 6, I will provide more detail on our signings. During the third quarter, we signed $342 million of annual recurring revenue and $1.6 billion in total contract value. On a trailing 12month basis, total contract value increased $4 billion, representing a 32% growth over the prior period, which is the highest level we have ever achieved in the company.

Total contract value of all new sales and renewals was $2.7 billion, with trailing 12month value of $8.8 billion. Our record results are evidence that our services are in great demand. Third quarter signings were particularly strong in healthcare and [inaudible] segments. We expanded existing relationships in healthcare payer and in government healthcare. The communications and consumer goods vertical in our commercial segment was also a contributor to our third quarter signings growth.

If you will now turn to slide 7, I will give more color on renewals. In the third quarter, we renewed $324 million in annual recurring revenue, with a total contract value of $890 million. Our renewal rates were 84% for the quarter and 85% for the yeartodate period. Third quarter renewal rates were primarily driven by renewals in our transactional BPO business. On a trailing 12month basis, we've renewed $1.4 billion of annual recurring revenue and $4.2 billion in total contract value.

If you will now turn to slide 8 for some additional color on our pipeline of $2 billion at March 31. We continue to have a strong pipeline, even with record signings of over $300 million. Our pipeline is in several areas of strength across both segments. We are seeing several opportunities in ITO with new local and existing clients. We're pursuing numerous state local prospects across our broad service offering. We continue to see excellent opportunities around the globe in transportation. Transactional BPO has many good prospects, as does government healthcare.

On slide 10, we'll cover our commercial segment results. Commercial internal revenue growth was 3% and the total revenue growth was 6%. Internal growth was driven broadly across the business. In particular, we generated good growth as we ramped new business in healthcare payer vertical, the financial services and mortgage vertical, and in our finance and accounting and business.

As Lynn indicated, revenue growth from commercial was offset by certain economic sensitivity as we experienced lower customer care and trucking volumes. We also experienced lower consultingrelated revenue as we saw our discretionary spending at our commercial clients tighten. Current year acquisitions in communications and consumer good contributed to total revenue growth.

Now let's move to margins. Yearoveryear and sequential adjusted operating margins increased as several of our contracts in finance and accounting, HR, healthcare payer, and communications and consumer good entered the steady state operational phase and generated better margins. We also saw sequential benefit to margins from lower spend related to Project Compete.

Let me take a moment and give you a brief update on this important project. We continue to make progress towards our goal of increasing our global production workforce. During the third quarter, we added in excess of 1,000 global employees and have added over 3,000 incremental international head count under Project Compete for 75% of our stated goal of 4,200. We expect to complete the project over the next two quarters. Kevin will provide you details on our financial projections related to Project Compete.

If you will now turn to slide 11 for a brief summary on our most recent acquisition in the commercial segment. During March, we closed the acquisition of eServices, a Jamaicanbased provider of BPO and outsource customer care. This acquisition provides us with a pureplay, nearshore Englishspeaking BPO and customer care center that has a strong base of recurring revenue. EServices has a talented leadership team with local market experience that has developed a strong culture of growth.

The acquisition provides us with potential for incremental BPO crossselling opportunities as well. From a financial perspective, eServices generated trailing 12month revenue of approximately $65 million. The purchase price was $85 million. Based on it growth, profile, and attractive operating margin, eServices should be modestly accretive to EPS. We believe this acquisition will be a really nice addition to ACS and helps expand our global production model.

Now let's move on to the government segment results in slide 13. Government segment revenue grew 3% in total and 1% internal. We received several questions regarding how state and local budgets would affect our government segment. Let me assure you we are empathetic to the budget issues our state and local clients are tackling with limited resources they have available. We're working closely with these clients to help them overcome their budget shortfalls.

Due to the nature of the services we provide, our state and local business is performing as we would expect. In fact, when you consider our government business, excluding the transportation business, we generated strong internal revenue growth. Internal growth was primarily driven by the ramp of new business in electronic payment services and particular BPO services related to unemployment insurance benefits and due to increased volumes in our student loan business.

Our ability to grow in this environment is a great accomplishment and reflects the durability of our business model given everything our government clients are dealing with today.

Next, let me provide some additional color on the transportation business. Growth in our transportation business has been impacted by the economy more than and longer than we had originally expected. On a yearoveryear basis, driver miles continue to be down; but we're seeing stabilization on a sequential basis. We expect the yearoveryear impact of driver miles to continue through the remainder of the fiscal year.

We're also seeing an impact on volumes in our violation processing business, as we see fewer commuters in city centers and therefore fewer parking violations.

The economy has slowed decision making related to transportation project work as well, including tolling projects and parking projects. Longterm, we believe transportation will be an area of growth for the company. Total revenue growth in the government segment was positively impacted by the prior year acquisition of TMS in our transportation business.

On an adjusted basis, government operating margins decreased yearoveryear primarily due to lower transportation projects that are typically higher margin business and the expiration of the Lockheed Martin noncompete that expired in the second quarter of fiscal 2009.

Adjusted operating margin decreased sequentially primarily due to higher postage costs in education institutions due to yearend mailings and the Lockheed Martin noncompete.

Let me close by saying that I am proud of the performance of our diversified business model. Both segments grew in total and internally. The commercial segment generated strong improvement in adjusted operating margin, which flowed through to consolidated operating margin. I am confident in our competitive position today; and with our continued investment in innovation, sales, and our global production model, we are fortifying our future competitiveness. Now, let me turn it over to Kevin to take you through the financials.

Kevin Kyser

Please turn to slide 15, and I will spend a moment on the financial highlights of our third quarter results. Third quarter revenue was $1.6 billion and represented 5% total revenue growth, excluding divestitures, with 3% from internal revenue.

In addition to the comments Lynn provided earlier, the rate at which bookings ramped to revenue is having an impact on internal revenue growth. While bookings growth has accelerated, we are experiencing slower ramp rates on our bookings from fiscal year 2008 and the first half of fiscal year 2009. It typically takes 9 to 12 months for new business to ramp to 100%. However, some of the contracts that we have highlighted in the prior quarters are taking 18 to 24 months to reach 100% ramp just due to the type of work.

To look at it in a different way, under our revenue model, we typically see 25% to 30% revenue from our current year bookings and 60% to 65% revenue from the prior year bookings. However, the bookings in the first half of fiscal 2009 are generating revenue at a slower rate; and fiscal year 2008 bookings are only generating an incremental 50% to fiscal year 2009 compared to our historic 60% to 65%.

We are pleased that the record third quarter bookings of $342 million has broken the string of slower ramp and should actually ramp faster than our historical rate.

On margins, consolidated adjusted operating margins were 11.3% for the quarter compared to 11.2% in the prior year and 10.7% in the prior quarter. Project Compete costs were lower in the third quarter when compared to the second quarter, and the deferred comp expense that benefited second quarter margins was back down to historic levels.

When looking at the margin improvement sequentially, these two items basically offset one another; and the sequential adjusted operating margin increase was due to the operational improvements in the commercial segment.

Our effective tax rate for the quarter was 35.6% and lower than our expectations. Third quarter adjusted earnings per share increased 10% over the prior year to a record of $1.00. We are extremely pleased with earnings per share for the quarter.

Let's move on to cash flow. Please turn to slide 16. Third quarter of fiscal 2009 operating cash flow was $142 million or 9% of revenues. Free cash flow was light this quarter at $46 million or 3% of revenues due to higher CapEx and the timing of vendor payments.

Our collections were good during the quarter as we reduced our accounts receivable by $20 million. The timing of vendor payments negatively impacted us by about $42 million in the quarter. As expected, CapEx and additions to intangibles increased to $96 million or 6% of revenue driven by the 29% growth in trailing 12month bookings.

On a sequential basis, free cash flow in the quarter was negatively impacted by an additional payroll cycle, which equated to approximately $75 million. On a yeartodate basis, we have paid $75 million more in federal tax payments this year than last. On average, during the fourth quarter we typically generate 10% to 15% free cash flow as a percentage of revenue; and we expect another strong finish to the year with fullyear free cash flow in our stated range of 6% to 8% of revenue.

I have recapped the major fluctuations in our balance sheet categories from December on slide 17. Our cash balance at the end of March was $497 million, a decrease of $70 million primarily due to the acquisition of eServices with cash during the quarter.

As I previously stated, accounts receivable declined $20 million primarily due to strong cash collections. Good will increased due to the acquisition of eServices. Accounts payable and other accrued liabilities decreased $11 million due to the timing of vendor payments. Accrued compensation decreased $25 million due to the timing of payroll cycles and severance accruals related to Project Compete.

Please turn to slide 18 for a financial update on Project Compete. During the third quarter, we incurred $4 million in transition costs which was below our expected range of $10 million to $12 million. We reduced our overall severance accrual by $3 million in the quarter as we do not expect to pay out the full severance we originally recorded. We are experiencing higher efficiency from our offshore workforce than we originally anticipated and are incurring lower transition costs as a result.

We expect to incur $11 million to $14 million of transition costs over the next two quarters with $6 million to $8 million of costs in the fourth quarter. After investing in sales and innovation, we are still confident 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 fourth quarter. Due to the slower ramp and the impact from the economy, we are expecting the acceleration of internal revenue growth to be delayed into fiscal year 2010; and we expect the fourth quarter internal revenue growth to be similar to the third quarter.

Adjusted operating margins are expected to temporarily dip to the mid10% range in the fourth quarter due to higher Project Compete costs, the startup costs from the bookings that we signed this quarter, and the achievement accrual of our management bonus. The full year adjusted operating margin should be in the 11% range. Our effective tax rate for the fourth quarter is expected to be 36% to 37%.

Including the impact of Project Compete, we expect adjusted earnings per share will be in the range of $0.95 to $0.97.

Let me provide some comments on what we're expecting for fiscal year 2010 revenue growth. We are assuming the economic environment in our fiscal year 2010 will be consistent with current conditions. With the bookings acceleration in the second half of 2009, we should see an acceleration of internal revenue growth in fiscal 2010.

In a little more detail, a minimum of $900 million in fiscal year 2009 bookings should contribute approximately $500 million of incremental revenue in fiscal year 2010. If we were to book approximately $1 billion in fiscal 2010, this should contribute approximately $250 million of revenue in fiscal 2010. We are not seeing an increase in discounts or pricing pressures on renewals. We still expect annual revenue attrition of 6% from discounts, renewals, and contractual pricedowns.

Although we expect to close additional acquisitions in fiscal 2010, acquisitions already completed should add another 1% of top line growth.

Overall, this was a strong quarter in any environment. The investments in sales and innovation are beginning to pay off, and our cost of delivery is being positively impacted by Project Compete.

That is all the prepared comments that we have at this time. Let's open it up for questions. We have several people on the line, so if you would, hold your questions to one per caller. Operator, you may begin the Q and A session.

QuestionandAnswer Session

Operator

Bryan Keane of Credit Suisse, you may ask your question.

Bryan Keane Credit Suisse

Good afternoon. I guess some of the onetimers, the projects in consulting, I guess it's more shortterm work, that was the big negative surprise in the quarter. Can you talk about that going forward? Are we vulnerable for misses in that business in the fourth quarter and then looking into fiscal year '10?

Lynn Blodgett

What we're looking at is that they are shortterm. These are projects that, as you pointed out, it was the area of the biggest miss for the quarter. We're not expecting that those projects are going to come back in the fourth quarter. We do think they will. We think that these are projects that need to be done, but as people have been a little more careful on their discretionary budgets, some of these things have moved to the right. We expect to see it, but we're not optimistic to think that it's going catch all up in the fourth quarter.

Bryan Keane Credit Suisse

And then, my second question, Kevin, on government margins, or I guess, Tom, either one can answer. Just on government margins, quite a bit down yearoveryear, I think almost a little over 200 basis points. It says federal solutions is part of the reason for the margin decrease but maybe you can give us a little color there.

Tom Burlin

The noncompete with Lockheed Martin expired last quarter, so we saw the impact of that yearoveryear in this quarter. That's pretty direct. As you look at the operating margins, those things that we can affect, we actually saw pretty consistent margins yearoveryear and sequentially in our government portion, if you will, the state and local and federal piece of that.

While we grew that business pretty healthy, the impact was fairly well isolated to our transportation market. Two things impacted us there. We saw some incremental decline in the volumes, the transaction volumes which tend to operate at a little better margin than the norm. Then projects naturally operate at a higher margin than the average; so while they impacted revenue, they had a disproportionate impact on our margin.

Bryan Keane Credit Suisse

And on those margins going forward, is this kind of the right run rate to think about?

Tom Burlin

Clearly, the Lockheed Martin component won't come back to it. But I would expect that as we see those projects come back and we see the volumes pick up in the transportation segment in particular, that we should see some pick up, but I think in the near term, this is pretty close to right.

Kevin Kyser

I think obviously the last transaction that you do is probably the most profitable. So, as Tom said, the loss of incremental transactions there is what really hits us on the margin line. I think one of the things that at least was a good note on the quarter is that even though those margins declined on the government side, the commercial side more than overcame those as they increased almost 200 basis points.

Now I think that was a definite, again, it goes to the diversity of our business model and having a different industry, different segments that we operate in. Clearly the commercial segment margins increased really well as some of the contracts matured, we are able to get some of the cost efficiencies out of those contracts, as they were modeled to do.

Obviously, Project Compete will help the commercial side, but more than it will on the government side. To Tom's comment, I think the 15 range, we'll probably be in that range until some of the project work and the transactions come back in transportation. But still, a pretty healthy margin there.

Bryan Keane Credit Suisse

Then, last one from me. I know you gave it some color on fiscal year '10. Is there an organic growth range that comes out to, Kevin?

Kevin Kyser

It would be an acceleration from where we are today. We will definitely give you more color on our guidance in the fourth quarter. We just wanted to kind of what we were seeing today. Obviously we haven't closed fourth quarter. We don't know what fourth quarter bookings are yet. Pipeline is good.

But we'll see how the fourth quarter comes out and then give you, but today, sitting here today, because of the very good bookings this quarter, the ramp characteristics of those $342 million, we feel pretty confident about acceleration of internal revenue growth in fiscal '10.

Bryan Keane Credit Suisse

I know we were talking about $500 million for bookings for the second half of the year. Obviously, big bookings this quarter. If we keep that same number, we're only talking about $160 million or so for this quarter. Is that what we should expect? And is it potentially possible that some of the bookings just got pulled forward?

Lynn Blodgett

As I mentioned, we're confident we're going to make our 900 number; and we're going to push people to try to exceed that number. We're starting to get the machine, it's becoming a little more robust and we hope we'll continue to see good bookings. We're not going to have another $300 million quarter, but we should have a good quarter.

Kevin Kyser

Bookings are lumpy, right? But I will tell you there was no pull forward on this quarter. That just doesn't happen. I wish that happened in our business, but it just doesn't. If anything, things push to the right. The other point that you made, and I didn't answer it very well, is that vulnerability on project work in the transportation business. Clearly, it hit us this quarter.

The way that we need to counter that, and I think we're doing the things to do so, is to build the pipeline in project revenue. We've got to build, we're going to have to do more to sell more of that stuff so that we don't have this happen to us again. That's going to take us a little bit of time, but we're adding new sales people in transportation and we'll target this area to try to get a bigger pipeline so we don't have that exposure.

Operator

David Grossman, you may ask your question.

David Grossman Thomas Weisel Partners

Just maybe back to the question on the revenue comments for fiscal '10. If I am understanding it right, Kevin, are you trying to telegraph that the $900 million, I don't know if I got these numbers right, but if you contribute $500 million next year, that's 55%, which is typically 7% or 8% less than you would typically get, and then similarly, the fiscal '10 bookings would be at 25% contributions. So again, ramping a little bit slower than you would ordinarily see. Is that kind of what you're trying to communicate with those numbers?

Kevin Kyser

We kind of know what's in three quarters of the bucket today, or $747 million of the $900 million. And obviously making an assumption about fourth quarter and we think conservatively it would be 55% revenue contribution or $500 million in fiscal '10. Obviously in the first, remember in the first couple quarters, and you're right, that is slower. Remember in the first two quarters we have some slower ramping business.

Going into fiscal '10, though, a 25% to 30%, we're actually expecting bookings to get back to normal levels of ramp. 25% to 30%, I believe, is in our expected range as we laid out for folks back in May at the [inaudible], we kind of built the revenue model. We're expecting normal ramp volumes in fiscal '10 bookings as we move forward.

David Grossman Thomas Weisel Partners

Just going back to some of those contracts in the first half of the year. I guess specifically thinking about the Social Security contract with the treasury department. Can you just perhaps give us a quick update on how that contract is tracking and some of the changes that you've implemented with Comerica and how the uptake is on that service?

Tom Burlin

Couple things. One, we have a lot of experience with electronic payment cards in the state and local market and a pretty good metrics on how that population behaves. What we learned here was that this is a somewhat different demographic than we were used to. So working both with Comerica and with the Treasury Department, we're learning a lot about how that demographics responds.

One of the things we've learned is that we have to address them differently to bring them into the fold. So we are seeing a pickup in the average rate of enrollment, which is positive. We've changed our marketing, if you will, to the approach to enlisting people into this. And the department is assisting us in this endeavor, too, because it's to their advantage to move more people from paper checks to electronic payment cards.

While we're behind where we had hoped to be, remember, we knew this was a slower ramping project in total. We expected a longer ramp because we had a 6month startup to the implementation and then the signup. All of that has contributed to not only a startup expected slower growth, but slower than we even expected. But we are seeing an increased rate of signup and this project, as Lynn said, this is not lost revenue in the whole scheme of things, this project will continue to grow quarter over quarter as new recipients come into the electronic payment card.

David Grossman Thomas Weisel Partners

One last question. Looking at the margins, obviously, you had a bump up this quarter and for the various reasons you mentioned, you are going to see it go back down in the fourth quarter. What should we think about for that $40 million of incremental margin that you expect to get, should we use the 11% as the base or based on what you're seeing, would we perhaps think about a higher base, particularly if some of this projectbased work starts to improve?

Kevin Kyser

I think that you ought to use an 11% base to build off of. Clearly, the margin decline that we're going to see next quarter is a good thing. It's not a bad thing. It's positive from my perspective because really it's being impacted by the ramp of the new business. The stuff that is coming on really quickly, we've got to spend startup costs to get that on board and we're doing that today. That's a ramp of new business.

From a margin decline perspective from Q3 to Q4, we're in a position where we're going to start accruing bonus in the fourth quarter. We, as a management team, are getting hit. We took, if you will, the risk on the severance because the severance we recorded in the second quarter of fiscal '09 counted against our bonus program. It forced the accrual of bonus later into the year. We're accruing more bonus going into the fourth quarter.

Lynn Blodgett

We had to. We had to overcome that in order to [inaudible].

Kevin Kyser

Exactly. Those are the things. We've view the temporary decline in margins next quarter as being a positive, not a negative. Then I think you just build off your margin improvement off the 11%.

David Grossman Thomas Weisel Partners

But theoretically, if the project businesses improve, the 11.5% is already assuming a pretty negative outcome for that segment of the business, is that fair?

Kevin Kyser

I guess I would say obviously we had the project business last year in fiscal '08 and we kind of ended at about 11.1% or so in operating margins. You could probably go a little bit higher, but you know what, I am not ready to call that project work coming back in this environment. I really would go from the 11%.

Operator

Moshe Katri of Cowen & Company, you may ask your question.

Moshe Katri Cowen & Company

Can you remind us what's embedded in fiscal '09's revenue guidance from transportation and customer care?

Kevin Kyser

What's embedded in '09 guidance, are you talking about how large those are?

Moshe Katri Cowen & Company

Yes, in terms of revenue.

Kevin Kyser

The transportation business in total is probably in the $800 million range. And then customer care is going to be in the $500 million, $600 million range.

Moshe Katri Cowen & Company

Then can you give us an update on GM? Obviously, there's a lot of press out there in terms of some of the risks and maybe talk about some of the exposure in terms of receivables?

Kevin Kyser

Obviously, the key, we're watching GM and obviously Chrysler very closely. We've seen some of the reports out of Chrysler today. We've been through bankruptcies before with airlines several years ago. Really, a couple of things, we're providing missioncritical services, which is to our benefit and we continue to provide those services typically postbankruptcy so we don't see any interruption there. It may be a little bit different, services may be a little bit less in services.

But in terms of Chrysler and GM, they're both current on their AR. We've got good, clean AR there; and they're paying within their terms. Chrysler for us is a smaller client; it's less than a quarter of a point of revenue for us. We feel like we're a preferred vendor there, and hopefully we won't have a lot of exposure there in terms of the AR. On GM, it's uncertain as to the outcome there. We're continuing to watch it closely. GM is about a 2% client for us.

Lynn Blodgett

I want to just add we're obviously very mindful of the difficulty. They're both great clients of ours; and we're working with them to try to help them through this situation how else that we can.

Operator

James Kissane of Bank of America, you may ask your question.

James Kissane Bank of America

Did the slower ramp in the commercial contract actually help the commercial margin in the third quarter? and then that's going to reverse a little bit in the fourth quarter?

Kevin Kyser

It really didn't. I think you're going to see, you're actually going to see hopefully, the commercial margin stay in the doubledigit range. Really what helped the margins in the commercial business was the maturing of some of the contracts in the F&A space, in the HR space.

As we're getting some efficiencies out of those, the expected efficiency gains out of those contracts, internal revenue growth last quarter, in Q2 was 3% for commercial as well. And you saw increased margins over that period. Again, I was very pleased with the 11% margins in commercial.

Lynn Blodgett

I think what's really going on in commercial is that the Project Compete, the most of the impact of Project Compete is hitting the commercial segment. That's helping. You are going to start to see that we talked about getting those costs recouped this quarter. That's going to start to help drive them.

Then as somebody mentioned in their remarks, the fact is we've got several of our F&A contracts and HR contracts that are reaching that operation phase when we're out of the startup, which is obviously a drag, and we're seeing that contribution, that improved contribution from those more stable contracts. That's what's really going on. These are real operational improvements that you're seeing.

James Kissane Bank of America

But the dip in the fourth quarter will be on the commercial side primarily, right?

Kevin Kyser

I think you're going to see some of a dip, but I expect it to stay up in the double digits.

James Kissane Bank of America

One last question.

Need a little more color on the nature of the commercial BPO business that you signed in the quarter. And was there any one or two big, big contracts in the signings?

Lynn Blodgett

What we were able to do is our healthcare vertical, both in the government area and the commercial area, is where we saw the strongest signings. We are getting to the point now where we are starting to be able to win on deals that are a little bit bigger. And we had a nice deal on our commercial payer side that contributed to the signings and we also had a couple nice deals on our government side in healthcare.

We are getting more confident in our ability to compete. Our deal size tends to be going up, which is from my viewpoint a good thing.

Operator

Jason Kupferberg of UBS, you may ask your question.

Jason Kupferberg UBS

I am going to ask another question on the bookings. In terms of the, I know you mentioned the "type" of work that's been causing some of the slower ramps and you highlighted the treasury contract. I know you've talked about it in the past.

But can you maybe give us a little more color on the specific types of work that you signed in the third quarter because it seems like you're getting off to a better start in terms of ramps on those. And obviously where I am going with this is getting up to the visibility on the organic growth acceleration in fiscal '10 now that there's obviously been some pushouts from fiscal '09.

Just wanted to get a better sense of what the real different nature of this work is that makes you comfortable and confident that you won't see the kinds of disruptions in ramp that we've seen recently.

Lynn Blodgett

That's a great question. The type of work that we're seeing that is typically, if we have a deal, an ITO deal ramps many times over like a light switch. Sometimes in our BPO space, the transaction in BPO space, things kind of tend, some of them can be protracted and some can ramp very quickly.

These happen to be, a couple happen to be deals that we're able to ramp up very quickly. So we have visibility on that. When we tell you that we're going to be running at 50%, at least 50% of the ramp volume by the end of the quarter, that's based on really good visibility to it. These have tended to be the kind of BPO deals that when we go into them, we're able to essentially take over operations and you just see a much quicker ramp.

The nice thing, too, about that is that we don't have as much in the way of development costs. And we can utilize existing systems so we don't have some of the transition difficulties in terms of moving into new technology and so on. We tend to evolve into that rather than having to get all that implemented and then go to a startup. Does that make sense?

Jason Kupferberg UBS

It does. Just shifting gears to the projectbased business. Can you lay out for us the way you guys view it and define it? How big is that projectbased business as a percent of revenue? I know you threw out the 85% recurring number earlier. Do you view projectbased work at 15% or so of revenue? Because I think on the surface, the $24 million shortfall in the quarter probably took some people a little bit by surprise, so I just wanted to make sure we have the right sizing of that business in terms of how you guys view it.

Kevin Kyser

I think we view it as kind of in the 10% range. That spans several different segments in businesses, but predominantly in the transportation space. Then the rest of it would be consulting work and other kind of nonrecurring work.

Lynn Blodgett

It's probably, think about what made up that $22 million is in excess of eight or nine different projects, so no single project was a massive project. It's the relatively small projects and just happens to be a number of them that we saw the delays of.

Kevin Kyser

We do have project work that is tied in. Our preference is to do project work that's tied into a longterm kind of BPO contract. But we do have some that just we do development and or development and delivery of things and those are straight up projects.

Operator

Ashwin Shirvaikar of Citigroup, you may ask your question.

Ashwin Shirvaikar Citigroup

Congratulations to the team for the very good bookings number. The question I had, however, was just going back to the margins. I hear what you're saying with the explanation on government margins, but government operating margins have been going down from the 19% range at the end of 2007, steadily they've been going down to the 15% range.

I am just kind of wondering is it just the explanation you've given, or is there something else more fundamental going on in there? And I wanted to get a little bit more into the explanation of the Lockheed noncompete as well. Could you provide some metrics around, was there a payment that Lockheed was making or something like that for the noncompete? What was going on there? Is it investment?

Kevin Kyser

The Lockheed noncompete was the fiveyear noncompete that we entered into back in 2001, 2002 when we sold our federal business and took over a commercial business. In essence, they paid us on a quarterly basis about $3.5 million, and that went away fully this quarter. We had a little bit of it last quarter and now that is gone. It was a payment on a quarterly basis that we received from Lockheed Martin.

With respect to the operating margins in 2007 versus 2009, what is different, I think clearly what you see is that 2007, we probably were not investing in innovation and really probably not investing as much in sales. Lynn and Tom have both made a commitment to invest more in sales in those businesses, which we all think is the right answer. That definitely, sales force, increasing the sales force chasing after the pipeline is obviously an investment that's very costly, but it's one that is well worth it.

I think that's really what you've seen there in terms of the margin decline, as well as investments we've made in our new enterprise system in government healthcare and having to refurbish that system and become state of the art. Because with that we're winning new MMIS deals with that new technology and that, too, is a very costly investment as well.

Ashwin Shirvaikar Citigroup

That's a good explanation, thanks for that. But if I assume that the postProject Compete that you do have a much better cost structure in the commercial side and on the government side margins start coming back. What's the sustainable corporate margin at that time?

Kevin Kyser

I would think we would be in the middle part of our range at that point in time. And if the volumes came back, we might be just slightly above that.

Operator

James Friedman of Susquehanna, you may ask your question.

James Friedman Susquehanna Financial Group

I just wanted to probe a little bit about the eServices acquisition. It sounded, Lynn, from your commentary at the opening that you had observed some shortfall in the number of calls that you had modeled, the 19 million versus 18 million. But at the same time you're buying some exist with eServices. I was just trying to reconcile how it is that maybe customer care may be underperforming but you're increasing your capacity.

Lynn Blodgett

That's a fair question. We did not do eServices or Grupo Multivoice for excess capacity. We're pretty careful about building out capacity as it's needed by the customers. We did those deals because they give us an expertise or a capability in terms of a pureplay BPO model, but they don't have tons of excess capacity sitting around. They have the expertise to do it. That's how their delivery mechanism is a pureplay and we picked up that capability. We did not pick up excess capacity. That was not the reason for the acquisition.

The other thing that we did by those acquisitions is it gave us clients in Europe and the big part of what we're trying to do is to grow our European footprint, and the Grupo Multivoice has a number of customers that are based in Spain and in other parts of continental Europe. So it was to pick up a capability but not call center capacity. Building out seats is not the most difficult part of this thing. We can add capacity pretty easily. It's that additional expertise and access to that customer base that are really the things that are relevant.

James Friedman Susquehanna Financial Group

Just one final question. In prior quarters you have given us an update about the sales force head count, particularly with the federal mix; and it sounded like that had been ramping. If you might have that figure, that would be helpful.

Kevin Kyser

I think we finished the quarter at about 80 additional sales people and we expect to finish the year at in excess of 100.

Operator

George Price of Stifel Nicolaus, you may ask your question.

George Price Stifel Nicolaus

First of all, on the new business, congratulations on the new wins. Maybe if you can comment a little bit more to help us get some comfort around the terms of the new business, so expected margins from the work that you're signing, capital intensity. You hit the pricing topic, I think, pretty well, but any other terms particularly given that you have constrained clients and certainly in our industry checks out there we're hearing that clients are looking to take advantage of providers to help them get costs out sooner rather than later, which generally means capital and transition costs and other terms that may be less favorable to you.

Lynn Blodgett

The funny thing about the pricing is that, I have said this for a number of years, our clients demand a supergreat price no matter what; and they seem to be able to get it. We aren't seeing anything that is materially different than what we saw a year ago. People push us about as hard as they can, and we figure out how we can win the business and there's nothing in this work that inherently is different than that in terms of the competitive nature. In terms of capital, actually some of this work is pretty light from a capital intensity standpoint. So we don't expect that we'll see a big shift in CapEx. Kevin, I don't know if you want to add any color to that.

Kevin Kyser

Because of the quick ramp nature of the lower development costs up front, there's just a lower capital intensity of this book of business. From a margin perspective, I think the margins are right at corporate average, maybe slightly above over the term of the deals. Obviously it's going to impact them first quarter, next quarter out of the gate. This is a, I think it's a very good mix of business.

Operator

Eric Boyer of Wachovia, you may ask your question.

Eric Boyer Wachovia Capital Markets

I was just wondering, can you talk about your state and local pipeline. I am most interested in the pace of the deals and the type of work entering that pipeline. If you're seeing any changes there in state and local budget dynamics and the overall economy.

Tom Burlin

We are seeing a fairly healthy pipeline in our state and local market overall. Electronic payment services, those things associated with entitlement programs and unemployment insurance programs and those sorts of things, continue to be strong leaders in that market. And we're continuing very well interest, having great success.

The Medicaid market, over the next 18 months, 26 Medicaid programs will be up for bid. Of those 26, four of them were income. Four of them, the state are self performing; and the balance of those are with our competitors. That's heavily weighted towards our other big competitor in this market who has the lion's share of those that are coming up for renewal.

It's part of the reason that it's sort of a follow on to the answer that Kevin gave. It's part of the reason that we foresaw this great opportunity in this part of the market and why we invested so heavily in our government healthcare segment. So, good offerings and good opportunities in that segment of the market. Of course, as we go into the federal market, we're seeing a great opportunity for what are effectively our BPO commercial offerings into the federal space. We will continue, I hope, to see bigger and more regular opportunities to compete in the federal market as we grow out that sales force that we talked about.

Last, but not least, internationally, our transportation market, we're still seeing good opportunities both domestically and outside the U.S. in our transportation markets. The pipeline is pretty healthy and broadly across our offerings.

Lynn Blodgett

Operator, I think with that we'll go ahead and conclude. I just wanted to finish with a couple of comments. This has been, from my viewpoint, a great quarter, the best bookings that we've ever had, very strong, the pipeline continues to be very strong, very good business with a more rapid ramp, which are all things that are positive. I think the fact that we had our strongest EPS in our history is also pretty remarkable.

I'm also very pleased that we've done fundamental things to get our cost structure in the most competitive shape that we can get it, and that's coming through in terms of margins as we talked about. I'm very proud of our people, very proud of the performance of this quarter. We thank each of you for participating with us today. Thank you very much

Operator

Thank you for your participation. Your call has concluded, you may disconnect at this time.

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Source: Affiliated Computer Services, Inc. F3Q09 (Qtr End 3/31/09) Earnings Call Transcript
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