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Unisys (NYSE:UIS)

Q3 2013 Earnings Call

October 22, 2013 5:30 pm ET

Executives

Niels Christensen

J. Edward Coleman - Chairman, Chief Executive Officer and Member of Finance Committee

Janet Brutschea Haugen - Chief Financial Officer and Senior Vice President

Analysts

William S. Smith - Wm Smith Securities, Inc.

Glenn Mattson - Sidoti & Company, LLC

Operator

Good day, and welcome to the Unisys Third Quarter 2013 Results Conference Call.

At this time, I'd like to turn the conference over to Mr. Neils Christensen, Vice President, Investor Relations at Unisys Corporation. Please go ahead, sir.

Niels Christensen

Thank you, operator. Good afternoon, everyone, and thank you for joining us. Earlier today, Unisys released its third quarter 2013 financial results. With us this afternoon to discuss our results are Ed Coleman, our CEO; and Janet Haugen our CFO.

Before we begin, I want to cover a few housekeeping details. First, today's conference call and the Q&A session are being webcast via the Unisys investor website. Second, you can find the earnings press release and the presentation slides that we will be using this afternoon to guide our discussion on our investor website. Third, today's presentation, which is complementary to the earnings press release, include some non-GAAP financial measures. These have been provided in an effort to give investors additional information. The non-GAAP measures have been reconciled to the related GAAP measures and we provided reconciliation charts at the end of the presentation.

Finally, I'd like to remind you all that all forward-looking statements made during this conference call are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. These factors are discussed more fully in the earnings release and in the company's SEC filings. Copies of these SEC reports are available from the SEC and from the Unisys investor website.

And now I'd like to turn the call over to Ed.

J. Edward Coleman

Thanks, Neils. Hello, everyone, and thank you for joining us today to discuss our third quarter 2013 financial results. Please turn to Slide 4 to begin our discussion.

Despite margin improvement in our services business during the third quarter, we were unable to offset significantly lower technology revenue. As a result, while profitable on a pretax basis, we had a net loss in the quarter.

As we've previously said, our technology revenue can vary significantly from quarter to quarter, depending on the timing of deal closures, which is why this business is best measured on an annual rather than a quarterly basis. We look for a strong fourth quarter in our technology business and have already closed a number of key deals. We remain focused on achieving our goal of maintaining stable technology revenue for the full year of 2013 compared with 2012 levels.

In our services business, revenue was down 4% in the quarter, mostly driven by weakness in the public sector market in our Asia Pacific region. However, we saw improvement in our services operating profit margins in the quarter, as we focused on higher margin services and worked to lower our cost of service delivery. We were also encouraged by improvement in our services orders, our second consecutive quarter of year-over-year services order growth.

As we look ahead to 2014 and beyond, we're excited about our growth opportunities in the solution areas where we are investing.

Slide 5 shows these investment areas. In our technology business, we're investing in software and server products to take advantage of our engineering strengths and intellectual property to help organizations address mission-critical computing challenges. Earlier this month, we announced 2 exciting new technology offerings: Stealth for mobile, which is the newest member of our growing family of Stealth cybersecurity products; and Forward! by Unisys, which is our new Intel-based fabric computing platform.

Stealth is a disruptive technology that goes beyond traditional perimeter-based security approaches, which are proving to be increasingly ineffective in protecting against cyber attacks in an age of proliferating consumer devices and exploding data usage in the workplace. Our Stealth products use advantage cloaking technology to protect critical assets by making data and endpoints effectively invisible to hackers and intruders.

Our new Forward! server platform combines our secure partitioning technology, originally developed for our ClearPath systems, with the power of industry-standard Intel Xeon processors to offer organizations an alternative to expensive proprietary UNIX systems for running their mission-critical applications.

Forward! offers a secure and predictable platform for handing Linux and Microsoft workloads, high-volume cloud applications and ERP applications in a mission-critical environment. The Forward! platform is also ideal for server consolidation. It gives organizations the opportunity to standardize entire data centers, including their mission-critical workloads, on a flexible and secure implementation of the Intel x86 architecture.

Stealth and Forward! move Unisys into large growing technology market segments. Along with continued investments in our core ClearPath systems and technologies, we believe Stealth and Forward! provide us with opportunities to shift our technology business into growth mode.

In our services business, we continue to invest in growth opportunities in our strategic businesses of IT outsourcing and systems integration. In both of these areas, we're leveraging our idle-based global services delivery model along with our capabilities in cybersecurity, cloud computing, mobile computing and other disruptive technologies, to provide organizations with more cost-effective ways of delivering IT services and solving mission-critical solutions -- mission-critical problems.

For instance, we now offer an as-a-service version of our IT service management solution, which dramatically speeds implementation and reduces capital cost for our clients. We currently have about 150 clients using our cloud-based ITSM solution and we see growth opportunities for this solution moving forward.

We also continue to broaden the market for our industry software solutions by offering them via software-as-a-service model. The examples include our cloud-based air cargo solution, the software-as-a-service version of our InfoImage Enterprise Content Management software and our recently available cloud-based luggage solution in the U.K., where we continue to add new clients.

In addition, while the market for project-based services work continues to be challenging, we're pursuing targeted opportunities for mission-critical systems integration projects that leverage our strengths. In Europe, for instance, a Unisys-led consortium was selected in the third quarter for a framework contract to modernize the mission-critical communications network used by European Union member states to share vital customs and tax information and protect against fraud. And in Brazil, Unisys is part of a consortium that won a contract in the third quarter to provide IT infrastructure support for the 2014 World Cup.

In the area of end-user outsourcing, where Unisys is recognized by a market leader by Gartner, we continue to add new clients and have a significant pipeline of opportunities. And in the data center outsourcing market, we're pleased to have been recently selected as the winner of 2 large cloud-centric public sector bids that we expect to close in the near future.

Complementing these outsourcing businesses, we continue to pursue adjacent market opportunities in the application managed services, where we're encouraged by the activity and the pipeline we're seeing.

To increase market awareness of our offerings and drive growth, we are increasing our marketing and sales initiatives. We continue to build out our network of value-added reseller partners to augment our direct sales force in representing our solutions in the market.

As you may recall, our goal is to increase the percentage of our revenue that comes from resellers and distributors, which currently is low relative to our competition. We now have about 50 VARs who are initially focused on selling our suite of Stealth cybersecurity products to businesses and government agencies in North America and Europe. These channel partners are opening up new sales opportunities for Stealth in new accounts. We're excited about the potential of our channel program as we move into 2014 and beyond.

Moving to Slide 6. In recent months, we've showcased our portfolio in high-profile events around the world and we're pleased by the level of interest we're seeing in Unisys and the innovations were bringing to market. Most recently, we took part in the Gartner symposium event in Florida, where we announced both Stealth for mobile and Forward!. This slide highlights some of the positive market response we're receiving.

In summary, turning to Slide 7, while this is a tough technology quarter for us, we're pleased with the services operating profit margin improvement and the progress we made in developing new innovative products and solutions. We look to close out the year with a strong fourth quarter and continue to invest in our growth programs to position the company for revenue growth in the future. I look forward to updating you on our progress in our next call.

Now here's Janet to take you through our results in more detail and then we'll be happy to take your questions. Janet?

Janet Brutschea Haugen

Thanks, Ed, and hello, everyone. Let me start with our overall third quarter 2013 financial results. Please turn to Slide 9. At the top line, we reported revenue of $792 million in the quarter, which was down 10% year-over-year. Currency had a 1 percentage point negative impact on our revenue in the quarter.

Following a strong second quarter, our technology revenue declined 44% year-over-year in the third quarter, principally due to lower ClearPath sales. We remain focused on achieving our goal of flat technology revenue for the full year. We closed a number of technology deals early in the fourth quarter and are working many fourth quarter technology opportunities.

Services revenue declined 4% year-over-year, down 2% on a constant currency basis. Based on today's rates, we anticipate currency will have a minimal impact on revenue comparisons in the fourth quarter of 2013 when compared to the fourth quarter of 2012.

As a result of the lower year-over-year technology revenue, our gross profit margin declined from 24.9% in the third quarter of 2012 to 21.7% in the third quarter of 2013.

Operating expenses fell by 6% year-over-year in the third quarter of 2013. Our operating expense reductions in the quarter more than offset the incremental investments we continue to make in our growth initiatives, including Stealth, Forward!, application managed services and ITSM.

Interest expense decreased by more than 2/3 from $7.8 million in the third quarter of 2012 to $2.4 million in the third quarter of 2013, reflecting the impact of our debt reduction and the refinancing in the third quarter of 2012.

Other income expense for the third quarter of 2013 was $1.9 million of other income. This compares to $25.8 million of other expense in the year ago quarter, which was primarily related to debt reduction charges of $23.1 million.

Third quarter 2013 pretax pension expense was $23.4 million compared to $29.9 million in the third quarter of 2012. We expect approximately $94 million in pension expense in 2013 compared with pension expense of about $108 million in 2012.

At the tax line, we had a $27 million tax provision in the quarter, of which, $11.4 million related to the U.K. enacted tax rate change, which I'll discuss in a moment. The $27 million tax provision on pretax income of $23.5 million compared with a $32.7 million tax provision in the year ago quarter on pretax income of $27.6 million. As I've said previously, our effective tax rate varies significantly from quarter-to-quarter based on the geographic distribution of our income.

The third quarter 2013 tax provision was impacted by the July 2013 passage of the U.K. finance act that we discussed last quarter. The U.K. corporate tax rate was reduced to 21% effective April 1, 2014 and to 20% effective April 1, 2015. These rate reductions reduce the future value of our U.K. net deferred tax assets and increased our third quarter 2013 income tax provision by approximately $11.4 million. We saw similar impact to our income tax provisions when U.K. rate reductions were enacted in both 2011 and 2012.

We reported a net loss of $11.6 million in the quarter versus a net loss of $12.4 million in the year ago quarter. Excluding the impact of pension expense in both years and the debt reduction charge in the third quarter of 2012, we reported non-GAAP net income of $11 million for the third quarter of 2013 compared with non-GAAP net income of $39.6 million in the prior year period.

Our third quarter 2013 diluted loss per common share was $0.26 compared to a loss of $0.28 in the year ago quarter. Excluding the impact of last year's debt reduction charge and pension expense in both quarters, our third quarter 2013 non-GAAP diluted earnings per common share was $0.25 compared to $0.85 in the third quarter of 2012.

Moving on to discuss our third quarter revenue in more detail, please turn to Slide 10. As noted earlier, services revenue, which represent a 91% of our revenue in the third quarter of 2013, declined 4% year-over-year. Technology revenue, which accounted for 9% of our total revenue, declined 44% year-over-year.

On Slide 11, you can see our overall services margins and our services revenue by portfolio. Year-over-year, IT outsourcing revenue declined 7% in the third quarter of 2013, principally due to lower volume within the public sector in Australia, as well as the impact of currency. Systems integration revenue declined slightly in the third quarter of 2013 compared to the prior year.

Services gross profit rose by about $3 million despite the $28 million decrease in services revenue and the services gross margin increased 120 basis points year-over-year to 21.1% from 19.9% in the third quarter of 2012. This increase reflected our focus on both a more profitable mix of services revenue and improved efficiency in our services delivery organizations. The services operating margin improved 170 basis points year-over-year to 7.7% in the third quarter of 2013. Excluding our U.S. Federal government business, our services operating margin was within the targeted range of 8% to 10%.

While we were pleased with the year-over-year and sequential improvement in our services operating margin, we still have work to do to achieve our goal of consistent operating margins in the targeted range.

Moving on to technology revenue and margins on Slide 12. Enterprise class software and server revenue decreased 56% year-over-year largely due to the lower ClearPath sales. Sales of other technology, all of which is third-party product, rose by about $12 million. As we have said previously, the technology and business performance is best measured on an annual basis and our goal remains to keep 2013 technology revenues stable with 2012 levels.

The lower technology revenue in the third quarter led to a decline in gross margin from 59.9% in the third quarter of 2012 to 35.3% in the third quarter of 2013. Our technology operating margin declined from 29.1% in the year ago quarter to a negative 11% for the third quarter of 2013.

Slide 13 shows our third quarter revenue by geography and industry. Our North America revenue, which represented 44% of the revenue in the quarter, declined 2%. Revenue from the U.S. Federal government represented 16% of total Unisys revenue in the third quarter. International revenue declined 15% in the quarter and was down 13% on a constant currency basis. Revenue in our European region was down 2% in the third quarter on an as-reported basis and declined 4% in constant currency. The decrease was principally related to a decrease in technology revenue.

The Asia Pacific region revenue decreased by 34% on an as-reported basis and was down 30% in constant currency. This decline largely reflected lower public sector revenues in Australia and New Zealand.

Our Latin America region saw a revenue decline by 19% on an as-reported basis and 12% in a constant currency. This decrease was, again, principally driven by lower technology revenue.

From an industry perspective, Public Sector, which reported an 11% year-over-year decline in revenue, remains our largest single industry revenue source representing 40% of total revenue. This decline was largely due to reductions in the public sector business in Australia and New Zealand.

Revenue from commercial industry customers represented 37% of our third quarter revenue, while the financial sector was 23%, both declines in the quarter primarily attributable to lower technology business.

Slide 14 provides more detail on our U.S. Federal government revenue over the past 7 quarters. In the third quarter of 2013, revenue from civilian agencies represented about 45% of our overall U.S. federal government revenue. Revenue from Homeland Security agencies represented 31% of our overall U.S. Federal government revenue, while the U.S. Department of Defense and various intelligence agencies represented about 24% of our overall U.S. Federal government revenue.

Compared to the year ago quarter, our U.S. Federal revenue declined approximately 1% to $128 million. We were pleased to see that revenue increased sequentially for the second consecutive quarter. We ended the third quarter of 2013 with about $356 million of U.S. Federal services backlog, which was up 8% versus the third quarter of 2012 and about 37% sequentially.

During the recent partial shutdown of the U.S. Federal government, approximately 80% of our workforce was deemed essential and continued to work. As a result of the 17-day shutdown, we lost approximately $5 million in revenue. Additionally, there may be revenue delayed into 2014 as a result of procurement delays caused by the shutdown.

For some comments on services orders, please turn to Slide 15. In the third quarter, our services orders were up slightly year-over-year with order growth in IT outsourcing and systems integration. From a geographic perspective, we saw year-over-year services order growth in our European region and our U.S. federal government business during the third quarter. Orders in the North American, Latin American and Asia Pacific regions declined in comparison to the third quarter of 2012.

We ended the third quarter with $4.8 billion in services backlog, consistent with the June 30, 2013, levels, but down versus $5.1 billion at September 30, 2012. The year-over-year decline principally reflected reductions in our ITO and BPO backlog.

Of the $4.8 billion in services backlog at September 30, 2013, approximately $630 million is anticipated to convert into fourth quarter 2013 services revenue. During the past 11 quarters, the amount of revenue and backlog at the start of the quarter has a range between 85% and 90% of our quarterly services revenue for the full quarter and the selling day revenue has accounted for the remainder.

Moving to cash, please turn to Slide 16 for an overview of our cash flow performance in the quarter. We generated $16 million of cash from operations in the third quarter of 2013 compared to $16.9 million in the year ago quarter. We contributed $40.3 million in cash to our defined benefit pension plans in the third quarter of 2013 versus $56.3 million in the third quarter of 2012. The pension funding contributions are reflected in the cash flow from operations.

Excluding the impact of the debt reduction charge in the third quarter of 2012 and pension expense in both periods, Unisys generated adjusted EBITDA of $85.9 million in the third quarter of 2013 versus $125.2 million in the prior year period.

Capital expenditures were $38.9 million in the third quarter of 2013 versus $31.5 million in the third quarter of 2012. We expect full year capital expenditures of about $150 million.

We have free cash flow usage of $22.9 million in the third quarter of 2013 versus free cash flow usage of $14.6 million for the same period last year. Our free cash flow generation before pension cash contributions was $17.4 million for the third quarter of 2013 versus $41.7 million in the third quarter of 2012.

Depreciation and amortization was $40.7 million in the quarter versus $40.1 million in the third quarter of 2012. Our debt balance was $210 million at September 30, 2013, consistent with the September 30, 2012, level.

Our cash balance of $556 million at September 30, 2013, was more than 2.5x our debt and our net cash position of $346 million was slightly higher than at September 30, 2012.

As we've discussed previously, in December 2012, our Board of Directors authorized the purchase of up to $50 million of the company's common and preferred stock through December 2014. There were no repurchases during the third quarter of 2013 and $38.5 million remains available for share repurchases under the board authorization.

Let me conclude by saying that we are pleased with the third quarter improvement in services operating margin, but we know we have more work to do to achieve our goal there and sustain that level of performance.

We are focused on delivering a strong fourth quarter in our technology business to achieve our goal of stable year-over-year revenue. And as always, we remain committed to aggressive expense management and intend to fully leverage our cost base to optimize profitability now and support improved profitability as we work to grow revenue in the future.

Thank you for your time. And now I'd like to turn the call back over to Ed.

J. Edward Coleman

Great. Thank you, Janet. Operator, we'd like to open the call up to questions, if we may.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll go to Bill Smith with William Smith & Company.

William S. Smith - Wm Smith Securities, Inc.

Ed, could you guys comment on Forward! in the fourth quarter, when you might be in the market or are you in the market now with Forward!, and what kind of follow-through you think you'll see there?

J. Edward Coleman

Bill, we announced that the first week of October at the Gartner symposium, formally announced that we have shipped a handful of data systems at this point to those initial customers and we're not doing -- the first real customer ship program begins at the first week of December of this year. So I would expect limited impact from Forward! in the fourth quarter, from a revenue and profit standpoint.

William S. Smith - Wm Smith Securities, Inc.

And on the marketing side, is that a direct sale or could that also be part of the VAR channel?

J. Edward Coleman

Yes, we anticipate that it will be part of the VAR channel, but certainly a direct sale, but we expect this will also go through indirect channels as well.

William S. Smith - Wm Smith Securities, Inc.

Great. And could you comment on Stealth, what you saw in the third quarter after you announced the Amazon relationship in June, what you've seen and what kind of a response you've gotten there with Stealth?

J. Edward Coleman

I think I feel good about the response we're getting from Stealth. I think it's still early days. We have a number of early implementations and first sales in a number of different accounts, but we are ramping that up. We're excited about the channel acceptance of it and they're ramping up to support and sell it. But again, it's early days and we'll continue to keep driving it on.

Operator

[Operator Instructions] We'll now go to Glenn Mattson with Sidoti & Company.

Glenn Mattson - Sidoti & Company, LLC

So it's nice to see the service business get a little bit better. I want to be clear though on the technology side. You keep talking about, I guess, projecting something stable year-over-year, so that would imply a kind of enormous ramp into Q4. And you did say you closed some deals, so is much of the weakness in technology a timing issue, is that basically what you're trying to say?

J. Edward Coleman

Yes, I think, Glenn, we've been saying for probably 3 years now, our goal has been to keep the technology business flat. And we've kept it flat -- actually grown it the last 3 years. And one of the things that we keep reiterating is the fact that it's a very difficult business to forecast on a quarter-by-quarter basis based on the timing of when customers elect to take on either increases in capacity or renew their existing software implementation. So quarter by quarter, it can be a challenging business to forecast, which is why we always say you ought to look at it on a full year basis.

Glenn Mattson - Sidoti & Company, LLC

Okay. But even thinking about that, though, with -- even assuming down year-over-year, marginally down or something, you still have to do almost like 50% of your enterprise class server and software sales in Q4 just to get to a number like that. And then that would even be year-over-year like something north of 30%, off of what's a strong Q4 '12. So but what you're saying is you think that kind of -- those kind of results are still achievable?

J. Edward Coleman

Yes, we see the capability of getting there and that remains our goal, to do just that.

Glenn Mattson - Sidoti & Company, LLC

Okay. That's great. And then -- so the weakness in Australia and New Zealand, can you explain -- it was public sector weakness, could you explain -- give a little more detail as to why we saw that?

Janet Brutschea Haugen

Yes, Glenn. There were some changing governmental -- in the governments within Australia that caused some projects to be put on hold, reevaluated. And that caused impact on us in the quarter. Not anything that we think is something that is a systemic problem in that business. It more has to do with the timing of activity and, in particular, project-based work there.

Glenn Mattson - Sidoti & Company, LLC

Okay. Sounds good. And then I guess the last thing I would've asked is that you also talked about -- when you talked about Stealth and Forward!, that there could possibly be more of a shift in technology into a growth mode. That's, obviously, the encouraging news. So I guess, will we look to maybe next quarter to get maybe a longer-term kind of layout of where we think technology segment can go over the next couple of years?

J. Edward Coleman

I think that's right. That's right.

Operator

And there are no other questions at this time. I'd like to turn the call back over to Ed -- Mr. Ed Coleman.

J. Edward Coleman

So, great. Just to reiterate what I said earlier and Janet said, as well, we, again, are pleased with the improvement in services business in the third quarter, but recognize that we have a big quarter coming up in the fourth quarter in order to hit our goals around the technology business and achieve the results that we're looking for. So we look forward to reporting back to you after the fourth quarter and appreciate you joining this call.

Thank you very much.

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