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Electronic Data Systems Corporation (NASDAQ:EDS)

Q3 2006 Earnings Call

November 01, 2006 5:00 pm ET

Executives

Allen Hamood - VP of IR

Mike Jordan - CEO

Ron Vargo - CFO

Ron Rittenmeyer - COO

Analysts

Bryan Keane - Prudential Securities

David Grossman - Thomas Weisel Partners

Adam Frisch - UBS

Rod Bourgeois - Bernstein

Gregory Smith - Merrill Lynch

Julio Quinteros - Goldman Sachs

Tien-Tsin Huang - J.P. Morgan

Jim Kissane - Bear Stearns

Patrick Burton - Citigroup

Operator

All lines have been placed on a listen-only mode until the question-and-answer session of today's conference. Also the conference call is being recorded. If you have any objections you may disconnect.

I would like to turn the conference call over to your speaker, Mr. Allen Hamood, Vice President, Investor Relations. Please go ahead, sir.

Allen Hamood

Thank you very much. I'd like to welcome all of you to our Third Quarter 2006 Earnings Call. With me on the call today are Chairman and CEO, Mike Jordan; CFO, Ron Vargo; and COO, Ron Rittenmeyer. You should have received an e-mail from me, a copy of our press release as well as the presentations to be read on today's call. I'd like to remind you that all those presentations are available on our website and will be archived there over the next 30 days.

The information covered on today's call which is not historical in nature including statements regarding financial guidance or future financial performance and the value of our new contract signings constitutes forward-looking statements within the meaning of the Federal Securities law. These statements are subject to numerous risks and uncertainties, many of which are beyond our control, which would cause actual results to differ materially from such statements.

For information concerning these risks and uncertainties, see the risk factors section in our most recently filed Form 10-K. We disclaim any intention or obligation to update these forward-looking statements whether as a result of subsequent events or otherwise except as required by law. In addition, we refer to you to slides posted on eds.com that accompany this call. Among other things these sides present a reconciliation of the non-GAAP financial information we discuss today and should be reviewed in connection and in context with that discussion.

With that done, let me turn the call over to Mike.

Mike Jordan

Thank you, and good afternoon. I'm going to turn to the second slide, that which is titled 'financial overview, the third quarter results'. Hitting the highlights; revenue of 5.3 billion, up 6% on an organic basis, essentially in line with our guidance; EPS, what we call adjusted, which you can go into, it's really excluding a few unique items is $0.24 versus our original guidance of 16 to 21. Operating margin here is up 1.6 points on efficiencies and this is despite relatively significant increases year-over-year in our investment funding. Free cash flow of $171 million, are still on track for our full-year guidance. Third Quarter TCV of 3.5 billion, our total year-to-date contract signings of 19 billion, up 28% year-to-date.

Turning to the next slide, a few comments on the growth; this is our third quarter in a row with positive book-to-bill ratio and our new logo trend is accelerating. So, we feel pretty good about where we stand in the marketplace. And as we see it, the market is pretty stable.

Next slide, the earnings drivers in this quarter were first around, execution around our mega-deals. NMCI continues to improve operationally and financially and we will have a very good year in Navy this year. We also are highlighting here something that was started earlier in the year which is a dedicated contract Start-Up team. We know that many of our problem contracts of previous years got in trouble with the start-up and now, we got a professional group that supervises the start-ups, and actually we're delivering performance that is exceeding our planned numbers.

Our global delivery centers are yielding solid productivity and quality improvements, new leverage. I'd call your attention to the zero outage mentality that's taking place throughout the company, that helps us reduce staffing levels and improves performance and voids penalties for the client but most importantly, it improves the client satisfaction, and obviously we continue to shift workforce to the Best Shore centers. Supply chain moves along. It's an important contributor to our year-on-year productivity. Real estate is one where we continued to drive our utilization up.

Finally, we continue our progress on pairing away regional and corporate overhead.

Turning to the investment; in this quarter, we had approximately $0.12 in investments around workforce alignment, primarily in Europe and some in the US. We continue good progress on our goal of 5,000 headcount reductions for the full year with 2,000 in this quarter. Best Shore continues to be our major goal. We will have roughly 30,000 people in cost advantage locations by the year-end '06 driving to 45,000 by year-end '08.

India is the primary beneficiary, but we continue to migrate workforces such as Brazil, Argentina, China, Hungary and Poland. The other investment area also around $0.12 in this quarter is around tools and other products that help us run our business better. First is the Global Services Network, which allows us to secure movement of the -- to get movement of data around the world in very secure fashion. And to say that our view of utility computing is a network centric view as opposed to some of our competitors who are data centric -- data center centric. So, this investment in the global security network was critical for our future success.

We're rolling out Service Delivery Automation and Business Management Transformation, work flow items; things that will help us do our business in a more efficient way. And finally, our Best Shore and other Global Service Delivery Centers as we are getting more efficiency as we consolidate centers into highly efficient hubs.

Let me just quick update on MphasiS. We named Jerry Rao, the original CEO of MphasiS as Chairman of MphasiS and leader of EDS, India operations; we're merging EDS, India into MphasiS. We are continuing to target 20,000 employees in India by year-end. Integration is going pretty well. We have a very experienced EDS person as COO at MphasiS, and as you have read, we commenced an offer to acquire an additional 20% of the stock on October 19th.

On the share repurchase, we completed 50% through the third quarter of '06 and for roughly 502 million. We now have about 500 million remaining under our $1 billion authorization.

Let me talk about something I think is on everybody's mind is after this quarter, the implications for 2007. We are on course to deliver our '06 goals and in achieving these goals, provides a clear road map to '07. As you'll recall, our '07 goals are to maintain, are the same as they were announced previously as a 6.3% operating margin or 7% pre-stock option and performance RSU's and $2 a share of free cash flow. The two drivers of these are growth, where we seek to maintain a mid-single digit growth rate which is essentially the same as this year and margin expansion.

The three drivers are reducing investments from the '06 peak as you'll see in Ron Vargo's presentation, roughly 4% of total cost improvement that we've achieved in '06 will also be achieved in '07. This helps us offset price compression and inflation with over one point falling to the bottom line. And finally, we continued to ratchet and leverage our SG&A. So, basically, from here forward, our '07 financial objectives are essentially very consistent with our current run rates of improvement in the business. So, that concludes my overview and I'd like to turn it now over to Ron Vargo, our CFO.

Ron Vargo

Thanks, Mike, and good afternoon. I plan on covering the results for the quarter, providing an update on 2006 and fourth quarter guidance and giving some more detail on our 2007 financial objectives and then we'll open it up for questions. With that, let me get started on slide two.

Total revenues were 5.3 billion for the year, up 9% as reported and 6% on an organic basis. The increase in organic revenues was driven primarily by our US Government segment on strong Navy contract revenues in the Americas; new contracts and add-on business with existing clients and retail energy and healthcare industries in Latin America; and in EMEA, contract revenues from the MoD DII contract.

Adjusted earnings per share were $0.24, up 85% year-over-year, reported earnings per share of $0.24 also, a reconciliation that I'll walk you through in the next slide. Free cash flow was $171 million, down $269 million last year but I'll remind you that we received a large prepayment from a government client of about $300 million in 2005. Quarterly bookings were $3.5 billion down 33% but we also had a very large contract extension with the Department of Works and Pensions in the third quarter of 2005.

So, in summary, we achieved solid revenue growth. EPS exceeded guidance and free cash flow and total contract value were on a pace to achieve our full year guidance. I'll provide more color on each of these metrics but first let me give you the brief reconciliation on our earnings per share, slide three.

GAAP earnings totaled $0.24 a share. Certain items included in our GAAP numbers which were excluded from our adjusted numbers were the discontinued operations which had a penny impact relating to losses in our MRO business and rounding of the penny to give you the same $0.24.

As we go through the financial detail of the quarter, starting on page four, you'll notice a few changes to the presentation on the slides that will follow. We've streamlined the presentation of our quarterly results to more clearly reconcile our earnings presentations to GAAP financial statements that we provide, simplify the key data points and takeaways. We now include in our adjusted results as well as reported results the impact of option and performance restricted stock expense, and we want to improve the understanding of the key drivers of the business while hopefully simplifying the modeling process for investors and analysts.

For reference, consistency and transparency purposes, we did include the familiar EPS walk that we've traditionally provided and it's on slide 18 in the appendix and we will continue to provide that throughout 2006. But let me go to this slide on the income statement, slide four. It contains summary level line items from our income statement, adjusted to exclude certain items, and again, the walk from the GAAP income statement is included in the appendix on slide 21. Key highlights are the revenue which we talked about, up 6% organically as a result of strengthened our recent contract signings as well as growth on existing clients.

Total operating profit up $97 million year-over-year as a result of revenue growth, operating leverage, and mega-deal performance; we continue to leverage our infrastructure and people to not only support revenue growth but also increase productivity and lower costs to serve our existing business and this translates into the improved financial results in the quarter. This improvement was achieved as Mike mentioned while we maintained a very aggressive level of investments. We invested approximately $190 million during the quarter, an incremental $90 million or $0.11 a share over last year and still achieved these results.

Interest and taxes are below the line. The net effect of interest and taxes had an unfavorable impact on earnings year-over-year, but interest and other was significantly lower in the quarter as a result of several extraordinary items effecting both years including aircraft lease investment write-downs in third quarter of '05 and gains from miscellaneous investment sales during the current quarter. The favorable variance in interest, however, was more than offset by higher tax expense and this was a result of '05 tax benefits not repeated in '06, and the R&D tax credit which is still not yet been adopted in 2006.

Looking forward, we still expect the full year tax rate to be approximately 31% for 2006, and that is based on the R&D tax credit being extended retroactive to January 1st, 2006, during the fourth quarter. In the event that the legislation is not passed, our '06 results could be adversely impacted until the extension is signed and could be reflected.

Diluted shares outstanding, I want to call your attention to the fact that there was an increase of 20 million shares year-over-year, and this resulted from the impact of the 3-7/8 convertible debt maturing in 2023, becoming dilutive under the if converted basis during the quarter. We had talked about that previously in our 10-Q. In the third quarter, these notes did meet the test to be considered as common stock equivalent, and therefore, in the third quarter, diluted shares outstanding were 546 million. The shares were added to the share account, and approximately $5 million of tax affected interest was added to income to compute the EPS number resulting in a net impact to EPS from the increased shares and lower interest expense that was negligible.

Going forward, our share count will continue to be affected by shares repurchased under the share buyback authorization, shares issued under employee stock-based comp programs, and the dilutive impact of the convertible notes. We do expect the convertible will be included in the fourth quarter '06 earnings per share calculation but not in the full year 2006 calculation. But then again, we do expect it to be included in the full year 2007 calculation. So, taking all that together, we would expect share count to be around 527 million shares, weighted average for 2006, and in 2007, assuming a completion of the share repurchase program, and expectations for our comp program, and shares issued thereby, we would expect the share account to be approximately 545 million shares which include 20 million shares from the convertible.

With that, let me go to slide number 5 which is a free cash flow slide showing third quarter free cash flow, third quarter year-to-date, and a comparison of third quarter year-to-date to last year's third quarter year-to-date numbers. Total year-to-date free cash flow was $495 million. Key year-to-date fluctuations include cash flow from earnings lower by about 50 million driven primarily by incremental investments year-to-date of $140 million, partially offset by non-cash charges including the UK pension charge in '05 and some other '05 asset write-downs. Change in working capital and other was driven primarily by higher pension contributions in 2005, severance accruals in 2006, and vendor payments.

Capital expenditures is slightly higher on both, a gross, and net basis than last year as a result of higher capital spending related to our investment program, and the startup of recently signed contracts. The 2005 sale leaseback transaction of about $150 million is included as an offset in 2005 to both the gross and net number; so about $150 million of the $250 million can be explained by that. Net-net, if you look at the 495 year-to-date, we are on track to hit our $800 million plus for 2006 with the fourth quarter traditionally being our strongest reflecting seasonality.

Finally, balance sheet movements on slide 6, the most notable movements include cash and marketable securities actually declining by $438 million. The major components of this are free cash flow of 495, offset by net share repurchases, the 502, Mike talked about in our buyback program, offset by about 200 million of employee-related proceeds in comp programs, so a net share repurchases of 300. The acquisition of the majority in stake in MphasiS about 350 million, a net reduction in our debt of $160 million, and dividends of about 80 million.

Accounts receivable increased by $186 million to about $3.5 billion primarily from foreign currency fluctuations and receivables in the MphasiS acquisition, as well as some revenue growth in recent new contract signings. Deferred revenue increased by $307 million, although it was essentially unchanged during the third quarter year-to-date $307 million as a result of client prepayments, most notably a government client that we discussed in the second quarter. And portions of these payments as we said before are being used to fund incremental transformational capital necessitated by requirements in the contracts.

Long-term debt decreased $160 million to about $3.1 billion, and with equity of $7.8 billion, our debt-to-total capital ratio at the end of the quarter was about 28%.

Turning to slide 7, total contract signings for the quarter were $3.5 billion. Significant signings included Visanet, about $209 million, a win driven by our transaction processing excellence, Dollar Thrifty Automotive Group, about $150 million, and Medical renewal driven by a very strong client relationship in our service delivery track record. Also note that renewals comprised about 42% of the total, and add-ons, and new logos represented the remainder during the quarter.

Net for the year were approximately 18.9 billion, up 20% -- 28% year-over-year, and we believe are on pace to achieve the $23 billion to $25 billion in TCV. As we have stated in the past, we've put a range on the full year to allow for the timing on the award of a number of contracts later in the year. If these contracts are awarded before the end of the year, we would expect to come in more at the high end of that range, if they're delayed beyond the end of the year, we would expect to be at the low end of the range.

Now, let me shift to slide eight. For the full year 2006, we will update guidance; revenue, our previous guidance was $21 billion to $21.5 billion. We're tightening that range a bit to $21.1 billion to $21.3 billion. Earnings per share, excluding certain items or adjusted of $0.83 to $0.93 at the end of the second quarter, we've also narrowed that range to $0.83 to $0.88, but we would expect to come in at the mid-point or better of the new range. Free cash flow of $800 million to $1 billion; again, no change as we said, we're tracking to the low end of that range and that continues to be the case, and TCV of $23 billion to $25 billion as I just discussed.

For the fourth quarter, revenue is forecast at $5.5 billion to $5.7 billion and adjusted earnings of $0.33 to $0.38 including the impact of expensing stock options and PRSUs.

Slide nine; third quarter 2006 full year quarterly EPS overview. We have updated this slide to reflect the revised expectations for the fourth quarter. The bar chart represents sequential earnings per share, the impact on earnings per share of investments and the earnings per share after including investments. As you can see, we continue to achieve sequential profit improvement both before and after our ongoing investments. We expect the fourth quarter to be around $0.65 before investments and investments are estimated at approximately 30, a step up from where we estimated them at the end of the second quarter. There were some timing difference here where we under-spent our investments by a few cents in the third quarter and we would expect to spend that in the fourth quarter.

The key drivers of earnings would be mega-deal execution, productivity, and the seasonally higher revenue growth in the fourth quarter. And as Mike mentioned, our investments which we expect to peak this year, will continue to include workforce alignment, and tools and capabilities. So net, while investments continue at a pace of three plus percent of revenue, business performance continues to improve as evidenced by the improving margins.

On the next slide, we're going to turn to 2007 and provide some additional color on our expectations. Our operating margin for 2007, as Mike said, remains unchanged. However, we are aligning the reporting convention to conform with our EPS reporting and guidance and include the expense for options and performance based restricted stock. On this basis, the 2007 operating margin objective is 6.3%. Again, there is no change from the margins that we've been discussing in the past.

Having said that, we continue to target free cash flow of approximately $2 per share in 2007. To illustrate our roadmap to include these objectives, I've included two analysis here on slide 10. The left side includes a 2006 and 2007 estimated free cash flow yield and per share analysis, illustrating the drivers behind moving from $1.50 to $2 per share and on the right side, wanted to demonstrate for you the progression that we've made in operating margin expansion between 2005 and 2006 and our expectations going forward. So, on the left side, let me talk briefly about the targeted ranges for cash flow.

Cash flow from earnings expected to be in the 11% to 12% of revenue, an improvement of about $1 a share versus 2006 driven primarily by margin expansion with some higher depreciation and amortization. Key drivers again are productivity, lower investments, and lower SG&A. Change in working capital and other is expected to be a use of approximately 1% to 2% driven predominantly by growth and payments relating to some of our 2006 workforce initiatives that will carryover into 2007.

Net CapEx is expected to be about 5% of revenue, a use of about $0.20 on a free cash flow per share basis and this is consistent with historical trends.

Next, on the right side of the slide, the progress made in margin improvement in the three key components all expressed as a percentage of revenue. Account contribution margin, improvement is the result of growth in productivity; growth from 2006 to 2007 again we expect mid-single digit growth. And productivity, this is a continuous process, we expect to drive another 4% in account contribution margin improvement with approximately 3% used to offset pricing and competition and over 1% falling to the bottom line. You should note that this will yield an account contribution margin in the 16.5% to 17% range, about 1.5 points higher than the 2006 account contribution.

SG&A and investments as a percentage of revenue are expected to total around 11.7% in 2006 and we would expect the combination of these two items to decline to somewhere between 10.2% and 10.7% in 2007. SG&A continues to trend down to the low 8s and we think it will be approximately 8.4% in the second half of 2006 driven primarily by initiatives to streamline business support, processes and increase Best Shore utilization.

Investments, as Mike stated, we expect this to peak in '06 and will begin to trend down in 2007 giving us a total for the SG&A and investments in the 10.2 to 10.7 range. We are confident in our ability to manage the dynamics of about three components in a manner that will yield our targeted 6.3% operating margin and we intend to give you more color in early 2007 when we announce our fourth quarter earnings.

In summary on Page 11, third quarter of 2006, we delivered on our commitments. We exceeded our EPS guidance despite a significant step-up year-over-year in investments; for the remainder of 2006, we're on track to achieve full year guidance. We will continue the momentum on operating margin expansion while pursuing an aggressive investment and severance program. And for the full year 2007, again we'll formalize the guidance around the $2 per share free cash flow and 6.3% operating margin or 7% excluding options and performance RSUs.

So, with that kind of long winded presentation, I'll turn it back to Al.

Allen Hamood

All right, operator. With that, we have plenty of time to open up the call for questions, but if you could, just try and limit it to one that would be excellent.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from Rod Bourgeois of Bernstein.

Allen Hamood

Rod? Operator?

Operator

One second, here.

Allen Hamood

Operator, do you want to go to the next caller?

Operator

One moment. Next question comes from Bryan Keane of Prudential.

Bryan Keane - Prudential Securities

Hi. Good afternoon. Just a couple of quick ones; I guess first on housekeeping item, the interest income obviously was up quite favorable and I guess you said, there was miscellaneous investment sales. Ron, can you just highlight what those were and how much that was?

Ron Vargo

Yeah, there are a couple things in that line, Bryan. One of them was the income from some sales of some land that we affected in the third quarter. As you know, over the last few years, we typically have some sales and revenues from sales. In this quarter, we had some land sales that generated in the ballpark of $49 million in revenue. The -- we also have some benefit from interest rate movements in the quarter where we have some floating rate debt that gets marked-to-market every quarter. That was also a benefit during the quarter. The sum of those two items is about $0.03 a share, probably $0.02 coming from the land and $0.01 from the interest rate movements on the interest rate swap movement.

Bryan Keane - Prudential Securities

Okay, but the interest rate swap movement was a benefit or was it detrimental to earnings?

Ron Vargo

It was a benefit to earnings. As we mark that swap to market every quarter, it can fluctuate from quarter-to-quarter as much as a penny a share, and this quarter it was a penny favorable.

Bryan Keane - Prudential Securities

Okay, and slide 10 is great. I love the extra detail. I guess just trying to look at how we've mapped out '05, '06, and '07, I guess even going forward to '08, do we just see more of the same three drivers, kind of SG&A investments, and account contribution margin, all having factors to get up to pass that 6.3% margin?

Mike Jordan

Yeah, we think so. Yeah, this is Mike. I mean, that's how we're driving the business, you know, productivity and growth on the account contribution, and lowered investment and lower G&A. So, it's not complicated, we're just doing it.

Bryan Keane - Prudential Securities

Okay. Thanks. Congratulations.

Operator

Thank you. Your next question comes from David Grossman of Thomas Weisel Partners.

David Grossman - Thomas Weisel Partners

Thanks. Ron, I was wondering if you could clarify a few things about the fourth quarter guidance, what is the tax rate and the share account that underlies your EPS?

Ron Vargo

In the fourth quarter?

David Grossman - Thomas Weisel Partners

Yes.

Ron Vargo

Yeah, the share account will include the convertible. So, it's in the ballpark of 545 million roughly shares, and the tax rate would probably be about the same as what we said the full year tax rate would be, kind of in the 31% area.

David Grossman - Thomas Weisel Partners

And what kind of tax rate do you think we should be using then for 06?

Ron Vargo

I think --

David Grossman - Thomas Weisel Partners

For '07, I'm sorry.

Ron Vargo

Yeah, '06 again the 31.

David Grossman - Thomas Weisel Partners

Right.

Ron Vargo

Kind of in '07, kind of the 34% tax rate that we've kind of had historically.

David Grossman - Thomas Weisel Partners

Okay. And --

Ron Vargo

Remember again, in the fourth quarter, we'd expect the R&E tax extension to be past retroactive.

David Grossman - Thomas Weisel Partners

Right.

Ron Vargo

Okay, so that's built into that tax rate that I just gave you a 31%.

David Grossman - Thomas Weisel Partners

Right. And just a question about MphasiS, I'm just curious, I know it's still relatively early, but can you give us a sense for whether or not you're seeing revenue growth outside of kind of transferring of business and contract revenue from your existing base over to them in contrast to perhaps new business that you're winning, perhaps as a result of acquiring them?

Mike Jordan

I'd say, it's Mike -- yeah, we are making progress. We've kept their sales force in place, and they cooperate in many pursuits with the EDS sales force because part of it will be sourced from the US or Europe, and part will be sourced from India. So, we are intenders to preserve them as an operating business as well as a platform for growth of our Indian capability.

Ron Vargo

Yes. I'd also say that they had had decent sequential revenue growth, and they have a pretty good pipeline as well, So, you know, we’re pretty optimistic about their to kind of farewell in addition to the work that EDS will be providing them.

David Grossman - Thomas Weisel Partners

Could you give us a sense of what the revenue contribution was in the quarter, Ron?

Ron Vargo

In the third quarter?

David Grossman - Thomas Weisel Partners

Yes.

Ron Vargo

Yeah, I'd say ballpark is $60 million, revenues.

David Grossman - Thomas Weisel Partners

Great. Thank you.

Ron Vargo

Yes.

Operator

Thank you your next question comes from Adam Frisch of UBS.

Adam Frisch - UBS

Thanks, good afternoon. Just a couple of housekeeping here, the 6.3% growth for operating margin for the full year, is that a goal for the full year or just a rate that you expect to be at when you exit the year?

Mike Jordan

Full year.

Ron Vargo

That's our goal for the full year.

Adam Frisch - UBS

Full year, okay. And I hate to bring up some old issues here with the Real Estate sale, was that booked in the free cash flow, or was it somewhere else in the cash flow statement?

Ron Vargo

That 49 million does get booked in the free cash flow area.

Adam Frisch - UBS

Okay. I don't want get into it again.

Ron Vargo

Please don't.

Adam Frisch - UBS

Yeah, its just the difference with your definition of CapEx -- okay, we'll take that offline, and then --

Ron Vargo

But I'd say, Adam, historically, we've always had some nominal amounts of cash flow from sales of land, primarily land around this Plano campus which --

Adam Frisch - UBS

Right.

Ron Vargo

And so, you know, I think last year, we had a big other than roughly 80 million from sale lease back. This 49 million, a little larger than what we've seen in prior years, but, we're always transparent on it as well, but it was in the number.

Adam Frisch - UBS

Okay. I'll be respectful there, Ron. Use of cash and the balance sheet capacity will -- how are you guys prioritizing at this point?

Mike Jordan

Well, obviously we want to finish our share repurchase programs. But we're -- our principal priority is to use our balance sheet to help augment our growth and to support growth initiatives and through targeted acquisitions in [Bolton] and we have a very active program there.

Adam Frisch - UBS

Okay. And then the European margin increase was pretty good. Where is that coming from, specifically? Is it MOD or is it--?

Ron Vargo

Yes. One of the drivers of our EMEA year-over-year performance is absolutely the MOD contract and the profitability from that this year versus last year. It's kind of -- it was only the second quarter of the contract in 2005.

Adam Frisch - UBS

Okay. And then last one. Thanks for making these go fast, but any significant one-time payments in free cash flow this quarter other than the land? I know first quarter -- first half rather had a couple in there. Was there anything in the third quarter?

Ron Vargo

No. Nothing that we didn't disclose.

Adam Frisch - UBS

Okay, just the land. Okay, guys. Thanks.

Operator

Thank you. Your next question comes from Rod Bourgeois of Bernstein.

Rod Bourgeois - Bernstein

Okay, great, Rod Bourgeois here. Listen, on slide number 10, which is by the way it's a helpful slide. I wanted to ask a more specific question that I think you touched on there, but I want to make sure I have these numbers right. I've been modeling about $0.83, $0.84 of what you've called investment expenses in 2006, and assuming that about a third of those investment expenses probably go away in 2007. But clearly, not all of those expenses will go away in 2007. Can you better quantify in this investment expense category, how much of the $0.84 2006 number will essentially go away in 2007 to help your margins?

Ron Vargo

Yes. Rod, you're right in the $0.84. I mean and if you go to slide nine, that's still kind of where we are at $0.84 for the year. I think we purposely didn't put specific percentages in the 2007 boxes, if you will, on slide 10. But that kind of ballpark thinking is probably right, but as we finalize our plans, I think we'll give a little more clarity to that later in the early first quarter.

Rod Bourgeois - Bernstein

All right, great. The -- but is it directionally correct to say, there's a very big portion of those '06 expenses that will continue into '07 but you'll clearly get some significant benefit at the same time?

Mike Jordan

Yeah. Let me answer that, Rod. Some of our technology investments, our technology investment level will come down, will still continue as maybe shifted to other areas of the business, and also our severance levels we predict will come down. So, it's really a combination of the two areas.

Rod Bourgeois - Bernstein

Okay, great. And then on a -- from looking at investments from a different angle and moves to the cash flow statement, historically, your CapEx has been in the sort of 6%, 6.5% range and your '07 targets require a 5% sort of net CapEx rate as a percentage of revenues. How are you thinking about that? I mean, are you assuming the capital intensity of the business has come down? Are you choosing to stay away from certain deals that would normally require a lot of upfront investments in order to keep the CapEx rate down? What's the strategy on being able to achieve that next year?

Mike Jordan

Well, there are two items really in that, Rod. First is, we have very active program to reduce the capital intensity of our business, whether it's working capital or CapEx around new deals. But secondly our -- we look forward to next year that our business mix will change more away from ITO and to applications, and BPO, so that will also take it down. And that's an area that we are -- we got a pretty comprehensive program around both of those.

Rod Bourgeois - Bernstein

Yeah.

Ron Vargo

But Rod, I would add though that I think if you look over the past couple years, our net CapEx has been in that kind of 5% area. So, I think there's definitely, as Mike said, a lot of effort here to reducing our capital intensity. But I don't think this 5% is too out of line on a net basis from what you've seen in the last few years.

Rod Bourgeois - Bernstein

All right, that makes sense. Mike, do you have a target in terms of where you want your IT -- excuse me, your application management and BPO business mix to be? I mean, you clearly are planning to ramp that mix up but is there a target level?

Mike Jordan

Well, we haven't really finalized those yet, we have to. One of the things that's happened clearly is our -- as we've been successful in our ITO -- ITO deals, actually our percentage has gone up. That will start to come down next year and subsequent years and we'll try to give you more feel for our ambitions in that direction when we have our meeting in February. But, yes, I mean we are devoting a build -- lot of resources to building our applications and consulting business as well as our managed services or BPO business. So, we got a lot of things going, but a lot of that will try to spell that out for you in February.

Rod Bourgeois - Bernstein

Okay, great. Thanks, guys.

Operator

Thank you. Next question comes from Gregory Smith of Merrill Lynch.

Gregory Smith - Merrill Lynch

Yeah, hi, guys. Just the revenue in the third quarter came in kind of at the low end of guidance but then your Q4 revenue, guidance looks fine, was there any reason, was there any slippage or any revenue that pulled into the fourth quarter that you can point to?

Ron Rittenmeyer

This is Ron Rittenmeyer. No, the third quarter was fine. It was pretty much in line with what we expected, remember there was a works and pension signing last year, so but this year, our signings were very, I'd say very much in line with our expectation and our plan. There's always a contract that moves plus or minus a quarter, but absolutely nothing significant that was an issue.

Gregory Smith - Merrill Lynch

Okay. And then just back to the question about the balance sheet, your debt-to-capital was I think 28% in the quarter? Do you guys have sort of a longer term target for debt-to-capital ratio?

Ron Vargo

I would say we don't have a specific target for debt-to-total capital. I think we would like to get back to investment grade with one of the rating agencies and maintain investment grade ratings on an ongoing basis, and I think with the improved financial performance and operating performance of the company, we can afford more leverage certainly than 28% on a going forward basis and still maintain investment grade ratings.

Gregory Smith - Merrill Lynch

Okay. That's what I was hoping to hear. And then just lastly on, any general color on the competitive environment? Are you seeing some of the pure play Indian firms more on the infrastructure outsourcing side and just what do you see?

Mike Jordan

No, we see some offerings around sort of remote monitoring, which is actually in our ITO contracts is what we're doing, not so much in India, but in Brazil and Malaysia and we're ramping that up in India, and maybe China. So, quite frankly, there, we see nothing that they can offer that we aren't already offering.

Gregory Smith - Merrill Lynch

Okay, thanks.

Operator

Thank you. Next question comes from Julio Quinteros of Goldman Sachs.

Julio Quinteros - Goldman Sachs

Sure, actually, this question, maybe if Ron can just kind of walk us through some of the items that you've talked about. I know you guys have talked about this but I just want to make sure I understand, what is it that will drive the capital -- working capital reductions as we look at the strategy that you guys have sort of laid out in '05 and '06 and kind of where you are now just to make sure we understand where that working capital improvements will come from?

Ron Vargo

Let me just ask you again to, are you referring to slide 10 or?

Julio Quinteros - Goldman Sachs

No, I'm just general. I'm not even looking at any slides. I just want to understand at the operating level, what's the kind of blocking and tackling situation that's going to allow that to happen.

Ron Vargo

Yeah, because Julio, what we're actually showing you between 2006 & 2007 is an increase in the use of working capital.

Julio Quinteros - Goldman Sachs

Okay.

Ron Vargo

Okay, so, while I think we continue to put a full court press on things like accounts receivable collection and other areas where we can have an impact, I think as you look from '06 to '07, two factors are going to drive working capital the wrong way, just some growth, so even if we keep our DSO the same, you're going to see some growth in receivables and secondly, this high level of severance in the second half of this year will absolutely have some carryover effect in funding in the first quarter of next year.

Julio Quinteros - Goldman Sachs

Okay.

Ron Vargo

Okay.

Julio Quinteros - Goldman Sachs

Got it. And then just on the comment about the high-end versus the low-end in terms of bookings. What exactly are we looking at? Is that a mix of large contracts, small contracts? Can you just kind of walk through what the delta could really be there in terms of number of contracts. Is it like one contract you guys waiting for, just trying to get a sense there.

Ron Rittenmeyer

In terms of the fourth quarter?

Julio Quinteros - Goldman Sachs

Correct.

Ron Rittenmeyer

It's a series of contracts. There is no, we have -- we probably have one large contract but it's not the fourth quarter numbers won't totally be dependent on that. The pipeline is such that the fourth quarter signings is really made up of a mix of various sizes, so we're not dependent on any one specific activity.

Julio Quinteros - Goldman Sachs

Got it, great. Thank you.

Operator

Thank you. Next question comes from Tien-Tsin Huang of J.P. Morgan.

Tien-Tsin Huang - J.P. Morgan

Hi, thanks, this is a question on the MphasiS alliance. What drove the decision to increase your stake in that business and I'm curious to hear how employee attrition is tracking in the region?

Ron Rittenmeyer

From an operating standpoint, clearly, we see MphasiS as a large part of our plan in India, so we drove our decision, I believe, was simply that we again see strategically it makes more sense to continue to own more of the business. From an employee attrition standpoint, there's nothing significant, there has been no change, its fairly consistent with historical levels. Management has all signed-up so from a business perspective, operating perspective, it's very stable and it's absolutely performing where we would expect it to be. So, again I think it continues to be a great decision for us, and a great market facing partner for us.

Ron Vargo

I'd just add to that, when we did our first tender for 51%, it was over subscribed, and we were limited in how many shares we could buy, so, to some extent, you can view this second tender as an opportunity for those tendering shareholders to have a second opportunity to sell their shares.

Tien-Tsin Huang - J.P. Morgan

Got you. Also sorry if I missed this, can you comment on pricing in your ITO and application business overall? Any surprises there trend wise?

Mike Jordan

No. I'd say our ITO, you know, the business has been going through a lot of price compression over the last 4 or 5 years. We see, actually see that compression flattening out, so -- and applications where it tends to be influenced by the mix of offshore. So that's the primary driver, but our margins are pretty steady with onshore or offshore work.

Tien-Tsin Huang - J.P. Morgan

Okay, and just a quick follow-up on the EMEA region, the profit growth there that had grew well ahead of revenue growth, is that principally coming from improvements in MOD, or is there something else going on in there?

Ron Vargo

I'd say MOD is a, definitely a part of it. I'd say the other thing is that we've been taking a lot of cost out in our European region, and which, I would attribute it also to the cost side that we continue to improve efficiencies overall in EMEA and it's been a -- the area has truly ramped-up and performance is much more consistent there.

Tien-Tsin Huang - J.P. Morgan

Okay, great. Thanks, nice job.

Operator

Thank you. Next question comes from Jim Kissane of Bear Stearns.

Jim Kissane - Bear Stearns

Ron, can you break out where the investment expenses are showing up on the P&L, or how much is in the cost-to-revenues, how much is in the SG&A?

Ron Vargo

Yeah. I mean we break it out for you separately, but in the P&L, you're right, a portion of it is in the cost of goods, a portion of it is SG&A. I'd say a great majority of it though is in the cost of goods, and, you know, probably 5%-10% of it is showing up in the SG&A.

Jim Kissane - Bear Stearns

Gotcha. And is it possible to break out an MCI's free cash flow contribution in the quarter?

Ron Vargo

No, we're not breaking out individual contract performance. We, -- you know, the contract continues to perform well operationally, and we expect it to continue to improve and be a solid performer in 2007 as well.

Mike Jordan

Yeah, we will -- we felt that it was appropriate to merge it in with our government business because it's not really much different from our overall government margins.

Jim Kissane - Bear Stearns

Okay, if I could get one last question, in terms of the $800 million of free cash flow this year, what portion would be coming from what, you know, something we would consider unusual or non-operating items?

Ron Vargo

We don't think about it that way, so I don't have a number at the tip of my fingers here, so, we'll try to, I mean, I'll clarify that for you if you have individual items that you think are one-time or something, you can kind of I think talk to Al maybe afterwards about them. Thanks.

Jim Kissane - Bear Stearns

Okay, thank you.

Allen Hamood

Okay, Operator. I think we have time for one more question, please.

Operator

Okay. Your last question comes from Pat Burton of Citigroup.

Patrick Burton - Citigroup

Hi. Thank you for taking the question. My question is also for Ron. Ron, you mentioned it was a $49 million gain on the Real Estate, how does that equate to $0.03, or was there a cost basis that comes out before figuring out the gain?

Ron Vargo

Yeah. I'm sorry if I have said a 49 gain. The 49 were the proceeds from the sale, and you know, so the gain was substantially less, and the gain was for a couple of pennies from Real Estate sales in the quarter.

Patrick Burton - Citigroup

Okay, thank you. So 49 was the cash flow, the cash in?

Ron Vargo

Yeah, that's correct. I'm sorry to misstate it earlier.

Patrick Burton - Citigroup

Well, that's okay, thank you.

Ron Vargo

Yes.

Allen Hamood

All right operator. With that, I'd like to thank everybody for joining today. I know there will be some of you with questions in our queue. Please feel free to call my office and we'll be glad to talk to you about them then.

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Source: Electronic Data Systems Q3 2006 Earnings Call Transcript
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