Convergys Corporation (CVG)
Q2 2006 Earnings Call
July 25, 2006 10:00 am ET
Executives
Jim Orr - Chairman and CEO
Earl Shanks - CFO
David Stein - VP of IR
Analysts
Jason Kupferberg - UBS
Tom Roderick - Thomas Weisel Partners
James Kissane - Bear Stearns
Peter Jacobson - Kaufman Brothers
Ben Abramovitz - ICAP Equity Research
Liz Grausam - Goldman Sachs
Scott Sutherland - Wedbush Morgan Securities
TC Robillard - Banc of America Securities
Matt McCormack - Friedman Billings Ramsey
Julie Santoriello - Morgan Stanley
Ashwin Shirvaikar - Citigroup
Julian Bu - Lehman Brothers
Presentation
Operator
Good day, ladies and gentlemen, and welcome to the Second Quarter 2006 Convergys Corporation Earnings Call. My name is Sheryl and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.
I would now like to turn the presentation over to your host for today's call, Mr. David Stein, Vice President of Investor Relations. Please proceed.
David Stein
Thank you, Sheryl, and good morning. I am David Stein, Vice President of Investor Relations, and I want to welcome you to the Convergys second quarter 2006 earnings call. This call is the property of Convergys.
With me on the call today are Jim Orr, our Chairman and Chief Executive Officer; and Earl Shanks, our Chief Financial Officer. Jim will begin today's call with a summary of the financial and operational results for the second quarter. Earl will follow up with segment results and forward guidance. Then we will open the call to your questions.
Today's discussion contains number of forward-looking statements, including future financial results, operating projections and cost estimates that involve potential risks for Convergys. Future results could differ materially from those discussed. Factors that could cause or contribute to such material differences include, but are not limited to, a loss of a significant client or significant business from a client, difficulties in completing a contract or implementing its provision, difficulties in completing or implementing an acquisition, continued consolidation in the markets we serve, terrorist activities and responses of the United States and other nations to such activities, changes in the legal and regulatory environment in which Convergys and a client operates, and competitive and other factors disclosed in the 10-K for 2005 and subsequent filings filed with the SEC by Convergys. Currently, we have no intention to revise or update any forward-looking statements that may be made during the call.
During the call, we will discuss non-GAAP financial measures, including free cash flow, revenue excluding Cingular, and earnings excluding non-cash stock-based compensation expense. These non-GAAP financial measures should not be construed being more important than comparable GAAP measures. Our second quarter 2006 earnings news release provides a more detailed description of these non-GAAP measures and their limitation. As noted in the release, Convergys' management believes these non-GAAP measures provide the users of the financial statement with a more comprehensive understanding of the company's underlying performance, and provide an additional and useful comparison of Convergys' current results with past and future periods. A reconciliation of these non-GAAP measures to the comparable GAAP measures is available on the Convergys website at www.convergys.com.
I'll now turn the call over to Jim.
Jim Orr
Thank you, David, and good morning. Convergys continued to deliver revenue growth and strong operating results in the second quarter of 2006. Our Customer Care business generated strong organic revenue growth and significantly improved operating performance. Our information management, international operations achieved very strong growth, largely offsetting declines in North America, reflecting lower Cingular revenues. We demonstrated strong progress in Employee Care during the quarter as well. We continue to see healthy demand for our solutions.
Large enterprises are increasingly looking for support to help improve their customer care operations. Communications carriers continue to enhance business support systems to manage convergent services, and as in recent quarters, we continue to see a number of major multinational firms interested in outsourcing their global HR services. Based on the strong performance and demand, we are again raising the full year 2006 guidance and today are providing initial 2007 earnings guidance.
In terms of financial performance, second quarter earnings were $0.28 per diluted share, up 56% from the prior year. This exceeded our guidance of $0.24 to $0.26. Operating income of $63 million, was up 65% from the prior year. Cost actions taken in 2005, strong organic revenue growth and our continued focus on operational efficiency, positively impacted performance in the quarter.
Second quarter revenue was $692 million, was up 10% from the prior year. Growth came from increases in Customer Care and Employee Care. Excluding Cingular, Convergys revenue grew 16% from the prior year.
Given these strong operating results, we are raising full year earnings per share guidance to at least $1.11 per share. In a few minutes, Earl will provide more details on our financial performance and forward guidance. First though, I'll focus on some of the highlights of the quarter.
In our Customer Care business, operating income was up sharply and revenues increased in all our industry verticals. Growth in the second quarter was broad-based among many clients. During the quarter, we were pleased to be recognized by Business World Magazine as the most respected BPO company in India. Through our professional services organization, we are leveraging our deep understanding of contact center operations to further penetrate the $230 billion in-house market. Our portfolio of contact center consulting professional services and technology offerings enables our clients to run their in-house operations more efficiently and effectively. In the second quarter, we initiated more than 25 new consulting engagements to address client specific contact center needs.
Our consulting services pipeline, a leading indicator of future business is strong and growing. Overall, we are well-positioned as a global services provider in the large and growing customer care market. Demand is strong for both US based and offshore customer care services. We are continuing to invest in our global capabilities and capacity to meet this demand.
Moving to the Information Management business, we saw a significant growth in our penetration of markets outside the United States. During the quarter, we signed new Infinys software and services agreements with a large communications client in Europe and a large communications client in South America. Both clients plan to migrate their customers to the Infinys platform over the next few years. We also made good progress in our Infinys implementations during the quarter. For example, our Infinys rating and billing software went live at ONO, the leading broadband communications operator in Spain. With Infinys, ONO was able to provide convergent blowing across its triple-play offerings of voice, data and video services.
Infinys also went live at Metronet, a provider of voice, data, Internet and video services for business customers in Croatia. The Infinys solution is supporting Metronet's triple-play billing, rapid introduction of new services and growth in Croatia's recently deregulated telecom market.
We continue to make progress leveraging our Information Management assets in the new client solutions during the second quarter. For example, the Infinys Customer Service Management module successfully launched at large North American wireless carrier, and we announce that SunCom Wireless is now using Convergys testing solutions in testing life cycle for its new price pants.
Convergys also received recognition during the quarter for Information Management's industry leadership. Our Information Management operation in Hyderabad, India, with more than a thousand employees operating in our development center, was named Best Startup Offshore Development Center by the Hyderabad Software Exporters Association.
Convergys also received the Best Overall Company Award at TeleStrategies' Billing World 2006. The award recognizes Information Management's ability to address changing client needs with its outstanding professional services and software products.
Overall, we continue to produce solid results in our Information Management business. Ongoing business transformation and focus on operational efficiencies positions Information Management well for continuing revenue and earnings contributions.
Turning now to Employee Care, revenue increased and operating loss declined significantly during the quarter. We made strong progress with key HR outsourcing implementations. Employee Care went live with Solectron in North America. We began providing HR lifecycle services, including recruiting and staffing benefits, HR administration, payroll inquiry and learning services. We expect to complete the implementation and reach full revenue recognition in nearly 2007.
We also went live with the initial phases of Boston Scientific in North America and Europe. This included upgrading the HR information system and deploying employee self-service tools. We are now providing benefits HR administration, US payroll, recruiting, vendor management and compensation services. We expect to begin recognizing revenue later in 2006.
We continue to make good progress with the DuPont implementation, and I am also pleased to report that early in the third quarter, Employee Care went live with Whirlpool in North America. We began providing payroll benefits and pension services. We ran on schedule to complete full implementation in early 2007. This will also include recently acquired Maytag employees.
Also during the quarter, we negotiated an extension of our 15-year relationship with a large diversified global company. And in addition, we continue to expand our global infrastructure in the Asia Pacific region, adding capacity in Kuala Lumpur, Malaysia; Bangalore, India; Dalian, China; and Singapore. Overall in Employee Care, we are making strong progress driving measurable business improvements and cost savings for large multinational clients.
Our focused business strategy is driving Employee Care market leadership. Unlike many of our competitors that pursue a lift-and-shift approach, our transform-and-transfer model positions us to help multinational firms standardize and improve the management of their global workforce. This strategy is contributing to our strong pipeline.
Now, I will spend a few minutes discussing our progress aligning the organization to best execute our strategy. We have taken several steps this year to organize for maximum performance. We instituted an enhanced metrics-based management approach. More intensive tracking of operating and cost metrics and driving their use across the organization is helping us to maximize execution success. We believe our improved operating performance reflects our enhanced focus on these areas.
During the second quarter, we further aligned our customer-facing organization with business units aligned against specific vertical markets. Each unit supports all our billing and customer care products and services. This better positions us to meet client needs and to continue to diversify our client base. Actions such as these allow us to enhance the value of our clients' relationships with their customers and employees. As you can see, we are taking deliberate steps to ensure successful project execution and superior business performance, which we believe will be reflected in our reported results.
In summary, we continue to solidify our market position as the leader in the Customer Care industry, our license business and Information Management is growing, and we continue to make strong progress implementing large and complex HR outsourcing solutions. We remain focused on effective cost management and project execution, and I'm confident, we can meet our 2006 guidance. There is healthy demand for our products and services across our business lines and we expect to grow revenue and earnings in 2007.
I'll now turn the call over to Earl, and he'll review the second quarter financial results in more detail and provide additional forward guidance.
Earl Shanks
Thank you, Jim, and good morning. Let me begin this morning by reviewing the performance of the Customer Care business. For the second quarter, revenue increased to $446 million, up 14% over last year. Customer Care grew in each vertical market. Communications revenue grew 9%, reflecting a strong increase with several large cable, wireless and wireline clients. This was partially offset by a reduction in spending by two large wireline clients.
Growth with several hardware clients drove the 15% increase in the technology vertical revenue over the prior year. Financial services revenue was up 4%. This was due to growth with several credit card issuers. Growth for the large global manufacturing client and several healthcare, retail and government clients, drove over 32% increase year-over-year in other revenue. We continue to make good progress diversifying our sources of revenue.
We are seeing increased demand for US-based services, particularly as we diversify beyond our three main verticals. Demand is also strong for offshore contact center services. At the end of the second quarter, Customer Care had approximately 19,500 employees in India and the Philippines. This was up from approximately 13,400 at this time last year and 17,500 employees at the end of the first quarter. Approximately 30% of our employees in this business now work in Asia.
In the second quarter, operating income for Customer Care increased to $48 million, up 146% from the prior year. This resulted from the cost actions taken in 2005 and organic growth of existing clients. We also continued to gain efficiencies from our ongoing process improvement initiatives. Recall that last year Customer Care's second quarter results included $8.3 million in restructuring expenses. Customer Care continued to deliver double digit operating margins during the quarter, in spite of 140 basis point negative impact from the effective changes in the US-Canadian exchange rate as compared to the second quarter of 2005.
I will now turn to the performance of our Information Management business. Second quarter revenue of $195 million was 3% below last year, but was up 3% from the first quarter. Data processing revenue was 12% below last year. Increased spending by a large wireless client partially offset the expected declines from Cingular. License and professional services revenue increased year-over-year, accounting for 62% of Information Management's revenue in the second quarter. We also achieved strong growth with client in multiple geographies outside the United States with our Infinys software and services.
Operating income of $31 million was down 16% from the prior year, this was largely due to changes in our revenue mix from data processing to professional services. An 18% reduction in SG&A expense for the quarter partially offset the decline in gross margin. This demonstrates our focus on structuring the Information Management organization for success and disciplined cost management.
Moving on to results for Employee Care. Employee Care revenues in the second quarter increased to $50 million, up 32% from the prior year. The increase in revenue was due to the depart in Texas Health and Human Services Commission programs. Revenue was down slightly from the first quarter, due to the impact of a one-time startup project for a new large client, the expected completion of relationships with two legacy clients and seasonal changes related to open enrollment.
Importantly, for the first six months of 2006, revenue was up 40%. This is on-track with our previous Employee Care revenue guidance for the full year. Employee Care's operating loss in the second quarter declined 34% to $8 million, from a loss of $13 million in the prior year. This was largely due to cost actions taken in 2005 and ongoing operating improvements. We are making strong progress with implementations by planning for and carefully managing the project change control process. We continue to expect significant reductions in the operating loss for the full year.
I will now turn to items reported outside our three operating segments, but included in our reported GAAP net income and EPS. In the quarter, we incurred $7 million in non-cash stock-based compensation expense. This expense was approximately $1 million more than in the same period in 2005. The cellular partnership equity earnings of $2 million in the second quarter were down from almost $6 million in the second quarter of 2005. Interest expense in the quarter was $6 million compared to $5 million a year ago. This reflects higher interest rates on lower levels debt.
The effective tax rate for the second quarter was 32.9%, down from 34.9% in the prior year. This is due to a sustained decline in the amount of taxes paid outside the United States and a change in the state income tax laws. The favorable impact of a lower tax rate on earnings in the second quarter was about $ 1 million compared to the prior year. We expect the effective tax rate for the full year to be approximately 35%.
Moving to cash flow. Cash flow from operations for the quarter was $63 million. Free cash flow, which is operating cash flow less capital expenditures, was $36 million. Our principal use of free cash flow during the quarter was to repurchase shares.
Net change in deferred charges in the quarter reflects an increase of $23 million. This is attributable to HR outsourcing implementations. As you'll recall, we typically defer direct cost associated with Employee Care contract implementations and we amortize those costs over the life of the contract. Deferral depends on an assessment of our ability to recover the costs from the client. Clients often pay for the implementation. We defer those proceeds and recognize them over the life of the contract as well.
Net capital expenditures for the quarter were $27 million, or 4% of revenue. As Jim mentioned, there is strong demand for customer care and employee care services. This will drive slightly higher capital expenditures as we build capacity. Net debt, which is debt less cash, decreased $13 million in the second quarter to $188 million. Our total debt to total capital ratio is now 22%.
Finally, we repurchased 1.7 million shares during the quarter for $31.7 million at an average cost of $18 and $0.82 per share. Approximately, 9 million shares remain authorized for future share repurchases.
Before we begin the question-and-answer session, I would like to expand on our guidance for the remainder of 2006 and provide initial expectations for next year. In the second half of 2006, we expect continued top line growth and margin expansion in Customer Care. This will be driven by seasonal increases in client volumes and global client ramp. We expect continued headwinds on revenue and operating income for Information Management. This is primarily due to the impact of the Cingular migration.
For Employee Care, we expect growth in revenues. We also expect to reduce operating losses for the full year. Note that we will not see significant increases in revenue from many of our current implementations until 2007. As Jim stated earlier, we have raised our 2006 GAAP EPS guidance to be at least $1.11. This includes approximately $29 million, or $0.13 per share, in non-cash stock-based compensation expense.
While we will provide more details on 2007 guidance later in the year, we are confident that our 2007 GAAP EPS will exceed $1.20. It is important to note that we expect this earnings growth despite the anticipated impact of the Sprint-Nextel billing decision, lower billing revenues from Cingular and higher costs resulting from the US-Canadian exchange rate. Our expectations for 2007 include continued growth in Customer Care, expansion in Information Management international operations and continued Employee Care progress.
Moving to our thoughts for the third quarter of 2006, our GAAP EPS guidance is $0.27 to $0.28, including non-cash stock-based compensation expense of approximately $7 million or $0.03 per share.
In summary, positive trends in our overall business allowed us to deliver strong second quarter results. We are poised for a solid second half revenue and profitability performance and increased visibility provides us with confidence that we will deliver growth in revenue and earnings in 2007.
At this time, I would ask the operator to open the lines for questions.
Question-and-Answer Session
Operator
Thank you. (Operator Instructions). Your first question comes from the line of Jason Kupferberg from UBS. Please proceed. Mr. Jason Kupferberg, your line is now open.
Jason Kupferberg - UBS
Yes, good morning. Can you hear me?
Earl Shanks
Yes, Jason.
Jason Kupferberg - UBS
I wanted to start by talking about the upside on the top line in the quarter and think ahead for the second half of the year a little bit. You just kind of gave some qualitative color on what we should we look for in the different segments. But is it fair to assume that even with the revenue spike in 2Q, you can still see continued sequential growth in the overall revenue base during the balance of '06?
Earl Shanks
Jason, we -- I intentionally just gave qualitative guidance for the year, because we are not going to continue to give kind of detailed on a line item basis. But certainly we feel pretty good about the momentum we have got in the business and the demand we see across the business. There is some lumpiness as you sign different contracts with and ramp up revenue on the different contracts in all three of the businesses. So, you don’t necessarily see the same overall growth rates that we will have seen in -- particularly in Customer Care as an example in the second quarter, but we feel pretty good about continued growth in total for the company across the balance of the year.
Jason Kupferberg - UBS
Okay. And then in Customer Care specifically, is there -- it sounds like there is still opportunity for margins to increase on a year-over-year basis in the second half of '06, if I'm hearing your commentary accurately, is that fair?
Earl Shanks
Yeah, absolutely, Jason. We believe for the business on a longer term basis that we can operate that business with operating margins in the 12% to 15% range, and as you’ll note, we’re not quite there yet. And so we are continuing to drive to get to that performance.
Jason Kupferberg - UBS
Okay. And then just turning to Employee Care quickly. As you guys pointed out, you are well on track as far as the top line, what you’ve guided to first, I think [it was] greater than 33% revenue growth. On the margin side though, it looks like it might be a bit more of a stretch to actually cut the operating losses there in half this year. Is that still a target that you think is achievable? Or does it make sense to soften that a little bit, and to the extent that’s the case? Is it still realistic for you to breakeven in this business in '07?
Earl Shanks
Jason, I think what we had said originally was that we cut it approximately in half this year, and I feel pretty comfortable that, that guidance is still the appropriate level of guidance on the business. I don't think anything has changed at all in there. And then, I think what we described is that we would expect in the first half of next year -- first part of next year to see likely continued losses in the business in the first half, but trend towards profitability at the end of the year. So, I think we’ll see exactly that pattern, at least as based on everything we know at the moment.
Jason Kupferberg - UBS
Okay. And then start on the implementation so far?
Earl Shanks
Thank you very much. We are pleased.
Operator
Your next question comes from line of Tom Roderick from Thomas Weisel Partners. Please proceed.
Tom Roderick - Thomas Weisel Partners
Hi guys. Good morning. Just wanted to start off asking a little bit here on the gross margin side for IMG that’s come down a bit certainly year-over-year, but you've done a nice job building up your services organization on the consulting side of the business. How should we think about the margin structure for IMG, even just thinking about it qualitatively over the next few quarters, is flattish the right way to think about it or as you continue to do more on the services side of the business should that gross margin trend down?
Earl Shanks
Tom, I would circle you back for a moment to the operating lines, and then I'll come back to gross margin. On the operating line, what we've said is we think this business over time we can mange to a number that looks like or approximately 20%. What we've also said though is in this period of time that we're transitioning a couple of major clients, we are pretty clearly on the operating line going to see some pressure and that's what we've certainly seen on a year-to-date basis and we'd expect to see that same kind of challenge certainly in the balance of this year as we look at it. When you think of what's going on specifically in gross margin, which you're asking about, we certainly see a mix shift on the gross margin and the gross margin we deliver on the professional services tends to be less than gross margin we get in data processing. And so as we're seeing a revenue shift between one and the other, we are seeing a bit of pressure on our gross margin line as a result of that.
Tom Roderick - Thomas Weisel Partners
Okay, good. And just building off that question, Earl. On the services side of your business, if we look at some other large services organizations out there, it seems as though pricing has come under pressure a bit for services, largely because of the move on the services side to lower cost regions like India, which you're capitalizing on the Customer Care side of your business. Can you talk a little bit about pricing on the services side for IMG there?
Earl Shanks
Certainly, Tom, we've been moving resources in that part of the business to Asia for a while as well. And Jim referenced in his comment the fact that we have got a thousand people in our development organization and certainly some of those toward the professional services part of the organization in India at the moment. So, we've been capitalizing on that for a while. When we look at overall trends and the details of the trends on pricing, we are actually seeing some improvement in our price per hour as compared to the reverse as we look at kind of the year-over-year and then month-to-month in quarter trend.
Tom Roderick - Thomas Weisel Partners
Good. And one last question for you, just a clarification, I want to make sure I understand one of your comments from the script. You mentioned that IMG, we saw some benefits this quarter from increased spending by a large wireless client. As you look at that specific client without naming names, can you give a sense that, that is -- that’s a sustainable increase in spend or are these activities that appear to be more one-time or temporary in nature?
Earl Shanks
Well, the increase was on the data processing side, and so unlike professional services, which can certainly be pretty lumpy, this is related to -- essentially related to subscriber growth in the data processing side.
Tom Roderick - Thomas Weisel Partners
Okay, very good. Thank you.
Operator
Your next question comes from the line of the Mr. James Kissane from Bear Stearns.
James Kissane - Bear Stearns
Hi, thanks. Earl or Jim, can you give us a little more insight in terms of the Customer Care growth? How much with some existing customers, old applications just growing and how much from new business added in the past year? Thanks.
Earl Shanks
Sure, Jim. I mean we saw a pretty good growth, I mean generally described it as existing customers. But as I know you understand, Jim, you can have existing relationships that take 12 or 18 months that even get to some levels of maturity. So, you might call some of that as new customers in some context. But certainly as we look at it, we're seeing growth across the portfolio with customers, and as you would expect not every single client growing, but the bulk of them are growing. And so, we're pretty encouraged when we look at it in total.
James Kissane - Bear Stearns
Do you think it's more cyclical or you are just picking up more of their business through outsourcing?
Jim Orr
I think, Jim, it's not so much cyclical. We are picking up more business as we perform and deliver good results for client. So, some of it, even from existing clients, is growth in their existing programs, some of it is because they are consolidating it and eliminating certain vendors, some of it is also new programs with an existing client. So, to the extent that client invests in the new marketing effort or other new initiatives that drives more volume, which in fact then obviously causes us to staff up and generate more revenue for that client. But to me it's very gratifying to see that we're gaining traction with a lot of existing clients, while at the same time bringing new clients, so on. Although, as Earl said, some of those relationships take time to really mature.
Earl Shanks
Yes, Jim. And I will go back to couple of other things just to highlight for you. Obviously, we had very, very strong growth in our other category and that is largely a new vertical over the last couple of years. So, we've been working to build that pretty aggressively. And then, the other data point that I think Jim provided to you is, we did have during the quarter, and it wouldn’t have had a huge impact on the reported revenue numbers, but it's an encouraging sign for future revenue, we did have more than 25 consulting engagements that we signed in the quarter, which will certainly give us an opportunity to have some of those clients become existing clients and then grow those existing clients more in the future.
James Kissane - Bear Stearns
Okay, great. And just one last question, the Employee Care pipeline and your sense of the competitive environment out there. I mean, a lot of your competitions have had problems, are they stepping back and kind of looking at their portfolios giving you an opportunity?
Jim Orr
Well, hard to really comment on our competitors. It is a competitive market, because it’s a huge market and it's one where the companies have a real need and are recognizing that need, which is leading to more an outsourcing. Having said that, we do appear to be extremely well positioned and my comments earlier really compared our business model, which is transform and then transfer, which really means sort of design the future state for how HR operate. So, put that in place and then move the business, as opposed to pick it up and try to then run it and move it at the same time. And obviously some of our competitors have struggled with that and to my knowledge we are the most successful at executing the transform and transfer model.
James Kissane - Bear Stearns
Okay, great. Thanks.
Operator
Your next question comes from the line of Peter Jacobson from Kaufman Brothers. Please proceed.
Peter Jacobson - Kaufman Brothers
Thanks, good morning. First, additional point relative to the prior Employee Care guidance, are you still looking to achieve a doubling of revenue in '07 versus '05?
Earl Shanks
Peter, I think, again, to try to specifically as possible quote the words I used in the past, I think, we described as approximately double, and I think we are directionally on exactly that line.
Peter Jacobson - Kaufman Brothers
Okay. And I believe last quarter you provided guidance for 5% year-over-year revenue growth for the business in 2006. Is that still the guidance?
Earl Shanks
Yes. We haven't updated revenue guidance at all, Peter. And again to remind you, I think the words I used were, more than 5% revenue growth.
Peter Jacobson - Kaufman Brothers
Okay. Do you have a number on Cingular as a percentage of total revenue in the quarter?
Earl Shanks
They were at 12.2%, and there is a schedule in the financials where you can see all the details that we put out this morning, but it is 12.2% of the quarter’s revenue.
Peter Jacobson - Kaufman Brothers
Okay. And any updates or changes as far as the Sprint migration schedule?
Jim Orr
No. I think the migration schedule really lies with Sprint, and some of you may have talked to Sprint, and I certainly am not going to comment on their behalf. They remain a valued client and we’re doing everything we can to serve them well and supporting whatever plans they chose to move forward with.
Peter Jacobson - Kaufman Brothers
Okay, thank you very much.
Earl Shanks
Thanks Peter.
Operator
Your next question comes from the line of Ben Abramovitz from ICAP Equity Research. Please proceed.
Ben Abramovitz - ICAP Equity Research
Good morning, guys. I’ve got a question. There are lot of moving parts in the Employee Care business obviously. For the last several quarters, revenue has been steadily increasing sequentially. We had a little bit of a dip here sequentially. I wonder if you can give a little bit of color on that, as well as any color you might give on the marketplace in the IMG business, especially overseas? Sorry.
Earl Shanks
Sure. I'll start on the Employee Care one, Ben, and then perhaps Jim will come back on the IMG question. With Employee Care, there were three things that we highlighted that happened between the first quarter and the second quarter. One of them was that in the first quarter we had some revenue for a program we did for a new client that was essentially one-time revenue. So, it had some impact. We did have a couple of legacy clients that transitioned off of the platforms that was a second impact on the quarter in terms of things that went on. And then the other one is we had some seasonal impact because of the open enrollment period. So, it was really those three factors that impacted the decline in revenue on the quarter -- sequential basis between the first quarter and second quarter. But in this business, and I talked about in all our businesses a few minutes ago, they tend to be a little lumpy in terms of when revenue started and that's why Jim and I as we talked through the comment, talked about where we were with specific clients and that we've began recognizing revenue later in this year for some of them and really not fully ramp on revenue recognition for some of the clients where we are performing services until a period of time into 2007. So, I think it is going to be a little bit lumpy on a quarter-to-quarter basis in terms of exactly what the growth rate is going to be.
Jim Orr
Good. With regard to IMG, Ben, if your question is, what's the international environment look like in terms of opportunities in Europe, as well as Asia and Latin America, we continue to see a large number of opportunities. And if you track our announcements, there have been quite a few from outside the United States, and as we said in the release that the progress that we have made in international operations in Information Management have largely offset any declines we've experienced in North America. We've also had a number of recent announcements in the Middle East. So, it's pretty broad based outside the United States, and there are many different companies and many different businesses, but one of the clear strengths that we have is the ability to handle convergent services, and that's going to drive both license and professional services growth. So, we feel very good about what the opportunities are, and perhaps more important as an indicator, the traction that our Infinys technology is getting, is really I think a precursor of continued growth in our Information Management business outside the United States.
Earl Shanks
And as reflected by Jim's comments during the earlier portion of the conversation, we don't -- we aren't able to announce everything that we would like to announce. Jim highlighted a large European communication client we hadn't announced. He highlighted a large Latin American client, we hadn't announced. So, I mean, there is pretty good momentum there.
Ben Abramovitz - ICAP Equity Research
Okay. Just one last quick question, not to get too far ahead. In what you laid out for '07, the assumption of the tax-rate there for '07 as we have some moving pieces again?
Earl Shanks
Ben, you might be too far ahead on that one.
Ben Abramovitz - ICAP Equity Research
Okay.
Earl Shanks
With respect to tax rate and everything on the P&L, we work hard to drive the performance kind of on a line-by-line basis. We will continue to look for opportunities to improve the tax rate, just as we look for opportunities to improve revenue and to reduce cost and expenses. So, we'll continue to drive that next year.
Ben Abramovitz - ICAP Equity Research
Thank you, guys.
Operator
Your next question comes from the line of Liz Grausam from Goldman Sachs. Please proceed.
Liz Grausam - Goldman Sachs
Hi guys. I’m just trying to understand the margin in the Customer Care business. You guys are sitting at a higher revenue level in the March and June quarters of this year, than you were in September and December of last year; you had a little lower margin. Can you help us understand if there has been a change in business mix, if it's really currency headwinds that's caused that or -- and how you feel confident going into the back half of the year, you're going to get to kind of a 12% to 13% margin level?
Earl Shanks
Liz, I think what happens in the business, there is some seasonality in the business from a margin standpoint because of some of the seasonality on the revenue side that comes in the second half. Clearly, as we look at the impact on a year-over-year basis, we've had some pretty dramatic impact on currencies. I mean, I did the comparisons for you earlier that we had a 140 basis point negative impact on currency between Q2 last year and Q2 this year. And obviously if you added 140 basis points back to these margins they'd be well over 12%. So, that’s certainly one of the impact, but we are going to continue to look to certainly take advantage of the seasonality, we will get the second half of the year, but more importantly to drive profits improvements and efficiencies in the business, which will help margin. I don’t think I necessarily said earlier that we get to 12% to 15% in the second half of the year, but I think we will continue to see both sequential and year-over-year improvement.
Liz Grausam - Goldman Sachs
Okay. And then any update on the T-Systems relationship over in Europe? That was a large contract you announced few quarters ago.
Earl Shanks
Liz, that’s -- we won't do details on specific contracts, but certainly that was an important win for us and continues to be an important opportunity and we continue to work with them very closely.
Liz Grausam - Goldman Sachs
Okay. Great, thank you.
Operator
Your next question comes from the line of Scott Sutherland from Wedbush Morgan Securities. Please proceed.
Scott Sutherland - Wedbush Morgan Securities
All right, great. Thank you and good morning. First question I had is, with what you are doing in Cingular and then migration of Sprint next year. At least with Cingular, I know you gained some professional services in migrating to some of your own platforms. How do you expect Sprint to play out next year? Is there a shift from -- do you expect any professional services there or is it mostly just a shift of data processing?
Earl Shanks
Well, Scott, as you can imagine in putting together the guidance we laid out, we took into account a number of potential scenarios on Sprint. And I think it’s a little early yet, given where we are at on the migration plan and given that what's public and what's not, what they've announced to get into details of those expectations. We've tried to take into account the range of potential outcomes, and certainly there are some of the range -- some of those outcomes that can be reasonably negative in the process and some that could be a whole lot better than that. But we've tried to take all of those into account as we laid out the better than $1.20 EPS numbers that we talked about earlier.
Scott Sutherland - Wedbush Morgan Securities
And looking -- listening to Cingular call on the 20th, it looked like your migration is almost done here. They expect to be done at the end of the year. Should there be an expected drop off in professional services by start of next year?
Earl Shanks
Well, Scott, as I know you understand, we signed a contract with them late last year, multi-year contract to provide them professional services to support the care platform. And based on everything we know, we will continue to do that based on the feedback --with the dialogue we had them.
Scott Sutherland - Wedbush Morgan Securities
Okay, and just a couple of more questions. Following up on the last question. On the Customer Care front on a sequential basis, your revenue was up, but your gross margins were down. I'm not sure how much of that was currency impact or is there something else there, because it seemed like, based on your comments, pricing has stabilized there on per hour basis.
Earl Shanks
I'm sorry, Scott, I lost you on that. My sequential operating margin in Customer Care is up two-tenths of a point versus the first quarter. Yes, I mean, there is certainly some movement as you look back and forth between the pieces. But I mean we are still continuing to drive improvement in operating margins and we are quite pleased with it. I wouldn’t -- I don’t think there is any trend in the gross margin numbers that are meaningful in that regard.
Scott Sutherland - Wedbush Morgan Securities
Okay, and last question. Looking at some other companies in telecom space, there has been some companies that haven’t had quite as good a quarter here. But your international licensing revenue on IMG was up. Also in Customer Care, your communications vertical was up. Do you see anything different there? Is there some -- just lumpiness in the quarter, or you're seeing some more positive trends there than some others are seeing?
Earl Shanks
Well, I think as compared to some of the previous quarters, certainly we have still had a decline in overall Cingular revenue for the company. But as we talked about, we were in the space that we began to see some stabilization there in the Customer Care side, which has certainly taken away one of the negatives we’ve had in the past. And overall, we’re just -- we’re making good progress and delivering value to our clients and therefore giving us an opportunity to earn more revenue.
Scott Sutherland - Wedbush Morgan Securities
Thanks. Appreciate it. Thank you.
Operator
Your next question comes from the line of TC Robillard from Banc of America Securities. Please proceed.
TC Robillard - Banc of America Securities
Thank you. I was wondering if you can just, kind of, help clarify, since I'm a little confused on here with respect to your commentary on the outlook for operating margins in the CMG business. When you were talking about expecting to see year-over-year improvement in those margins in the second half, were you talking about on a reported basis, because you had about $5.5 million charge in the fourth quarter last year. So I'm just trying to reconcile what numbers we should be looking at for that year-over-year comparison?
Earl Shanks
I would certainly expect that we’ll continue to see improvement, both on a reported basis and on an adjusted basis.
TC Robillard - Banc of America Securities
Okay. Then I guess I'm a little confused with a couple of questions prior where you said 12% margins wasn’t exactly something you guys were looking for, because on an adjusted basis, your fourth quarter '05 operating margins were 12.4% in the CMG business.
Earl Shanks
You're right, TC, and I had -- I was looking at the reported numbers when I made that comment and trying to reference back to it. But yes, certainly, we’re going to drive on an overall basis to get the business into the 12% to 15% range. I don’t expect and wouldn’t forecast that we’ll be there for the full year in total. But given the seasonality that we can and do see on a quarter-to-quarter basis and certainly we do see in the fourth quarter, you're right, we will be there in the fourth quarter. But again, that would be largely be seasonally driven.
TC Robillard - Banc of America Securities
Okay, that's very helpful. Thanks. And, also if you could kind of clarify a little bit more on the prior question with respect to guidance in the scenarios that you run for potentials for Sprint, I’m sure they are infinite. But have you guys taken kind of a worst case outlook for Sprint going into next year when you made your commentary about your guidance for $1.20?
Earl Shanks
Well, as I know you understand, there are a whole variety of different scenarios you have to take into account. And I won't tell you that I have provided simply the worst case scenario for every single potential outcome, and therefore we'll make $1.20 in even the worse case scenario. What we try to provide is blended guidance as we looked at all the different variables both Sprint and everything else that's going on and I highlighted besides Sprint obviously the effect on currency, the growth rates we expected in Customer Care, the growth rates we expect in Employee Care. There is a whole variety of things and there are some big positives and big negative moving pieces, and on a balanced basis we're confident that we'll get to better than $1.20 in EPS.
TC Robillard - Banc of America Securities
Okay. Then just lastly on IMG, sequentially it looks like the cost of service or operating costs were up about 4.5%, while revenue was only up about 3%. Can you give us some color as to why costs were kind of accelerating faster than the revenue, and how we should think about that over the back half of the year?
Earl Shanks
That largely has to do with the mix of revenue and as you -- on a quarter-to-quarter basis, we had some growth in some of the license and other revenue, and at the same time decline in data processing, the costs in data processing don’t go away really quickly, as we've talked about before. And yet you can pick up some other cost and some other signs, so that’s largely the balance between the two.
TC Robillard - Banc of America Securities
Okay. And so, if we think about then the operating margin for the division, where do you guys feel confident that it kind of bottoms out, as you continue kind of this mix shift from data processing, to kind of services?
Earl Shanks
Well, for this year, as we look at the year, I think we will roughly be in line with where we are at the moment or where we have been at the first two quarters. As we look into next year, that’s a bit a detail on the guidance that we'll get into next year.
TC Robillard - Banc of America Securities
Understandable, that's -- it's very helpful. Thanks Earl.
Earl Shanks
Sure.
Operator
Your next question comes from the line of Mr. Matt McCormack from Friedman Billings Ramsey. Please proceed.
Matt McCormack - Friedman Billings Ramsey
Yes, good morning. On the other revenue line, can you either quantitatively or qualitatively just talk about the healthcare retail and government verticals, what percentage that makes up and the type of growth rate in each one?
Earl Shanks
Well, Matt I'd love to do that, but the [finality] is there are so many different verticals that are in there and we would be down into -- each of them would be relatively small as we look at the total that we are -- we were not prepared yet to breakout that kind of detail. We talked about obviously a number of them that are growing our large manufacturing client, the government, the healthcare; we have seen growth overtime in insurance in that space as well. So, there is lots of opportunity there, and I'd love to start breaking it out and saying, okay, let me describe it exactly where the segment is, but not one of the segments he added to the point that we think they are large enough to do that. So, that will be a to come kind of disclosure I think.
Matt McCormack - Friedman Billings Ramsey
Okay. And in terms of, if you had to characterize growth from expansion with existing clients and that from new clients, would the other category mostly be from new clients and the other one is expansion from existing clients, is that a fair statement?
Earl Shanks
Well, Matt, as we talked to, with Jim's question earlier, I think it was Jim's question. The clients in this space, it's hard for us to determine when do you want to call them new and when do you want to call them existing. And the dollars that we're seeing this quarter, probably the bulk of them are absolutely from existing clients, probably they were clients a quarter ago. Were they clients two years ago, maybe not. But, I mean, the mix I think is you grow these clients individually. You start small and you grow them over time and that’s what we're seeing in this space.
Matt McCormack - Friedman Billings Ramsey
Okay. And then lastly, you mentioned that you got 25 new, I guess, consulting engagements for clients that run their own call centers in-house. Has that historically been a source of new customer wins or does that typically stay in-house?
Earl Shanks
We have significantly ramped up our effort to capture consulting engagements over the last year or so. It has been a big opportunity for us, that's not driving the revenue numbers because the consulting engagements generally are relatively small as compared to most of our clients. But we believe and certainly are seeing as we build relationships with these clients that it represents a big future opportunity to deliver significant revenue growth.
Matt McCormack - Friedman Billings Ramsey
Okay. And just -- I am sorry just a follow-up, would you characterize those customers as doing best work 100% in-house or mostly in-house?
Earl Shanks
It's mix between in-house, both existing clients and some clients that as well are doing with other people.
Matt McCormack - Friedman Billings Ramsey
Okay, great. Thank you very much.
Operator
Your next question comes from the line of Julie Santoriello from Morgan Stanley. Please proceed.
Julie Santoriello - Morgan Stanley
Thanks. Good morning. Wondering if I can get an update on the Sprint contract, as it relates to the Customer Care business. Have you seen increases in volumes with that account? And is there anything new going on with the prime contractor there, IBM and Sprint?
Earl Shanks
Julie, as we've said for a couple of quarters on this one, we've got -- Sprint is an important relationship for us, and we continue to work hard on both side of the business, but particularly in Customer Care, as you've asked about it, to deliver them quality of services and value, and that relationship continues. So, there is really not much of an update in that regard that I can provide for you.
Julie Santoriello - Morgan Stanley
Okay. And just a question on, I am thinking when it comes to guidance. First with the third quarter, I guess you are guiding to flattish earnings, and I am just wondering how you see getting to that. You've had such great revenue momentum over the last couple of quarters. Do you expect that to continue or would you -- are there reasons why you think seasonally revenue may flatten out a bit and margins will stay flat? Give us an idea of how those two pieces are moving to get to your EPS target.
Earl Shanks
Well certainly, Julie, when we look at the business, and I think you are specifically referencing Customer Care as you talk about it. I don’t necessarily think that we are going to see 14% revenue growth in either or each of the next two quarters. I think we will continue to see revenue growth and we will have some further margin improvement on that. We also though have some pretty big year-over-year negatives that we are fighting, and in particular in the third quarter the biggest single item is probably the cell partnership, and as you know when you look at the numbers, Julie, we had that about $0.02 negative impact this quarter and I think on a year-over-year basis it will have a negative impact as well next quarter, which is going to have some -- and I think the overall we will have earnings from the cell partnership, but it just would be quite small. And so the comparisons are bit of a challenge when we look at that. But we will continue to work to drive performance across the business, as I said.
Julie Santoriello - Morgan Stanley
And, if I can just get one more on the investment plans. You mentioned that you're seeing, because of the strong growth you're seeing in Customer Care and Employee Care, you may be stepping up some investments in those areas. Can you help us to quantify that and if you've thought a CapEx number at this point for '07? But if you have, that would be great, or even just generally what types of investments you see to grow those businesses from here?
Earl Shanks
Yes. In terms of what I had in mind with the comment, I think the previous guidance we had given you is about 4% CapEx for this year -- 4% of revenue for this year, and really that was meant to signal, but I think we’re going to be a little bit above that. And I wouldn’t say it’s a lot, but call it something like 5% above that potentially as we look at it. We haven’t really thought about CapEx in terms of numbers that we give for guidance next year on that. But as you know, our CapEx can vary based on how much capacity we choose to build for the business, and we choose to build a certain amount of capacity based on what we see as demand in the marketplace largely trying to build to the specific demand as compared to build on speculation, and we’ve been reasonably tied on that for the last several quarters. And, I think the place we’re at with capacity and the place we’re at with demand would suggest that we’ll grow a little bit.
Julie Santoriello - Morgan Stanley
Does part of that include offshore locations and/or people? Do you have any targets for that?
Earl Shanks
Well, I mean, obviously we’ve been pretty steadily growing our offshore workforce and our expectations is that our offshore workforce will continue to grow. That the client demand for offshore services is there, is strong, continues and will in response of that client demand have offshore resourcing and have more of them.
Julie Santoriello - Morgan Stanley
Okay, thank you.
Earl Shanks
Thanks Julie.
Operator
Your next question comes from the line of Ashwin Shirvaikar from Citigroup. Please proceed.
Ashwin Shirvaikar - Citigroup
Thank you. Hey, Earl, first of all I do like the increased disclosure, thank you for that.
Earl Shanks
You're welcome.
Ashwin Shirvaikar - Citigroup
With regards to the Employee Care business, I know a couple of questions have been asked about this. But I was a little bit surprised to see sequentially down revenues in spite of go live on Solectron and Boston Scientific. Could you explain a little bit, what exactly happens from an accounting and revenue recognition perspective when you go live? And why that, I mean, should not directly start contributing to revenue growth?
Earl Shanks
Sure. I think as you listen to the comments that Jim made about this as he talked through, he talked about the initial phases or early phases going live. But for many of the clients and the way the revenue recognition rules work, we do not in fact begin recognizing revenue until we get to full implementation. And Boston Scientific was an example of that where we went live and we will have -- we had in the second quarter zero revenue recognition, and as Jim said, we'll get to revenue recognition later in the year when we get some other services. It's an oddity of accounting rules and it's sometimes hard for some of us to understand why they work exactly the way they do. But it is the way that rules work that until when you've got these large programs, which are very interrelated, the rules require that you defer recognizing any of the new until you've got the program fully implemented or fully implemented to some pretty significant milestone. And that's really the position we are in with everything that you've referenced Boston Scientific and Solectron is perfect examples.
Ashwin Shirvaikar - Citigroup
Okay. And just talking a little bit more about the longer term prospects in the Employee Care business, for example. Would you expect comparable lifetime margins for your 13-year HRO contract as for your 7- to 10-year contract?
Earl Shanks
We price the contracts so that we can deliver at scale a 15% operating margin or better in this business, which means that we price on a contribution margin basis on the contracts on a pretty similar basis across the whole portfolio in order to make that happen. Obviously we make adjustments that depending on how we invest capital, and so we will take that up or down based on how much of the implementation the client is paying for. But in general, we price on a pretty similar basis across the portfolio.
Ashwin Shirvaikar - Citigroup
Okay. And one question on the billing question, if I may. Having praised your increased disclosure, I’m going to ask you for a little bit more. Is there anything you can do to, sort of, increase the professional consulting part of the mix over time, especially to offset de-conversion business, and how much is that de-conversion business from Cingular and Sprint?
Earl Shanks
Well, we've been working to grow our professional consulting business pretty actively over the last few years and have had great success on a year-over-year basis, limited success this last quarter, we are only up about 1% in professional consulting. But we have had overall great success in that business and we absolutely will continue to grow it. And certainly there is some part of that our revenue that's de-conversion, but the most of what we are driving is revenue that’s of the nature that we think we can continue in some form or another.
Ashwin Shirvaikar - Citigroup
What percent of that revenue is de-conversion related?
Earl Shanks
Ashwin, I'm not going to do more detail around that one.
Ashwin Shirvaikar - Citigroup
Okay. Well, thank you.
Earl Shanks
Thanks very much.
Operator
Your next question --
Earl Shanks
Operator?
Operator
Yes sir.
Earl Shanks
We have really just time for one more question.
Operator
Most certainly, sir. Your last and final question will come from the line of Mr. Julian Bu from Lehman Brothers. Please proceed.
Julian Bu - Lehman Brothers
Thanks for taking my question. First of all, the Cingular revenue, it seems $85 million this quarter down a little bit, but roughly in line with the prior two quarters. So, did both in the IMG piece and also EMG piece stay flat or one was going up, another went down?
Earl Shanks
Julie, I think, I'm not sure I understood your question. We are seeing, overall if you look at first quarter to second quarter, Cingular revenue is down a little further than where it was and certainly that’s been the trend overall. As you look at the mix of revenue from Cingular this quarter, as compared to what happened a year ago, and think about the second quarter a year ago, the predominant share of the decline in Cingular revenue is related to Information Management.
Julian Bu - Lehman Brothers
The fourth quarter of '05, the total Cingular revenue was 87, the first quarter of '06 was 88 some and it changed right now 85 or so. I don’t think we are seeing dramatic changes in this number right now. I just want to make sure, is CMG actually going up at this point a little bit to offset the IMG decline?
Earl Shanks
We may have a sequential increase. And again, it's probably more detail, Julian, than I really want to provide. But you could look at it and conclude, when you look at the year-over-year numbers, the numbers we have described and then we disclosed out here that we could see a sequential increase in CMG revenue on a quarter-to-quarter basis, because certainly there is some volatility on the revenue we get on that and there is some seasonality on that as well.
Julian Bu - Lehman Brothers
Okay, perfect. And regarding the MVNO opportunity you guys talked a lot about in the past quarter is -- I think ESPN is saying the customers signing up is much less than they projected. So just curious what's your outlook on that front?
Earl Shanks
We still believe the MVNO opportunity is an important opportunity. We can't comment specifically on how any particular MVNO is doing. I think you will have to refer to them, but we've always said, I think, with this one that it depends on how fast the signs up are and what the subscriber growth is. It's an important opportunity for us and it could generate a substantial amount of revenue over time, but they have to be -- the MVNOs themselves have to go out and get the subscribers.
Julian Bu - Lehman Brothers
Okay, thanks. Lastly, just could you comment on the economic sensitivity of the call center business, given the Fed has been trying to engineer a slow down in the economy?
Earl Shanks
Try that question by me again, Julian.
Julian Bu - Lehman Brothers
Just how economically sensitive is the call center business?
Earl Shanks
I think the call center business is sensitive to a variety of factors. As the labor markets get tighter, I think that there is some push to do more outsourcing. As you see more push on cost, companies have more pressure on cost, you often see more push to outsourcing. And in general, as we’ve been saying for sometime, we think there is over time a very strong secular trend anyway towards outsourcing, because it's our core business and it's not the core business of our clients to run call centers. So we think there is a number of factors that affected -- not one bright line factor that I can say, well, I know if GDP is 3.6 to 3.2, I know what the impact is going to be. I wish I was that smart, but I'm not.
Julian Bu - Lehman Brothers
Okay. Just also the -- I don’t want to get into too much of detail in terms of the '07 guidance. Is that based -- your assumptions, the economy will stay where it is right now or you are assuming the economy will go down a little bit, which will affect some cyclical volume.
Earl Shanks
Julian, that might be a bit more detail. Again, we’ve tried to make broad assumptions and deal with all the variables that are out there, and it's always hard to forecast that for in advance, but we’ve tried to balance our all of the potential presentations. But with that, we need to end the call.
Jim Orr
I just want to add that Earl and I will be available the remainder of the day to answer more specific or detailed questions on the second quarter results and the forward guidance that we’ve discussed. So at this time, we’ll have to end the call and thank you all for participating today.
Operator
Thank you for your attendance in today's conference. This concludes the presentation. You may now disconnect. Have a most pleasant day.
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