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Convergys Corporation (CVG)

Q4 2006 Earnings Call

January 24, 2007 10:00 am ET

Executives

David Stein - VP of IR

Jim Orr - Chairman and CEO

Earl Shanks - CFO

Analysts

Dave Koning - Robert W. Baird

Tom Roderick - Thomas Weisel Partners

James Kissane - Bear Stearns

Matt McCormack - Friedman Billings Ramsey

Brandon Dobell - Credit Suisse

Jeff Nevins - First Analysis

Jason Kupferberg - UBS

Ashwin Shirvaikar - Citigroup

Presentation

Operator

Good day ladies and gentlemen, and welcome to the Convergys Corporation Fourth Quarter 2006 Earnings Call. My name is Onika and I will be the operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. At this time, I would now like to turn the call over to Mr. David Stein, Vice President of Investor Relations. Please proceed sir.

David Stein

Thank you, Onika, and good morning. I am David Stein, Vice President of Investor Relations. Welcome to the Convergys fourth 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 fourth quarter. Earl will follow up with segment results and forward guidance. Then, we will open the call to your questions.

Today's discussion contains a 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 its clients operate, 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 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 as being more important than comparable GAAP measures. Our fourth 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.

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Jim Orr

Thanks, David and good morning, and thanks all of you who joined us today. I'm very pleased with our 2006 performance and the progress that we've made on many fronts. The company had a very strong year delivering record revenues, the highest earnings per share in our history and the best free cash flow in five years.

Customer Care industry trends are strong and our business in that environment is really thriving. Continuing success in the international arena offset the previously disclosed North American client migration in information management. Employee Care continued its contribution to overall revenue growth and increased operating income.

With the fourth quarter, we're ending the year on a strong note as evidenced by key contract wins around the globe and expand the relationships with many of our clients, greater financial capacity to invest in our long-term strategy to drive continuing growth in earnings, and management strength to execute the strategy successfully.

In terms of financial performance, Convergys revenue was $720 million in the fourth quarter, up 8%. This brought our full year revenue to an historic high of $2.8 billion. Operating income of $253 million was up 13% for the full year. For the fourth quarter, operating income was $58 million. Operating results in the quarter included an approximate $13 million net charge related to our previously announced restructuring plan. This charge reflects the aggressive actions we've taken to further streamline the organization. We will continue to pursue initiatives that drive efficiencies by rationalizing facilities, increasing productivity and managing our costs in 2007. These actions support our dedication to further profitability improvement.

Fourth quarter GAAP earnings per share of $0.32 doubled over the previous year. We again had strong cash flow in the quarter and 2006 free cash flow of $257 million was the highest in five years. We are proud of our record, delivering positive free cash flow every year since our IPO nine years ago. This is a function of management attention as well as the strength of our business model.

Customer Care revenue and operating income grew in the fourth quarter. Revenue increases allowed us to strengthen our leading position in the opportunity rich $50 billion customer care outsourcing market. We also deployed additional products and services to address the more than $230 billion in-house contact center market. Our continuing operating improvement in Customer Care reflects the positive impact of our focus on productivity and cost initiatives, and our recognition as the industry leader based on our ability to deliver value for clients.

As anticipated, Information Management revenues were flat for the year and down slightly in the fourth quarter. License and professional services revenue grew for the year in the quarter largely offsetting the data processing decline. This was driven by Information Management success addressing the demand for convergent solutions around the globe, reflected in the continuing strength of our international business.

As expected Employee Care revenues were up substantially for the full year and for the fourth quarter. As a result, we significantly reduced the Employee Care operating loss in 2006. While we continue to make progress, Employee Care was negatively impacted by some period costs in the quarter. Such costs included a reserve for the resolution of issues relating to the State of Florida contract, restructuring charge to further streamline operations, and costs related to a client implementation. A majority of loss in the quarter was due to these costs. Earl will provide greater detail on our financial performance and 2007 guidance in a moment. But first, let me discuss some of the highlights for the fourth quarter.

Like others in our industry, we were impacted by the Taiwan earthquake. It significantly disrupted our principal carriers, communication networks in the Philippines and throughout Asia. Despite this, we are able to minimize decline in financial impact by swift implementation of our business continuity and disaster recovery plans and the tireless work of our people.

Customer Care continued to grow with new and existing clients during the fourth quarter, and demand increased across all our market verticals. Since our last call, we had a capacity to address increasing customer care outsourcing demand. We are currently adding large contact centers in Albuquerque, New Mexico and Longview, Texas in North America and Cebu City in the Philippines. We will likely add more capacity in 2007 given the current demand. We are also encouraged by the demand for our Customer Care consulting practice. This is one way that we are further penetrating the very large in-house customer care market.

Moving now to Information Management. In the fourth quarter and throughout 2006, we had competitive wins across the globe. Tier 1 carriers continue to select our capabilities for billing convergent services. Notably in the fourth quarter, we announced wins with British Telecom and NTL Telewest. We are pleased to have extended our relationship with BT with a five-year contract to rate and bill all of its products and services. Infinys was helping BT to make strives to consolidate its highly complex billing operation, reduce total cost of ownership, and reduce time to market for new services. BT has also seen a significant return on the capital invested in the project. NTL Telewest will be using our billing technology to replace multiple legacy systems with the single billing in Customer Care infrastructure. The single platform will support NTL Telewest video, telephony and broadband customers.

In North America, we signed a five-year managed services contract with SunCom Wireless to provide billing and customer care support for SunCom’s rollout of GSM services. Sprint continued to be a significant client in 2006. However, Sprint’s data plan of record implies accelerated declines in billing revenue for the latter half of 2007.

Moving to our Employee Care business, revenue improved substantially in 2006 and in the fourth quarter. We made progress reducing the operating loss for the year. Balancing our enthusiasm for this business is the negative impact a project’s scope, schedule and cost changes. The rewards and risks are compounded by the size and complexity of the deals we’ve chosen to pursue.

Nonetheless, as our experience and success grows, we are better positioned to address these issues going forward and continue to believe strongly in its long-term potential. As anticipated late in the fourth quarter, we went live with the global test implementation for Boston Scientific, and began recognizing revenue. That's included deploying a full array of technologies with a comprehensive portal, self service and HRIS capabilities. We are now providing HR administration, US payroll, recruiting support, vendor management, compensation services, business intelligence, and learning services.

For Whirlpool, the North American implementation is complete. We are providing payroll benefits, pension, HR administration, relocation, and compensation services. We have integrated Maytag employees for which we are providing the same services. We began serving employees in Europe earlier this month.

Earlier in 2006, we began recognizing revenue for Solectron in North America. Services we provide include recruiting and staffing, benefits, HR administration, payroll and enquiry and learning services. We expect to complete the implementation and begin recognizing revenue for operations in Asia during 2007. We continue to make progress for DuPont in the fourth quarter. We now provide vendor management, payroll and benefit services for all US-based employees and retirees. We also provide payroll benefits and HR administration services to employees in several Western European countries. We continue to implement other services in locations for DuPont.

We believe our selective approach to the HRO market will allow us to grow revenue and improve the profitability of the Employee Care business in 2007. We have visibility to the major deals in this industry and we believe it's in the best interest of our shareholders to pursue revenues only when we are confident, they will be profitable and generate meaningful returns for shareholders.

In summary, I am very pleased with the strong revenue growth and operating improvements we delivered in 2006. Our portfolio of business has delivered overall growth despite challenges from migrating a billing client and managing complex HR BPO implementations. We lead in a large and growing and opportunely rich customer care industry. Our capabilities, strong client relationships, and global presence give us every indication we can further improve on a record 2006 performance.

2007, we need to capture the organic growth opportunity, further improve productivity and overcome the anticipated billing revenue migration. We'll continue to invest in building innovative products and services that leverage our combined billing and care capabilities. We also will invest in adjacent market opportunities where we are going to leverage our unique capabilities to meaningfully deliver incremental revenue and profitability. I'm confident of our long-term prospects in the large and growing markets that we serve and we are remain dedicated to believe that we can best create shareholder value by continued year-on-year growth in earnings. And I'm confident that in 2007, we'll deliver record revenue and earnings per share.

At this time, I'll turn the call over to Earl. He'll provide greater detail on the fourth quarter financial results as well as provide financial guidance for 2007.

Earl Shanks

Thank you, Jim and good morning. First, before I review segment results, I will briefly review the key drivers of earnings improvements in 2006. The five key drivers of our change in EPS this quarter versus the prior year were -- improvements in Customer Care operating income, better cellular partnership results, and a favorable change in the tax rate. These were somewhat offset by decline in information management and additional long-term compensation expense.

Looking at our performance on a sequential basis, the four key drivers impacting EPS between the third quarter of 2006 and the fourth quarter were, seasonal improvements in customer care operating results, the favorable tax rate, offset by additional long-term compensation expanse and the restructuring charge.

I will now take a moment to discuss the restructuring charge we had in the quarter. As Jim mentioned, we took the restructuring actions to rationalize facility costs, further streamline the organization and reallocate resources geographically. The $13 million restructuring charge consisted largely of $24 million severance expense offset impart by $12 million reversal of a previous reserve. Work force actions across each part in the business will impact approximately 630 employees when fully implemented. The facility abandonment cost reversal which for our Cambridge building, which we are bringing back into service to support consolidation of our UK operations.

I will now discuss the performance of our Customer Care business. Record Customer Care revenue of $468 million was up 10% for the quarter. This reflects continuing organic growth in contact center outsourcing across all our vertical markets. Communications client revenue grew 13%. This was largely due to increases with four large broadband and wireless service providers. Increases with the large software company and a large hardware manufacturer moved technology revenues up 9% for the quarter.

Revenue from financial service clients grew 8%, reflecting increases with several credit card issuers. Revenue in the other market segment grew 6%. This reflects continuing revenue expansion with a large automotive client. This was offset impart by revenue declines with the government client and two transportation clients. These declines were due to the completion of certain programs.

At the end of the fourth quarter, Customer Care had approximately 21,300 employees in Asia. This increase from 16,100 employees in the fourth quarter of 2005, demonstrates our core competency in hiring and training. There were 19,500 employees at the end of the third quarter of 2006. Approximately, 30% of our customer care employees now work in Asia. As Jim mentioned, demand remained strong for contact center outsourcing across geographies. We are adding significant capacity in United States and also adding capacity in Asia to meet the demand.

Customer Care operating income in the fourth quarter was $54 million, up 14% from the prior year. This included a $7 million restructuring charge to further streamline the organization. Restructuring charges this year and last year were about the same. Improvement in operating income is due to continuing growth with existing and new clients. It also reflects improvement across several key metrics including agent attrition, retention, agent productivity, seat utilization, service quality, and billing yield. We have delivered these improvements while reinvesting in the business. We have invested in new technology, additional capacity, increased professional services capability, and further market diversification. Customer Care operating margin increased to 11.4%. This includes a combined 390 basis point negative impact from currency exchange and restructuring cost.

Now, I will review Information Management performance for the quarter. Information Management revenue was down slightly to a $194 million in the fourth quarter. Our license software and professional services business continues to grow. This reflects the continuing demand for convergent services and broad acceptance of our billing system capability. License and other revenue grew 19% in the fourth quarter, reflecting increases with two large international carriers. Professional services revenue was up 1%. Revenue increases with several clients implementing convergent billing solutions were offset by declines, primarily related to the Cingular migration. Data processing revenue was down 14% in the quarter due to declines with Cingular.

Fourth quarter operating income of $31 million for Information Management was relatively flat sequentially. Operating results included $1 million net restructuring charge. This consisted of $13 million severance charge offset by the $12 million reversal of a pervious restructuring reserve. Fourth quarter operating margin held steady at the 2006 average of 16.1%.

Moving to Employee Care, revenue for the full year increased 30%. In the fourth quarter, Employee Care recognized $58 million in revenue. This reflects increases with DuPont, Solectron, and Boston Scientific, and also includes some consulting work completed for our large prospective HRO client. For the year, Employee Care operating loss was cut by 24%. In the fourth quarter, the operating loss increased by $2 million over the prior year, including an additional $1 million for restructuring.

As Jim mentioned, there were some additional period costs in the quarter. These included a reserve for the resolution of issues relating to the State of Florida contract, restructuring charges, and additional cost related to a client implementation. More than half of the loss in the fourth quarter was related to these three items. Clearly, implementation, project scope, schedule, and cost changes impact the timing of revenue recognition and resulting profitability improvement.

Nevertheless, as we have said previously, the size, scope, and profit potential of our global multi-year HRO contracts remain intact.

Turning now to other items outside of our reporting segments. We incurred $11 million in non-cash stock-based compensation expense in the fourth quarter. This was approximately $4 million more than the same period in 2005. Earnings from the cellular partnerships were $5 million in the fourth quarter. This compared to a loss of $5 million in 2005. As you will recall, accounting adjustments made by the general partner negatively impacted cellular partnership earnings in the fourth quarter of 2005.

The effective tax rate for the fourth quarter was 23.7%. This reflects the benefit from improved international performance and the UK facility reserve reversal. We expect the effective tax rate will be approximately 35% going forward. Cash flow from operations was $119 million in the fourth quarter. Free cash flow was $97 million in the quarter and $257 million for the full year. Contributing to our strong cash flow in the quarter was improvement in DSO, from 73 to 70 days and lower deferred charges. The change in deferred charges in the quarter net of amortization and deferred implementation revenue was $8 million. Net capital expenditures for the quarter were $22 million. Net debt decreased $16 million in the fourth quarter to $108 million resulting in a total debt to total capital ratio of 19.1%.

During the fourth quarter, we repurchased 2.8 million shares for $63.2 million at an average cost of $22.72 per share. Approximately, 5 million shares remained authorized for future share repurchases.

I will now move to our discussion of our forward financial guidance.

Let me take a moment to describe a change we have decided to make and how we will be providing earnings guidance going forward. We said in October, we will provide updates to our annual earnings guidance on our quarterly call. Beginning today, we will provide only annual earnings guidance on our quarterly calls. Each quarter we will provide updates to this annual guidance. Much has been written on the share from quarterly to annual earnings guidance, and we believe it is the right thing to do. This change is a continuation of our focus on long-term shareholder value creation, and we believe this change will benefit our shareholders. We remain committed to executing against our monthly, quarterly and annual plan targets, and we will continue providing the information needed to effectively evaluate the company. With that, let me move to our 2007 guidance.

Recognizing that we are only three weeks into the New Year, our guidance for 2007 remains unchanged. As we've said before, we continue to expect overall revenue and earnings improvement to yield GAAP EPS of more than $1.20. We expect some variability of results in the three business segments. Anticipated improvements in Customer Care and Employee Care will offset anticipated declines in Information Management. This annual guidance encompasses a range of potential outcomes across our three businesses. It balances anticipated execution risks with significant opportunities for revenue growth and operating improvement.

As I explained during the Analyst Meeting in November, risks include the continuing impact of Cingular and Sprint migrations, Canadian currency exchange, increases in wages and benefits, and execution risks in each business. Potentially offsetting these challenges are the opportunities for further margin improvement and for revenue growth in all three businesses. For the full year in Customer Care, our largest business, we expect continuation of the broad revenue growth trends experienced last year. Continued increases with existing and new clients will drive revenue growth approximately similar to our growth in 2006.

Note that Customer Care results in the second half of the year are typically stronger than results in the first half of the year. We expect this seasonality in our clients' customer demand to be true in 2007 as well. In Information Management, we built a plan with the expectation for lower revenue and as a result lower operating income for 2007. Our expectations for Information Management include decline in data processing revenue experienced with continued pressure on operating margins. This will be partially offset by further progress in our license and professional services business with growth in international operations and tight cost control.

For Employee Care, our expectations include improvement in revenue and operating income. We expect to deliver strong double-digit revenue growth for the year. Growth in 2007 is likely to be somewhat less than the 30% growth we delivered in 2006. We continue to anticipate Employee Care reaching profitability in 2008. As I said earlier, changes to HRO implementations are to be expected given their size and complexity. The project scope, schedule and costs changes and resulting impacts experienced in 2006, illustrate the HRO implementation risks on a going forward basis. We experienced the impact of risk in 2006 and we were still able to exceed our EPS guidance. Similar to the process we followed last year, implementation risk associated with scope, schedule and cost changes exists and has been taken into account in our 2007 guidance. As I said a moment ago, the profit potential of our HRO contracts remains intact.

Moving to the cellular partnership, while results have been followed on a quarterly basis, we have seen relative stability on an annual basis over the last two years. We expect 2007 equity earnings to be about the same as 2006 earnings. Regarding 2007 capital expenses, we will continue to build contact center capacity to address higher levels of customer care outsourcing demand. We expect capital expenditures to be in the range of 4% to 5% of revenue for 2007.

For the first quarter of 2007 on balance across our portfolio of businesses, we expect Convergys revenue to grow and earnings to improve compared to the prior year. We anticipate increases in Customer Care, and Employee Care will offset declines in the Information Management. In summary, we remain confident. We will set new records for revenue and earnings per share in 2007. That completes my comment.

Jim Orr

Earl, before we begin the question-and-answer session, I would like to add a few remarks. Obviously, 2006 was a very positive year for Convergys producing record revenue and earnings per share. These results reflect the work begun in 2004 to deliver better shareholder returns on restoring earnings growth by transforming our business. The significant purpose on operating performance, management development, enhanced use of metrics and greater accountability has driven a higher level of performance. We’ve only realized partially the benefit of these management organization and operation changes. We see significant opportunity for further improvement. During this period of transformation, we faced and overcome significant challenges. Similar to the past two years, we’ve recognized the future is not without challenges and risks. As we entered the new year, the key wins we are experiencing around the world, our financial capacity and momentum have us well positioned to face those future challenges and deliver further improvement in 2007 and beyond.

This time operator, please open the line for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Your first question comes from the line of Dave Koning with Robert W. Baird. Please proceed.

Dave Koning - Robert W. Baird

Yes. Good morning and congrats on continuing really strong trends in Customer Care.

Earl Shanks

Thank you.

Dave Koning - Robert W. Baird

I was wondering, you are continuing to add a lot of capacity in the Philippines, which is what we are seeing across the industry. Is there anyway to look at growth? You grew 10% in the quarter in Customer Care. Is there anyway to break that out in terms of where you are getting that growth from, for example are you growing low-single digits in the US but growing 20% to 30% in the Philippines. Is there anyway to break that out a little bit?

Earl Shanks

David, I think a fair way to think about it and the region we provide you the data around this is to think about, where the agents are at. And to use that as a measurement, doesn’t a directly tie the revenue because obviously an agent in the US generates more revenue than an agent in India and the Philippines. But as you think about it, we had at the end of last quarter about 30% of our agents in Asia, and we have about the same at the end of this quarter. So what that would suggest in general as you are seeing about the same growth turns between and probably a little bit biased from a revenue standpoint to the North America market.

Jim Orr

Yeah. It's obviously reflected and the fact that two other centers that we announced we are building, are North America and one in the Philippines.

Dave Koning - Robert W. Baird

Great. And just one follow-up. Are you seeing -- given that the capacity increases offshore or you seeing any wage inflation, I guess either offshore or on onshore, given just a market strike?

Earl Shanks

David, as you'll remember from our conversations in November and then in my comments a few minutes ago, we certainly highlighted the impact of wage inflation. It's one of the key variables of -- one of the key hurdles that we have to overcome every year in the business and the patterns we have seen on that really haven't changed significantly over at the past couple of years. I mean there is certainly wage inflation in Asia and certainly wage inflation in the US and that's one of the reasons that we have to continue to drive more productivity in the business and it's one of the reasons that we have to be reasonably aggressive in terms of how we deal with pricing. And so we can deal with it in a number of ways. But yeah, I mean there's absolutely wage inflation out there that's not changed.

Dave Koning - Robert W. Baird

Thank you.

Operator

Your next question comes from the line of Tom Roderick with Thomas Weisel Partners. Please proceed.

Tom Roderick - Thomas Weisel Partners

Hi, good morning. Thank you. Just wanted to ask a question on the IMG side of the business here. So, the guidance for next year calls for IMG to be down slightly. But can you talk a little bit about what sort of magnitude the impact of the Sprint migration has on the business in '07 and then how we should think about that magnitude going into '08? In short, when will we see stabilization on that migration so that the rest of the growth of the business can sell through?

Earl Shanks

Well, I’d comment. I think that really depends on exactly what is the -- plan is that Sprint actually executes as compared to their plan of record and obviously we're not a 100% certain what that’s going to be and we can’t be at this stage. Certainly with the plan of record as it's laid out, we will see progressive declines on our Sprint related revenue through the quarters in 2007 and that’s what we have built into the plan. On a comparative basis that means we won’t get past this until the end of the [year] essentially as you work out the math, that's pretty obvious. You’ll remember and I think the only public date out there in terms of the size of Sprint as a customer is that they were about $100 million of revenue in 2005. So at least it gives you some benchmark to say how big that business was. We haven’t broken out nor will we break out their specific revenue in 2006, so I wouldn’t expect in 2007.

Tom Roderick - Thomas Weisel Partners

Okay. That's helpful, Earl. Thank you. And just another question here on the IMG business where you’ve talked about some nice wins and some nice activity with NTL Telewest and NBT, as we've heard some of your competitors talk about challenges with these larger projects going on out there. Can you talk about how you see your projects progressing and what if any additional technology you think might be required to continue to build the IMG business, whether it's getting closer to the network in the OSS layer or adding additional features of the BSS side? If you could just talk about how your customers are progressing and what else they are asking you to --?

Earl Shanks

The short answer is we're really very pleased with the way our implementations are going. We have a lot of experience and a very strong track record of being able to deliver on time and within our own budgets and deliver the kind of functionality that the clients want and that we've committed to. OSS for us is not a big issue. On the other hand as you think about BSS and other related things, the underlying technology that we've developed is sufficiently flexible that it opens up a whole new arena of opportunities as much as we've talked about with some of our new product efforts in CSM for customer service and LTVO to identify and mange higher value customers more effectively. And there are series of those things that we are working on. So in terms of future technology it's not so much driven by short falls or needs that we have to enhance our technology like we -- I think many people regarded us having if not the best among the best technology in the industry, we also have very powerful and flexible rating engines, the ability to scale significantly. So we have addressed most of the underlying functionality issues that Information Management really needs. I think the big opportunity for us is how can we take that technology and turn it into increased opportunities, both within and outside the telecommunications industry. And, we think those opportunities exists and we are prudent about the way we are going about that, but we think there is some exciting things ahead.

Tom Roderick - Thomas Weisel Partners

Okay, maybe just one last short question to build on that answer, would you be looking to build that business through acquisition or are you pretty happy with the organic strategy you have developed so far?

Jim Orr

I think we are happy with our technology and our capabilities and organic growth for us, putting aside the migrations, we think offers a lot of opportunity. Having said that, we also are open to considering acquisitions for technology that further enhances our position or opens up new market for us.

Earl Shanks

If I can do a little addition on that Thomas, I have pretty constantly over the last couple of years been evaluating potential acquisitions in the marketplace, and we will, we are, and we will continue to do that. The challenge in the past couple of years for us is that we haven't seen opportunities that we thought the balance of risk and reward for our shareholders was the right balance given the prices that were out there in the marketplace, but we will continue to look for opportunities where we can get an adequate return for our shareholders with the acquisitions that we will do.

Jim Orr

Yeah, one other point to add on technology which I didn't cover is we are seeing tremendous interest and a great win rate, particularly where clients need mobile services handled through our common systems. So, triple and quadruple play look like competitive advantages for us, and the more of that occurs, we think the more opportunities we'll be faced with.

Tom Roderick - Thomas Weisel Partners

That's great. Thanks so much.

Operator

Your next question comes from the line of James Kissane with Bear Stearns. Please proceed.

James Kissane - Bear Stearns

Thanks. Earl these two things, you'll achieve breakeven in the Employee Care business side late this year?

Earl Shanks

Well, I mean in order to get profitability next year we’ve got to be some place in that range Jim. I haven't done specific forecast for you for this year for those numbers, but certainly that will be a requirement to get to the full year profitability next year.

James Kissane - Bear Stearns

Okay. Because I think last time, you did say breakeven by the end of '07.

Earl Shanks

I need to get to the math of full year profitability to be at some place in that range.

James Kissane - Bear Stearns

Okay. And then, can you just elaborate or be more specific in terms of the challenges around implementation. Is there anything new versus last quarter, I think last quarter some of that had to do with M&A?

Earl Shanks

Well, I think there are always challenges. These are very big implementations and there is a lot to be done and the -- it will be pretty typical in general for our clients not to know even everything that they need to know about an implementation when they walk into it. That's not different than what we were a quarter ago. It's the reality of the business, and it's the message we’ve been trying to deliver to the investment community for really the last year that we know there will be variability here. And, we try to plan for that variability and what we -- what we think about, how we talk about this.

James Kissane - Bear Stearns

Okay. And you have built-in -- at this last quarter, but you have built-in protections in the contract given all these uncertainties?

Earl Shanks

We have some built-in protections in the contract, but that obviously ends up being a relationship issue too and as we have said, what's important with us is we are building partnership relationships with our Employee Care client. And, we -- now over a very long period of time, we and they have to take that perspective to talk about how do -- how do we end up helping them to deliver their business case. And our clients understand that they have to help us end up delivering profitability to our shareholders and that’s really -- that’s really the balance is. This is not so much a contractual conversation. It's a -- how do you deliver the partnership benefits to both side.

James Kissane - Bear Stearns

Okay. If I can get one last question, it seems like this -- from the outside, it seems like the Sprint de-convergence is probably taking a longer than originally anticipated. Is that fair to say from your perspective?

Jim Orr

Well. I think from a cycle standpoint, we never expected to have much impact on 2006. So from that standpoint, I would say no difference at all. In terms of all the details, maybe if some of the details have slipped a bit, but obviously I defer you back to the comments that they are making generally about what they expect to happen in 2007 and if they expect to be done.

James Kissane - Bear Stearns

Okay. Thanks and good job.

Jim Orr

Thank you.

Operator

Your next question comes from the line of Matt McCormack with Friedman Billings Ramsey. Please proceed.

Matt McCormack - Friedman Billings Ramsey

Hi, good morning. The Customer Care division, I think you said was effected 300 basis point spike currency in that, that’s no different than the last few quarters. If I recall that’s mostly the Canadian dollar which has depreciated significantly over the last three months. So, as we look into '07, is it possible that could be a positive factor or since you hedge about a year out is it going to be, if the spot rate stays the same, is there something in '08 that should be a positive factor getting into your 15% target margin or so in the year end?

Earl Shanks

Yeah, great question, Matt. Couple of things to touch on there, there is 390 basis points I referenced is both the currency and the restructuring in the quarter, so it’s a combination of the two and obviously we broken out how much the restructuring you will come back into the numbers that’s not very complicated. As we look at 2007, certainly a -- you are right, the currency recently has gotten better and I am very encouraged by that, but that doesn’t have much impact on 2007. Essentially our 2006 results were in 2005 currency rates because we’d hedged out during 2005, and so the 2007 results will be much more impacted by what the 2006, actual currency rates are. So the upside potential here on currency is baked into the 2008 environment, is where we could start seeing some upside on a year-over-year basis in currency. A little hard to tell it and the truth is it hasn’t moved that much from the average rate we had last year or so in 2006, so it's probably too early to declare victory there, but certainly that's an upside we look at. When we think about getting to our target margins of 15% and how we do that over the next few years, I think the way to get there is largely through the operating improvements along with revenue growth that we've talked about. And that -- we've got a pretty clear plan about what can and needs to be done with the key metrics in the business and how now we have to combine that with revenue growth overall to make that happen.

Matt McCormack - Friedman Billings Ramsey

Okay. And then in terms of labor cost, we have a pending minimum wage increase going to congress, could you talk about if that is going to affect your cost -- the cost sides? And then also longer-term, how do you think that will play out in terms of demand for offshore services?

Earl Shanks

We are paying people in excess of minimum wage now, Matt. So, I don’t expect it to directly impact us. I think the relevant part of the question that you also ask is what will happen in longer-term? You know that may or may not create more wage inflation, you would certainly, it would seem that it likely would and ultimately I think that will probably impact pricing as well in the marketplace. And so that will all probably repel through

Jim Orr

Yeah, I mean if in fact that happens, that affects the cost of those people doing this work in-house which is our biggest market opportunity, and so if their costs go up, it increases the need for them to look at more cost effective and higher value alternatives and that I think may play to our strength.

Matt McCormack - Friedman Billings Ramsey

Okay. And then just lastly real quick, what’s the tax rate we should be using for '07 and then also just could you talk about CapEx?

Earl Shanks

Sure, I would be happy too. We would – I would generally expect that we should have a rate above 35% although I will highlight to you we continue to work tax line like every thing else, so we'll continue just to see if we can improve that, and with CapEx we expect something in the 4% to 5% range.

Matt McCormack - Friedman Billings Ramsey

Great. Thank you so much.

Operator

Your next question comes from the line Brandon Dobell with Credit Suisse. Please proceed.

Brandon Dobell - Credit Suisse

Hi thanks. At the offset you’ve been talked a little bit about the momentum in the in-house contact center market, where would we see that show up or when will we see it show up in terms of it having enough scales up to?

Jim Orr

Brandon, are you using those speaker phones.

Brandon Dobell - Credit Suisse

No.

Jim Orr

Okay. You are breaking up a little bit. We are having hard time hearing you.

Brandon Dobell - Credit Suisse

Sorry, amongst one of those headset issues that I have, it was -- questions were on contact centers-- in-house contact center opportunity where should we see that show-up? What would the relative profitability look like? And what kind of timeframe do you think we should have in mind for that making an impact to the CMG business?

Jim Orr

Brandon, as we've talked about that, the key impact of that is to solidify our kind of market leading position and thought leadership position with our customers and so while we will have incremental revenue impact across the verticals that we report, it will not -- I don't expect it to be the key revenue driver directly. So, we won't go report in professional services dollars and then certainly what it's going to become. But the key is we will grow that business and then the ripple effect on the other business as we get out of it, the Live Asian business is in example. We think we will be substantial. And so, it’s a more of ripple effect impact that we are looking for.

Earl Shanks

But to be clear, we expect that business to be profitable and the margins should be as higher as our overall Customer Care margins.

Jim Orr

Right and that’s actually to one of the earlier questions, that's one of things that will also help us to get more towards 15% margins.

Brandon Dobell - Credit Suisse

Okay. And then if you look at capacity additions, let's call it 20%, 25% the past 12 months and not a whole lot of change in operating margin. I realize that the currency had an impact there. If we are going to compare what overall utilization or utilization momentum would look like right now heading into '07, how would that kind of feel relative to the last six or nine months, with a lot of that capacity added in, well in advance of contracts, it is for existing customers who are building up programs. Just trying to get a sense for when that inflection point on the utilization, especially the last kind of three or four months or so would start to show up?

Earl Shanks

I think Brandon, if you look at our capacity additions, well, we added some capacity in '06 -- for '06 that was pretty limited in terms of what we did. The capacity additions we've been working on now for the last several months have been primarily capacity additions for '07 and ultimately for '08 because that's how it's rolls on.

Jim Orr

Right.

Earl Shanks

So, we are in a sense early in the capacity addition cycle for the '07,'08 timeframe at this point.

Brandon Dobell - Credit Suisse

Okay and then finally got a two housekeeping questions. You mentioned 4% to 5% of sales for CapEx, any color on how we would break that out between the different segments? And then you also mentioned deferred charges not up that much in the fourth quarter. How should we think about that as a cash flow impact in '07? Thanks.

Earl Shanks

Sure. We don’t as you know do specific forecast by business unit that we publish externally around the CapEx expenditure. We are certainly spending to grow capacity in the Customer Care business and so that will certainly be important in that space. As to IM, in Information Management where that really depends more on the specific needs of the technology in the point in time that we need to do it and Employee Care is pretty low terms of capital spending broadly.

Brandon Dobell - Credit Suisse

Okay.

Earl Shanks

And then in terms of deferred charges, we will continue to be doing implementations in '07 just as we were in '06. Obviously, we are not done with all of the implementations. So, we will continue to see reasonably significant deferred charges again in '07.

Jim Orr

And one thing, just to be clear, the capacity that we have added was to meet existing demand, not in an anticipation of future demand. And when Earl talked and I talked about adding more capacity in 2007 that again will likely be driven by existing demand as opposed to [abetting on the come]. So, just to be clear about, why we continue to feel very bullish about our Customer Care business both in terms of revenue growth and margin improvement.

Brandon Dobell - Credit Suisse

Great. Thanks.

Operator

Your next question comes from the line of Jeff Nevins with First Analysis. Please proceed.

Jeff Nevins - First Analysis

Good morning. Just kind of a two broader questions. Do you with the AT&T-BellSouth merger, its look like it's been improving going through. Do you see that impacting your business? And one of the questions I had was there was several thousand jobs that are suppose to be brought back to the States as part of the merger, I didn’t know if that effected you at all?

Earl Shanks

Well, in a simplest from, it's going to effect our reporting a little bit because we are going to have to -- we no longer are going to show Cingular as our largest client, we are going to show AT&T as our largest client and then it will be a little bigger obviously than Cingular was. We view it marginally as an opportunity. We have relationships across the different parts of the organization and have been delivering value across some of the different parts of the organization and some of the people movements that we have seen so far and in terms of the relationships, we think our movement step will help us overtime. So we are encouraged by that. But as with all our clients we have to everyday go out and win the business and provide them value.

Jeff Nevins - First Analysis

Okay. I think, Jim in our opening comments or one of you in the openings comments had mentioned the Taiwan earthquake. Did that affect your Customer Care to the negative in the fourth quarter at all?

Jim Orr

It did, but our ability to recover minimized the impact and I guess for us while you never like to see those happen. The fact that we are able to respond so quickly enabled us to deliver the kind of service that our clients have come to expect from us. So, we certainly feel good about our ability to respond to that, but it did have an impact although relatively small.

Jeff Nevins - First Analysis

Okay. And then the other question I had was, you had acquired at least by a separate news group the AOL Call Center. Was that something that closed in the fourth quarter or was that in the first quarter?

Earl Shanks

That's closed here at the end of the year and -- but the reality wouldn’t have had any impact on revenue in the numbers at all. That’s simply an example of how we are adding capacity and happened to be a fairly efficient way for us to add capacity both from a capital and the ramp time, which is why we did it.

Jeff Nevins - First Analysis

And Earl was that a number that will be in the filings in terms of what you paid for that?

Earl Shanks

I think its too small to show up there.

Jeff Nevins - First Analysis

Okay. Last question is, it looks like your number of agents based on the numbers you have given us, that you have in Customer Care is around 70 or 71,000 agents, do you know or do you have the number from the year-ago period?

Earl Shanks

Yeah, but not right at my fingertip.

Jeff Nevins - First Analysis

Okay.

Earl Shanks

Those are not numbers that we generally publish. The only two we published are the -- well, I mean in terms of the percentage, I think last year we were at 16,000 and it was about 25% at the time as I recall.

Jeff Nevins - First Analysis

Okay.

Earl Shanks

But I don’t remember it exactly. Those were the numbers we published. We were at 16,100 last year in terms of the employees in the fourth quarter, and I think it represented about 25% of our customer care workforce, although I have to go back and check.

Jeff Nevins - First Analysis

And is it wrong to imply that that may indicate you have anywhere from 40 to 45,000 seats in that whole group worldwide?

Earl Shanks

We don’t publish number seats externally, so I won't comment on that.

Jeff Nevins - First Analysis

Alright, thank you.

Operator

Your next comes from the line of Jason Kupferberg with UBS, please proceed.

Jason Kupferberg - UBS

Thanks. Just a clarification to start guys, is '06 full-year revenue growth in the Customer Care business was about 10%, correct?

Earl Shanks

Yes.

Jason Kupferberg - UBS

And you guys are expecting about 10% again in 07, if I heard you correctly?

Earl Shanks

Yeah, something broadly in that range Jason. I don't -- we didn’t provide a specific number on '07, but certainly we're going to continue to see the same kinds of trends in '07 that we saw in '06.

Jason Kupferberg – UBS

Okay. And I wanted to just drill down onto the DuPont employee care contract a little bit since it is your largest, can you talk about some of the milestones you’re looking forward to there in ’07?

Earl Shanks

Yes, I mean, Jason, there is a whole -- there is a whole multi-page list of milestones on any of the implementations that we work through. There is a whole series of them, and this contract because of its nature is broken up into more different pieces, so there is not the same kind of pipelines necessarily that you would see in smaller contracts. Just because of the scale of it, I'm not sure exactly what you are looking for, but it's a bit hard to answer.

Jason Kupferberg - UBS

Well, I am just trying to get a sense of -- like you've talked on some of the other implementations about going live in different regions and then, when revenue recognition might accelerate and all that color is great and you have given some of that on DuPont historically, so I am just wondering what we should look for? I think full implementation is now scheduled to be completed in '08, so what are some of the major highlights that you guys are looking to achieve in '07?

Jim Orr

Yeah, I mean, some of the key milestones do point around revenue recognition in DuPont for this year are not till later in the year, not till the second half of the year. So, we won't -- from a revenue standpoint, I don't expect to see huge ramps in the near term with DuPont because that will be more second half kind of stuff.

Earl Shanks

Let me clear the two of the things that will happen and you should expect to see happen in the next 18 months, are continuing growth on the services provided in the places where we already provide service like the US and certain Western European countries, as well as continued geographic expansion as we rollout new countries and new regions with the full range of services. So, it's a little hard to be very precise because there are a whole series of pieces here. And in some cases, priorities can change a little bit and some things will move up and some things will move back, but clearly we have significant geographic expansion still to rollout beyond where we are as well as additional services around the globe.

Jason Kupferberg - UBS

Okay, that color is great, and just one more question on Employee Care, can you talk a little bit about, what the pipeline kind of looks like, your comfort level in terms of taking more implementations and along with that, just kind of where you see the mindset of the HR BPO buyer, are prospective customers comfortable committing to large scale global comprehensive HR BPO type contracts, or are you seeing a tendency more towards a modest initiatives that might be broken up into smaller pieces?

Jim Orr

I think in overall terms what we see are larger companies and more global implementations being the primary opportunity. The fact that so many large companies have already started down this road, I think it's a demonstration of the critical need the corporations have for better systems, better processes, more cost-effective solutions to serve their employees and that is playing to strength that we have. And so, I think we said earlier, we are also going to be very selective. If this is driven too much by price and not enough by relationship -- long-term relationship, value-added services, then we don't think that will be in the best interest of shareholders to pursue this kinds of deals. On the other hand, I would say if you said the mindset of the buyer, I think what we are seeing is increasing sophistication among the large companies who are trying to evaluate what they should do and recognizing that the really answer is getting the best solution, and we think that is very encouraging for us because it means you can create a true partnership, which offers value to both sides. I think the other thing that I would say is the fact that we can in fact provide a global solution. We think it's really appealing to many of the largest corporations because they are looking for one answer not multiple answers around the globe. And I think as I said earlier, with regard to the implementations, certainly these are big and complex and challenging as Earl said. On the other hand, the fact that we are gaining so much experience every new contract and every new situation we have, we have a better base of learning to apply to that, and so our institutional knowledge and experience is becoming a real help and a real advantage as we look out and pursue some of these very large opportunity. So, we again are without challenges and don’t under estimate the complexity and the difficulty of implementing these things. On the other hand, I think we are increasingly becoming better and more skilled at doing that and that’s why we believe so strongly in the long-term potential of the business

Earl Shanks

Operator, there is time for just one more question.

Operator

Your final question comes from the line of Ashwin Shirvaikar with Citigroup, please proceed.

Ashwin Shirvaikar - Citigroup

Thank you, first of all congratulations on the quarter especially cash flow, a fabulous performance there.

Earl Shanks

Thanks, Ashwin.

Ashwin Shirvaikar - Citigroup

Hey Jim, you can consider that the [tug] on my behalf for Earl’s long-term compensation. With regards to cash flow growth though, do you expect 2007 to be a similar performance and do you expect continued working capital improvements?

Jim Orr

Ashwin, when we look at our overall cash flow the general guidance side given and I continue to believe is that cash flow in general to be in the range of net income perhaps a bit above net income. Obviously, we did a lot better than that both of the last two years, but I continue to believe that’s the right framework if you look at -- if you go into the details of what happened in 2006, what you see is that we were really pretty effective at managing the balance sheet in 2006 and that helped our cash flow pretty significantly. We had improvements in DSO. We had other key balance sheet changes, which helped us, whether or not, those aren't the kind of things you can necessarily repeat every single year, which is why I think the model is net income or net income plus is the right way to think about it.

Ashwin Shirvaikar - Citigroup

Okay. And with regards to the restructuring charge, what’s the benefit from the restructuring charge? And would you expect given the continued expected decline in Information Management, would you expect more restructuring charges to come?

Jim Orr

Well, in terms of the benefits, obviously the restructuring charges, about half of the actual severance costs in the year was devoted to Information Management, so we were doing much more in that. It obviously didn’t show up on that basis. In terms of the benefit, we think of it generally as about a one-year payback something in that range anyway. When it is fully implemented, which means obviously it won’t be -- it's not fully implemented today although we are significantly way through the process. And whether or not, we do another one in IM, I think depends on how the business like goes out and how successful we are with our sales and taking cost down in other ways. The nice thing about the long migration is not that they are good news, but you do have plenty of time to plan for the actions that need to take place over time, and therefore can mitigate the need in some cases to take charges.

Ashwin Shirvaikar - Citigroup

Okay. And last question on HRO, if I may. If you sign say couple large new contracts, what happens to your profitability estimates?

Jim Orr

The new contracts don’t impact profitability in the short run.

Ashwin Shirvaikar - Citigroup

Sorry, you broke up there --

Jim Orr

New contracts do not impact profitability in the short run.

Ashwin Shirvaikar - Citigroup

Well, I guess, don’t you have to invest in those new contracts?

Jim Orr

But generally, the cost and the investment, the implementation costs would go on the balance sheet which is the deferred charges we are taking every quarter. So, that's why I don’t see short-term profitability impact.

Earl Shanks

But, Ashwin, to be clear as we've said in the past, the key to long-term profitability in the Employee Care business is achieving the scale that we think we're capable of achieving. So, we've made investments that we think will pay out with increased revenues. So, in the end over any period of time, new contracts and added volume is going to make the path easier to profitability and margins long-term that we’re targeting. So, I think if you would have to look at that in general, your conclusion would be, as we win significant new contracts, we'd moved closer to the certainty of providing the kind of return to shareholders that we believe is possible.

Ashwin Shirvaikar - Citigroup

Got it. Thank you.

Jim Orr

Thank you. I’d like to add that Earl and I will be available the remainder of the day to answer any questions about our fourth quarter results or the forward guidance that we’ve discussed on the call. But at this time, I just want to thank you all for participating today and have a good morning.

Operator

Ladies and gentlemen this concludes the presentation. You may now disconnect. Thank you and have a good day.

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