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Electronic Data Systems Corporation (NASDAQ:EDS)

Q4 2006 Earnings Call

February 7, 2007 5:00 pm ET

Executives

Allen Hamood - VP of IR

Mike Jordan - Chairman and CEO

Ron Rittenmeyer - President and COO

Ron Vargo - CFO

Analysts

Rod Bourgeois - Bernstein

George Price - Stifel Nicolaus

Greg Wilson - Banc of America Securities

Bryan Keane - Prudential

Greg Smith - Merrill Lynch

Adam Frisch - UBS

Joseph Vafi - Jefferies & Co.

Jim Kissane - Bear Stearns

David Grossman - Thomas Wiesel Partners

Julio Quinteros - Goldman Sachs

TRANSCRIPT SPONSOR
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Operator

Good afternoon, and welcome to the EDS Fourth Quarter and Full Year 2006 Earnings Call. At this time, I would like to inform all participants to be on a listen-only mode until the question-and-answer session of today's program. Also, the call is being recorded. If you have any objections, you may disconnect.

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

Allen Hamood

Thank you very much, Mike. I would like to welcome all of you to our fourth quarter and full year 2006 earnings call. With me today on the call are Chairman and CEO, Mike Jordan; Chief Operating Officer, Ron Rittenmeyer; and Chief Financial Officer, Ron Vargo. Additionally, we have Dave Kost with us as well who will be joining me Investor Relations -- in running the Investor Relations team, subsequent to March 1st.

You should have received an e-mail from me, a copy of our press release as well as the presentations to be read on today's call. I'd like to remind all of you those presentations are available on our website and will be archived there over the next 30 days.

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

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

The format for the presentations will change slightly where Mike will give an overview and then our President and COO, Ron Rittenmeyer, will give a discussion on growth and some of our productivity initiatives, and then our CFO, Ron Vargo will talk about the financials. We will then wrap it up and open it up for Q&A.

With that, I'll turn it over to Mike.

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Mike Jordan

Thank you, and good afternoon. It's actually a pleasure for me to open this call with concluding that it is the best quarter that we have had at EDS since I joined, almost four years ago. We finished the year very strong in both productivity and growth and that momentum will carry forward into 2007 and help us meet the guidance that we have laid out to you, $1.60 a share, which is right on the guidance what we've been saying for over the last year or more.

So without further due, let me turn it over to Ron Rittenmeyer, who will take you through the specifics of our accomplishments.

Ron Rittenmeyer

Thanks, Mike, and good afternoon. Let me take you first through some of our 2006 key growth highlights and then I'll turn to the key investment and productivity related initiatives that we achieved during 2006.

So, if you please turn to slide 4. 2006 was a very strong year of signings. We finished the year with $26.5 billion. Our full year signings were up 32% over 2005. Our strategy offering solutions and commitments to service excellence are resonating, and they are resonating not only with new, but existing clients as well. And I think that's evidenced by our backup and our improved new logo trend.

This point is best illustrated when you look at the chart on the left side. It shows our buildup -- our building backlog chart. As you can see, since the fourth quarter of 2005 our book-to-bill ratio has been greater than one on a trailing 12 months basis. We continue this trend in the fourth quarter with strong signings. Fourth quarter totaled $7.6 billion, which was up 43% over prior year. This increasing backlog provides us with the foundation for growth as we launch into 2007.

On the right side of the chart, it illustrates the increased level of bookings from new logos. For us it was a 70% improvement in 2006 versus last year and I think you already know many of the premier names such as Kraft, Vodafone, Fondiaria and Cardinal Health are some examples.

You should also be noted that within this 2006 deal mix, we signed 26 contracts with TCV greater than $100 million, clearly more volume than in previous years. So, net-net, we are driving market share gains from both new and existing clients, and we are building our backlog through the selective pursuit of quality client transactions.

Slide 5. As I mentioned, total contract signings during the quarter were $7.6 billion, 43% from the $5.3 billion versus the fourth quarter of 2005. Significant signings in the quarter included contracts with the MoD; we signed $1.3 billion in total contract value for Increment 2 of the Defense Information Infrastructure contract or what we call DII.

Vodafone is a new logo, which expands our applications format. This was an important win for us for two reasons. First, the client recognized the importance of our global scale and reach, along with the depth of our applications experience both onshore and offshore. Second, we were able to leverage our investment in MphasiS and utilize their talent as part of our overall solution. They were clearly a key differentiator in the win.

Fondiaria, Italy's second largest insurance company is another new global logo we signed in December for approximately $463 million. So for the quarter, our signings reflect strong performance in applications driven primarily by the Vodafone win, while the contract add-on's with the UK Ministry of Defense drove strength in EMEA, as well as our government business.

As these growth and signing charts indicate our strong signing performances diversified across the key geographies and industries with a focus on government, financial services and manufacturing. These industries all represent large growing markets with IT demands that are closely aligned with our specific strengths.

Now, let's turn over to Investments. Could we go to slide 6, please? From an investment standpoint, we continue to invest heavily in our workforce reduction programs. We invested approximately $0.14 during the quarter. The focus continues to be a reduction on higher cost locations Europe and the US primarily. And we achieved the 2006 full year goal of 5,000 headcount reductions with 1,700 of those during the fourth quarter.

We continue to focus on optimizing our workforce through strong offshore capabilities. A fact that the end of this year we have approximately 32,000 people and what we consider to be cost advantage location, more than doubling the headcount in the last 12 months. India is a primary beneficiary, as you know, but we continue to migrate workforces to other cost advantage areas in Brazil, Argentina, China and Hungary.

Finally, we continue to focus on reducing our SG&A as a percent of revenue as we improve and streamline our -- what I would call our G&A cost structure, while investing more in our sales resources.

Slide 7. The other area of investment relates to our tools and products that helped us run our business more efficiently at a lower cost. We invested approximately $0.12 in this area during the quarter. Our intention and focus of these investments is to drive standardization and automation within the business model and ultimately to the client base. As you know, we've had three key initiatives, Service Delivery Automation or what we call SDA, Business Management Transformation or BMT project, and our Global Service Network, GSN project.

Let's take a minute on SDA and BMT. We are rolling out the workflow items in these two areas. We completed the implementation of these items at our first two accounts General Motors and the UK Department of Works and Pensions. In 2007, we are going to roll these items out to other targeted large accounts and beyond.

Second the Global Services Network. The implementation rollout of the network backbone is complete, enabling the secure movement of data around the world. And finally, we continue to leverage our strategic acquisitions. MphasiS that we've talked about many times in expansion of our Best Shore capabilities and most recently GEMS, it's a very small but important play for us in the SAP enterprise management market where the 150 SAP true experts located both onshore and offshore. So net, these investments and resources are providing the foundation for the future.

Finally, the results and benefit of these investments is the continued extraction of productivity gains which enabled $1 billion in gross cost savings in 2006. I'm not going to spend much time on these today, however, we'll discuss these key initiatives, as well as sources and uses of productivities at our Security Analyst Meeting in New York on February 20. So all-in-all, from gross to operations and our investment strategies, we continue to make very good progress as evidenced by the strong quarter.

So with that, let me pass it over to Ron Vargo for more details regarding our financial performance. Ron?

Ron Vargo

Great, thanks Ron, and good afternoon. I plan to cover the results for the quarter, and the full year and outlook for 2007. So, let's go onto slide 9.

Total revenues in the quarter were $5.7 billion, up 11% as reported and up 7% on an organic basis. The 7% increase in organic revenues was driven primarily by US Government, continuing theme of strong NMCI contract revenues, in the Americas improvement in select large accounts, and finally, in EMEA, UK Government mega-deal execution.

Our adjusted earnings were $0.47 a share, up 124% versus last year's fourth quarter and reported earnings $0.40 of reconciliation that I'll walk you through in a minute.

Free cash flow, $392 million, up $249 million versus last year, and bookings, as Ron said, were $7.6 billion, a strong finish to the year and up 43% over last year's fourth quarter.

In summary, we achieved solid performance across the board on each of these metrics.

Now, let me provide you with a reconciliation of earnings per share, slide 10 please. On slide 10, a quick reconciliation. GAAP earnings were totaled $0.40 a share and the items included in our GAAP numbers, which we exclude from adjusted earnings are discontinued ops, a $0.02 impact relating to losses associated with discontinued operations and a loss on the divestiture of our European Global Field Services business, which closed in December of last year, that was a $0.05 impact. So, adjusting for these items, adjusted earnings were $0.47, well outside of our guidance of $0.33 to $0.38 a share.

So, let me give you a few reasons why the earnings exceeded guidance. First, revenues are slightly higher than even the high-end of guidance that we provided for the quarter. Second, improved contract execution, pretty much across the board, including the achievement of some key contract milestones in EMEA and elsewhere, slightly lower investment spending of about $0.04, partially due to the sale of the Global Field Services business that reduced the need for severance during the quarter, and about $0.03 to $0.04 relating to an amendment to a customer contract, which I will provide some more color on in the coming slides.

So, let's go to slide 11. Slide 11 is a summary of our income statement and it contains summary level line items adjusted to exclude certain items to get back to the adjusted earnings number. And we provide a walk from the GAAP income statement to this adjusted format in the appendix on slide 26.

Key highlights include revenue up 7%, total operating profit $164 million, year-over-year operating profit improvement as a result of revenue growth, improved operating leverage, achieving the key contract milestones in overall mega-deal performance improvement. This improvement was partially offset by a continuing aggressive level of investments. We invested over $200 million during the quarter and incrementally $70 million or about $0.09 a share over last year's fourth quarter.

The net effect of interest and other and taxes was as follows: Interest and other favorable, do in part to a 2005 write-down on our leverage lease aircraft and higher 2006 interest income. In taxes, while we benefited from the retroactive passing of the R&D tax credit, this benefit was assumed in our guidance and it was more than offset by some other tax valuation allowances and obviously we had higher tax expense due to the higher earnings.

Diluted shares outstanding increased by approximately 18 million year-over-year, and this was due to the inclusion of the 20 million shares associated with our 3-7/8% convertible debt. Excluding that, the share repurchase program offset any other share creep from our compensation programs.

Going forward, we continue to expect the convertible to be included in the full year 2007 share count, but not in the first quarter of 2007. On a full year 2007 weighted average basis, assuming that we complete our $1 billion repurchase program and we have certain expectations for employee-based comp programs, we expect the share count to be in the $545 million area. Again, that includes 20 million shares for the convertible debt. So, clearly, the overall expansion in operating margin and earnings continues to be driven by solid operational results and ongoing business improvement.

With that, let me flip to slide 12, free cash flow. Total free cash flow for the quarter is $392 million. It's a very strong quarter, driven by higher earnings and solid working capital performance, partially offset by more than approximately $130 million in pension plan contributions. And of this $130 million, approximately $90 million was purely discretionary.

Total free cash flow for the year is $887 million and key variances versus 2005 include cash flow from earnings at $91 million, the net income improvement offset by some significant non-cash charges in 2005, including a UK pension charge and some asset write-downs.

Change in working capital, we improved our receivables collection and our DSO improved by two days from year-end 2005. We also had significant accruals, including severance accruals on the books at 2007. Those severance accruals will be funded in 2007. They are on the books at year-end 2006 and we made some large vendor payments in 2005 that we're on the books of 2004.

Capital was higher on both the gross and net basis than last year. Two driving factors; one, we did a large sale in leaseback on real estate last year; and two, we had higher investment programs in 2006 related to our strong bookings in '05 and '06. For the years, our net capital expenditures are about 5% of revenue, consistent with our previous guidance.

One other item to note, during 2006, Verizon made the strategic decision to handle IT system support in-house, including the MCI IT services work that was being managed by EDS. The IT services contract between MCI and EDS included minimum annual purchase obligations that ran through January of 2008. However, it was amended to reflect the change in Verizon's strategy and contemplate a significant reduction in services that we've provided to MCI. In addition, the network agreement under which we procure telecommunications networks services from MCI was also amended to among other things, reduce our minimum annual spend commitment and offer us additional flexibility.

As a result of the contract amendments, EDS transitioned most IT services back to the client in December of 2006 and received $90 million for assets and transition services. The free cash flow impact of this payment was more than offset by $130 million in pension plan contributions during the quarter, including the discretionary 90 million plan contribution that we made to our UK pension plans.

So, net-net, we feel that we had another very solid year of improvement in free cash flow and achieved our guidance while continuing to invest in the business for future growth.

Slide 13 is a summary of some balance sheet movements. I'll just hit a couple of highlights. Cash and marketable securities actually declined by 203 million. The cash flow of 887 was more than offset by 670 million of share repurchases, the acquisition of the majority stake in MphasiS for about $350 million and reduction in debt by $210 million in our dividends.

Accounts receivable increased despite the DSO being two days lower, primarily because of solid revenue growth, foreign currency fluctuations, and inclusion of MphasiS receivables.

And finally, our long-term debt declined by 161 million net to about 3.1 billion at the end of the year and our debt-to-total capital ratio on a book basis ended the year at about 28%.

So, let's go to the full 2006 results on slide 14. For the full year, 21.3 billion in revenue, 8% year-over-year, increased 7% organic, $0.99 adjusted earnings. I’ll walk again in the appendix to get back to GAAP. And free cash flow of 887 million, up 268 million year-over-year. And finally, signings of 26.5, up almost a third year-over-year. So, a very strong year.

Let's go to 2007 guidance. For the full year, we expect the following revenue in the 22 to $22.5 billion range, up about 4%, adjusted EPS of 160, driven by our year-over-year operating margin expansion of 240 basis points to 6.3% margins, free cash flow of 1 to $1.1 billion. Free cash flow will be somewhat pressured by the 2006 severance actions and capital to support the 2006 contract signings. TCV of 23 billion plus, maintaining a book-to-bill ratio -- a continuing book-to-bill ratio of greater than 1.0. And for the first quarter, revenue of 5.1 to 5.3 and earnings of $0.17 to $0.22 per share.

Our formal guidance is consistent with the directional guidance that we have been providing previously. This EPS and free cash flow guidance is not significantly impacted by the change in the scope of the IT services that we provide to MCI-Verizon that I discussed earlier. We will continue to provide a significantly reduced level of services to this client through the end of 2007. However, in addition, related to the contract amendments, we received a payment from Verizon of $225 million in January 2007.

As a result of this payment as well as the services we will continue to provide to Verizon, we do not expect this contract to have a significant financial impact on EDS in 2007 compared to what we would have experienced had the contract continued unchanged through the end of the year. I do want to point out that this payment, which will be reflected out of first quarter for cash flow, is expected to be recognized in our income statement in the first and third quarters of the year, due to certain contingencies in our agreement with Verizon, a little less than half of the payment in quarter one, and a little more than half of the payment in quarter three.

Let's go to slide 16. We provided a similar slide in the third quarter call. This illustrates the progress that we made throughout the year in our margin expansion and breaks it down into the three key components. Looking forward into 2007, we expect the margin to be 6.3%, as I stated earlier, and the improvement will be driven by three key dynamics. First, account contribution margin. We continue to show progression as the benefits from key productivity initiatives and solid performance on mega-deal and new contract start-ups continues. We expect the improvement to continue into '07, as we realize incremental benefits from these initiatives, yielding an account contribution in the 16.5% to 17% range for the year.

Second, SG&A should continue to decrease as a percentage of revenue. We have additional focus and work teed-up for 2007 and expect further reductions in this line item. And finally investments, as we indicated, we expect 2006 to be the peak year for our investments and we expect spending as a percentage of revenue to trend down in 2007. And we expect to manage the dynamics of these three items such that together it will be in the 6.3% area for total net margins. And these are based, as I stated earlier, on an assumption of 4% revenue growth year-over-year.

Operating margin will in turn drive free cash flow. So, finally on slide 17. We have established our free cash flow guidance around the $1 billion to $1.1 billon for 2007. The drivers for the improvement are expressed here as a percentage of revenue, cash from earnings in the 11% to 12% range and improvement driven by the operating margin expansion. Change in working capital should actually be a slight use driven predominantly by growth and payments related to '06 restructuring actions. And net CapEx, a little higher than the 5% historical average but pretty consistent with our trends. So net-net, we expect '07 free cash flow to be in the $1 billion to $1.1 billion area, an improvement of about a $160 million on a year-over-year basis.

So with that, let me pass it back to Mike Jordan to summarize for you.

Mike Jordan

Yeah, let's -- here is sort of the summary of our expectations going into '07. We expect to continue our margin expansion based around the profitable growth we've been booking and on a relentless focus on quality and cost improvements.

We must execute against our 2006 key new contract success, as we have been over the last year-and-a-half, where we have started up flawlessly all of our major accounts. We will continue to invest and expand new product offerings not only in the infrastructure but in applications as well.

I think the major news, which we will talk to you about at the Securities Analyst Meeting on February 20 is that, we do need to shift to a more aggressive growth posture, what we are calling act two, if getting the 7% or 6.3% is after stock-based compensation, is the basic of the turnaround that we need to drive growth. So, we will talk about how we utilize our balance sheet to drive greater future value to expand our presence in key industry segments and who strengthened our capability GAAP as we've done this year. So, a lot of that will be covered in great depth at Securities Analyst Meeting. We hope to see you there.

Allen Hamood

All right. Operator, for those that may have joined during the call, I just want to remind them that we will open the call up for questions. Again, I have Mike Jordan, our Chairman and CEO; Ron Rittenmeyer, our President and Chief Operating Officer; and Ron Vargo, our CFO. Again, as I always ask, please try and limit it to one call per person as we have a fairly sizeable pipeline of people in the queue to talk.

So with that, I'll turn it over to you.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Rod Bourgeois.

Rod Bourgeois - Bernstein

Yes, guys. It's Rod here. I just wanted to talk to you about the growth outlook for 2007. I guess I am wondering whether you're facing somewhat of a trade-off between growth and free cash flow. I am looking at your TCV, your signings target for 2007 at $23 billion plus, which puts you about in line potentially with where you ended up in 2006. So, your signings target doesn't really reflect aggressive sort of bookings targets, although I guess you can call them solid bookings target. And in order to hit your free cash flow guidance, you have to limit CapEx to 5% to 5.5% of sales. So, I guess I am wondering if you go to act two, when you turn on the growth engine. Does that create a trade-off with your free cash flow target? Or do you have a specific plan to be able to turn on the growth engines without sacrificing the free cash flow?

Mike Jordan

Rod, good question. I mean I think a high percentage of our active focus will be in non-infrastructure, non-capital intensive businesses, building our applications business, more Vodafones et cetera, which have much less capital intensity to them. As you will see building somewhere industry segments where we have great strength that are not capital intensive is really going to be sort of center piece, as we try to change significantly our business mix going forward. We like the ITO business. It's been a major growth base for us, getting new contracts, new accounts. We're improving the capital efficiency. We're improving the margin so that we will -- we're in fact now, we will be returning our cost of capital in the infrastructure business with a solid margin. But we know that to really accelerate growth, we are going to have to move more aggressively outside that, so we will talk about that in some detail on the 20th.

Rod Bourgeois - Bernstein

Okay. And just as -- I guess the follow-up to that, in using your balance sheet to drive the growth I assume that means you will be looking at other sort of niche acquisitions?

Mike Jordan

Right, I mean we definitely will be looking at continued bolt-on acquisitions probably at a higher pace than we have been.

Rod Bourgeois - Bernstein

Does the revenue guidance for '07 include acquisitions or is that an organic revenue target?

Mike Jordan

It's organic.

Rod Bourgeois - Bernstein

Okay, thanks guys.

Operator

Our next question comes from George Price with Stifel Nicolaus.

George Price - Stifel Nicolaus

Hi, thanks very much. First of all, Ron Vargo, I wanted to make sure I understood completely what was going on with Verizon, the $227 million payments. So you are going to get that all in cash flow in the first quarter and recognize it half and half in the first and third on the P&L?

Ron Vargo

Just to clarify, we did receive the payment, it was $225 million.

George Price - Stifel Nicolaus

Right.

Ron Vargo

And we said it would be a little less than half in the first quarter, a little more than half in the third quarter. So around the 45%, 55% numbers would be good to use.

George Price - Stifel Nicolaus

Okay, how are we going to see that impact the P&L?

Ron Vargo

Yeah. Well, if you think about it, we signed a major contract amendment with them, affected both our network services contract where they are providing services to us, it affected the IT services contract where we provide services to them. We transitioned the IT services essentially in full at the end of last year and this payment was made in association with that. But there are some contingencies in the agreement. I don't want to go into a lot of detail. But because of those contingencies, we are going to recognize it in the P&L in the first and third quarters of those percentages that I talked about. And as I mentioned earlier, we don't expect the affect of that to have a material impact on EDS compared to what we would have experienced had the contract been in place throughout the year.

George Price - Stifel Nicolaus

Okay. So the associated profit and cash flow it's a timing issue you would have recognized that the same amounts both ways for the full year anyway?

Ron Vargo

Not the material difference between the two.

George Price - Stifel Nicolaus

Okay. And just a follow-up, with the $90 million asset payment that you received in December, you noted the $130 million pension contribution and the $90 million discretionary portion. What was the timing of the $90 million discretionary portion of the pension payment?

Ron Vargo

December.

George Price - Stifel Nicolaus

Okay. Thank you.

Ron Vargo

Yeah.

Operator

Our next question comes from Abhi Gami of Banc of America Securities.

Greg Wilson - Banc of America Securities

Hi Ron, this is [Greg Wilson] calling in for Abhi. I just want to get a sense for how much of your $13 billion of IPO business do you think that you can actually move offshore and to more of a capital-like model? And then as a follow-up, any thoughts on any of the new entrants from India in this space?

Ron Rittenmeyer

Let me see if I understood the question. You say how much could we move -- you are breaking up a little bit?

Greg Wilson - Banc of America Securities

Yes.

Ron Rittenmeyer

How much of the $13 billion we could move offshore?

Greg Wilson - Banc of America Securities

Correct.

Ron Rittenmeyer

While, we have -- we already have, I don't have the specific number for you. But we already have a significant presence in Malaysia, in South America, where we do and shortly in Eastern Europe where we are doing certainly in Malaysia and in Brazil and Argentina, primarily Brazil. We do a significant amount of monitoring and operating of our virtual control center products out of those locations. So India, while we -- we certainly have the ability to add further in India to our base over there. We have some over there already. Malaysia from a price point standpoint tends to be pretty consistent and it's a much more stable environment. Our global network reaches both -- to all of these locations. So, it's not just monitoring that is critical when we talk moving. It's ticket identification, problem resolution, alert management. And so, we are much deeper than just monitoring in these locations. We've got a whole package. And we've been doing it to some level for several years with this last year being really the deployment of the Service Delivery Automation process. So, many of the clients that we take over, we go lights out in the data centers. We take over almost within 30 days, and we begin to monitor them offshore immediately. So, how much more would be move out? I really don't have the specific numbers since a lot of that's client driven. All new clients when they come on board, now though we look at those options and we tend to start at that point. And that tends to give us a favorable advantage from a pricing standpoint as well as a margins standpoint. Your -- second part of your question?

Greg Wilson - Banc of America Securities

Any thoughts on any of the new entrance from India in this space like TATA?

Ron Rittenmeyer

You know, I think that you always should be -- as I've said before, you should always be respectful of your competitors. But quite honestly, I mean monitoring is a -- or IMS the way people try to come up with new names for it. It's a very -- that's kind of one part of the quiver. There is one arrow in the quiver. You've got to kind of have a whole offering to be significant. I think that I am never nervous about competitors, but at this stage, I think we have a pretty solid deep and repeatable offering from more than one location. So, we are not dependent on just one part of the globe.

Mike Jordan

Yeah, let me make another comment on that. We've heard the marketing proposal. Basically in hardware, we end up financing a large percentage of the hardware through our alliance partners. So, that's essentially a capital-light as far as we are concerned. We run a capital-light model on infrastructure. And as Ron said, we have a very, very complete infrastructure management system which includes both onshore and offshore. And so, the hype about monitoring, it's like going in the Toyota, and you say, power windows standard and air conditioning standard, all of that is built into our standard offering, and which is much broader and more complete than anybody else in the industry.

Greg Wilson - Banc of America Securities

Great. Thank you very much.

Operator

Our next question comes from Bryan Keane with Prudential.

Bryan Keane - Prudential

Hi, good afternoon. I just wanted to follow up on the payment from Verizon. The $225 million payment, is that like a one-time cancellation fee for the contract? And is there any work associated with that or is that a 100% margin that will be recognized in the first and third quarters?

Ron Vargo

Yeah, Bryan, Ron Vargo. The contract hasn't technically been terminated, but effectively we've transitioned all of the IT services to them. I mentioned there are some contingencies around the payment of the $225 million, which cause it to be recognized in those two quarters. But essentially, the IT services have been transitioned them, but for a very small percentage of services that we will continue to provide the client through the end of 2007.

Mike Jordan

Let me make an add-on to that. Yes, essentially those contracts -- essentially run -- would have run out anyway at the end of 2007. And so, it is essentially what you say, Bryan. And so, yeah, we are a losing a pretty good contract in 2008. But then, we've lost Inland Revenue and rebuilt our business pretty dramatically in the UK. So, that's a very sort of game you win, some you lose, and we win more than we lose. So, we've been down this track before.

Bryan Keane - Prudential

You had a good year of bookings that will fill the gap.

Mike Jordan

Yeah, that will help, yeah.

Bryan Keane - Prudential

But the margin you'll recognize, just to make sure, Ron, it sounds like it's a pretty much though. It will be transition services, but it sounds like it's going to be pretty much just profit. Just want to be clear on that.

Ron Vargo

Yeah, I think about it that way.

Bryan Keane - Prudential

Okay. And then just lastly, bookings obviously you are talking about $23 billion plus. Just can you talk about the market going forward? Is that more -- do you see the pipeline in ITO and BPO and Apps any different kind of from where we've seen in the last 12 months or do you still see a pretty robust environment?

Ron Rittenmeyer

This is Ron Rittenmeyer. I would say that from our pipeline perspective, we are very comfortable. It's a good marketplace. Lot of competitions as we all know. But I think we're pretty disciplined in our deal qualification process. And from our standpoint, we've set our targets and we feel pretty comfortable with it.

Bryan Keane - Prudential

Okay, great. Solid quarter.

Ron Rittenmeyer

All right. Thank you.

Operator

Our next question comes from Greg Smith with Merrill Lynch.

Greg Smith - Merrill Lynch

Yeah. Hi, guys. Regarding the investments that you continue to sort of call out at each quarter. The fact that you are calling out those at least implies to me that those will eventually fade. Can we start to get excited about 2008 as those investments roll off? Is that a fair way of thinking about things at this point?

Ron Vargo

I'll start and then I think Mike will probably follow-up. And I'd start by saying part of what we've called investments has been severance in some of the bestshoring expense, as we're bestshoring a number of positions in '06 and '07. There will be continued spending related to both severance and bestshoring for the foreseeable future. Whether we continue to call them out as separate investments or not, I think we'll probably start just talking about those as part of our ongoing cost, as they get down to a more of a steady-state level. And the investments that we have been making associated with investing in technology, building out the network, new tools, and processes and so on. Again, I think, those peaked, but we will continue to invest in tools and processes and technologies at lower levels than we have in some of the peak years.

Mike Jordan

Yeah, a little color around that. For last -- the 2005 and '06 were very heavy investments in our infrastructure tools and our network, because our infrastructure business was sort of largest one and the one where we saw an opportunity to gain that competitive advantage, which we think we have. In '07, a lot of that spending will migrate to the application side, where we're strengthening our tools and processes and building up high-end practices like SAP and PLM and so forth. And so those, as Ron says, yeah, we really peaked in '06. We will always have a steady-state investment, but probably won't call them out as such, because these were more or loss across the board. The future investments beyond '07 will tend to be specific to specific businesses or industries. So, those will be included as sort of business or marketing investment.

Greg Smith - Merrill Lynch

Okay. And then just quickly, that was very helpful, thank you. Just on the acquisition outlook, you mentioned tuck-in acquisitions, but it clearly seems like the balance sheet now teed-up to maybe do something bigger, I am not sure how you are defining tuck-in, but is there any chance we might see sort of a full larger acquisition out of EDS over the next 12 months.

Mike Jordan

Depends on what you mean by larger but--

Greg Smith - Merrill Lynch

North of 1 billion.

Mike Jordan

North of 1 billion? I mean, there is some possibility. We are looking at lot of different sectors, where we participate in and we want to grow. We'll talk about -- some about this in the 20th, some of those sectors, but there are opportunities to acquire larger companies in some of these areas and we'll do, it makes sense. So, we don’t want to take a lot of dilution. We measure dilution in sort of cash flow per share rather than pure EPS. So, that’s -- but we will talk more about that in February.

Greg Smith - Merrill Lynch

Okay. Thank you very much.

Operator

Our next question comes from Adam Frisch with UBS.

Adam Frisch - UBS

Thanks. Good afternoon guys. Before I begin my questions, I just wanted to say congratulations to Allen, good luck in your new role there. I just want to clarify this because it's a pretty big deal that we are going to. I know a lot of people talked about the Verizon contracts. It’s sort of hard bottom, but the $90 million from Verizon in the fourth quarter, that was included on the P&L as well, correct?

Ron Vargo

It's Ron again, Adam. A portion of that sell-through to the bottom-line, a significant portion did. There were transition costs that we had to bear. There were fixed assets that we transferred, but a significant amount of the $90 million did fall through to the bottom-line. We had anticipated a number in the fourth quarter and the number that actually fell through to the bottom-line was about $0.03 or $0.04 more than what we had anticipated, because we did such a great job on the transition side of it.

Adam Frisch - UBS

Okay, but if I just -- tax effect of $90 million, that’s almost a dime to EPS in the quarter, maybe there is a few pennies below that. Is that the right way to think about it?

Ron Vargo

No, I don’t think it’s a right way to think about it, because I think that, as I mentioned, there were costs associated with transitioning that we bore, and there were assets that we transferred in that 90 million, covered both of those, and the net fell through to the bottom-line.

Adam Frisch - UBS

Okay. And then, should I assume just in continuing that thought process that the 6.3% operating margin target for '07 includes the margin from the $225 million, which I guess is an effect of termination payment or whatever?

Ron Vargo

Yeah. I wouldn’t call it a termination payment, but it is a significant contract amendment payment.

Adam Frisch - UBS

Okay.

Ron Vargo

What I have said a couple of times, and just to be clear, is that it does get counted in the margin, and what we've said was as we provided guidance around 2007, we do not expect that this contract result will impact the margin guidance that we gave in the past. And so, we are holding the 6.3. The 6.3 that we provided last year included the operating performance of the contract, as if it had stayed in through 2007.

Adam Frisch - UBS

But now in 2007, at that 6.3% includes the proceeds from the $225 million payment or amendment, I guess correct? I just want to be clear on that because 6.3% was coming from continuing operations in the business, it's a different story than 6.3 coming with a significant chunk from what this amended payment is?

Ron Vargo

I don’t think -- I understand the logic. But -- I mean the revenue difference is not significant in a $22 billion company, so…

Adam Frisch - UBS

Not the revenue I'm talking about, it's the margin. May be I should just…

Ron Vargo

But Adam the margin dollars is exactly the same -- roughly the same. So…

Adam Frisch - UBS

Okay, I got. Maybe I'll call you guys after the call because also you should carry this over to the free cash flow aspect of it and that would be 23% of your free cash flow guidance for the year. I'll follow up with you on that. I just wanted to ask, also there was a negative report from GAO on the NMCI program talking about the program isn't fulfilling certain things or whatever. One side of the story, you guys haven't had a chance in a public forum to respond to that. So, would you mind commenting on how the NMCI program is going in terms of rollouts and user satisfaction levels and all that kind of stuff?

Ron Vargo

Sure, I mean the GAO report focus solely on the qualitative aspects of user satisfaction and was pretty well refuted by the Navy. We have not gone public, but we support the Navy's position. This is anybody who takes freedom away from somebody. They do exactly what they want in the interest of security is not going to -- they are not going to be happy and that was a basic, as I recall, the basic trust of the GAO reports. So, in our mind, that was not a significant issue and I think our customer, the Navy has pretty much [bloom by it].

Adam Frisch - UBS

Okay. Final question, first quarter guidance a little weaker than consensus, obviously things come and go in different quarters of the year. But is it safe to assume that the third quarter -- I guess what I am wondering is why is first quarter low if you are benefiting from that Verizon stuff in the first and third quarter, how should we think about the year there?

Ron Vargo

Yeah, I will talk about that. I think it's primarily the seasonality in the business where the first quarter is always the weakest. If you go back to last year, we earned six pennies in 2006 first quarter, about 6% of full year number.

Adam Frisch - UBS

Right.

Ron Vargo

Lot of reasons for that, volume drop from a strong fourth quarter traditionally, pricing resets, productivity not yet kind of taking hold, compensation up in the quarter usually from compensation actions. So, I think it's just following kind of past seasonality trends.

Adam Frisch - UBS

Okay. Thank you.

Ron Vargo

Yeah.

Operator

Our next question comes from Joseph Vafi with Jefferies & Co.

Joseph Vafi - Jefferies & Co.

Hi gentleman, good results here this afternoon. I was wondering if we could talk a little bit on the gross margin for 2007? Ron, I know in some of your slides, you talked about reductions enforced during the year and some addition you gained on the gross margin side. And you've given us some color here on operating margin for '07. Anything on the gross margin side that these -- that the efficiency gains there might -- or in order of magnitude, I guess in terms of gross margin improvement will be helpful?

Ron Vargo

Yeah, I mean if you're referring to slide 16 in the deck, I think what we've shown is, account contribution margins kind of going up by about 1% or 1.5% on a year-over-year basis. And it's everything. It's a productivity improvement. It's the impact from the investments that we've made in 2006. It's competitive pressures and pricing and some of the contracts that will depress some of the earnings in 2007. So on a net basis, we feel good about the ability to expand margins. But there is just a lot of competitive pressure and pricing pressure I think that prevents them from going up further.

Joseph Vafi - Jefferies & Co.

Okay. And then, maybe just one housekeeping question on tax rate you expect for '07 and preliminarily for '08.

Ron Vargo

Yeah, probably not too far from where we've been traditionally in the 34% kind of area for '07, and kind of 34% to 35% probably for '08.

Joseph Vafi - Jefferies & Co.

All right. Thank you.

Operator

Our next question comes from Jim Kissane with Bear Stearns.

Jim Kissane - Bear Stearns

Thanks. Ron Vargo, can you quantify the milestone payments that you recognized in the fourth quarter, I think on some Asian contracts?

Ron Vargo

Jim, the short answer is no. We have -- in the fourth quarter we had a number of contracts as we do in any quarter that have quarterly milestone achievements. I think we probably had an extraordinarily high number of them in both EMEA as I mentioned as well as other locations. So, we really usually don't get into any specific contract information.

Jim Kissane - Bear Stearns

I mean, you flagged them, so I just thought may be they were more material than normal?

Ron Vargo

No. I just think it was a driver behind the strong quarter.

Mike Jordan

No, its one of the things you have to note is when we talked about first quarter and fourth quarter, our business is highly seasonal, partly because price reductions usually get implemented on January 1, price concessions or contractual concessions and productivity and then contract milestones build up during the year. So it skews, it gives us a very significant first quarter to fourth profits skew. So, it's very unusual just by the nature of our business but these milestone payments will probably increase as we do -- as we grow our applications business and our applications development business more strongly. Not this year, this was the first year. We have really grown our applications revenue. Am I right Ron?

Ron Vargo

Yeah.

Mike Jordan

And so, we actually had a -- we have been sort of drifting off slightly for the last three or four years and we really turned that around this year. So, we didn't mention that and -- so we can expect to see a little more of this. But that's fair because this is higher margin lower capital business.

Jim Kissane - Bear Stearns

I don't want to harp on the Verizon payment. Was that contract going through '07 or was it going through '08?

Ron Vargo

07.

Mike Jordan

07.

Ron Rittenmeyer

Through '07, with just a little bit of continuation into the January of '08?

Jim Kissane - Bear Stearns

So you would have received on the revenue that you are going to generate $225 million of profit?

Mike Jordan

More or less. Yeah, pretty close.

Jim Kissane - Bear Stearns

Thank you.

Operator

Our next question comes from David Grossman with Thomas Wiesel Partners.

David Grossman - Thomas Wiesel Partners

Thanks. It seems like you have been able in the last couple of years and projected in '07 to generate free cash flow well in excess of your net income and just looking back at the envelope at G&A and CapEx, it seems to be coming from working capital gains. Can you give us a sense for how much more there is to be gained after '07 from working capital and how we should think about that on a more of a secular basis when you are comparing free cash flow to net income?

Ron Vargo

Yeah. I'll just give you a real summary sense of where I am and then you can maybe follow up later, but if you think about the impact stock options in PRSU expense in the $0.22 to $0.24 per share range. That's an add to our reported EPS to get the cash flow. And that's probably half or more the difference between what we are guiding to in EPS versus kind of free cash flow per share in 2007. Working capital can be volatile. We probably still have a little bit of room that we can improve our receivables. But I think if you start getting out in '08 and beyond those two numbers free cash flow per share and EPS per share probably are to start converging more tightly?

Mike Jordan

I mean the difference between capital expenditure and depreciation is always an issue, but I don't know anybody in modern business that spends their depreciation and capital on the business if they get the depreciation, and as you are always looking for ways to minimize your capital spending and become, as we say, we take over a contract with 10,000 servers, we are obliged to refresh them. By the time we refresh them, we got them down to 4,000. So those are the kinds of things we try to do to minimize the capital intensity of our business which will contribute, I think always contribute to a positive depreciation to CapEx number.

David Grossman - Thomas Wiesel Partners

And just on that context, is it an easy decision to determine whether to -- bringing a third party to sacrifice the interest spread and send it to a third party versus keeping it on your own balance sheet or is it becoming increasingly easy to make that decision of the tradeoff between the interest income and carrying the CapEx?

Ron Vargo

I think in general as we start thinking more of about a return on invested capital basis, it's probably easier to let somebody else finance it, particularly if we're not able to get sufficient return by financing it ourselves.

David Grossman - Thomas Wiesel Partners

Great, thank you very much.

Allen Hamood

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

Operator

Our last question comes from Julio Quinteros with Goldman Sachs.

Julio Quinteros - Goldman Sachs

Hey guys sorry. Real quickly on the percentage of the deals that have -- you've been awarded this year and as you kind of look at the pipeline. Can you give us a sense on what percentage actually comes from the leveraging the global delivery network?

Ron Rittenmeyer

In terms of what percentage of deals comes from leveraging it? Most of our deals -- well, I don't have a really specific number. When you look at the mega-deals that we did, we four deals over billion. Those four deals clearly -- of those four deals two of them were global, two were not. But then of the remaining 26 deals that were over 100 million each, I would say probably 50% to 60% of those had a global or more than one country involvement. So from a delivery network, we deliver a lot of deals, even say for example, we deliver stuff in the US to customers from offshore locations. So, I would say that except for government -- specific government contracts, almost every deal leverages the global network, and the global delivery process that we use. So, outside a government, which tends to be pretty specific to the country and to a state you are in, it pretty much is every other deal gets some involvement either from a monitoring standpoint, problem and solution standpoint etcetera, depending on where we think the best and the best price point assets are.

Julio Quinteros - Goldman Sachs

Okay. And then related to that, working with MphasiS and going into market together, how many deals have you guys actually been able to pull in on the joint basis?

Ron Rittenmeyer

It's hard to say that -- again, that's not a number that I have in front of me. It's fair to say that MphasiS is making part of probably a majority of our deals. And so, we tend to go to market with them pretty commonly, really. But I don't have a specific number, but they are fairly active in our process.

Julio Quinteros - Goldman Sachs

Okay. And then finally, on the just to go back to the impact of the Verizon and the free cash flow, et cetera. If we were to take that out of the results just to understand in 2007, would the 6.3 and the $1 billion have still been achieved? I think -- and this is more -- I think I am still a bit confused in terms of what the results included prior and what we are expecting now. So, if you were to strip that out completely from '07, which is still have be on target for the previous 6.3 operating margin and free cash flow targets?

Ron Vargo

Yeah. I think what we said was, if we had maintained the contract in place at its levels that we were running at in 2006, we would have achieved our targets for 2007, that’s right.

Mike Jordan

I think you have to realize that this was a trade-off negotiation. We got something forward in terms of increased flexibility, in terms of telecommunications, purchases and they wanted to bring the stuff in house, and they paid essentially the freight to bring it in house. So, it was worth our while to terminate the contract early.

Julio Quinteros - Goldman Sachs

Okay. Thank you.

Allen Hamood

All right, I want to remind everyone that we will be holding our 2007 Securities Analyst Meeting in New York on February 20th. Please be sure to call my office to register, if you have not already done so.

With that operator, I would like to thank everyone for joining us today. I know there are few questions still in our queue. Please feel free to call my office and we'll be glad to get back to you and talk to you then. Thank you so much. Bye.

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