Niels Christensen -
Janet Haugen - Chief Financial Officer and Senior Vice President
J. Coleman - Chairman of the Board, Chief Executive Officer and Member of Finance Committee
Joseph Vafi - Jefferies & Company, Inc.
Ned Davis - Wm Smith & Co.
Unisys (UIS) Q2 2011 Earnings Call July 25, 2011 5:30 PM ET
Good day, and welcome to the Unisys Second Quarter 2011 Results Conference Call. At this time, I'd like to turn the conference over to Mr. Niels Christensen, Vice President of Investor Relations at Unisys Corporation. Please go ahead, sir.
Thank you, operator. Good afternoon, everyone, and thank you for joining us. Earlier today, Unisys released its second quarter 2011 financial results. With us this afternoon to discuss our results are Ed Coleman, our CEO; and Janet Haugen, our CFO. Before we begin, I wanted to cover a few housekeeping details. First, today's conference call and the Q&A session are being webcast via the Unisys investor website. Second, you can find the earnings press release and the presentation slides that we will be using this afternoon to guide our discussion on our investor website. These materials are available for viewing, as well as downloading and printing. Third, today's presentation, which is complementary to the earnings press release, includes non-GAAP financial measures. These have been provided in an effort to give investors additional information. The non-GAAP measures have been reconciled to the related GAAP measures and we have provided reconciliation charts at the end of the presentation. Finally, I'd like to remind you that all forward looking statements made during this conference call are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. These factors are discussed more fully in the earnings release and in the company's SEC filings. Copies of these SEC reports are available from the SEC and from the Unisys investor website. Now I'd like to turn the call over to Ed.
Thanks, Niels. Hello, everyone. Thank you for joining us today to discuss our second quarter 2011 financial results. Please turn to Slide 1 to begin our discussion. As you saw in our earnings release, we reported a net loss in the quarter driven by the previously announced debt reduction charge. On a non-GAAP basis, diluted earnings per share were $0.93 and we generated adjusted EBITDA of $106 million. We made progress in the second quarter toward our 3-year financial goals, despite continued weakness in the U.S. Federal Government market and lower revenue number in our Technology business. In our Services business, we continue to be impacted by lower revenue in our U.S. Federal business due to the ending of the TSA contract and the uncertainties in Washington. Outside the U.S. Federal business, our overall services revenue was essentially flat year-over-year in the quarter helped by currency. We were able to improve the profitability of the Services business in the second quarter even with the lower revenue, driven by continued improvements in service delivery execution. We reported a service's operating profit margin of 7.1%, up from 6.1% a year ago and up from 4% in the first quarter of this year. As you may recall, one of our goals is to drive a consistent 8% to 10% operating profit margin in our Services business. While we're not there yet, I'm pleased with the progress we've been making towards the goal. In our Technology business, our revenue in the quarter was impacted by lower sales in ClearPath systems against the strong quarter a year ago. As you know, our ClearPath sales can vary significantly from quarter-to-quarter, which is why we believe the best way to measure this business is on an annual basis. We grew our ClearPath sales in the first quarter of this year and for the full year 2010. For 2011, we continue to focus on our goal of maintaining ClearPath revenue roughly flat with 2010 levels. We also continued progress during the quarter in strengthening the balance sheet. We completed a cash tender offer that reduce our debt by $179 million, another major step towards our stated goal of cutting our debt by 75% from September 2010 levels. The debt reduction actions we took over the past 2 quarters have cut our annualized interest expense in half, which is key to reaching our pretax profit goals for 2013.
I want to take a moment to highlight the balance sheet improvement we've made. Slide 2 shows the balance sheet journey we've taken over the past 2.5 years. When we started, we had $1.1 billion of debt. Today our debt is under $450 million and our financial position is significantly improved as cash exceeds our debt by $178 million. Turning to Slide 3, from a top line perspective, while our overall revenue declined in the second quarter due to the lower U.S. Federal and Technology revenue, we're encouraging points of progress in the quarter. As you may recall, our 3-year financial goals are based on growing our IT outsourcing and Systems Integration services revenue at market rates, adjusted for the fact that we no longer have the GSA revenue in 2011, while maintaining flat Technology revenue over the same period. Against these goals, we saw a continued growth during the second quarter in our IT Outsourcing business. Outside the U.S. Federal business, we grew our IT Outsourcing revenue 7%. This represents the sixth consecutive quarter of year-over-year revenue growth in this business. We've done work in recent years to enhance our portfolio of outsourcing solutions and to focus on providing world class levels of service and support. And these efforts are paying off in a stronger deal pipeline and improved customer satisfaction. In fact, about 30 IT outsourcing orders we received in 2011, have been for expanded work from existing clients, which speaks to the quality of our services and our customer relationships. In our project-based Systems Integration business, while we've not yet turned the corner on revenue growth, I'm encouraged that we see 2 consecutive quarters of year-over-year order growth. Our commercial Systems Integration business has historically been tied to vertical industry services and solutions based on our own technology and software applications. To grow this business, we're making investments in our industry solutions, while also pursuing new growth opportunities to help clients address and take advantage of disruptive technology trends. They're changing the way people work and do business today. For example, in the area of cloud computing, we're applying our expertise in complex mission-critical systems integration to help clients integrate and build their own secure cloud-computing environment and applications. As part of this effort, we've recently announced alliances with CA Technologies and BMC to work at their systems integration partner on cloud projects. We're also working to expand the market for our industry solutions by offering them to a software-as-a-service model. We've seen success doing this with our cloud-based air cargo solution, while we continue to add new clients. We're pursuing similar initiatives working in tandem with our clients for some of our financial services solutions. In the area of security, in addition to the work we do and identity management and credentialing, fraud detection and airport and seaport security for organizations around the world, we're applying our consulting and integration skills to help clients protect their networks against cyber attacks and secure the exploding number of mobile devices and social applications being used within the enterprise. We also see commercial and government growth opportunities for self-network technology, which was recently certified by the National Security Agency as meeting its requirements to protect classified government data.
Finally, as I mentioned to you in our last call in April, to drive profitable revenue growth, we're focused on improving our sales execution and productivity. In addition to strengthening our sales leadership, we're adding experienced, talented sales personnel across the world, but the consultative selling capabilities needed to represent our enhanced solution portfolio. Year-to-date, we've refreshed about 15% of our global sales force to this process, and we anticipate that percentage to grow to 25% to 30% by year end.
In summary, turning to Slide 4, in a quarter where we had a challenging Federal marketplace and lower Technology revenue, I'm pleased we're able to make the continued progress towards our 3-year financial goals. I'm encouraged by the margin improvement we've made in our Services business, further progress in strengthening the balance sheet, and continued revenue growth in IT Outsourcing outside the U.S. Federal market. As we build on our strength as a mission-critical provider of IT solutions and services, we continue to see growth opportunities in the market for both long-term outsourcing and project-based services. And in our Technology business, we continue to enhance our flagship ClearPath server platform with innovative open system capabilities, and of course, we're focused on closing key sales opportunities. During the quarter, we announced our most powerful ClearPath models ever, as well as support the mobile devices such as Apple iPad, Androids and Blackberrys. In our U.S. Federal business, while we work through the continued uncertainties in Washington, we're retooling our business model to respond to changes happening within the federal market in terms of how agencies are buying and a new types of solutions they need to reduce cost and be more responsive to citizens. We can see the shift occurring for instance, with the government's increasing interest in cloud-based solutions. The Unisys is doing innovative work with GSA, the National Oceanic and Atmospheric Administration and other agencies. As we look to the second half, we're focused on executing our strategy and continuing progress against our stated goals. Thanks again for joining us today. Now here's Janet to take you through our results in more detail and then we'll be happy to take your questions.
Thanks, Ed, and hello everyone. As Ed said, our second quarter results were impacted by the continued weakness in the U.S. Federal marketplace, and the lower year-over-year ClearPath sales. However, we were encouraged by the improving services operating margin, which improved to 7.1% for the quarter, up from 4% in the first quarter of 2011 and moving closer to our targeted range of 8% to 10%. We are continuing our discipline in controlling operating expenses, which were down 9% from the second quarter of last year, down 14% at constant currency rate. As we've discussed, in April, we further reduced debt by $179 million. We incurred $45.7 million charge in the quarter for the debt redemption. On a non-GAAP basis, excluding the debt retirement charge and the impact of the old Brazilian above-the-line tax item, Unisys had net income from continuing operations of $47 million in the quarter. We generated positive free cash flow during the second quarter of 2011, and ended the quarter with cash net of debt of $178 million, a $518 million improvement from June 30, 2010. We ended the quarter with $625 million of cash. I'll now provide some more details on our second quarter results. We ended the second quarter with $5.7 billion in services backlog, which was down 1% from December 31, 2010, and about 5% on a constant-currency basis. Year-over-year, services backlog was up 3% but down 5% at constant currency rate. Second quarter services orders decline by double digits versus the second quarter of 2010. This decrease was attributable to lower year-over-year orders in outsourcing. These declines more than offset orders growth in Systems Integration and infrastructure services. In the term of geographic trends in the second quarter, we saw year-over-year services order growth in our North America region, excluding U.S. Federal and in our Asia-Pacific region. Orders in our U.S. Federal business and other geographic regions were down versus the second quarter of 2010. Slide 5 highlights our financial results in the second quarter. At the top line, we reported total revenue of $937 million in the quarter, which was down 10% year-over-year. This decline was driven by lower revenue from the U.S. Federal Government and in our Technology business. Currency had a 5 percentage points favorable impact on our revenue in the quarter. And based on today's rate, we anticipate currency to have about a 5 to 6 percentage point positive impact on revenue in the third quarter of 2011. We reported an operating profit of $48.1 million in the quarter compared to the year-ago's operating profit of $106.5 million. Declines in our gross profit margin related to the lower Technology revenue, which more than offset improved gross margin in our Services business and continued reductions in operating expenses. As a result, our operating profit margin was 5.1%, down from 10.3% a year ago. Other expense for the second quarter of 2011 was $49.4 million, which included a $45.7 million charge related to the April debt reduction. For the second quarter of 2011, our pension expense increased $9.9 million, compared to the second quarter of 2010. We continue to expect approximately $33 million in pension expense in 2011, compared with pension income of about $3 million in 2010. At the tax line, we had a $9.2 million tax benefit in the quarter, compared with the $13.3 million tax provision in the year-ago quarter. The second quarter 2011 tax benefit reflect the impact of settling 2 European tax cases, which benefited our tax provision by $30.3 million. Offsetting these favorable events is a negative impact of not reporting a tax benefit on losses for some of our legal entities that have full valuation allowances. In addition, as I've said previously, our tax provision continues to be highly variable from quarter-to-quarter depending upon the geographic distribution of our income. We reported a net loss from continuing operations before preferred stock dividends of $7.6 million in the quarter versus net income of $59.2 million in the year-ago quarter. Excluding the impact of the $45.7 million debt reduction charge and the $13.5 million charge related to the Brazilian tax case, Unisys generated adjusted EBITDA of $105.5 million for the quarter. The second quarter 2011 loss per common share was $0.27. Excluding the impact of the debt reduction charge and the Brazilian tax item, our non-GAAP diluted EPS was $0.93 per share. In the second quarter of 2010, we reported diluted EPS from continuing operations of $1.36.
Moving to our second quarter revenue and margins by portfolio. On Slide 6, Services revenue declined 6% year-over-year. Outside of our Federal business, Services revenue was essentially flat. Currency had a 6 percentage point favorable impact on revenue in the quarter. Improved service delivery execution across our Services business drove higher gross profit margin as a percentage of revenue. Services gross profit margin increased 80 basis points year-over-year to 20.1% from 19.3% in the second quarter of 2010. Reflecting the higher gross margin and lower operating expenses, our Services operating margins improved by 100 basis points year-over-year to 7.1% and was up sequentially from 4% in the first quarter of 2011. Systems Integration and consulting revenue declined 15% year-over-year. Within outsourcing, ITO revenue was down 3% versus the second quarter of 2010. ITO revenue from the U.S. Federal Government was down for the quarter principally due to the loss of revenue from the ending of the TSA contract, which ended effective November 30, 2010. The TSA contract represented 10% of our ITO revenue in the second quarter of 2010. Outside of our business with the U.S. Federal Government, ITO revenue rose by 7% year-over-year. Infrastructure services revenue increased 13% compared to the second quarter of 2010, due to deal-specific third-party sales and new business wins in our private label maintenance business. Core maintenance revenue declined 3% year-over-year, business process outsourcing revenue declined 5% versus the second quarter of 2010. Approximately $750 million of the June 30, 2011 services backlog is anticipated to convert into third quarter 2011 Services revenue. Over the past 10 quarters, we had typically between 87% to 93% of our quarterly services revenue in our opening backlog. The balance of our Services revenue comes from sell-and-build business during the quarter.
Moving on to Technology on Slide 7. Technology revenue decreased 35% due to lower ClearPath sales. We reported a Technology gross margin of 49%, down from the prior year principally because of lower ClearPath volume. Our Technology operating margin declined to 2.4%, compared with 26.8% in the second quarter of 2010. As we've said previously, because ClearPath sales can vary greatly from quarter-to-quarter, we believe the best way to measure this business continues to be on an annual basis. We remain focused on achieving our goals of maintaining essentially flat ClearPath revenue compared to 2010 levels. Slide 8 provides more detail on the performance of our Federal Government business over the past 6 quarters. As a reminder, our Federal Systems business serves 3 primary sectors of the U.S. Federal Government: Brazilian, Homeland Security and Department of Defense. Civilian agencies represent our single largest revenue base within the U.S. Federal Government, accounting for about 50% of our overall U.S. Federal Government revenue in the second quarter. Revenue from agencies within the U.S. Department of Defense and various intelligence agencies represent about 28% of our overall U.S. Federal Government revenue, or about 4.5% of overall Unisys' revenue. With the end of the TSA contract late last year, revenue from Homeland Security agencies has declined significantly as a percentage of our total federal revenue and in the second quarters 2011, represented about 22% of our overall U.S. Federal Government revenue. As you can see in the slide, our overall U.S. Federal revenue declined $62 million or approximately 29% in the second quarter of 2011, to $152 million of about half of that decline due to the end of the TSA contract. We were also impacted by the continued weakness in the U.S. federal government marketplace.
We ended the second quarter of 2011 with about $300 million of U.S. federal services backlog, which was down 17% compared to the second quarter of 2010. Excluding the impact of the TSA contract, federal services backlog declined by about 8.5% year-over-year. Slide 9 shows our second quarter revenue by geography and industry. Our North America revenue represented 40% of our revenue in the quarter and declined 19%. Within North America, our revenue from the U.S. Federal Government represented 16% of our total Unisys' revenue in the second quarter. And as we noted earlier, declined 29% year-over-year due to absence of our TSA contract revenues, as well as the impact of the challenging U.S. federal marketplace. Excluding the U.S. Federal Government business, our North America revenue declined by 10% due to lower technology sales. International revenue declined 2% in the quarter due to lower revenue in our Asia-Pacific and European region. On a constant-currency basis, international revenue was down 12%. From an industry perspective, public sector remained our largest single industry revenue source. The 9% decline in public sector revenue year-over-year was driven by the decline in our U.S. Federal Government revenue. The balance of our Public Sector business grew 9% compared to the revenue in the second quarter of 2010. Revenue from commercial industry customers was down 16% versus the prior year and represented 34% of our second quarter revenue. The financial sector, which had flat year-over-year revenue, represented 22% of revenue. Turning to Slide 10. You can see our revenue mix as we reshape our business. As we leverage our capability and Systems Integration, IT Outsourcing and Technology, and continue to invest in those areas, our goal remains to drive growth at market rate in our ITO and Systems Integration business adjusting for the ending in the TSA contract, while holding Technology revenue stable. Please turn to Slide 11 for an overview of our cash flow performance in the quarter. We generated $36 million of cash from operations in the second quarter of 2011, compared to $52 million in the year-ago quarter. As part of our ongoing focus to reduce the cash requirements of our business model, capital expenditures were $29 million in the second quarter of 2011, down $19 million from $48 million in the second quarter of 2010. Our free cash flow was $7 million in the second quarter of 2011 versus $4 million for the same period last year. Depreciation and amortization was $50 million in the quarter, down from $63 million in the second quarter 2010. For the full year 2011, we expect depreciation and amortization of around $200 million. We contributed $20.6 million in cash principally to our international pension plan in the second quarter of 2011. For the full year, we continue to anticipate contributing approximately $150 million of cash to these pension plans. Our cash balance is $625 million at June 30, 2011. Our cash balance of $625 million at June 30, 2011 was up $128 million from June 30, 2010. With $389 million less debt at June 30, 2011, compared to June 30, 2010.
Turn to Slide 12 for an update on our balance sheet, capital structure and liquidity. During the second quarter, we took a significant step towards our debt reduction goal with the use of $221 million of cash on hand in April to complete a tender offer for some of our high-coupon debt. We remain focused on our 3-year goal of reducing debt by approximately 75% or approximately $625 million from September 30, 2010 levels. Our long-term debt levels are now about 53% of what they were at September 30, 2010. Through the first half of 2011, we've achieved about 60% of our 3-year debt reduction goal. Lower leverage was one of the key factors cited by both S&P and Fitch for raising their credit ratings to BB- during the second quarter. We view this as positive evidence of our continuing success in strengthening the balance sheet. The initial benefit and lower interest was evident in the second quarter results as we reported interest expense of $13.3 million versus $25.3 million of interest expense in the second quarter of 2010. Our first-half 2011 actions to reduce debt have reduced our annualized interest expense by approximately $53 million. We expect about $37 million of interest expense savings in 2011 from these actions. From a cash perspective, this benefit is partially offset by the payment of $16 million in dividends annually on a mandatory convertible preferred stock during the 3 years until it converts into common stock. On June 23, 2011, we entered into $150 million 5-year secured revolver that replaces the back-up liquidity provided by our former accounts receivable securitization facility. This revolver is secured primarily by our U.S. accounts receivable and has a junior interest in certain other assets of the company, second to the 2014 and 2015 secured notes. Similar to our prior accounts receivables securitization facility, the borrowing limits are based on the amount of eligible U.S. accounts receivable. And the interest is based on LIBOR and prime rate. In addition to providing additional liquidity as a loan facility, the revolver also allows for the issuance of up to $100 million in letters of credit. Our former accounts receivable securitization facility did not allow for the issuance of letters of credit. This will enable us, over time, to free up the cash collateral currently securing existing letters of credit. We are pleased with the level of interest from the banks and their level of support, some of whom are long-term customers of Unisys. In closing, this was a bit of a mix quarter. We have continued to see weakness in the U.S. federal government market and a different quarterly pattern of ClearPath revenue as compared to last year. But we made important progress towards our 3-year goal. The services operating margin was up sequentially and year-over-year to 7.1%. We demonstrated continued discipline over operating expenses, which declined again. We generated free cash flow and we strengthened the balance sheet. We remain focused on making quarter-by-quarter progress towards achieving our 3-year financial goal. Thank you for your time. And now I'd like to turn the call back over to Ed.
Great. Thanks, Janet, very much. Operator, we'd like to open the call up to questions at this point.
[Operator Instructions] And first, we'll hear from Joe Vafi with Jefferies & Company.
Joseph Vafi - Jefferies & Company, Inc.
Just wondering if we could start on the margins. Obviously, some good progress there on Services. Janet, was there any boost to the service margin due to less mix from the government, or is it really mostly efficiency gains or did lower government revenue actually become a margin headwind for Services?
Joe, when we look sequentially between the 4% first quarter Services operating margin and how we improved going into the second quarter operating margin to 7%, our federal revenue was down slightly. So I think that's a good comparable to talk about where our business is and where the improvements came. About 2 points of that improvement in Services operating profit from the 4% to the 7% came in the gross margin line and that clearly came from 2 items: continued service execution, quality service execution delivery and then additionally, we had some time to adjust our federal cost base for the declining revenue. The other point came from continuing reduction in the operating expenses. So as we look at the Services operating profit at 7%, it is improved, 2 points in the gross margin line from service delivery, execution improvements across the business, as well as the benefit of being able to have some time to adjust the federal government across base for the lower revenue. And then an additional 1 point coming from the focus on reducing operating expenses in the business.
Joseph Vafi - Jefferies & Company, Inc.
Very good. Where are we now in terms of, I guess, kind of continued talk on some of that cost reduction and services? And where are we in terms of personnel and lower-cost geographies now, and is there still some room to go here in 2011 on that front?
Joe, we ended the quarter at 29% of our headcount in the low cost, lower cost labor pools. We got up as high as 30% at the end of April. We reduced that a bit based on some work going away in South America back to 29%. But, yes, we still think that there's still room to improve there. We still look at the competition and see our competitors in the 35% to 40% range. And that's what we fully expect to get. What would take us there is new work. The biggest driver for us to increase that percentage is winning new outsourcing contracts.
Joseph Vafi - Jefferies & Company, Inc.
And then, it does seem like outside of government, you're definitely making some progress here in terms of getting the growth in the Services business. How do you feel at about some of your lines of business that aren't maybe as the highest focus as maybe some of your outsourcing lines of business or your ITO business, let's say, in terms of stabilization in those businesses as we look forward and towards the end of this year and into next year?
I think the 2 major groups that we think about are the IT Outsourcing business and the Systems Integration business, 6 consecutive quarters of year-over-year growth in ITO makes us feel like we're on the right path there. The SI business is getting stronger, but as I mentioned, we still haven't turned the corner there to hit actual growth in that business. Some encouragement this past 2 quarters that orders have grown year-over-year, 2 quarters in a row in the SI business. But we still have work to do there. Again, our goal is to grow that business as well at industry rates and we think that's probably in the mid-single digits. But we have work to do there. But I'm feeling better about the focus that we have on the solutions that we're bringing to market and I think we're seeing some signs in the order rates that says that we're on the right track.
Joseph Vafi - Jefferies & Company, Inc.
Right. and then just finally, just how you're seeing the macro IT spend environment right now just as we here in the middle of the year seems like there's kind of some mix commentary coming out of management team this earnings season on budget available, but now not being spend as much as it was or how are you seeing it?
Yes. I think the way we thought about this at the beginning of the year is probably still pretty solid. At least the forecast that I've seen would say mid-single-digit growth in the ITO business and the SI business is reasonable growth for 2011. I think Gartner just raised their estimate to, I think, between 6% and 7% for IT services for the year. So I think it's still in the range where we expected it to be.
Next we'll hear Ned Davis, William Smith & Co.
Ned Davis - Wm Smith & Co.
I just want to try to get a little bit more color on the comment you made about changing the way you're approaching your Federal Government business. I know you mentioned that this involves trying to win business in the cloud area and things of that sort. Can you give a little bit more color and then what your expectations are for what the metrics might be for that over the next 3 or 4 years if you're successful?
The primary thing that we're referring to, one was the kinds of services that the federal government, we believe, will be buying, and certainly cloud -- and moving to the cloud is a major initiative of many of the government agencies today and we're pleased that we're perceived in acting as the leader in that part of the business, particularly with the work we do in the GSA and NOAA. The other part of the comment I was making in terms of how we're retooling the federal business is to change the way we operate a bit from focusing the business on large multi-year programs, which have difficulty in getting funded, to more tactical task order kind of business, shorter-term projects, smaller transactions and projects that we see are getting funded. So that forces us to change a little bit on how we think about selling to the federal government, as well as the back office processes, sales operations processes to support those efforts. But we think there's more business being done in smaller transactions perhaps, than it has been in the past.
Ned Davis - Wm Smith & Co.
Just one other thing. Could you kind of give us any kind of an update on some of these partnership initiatives, particularly Computer Associates and Google, Apple? Is there any specifics that you can give us on any deals or progress there?
Well, certainly, the Google relationship has been important relationship for us. And as we've announced, the GSA movement to the cloud is being done in a partnership between ourselves as a prime and Google as a service provider. So we're very pleased with that relationship. And think that there's opportunities in the future to do more work together. Likewise with Apple, CA and BMC, these are all important relationships to us. We think they're good relationships and we're working hard to deliver additional business in the company through them. And as we have wins that we're able to announce and can announce, we certainly will do that.
I show no further questions at this time, I'd like to turn the conference back over to the speakers for any additional or closing comments.
Well, thank you all for being on the call. We certainly appreciate it, and look forward to our next call when we report our third quarter results. Thank you very much.
Once again, that does conclude today's conference. We thank you all for joining us.
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