Perot Systems Q2 2007 Earnings Call Transcript

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Perot Systems Corp. (NYSE:PER)

Q2 2007 Earnings Call

July 31, 2007, 10:15 AM ET

Executives

John Lyon - VP and IR Director

Peter Altabef - President and CEO

Russell Freeman - VP and CFO

Analysts

James Kissane - Bear Stearns

George Price - Stifel Nicolaus & Company, Inc.

Rod Bourgeois - Sanford C. Bernstein

Joseph Vafi - Jefferies & Co

Eric J. Boyer - Wachovia Securities

Ashwin Shirvaikar - Citigroup

Susan Chen - Merrill Lynch

Cynthia Houlton - RBC Capital Markets

Presentation

Operator

Good morning, thank you very much for standing by and welcome to the Perot Systems Second Quarter 2007 Earnings Conference Call. At this time, all participants are in a listen-only mode. And later, we will conduct a question-and-answer session with instructions to be given at that time.

During the course of today's call, Perot Systems will be making forward-looking statements that contain risks and uncertainties. These statements are only predictions and actual results may vary materially. Perot Systems disclaims any intention or obligation to update any forward-looking statements, as a result of new information or otherwise. Please refer to the Perot Systems Form 10-K for the fiscal year ending December 31, 2006 for a listing of risk factors that could cause actual events or results to vary from those contained in the forward-looking statements.

Now I'd like to turn the call over to John Lyon, please go ahead, sir.

John Lyon - Vice President and Investor Relations Director

Good morning. Welcome to our second quarter 2007 earnings conference call. During our call today, Peter Altabef, our CEO will provide an overview of our second quarter results and the performance of our major units and Russell Freeman, our Chief Financial Officer will review our financial performance and forecast and will highlight some of our priorities in the second half of the year.

Before we begin, let me remind you that in addition to our press release, we have placed a downloadable financial summary for your convenience in analyzing our results at perotsystems.com. In addition, we will refer to certain non-GAAP financial measures today. Free cash flow is a measure we use to assess the net cash production of our operations, including long-term and short-term capital, and is calculated as operating cash flow less capital expenditures.

Organic revenue growth is a measure of our pre-acquisition revenue growth and is calculated by taking total revenue growth less the revenue growth contribution from acquisitions completed in the past 12 months. The information necessary to calculate these measures is available in our earnings press release. Once again, I want to thank you for joining us and I will turn the call over to Peter.

Peter Altabef - President and Chief Executive Officer

Thank you, John. Good morning and thank you all for joining us today. We had a solid quarter of business accomplishments. Our financial results were in line with our expected range, with revenue growing to $635 million and earnings per share of $0.18.

We won new business with a total contract value of $241 million, but more importantly, we advanced sales opportunities that positioned us for a very good third quarter of new sales. And we prepared our company to expand earnings and profit margins in the second half of the year.

Operationally, we positioned our company to benefit from contract profitability improvements although there is more for us to accomplish on this front. As our business and operations have become more complex, we have and will continue to implement changes to improve our operating effectiveness. Our local delivery model continues to mature and our new infrastructural operation in Mexico which went live in the first quarter achieved breakeven in the second.

Also in the second quarter, we saw some changes in the levels of discretionary project work. We reported 6% gross sequential revenue growth in our Consulting and Application Solutions Group with strength in the consulting area. We also saw a sequential increase in technology project work mainly in the healthcare provider sector.

Turning to our review of the performance of our major business units, let me remind you that for comparison purposes, Industry Solutions is affected by the exploration of the UBS infrastructure outsourcing contract. That exploration occurred at the beginning of this year. And Government Services is affected by the first quarter 2007 acquisition of QSS.

For Industry Solutions, we reported a 3% year-to-year revenue decrease, but when you adjust to the loss of UBS, the underlying business grew by 14%. Our Healthcare business grew by 16% year-to-year, with the major drivers of growth being clinical applications revenue, which grew by 35% year-to-year, and core outsourcing revenue, which grew by 14% year-to-year.

In terms of healthcare outsourcing activity, we think the market continues to be good. Our second quarter signings included smaller wins in many of our service areas, encompassing both information technology, and business process services. And in addition, we have recently been awarded our first task orders under the Veteran's Administration District program. So far in the second and third quarter, we have been awarded task orders by the VA valued at approximately $200 million of total value, most of which occurred early in the third quarter. The Veterans Administration awards are the culmination of a more than two year effort to achieve a significant role in the government healthcare space. We are very excited about this market, and the services we can provide to it.

Let me now take a moment to update you on our contract with client. Community Health's acquisition of Triad closed last week on July 25th, and we remain committed to providing outstanding support to Triad. We believe that the change of control will result in a change in the delivery of services, in particular around the nature and timing of the implementation schedule although the extent and nature of the change is uncertain. Russell will provide you with more detail of this.

Revenue of our commercial areas within Industry Solutions decreased by 33% year-to-year, but when you adjust for UBS, the underlying business grew by 9 % year-to-year. This revenue came primarily from our product engineering business, which grew revenue by 30% year-to-year, our Insurance and Business Process Solutions unit which grew revenue by 15% year-to-year and new client additions.

We also are continuing to be recognized for the quality of our services. For the second year in a row and the third time in four years, we have been recognized by the Outsourcing Center for partnerships we have with our clients. This year our life insurance policy administration contract with Old Mutual was rated the best partnership in the entire information technology and business process solutions industry, and showing that the market understands our trusted partner approach and our capabilities is an important part of our sales process. And to further this goal, we have appointed Atul Vohra as our first ever Chief Marketing Officer.

Within government services, we continue to face a challenging market environment. The 7% organic year-to-year revenue growth we produced came primarily from New Year work with the Department of Education and some contract expansion within the Department of Defense. While we believe that spending in the Department of Defense and many of the civilian agencies will remain tight in the near future, we see the prospects for healthy sales activity within the Departments of Education and Homeland Security.

Overall, our Government Services team is doing a very good job positioning us for long-term growth. We have a very healthy sales pipeline and the integration of QSS has gone very well. We are not, however, seeing the level of revenue acceleration, we expected to see this year and our new sales growth is being pressured by scope reductions on existing programs. So we are taking a more cautious stands on the level of near term government revenue acceleration, where there we can achieve.

Revenue for our Consulting and Applications Solutions line of business grew by 19% year-to-year. Consulting revenue for this unit grew by 21%, and applications revenue for this unit grew by 18% year-to-year. In the first six months of 2007, our Consulting and Applications Solutions unit added more than 20 new clients, with approximately one-half of these being joint clients with other units within our company. This line of business continues to post good results toward a period of business change, as we work to making this a premier unit and achieve our target growth rates in the mid 20s.

We are focused on continuing to build balance in this team between direct to market sales and collaborative work with our other units, and we have added key operational and sales units leaders to this unit, as we continue to build out a senior set of client executives to lead and grow our direct application delivery engagements. We also recently announced Anurag Jain as the new leader for this organization. Anurag has a distinguished track record of developing and growing global technology businesses and has an excellent record of accomplishments within Perot Systems. Anurag is already implementing improvement initiatives to help us continue to strengthening the growth and profit margins of this unit.

Joining Anurag as a senior leader, working with our Consulting and Applications Solutions unit is Raj Asava. Raj joins Perot Systems from Satyam, where he served as Senior Vice President of the Strategic Deals Group. He has significant business development experience and accomplishments in global software delivery. Raj played a central role in developing Satyam's Strategic Deals Group and helped that organization plan, pursue and win large and strategic deals. Anurag's and Raj's operational and business development expertise will help us to continue to strengthen.

Looking forward to the third quarter, we see a good sales pipeline and we also see... expect to close in acquisitions. We are in the late stages of negotiations with a potential acquisition prospect which operates in one of our core focus markets and which generates approximately $80 million to $90 million of revenue per year. We believe this acquisition is very attractive from both the strategic and long-term financial perspective. Russell will provide the financial details in his remarks.

So as we enter into the second half of the year, we believe our business is moving in the right direction. As we discussed last quarter, we expect to report higher earnings in the second half of the year and are committed to strengthening our earnings and profit modules. We are proud with the progress we are making, but we also realize that there is more to accomplish. I want to thank you for joining us and Russell will now detail our financial results and forecast.

Russell Freeman - Vice President and Chief Financial Officer

Thank you, peter and I want to thank everyone for joining us today. Overall, our second quarter performance was in line with what we expected it to be. Revenue expanded sequentially to $635 million and earnings per share was $0.18. We produced sequential operating profit growth and expect the earnings momentum that began in the second quarter to continue as we enter the second half of the year.

In the third quarter, revenue will range from $650 million to $665 million, putting out for an annualized revenue of more than $2.6 billion. The sequential revenue growth will come primarily from new sales within Industry Solutions and an expected acquisition.

Earnings per share will grow sequentially by up to 28% and range from $0.20 to $0.23. This represents $0.02 to $0.05 sequential growth in earnings. This increase to profitability will come primarily from higher existing contract profits within Industry Solutions. We also have a little more than $0.005 per share sequential benefit from the severance expanses we incurred in the second quarter. Although our projected earnings growth is strong, the midpoint of our current range is approximately $0.01 per share lower than it was previously. The major reason for this is an unanticipated production in the amount of project and new sales revenue and profit in the third quarter.

Also providing some earnings pressure from our last forecast is worthy rupee appreciation and moving to zero profit recognition on the implementation element of the Triad contract. Regarding Triad, based on limited discussions with our new client, we believe that the software implementation schedule will change in the coming months, for we are uncertain as to the extent of those changes. From an accounting perspective, when you had to... expect to have a profitable implementation element, but there is level of uncertainty that we are experiencing today. The appropriate method of accounting is to start recognizing profit until there are reasonable estimates. This is what we did in the second quarter and what we are factored into our third quarter forecast.

As I've discussed previously, the overall profits we have been generating on the Triad contract were not material to our earnings, but this contract is expected to contribute to future profit and margin expansion. In the second quarter, the Triad contract was approximately breakeven. Also contributing to our third quarter results will be the expected acquisition that Peter mentioned. This acquisition which is in the late stages of the process is compelling both from a strategic and a financial perspective. We expect that it would contribute approximately $8 million of revenue in the third quarter and will be slightly dilutive to earnings per share during its initial phases. We expect to use a combination of cash and debt to finance this transaction.

Looking at our second quarter financial results in more detail; revenue was $635 million for the second quarter, an increase of 11%. Looking at the components of this growth, the acquisition of QSS contributed $69 million of revenue equal to 12 percentage points of growth. This means that on an organic basis, revenue decreased by 1% year-to-year.

Excluding the UBS infrastructure contract from last year's revenue, the underlying organic growth is 12%. All of our major business units made an important contribution to this level of growth, with healthcare and consulting and application solutions providing the strongest level of growth.

We were disappointed by the level of growth in our Government Services unit in this quarter. We did not achieve our expectations, although the level of new contract wins over the past year has been very encouraging. We believe the team is doing an excellent job positioning us for the future and integrating QSS. QSS was neutral to earnings in the second quarter, which is ahead of schedule.

In terms of year-to-year earnings per share growth, we reported $0.21 of earnings per share for the second quarter of 2006. Last year, the UBS infrastructure contract contributed $0.07 per share in the second quarter, meaning that we had to grow off a base of $0.14 as UBS comprised one-third of our earnings per share in the second quarter of 2006. This quarter, we achieved $0.04 of growth over the $0.14 base which gets us to $0.18. This growth came from actions to strengthen our profitability comprised of cost containment initiatives and a reduction to employee related expenses, including incentive compensation, possible new sales within industry solutions and growth in our core consulting and applications solutions unit. Partially offsetting this benefit was account related pressure in Industry Solutions and Government Services, including pressure on the Triad contract related to the accounting change, and the new tenant contract, where we assumed a new scope of work that initially pressures profits, but will drive incremental profits as 2007 progresses.

We also had profit pressure related to early stage contracts in our Physicians Group, which is a relatively new area in our healthcare unit. This earnings pressure related to the physicians practice will decrease in the second half of the year. As we move to the second half of the year, we have a number of operational priorities that will produce financial benefits. First, there are several important deliverables that will help us realize contract efficiencies, some of which are part of our third quarter guidance. These include completing the data center transition for a complex infrastructure outsourcing contract, improving profitability in the physician's area, and finishing the globalization of certain functions. Increasingly, our clients want more of an asset like, more globalization heavy outsourcing model. We are in the process of realizing efficiencies related to deploying a global workforce for certain operations.

We will also be working to address approximately three days of DSO slippage in the second quarter. We have a few clients with timing issues in processing our billings. We believe that these situations will be resolved in the third quarter. For the second quarter however, this kept our DSOs in the low 60s. We expect DSOs to be in the 55 to 58 days range, given our current mix of contracts. We do not see this as a long term issue, but it will have the full attention of our leadership.

So as we move into the second half of the year, we have important operative deliverables to achieve. Growing earnings in the second half of the year is an imperative for us. We are positioned to demonstrate healthy EPS growth in the third quarter, and a position to build on this expansion in the fourth quarter. I want to thank you for joining us and we'll now be glad to answer your questions.

Question And Answer

Operator

This concludes the formal portion of the conference call. A question-and-answer session will now be conducted. [Operator Instructions]. The first question is from Jim Kissane with Bear Stearns.

James Kissane - Bear Stearns

Thanks. Peter, can you be a little more specific in terms of what market the potential acquisition serves?

Peter Altabef - President and Chief Executive Officer

Well Jim, we... this is the second time we have kind of given a foreshadowing of an acquisition. The first time was a several quarters ago when we said that we had another acquisition lined up, we gave the size of the acquisition, but we didn't say where it was and that of course later became the QSS acquisition.

Because its not... we have not yet signed the acquisition contract yet, I'm very hesitant about giving the location, if you will and where the acquisition is. We have given you the size between $80 million to $90 million, it is close. I expect that we'll actually sign the acquisition contract in August for that deal, so we'll be able to provide you specific detail about where it is relatively soon.

James Kissane - Bear Stearns

Okay. Thanks Peter. And can you break up the signings by market for the quarter and maybe what you've done so far in July and in terms of the business pipeline, which markets are strong and which are weak. Obviously government's a little bit weaker than you expected?

Peter Altabef - President and Chief Executive Officer

Government is weaker. As you saw for the second quarter, we had TCV about $241 million. That is below... as you know Jim as well as anyone, there is a lumpiness in our business and $241 million for us in terms of sales is on the low end of lumpy. So I wasn't particularly pleased with that size of signings. You saw in July alone and of course we've got another day left in July or today, we've had about $300 million of TCV in July, so more than the second quarter in its entirety, so that kind of goes to prove the lumpiness of how this works.

If you look at our signings in the second quarter; that 241, they are actually very well dispersed between our commercial units which includes our life insurance unit, our healthcare unit and was fairly light on government signings, but does includes some government signings. When you look at the $300 million in July, what you see is that is predominantly healthcare related and the majority of that is on the healthcare side. So, if you look at July and the second quarter, you have about $540 million; excuse me of TCV over that period of time. In that $540 million, is about $200 million of the VA contract and the VA contract is not quite finished yet. There are still more contracts to be let but that is ahead than where we are at this point.

And as I noted, we are very proud of that. When I started as CEO about 3 years ago, one of our initiatives was to do work in the government healthcare space. We traditionally had not been in that space. Our healthcare team had focused only on commercial projects and the government team was really focused on the Department of Defense at that point. Since then, we launched that effort and $200 million plus of TCV we signed in the last really 45 days, 50 days is a very good sign for our ability to develop the government healthcare space.

In terms of the government space, we've also developed away from a Department of Defense centric approach and are much, much, much more deep now in the Department of Homeland Security as well as the Department of Education and we had very good sales in the Department of Education as you know in the last 12 months. We expect that to continue and we are very optimistic about Homeland Security as well as we are developing that. Hope that helps you.

Operator

The next question is from George Price with Stifel Nicolaus.

George Price - Stifel Nicolaus & Company, Inc.

: Good morning, thanks very much for taking a couple of questions. Just Russell, if we could just talk a little bit about the outlook, first on the margin side. Can you give us an update maybe where you see the operating margin coming for the year and exiting the year at this point and are you still comfortable with the 50 to 100 bps of operating margin improvement per year starting next year?

Russell Freeman - Vice President and Chief Financial Officer

Yes, good question. The 5.7% is that we had in terms of operating margin in the second quarter obviously is lower than we would like. However, it was in line with our expectations coming into the quarter. And as far as where we expect to finish the year, we are still approximately in that 6.5% operating margin on a full year basis for the full year and we do expect to ramp operating margins 0.5 point or full percentage point every year through 2011. So we are still expecting to finish the year around in the fourth quarter around the 7% operating margin and ramping from there.

George Price - Stifel Nicolaus & Company, Inc.

Okay. And then in terms of the free cash, given how DSOs are moving, I think last time you said low to mid $80 million range or for the year was kind of what you guys are targeting, any change there?

Russell Freeman - Vice President and Chief Financial Officer

Well, our free cash flows were weaker than we had expected. We actually were surprised by that $37 million in the quarter and all of that relates to timing issues that will reverse themselves as the... as we move into the back half of the year. Right now we are looking at free cash flow in the third and fourth quarter combined of about $140 million to $150 million, so we are still approaching that $80 million range.

Operator

Your next question is from Rod Bourgeois with Sanford Bernstein.

Rod Bourgeois - Sanford C. Bernstein

Yes, hey guys. Rod Bourgeois here. I wanted to inquire about Triad, I mean we knew there was some uncertainty because of the ownership shift there and I know you are incurring an accounting change here. What I want to understand here is the accounting change and the sort of zero profit recognition on that contract, is that more likely due to a timing issue on the contract where the economics are getting pushed out or could that issue be a change to the overall value of the contract over time or I think just too uncertain at this point to even answer?

Russell Freeman - Vice President and Chief Financial Officer

Well first of all to begin, I want to emphasize the transaction closed last week, with Triad. And we have had very, very preliminary discussions and communications with the new owner and as Peter said and I said on my speech, we do expect changes to the implementation schedule with regard to the Triad platform. We expect that the platform that will be deployed in the Triad hospitals will be different than we had anticipated in the contract. However, until we are able to put together with the client a new implementation schedule under what platforms we will be going and which hospitals, we have too much uncertainty with respect to the contract. So the change in accounting did not relate to a change in the overall profitability expectations for the contract. It related to the uncertainty on the implementation element and that is a prescribed GAAP accounting treatment. Hopefully, that answers your question.

Peter Altabef - President and Chief Executive Officer

And Rod, keep in mind that as Russell is talking about the implementation element. There are two elements. There are two parts to that contract. There is an operational part, as well as the implementation part. And those two, both have so much different accounting treatments.

Russell Freeman - Vice President and Chief Financial Officer

That's correct. Now again, we are in the really the initial phases of both elements, you have transitions going on, and this is the type of contract that ramps in terms of profitability, as it matures. As we said on the call, this contract in the second quarter was neutral to our earnings. So as we look at Triad, and where we sit with Triad today, that is a potential boost to our earnings going forward in '08 and beyond.

Rod Bourgeois - Sanford C. Bernstein

Okay, alright that's helpful. And then on the sales pipeline front, we knew in the first half of the year that your pipeline for Q2 and Q3 was very strong, and I recognized that you were somewhat disappointed with the signings in Q2, although Q3 looks like it's shaping up well. My question there is did something change in your pipeline to make it less attractive than you thought... than what you thought was in place at the beginning of the year, or did you experience some push outs, and I know we were arguing early this year that there was some hesitation in the outsourcing industry sales pipeline. Are you seeing some of that, or have yields fallen out of the pipeline, or are they just pending right now?

Peter Altabef - President and Chief Executive Officer

Well some of the timing. I think I was pretty careful last quarter to say that we expected that pipeline and those sales to come in Q2, Q3, because there were some question as to exactly when some of these would materialize. I think some of what you are seeing with the $300 million of sales in July are stuff that could have been closed in Q2, and slipped over to Q3. So... in terms of do we believe our pipeline is weaker in any material way from where we were at the beginning of the year? We don't, obviously you don't win every deal you go after, but more deals come on the horizon. I think our win rate has been pretty good and as I look at the pipeline through the rest of the year, it's still a very good pipeline. So I wouldn't read anymore into it other than we close $300 million worth of work in July.

Operator

Your next question is from Joseph Vafi with Jefferies & Co.

Joseph Vafi - Jefferies & Co

Hi guys. Good morning. I was wondering if you could drill down into the VA business a little bit more. It's nice to see some tasks here. You comment maybe on your win rate in that... on that overall vehicle and have you bid everything that has come out and I know Peter, you mentioned there could be some more tasking coming down the pipe and some more color there would help... would be helpful. Thanks.

Peter Altabef - President and Chief Executive Officer

Well, I need to be careful about that because we're... they are still in the process. Not everything that is anticipated to be awarded on those series of contracts has been awarded. And so I really don't at this point want to get in to a detail about the process and of course anytime we work for a government plant we are very sensitive about how we would describe the work. So right now, given the fact that we are kind of ... where we are in that process. It's hard for me to go into any greater detail.

Obviously we haven't issued a press release given the details around the work and we would only do that after we got approval from the VA to do so. So I'm not trying to be too helpful for you other than to underscore my enthusiasm about what we are doing here. This is a very big deal for us. Perot Systems is a leader in the healthcare market. We had not entered the government healthcare market at any meaningful way until this recent push. And our service, our approach has been very well received as you can see. We're very excited about it and we think this is a very important step for the future as we continue to flush out that healthcare project.

Joseph Vafi - Jefferies & Co

Okay. And then if we could just... should we see revenue here in second half on some of these tasks then?

Peter Altabef - President and Chief Executive Officer

Yes.

Peter Altabef - President and Chief Executive Officer

Okay, thank you very much.

Operator

: The next question is from Eric Boyer with Wachovia.

Eric J. Boyer - Wachovia Securities

Hi thanks. I don't know if you just answered that but you talked about a more muted government outlook now, can you talk about what your new government organic revenue growth target is I believe, or I think it was 11%.

Russell Freeman - Vice President and Chief Financial Officer

Our current projection is for the full year of mid single-digits and again this is weaker than what we have anticipated in previous quarters. We really had a combination of things that had impacted growth rate that were surprise to us, we have had ramp up a revenue on both business that has come in lower than we had anticipated we have had projects full bags within the discretionary side of the government that we did not anticipate and then we also had a pipeline that has moved slower than we had anticipated. But all in all, this quarter again we hit at 7% year-on-year growth and we expect this single digit for the full year.

So I guess in the quarter came in about a million higher than QSS revenue assumptions that you had before, is it fair to assume that a slowness is away from the QCC business?

Russell Freeman - Vice President and Chief Financial Officer

I think QSS is generally inline, we were stronger certainly on the profit side as you look at the QSS business year-on-year and comparison to their results prior to the acquisition we have been very pleased with their growth, excluding the 8A work that had in place and you got mid teens growth year-over-year within QSS.

Peter Altabef - President and Chief Executive Officer

And the government growth of those does numbers that Russell is giving you about growth rate do not include the VA work for the government, just to be clear. That we would consider as a part of the healthcare growth.

Operator: Your next question is from Ashwin Shirvaikar with Citigroup.

Ashwin Shirvaikar - Citigroup

Hi, thanks for taking my question. If I look at your track record with margins in the last couple years, why should I have any confidence at all that you can sustain a multi-year period of improved profitability, I mean you will always going to have things like ramps move out, ramps move in, contracts move out and there is M&A in our client phase. You are always going to have that. So with that as the background, can you give me some confidence that you can do what you seeing?

Russell Freeman - Vice President and Chief Financial Officer

I think there is a number of things that will drive that. Number one is you look at the traditional peer set and at the level of SG&A spend we believe that we will gain significant leverage over the coming years in terms of our overhead rates. So today in the second quarter basically we are at 11% SG&A rate as a percentage of revenue. If you stale us with the size of the traditional peers you actually pick up about 3 percentage points of margin just being at that size which means that as you grow, you are adding SG&A at a lower incremental rate then you have in your existing base.

Secondly, we have a relatively young portfolio with fix price contracts; we coming into 2000 over 80% of our business was cost plus and counted material. The economic landscape and the profit recognition on fix price contracts is one that they ramp in terms of profitability as the contract matures. Again, the average age of our contract is probably in the probably in the 3.5 year range and so we have upside potential from that perspective and then specifically we have contracts that we feel good in terms of a more accelerated brand and profitability, so as we move into the third quarter we are actually looking at about $0.025 of increased profitability from our industry solutions account base. I don't know if that gives you confidence, that s what we are looking at and what we believe.

Ashwin Shirvaikar - Citigroup

Okay. Then the follow up question to that becomes, in the quarter you had whatever performance that you had was led by controlling SG&A to some extent while gross profits were down. And that's to be expected because of UBS and so on and UBS and QSS. But how much was because of adjusting variable compensation and which would come back next year?

Russell Freeman - Vice President and Chief Financial Officer

Well, as you look at gross margin again, I don't think it was expected that our gross margin would be as low. I consider that would more of an oscillated quarterly event as opposed to a long-term trend. But our account base was less profitable than we had anticipated coming into the quarter, but it is that same account base that's ramping that $0.025 as we move into the third quarter. Now on the flip side, we did have cost containment actions that gave us a greater level of benefit. We are not going into the specific areas or groups that related to but we were able to offset the pressure within our account base with respect to incentive compensation. Our incentive compensation program is the performance-based program and this is the year when we have earnings pressure, we had anticipated having lower incentive compensation coming into 2007 and what we are looking at right now we believe that we have opportunities for earnings expansion to produce solid earnings growth in 2008 and move our incentive compensation to higher levels.

Peter Altabef - President and Chief Executive Officer

One of the issues that Russell just touched on was some of the changes between the second and third quarter on our operation side, and I want to reflect on one of those that is mentioned in the press release, and also mentioned in Russell's comment, and that's the physicians market. The physicians market is a market that we really entered last year, and have been really significantly developing, and pushing. So as you look at our overall healthcare strategy, that strategy is to extend our markets, to broaden our markets, and to deepen them. And by extend, I mean go into geographies beyond the geographies that we are servicing today. By broaden, I mean to offer a wider service, wider offering of service, and by deepen I mean to go further into markets, and to develop those markets. So for instance under the deepen category, the majority of the hospitals that we currently service are what would be characterized as large hospitals. And so one of our efforts is to move into the community sized hospital markets, and you will see a greater and greater emphasis on us in getting access to and providing services to those community hospitals.

Now as you do that, and as you deepen into community hospitals, you have to broaden as well by providing some similar, and some different services than you do to a large hospital. Similarly, just like we are moving into the community hospital environment, we are also moving into the physician environment, and that is large academic physician groups, and other large groups. That work really only started for us last year, and so it is a start up, and it's enough start up phase, and anytime you've moving into a new market, physicians is probably more different from large hospitals than to small community hospitals from large hospitals for instance. And so we are experiencing some startup phase stuff there, but the sales activity in that market is very strong and we think we have a pricing model going forward that's also very strong. So that's work that we are enthusiastic about and that some of the stuff that Russell was talking about in terms of operating changes that you think we will see going forward, in particular that one as the physicians market matures for us.

Operator

Your next question is from Susan Chen with Merrill Lynch.

Susan Chen - Merrill Lynch

Thanks. Russell, you mentioned that rupee appreciation is the factor of negative impact of the margin. Can you give us a little more detail on what is the impact of scale would be like some kind of sensitivity in numbers like every 1% of rupee changes and what will be the basis point in operating margin?

Russell Freeman - Vice President and Chief Financial Officer

Well let me give you some idea of the exposure that we have. We have roughly 25% of the combined consulting and application solutions area with IDPS which is exposed to rupee appreciation and that would be an annualized run rate of approximately $100 million per year. In terms of the impact to us, we had a Q3, excuse me; we have a Q3 forecast with an exchange rate of about 40.33. The impact to us in the current quarter year-on-year was about $2 million or about 5%, rupee sequential impact on us was about $1.4 million, which had a direct impact on margin and as we move forward into the third quarter we are looking at about a $0.5 million sequential pressure moving forward and again we had an adjustment to our prior forecast as a result of the rupee.

Susan Chen - Merrill Lynch

So you are 6.5% for the full year margin target you incorporated this expectation of exchange rate?

Russell Freeman - Vice President and Chief Financial Officer

That is correct.

Susan Chen - Merrill Lynch

Thank you.

Operator

Your last question comes from Cynthia Houlton with RBC Capital Markets.

Cynthia Houlton - RBC Capital Markets

Hi just a couple of things; first on you made some comments about the... about your global delivery migration and kind of where customer requirements are. Could you just give us a little bit more color on kind of where you are and perhaps any changes you made in terms of where you are expanding headcount and kind of what are the customers they are going to change in and just kind of elaborate on that point that you've made earlier.

Russell Freeman - Vice President and Chief Financial Officer

Let me just... there were some specific references to contract efficiencies and globalization and principally those contract efficiencies in the near term relate to infrastructure type services, one with the recently expanded contract and one with a relatively early stage contract in our commercial area. It's been both the commercial area and healthcare. Those operations that we referenced relate to Mexico however, we have been in a process over the past couple of years improving our global footprint and with that I will turn it over to Peter to elaborate.

Peter Altabef - President and Chief Executive Officer

Our global footprint continues to expand I'd say, this time last year about 29% of our people were in low cost geographies, this is now up to about 32% so it's roughly a third of our folks, that continues to grow. Our global headcount in low cost geographies year-to-year grew by 27%, while our high cost population grew by 11%. So you can see one of things about Perot Systems is there is some balance and that higher cost population is growing and continues to grow and we think that's a source of strength for us in terms of our ability to be at the client side and delivering innovation from that comes from understanding their business by being there, but at the same time that growth is a little less than the third the growth at a low cost geographies and you would expect that low cost geography growth to continue to remain a pace.

So, that's really our approach, the vast majority of our large clients now do use a global delivery platform, we expect that to be frankly standard at this point. We are going to service our clients in the best way that we can. The fact that we have a population that's growing both onshore and offshore however frankly makes that a little easier than perhaps in some environments where you don't have the same mix and perhaps is more concerns about job bleeding. So we think that this is a very good formula for us and its working well and its working for our clients.

Cynthia Houlton - RBC Capital Markets

Great. Can I just get follow up on the comments that you made of Triad about probably some confusion or not maybe confusion is the right word about adjustments in the flat software platform that's going to be used in and some of the things aren't entirely clear? Is there a possibility that there in terms of material changes to what your role or I guess your comments seems a little unclear how this contract is going to move forward? Have they given you a sense of... do they have at least a set period of time when all this is going to be determined or can you give us a little bit more color on how your discussions are moving forward with that and if they have given you some time lines?

Russell Freeman - Vice President and Chief Financial Officer

We have a very specific contract. Specifically as it related to implementation schedule that has specific platforms by hospitals. What we know is that there the acquirer's desire will be different in terms of that platform. We had no indication that there would be any material changes to our contract.

Operator

This ends the Q&A portion of the call. Peter Altabef will now make his closing remarks.

Peter Altabef - President and Chief Executive Officer

I want to thank everyone for joining the call this quarter. As always, we remain available to you. We have as I know each of you on the call, familiar with what I hope is a user friendly two page downloadable on our website and I encourage you all to visit that. Look forward to our continuing dialogues and look forward to our next call. Thank you again.

Operator

Thank you participating in today's Perot Systems second quarter 2007 conference call. You may disconnect at this time.

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