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Electronic Data Systems Corporation (EDS)

Q2 2007 Earnings Call

August 1, 2007 5:00 pm ET

Executives

Dave Kost - VP of IR

Mike Jordan - Chairman and CEO

Ron Rittenmeyer - President and COO

Ron Vargo - CFO

Analysts

Julie Santoriello - Morgan Stanley

Rod Bourgeois - Bernstein

Julio Quinteros - Goldman Sachs

Jim Kissane - Bear Stearns

George Price - Stifel Nicolaus

Adam Frisch - UBS

Tien-Tsin Huang - JP Morgan

David Grossman - Thomas Wiesel Partners

Nathan Rose - Citigroup

Joe Vafi - Jefferies & Company

TRANSCRIPT SPONSOR
Wall Street Breakfast

Operator

Good afternoon and welcome to the EDS Second Quarter 2007 Earnings Call. At this time, all participants are on a listen-only mode. (Operator Instructions) Today's conference is being recorded. If you have any objections, you may disconnect at this time.

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

Dave Kost

Thank you very much, Mary. Hello everyone and welcome to our second quarter 2007 earnings call. With me today on the call are our Chairman and CEO, Mike Jordan; President and COO, Ron Rittenmeyer; and CFO, Ron Vargo.

You should have received an email from me with a copy of our press release as well as the presentation to be used on today's call. We must apologize for the premature media distribution of our earnings press release, by a Canadian affiliate of PR Newswire. The presentation along with the web cast, 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 constitute forward-looking statements within the meaning of the Federal Securities Laws. These statements are subject to numerous risks and uncertainties, many of which are beyond our control, which could cause actual results to differ materially from such statements.

For information concerning these risks and uncertainties, see the risk factor section of our most recent 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 you to the slides posted on eds.com that accompany in this call.

Among other information, these slides and our earnings release present a reconciliation of the non-GAAP financial information to be discussed today and should be reviewed in connection with this discussion.

With that let me turn the call over to Mike.

Mike Jordan

Thanks Dave. Just a few comments, first I believe the second quarter was a pretty solid quarter for EDS. We met or exceeded our revenue and EPS goals. More importantly we made a lot of progress in the operating parts of our business and in our changed programs. Our growth in applications and our continued productivity improvements have let us believe that we can really accelerate those efforts greatly going forward and Ron will take you though the details, but we have a lot of ambition to carry that program forward and further improve margins.

You will note that we adjusted our free cash flow guidance downwards by about 9% to reflect some start-ups and resulting from 2006 signings, but we think if you look at this free cash flow in contrast to previous years where there was a lot of controversies shall we say about the quality of our free cash flow. This $900 million to $1 billion represents we think the earning power of the business and clearly it includes the Verizon payments for a substitute for the profit we would have earned this year, but the sale we think that’s reflective of the business as it exist. Clearly that’s poll that we will have fill in 2008.

We have layout our goal of achieving approximately the same level of free cash flow in '08 and '07 despite these negatives.

So, let me turn it over to my partner in crime and successor here, Ron Rittenmeyer to take you through the details.

Ron Rittenmeyer

Thanks Mike and good afternoon. Let me take you now through our business highlights for the second quarter, so turning to slide four. Our second quarter signings total $4.3 billion, primarily coming out of the Americas and EMEA and I would say a very balanced performance for the quarter.

Bear in mind, that last year in this quarter we signed $1.7 billion Kraft deal, so that’s make this a bit of a tough comparison. But helped by the signings of KarstadtQuelle in Germany the Application Service line represented 43% of our bookings in the quarter, we are very proud of that. We are very pleased with the six deals we signed with TCV greater than $100 million, and that 30% of our TCV was actually from new logo clients.

We had the pipeline to sign more than $4.3 billion, but three large deals did slip in the Q3. And I just want to make the point as we've said before, that we're not going to allow the quarterly target to influence whether we sign a deal in a specific quarter, if we don't think it's write to sign it. So movement can and should be expected in these types of things. But, all-in-all we are off to a very good start in the second half, and in fact, one of those three deals that slipped has already been signed.

Across the vertical markets; retail, government, and financial services, we also saw very good strength. So all-in-all signings were very solid. Next slide.

Slide five, shows for the full year, we continue to see line of site to our target of one book-to-bill ratio. We also expect progress with new logo signings to continue the positive trend that we've already established. We're further investing in our sales model, both with an increase to sales people. In fact, we've hired about 8,200 globally so far this year. As well as in-ways we're going to market within each service line.

Our application sales activity is being enhanced to more effectively sell and deliver that portfolio. So net-net, our full year TCV should be approximately $23 billion. Again, deals may move a bit, but what's critical is our pipeline, which really remained solid. In fact, we have more than 50 qualified mega deals in the pipeline already for the second half of this year.

Moving in to 2008, our pipeline is up over 20% with all service lines up versus second quarter of '06. And we have mega deals in our pipeline. Even though we had mega deals I should say in our pipeline and always will, we also recognize a change in dynamics in the market place. Smaller, unbundled deals, but what we've seen is a larger volume of deals. So this really has resulted in reducing our dependencies on deals that are greater to $100 million.

Our pipeline has been adjusted to reflect that we are investing in sales, we are investing in offerings and industry practices to also reflect those changes, which really gives us much greater flexibility and broader reach in the market place.

Let’s talk a little bit about our growth initials on slide six, a couple of examples of where we see revenue that we expect to contribute to our growth engine in the future. In the BPO service line we just launched the midrange credit card platform to further secure our position with a leading credit card processor outside the U.S. Outside the U.S. we still see growth in this area that continues to be an area of opportunity.

In the HR Outsourcing segment, ExcellerateHRO has released its new health and welfare and to find benefits administration platforms. We've actually converted EDS to that systems, same as will be done with our clients, and we've begun to generate interest in the market place. We've signed several new clients to the platform, and we are converting existing clients.

With regard to the next generation and end-to-end platform in HRO, we've actually gone live with the first series of capabilities for very large global client. We are also converting EDS to the eHRO platform to further validate not only the capability, but the size and the scale of that offering. We will be client one in many of these, to show our commitment. So we are turning our focus now for building a pipeline of opportunities based on these offerings. I think those are a few good examples of the way we are expanding offering and services to further enhance our growth.

Next slide, we are very excited with applications. Our second quarter revenue was $1.6 billion, which is up 8% versus a year ago. Application services accounted for 43% of our TCV in Q2. Looking ahead, our pipeline for application services is up 20% versus second quarter '06, and we expect this to continue.

We consolidated the testing organization of EDS, MphasiS and RelQ. RelQ you'll recall is our recent acquisition into a global group. This group will run as a practice. It will significantly improve the quality and efficiency of our global application centers as well as provide some sales expansion. We've also formally consolidated EDS India into MphasiS, and that's a move that facilitates the more aggressive plans we have for India.

To maximize our opportunities and applications, we have organized Charlie Feld's group to operate, not just as a service line but as a business with full P&L responsibility within the regions. Our strategy of developing applications that are designed to run is truly resonating with our client base, and generating modernization opportunities.

For EDS, this means starting the design and engineering, with the tension to running efficiently given security, privacy, network utilization and infrastructure considerations, which all impact the ongoing cost of maintenance. Ongoing cost to operate as an application is a key part of our design, and something that our clients are very excited about. We are making progress organically, but expect to make acquisitions to enhance our consulting in Apps development capabilities. All-in-all, the application service line is providing growth and margin expansion consistent with our overall mixed strategy.

Slide eight; within our global service network, we also created a competitively differentiated service that has resulted in a significant pipeline of sales activity for our network management services. As you know, we developed our own secure network. So from an operational standpoint, we are now managing one network versus six in our old network architecture. And we have shut down the majority if not all of the old networks. It has allowed us to shut the high cost of running multiple networks and carrying expensive spare parts.

From a sales perspective, it is truly a hot commodity with clients and recognizes a strong offering. A significant pipeline has been built as a validation of the value we offer.

Our SDA or Service Delivery Automation and BMT or Business Management Transformation initiatives are part of what we call Enterprise Services. They are the tools that are based on the (inaudible) standards, that standardize workflow and also automate and change what we do, helping us deliver work more effectively and efficiently, but really also helping our clients with improved performance and transparency. And we are deploying those, and the clients as well as EDS are realizing the benefit.

In Best Shore, we think we focused on improving the day-to-day services within our Best Shore service centers. We have been consolidating resources into our leverage centers, which mean fewer decentralized locations, improved leverage resulting in improved service, improved costs. We are also had in other locations the better balance our mix across the globe.

Slide nine, thank you. As you can see on the barograph, we are now up to 38,000 employees in Best Shore locations. Q2 was the highest quarter yet for our migrations. We have formally opened up our Wuhan facility in China and it has gotten off to a very positive start.

We are very excited about the partnership we’ve established with the Chinese Ministry of Commerce, which should help to solidify our position in the Chinese IT market. To put our resource count into perspective when you exclude our employees who support government work, approximately 34% of our workforce are now in lower cost locations, that’s a significant movement from two years ago and will continue. We are going to continue to optimize our workforce and clearly we see it as a great opportunity.

Slide 10. Quality remains one of our critical pillars. We've talked about this many times. Quality improvement is what we do everyday and it continues to be one of the vitally important responsibilities that each employee at EDS has as an accountability.

Our Severity 1 incidence has continued to decrease significantly year-over-year as our zero outage mentality continues to take hold in the company. Q2 was a significant month from an improvement standpoint. In the first half of '07 our Severity 1 outages are down 60% with a 72% improvement in Q2. Clearly, our zero outage mentality is producing positive results and we are very proud of that as a company.

So to summarize our highlights, we've had strong strength in our sales pipeline, which gives us very, very solid confidence in our future revenue growth. We are starting to see revenue generation from our all of our initiatives. Apps business is making meaningful progress and growing the business while transforming the global resource mix.

Best Shore migrations continue to ramp up. Global resourcing mix, excluding our government business continues to show scale, and as we look ahead, we do see future opportunities and some challenges, but we're going to proactively adjust to these challenges and continue our aggressive cost business restructuring alignment. That means continued aggressive Best Shore alignment to further this resource-mix-change and more aggressive build out of our apps practice.

We are convinced that our offerings and value propositions will generate upside in not only revenue but margin and equally in cash flow and we're going to continue these actions through 2008.

Doing this we'll provide in our opinion a much better return in 2009 and we see much more available upside and consider these actions as prudent ways to go about building a better performing company.

At this point, we need to build out some of the tactical elements of that plan and as you know that’s the time here, we are in right now and we will provide a much more detail growth map later this year as we build out those specifics.

So, with that I would like to pass it over to Ron Vargo for more details regarding our financial performance, Ron?

Ron Vargo

Great thanks Ron and good afternoon. I will be covering results for the quarter and commenting on our third quarter and 2007 full year guidance.

So with slide 13, total revenues were $5.45 billion up 5% on a year-over-year basis and up 1% organically with the primary difference to the currency exchange rates. Adjusted earnings were $0.27 a share, up 35% and GAAP earnings were $0.26 a share up 30% versus the second quarter of 2006.

Free-cash flow was positive $156 million, down from last years second quarter, when we benefited from two large onetime client payments. And finally, total contract value signed was approximately $4.3 billion, which was impacted by three large deals slipped into the third quarter as Ron stated.

I will provide a bit more color on these metrics in a moment. First, let me discuss our GAAP and adjusted earnings on slide 14. Again GAAP earnings were $0.26 a share, and we had one penny of adjustments from discontinued operations mainly related to divested businesses resulting in the adjusted earnings of $0.27 for the quarter at the high-end of our expectations.

Now I will take you to the income statement. This slide contains summary level line information from our income statement. Adjusted to exclude certain items and as you know the income statement and the other financials are provide with our earnings release as well. Here we provide a walk in this deck in the appendix to walk you from the GAAP income statement to the adjusted format and that’s on slide 28. So a couple of highlights on this income statement; Revenue up, $255 million, again currency exchange rates, MphasiS revenues and organic growth was partially offset by the 2006 divestiture of our European field services business.

Excluding Verizon revenues from both the second quarter of '06 and the second quarter of '07, revenue would have grown 7% over 4% on an organic basis. Operating income was up $82 million or 35% due to contract performance improvement and productivity programs. And our tax rate was 28.6%, benefiting from recently enacted Texas Tax Legislation that permitted a recovery of $13 million of deferred tax assets.

Contrasting that though, in the second quarter of 2006, our tax rate included favorable changes to tax liabilities for contingencies that resolved at an effective rate net quarter of only 15%. As we look out for the full year of 2007, we are projecting a full year tax rate of approximately 37% for the company. And finally diluted shares outstanding were $541 million, and we continue to expect the full year count for 2007 to be $545 million shares on a weighted average basis. So in summary, it was a solid quarter, high end of revenue and earnings per share expectations.

Now I will update you on free cash flow on slide 16. Again free cash flow was $156 million in the quarter and $148 million year-to-date for the first half of 2007. Working capital movements and capital expenditures were key drivers, both are absolute first half cash flow, and as well there were some material differences in these items between the first half of 2006 and the first half of 2007.

So let me discuss the changes in working capital movements on a year-over-year basis. First, deferred revenue, the impact of the two large client payments we received in 2006 second quarter from Navy and another large government client provided a significant difference in deferred revenue on a year-over-over basis.

Receivables due primarily to an increase in day sales outstanding in the first half of ’07, which I will talk about in the next slide and an increase in deferred contract cost from 2007 over 2006 associated primarily with the ramping up of some of the large contracts we’ve signed over the last few years. And these items were partially offset by lower tax payments and higher provision for taxes.

Capital expenditures, Net capital expenditures were up $89 million on a year-over-year basis. Gross capital, which includes real estate leases as well as hardware, software and other capital increased $321 million on a year-over-year basis. And this was impacted significantly by refinancing our Tulsa data center and other office space leases including significant rentals for Best Shore office space.

In addition, we have conventionally reported our gross capital net of any asset sales or other asset proceeds, and on a year-over-year basis we had $114 million lower asset sales and other asset proceeds which affects the net capital expenditures.

Now, let's turn to the DSO. Slide 17. On this slide I'll just update you on where we are on a receivables DSO. We did make some improvement from second quarter to first quarter our DSO declined by 2 days from 64 to 62 days. But on a year-over-year basis we are still impacted by certain contract term changes that took affect in the first quarter of 2007.

We are still confident in targeting a DSO at the end of 2007 in the mid-50s, and we think several factors will get us there over the next six months. Process improvements, addressing the timeliness of our invoicing process, reductions in outstanding past due receivables, as well as certain payment structures that should result in higher fourth quarter collections as they did in the fourth quarter of 2006.

Now, for a summary of select balance sheet movements; We'll turn to slide 18. This slide highlights notable balance sheet movements between December 31, 2006 and June 30. I'll only mention on this slide, our shareholders equity that increased by $319 million due to earnings and foreign exchange effects, partially offset by share repurchases during the year. That combined with our debt staying essentially flat, up $10 million on a year-over-year basis, resulted in a debt-to-total capital ratio of 27%.

Now I will turn to our financial guidance. We are maintaining our full-year 2007 revenue and earnings per share guidance at $22 billion to $22.5 billion for revenues and $1.55 to $1.60 per share respectively for earnings.

We are revising our full-year 2007 free cash-flow guidance to a range of $900 million to $1 billion, due primarily to higher investments in both capital and working capital including deferred cost.

We are adjusting our full-year 2007 TCV guidance to approximately $23 billion from $23 billion plus.

For the third quarter, we expect revenue between $5.6 billion and $5.8 billion and earnings in the $0.37 to $0.43 per share range. The key earnings per share drivers in the quarter are expected to be, first the income from recognizing the remainder of the Verizon contract payment. As you recall we recognized a portion of that in the first quarter of 2007, and upon the removal of certain contingencies, we expect to recognize the second portion of that in the third quarter.

We will also benefit from sequential revenue growth and continued momentum in our productivity and operational performance. Offsetting these pluses will be a non-cash German tax asset charge which we told you about in the first quarter call which will be approximately $0.7 a share. And a step-up in our severance and Best Shore expenses as we drive forward with our work force initiatives.

So in summary we had a solid second quarter, with revenues and earnings significantly higher than last year. And we improved our operating margin to 4.3% in the quarter. We began making progress on our DSO's and expect further improvement across the second half of 2007. Our cash flow was $156 in the quarter, and expect it to be $900 million to a $1 billion for the full year, greater than the full year 2006 total.

And we will continue to take aggressive actions into 2008 to manage our cost structure. As a result, currently we would target free cash flow in 2008 to be roughly in line with our 2006 and 2007 levels and expect improved financial performance in 2009. So with that let me pass it back to Ron Rittenmeyer.

Ron Rittenmeyer

Thank you Ron. Let me just summarize then before we move to questions. We've had a solid quarter two business performance, significant year-over-year earnings improvements continuing our three year trend. We are confirming guides for revenue and EPS in 2007 and we are adjusting our full year 2007 free cash flow, which both Mike and Ron spoke to you. We have lined aside, a very strong pipeline for our $23 billion forecast in bookings. And we really have continued commitment and conviction that as we go through to 2007 with the improvements we are making in operational performance for aggressive actions we see that continuing. 2007. Because we think that much opportunity does exist and we believe that will be the pillar that will continue to further improve EDS’s overall performance.

So with that, I will turn it back to Dave Kost.

Dave Kost

Okay, Mary, I would like to open up the call for questions and I would ask that you try to limit your questions to one per person.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Julie Santoriello with Morgan Stanley. Ma'am your line is open.

Julie Santoriello - Morgan Stanley

Okay, thank you. Good afternoon. I wanted to ask you, in light of some of the additional cost moves that you are taking, can you talk about any change potentially in the long-term margin targets?

Ron Rittenmeyer

Well, we don’t have at this point I think specific numbers to talk about in 2008, I said we'll do that probably in the next quarter’s call when I think we’ve had a little more detail around this. But, clearly we obviously know this investment will result in step-up of our performance. So, at this point I think I’d rather wait until third quarter to get into those types of details as we formalized this, but suffice to say that we expect to have a step up and that’s what our direction will be.

Julie Santoriello - Morgan Stanley

Thanks, and if you can just elaborate a little bit more on those three large contracts that were pushed out beyond the second quarter. Can you talk a little bit about the circumstances around that, and if this is what you think something that is endemic in the industry right now?

Ron Rittenmeyer

Well, I don't know if it's endemic in the industry, and given the quite confidentiality of some of these, I can't get in to specifics. But, so far here's what I would say, is that, when you are negotiating the deal and you get close to the end of that negotiation as you bump up against the quarter. I was a customer. If it's obvious that you have a lever, that you want to negotiate a little further with, you got to decide whether or not that's a real lever and whether or not we're willing to do that. And I wouldn't say that it's endemic issue, but it's something we have to be conscious of.

In some cases, it's just because they haven't been able to get their board approval in time. In some cases, it's because we still have one or two open points. But in the end, for example, one of the three already signed. In fact, signed three days after the quarter. So it's just kind of the way it happens and falls. But I don't want us to be making a rash decision if, in fact, just to get to a number. But I am comfortable about the pipeline, and I think that's what important.

Mike Jordan

Just a historical comment. As we looked at our 20 plus major problem contracts several years ago, a very high percentage of them were signed in the last week of the quarter. So, haste makes waste and so we are pretty conscious of doing the right thing, and we're not worrying about where it falls in the quarter.

Ron Rittenmeyer

And we have a tough governance process now, so there is a lot of oversight in that, which make us I think keep our objectivity.

Julie Santoriello - Morgan Stanley

Thank you, Ron.

Operator

Our next question comes from Rod Bourgeois with Bernstein.

Rod Bourgeois - Bernstein

Hey guys.

Ron Rittenmeyer

Hello Rod.

Rod Bourgeois - Bernstein

We've notched the free cash-flow guidance down a little bit for this year. We are planning to keep it flat in the 2008 timeframe, which means the allure in many respect for investors to be interested in EDS's stock has a lot to do with 2009. I know it’s extremely premature to ask this, but you are sort of advertising improved financial performance in ’09, can you talk about what’s behind the ’09 financial performance improvement. I mean do you have any cash-flow target that you are thinking about for the ’09 timeframe, as I do think a lot of the and particularly the value of investors that look at your stock are going to want some idea on what the plan might be, at least a ballpark plan for the 2009 timeframe at this point. Can you say anything along those lines?

Mike Jordan

Ron this is Mike. You know I don’t think we can say anything right now. As Ron said we are targeting to move our operating margins sort of significantly above the ’07 target, which we looked to be on track to hit. And the cash flow will obviously come with that. Now we are just not far enough for long and pinning down what’s in our way and what’s going to slip into ’09. So we will try to give you a little more color than this on the third quarter call when we present, usually present our guidance for ’08. But just to say, we are targeting a significant margin improvement going forward with obvious impact on free-cash flow.

Rod Bourgeois - Bernstein

Okay. And just for Ron Rittenmeyer, as Ron assumes the CEO spot I am wondering if there are any messages that will be conveyed to the employees, to the customers or even to investors, in terms of strategic changes or operational philosophy changes or anything along those lines that will be communicated as Ron moves into the CEO role I am wondering is there anything along those lines that will be communicated?

Ron Rittenmeyer

This is Ron. I think Rod what I would say is that Mike and I have been pretty close. Clearly the last six months we have been very close as we work through this transition, so I think the messages that you are hearing about improved performance, stepping it up a little bit more, being a little more aggressive, not even little bit more aggressive, a lot more aggressive and more focused on some of the key measures. I think you are going to see that continue and I don’t see any significant change that I would want to say today. I think we are already on the trajectory and that's where we are going to head.

Rod Bourgeois - Bernstein

Just a quick related question on the strategy. It seems that a lot of this strategy that was outlined earlier this year and what hinges on the ability to acquire higher margin, higher growth businesses. We haven’t seen a lot in the way of acquisitions this year and so can you give us any update?

Mike Jordan

Yeah just a quicky on that; we have got probably seven maybe eight active negotiations going on. The first half of this year was a tough year for strategic investors, for obvious reasons as we saw the private equity craze come in and scoop up stuff but had no business buying in our minds. But we didn’t chase stuff that was uneconomic and in some respects this crunch in the credit markets favors strategic investors as it was pointed out in the journal yesterday or the day before, so we think the second half will be much more productive than the first half.

Rod Bourgeois - Bernstein

Right that makes sense. Thanks, guys.

Ron Rittenmeyer

Thanks Rod.

Operator

Our next question comes from Julio Quinteros with Goldman Sachs.

Julio Quinteros - Goldman Sachs

Hey, first of all congratulations Ron on the new position here, I mean clearly the track record on the operating side is pretty well established, I guess I am wondering more about the growth side of the equation here as we begin to kind of look to 2008 and beyond, with bookings now at the lower end of trajectory here and expected to be down year-over-year to double-digit range. Just give us a sense beyond acquisitions where other sources you think are for real revenue growth in this model on an organic basis?

Ron Rittenmeyer

Again, I guess, as I said earlier that our bookings I think are still pretty positive when I look at our, you got to go back to 2006 and realize that you had the big GM re-compete and the Navy re-compete, so those did somewhat skew the overall number. When you look at it on a basis of year-over-year growth we continue to show I think pretty positive growth. We are reflective of that growth relative to the balance of capital and the investment required. So, I mean there's got to be a balance between margin, free cash flow and revenue.

We are really putting a lot of focus on applications, I think the applications, clearly from our standpoint have higher margin opportunities for us, less capital usage, that’s things we’ve already talked about. So, we have seen that type of improvement, when I compare it to last year, its up significantly, we are investing in the practice area, we are putting lot of our focus on building out applications and things like the RelQ testing, the combination of India with MphasiS and EDS now been finalized. I believe that the future growth of this company will skew more. We'll spend much more emphasis in to the applications side of the business.

And even though we say we're going to be less dependent on mega deals, the reality is there are still a lot of $100 million deals in the pipeline, and those are good deals. Now, we may have few qualified 50 deals for the second half, that doesn't mean we'll certainly win all those and some of those are spillover to the future years, but having said that I am pretty comfortable that we have a very good line aside and that the growth will continue to be pretty positive.

So, I am not concerned about that if that's where you are heading. I think our strength in deals is still pretty good. Our win rates, our win rates continue to be very positive, so, overall, I think our growth looks actually pretty solid.

Julio Quinteros - Goldman Sachs

Okay. Well, at this point at least to take it to a number for sort of the out years?

Ron Rittenmeyer

No, I don't think so. It will follow with the rest of the guidance that we do.

Julio Quinteros - Goldman Sachs

Okay. Thank you.

Ron Rittenmeyer

Thanks, Julio.

Operator

Our next question comes from Jim Kissane with Bear Stearns. Your line is open.

Jim Kissane - Bear Stearns

Thanks. Ron, can you elaborate on your comments regarding the capital requirements going up. I mean, it sounds like the business is getting more capital in terms of the gain, but you are saying that your application services contracts are growing as a percentage of total. I am just trying to reconcile the two things?

Ron Vargo

We'll go with Ron Vargo first and Ron Rittenmeyer, can join him if he wants to, because I talked about capital and the free cash flow statement. I said that one of the drivers of taking our cash flow down for the year by $100 million was higher capital and working capital in 2007.

And I don't think it's a dramatic shift Jim, but, and I also pointed out the fact that we've benefited, historically, from asset sales and those are down year-over-year. So, I think it's a combination of a little bit more intensive capital from some of the bigger and newer deals that we signed in deferred cost. A little bit of built out of some of our Best Shore investments, and overall working capital that’s driving the cash forecast down for the year, Ron do you want to add anything?

Ron Rittenmeyer

No, the only thing I would like to add to that I mean those are all correct and as you, even as you grow we call capital [elite], which is continuing to be a focus, we still like to built seats out in India and we still like to build seats out in some of these new locations. So, there are some upfront capital things that we have to deal with it, it’s a really of the business, those should payout to much greater returns going forward.

Jim Kissane - Bear Stearns

And Ron, just a margin on the smaller unbundled deals that you talked about versus the mega deals?

Ron Rittenmeyer

Yeah.

Jim Kissane - Bear Stearns

Can you comment on the margins on the HR/BPO business?

Ron Rittenmeyer

Yeah, those margins are good. You know again I think they are inline with certainly some of those deals, those margins would be inline probably better than ITO, less than applications, so kind of somewhere in the middle there. I don’t want to give a specific number obviously for competitive reasons, but the margins are more than acceptable, so they are bit solid margins.

Jim Kissane - Bear Stearns

Including HR/BPO.

Ron Rittenmeyer

Well HR/BPO, again you have got two types of HR/BPO, you have benefits admin business which is a very good business, and you have got the larger HRO deals. The larger HRO deals just like any large deal tend to be less, benefit admin tends to be better, so. Then we have a healthy mix, the platform we have just released and we have converted a lot people, RO is in the better admin space.

Jim Kissane - Bear Stearns

Great. Thanks, thanks Ron.

Ron Rittenmeyer

Sure.

Operator

George Price with Stifel Nicolaus, your line is open.

George Price - Stifel Nicolaus

Thanks very much. Main point is I want to drill down a little bit more on what’s going on with free-cash flow. Ron Vargo just, you mentioned three things just now, right. Capital needed for some of the bigger deals signed last year, building out a Best Shore, and then overall working capital. Can you kind of disaggregate those and help us understand what each of those is. What impact each of those is having on the free cash flow, the change in the free cash flow guidance? And then I would add to that also on the capital needed for some of the bigger deals signed last year. Why is that -- why are we hearing about that only now when those deals were presumably things yet, yet more visibility on.

Ron Vargo

Yeah, okay George. I don’t think it's any one area that's causing a significant impact. So it's really more of a combination of things, including lower asset sales and slightly higher deferred cost. So I talk about the deals that we've signed over the past couple of years. I'd say those are more just slightly higher deferred cost that we are seeing. And then when you go to the best shoring activity, I think we are moving a significantly higher number of jobs offshore. We are building out infrastructure in those countries. We are outfitting those desks with hardware and software. And I think the combination of those things is causing a slightly higher amount of capital this year. But I would not say it's any one individual thing. And I would say some of the best shoring has been happening over the last couple of quarters in increasing amounts, even increasing higher than we thought it would, in terms of number of jobs we've been best shoring.

George Price - Stifel Nicolaus

Let me ask something more directly. Is any of this cash being deployed to address execution issues on any of the contracts that you have singed over the last year or so?

Ron Vargo

No, absolutely not.

Mike Jordan

No, let me make a couple of comments on this. Free cash flow number is always volatile, because of timing issues on capital. But as I try to emphasize, if you take out the sort of one-time as we had last year, this is a significant improvement in free cash flow over the prior year. And that flew lower than we thought, but we’ve got surprised by couple of things like India, the need of India staff. But I think we are on a pretty solid trend of improving earnings, and we will also improve capital efficiencies. And I think it would be a mistake to read some dire trend here.

George Price - Stifel Nicolaus

In terms of the prior guidance that you've given, you've split it up between cash from ops. I think it was Ron last – that your guidance is 10% of revenues and cash from ops and that 5% to 5.5% CapEx. Can you kind of re-clarify those?

Ron Vargo

Yeah, George. Our expectations are that CapEx would still come in at that 5% to 5.5% range for the year, probably more in the high end. I think working capital with the accounts receivable, deferred contract cost and the changes will probably be very much at the high end of the 1% to 2%. So the combination of those two being up at the high end along with our cash flow from earnings being kind of where we expected it to be, is what drives us a little bit lower than the 4.5% to 5% for the full year as a percent of revenues.

George Price - Stifel Nicolaus

Okay, last one. Below the operating margin line, you may have commented or not I may have missed it. But just, obviously, at the lower tax rate the operating income was actually pretty spot on to what we were expecting, but the below line impact was negative impact, it was much larger. Can you take apart that other income expense line below the line a little bit? Thanks.

Ron Vargo

Yeah. Briefly, we had a little higher interest in others, I think, than we expected. We have interest grade swaps on a significant amount of our debt and some of those get mark-to-market every quarter. And with the interest rate movements in the second quarter, we had a pretty high provision for our swap in the second quarter. That could very well reverse in this quarter, if you see interest rates continue to be at very low level. So, there is some volatility there caused primarily by some of our interest rate swaps.

George Price - Stifel Nicolaus

Thank you.

Operator

Adam Frisch with UBS, your line is open. Mr. Frisch, your line is open.

Adam Frisch - UBS

Thanks. Good afternoon. George did a good job on free cash flow, but I had a couple of other questions there. First, Ron Vargo, under EITF 00-21 higher deferred-cost are indicative of contracts that are a little bit maybe behind schedule, is that correct?

Ron Vargo

Not necessarily. Several of these large contracts Adam, have some significant construct and build portions to them, where the cost gets put on the balance sheet.

And again, I would kind of go back to Mike's comment around capital generally in deferred-cost individually. These are not going to ramp in alarming changes.

Ron Rittenmeyer

Or problem contracts.

Ron Vargo

Or problem contracts for that matter, yeah.

Adam Frisch - UBS

Okay. Investments supposedly peaked last year, and I am assuming would theoretically be accretive to cash flow this year, just on the math of easier comps as well as the operational savings, so why is that being stated as a reason for free cash-flow weakness?

Mike Jordan

Yes its what we called investments outside of severance, they are not incremental, they are more investments in rolling out, part of rolling out say SDA to our data centers and things like that. So, I think that the point is there is, attached and lurking here, besides kind of normal volatility.

Adam Frisch - UBS

If they are less this year then they were last year, I know and when last year you saving your money, will that be accretive to '07 free cash-flow?

Mike Jordan

I am not sure where you headed here but --

Adam Frisch - UBS

I guess where I am headed is, to be blunt is, investments were suppose to go down last year when it was the peak and why are they still I guess at equal or elevated levels or why aren’t the one that you made --

Mike Jordan

We are not saying that.

Ron Rittenmeyer

We didn’t say that Adam, I think maybe you are confused here around capital investments and you know sort of this capital we used in the past around the P&L investments in our --

Mike Jordan

Technology.

Ron Rittenmeyer

Technology and our severance cost which the combination of those are coming down on year-over-year basis.

Adam Frisch - UBS

Okay. I will take that off around Ron, maybe after the call. But last question I have on free cash-flow was the assets sales in the quarter, they are about $23 million, first half $69, last years first half was I think $183 according to your slide, I think it was related to like building and land sales and stuff like that, what was done in the quarter and in the first half of '07 so far?

Ron Rittenmeyer

What you seeing the big change on year-over-year basis is the runoff of the treatment of the navy contract leases which makes up the bulk of both of the numbers and then the remainder is just some miscellaneous asset sales and there was nothing really significant to note in the either period.

Adam Frisch - UBS

Okay. And then Mike Jordan, in the Analyst Day you basically said that given your current revenue mix margins were close to as not at peak levels and to get it higher you would need to do some acquisitions, schedule further up the values wagon and so forth. Is M&A part of that expansion story here or can you just?

Mike Jordan

No actually it isn’t. I mean it partially is supporting our applications, but basically I think we sort of changed our tactic, we think even without a significant mix change, we can drive our operating margins further, because we have just made so much progress on the cost side and we just think there is more opportunities. So when we said the 7% to 8% sort of pre compensation expense as target margin, we think we can push higher than that. And obviously applications mix and growing applications faster will help that. But it doesn’t need a significant M&A to do that. We are not counting on that.

Adam Frisch - UBS

Okay. And then promise Dave here, last question for Ron Rittenmeyer. Mega deal you said there were 50 in the pipeline. Are those now being defined as deals greater than $100 million?

Ron Rittenmeyer

Greater than $100 million.

Adam Frisch - UBS

Okay, thank you.

Operator

Tien-Tsin Huang from JP Morgan. Your line is open.

Tien-Tsin Huang - JP Morgan

Just a follow-up question; I have questions on the Mega deal. How many over a $1 billion in TCV of the 50 that you talked about?

Ron Rittenmeyer

How many over a $1 billion, is that what you said?

Tien-Tsin Huang - JP Morgan

Yeah.

Ron Rittenmeyer

The only thing I really want to talk about we have 50 over $100 million and that's kind of the cut we will make at this point. There are deals in the pipeline that we were considering to be over a $1 billion, not a significant number. But, that's kind of what we talked about at this point.

Tien-Tsin Huang - JP Morgan

Okay. And then also on the acquisition pipeline, are you still targeting $1 billion to $2 billion in spending there per year and if so

Ron Rittenmeyer

Yeah, we are.

Tien-Tsin Huang - JP Morgan

So I was curious would you consider doing a single large deal there outside of that range if the right one came along?

Mike Jordan

If the right one came along, yeah.

Tien-Tsin Huang - JP Morgan

So they are not limited to, we could see a large deal?

Mike Jordan

Well it depends how large is large, depends on your financial capability. But yeah I mean, we think the market is improving for strategic acquisitions as I mentioned before, and so we got lot of irons in the fire and we have a lot of parts of our business we want to strengthen through this, so stay tuned, we think will get quite a bit in the second half.

Tien-Tsin Huang - JP Morgan

Is it fair to say that perhaps maybe BPO is sort of a higher priority on acquisition side and applications, given that application is going pretty well here given the MphasiS deal?

Mike Jordan

We are looking at improving specific capabilities in applications, we were short on the talent in the industry orientation, we have some of the other ones that we talked about like healthcare is still a high priority for us in addition.

Tien-Tsin Huang - JP Morgan

Okay, very good, Ron congrats on the CEO role and Mike good luck.

Ron Rittenmeyer

Thank you, Tien-Tsin.

Operator

David Grossman with Thomas Wiesel Partners, your line is open.

David Grossman - Thomas Wiesel Partners

Hi, thanks. And you may have answered this in parts of other questions, but kind of just in summary can you other than the Verizon contract, can you review what the primary plus and minuses are in a free cash flow in 2008? And also help us understand whether your '07 and '08, are you assuming you'll get to that mid 50s kind of DSO target by the end of the year?

Ron Vargo

Okay. I'll start with the -- it's Ron Vargo. I'll start with the DSO number, and we would target to get down to the mid-50s by the end of this year. So approximately the same as last years' ending number, 56 days. And be able to hold or marginally improve that in the future.

I don't think there are significant pluses and minuses to talk about in '08 other than Verizon. I think we're kind of just putting some boundary around where we think the '08 cash flow will be. But it's really pretty mature to really kind of go beyond that right now. And as we told you, we'd get back later in early fourth quarter to talk more about our views of '08 and beyond.

David Grossman - Thomas Wiesel Partners

And is there a way, as I recall at one time it was going to be a refresh year for NMCI, is that still the case or when you…

Ron Vargo

We are doing that this year

David Grossman - Thomas Wiesel Partners

Kind of last year, did that change?

Ron Vargo

It actually started this year and will continue next year. That's correct.

Ron Rittenmeyer

We're doing it now.

Ron Vargo

Yeah. We got heavy spending now so…

Ron Rittenmeyer

And next year as well.

Ron Vargo

And next year.

David Grossman - Thomas Wiesel Partners

Okay. And I guess, could you answer, there was a question on the tax rate, and again, maybe I missed this. So you are assuming about 37% for the year. Is that right number going forward in to '08, and I guess secondly, is the German kind of item that you talked about in the third quarter, is that reflected in that 37% rate?

Ron Vargo

Yeah, it is. We had some pluses and minuses in the year. This German item is a significant hit to the tax rate if you were expecting it to happen in the third quarter. 37% is the expectation this year on a going forward basis; we would expect it to be closer to 35% or 36%.

David Grossman - Thomas Wiesel Partners

Okay. And I guess just one last question, just on the guidance for the year. Is that with or should we assume that with the discontinued operations and the adjusted EPS or the GAAP number that you are guiding too?

Ron Vargo

We guide to adjusted earnings, not the GAAP number.

Dave Kost

Thank you David.

David Grossman - Thomas Wiesel Partners

Thank you.

Operator

Pat Burton with Citigroup, your line is open.

Nathan Rose - Citigroup

Hi this is [Nathan Rose] in for Pat Burton. I wanted to turn to the question to ask about the pipeline a bit and the booking numbers. You mentioned that you were moving more towards the smaller contracts being [comfortable] to the larger ones. Is that just due to market demand or are those contracts more profitable in your view?

Ron Rittenmeyer

Yeah its not necessarily preferable. The market requirement -- we have seen more movement towards unbundled contracts and therefore smaller contracts. So what we have done is align our organization to be able to deal with us. But I think there is a balance of deals greater that $100 million and deals less than $100 million. We don’t want to be a corporation that’s fully dependent on these mega, mega deals as carrying the business. You know we’ve signed a few this year. You know [karstakvalo] was a great example. It’s a great deal, we should love it. It’s a great Apps deal and it’s a big one. So those kinds of deals we are going to do every time. But having said that, we are not going to be dependent on only elephant honey. I think we have the capability of doing other things as well, so we've adjusted accordingly and so far its playing out pretty well, so.

Nathan Rose - Citigroup

Okay. And then given that we are about a third of the way to the full year goal. Is it the trend towards the smaller deals that's slowing up the progression of bookings or is it more just a seasonal trend towards the back Apps.

Ron Rittenmeyer

Again, I think if you compare where we are this year compared to last year, we signed 4.3, which is up 20%. 6 included the Craft deal and another large deal. So when I look at net-net, I don’t know if it's slowing down or not. I feel like we have actually had a pretty good quarter, and I would suspect the $23 billion we are saving for the year is a good number. I just wanted to address the bookings to say approximate, to give myself some reflection of some of the deal slippage that I think it occurs for the reasons we talked about it earlier. So no signal that the deals are not there in the pipeline. I think the most important point to realize is the pipeline. When I look at overall pipeline it's still up significantly year-over-year. So..

Nathan Rose - Citigroup

Okay. And then if the three deals that had slipped out of this quarter if those had come to fruition, about how much would that have helped close the gap to the full year?

Ron Rittenmeyer

More, more. I get scared. I don’t want to quote numbers because we haven’t signed. We have just signed one of those and announced it. We haven’t signed the others. We announced the Bank of Australia and the CBA deal, and that's already been announced publicly. The other two, I can't talk about because they are just not signed and it would be inappropriate to talk about numbers.

Nathan Rose - Citigroup

Okay understood. And then just a last question on free cash for '08. The question there is that, does the assumption that it will be similar level to '07 include continued investment related to off shoring or due you expect those investments to be completed this year? Thanks.

Ron Vargo

No, we expect off shoring or Best Shoring as we call it to be important part of that company’s strategy going forward as well.

Ron Rittenmeyer

Yeah. To the extent that we are going to expand that, we are going to continue investing in it. It reduces our cost and gives us a much better quality and cost footprint. So I think it makes all the sense in the world to continue doing it.

Nathan Rose - Citigroup

Okay, thank you, guys.

Dave Kost

Okay, operator we have time for one more question.

Operator

Thank you. Our last question comes from Joe Vafi with Jefferies & Company. Sir, your line is open.

Joe Vafi - Jefferies & Company

Hi, gentlemen, good afternoon. Maybe just one question on the Best Shoring strategy; If we look out five years from now, do you have a feel for what you are with, if you look at your delivery mix and headcount. Where you see the mix being in lower cost geographies versus maybe more traditional geographies? And where we are in that progression now?

Ron Rittenmeyer

This is Ron Rittenmeyer. First of all, remember we have a large government business, so some of this will be dependent on how much we grow government versus commercial. Government's not going be significantly Best Shore to maybe some, but it won’t be material. So we are already 34% of our non-government workforce Best Shore. I think that will go up to the 50-50 mix. Going forward, I also believe that you will see a higher percentage on the applications side, more around managed work compared to time and material works. So the more we do managed work, the more we will be moving that offshore. So I don’t know if that answers you questions, but directionally that’s what I would say.

Joe Vafi - Jefferies & Company

That’s helpful. And, as you move more of your -- as the geography and the delivery mix changes, you had to change contracts and should we be worried about revenue cannibalization and some other traditional businesses?

Ron Rittenmeyer

I think any time you move you have revenue cannibalization. The key is can you provide the values. When you are moving you should be providing the value scenario that shows that reinvestment of that gives the client significantly more than what they had. So I think the pure sense to your statement, yeah, there is revenue cannibalization. But what we've also been successful doing is reapplying that, that savings that the client gets [steadied] to their bottom line they have actually reinvested it in more work. So I actually think it's a greater opportunity to further solidify your position.

Joe Vafi - Jefferies & Company

Thank you very much.

Ron Vargo

Thank you, Joe.

Dave Kost

With that operator, I would like to thank everyone for joining us on the call today. If there are still some questions in the queue, I'll be available afterwards. Feel free to call my office and I'll be glad to talk those through.

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