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Executives

Jack McHale - VP of IR

Joe McGrath - President and CEO

Janet Haugen - SVP and CFO

Analysts

Julie Santoriello - Morgan Stanley

Jason Kupferberg - UBS

Ashwin Shirvaikar - Citigroup

Susan Chen - Merrill Lynch

Jerome Land - Milbert Capital

Unisys Corp. (UIS) Q3 2007 Earnings Call October 23, 2007 8:15 AM ET

Operator

Good day and welcome to the Unisys Third Quarter 2007 Results Conference Call. At this time, I would like to turn the conference over to Mr. Jack McHale, Vice President of Investors Relations at Unisys Corporation. Please go ahead, sir.

Jack McHale

Thank you, operator. Hello, everyone, and thank you for joining us this morning. Earlier this morning, Unisys released its third quarter 2007 financial results. With us this morning to discuss the results are Unisys' CEO, Joe McGrath; and our CFO, Janet Haugen.

Before we begin, I want to cover just a few housekeeping details. First, today's conference call and the Q&A session are being webcast via the Unisys Investor website. This webcast, including the question-and-answer session, is being recorded and will be available as a replay on our website shortly after the conclusion of the live event.

Second, you can find on our Investor website the earnings release as well as presentation slides that we will be using this morning to guide the discussion. These materials are available for viewing as well as downloading and printing.

Third, today's presentation, which is complementary to the earnings press release, includes some non-GAAP financial measures. Certain financial comparisons made in this call will be with and without the impact of retirement expense and restructuring charges. In the presentation we have provided a reconciliation of our reported results on a US GAAP basis compared with our results excluding the impact of these items.

Finally, I'd like to remind you that all forward-looking statements made in this conference call are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. These factors are discussed more fully in the earnings release and in the company's periodic reports as filed with the SEC. Copies of the SEC reports are available from the SEC and from the Unisys Investor website.

Now let me turn the call over to Joe.

Joe McGrath

Thanks, Jack. Hello, everyone, and welcome to today's call. To begin our discussion this morning, please turn to slide 1.

Two years ago this month we announced an aggressive plan to fundamentally reposition Unisys in the marketplace and achieve a competitive profit level for this company. We aimed high, setting a goal of 8% to 10% operating profit margin, excluding retirement expense. Given where we were coming from, this would represent a huge leap forward.

Today, two years later, we can point to clear, strong and continuous progress. In fact, as I'll show you in a few moments, we have increased our services operating profit to a level we haven't seen in nearly four years. That's not where we want to be at. We still have challenges to work through and opportunities we plan to take advantage of. But I am very encouraged by the transformation we're seeing in this company's profile and business model.

I'm proud of the work our people have done and the tenacity they have shown in stepping up to a big challenge. We look to close out this year with a strong fourth quarter. Our CFO, Janet Haugen, will go through the financial results in detail in a moment.

Please turn to slide 2 for financial highlights. Starting with orders, our services orders showed single digit growth in the quarter and year-to-date. Our services order growth in the quarter was driven by growth in outsourcing and infrastructure services, while systems integration orders were down in the quarter following substantial gains in the second quarter. Systems integration orders were up slightly through nine months.

At the topline, revenue was down slightly in the quarter as we continued to rationalize our portfolio. Within our revenue base, we continue to see a shift towards strategic programs while we deemphasize lower value-added areas of the portfolio.

In our services business, which now represents 87% of our business, revenue was flat in the quarter. We saw continued revenue growth in outsourcing, which was offset by declines in infrastructure services and core maintenance.

We did see a positive sign in our systems integration and consulting revenue, which was flat in the quarter following declines over the past year. Technology revenue declined 9%, driven primarily by a continued secular decline in mainframe revenue. But we expect a strong rebound in this business in the fourth quarter.

At the bottomline, we reported an operating profit of $44 million in the quarter. This is an $87 million improvement from a $43 million operating loss a year ago. Our tax expense more than doubled in the quarter, and we also incurred $19.3 million in other expense compared with slight other income a year ago.

Including these items, we reported a net loss of $31 million in the quarter. This compared to a $77.5 million net loss a year ago, which included a restructuring charge. As we implement our repositioning program, we continue to see significant improvement in our profitability.

Slide 3 shows how our overall operating profit margins have progressed over the past two years. This is on a GAAP basis, including restructuring charges and retirement expense.

Slide 4 shows our operating margin progress on a non-GAAP basis, excluding retirement related expenses and restructuring charges. As you can see on this slide, we improved our non-GAAP operating profit margin to 4.6% in the third quarter. This is a 170 basis point improvement over the year ago quarter. The year-over-year margin improvement is even higher in our services business.

Slide 5 shows our services operating profit margin over the 2006 to 2007 period on a GAAP basis.

Slide 6 shows our services operating margin progress on a non-GAAP basis excluding retirement expense. As you can see, we increased our services operating profit margin to 5.3% in the third quarter. This is the highest services operating profit margin that we've achieved in 15 quarters, going back to the fourth quarter of 2003.

We expect this improved services margin trend to continue in the fourth quarter. We're also expecting a strong rebound in our technology revenue and operating profit in the fourth quarter. The combination should enable us to close out 2007 with continued year-over-year improvement in our overall operating margin in the fourth quarter.

We are achieving this margin progress despite two issues that have been weighing on our operating profitability this year. Those two issues are higher temporary contract labor costs and weakness in our systems integration and consulting business.

Please turn to slide 7 for an update on these two issues. As you recall, our use of third-party temporary labor has increased in 2007 to help maintain our service delivery levels during the transitional period as we implement headcount reduction. We continue to take actions to reduce our use of temporary contract labor. Our largest use of contract labor is in our outsourcing business, where we have seen the most growth and the most number of people working on client engagements.

We have worked through an extensive benchmark process and are now reengineering processes in our outsourcing business and throughout our services operations. This is proving to be somewhat more difficult than we thought, and we're stepping up our efforts by placing more resources, including additional teams of Six Sigma Lean experts, to address it.

We did make some progress in the third quarter, taking out some of these increased contract labor costs. We expect to take out an even larger amount of these temporary costs in the fourth quarter, and we have targeted to then complete the effort in the first quarter of 2008. So it's taking us an extra quarter or so. But, as we get these costs out, we expect to see the benefits in our margins.

Regarding our systems integration and consulting business, we continue to work through disruptions in this business related to changes we've made in our repositioning program. As I think you know, our systems integration and consulting business at Unisys is closely linked to creating high end solutions for specific vertical industry markets, such as banking, insurance, airline reservations and communication messaging.

Coming into the repositioning, we had some powerful industry solutions, but they were fragmented and were often proprietary in nature. We needed to refresh our portfolio of solutions and move our clients to the next generation of technology. This has been, and continues to be, a major reinvention process.

To refocus our solution set, we have deemphasized many programs and narrowed our portfolio to about 20 key solutions that take advantage of the cost efficiencies of new technologies such as open source, Microsoft and real-time infrastructure.

Slide 8 shows our new, more focused, roadmap for industry solutions in our systems integration and consulting business. As you can see, we are focused on three industries; financial services, public sector and commercial markets such as transportation and communications.

Horizontally across all three industries, we are using our business blueprinting methodology as the foundation for building service-oriented architecture-based solutions. Also, across all three industries, we are focused on providing application services and enterprise security services, given the growth opportunities and our capabilities in these areas.

We don't have time to go into all the specific programs, but let me just focus on just one growth opportunity in each industry. In financial services, we see significant growth opportunities in the area of enterprise payment.

For example, a few years ago, with the passage of the Check 21 legislation in the United States, banks became free to accelerate their move from paper-based check payments to electronic images. The reality was that many banks didn't move aggressively in this direction because of the sheer size of their payment operations and the cost and effort associated with moving to electronic images.

Now, with the availability of lower-cost open source and Microsoft software and the advent of real-time, virtualized servers, the technology is here to allow banks to cost efficiently make the shift to image-based processes. To stay competitive, banks are increasingly adopting image-based solutions to reduce the costs of their payment operations and integrate electronic checks with the rest of their payments.

They are also rapidly adopting remote image capture at their teller locations to reduce float and get deposits more quickly into their payments streams. We believe the market for electronic enterprise-wide payments will grow aggressively in the coming years, and Unisys, as a longtime leader in the payments market, is well positioned to capitalize on this growth.

To capitalize on these opportunities, we have developed a comprehensive end-to-end suite of solutions for enterprise payments. This includes a next generation electronic image exchange system based on an advanced open source and Microsoft technology. Last quarter we sold this solution to the Federal Reserve Banks in the US, and we see strong interest in this solution and other payment solutions among additional financial institutions worldwide.

As another example in the public sector, we see growth opportunities in the area of health and human services. With the 2005 passage of the Deficit Reduction Act, state Medicaid programs need to reduce their spending on entitlement programs such as Medicaid and Medicare. States are increasingly moving from legacy Medicaid processing systems to more cost-effective platforms that can handle electronic and web-based transactions, integrate with systems from other agencies, and more flexibly handle changes as they happen.

Unisys has built a new solution here called Health PAS. Built with cost efficient Microsoft technology, the Health PAS system is the only federally certified Medicaid management information system in the country that is made from commercial off-the-shelf software. The state of West Virginia is successfully using this solution, and we are seeing strong interest in other states in moving from proprietary legacy systems.

In our commercial industry, we see growth opportunities in the areas of airline passenger reservations and communications messaging. Airlines want to move from closed, proprietary distribution system to flexible platforms where they can open up access to their reservations and drive new revenue by integrating bookings information with their customer loyalty systems.

Telecommunications providers need new, more powerful, platforms to offer new text, video and entertainment services on messaging platforms. Unisys has developed next generation solutions in both areas. In airline reservations, Hahn Air Systems recently went live with the first phase of a new airline booking system based on our next generation AirCore solution, which in their case is built on Microsoft technology.

We are seeing interest among some of the other major players in this market. In the area of communication messaging, we have developed a next generation messaging platform also based on a flexible, modular architecture using open source technology.

During the third quarter we signed a five-year multimillion dollar contract to help Sprint enhance its voicemail infrastructure. We will develop a next generation messaging platform that will provide Sprint the flexibility to deliver new enhanced services to its millions of customers. We currently provide the communications messaging platform for a subset of the Sprint wireless network.

Again, we don't have the time this morning to go through all of the growth areas that we're focused on in our systems integration and consulting business. The point I want to leave you with is that Unisys is right in the center of some large, shifting, and growing markets. We're making highly focused investments to build complex, value-added solutions for each of them.

As we begin to get traction in selling these solutions into these markets, we expect this too to help drive improved growth and margins in our services business.

Turning to slide 9, on the subject of growth, let me update you on progress we are making in our strategic growth programs. You'll recall I've used this slide in the past to depict the transition we are seeing within our business mix as we focus on new growth areas, while deemphasizing lower value-added areas of the portfolio. As a reminder, our focused growth areas are outsourcing, enterprise security, open source, Microsoft solutions, and real-time infrastructure.

Revenue from these programs grew more than 10% in the third quarter, and is up about 10% year-to-date. We continue to look for revenue from our strategic growth areas to grow to about 70% of our total revenue in 2008, up from about 50% of our revenue in 2006.

Turning to slide 10, before I close, let me just say a few words about our ongoing cost reduction program. Our primary focus so far in the repositioning program has been on addressing our profit model. We are now turning more attention to driving topline growth, but I want to stress that we are not done in terms of transforming our cost structure.

While I believe that we have the bulk of the restructuring behind us, we continue to explore ways to further streamline our costs and expenses. As Janet will discuss in her remarks, we plan to take actions in the fourth quarter to further consolidate facilities.

As I mentioned earlier, we continue to drive initiatives to enhance the productivity of our services delivery workforce, and we continue to expand our lower cost offshore delivery resources. At the end of the third quarter, we had about 3,800 Unisys and vendor resources providing offshore delivery services from India, China and Eastern Europe. We continue to target having about 20% of our workforce providing services from these offshore locations by the end of 2008.

Turning to slide 11, in summary, this morning, we made continued good progress in the third quarter in driving our repositioning program. Our non-GAAP services operating margins grew to 5.3% in the third quarter, the highest level since 2003. We expect services operating margin to continue to improve year-over-year in the fourth quarter.

Our technology non-GAAP operating margin was 4.9% in the third quarter due to seasonality in the business. As we said back in July, we expect a stronger second half of 2007, driven by ClearPath. There is no change to that, and we expect strong technology operating margins in the fourth quarter.

Looking ahead, we continue to drive toward a goal of an 8% to 10% operating profit margin, excluding retirement-related expense. As I mentioned earlier, this was an aggressive goal. And as we get closer to 2008, we are beginning to get more clarity on where we will likely end up relative to this target.

We are still working our plan for 2008, but our view at this point is that we expect to hit that 8% to 10% range for the second half of next year rather than for the full year. The 8% to 10% range remains our goal for the business and a level of profitability that we look to build on as we move beyond the repositioning program.

Thank you again for joining us this morning. Now, I'll turn the call over to Janet for a discussion of our third quarter financials. Janet?

Janet Haugen

Thank you, Joe, and hello, everyone. This morning I would like to provide more details on our third quarter 2007 financial results, and I'll also discuss cash flow and our debt refinancing strategy.

To begin, please turn to slide 12. At the topline, we reported revenue of $1.39 billion for the third quarter of 2007. This was down 1% from the year ago quarter. Currency had a 3 percentage point positive impact on our revenue in the quarter.

Our third quarter results include $22.8 million of pre-tax retirement-related expense compared with $47.5 million a year ago. Our results in the third quarter of '06 included a pre-tax restructuring charge of $36.4 million.

We reported operating income of $43.6 million in the current quarter compared with an operating loss of $42.9 million a year ago.

You'll note that we had other expense of $19.3 million in the third quarter 2007. Other income expense can vary from quarter-to-quarter, as you know, and in this quarter, included about $11 million related to the settlement of a very old escheat item and approximately $6 million of foreign exchange losses.

Our tax expense also increased significantly in the quarter to $36.8 million from $16 million a year ago. Our tax provision in the quarter includes a onetime adjustment of $9 million related to a tax law change in the UK. Our higher tax expense also reflects the improved profitability that we are seeing in certain international regions resulting from our repositioning action.

Including other expense and tax expense, we reported a third quarter 2007 net loss of $31 million or $0.09 per share. By comparison, in the year ago quarter, we reported a net loss of $77.5 million or $0.23 cents per share, which included the restructuring charge.

At the back of the presentation slides, we have provided supplemental slides showing details on restructuring charges and retirement-related expense for the third quarters of 2007 and 2006.

Turning now to revenue, please turn to slide 13 for an overview of our third quarter revenue by geography. Our US revenue represented 44% of our revenue in the quarter and declined 5%. International revenue grew 2% in the quarter. We saw growth in Latin America and Pacific Asia regions, partially offset by declines in Japan and Europe. International revenue accounted for 56% of our overall revenue in the third quarter. On a constant currency basis, international revenue declined 4% in the quarter.

Slide 14 shows our revenue by business segment. Services revenue was flat in the quarter and represented 87% of our third quarter revenue. Our technology revenue declined 9% and represented 13% of our revenue in the quarter. For more detail on our services revenue, please turn to slide 15.

Within services, our outsourcing revenue grew 7% in the quarter. And, as Joe mentioned, our systems integration and consulting revenue was flat in the quarter. The growth in outsourcing was offset by a 12% revenue decline in infrastructure services revenue and a continued secular decline in core maintenance revenue. The decline in infrastructure services was due to weakness in network design and consulting projects, as well as the shift of project-based infrastructure work to managed outsourcing contracts. We expect this trend to continue.

Turning to slide 16, in our technology business, revenue from enterprise servers declined 8% and represented 76% of our technology revenue in the quarter. Within enterprise servers, revenue from ClearPath systems was down double-digits in the quarter, as expected. As Joe mentioned, we expect stronger ClearPath revenue in the fourth quarter.

Moving to expenses, we continue to drive our program to reduce expenses in line with our more focused business model. Our efforts to reduce operating expenses are yielding good results.

Slide 17 shows our operating expenses through 2006 and the first nine months of 2007. This is on a GAAP basis, including restructuring charges. Operating expenses presented here include both SG&A and research and development expenses.

Slide 18 shows our operating expenses over this period, excluding restructuring charges and retirement-related expense. As you can see on this non-GAAP basis, operating expenses declined from 22% of revenue in the first quarter of 2006 to 18.8% of revenue in the current quarter.

One area where we're doing a lot of work right now is around consolidating facility space. As I mentioned last quarter, we are working opportunities here to further reduce our expenses given our headcount reductions and also the increasingly mobile nature of our services workforce. We expect to further make progress in that in this quarter and we expect to take a charge in the fourth quarter to further consolidation of space.

Moving on to segments margins, you may remember that Unisys has a longstanding policy to evaluate business segment performance on operating income exclusive of restructuring charges. Therefore, my comments on segment performance exclude the third quarter 2006 restructuring charge. As we continue to streamline our operations and implement other aspects of the repositioning, we are seeing benefits in our services margins.

Slide 19 shows margins for our services and technology segments in the third quarter. On a non-GAAP basis, excluding retirement-related expenses, services gross margins improved 240 basis points from the third quarter of 2006. Services operating margins improved 320 basis points to 5.3% from 2.1% a year ago.

Technology gross and operating margins declined in the quarter from a year ago, reflecting lower sales of enterprise server products. We expect stronger enterprise server sales and technology operating margins in the fourth quarter, and we are also continuing to look for ways to further streamline our operations and reduce costs in the technology business.

Now, please turn to slide 20 for an overview of our cash flow in the third quarter of 2007. We generated $7 million of cash from operations in the quarter. In the year ago quarter, we generated $27 million of cash flow from operations. As you may remember, the year ago period included the collection of $112 million related to our royalty agreement with NUL. Items that helped offset this decline were improvements in working capital management and lower restructuring cash payments.

In the quarter, we used approximately $37 million of cash for restructuring payments compared with $71 million in the third quarter of 2006. For the full year 2007, we expect $150 million $160 million in restructuring payments.

Total capital expenditures in the third quarter of 2007 were $71 million compared with $60 million a year ago. The increase reflects higher expenditures on two outsourcing projects. After deducting capital expenditures, we used $64 million of free cash in the third quarter of 2007 compared to free cash usage of $33 million in the year ago quarter.

Depreciation and amortization was $87 million in the third quarter of 2007, and we ended the quarter with a cash balance of $449 million. Looking ahead for the full year 2007, we continue to anticipate capital expenditures of around $300 million and depreciation and amortization in the $360 million to $375 million range.

One last comment regarding our debt refinancing plans. We have been watching the debt markets closely since the correction in July and August. We are seeing improvements in the markets. Our goal is to complete a refinancing of $200 million 7 7/8% senior notes that are due in April of 2008, complete the refinancing by the end of the year. We will continue to closely watch for the opportune time to enter the market.

That concludes my comments this morning. And now I'd like to turn the call over to Jack for questions.

Jack McHale - VP of IR

Well, thank you, Janet, and thank you, Joe. Operator, we'll now like to open the call up to questions from investors please.

Question-and-Answer Session

Operator

(Operator Instructions)

And we'll take our first question from Julie Santoriello with Morgan Stanley.

Julie Santoriello - Morgan Stanley

Thank you. Good morning. Joe, on the change in the operating margin goal, it seems to have slipped a bit to the right here with the goals of 8% to 10% operating margin for the second half of '08 now. Can you talk about just what's changed there in your mind? I mean: were there any some delays, perhaps, in some of the cost realization? Are you spending more than you thought, is revenue just not cooperating?

Joe McGrath

Yeah. Thanks, Julie. The two main reasons are the reasons I covered earlier, but I'll just give you more color now. Frankly, in this area of these temporary contractors, this has really been probably the single largest issue. We would have liked to have made more progress at this point and we haven't, so we recently doubled our efforts. We had about 25 black belts and master black belts focused on this, and we've now doubled the number of people and the number of teams to over 50.

The target here is actually slightly more than 30 major basis processes primarily in our out sourcing business. And our real objective is an end-to-end process redesign between what they call in the outsourcing business, the independent service towers. There's one for call center, one for data center and one for desk-side support. And so, our objective is to eliminate idle time and drive up individual levels of productivity in call centers, (inaudible), people and so on. And this has emerged as my single highest priority.

Our target here is to get, at least, a $20 million quarterly reduction. And so we target that over the next two quarters. So this sliding into Q1 is probably our single biggest issue of affecting the first half results versus the second. And remember, although we've developed our strategic plan, we're kind of in the process of crystallizing our operating plan. We just wanted to set expectations straight on this and didn't want to be in a position where we surprised anyone.

Julie Santoriello - Morgan Stanley

Okay. And related to that: what about the consolidation of facilities here that is going to be coming up in the fourth quarter? Is that going to have an effect of actually helping margins a bit more in 2008? Why are we seeing that sort of help to offset maybe some of these other issues?

Joe McGrath

Yeah. I'll defer to Janet on this since she's leading that project, Julie.

Janet Haugen

Good morning, Julie. We have been working on consolidating our facilities throughout the time period that we have been in this transformation. And we have continued to reduce our square footage under lease and operations as leases expire and as we have the ability to enter into sublease.

So there isn't a major amount of new facility consolidations for which we could see savings in early 2008. We have been gradually reducing down that expense as the workforce has come down. So there are opportunities and facilities not to the magnitude of which Joe is talking about in the contractor side.

Julie Santoriello - Morgan Stanley

Okay. Thanks, Janet. Continuing on with this, restructuring seems as though it's going to, you know, pretty high amount of restructuring in 07, you said $150 million to $160 million. Seems that that's going to fall off dramatically in 2008. Can you give us just a general estimate of kind of restructuring charges you think you may have to take in 2008?

Joe McGrath

Yeah. We're still on the fence on restructuring for 2008. And here's why we're torn a bit, frankly. In terms of the morale of our population, we've really held it pretty strong through this whole process, but it's clear that the largest part of our team wants to get this restructuring behind us.

So here's what we've been trying to do. For all new jobs, we're trying to get a fair portion of those offshore right from the beginning. Remember, one-third of the people we restructured, we actually moved to low cost countries like India, China and Hungary. And so, we would like to do it as a normal course of business, part one.

And part two is, we have something we call a closed loop labor model. Meaning, every time someone voluntarily leaves our company, we look at moving their jobs offshore or to a lower cost country or to what we call lower cost subsidiaries.

So: will there be a need for some restructuring? The answer is: yes. We want to minimize it; however. We want to be able to share with our team that the vast majority of this is behind us and we can manage the rest of the people out via this attrition management process.

Now, our most recent attrition numbers are about 15%. Last year it was 12%. The 15% is a little bit higher than the industry average. We don't know the 2007 voluntary attrition rates, but we know last year they were 10. So, at that rate, we believe we can make a lot of progress if we much more successfully manage on a proactive basis, attrition management. Now, you'll still see some things from us, but ideally they won't be major on a forward-looking basis.

Julie Santoriello - Morgan Stanley

Okay. Thank you. That's helpful. And if I could get one more quick one for Janet. Just on the $200 million debt that is coming due by the end of the year. I know you're looking at several options, which included, perhaps, getting an extension or paying it off in cash. I just want to be clear: are you definitely planning on actually refinancing this in the fourth quarter? And, if so: what kind of rates do you think we might be looking at here?

Janet Haugen

Julie, you're right to read into my comments that our expectation now is to refinance that in the quarter. The markets have started to improve from what we can see and from what we can tell from talking to the bankers, so our expectation is to refinance it. Obviously, we don't think that the 7 7/8 is probably the environment that we're going to see, but hopefully below 10.

Joe McGrath

Julie, let me make one last comment on restructuring. I didn't mean to mislead you. There'll be none. What we're trying to do is stabilize our population. There are some regions in the world that we still have challenges and so you might see some things from us there. But on a broad basis around the world, we didn't intend to have any type of actions that have the size or the scale of actions you've seen in the past. So don't be surprised if you see us do something that is more sharp shooting. But we'd like to generally stabilize our overall employee population.

Julie Santoriello - Morgan Stanley

Okay. So in essence though the amount of restructuring taken in 2008 should be pretty well less than $150 million to $160 million in '07.

Janet Haugen

Julie, you're talking about the cash requirement on restructuring?

Julie Santoriello - Morgan Stanley

Yeah.

Janet Haugen

The cash requirement was $198 million that we paid in 2006. Right now, in 2007, we expect it to be $150 million to $160 million. And based upon the actions that we've taken so far as well as the fact that the majority of the facilities charge in the fourth quarter will be a non-cash item, there'll be minimum amount of cash for true-ups of the building before we exit. Our expectation is that right now you'd be at $100 million or below in 2008 on cash expense standpoint.

Julie Santoriello - Morgan Stanley

Okay. Thanks very much.

Joe McGrath

Great. Thank you.

Operator

And we'll take our next question from Jason Kupferberg with UBS.

Jason Kupferberg - UBS

Hi, guys. Good morning. A question on the margins here. So, it seems like we continue to have some really divergent trends here. On the one hand services looking pretty strong, best in fourth quarter of 2003, but the hardware margins, obviously, down pretty significantly on a year-over-year basis. I know you expect it to come back in the fourth quarter, but it just seems like this is yet another example of hardware impacting the volatility of the quarterly P&L.

And I'm wondering: at this point, if you can really walk us through what the management team's rationale is for keeping the hardware business? Especially, now that you've made progress in getting services closer to more normalized margin levels.

Joe McGrath

First let me deal with it as a standalone. You are right. We had a very tough comparative third quarter '06. And that's one of the real challenges of the business which you've identified. We can tell how much will happen in the second half, but as you just called out, it's very hard for us to call 3Q versus 4Q. Last year there was a very successful 3Q. This year we expect a very successful fourth quarter. And so, it's very hard to manage that on a calendarized basis.

That said, you might be surprised at some of the examples I gave you a second ago of the effectiveness of the technology business in driving the out sourcing in the systems integration business. I'll just replay a few of the illustrations I just gave you. In the case of the Fed Reserves, we replaced or the target of our system is to replace a very, very large main frame application that has very high scalability, very high peak periods and so on. And, in that we're replacing it with standard ES7000 using open source and technology like VMware.

Our systems integration team alone couldn't match these extremely high performance levels and peak periods of traditional enterprise servers on this much lower cost, better priced performance hardware platform. And so, as we continue to work this hand-in-hand with the folks from the Fed Reserve, it was the technology people that tuned the databases, the operating systems and so on, and actually dramatically exceeded their expectations for peak periods on a forward-looking business.

We found that to be true not just in the Fed Reserve, but in airline reservation systems. There's a number of deals that are underway that we can't share with you, where they have some of the highest peak periods in the overall transaction processing business. So, on an industry by industry diagnosing basis, whether it's banking, insurance, communications, and in that case, airline reservation systems, they have proved to be very useful.

The second part of it is, that's now, as you yourself know, have fallen to only 12% of our overall business. So it has less an impact, but you identified there was one here in the third quarter. In the fourth quarter, although we haven't been explicit about exactly where all of those businesses land, you'll see that it will make a very big contribution. So with that in mind, smaller part of the total, very helpful in helping our other core services businesses differentiate themselves from companies like Accenture that can't do those things. And at the end of the day, as long as our costs are in line, which we believe they are now, it generates an awful lot of profit for our company, very profitable business.

Jason Kupferberg - UBS

Can you give some color on services margins? And: the rate of year-over-year improvement did accelerate in the third quarter? Can the magnitude of year-over-year improvement continue on that tread line in the fourth quarter of '07? Or: do you naturally see a little bit of slowdown in the pace of year-over-year?

Joe McGrath

First, let me just reinforce where we landed. The 5.3 at first maybe doesn't jump out at you, but it actually is our best to support the quarter of 2003. Our best results in operating margin services in 15 quarters. So we really believe it took a strong effort to get us there.

We believe, on a year-to-year basis, we can continue to have that improve. And even though the bad news that we shared with you that we hadn't gotten all the contractors we wanted to, you can actually do the math of the flow through as we start to get them out. It's continuous improvement through the fourth quarter and the first quarter of next year and start to really pay off in the second quarter of next year.

Jason Kupferberg - UBS

Okay. And just finally on the services revenue growth here, maybe a little bit less than we were expecting, coming in flat, a little better than the past couple of quarters. Now looking at the fourth quarter, I think you definitely have a higher base to try and grow off of, but you did still have respectable services order growth in the third quarter despite a tougher comparer there.

So: can you give a sense of how the services revenue growth picture might look for the fourth quarter? Looks like it would be tough to be in positive territory, but: are you seeing any acceleration in the flow through or conversion of the order growth trends from the last six quarters and for P&L?

Joe McGrath

Yeah. It depends on the business or segment within the services business. Frankly, the disappointment this quarter was actually our infrastructure services business. But I think you're speculation is right where you're going to start to see the impact of the prior order growth of the out sourcing business and the overall systems integration business start to come online. But, as you know, we've tried to avoid giving guidance in these areas.

Jason Kupferberg - UBS

Okay. Thanks.

Joe McGrath

Thanks, Jason.

OPERATOR

And we'll take our next question from Ashwin Shirvaikar with Citigroup.

Ashwin Shirvaikar - Citigroup

Hi Joe, hi Janet.

Joe McGrath

Hi Ashwin.

Ashwin Shirvaikar - Citigroup

My question is going back to something that Jason asked: can you actually get rid of hardware and keep the highly profitable core maintenance services revenue stream? Because that would obviously be smaller, it would still be very worthwhile if you could actually do that.

Joe McGrath

Here's an interesting thing and we've been hoping to actually keep the lid on an evolving strategy in that business going forward. And unfortunately, it's going to take a little bit longer of an explanation, but as we get out of the custom CMOS chip design business, we're on our ClearPath line, we eliminated one of the large, very fixed costs in R&D for that business. So that was part one. So, in '08 and beyond, that will run on standard Intel hardware.

The second part of it was the partnership where we actually licensed intellectual property of NEC to get out of the hardware design business. And you'll see those products start to come online, that next generation platform in the second half of 2008. You may ask why am I taking you through the chip business or the hardware business. It's been our strategy for some time to evolve that business to a software services business. So, what's today a hardware business, we intend to evolve to a software services business.

The reason I said we've tried to keep the lid on it is we have a new President of that division, we recruited from the enterprise services division of Hewlett Packard. And behind the scenes, he is finalizing his strategy in the next phase of that evolution. We weren't prepared to share it with you until the first quarter of next year, but we'd like to believe you'll see a very different profile of that business as it evolves to primarily software and services.

So, that's as much as I'd say here. So you'd see a larger suite of software around the area of real time infrastructure, virtualization, those type of capabilities, that's the highest growth area of the hardware business. That sounds counterintuitive. Software is the highest area of hardware business, but it's true.

And the second part of it is, that services business is growing very aggressively for us. As people move to this area of virtualization, that's a very high growth area for services. You yourselves have seen what's happened to VMware, the division of EMC, you can imagine what it's doing on the services side as well. So you're going to see a real, I'm reluctant to call it a shift, but a change for us here in terms of the expansion of the software services part of that and it will move closer to our more traditional business model.

Ashwin Shirvaikar - Citigroup

Okay. I guess shifting gears to bookings and revenues. It was nice that you guys provided a nine-month sort of retrospective that bookings are up slightly over last year. If you annualize those bookings, which is probably a more useful metric to convert to revenue, annualized bookings, are they also up slightly? And so, between annualized bookings being up slightly and currently giving you maybe a 3% benefit, maybe we could look for low single digits growth next year?

Janet Haugen

Ashwin, this is Janet. Good morning. We did provide that year-to-date nine-month number. We think with the way orders get booked that that nine-month number is pretty consistent with what we would expect to see on an annualized basis. So your assumptions with regard to currency and how that would affect that number would appear valid.

And as we've said before, we are continuing to move the strategic portfolios forward. And Joe mentioned that for year-to-date they're around 10% growth in the strategic portfolio offerings area. But from the overall services business, you're right that it's in the low single digits, and with currency impact, that should translate in the way that you've talked about with regard to 2008.

So as we have commented previously, we're trying to make sure we do this in a measured approach to make sure that we transition the revenue into the strategic program areas. And when we do that, we know that has a negative impact in some of the program areas that we have deemphasized. So as we go through this transition, we are encouraged by the services order growth year-to-date in the low single digits because that reflects a strong 10% growth in the strategic program offerings that are being offset by some of the programs that we've emphasized as part of the continuation of the transformation.

Ashwin Shirvaikar - Citigroup

Got it. And just some clarification, I apologize if I missed this, but in terms of the tax that you paid this quarter and the other income, if you could go into some detail.

Janet Haugen

Sure. Roughly $11 million relates to escheat laws, which, in our case, I said were very old. Goes back to the 1980s believe it or not. This is not something that is an issue for us in the '90s or in the 2000s. It is an old issue that's been outstanding that there have been a multiyear audit going on, and based upon the progression of that and how long the time has taken, we chose to settle this. But this does go back to beginning in 1982, in the '80s time period.

Ashwin Shirvaikar - Citigroup

1982. Okay. And in terms of your expectations for tax rate: will it be more reasonable, more inline with pretax income and normal accrual rate of 35 to 40? Is that a good expectation?

Janet Haugen

Ashwin, we won't get to that rate until we're in the situation that we're through the transformation generating pretax income on a consistent basis, so that we can go back to tax affecting all of our operations.

When we had to write that deferred tax asset off, and can no longer provide a global provision based upon all of our pluses and minuses. That's what causes a significant variation in the tax rate.

It's difficult for us to predict what's that tax rate is going to be in the near-term horizons because it's a function of where the transactions occur, but as we continue through the transformation, move to the point where we're generating pretax on a consistent basis, and we've crossed the gap hurdle with regard to recognizing the deferred tax asset again.

That will be the point in time, where we can go back to a more normal tax rate.

Ashwin Shirvaikar - Citigroup

Okay. Got it. Thank you.

Janet Haugen

Thanks, Ashwin.

Operator

And we'll take our next question from Susan Chen with Merrill Lynch.

Susan Chen - Merrill Lynch

Thank you. Question for Janet. For free cash flow: when can we see a positive free cash flow quarter especially given potential increase in CapEx from out sourcing contracts in 2008?

Janet Haugen

Good morning, Susan. Let me just comment on the out sourcing expenditures in the current quarter. In my comments, I mentioned that these outsourcing expenditures that occurred in the quarter, relate to two projects.

You should not expect that the current rate that we saw in the third quarter would be the ongoing rate for our CapEx, and so don't conclude that the third quarter trend of that increase is something that you would expect to see as you move into the fourth quarter and into next year.

These were two very specific contracts where we made a decision based upon the return to do higher than our normal, which is around 3% to 5%, roughly around 5% of contract value for CapEx, so that's a little bit of an anomaly, and that's why I called it out in my comments to be clear on that.

We have not given any guidance on free cash flow generally from the historical perspective and the seasonality of the business. The third quarter is probably our softest quarter with regard to free cash flow. Fourth quarter is our strongest as we close out the quarter and close out the year, but we see no reason why that trend won't continue.

Susan Chen - Merrill Lynch

Thank you.

Janet Haugen

Thanks.

Operator

And we'll take our next question from Jerome Land with Milbert Capital

Jerome Land - Milbert Capital

Good morning. Can you go into a little bit more detail on the decline in infrastructure? And you referenced in your remarks, Joe, a trend, I'm sorry, maybe it was Janet. A trend that will continue, but I'm not certain that was the overall trend rather than a piece of that business.

Janet Haugen

Good morning, Jerome. In our infrastructure services business, there are three types of offerings that are included in there. The first is our business where we support companies like Dell and EMC.

That business continues to move along, but consistent with what else we're doing in the rest of the portfolio. We are turning down opportunities there if they do not meet our profit criteria or cash flow criteria, so that has been moving along steadily.

The second area of that business is where we're doing shorter project-based work, whether it's network infrastructure work or shorter projects around the design of help desk and other, what Joe referred to as the powers of the offerings that we do.

In that area, we are seeing a shift towards more of that going from not being initial consulting projects, but we're going right into a multi-year managed out sourcing environment, so we have a little bit of a shift between this line and that line.

And then the last area that's in there is on occasion, as infrastructures are built out, we, as part of the project, install hardware, Cisco routers, those type of switches and that type of hardware that is part of the solution, but not the critical portion of the solution, and we're seeing a decrease in that.

Jerome Land - Milbert Capital

So: which of these trends do you expect to continue and to what magnitude?

Janet Haugen

Right, so we expect to see the overall shift from that line into the infrastructure services area. We expect to see, so you got three pieces in that line item. We expect to see, in the first area, what we refer to as TSM, third-party service support in the Dell EMC area. We expect that to continue, we're working on those relationships, but making sure we go after those deals that are attractive from a profit and cash flow perspective.

It's in the second two areas that we expect to see a decline in the area of the project-based work. We see a shift from this line into the growth we're seeing into out sourcing. And then lastly, in the hardware area, we're seeing that decline as well.

So you have three components in there. One that's relatively stable. The second that's causing a shift between this line and into the out sourcing line and a third which a decline overall.

Jerome Land - Milbert Capital

So: you're not really growing in out sourcing in the matter that, the slide 15 suggests? If you want to corden off infrastructure, you're kind of…

Janet Haugen

Jerome, I don't think that I wouldn't conclude that step, because in this infrastructure services area, these are short-term projects, and so we are growing in out sourcing and we are going from something that is a short-term project-based business into something that you can quickly get into a multi-year annuity stream for the company.

And that is not all the reasons for the growth in out sourcing. We're growing in the IT outsourcing area, we are growing in other areas of that business as well, but it is a contributor to the growth.

Jerome Land - Milbert Capital

Can you quantify those three contributors, or those three pieces of infrastructure?

Janet Haugen

We have not broken that line out by component. The largest component is the third-party service maintenance and support area that I talked about. It is the largest portion of that business and the other two are smaller.

Jerome Land - Milbert Capital

So: on the next quarter and in 2008 basis, do you expect the trajectory of that business to overall stay the same? Get better? Get worse?

Janet Haugen

As I said in my comments, we expect the trend in that to continue into the fourth quarter and into 2008. And it is part of making sure that the revenue that we are getting has got the right economic benefit both in the profit and in the cash flow.

And so, while it may mean a short-term foregoing of revenue, we believe it is better, from an overall bottomline profitability and cash flow, to do that.

Jerome Land - Milbert Capital

Can you quantify the short fall in systems integration consulting and in the use of temp labor in this quarter?

Joe McGrath

Jerome, I don't know if we're going to call out the specifics of what was the GAAP.

Janet Haugen

So if you're looking, Jerome, when you're asking, there's two portions we talked about. One is the systems integration. Against our expectations for the full year that has been the portfolio that has gone through the most amount of change, and we did see that revenue go flat in this quarter.

So in this quarter, we were at the flat level. That's an area of the business from a longer-term perspective that we expect to grow. So it's just to give you a sense you can see it on the financial statements where that revenue is and expectation as we fully implement the transformation. That should, as we move through 2008, continue to grow.

In the contractor's area, I think Joe commented on the magnitude of that in his earlier comments of about $20 million.

Joe McGrath

Right, it's about $20 million, and we expect to work that out over the next two quarters. So that's $20 million on a quarterly run rate basis.

Jerome Land - Milbert Capital

Got it. Thank you very much. I want to ask you about guidance overall. And this relates to disclosure and a lot of things we already asked about, but things like backlog and go-forward guidance.

You're two years into the restructuring, give or take, or almost, you have a target out there for 2008, but as the target gets moved, I think it causes the market increased concern and uncertainty that we can't track your progress against it.

And so I'm wondering: why, this far along in the process, you can't look at beginning to give specific guidance.

Joe McGrath

Jerome, that's a great question. At the very beginning of this process we were strongly encouraged by our board not to do that, because the transformations of this magnitude size never go in a straight line. And so you end up disappointing people more than you end up fulfilling their expectations.

We committed to them that we would revisit this issue of guidance in 2008. We understand the challenges it presents to everyone that's on this call. And so we're going to go back to them to see at what rate they would like to give guidance.

I will tell you, even in this particular quarter, for them, they believe until we really start to hit the targets that we've communicated with you, they have a fair amount of reluctance on this. And so, it's not that we don't have engaging discussions every quarter on when we should begin giving guidance, because of the challenges it presents in you creating your model.

So, we do understand that, but we have not gotten their support yet and we completely understand: why, in starting to give guidance on a forward-looking basis, but we will continue to revisit it, and maybe you'll see that sometime in 2008.

Jerome Land - Milbert Capital

Okay. And I want to clarify: “Why I asked that?” It's not about: just creating the model and it's not about: trading you on a quarter-to-quarter basis or making sure you hit quarterly numbers. It's about: tracking the progress.

So we make sure that we don't get into the second quarter calendar next year, you're releasing first quarter earnings, and we're looking at a hockey stick to get you to the target. And then we're moving it out again, and now it's going to be in 2009, not 2008.

There's more to it than just measuring progress moment-to-moment. It's about: being able to see whether you are in fact tracking towards that goal, which today has been pushed out an extra six months. And I can tell you, major investors have caused us a lot of consternation, I'm sure you can imagine.

Joe McGrath

Yep.

Jerome Land - Milbert Capital

So, it's very important to us that we understand whether or not you're making progress.

Joe McGrath

I don't disagree, and that's precisely the discussions, as I said, we have with our board and we'll continue to have.

Jerome Land - Milbert Capital

Okay. And one last question, if I can. Do you have any comment on the DHS investigation that was reported a few weeks ago in the Washington Post and elsewhere? Particularly, as some time has passed and you might have had more opportunity to speak with the authorities.

Joe McGrath

Yeah. Here's what we've said and let me reinforce it. The facts and documentation we have contradict the claims that were made in that article. We believe a proper investigation will show that we acted in good faith.

And we really have provided the DHS with accredited and government-certified security systems and program. And frankly, we're proud of the work. Now, are there investigations going on? There's some things that we're aware of, there's things that we're not aware of that were referenced in that article. So we have reached out to the DHS, Inspector General's Office, and said we would love to actively cooperate in anything and they haven't gotten back to us.

Jerome Land - Milbert Capital

Okay. Thank you.

Joe McGrath

Great. Great, we thank you all of you. I'd just like to reinforce that we do expect a strong fourth quarter as we said earlier, and we expect services operating margin to continuously improve on a year-over-year basis on our way to the fourth quarter and a strong technology operating margin in the fourth quarter, which is a reflection of what we believe is strong continued progress in our transformation program.

So thank you very much for joining us.

Operator

That does conclude today's conference. Thank you for your participation and have a great day.

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