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Unisys Corp. (NYSE:UIS)

Q3 2007 Earnings Call

October 23, 2007 8:15 am ET

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

Operator

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

Jack McHale

Thank you, operator. Hello, everyone, and thank you forjoining us this morning. Earlier this morning, Unisys released its third quarter2007 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 housekeepingdetails. First, today's conference call and the Q&A session are being webcastvia the Unisys Investor website. This webcast, including the question-and-answersession, is being recorded and will be available as a replay on our website shortlyafter the conclusion of the live event.

Second, you can find on our Investor website the earningsrelease as well as presentation slides that we will be using this morning toguide the discussion. These materials are available for viewing as well asdownloading and printing.

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

Finally, I'd like to remind you that all forward-lookingstatements made in this conference call are subject to various risks anduncertainties that could cause actual results to differ materially fromexpectations. These factors are discussed more fully in the earnings releaseand in the company's periodic reports as filed with the SEC. Copies of the SECreports 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 tofundamentally reposition Unisys in the marketplace and achieve a competitiveprofit level for this company. We aimed high, setting a goal of 8% to 10%operating profit margin, excluding retirement expense. Given where we werecoming from, this would represent a huge leap forward.

Today, two years later, we can point to clear, strong andcontinuous progress. In fact, as I'll show you in a few moments, we haveincreased our services operating profit to a level we haven't seen in nearlyfour years. That's not where we want to be at. We still have challenges to workthrough and opportunities we plan to take advantage of. But I am veryencouraged by the transformation we're seeing in this company's profile and businessmodel.

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

Please turn to slide 2 for financial highlights. Starting withorders, 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 outsourcingand infrastructure services, while systems integration orders were down in thequarter following substantial gains in the second quarter. Systems integrationorders were up slightly through nine months.

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

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

We did see a positive sign in our systems integration andconsulting revenue, which was flat in the quarter following declines over thepast year. Technology revenue declined 9%, driven primarily by a continuedsecular decline in mainframe revenue. But we expect a strong rebound in this businessin the fourth quarter.

At the bottomline, we reported an operating profit of $44million in the quarter. This is an $87 million improvement from a $43 millionoperating 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 otherincome a year ago.

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

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

Slide 4 shows our operating margin progress on a non-GAAPbasis, excluding retirement related expenses and restructuring charges. As youcan 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 agoquarter. The year-over-year margin improvement is even higher in our servicesbusiness.

Slide 5 shows our services operating profit margin over the2006 to 2007 period on a GAAP basis.

Slide 6 shows our services operating margin progress on anon-GAAP basis excluding retirement expense. As you can see, we increased ourservices operating profit margin to 5.3% in the third quarter. This is thehighest 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 inthe fourth quarter. We're also expecting a strong rebound in our technologyrevenue and operating profit in the fourth quarter. The combination shouldenable us to close out 2007 with continued year-over-year improvement in ouroverall operating margin in the fourth quarter.

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

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

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

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

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

Coming into the repositioning, we had some powerful industrysolutions, but they were fragmented and were often proprietary in nature. Weneeded to refresh our portfolio of solutions and move our clients to the nextgeneration of technology. This has been, and continues to be, a majorreinvention process.

To refocus our solution set, we have deemphasized manyprograms and narrowed our portfolio to about 20 key solutions that takeadvantage 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 industrysolutions in our systems integration and consulting business. As you can see,we are focused on three industries; financial services, public sector andcommercial markets such as transportation and communications.

Horizontally across all three industries, we are using our businessblueprinting methodology as the foundation for building service-orientedarchitecture-based solutions. Also, across all three industries, we are focusedon providing application services and enterprise security services, given thegrowth opportunities and our capabilities in these areas.

We don't have time to go into all the specific programs, butlet me just focus on just one growth opportunity in each industry. In financialservices, we see significant growth opportunities in the area of enterprisepayment.

For example, a few years ago, with the passage of the Check21 legislation in the United States,banks became free to accelerate their move from paper-based check payments toelectronic images. The reality was that many banks didn't move aggressively inthis direction because of the sheer size of their payment operations and thecost and effort associated with moving to electronic images.

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

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

To capitalize on these opportunities, we have developed acomprehensive end-to-end suite of solutions for enterprise payments. Thisincludes a next generation electronic image exchange system based on an advancedopen source and Microsoft technology. Last quarter we sold this solution to theFederal Reserve Banks in the US,and we see strong interest in this solution and other payment solutions amongadditional financial institutions worldwide.

As another example in the public sector, we see growthopportunities in the area of health and human services. With the 2005 passageof the Deficit Reduction Act, state Medicaid programs need to reduce theirspending on entitlement programs such as Medicaid and Medicare. States areincreasingly moving from legacy Medicaid processing systems to morecost-effective platforms that can handle electronic and web-based transactions,integrate with systems from other agencies, and more flexibly handle changes asthey happen.

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

In our commercial industry, we see growth opportunities inthe areas of airline passenger reservations and communications messaging.Airlines want to move from closed, proprietary distribution system to flexibleplatforms where they can open up access to their reservations and drive newrevenue by integrating bookings information with their customer loyaltysystems.

Telecommunications providers need new, more powerful,platforms to offer new text, video and entertainment services on messagingplatforms. Unisys has developed next generation solutions in both areas. Inairline reservations, Hahn Air Systems recently went live with the first phaseof 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 playersin this market. In the area of communication messaging, we have developed anext generation messaging platform also based on a flexible, modulararchitecture using open source technology.

During the third quarter we signed a five-year multimilliondollar contract to help Sprint enhance its voicemail infrastructure. We willdevelop a next generation messaging platform that will provide Sprint theflexibility to deliver new enhanced services to its millions of customers. Wecurrently provide the communications messaging platform for a subset of theSprint wireless network.

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

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

Turning to slide 9, on the subject of growth, let me updateyou on progress we are making in our strategic growth programs. You'll recall I'veused this slide in the past to depict the transition we are seeing within ourbusiness mix as we focus on new growth areas, while deemphasizing lowervalue-added areas of the portfolio. As a reminder, our focused growth areas areoutsourcing, enterprise security, open source, Microsoft solutions, andreal-time infrastructure.

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

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

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

As I mentioned earlier, we continue to drive initiatives toenhance the productivity of our services delivery workforce, and we continue toexpand our lower cost offshore delivery resources. At the end of the thirdquarter, we had about 3,800 Unisys and vendor resources providing offshoredelivery services from India, Chinaand Eastern Europe. We continue to target having about20% of our workforce providing services from these offshore locations by theend of 2008.

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

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

Looking ahead, we continue to drive toward a goal of an 8%to 10% operating profit margin, excluding retirement-related expense. As Imentioned 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 tothis target.

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

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

Janet Haugen

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

To begin, please turn to slide 12. At the topline, wereported revenue of $1.39 billion for the third quarter of 2007. This was down1% from the year ago quarter. Currency had a 3 percentage point positive impacton our revenue in the quarter.

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

We reported operating income of $43.6 million in the currentquarter 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 thethird quarter 2007. Other income expense can vary from quarter-to-quarter, asyou know, and in this quarter, included about $11 million related to thesettlement of a very old escheat item and approximately $6 million of foreignexchange 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 quarterincludes 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 areseeing in certain international regions resulting from our repositioningaction.

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

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

Turning now to revenue, please turn to slide 13 for anoverview of our third quarter revenue by geography. Our USrevenue represented 44% of our revenue in the quarter and declined 5%.International revenue grew 2% in the quarter. We saw growth in Latin Americaand Pacific Asia regions, partially offset by declines in Japanand Europe. International revenue accounted for 56% ofour 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. Servicesrevenue was flat in the quarter and represented 87% of our third quarterrevenue. Our technology revenue declined 9% and represented 13% of our revenuein the quarter. For more detail on our services revenue, please turn to slide15.

Within services, our outsourcing revenue grew 7% in thequarter. And, as Joe mentioned, our systems integration and consulting revenuewas flat in the quarter. The growth in outsourcing was offset by a 12% revenuedecline in infrastructure services revenue and a continued secular decline incore maintenance revenue. The decline in infrastructure services was due toweakness in network design and consulting projects, as well as the shift ofproject-based infrastructure work to managed outsourcing contracts. We expectthis trend to continue.

Turning to slide 16, in our technology business, revenuefrom enterprise servers declined 8% and represented 76% of our technologyrevenue in the quarter. Within enterprise servers, revenue from ClearPathsystems 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 toreduce expenses in line with our more focused business model. Our efforts toreduce operating expenses are yielding good results.

Slide 17 shows our operating expenses through 2006 and thefirst nine months of 2007. This is on a GAAP basis, including restructuringcharges. Operating expenses presented here include both SG&A and researchand development expenses.

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

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

Moving on to segments margins, you may remember that Unisyshas a longstanding policy to evaluate business segment performance on operatingincome exclusive of restructuring charges. Therefore, my comments on segmentperformance exclude the third quarter 2006 restructuring charge. As we continueto 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 technologysegments in the third quarter. On a non-GAAP basis, excludingretirement-related expenses, services gross margins improved 240 basis pointsfrom the third quarter of 2006. Services operating margins improved 320 basispoints to 5.3% from 2.1% a year ago.

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

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

In the quarter, we used approximately $37 million of cashfor restructuring payments compared with $71 million in the third quarter of2006. For the full year 2007, we expect $150 million $160 million inrestructuring payments.

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

Depreciation and amortization was $87 million in the thirdquarter 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 capitalexpenditures 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 havebeen watching the debt markets closely since the correction in July and August.We are seeing improvements in the markets. Our goal is to complete arefinancing 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 closelywatch for the opportune time to enter the market.

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

Jack McHale - VP ofIR

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

Question-and-AnswerSession

Operator

(Operator Instructions)

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

Julie Santoriello -Morgan Stanley

Thank you. Good morning. Joe, on the change in the operatingmargin goal, it seems to have slipped a bit to the right here with the goals of8% to 10% operating margin for the second half of '08 now. Can you talk aboutjust 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 revenuejust not cooperating?

Joe McGrath

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

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

Our target here is to get, at least, a $20 million quarterlyreduction. And so we target that over the next two quarters. So this slidinginto Q1 is probably our single biggest issue of affecting the first halfresults versus the second. And remember, although we've developed our strategicplan, we're kind of in the process of crystallizing our operating plan. We justwanted to set expectations straight on this and didn't want to be in a positionwhere we surprised anyone.

Julie Santoriello -Morgan Stanley

Okay. And related to that: what about the consolidation offacilities here that is going to be coming up in the fourth quarter? Is thatgoing to have an effect of actually helping margins a bit more in 2008? Why arewe 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 thatproject, Julie.

Janet Haugen

Good morning, Julie. We have been working on consolidatingour facilities throughout the time period that we have been in thistransformation. And we have continued to reduce our square footage under leaseand operations as leases expire and as we have the ability to enter intosublease.

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

Julie Santoriello -Morgan Stanley

Okay. Thanks, Janet. Continuing on with this, restructuringseems as though it's going to, you know, pretty high amount of restructuring in07, you said $150 million to $160 million. Seems that that's going to fall offdramatically in 2008. Can you give us just a general estimate of kind ofrestructuring charges you think you may have to take in 2008?

Joe McGrath

Yeah. We're still on the fence on restructuring for 2008. Andhere'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 clearthat 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 lowcost countries like India, Chinaand Hungary. Andso, 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 looplabor model. Meaning, every time someone voluntarily leaves our company, welook at moving their jobs offshore or to a lower cost country or to what wecall lower cost subsidiaries.

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

Now, our most recent attrition numbers are about 15%. Lastyear it was 12%. The 15% is a little bit higher than the industry average. Wedon't know the 2007 voluntary attrition rates, but we know last year they were10. So, at that rate, we believe we can make a lot of progress if we much moresuccessfully manage on a proactive basis, attrition management. Now, you'llstill see some things from us, but ideally they won't be major on aforward-looking basis.

Julie Santoriello -Morgan Stanley

Okay. Thank you. That's helpful. And if I could get one morequick one for Janet. Just on the $200 million debt that is coming due by theend 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 youdefinitely planning on actually refinancing this in the fourth quarter? And, ifso: 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 ourexpectation now is to refinance that in the quarter. The markets have startedto improve from what we can see and from what we can tell from talking to thebankers, so our expectation is to refinance it. Obviously, we don't think thatthe 7 7/8 is probably the environment that we're going to see, but hopefullybelow 10.

Joe McGrath

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

Julie Santoriello -Morgan Stanley

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

Janet Haugen

Julie, you're talking about the cash requirement onrestructuring?

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 basedupon the actions that we've taken so far as well as the fact that the majorityof 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 oncash 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 withUBS.

Jason Kupferberg - UBS

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

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

Joe McGrath

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

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

Our systems integration team alone couldn't match theseextremely high performance levels and peak periods of traditional enterpriseservers 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 FedReserve, it was the technology people that tuned the databases, the operatingsystems and so on, and actually dramatically exceeded their expectations forpeak periods on a forward-looking business.

We found that to be true not just in the Fed Reserve, but inairline reservation systems. There's a number of deals that are underway thatwe can't share with you, where they have some of the highest peak periods inthe overall transaction processing business. So, on an industry by industry diagnosingbasis, 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, butyou 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 businessesland, you'll see that it will make a very big contribution. So with that inmind, smaller part of the total, very helpful in helping our other core servicesbusinesses differentiate themselves from companies like Accenture that can't dothose 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 ourcompany, very profitable business.

Jason Kupferberg -UBS

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

Joe McGrath

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

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

Jason Kupferberg -UBS

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

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

Joe McGrath

Yeah. It depends on the business or segment within theservices business. Frankly, the disappointment this quarter was actually ourinfrastructure services business. But I think you're speculation is right whereyou're going to start to see the impact of the prior order growth of the outsourcing business and the overall systems integration business start to comeonline. 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 withCitigroup.

Ashwin Shirvaikar -Citigroup

Hi Joe, hi Janet.

Joe McGrath

Hi Ashwin.

Ashwin Shirvaikar -Citigroup

My question is going back to something that Jason asked: canyou actually get rid of hardware and keep the highly profitable coremaintenance 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 toactually 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 ourClearPath line, we eliminated one of the large, very fixed costs in R&D forthat business. So that was part one. So, in '08 and beyond, that will run onstandard Intel hardware.

The second part of it was the partnership where we actuallylicensed intellectual property of NEC to get out of the hardware designbusiness. And you'll see those products start to come online, that nextgeneration platform in the second half of 2008. You may ask why am I taking youthrough the chip business or the hardware business. It's been our strategy forsome time to evolve that business to a software services business. So, what'stoday 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 wehave a new President of that division, we recruited from the enterpriseservices division of Hewlett Packard. And behind the scenes, he is finalizinghis strategy in the next phase of that evolution. We weren't prepared to shareit with you until the first quarter of next year, but we'd like to believeyou'll see a very different profile of that business as it evolves to primarilysoftware and services.

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

And the second part of it is, that services business is growingvery aggressively for us. As people move to this area of virtualization, that'sa very high growth area for services. You yourselves have seen what's happenedto VMware, the division of EMC, you can imagine what it's doing on the servicesside 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 servicespart 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. Itwas nice that you guys provided a nine-month sort of retrospective thatbookings are up slightly over last year. If you annualize those bookings, whichis probably a more useful metric to convert to revenue, annualized bookings,are they also up slightly? And so, between annualized bookings being upslightly and currently giving you maybe a 3% benefit, maybe we could look forlow single digits growth next year?

Janet Haugen

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

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

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

Ashwin Shirvaikar -Citigroup

Got it. And just some clarification, I apologize if I missedthis, 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, inour case, I said were very old. Goes back to the 1980s believe it or not. This isnot something that is an issue for us in the '90s or in the 2000s. It is an oldissue that's been outstanding that there have been a multiyear audit going on, andbased upon the progression of that and how long the time has taken, we chose tosettle this. But this does go back to beginning in 1982, in the '80s timeperiod.

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 accrualrate of 35 to 40? Is that a good expectation?

Janet Haugen

Ashwin, we won't get to that rate until we're in thesituation that we're through the transformation generating pretax income on aconsistent basis, so that we can go back to tax affecting all of ouroperations.

When we had to write that deferred tax asset off, and can nolonger 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 isgoing to be in the near-term horizons because it's a function of where the transactionsoccur, but as we continue through the transformation, move to the point wherewe're generating pretax on a consistent basis, and we've crossed the gap hurdlewith regard to recognizing the deferred tax asset again.

That will be the point in time, where we can go back to amore 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 withMerrill Lynch.

Susan Chen - MerrillLynch

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

Janet Haugen

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

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

These were two very specific contracts where we made adecision 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 ofan 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 generallyfrom the historical perspective and the seasonality of the business. The thirdquarter is probably our softest quarter with regard to free cash flow. Fourthquarter 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 - MerrillLynch

Thank you.

Janet Haugen

Thanks.

Operator

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

Jerome Land - MilbertCapital

Good morning. Can you go into a little bit more detail onthe decline in infrastructure? And you referenced in your remarks, Joe, atrend, I'm sorry, maybe it was Janet. A trend that will continue, but I'm notcertain that was the overall trend rather than a piece of that business.

Janet Haugen

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

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

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

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

And then the last area that's in there is on occasion, asinfrastructures 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 ofthe solution, but not the critical portion of the solution, and we're seeing adecrease in that.

Jerome Land - MilbertCapital

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

Janet Haugen

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

It's in the second two areas that we expect to see a declinein the area of the project-based work. We see a shift from this line into thegrowth 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 relativelystable. The second that's causing a shift between this line and into the outsourcing line and a third which a decline overall.

Jerome Land - MilbertCapital

So: you're not really growing in out sourcing in the matterthat, the slide 15 suggests? If you want to corden off infrastructure, you'rekind 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 ashort-term project-based business into something that you can quickly get intoa multi-year annuity stream for the company.

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

Jerome Land - MilbertCapital

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

Janet Haugen

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

Jerome Land - MilbertCapital

So: on the next quarter and in 2008 basis, do you expect thetrajectory 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 tocontinue into the fourth quarter and into 2008. And it is part of making surethat the revenue that we are getting has got the right economic benefit both inthe 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 - MilbertCapital

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

Joe McGrath

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

Janet Haugen

So if you're looking, Jerome, when you're asking, there'stwo portions we talked about. One is the systems integration. Against ourexpectations for the full year that has been the portfolio that has gonethrough the most amount of change, and we did see that revenue go flat in thisquarter.

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

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

Joe McGrath

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

Jerome Land - MilbertCapital

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

You're two years into the restructuring, give or take, oralmost, you have a target out there for 2008, but as the target gets moved, Ithink it causes the market increased concern and uncertainty that we can'ttrack 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 ofthis process we were strongly encouraged by our board not to do that, becausethe transformations of this magnitude size never go in a straight line. And soyou end up disappointing people more than you end up fulfilling theirexpectations.

We committed to them that we would revisit this issue ofguidance in 2008. We understand the challenges it presents to everyone that'son this call. And so we're going to go back to them to see at what rate theywould 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 communicatedwith you, they have a fair amount of reluctance on this. And so, it's not thatwe don't have engaging discussions every quarter on when we should begin givingguidance, because of the challenges it presents in you creating your model.

So, we do understand that, but we have not gotten theirsupport yet and we completely understand: why, in starting to give guidance ona forward-looking basis, but we will continue to revisit it, and maybe you'llsee that sometime in 2008.

Jerome Land - MilbertCapital

Okay. And I want to clarify: “Why I asked that?” It's notabout: just creating the model and it's not about: trading you on aquarter-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 quartercalendar next year, you're releasing first quarter earnings, and we're lookingat 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 progressmoment-to-moment. It's about: being able to see whether you are in facttracking towards that goal, which today has been pushed out an extra sixmonths. 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 - MilbertCapital

So, it's very important to us that we understand whether ornot you're making progress.

Joe McGrath

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

Jerome Land - MilbertCapital

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

Joe McGrath

Yeah. Here's what we've said and let me reinforce it. Thefacts and documentation we have contradict the claims that were made in thatarticle. We believe a proper investigation will show that we acted in goodfaith.

And we really have provided the DHS with accredited andgovernment-certified security systems and program. And frankly, we're proud ofthe work. Now, are there investigations going on? There's some things thatwe're aware of, there's things that we're not aware of that were referenced inthat 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'tgotten back to us.

Jerome Land - MilbertCapital

Okay. Thank you.

Joe McGrath

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

So thank you very much for joining us.

Operator

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

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