Affiliated Computer Services F1Q08 (Qtr End 9/30/07) Earnings Call Transcript

Nov. 2.07 | About: Affiliated Computer (ACS)

Affiliated Computer Services, Inc. (ACS) F1Q08 Earnings Call November 1, 2007 4:30 PM ET


Jon Puckett - Vice President of Investor Relations

Lynn Blodgett - President and Chief Executive Officer

Tom Burlin - Chief Operating Officer

Kevin Kyser - Chief Financial Officer.


Moshe Katri - Cowen

Ashwin Shirvaikar - Citigroup

Adam Frisch - UBS

Julio Quinteros - Goldman Sachs

James Kissane - Bear Stearns

Bryan Keane - Credit Suisse

George Price - Stifel Nicolaus

David Grossman - Thomas Weisel Partners

Tien-tsin Huang - JPMorgan

Cynthia Houlton - RBC Capital Markets


Good afternoon, and welcome to the ACS First Quarter Fiscal2008 Conference Call. Today's call will consist of prepared statements by ACSfollowed by a question-and-answer period.

All participants will be able to listen only until thequestion-and-answer session begins. The call is webcast live on the Company'swebsite and available for replay purposes. If you have any objections, you maydisconnect at this time.

I'd now turn the call over to Jon Puckett, Vice President,Investor Relations. Mr. Puckett, you may begin.

Jon Puckett

Thank you Mary Anne. Good afternoon, and thank you forjoining us today to discuss our first quarter fiscal year 2008 results. Todayon the call we have Lynn Blodgett, President and Chief Executive Officer; TomBurlin, Chief Operating Officer; and Kevin Kyser, Chief Financial Officer.

As always, I must caution everyone that any statements onthis call that are not historical facts may be considered forward-lookingstatements within the meaning of the federal securities laws.

As you know, forward-looking statements are subject to knownand unknown risks and uncertainties that could cause actual results to differmaterially from those expressed in or implied by these statements.

Additional information concerning these factors is containedin the Company's filings with the SEC. Copies are available from the SEC'swebsite, from the ACS website or from ACS Investor Relations.

We also provided a presentation on our website that we willrefer to during our discussion. We will reference certain non-GenerallyAccepted Accounting Principal financial measures which we believe provideuseful information for investors.

We have posted both the presentation and the reconciliationof those measures to Generally Accepted Accounting Principals on the InvestorRelations page of our website at finally, we disclaim any intention to and undertake no obligation to updateor revise any forward-looking statement.

I will now turn it over to Lynn Blodgett, our ChiefExecutive Officer, who will provide a summary of the significant events duringthe quarter.

Lynn Blodgett

Thank you, John, and thanks to everyone for joining us onthe call today. Earlier this week, Cerberus Capital Management withdrew itsoffer to acquire ACS due to the continued poor conditions in the debt market.

Removing the uncertainty about our ownership will helpremove the non-operational distraction that we've had for the last eight monthsand will remove a significant impediment that has limited our commercial salesefforts for the past two quarters.

I look forward to remaining a Public Company and providingthe best services to our clients, opportunities for our employees and values toour shareholders. Today there's been information in the press regarding theresignation of the Company's independent directors. ACS is pleased that theCompany's independent directors have agreed to resign.

This action is clearly in the best interest of theshareholders. ACS is more than confident that the new directors proposed areindependent and will respect all shareholder rights. We welcome an examinationof their independence provided it is done in a reasonable time that allows ACSto quickly move forward and focus on its business.

I do not intend to comment further on this matter in today'scall or to take questions at the end of the call. Before I begin discussing thequarter's results, let me take a moment and share with you some observations Imade on a recent trip to ACS locations around the world.

Please turn to slide number 3. I visited many of our sitesworldwide and met face to face with approximately 5,000 of our employees.During my journey, I held town halls with our employees to discuss our goals asa Company and to field questions. I learned several things from these townhalls.

First, I was reminded that ACS has a significant globalpresence. Several years ago we led the charge offshore. As a result of ourleadership, we have most extensive and well-developed global delivery models inthe world.

We have a developed workflow software backbone that has beenconstantly improved over the past 11 years. This tool allows us to disassemblework, produce the work in the lowest cost region of our global network, andthen reassemble it for delivery to our clients.

Our ability to disaggregate work provides us with a hedgeagainst currency, wage inflation and natural disasters like floods orhurricanes. You could say that we've matured. With maturity comes a tried andtrue model to go offshore more selectively and more deliberately.

An example of our leadership using this model can be seen inour site selection process. Some of our competitors pursue offshore strategiesin well-known tier 1 cities. In India, where wage inflation is a legitimateconcern, we began using tier 2 cities in advance of the competition.

We are now developing a hub-and-spoke concept that willfurther strengthen our offshore leadership position. We've always tried tostretch the globe as far as possible and will continue to do so.

We believe the benefits of this strategy are lower wageinflation, less attrition, a more stable workforce and the most appropriateresource for our clients. In many of our locations, we are the largest localemployer and positively impact the community where we choose to locate.

My trip allowed me to shake hands and answer questions ofour wonderful people and to help them feel a deeper connection to ACS. I have amuch greater sense and appreciation and gratitude for our people and theamazing things that they do.

I'm also impressed by the complexity and quality of workthat we do offshore. We are performing level 2 and level 3 work offshore thatwe would not have imagined doing a few years ago.

From one of our locations in India, we deliver worldwidepurchasing services for one of the largest automotive companies in the world.Portions of our health care claims process are completed in several locationsglobally for some of the largest health care payors.

From Montego Bay, Jamaica, we perform payroll operations forone of the largest financial institutions in the world. We perform complex financeand accounting work from our Sao Paulo, Brazil site.

We perform administrative HR functions from our Barcelona,Spain site for numerous multinational companies. These are just a few examples.In addition to visiting our offshore locations, I also spent time in several ofour locations in Europe.

Our level of innovation internationally is astounding. Theresearch and development capabilities in our transportation business are worldclass and worldwide. We provide services from Geneva, Switzerland to MexicoCity, Mexico.

We are reengineering our clients' processes from beginningto end with our hardware and software solutions. We are comfortable with thecomplex implementations in this business and in leading the way for ourclients.

I am impressed with our capabilities and our ability totransform the way our clients do business. Our innovation, existing customers,and global presence are leading us to prospects that we could not haverealistically pursued until now.

These prospects span from significant new businessopportunities to potential acquisition candidates.

I am thrilled that we are beginning to see tangible resultsfrom our global expansion. We are succeeding in our efforts to grow Europe. Wehave been down selected on new business from European-based global companiesand we'll use our global delivery model to serve these customers.

Unlike many of our competitors who have been in Europe forsometime and have already seen it's impact on their growth, it is a new marketfor us and represents a major source for incremental growth.

We believe that the early results we are seeing today willtranslate into visible results for our stockholders in the near future. Thistrip helped to confirm what I already believed, that our 62,000 employees are aspecial group and that ACS is truly a global Company with boundlessopportunities in front of us.

Please turn to slide number 4 and let's talk about firstquarter results. Since becoming CEO, I have challenged our organization to growand execute. Growth is one of the primary focus areas for ACS because itprovides our employees with additional opportunities, enables us to expand ourservice capabilities, and allows us to have a greater impact for our clients.

This growth ultimately results in better returns for ourshareholders. Execution is critical in order for us to grow profitably. We haveimproved our execution dramatically over the past several quarters. I believeour first quarter results reflect our people, our people are hearing themessage and we are right on track.

I commend our employees that have helped us deliver stronggrowth in most operating metrics in the first quarter of 2008. Let me alsohighlight that we met our internal growth in operating targets for the quarter.

We grew consolidated revenues by 8%. Internal revenue growthwas 6%, which represents a 2-percentage point improvement in internal growthfrom the prior year quarter. I'm particularly proud of our revenue growth giventhe headwinds our commercial business has endured from the potential buyout.

We improved adjusted operating margins 30 basis points overthe past quarter to 11%. This improvement was driven by improved execution onour most complex accounts and our continued focus on cost. We continue toleverage our offshore resources and increase the penetration rate on ourincentive based-compensation plans.

We delivered growth in several other areas in the firstquarter. We grew adjusted operating income by $15 million, or 10% over theprior year quarter. We increased adjusted EPS by 18% over the prior yearquarter.

The one negative in the first quarter was our cash flowperformance. Remember that our first quarter is typically low due to the timingof our annual management incentive compensation payments.

Despite this trend, I am disappointed with our cashcollections this quarter. In order to prevent these poor results from happeningagain we have changed our management incentive compensation plan to include aquarterly, rather than annual cash flow metric.

I believe this will provide the proper focus for ouremployees and more predictable quarterly cash collections going forward.

We have a strong track record of good cash flow. We know howto collect our receivables and manage the other components that contribute tocash flow. I am confident that our operating cash flow results will improvethroughout the fiscal year and we will achieve our historical operating andfree cash flow metric.

Operationally, we continue to deliver excellent service toour clients and achieved a 94% renewal rate during the quarter. This isconsistent with our fiscal 2007 renewal rates, which were greatly improved fromfiscal 2006.

We also maintained a strong and broad pipeline of $1.7billion that includes excellent opportunities in both segments. We must convertthis pipeline of great opportunities into bookings and revenue. I am confidentthat we will see an improvement in our conversion rates.

In summary, we had a strong start to fiscal 2008. I ampleased with the growth we've been able to generate. Our operationalimprovements have resulted in better execution. I am confident that we will seesteady improvement in our signings and our overall growth rate through 2008,which will result in a strong year. Now, let me turn over to Tom Burlin, whowill provide an operational overview.

Tom Burlin

Thanks, Lynn. Please turn to slide 6 and I'll review newbusiness signings. In the first quarter, we closed approximately $141 millionof annual recurring revenue, which represents approximately $604 million oftotal contract value.

While our trailing 12-month annual recurring signings arestill negative, our trailing 12-month TCV turned positive this quarter andincreased approximately 6%. This is consistent with the increased mix of governmentin our trailing 12-month signings, which are generally longer term than ourcommercial contracts.

For the quarter, new business signings by segment wereconsistent with our overall revenue mix. The commercial segment representedapproximately 58% of total signings and primarily included expansion atexisting customers. Commercial signings decreased from the prior year quarterby approximately 21%.

Our government signings more than doubled over the prioryear quarter and represented 42% of total signings. The growth in governmentgood signings was driven primarily by our government health care group wherewe’re seeing momentum from our new Medicaid system.

We signed a new Medicaid contract with Alaska and alsorenewed and expanded an existing Medicaid contract with the District ofColumbia. We continue to expand our international transportation business withwins in Dubai, Austria and Australia for fare collection. New business signingsby service line were relatively consistent with our overall business mix ofabout 77% BPO and 23% IT solutions.

Turning to renewals, we continued in the first quarter wherewe left off in fiscal 2007 by maintaining a renewal rate of 94%. Renewals forthe quarter represent approximately $90 million of annual recurring revenue andtotal contract value of approximately $234 million.

By segment, renewals were consistent with our overallrevenue mix. We could not have achieved these excellent renewal results withoutdelivering outstanding service to our clients.

Now, if you please turn to slide seven. Our new businesspipeline remains strong and broad at $1.7 billion of annual recurring revenueas of September 30, 2007. By segment, commercial comprised approximately 68% ofthe pipeline with the remaining 32% in government.

By service line, 75% of our pipeline is BPO business andapproximately 25% is IT Solutions. We're seeing particular strength incommercial and IT services, health care, transactional BPO, Multi-scope HRO andF&A deals.

In the government segment, we're seeing pipeline strength ingovernment health care business, our transportation business, includinginternational opportunities, and federal government opportunities. Before wedive in the segment results, I want to highlight that we've restated our historicsegment operating results to reflect our internal operating and reportingstructures, which we realigned during the first quarter.

Our commercial segment was performing work for few federalclients and we moved these over to the government segment as we assembled a newgroup to focus on opportunities in the federal market. This restatement has noimpact on our consolidated results, which have not been restated.

Please turn to slide nine. Total revenue growth for thecommercial segment was 6% with 3% internal growth. While commercial remainsbelow our goal on growing organically, at least in line with the market, I'dlike to highlight that internal growth increased by 1 percentage point from thefourth quarter despite being challenged by the commercial trailing 12-monthsignings, which declined 31%.

Our internal growth was driven by growth at existing clientsin our IT outsourcing business, increased volumes at our customer care clientsand decreased demand for our HR consulting services. First quarter fiscal 2008revenue growth was also positively impact by known client losses thatanniversaried in the quarter.

Turning to profitability, on an adjust basis year-over-yearoperating margins increased by 170 basis points driven by improved operationsin our multi-scope HR and F&A businesses. Increased customer care volumesalso added incremental margin. We also improved our execution in our financeand accounting business, which was partially offset by start-up costs relatedto a new contract.

On a sequential basis, commercial adjusted operating marginsdecreased 30 basis points primarily due to start-up costs in our F&Abusiness and lower health care consulting business, which has higher margins.

If you’ll please turn to slide 10. You may recall wehighlighted some areas of focus for our commercial segment for fiscal 2008. Letme update you on our progress to date. Our primary goal in commercial is togrow new business signings. As you can see from our results, we still have workto do here.

We believe the clarity we now have regarding the buyout willhelp accelerate commercial signings throughout the year. We anticipateincreasing our commercial new business signings and improving internal revenuegrowth throughout the fiscal year.

We are deepening our relationships with our clients andbecoming a stronger operations partner. Growing our relationship is a focus inall of our lines of business. Let me give some examples.

We grew revenue in the quarter with existing clients incustomer care space, IT outsourcing business, and our HR consulting business.We also maintained our existing relationship with valued clients as representedby our outstanding renewal rates. In fact, we have weathered the past fewquarters due to the loyalty we receive from our existing client base. Weappreciate the trust our clients have in ACS.

Another focus area for 2008 is to pursue strategicacquisitions to fortify and build upon our service capabilities. Our HRconsulting and our Intellinex acquisitions are excellent examples of thisstrategy. Acquisitions like these provide us a new entry point into clients andmarkets with the ability to leverage growth in both.

We believe this strategy is sound and will continue to focuson strategic acquisitions. Let me also emphasize that we've been and willcontinue to be disciplined in our approach to acquisitions and valuations. Wehave a time-tested process of pursuing the right acquisitions at the rightvaluations. This discipline will not change.

We've challenged our line of business to create expandedproduct and service offerings in fiscal 2008. During the first quarter, weformed a strategic alliance with UBS Global Asset Management to offer anend-to-end retirement solution for defined contribution and defined benefitplans.

This is a unique partnership that takes advantage of UBS isexcellent retirement offerings and ACS industry leading plan administrationcapabilities. In addition, we recently introduced a new innovation for thetransportation industry. This new service offering, Incab scanning, allows longhaul truck drivers another option to advance their paper work which saves themtime and money.

Finally, we indicated that we would continue to identify andfurther train strong leaders in our organization, as well as aggressivelyrecruit top talent in our industries. For example, in human capital managementservices, we recently hired Brad Everett. Brad comes to ACS with over 30 yearsof experience in delivering technology services. Bred has deep experience inHRO and has held leadership positions at industry advisory firms and HR serviceproviders.

We also strengthened our finance and accounting organizationwith the addition of Ron Gillette as Senior Managing Director of Finance andAccounting. Ron is a seasoned veteran in the outsourcing industry with 18 yearsof experience in outsourcing. His past experiences include Accenture where hewas responsible for growing their BPO business globally.

Adding these two strong leaders should help accelerate ourmomentum in these businesses. We are excited to have them on the team. Tocontinue to strengthen our executive development program curriculum, our goalremains to train future ACS leaders by combining practical experience withexternal training.

Programs like this will improve our talent base andsupplement our succession planning. We still have some areas to work on, but wemade good progress during the first quarter in the commercial segment.

Now if you'll please turn to slide 12. Government segmentrevenue growth was 11% with 10% internal growth. Internal growth was driven byan almost 33% increase in trailing 12-month signings, increased transportationbusiness and eligibility contract ramp.

As we indicated last quarter, we did not anticipatecontinuing to grow at twice the industry average, but as you can see we stillachieved excellent growth in the government segment on a year-over-year basis.Looking sequentially, revenue decreased approximately $34 million due to thecompletion of project work in our government health care business and a declinein our lumpy non-recurring unclaimed property business.

Revenue was also negatively impacted by descoping thesoftware development component of the Department of Education contract. On anadjusted basis, government-operating margin declined approximately 120 basispoints on a year-over-year basis and 140 points sequentially.

The primary driver of the year-over-year decline was theramp of the Indiana eligibility contract. Sequentially, margins declined due toproject work that we completed in the fourth quarter as well as the ramp of theIndiana contract. As we've always said, margins will typically be pressured intimes of growth as we initially ramp business.

If you'll now turn to slide 13. Last quarter we highlightedsome areas of focus for the government segment for fiscal 2008. Let me take amoment to update you on our progress here. Innovative solutions and platformsis one area of focus for government.

We have been investing in our innovative next generationMedicaid system, which we believe is the most advanced solution in the market.During the first quarter, we continued to see the fruits of our efforts with anew Medicaid win in Alaska and a renewal and expansion of our Medicaid contractwith the District of Columbia.

Our transportation business continues to lead the chargewith creative solutions that have global reach. We have also been recognizedfor our quality in this business. Our New York E-ZPass customer servicesolution was recently distinguished at a center of excellence for itsworld-class service, placing it among the top 10% of customer care centers.

In Indiana, the first consolidated service center went livethis week servicing 12 Northern Indiana counties. Recipients of various formsof public assistance will, for the first time, be able to apply for aid usingthe phone and Internet.

This eliminates the double penalty of those least able toafford lost work time and additional travel expense. This solution provides aprivate, confidential and convenient option to request assistance. We continueto grow our business internationally.

We are dominant player in the international transportationbusiness. During the first quarter, we continued to leverage this businesssigning three fare collection contracts using our contactless ticketingsolution.

We believe that our continued expansion into additionalglobal markets provides us the critical foot in the door to provide othertransferable solutions that address the needs of governments around the globe.

Our efforts in fiscal 2008 will focus on continuing tooptimize our costs. We intend to increase penetration of activity-basedcompensation in fiscal 2008. Activity-based compensation is one of our greatestcompetitive advantages. We have teams that help us leverage ABC. Their primaryfocus to identify opportunities for our ABC, pilot the program, implement, andfinally move it into production.

This process generally takes from one to three months.During the quarter, we expanded the percentage of government segment employeeson ABC to approximately 33% of the total government workforce. This is morethan double the percentage government achieved in the prior year quarter.

These efforts generate cost savings, improve productivity,reduce turnover and deliver better client outcomes. While we are making stridesin this area, we have much more to do. In the first quarter, our governmentsegment grew revenue at approximately 2 to 3 percentage points faster than theaverage industry growth rate. We anticipate Government internal revenue growthwill continue to be at or above the industry average growth rates over the longterm.

In summary, we delivered a strong quarter. We grew revenuesin both segments, increased margins in Commercial and continued to innovateacross both lines of our business. I'm pleased with our progress and lookforward to a strong fiscal 2008. Now let me turn it over to Kevin to take youthrough the financials.

Kevin Kyser

Thanks, Tom. Please turn to slide 15. On this slide, we haveprovided reported and adjusted non-GAAP results for the first quarter's offiscal 2008 and 2007. We have adjusted our reporting results for the ongoingstock option investigations and related re-pricing for certain options, buyoutcosts, and related lawsuits.

We believe this will give you a truer picture of ouroperating results and mirrors the way management views the business. As Lynnstated earlier, we met our internal targets for the quarter and overall we werepleased with our results.

Let me take a moment to highlight a few significant items.Revenue growth was solid at 8% and although we don't provide guidance was inline with Wall Street estimates. Adjusted operating income of $164 million grewby 10% year-over-year and also was consistent, with most analysts' estimates.

During the quarter, we incurred certain severance costs aswe continued to trim our workforce. And we incurred a $3 millionpre-acquisition claim for which we were not indemnified. These items areincluded in our adjusted operating income that is they were not added back.

Year-over-year we expanded adjusted operating margins by 30basis points. This margin expansion can be attributed to our improvedoperational execution especially on some of our most complex accounts. Inaddition, we continued to use our most effective tools, ABC, offshoring and ourprocurement initiative to help control our costs.

Adjusted pre-tax profit was $120 million during the quarterand grew 11% over the prior year. While revenue and operating profit were consistentwith most analysts' estimates we noted that our pre-tax profit diverged fromWall Street models.

We suspect the difference is due to analysts assuming lowernet interest expense than we actually incurred. Despite this point, we grew ouradjusted non-GAAP EPS by 18% year-over-year. Before I move from this slide, letme give you an update on new accounting rules that impacted us this quarter.

During the quarter, we adopted FIN 48, accounting foruncertainty in income taxes, which clarifies the accounting for and disclosureof uncertainty in tax position. FIN 48 also requires us to record interestexpense on our tax liability each quarter. That interest expense will now beshown as a component of our effective tax rate.

During the quarter, we recorded approximately $1 millionafter tax or $0.001 of EPS related to interest expense on FIN 48. We fullyanticipate that FIN 48 will increase the variability of our quarterly taxrates. We also had some interest income on tax refunds that moved through the effectivetax rate this quarter causing the rate to be lower.

Please turn to slide 16 and let me spend a minute on the Q4to Q1 trends. Our sequential results this quarter were generally consistentwith our historical Q4 to Q1 trends. Over the last three out of four years,revenue and profit have been flat to slightly down on a sequential basis.

The primary reason for this trend is lumpiness in some ofour non-recurring business, like our unclaimed property business, completion ofgovernment project work in the fourth quarter, and contractual client ratereductions that take effect in the first quarter. Our non-recurring businessand project related work is typically more profitable than the consolidatedaverage. And therefore has a larger impact on our operating margins and EPS.

In addition, the impact of merit increases in certain linesof businesses take effect July the 1st. All these items combine to pushrevenue, profits and operating margins down from the fourth to the firstquarter. During the fourth quarter conference call, we highlighted that youshould consider our trends over the last several years when building yourmodels and these are the trends to which we were referring.

In addition, EPS from Q4 to Q1 was impacted by our adjustedeffective tax rate, which was 33.5% in the fourth quarter as compared to 35.2%in the first quarter. As we noted, the lower effective tax rate in the fourthquarter of last year was due to the higher mix of foreign earnings taxed at alower rate.

Please turn to slide 17, and let me give you some color onour cash flow for the quarter. As Lynn mentioned, we weren't satisfied with ourcash flow results this quarter. During August, we pay annual managementincentives, which cause the first quarter to be the lowest cash flow quarter ofthe year.

During the first quarter, we paid almost $56 million inannual management incentives. For comparative purposes, we only paidapproximately $6 million during the first quarter of last year. Due to payrollconversions in certain parts of our business, this quarter also included anadditional payroll cycle compared to the prior year.

Our cash collections on accounts receivable during the firstquarter were not sufficient to adequately cover these working capitalrequirements. We have demonstrated in the past that we know how to collect AR.We have implemented a quarterly cash flow metric in our management incentivecomp plan, which will put a more consistent focus on cash collectionsthroughout the year.

I am confident we will get this fixed for the second quarterand we continue to believe that our annual cash flow results will be consistentwith our historical cash flow metrics. CapEx and additions to intangibles was abright spot during the quarter at 5% of revenue and at the low end of ourhistorical range. This is 3 percentage points lower year-over-year and wasdriven by lower client CapEx requirements and our ongoing procurementinitiative.

As you know, we analyze cash flow on an unlevered basis,which excludes certain items that we have highlighted on slide 17. Interestpaid and cash payments related to the stock option investigation and buyouttotaled approximately 2.8% of revenue for the first quarter of fiscal year2008.

Now let me shift to the balance sheet. I've recapped ourmajor balance sheet categories on slide 18, as well as the most significantfluctuations from June. Consistent with my comments on cash flow you can seethat our poor cash collections resulted in a $131 million increase in accountsreceivable.

Accrued comp decreased approximately $107 million primarilydue to the timing of our annual incentive compensation payments and the timingof our payroll cycles. Other accrued liabilities decreased by approximately $24million primarily, due to two acquisitions earnout payments.

Other long-term liabilities increased approximately $52million predominantly, due to the adoption of FIN 48 and the related reclassesfor deferred tax and income taxes payable. Our debt to capitalization ratiodecreased to 53% this quarter, and we continue to be comfortable with our levelof debt due to our long-term contracts, recurring revenue, and our history ofgenerating strong cash flow. We believe we are well positioned given thecurrent credit markets.

While we do not provide financial guidance, I'd like toprovide you with some color on certain key items to consider as you update yourfinancial models. We believe our signings, while lumpy, will acceleratethroughout the year given that we now have certainty in our ownership. However,you will not see that acceleration show up in the financial statementsovernight. It will take sometime.

Historically, operating margins in the first quarter of thefiscal year are low and they moderately increase from there. As I mentionedearlier, our first quarter revenues and adjusted operating income were bothconsistent with Wall Street estimates, but it diverged at pre-tax income.

I would encourage you to review your net interest expense ascompared to our first quarter and adjust your models accordingly. While therewill be fluctuations in our quarterly tax rate, I anticipate our full year taxrate will be consistent with our historical tax rates prior to the fiscal year2007.

In summary, the first quarter results showed strong growthyear-over-year and we are in line with our expectations. One weak spot in thequarter was cash flow and we will get that fixed this quarter. I'm excitedabout our global opportunities for growth and the fact that our ownershipstructure is now clear.

That is all the prepared comments that I have at this time.Let's open it up for questions. We ask that all participants please hold yourquestions to one per caller. Operator?

Question-and-Answer Session


(Operator Instructions) Our first question comes from MosheKatri of Cowen.

Moshe Katri - Cowen

Thanks. This is a question for Kevin. Kevin, you mentionedsomething about severance cost of $3 million and a pre-acquisition claim ofanother $3 million. Can you clarify that? And I think that may be another twomore items that we may need to get into, kind of add back into our numbers?Thanks.

Kevin Kyser

Yes. Sure, Moshe. Those are just items that we chose to haverun through our operating results. We've really come to the conclusion thatseverance and cost cutting and investments from that require us to cut cost arejust part of the day-to-day operations that we have at ACS.

So we didn't actually quantify the severance cost. We didquantify the pre-acquisition claim that was about $3 million, but we are justnot adding those back into our adjusted numbers.

Moshe Katri - Cowen

Again, then just very briefly, you mentioned something aboutbeing down selected on a couple of European deals. Is that included already inthe booking number for the quarter and maybe you can elaborate on that? Thanks.

Kevin Kyser

Yes, thanks, Moshe. Those are not included in our bookingnumber. Those are things that we are working on and hope to close this quarteror certainly in the third quarter, and the 141 would not included down select.It's only if they've officially signed and are closed.

Moshe Katri - Cowen


Jon Puckett

Operator, let's move to the next question.


Our next question is from Ashwin Shirvaikar of Citigroup.

Ashwin Shirvaikar - Citigroup

Thanks. When you began, CEO Lynn, you had mentioned $10billion in revenues by 2010, I believe. Can you update us on whether thatremains an aspirational goal and what kind of growth rate is reasonable nowthat the overhang of the LBO process is gone?

Lynn Blodgett

You bet. The goal to reach $10 billion by 2010 is still agoal. We are trying to be realistic given there was some impact on our growth,obviously, from this overhang that we've talked about, so we are a littlebehind where we would like to be right now, but we are still continuing to workforward and work towards that goal.

Now that being said, we are not going to do something crazy,a crazy acquisition or a crazy deal simply to say that we hit our $10 billionby 2010. We are going to be disciplined and continue to drive the organizationforward and push for growth, but we are going to do it in a disciplined way. Soyou can be comfortable we are not going to get there at the expense of doing abad deal.

Ashwin Shirvaikar - Citigroup

Okay. Thanks.


Our next question is from Adam Frisch of UBS.

Adam Frisch - UBS

Thanks. Good afternoon, guys.

Lynn, this is for you, and I certainly don't expect you torespond to the letters that are going back Deason and the independentdirectors, but some of the things that were in the independent directorsletters were pretty serious and go down beyond Deason and into your seniormanagement team.

So you've done a great job in your first year resetting theagenda and all that kind of stuff, which, I think, again is very admirable andwe've written that.

But as the new CEO you have a pretty big task here in termsof rallying the troops and potentially proving to investors of what yourintentions are and how you are going to do it. So, again, don't expect you torespond to that because I know there are legal issues which prevent you fromdoing that, but how do you go out and reestablish the confidence bothinternally and externally in this management team's ability to driveshareholder value?

Lynn Blodgett

Well, I think the way we do it, Adam is focusing on thebasics, focusing on, as I look at this quarter, we had, our operating incomegrew 10%. Our EPS grew 18%. Our revenue grew 8%. We are going to continue andwe had lousy cash flow, which we have admitted and we'll fix that. We know howto solve our cash flow issue.

I think, the way that we continue to build confidence is toexecute and to set reasonable goals as I've said in my press release. We wantto show consistent growth. That's our primary objective is to show consistent,good growth, and we believe if we do that in earnings, in revenue, in EPS thatthat's what our investors expect and they'll reward us for that.

In terms of the employee base, I think, that the employeesare happy to have the uncertainty of the buyout behind us. I think that theseissues relative to the Board will sort out quickly and I'm confident that, as Isaid in my notes, I've spent the last, I've spent about a month two months agoout on the road visiting with our employees across the globe.

They are enthusiastic and have a lot of hope and optimismfor the Company, and we just need to continue. People want to be part of awinning team and I think, if we continue to meet reasonable growth objectivesevery quarter, then people both our investors and our employees, will becomfortable and we'll move forward.

Adam Frisch - UBS

Thanks, Lynn.

Lynn Blodgett

Thank you.

Jon Puckett

Operator, next question.


Our next question is from Julio Quinteros of Goldman Sachs.

Julio Quinteros - Goldman Sachs

Hi. Real quickly on the cash flow. Kevin, can you walk usthrough, I think, you mentioned the cash flow metrics should be back tohistorical levels given all the sort of moving targets in terms of numbers,what is the historical range that you have in mind either on a percentage ofrevenue basis or whatever metric you want to give us there? And then alsorelated to that what is the plan for the buyback activity going forward fromhere with this take out situation behind us?

Kevin Kyser

Sure. I'll address the latter first. Obviously, we are notbuying back shares at this point in time. We always like to keep theflexibility, balance the need for capital for acquisitions, for paying downdebt, all those different items.

Actually, we have not been able to buy back shares for sometime because of the situations and the investigations that we've been in andthe buyout offer. So it's something that we'll continue to monitor and seewhere that takes us from a share repurchase, but we are not buying back sharesat this point in time.

Julio Quinteros - Goldman Sachs

Can we assume that the plan, the previous plan has beenscrapped then at this point in terms of having levered up to buy back stock?

Kevin Kyser

The previous plan. Well, I mean I think we still have anauthorization and we still have credit availability, but we are not buyingshares today.

Let me talk briefly about the cash flow. Historically, we'vebeen a 13% to 14%, as a percentage of revenue, operating cash flow has been inthe 13% to 14% range. You take away 5% to 6%, 6.5% for CapEx and additions tointangibles and that gets you down to the 6% to 8% range of revenue.

And that's where we historically have been and we feelpretty comfortable with that range.

Julio Quinteros - Goldman Sachs

Great. Thanks, guys.

Kevin Kyser

You bet.


Our next question is from James Kissane of Bear Stearns.

James Kissane - Bear Stearns

Lynn or Tom, can you give us an update on the progress inthe HR space and maybe can you take a stab at the long-term target forcommercial margins? Thanks.

Lynn Blodgett

Yes. In terms of the progress in the HR space, we've madetremendous progress from an operational standpoint that I think we've talkedover each of the calls in the last several quarters about our focus there atimproving performance.

We just completed our annual client symposium for our HRbusiness in New York a couple of weeks ago and I met with a number of our majorcustomers, the ones that we were concerned about operationally. And I can tellyou that there has been dramatic improvement in the execution with thosecontracts.

So we are feeling much, much better in terms of our abilityto execute and where we are with that and I'm talking specifically, Jim, aboutthe multi-scope HR. Our other areas where we do total benefits outsourcing andour learning tower, where we provide these discreet services, are aboutconsulting services, those are things that we delivered well over a long periodof time.

So the thing I'm referring to specifically are themulti-scope deals that we are moving along very well there and the clients aremuch happier today than they were a year ago, if you want to use that as awater mark.

In terms of the margins, as we've said, we are comfortable,but in terms of that our margins are stable. We feel good about that. You saw alittle bump in margins this quarter by 30 bips.

So, we are going to continue to work to cut costs and so on,but we are also going to focus on growth and we would rather see absoluteearning dollars increase keeping our margins consistent rather than invest asmuch as we can in growth.

Tom Burlin

Yes, and I'll just add on the margin line, Jim, you followedthe company for a long time and you do realize that it's really a mix. It'spredicated on the mix of the business and we have some businesses in ourcommercial side that generate above average operating margins.

And then we have some that are in a growth mode and we arehaving incur some up front start-up costs and that really hits us really in theF&A business and the HRO business. So it's always a mix issue.

It's also growth, slower growth, faster growth, all thatwashes out and ultimately we think, as Lynn said, our margins are stable and wehope to improve them ever so slightly year-over-year.

James Kissane - Bear Stearns

Thank you very much.

Tom Burlin

Thank you.

Jon Puckett

Operator. Next question?


Our next question comes from Bryan Keane with Credit Suisse.

Bryan Keane - Credit Suisse

Hi. Good afternoon. The Commercial bookings continue to beweak, but it sounds like you guys expect that to pick up in the rest of thefiscal year.

I just want to make sure I understand why and if it is justCerberus then when you were having conversations with your clients, were theynot signing with ACS as a result of this strategic review process?

Tom Burlin

Yes. This is Tom. I'll take a crack at that. I think there’stwo things that I would mention.

One, yes, as I think as we go into clients where we haveopportunities, they have expressed concern in the past over the structure ofthe ownership and in particularly whether or not there might be a transfer ofownership and, therefore, a transfer of process and all those things that thedelivery people would worry about.

That being said, I think, we talked about over the pastcouple of quarters a reentry into this market and of course, it takes time tobuild that pipeline and secure the confidence of those folks who areconsidering us.

As we've said, we've been down selected. We've talked aboutthe strength in HRO and F&A market that we're starting to see not only inthe pipeline but in selected down selected deals.

So I think you can expect over the next couple of quarters,as Lynn alluded to, that you'll see an up tick in those markets in particularand I do believe that the clients will be more comfortable with our currentownership structure and the knowledge that will continue for the foreseeablefuture.

Lynn Blodgett

Yes, I think the issue here was not as much as with theclient’s concerned, whether we were public or private, it's the uncertaintythat has caused most of the challenge and the difficult.

And we know for certain that there were opportunities thatwe did not close as specifically because of this uncertainty. We are thrillednow to be able to put that behind us and we think that again, we are certainthat that will help in increasing bookings.

But the uncertainty was the bigger issue rather than whetherwe were public or private and I mentioned that on the call last quarter that weneed to run the business, make increase profits, do a better job in serving ourcustomers and grow our revenue whether we are public or private. People justwanted to know what we were going to be.

Bryan Keane - Credit Suisse

I guess my only question with that, Lynn, is looking at theBoard's letter today and it sounds like there's some strategic buyers of ACSand a new Board coming in.

Doesn't that still create some uncertainty or why is thatnot going to affect you guys going forward?

Lynn Blodgett

Well, I think that as I said at the beginning, it'sdifficult for me to comment a lot on the letters that were flying back andforth.

I am comfortable and confident that at this point in time weare proceeding just as I said over the last end of the last quarter that we'lloperate as a public Company.

I think the question relative to the Cerberus deal isclearly dead, so that puts that to bed. Now what happens in terms of thefuture, if there are other opportunities that come along, that's probably nodifferent than any other public company that you have always have the potentialof that. But, we are certainly moving forward as a public Company.

Bryan Keane - Credit Suisse

Okay. Thank you.

Jon Puckett

And operator. Next question?


Our next question comes from George Price with StifelNicolaus.

George Price - Stifel Nicolaus

Hi. Thanks very much. Just Kevin, if you could talk about acouple of things on the cash and profit side.

First, just remind us what the pre-acquisition claim wasabout, and then the CapEx, you said lower client requirements, but alsoprocurement initiative, a little bit more there, and if you see any variancesthat we should take into consideration over the next couple of quarters?Thanks.

Kevin Kyser

Okay, great. George, in your normal format you give me afive-part question and I'll try to answer.

The pre-acquisition claim, we didn't give a lot ofbackground on it. Obviously, when we acquire a company, we did not getindemnification for this type of claim. It was a risk we took and it didn't panout for us. So we had to take that charge this quarter.

From a CapEx perspective, obviously, it's the good side andthe bad side of CapEx. We love to spend CapEx, because it typically means wehave new business coming on. So, obviously, we've got less requirements, thenew business signings are down somewhat. As you would expect, the CapExrequirements flow down with that, as well.

In addition, we've been touting our procurement initiative.We've actually kind of gotten smart on leveraging some of our spend on ourcapital equipment. We've actually received better prices. We've seen that makea dent in our CapEx numbers, as well.

But that, obviously, is something that is good in the shortterm, but it's not good in the long term. So we feel like, obviously, a 5% willgo up in the future as bookings begin to come back on.

As it relates to the variances, obviously, fromquarter-to-quarter, I think I kind of went through those in the speech, butclearly there was somewhat of a disconnect in analyst models with the netinterest expense.

Obviously, we don't give you guidance, so I can understandthat, but it was pretty significant that disconnect from that because all ofour other metrics, operating income and revenue were on point.

So, the business hasn't changed that much that it should, weshould differ very wildly between the quarters from what we've done in thepast.

So you should be able to go back to the past and look at howwe progressed through this quarters, how we progressed through the year and usethat as a guide as you build you’re the course and then, again, the biggestdisconnect was on the interest expense, I think. So look at that, as well.

Lynn Blodgett

I'm going to add one other comment, Kevin, in terms ofCapEx.

We have pretty significantly improved our CapEx process. Wehave done that over the last year, so I do think that has had, I agree witheverything Kevin said, but that has also had, its better management.

Jon Puckett

We've tightened it down.

Lynn Blodgett

Yeah. We've tightened it down and we'll spend less moneyjust because of a better process. So, we will see increases just as Kevin pointedout, but we are also managing it better.

Jon Puckett

Operator, next question.


Our next question comes from David Grossman with ThomasWeisel Partners.

Jon Puckett



Please check your mute button.

David Grossman - Thomas Weisel Partners


Jon Puckett

Hi, David.

David Grossman - Thomas Weisel Partners

Okay. Sorry about that. I have turn out few minutes late soI apologize if this has been covered, but can you give me an idea of how muchleverage you feel comfortable with on the balance sheet, and perhaps what yourcapacity is?

And, I guess, Kevin, you've mentioned a couple of times thatwe are all off the interest expense line and perhaps you can share with us whatthe average rate was up therefore rate up during the quarter?

Kevin Kyser

Okay. Well, I think today we are leveraged at about 53%debt-to-cap. Obviously, we are comfortable with that. We've been at higherpercentages in the past, so because of the recurring revenue, the cash flowmetrics that gives us the comfort that we need. From an interest cost, I thinkour senior notes are around about 5%.

Those are the bonds that are sitting out there. Thepredominant major component of our debt is the term debt and that's probablysitting at about 7%. And then we don't have a lot drawn on our, we have verylittle drawn on our revolving line of credit. I think that's probably around7%, as well.

But, hopefully, that will give you a little bit ofvisibility and, obviously, we'll be filing our 10-Q in a couple of weeks andyou can get some of the details from that, as well.

David Grossman - Thomas Weisel Partners

Okay. Thanks. Can I just take one more and maybe for Lynn. Iknow the question was asked about the commercial signings and where yourconfidence stands. Is there anything that you've done organizationally over thelast three to six months in terms of profit (ph) or anything else internallythat would give you the confidence that now that some of this uncertainty isbehind you that you're going to acceleration on the commercial side?

Lynn Blodgett

Yes. Absolutely. We are about five months ago, weimplemented, six months ago; we implemented an approach we called "divideand conquer" and specifically in sales in the commercial organization.

We actually split our commercial organization into two, sowe could have twice as much, essentially we took the person that was runningthe entire organization cut their world down by about half so they could focustheir attention on a smaller number.

Took another very capable individual promoted them over theother half and we do believe that from a structural standpoint the concept of"divide and conquer" helps us to focus, put more attention on thewhatever that issue is whether it's operational issue or sales issue.

So we've made that change, and I think that that is helpingyou to see the pipeline has grown in both of those lines of business at a morerapid rate than it had been growing before, so that's proof of that.

We still need to, as I said in my prepared comments, we needto convert this good pipeline into closed deals, but organizationally we didthat. We also have done some things with some incentives with our operatingpeople in terms of helping to support our sales organization in pursuing newdeals where they get a little bit of a stiff if they can help the operationspeople and that's having an advantage.

We also have implemented more of our base salesorganization, where we actually assign what you might call a farmer to ourcustomer base so that we have people that are out selling new logoopportunities and we've done more with having people specifically assigned toour existing base and helping farm that base and we've seen increased revenuegrowth out of that area. In fact, last quarter that's where a great deal of itcame from.

David Grossman - Thomas Weisel Partners

Thank you.

Jon Puckett

Operator, next question.


Our next question comes from Tien-tsin Huang with JPMorgan.

Tien-tsin Huang - JPMorgan

Hi, thanks. How did the non-recurring short-term projectrelated work perform versus playing in both the Government and the commercialsegment, and how does the short-run outlook feel to you on the non-recurringside?

Tom Burlin

Tien-tsin, this is Tom. Two areas, in particular where wesee sort of peaks and valleys in those projects. In particular in ourGovernment business, particularly in our health care business where we see newlegislation that passes through.

We saw it with HIPPA. Most recently we saw it with a programcalled the National Provider Indices. Typically, those come through a largefederal funding. They flow down to states and then they tend to run fromanywhere from a year to two years, so they are meaningful projects. They arenot short-term projects.

But they usually have deadlines that either the funding runsout or they must be implemented. And that's what we saw in the health carebusiness with National Provider Indices. So those tailed off at the end of thequarter.

But we typically see change across there, so we'veexperienced over multiple quarters that these peaks and valleys re-occur as newlegislation, new technology rolls out in that market.

In our transportation market, we have a veryproject-oriented, again, they tend to be pretty significant projects where weinstall new fare systems or new parking systems and may take us anywhere from12 to 18 months to install those.

And we typically see the higher end of the profit come as wemake the later deliverables. The projects are usually constructed in such a waythat the clients pay a better portion of the project as we complete.

Then again, at the end of last quarter, simply because oftiming on sales, we saw a lot of those projects end and we're in the phase ofbuilding out new, recent set of new wins. So we'll see that revenue ramp up asthose projects become more mature.

So I think it's just a cyclical, it's not necessarily highlypredictable by quarter, but we will see that from time to time.

Lynn Blodgett

And I think, the other thing that I want to add there isthat our non-recurring bookings, which a lot of your project work falls intothat area, as an area of a lot of focus for us and we've had, those bookingscontinue to grow and so we are comfortable that.

We have to look at recurring and non-recurring as we havemore businesses like consulting businesses that do rely on projects. So wewatch that closely and we are confident that it will make its appropriatecontribution for the year.

Tien-tsin Huang - JPMorgan

Kevin, can you remind us of the mix of non-recurring revenuein each of the commercial and the Government segments?

Kevin Kyser

We don't break it down that way, Tien-tsin. We break it downoverall. I think non-recurring revenue is about 15% of total revenue. Give ortake.

Tien-tsin Huang - JPMorgan

Okay. Great. Thanks.

Kevin Kyser

All right, thanks. And, operator, we have time for one morequestion.


All right. Our next question comes from Cynthia Houlton atRBC Capital Markets.

Cynthia Houlton - RBC Capital Markets

Hi. Good evening. Just on the free cash flow number, youmentioned that the two different issues were collections and then also a bonuspayment. Can you just walk through what was different year-over-year in termsof the makeup of bonus payments or timing, and then also kind of whatspecifically drove slower collections?

Was there large contracts? Was it customers extendingpayment terms? If you can you just comment on those two aspects of cash flow?

Kevin Kyser

Sure, Cynthia. This is Kevin. From a year-over-yearperspective, there was about a $50 million difference between Q1 of this yearand Q1 of last year. Now recall that fiscal year, so we paid fiscal year '07bonuses in August, so in the first quarter.

So the first quarter payments that were lower in prior yearwere for fiscal year '06, and if you recall, that was a year in which our bonusprogram, which is based on growth, we didn't hit and so we paid very littlebonuses in that year. That's really the dynamics of it. Fiscal year '07 was amuch better year and we hit the growth targets and therefore, we paid out morebonus.

From an AR perspective, I would say, a little bit of the ARcollections is just focused, obviously, we had, if you go back one quarter, itshows you how lumpy cash flow can be, but Q4 was a record quarter, it was ablowout quarter. There hasn't been another quarter that even came close to Q4.

And I think, we set aside, patted ourselves on the back, andI don't think we were as focused in the first quarter as we should have been.So from that perspective I think it's a very easy thing to turn around and weare, actually we are off to a very strong start this quarter.

October has been very good for us, so I'm confident we'llsee better results this quarter.

Cynthia Houlton - RBC Capital Markets

Okay. Thank you.

Kevin Kyser

All right. Thank you. Well, that wraps it up. I want tothank everyone for joining us today. John and I will be around to answer anycalls afterwards. So, please give us a call. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!