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Electronic Data Systems Corporation (NASDAQ:EDS)

Q3 2007 Earnings Call

November 2, 2007 9:00 am ET

Executives

Ron Rittenmeyer – President, COO

Dave Kost - IR

Mike Jordan – Chairman, CEO

Ron Vargo – EVP, CFO

Analysts

George Price - Stifel Nicolaus

Rod Bourgeois - Bernstein

Bryan Keane - Credit Suisse

Tien-tsin Huang – JP Morgan

Abi Gami - Banc of America Securities

Adam Frisch - UBS

Julie Santoriello - Morgan Stanley

Operator

Good morning, ladies and gentlemen, and welcome to the EDS third quarter 2007 earnings conference call. (Operator Instructions) I will now turn the call over to Mr. Dave Kost, Vice President of Investor Relations.

Mr. Kost, you may begin.

Dave Kost

Thank you very much, Tatiana. Hello everyone, good morning and welcome to our third quarter 2007 earnings call. With me today on the call are Chairman Mike Jordan; President and Chief Executive Officer Ron Rittenmeyer; and EVP and CFO Ron Vargo.

You should have received an e-mail from me with a copy of our press release as well as the presentation to be used on today's call. I'd like to remind you that the presentation, along with the webcast, are available on our website and will be archived there over the next 30 days.

The information covered today on today's call, which is not historical in nature, including statements regarding financial guidance or financial future performance and the value of our new contract signings, constitutes forward-looking statements within the meaning of federal securities laws. These statements are subject to numerous risks and uncertainties, many of which are beyond our control, which could cause or actual results to differ materially from such statements. For information concerning these risks and uncertainties, see the risk factors section of our most recent Form 10-K. We disclaim any intention or obligation to update these forward-looking statements, whether as a result of subsequent events or otherwise, except as required by law.

In addition, we refer you to the slides posted on EDS.com that accompany this call. Among other information, these slides and our earnings release present a reconciliation of the non-GAAP financial information to be discussed today and should be reviewed in connection with this discussion.

With that, let me turn the call over to Ron.

Ron Rittenmeyer

Thank you, Dave. Good morning to everybody and thank you for joining us. Let me start by taking us through the business highlights of our third quarter. So if you would, please turn to slide 3. Our assessment is we had a very good quarter. We reported adjusted EPS of $0.42, which is a 75% year-over-year improvement. Operating margin was 6.4% compared to 4% in the third quarter of last year.

Revenue was $5.6 billion, up 6% year-over-year-over with organic revenue up 4%. It was up solidly on a percentage basis and in line with guidance. We are seeing some current-year weakness from being more back-end loaded in our TCV production, which we'll continue to talk about.

Free cash flow came in at $181 million, and our third quarter TCV was $5.7 billion, which is up 61% versus last year and actually the best third quarter in more than five years. We've had very strong year-over-year increases in EMEA and Asia Pacific and pretty strong bookings overall in the government sector.

Turning to slide 4, talking about our third quarter signings, 75% of the TCV was signed in the U.S. and EMEA; that compares to approximately 80% in last year which reflects some increased production from our smaller regions. The ITO product line turned in the strongest sales performance, but it's important to note that application services continues to show really strong performance, which is in line with the strategy and the vision we've been talking about.

Overall, across all of our vertical markets, government and financial services continue to be the strongest. We had eight deals with a TCV greater than $100 million, an increase compared to both third quarter of 2006 and last quarter. To just talk about a couple, we signed a deal with Sabre for $630 million, which gives us a contract extension through the year 2014, we signed on an add-on business deal with the U.K. Ministry of Defense for Increment 2B through 2015 for $489 million.

As with last quarter, we did have some deals slide into Q4 and also some deals slide forward into 2008. Deal movements is going to continue to be a dynamic, ensuring we have the right deal structure which will provide both our clients and EDS with a solid solution to these typical complex problems. All in all, even though we had some sliding deals, signings were very solid and our sequential quarterly production continues to increase.

Moving to slide 5, I want to point out on the right side of the slide first that our TCV last time I talked about because approximately $23 billion, we're going to set a range of $21 billion to $23 billion. I think we're goings to some of this because of the timing shift in the 2008 that we've seen. But it is not a decrease, and I want to emphasize that, in the opportunity that exists in the opportunity that exist in the marketplace.

I think it's important to look at this slide and starting on the left side, if you look at our year-to-date signings for '06 and '07, remember, last year we signed both the GM and NMCI deal, which were worth, by themselves, about $7.5 billion. So when we look at our '06 to '07 comparison, and we look at normalized bookings, which is really our base business and we isolate those super mega deals, our base growth is actually about 17% year over year from a year-to-date standpoint.

If you look at our overall signings for '07 that we're talking about, our base business would look closer to 11% to 21% over 2006, when you take out those two super mega deals which were actually renewals.

I think it's important that we keep perspective on deal size and the impact of these really, really extremely high deals that come by every so often. Our actual fundamental business is actually very, very positive. So my assessment is we are achieving solid signing growths based on a normalized view of the company.

The next slide, on outlook and pipeline we continue to work on sales effectiveness, our win rate year over year continues to improve. We've added and are continuing to add application sales resources. We continue to integrate the EDS and MphasiS sales team to respond to smaller scope deals that are typical in the application market and we're investing more in our industry-based sales model.

When I look at 2007, it has actually been a very successful new sales year for our government industry. There are substantial IDQ wins that we've got and they are not reported in our TCV as some of our competitors do. We wait until we win the actual task order. Of course, task orders are a little bit slower and a little bit sluggish because of government spending being redirected to the war effort. On both a volume and award basis, our 2007 production has increased over historical trends.

As I mentioned, our TCV is tracking to the $21 billion to $23 billion range. We are very pleased with the pipeline expansion; that is a good leading indicator. We continue to be thoughtful about how and when we sign business and on a multi-quarter trend which is how we're looking at it, we continue to book very solid growth.

From a longer-term perspective, 2008 pipeline already is up over 20% with strength equally split between ITO and apps, which fits with the vision and strategy we talked about.

Our financial service industry had the strongest year-over-year growth in the pipeline and the government sector has the most potential TCV in our pipeline as measured by just absolute dollars. When we look at the number of mega deals in the pipeline, we see a steady to increased level of opportunity, based on TCV award values and the number of opportunities. So we see it in both areas.

Finally, we recognize the changing dynamics in the marketplace and continue to realign the segment and our sales resources to address changing market demands.

As an aside, when we forecast TCV also at the beginning of the year we hold our foreign exchange rates pretty constant. Any weakness in the dollar, as in this year, has an impact on actually what ends up being reported against our target. In fact, when you compare how we set this in the formula we use, we're actually due to foreign exchange rate, reporting $700 million less in TCV under the same scenario when we forecasted it. Ron can speak to that if you have further questions.

Let me provide some insight now into the progress of the quarter. On slide7, we've made very good progress in each of our portfolios. In applications we've taken further steps in moving up the value chain. We launched our testing practice, which we see as positioning us to pursue this $13 billion market that has an expected compounded growth of more than 20% over the next three years. This practice both strengthens our service line capabilities and fits within the vision that we set.

We forged a very important expanded relationship with SAP, to help strengthen and build out our SAP practice. SAP is providing us access to tools, methodology, recruiting and pipeline. It will enable us to build our end-to-end consulting and implementation capabilities. This is a key to the application strategy, but also important to cross-selling synergies with other service lines.

In the BPO area, we expanded our credit card utility platform into Australia, which further secures our position as the leading credit card processor outside the U.S.

In ITO, our network management service offerings are being well-received and our pipeline for these services continues to be very strong. Many enterprises are seeking a solution to the complexity of operating and transforming their networks to support new, more demanding applications and converged voice services. We offer a powerful combination of managed services delivery over the global service network, plus management of the network inside the enterprise via these network service offerings. We've been getting very positive reception in the market.

These are just a few examples of the ways we're expanding capabilities, offerings and services to drive future growth.

Next slide is slide 8, it talks about applications; we are very, very pleased with applications progress across all fronts. Third quarter revenue in this segment was $1.6 billion; that's up 9% versus a year ago. Applications services increased to 31% of our total revenue. Application signings represented 26% of total TCV in the third quarter, and 33% of total TCV signed year-to-date.

Looking ahead, the pipeline continues to improve and it's actually up about 15% year over year. Our momentum in applications continues and validates the importance of the MphasiS acquisition last year.

Slide 9, Best Shore, as you can by the bar graph, we are now up to 40,000 employees in Best Shore locations; we have about 25,000 of those in India. We continue to expand our Best Shore delivery network in other strategic regions and we're delivering a healthy mix of all service lines from Best Shore locations, and we're even doing more with ITO services from Best Shore locations.

We expect continued steady progress as we build this out. Now that we have scale, we're putting increased focus on both quality and the integration of seamless global delivery capabilities. We're continuing to optimize our workforce and integrate delivery, but clearly we're not done and we have more work to do in this area.

Quality, which I think you know from our standpoint is one of the things that we believe truly differentiates us. Our improvement continues to be vitally important, the responsibility of every single employee in EDS. Our severity 1 incidences continue to decrease significantly year over year as we work toward a zero outage goal. Third quarter severity 1 outages were down 82% over the third quarter of last year. That's a 10% improvement over the last quarter and a 50%-plus improvement from Q1.

This improvement has been driven by utilizing our global secure network as well as enhancing software and process changes. Importantly, these types of improvements are sustainable going forward.

Let's take a minute now and look into 2008. I told you in the past we would provide a road map 2008 in our last call, and Ron Vargo's going to provide a broader view into that, but let me set the framework.

From a revenue standpoint, we see approximately 2% growth. When you peel that back to the next layer, in 2008 there will be higher than normal runoff. We had the Verizon contract termination and we have impacts from price adjustments which is normal in these businesses for many of those larger signings from the previous years. Underlying this runoff is solid revenue growth that is more than offsetting that impact.

Secondly, we are going to be taking higher workforce and capacity management charges in support of our productivity and Best Shore actions. But when looking at the business before severance and before these charges, our operational performance will continue to improve as we focus on changes of how we do work.

We're going to double the severance investment as we continue to drive to the most efficient and effective resource mix on our global basis. In addition, our deployment of automation and standards will drive the need for severance. These actions will have a stronger payback in 2009 as we drive towards higher levels of revenues, earnings, margin and cash flow.

So in summary, it was a very solid quarter for earnings and margin performance. Sales performance was very good with excellent performance from the ITO service line. We've achieved strong growth in our sales pipeline, and we continue to feel very good about that. Our quality metrics continue to improve and reflects sustainable improvement in delivery of services to clients which is, by the way, what we get paid to do.

We've reconfirmed our full '07 guidance for revenue EPS and free cash flow and we are tracking to the lower end and we continue to focus on upgrading that as much as we can. 2008 is going to be more of a transition year as we make further improvements to our cost structure and resource mix.

So with that, let me pass it over to Ron Vargo, who can give you more details on our financial performance.

Ron Vargo

Thanks, Ron and good morning. I'll be covering results for the quarter and outlook for the year, and giving a little more detail behind our preliminary 2008 and 2009 full year financial targets.

As you can see on slide 14, total revenues were $5.6 billion in the quarter, up 6% as reported and up 4% on an organic basis. Adjusted and reported EPS were both $0.42, up 75% versus the third quarter of 2006. Free cash flow was $181 million, up $10 million versus last year's third quarter and the total contract value signed was $5.7 billion, up 61% versus last year's third quarter. I'll provide additional detail on these metrics in a moment, but first, let me discuss the income statement.

Slide15 contains summary level line items from our income statement adjusted to exclude certain items. A walk from the GAAP income statement to this adjusted format, as usual, is included in the appendix. Key highlights include revenue up $337 million, or 6% compared to third quarter of '06. The net effect of acquisitions, divestitures and currency effects was 2%, resulting in organic growth of 4%. You may recall that our 2006 results included about $75 million of revenue from a business, Global Field Services, which we sold in late 2006.

Operating income was $362 million, a $148 million year-over-year increase. Key drivers included the impact from recognizing the second portion of the Verizon settlement, lower severance costs during the quarter on a year-over-year basis, and improved productivity, offsetting all other impacts.

Our third quarter tax rate was 37%, higher than normal, resulting from a German tax charge -- which we have discussed in previous calls -- of about $0.06 that was partially offset by various valuation allowance true-ups.

Slide 16 takes you through a summary of the free cash flow statement. As we said, free cash flow for the quarter was $181 million and year-to-date, $329 million. A key driver in the third quarter continued to be working capital use, which results in part from the recognition of the balance of the Verizon payment out of deferred revenue, plus the recognition of deferred costs in the quarter net of all other items. Free cash flow on a year-to-date basis is down $166 million from 2006.

Let me take you through a few of the key items. Cash flow from earnings up $379 million as a result of improved operating performance; working capital through nine months was a use of $580 million or $392 million worse than 2006, due to deferred contract costs, the impact of recognizing deferred revenue, primarily associated with prepayments in 2006, lower accruals and higher accounts receivables; offset somewhat by favorable tax accruals. We'll talk a bit more about this when we talk about our fourth quarter view.

Gross capital before financing was significantly higher on a year-over-year basis, $619 million. That includes an increase of $333 million year-over-year in real estate leases, which is included both in the gross capital and the CFT leasing line. These relate primarily to two major data centers.

The amount of non-real estate assets financed increased year-over-year by $133 million, but asset sales and proceeds relating to the NMCI contract decreased year over year by $178 million, and the impact of all of these items resulted in reporting net capital of $153 million higher on a year-over-year basis.

I provided in the appendix a more detailed walk so that you can understand the impact of real estate leases and capital and financing.

Now the balance sheet on Slide 17. I'll take you through the most notable balance sheet movements from December 31 to September 30. Cash and marketable securities up $91 million, as our free cash flow was offset by net share repurchases and dividends. Accounts receivable, up $265 million, impacted by an increase from December 31 in DSOs of six days, and currency FX relating to non-dollar receivables.

Deferred contract costs increased by $178 million, and this increase is due primarily to contract start-ups; that includes deferred costs relating to a large U.K. government contract. The change in 3Q is pretty much back in line with expectations after a slightly higher than expected second quarter.

You should also note that the amortization of our deferred contract costs on the cash flow statement is reflected in the depreciation and other portion of the cash flow statement, while the additions to deferred contract costs flow through the working capital line.

Deferred revenue down $134 million, primarily due to the recognition of 2006 prepayments, and shareholders' equity up $681 million, due to earnings and currency impact, partially offset by our share repurchases.

So in summary, the balance sheet continues to remain strong with a relatively low level of debt, and our debt-to-capital ratio remains below 30%.

Now, I want to take you to the fourth quarter. Slide 18 gives you more insight into our expected step-up in earnings in the fourth quarter to achieve our full year guidance of 155 to 160, which will result in fourth quarter earnings of $0.55 to $0.60. So our adjusted EPS for 4Q is $0.55 to $0.60, excluding the charge associated with our early retirement option that I will discuss shortly. That is expected to be about $0.17 a share.

Starting with the third quarter EPS of $0.42, we will not have the sequential impact of the Verizon settlement, so that is $0.15 on a quarter-to-quarter basis. However, contract performance, which should provide on a net basis about $0.06, includes the net effect of numerous significant contracts, and we expect the $0.06 favorable outcome as a result of recognition of various milestone achievements and other contract improvements, which would more than offset sequential declines in other contracts on a third quarter to fourth quarter basis.

An increase of approximately $0.12 due to seasonality, such as higher volumes and utilization, and if you look at EDS' performance in prior years, I think you'll see that there is a trend of sequential improvement on a quarter-to-quarter basis, third quarter to fourth quarter, in prior years.

Productivity and other effects driven by our major initiative programs, as well as reduced discretionary costs in the fourth quarter are expected to add approximately $0.12, resulting in a fourth quarter EPS of $0.55 to $0.60.

On Slide 19 I'll take you through a similar walk to describe our expected free cash flow in the fourth quarter. Walking again from our year-to-date free cash flow at September 30 of $329 million, we expect cash flow from earnings in the fourth quarter of roughly $700 million, which is consistent with historical sequential trends.

Working capital improvements are expected to generate about $100 million of positive free cash flow and the primary driver is an improvement of our DSO to 56 days from 62 at the end of the third quarter. This will result in cash flow of approximately $350 million and will be offset partially by other working capital uses such as deferred costs, deferred revenue, and taxes.

Net CapEx is expected to be approximately $225 million but could be lower, resulting in full-year free cash flow at the very low end of our $900 million to $1 billion guidance.

Now, what I'd like to do is provide an update on the early retirement offer. On September 11, EDS announced an early retirement offer to approximately 12,000 eligible United States employees. The deadline for acceptance of the offer for the majority of the employees was October 30, but there's an extended deadline for a small percentage of employees. Based on current results, we expect that approximately 2,400 employees, or 20% of those eligible, will have accepted the offer.

The fourth quarter earnings charge associated with this is approximately $145 million, or $0.17 per share, and substantially all of that charge will be non-cash and will be recognized in increased pension expense. The near-term cash flow impact is immaterial, due to the funded status of our EDS U.S. retirement plan.

In 2008 and beyond, we expect favorable impacts. We're still assessing what those impacts would be as we look at the plans to fill various positions that would be vacated by individuals accepting the offer. So it's premature to discuss any specific numbers about the 2008 and beyond impact.

Now let me discuss our full year guidance. As Ron said earlier, we are not changing our full year 2007 revenue EPS and free cash flow guidance, but are currently expecting to come in at the low end of our ranges for each of these three. Revenue of $22 billion to $22.5 billion, adjusted earnings of $1.55 to $1.60 and free cash flow of $900 million to a $1 billion. As Ron discussed, we are putting a range around our full year TCV guidance of $21 billion to $23 billion, due primarily to the delay of some pursuits into 2008. Of course, these numbers exclude the estimated $0.17 ERO charge.

Slide 22, first let say that we are still in our 2008 planning process in the company, but we do have a preliminary view of certain financial targets for the year, as well as an early view for 2009. 2008 is expected to be somewhat of a transition year as we strive to offset the loss of significant revenue and operating profits from our Verizon relationship and other contracts, while we continue to invest in our applications business, and increase our workforce management costs.

These, what we call workforce management costs, include both severance charges and certain costs associated with the Best Shore’ing of positions, such as training and knowledge transfer. We expect revenue growth of approximately 2% in 2008, and an operating margin net of the workforce management costs to be approximately 5.5%, resulting in adjusted earnings in the area of $1.35 a share.

Finally, free cash flow of approximately $900 million.

Staying on 2008, we've highlighted in the middle of this slide the impact of workforce management costs. As you can see, we're expecting to increase our workforce capacity management costs by approximately 2X from the level in 2007. This is the pre-tax earnings impact; the cash flow impact will depend upon the timing and the tax status of the expenses.

At the bottom of the slide, we show the anticipated performance level before the workforce management-related costs, and as you can see on a margin basis, 2008 is similar to 2007. Again, the key drivers of this change are the headwinds from the Verizon contract loss and other contract runoff impacts, and the higher level of workforce capacity management costs. The impact of the early retirement offer and other improvements will obviously provide an offsetting positive impact to 2008.

In 2009, for directional purposes, we are targeting revenue growth of approximately 5% with margins in the 7% range, and free cash flow in the area of $1.1 billion. Further refinements will be made to our 2008 plans and we'll provide additional details and any adjustments to these numbers in early 2008.

So with those words, I'll turn it back to Ron Rittenmeyer for a wrap up.

Ron Rittenmeyer

In summary, we did have a very good third quarter; continued year-over-year and multi-year earning improvements. We remain focused on margin improvement and free cash flow for the long run. Key important elements of our strategy will remain in place. We intend to change this revenue mix through increased focus in applications and BPO, but primarily we are very focused on applications.

We continue to look at selected acquisitions for capability enhancement as well as solutions in the selective industries. We will revisit everything else. We clearly want to look at how we run this business and significantly change the status quo, and I'll speak more to that after the first of the year. But other than these other key elements, the rest of how we go do our work, I think, is up for revisiting and rethinking.

We remain very committed to cost structure improvements, and we're going to invest in 2008 to improve the overall value as we move forward.

With that, Dave, I'll turn it back to you.

Dave Kost

Thank you, Ron. Tatiana I'd like to open it up for questions and ask that you limit your questions to one per person.

Question-and-Answer Session

Operator

Your first question comes from George Price – Stifel Nicolaus.

George Price - Stifel Nicolaus

Thanks very much. Looking out to 2009 with all the actions that you're taking in '07 and expected actions in '08, and prior comments from management in terms of potential normalized margin ranges you think you can achieve in this business, I would have thought that we could see more in '09 than you're suggesting, particularly in terms of margin. I wonder if you had comments on that? If you could also tell us what share repurchase assumptions are embedded in the numbers that you have on slide 22? Thanks.

Ron Vargo

Our assumption on share repurchases in these numbers is that there will not be a significant share repurchase program. We would intend to manage the number of shares at a constant basis around current levels across 2008 and 2009. Addressing your first question, I would say these are preliminary numbers, George. Obviously what we're going to do is go after all the improvements we can to generate even better performance in 2009 than we're showing here; but we thought at this point in time it would be prudent to indicate that we can achieve 7% and we'll go after everything we can to improve that.

Ron Rittenmeyer

The issue, George, when you sit here and talk about how do you peg numbers, I wish that I could tell you more specifics in '09 but I'm still digging under '08 and I think I made the point at the end that there's a lot of other things that we want to revisit.

I would suspect that our targets would be directionally wanting to be higher, obviously, but at this point just for disclosure purposes, I want to be a little cautious until such time as I've got a better framework around the actual things I'm going to change.

George Price - Stifel Nicolaus

Just to follow up to your comment on the share repurchases and managing to a constant level of diluted shares outstanding, given where the stock is now, given the balance sheet and lack of M&A and the fact that you're going to be generating a material amount of cash flow based on your expectations, even including some of these actions that you're going to be taking, why aren't you buying more stock?

Ron Vargo

M&A for the company in the first half clearly was compressed due to the private equity pricing issues that were going on. So the good news is, we didn't overpay for something; the bad news is we didn't get anything. I would tell you that I think we are moving much more aggressively now, and I'd like to keep our powder somewhat dry to see if we could pull off some of these deals that we're working on. I think that's much more effective to us.

Every analysis we look at, if we can get this thing more in high gear, which we are very, very focused on right now, we've resorted that organization, we've put in different leadership and we have been much more precise in the terms the things we want to do. So from my standpoint, it's not time yet to spend that money on something that may give us a very short-term bump; it's not going to give us a long-term move. We need to sort this thing out over the next couple months.

I would tell you that I spend a significant part of my time now in this area and so it's a question of sorting through this very quickly and my commitment is to do that.

Operator

Your next question comes from Rod Bourgeois - Bernstein.

Rod Bourgeois - Bernstein

Ron, I wanted to clarify on slide 22, you have an adjusted EPS number for '08 of $1.35 at the top of the slide, and then at the bottom of the slide, $1.65 in adjusted '08 EPS. I'm assuming the $1.35 number is essentially close to a GAAP number, whereas the $1.65 number, I'm assuming, is really a pro forma number excluding what you consider to be one-time items. Is that an accurate way to read that?

Ron Vargo

Yes, I think about it, Ron, as the $1.65 is the number before our workforce capacity management charges there of $2 to $2.50, and so if those are in the approximate $0.30 EPS range you get to $1.35 up above.

Rod Bourgeois - Bernstein

So the $1.35 is closer to a GAAP number?

Ron Vargo

Yes.

Rod Bourgeois - Bernstein

I'm assuming though, that the $0.30 working capital management expenses, do you guys have specific plans on that or is that a big bucket that you're creating and now you're going to go get the plan in place?

Ron Vargo

The workforce capacity management plans, we do have plans. I wouldn't say we have names but we have some general plans.

Ron Rittenmeyer

Let me put it this way. As we did this business plan as we look at '08, each of the regions have specific plans to deal with the majority of this. You always plan to maybe it's 80% in some cases, and 20% above that you have to work through. I have a meeting with all of my senior leaders the week of November 12, at which point I plan to draw that to somewhat of a close.

I'd say we're in pretty good shape in terms of understanding what we have to do. Some of this ties into the application side in terms of further expansion offshore; some of this ties into just the shift in terms of process improvements in terms of how we want to get work done. I feel comfortable that we have the majority of this directionally, in some cases precisely, understood but there's always some gap in there because you have to have a little bit of room to figure out things you didn’t know as you put the rest of it together.

Rod Bourgeois - Bernstein

EDS early in the year expressed a heavily acquisition-focused strategy. Is your strategy going forward going to be more focused on M&A and acquisitions or on really improving the core operations of EDS? If you were to emphasize one versus the other, where would the emphasis be? In my mind, it's encouraging that you might be downplaying the acquisition side and focusing more on improving the underlying operation.

Ron Rittenmeyer

First of all, I think I've said this in both what I spoke to earlier and what I've said in interviews, the bottom line is we have to continue to be very focused on our core business. We have to be focused on changing our overall cost structure, not only in applications, but in every line of business that we do. Fundamentally Rod, to answer your question, it would be the core business.

But I do want to say that there are some things we need to do from an acquisition standpoint and we need to do those sooner than later. But we need to do those thoughtfully so that when we do them, we don't screw up the first piece that we're talking about. Because that is the primary reason we're here.

Rod Bourgeois - Bernstein

The '08 outlook, even excluding one-time items, seems lower than where you guys probably thought you would be at the beginning of this year. I'm wondering, since the beginning of '07, what's been the meaningful change in the business or in the market that has, in some ways lowered the outlook for '08 earnings, even excluding the one-time items?

Ron Rittenmeyer

Well, it's hard to exclude some of the one-time items. Verizon clearly is a climb back up the hill thing from the U.S. standpoint. We've had some other contract runoff that when you look at it, it has the same type of impact. Having said that, the pipeline is good. We've seen deals slide partially because I think people are not moving as quickly as they were in the past. We've also seen the government business, while these IDQs are very positive, we have won more IDQ opportunities, both in number and dollar potential than we've done in the past; historically, we're up significantly.

We are going through a little bit of funding issues where the government is still balancing money relative to the war effort versus other things. So I don't know, Rod; I'm trying to be cautious that we don't over promise, and get all excited about some of these things but that we keep very steady focus in very high internal expectations on delivering against a set of numbers that obviously my goal internally is greater than my goal that I'm talking about in terms of what I expect us to do, but I want to be realistic which you do the math, you end up with these numbers.

So I don't know, maybe I'm a bit conservative.

Operator

Our next question comes from Bryan Keane - Credit Suisse.

Bryan Keane - Credit Suisse

Ron Vargo, the $1.35 that you're talking about in 2008, is that comparable to the $1.55 to $1.60? Is that the adjusted EPS number that you guys are guiding to? There's a lot of moving parts, I want to make sure I'm clear.

Ron Vargo

Bryan, first welcome back. Second, it is comparable to the 2007 number of $1.55 to $1.60.

Bryan Keane - Credit Suisse

The other question, Ron, is just on the use of CFTs. That does have a favorable impact on cash flow. Can you talk about the change that you expect in 2007 versus 2006?

Ron Vargo

CFTs, for those who don't understand how we finance assets sometimes, these customer financing transactions are done when we are able to bring a third-party financing vehicle, a bank or another financial institution, between us and our customer and they would finance the assets. Sometimes these are done on large contracts, sometimes small contracts. We used to do them in very high numbers back in the late 1990’s, early 2000 around U.K. government clients and the Navy. We've scaled back a bit since then.

It provides an effective way of matching the cash flows associated with our contracts to the financing charges, and is done on a non-recourse basis typically so that it's not EDS' credit.

I would say the majority of the step-up in financing in '07 over '06 though that we're showing, is not CFTs per sae, but asset financing, software financing and other more traditional leases that is causing the increase in financing year over year.

Bryan Keane - Credit Suisse

It's up $466 million so far year-to-date. Does that number go higher into the fourth quarter as well?

Ron Vargo

First of all, that $466 million includes the step-up in real estate leases. If we enter into a long-term lease of a building, that goes into the financing number and the gross capital number. That's a big part of that step-up year over year. I think what I said, that on a year-over-year basis, the true increase from non-real estate assets is substantially less than that, and more like $133 million.

Bryan Keane - Credit Suisse

Ron Rittenmeyer, the thought process was 2004 to 2006 was the transition years and then 2007 we get to a stabilized number; '07 and beyond was going to be the growth years. Now, we're calling 2008 a transition year. I'm just trying to figure out what the difference between the transition years we had before and then now we have another transition year in 2008?

Ron Rittenmeyer

Well, I wasn't here but I'll give you my view. First of all, 2004 this company as I look back was in pretty rough shape. I consider probably the same timelines but as you get into these things, several things have occurred. The market has changed pretty dramatically in the last couple of years. Indian players have arrived on scene and been pretty darn incredible and we have to be realistic about that. We finally got our offshore energies in gear probably early last year, at the earliest.

So part of the transitional years, were in fact transitions from where they were, from where EDS was and very positive things both from a balance sheet management standpoint getting rid of debt, restructuring us financially.

But the core fundamental operations of the company, in my view, did not have significant change because we organized and did those things with still the same fundamental how we do business.

We are now in a position where with that behind us and the external market changes and some of the other things we've seen occur relative to the ITO line of business, where pricing has obviously gone down more dramatically; with other player entrants; with Asia taking on a different role than I think in the past it had; we're now in a position where we still have to do something because we are fundamentally the same business of years ago that continues to change.

So I think we probably have identified and understand, at least from my two-and-a-half years, the first year I think I spent coming in here and diving into a lot of things but realistically, this is a very complex business. That first year, it took me to figure out what the business was. In the last year, year-and-a-half, the focus now has been setting the stage to make some much more dramatic changes.

I think if you look at just our Best Shore and our India presence, regardless of MphasiS, we made some pretty big commitments and some pretty big changes. Next year, going forward I think this is going to be a continuation. The question is, can we make a significant impact in 2008? I believe the answer is we got that and we understand that, and that's where we're focused on the core operational business.

Having said that, once we get that accomplished I don't think you can wipe your brow and say we're done because I think this effort of continuing the transition is going to be somewhat led by what we see happening in the market.

But the big impact should be next year, because I do think that's much more fundamental deep core operational changes that we're trying to make. So I don't know if that gets to your answer, but that's how I view it.

Operator

Your next question comes from Tien-tsin Huang - JP Morgan.

Tien-tsin Huang - JP Morgan

A question about the revenue growth of 2% in 2008 with the higher than normal runoff; are you taking a more cautious view on renewing this business or are these projects just maturing and not getting rebid?

Ron Rittenmeyer

Probably all the above. There's a mix of things that occur. As we relook at some of this revenue and rebid the revenue, I mean, Best Shore plays into it, which is obviously less revenue for the same work, but better margins; but on absolute dollars it's less revenue. In addition, some of this work, we may or may not renew. We may walk away from some of it in some cases because we don't think it's profitable enough. In the end, it's better for us from a long-term margin standpoint to start letting it run off and use those resources doing something else. Thirdly, as we change the mix into applications to some degree, these are shorter term projects for us and as we move into that, that does create more churn.

I think it's a mix of things, '08 is a higher run-off year for us tied to other contracts in the past, and it is what it is. We have to address that by still signing a significant number of deals. The other comment is we're really working hard on ensuring that the deals we sign are the right deals. That does play out to some degree on the revenue side.

Ron Vargo

I'll just remind you that Verizon, between the settlement payment and the fact that the account has been generating some revenues this year, that alone will probably contribute $300 million of decline on a year-over-year basis.

Ron Rittenmeyer

That's a real number. I mean, that's something we really do have to recover, I think the fact that we're recovering it speaks to itself.

Tien-tsin Huang - JP Morgan

Acquisitions, particularly in BPO, I can't help but ask about ACS and the article in the Wall Street Journal today are where EDS was not mentioned as a bidder. Can you comment on that?

Ron Rittenmeyer

Only what the article said, I think that's pretty accurate. We're not a bidder.

Operator

Your next question comes from Abi Gami - Banc of America Securities.

Abi Gami - Banc of America Securities

I think last quarter you suggested directionally that '09 free cash would be somewhat similar to '08 free cash. This quarter you're letting us know that '09 free cash might be directionally a bit better than '08. I know you haven't firmed up the '09 plan but could you talk about what you think is changing your perspective on the improvement in year-over-year free cash?

Ron Vargo

I think we said in the last call that '08 free cash flow would be at levels approximately equal to 2007 or 2006. The approximate $900 million in '08 is still kind of in that ballpark. So '09, we've anticipated an improvement in margins and that should drive free cash flow improvement in 2009.

Abi Gami - Banc of America Securities

Also, I want to talk about the early retirement program. How do the 2,400 acceptance compare to your expectations? It sounds like you're going to go in and do some additional cuts behind that, but is that in line with what you need for your early '08 plan, or do you need to do some additional work in the near term?

Ron Rittenmeyer

I can answer that two ways. First of all, we turn this out to a large number of people and they made their choice. We're happy for the people that made the choice, we think it was a great program and we think that it provided people with an elegant way to deal with this and for us to deal with it from the fact that we have over-funded pensions and we're probably one of the very few companies that can even say that statement.

Having said that, clearly by the numbers that you see in our workforce capacity management, we're not done and I can't sit here and say it should have been more or less; it was what it was. We're going to continue to move forward on restructuring the business. So people made their choice and I'm happy for those who did and for those who didn't, I'm sure that there was a reason for that and I can't tell you where that will fall. Does that make sense?

Abi Gami - Banc of America Securities

It does. Are these reductions, are they primarily within certain business lines or verticals or are they cut really across the board?

Ron Rittenmeyer

I think it's the U.S., so it's cut cross everything, you've got the people that are operational in the U.S., which includes headquarters and the U.S. operations, with some exclusions. So it's pretty much across the board, and some will be replaced at a different rate and many will not.

Abi Gami - Banc of America Securities

Final question on that same note, are you contemplating any divestitures as part of this restructuring program?

Ron Rittenmeyer

Not at this point.

Operator

Your next question comes from Adam Frisch - UBS.

Adam Frisch - UBS

Two questions on free cash flow. First, if we exclude Verizon, the free cash flow for the rest of the business is down about $200 million by our calculation. How do you think we should connect the dots there?

Second, Ron Vargo, you need about $600 million or $700 million or so in the fourth quarter to hit your target for the year. Haven't come close to that figure for a single quarter since '02 when the accounting guidelines were different. What's the main driver specifically in the cash from earnings you spoke to in your slides? We only have net income going up by like $60 million or $70 million or so?

Ron Vargo

I'd say last year in the fourth quarter we generated a little under $400 million I think, in positive free cash flow in the fourth quarter, but we also made a substantial contribution to our U.K. pension plan in the quarter and made a significant tax payment in the quarter, or else the number would have been far north of $400 million.

Even so, this year's fourth quarter is going to require a step-up from even a healthy fourth quarter last year. I did say over half of that is expected to come from receivables collection. So that's critical.

On the earnings side, I think if you just step back and look at the $700 million it looks like a pretty reasonable number given our projection for EPS and what you've seen out of cash flow from earnings over the first three quarters.

On free cash flow ex Verizon in 2006 we had Verizon in our free cash flow at approximately the same level as 2007. So on a year-over-year basis, we generated a little under $900 million free cash flow last year. So the low end of our $900 million to $1 billion this year, I think, is where we said we would expect to come in this year.

Adam Frisch - UBS

The WCM initiative, Ron Rittenmeyer, that you are talking about. Why do you think The Street should view that as a one-time item in '08, when you had personnel charges, three major personal charges, three of the past four years in the company? Mind you, this was before you came into your currently role, but that the expenses going forward would be view as operating and not one-time?

Ron Rittenmeyer

Well, I don't know if I can totally answer that, Adam. I would tell you that my view is at least since I've been here and watched this, we have taken out a lot of the edge stuff and a lot of the workforce management activities we've taken where more of the -- I don't want to say the easier work because it's never easier -- but in some respects they were driven more by non-core operating stuff, just kind of muscling. This one I believe the focus is much more on realigning on how we do business and much more driven at a lower level in terms of processes etcetera.

So as we restructure this group I know the approach that were trying to take and the approach that I'm expecting to take is eliminating work versus just eliminate the job. The key in restructuring and it's hard in a company like this that's made up of many individual contracts, but the real key and I think the success of something like this so you don't refill those jobs is you don't just eliminate a job and expect everybody to work harder. What you have to eliminate is the work that that person is doing by restructuring the process. When you do that, you obviously eliminate the need for the individual.

So as we move jobs overseas, because some of this number goes to that, as we move jobs to Best Shore, as we move jobs at the same time, we have to do more than just move the job. We have to restructure the process that that job is doing.

So I don't know if that answers it, but that is directionally what I would say is the big difference.

Dave Kost

We only have a couple minutes left, really one or two, so let me just ask the operator to take one more call and try to limit that to one.

Operator

Your final question comes from Julie Santoriello - Morgan Stanley.

Julie Santoriello - Morgan Stanley

More broadly, I know Ron you are still very much focused on the cost structure. You still feel that there is more to do, so can you give us a feeling for what you think is the right margin for this business? You are talking about getting to 7% in 2009, where do you think that that can go ultimately?

Ron Rittenmeyer

If I do that, you'll be reporting that I said the margin could be whatever. I am focused on 7% in '09, but I would say that's not the top end of where I expect to be, but for now that's how I've done it and I have to be careful what I say. So I think I will stick with what I'm saying publicly, Julie, for now if that's okay.

Julie Santoriello - Morgan Stanley

Just a follow -up to that I know that one of the headwinds here has been all these re-compete contracts that are coming up and they come in at lower prices, a lot of times because of offshore, but they also come in at lower margins just because the business has changed and the legacy contracts are changing and they are being restructured.

Is there a time that you are going to anniversary some of this and it will less of a drag on your growth and margins?

Ron Rittenmeyer

The problem is the definition of legacy, right? I mean when you do five-year contracts, when you renew them then you still have legacy from three years ago. So legacy is a moving target because you are constantly in a cycle of on the IPO side we are going to be doing five year deals to six year deals. On the application side we are going to be doing six months to 18 months deals.

As we change that mix it will somehow change those overall relationships. I'm not sure just like in improving your cost structure, I don’t think there ever is an anniversary where you say you are done. The belief I have is that the restructuring in this business is driven somewhat by the market conditions and the changes in technology as well as the changes in opportunities within the market. So as we do more business offshore and more of our revenue comes from other parts of the world, we talked a little bit about Asia improving this quarter. As we grow our business in that sector we are going to see a different mix and were going to see different requirements.

I don't know if there is ever an anniversary. I just think this is a type of business that will continue to compress costs as a basis and continue to price to market. I don't think there is an answer to that that says in 18 months that we all be able to celebrate and say that's over. It's just not that type of business.

Dave Kost

We are out of time. With that I'd like to thank everyone for joining us on the call today. I know that there are some of you still in the queue with questions. Please call my office and we will be glad to talk to you about those questions. Thank you.

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Source: Electronic Data Systems Q3 2007 Earnings Call Transcript

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