PeopleSupport Q3 2007 Earnings Call Transcript

PeopleSupport Inc. (PSPT)

Q3 2007 Earnings Call

November 6, 2007 5:30 pm ET

Executives

Peter Hargittay - Marketing and Communications

Lance Rosenzweig - Chairman and CEO

Caroline Rook - CFO

Analysts

David Scharf - JMP

Joseph Foresi - Janney Montgomery Scott

Moshe Katri - Cowen

Matt McCormack - FBR Capital Markets

Josh Vogel - Sidoti & Company

Dan Wimsatt - AD Capital

Cynthia Houlton - RBC Capital Markets

Mark Marostica - Piper Jaffray

Barry Caplin - Maple Tree Capital

Brad Manuilow - American Technology Research

Presentation

Operator

Good day and welcome everyone to the PeopleSupport Third Quarter 2007 Earnings Result Conference Call. Today's call is being recorded.

At this time, I would like to turn the call over to Mr. Peter Hargittay with Marketing and Communications. Please go ahead, sir.

Peter Hargittay

Great. Thank you and good afternoon everyone. Welcome to PeopleSupport's third quarter 2007 earnings call. On the call today are Lance Rosenzweig, PeopleSupport's Founder, Chairman, and CEO and Caroline Rook, PeopleSupport's Chief Financial Officer. This call is being broadcast from the Investor Relations portion of our website, and a replay of this call will be available shortly.

Our third quarter 2007 earnings release was issued earlier today. We will start with a brief statement on the performance of the company during the third quarter and then provide our outlook for the fourth quarter 2007. After that, we will open up the discussion for question-and-answers.

Before I hand the call over to PeopleSupport's management team, I would like to remind you that some of the comments we'll make today may be forward-looking statements, and these must be read in conjunction with the risks that the company faces. Management may make statements regarding our anticipated future financial results and operating performance, our business, our expectations regarding our expenses, industry and competitive trends, anticipated market conditions and expansion of our service capabilities.

We base these types of forward-looking statements and information on our beliefs, projections and expectations, and assumptions we made using currently available information. You should not rely on these statements as predictions of future events. Our actual results could differ materially from those projected due to a variety of factors, some of which cannot be predicted or quantified, or are out of PeopleSupport's control.

Risks and uncertainties that could cause our anticipated results to differ from those described in the forward-looking statements include, our dependence on a limited number of clients and a potential for client losses or client declines, competitive conditions in our markets, currency exchange-rate fluctuations, risks associated with our operations in the Philippines and Costa Rica, our ability to manage growth, technological changes, and other risks identified from time-to-time in our SEC filings. Particular attention is directed to the portions of our filed reports or statements entitled, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors."

Our comments speak as of today only, and you should not rely on them as representing PeopleSupport's views in the future. We undertake no obligation to update or revise our views following future events or circumstances.

I will now turn the call over to PeopleSupport's CEO, Lance Rosenzweig.

Lance Rosenzweig

Thank you, Peter, and good afternoon, everyone. Thank you for joining us today for PeopleSupport's third quarter 2007 earnings call.

PeopleSupport delivered a strong quarter. We continued our topline growth with revenues of $36.9 million, up 23% year-over-year and 8% quarter-over-quarter. In addition to this increased demand for our services, our focus on improving operational efficiency and productivity drove substantially higher margins in profitability.

Operating margins improved to 6.5% up significantly from 1.5% in the previous quarter. Normalized operating income adjusting for non-cash stock-based compensation charges related to FAS 123R was 10.3% in Q3 '07.

Net income was $6.4 million a significant improvement over $3.5 million in the same quarter last year. Cash flow from operations was strong at $10.5 million for the quarter and $22.6 million year-to-date.

Last quarter, we announced a $25 million stock-repurchase program underscoring our confidence in PeopleSupport and our business model. I am pleased to report that as of today we have completed our $25 million stock-repurchase program.

In today's call I will cover three key themes. I will then turn the call over to Caroline Rook, PeopleSupport's Chief Financial Officer, to discuss our financials in detail and guidance for the year. We will then answer your questions.

Our key themes are, one, PeopleSupport is executing increasing well for our clients. Two, demands for PeopleSupport's high quality BPO services is strong and growing. And three, PeopleSupport is enhancing our business model to become a higher margin consistent growth company with less volatility.

On to our first theme, PeopleSupport is executing increasing well for our clients. In 2007, we put a tremendous amount of energy into optimizing our operations and delivering for our clients.

We worked closely with our clients, we empowered our employees and they rose to the occasion, through this process we made several substantial improvements to our operations.

First: PeopleSupport realigned our operations along industry verticals, travel and consumer, financial services, tech and telecom, health care and media services. Our focus on industry verticals, allows us to develop deep domain knowledge, which in turn helps us and our clients implement and continually improve their outsourcing strategies.

Second: we began to reconfigure our seats to achieve increased operational efficiencies and productivity. This action has allowed our employees to increase productivity across the board.

And third: we have enhanced our quality program through the hiring of the of Six Sigma black belt experts, along with the other people with industry-level process expertise. I am happy to report that these efforts are paying off, as demonstrated by our strong operating and financial performance in the quarter and we expect more to come.

I will now talk about PeopleSupport's strategic clients, those that represent more than $10 million in annual revenues. Overall, we made excellent improvements in terms of customer satisfaction, and we strengthened our strategic relationships with our clients in the quarter.

Expedia remains our largest client at 23% of revenues, up over 70% year-over-year which is the result of paying attention to their requirements and responding accordingly. We were pleased with this performance during the quarter. Given the fourth quarter seasonal slowdown in the travel sector, we expect Expedia to be in the high teens as a percent of our overall revenue in Q4.

Washington Mutual represented approximately 16% of revenues, up 40% year-over-year. As an example of our enhanced customer satisfaction, our Costa Rican operation has achieved excellent results. For the third month in a row, we are WAMU's top vendor site. In Manila, where we do most of our business with WAMU, there was a significant growth which I attribute to our team's ability to continue to deliver excellent service levels.

EarthLink represented 13% of revenues, up slightly year-over-year. We believe that PeopleSupport has a strategy relationship with EarthLink, and will play a significant role in their efforts to enhance their business model. We are proud of our partnership, and we congratulate EarthLink for recently winning the J.D. Power Award for customer service, and several other measures of customer satisfaction. We are working closely with EarthLink's new management team as they review and improve their processes.

At this time we expect EarthLink's overall purchases of outsourced services to decrease, and we do anticipate that this will result in reduced volume with us. I am excited to announce, the JP Morgan Chase is now our fourth largest client at 11% of revenues. PeopleSupport began supporting JPMC in the second quarter of 2006, and we recently won additional business from them as well. JPMC is expected to continue to ramp nicely. Our mix of business with JPMC includes outsourced and captive services, some of which is short-term in nature.

I will comment more about our exciting new captive services offering momentarily. And our fifth largest client, a large travel company, with under 10% of revenues in the quarter and continues to be strategic client. PeopleSupport recently achieved the highest customer satisfaction level ever achieved in-house or through any outsourcing relationship in this company's history.

In addition to this group, PeopleSupport provides services to a number of significant clients, which we define as those clients that are expected to generate between $1 million and $10 million in annual revenues. PeopleSupport had six such significant clients in the third quarter, one of these clients is Vonage.

Earlier this year, we mentioned that Vonage was substantially reducing its business with PeopleSupport. Recently, PeopleSupport has agreed with the new management team of Vonage to maintain an ongoing relationship as a significant client, but with improved terms.

Additionally, our more recent client wins, such as the high tech and healthcare clients we announced last quarter are ramping nicely. In summary, I am very pleased with how our operations team is responding to our current and new customers, and I look forward to continued progress in the quarters ahead.

Now our second theme: Demand for PeopleSupport's high quality BPO services is strong and growing. The trend of offshore BPO services is stronger than ever. We see increased gross demands in the countries where PeopleSupport operates. As we move forward into 2008, I am confident that are commitment to partnering with our clients to improve the quality of their services and customer satisfaction while providing a cost effective solution will lead to continued strong growth for PeopleSupport.

Even with the normal seasonal variations, the business trend is clear. Only a small portion of the potential BPO market is being served. Therefore, PeopleSupport is well positioned to benefit substantially from this trend. PeopleSupport has placed a great focus on building out the main knowledge and process expertise for specific vertical industries, which help us to deliver an even higher quality of service. And this is well received by our clients and prospects alike. I am confident that our success in expanding within our key vertical industries will continue. In addition, we will continue to explore verticals that open new opportunities for PeopleSupport.

Our sales pipeline is the strongest in our history and consists of both small and large prospects in the US and in other English speaking countries, including the UK. In total, we have identified several hundred new opportunities that qualified portion of our sales pipeline consists of more than 40 qualified prospects, and many of these are potentially significant. We define qualified prospects as those who have either visited our centers in the Philippines, to whom we have submitted proposals or those where PeopleSupport has been short-listed.

Our sales team is excellent and highly effective. In the third quarter PeopleSupport won five new clients that are potentially significant, with the ability to deliver over $1 million in revenue per year when fully ramped. Additionally, we have already seen healthy activity in the fourth quarter. Due to growing demand, PeopleSupport is investing in its sales team. Our sales organization consists of approximately 25 professionals including seven sales directors who are focused on specific vertical industries.

In the third quarter, we announced the appointment of Michael Donegan as Director of Sales for Europe, and we expect to continue to add to our sales team going forward. Europe is an exciting market opportunity for PeopleSupport. Europe has a large English speaking population, and of course has a need for BPO services in Spanish as well, although, PeopleSupport will initially focus on English opportunities.

According to Gardner, the UK currently accounts for more than 50% of the European market for BPO services, which is estimated to be approximately EUR24 billion.

In 2006, only 3% of the UK BPO market was delivered from offshore locations. The demand is growing for all types of BPO services in Europe. Indian based IT service providers have experienced significant success in Europe and Europe is now ready for voice related BPO services.

We have several years of experience supporting UK customers for US based clients with operations in Europe and we are looking to include a number of EU customers to our portfolio of satisfied clients. Again, the addressable market for high quality offshore BPO services is fairly large and growing rapidly and PeopleSupport is well positioned to benefit from these trends.

And now our third theme, PeopleSupport is enhancing our business model to become a higher margin consistent growth company with less volatility. Our objective is to drive long-term value for our shareholders by profitably responding to customer and market requirements.

PeopleSupport is taking the necessary action to further our desired long-term success. In response to client demand, PeopleSupport is launching a new service offering called Captive Services, which consists of outsourcing our facilities, technology and telecommunications to customers who want to manage their own call center and back office operations. In other words, we allow our clients to run their own operations using their own people but utilizing PeopleSupport's facilities and data and telecom networks.

We believe that the Philippines is the premier location for offshore operations for both captive and outsource services, and we are seeing particularly strong demand for captive services in Manila. US companies who chose to establish captive centers in the Philippines will benefit greatly from working with PeopleSupport. They will have access to world class facilities with excellent and highly scalable technology in telecom infrastructure, including redundancy and dedicated lines to the US.

PeopleSupport makes it extremely easy for US companies to set up a captive centre in the Philippines and to do it quickly. This supplemental service offering creates a significant amount of value for PeopleSupport. These new clients include short-term projects, which will provide us with great flexibility to smooth out and optimize the utilization of our facilities.

Improved utilization will lead to higher margins, which we're already seeing. This new service will also allow PeopleSupport to work with new strategic prospects that might have a need for PeopleSupport's full BPO offering in the future.

PeopleSupport has already demonstrated its success with Captive Services, which generated approximately $1.5 million in revenues in the third quarter, with enhanced margins. To put it in another way, PeopleSupport's revenues in Q3 increased by $2.6 million from the prior quarter, while our headcount fell modestly and margins increased.

This illustrates the greater scalability and tangible improvements to our operating margins, through expanded business model and operational efforts. Going forward, we're confident that our Captive Services will enable us to diversify our client base, improve our utilization rates and achieve margin enhancements.

At PeopleSupport, we're focused on increasing the utilization of our production seats, which we define as the workstations we use to deliver our services. Our production seat utilization rate in Q3 was 64%, up from roughly 60% in the prior quarter. We're continuing to reconfigure our operations and add production seats to existing space, which results in improved performance. We're also focused on maximizing our occupancy rates and revenues generated for each of our seats. All of these efforts are paying off as illustrated in our expanded margins.

I would now like to comment on our facilities strategy. Early this year, PeopleSupport acquired land in Cebu and Manila, as we assessed how we would deal with our expansion and growth requirements in a cost effective manner and at the same time improve margins and deliver long-term value for our shareholders.

The purchase of land has provided us with flexibility given the growth dynamics in the Philippines. We could construct our own facilities or partner with another party, or just seek a leasing arrangement as we have done in the past. In any event over the last few months, we believe that the value of our land has increased substantially, which will provide us with greater flexibility in developing our facilities strategy. Peoplesupport remains focused on minimizing our facility cost going forward with the highest return on assets.

Now let's talk about the situation in Cebu, which has been a highly successful location for PeopleSupport. We are seeing extremely strong client demand for services from this city. In fact, we are near full capacity and yet have a great deal of interest from prospects. The lease for a large portion of our current space in Cebu expires in 2009, at which time we must exit current facilities since they will be physically torn down.

Commercial office space is limited in Cebu and not as well developed as in Manila. PeopleSupport is developing plans to build a 4,000 seat center on the land we repurchased that will be the most efficient BPO facility in the region. Our clients and prospects are highly enthusiastic about PeopleSupport making this investment in Cebu, which will be a key differentiator for us and at the same time allow us to protect our margins. We anticipate that construction will begin in early 2008 and will be finished within two years.

We plan to move our existing operations in Cebu into the new center. Our existing operations alone could take up to 60% of the total capacity. The incremental capital expenditure for this operation excluding build out costs, which must be borne, whether we own or lease facilities will be $20 million to $25 million over a two year period.

Now for an update on Manila: PeopleSupport purchased land in the Fort Bonifacio area of Manila. Land, which has appreciated measurably over the past few months.

PeopleSupport is now considering various sale-leaseback and other strategic arrangements regarding this land to meet the growing requirements for cost effective space in Manila. We believe the fact that we have some very desirable land in Manila, will allow us to achieve the required margin protection as we continue to grow. The sale-leaseback proposition is looking very encouraging as a cost effective strategy that takes advantage of our current position and appreciated land value.

PeopleSupport has great potential to become a large diversified and global outsourcing firm known for its high performance services. Over the course of 2007, PeopleSupport took the right steps to deliver long-term value to our shareholders. We restructured our operations along industry verticals, driving higher service levels in client satisfaction and deepening our domain knowledge.

We scaled back our capital expansion driving enhanced asset utilization and we reconfigured our seats fostering improved productivity. We implemented a currency strategy that has yielded very positive returns given the strengthing Philippine Peso. We bought land at attractive prices enabling us to lock-in long-term savings and facility costs, and we completed a $25 million stock repurchase program underscoring our confidence in our business.

Now we are excited about our future, we are investing in our sales organization to take advantage of the strong secular growth trends. We are expanding our service offerings to improve the scalability and margin structure of our business. We continue to optimize our infrastructure and focus on improving margins. And most importantly, we are passionate about delivering excellent value and service levels for our clients. The strategy is in place and our team is capable and focused on achieving our goals.

I would now like to introduce our Chief Financial Officer, Caroline Rook to go over Q3 results in more detail and to provide the guidance for the remainder of the year.

Caroline Rook

Thank you, Lance, and good afternoon, everyone. As Lance, has already mentioned PeopleSupport delivered record revenues of $36.9 million in third quarter '07. Net income was $6.4 million in the third quarter a significant increase year-over-year and quarter-over-quarter. PeopleSupport benefited primarily from strong demand for BPO services, as well as improved infrastructure utilization, operational efficiency gains, and a net gain in other income from our forward foreign-currency contracts.

Quarterly diluted EPS was $0.27 based on $23.8 million diluted weighted-average shares outstanding, compared to $0.18 in the year ago quarter, based on $19.1 million diluted weighted-average shares outstanding. And $0.16 in the second quarter '07, based on $24 million diluted weighted-average shares outstanding.

Operating income for the third quarter was $2.4 million and an operating margin of 6.5%, compared to second quarter of '07 with operating income of $0.5 million and an operating margin of 1.5%. We're working hard to improve operating income margins overtime, although it is expected to be impacted near-term by our usual expected seasonal decrease in revenues in the fourth quarter, primarily from our clients in the travel and somewhat technology verticals.

Year-over-year operating margins remained lower as expected, primarily resulting from an unfavorable currency exchange-rate and to a lesser extent increased FAS 123R non-cash stock-based compensation expense, and build out of additional operational capacity including our new centre in Baguio, Philippines.

Normalized operating income adjusting for non-cash stock-based compensation charges related to FAS 123R was 10.3% in Q3 '07, 15.6% in 'Q3' 06 and 5.5% in Q2 '07 and that we adjust operating margins for the Peso impact relative to Q3 of '06 Peso rate of 51 Pesos to the US dollar as well as exclude the FAS 123R stock-based compensation costs, operating margins would have been 15.8% in Q3 '07 as compared to 15.6% in Q3 '06 and 10% in Q2 '07.

Our operating margins pick up this quarter, benefited from a higher value short-term Captive Services project, which Lance described, in which we outsource BPO infrastructure to captive providers. This contributed over 2% margin this quarter with this project currently expected to expire in early '08.

Also cost of sales reduced by $0.4 million as a result of an adjustment to our pension plan assumptions after a third-party [actuarial announces]. Furthermore there was $0.3 million benefit from the management incentive plan largely impacting cost of sales, as we released the accrual for the unused portion of the plan, upon plan termination. These two later items contributing around 2% margin for the quarter.

To give you some further foreign exchange details, the average exchange-rate for the Peso in the third quarter '07 was 45.9 Pesos to the US dollar, up approximately 2.1% compared to an average 46.9 Pesos in the second quarter of '07. And up about 10.5% compared to an average of 51.3 Pesos in the year ago quarter.

The 2.1% depreciation from Q2 '07 impacted operating margins by approximately 1.1% whereas the 10.5% depreciation year-over-year impacted operating margins by approximately 5.5%. As a reminder, a positive impact from our forward foreign currency contracts is recorded in other income.

As we mentioned in our previous call, our forward foreign currency contracts go through mid 2009, covering approximately 80% to 100% of estimated Philippine Peso operating expenses. Current contracts range from an average Peso to US dollar rate of around 48 Pesos in the remainder of '07, 46 Pesos in 2008 and 45 Pesos in the first half of '09. This program helped to mitigate the Peso impact in the third quarter by approximately $2.2 million recorded in other income below the operating line, or an estimated $0.08 diluted EPS.

If we add the actual realized FX forward gains of $1.1 million to operating margins, this addition would have increased operating margins by 3.1% in Q3 '07, and Q2 '07 realized FX forward gains would have increased operating margins by 2.7% in that period. I would like to point out that our forward foreign currency contract program has worked to our benefit, since we initiated the program. These programs are intended to minimize the downside risk of a decline in the US dollar to the Philippine Peso. However, there might be periodic financial statement losses as the forward contracts are measured at fair value at period ends. Should the exchange rate between the Philippine Peso and US dollar shift directions, PeopleSupport would face a loss in recording our FX forward program, both in the realized portion for the period, as well as the unrealized future portion.

Our future FX forwards are valued to market on the last day of the each period. If on that day, the mark-to-market rates were 1% below the previous mark-to-market rates used in the prior period end, and on our existing remaining forward contracts at the end of September ’07 of around $180 million, the impact on other income could be an estimated $2 million expense. On the next day as the mark-to-market rates swung back, the FX forward contracts would then be recorded as a gain of $2 million.

Non-cash FAS 123R stock-based expense was $1.4 million in the quarter, compared to $0.7 million in the year ago quarter, and $1.4 million in the second quarter of '07. FAS 123R reduced operating margins by 3.8% in the third quarter of '07, 2.4% in the third quarter of '06, and 4% in the second quarter of '07. As of September 30, '07, cash and cash equivalents and marketable securities totaled a $129.4 million, slightly lower than the second quarter of '07 as a result of $13.6 million used to repurchase PeopleSupport stock in the quarter.

Net cash used for financing activities included $13.6 million in acquisition of PeopleSupport common stock, as a part of the Company’s $25 million common stock repurchase program. As of today, PeopleSupport is done with the stock repurchase program, having repurchased $25 million of stock and slightly over 2 million shares through the present. Per our expectations, since the repurchase program was initiated mid-quarter, the program had a minimal impact on EPS with interest income forgone, offsetting the impact of the reduction in average shares outstanding for the period.

CapEx for the quarter was $2.6 million in line with expectations, compared to $3.1 million in the previous quarter. Year-to-date CapEx was $20.1 million. Total CapEx including the land purchase of $9 million in Q1 '07 for the year is now expected to be around $22 million to $24 million, primarily for least production capacity build, IT infrastructure expansion and upgrades.

Net cash provided by operating activities was $10.5 million for the quarter, resulting in the net cash from operations of $22.6 million for the first nine months. Excluding the land purchase of $9 million in Q1 '07, free cash flow would have been $11.5 million for the first nine months of the year. DSOs were a healthy 43 days.

During the quarter, PeopleSupport streamlined existing operations and focused on gaining efficiencies from our existing capacity. We entered the quarter with approximately 7,500 production seats worldwide. This is a slight increase from the previous quarter. We did not add rented space. In fact we're overhauling our PeopleSupport center floor plan in order to optimize our operations.

PeopleSupport ended the quarter with over 9,000 employees, a reduction of approximately 300 employees from the previous quarter end. And yet, we improved revenue significantly due to improving the efficiency of our operations, the productivity of our people and the outsourcing of our technology platform.

And now for guidance. For Q4 guidance, we assumed the following aspects. One, our usual downward seasonality with reduced revenues driving a similar impact on our operating forecast for the quarter. Typically, we see a downward fourth quarter, due to both revenue and expense seasonality with the usual pickup after seasonality in following quarters. Our largest vertical namely travel is seasonally low in Q4.

Whilst revenue seasonally ticked down within the quarter, we continue to maintain headcount for some of these accounts, resulting in lower margins as we usually see a pickup to normalized activity in the following quarters. We're forecasting that revenues in this sector be down from Q3 '07, by a percentage around the low-to-mid teens, which is consistent with prior year.

We forecast around $1 million decline in Earthlink revenues, given the client's refocusing of its operations, reducing contribution to our fixed costs. A continuous decline in the US dollar in the quarter and then average and period end Philippine Peso rate of 44 Pesos to the US dollar. We estimate that a 1% change in the Peso could impact our operating margins by 0.6%. The Peso rate assumption of 44 Pesos this quarter compared to Q3 '07's average of 45.9 Pesos is an estimate of 4% and would equate to an approximate reduction of 2% of operating margins, with pickup from our FX forward contracts conversely in other income.

Following on, I have point five, which is FAS 123R non-cash stock compensation costs increased from Q3 of $0.35 million, from both retention and annual grants in Q4 '07.

Point six, we have substantially completed with our $25 million stock-repurchase program as of this call, reducing both interest income before free cash flow, and average shares outstanding. Per our expectations the associated interest income forgone is forecasted to primarily offset the impact of the reduction in average shares outstanding for this year.

With Q4 diluted EPS forecast to be slightly accretive by $0.01 from this program. With that for the fourth quarter of '07, we expect revenue to be slightly down from Q3 between $35.7 million and $36.5 million, operating income to be almost breakeven in the range of loss of $0.5 million, to a loss of $0.1 million, non-cash FAS 123R expense to be approximately $1.8 million. Given the Philippine Peso rate assumption above, we are forecasting our corresponding FX gain and other income of $5.9 million on today's assumed mark-to-market rates for the remaining period or $0.23 diluted EPS impact.

Diluted EPS to be $0.28 to $0.29 range. EPS is based on an average of 22.3 million shares on a diluted basis. Tax charge of around $0.8 million. As a reminder, fiscal year 2008 guidance will be given along with our Q4 '07 conference call in the first quarter of 2008.

With that let me turn the call back to Lance.

Lance Rosenzweig

Thank you, Caroline. I would like to conclude with three key points before opening the call for questions. First: PeopleSupport is executing increasingly well for our clients. Second: demands for PeopleSupport's high quality BPO services is strong and growing, and third: PeopleSupport is enhancing our business model to become a higher margin consistent growth company with less volatility.

Thank you for listening and we will now turn the call over to the operator for the Q&A.

Question-and-Answer Session

Operator

Thank you, sir. Today's question-and-answer session will be conducted electronically. (Operator Instructions). And we'll go first to with David Scharf of JMP.

David Scharf - JMP

Hi, good afternoon.

Lance Rosenzweig

Hi. David.

David Scharf - JMP

Lance, few things, obviously there is terrific top line and bottom line results for the quarter, just trying to get a little more clarity on the numbers in between. Can you talk about the cost of revenues that seem to be the biggest variants in from expectations? It looks like sequentially your revenue was up 7%, 8% on an absolute dollar basis, your cost of revenue actually went down. I know you said headcount was down a little bit, but can you help us understand how to think about that gross profit number?

Caroline Rook

Sure. I mean, David, I'll take this question. So, cost of sales did go down from both operational efficiencies as well as some analysis that we had cost benefits from that I talked about. One of them being the pension expenses in the Philippines about $0.4 million was the cost benefit in cost of sales and also about $0.3 million of the management incentive plan accrual reversal, was primarily in the cost of sales. So, that's about $0.7 million there. Also, we benefited from a full quarter's worth of our Captive Services, which was as Lance mentioned there was about $1.5 million in revenues where we had some very, very high margins David which also contributed towards our reduction in costs of sales.

So those three aspects as well as, we don't want to take away from operations really beginning to hit their stride, really contributed to the cost of sales before FAS 123R reducing from about 74% in Q2 this year to, a shade less than 70% in Q3.

David Scharf - JMP

So the pension benefit in the accrual, but those are sort of one-time, should we think of this 31% kind a gross margin level as a fairly stable number going forward?

Caroline Rook

Well, it's not expected to be there in Q4, of course just given…

David Scharf - JMP

…on an annual basis though?

Caroline Rook

Seasonality, as I said, that's about $0.7 million of benefits that we saw. The Captive Services also helped contribute to our margins, as we said and that's expected to terminate in early '08. And also the Peso, it depends what the Peso does to us as, you know, we record the Peso at whatever the cost it is, operating cost of sales. And that's a variable that we can't predict and we get the benefit on our current programs in other income.

Lance Rosenzweig

David, I would add as well, that we're working hard at improving our margins on a client-by-client basis. And in some cases that involves productivity improvements or efficiency improvements and in another cases it involves price increases, which we've been very focused on given the strength of the Peso. And so, we think the fundamental margins of the business are improving.

David Scharf - JMP

Okay. Can you talk a little more about Captive Services, is it essentially outsourcing your facilities, your seats during non peak-hours when you are not incurring any labor expense?

Lance Rosenzweig

Not really. Let me give maybe an example of what we did during the quarter, one of our clients has several lines of business. In some lines of business it wants to do with its own in-house employees and other lines it wants to do with outsourced employees. So we were able to offer that client a combination of full outsourced services with PeopleSupport team members, as well as captive space where they're riding on the PeopleSupport infrastructure and facilities in telecom and data lines in an integrated sense.

And it enables us to provide a more holistic outsourcing offering to this company. So it's not just on the off-hours, but they have both captive space and captive facilities for their people as well as outsourced space and facilities for our people.

David Scharf - JMP

So when you provided a 64% utilization figure. Does that take into account seats that are being occupied by these Captive Services own employees?

Lance Rosenzweig

Yes.

David Scharf - JMP

Okay. And how visible is this, are there any longer term relationships with the $1.5 million, should that be viewed near-term as kind of one-time project oriented or is this something that's going to be pretty regular, I mean, do you have a pipeline, so to speak?

Lance Rosenzweig

Right. So the existing client that we talked about is more short-term oriented. But we are turning it really into a longer term oriented business. So we are building a pipeline, we see some good opportunities. We think it's just a great way for us to improve our asset utilization, improve our facilities utilization and boost our margins with greater flexibility, and a greater mix of clients.

David Scharf - JMP

Okay. Now relative to your revenue guidance, looks like was Vonage a surprise during the quarter. Is that a relatively new development or you've decided to retain some of that business?

Lance Rosenzweig

Relatively new development, what we saw is that Vonage has put in place a very new management team and at the same time has improved a lot of its own business issues and legal issues, and we agreed with the new management team, that it would make sense for us to maintain an ongoing relationship. Nothing like the scale of what we had before, and with much better terms than we had before, but, we think it makes sense on an ongoing basis.

David Scharf - JMP

Okay. So it's no where near a 10% customer going forward, but more than a rounding area it sounds like?

Lance Rosenzweig

Yeah, correct. We call it a significant customer, which should be a customer with $1 million to $10 million of annual revenues.

David Scharf - JMP

Okay. And one last financial question, I'll let others hop on. The foreign exchange contracts, I'm just having, I mean these are wonderful results, but I'm just having a hard time as I look at the last couple of quarters, and then I look at the guidance going forward really understanding, just inherently what a stabilized level of profitability this company is supposed to have.

I mean just looking at the second half of the year it looks like 40% of your pre-tax earnings are coming from foreign exchange gains. And I realize that the appreciating Peso should put pressure on cost of revenues, and that should may be a proportionate pick up below the line. Then we move to the fourth quarter and there is a $6 million gain.

Can you give a little more granularity on how we are to think about what sort of normalized operating margins are, when you factor in both your expected currency gains and gross margin pressures from the Peso, because it's just tremendously valuable from quarter-to-quarter?

Lance Rosenzweig

David, yes. So the normalized operating margins that we talked about for this quarter 10.3% were without any currency forwards. So that's pure operating profit adjusted for FAS 123R. The impact of the foreign exchange forwards are in the other income line below the operating income line, and there will be quite a bit of volatility with that, as the Peso moves. And the way we think about it internally is that there is two elements of it, there're realized and there are unrealized gains and losses. And the realized gains and losses are what we realized in the actual quarter, and the unrealized is our marking-to-market, all the future forwards that we have in taking that impact in the quarter as well. And so, I think kind of a way of looking at it together with operating margins is maybe to look at the realized portion in that quarter. If the Peso flips around, you could see equally large swings in the opposite direction.

David Scharf - JMP

I understand that, I guess looking to the fourth quarter it's such a huge tick up, $6 million of gains. Does it say how much of that is realized or unrealized?

Caroline Rook

We don't split that out.

David Scharf - JMP

I expected it to be, because it looks like over half of your pre-tax earnings this year are foreign exchange gains?

Caroline Rook

Yeah. We picked up a pretty good rate earlier in the year, when we first hedged out 12 months at 49 Pesos, David, but that expires in early ‘08 and as we hedged back in, those are at lower rates. So I generally expect that as our 49 is [tolled] away that you would have less of a pickup. But just to give you an idea, in Q3 we had $1.1 million of realized gains as I had discussed, which is I think it's a shade less than 3% of revenues.

David Scharf - JMP

Right. Okay. Thanks so much.

Lance Rosenzweig

Thank you.

Operator

And we will take our next question from Joseph Foresi of Janney Montgomery Scott.

Joseph Foresi - Janney Montgomery Scott

Hi gentlemen, just my first question here, again with taking the Captive Services and sort of reducing the headcount, what can we extrapolate from this? First of all, how was the headcount reduced? And secondly, was there a considerable amount of excess capacity here that sort of, is now being taken care of, in sort of the short-term until you can fill that with maybe your own personal contracts?

Lance Rosenzweig

Yeah, Joe. What I would say is that, but, first of all, again, those numbers that we give out at period end. So there are not necessarily averages or anything like that for the quarter. But we are as an operating team very, very focused on our productivity and our utilization. And we're kind of maximizing the potential of our people and really delivering well for our clients, and where we can increase our revenues without having increased our headcount, that's great.

Joseph Foresi - Janney Montgomery Scott

Sure. But I guess what I am saying here is that obviously you had the capacity available to sell rather quickly, and then the headcount, was there something happening on the client base were the 300 people due to attrition, any color on any of those two areas?

Lance Rosenzweig

I see what you're saying. I mean, remember where our capacity was at the end of the quarter was 64%. So we still have quite a bit of capacity available for expansion. And most of this would have been from attrition, it just would have been we hired fewer than we attrited during the quarter.

Joseph Foresi - Janney Montgomery Scott

Okay. And just your plans for next quarter as far as organic seat build outs, and any plans for maybe the organic utilization and conditions?

Caroline Rook

I don't, we generally expect any organic seat build outs. What we are doing this quarter, and maybe forthcoming in the next quarter, but primarily this quarter. We have some seats in the PeopleSupport center in our big lease built-to-suit center in the Philippines that are being used for non-operational staff, and we're very focused on the expense of that. So we are spending a little bit of money, not a lot, converting those seats to operational seats that can be used during peak hours by operational folks. And then the same non-operational folks would be using those seats that used to be there all the time in the non peak hours. So there would be some build out in more operational seats that we would have in the foreseeable future.

Joseph Foresi - Janney Montgomery Scott

Okay, and how many seats are in that particular area? I mean, this isn't really actually new seats are just sort of converting them in part?

Caroline Rook

Yes, so no new facility. It would just be a little bit of CapEx spend, and associated depreciation, but, I want to say, now you caught me. I want to say it's more than 200 and it's probably less than 500. So, it's something like that.

Joseph Foresi - Janney Montgomery Scott

Okay. And at the conclusion of the Captive Services arrangement, what then takes place? Is that -- those employees then return to the -- I mean how is that dissolved? I guess that's what I'm asking.

Lance Rosenzweig

Yeah. The employees are our client's employees. Right, so, they are depending on the arrangement with them. It could be for a temporary project, it could be somebody moving into their own facility or it could be an ongoing kind of relationship, and then we have maximum flexibility, because we can use that space for area of our operations. We can use it for other Captive Services operations. It's just a great way for us to improve our utilization of assets and really provide a value that our clients are really certainly looking for.

Joseph Foresi - Janney Montgomery Scott

Okay. And just my last question, here: Did I hear it correct, that you said on the real estate front you are going to build in Cebu, and then in Manila there is going be a sale lease pack? Is that correct first of all? And, secondly, why the divergence in those of the two arrangements and thanks?

Lance Rosenzweig

Yeah, that's essentially correct, although we haven't finalized the arrangements in either city yet. But that, it steps directionally where we are heading, and the difference is, that in Cebu our leases are expiring and the buildings are actually being torn down, and so we have to move to new space. And there is very, very limited space available. There are also, not the sophisticated real estate markets that you find in Manila, which is really a world class city and Cebu. And so, we find that in Cebu, we can construct our own center do it very efficiently have a great operations for our clients and do at a relatively minimal CapEx about $20 million to $25 million of incremental CapEx. In Manila, where the land is much more valuable and where there is much more established real estate market. We believe that we can work with a third party real estate developer and more of sale leased back transaction and utilize on a leasing basis the seats and the floors that we need.

Joseph Foresi - Janney Montgomery Scott

Okay, thank you.

Caroline Rook

Joe, about the PeopleSupport center is mores like 400 seats that we would convert from non-operational to operational.

Joseph Foresi - Janney Montgomery Scott

Okay. Then, I imagine the cost would be much less, may be half of which you spend on normalcy?

Caroline Rook

It's not a huge amount.

Joseph Foresi - Janney Montgomery Scott

Okay. But headcounts are going to stay static?

Caroline Rook

Yeah.

Joseph Foresi - Janney Montgomery Scott

Okay, thank you.

Operator

And we'll go next to Moshe Katri of Cowen.

Moshe Katri - Cowen

Thanks. Going back to some of the one-time contributors to the quarter and again, I apologize if I am asking the same question again. Going back to the Captive Services engagement, can you quantify the contribution to revenues? And then, just I think you said the operating income contribution was $1.5 million. Can you confirm that?

Caroline Rook

Yes. Sorry, the revenue contribution was $1.5 million and the contribution to operating margins was a shade over 2%.

Moshe Katri - Cowen

So it's about 200 basis points.

Caroline Rook

Yes.

Moshe Katri - Cowen

Okay. And that engagement ends when?

Caroline Rook

Early '08.

Moshe Katri - Cowen

Okay. That's fair. And then, there are some other items may be Caroline you could repeat them in cost of sales that also helped there were also, some sort of reversal there?

Caroline Rook

Sure. So, we did an actuarial analysis of what we needed for pension costs in the Philippines which is required by law given our establishment age there and the number of people that we have and that resulted in a benefit of around $400,000 in the quarter and also the management incentive plan which was triggered by the IPO three years ago have been accrued, and we had not paid back around $300,000 worth of that plan, so we released that accrual. So that was again a benefit there.

Moshe Katri - Cowen

Okay. And then, there is also a pension adjustment for $1.5 million as well?

Caroline Rook

No, no. I just talked about pension adjustment Moshe of about $400,000.

Moshe Katri - Cowen

That's $400,000. Okay. And then, you didn't pay any taxes during the quarter?

Caroline Rook

Very little. I want to say it's like $200,000 or $300,000 net.

Moshe Katri - Cowen

Is that sort of we are kind of factoring roughly 15% to 20% in terms of an effective tax rate?

Caroline Rook

Yeah, so Moshe we are very tight positioned at the moment where most of our taxable income is being recorded not in the US. It's being primarily recorded in countries where we have tax holidays. And therefore, the US effective tax rate is very minimal.

Moshe Katri - Cowen

And is that sustainable until next year and to Q4 as well?

Caroline Rook

I think that it is a tax strategy that we would try to implement as long as we could.

Moshe Katri - Cowen

So is that sustainable into next year?

Caroline Rook

Next year tax rate Moshe, we would give you updated guidance on that during our Q1 conference call.

Moshe Katri - Cowen

Okay. And then, Lance, you spoke about different areas that you wanted to invest in on a forward basis. Is there anyway to quantify the impact of these investments on margins? And again, this is something that if you recall, we had some controversy about this early this year when you provided guidance for '07. So, does it make sense for you to talk a bit about the investments that you need to actually put in place into the business to get to actually expand these services? Thanks.

Lance Rosenzweig

Sure. I think, we were really talking about just kind of excitement given the demand trends for the business. So, we're investing our sales team. We are adding additional sales directors, we added one in Europe recently and we're looking for more. We're adding new managing directors in our vertical markets.

But these are people that are driving real value to PeopleSupport. In terms of facilities investment, we had as we talked in prior quarters a new building being constructed in Baguio. And that building will be complete in the early part of next year. However, we don't anticipate actually building out the floors of that building until the demand is required for that space. So that CapEx would follow demand. And then, the only other investment which I talked about was the center in Cebu which is a two year roughly project at about $20 million to $25 million.

Caroline Rook

Yeah. And just to the $20 million to $25 million, if we did sell our land in Manila, we could potentially reduce that cost by almost 50% potentially. So, it's not that big net-net if you look at total spend.

Moshe Katri - Cowen

But again, I think, what a lot of us are trying to do here is trying to understand what's sustainable, what sort of an EBIT margin is sustainable for this company on a normalized basis though we have 6.5% EBIT margins for the quarter about 200 basis points came from a short-term engagement that ends at the beginning of '08. And then, you had some other one time gains that also helped operating margin during the quarter. So, we are really probably talking about 3% to 4%, what will drive the 3% to 4% operating margin on ongoing basis you have been able to increase utilization rates about 64%. Do you think, are you planning to get it to 70%-75%? May be you can talk about some of the drivers that can actually help you get this 3%-4% EBIT margin to 10% or maybe above that number? Thanks.

Lance Rosenzweig

Yeah. Absolutely, and bear in mind that EBIT margin is not normalized. So, that's after FAS 123R charge.

Moshe Katri - Cowen & Company

But that’s normalized, that's GAAP. We have to look at GAAP EBIT margins line?

Lance Rosenzweig

Correct. Yes. I'm just clarifying, Moshe. That's GAAP EBIT margins. So, going forward we see a number of things which I think can help us to sustain and improve that margin overtime. First: as we mentioned the captive services, we do have a project now which ends early next year. But we're looking to expand that offering to other companies, so that we can take further advantage of that overtime.

Secondly: we are focused on improving our utilization rates. So, we have made good progress in the quarter from 60% up to 64% and we are looking to continue to push that north and we would like to be in the 70s, which I think would help to drive additional margins longer-term as well.

And third: as we work with clients and prospects, we are continuing to push higher prices. And we feel given what's happened in the market and with the peso, that there is a good opportunity for us to have margin expansion through price increases as well.

Moshe Katri - Cowen & Company

Thanks.

Lance Rosenzweig

Thank you.

Operator

And we will take our next question from Matt McCormack of FBR Capital Markets.

Matt McCormack - FBR Capital Markets

Hi. Good evening. In terms of this Cebu facility, the 4,000 seats, that 20 million to 25 million, you said that's incremental. Does that include building the building and then also building out the workstations or is that just building out the workstation?

Lance Rosenzweig

Yeah, Matt, that's building the building itself.

Matt McCormack - FBR Capital Markets

Okay.

Lance Rosenzweig

If we were to lease a building, we will have to build those workstations, and if we were to use our own buildings, we would have to build that workstation. So, that's the incremental CapEx that we anticipate by building the building. Maybe Caroline, can give some clarity on the build out costs.

Caroline Rook

Yeah. We generally see at the moment anywhere between 5,000 to 7,000 per operational feet. So, if we can get some economies here at that lower end, you might be at the high-teens to early to mid-20s on the build out. But we don't need to do that entire build out at one go. You obviously have to build the building in one go, you can't add extra floors. But as we needed you can scale the build out in.

Matt McCormack - FBR Capital Markets

All right. So, in terms of your plans right now, so the building is going up in '08 and then what percentage of the build out do you think is going to be done in '08 versus '09?

Lance Rosenzweig

I think the building won't be opened until '09.

Matt McCormack - FBR Capital Markets

Right.

Lance Rosenzweig

So, really none of the build out will be done in '08, and we will build that out as demand requires, then we are ready to move in.

Matt McCormack - FBR Capital Markets

So, you are not going to spend any cash until '09?

Caroline Rook

No, no. We have to spend the construction cash. If you are asking how much is that, 20-25 is being, or is going to be, spent in '08. We are still evaluating that and hopefully, we can give you some further aspects during our Q4 conference call.

Matt McCormack - FBR Capital Markets

Okay. And so in terms of the sale leaseback, you'll get cash back if you sell it. But you still have a similar CapEx, call it, 25 million or so to build that out, would you have either way if you don’t release. Is that correct?

Lance Rosenzweig

So, the sale leaseback would be something that we would do in Manila.

Matt McCormack - FBR Capital Markets

Right.

Lance Rosenzweig

And so in Manila, we would receive cash for the land and then a third-party would build the building at it's expense and PeopleSupport would a tenant in the building, and would pay for the build outs of the space that we require in that building.

Matt McCormack - FBR Capital Markets

Right and that's about 5,000 to 6,000 proceed?

Lance Rosenzweig

Yeah. That would be the capacity of the entire building but we would not anticipate taking the entire building ourselves.

Matt McCormack - FBR Capital Markets

Right. Okay. In terms of I guess, looking out into '08, after the last call, you put out the release saying margins would come in between 1% and 5%. Can you provide us any update on that?

Lance Rosenzweig

Yeah. As Caroline mentioned, we do plan to give '08 guidance in our next earnings call, but otherwise we're not commenting on that today.

Matt McCormack - FBR Capital Markets

Okay. And then lastly, you filed a poison pill during the quarter and that’s arguable if that benefits anybody other than management and the Board. So, I guess could you walk us through what your logic was in doing that?

Lance Rosenzweig

Sure, yeah. I think we commented on our last call that I'm happy to talk about that again. We found ourselves last quarter with a very concentrated shareholder base; with our largest shareholder owning almost 25% of the company. Our Board, after doing a lot of reviewing of it, and consulting with the legal advisors and financial advisors, decided to go ahead and implement the shareholder rights plan, and there are really three reasons that drove that.

First, is to have a preference for a more diversified shareholder base. And second is that, greater liquidity in our company stock. And third is, so that the Board can more effectively exercise its fiduciary obligations to all shareholders.

It's not designed to award a takeover. It's not designed to help management. It's designed really with those goals in mind. If someone wants to acquire the company, we believe that they should do that at a full and fair value as negotiated with the company.

Matt McCormack - FBR Capital Markets

Okay, great. Thank you.

Lance Rosenzweig

Thank you.

Operator

And we'll go next to Josh Vogel of Sidoti & Company.

Josh Vogel - Sidoti & Company

Hey, good afternoon. I was just hoping for a little bit of more clarity here. I understand you have some seasonal weakness in Q4, and you mentioned the one-time gains of 700,000 in Q3. But, you are expecting the captive, the short-term contract to roll-off in early '08, and it just seems that there is a really big fall-off in your EBIT guidance for Q4 versus Q3, and I was wondering if you could give just a little bit more clarity, why you're looking for an operating loss?

Caroline Rook

I'll take that Josh. First of all, the peso we are expecting was currently forecasting at 44 pesos, which I think was about 4% drop, which is about 2% drop on the operating margins from Q3 to Q4, which is a main driver of that. We did have some one-time pickups in Q3. Revenue was seasonally lower. We do have some fixed cost of course, Josh, so the contribution to fixed costs also are impacted in Q4. In fact, 1, 2, 3 years up slightly from some retention in annual grants that we normally do, by about $0.35 million in Q4. And I think that's pretty much it. Some interest income from our stock buyback is forgone, although we are net cash flow positive. So, that's probably less with an impact.

Josh Vogel - Sidoti & Company

Okay. With this captive services, are these can it be primarily dedicated seats or are you going to have access to this seats during off peak hours?

Lance Rosenzweig

No, seats would be reserved for the particular clients.

Josh Vogel - Sidoti & Company

Okay. So, you can't do any daytime work there, is there an option then?

Lance Rosenzweig

No, but we have plenty of our own capacity for that daytime work.

Josh Vogel - Sidoti & Company

Okay. As far as your leases in Manila, are there any notable ones expiring in 2008, there you have to renegotiate?

Caroline Rook

There are none expiring in 2008. There isn't much older facility that we have, that it's potentially expiring in '09.

Josh Vogel - Sidoti & Company

Okay. And I don’t know, maybe I'm just reading this wrong, but with your guidance, it just seems that your full year EPS, if you're in $0.28 or $0.29 in Q4, that come out to $0.70 - $0.88 for your further guidance to $0.84 - $0.85. Am I just reading this wrong?

Caroline Rook

Full year guidance is $0.84 to $0.85, Josh.

Josh Vogel - Sidoti & Company

Right. But if you're going to earn $0.28 or $0.29 in Q4, I'm coming out to $0.87 or $0.88?

Caroline Rook

Just checking on that Josh.

Josh Vogel - Sidoti & Company

Okay.

Caroline Rook

Yeah, that is right.

Josh Vogel - Sidoti & Company

Okay. Thank you.

Operator

And we'll go next to Michael Perna of AD Capital.

Dan Wimsatt - AD Capital

Hi, this is Dan Wimsatt for Mike Perna. Good afternoon and congrats on a good quarter.

Lance Rosenzweig

Thank you, Dan.

Dan Wimsatt - AD Capital

Two or three unrelated questions: The captive is very interesting; there hasn’t been a lot of discussion about this until now. Lance, can you talk about, do you look at this as -- take this from your clients perspective. Do they start with services that have caused you to divest, that they are less excited about outsourcing, and so they will pay more to you with the wrong people, just because they want to keep it for security or quality or whatever reasons? And then ultimately, once they try, they are getting used to the Philippines and after that, they either make a decision and do something themselves or they give you more on the labor side. Is that way that works, you think? And, why couldn’t this be a significant basis for you? And can you talk about how much better margins are, given that the equipment's are already there?

Lance Rosenzweig

Yeah. I think that’s a great question. I see two elements for it. First, I'll clarify that, in the US, the market for call center services is predominantly in-house or captive; it's not outsourced. So, I think something like three-quarters of all call centers in the US are done in-house. And a lot a companies just have a philosophy of keeping their call center work with their own employees. And as these companies look to outsource offshore, we have a really great offering for them to do that much more rapidly, much more efficiently through a very established infrastructure.

Secondly, there is also a base of companies that want to mix, and some might want to start with their own captive seats and then expand to outsource seats. Some might want to have ongoing of both types. And we believe that it’s a great way digging entree into new types of clients that otherwise we would not be able to tackle. And overtime, many of them we may be able to up sell into outsourced services as well.

Dan Wimsatt - AD Capital

How tough is it for these clients to get their own people over there? I mean, obviously they are trying it out. It seems like it's temporary?

Lance Rosenzweig

Right. It probably depends on your sophistication and skill. And would say that depending on client requirements, PeopleSupport could very well offer its recruiting services to help them in recruiting the teams that they need as well, we have an outstanding and very well established recruiting team throughout the country, and we'd be happy to offer that to our clients also.

Dan Wimsatt - AD Capital

And Lance, can you talk about, I understand if you can't, but any sense in terms of incremental margins on the captive business?

Lance Rosenzweig

Yes. Margins on captive business are definitely higher than the margins on the labor intensive businesses. Revenues are not as high, because we are not getting a mark-up on labor. But margins are definitely higher, but we haven’t given specific percentages there.

Dan Wimsatt - AD Capital

Maybe next year.

Lance Rosenzweig

Yeah. Actually, Caroline did mention that the project that we had in the quarter was about $1.5 million of revenues, and about 200 basis points of operating margin. So, we did give some margin information.

Dan Wimsatt - AD Capital

Okay. And then, is Sabu, that’s in round numbers 1,200 seats right now?

Lance Rosenzweig

Well, we said about of 40% of the 4,000. So, about 1,600 seats.

Dan Wimsatt - AD Capital

Okay. I missed the 40. Sorry.

Lance Rosenzweig

Yeah.

Dan Wimsatt - AD Capital

So 1,600 seats, and as I recall, this was ramping slowly.

Lance Rosenzweig

Hey, Dan, sorry. Correction, it's 60% of the current seats. So that will be 2,400 seats that we currently utilize in Cebu.

Dan Wimsatt - AD Capital

Okay. Utilization in Cebu relative to Manila, or do I even care about that? Are the margins higher/lower in Cebu than in Manila?

Lance Rosenzweig

Utilization rates probably on average are higher than Manila and margins are probably a bit higher as well.

Dan Wimsatt - AD Capital

Okay. But again people are -- it's starting to -- the uptake is now greater than it was?

Lance Rosenzweig

Yes, very strong demand for Cebu. Excellent employee base, very loyal, excellent attrition statistics, great performance. We've seen some really, really good progress in Cebu.

Dan Wimsatt - AD Capital

Okay. Utilization, I've had this discussion more than once just in terms of what that number can and should be, and I think that 86 was your previous high watermark. Just about every other publicly traded company has 7, if not an 8, in front of their number. Why is 64 good? Why is 70 good? Why not something higher than that? And does there come a point in time you talked about adding resources in Europe, et cetera, but I think it's a little frustrating for us trying to understand and maybe there is a good reason why utilization is so low for you relative to everybody else?

Lance Rosenzweig

Right. Utilization is -- I would say that 64 is better than 60, but not really where we like it to be. Utilization became in the 60s because of the capacity expansion that we did earlier this year together with the loss of seats from Vonage, and those are really the two things that drove that low utilization rates.

We are pushing to increase that. We would like it to be in the 70s. We think once it gets close to 80, there is really a demand for additional seats. We also think about it on a regional basis. So aggregate utilization may be in the 60s or low 70s, but we might be out in a certain city where there are client demand requirements.

And also to a certain extent, our utilization is adversely affected by our new center in Baguio, which will take some of additional time to fill. But we're working hard to fill that, both with out outsource services and we think we'll even have better success at it now that we have captive services as well.

Dan Wimsatt - AD Capital

And I think you said, last call, that until the utilization rate was, there was a seven in front of it, that you wouldn't add capacity; so maybe that implicitly suggests where you hope you will be by the time Cebu is up and running with the new seats?

Lance Rosenzweig

Yeah. I mean it's a couple of years away.

Dan Wimsatt - AD Capital

Yeah.

Lance Rosenzweig

So we think we can make a lot of progress between now and then.

Dan Wimsatt - AD Capital

Okay. And there's anything on the Earthlink you mentioned just down a little bit, $1 million, Caroline?

Caroline Rook

Yeah. Our estimate for Q4 is about $1 million. We don't know what the translation is for '08 yet, and hopefully, we can add better clarity once we give our Q4 conference call.

Dan Wimsatt - AD Capital

Okay. And nothing new in Puerto Rico? That's had big financial services client that seems to be in the news a lot.

Caroline Rook

Puerto Rico?

Lance Rosenzweig

Dan, we do nothing in Puerto Rico.

Caroline Rook

Costa Rica.

Dan Wimsatt - AD Capital

You know what I mean. It's been a long day.

Lance Rosenzweig

We got a great operation in Costa Rica, hitting, winning customer services awards, team is doing very, very well.

Dan Wimsatt - AD Capital

Great, congratulations.

Lance Rosenzweig

Thank you very much.

Caroline Rook

And just to clarify with Josh's comments on the full year forecast, don't forget we've got a different average for the year on the shares as opposed to just adding each quarter. But we're currently looking at $0.86 to $0.88 EPS.

Operator

And we'll take our next question from Cynthia Houlton of RBC Capital Markets.

Cynthia Houlton - RBC Capital Markets

Hi. Just a couple of quick questions: First, you mentioned JP Morgan as a new 10% customer and you said that there is an opportunity for that client to continue to ramp. Could you just provide a little bit more detail on the nature of the work that you're doing with them? How large this client is? Whether its seat count or revenue contribution, kind of what expectations are there? And just a little more detail would be great.

Lance Rosenzweig

Sure. We're very excited about our new work with JP Morgan Chase. It's a pretty broad based relationship, and we're servicing a number of different areas of the bank. We think that there is good opportunity for growth within other categories of services that we're offering for them, but we don't breakout the types of business because of confidentiality requirements. We don't breakout the type of businesses that we do for them.

Cynthia Houlton - RBC Capital Markets

And no visibility on, you know, is this going to be 15% to 20% or right now, I mean, you must have a sense of where they plan on ramping with your current project?

Lance Rosenzweig

Yeah, we hope to be able to provide much more information into '08 in our next earnings call.

Cynthia Houlton - RBC Capital Markets

Okay. And then just a follow-up. You talked about some price increases that you're getting from clients based on, obviously, the movement of the Peso. In these contracts, I would assume clients also want concession if the Peso goes in the other direction. Is that correct or do they just willingly accept higher rates without any protection if the Peso goes the other direction?

Lance Rosenzweig

Yeah. Our clients for the most part are very large sophisticated companies, and I would not say that they willingly accept price increases. We work really, really hard to maximize our situations really to be fair with our clients. They're sophisticated. They're following in both directions. I'm sure if it reverses, they'll be on the phone to us as well.

Cynthia Houlton - RBC Capital Markets

Is that how the contracts are configured, meaning that is there a provision in place when you put on these price increases based on Peso?

Lance Rosenzweig

It varies by clients. So in some of the newer cases, we're building in co-lo provisions or we are having shorter term pricing arrangements where, for example except for a year, and then renegotiated at the end of the year.

Cynthia Holton - RBC Capital Markets

Okay. Thank you.

Lance Rosenzweig

Thank you.

Operator

And we'll go next to Mark Marostica of Piper Jaffray.

Mark Marostica - Piper Jaffray

Good evening, just a follow-up on the EarthLink question. Can you just clarify whether we're strictly talking about reduction in volumes or if they given you indications of a reduction in seat count?

Lance Rosenzweig

You know, EarthLink it would be both, right, they attract each other. Reduced volumes would result in reduced employees; that will result in reduced seats counts.

Mark Marostica - Piper Jaffray

Okay. Can you give maybe a little better granularity then, as to sort of how that tracks then in to the next couple of quarters, I mean, you mentioned $1 million next quarter. But is this sort of a steady decline into '08 or are we looking at more of a steep drop off at some point in '08?

Lance Rosenzweig

Yeah, we are expecting about $1 million decline from Q3 to Q4 this year, and again we hope to give much more information in our next earnings call about '08.

Mark Marostica - Piper Jaffray

Okay. And just couple of house keeping things, I might have missed. Q4 what is the tax rate assumption?

Caroline Rook

We said that the actual dollar amount for the tax rate was about $0.8 million.

Mark Marostica - Piper Jaffray

Okay, thanks. And then, also the captive contribution to utilization Q3?

Caroline Rook

You know, I generally expect Q4 to be the same as Q3.

Mark Marostica - Piper Jaffray

Okay, excellent. Thank you.

Lance Rosenzweig

Thank you.

Operator

And we'll go next to [Barry Caplin] of [Maple Tree Capital].

Barry Caplin - Maple Tree Capital

Thanks. Could you talk a little bit, if you have already, I got right about wage pressures in Philippines and also the extent to which it's differs in every city?

Lance Rosenzweig

Hey, Barry, just repeat the second part of your question, you said wage pressures and what was the second part?

Barry Caplin - Maple Tree Capital

Wage pressures in general in the Philippines, and the extent to which it differs in every city. Then in the Philippines that are you paying materially different wages?

Lance Rosenzweig

Yes, I see. Yes, wages have been running, wage inflation has been running, pretty consistently in the past few years, in the high single digits. And we see really nothing that’s changing that going forward. Unfortunately with the Peso appreciating, it's kind of magnifying the impact on us. It was very different when the Peso was going the other direction.

So now we are seeing, kind of high single digit wage pressures in Peso denominated terms, which is obviously much more in dollar denominated terms. There were regional nuances within the country and people who tend to follow, wage patterns as is appropriate in each of the cities in which it operates.

Barry Caplin - Maple Tree Capital

Okay, the only other questions just for the clarification, I think air line bad debt that was lean [6 million] actually in '09 in Manila. What it's potentially be?

Caroline Rook

Well we obviously have the option to pick it up should we need it at that time.

Barry Caplin - Maple Tree Capital

Okay so you could risk space.

Lance Rosenzweig

Yeah we have flexibility we can potentially extend the leases we can move out and consolidate into other centers we can move into new locations etcetera.

Barry Caplin - Maple Tree Capital

Thank you.

Lance Rosenzweig

Thank you.

Operator

And we’ll take our next question from Brad Manuilow of American Technology Research.

Brad Manuilow - American Technology Research

Thanks. Just one quick question on, do you guys expect the same level of contribution from captive services in Q4 as you saw in Q3. Thanks.

Caroline Rook

Yes I believe I did indicate that.

Brad Manuilow - American Technology Research

Okay, thanks.

Lance Rosenzweig

Thank you

Operator

And we will go to a follow-up question from David Scharf of JMP.

David Scharf - JMP

Hi Lance just wanted to delve into some client specific data points again. I guess following up on JP Morgan Chase, and somebody asked earlier. I guess a month ago when our findings suggested you were doing inbound fraud work for their card division but I hadn't realize this has been a client going back to early '06 are there other divisions within the bank you are working for?

Lance Rosenzweig

Yeah, I mentioned David, unfortunately, we can't comment on the specific lines of business that we are working on with the bank.

David Scharf - JMP

Well, what about your relationship today in terms of vendors. I mean, I was hearing they were doing some cut inbound hard work in the Philippines with Convergys. Are you regarded as the primary vendor for whatever service you're delivering to them in the Philippines?

Lance Rosenzweig

We are very, very excited with that relationship and with the extent that we are working with the firm and the opportunities we have going forward. But we can't comment on anything they do with any other companies.

David Scharf - JMP

Okay. Switching to EarthLink, the million dollar reduction. Is that demand-related or is that a specific contract, because we had heard the internet cable contract went away?

Lance Rosenzweig

EarthLink is doing a very, very significant amount of restructuring of its business. And I think, part of that is to deemphasize certain lines of business and to have some lower marketing expenses which will drive lower call volumes. And it's really, I think, kind of across the board, affect to cross EarthLink's lines of business. And as EarthLink then shifts these around with different countries and different locations, there will be some new answers and movements and we won't necessarily kind of track overall call volumes, but its sort of indicative that, I think the general call volumes that they are receiving are declining.

David Scharf - JMP

Okay. Can you expand a little on healthcare? I know you mentioned a few new clients in that area last quarter or two. We had come across the bunch of job postings particularly in Sabu that seemed to be medical-related, are these insurance companies that managed care providers and are these clients that by '08 are expected to be pumping up against 10%?

Lance Rosenzweig

Sure. We are actually, as we mentioned last quarter, very excited about long-term opportunities in the healthcare industry. It's an industry that is really right for offshore outsourcing, and we think the Philippines with its very, very closely aligned medical system to Latin America is particularly well suited from medical-related work in the Philippines. We do have some new clients in that area that we mentioned, and while it's somewhat broadly based, we think that there is particularly a strong opportunities in more of the payor side.

David Scharf - JMP Securities

Got you. And lastly, the names may be shifting around every year, but when we look out a year from now, based on what you expect to sign up and additional work from existing clients, would you expect the same level of client concentration from your top three, four, five customers regardless of who they actually are? The rankings may shift, but would we probably be looking at about 60% of revenue from maybe the top four clients a year from now, does it sound about right?

Lance Rosenzweig

I think that's really hard to predict right now, because some of the existing accounts we have are potentially rapid growers, others not. Hard to predict the news closes that will come in, I think we will be able to give much more detail there in our next call when we give '08 guidance.

David Scharf - JMP Securities

Okay, great. Thank you.

Lance Rosenzweig

You are welcome.

Operator

And we will go next to a follow-up from Moshe Katri of Cowen.

Moshe Katri - Cowen & Co.

Hi, thanks. Caroline, can you quantify to us what a 100 basis point improvement in utilization rate could actually -- how much will it impact EBIT margin. Do you have that sensitivity analysis in front of you?

Caroline Rook

I have that sensitivity analysis Moshe. But, we don't share that because the Peso is so impactive to us and also dependent on the program, the pricing and the margin of that program would give us different swings.

Moshe Katri - Cowen & Co.

Yeah. Well, assuming the Peso is flat and assuming maybe you can give us a range?

Caroline Rook

You know may be that is something that we can look at for our next conference call.

Moshe Katri - Cowen & Co.

Understood, thanks

Lance Rosenzweig

Thank you

Operator

And we'll go next to a follow-up from Josh Vogel of Sidoti & Company

Josh Vogel - Sidoti & Company

Thank you. Caroline, I just wanted to touch on something you said earlier, did you say that you have less favorable Peso rates locked in beginning in '08?

Caroline Rook

Yes. When we locked in, we started our foreign exchange program in early '07 and we locked in at around 49 pesos for around 12 months, I want to say. So that's coming to an end, and as we lock in over a period of time that you can appreciate just given the Peso appreciation, the rates that we could lock in was less than 49.

Josh Vogel - Sidoti & Company

Okay. So basically, if we just assume that the Peso appreciate, let's say 2% a quarter, your benefits from FX is going to decrease significantly from what you are expecting, say in Q4, when you look out into '08 and beyond?

Caroline Rook

Potentially.

Josh Vogel - Sidoti & Company

Okay. Thank you.

Operator

And ladies and gentlemen, we have no further questions at this time. Mr. Rosenzweig, I would like to turn the call back over to you for any additional or closing remarks.

Lance Rosenzweig

Great, thank you very much. And we look forward to catching up with everyone in our next quarterly call. Thank you.

Operator

And that does conclude today's conference call. Thank for your participation. You may disconnect at this time.

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 www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!