Computer Sciences Preliminary F1Q08 (Qtr End 06/29/07) and F2Q08 (Qtr End (09/28/07) Earnings Call Transcript

Computer Sciences Corp. (CSC)

Preliminary F1Q08 (Qtr End 06/29/07) and F2Q08 (Qtr End (09/28/07) Earnings Call

December 20, 2007 5:00 pm ET

Executives

Bill Lackey - Director of IR

Mike Laphen - Chairman and CEO

Mike Keane - CFO

Analysts

Moshe Katri - Cowen & Co

Adam Frisch - UBS

George Price - Stifel Nicolaus

David Grossman - Thomas Weisel Partners

Rod Bourgeois - Bernstein

Abhi Gami - Banc of America

Eric Boyer - Wachovia

Greg Smith - Merrill Lynch

Tien-Tsin Huang - J.P. Morgan

Pat Burton - Citi

Operator

Good day everyone and welcome to the Computer Sciences Corporation fiscal year 2008 preliminary first and second earnings call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the conference over to Mr. Bill Lackey, Director of Investor Relations. Please go ahead, sir.

Bill Lackey

Thank you, operator, and good afternoon everyone. Welcome to CSC's earnings conference call and today we'll be discussing our preliminary first and second quarter results for fiscal 2008, which were released earlier this afternoon. Mike Laphen, Chairman and Chief Executive Officer, will open with some remarks, and then Mike Keane, Chief Financial Officer, will review the two quarter's and first six months financials.

As usual, this call is being webcast live at CSC.com, and we also welcome those joining us via that process.

Any information we cover that is not directly and exclusively related to historical facts constitutes forward-looking statements under Federal Securities laws. For a written description of these factors that could cause actual results to vary from those statements. Please refer to the section titled Risk Factors of CSC's Form 10-Q for the year ended March 30, 2007.

Also on today's call, we will reference certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures are provided in the tables attached to the earnings press release and will be posted on the Investor Relations section of CSC.com. The non-GAAP financial measures referred to during this conference call are not meant to be considered in isolation or as a substitute for results prepared in accordance with GAAP.

Finally, we assume no obligation to update the information presented on this conference call. And it's now my pleasure to turn the call over to Mike Laphen.

Mike Laphen

Thank you, Bill, and good afternoon, everyone. It's my pleasure to have this opportunity to update you on CSC's current business position and our strategic direction. As I highlighted during our last earnings call, we are focused on ramping up our growth as well as improving our profitability and ROIC.

Project Accelerate, comprised of five initiatives designed to accomplish these goals over the next several years, is being implemented and we've made good progress to date. To briefly review the five initiatives are: one, enhancing our industry specific offerings through the delivery of the differentiated business solutions. Two: aggressively growing and leveraging our NDA capabilities. Three: expanding our global footprint. Four: repositioning our commercial outsourcing segment including a special emphasis or midsize deals. And five: focusing on high growth segments within the North American public sector market.

The goal of these initiatives is to achieve a more balanced portfolio of services with both current and prospective clients as well as to deliver longer term revenue growth, operating margins and ROIC of at least 10%.

Core business profitability reflects a favorable trend. For the trailing 12 months our global commercial internal operating income margin was 9.1%, reflecting an improvement of 130 basis points over the prior comparable period. Our North American public sector margin has remained stable in the upper 7% range with the exception of the second quarter non-cash charge that Mike Keane will elaborate on.

Respective margin improvement will be the result of our continuing focus on cost reductions and a change in business mix. We also continue to make progress towards our goal of achieving 10% or greater ROIC. Our emphasis on reducing capital asset intensity and improving working capital continues to be a high priority.

Overall, revenue for the six months grew nearly 10% with positive growth in all six of our industry verticals. These increases were lead by financial services and healthcare with double-digit gains along with solid growth from our North American public sector activities.

Our recent focus on addressing midsize outsourcing opportunities is also delivering results. The restructured sales approach and dedicated sales force have been implemented for midsize deals, which include total contract values between $50 million and $350 million.

During the past three quarters, 15 awards have been the result of this focus, representing nearly $2 billion in awards. The pipeline for midsize deals has grown ten-fold over the past year and our win rate has improved significantly.

The closing of the Covansys acquisition in early July represented an important step in aggressively growing and leveraging our India capabilities. To-date we are pleased with the progress achieved in the integration of Covansys and CSC.

India is now our second largest country of employment with over 15,000 employees. Those employees, along with approximately 2,500 additional employees in other low-cost regions, represent about 27% of our total commercial workforce. More importantly, we can now offer our collective clients a wider range of BPO outsourcing and business services and solutions.

In order to strengthen our domestic and offshore healthcare expertise and service offerings, on October 31st, we announced an agreement to acquire First Consulting Group in an all cash transaction for approximately $365 million.

Further this project accelerates strategy by enhancing our capabilities associated with the key healthcare vertical market and expanding our global delivery, including a new world sourcing location in Ho Chi Minh City, Vietnam. Importantly this acquisition will strengthen our core business in all three healthcare markets: healthcare providers, health plans and life sciences.

The transaction is anticipated to be completed in the first calendar quarter of 2008. Our progress on the NHS contract continues. The final stage of the transition from Accenture occurred in October, when all services were successfully moved in to two new CSC data centers in the South of England.

Additionally, we continue to make strong progress across all regions in terms of appointments. As you are probably aware, iSoft is a key sub-contractor and the acquisition of iSoft by IBA Healthcare was completed at the end of October. To ensure the continued successful development of the Lorenzo product, we have assumed from iSoft the direct responsibility to manage the resources and processes necessary for the fulfillment of our obligation under the NHS contract.

The commercial step in process was conducted under terms read between iSoft and CSC, and this new approach is expected to be earnings neutral.

As I mentioned earlier, one of the key elements the project did accelerate was to achieve market growth with a combination of technology and electrical property in industry expertise, and providing clients with global business solutions delivered in our six vertical industries.

For the first half of the year, business solutions grew organically 16% including the contribution of Covansys, the growth was about 25% year-over-year. Business solutions currently constitutes approximately 24% of our total revenue and is anticipated to grow as a percent of total, as we move towards a more balanced service portfolio.

Our North American public sector operations also delivered a strong performance for the first six months. We experienced good traction in the six high growth market segments we have identified. And these accounted for more than 50% of the first half North American Public Sector total awards. We announced total awards of $8.5 billion during the first six months, continuing the strong momentum established in fiscal 2007.

A quality and quantity of both our commercial and public sector pipelines are strong. We are adding numerous opportunities in both markets over the balance of fiscal year -- we are addressing numerous opportunities in both markets over the balance of fiscal 2008 and anticipate another solid year of award totals, positioning us well for next year. That's a brief review of our business.

And now, I'll turn the call over to Mike Keane for further details on our financial results.

Mike Keane

Okay. Thanks, Mike, and thanks, everybody, for joining us today. Let me start providing a general outline. First, we'll cover a number of items of interest since our last earnings call. These include the restatement of the prior year financials, creation of other income line for foreign currency translation and non-operating gains and losses within those statements, the adoption of FASB interpretation number 48 or otherwise known as FIN 48, our share repurchase status, special items charges and the settlement of the serious contract disputes.

After discussing these items, we'll move to our normal discussion of income statement balance sheet and cash flow items. So let's move on to the first item, the restatement of prior year financials.

The restatement stems from a discovery of certain accounting errors relating to the company's accounting for income taxes and for the effect of foreign currency exchange rate movements on certain intra-company balances. The corrections in accounting for income taxes resulted in a cumulative charge from fiscal years 1995 through the end of fiscal 2007 of $303 million.

Of this $303 million, more than half relates to accruals for interest and penalties. Other significant adjustments relate to errors and tax basis depreciation and certain transaction between the company's U.S. and foreign entities.

Interest and penalties are a function of both the incorrect competition of taxes payable from the errors as well as earlier utilization of net operating losses as a result of higher taxable income in prior fiscal years.

Corrections in accounting for currency exchange rate movements resulted in the recognition of cumulative after tax gains of $193 million between fiscal year 1995 through fiscal year 2007.

In the past, the company entered into certain transactions between the parent and its subsidiaries, company's policy was to treat these transactions with the foreign entities as long-term net investments.

According to an exception provision of FASB 52, in other words, the GAAP accounting, the foreign currency gains and losses were recorded in the cumulative translation adjustment on the balance sheet.

On further review the company determined the some of these transactions were incorrectly recorded as long-term investments and the foreign currency translation movements should have been recorded within the income statement.

The net effect of the two corrections along with other minor adjustments resulted in a cumulative $110 million charge to retain earning through fiscal year 2007. The company will soon file an amended annual report on Form 10-KA for the year ended March 30, 2007, which will restate the financial statements previously filed.

As a result of the corrections in accounting for currency exchange rate movement, we created a new line in our income statement called other income to capture gains and losses our foreign exchange activity, as well as other miscellaneous transactions.

Currently many of the intracompany and other balance sheet exposures giving rise to the foreign exchange gains and losses are now being hedged to minimize the volatility in earnings from exchange rate movements.

The third topic is our adoption of a new accounting guidance on tax FIN 48 and its impact on our financial statements and tax rates going forward.

FIN 48 clarifies the accounting for uncertain tax positions taken or to be taken in a tax return. We performed a review of prior tax positions based on FIN 48 guidelines and as a result the company has recorded $1.4 billion of unrecognized tax benefits or tax liabilities if you will within the consolidated balance sheet with no net impact to the consolidated statements of income.

Of this amount approximately $163 million was accounted for as a reduction to the March 31, 2007 retained earnings balance, in accordance with the implementation provisions of FIN 48.

Included in our unrecognized tax benefits are $602 million of uncertain tax positions and $156 million of penalties accrued that would possibly impact our effective tax rate if recognized in the future.

The fourth topic is an update of our share repurchase program. The Board authorized the share repurchases program of up to $2 billion in June of 2006. At that time we entered into an accelerated share repurchase up to $1 billion in a purchase agreement under a 10b5-1 plan to acquire an additional $1 billion worth of common shares once the first phase was completed.

The final settlement of the accelerated share repurchase took place in July of 2007. In August of 2007, we began purchasing shares through daily open market transactions under the 10b5-1plan. During the second quarter of fiscal 2008, the company repurchased 3.1 million shares for just nearly a $169 million, resulting in an average purchase price $54.45.

We continue to buyback shares based on our pricing grid, and currently expect shares to be repurchased over approximately four quarters through July of 2008.

Our fifth item or special items for the second quarter totaled $26 million and consisted entirely of pretax restructuring charges for the program we announced last year. Special items for the first half totaled $75 million and consisted of $53 million pretax restructuring charges and $22 million pretax charge related to the retirement of the company's former chairman and CEO. Remaining pretax restructuring charges expected during fiscal 2008 are estimated to be approximately $70 million.

The dispute with Sears has been settled as reflected in the press release issued on October 22, 2007, and a subsequent timely 8-K filings. Under the agreement Sears will pay the company $75 million by January 8th, 2008, to settle all claims and purchase certain specified equipment. In addition certain previous payments made by Sears will be retained by the company. The settlement resolves the company's net asset position as of as of September 28, 2007 with no material impact to end income.

Before moving on to our customary discussion points, let me outline the basis of presentation. All data in comparison unless indicated otherwise will be on a fully restated basis. Similarly except as indicated otherwise, quarterly full year and prior year results exclude the impact of special items. So this discussion, we'll be focusing solely on the second quarter and first half results, so please refer to either the press release table or Form 10-Q when filed for information related to the first quarter.

Beginning our discussion, total reported revenues increased 11% or 8% in constant currency during the second quarter and approximately 10% or 7% in constant currency year-to-date as a result of solid growth in both of our primary segments.

Turning our attention to the segments. Our North American Public Sector, which is previously known as our US Federal segment and is now referred to as NPS for short, generated $1.4 billion of revenues during the second quarter, resulting in a growth rate of 7% compared to the same quarter last year. Year-to-date, NPS revenues have increased 8% to $2.9 billion versus the same period last year.

The increases in second quarter and first half revenues were driven by new programs in the Army and the Air Force, as well as continued growth on our existing contracts for other defense related customers. Additionally, the acquisition of Datatrac completed last December, contributed to growth in NPS of almost 3% for the quarter and the first half of the year.

Global commercial revenues increased 14% during the quarter to $2.6 billion and increased 11% year-to-date to $5 billion. In constant currency terms global commercial revenues increased 9% during the quarter and 6% on a year-to-date basis.

Now, let's look at the individual pieces that make up global commercial business to understand the drivers of the performance. North America commercial outsourcing revenues fell 3% during the quarter and 4% in the first half versus the prior year.

While we added several new outsourcing customers, the revenues in the early stage of these contracts were not enough to offset the decline due to completion of certain other contracts. North America consulting and systems integration revenues were essentially flat for the second quarter, but rose 3% year-to-date as higher billing rates were slightly offset by softer utilization rates.

European revenues grew 18% during the quarter and 17% year-to-date. In constant currency, second quarter and year-to-date revenues increased 9%, making Europe our strongest performer in constant currency. Approximately 7 of the 18 points are attributable to new business wins, with about half of that coming from our expanded relationship with National Health Service.

Most of the remaining growth is the result of higher revenues in our European consulting and systems integration business. Our Asian and Australian operations continue to generate growth in the quarter and year-to-date. Revenues in Asia rose approximately 9% in the second quarter and 13% year-to-date.

At constant currency revenues increased 6% during the quarter and 9% year-to-date. Growth in Asia continues to be driven by strengthen in our larger global customer accounts. Australia revenue increased 20% in both the second quarter and the first half of the year. In constant currency revenues increased approximately 8% during the quarter and year-to-date.

The growth was mainly due to increases in project work and continue to expansion in our local taxes IT recruitment business. The Covansys acquisition closed in early July and added an incremental 3% to our second quarter growth in revenues over the same period last year.

Now let's look at our awards to date. Announced awards totaled $4 billion for the second quarter and $8.5 billion for the first half of the year. Federal continued the momentum from the record of over $9 billion of federal signings recorded in fiscal 2007. Our federal pipeline continues to look strong with $35 billion of opportunities scheduled to be awarded over the next 15 months and given our normal strong win rate we expect to continue to capture a sizeable share of this market.

Our commercial signings were soft for the second quarter but results should improve in the future with execution within our existing commercial pipelines opportunities during the second half, and with our comprehensive growth strategy outlined under Project Accelerate. We have seen considerable improvement within our middle market pipeline of opportunities.

Moving on to our expenses, cost of services as a percentage of revenue was 81% for the second quarter and 80.8% for the first half of fiscal year 2008. The second quarter and first cost of service ratios were 90 and 30 basis points higher versus prior year comparable periods. Despite the benefits from cost savings initiatives and restructuring activities across multiple business units, costs of services increased mainly due to $42 million pretax charge recorded within NPS.

Excluding the charge, the second quarter cost of services ratio would have been approximately 20 basis points favorable versus the prior year period and the first half ratio would have been approximately 20 basis points favorable as well.

Our NPS operation was adversely impacted in the second quarter by a near-term customer funding constraint and a related non-cash charge resulting from a reassessment of recoverability of an asset on the IRS Business Systems Modernization Program. This program represents only about a third of our current business generation within the IRS.

The reduced asset is relative to the core computing infrastructure that is applicable to a significant number of future releases under the contract. While our overall business with the IRS is profitable, the current release loss under the modernization program required us take a non-cash charge under developing accounting guidance, equal to $34 million, approximately half of the investment balance.

The forward loss recorded in the second quarter related to current release is $8 million. The total combined $42 million pretax impact is equivalent to about $0.16 of earnings per share.

Selling, general and administrative expenses were 6% revenue in the second quarter versus 6.3% a year ago, an improvement of 30 basis points. For the first six months of the year, our SG&A costs as a percent of sales improved 23 basis points from 6.3% to 6.1%. The improvement was also driven by the effect of restructuring activities as well as more efficient business development costs in our commercial operations, particularly within Europe. These improvements were partially offset by an increase in professional fees incurred at corporate headquarters as a result of the implementation of FIN-48 and the restatement of prior year financial statements.

Depreciation and amortization expense as a percent of revenue improved 11 basis points in the quarter and 8 basis points in the first six months to 7.3%. The improvement was largely due to growth in less capital intensive businesses.

Looking at taxes, the adoption of FIN-48 and the restructuring program have added some complexity that we'll try to describe. The company’s reported effective tax rate for the first half of the year was approximately 46%. Excluding the impact of special items including some non-deductible restructuring cost, the effective rate would have been 43% versus a previously expected rate in the mid-30% range.

Approximately two percentage points of that increase is due to tax interest charges. In prior years, before the adoption of FIN-48, we carried such charges on the interest expense line rather than on the tax provision line. We feel that the revised presentation gives better transparency to both lines, but bear in mind though that not the entire two points represents a year-over-year impact to earnings per share.

Approximately three percentage points of the increase is due to the reduced benefit of certain permanent tax differences as recognized under FIN-48, as a significant portion of such benefits are reserved for after not meeting the more likely than not threshold for benefit recognition.

In addition, during our second fiscal quarter there were future statutory rate decreases announced within two foreign jurisdictions that resulted in a discreet adverse impact and the valuation of certain foreign subsidiaries deferred tax assets. This increased the second quarter and six month effective rate by 7 percentage points respectively and 3 percentage points respectively; the 7 for the second quarter, and 3 percentage points for the six-month. I have some more comments on the tax rates and interest later.

In summary of our earnings before special items, second quarter diluted earnings per share were $0.54 for continuing operations compared to $0.68 for the second quarter last year. Notable is that the second quarter results were adversely impacted $0.12 by the increasing tax rate and another $0.02 by higher tax interest. Combined with earnings per share of $0.61 for the first quarter, earnings per share increased 6% over the prior year first half.

First half diluted earnings were negatively impacted by several items, including the $42 million pretax charges related to the IRS program. Higher than expected non-cash amortization charges associated with the preliminary valuation of purchase intangibles from the Covansys acquisition and higher than expected consulting and auditing fees for the restatement and FIN 48 adoption. Partially offsetting these impacts were foreign exchange gains recorded within other income.

Now, an update on our restructuring program. Pretax restructuring charges for the second quarter and first half of fiscal year 2008 were $26 million and $53 million respectively. Restructuring charges of $333 million were incurred during fiscal year 2007 and we do not expect to exceed $125 million in restructuring charges for the full year of fiscal year 2008.

Workforce reductions totaled approximately 800 employees for the first half of fiscal year 2008, it’s against the plan of approximately 2,000 for the full year. Partially offsetting these reductions were planned headcount increases in the lower cost regions of approximately 106 employees at the half. Under the restructuring plan approximately 800 additional hires in lower cost regions are anticipated for the remainder of the year. Our increased used of high value lower cost global resources have helped to improve our commercial margins.

Now some items to note on our balance sheet. We ended the second quarter with approximately $500 million of cash and cash equivalents. The cash balance decreased by approximately $560 million from year end due to the use of cash for the Covansys acquisition as well as funding for share repurchases in working capital requirements.

The increase of $314 million and accounts receivable results primarily from growth within our European and North America public sector businesses as well as the addition of Covansys.

The $1.2 billion increase in goodwill is primarily resulting from the Covansys acquisition. The adoption of FIN 48 reclassified approximately $1 billion of current income taxes payable and differed tax assets into differed tax liabilities.

Long-term debt has increased 1.1 billion due primarily to the funding of the Covansys acquisition. Our day sales outstanding was 103 days, three days higher than the comparable period last year as a result of some slower cash collection performance within our North American and European commercial business units.

The increase is primarily timing related and accounts specific and we expect our overall DSO measurements to improve by the end of the year. The debt-to-capital ratio at the end of the second quarter was 34% mostly due to the increased debt from the Covansys acquisition.

We plan to initially -- use debt financing to also fund our investment in first consulting group anticipating our close within the first calendar quarter 2008. We expect to use our cash flows to reduce our debt and we are still targeting our leverage to be in the 25% to 30% range over time.

Within NPS the 16 requests for equable adjustment and subsequent conversion into interest-bearing claims currently totaled approximately $900 million. The associated balance sheet assets for these claims totaled approximately $825 million of unbilled accounts receivable and deferred costs related to the contracts.

Despite recent government opposition as it claims, we will continue to pursue the claim entitlements. With respect to a larger set of claims during the first quarter of fiscal 2008, U.S. Federal Contracting Officer for the contract of the larger set of claims denied the claims and issued a $42.3 million counterclaim. The company disagrees with the government denials both factually and contractually and initiated litigation at the Armed Services Board of Contract Appeal or ASBCA on September 11, 2007 with regards to larger the two sets of claims and the counterclaim.

During the third quarter of fiscal year 2008, the company and its litigation team performed a standard review of the value of the claims associated with this contract. Such value is subject to periodic routine adjustment as new facts are uncovered, because of contract modifications and funding changes, ordinary rate adjustments and our estimated cost that we replace with actual cost.

Upon completion of the review, expected during the third quarter of fiscal 2008, the company will amend the complaint that filed with ASBCA on September 11, 2007 and projects it will downward adjust its value with such reductions reflected in the $900 million total value of both sets of claims above.

This adjustment is fully to the amount claimed, and does not affect the amounts currently in the company's balance sheet. With respect to the second set of claims, the government issued a denial on November 15, 2007. The company is analyzing this decision and has until February 12, 2008 to initiated litigation in the US Court of Federal Claims. These denials or claims by the government were somewhat expected, and do not change our outlook as to our recoverability of costs and assets. We believe that recovery at least in that balance sheet assets is probable. We will pursue appeals as necessary and are therefore unable to predict the timing of recovery for these claims.

Moving on to cash flow. Given the trends of our business, our cash flow tends to have significant inner quarter volatility within each fiscal year and the first half is traditionally a cash utilization period. In addition we mentioned in our fourth quarter call that a significant amount of cash from the NHS contract was received a quarter earlier than anticipated, thereby lowering this year's reported cash inflow.

With that said, free cash flow for the first half of the year was an outflow of $676 million, and this compares to $357 million outflow for the first half of last year. The net cash used in operations of $92 million for the first half of fiscal year 2008 is $160 million higher usage than the same period last year. The main factor driving our working capital increase was $325 million cash outflow from accounts payables and accruals during the first quarter for capital expenditures made right towards the end of fiscal year 2007.

The net cash outflow for investing activities was significantly higher in the first half of fiscal 2008 when compared to the same period last year, as a result of the $1.3 billion cash investment for Covansys. In addition, our fiscal year 2007 investing cash flows included $126 million beneficial impact from the redemption and accumulated dividends of DynCorp International preferred stock received as compensation in the previous sale of the business.

Before I conclude my remarks, let me take you through our revised guidance for fiscal year 2008. We expect full year revenues to be in the $16.2 billion to $16.5 billion range, representing between 9% and 11% growth for the year. This does not include any impact for the purchase of First Consulting Group. The tax provision including interest and penalty accruals for fiscal year 2008 is estimated to yield an effective tax rate in the 40% range. In the future, we expect this rate to be volatile as global tax positions are concluded under tax audits.

Taxes deserve a few moments of discussion, has been widely commented in FIN 48, which is intended to reduce discretion and the recognition of tax contingencies has accordingly introduced greater volatility. CSC now has $1.4 billion of unrecognized tax benefits under FIN 48, including approximately $750 million that would benefit the income statement if the tax return positions we have taken were to prevail.

The potential re-recognition of these benefits that have been reserved for under FIN 48 is a potential source of volatility. Another source is interest accruals and potential reversals on a related accrued tax liabilities. For the first half of the year, CSC accrued approximately $47 million of interest on tax liabilities. This figure is before the tax benefit of interest and before interest reversals associated with changes and accounting methods reported to the IRS.

Tax interest represents potential significant adverse impact or earnings and a disposition on liabilities either as repayment or recognition of the benefits is difficult to forecast. Currently our guidance treats this amount as an approximate run rate.

We now expect full year earnings per share to be in a $3.70 to $3.90 range compared to our prior expectation of $4 to $4.20. The primary reasons for the reduction in our outlook include the non-recurring impact of the IRS program write-off which was approximately $0.16 and the higher rate in tax interest accruals associated with the adoption of FIN 48, which in the current year is approximately another $0.18 impact.

Finally, we still expect to be able to meet our two-year free cash flow as a percentage of net income ratio of approximately 80% to 90%.

Free cash flow used in the net income ratio excludes restructuring cost. We do not expect a collection of any of the identified $900 million of government contract claims within the current fiscal year.

Well in closing some key take aways from the quarter end and the first half results include one, we are achieving overall strong growth with our top line revenues. Two, our core commercial operating performance is benefiting from the restructuring investment begun in the prior fiscal year particularly within our European operations.

Three, our North America public sector business continues to achieve a healthy pipeline of business opportunities and is performing well within its current contracts. And four, the implementation of Project Accelerate initiatives should provide the focus to continue to grow profitably both organically and thorough strategically focused acquisition, while striving to provide the consolidated ROI performance above 10%.

I would like to turn that back over to you now Bill.

Bill Lackey

Thank you, Mike. Before we get into Q&A portion, since we have covered quite a bit of information we really appreciate your questions being limited to one if you need to get back at the queue. Please reenter so, we can ensure that we get to everybody's question.

Operator, we are ready now to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Moshe Katri with Cowen & Co.

Moshe Katri - Cowen & Co

Hey, thanks. Thanks for all the clarifications here. Can you give us an update in terms of: where do you think you are in Project Accelerate ROE basically halfway through? And then also may be you can remind us: what sort of EBIT margin targets are you looking for by the time the project basically is completed? Thanks.

Mike Laphen

Moshe, this is Mike. It's envisioned to be about a three year program, we began at April 1st, so we are about nine months into it. So we will continue to roll it out. We haven't talked in terms of EBIT margins, but we have talked in terms of operating margin and our target there is to be in excess of 10%.

Moshe Katri - Cowen & Co

So: at this point you think you are basically about a third, you are done with about a third and there is about two-thirds to go?

Mike Laphen

Yeah, we are just shy of a third Moshe.

Moshe Katri - Cowen & Co

Thanks.

Bill Lackey

I am sorry, next question please operator.

Operator

Thank you. So we will go next to Adam Frisch with UBS.

Adam Frisch - UBS

Thank guys, glad to have you back.

Bill Lackey

It’s good to be back.

Adam Frisch - UBS

All the data, kind of sort of, get what [I would] ask for, right. I wanted to ask about free cash flow and restructuring and: how many more quarters of restructuring charges do you expect if you kind of qualify or quantify that? And then: what do you expect for free cash flow for the full year excluding items?

Mike Keane

Hi Adam. First of on the restructuring, we expect the charges to stop after the end of the fourth quarter. At the end of this year we will be essentially done, because these are small amounts that fall into the first quarter but we really don't expect it up next year, but we don’t expect it this time. In terms of free cash flow you have to combine the two years. So, basically: if you take our net incomes for both years and calculated at times 80% to 90%, that will give you the free cash flow over the two years combined. That’s what we expect to be in that range.

Adam Frisch - UBS

Okay. And then

Mike Laphen

And that excludes restructuring.

Adam Frisch - UBS

Got it, okay. And then just a quick follow-up on Covansys: how much is that adding per quarter and for fiscal '08 in general -- in total rather?

Mike Keane

Well it added about, it was 3% of our growth in terms of the second quarter.

Adam Frisch - UBS

It's about $40 million or so from that ballpark there?

Mike Laphen

No, that’s low; it’s about $130 million.

Adam Frisch - UBS

Yeah about a $130 million, okay. You see the one there. Okay, thank you.

Bill Lackey

Next question please operator.

Operator

We'll go next to George Price with Stifel Nicolaus.

George Price - Stifel Nicolaus

Thanks very much. I am sorry, maybe you got to it and I missed it, but Mike: what was in the first half of the year? And: if you can break it up by quarters: What was the restructuring impact to cash flow? Because that's all -- that's not been removed from the 676, correct?

Mike Keane

That’s correct.

George Price- Stifel Nicolaus

And: did you mention it? If you did, I apologize, but: could you repeat it?

Mike Keane

No, I didn’t mention it, but the cash expenditures against the accruals in the first half of the year were about $87 million.

George Price- Stifel Nicolaus

Okay. And: can you give us any sense of your estimation for the rest of the year?

Mike Keane

I think that, basically, its round about the same rate. For the second half year might be a little bit higher.

George Price - Stifel Nicolaus

Okay. And: if I could just ask you just then also to comment may be on the broader discretionary commercial environment? May be U.S. versus Europe? I know that’s a topic I think a lot of people are interested in and thanks very much.

Mike Laphen

The European environment, I am pleased to say, has picked up for us quite nicely both in France and related Belgium and in our, what we call our central market, which as many of you don't know who follows. We've struggled to get there but that has bounced back nicely.

So I would say, of course, Europe, with the exception of Italy; we still struggled a bit there. We're seeing good performance there. North American is -- on the project side, the pipeline has picked up significantly. Most recently, our geographic consulting practices are actually doing about mid-single digit now in terms of growth. So it was a bit slow the last quarter or so, but what we're -- in North America I am speaking now. But it feels better as we're looking forward.

George Price- Stifel Nicolaus

Great! Thank you.

Bill Lackey

Next question, please, operator.

Operator

And we'll go next to David Grossman with Thomas Weisel Partners.

David Grossman - Thomas Weisel Partners

Thanks. Mike: could you help us maybe on the tax rate a little bit? In terms of, understanding: how much of that is a GAAP versus a cash tax rate, going forward as we, kind of, look at it?

Mike Keane

The GAAP rate would be higher than the cash rate outflow. And the main reason for that is a couple of items. One is that in order for an item to be recorded as a benefit it has to reach in more stringent requirement under FIN 48. So, therefore, we have more positions that are reserved against, and, therefore, that raises your accrual rates.

Another reason is that on these positions, reserve positions, you make the assumption as if you're going to lose your position and you accrue the related tax, interest and penalties on that at the same time. And you also assume that if all that occurs that any net operating loss coverage that you’ve had before goes away, so these have a compounded effect. As a result of that it's driving the accrual rate higher.

David Grossman - Thomas Weisel Partners

Can you give us an order of magnitude on the 40% for the year?

Mike Keane

In terms of: relative to cash payments?

David Grossman - Thomas Weisel Partners

Yeah. Exactly.

Mike Keane

Well, its going to be a little lumpy, so basically, we may have a single payment but if I -- that just as a catch up adjustment on some areas we identified which is already fixed into our free cash flows from that. And, but, if I remove that basically we are running a rate that's more cash rate that’s going to run closer to the statutory of about 35%.

David Grossman - Thomas Weisel Partners

Alright. And you give a lot of information on the REAs that are out there, when you could perhaps, it’s, quite frankly, I kind of lost you about midstream: can you perhaps just give us, the thumbnail summary on…?

Mike Keane

Okay.

David Grossman - Thomas Weisel Partners

You had $900 million they have contested, so…

Mike Keane

Okay I’ll give you the Readers Digest version.

David Grossman - Thomas Weisel Partners

Yeah.

Mike Keane

Basically the government, there has two set of programs here, and on both sets of programs the government has denied our claims, this was not a surprise to us, its kind of their first sale though. And, in one of the cases, they actually counter claim, but we don't believe it has much merit or basis. So, that means: we now move on to a litigation phase of the claims and we believe that our position is very strong, very supportive. But what it really does is give us less visibility in terms of timing and completion. At the same time we previously had approximately $1 billion estimate in turns, we previously had approximately $1 billion estimate in terms of claim coverage that we submitted. We've basically scrubbed that and now reduced that down to $900 million number, still accruing interest, which we are not booking. And that’s covering our balance sheet, related balance assets of $825 million.

David Grossman - Thomas Weisel Partners

So: what's the next milestone?

Mike Laphen

This is Mike. Well with respect to the larger program, a large [mod], we expect it to be the first hearing in front of an assigned judge that takes place in the January-February timeframe of '08. At that point the judge has the option to suggest that we and the army move towards alternative disputes resolution process, as its name would indicate an alternative method to full litigation. That will be at the judge’s discretion, so if it goes down that way it could get resolved faster than you would expect it to get resolved under a full litigation.

The second program, we don’t think we will be at that stage and probably until this summer of '08.

David Grossman - Thomas Weisel Partners

Okay, I got it. Great, thanks very much.

Bill Lackey

Next question please operator.

Operator

We'll go next to Rod Bourgeois with Bernstein. Please go ahead.

Rod Bourgeois - Bernstein

Hey guys, just wanted to clarify the free cash flow trajectory. If I understood it correctly: in the first half of the year, your free cash flow was negative $676 million and: is that accurate?

Mike Laphen

That is correct.

Rod Bourgeois - Bernstein

Okay and the restructuring component of that was $87 million?

Mike Laphen

That does not include the $80 million -- $87 million.

Rod Bourgeois - Bernstein

Okay, got it and so, in order to get to a cash flow positive for the year, are you expecting another March quarter where you have a sort of huge cash in flow, for…

Mike Keane

We have got a big hockey stick in the second half of the year.

Rod Bourgeois - Bernstein

Right.

Mike Keane

As we've had traditionally, unfortunately for the last three years or so.

Rod Bourgeois - Bernstein

Alright. And so, given the big ramp that's required, and I know this is an annual “sort of” event for us, but last year’s big event in Q4 was NHS and the milestones related to that deal. Can you characterize the big milestones needed in order to get to your free cash flow target for fiscal '08? Because it’s another one of those big ramp years.

Mike Keane

I think its spread evenly, spread more evenly. Now, there are some milestone payments, but not as exaggerated as they were in the prior year and hopefully not on the last day of the fiscal year as we had last year. So, it's just a matter of many programs spread across both geography and across business units showing basically the positive cash flow in the second half of the year.

Rod Bourgeois - Bernstein

Right. And: does it require DSO's to come down to more normalized levels?

Mike Keane

Yes.

Rod Bourgeois - Bernstein

Okay, got it. And then are you seeing the level of restructuring benefits flow through that you would have expected at this point in the turn around. I mean: it's tough to tell with the financials, but with the negative cash flow, it leaves a question as to whether the restructuring savings are really coming through, but it's tough given some of the noise and the numbers to really figure that out. Are you feeling like its flowing through at the pace you would have expected at this point?

Mike Keane

Yes, as we had indicated earlier. We thought the positive impact would be about $300 million pretax for this year and we’re actually running slightly ahead of that rate in the first half of the year.

Rod Bourgeois - Bernstein

Alright. But: I guess the earnings benefited differently than the, sort of, free cash flow benefit that you are seeing from the restructuring?

Mike Keane

Well, the free cash flow as we've always indicated is going to be extremely lumpy and volatile from quarter-to-quarter. So I don't think you can measure in that regard.

Rod Bourgeois - Bernstein

Okay. Thanks, guys.

Bill Lackey

Next question please, operator.

Operator

And we'll go next to Abhi Gami with Banc of America.

Abhi Gami - Banc of America

Thanks. Back to the REA question: You mentioned that you have the high probability of recovering claim. Is that based on prior situations that are similar to this kind? Can you give some examples? Or: what gives you that expectation that's probably look like those?

Mike Keane

No. Historically, we actually haven't gotten into a lot of claims. We know the facts and circumstances that got us into this position and reflecting on those, as well as having outside council review them thoroughly and go through extensive reviews of the numbers including this, what I'll call, true-up that we just went through. We feel we're well entitled to those funds and we'll fight aggressively for them.

Abhi Gami - Banc of America

But: was the $100 million true-up? Was that more of a specific element within one of the REAs that you determine may not be probably reflected? What was that, kind of, a discounting of probability?

Mike Keane

No, I think it was a general, if you will, scrubbing of the estimate. And, as I indicated, in certain parts of the claim we had estimated numbers and as you bring forward and actually fill those with actual numbers, you get better clarity as to what the amount is. So that's an essence what was occurring.

Abhi Gami - Banc of America

And then just to clarify, you mentioned that earlier you are accruing interest on that, but you haven't actually received any cash against the…

Mike Keane

Well, when I say accruing, it's economic accrual. We're not recording any interest accruals on the claim. But we are -- the clock is running and we are benefiting from an interest accrual now on the $900 million.

Mike Laphen

Yeah, under federal procurement rules, under any kind of claim situation like this, if the claim is found to be valid we are entitled to accrued interest from the date that we filed claim.

Abhi Gami - Banc of America

That's all, thank you.

Bill Lackey

Next question please Operator.

Operator

We'll go next to Eric Boyer with Wachovia.

Eric Boyer - Wachovia

Hi, thanks. You are talking working capital improvements in bringing down DSOs: where can you get them struck really? And: over what time period?

Mike Keane

I think it's a constant effort. Generally, given our business cycle we tend to see that occur in the second half of the year and also you would expect that sometimes that occurs because there are incentives involved for that to happen. But it just so happens that there is a number of our contracts and number of our business flows that tend to have heavier cash usage in the first part of the year. And then there is a turnaround in the second half of the year.

We actually are trying to get that to be more modified and reduce the volatility, but that's not going to occur this year. So, over time, we are pushing for better efficiency in our DSOs, better cash collections. And more importantly away from the working capital, changing our mix of business to be less capital intensive where it is capital intensive, attempting to structure the deal that we recover that capital in a shorter time period, in terms of receipts from our customers.

Eric Boyer - Wachovia

Is there a number that you are targeting as far as DSO?

Mike Keane

Well, we would like to see the DSO in the low 90s. Now remember that number in itself is a higher number for us but it also includes some stagnant amounts that are related to these claims. So there is a large number of receivables there that are not turning and when they do you are going to see that number come down precipitously. But as long as its there in terms of external measurement, we are targeting to get that number down below 90's and we like to go below that.

Eric Boyer - Wachovia

And finally: are you still expecting high-single digit revenue growth for you public sector? And: any thoughts on the government budget process? It’s looking like it’s over now?

Mike Laphen

Yes, we are still expecting high-single digits for our Federal business. We are very gratified that the omnibus bill was signed this week. That will help us significantly on the civilian side of the spectrum. They have been carrying the most pressure, not that there has been pressure across the board. So: yeah, we think that will be quite helpful going forward.

Eric Boyer - Wachovia

Thank you.

Bill Lackey

Next question please, operator.

Operator

We'll go next to Greg Smith with Merrill Lynch.

Greg Smith - Merrill Lynch

Yeah, hi guys. Can you just talk a little more about the Covansys integration? Sort of: what steps you've taken? And: what still needs to come on that front?

Mike Laphen

Well we have integrated both our legacy CSC India resources as well as the Covansys resources within India. So that is integrated as one unit. We are doing all the back office activities that are associated with that. That’s expected to be completed as we roll into the new fiscal year, April 1st. So, that's operating as single organization. And then we have the go-to-market activity that goes along with that led by Raj Vattikuti, who came over from Covansys. So, Raj has both the India direct go-to-market focus whereas, as well as, all of our offshore resources in India. So, he is both a go-to-market organization and at the same time supports the broader CSC on a support basis.

Greg Smith - Merrill Lynch

Okay. And: have you seen retention tick up at all among the legacy Covansys employees?

Mike Laphen

Yes, we've seen a drop in turn over and I don’t want to characterize it as huge, but we’ve, yes we've seen a drop there. So, we're pleased with that as well.

Greg Smith - Merrill Lynch

Okay. Thank you.

Bill Lackey

Next question please, operator.

Operator

We will go next in Tien-Tsin Huang with J.P. Morgan.

Tien-Tsin Huang - J.P. Morgan

Hi, I just had a follow-up on the REA, it’s just to try and better understand: why the government is pushing back on the claims? They were just alleging that they were over charged on our projects and improperly billed? I am just trying to better appreciate that.

Mike Laphen

Yes, I don’t want to get into, given these are going into litigation. I really don’t want to go into too much discussion around all that, not because we're not trying to be transparent. It is going to litigation. I will say that, I think an important perspective here is, we are continuing to perform on both of these programs with both of these customers and I believe and I think you could validate that, we will proceed to be excellent performers on both of those program. So: yes, we have a contractual dispute. We do not, by any means, have a performance dispute. We're performing, as I said, I believe: with excellence. And we're continuing to get new contract work and new contract extensions from both these customers.

Tien-Tsin Huang - JP Morgan

Okay. Great! That's good to know. Then if I could ask something about free cash flow, just: is it reasonable for us to think that you can approach breakeven in free cash flow year-to-date in December? I ask because, obviously, we're pretty close to the end of December here. So some kind of picture there would be helpful.

Mike Keane

Well, I don't think we'd expect it by the end of our third quarter because fourth quarter tends to be a very significant contribution to our free cash flow.

Tien-Tsin Huang - JP Morgan

Okay. Just, as usual, more heavily weighted towards forecast?

Mike Keane

That's correct.

Tien-Tsin Huang - JP Morgan

All right. Thank you.

Bill Lackey

Operator, I think we have time for one more question please.

Operator

Our next question will come from Pat Burton with Citi.

Pat Burton - Citi

Hi. Thanks. My question just relates to the balance sheet. Mike, just briefly, go over the rise in prepaid expense from the March to September period. And then, also, on the liability side the drop in the accrued -- other accrued expenses as well as the deferred revenue.

Mike Keane

Okay. The prepaid is actually a natural phenomenon we have over here. We have a lot of prepaids that occur in the first quarter. And also, within that line item, we tend to have work-in-process included as well and so, one of the large drivers of our work-in-process accounts is the NHS contract. So that's what you're seeing a little bit there.

Also NHS contract tends to affect deferred revenue where we’ve received and from an accounting perspective received advance payments. And we're working against those in recognizing revenue. The reduction in accrued expenses relates to a comment I made earlier, where we had purchased a significant amount of capital expenditures program related towards the end of the fourth quarter and those ended up getting paid for within the first fiscal quarter this year.

Pat Burton - Citi

Okay. So, on the deferred revenue running down: should we read into that then you are hitting more of your milestones?

Mike Laphen

Now, we are on track, we are meeting our estimates to completion and recognizing revenue ratably. So, yes, we are meeting our milestones.

Pat Burton - Citi

Okay.

Mike Laphen

(multiple speakers)

Pat Burton - Citi

Thank you. And congratulations on digging out and get me current.

Mike Laphen

Thank you.

Mike Keane

Thank you, operator. Mike?

Mike Laphen

Yeah, this is Mike Laphen, I just want to say it's great to be back dialoging with all of you. Thanks for joining us today, I apologize for the short notice that we had, but I hope you can appreciate the situation we were in, in terms of trying to get to this point. So thank you for that and I want to extend everybody wish for very, very happy holidays and very healthy and successful New Year. Thank you very much.

Operator

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

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