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Executives

John Lyon - Director of IR

Peter Altabef - CEO

John Harper - CFO

Analysts

Rod Bourgeois - Sanford Bernstein

Abhi Gami - Banc of America

Joseph Vafi - Jefferies & Company

Jim Kissane - Bear Stearns

George Price - Stifel Nicolaus

Ashwin Shirvaikar - Citigroup

Susan Chen - Merrill Lynch

Perot Systems Corp.(PER) Q4 2007 Earnings Call February 5, 2008 10:15 AM ET

Operator

Good morning. Thank you very much for standing by and welcome to the Perot Systems fourth quarter 2007 Earnings Call. At this time, all participants are in a listen-only mode. And later, we will conduct a question-and-answer session with instructions to be given at that time.

During the course of today's call, Perot Systems will be making forward-looking statements that contain risks and uncertainties. These statements are only predictions and actual results may vary materially. Perot Systems disclaims any intention or obligation to update any forward-looking statements as a result of new information or otherwise. Please refer to the Perot Systems Form 10-K for the fiscal year ending December 31, 2006, for a listing of risk factors that could cause actual events or results to vary from those contained in the forward-looking statements.

Now, I'd like to turn the call over to John Lyon. Please go ahead, sir.

John Lyon

Good morning. Welcome to our fourth quarter Earnings Call. During our call today, Peter Altabef our CEO will review our 2007 accomplishments and how those position us as we enter 2008. And John Harper our Chief Financial Officer will provide a review of our financial performance and forecast.

Before we get started, let me remind you that in addition to our press release, we have placed a downloadable financial summary for your convenience in analyzing our financial results at perotsystems.com.

In addition, we will refer to certain non-GAAP financial measures today. Free cash flow is a measure we use to assess the net cash production of our operations including long-term and short-term capital and is calculated as operating cash flows plus the capital expenditures.

Organic revenue growth is a measure of our pre-acquisition revenue growth and is calculated by taking total revenue growth plus the revenue growth contribution from acquisitions completed in the past 12 months. The information necessary to calculate these measures is available in our earnings press release. Once again, I want to thank you for joining us. I'll now turn the call over to Peter.

Peter Altabef

Thank you, John. Good morning. And thank you for joining us. In my review today, I will provide a look back to some of our major 2007 accomplishments and how those position us for a good start to 2008. I will also provide you with visibility and to what we are seeing in the market today.

In 2007, we made significant additions to our capabilities that strengthen our competitive position and better prepare us to capture new areas of demand in healthcare and government services. We also continue to strengthen our solutions and build a leadership position in the commercial developing markets we are targeting.

Within healthcare, our ability to revolve with the means of the market has us entering 2008 with the comprehensive suite of solutions, including IT outsourcing, clinical transformation, system development and hosting, revenue cycle solutions for both hospitals and physicians, claims processing and health benefits, administration services and software.

We can deliver our solutions locally or using our low cost global delivery model. Global delivery is increasingly being adopted by our healthcare clients, and we are well prepared as the market leader to provide healthcare IT and business process outsourcing solutions to a wide range of clients both large and small.

An area of growing demand within healthcare is the community health system market, where our acquisition of JJ Wild complements our existing suite of solutions, while there are approximately 1000 hospitals in the large heath system market in the United States there are approximately 5000 hospitals in the community space.

This community market is reaching the point where market forces including competition and pay-for performance are creating a greater need for operational savings and advance clinical information systems.

This need is resulting in increased community health system activity within our sales pipeline. We also believe that clinical software platform upgrades will create an increased need for services.

The healthcare market in 2007 did not contain the number of larger deals that we have seen in the past while the market for large deals is still lighter than we have traditionally seen. We believe that over time the market for larger deals will pickup.

In light of these dynamics our decision last year to expand our community health system offerings and capabilities, was clearly the right one. We have a very healthy pipeline of smaller to mid-sized deals and the interest in that market is accelerating.

We believe that in the in the aggregate 2008 will be a good year for healthcare sales and that the nature of transactions will allow us to reach normal profitability levels for those deals faster.

Evaluating market conditions and evolving our solutions to meet changing healthcare industry demands has been critical to our success and growth.

We have added clinical solutions, federal government healthcare, globally delivered services and revenue cycle management to our provider offerings while also adding solutions for consumer directed healthcare, Medicare Part D and administrative processing to the payor market.

Two new areas that we see growing demand are physician services and international demand for our healthcare offerings. Our solutions for physician practices includes deployment of electronic medical record solutions and revenue cycle services that helps to streamline the billing and cash cycle thereby accelerating cash flow.

Internationally, we are seeing interest in adopting electronic medical records which has resulted in the expansion of our addressable market.

As we move into 2008, our healthcare revenue should reach a floor in the first quarter as the Triad relationship transitions from an outsourcing focus to a project services focus. Based on the sales opportunities we have, we expect healthcare revenue to expand sequentially from there.

For government services, 2007 was a year where we rounded out our capabilities through the acquisition of QSS, added key government wide acquisition contracts and one contracts value to $692 million of total value. That will result in an accelerated rate of organic growth in 2008.

The EDUCATE contract was an important contributor to our new sale success in 2007. This was our fifth award at the Department of Education over the past three years and our largest to date. Under this contract we have significant responsibility for department information technology, which enables our client to focus on its core mission of providing educational services to students, parents, and teachers without the added burden of also managing IT and other non-core services.

We are very pleased that the level of service we have provided and the responsiveness we have demonstrated has consistently created new opportunities for us with this as well as other clients.

With approximately 70% of the total contract value we signed in government services occurring late in the year. We have a backlog of signed business that will boost revenue beginning in the first quarter.

Our ability to build on this base of backlog will be benefited by developing the contract vehicles that we have added over the past two years into a new source of revenue. Task order activity in certain areas of the Department of Defense, civilian areas, and the Department of Homeland Security is good and would fall with in existing contract vehicles. From our macro Federal Government spending perspective, the budget environment seems stable for the programs we have in our target. With the traction gained in 2007, and the opportunities in 2008, we expect government services to produce solid growth in 2008.

Our commercial areas ended 2007 on a strong note. Outside the loss of UBS, which causes a reported decrease in our commercial revenue year-to-year, this area continues to post very solid growth, 14% year-to-year this quarter.

The growth we are producing in this area is balanced between new clients and existing client expansion. As we move into 2008, the pace of commercial new sales continues to be good while the strategic initiatives we are implementing in our developing focus areas are better positioning us to capture growth and build market leadership positions.

Within our life insurance policy administration business, we grew policies that we administer by 31% in 2007, while expanding our processing capabilities to include a wide array of insurance products.

As we enter 2008, a growing base of clients and contracts reaching their operational phase has set the stage for a good year of revenue growth.

For product engineering, global expansion is a priority, as our clients are taking us to new geographies. Our global collaboration center facilitates this expansion through its workforce push technology. We expect both of these developing areas to grow by more than 20% in 2008.

Turning to our low cost delivery capabilities, low cost global delivery is increasingly becoming an integral part of our outsourcing contracts. Global delivery is a way for us to help our clients reduce the expense of their technology operations in a seamless and transparent manner.

It has become a central part of our delivery model for all non-government services. With prospective clients responding well to our integrated globally delivered solutions, we continue to expand in this area.

We added two new delivery locations, Mexico and the Philippines, into production in 2007. And we grew our headcount in lower cost geographies by 16% for 2007, with these areas representing more than 50% of our headcount growth last year.

At year end, one third of our headcount comes from our low cost global delivery operations. Even more importantly, over 85% of our largest 25 non-government clients now use our global delivery capabilities. This is an exciting time for us and the opportunities for expanding these areas in 2008 are significant.

With the potential for a weakening economy, I thought it would be useful to review our revenue mix with you. With approximately 70% of our revenue coming from the healthcare industry and the federal government, our exposure to the effects of an economic slowdown is limited. These two areas have proven to be relatively well insulated from the downturn of past economic slowdowns.

Of the remaining 30% of our revenue outside of healthcare and government services, approximately 1.5 or 15% of our consolidated revenue comes from secure contractual backlog. We have not seen significant deterioration in the remaining 15% of our work that is more discretionary in nature.

We have a relatively modest exposure to the financial services market with approximately 7% of our total revenues of which approximately two thirds is more discretionary and primarily offshore focused.

We believe that we may have an opportunity to expand our revenue in this space in the current climate. Although, we are starting to see the beginnings of a more intense pricing pressure in some of the financial services areas.

In addition to understanding the cyclical demand characteristics of our revenue, I think, it is important to understand that each economic slowdown may have a different impact on IT services.

For example, as we entered the last recession, discretionary IT spending was at an all time high. This investment was partially driven by dot com companies and partially as a defensive spend by traditional companies reacting to dot com start ups.

In some cases, it was speculative and associated with new venture oriented projects. It was not necessarily return oriented spending. When the economy slowed, there was a significant pullback in this discretionary investment.

Today, discretionary investment appears to be much more focused on return oriented projects. In addition, our revenue mix is substantially different than it was at the time of the last recession. As I said a moment ago, approximately 70% our revenue comes from markets less affected by economic slowdown, whereas only 25% of our revenue came from these markets when the effects of the last slowdown began.

At the time of the last recession, we were much more exposed to general project work and industry is hit hard by the economic downturn.

Finally, it appears that CIOs and others in client decision making roles are increasingly looking at outsourcing as an opportunity to cut cost and become more competitive. Our solutions health plans become more efficient, reduce costs and improve productivity. All of which should appeal to buyers in the current economic climate.

I want to stress that within IT services, there is no such thing as being recession prudent. However, we believe that we are well positioned if the economy continues to slow. As it is, however, client investment continues as we enter 2008 and our business is in fact strengthening.

To summarize, where we are as we enter 2008, our strategic initiatives in sales and cost optimization actions have put us on a good footage and our business is positioned predominantly in growing industries with the substantial amount of our revenue coming from markets that are relatively well insulated from an economic downturn.

I want to thank you for joining us and John Harper will now detail on our financial performance and forecast. John?

John Harper

Thank you, Peter. Good morning. Welcome to our fourth quarter earnings call. Overall, the fourth quarter was a positive step forward. Our results and discussions with our client and prospective clients provided us greater confidence in the overall market environment and our ability to grow earnings in 2008.

Before I provide the detail reviews of our financials, let me summarize the impact of the Triad termination-related benefit and the cost actions.

In the fourth quarter, we realized revenue of $59 million, pre-tax profit of $46 million and earnings per share of approximately $0.23. This is consistent of a termination fee of $26 million and the recognition of previously deferred contract revenue and cost of $33 million and $13 million respectively.

The revenue was higher than our guidance. This was not an economic change but rather the change to how we ultimately booked the previously deferred amounts.

With respect to our cost actions, we incurred severance expense of $18 million or approximately $0.09 per share which was $2 million or $0.01 per share less than expected.

We continue to expect approximately $34 million of savings next year with approximately one half of these savings being reinvested into our business. Combined these two items contributing net $0.14 benefit for the quarter, which was slightly higher than our guidance.

After adjusting for these items, our revenue was stronger than expectations and our earnings were in line with the expectations. Off-shore projects, new sales and cost containment contributed to stronger revenues and profits, and the result of the profit improvement, there was a course filing increase to annual incentive compensation.

Turning to review our sequential performance, revenue increased from $655 million to $732 million. In addition to the Triad impact, the major drivers of sequential revenue growth or community hospitals predominantly through the acquisition of JJ Wild, new sales within industry solutions and government severances and increased projects from our consulting and application solutions grew.

For the quarter, we reported earnings per share of $0.35. From a sequential earnings perspective, the new sales that produced are revenue upside, also produced incremental profits.

As you know, this is not always the case in outsourcing contracts, whether it's typically profit pressure in first year. We also had an SG&A benefit in the quarter, which was driven primarily by the cost reductions, the timing of sales per suite expense and the general cost containment, partially offsetting this earnings benefit was an increased incentive compensation expense and expected seasonal pressure within consulting and application solutions.

Keep in mind that with our consulting and application solutions unit, we added a significant number of new hires in the fourth quarter and also have fewer working days. With another quarter to monitor the state of the market, our view is more positive than it was 90 days ago. The few decreases to projects that we discussed last quarter appear to be more related to clients' specific directions rather than an early sign of a changing market.

With one of our contracts where project work decreased last quarter, the changes in the clients operating strategy is actually creating a new opportunity for us. We are currently working on a new contract with this client that will expand the scope of our contract and extend for a longer term.

From a new major contract sales perspective, the fourth quarter was a good ending to another good year. We posted fourth quarter total contract value signed of $555 million, bringing the full year to $1.8 billion.

The contribution to fourth quarter new contract signings was broad and balanced across the company. Healthcare group sales consisted of IT outsourcing, international expansion and BPO. Our commercial areas contributed a major BPO contract while continuing a healthy pace of IT outsourcing wins.

Our government services unit posted yet another Department of Education win in the forth quarter, while also winning new business under our ITES2 contract vehicle with the US Army.

As we looked into the first quarter, we are starting the year on a good note. We are on target with our financial plan and are looking to report first quarter year-to-year growth and revenue between 13% and 15%.

Earnings per share between 11% and 21%. Operating margin expansion between 50 to a 100 basis points. For the first quarter, we expect revenue to range from $655 million to $680 million. On sequential fourth quarter to first quarter basis, we will experience a reduction in revenue related to our forward Triad contract now our CHS relationship of approximately $70 million, $59 million of this reduction is related to the fourth quarter termination related revenue. All the remainder is associated with us transitioning from the outsourcing contract to the project services relationship.

In addition, we expect a sequential revenue contribution from new sales within industry solutions and government services. With respect to earnings, the net fourth quarter benefit of $0.14 will now recur in the first quarter which puts us on a base of $0.21, as we enter the first quarter.

From this space, we see sequential earnings per share growth of up to $0.02. This potential growth comes from the net effects of the following items. These sales have been industry solutions and government services and increase to account profits within industry solutions and the full quarter effect of the cost actions we implemented in the fourth quarter.

These benefits will be partially offset by three items. First, reinvestment of the cost savings action, as I discussed a moment ago, second a due large outsourcing contracts that we're signed late in 2007, will still be ramping. Once we get past the first quarter, we don't see new outsourcing contracts causing additional earnings pressure and third, an increased SG&A going into the first quarter at the level of fourth quarter SG&A, its not sustainable long-term.

For the first quarter, we expect earnings per share to range from $0.21 to $0.23. This level of earnings per share represents a year-to-year increase between 11% and 21%. From a margin perspective, we expect to enter 2008 with an operating margin slightly north of 6.5%.

As we look at our business fundamentals, the potential we have to grow earnings and the pullback in the broad markets are centered in our stock. We believe that repurchasing our stock is an excellent use of cash.

Since our last earnings release, we repurchased approximately 3% of our Class A Common Stock at an average price of $13.33. We used $51 million of cash for this repurchase of which $47 million is included in our fourth quarter financial statements. The remainder will settle in the first quarter.

For 2007, we ended the year with the $187 million of cash and $23 million of short-term investments. Fourth quarter free cash flow was $74 million. We ended the year with debt of $219 million. With our financial position, the level of cash reduction we expect in 2008 and current valuation levels we are prepared to continue stock repurchase activity.

From a capital expenditure perspective, our requirements have significantly decreased following the completion of a major data center expansion initiative that was completed mid-2007.

For the fourth quarter, capital expenditures were $9 million or 1.2% of revenue. In 2008, we expect capital expenditures to be in line with our long-term target of 3%. Consistent with the past, we are not deploying significant amounts of capital into our outsourcing contracts.

When prospective clients request and assets heavy contracts we work hard to educate them on the cost of transferring these assets and capital typically comes out of the contract. This results in higher quality contracts that produce better returns for us and a lower overall cost for our clients.

Overall, our business is moving in the right direction, but we have more work to do. For two quarters in a row, we have expanded our operating margin. We believe, we are positioned to meet our operating margin target for 2008. So, market environment appears stable, although, we remained cautious.

Lastly, our sales pipeline contains very good opportunities for expansion in 2008. I thank you for joining us. We will now answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from the line of [Rod Bourgeois] with Sanford Bernstein.

Rod Bourgeois - Sanford Bernstein

Hi guys, I just wanted to first ask about some of your thoughts about your revenue growth for 2008. As you pursue the smaller deal healthcare market, what kind of growth do you see coming out of that initiative and how long will it take to ramp it up? And then, I guess, the second part of the question, I'll go ahead and throw out now is, is to what extent do you anticipate investment requirements and execution hurdles as you pursue more aggressively this small deal healthcare market? And so, part A is, what is the growth prospects? And part B is, how much will it cost to get there?

Peter Altabef

Rod, thanks for the question. I'll actually start the answer and then I'll hand it over for John as well. The community health system market for us, and I do want to stress this is not new. So, we have been working with smaller health systems for several years. They tended to be overlooked because you have these giant TCV deals, but it is something that we are used to doing and we have got knowledge of the market. We had added to our capabilities in that market. So for instance we have traditionally had significant capabilities on the clinical implementation side or on Epic and McKesson and Cerner and we now added Meditech significantly with the acquisition of JJ Wild.

The other thing that JJ Wild gave us last year was really an immediate familiarity with a host of hospital systems that we simply were not at before. So, from a sales pipeline standpoint, it really opened up our ability to have immediate access to a lot more clients. But the services we were providing around IT, around infrastructure work, around revenue cycle, and around administrative work were all services we'd actually already provided to what we call community hospital environments.

So, I want to stress, what happened last year is, we got access to more faster and we got some more capabilities with the Meditech focus, but it is not brand new stuff. And I think that means that we feel pretty good about the pipeline and our ability to close these and as you pointed in your question, our ability to do these successfully.

Our track record in healthcare outperforming against pro forma models on the community health systems side is frankly much better than our track record on the large health system side.

So, all-in-all, we feel very good about where we are positioned right now. And now, I will turn it over to John.

John Harper

Right, two follow ups to that. At first, you asked about capital intensity, we don't see any greater level of capital intensity going into the community space. Probably less so than these large deals. That doesn't mean there isn't some, but those are things that we fund with internal kind of normal course stuff.

So, there is no big pressure there in terms of capital intensity. In terms of where revenue is going for the year, obviously we do have some unfavorable comparisons because of the loss of Triad, I mean you are looking at $59 million the one-time, that's in 2007 and in addition, our revenue will be somewhere in the $70 million less in 2008 than it was in 2007 because of the loss of the recurring contract.

So, that puts us on a pace entering 2007 of about $2.6 billion in revenue. We think the first quarter as Peter noted in his remarks will be a floor for us and we think we will build sequentially from there. If I were looking forward to axing the year, we're probably axing the year on annual run rate that would get us to about $2.9 billion in revenue, where we exit the year.

Rod Bourgeois - Sanford Bernstein

Alright, that's very helpful. If you exit the year at $2.9 billion and as you move into these smaller healthcare deals. The smaller deals, are they going to be accretive to your margins in the early stages of that market pursued, or is there margin pressure as you try to ramp up that practice?

John Harper

Rod, I think, $2.9 million is an annual run rate as we exit the year.

Rod Bourgeois - Sanford Bernstein

Understood.

John Harper

If we're going to be $2.9 for the year. And to your second part of that question, or your second question is, they tend to be much more accretive to margins early on. Some of the very large deals as you know create pressure early in the last cycle. Here, we are seeing greater profitability and greater profitability early.

Operator

Your next question will come from the line of Abhi Gami with Banc of America.

Abhi Gami - Banc of America

Hi, thanks. Just a quickly follow-up on the last comment, when you say there's greater profitability in the smaller deals or smaller size of deals, can you give us a magnitude of difference, are we talking about hundreds of basis points or smaller margins?

John Harper

Well, each deal takes a life its own. And I don't want to characterize the size of our small deal margin versus large deal margins but in many cases they can be significantly more profitable. So, I think it's a safer execution model and it tends to be more profitable and the last point it tends to be more profitable early.

Abhi Gami - Banc of America

Okay, great. And then, on the same veins a couple of JJ Wild questions first of all, the $21 million of revenue a little bit lower than the historical run rate of this last 12 months revenue ran rate of the business is that just seasonal or was there some kind of one-time drop-off as you took over business? And then also, if you can talk about any results get from cross sale of your services into JJ Wild customer base is the too early to see those benefits?

Peter Altabef

Well, I guess, let me speak to the second question first and let John speak to the first about the revenue number in the fourth quarter. We are seeing, as I said one of the things that JJ Wild does give us is access to a larger number of relationships that we've had in past.

One of things we are adding to with the traditional JJ Wild set of service in those hospitals is hosting services, IT infrastructure services as well as some other BPO services. It is still at the relatively early stage or the first rule with these acquisitions as you don't break them and we have certainly not done that. But the pipeline and the level of interest from those hospitals is, I would say better than we anticipated and we had pretty decent expectations going in.

We are very encouraged by the marketplace, this community marketplace, we think really is right for adoption of some of the more clinical solutions that have already been adapted in some of the larger health systems. So, the percentage, if you will of adoption in the community side is lower than at the large health system side. And JJ Wild is providing us with cross selling opportunities into that marketplace.

John Harper

And on the fourth quarter results, that was seasonal impact and if you look at our model that we have build for, we were right where we expected to be.

Operator

Your next question will come from the line of Joseph Vafi with Jefferies & Company.

Joseph Vafi - Jefferies & Company

Hi gentlemen, good morning. Good results. I wondered if we could talk a little bit more, I think John you kind of give us a little bit of a view into the run rate here on revenue and maybe you could just describe maybe some driver for margin expansion as you see it in '08 versus '07, especially for focusing on maybe some smaller community hospital deals and the troughing out here of the Triad deal in Q1, how we might look at margins as we move through the year here?

John Harper

Well, thanks for your question. In terms of margin expansion, again, I want to step back to the third quarter and we shift margin expansion in the third, margin expansion in the fourth. We expect margin expansion going into the first and we think we are in a position to continually to expand margin in 2008.

So, while I think the first quarter will be a forward for revenue, I don't expect it to be a gross margin or I mean I'm sorry, operating margin I think we'll continue to progress from there depending on what the results are for the first quarter? So, we do have good margin expansion opportunities as we move into 2008.

Joseph Vafi - Jefferies & Company

Okay. Just kind of following up on that, you said that you are kind going to have a floor, or I am sorry the Q4 SG&A run rate was a little bit unsustainable, is there, what kind of an investment do you think you need in your infrastructure and sales engine to be at what you consider to be the right level here for '08?

John Harper

Moving into first quarter, as we said, the fourth quarter was a little low, I think, moving into the first quarter, you are looking more than that 10.5% range. So, you will see a pickup there. Some of the investments, are additional investments in sales per suite, and some of the investments were making into training, and quality programs. So and I don't know if Peter wants to add anything to that, but…

Peter Altabef

Yeah. On the technology side, Joe, thank you for your comment about the earnings performance as well. On the technology side, as I mentioned on the hospital side, you see an increased focus on hosting for those community hospital. So, you have got investment there. You also have investment in virtualization and what I would consider kind of around the corner computing technologies. We are very focused on making sure that we have a competitive infrastructure offering going forward. So, we are continuing to invest on that side of the table, which is why you are seeing that 3% number for the year.

Operator

Your next question will come from the line of Jim Kissane from Bear Stearns.

Jim Kissane - Bear Stearns

Thanks. I just want to reconcile some things on the margins. And then not to harp too much on the margins, but I think earlier you had been targeting 7% operating margin on year end '08 and John, I think you'd said on the call toady 6.5%. So, just giving some of the comments on the healthcare margins expanding, if you can reconcile that?

John Harper

Well, let me, what we say is, we reported operating margins in the fourth quarter at 6.5% and going into the first quarter, we expect that margin to expand again sequentially. And we think from that base of margins in the first quarter, we think we expand again, we have the opportunity to continue to expand margin throughout 2008.

Jim Kissane - Bear Stearns

Okay. So…

John Harper

I am sorry.

Jim Kissane - Bear Stearns

Okay. It was not 6.5% for year-end '08?

John Harper

No.

Jim Kissane - Bear Stearns

Then I heard incorrectly. Okay. And then…

John Harper

Again, just going back, again to kind of our traditional review or traditional view is that we see ourselves on a path year-on-year, calendar year to calendar year of increasing margins to 50 to 100 basis points. And so, we see that has kind of our path and we are doing that. One of the things I do want to point out, as I know everyone is aware, we discussed in the third quarter earnings call, we did not have a great year in '07 around incentive compensation. And that was, if you will a tale off from the loss of UBS, the UBS infrastructure contract going away. We all knew that incentive compensation could be challenged in '07 and it was.

We were able to increase some incentive compensation in fourth quarter, and that was good. But we continue, we are planning to continue to increase incentive compensation into '08 to get us back to, if you will a normal level of incentive compensation. So, you've got that factor to also deal with.

Jim Kissane - Bear Stearns

Okay, perfect. And Peter, it sounds you're somewhat more upbeat about the federal business than you've been probably over the past three quarters. What's changed there and I think you had said, you expect a solid organic growth in '08. Can you put some definition around what you mean by solid?

Peter Altabef

Yes. I can refer to John and see how much definition he is willing to give you around solid. But we're more bullish about the federal government business. We had a very strong last several months in the federal government space with closings. As you saw we had almost $700 million of TCV closing in the federal space last year, the vast majority of that was at the tail end of the year.

And so, that has really positioned us, one of our concerns last year was, as you know, we were expecting sales and they were deferring, deferring and at some point you’re not willing to go out there and say they’re going to come in, they came in, in the last half of the year- the last several months. And so, just from a run rate basis and from revenues we’ve already booked, we see some pretty significant revenue upside in the government space and we think the pipeline is also good.

The areas that we are focusing on when you again, the President Bush’s budget only came out yesterday and who knows, if they will actually get anything passed anywhere close to what he is requesting, but when you look at those areas of emphasis and you look at the other areas where we expect technology to be increasing in 2008 we think we’re pretty well positioned for all of those.

John Harper

And, Jim, just a follow-up on what Peter is saying we are little more bullish on the government services market this quarter. What we saw was an environment that was relatively stable. There were some budget pressure out there, but you didn’t see the large program reductions, and again, we’re upbeat about moving end of the quarter. We think, the first quarter, we think we got the opportunity for non-sequential growth moving into the first quarter and as Peter said we got real nice pipeline.

Peter Altabef

That said what make us more bullish right now is the fact that we’ve already, if you will booked some nice revenue growth. I will say the QSS acquisition, which we made in January of last year has really positioned us where we wanted to be. The contract vehicle that we were able to acquire was QSS, really are what we needed to build that platform.

So for instance the ITES vehicle already last year substantially increased our revenues with the army and we think that we have a good opportunity to continue to increase our army business substantially this year. Around homeland security, the aligned contract and the aligned vehicle will continue to help us in the Coast Guard, and of course as you know, we are one of the subcontractors to Boeing in the SBI net initiative. And that initiative did not progress as we had thought it would last year. One of the disappointments of 2007 government was the lack of progress in the SBI initiative. If you look at President's Bush budget for that he submitted yesterday, you see substantial increase in SBI net spending. And then finally on the civilian side, both the opportunities in NASA and with the Department of Education and things that we are pretty excited about.

Operator

(Operator Instructions). Your next question will come from the line of George Price with StifelNicolaus.

George Price - Stifel Nicolaus

Thanks very much. Some good numbers. Just wanted to first of all, step back for a second, just make sure I'm clear on some of the puts and takes going into '08, what's the Triad headwind in '08 versus '07 in terms of revenue, $70 million all end?

John Harper

Okay, well you've got the $59 million onetime.

George Price - Stifel Nicolaus

Right.

John Harper

And roughly $70 million reduction from the loss of the recurring outsourcing contract.

George Price - Stifel Nicolaus

So those were not exclusive, those were together, items together?

John Harper

Correct.

George Price - Stifel Nicolaus

Okay. And then what's the anticipated level of project work in '08?

John Harper

In terms of the new CHS relationship?

George Price - Stifel Nicolaus

Correct.

John Harper

We are doing project work for them. At this point it is not a material number.

George Price - Stifel Nicolaus

Okay. Is that, what are your thoughts on the outlook of that relationship.

John Harper

Well, we are encouraged. I will let Peter comment on it, but they are excellent organization working well with them and as I said currently they are at high. We are doing project work with them.

Peter Altabef

There as we mentioned, on the last couple of calls, their operating philosophy is very clear. They have been very clear with us, in terms of their desire to operate their infrastructure and to the lions share hold that work. So it really will be an opportunity for us to incrementally grow project work, but as John said, it is not a material or significant amount of work.

George Price - Stifel Nicolaus

Okay.

Operator

Your next question will come from the line of Ashwin Shirvaikar from Citigroup.

Ashwin Shirvaikar - Citigroup

Hey guys, nice quarter.

Peter Altabef

Thank you, Ash.

Ashwin Shirvaikar - Citigroup

Question I have is, in terms of your free cash flow expectations going forward, what's the ratio of free cash flow to net income that you are shooting for in 2008 as you net out higher comp CapEx, the changeover is to a smaller sized contract make and so on?

John Harper

Thanks for the question. In 2008, we are looking for free cash flow that normalized to our traditional 80% to 90% net income level.

Ashwin Shirvaikar - Citigroup

And what are the puts and takes that go into that. What kind of investments do you need to make and so on?

Peter Altabef

Well, we don’t, necessarily need to make investments. We are looking at a lowering, a relatively small lowering of the DSO's going into the year. We will be paying off 2007 bonuses and that is a smaller amount that was last year. So, those are some of the puts and takes in terms of getting that backup just mechanically working through some of the changes in the balance sheet account. But we expected it to normalize back to our traditional cash flow level.

Ashwin Shirvaikar - Citigroup

Okay. And could you update us on your non-India offshore investment, where do you stand and what more remains to be done?

Peter Altabef

Our delivery platform if you will ask at this point is, is pretty stable. It is, India is a lions share. As you know we have four facilities there that are up and running and actually looking at expanding that number. We fill out that capability with the Philippines, Mexico and Romania.

And we think those four countries provide a very solid base for us. We will constantly review that and see if we want to move into additional, if you will delivery platform areas. But we think recovery time zone is very well and we're building scale. So, we're focused on those four facilities and four countries right now.

I will say, we've been very encouraged by what we've seen in Mexico. We've got, just an outstanding workforce there and that is really providing us some very good near shore coverage for North America and of course Romania is doing equally well in Europe, although from a smaller scale.

Operator

Your last question comes from the line Susan Chen with Merrill Lynch.

Susan Chen - Merrill Lynch

Thank, nice quarter. Can you comment on your line the application solutions business, do you expect growth in 2008?

Peter Altabef

I am sorry. Could you repeat the question?

Susan Chen - Merrill Lynch

Sorry. Can you comment on the application solutions business? And do you expect growth in 2008?

Peter Altabef

Yes, we do expect growth in 2008 and as I think John may want to give you some details. We think it performed very well in the fourth quarter of 2007. Our business around application solutions, I believe is kind of migrating. I think as we continue to look at the maturity of that marketplace it's becoming more and more important that we focus sales efforts in those areas to industry domain expertise for the company.

So, what you're seeing around those application solutions teams is a real effort to marry up with, if you will our traditional go to market for our industry solutions teams, because that's where we really think we are going to be able to increase margin in that margin overtime, as we get more, if you will focused on domain solutions rather than more horizontal applications offerings. So I think we are in a period of migration there, but while we're migrating to that focus? We are performing pretty well and I let John discuss that.

John Harper

And in the quarter 24% growth year-over-year, 73% growth in that internal channel as Peter spoke about, cooperation between the business units there and that really becoming increasingly an aligned with those units. And our consulting group was up sequentially as well, about 12%. So, very solid quarter, out of the consulting and application services group.

Susan Chen - Merrill Lynch

Thank you.

Operator

That ends the Q&A portion of the call. Peter Altabef will now make his closing remarks.

Peter Altabef

Thank you. I again want to thank everyone for spending their time with us on this call. I hope we were able to give you some insight beyond the published numbers into what we are doing and where we are headed. I want to encourage you to take a look at the downloadable that we put on our Investor Relation site and as always, if you have follow-up questions please don't hesitate to contact John Lyon. Thank you again.

Operator

Ladies and gentlemen, this does conclude the Perot Systems' fourth quarter 2007 earnings conference call. You may now disconnect.

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