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Perot Systems Corp.(NYSE:PER)

Q4 2007 Earnings Call

February 5, 2008 10:15 am ET

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

Operator

Good morning. Thank you very muchfor standing by and welcome to the Perot Systems fourth quarter 2007 EarningsCall. At this time, all participants are in a listen-only mode. And later, wewill conduct a question-and-answer session with instructions to be given atthat time.

During the course of today'scall, Perot Systems will be making forward-looking statements that containrisks and uncertainties. These statements are only predictions and actualresults may vary materially. Perot Systems disclaims any intention orobligation to update any forward-looking statements as a result of newinformation or otherwise. Please refer to the Perot Systems Form 10-K for thefiscal year ending December 31, 2006, for a listing of risk factors that couldcause actual events or results to vary from those contained in theforward-looking statements.

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

John Lyon

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

Before we get started, let meremind you that in addition to our press release, we have placed a downloadablefinancial summary for your convenience in analyzing our financial results atperotsystems.com.

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

Organic revenue growth is ameasure of our pre-acquisition revenue growth and is calculated by taking totalrevenue growth plus the revenue growth contribution from acquisitions completedin the past 12 months. The information necessary to calculate these measures isavailable in our earnings press release. Once again, I want to thank you forjoining 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 tosome of our major 2007 accomplishments and how those position us for a goodstart to 2008. I will also provide you with visibility and to what we areseeing in the market today.

In 2007, we made significantadditions to our capabilities that strengthen our competitive position andbetter prepare us to capture new areas of demand in healthcare and governmentservices. We also continue to strengthen our solutions and build a leadershipposition in the commercial developing markets we are targeting.

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

We can deliver our solutionslocally or using our low cost global delivery model. Global delivery isincreasingly being adopted by our healthcare clients, and we are well preparedas the market leader to provide healthcare IT and business process outsourcingsolutions to a wide range of clients both large and small.

An area of growing demand withinhealthcare is the community health system market, where our acquisition of JJWild complements our existing suite of solutions, while there are approximately1000 hospitals in the large heath system market in the United States there are approximately5000 hospitals in the community space.

This community market is reachingthe point where market forces including competition and pay-for performance arecreating a greater need for operational savings and advance clinicalinformation systems.

This need is resulting inincreased community health system activity within our sales pipeline. We alsobelieve that clinical software platform upgrades will create an increased needfor services.

The healthcare market in 2007 didnot contain the number of larger deals that we have seen in the past while themarket for large deals is still lighter than we have traditionally seen. Webelieve that over time the market for larger deals will pickup.

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

We believe that in the in theaggregate 2008 will be a good year for healthcare sales and that the nature oftransactions will allow us to reach normal profitability levels for those dealsfaster.

Evaluating market conditions andevolving our solutions to meet changing healthcare industry demands has beencritical to our success and growth.

We have added clinical solutions,federal government healthcare, globally delivered services and revenue cyclemanagement to our provider offerings while also adding solutions for consumerdirected healthcare, Medicare Part D and administrative processing to the payormarket.

Two new areas that we see growingdemand are physician services and international demand for our healthcareofferings. Our solutions for physician practices includes deployment ofelectronic medical record solutions and revenue cycle services that helps tostreamline the billing and cash cycle thereby accelerating cash flow.

Internationally, we are seeinginterest in adopting electronic medical records which has resulted in theexpansion of our addressable market.

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

For government services, 2007 was a year where we rounded out ourcapabilities through the acquisition of QSS, added key government wideacquisition 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 animportant contributor to our new sale success in 2007. This was our fifth awardat the Department of Education over the past three years and our largest to date.Under this contract we have significant responsibility for departmentinformation technology, which enables our client to focus on its core missionof providing educational services to students, parents, and teachers withoutthe added burden of also managing IT and other non-core services.

We are very pleased that thelevel of service we have provided and the responsiveness we have demonstratedhas consistently created new opportunities for us with this as well as otherclients.

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

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

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

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

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

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

For product engineering, globalexpansion is a priority, as our clients are taking us to new geographies. Ourglobal collaboration center facilitates this expansion through its workforcepush technology. We expect both of these developing areas to grow by more than20% in 2008.

Turning to our low cost deliverycapabilities, low cost global delivery is increasingly becoming an integralpart of our outsourcing contracts. Global delivery is a way for us to help ourclients reduce the expense of their technology operations in a seamless andtransparent manner.

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

We added two new deliverylocations, Mexico and the Philippines,into production in 2007. And we grew our headcount in lower cost geographies by16% for 2007, with these areas representing more than 50% of our headcountgrowth last year.

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

With the potential for a weakeningeconomy, I thought it would be useful to review our revenue mix with you. Withapproximately 70% of our revenue coming from the healthcare industry and thefederal government, our exposure to the effects of an economic slowdown islimited. These two areas have proven to be relatively well insulated from thedownturn of past economic slowdowns.

Of the remaining 30% of ourrevenue outside of healthcare and government services, approximately 1.5 or 15%of our consolidated revenue comes from secure contractual backlog. We have notseen significant deterioration in the remaining 15% of our work that is morediscretionary in nature.

We have a relatively modestexposure to the financial services market with approximately 7% of our totalrevenues of which approximately two thirds is more discretionary and primarilyoffshore focused.

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

In addition to understanding thecyclical demand characteristics of our revenue, I think, it is important tounderstand that each economic slowdown may have a different impact on ITservices.

For example, as we entered thelast recession, discretionary IT spending was at an all time high. Thisinvestment was partially driven by dot com companies and partially as adefensive spend by traditional companies reacting to dot com start ups.

In some cases, it was speculativeand associated with new venture oriented projects. It was not necessarilyreturn oriented spending. When the economy slowed, there was a significantpullback in this discretionary investment.

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

At the time of the lastrecession, we were much more exposed to general project work and industry ishit hard by the economic downturn.

Finally, it appears that CIOs andothers in client decision making roles are increasingly looking at outsourcingas an opportunity to cut cost and become more competitive. Our solutions healthplans become more efficient, reduce costs and improve productivity. All of whichshould appeal to buyers in the current economic climate.

I want to stress that within ITservices, there is no such thing as being recession prudent. However, webelieve 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 infact strengthening.

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

I want to thank you for joiningus 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 apositive step forward. Our results and discussions with our client andprospective clients provided us greater confidence in the overall marketenvironment and our ability to grow earnings in 2008.

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

In the fourth quarter, we realized revenue of $59 million, pre-taxprofit of $46 million and earnings per share of approximately $0.23. This isconsistent of a termination fee of $26 million and the recognition ofpreviously deferred contract revenue and cost of $33 million and $13 millionrespectively.

The revenue was higher than ourguidance. This was not an economic change but rather the change to how weultimately booked the previously deferred amounts.

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

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

After adjusting for these items,our revenue was stronger than expectations and our earnings were in line withthe expectations. Off-shore projects, new sales and cost containmentcontributed to stronger revenues and profits, and the result of the profitimprovement, there was a course filing increase to annual incentivecompensation.

Turning to review our sequentialperformance, revenue increased from $655 million to $732 million. In additionto the Triad impact, the major drivers of sequential revenue growth orcommunity hospitals predominantly through the acquisition of JJ Wild, new saleswithin industry solutions and government severances and increased projects fromour consulting and application solutions grew.

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

As you know, this is not alwaysthe case in outsourcing contracts, whether it's typically profit pressure infirst year. We also had an SG&A benefit in the quarter, which was drivenprimarily by the cost reductions, the timing of sales per suite expense and thegeneral cost containment, partially offsetting this earnings benefit was anincreased incentive compensation expense and expected seasonal pressure withinconsulting and application solutions.

Keep in mind that with ourconsulting and application solutions unit, we added a significant number of newhires in the fourth quarter and also have fewer working days. With anotherquarter to monitor the state of the market, our view is more positive than itwas 90 days ago. The few decreases to projects that we discussed last quarterappear to be more related to clients' specific directions rather than an earlysign of a changing market.

With one of our contracts whereproject work decreased last quarter, the changes in the clients operatingstrategy is actually creating a new opportunity for us. We are currentlyworking on a new contract with this client that will expand the scope of ourcontract and extend for a longer term.

From a new major contract salesperspective, the fourth quarter was a good ending to another good year. Weposted fourth quarter total contract value signed of $555 million, bringing thefull year to $1.8 billion.

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

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

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

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

In addition, we expect asequential revenue contribution from new sales within industry solutions andgovernment services. With respect to earnings, the net fourth quarter benefitof $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 seesequential earnings per share growth of up to $0.02. This potential growthcomes from the net effects of the following items. These sales have beenindustry solutions and government services and increase to account profitswithin industry solutions and the full quarter effect of the cost actions weimplemented in the fourth quarter.

These benefits will be partiallyoffset by three items. First, reinvestment of the cost savings action, as Idiscussed a moment ago, second a due large outsourcing contracts that we'resigned 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 andthird, an increased SG&A going into the first quarter at the level offourth quarter SG&A, its not sustainable long-term.

For the first quarter, we expectearnings per share to range from $0.21 to $0.23. This level of earnings pershare represents a year-to-year increase between 11% and 21%. From a marginperspective, we expect to enter 2008 with an operating margin slightly north of6.5%.

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

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

For 2007, we ended the year withthe $187 million of cash and $23 million of short-term investments. Fourthquarter free cash flow was $74 million. We ended the year with debt of $219million. With our financial position, the level of cash reduction we expect in2008 and current valuation levels we are prepared to continue stock repurchaseactivity.

From a capital expenditureperspective, our requirements have significantly decreased following thecompletion of a major data center expansion initiative that was completedmid-2007.

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

When prospective clients requestand assets heavy contracts we work hard to educate them on the cost oftransferring these assets and capital typically comes out of the contract. Thisresults in higher quality contracts that produce better returns for us and alower overall cost for our clients.

Overall, our business is movingin 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 meetour operating margin target for 2008. So, market environment appears stable,although, we remained cautious.

Lastly, our sales pipelinecontains very good opportunities for expansion in 2008. I thank you for joiningus. We will now answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Yourfirst question will come from the line of [Rod Bourgeois] with SanfordBernstein.

Rod Bourgeois - Sanford Bernstein

Hi guys, I just wanted to firstask about some of your thoughts about your revenue growth for 2008. As youpursue the smaller deal healthcare market, what kind of growth do you seecoming out of that initiative and how long will it take to ramp it up? Andthen, I guess, the second part of the question, I'll go ahead and throw out nowis, is to what extent do you anticipate investment requirements and executionhurdles as you pursue more aggressively this small deal healthcare market? Andso, part A is, what is the growth prospects? And part B is, how much will itcost 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. Thecommunity 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. Theytended to be overlooked because you have these giant TCV deals, but it issomething that we are used to doing and we have got knowledge of the market. Wehad added to our capabilities in that market. So for instance we havetraditionally had significant capabilities on the clinical implementation sideor on Epic and McKesson and Cerner and we now added Meditech significantly withthe acquisition of JJ Wild.

The other thing that JJ Wild gaveus last year was really an immediate familiarity with a host of hospitalsystems that we simply were not at before. So, from a sales pipelinestandpoint, it really opened up our ability to have immediate access to a lotmore clients. But the services we were providing around IT, aroundinfrastructure work, around revenue cycle, and around administrative work wereall services we'd actually already provided to what we call community hospitalenvironments.

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

Our track record in healthcareoutperforming against pro forma models on the community health systems side isfrankly much better than our track record on the large health system side.

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

John Harper

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

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

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

Rod Bourgeois - Sanford Bernstein

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

John Harper

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

Rod Bourgeois - Sanford Bernstein

Understood.

John Harper

If we're going to be $2.9 for theyear. 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 largedeals as you know create pressure early in the last cycle. Here, we are seeinggreater profitability and greater profitability early.

Operator

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

Abhi Gami - Banc of America

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

John Harper

Well, each deal takes a life itsown. And I don't want to characterize the size of our small deal margin versuslarge 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 andthe last point it tends to be more profitable early.

Abhi Gami - Banc of America

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

Peter Altabef

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

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

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

John Harper

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

Operator

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

Joseph Vafi - Jefferies & Company

Hi gentlemen, good morning. Goodresults. I wondered if we could talk a little bit more, I think John you kindof give us a little bit of a view into the run rate here on revenue and maybeyou could just describe maybe some driver for margin expansion as you see it in'08 versus '07, especially for focusing on maybe some smaller communityhospital deals and the troughing out here of the Triad deal in Q1, how we mightlook 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 quarterand we shift margin expansion in the third, margin expansion in the fourth. Weexpect margin expansion going into the first and we think we are in a positionto continually to expand margin in 2008.

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

Joseph Vafi - Jefferies & Company

Okay. Just kind of following upon that, you said that you are kind going to have a floor, or I am sorry the Q4SG&A run rate was a little bit unsustainable, is there, what kind of aninvestment do you think you need in your infrastructure and sales engine to beat what you consider to be the right level here for '08?

John Harper

Moving into first quarter, as wesaid, the fourth quarter was a little low, I think, moving into the firstquarter, you are looking more than that 10.5% range. So, you will see a pickupthere. Some of the investments, are additional investments in sales per suite,and some of the investments were making into training, and quality programs. Soand 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 thetechnology side, as I mentioned on the hospital side, you see an increasedfocus on hosting for those community hospital. So, you have got investmentthere. You also have investment in virtualization and what I would considerkind of around the corner computing technologies. We are very focused on makingsure that we have a competitive infrastructure offering going forward. So, weare continuing to invest on that side of the table, which is why you are seeingthat 3% number for the year.

Operator

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

Jim Kissane - Bear Stearns

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

John Harper

Well, let me, what we say is, wereported operating margins in the fourth quarter at 6.5% and going into thefirst quarter, we expect that margin to expand again sequentially. And we thinkfrom that base of margins in the first quarter, we think we expand again, wehave 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% foryear-end '08?

John Harper

No.

Jim Kissane - Bear Stearns

Then I heard incorrectly. Okay.And then…

John Harper

Again, just going back, again tokind of our traditional review or traditional view is that we see ourselves ona path year-on-year, calendar year to calendar year of increasing margins to 50to 100 basis points. And so, we see that has kind of our path and we are doingthat. One of the things I do want to point out, as I know everyone is aware, wediscussed 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 fromthe loss of UBS, the UBS infrastructure contract going away. We all knew thatincentive compensation could be challenged in '07 and it was.

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

Jim Kissane - Bear Stearns

Okay, perfect. And Peter, itsounds you're somewhat more upbeat about the federal business than you've beenprobably over the past three quarters. What's changed there and I think you hadsaid, you expect a solid organic growth in '08. Can you put some definitionaround what you mean by solid?

Peter Altabef

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

And so, that has reallypositioned us, one of our concerns last year was, as you know, we wereexpecting sales and they were deferring, deferring and at some point you’re notwilling to go out there and say they’re going to come in, they came in, in thelast half of the year- the last several months. And so, just from a run ratebasis and from revenues we’ve already booked, we see some pretty significantrevenue upside in the government space and we think the pipeline is also good.

The areas that we are focusing onwhen 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 isrequesting, but when you look at those areas of emphasis and you look at theother areas where we expect technology to be increasing in 2008 we think we’repretty well positioned for all of those.

John Harper

And, Jim, just a follow-up onwhat Peter is saying we are little more bullish on the government servicesmarket 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 programreductions, 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 growthmoving into the first quarter and as Peter said we got real nice pipeline.

Peter Altabef

That said what make us morebullish right now is the fact that we’ve already, if you will booked some nicerevenue growth. I will say the QSS acquisition, which we made in January oflast year has really positioned us where we wanted to be. The contract vehiclethat we were able to acquire was QSS, really are what we needed to build thatplatform.

So for instance the ITES vehiclealready last year substantially increased our revenues with the army and wethink that we have a good opportunity to continue to increase our army businesssubstantially this year. Around homeland security, the aligned contract and thealigned vehicle will continue to help us in the Coast Guard, and of course asyou 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. Oneof the disappointments of 2007 government was the lack of progress in the SBIinitiative. If you look at President's Bush budget for that he submittedyesterday, you see substantial increase in SBI net spending. And then finallyon the civilian side, both the opportunities in NASA and with the Department ofEducation and things that we are pretty excited about.

Operator

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

George Price - Stifel Nicolaus

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

John Harper

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

George Price - Stifel Nicolaus

Right.

John Harper

And roughly $70 million reductionfrom 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 theanticipated level of project work in '08?

John Harper

In terms of the new CHSrelationship?

George Price - Stifel Nicolaus

Correct.

John Harper

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

George Price - Stifel Nicolaus

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

John Harper

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

Peter Altabef

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

George Price - Stifel Nicolaus

Okay.

Operator

Your next question will come fromthe 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 ofyour free cash flow expectations going forward, what's the ratio of free cashflow to net income that you are shooting for in 2008 as you net out higher compCapEx, 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 takesthat go into that. What kind of investments do you need to make and so on?

Peter Altabef

Well, we don’t, necessarily needto make investments. We are looking at a lowering, a relatively small loweringof the DSO's going into the year. Wewill be paying off 2007 bonuses and that is a smaller amount that was lastyear. So, those are some of the puts and takes in terms of getting that backupjust mechanically working through some of the changes in the balance sheetaccount. But we expected it to normalize back to our traditional cash flowlevel.

Ashwin Shirvaikar - Citigroup

Okay. And could you update us onyour non-India offshore investment, where do you stand and what more remains tobe done?

Peter Altabef

Our delivery platform if you willask at this point is, is pretty stable. It is, India is a lions share. As you knowwe have four facilities there that are up and running and actually looking atexpanding that number. We fill out that capability with the Philippines, Mexicoand Romania.

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

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

Operator

Your last question comes from theline Susan Chen with Merrill Lynch.

Susan Chen - Merrill Lynch

Thank, nice quarter. Can youcomment on your line the application solutions business, do you expect growthin 2008?

Peter Altabef

I am sorry. Could you repeat thequestion?

Susan Chen - Merrill Lynch

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

Peter Altabef

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

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

John Harper

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

Susan Chen - Merrill Lynch

Thank you.

Operator

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

Peter Altabef

Thank you. I again want to thank everyone for spending their time with uson this call. I hope we were able to give you some insight beyond thepublished numbers into what we are doing and where we are headed. I want toencourage you to take a look at the downloadable that we put on our InvestorRelation site and as always, if you have follow-up questions please don'thesitate to contact John Lyon. Thank you again.

Operator

Ladies and gentlemen, this doesconclude the Perot Systems' fourth quarter 2007 earnings conference call. Youmay now disconnect.

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Source: Perot Systems Q4 2007 Earnings Call Transcript

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