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EDS (NASDAQ:EDS)

Q1 2008 Earnings Call

April 24, 2008 9:00 am ET

Executives

David Kost - Investor Relations

Ronald Rittenmeyer - Chairman, President and Chief Executive Officer

Ronald Vargo - Executive Vice President and Chief Financial Officer

Analysts

George Price - Stifel Nicolaus

Julio Quinteros - Goldman Sachs

Bryan Keane - Credit Suisse

Rod Bourgeois - Sanford C. Bernstein

Greg Smith - Merrill Lynch

Tien-Tsin Huang – JP Morgan

Adam Frisch - UBS

Operator

Welcome to the EDS first quarter 2008 earnings conference call. (Operator Instructions) I will now turn the call over to Mr. David Kost. Mr. Kost, you may begin

David Kost

Thank you very much, Teresa. Good morning everybody and welcome to our first quarter 2008 earnings call. With me today on the call are our Chairman, President, and CEO Ron Rittenmeyer and our CFO Ron Vargo. You should have received an email from me with a copy of our press release along with the presentation that will be used today. I’d like to remind you that the presentation along with the webcast are available on our website and will be archived there for the next 30 days.

The information covered on today’s call which is not historical in nature including statements regarding financial condition, guidance or future financial performance and the value of our new contract signings constitutes forward-looking statements within the meaning of the federal securities laws. These statements are subject to numerous risks and uncertainties, many of which are beyond our control which could cause actual results to differ materially from such statements.

For information concerning these risks and uncertainties, see the risk factors section of our most recent Form 10-K. We disclaim any intention or obligation to update these forward-looking statements whether as a result of subsequent events or otherwise, except as required by law. In addition, we refer you to the slides posted on EDS.com that accompany this call.

Among other information, these slides and our earnings release present a reconciliation of non-GAAP financial information to be discussed today and should be reviewed in connection with this discussion.

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

Ronald Rittenmeyer

Thanks, David. Good morning. Let me take you through our business highlights. Turning to slide 3, we had a very good first quarter and I am pleased to report that we’ve made steady progress. Our revenue was up 3%, $5.4 billion, which exceeded our guidance. EPS was $0.12; again, exceeding our guidance of $0.05 and we will talk about how that is split up. Ron Vargo will go through some of that.

Free cash flow, very typical. In our first quarter we came in at $126 million use of cash. Remember in first quarter we did have the Verizon payment of $225 million so year over year it makes a little tougher to compare.

First quarter signings, TCV production was very good, $5.6 billion. That is up 66% versus first quarter of ‘07. I think there are a couple highlights that are important. We did close 12 contracts over $100 million each in total contract value and I am pleased to report we did close most of the deals that were material that we said had been delayed, and as I have said before, these things do slip quarter to quarter. It is kind of a moving thing but when you look at our year-over-year increases, even excluding that, our first quarter is up well over 33%. So compared to first quarter of ‘06, I think even if you take out those one-time GM and NMCI odd bookings, those very, very high bookings, we had an excellent quarter, almost 80% up. So we feel very good about our signings.

We have strength in all geographic regions. Asia-Pacific came in very strong. With the strong second half ‘07 bookings and a strong Q1, our trailing 12-month book-to-bill ratio is back near the 1:1 level which we established as one of our targets. Finally, industry sectors were very good, strong bookings in government and energy.

Let’s go to slide 4. When you look at our first quarter signings, geographic mix, pretty well balanced: Americas 43%, EMEA 37%, Asia-Pacific about 20% of the total. That $1.2 billion deal signed in Asia-Pacific represents a record level of quarterly production, obviously, for that region. Service line, ITO again represents a majority of our bookings but what is interesting is in absolute dollar volume, applications bookings have increased as well so that is good news from our standpoint.

From an industry pie chart, on the right side of the page, government and energy, as I have already said, were the strong industry sectors, and those was really led by the two large marquee deals that we signed with Singapore Government and Royal Dutch Shell. We were extremely pleased with the achievement of signing 12 deals with TCV greater than 100. It’s a level of performance early in the year, in the first quarter, that we haven’t seen for the last five years. So we feel very, very good about that, and it obviously continues to help our revenue.

40% of our TCV -- this is a very important point -- was with new logo clients, which is actually double the average of what we typically book. So in terms of new business out there and getting new deals, this is a very important point. High level of revenue that’s incremental and very good. So all in all, I would say we’re pleased, very pleased with the level of signings. It’s the third quarter in a row with strong bookings, particularly in view of the economy which we’re still very sensitive to and watch very closely.

I would comment that while I can’t announce the name, we just completed signing of another billion-dollar contract that’s going to be booked in Q2, so we just closed that deal. While I can’t disclose the name, it’s a government contract and it’s obviously a very large contract, so.

Annualized contract value, we showed that to you -- slide 5 -- in the security analyst meeting. A lot of people use this. In the first quarter we continued the upward trend, annual contract values up 18% year over year. Long-term trend is up. We expect that to continue as we sell a greater portion of project-based work.

We track this metric now in addition to TCV because we expect to have an increasing percentage of our bookings come from shorter-term duration contracts, especially in the applications area as we expand more into these project services. So as measured by both ACV and TCV, sales efficiency and production overall are improving.

Let’s move to slide 6, pipeline, which would be the other part of the book-in. We’ve seen a solid increase in our pipeline, sharp increase in the US and EMEA is also up very nicely. Opportunities with our existing client portfolio are up 8%, and given the strategic importance of expanding our application business, our apps deals less than #10 million in size are up 21% versus a year ago. So that is an important metric for us to follow. The total pipeline is up about 7% in total and given the level of signings we’ve had that have obviously drained that pipeline, we’re pleased with the production in that area.

For the full year, we have gotten off to a good start from a sales perspective. Second quarter, as I said, already looks pretty good. I did mention that deal we just signed. It’s not a down select, it’s a signed deal, so we’ve got it. We’re confirming the full year TCV guidance of greater than $20 billion, and our new logo production started off nicely. We expect 2008 to have a higher level of new logo signings compared to the past years, so very good overall.

Let’s move to slide 7 which talks about applications. We continue to build the foundation for an enhanced application business augmenting the strong management and maintenance business with project-oriented services, specifically ERP implementations, modernization and development work.

As I said, first quarter bookings in the segment were up 19% versus year-ago and embedded in the TCV, we had a significant increase in number of application projects versus first quarter of ‘07. We have seen a 32% increase in transactions under $10 million representing projects service markets, so as a measure of future growth the applications pipeline expanding by 17% versus a year ago, so we’re very pleased with that.

Turning to the growth update in our apps segment, the establishment of the SAP practice continues to make very healthy progress. We have hired experienced veteran SAP leaders to run our practice in each of our large regions. They are building the teams. We continue to ramp up. We now have over 3,000 experienced SAP resources in our business. We have built some initial success stories with existing clients and we continue to refine and build our market differentiation and messaging in this space, as we’ve said.

We’ve also begun the rollout now of the Oracle practice. That practice will be organized under the industry alignment we’ve established. We are starting with a government tax practice that services tax and revenue agencies around the world and we are going to leverage our 2007 acquisition of Saber Government Solutions to enhance and grow that business. So we continue to invest in this important area, and I think we are now beginning to see some very positive early momentum.

Slide 8, Best Shore. As you can see by the bar graph, we’re now at about 43,000 employees in our Best Shore locations, and driven by the recent contract with Shell, we’ll be doubling our Malaysian center this quarter which provides primarily ITO-related services and will give us another outstanding Best Shore ITO location in the right part of the world and the right price point.

Our plan this year is to target approximately 8,000 more resources on Best Shore. Half of that headcount will come from migration of current onshore headcount, and the other half will be to support new business signaled during the year, so people hired directly into Best Shore. Our current target is to drive at least 60,000 resources into Best Shore locations and we obviously anticipate that over the next couple years. We’re going to do it sooner if we can, but we’ve got to balance that with the cost of doing that.

We have size and scale. We’re getting closer to the desired labor mix we are targeting. Quality of work has been excellent and I guess I’d say overall we are ensuring the process and coordination of delivery is seamless on a global basis.

Slide 9, our growth update. We’ve made two key acquisitions. I’d like to briefly talk about those. Vistorm was an acquisition in the United Kingdom focused on provisioning the information assurance and managed security services on a global basis. The business serves organizations of all sizes, all industries, and specializes in financial services. So we are going to combine our existing capabilities in IT security in the UK into the new Vistorm entity. We think that combination of resources will create an organization with about 400 information security specialists in the EMEA market and it will make it a very, very formidable European provider of information security services as well as having industry-leading tools, software platforms and methodologies in IT security, so good acquisition.

Nexagent was an asset acquisition that will strengthen our network management capabilities and offering. Leveraging their software tools will allow us to automate and accelerate the design, transition and operation of enterprise service delivery, and we think it sets a standard for higher availability connection of clients to our global service network. So it fits right in with what we were doing from a global service network standpoint, and it’s obviously very valuable for network connections that span multiple carriers and multiple regions, something that we are trying to take a leadership in offering.

Looking at our marquee signings, a contract with Singapore Government was very exciting, $1 billion over eight years. We are going to deliver end-user services to and link 60,000 workstations across 74 agencies. We will also integrate voice, video and data communications in Singapore and around the globe. The significance of that deal to us is extending what we do best, and we do this very well to a number of clients, and it now brings us into a very prominent position in this area in the Asia-Pacific market. It’s also allowing us to provide an integrator role for clients and serving as the general manager for a consortium of suppliers which is something that we have been offering and this gives us even further creditability and strength.

The new contract with Shell has some very strategic importance. It’s a $1 billion deal but it’s over five years. We are going to be delivering end-user services to 150,000 employees in 150 countries. When we sign a marquee client in a new industry, we are able to leverage that and build a stronger industry presence with valuable industry skills. We believe that transaction is going to do that for us in the energy sector.

We structured the deal with a much lower capital structure which will enhance our cash metrics, and compared to historical mega-deals we’ve signed, we expect improved financial metrics actually on both of these deals, so we feel very good about these.

Slide 10, looking ahead, we clearly are in an uncertain economic environment. We’re very sensitive to that. We spend a lot of time looking at that and trying to think about that, but we believe we are executing the plan. We’re pleased with the results. We’ve had some impact from economic conditions through volume or where other certain clients had to look at cutbacks and delays but overall, we’ve also had other clients where we are finding opportunities. So on balance, we feel pretty good about things right now. The net impact is limited, as I’ve said, it is in line with our expectations.

We continue to see opportunities so we’ve begun investing in our sales engine. We are going to continue to do that primarily in 2008. We’ve begun a new extensive sales training and development for our sales resources. This is a two-week program that’s very intense, and it’s starting to pay off already. We continue to execute it and we think it’s going to really make a difference.

We’ve organized our industry practices into a more effectively sell applications and we expect that structure is going to continue to enhance our add-on sales with existing clients. We are going to continue with the workforce reductions. The company will continue to realign and we will continue to adjust our workforce globally and continue to seek lower cost, higher quality locations. So we expect more than half of our plan number is going to be done in the first half and that should help drive our second-half improvements, which we’re projecting in margin, EPS, and free cash flow.

So overall a good quarter, and I’m going to pass it on to Ron Vargo now to get specific about the financials.

Ronald Vargo

Thanks Ron, and good morning. I’ll be the covering the results for the quarter and providing an EPS outlook for the second quarter as well as an updated full-year 2008 guidance.

So let’s go to slide 12, summary results. As we look at our first quarter results and compare to 2007, you will see that on a year-over-year basis we are impacted by the effects of the Verizon termination in 2007. We’ve been reporting this now for over a year, so of course this should be not be news to anyone.

Total revenues in the quarter were approximately $5.4 billion, up 3% as reported and 2% down on an organic basis. Excluding the recognition of $100 million of revenue related to the Verizon termination payment in the first quarter of ‘07, organic revenues were flat year over year.

Adjusted and reported EPS were $0.12 versus $0.31 in 2007, and free cash flow was a use of $126 million versus a use of $8 million in the first quarter of ‘07. Again, the Verizon termination contributed $225 million of cash, and $0.13 of earnings in the first quarter 2007. TCV signed was approximately $5.6 billion, 66% over last year’s first quarter.

In summary, an outstanding signings quarter, and we exceeded our own financial guidance and we knew this would be a tough quarter to compare against first quarter 2007’s financial results.

Slide 13. This detailed slide actually contains summary line items from our income statement, again adjusted to include certain items, and a walk from GAAP is included in the slides in the appendix on page 26. Key highlights include revenue up by $141 million compared to the first quarter of ‘07, resulting from currency effects, the ramp-up of sales from ‘07 signings, the impact of acquisitions offset by the impact of the Verizon contract termination of $100 million, price reductions, which we’d discussed with you in prior calls, and other contract run-off.

SG&A increased by $22 million year over year, driven by investments in our sales channel as we added capacity and investments in our applications business. Corporate overhead actually was down year over year.

Operating income was down $168 million due to the impact of the Verizon termination payment, as well as the net effect of price adjustments and run-off, and higher workforce and capacity management spending on a year-over-year basis.

Interest and other actually contributed $6 million in the quarter and was favorable $13 million versus the first quarter of 2007. A major driver of the first quarter interest and other was a revaluation of our interest rate swaps as a result of lower interest rates during the quarter.

We had a 39% tax rate in the quarter, mainly because legislation renewing the R&D tax credit has not yet passed in 2008. We continue to forecast a 36% tax rate for the full year. This assumes that the R&D tax credit is passed but in our second quarter guidance, which will get to shortly, we continue to expect a 39% effective rate, because we are planning on the credit to pass in the second half of the year retroactive to January 1st. Of course, we hope that it passes earlier.

Diluted shares outstanding declined by 32 million on a year over year basis for two primary reasons: During the quarter, we purchased 11.5 million shares at a cost of $213 million, which helped drive the average share count down on a year-over-year basis. And, the impact of our convertible debt was such that it is not dilutive unless earnings are in the $0.23 or $0.24 area, and therefore the 20 million shares associated with that convertible debt come out of the share count and the interest expense goes into the earnings.

On a full year 2008 weighted average basis, we continue to expect the share count to be about 530 million shares, which includes the full effect of the convertible notes. So let’s go to an EPS walk now, taking you through the first quarter of 2008. This is a slide which will walk you from our 2007 $0.31 per share to our guidance of $0.05 per share and then to the $0.12 per share that we reported in the quarter.

The first bar is the Verizon contract termination payment which contributed $0.13 to first quarter ‘07 earnings. Next, as we began to ramp up our workforce and capacity management spending in the first quarter of 2008, we expected to incur an additional $0.05 of costs in the first quarter of ‘08, or $0.08 total compared to first quarter of ‘07. The impact of interest and other and the tax rate was expected to be a penny worse year over year.

Finally, the combination of strong first quarter 2007 contract performance plus first quarter of ‘08 contract price adjustments and run-off net of productivity was expected to impact our first quarter by $0.07, resulting in the guidance of $0.05 per share.

So on the second half of this chart, I will now walk you to the drivers of EPS that enabled EDS to exceed guidance, so moving to the walk from $0.05 to $0.12. We actually did an effective job in the first quarter of managing contractor-related headcount down and did not spend as much on workforce and capacity management, resulting in the $0.03 improvement. However, we do plan on carrying over this spending into the second quarter of 2008.

The combination of interest and other and taxes was $0.02 better than we expected, as we benefited from lower rates and again, we did expect the 39% tax rate in the quarter. Finally, the impact of productivity and operational performance netted to a positive contribution of $0.02 per share. So we came in better than expected due to operational performance, lower below the line costs, and timing of our workforce costs.

Now we’ll go to cash flow. Total free cash flow for the quarter was the use of $126 million, and the short story is that the operating cash flow, a small improvement on a year-over-year basis, was more than offset by an increase in net capital expenditures.

However, key variations are worthy of some further explanation. Cash flow from earnings declined by $13 million due primarily to earnings down, partially offset by higher D&A and other. The change in working capital had a number of plusses and minuses, including the impact of the $225 million Verizon settlement payment in the first quarter of ‘07 that resulted in recording $125 million of deferred revenue and working capital.

This was partially offset by a financing of lease receivables in the first quarter of ’08, a $150 million financing that was part of our overall 2008 financing plan in the quarter, it had a net effect of about $110 million of net financing of lease receivables.

We also had a lower level of cash severance payments in the quarter. Recall that in 2007 we had a high level of funding of severance that had been incurred in the fourth quarter of 2006.

Similar to the first quarter of 2007, we experienced an increase in our DSO from prior year end levels. First quarter 2008 DSO ended at 63 days. Some of this was anticipated due to structural terms that will result in a step-up in DSO from the fourth quarter to the first quarter. We continue to expect that by year end 2008, we will get back to year end 2007 levels or better.

Net capital increased by $127 million, however this was due to the timing of certain software-related expenditures and data center facility expenditures that will not recur. The data center expenditures are actually expected to be part of a larger data center financing that we will do later in the year. The total of those two items was $70 million in the quarter.

We continue to expect $900 million of free cash flow for the year, but like 2007 and prior years, this will be second-half weighted. We continue to expect the mix of free cash flow during the year to be roughly in line with the categorization that we discussed at the security analysts meeting in terms of the split between cash flow from earnings, working capital, and capital expenditures.

Slide 16, balance sheet movements, a few highlights here. Cash and marketable securities down by $381 million, primarily driven by the free cash flow in the quarter and share buybacks and dividends. Accounts receivable increased by $193 million, again, the higher DSO which is seasonal primarily and to repeat, we expect to reduce DSO to a level in the mid-50s comparable to year end ‘07 by the end of the year.

Deferred contract costs grew by $101 million. This was due to a continued planned ramp-up for certain clients as we rollout future-state IT environments. Accrued liabilities down $126 million. This is driven in large part by seasonal compensation payments.

Shareholders’ equity declined by $73 million due to the share repurchases, offset by increased earnings and foreign currency effects. Again, in the quarter, we bought 11.5 million shares, program to date, 14.2 million shares, at a cost of $270 million. So, we have bought $270 million of the $1 billion authorization that the board provided in December.

The balance sheet obviously continues to remain strong with a relatively low level of debt. Debt to total capital ratio in the 25% area. You’ll note that during the quarter, we did receive two credit rating upgrades. Fitch Ratings upgraded our long-term debt to BBB flat, and Moody’s upgraded us to Baa3, taking us back to investment grade.

So let’s now go to second quarter earnings per share outlook. For the second quarter of 2008, we expect EPS in the range of $0.24 to $0.27. Key earnings per share drivers for the second quarter are expected to be first, the negatives -- workforce management. As I mentioned, we are carrying over the $0.03 that we did not spend in the first quarter and we will be stepping up workforce management generally in the quarter to a level of approximately $80 million to $100 million of workforce management costs incurred in the second quarter of 2008.

Second, a higher tax rate. Again 39% and in 2007, we got some benefits and had a tax rate below 30%.

The impact of contract price adjustments and run off. Again as we discussed late last year, a large U.S. government contract has a price adjustment and there is some higher run-off during the year from contracts generally. We expect these price adjustments and run-off to have much less of an impact going forward beyond the second quarter of 2008, when comparing on a year-over-year basis.

The positives in the quarter will be the continued productivity benefits that we’re getting from the early retirement program that was taken in the fourth quarter of last year, as well as incremental productivity and expense management reductions, as well as contract performance and growth.

We expect the second quarter revenues to be in the range of $5.6 billion to $5.8 billion.

Finally, full year 2008 guidance. We’re taking our revenue guidance up and revising it to a range of $22.5 billion to $23 billion. This reflects the impact of revenue from the recent acquisition of Vistorm, a company we acquired in April, plus some expectation that the dollar will continue to remain weak and impact revenues on a going-forward basis.

Adjusted earnings per share are revised from 135, approximately, to 135 to 139 and free cash flow remains at $900 million, and TCV at greater than $20 billion. The key driver for 2008 free cash flow continues to be expected improvements in working capital compared to 2007. Many of our working capital balances, prepays, accounts payable and accrued balances are expected to drive meaningful year-over-year improvement.

So with that, finally, let me turn it back to you, Ron.

Ronald Rittenmeyer

Thanks Ron. Let me just summarize then. We had a great quarter with bookings, I think everybody would agree with that. The highlight of the quarter obviously was the two large bookings and the new logo wins overall for us were clearly important to us, especially in the sluggish economy.

Service lines, every one of them have initiatives and actions that are improving their businesses. We are very driven in those areas. We talked about the importance of the application business. This business is clearly trending positively so very good about that.

Some exciting developments in our service offerings. To highlight one, we have been chosen as the partner of choice with Microsoft as they take their Dynamic CRM product to the enterprise market. We are going to provide all the implementation and support services in this very important and growing area and I just attended Microsoft’s big, big program in Florida and was on stage with Steve Ballmer announcing the partnership so from my standpoint that’s a very good thing for EDS.

I’d like to emphasize that we have a solid and predictable business model. We do have a lot of defensive characteristics as the economies of the world potentially slow down. A large percentage of the revenue comes from our contractual backlog. The service we provide is predominantly tied to running clients’ most critical, core systems so I think that’s pretty important. We do have discretionary work tied to our revenue but it’s holding up so far and it’s generally tied to the core system that we’re running so I feel strong about that.

Our sales are strong and we are very sensitive to the economy. I don’t want people to think that we don’t worry about that at night; we don’t worry about that during the day; we think about it all the time but the facts are we are sensitive and we anticipate and hopefully we are ready for that.

So overall, I think we have had a good quarter. Dave, I’m going to turn it back to you now for questions.

David Kost

Teresa, we can open up now for questions. I would ask that you limit your questions, being mindful of the others that are in the queue. Teresa, if you would start.

Question-and-Answer Session

Operator

Our first question comes from George Price - Stifel Nicolaus.

George Price - Stifel Nicolaus

The workforce reduction expenses in 1Q08, Ron, $0.02; was that around $20 million?

Ronald Vargo

In first quarter of ‘08, they are approximately $37 million. First quarter of ‘07 about $25 million, so the year-over-year about $12 million increase, about $0.02.

George Price - Stifel Nicolaus

Any changes to the workforce reduction expectations for the full year?

Ronald Vargo

No, we are still in that range we talked about, of 200 to 250. If we do the 80 to 100 in the second quarter, we’re kind of 117 to 137 for the half year so we are still expecting more than half of the spending to be incurred in the first half of the year. We got to get on it in second quarter to get those benefits in.

Ronald Rittenmeyer

We’re also focused obviously on managing the contractor supply tighter. We’re also focused on performance, employee performance, which we should be focused on anyway. We’re also focused on attrition in terms of reengineering jobs before we replace every single person that departs the company voluntarily. So we’ve got a lot of things in play here and I think we are hitting it from all angles but for now, I agree with Ron, we’re staying focused on the number, because at this time, that just makes the most sense to me, to do as much as we can for the dollars that we’ve planned, so.

George Price - Stifel Nicolaus

Just to be clear, the share count guidance for the second quarter, given where EPS is that will add back in [inaudible]?

Ronald Vargo

Yes it does. That is correct.

George Price - Stifel Nicolaus

Where does the share repo stand right now, and what do you have implied in guidance? What is the timeline you think that use that given where the stock is now? Thanks.

Ronald Vargo

As I mentioned, we have done $270 million of the $1 billion, and the guidance assumes that the $1 billion will play out over the next year to year and a quarter.

Operator

Your next question comes from Julio Quinteros - Goldman Sachs.

Julio Quinteros - Goldman Sachs

Ron Rittenmeyer, on the Americas side, can you just walk us through the decline in the year-over-year number? I just want to make sure I’m not missing anything there. It was about a 9% decline?

Ronald Rittenmeyer

The comments I would make about that is we clearly have had a little bit higher run-off. When you look at their overall move, the Verizon termination payment clearly had an impact on that. So that is probably the biggest thing. We had some renewals. One of the things that, obviously as you guys know, when we do Best Shore increases of existing contracts, last year was a big renewal year in the Americas. So you’re seeing some price adjustments as we made that. We are through the majority of those now so I feel less concerned about that going forward.

We had historical contracts that as we recompeted those and won them that was the good news. The unintended consequence of that, of course, is you start putting some of that offshore. So as we grew this offshore business on recompetes you tend to take a greater amount of what we classify as run-off and it’s not really run-off, it’s just price adjustment. So however you want to call it, it’s an adjustment. But when I look at total contracts signed, we are still in good shape from the Americas standpoint.

Bottom line, I feel positive about the overall strength of the Americas. The pipeline is clearly up in the Americas, as I said earlier, so Julio, I think that when you think about it in total, a lot of it has to do with the recompetes and where we are now and as I said, I don’t see that as strong as of an issue for this year.

Julio Quinteros - Goldman Sachs

Ron Vargo, can you just help us understand the timing on the ramp-ups of the Government of Singapore contract and the Dutch Shell contract just from a CapEx perspective, a financial perspective? How do we think about this as we go through the next couple of months here? As you guys begin to ramp that stuff up, what kinds of outflows should we expect and what is the pay-back period that you are looking for there?

Ronald Vargo

First I’d say it’s all included in our guidance. Secondly, I would say that the way that we structured these contracts really mitigates the capital impact that we’re going to see from both contracts in terms of either suppliers taking on some of the capital responsibilities, or the actual customer owning the capital.

So I think the majority of the cash impact is going to be as these start ramping up, working capital impacts and less impactful on the CapEx. So I would answer you by saying, it’s not going to have a material impact as we go through the year, and it’s already in the guidance.

Julio Quinteros - Goldman Sachs

In the 900?

Operator

Your next question comes from Bryan Keane - Credit Suisse.

Bryan Keane - Credit Suisse

Ron Rittenmeyer, when you were talking about volume declines and delays due to the economy, is that new this quarter and can you talk about what industries you’re seeing that in? I’m just trying to get an overall economy picture.

Ronald Rittenmeyer

I would say that clearly we’ve seen some pullback in general. When you think about manufacturing, we’ve probably seen some add-on business slow down a bit. Consumer, we’ve seen some add-on business slow down a bit. Obviously, energy has been good for us. On balance I think that I’d probably put them in those sectors but I don’t think it’s, again from our standpoint, we haven’t seen it as a critical issue but we are trying to separate that from projects that have been completed, too. So we are completing some projects, for example, in the GM sector which allows us to now free up some people to go do some other manufacturing stuff.

But I would probably put it more in consumer and manufacturing as the two primary sectors from an overall economic perspective.

Bryan Keane - Credit Suisse

Is it just delays, or are there some cancellations in some contracts as well?

Ronald Rittenmeyer

No, there have not been any real cancellations. I would say it’s slower, and I think we have seen some projects just take a little bit longer to get booked out and it’s mostly on project work, add-on project work. But again, from a macro standpoint we haven’t felt as much pressure as I was worried about, so I feel pretty good about the signings.

When you think about the number of contracts I mentioned that we signed in applications, for the smaller than $10 million stuff, if you recall when I talked about that, I think the key there is that we have seen those contracts continue, a 32% increase. Granted, we came from a different base, but in contracts under $10 million, I think that’s a very positive sign. So there is business out there and from our standpoint, I think rile of large numbers, we are able to manage that. So I mean, having a business that can move globally has really allowed us to do that. Government is good too, and financial services has still been pretty strong for us, so.

Bryan Keane - Credit Suisse

Ron Vargo, under EMEA the profit was down a little bit, and one of the impacts there was price adjustments. Is that the move in Best Shore, or what happened there?

Ronald Vargo

I would say that the EMEA stuff there is a couple things. One is we have invested in some stuff over there, competitively, I’ll just say that and so that was part of it. The other reason was we talk about price adjustments. I mean, we have government contracts that are still very profitable, very positive, but we do adjustments in those and some of that is as they run longer, you tend to make some adjustments. So nothing that we see as a critical issue.

Ronald Rittenmeyer

And not that it can’t be recovered. Again, we have had other signings.

Bryan Keane - Credit Suisse

Remind us again on the free cash flow walk from 2008 to 2007. I know you expect it to be flat, but obviously margins are going to be down in ‘08, and we don’t have the Verizon payment but yet we’re talking about the same free cash flow. So can you help us through that?

Ronald Vargo

I will hark back to a more thorough discussion that we had at the security analysts meeting. We expect working capital to not be the significant user of cash that it was in 2007, so a little bit less coming out of cash flow from earnings on a full-year basis, a little better performance in the working capital area, and CapEx kind of flat to a little bit worse.

Operator

Our next question comes from Rod Bourgeois - Sanford C. Bernstein.

Rod Bourgeois - Sanford C. Bernstein

Nice start to the year. You cited $0.02 of operational upside relative to the guidance that you gave us three months ago. We can hearken back to the Q4 period where you had some troubled contracts that hurt margins. So the question I have is, where did this $0.02 of operational upside come from? Does that reflect some progress with contract execution? Can you give us some more specifics on that front?

Ronald Rittenmeyer

What I would say, Rod is that first of all the choice of words of contract execution problem was a poor choice of words. So I’ve learned that lesson. The important thing is that, yes, it comes from execution. It comes from improved execution at the contract level, it comes from improved execution of the business, it comes from improved execution of the stuff we’ve said we’re going to do here in terms of streamlining the company, et cetera.

So on an overall balanced basis, we had a very good quarter, we don’t have anything that I would highlight as a concern contractually. We are hitting a lot of good cylinders, quality was excellent, our quality operations were good. Fundamentally it comes back to tight management. In my view that is an opportunity that will be endless and we are going to be very focused on operationally executing this business at a much higher level every quarter than we’ve done in the previous quarter.

So I don’t want to get specific about contracts, but I would just say that I’m very comfortable with the focus that the company has gained in the last few quarters on operational excellence.

Rod Bourgeois - Sanford C. Bernstein

Can you give us some ranking of where the operational improvement came from? If I said one category would be improvement on the troubled yields from Q4, another category would be improvement on other deals besides the ones that were troubled in Q4, and the other one would be just benefits from the restructuring that you have done since last summer, since you started ramping up some of the restructuring activities. Is the improvement coming from a balanced set of performances across those three categories?

Ronald Rittenmeyer

I would answer that you’ve kind of testified for me. Those are exactly right. Clearly, any contract that I felt was lagging we have put a real focus on and we’ve seen an improvement. Overall contract performance is sharper than it was in the past. Just like Ron mentioned, our G&A is down. We have a big focus here on trimming back G&A overall, while we reinvest in sales. So you notice, we try not to talk about SG&A, because I think sales is something that we ought to be investing in and we ought to be paying for that by tightening up the G&A part of the company, the overhead part of the company. I still see that globally as a great opportunity.

So it’s all the above. It’s contract performance would be number one, number two would be just operational improvement across the board, whether it’s in data centers or reengineering stuff we’ve talked about. Number 3 is offsetting the sales investments with other general and administrative expenses and still tightening that even further. So, it’s just good operational business management and it’s something we talk about every single week along with how do we grow sales so. Anyway, I hope that helps.

Rod Bourgeois - Sanford C. Bernstein

Specifically now if we look at the execution topic, you’ve now signed some large deals. It’s very encouraging that you’ve got seemingly better than normal capital requirements on those contracts. But operationally, has anything been developed in the last six months on the contract execution side that will be applied on these new deals that allows you to give us more comfort that contract execution will be strong on these new deals?

Ronald Rittenmeyer

The Singapore deal, for example is going to be run, our AE on that deal’s come in out of the NMCI team. We already do that at NMCI. So it’s actually the same project in many respects, at least the foundation of it. So, the team that we’ve deployed to that is a team that is experienced, the core team, and we’ve pretty well documented the steps we take when we do these kind of things. So, if you think about DWP, we do the same thing over there. So, in many respects, the teams that we are deploying are experienced teams.

The Royal Dutch Shell deal is, again, a similar project to what we’ve done before. We already are managing a consortium of suppliers for a couple of other large deals so we’re going to deploy those same tools and experience. So we are not trying to get out there and do something in the dark that we have never done before. These are things that we have already done, and we’re deploying many of the same resources because now we have worked very hard at building a training frame to bring new people on board to replace some of these people that we can move to these locations.

So we are not starting as a greenfield. We are actually putting an experienced team on the ground for a period of time, along with some experienced leadership in each one of these. So I feel very confident that we’ve got our head around how we’re going to execute this.

Rod Bourgeois - Sanford C. Bernstein

You’ve been mentioning run-off and price concessions as a bit of a headwind over the last year, and that makes sense as the business migrates offshore, some of that’s being caused by the offshore migration. But you’ve now got a much higher offshore mix today than you’ve had at the past. Do you expect from now forward that this run-off issue will attenuate as a headwind, or are you still going to be dealing with that in the same way over the next year? Is the tide starting to turn on the run-off side?

Ronald Rittenmeyer

My view of that would be that it will be less, but we’re not done with it but it’s dramatically less. I think we’ve hit the big waves already, so now we’re into the smaller back wave, if you will, but there’s still some of that. We are talking about 60,000 people or more. We’ve got 43,000 so you have got another 20% to build over there. A lot of that will be built by new deals that are signed, so you don’t quite have the run-off impact, but there are still some deals out there to restructure and re-do.

The second wave of these deals as they come through, at some point you can only move people once, right? So at some point it’s less of an issue. But I am confident that we have gone through a lot of the big hits. Now we’ve got some stuff to clean up yet, et cetera.

Operator

Our next question comes from Greg Smith - Merrill Lynch.

Greg Smith - Merrill Lynch

Ron, on the applications business broadly, do you feel like you are actually gaining some share at this point or more growing with the market overall?

Ronald Rittenmeyer

That’s an interesting question. Number one, it’s hard to know that because you don’t know the total market activity. My sense is we are gaining share in practice areas, and we are gaining share in existing clients.

The overall market, I don’t know whether you could mathematically come up with a formula that says we are knocking out share in the overall market at this stage. So I think what we’ve done is, we have penetrated existing clients in a much deeper way around the project side, we are building out the practices. So I don’t want to answer that; I find that a hard question to answer today, because I think that we are going to -- remember, unfortunately this Verizon thing also had some app stuff in it so it kind of distorts our numbers, but we look at, we developed a report called a 101 report which is so granular, it goes down deep into every client. So we now know at a client level whether we are gaining ground or losing ground, and so far, by that type of granularity, we’ve been able to really get our arms around which clients we want to grow in and which clients we don’t see growth in.

So within the client base that we’ve got, I would say we are doing much, much better. Within the marketplace, I would relate that more to the practice side. But overall, on a macro basis, it’s a little early to make that claim, or to make any claim.

Greg Smith - Merrill Lynch

That’s helpful. Can you talk a little about the acquisition outlook and maybe specifically on the New Shore side, any chance you are likely to fill that gap to the 60,000 with an acquisition?

Ronald Rittenmeyer

Let me answer that two ways. On the acquisition front, we are looking at things. Clearly with the change in the marketplace, it’s interesting. Our view is that the lagging price indicator, some prices haven’t caught up with yet that the market’s changed. So you still have some people out there who think that their valuation ought to be the same as when the market was so heated up. So there are some realities that people are struggling through yet. We have several things that we are in the middle of working on that would supplement our business and supplement our business in the appropriate way.

On the New Shore question of whether or not we would do that with an acquisition, I would answer that with a yes, I would, if in fact it makes the most sense. We did the Real Q and the GEMS thing which was very good for us. Those things have really built out well. If there are other opportunities in those spaces, we are going to go get them if we see that they fit in appropriately.

But again, I got to tell you, I think we have to be sensitive to price. The last thing we want to do is spend more money than something is worth and then live with that. So, organically we are doing pretty good at adding headcount, and I think we just have to watch that. But I hope that helps.

Operator

Our next question comes from Tien-Tsin Huang – JP Morgan.

Tien-Tsin Huang – JP Morgan

I just wanted to first understand what’s driving the sharp increase in the US pipeline, and also the increase in EMEA. What type of work is being demanded?

Ronald Rittenmeyer

It’s a mix. I wouldn’t say there is anything specifically that’s jumping out. Obviously I don’t want to get into the pipeline details but from a competitive standpoint, I would say generally speaking, it’s pretty much what we have been talking about it. We still see a fair number of ITO things. I mean, there is no slowdown that we have seen; there is not a change that we’ve seen in people wanting to go do things. I think the economy makes people even more interested in how do we do this and rationalize our business better.

I think our service quality, while some people say well it can’t be that big of a deal, it actually is a big deal. Our service quality is making a difference in our ability to have referenceable clients and I hope you’ve seen our new ad campaign. I will be disappointed if you haven’t. There will be some ads on CBS – let me just plug that – on CBS News this week, [inaudible].

But this whole concept about being a business ally is getting some traction, and as you’ve seen, we are doing ads in conjunction with major clients which goes a long way to referenceability. I don’t think there is anything dramatically different in the mix.

Tien-Tsin Huang – JP Morgan

Does the sharp increase apply to the U.S. government business as well? I am curious to hear if there is any color on federal.

Ronald Rittenmeyer

The U.S. government business has a reasonable amount of pipeline, we are very comfortable with it. The ID/IQ stuff, we don’t report ID/IQs the way some people do. We don’t take the credit for having signed an IDIQ because obviously the real key is getting the deal within the ID/IQ. So some people claim that as a win, but I don’t know how you could do that unless you actually get a signed deal.

From an ID/IQ standpoint, we are participating in a much broader group of things that we’ve been awarded to participate in. So the US government I’m comfortable with. We have a new leader over there, Dennis Stolkey, who is doing a great job and they are driving that pretty hard.

Tien-Tsin Huang – JP Morgan

The airline industry, a lot of consolidation, bankruptcy news. Any impact there to EDS?

Ronald Rittenmeyer

No. We still maintain, it’s a tough business for the airlines, it’s a good business for us. We were obviously involved in some of those bankruptcies. Frontier, Aloha, et cetera but it’s de minimus; I mean it’s a rounding error in terms of impact to us. We are sensitive to that and aware of that, but our key partners, the primary airlines that we support, are absolutely great partners and so no impact at all.

Tien-Tsin Huang – JP Morgan

I was hoping to maybe get the annual revenues for the two acquisitions that were announced in the quarter? Just to give a rough idea for modeling purposes?

Ronald Rittenmeyer

Can we do that one offline? I don’t think we have that right here in front of us. Can you do that maybe with Ron or Dave after?

Ronald Vargo

The Nexagent is quite small, and Vistorm is more substantial. I think on an annualized basis it’s around $100 million and Nexagent is a rounding error probably right now.

Ronald Rittenmeyer

You guys can have that conversation later.

Tien-Tsin Huang – JP Morgan

That’s useful. Thanks a lot. Nice job on the quarter.

Operator

Our final question comes from Adam Frisch - UBS.

Adam Frisch - UBS

Thanks, it was worth sticking around. Two questions, most of it has been asked already. On the timing of the workforce management initiative, if Q2 doesn’t ramp as fast as you said, in the $80 million to $100 million range, could we see a downward revision of the free cash flow target or is the difference between a quarter or two not really matter enough to change the full-year target?

Ronald Rittenmeyer

I’ll let Ron Vargo answer that as well; I mean, my view is I don’t think so, Adam. I think at this point I don’t anticipate any downward revision. Ron?

Ronald Vargo

I agreed with that. We expect to spend $80 million to $100 million, and if we didn’t, I would not expect a downward revision.

Adam Frisch - UBS

The only other question I had also on the free cash flow. The slide in the deck, I don’t think it was in there. It was in prior presentations, but what was the total for CFTs in the quarter and how does that compare year-over-year? How do you think that will run for the full year ‘08?

Ronald Vargo

I don’t have the data in front of me, but I would say CFTs will be higher year over year, substantially higher year over year but some of the capital leases and software financing will be down substantially year over year because I think about the overall asset financing on a full-year basis, ‘07 to ‘08, I don’t expect material changes year to year.

David Kost

Teresa, I’d like to thank everyone for joining us on the call today. I know there are still some of you in the queue, so feel free to contact my office. We’ll be glad to get to you over the course of today.

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Source: EDS Q1 2008 Earnings Call Transcript
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