Unisys Corporation (UIS)
Q1 2008 Earnings Call
April 30, 2008 8:15 am ET
Jack McHale – Vice President Investor Relations
Joe McGrath – President, Chief Executive Officer
Janet Haugen – Chief Financial Officer
Jason Kupferberg – UBS
Julio Quinteros – Goldman Sachs
Eric Boyer – Wachovia Securities
Good day everyone and welcome to the Unisys first quarter 2008 results conference call. At this time I would like to turn the conference over to Mr. Jack McHale, Vice President of Investor Relations at Unisys Corporation. Please go ahead sir.
Well thank you operator. Hello, everyone and thank you for joining us this morning. Earlier Unisys released its first quarter 2008 financial results and with us this morning to discuss our results are Unisys President and CEO Joe McGrath and our Chief Financial Officer Janet Haugen. Before we begin I want to cover just a few housekeeping details.
First, today's conference call and the Q&A sessions are being webcast by the Unisys investor website. This webcast including the question and answer session is being recorded and will be available as a replay on our website shortly after the conclusion of the live event. Second, you can find on our investor website the earnings release as well as presentation slides that will be used this morning to guide our discussion. These materials are available for viewing as well as downloading and printing.
Third, today's presentation, which is complimentary to the earnings press release, includes some non-GAAP financial measures. Certain financial comparisons made in this call will be with and without the impact of retirement expense and restructuring charges. In the presentation we have provided a reconciliation of our reported results on a US GAAP basis compared with our results excluding the impact of restructuring charges and retirement expense.
Finally, I'd like to remind you that all forward-looking statements made in this conference call are subject to various risks and uncertainties that could cause actual results to differ materially from expectations. These factors are discussed more fully in the earnings release and in the company's periodic reports as filed with the SEC. Copies of these SEC reports are available from the SEC and from the Unisys investor website. Let me now turn the call over to Joe.
Thanks Jack. Hello everyone, welcome to today’s call to discuss our first quarter 2008 financial results. Please turn to slide 1 to begin our discussion. We continued to enhance the profitability of our operations in the first quarter. We were pleased by the continued steady margin improvement of our services business which represented 87% of our revenue in the quarter.
In services, we were able to drive continued year over year improvement in our margins as a result of the portfolio repositioning and cost actions that we’ve been taking. There were other important points of progress in the quarter. Our annuity based outsourcing business continued to grow as clients saw value in our outsourcing portfolio as a way to reduce costs and enhance client service in a difficult business environment.
Our services order grew by a double digit rate in the quarter. It was driven by gains for outsourcing and systems integration and consulting services. We saw stabilization of our systems integration and consulting revenue in the quarter and believe that we are beginning to see improvement in this business. We were able to eliminate the remaining excess temporary contractor costs that have been impacting our margins and this issue is now behind us.
Outside of our Federal business, our strategic program revenue continued to grow at a double digit rate. Our revenue in the quarter came in lighter than we expected due to some softness in our US business. The most significant revenue decline was in our US Federal business, which was impacted by contracting delays at certain agencies. We also saw some impact in our US technology sales as some clients tightened spending on IT projects in an uncertain economic environment.
The Federal revenue decline in the quarter was, we believe, a timing issue and we look for revenue trends in the Federal business to improve in the second quarter. We also believe that our services business is poised to return to revenue growth as we move through the year. An important challenge we are facing right now is the decline in our technology sales and the impact that it’s having on our technology margins.
We are rolling out a new growth strategy and portfolio offering in our technology business around real time virtualization software and services. We look to begin seeing results from this new strategy later in the year. In the meantime, we are taking measures to drive short term revenue opportunities across the business as we work through the softening in the US.
We are also continuing to drive our ongoing cost reduction program across the organization to enhance our margins. This morning I will spend some time going through our strategy for 2008 as we finish up our three year repositioning program. First, I’d like to briefly review our first quarter results. Our CFO Janet Haugen will provide details on the results, but please turn to slide 2 for a high level overview of our revenue in the first quarter.
At the top line you can see our revenue was down 3% in the quarter. Geographically this was driven by an 11% decline in our US revenue. From a business segment perspective, the revenue decline was primarily in the technology business, down 16% in the quarter while our service revenue was down 1%. Peeling the onion a little more, the revenue decline in our technology business was centered in the US.
Technology revenue outside of the US grew in the quarter. The largest contributor to our US technology revenue decline was our Federal business. The rest of the US technology revenue decline was in various commercial industries as organizations reacted to economic uncertainties by tightening spending.
In our services business outsourcing revenue continued to grow in the quarter. As I mentioned earlier, a positive indicator in the quarter was in our systems integration and consulting business. Revenue in this business was flat in the quarter after the recent declines we’ve seen in this business. Another positive indicator was our infrastructure services business.
While infrastructure services revenue declined double digits from year ago levels, the business has stabilized at about the same revenue level for three consecutive quarters. As I’ve described in past calls, in both these businesses we’ve been doing a lot of work to deemphasize non-strategic lower margin business as we focus on our strategic services business of outsourcing, enterprise security, open source and Microsoft solutions.
We believe we have now completed most of that transitional work and based on our order and pipeline trends, we are poised to begin growing again in services. Slide 3 provides an overview of our orders for the quarter. As you can see our services orders showed strong double digit growth in the quarter. We saw double digit order gains in both our US and international services businesses.
The US order gains were driven by contract signings in the public sector, including growth in Federal. Based on order strength, we anticipate that our Federal revenue will recover in the second quarter. More broadly, we continue to work a robust pipeline of service opportunities that we are pursuing in our strategic program areas. This order and pipeline strength should enable us to return our services business to growth again as we move through the year.
Slide 4 shows our operating profit trends in the quarter. As we’ve done in the past, we have provided operating profit on a reported basis as well as excluding cost reduction charges and retirement related expense. This is so you can track our progress against our ongoing corporate goal of an 8-10% operating profit margin, excluding retirement expense.
As you can see, excluding retirement expense, we saw a significant improvement in our services operating profit margin in the quarter to 2.4% from 0.8% in the year ago quarter. We lost some of that profit improvement, however, in our technology business where we had a year over year profit decline driven by lower sales volumes.
As a result, our overall corporate operating profit improved only slightly year over year. We need to begin building real traction from our new technology strategy and offerings around real time infrastructure to ensure this business is contributing to the profit improvement of the overall company. I will talk about this in a few minutes.
But first let me review the significant profit improvement we’re making in our services business. Slide 5 is one that we’ve been presenting over the past two years to show our services profit progress. This shows our quarterly services operating margins and excluding retirement expense as we’ve progressed through the repositioning.
If you follow Unisys you know we see a seasonal pattern in our services profit margins which are typically lower in the first quarter and trend up later in the year. Through 2007 and into the first quarter of 2008, we’ve made steady year over year progress in our quarterly services margins. In fact, this is the ninth consecutive quarter that our services operating margins have improved on a year over year basis.
We look for the services margin improvement to continue as we move through the year. Turning to slide 6, we see four key drivers that will benefit our services margins in 2008. First, we have essentially eliminated the added temporary contract labor costs that impacted our services margins in 2007. You’ll recall that we increased our usage of temporary outside contractors to meet service delivery requirements over the transitional period as we implemented headcount reductions.
These contractors added about $20 million in costs per quarter in the first three quarters of 2007. We took out about half these quarterly costs in the fourth quarter and we have now eliminated the remainder of the costs. This will help our services margins going forward. Second, in 2008 we will be getting the benefits of cost savings from restructuring actions taken over the past year.
We completed about 1,600 headcount reductions in 2007 and another approximately 375 reductions in the first quarter of 2008, so those should also help our margins going forward. Third, our margins benefit as we continued to expand our global sourcing capabilities by making use of lower cost delivery resources in India, China, Eastern Europe and other countries.
Unisys now has about 4,300 resources in these countries providing delivery services for client engagements around the world. We continued to target increasing that number to about 6,000 resources by the end of the year. That would represent about 20% of our overall workforce. We’re looking to continue increasing that percentage in 2009 and beyond.
Finally, we continue our work to reengineer processes throughout our services operations to increase productivity and enhance our margins. In the US, for instance, we’re rolling out advanced new capacity planning models and automated call scheduling tools for our field service teams who handle support calls for Unisys and partner engagements.
These tools have been very successful in pilot programs in terms of increasing daily call productivity and we are rolling them out to additional regions. Offsetting some of the margin benefits from these areas will be continued margin erosion from the declines in our core maintenance business. So we’ve really been implementing a major repositioning of our services business.
That repositioning is paying off in terms of improved profitability and we expect revenue growth to soon follow. Moving to slide 7, one of the best microcosms of this repositioning is the work we’ve done to turn around our US health information management or HIM business. This is the business where we provide Medicaid processing services and solutions to state agencies.
Over the past three years we’ve been successfully transforming this business from an underperforming operation with a small client base into an approximately $100 million annual business with a unique leading edge solution that is winning major new clients and delivering growing annuity revenue.
A few years ago our HIM business only had a few state Medicaid contracts. We were able to turn around an underperforming contract by working closely with the client, understanding its needs, understanding the changing landscape of the US healthcare and Medicaid market and coming up with a novel solution that today is being adopted by an increasing number of states.
Many US states today are operating with old rigid information systems based on proprietary technology. State agencies are frustrated by the high costs of maintaining these systems and the difficulty of making changes to support constantly evolving Medicaid program requirements. Working jointly with our customer, Unisys worked to develop our Health Path solution. We designed it from the start to be modular and highly flexible, building it on the standard off the shelf components and Microsoft software.
Clients can easily make changes in one component of the system without having to re-write other modules, dramatically reducing the need for change orders. As a result, the solution can enable clients to significantly reduce costs. And because we continually refresh components of the solution with new versions of commercial technologies, the entire solution continues to evolve and stay up to date.
Health Path is today the only Federally certified Medicaid management system in the market that is based on commercial off the shelf technology. Our original client of Health Path has become so pleased with the solution that last year it renewed its contract at significantly improved terms. We’ve since won two major clients in our HIM business, the state of Idaho in the fourth quarter of last year for a total potential value of $167 million and the state of Maine in the first quarter of this year for an estimated value of $179 million.
In the next few years, many state Medicaid processing contracts are coming up for rebid. In the next two years alone, we expect to be bidding some eight opportunities worth over $5 billion and we expect we are well positioned for this business. Turning to slide 8, a number of you have asked us about our exposure in our services business to a slowing economic environment.
Our services business is not immune to economic pressures, of course, but we do have some critical advantages as we work through the current US economic softness. As you can see in this slide, 43% of our services revenue today comes from outsourcing contracts. These are long term annuity contracts, where as I mentioned, we have generally good client relationships and retention rates.
We have a strong portfolio of offering in outsourcing that are well regarded by industry analysts such as Gartner and we continue to grow our base of business. I mentioned last quarter that we have employed new mega-deal teams to go after major outsourcing opportunities in our focus top 500 accounts. These are typically in the $50-$150 million range and sometimes larger.
We are seeing good success in winning large attractive outsourcing deals. In the first quarter, for instance, we signed an IT outsourcing contract valued at an estimated $225 million to support IT support services to 460 Department of Defense sites across Australia. This work had been done internally by the client.
In Europe we signed a five year contract with an estimated value of $65 million to provide IT outsourcing services to a global semi-conductor firm in Europe and North Africa. The deal expands on our existing outsourcing business with the client in the US. In total, we will be supporting some 30,000 employees in these regions.
In the US, as I mentioned earlier, we won a seven year contract from the state of Maine to provide a new Medicaid management information system based on our Health Path solution. Outside of outsourcing, our core maintenance business while in secular industry decline also represents annuity contracts. So more than 50% of our services business is annuity based and less subject to economic volatilities.
Our other services business, systems integration and consulting and infrastructure services are shorter term project work. In these businesses, given the current business environment, we are placing greater focus on projects that can deliver a short term clear payback to clients in terms of cost savings, while minimizing their upfront investments. For example, we are aggressively pursuing opportunities to sell application modernization services to help clients modernize their existing IT environment and realize significant and quick cost savings.
We recently enhanced our portfolio of offerings in this area. We are offering client opportunities to host new Unisys applications rather than having to invest upfront dollars in capital expenditures. This also provides us with more predictable annuity based revenue streams.
Overall, we believe we have positioned our services business to capture opportunities in the current economic environment. Turning to slide 9, economic issues present more of a challenge in our technology business. This is the area where we typically first see the impact of economic uncertainty as clients become more cautious and defer spending on new hardware and software.
We saw that first in the US in March and we expect to continue in the near future until the economic picture clears. In addition, we are facing two challenges specific to our business. As you know, our Clear Path server revenue is in long term decline as the mainframe market in general experiences industry-wide secular declines.
But, also, starting in the second quarter we will no longer be recognizing revenue for an intellectual property license to Nihon Unisys Ltd. in Japan. You’ll recall that in 2005, NUL paid us a onetime $225 million fee for access to certain of the company’s intellectual property. We have been recognizing this onetime fee as revenue over a three year period that ended March 31.
It amounted to $75 million annually or $18.75 million per quarter. We have been planning for the loss of this revenue stream throughout our restructuring program and efforts to reduce our breakeven point in technology. But the US economic slowdown has added to this challenge. Given these economic and business specific challenges, we are placing a significant amount of focus in 2008 on changing the model of our technology business.
Our goal is to create more consistency in the financial contribution made by this business. We continue to be too dependent on seasonal buying patterns and the timing of specific customer deals, all of which can be impacted by economic fluctuations. When the volume falls off as it did this quarter, it hits us at the bottom line.
To create more consistency in the business and drive growth, we are shifting our technology business model away from a historical hardware centric approach to a more predictable software and services driven model. As I mentioned last quarter, we have completely rebuilt the leadership team in our technology business under our new technology president Rich Marcello.
The tame has been rolling out an exciting new strategy and portfolio of offerings around real time virtualization software and related technology services. The market is seeing tremendous growth in virtualization software and services. Clients are struggling with how to get better utilization from the dozens or even hundreds of servers throughout their organizations.
At the same time, power, cooling and server management costs continue to escalate and today eat up 80% of every dollar spent on information technology. Virtualization technology offers a new way for organizations to get more from their computing assets while significantly reducing operating costs.
Unisys has tremendous assets and capabilities to bring to this emerging and rapidly growing market. We know mission critical technology. We have the expertise. We have the capabilities and the technology. We have the services to bring together the complex components needed to help clients realize the benefits of a virtualized real time server infrastructure.
Our strategy for the virtualization market is unique to the market in that it is based on best of breed technologies. Our competitors want to lock clients into their own proprietary hardware and software. We base our solutions on standard best of breed technologies from Unisys and a wide range of partners.
In February, we announced a number of new solutions for the real time infrastructure market and we’re planning an additional round of new introductions this quarter to continue to round out our portfolio.
Without getting too much into technical details, our new portfolio of technology offerings enable such sophisticated capabilities as repurposing of computing assets on demand in real time, automating IT processes that run a business, overseeing critical business processes and recommending corrective actions and managing resource consumptions.
We are excited by this new solution led strategy in technology and this new solution led portfolio. We have received very positive feedback from industry analysts and clients and we have already won some initial orders. We believe that this new direction will begin to shift trends in our technology business. But it will take time for this to happen and especially with the current economic pressures, we don’t expect to see the benefit from this new technology portfolio until later this year and into 2009.
Turning to slide 10, in summary today we continue to drive a major complex multi-year repositioning effort at Unisys. The repositioning continues to payoff in steady, tangible improvements in the profitability of our services business which we expect to continue throughout the year. Our multi-year outsourcing revenue continues to grow and we’re seeing encouraging signs in our systems integration and infrastructure services business.
Our services orders grew double digits in the quarter and we believe we are reaching an inflection point where our services business is poised to grow. We expect our Federal business to recover in the second quarter and within our technology business, our biggest challenge is driving improved results in a softer US economy. But we have a new strategy and a powerful portfolio of solutions for a growing market and we look for that strategy to begin paying off at the end of this year.
We continue to target achieving an 8-10% operating profit margin in the second half of the year and we’ll build on that as we go forward. Thank you again for joining us this morning, now I’ll turn over the call to Janet for a more in depth review of our financials. Janet.
Thank you Joe and hello everyone. This morning I will provide more details on our first quarter 2008 financial results, including cash flow. To begin, let me start with an overall summary of our first quarter 2008 financial results compared to the first quarter of 07. So please turn to slide 12.
At the top line, we reported revenue of $1.3 billion for the first quarter of 2008. This was down 3% from the year ago quarter, driven by a double digit decline in our technology business. Currency had a 5% positive impact on our revenue in the quarter. We anticipate a similar 4-5% positive impact on revenue in the second quarter. As a reminder, our first quarter 2007 results included a $32.7 million pretax restructuring charge.
Pretax retirement related expense was $600,000 in the current quarter compared to $23.5 million a year ago. Including these items, we reported first quarter 2008 operating income of $28 million compared with a first quarter 2007 operating loss of $29.6 million. Interest expense increased by $2.7 million year over year primarily due to increased interest rates and debt related to the refinancing of the $200 million 7.875 senior notes that were repaid in January 2008.
We reported $6 million of other expense in the current quarter compared with other income of $25.5 million in the year ago period. The principle reasons for the year over year change was that the prior period benefited from a $23.7 million gain on the sale of a business. On a pretax basis, we were slightly positive in the quarter compared with a $23 million pretax loss a year ago.
On taxes, as you know, since the write off of our US deferred tax assets in the third quarter of 2005, our tax provision can vary significantly from quarter to quarter depending upon the geographic distribution of our income. In the current quarter, we had $23.8 million of tax expense reflecting taxes on profit in countries outside of the US where we do not have full valuation allowance on our deferred taxes.
In the year ago quarter, we had a $26.6 million tax benefit which did include a $39.4 million tax benefit related to an income tax audit refund. At the bottom line, after taxes, we reported a first quarter 2008 net loss of $23.4 million or $0.07 per share. By comparison, in the year ago quarter, including the gain on the sale of the business, the tax refund benefit and the restructuring charge, we reported net income of $3.6 million or $0.01 per share.
As we’ve done in previous quarters, at the end of the presentation slides, we have provided supplemental slides showing details on cost reduction charges and retirement related expense. Please turn to slide 13 for an overview of our first quarter revenue by geography. As Joe mentioned, we saw softness in our US business in the first quarter. Our US revenue declined 11% in the quarter driven by declines in Federal and technology revenue.
The US represented 41% of our revenue in the first quarter. International revenue accounted for 59% of our overall revenue in the first quarter and grew 3% in the quarter. On a constant currency basis, international revenue declined 6% driven primarily by a revenue decline in Europe.
Slide 14 shows our first quarter revenue by business segment. Services revenue declined 1% in the quarter and represented 87% of our first quarter revenue. Technology revenue declined 16% and represented 13% of our revenue in the quarter. For more detail on our services revenue, please turn to slide 15.
Within services we saw continued growth in our outsourcing business which grew 5% in the quarter and represented 43% of our services revenue this quarter. Infrastructure services revenue declined in the quarter, however this revenue has sequentially stabilized as we’ve worked through changes in this portfolio. As we discussed in previous quarters, we have deemphasized non-strategic commodity based work.
Our systems integration and consulting revenue was flat in the quarter after recent declines that we’ve seen in this business. Core maintenance revenue declined 9% in the quarter. That’s consistent with the secular trends in this business. We ended the quarter with $6.97 billion in services backlog which is up 7% versus March 31, 2007 and up sequentially 2% from December 31, 2007.
Turning to slide 16. The 16% revenue decline in our technology business was driven by declines in both enterprise servers and specialized equipment. The technology revenue decline was in our US and Federal businesses. Technology revenue grew internationally driven by growth in the UK and continental Europe and the benefit of currency.
Enterprise server revenue declined 14% in the quarter and represented 78% of our technology revenue this quarter. Within enterprise servers, we saw a double digit decline in Clear Path revenue. Specialized equipment which represented 22% of our technology revenue declined 21% in the quarter. The decline primarily reflected lower payment systems revenue as we work through a product transition in that portfolio.
Moving to operating expenses on slide 17, we continue to drive our ongoing program to reduce operating expenses, although our progress in the first quarter is somewhat masked by the impact of currency on operating expenses. Operating expenses excluding time related expense declined slightly compared to the year ago period and were down approximately 5% on a constant currency basis.
As Joe mentioned, we are continuing our efforts to reduce our operating expenses. For a review of our services and technology segment margins in the first quarter, please turn to slide 18. As a reminder, Unisys has a long standing policy to evaluate business segment performance on operating income, exclusive of cost reduction charges and unusual or non-recurring items, therefore, these segments exclude such items.
We continue to make progress year over year in improving our profit margins in our services business. On a non-GAAP basis, excluding retirement related expenses, services gross margins improved to 18.5% in the first quarter, a 210 basis point improvement over the year ago period. Services operating margins on a non-GAAP basis improved 160 basis points to 2.4%.
Technology gross margins excluding retirement related expense were down slightly in the quarter over the year ago period. Our technology operating margin on a non-GAAP basis fell to 0.5% in the quarter from 4.5% a year ago, reflecting lower sales volumes against fixed costs.
Now please turn to slide 19 for an overview of our cash flow in the first quarter of 2008. The company used $49 million of cash from operations in the quarter compared to operational cash usage of $104 million in the first quarter of 2007. We used approximately $21 million of cash in the quarter for a restructuring payment compared with $50 million in the first quarter of 2007.
Total capital expenditures were $65 million in the quarter, compared with $83 million in the year ago period. After deducting capital expenditures, we used $114 million of free cash in the first quarter of 2008 compared to a free cash usage of $187 million in the year ago quarter. Depreciation and amortization was $100 million in the first quarter, and looking ahead for the full year of 2008, which continued to anticipate capital expenditures of around $300 million, and depreciation and amortization in the $360-$380 million range.
In terms of cash flow from financing activities, during the quarter we redeemed at par all $200 million of our 7.875 senior notes using proceeds from the senior note placement that we completed in December. We closed the quarter with $490 million of cash on hand. This concludes my comments this morning and now I’d like to turn the call over to Jack for questions. Thank you.
Well thank you Janet, thank you Joe. Operator we’d now like to open the call up for questions please.
(Operator instructions) Your first question comes from Jason Kupferberg – UBS.
Jason Kupferberg – UBS
I had a question on the services margin to clarify it to start. If we look at first quarter 07 versus first quarter 08 and if we exclude retirement expense and restructuring, can you give us the true apples to apples comparison in the services margins so we can really see what’s happening with core operations there?
The services operating margin excluding retirement expenses and the restructuring in the first quarter of 08 was $9.6 million or 0.8%. In the first quarter of 08 it’s $27.8 million, 2.4%.
Jason Kupferberg – UBS
So 160 basis points of improvement stripping out both those items?
Jason Kupferberg – UBS
As far as the services growth outlook, I know you talked about a return to growth and a potential inflection point, are we thinking 2Q here or is this more of a second half event?
In outsourcing as you saw, we’ve continued to climb and that’s a fairly predictable business for us. And so you’ll see that increase, or you’ll see the growth in that business continue. What you saw in this quarter was the stabilization which we’ve been working on for some time. Remember we’ve tried to work ourselves out of marginal portfolio items to a much greater focus on a vital few key set of portfolio items.
The same thing was true in terms of customers, trying to move toward our top 500 and top 50 away from a much wider, broader, unfocused customer set. We believe that stabilization has occurred in systems integration and you’ll start to see that business improve over time.
The same thing’s true of infrastructure services and if you remember we talked about a lot of low, unprofitable, unfocused engagements in infrastructure services. We believe as you’ve heard because of three consecutive quarters now of stabilized revenue in there, although the year over year compares are off, that business has stabilized.
So the only declining business now if you look across the various services segments is core maintenance which is in secular decline and that’s very predictable. You’ve been able to watch that over the last couple of years and I think it’s easy for you to incorporate that into your models. So all things considered, that’s why we talked about this inflection point. I think you’ll start to see that increase over the second half of the year.
Jason Kupferberg – UBS
A two-parter, first is there a plan for any further restructuring charges that you guys could call out this year and can you give us any update on your pursuit of potential portfolio rationalization or other types of strategic alternatives that you had announced earlier this year?
Let me start with the restructuring, we’re about 95% of our way through the initial restructuring efforts. And as you’ve heard, I think it was around 325 this quarter and there’s 300 plus for the remainder of the year. Each of the businesses continue some additional restructuring, as long as they are short term paybacks. So we’re not calling out reserves for restructuring if they can do it in the current quarter and so on.
And so we’ve gotten into a cadence where we’re trying not to call out reserves. People were doing it as part of a normal operational cadence. The second part of that is we’ve used a very careful management process around voluntary attrition, what I mean by that. And certain of our populations, whether they’re call centers, break fix analysts in the field, systems integration people, even headquarters people, when there is voluntary attrition we’ve developed the systems, some clear targets in back fill rates.
So instead of having to continue to restructure, we’ve tried to manage through this very careful management attrition program and continuing to right size targeted areas of our company. Now there’s two parts to it, so it might be a two for one replacement of a particular job code. But more importantly for us, we’re trying to manage a fair amount of that voluntary attrition in a movement to offshore locations.
So if it might be a call center in Austin, Texas or Salt Lake City or somewhere around the United States, we carefully try to manage that attrition where we have higher voluntary attrition rates to continue to move to our higher percentage of global sourcing. In terms of strategic reconfiguration, I think that was the semantics you used, let me deal with that in two ways.
One, you avoid MMI but I wanted to be very specific there. We have continued frequent contact with MMI, that interaction remains very constructive. Frankly we want what they want which is increasing the value of the company. And with that in mind, as you are aware, we’re looking at a number of strategic alternatives here. We have not been clear, deliberately because of fear of how that might affect various elements of our business.
But that’s work that’s ongoing and we will continue there. Let me answer a third part of the question that you might have asked which is, I think we were clear that Bear Stearns was actually the team that was supporting us there. Frankly they had done a fine job in supporting us, it’s unfortunate what’s happened to a fine company in this marketplace. But we know that J.P. Morgan will have to make the tough choices that they have to make to be effective in their business.
So I’ll answer a question you didn’t ask, but I know is probably on the tip of your tongue, are we exploring alternatives and as you might expect the answer is yes. We haven’t publicly announced any decisions here but you know it’s obvious that we would have to do that. So, I know I didn’t answer your question specifically but I think Jason you knew I couldn’t.
Your next question comes from Julio Quinteros – Goldman Sachs.
Julio Quinteros – Goldman Sachs
Joe, can you go back through the comments that you made on slide 10 regarding the model changes in technology, help us understand what the impact would be from the shift to a software based model from a revenue perspective and then any incremental expenses that would be required to actually drive the change in the technology segment.
Let me start at a very high level and kind of zoom down. The technology business has been an entirely new strategy and a new business model. And there’s a number of elements that we didn’t talk about today because we had done this work starting a number of years ago. And that is, at the high end of the market, if you really look, most of the major players there have really gone to standardizing on standard chips.
We came to the conclusion that producing our own custom CMOS chips a number of years ago didn’t make any sense any longer. And we chose to exit the customer semiconductor business. Now we used other peoples to fabricate, we designed those chips and a number of years ago we announced the strategy with NEC at our high end on an all Intel based strategy, because we came to the conclusion, once you exited the chip business, it was very hard to differentiate yourself on the high end of the hardware business.
We’ve licensed a lot of our proprietary technology to NEC to build a whole next generation platform there. Once you’ve crossed that bridge that you’re going to choose to, A, exit the semiconductor design and manufacturing business, B, exit the design. Now we’re still involved in co-designing with NEC the high end of our product line. But we will by the end of this year introduce the first model in that family of the joint effort and they will do all the manufacturing for us.
We’re frankly going to exit manufacturing, we’ve closed our plant, we’ve moved temporarily to another plant that’s an R&D lab in Southern California. And you’ll see NEC manufacturing our high end. Once you cross that bridge, you’ll notice that if you look at the overall high end of the market, almost all of the revenue and margin is moving to software.
So once Intel and AMD take the intellectual property and they move that in one direction for hardware, all the rest of it is in software and services. So, you’re going to see us, we haven’t introduced all the, you will see the introduction later on this quarter, you’ll see us flesh out a much broader technology platform family. And I’m not prepared to announce it today.
But not just the high end with NEC, a much broader platform, but we believe going forward, the vast majority of the profit, in addition to operating systems will be in virtualization software, real time infrastructure software and services. And so we’re going to remain loyal to continue to do R&D work for the Clear Path operating system as the core of what remained in that business.
But all the major new effort is around virtualization, real time infrastructure which is essentially a software business and the services required to be, what I will call, think of it as a data center systems integrator, taking both ours and others and this is the big change and why we’re different from anybody else, everybody else’s Intel based technology platforms, whether they’re Microsoft, open source and so on and build these virtualized data center of the future.
Now, we’re making big investments in that in terms of the sales side, in terms of partnering, in terms of alliances and rolling out a new technology platform that is not, that is co-designed by us on the high end but is not manufactured by us through the entire product family and that will end up being with the exception of our Clear Path business which we continue to make investments in, end up being a services and software business.
So eventually we’re going to have to even track ourselves differently in terms of segment reporting, once this has enough of a mix shift over time. And so it’s hard for that business today because they’re still reported as a standalone kind of naked technology segment. Knowing they’re in the very early days of their evolution, they eventually could be tracked from segment reporting as services and software.
Early stages, won’t start to see the real traction in the growth of this, starting in the third and aggressively in the fourth quarter of this year, but it’s a very different strategy and a very different business model. So I tried to capture a lot of things in a short period of time, I don’t know if I caught all of that for you.
Julio Quinteros – Goldman Sachs
I guess I’m just trying to understand two things. I guess one is as it relates to either the revenue or the pricing models as this stuff begins to come online. How do we think about this, is this more deflationary to the revenue profile of the business, you know sort of the initial stages until it ramps I guess from the revenue side.
And then from the expense side, how much is all of this shift going to cost you guys and how do we think about the incremental expense associated with going through the shift?
Normally when people think of it as being deflationary, they think of, for the sake of argument, four servers going to one and that’s deflationary in terms of revenue on the hardware side. We believe that’s going to be true, you see those kind of economics. The reason there’s a bit of schizophrenia in the market between the mid and high end server manufacturers is this is the hottest trend in the market and they’re schizophrenic because they know hardware sales will decline.
Right, because if you’re going form machines at 20% utilization to 80% utilization, I mean there’s a theoretical 4:1 case there. So most people don’t know if they should accelerate that or put the brakes on this if you’re a hardware provider. For us, because we’re exiting the hardware business, we’re agnostic in that argument of 4:1 because it isn’t going to be our hardware. And so we expect to see software to grow, we see services to grow.
In our core technology business which is Clear Path, it frankly has no impact. Now, some of the, remember we exited hardware manufacturing so you know we’ve taken what used to be fixed costs, manufacturing and made them variable costs and they’re imbedded in the unit manufacturing costs we get from a company like NEC.
Do we have R&D in this space, yes. The majority of our R&D today is still in support of our Clear Path base. And so you almost have to create two different models for this, what’s happening to our Clear Path business which is in secular decline and what’s happening to this business which is in a ramp over the next few months.
Julio Quinteros – Goldman Sachs
I didn’t hear you mention ES7000.
ES7000 is being refreshed as part of the NEC relationship later in this year. There will be other ES7000 family members introduced in the interim. And you will see a much broader family that I don’t want to give an early introduction to these May announcements for the technology business. But you’ll see a much broader ES7000 family, knowing full well that the high end co-designed by us and the low end designed to our specifications.
Julio Quinteros – Goldman Sachs
For Janet, do you have the segment constant currency numbers for services and technology?
The segments generally follow the pattern from the overall company standpoint. That’s pretty much true on the services side. And so the trends on revenue and orders, about the 5%, little bit less than technology than you see for the services company. The services at 87% of the total business, really right now because of the size of that, it is very much consistent with what our overall currency rate is.
And the technology business, historically and what we would anticipate going forward based upon the mix of revenue, that can be about one point different. But it’s generally in line with total company.
Your final question comes from Eric Boyer – Wachovia.
Eric Boyer – Wachovia Securities
I just wanted to dovetail on that last question if you could break out the US non-Federal commercial services revenue growth in the quarter.
We had commented that the US business overall is down 11% and the main driver in that was the Federal business. While we’re not going to break that between the Federal and the commercial side of the business, we did have declines in both businesses, but the percentage decline was larger in the Federal business than it was in the rest of the US commercial business.
Eric Boyer – Wachovia Securities
You talked about order growth being driven by the public sector I guess in the quarter, can you comment on the commercial sector services pipeline?
I think the public sector pipeline is the strongest for us, both Federal as well as other Federal governments around the world and state and local governments. So that’s pretty broad based and isn’t tied to one segment within public sector. In terms of commercial, it’s a bit weaker than the public sector business, but it’s still a pretty strong pipeline.
Eric Boyer – Wachovia Securities
Janet what was the drag on the quarter from the temporary labor costs?
The drag in the quarter on the temporary labor cost as Joe mentioned in his comments, we have gotten through that. There may be a residual amount of that in the quarter itself but we believe from where we were when we first started talking about this problem in the second quarter of 07, we have worked our way through it and only have a residual amount of an impact in the quarter.
Eric Boyer – Wachovia Securities
But you can’t be any more specific as far as the sequential decline?
The sequential decline, I guess what we had talked about last year about roughly a $20 million impact. And so in the quarter on a year over year basis, we probably have about $18 of that $20 improvement.
Eric Boyer – Wachovia Securities
You also talked about Federal delays. I was just wondering which agencies you saw some of those delays?
Based on our relationship with our clients, we’re really not prepared which agencies. But one of the things that you often find in the end of an administration, there’s often jobs that remain open in things like contracting and so on. And so you’ll find it pretty pervasive across the government these days.
And so it’s not as though people are deferring or pushing out contracts, it’s actually a resource constraint in the contracting part of the major agencies. We’re not prepared to tell you who they are for confidentiality reasons with those clients.
Eric Boyer – Wachovia Securities
And finally just an update on the TSA contract and where that rebid stands.
As you’re probably aware, April 17, the first phase of the RFP, it’s called information technology infrastructure program. As you might imagine we’re excited about the opportunity because it actually expands beyond the original opportunity. It’s actually over the life of the contract up to a $2 billion opportunity.
The first response is due May 14, we’ve been preparing for this for over nine months. We have an excellent team in place ourselves. We’ve recruited other great team members, Booz Allen, Nortel and many other key partners. From our perspective, it’s the most comprehensive re-compete effort at least in my memory since we’ve been here and the memory of most of the people in our Federal government unit.
In parallel, we’ve worked very hard to drive what we call a sea of green. As you might imagine, sometimes when people are re-competing for their own contract they don’t put the right level of effort to ensure that service level agreements are 100% green. Our customer satisfaction are at the highest levels that you could drive and so we’ve had two parallel teams, one trying to drive the highest service levels and customer satisfaction we’ve ever had and we reached that.
And the other team is a dedicated team just around this re-compete. That said, we have some very tough competition, this is one of the largest contracts in the government in the last few years and will be in the next few years. So as you might imagine, everyone is going to compete in this one. And so we knew that and that’s the reason we’ve made an investment where we essentially dedicated an entire floor of our Reston facility to pre-work everything from technology and innovation strategies, HR strategies, governance and so on.
So we expect a final decision in August or September or so. And we’re doing everything in our power to win this re-compete.
We’ve run out time so let me just summarize briefly. As you’ve heard we continue to drive our multi-year repositioning effort. And we’re encouraged by this steady year over year progress in our services margins. We’re encouraged by outsourcing continuing to grow. Double digit order growth which is really going to drive this inflection point comment I made in services.
We do have a challenge in our technology business but we expect to drive improved results and expect that at the end of the year and we continue to target this 8-10% operating profit margin for our business. Thank you very much.
That does conclude today’s teleconference, thank you all for your participation, you may now disconnect.
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