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Executives

John Lyon - Director of Investor Relation

Peter Altabef - Chief Executive Officer

John Harper - Chief Financial Officer

Analysts

Rod Bourgeois - Stanford Bernstein

Joseph Vafi - Jeffreys & Company

Eric Boyer - Wachovia

George Price - Stifel Nicolaus

Perot Systems Corp. (PER) Q2 2008 Earnings Call July 29, 2008 10:15 AM ET

Operator

Good morning. Thank you very much for standing by and welcome to the Perot Systems Second Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen-only mode and later we will conduct a question-and-answer session with instructions to be given at that time.

During the course of today's call, Perot Systems will be making forward-looking statements that contain risks and uncertainties. These statements are only predictions and actual results may vary materially. Perot Systems disclaims any intention or obligation to update forward-looking statements as a result of new information or otherwise. Please refer to the Perot Systems Form 10-K for the fiscal year ending December 31, 2007 for a listing of risk factors that could cause actual events or results to vary from those contained in the forward-looking statements.

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

John Lyon – Director of Investor Relation

Good morning. Welcome to our second quarter earnings conference call. During our call today, Peter Altabef, our CEO, will review the performance of our major units and John Harper, our Chief Financial Officer will provide a review of our financial performance and forecast.

Before we get started, let me remind you that in addition to our press release we have placed a downloadable financial summary for your convenience in analyzing our financial results at perotsystems.com. In addition, we will refer to two non-GAAP financial measures today.

The first is free cash flow which is a measure we use to assess the net cash production of our operations, including long-term and short-term capital. It is calculated as operating cash flow less capital expenditures. The second is organic revenue growth, a measure of our pre-acquisition revenue growth; it is calculated by taking total revenue growth less the revenue growth contribution from acquisitions completed in the past 12 months and comparing it to second quarter 2007 revenue. The information necessarily calculate these measures is available on our earnings press release.

Once again, I want to thank you for joining us today, I'll turn the call over to Peter.

Peter Altabef – Chief Executive Officer

Thank you, John, good morning and thank you for joining us, we had another good quarter. Revenue was strong at 705 million. Earnings and profit margins continue to expand earnings per share of $0.24 represents year-to-year growth of 33%. Our operating margin expanded by one percentage per year to 6.7%. New contract signings were 261 million for the quarter bringing the total value of contract signed during the past 12 months to 1.8 billion, and cash flow strengthened as a number of days our accounts receivable with outstanding decreased. For the quarter revenue grew by 11% year-to-year on a mix of new client sells and existing client expansion. We are still seeing existing contracts expand and discretionary investment continue, and the level of clients satisfaction we are generating continues to present us with new opportunities to expand our relationships. We are honored that the trust we have developed with our clients is not only presenting us with opportunities to serve them in new ways but the references they provide are critical to winning new business. This client’s feedback is also resulting in industry recognition.

In the second quarter the outsourcing center recognized our relationship with Howard Pilgrim as the best outsourcing partnership, and our national relationship for the best first steps. This is the third time in five years that one of our outsourcing was recognized as the best outsourcing relationship. In addition, we have received the number one ranking in the well known healthcare industry class survey of professional services firms that provide clinical implementation services. In fact, Perot Systems was the only company of our healthcare industry providers that was ranked above the industry average in all business and performance categories.

Turning to a review of our inner performance within healthcare this represents 46% of our revenue, we continue to see sales activity broader in terms of the provider organization served and the services delivered. Where our provider revenue historically consisted mostly of large hospitals clients, we have been able to build upon our market leadership position to take our solutions to developing areas of this market. Today one half of our provider revenue comes from these developing areas including IT outsourcing and clinical solutions for small-to-mid size hospitals, revenue cycle management for hospitals and large physician groups, providers in the international community and the federal government. In total these developing areas grew organically by 25% year-to-year in the second quarter.

However, as we discussed last quarter there were two years of year-to-year revenue weakness within healthcare. First, payers and health insurance companies where we had spiking projects last year. The spiking projects caused a sequential revenue decrease entering this year. However, payer revenue grew 2% sequentially in the second quarter. Second, large health systems where market activity has been slow. On our last earnings we reported an increase in sales activity; we subsequently led to two expansion contracts with an aggregate value of approximately $80 million in the second quarter. One of these contracts is related to a multiyear clinical initiative and other data warehousing and business intelligent solution. From a sales perspective current activity within healthcare is broad with opportunities in all of the major segments we serve.

Government services which represents 23 percentage of our revenue grew by 11% year-to-year with this growth coming predominantly from three sources. Our Department of Education contract wins form late last year; the Coast Guard and the United States are made through our eye test tube contract vehicle. New contract bid activity still consist predominantly of smaller test orders.

Our commercial business which consists of our commercially focused areas within industry solutions and our consulting applications solution line of business represents the remaining 31% of our revenue. Combined these two areas have been growing at a rapid pace, 25% year-to-year in the commercial quarter with commercial growing by 30% year-to-year and consulting and application solutions growing by 23% year-to-year. This growth came from a mix of IT outsourcing, globally delivered application services and consulting. The pace of our commercial business continues to be positive. As we’ve discussed previously our industry solutions areas and our consulting and application solutions unit have been increasingly working together to serve clients. As we moved to the third quarter we are realigning our organization to continued building upon this collaboration and our consulting and application solutions unit will become part of industry solutions. While this realignment does not represent a major operational changes, a real unify teams with our two lines of business that had overlapping end market, it will leverage the domain expertise that exist in this two units and it will build upon the growing collaboration between the lines of business in providing globally delivered services.

Global service delivery has become the standard in our industry, the lines which we in onshore and offshore have blurred within our operations has team serving clients and multiple countries and locations. Today, 40% of our non-government service head count is a low cost geographies and we provide a full range of services globally including infrastructure applications and business process services. This realignment of our commercial and consulting applications capability will help us to continue to build our leadership position to provide globally delivered services. Overall, the second quarter represented another positive straight forward for our business.

John Harper will now detail our profound our financial performance for you.

John Harper - Chief Financial Officer

Thank you, Peter. Good morning everyone. I want to thank you for joining us today. In the second quarter, we continue to build upon the solid growth foundation we established. Revenue, earnings per share, operating margins and free cash flow all expanded sequentially. With this latest profit margin expansion we are now operating in our target operating margin range for the year and are seeing greater potential for free cash flow in 2008. It was a good first half of 2008. We look to continue building upon this progress in the second half of the year. I will begin my detail review of our financial performance with revenue. Revenue grew by 11% year-to-year. We have 8% organic growth plus a $22 million or 3 percentage point contribution from acquisitions. By line of business, industry solutions revenue grew by 11% year-to-year with acquisitions contributing 5 percentage points of this growth. Organically, most of our revenue growth in this line of business came from new client contract wins. Although, our existing contracts continue to grow up 1% year-to-year, government services revenue grew by 11% year-to-year. 69% of our growth came form new outsourcing contract signed over the past year. With the existing programs growing by about 3% year to year as a result of program expansion in the army and Coast Guard business.

Consulting and application solutions revenue grew by 23% year-to-year. Consulting services continue to perform very well growing by 35% year-to-year on demand for SAP and operational optimization services. Globally delivered applications services grew by 19% year-to-year.

With questions about the state of the economy and its potential impact on services I thought that review of our revenue composition would be helpful. Approximately 70% of our business comes from markets that have traditionally been less cyclical healthcare and government services. These areas produce second quarter year-to-year growth of 3% and 11% respectively. Our commercially focused areas comprised the remainder of our business and increased by 25% year-to-year. With this part of our business we continue to see favorable growth trends in both the backlog and add on components of our business. 52% of our commercial revenue comes from backlog which is stable and more secure. This revenue grew by 25% year-to-year and 8% sequentially. The non-backlog component of our commercial revenue represents the remaining 48%. This grew by 26% year-to-year and 13% sequentially. From these results you could see that our business continues to form well in the current economic environment. We are pleased of what we have seen in terms of contract expansion, projects and consulting growth during the first half of the year. However, we still maintained a cautious stands given the broad economic environment.

Earnings per share grew by 33% year-to-year to $0.24. This growth comes from strong performance in our industry solutions and consulting application solutions line of business. For industry solutions, pre-tax income grew by 9 million. This growth comes from strengthening profitability on existing contracts, operating efficiencies and new business. Partially offsetting this growth was an increase to incentive compensation expense related to rebuilding our bonus for this year.

Within our existing contract base stronger profits resulted from core contract efficiencies, project related, expanding volumes an increases to sculptor services we provide. Market signs continue to be positive in the quarter.

For consulting and application solutions, pre-tax income grew by 50% year-to-year, a contributions from new business and higher overall utilization. These increases were partially offset by government services or we entered the year with a few early stage fixed price outsourcing contracts. Consistent with the traditional IT outsourcing model, early stage contracts tend to create profit pressure and so operating efficiencies can be achieved which is why we expected government services profits to be pressured in 2008.

Our operating margin increased by one percentage point year-to-year to 6.7% for the quarter. Rebuilding our bonus tool added approximately 1.5 percentage points of market. So the underlying increase was approximately 2.5 percentage points. The factors behind this margin are the same as I discussed moment ago, the increase to existing account profitability, efficiency gains and margin expansion for consulting and application solutions.

For the third quarter we expect revenue to range from 700 to $715 million. The major drivers of sequential revenue growth will be new sales with the amount of growth realized being dependent on the timing and level of sales closed in the quarter. The greatest potential for new contract signings will likely come in the second half of the quarter, these increases will be partially offset by slightly higher faster revenue in the second quarter that will not recur. From an earnings perspective we expect increase in account profits to be at least partially offset by normal startup cost pressure from new sales and a slight increase to SG&A. SG&A should normalize between 10.5 and 11% of revenue. We expect earnings per share to range from 2030 to $0.25 per share.

Cash ended the quarter at a $196 million, free cash flow was 46 as day sales outstanding improved sequentially by 3 days to 62 days. Capital expenditures totaled 1.8% of revenue, as capital requirements remain low. In looking at our free cash flow for the year the level of DSOs at which we are operating and generally low requirements for capital make us comfortable that free cash flow for the year should approach the level of net income. The trends regarding cash flow have been positive which has resulted in this increased expectation.

Other major uses of cash for the quarter were acquisitions at $21 million primarily related to high QIT and original solutions and a $30 million reduction in the months outstanding or a line of credit. Overall, our cash flow was progressing well this year as earnings advanced, profit margins expand and capital requirements remain low. To conclude, we are building upon the growth foundation we established at the beginning of the year. We are working to move our business forward one step at a time with the objective of demonstrating steady financial progress. I will thank you and we will now answer your questions.

Question-and-Answer Session

Operator

This concludes the formal portion of the conference call a question-and-answer session will now be conducted. [Operator Instructions].

The first question is from Rod Bourgeois with Stanford Bernstein.

Rod Bourgeois

Yes, Rod Bourgeois here. Hey good morning.

Peter Altabef

Good morning.

Rod Bourgeois

A two part question on the demand front, so it sounds like you’re experiencing solid add on work it looks like you’ve actually had growth in that add on work category, I was wondering if you could give us some specifics on what is helping growth in your add on work, and specifically in the commercial and in the healthcare units that would be very helpful. And then the second part of the question on demand is, can you just give us an update on what’s happening in the larger outsourcing deal pipeline in the healthcare vertical, is that starting - is that continuing to look a little better or we still in a bit of an uncertainty particularly as we approach the election? So, first add on work, and second large deal healthcare market?

Peter Altabef

On the add on work question Rod, that is one obviously for the last two quarters has been consistent issue about project work. I would say to you that add on work is broadbased, there are some areas where I wish it was stronger, for instance, on the add on work in healthcare consulting in particular there is not as much work there as I would have expected and we would have hoped, and I think that is an area where the economy is hitting some of the healthcare providers in their discretionary patterns, other than in healthcare consulting, I think the add on work that we’ve had has been pretty broad based.

With respect to the pipeline and looking at it and seeing where its headed, your second question, I would say it is also changing, I would tell its changing for the positive so that the last quarters we have been pretty cautious for instance about the healthcare pipeline. I think the healthcare pipeline is looking better than it has in the last two quarters, it is certainly than it has been, many more deals, more life stage deal, more activity, and as I mentioned in my remarks that activity is really across the board whether that’s in some larger deal work, the small-to-medium hospital work, the physician work, the international work as well as the government work that we’ve got really is broad-based, I wish we have been selected for some work internationally in the Mideast which is continuing to expand our international footprint and we are very excited about those opportunities.

The one thing about that healthcare pipeline, I would say Rod, it is still not populated with very large deals. So it caps out you know, currently at what traditionally we would have considered a relatively modest size. So aren’t any mega deals in front of us in terms of new client work. But we are continuing to work on that and we are hopefully that that piece of the market will come back. The rest of the market looks in fact quite healthy.

With respect to the non-healthcare part of our pipeline, you know, the commercial unit as I mentioned in my remarks has been growing and growing nicely. That’s continuing again, this is not a market that I would say is characterized by a lot of large deals, but it’s characterized by a lot of mid size deals.

Finally in government, you know, government is as you can see from several of our comments, we have signed a very large client and towards the end of the last year with the Department of Eduction, largest government new sales client we had signed. And we are working through that, it did affect margins of a second quarter and I think you know, we are hopefully that that will begin to turnaround in the third quarter. The pipeline and government is largely also on the small to medium size at this point. And I would expect much else on that given the budget situation for the rest of the year with Congress.

Rod Bourgeois

All right.

Peter Altabef

I hope that helps you.

Operator

The next question is from Joseph Vafi with Jeffreys & Company.

Joseph Vafi

Gentlemen, good morning. Good results here. Maybe we would start with couple of question I guess, my first one would be on the incentive comp levels that were accrued in the quarter. Are we expecting -- I mean I know that you are a little bit behind in incentive comp, are you accrued up to a good level now or are we going to continue to be accruing at maybe higher than average levels on incentive comp for the rest of the year? And then secondly, maybe we could get an update on your VA work? Thanks.

John Harper

Thanks Joe. On incentive comp we are essentially accruing what I will call a full market level. For the year I anticipate that accrual will be some $30 million in excess of what it was last year. For the quarter it’s in the range of about $10 million or about $0.05 of earnings per share pressure in the quarter. So that’s one of the things we are most pleased about as we made really good progress on the margin front, while refilling that bonus approval and that that shouldn’t be underestimated. In terms of VA, I will let Peter take that.

Peter Altabef

Yeah, I would. We are very proud of the work Joe that we are doing at the VA that work continues and continues to expand. I would say not expanding as much as we would like, because there are some issues inside the VA with respect to their contracting posture at this point. So they are at the number of awards being issued out of the VA as we would like. We expect that to turnaround and when it does we expect to be very well positioned to grow in the VA.

John Harper

Now that we do have some current growth prospects that we are working with them as we speak.

Operator

The next question is from Eric Boyer with Wachovia.

Eric Boyer

Hi, thanks. Just on the revenue guidance, if you look at the low end of that, I am just wondering what lines of business you may see pressure that would lead for it to be down quarter-over-quarter?

John Harper

Are you talking about that -- Eric are you talking about the third quarter?

Eric Boyer

Yeah, the third quarter.

John Harper

Well if you look at that you know, if you look at government services, you could see some sequential up lift moving to the third quarter, but could be relatively flat, it is really depends on where we come out on some of these task orders. If you look at -- just kind of break down the quarter, you start with 705 million in the second quarter. We did have some pass-through in the quarter about $6 million that’s gets to you about 699 for the quarter. We give in the revenue range of 700 to 715, you know, which is a fair growth of the 699. The revenue growth depend as I said in most areas on new contract wins, so that really you know, healthcare will probably be relatively flat again unless we have signings that impact the quarter, although, we expect most of our signings to be toward the back end of that quarter.

John Harper

Okay. If I remember correctly, I think you've had an unusually large amount of government recompetes pushed out into 2009? And I am wondering if you can quantify operating margin benefit that may provide in '08 and should we be thinking of that as being possible headwind in 2009

Peter Altabef

In terms of the recompetes with government, as we have worked through the year, there have been actually less recompete work for our clients this year than we would have expected. So you are dealing with a lot of contracts that are getting pushed six months, pushed out 12 months. In terms of what we have holding the next 12 months, we have about 20% of our government work that will come up for recompete, which is not an extraordinarily high number. So we are focused on it and working on it, but it's 20%. In terms of our operating margin for government work, obviously we expect it to increase from where it is this quarter as we kind of work through the fact that we have in-government which was relatively unusual for us kind of a large contract not dissimilar from some of those commercial contracts for this time in the government space.

Operator

(Operator Instructions). There is a question from George Price of Stifel Nicolaus.

George Price

Hey, thank you. Good. I got my question on the government recompete. So congratulations on some good numbers. If I could just kind of follow up and then my main question. The follow up is really to the comments that you have made on the healthcare pipeline particularly around the small mid sized deals. You have ticked up on the potential that there maybe some layoffs going on at JJ Wild, which is obviously kind of in the core area that you are focusing on in the small to mid sized particularly around Meditech. Could you comment on that at all and how it relates to the demand that you are seeing?

Peter Altabef

Sure. I gave a number in my talk George about our developing provider market which is really the brighter market outside of, if you will, that large hospital contacts. I think the number I gave was that year-to-year, that was about 25% organically and that was excluding the JJ Wild in that figure. Had we included JJ Wild, I think the number would have been 47%. With respect to JJ Wild, we are very excited about that acquisition. There is a change, if you will, in the composition of the labor force there, the consulting work that we have at JJ Wild has been dramatically increasing and it's really a change of composition. In terms of revenues sequentially from the first quarter to the second quarter, our revenue at JJ Wild increased by 4%. So we think that that is an acquisition that it is getting back to where we had expected it to be and it's just doing it in a little different form than we had thought, but that’s kind of the way it works. I will defer it to John for any more specifics.

John Harper

No, I think that’s right. Peter noted that the consulting revenues doing well, it was up 18% sequentially. So that's still a big key, I mean the JJ Wild business, the capability, the relationships they have, the solutions are still front-end center and critical to our bid market offering. So we are very pleased with the partners we are making there. George, did you have a follow up question?

Operator

Your last question comes from Joseph Vafi with Jefferies and Company.

Joseph Vafi

Hi. Thanks for the follow up.

Peter Altabef

Hi.

Joseph Vafi

We talked a little bit about higher pass-through revenue in a quarter, higher accruals here on the incentive comp line and even maybe a little bit of startup cost pressure here in some of the government work and still you came out with a pretty good operating margin and a little bit up sequentially here. I was -- and I know you talked a little bit about some of the drivers there. If we kind of look towards the second half of the year and we saw maybe some of those pressure ease, I mean, are we in a position really to more margin expansion play out here over the next few quarters?

Peter Altabef

I mean of course that’s always our goal, but it really depends on revenue growth I mean, when you get new contract when you do have some normal startup profit pressure as we noted SG&A will be increasing slightly. So it really just depends for example, how much project work we get, project work has been very good and strong in our results, we’ve seen good benefits from areas like financial services which is harder to forecast into the future. So, net, net we are very comfortable and hopeful to be operating in that margin guidance range that we laid out.

Joseph Vafi

Okay, that’s helpful, and then just maybe finally you commented on a couple of pieces of healthcare, some larger pieces of healthcare business, would those be typical in an outsourcing nature and have kind of – a little bit of a profit share on the startup, are they more project based work?

John Harper

Well, most of that – we are not looking at, as Peter noted we’re not looking at these large mega deals. So you don’t see the real big upfront pressure, we’re talking about smaller deals that tend to be more profitable upfront, you still can have the kind of normal upfront profit pressure, but not the big mega deal kind economics.

Peter Altabef

And I would say as you go through the long term on healthcare we remain very bullish in the field, there was a question earlier about government healthcare, the statistics I have seen on government healthcare are that within the government that is one of the higher growth areas over the next three or four years. Healthcare is a long term play for us, it will be for wealthy, but it is a long term, it is a long term. We are actively sticking as you saw in the last couple of quarters through the pipeline issue and we continue to invest their. So as we look merger and acquisition work we are actively seeking for healthcare opportunities there as well, we think this a very good time to consolidate some positions in the healthcare field and we’ll continue to work on those.

Operator

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

Peter Altabef

I would like to thank everyone for joining us on the call today. As it was mentioned in beginning there is a two page downloadable on our website which I hope you’ll find helpful and of course we are always available for questions. Thank you I would look forward to speaking with you on the next call.

Operator

Ladies and gentlemen thank you for participating in todays Perot Systems conference call. You may now disconnect.

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