Computer Associates F3Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (CA)

| About: CA Inc. (CA)
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Computer Associates (NASDAQ:CA) Q3 2006 Earnings Conference Call January 24, 2006 5:00 PM ET

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Executives

John A. Swainson, Chief Executive Officer, President

Olivia Bellingham, Vice President of Investor Relations

Jeff Clarke, Chief Operating Officer, Executive Vice President

Robert W. Davis, Chief Financial Officer, Principal Accounting Officer, Executive Vice President

Analysts

John Rizzuto, Lazard Capital Markets

Walter Pritchard, SG Cowen

Michael Turits, Prudential Equity Group

Trip Chowdhry, FTN Midwest Securities

Sarah Friar, Goldman Sachs

Todd Raker, Deutsche Bank

Jason Maynard, Credit Suisse

Gregg Moskowitz, Susquehanna

Steve Mahedy, Banc of America Securities

Operator

Good afternoon, my name is Rocky and I will be your conference operator. At this time I would like to welcome everyone to the Computer Associates Third Quarter Fiscal 2006 Conference Call. All lines have placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. If you would like to ask a question during this time simply press “*�? then the number “1�? on your telephone keypad. If you would like to withdraw your question press “*�? then the number “2�? on your telephone keypad. Thank you. Mr. Lasher, you may begin your conference.

Olivia Bellingham, VP, IR

Hello and thank you for joining us. My name is Olivia Bellingham, Vice President for Investor Relations. With me today are John Swainson, our CEO; Jeff Clarke, our COO; and Bob Davis, our CFO. The purpose of today's broadcast is to discuss our third quarter fiscal 2006 financial results. Before we begin, please note that a slide presentation for the call is available on our website at www.investor.ca.com. This call is being broadcast over the phone and via live webcast open to all interested parties. All content is the property of CA and is protected by U.S. and international copyright laws. It may not be reproduced, transcribed, or produced in anyway without the expressed written consent of Computer Associates. We consider your continued participation in this call to be consent to our recording.

During this call non-GAAP financial measures will be discussed. Reconciliations of those non-GAAP financial measures to their most directly comparable GAAP financial measures are included in the earnings release and/or the supplemental financial information package, both of which are available on our website at www.investor.ca.com.

Today's discussion may contain forward-looking statements. Consistent with all of our public statements, there can be no assurances that these forward-looking statements will prove accurate, and actual results could differ materially from forecasts and estimates. Please refer to our SEC filings for further elaboration of the risks involved. In accordance with SEC regulations, all guidance given regarding our business and future performance will be disseminated in a public forum such as this call, which is webcast and available to any interested party on our website.

With that, I'll turn it over to John Swainson. John?

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John Swainson, Chief Executive Officer, and President

Good afternoon and thank you for joining us. I’ll start by giving you an overview of our financial results and a business update. Then I'll hand it over to Jeff Clarke to review the quarter in more detail, and to Bob Davis to discuss the financial results. When Bob is finished, we'll open it up for Q&A. Finally, I'll come back with a few closing comments.

Let me get right into the financials. For the third quarter, revenue was $967 million, up 5% from a year ago, and up 8% on a constant-currency basis. GAAP EPS from continuing operations was $0.09, up 80%. Non-GAAP operating EPS was $0.24, up 33%. Billings were 1.29 billion, down 1%, but up 2% on a constant-currency basis. Adjusted cash flow from continuing operations was 433 million, down 6% for the quarter but up 17% year-to-date.

Billings were adversely affected by the performance of our mainframe business, our restructuring of international operations, and the ongoing refocus on our sales force. On the positive side, we continued to see growth in our distributed product lines, particularly around some of the new acquisitions. I'll let Jeff and Bob provide you with more details on our results.

I also want to emphasize that we are increasing our guidance for adjusted cash flow growth from the previous 10% to now 12% to 15% for the full-year. And we're maintaining our guidance of mid to high-single-digit billing growth for the full fiscal year that ends on March 31st. This will reflect the strongest billing and cash flow performance in the last five years.

Let me change to talk now about the company. We're continuing to change the DNA of the company. As you know changes like this take time and despite the best planning are never as swift or as smooth as we would like. Nevertheless, CA's senior management team is incredibly proud of the improvements we've made to the Company in the last three quarters and sees great opportunity going forward.

Let me talk about some of the things that we've achieved. In November, we held CA World, where we unveiled our Enterprise IT Management strategy, and immediately announced 26 EITM-enabled products, including the release of Unicenter Release 11. This was CA's first Unicenter upgrade in four years and CA's biggest product launch ever. CA's EITM vision addresses the issues of fragmentation, cost, and vulnerability our customers face today. EITM simplifies and unifies technology ownership, enabling our customers to leverage their past, present, and future IT investments more effectively than ever before. CA's the only company that integrates management across security, storage, systems, networks, applications, and databases regardless of the vendor.

Our sales force has worked very hard to sell additional products to existing customers like Xerox, Oppenheimer, and Expedia, and we've attracted new customers such as Highbridge Associates, and XM Satellite Radio. This quarter we also made major changes to our brand and launched a new marketing campaign. We're now called just "CA," and we've updated our logo. These changes are symbolic of what we are doing to rebuild our marketing capabilities and take the company forward. We're asking our customers and employees to "Believe Again" in the power of IT, and giving them the reasons to do so.

This was the first full quarter that we've operated with our three largest recent acquisitions in place - Netegrity, Concord, and Niku. Over the past 18 months, we've made a number of strategic acquisitions to continue to round out our technology portfolio and expand on our EITM architecture, including the acquisition of iLumen in Q3. Earlier this month we announced our intention to acquire Wily Technology, a leader in application performance management. This acquisition when completed will expand CA's management capabilities into the application area, a sector that is showing explosive growth and is highly synergistic with our core systems management and security businesses. We are excited about the people, the technology, and the capabilities that these companies bring to CA.

I'm very encouraged by the trends I'm seeing in the overall software market. While customers continue to be discerning about their IT purchases, CA is increasingly invited to more in-depth, multi-product assessments. This is particularly driven by customers' excitement about CA's strategic, market-leading acquisition. This shift from selling point products to business solutions, which often involves systems integrators who are our key partners. And while multi-product engagements may lead to a longer sales cycle, the opportunity for CA is ultimately much greater.

Finally, I've met with hundreds of customers this quarter. These customer visits validate the importance of broader solutions and greater integrations, and the importance that customers feel in having CA as being a leading partner for them.

With that, I'm going to turn it over to Jeff Clarke.

Jeff Clarke, Chief Operating Officer, and Executive Vice President

Thanks, John. Quarterly billings were $1.29 billion, down 1% year-over-year, and up 2% on a constant-currency basis. Organic billings for the quarter were down 5% or down 2% on a constant-currency basis.

We've said a number of times that our billings and cash flow performance is lumpy, and we would experience swings quarter-to-quarter due to the timing of contract renewals and variations in customer payments. In our industry it is normal that some customers pay the entire contract value in one single installment. This contributes to variations in quarterly billings performance.

I'd like to highlight one customer who contributed significantly to our billings and cash collections in the quarter. A very important strategic outsourcer who is seeking to simplify its arrangements with certain customers entered into two transactions with CA. CA was able to lock-in products in a changing customer environment, selling new products, renewing past products, and even replacing some competitive products. The outsourcer financed the transaction resulting in CA receiving the full contract amount in one billing. This had a favorable impact on the quarter contributing $59 million more in the period than it would have been billed if the contract had been invoiced on an annual basis over the life of the contract. In the same period last year CA had three deals in excess of $15 million, for which we received the full contract amount in one installment.

As always, we encourage investors to look at billings over multiple periods. On the last 12-month basis or LTM, billings were $4.45 billion, up 1% year-over-year. Organic billings are down 2% in the period.

Let me touch on the billings performance of a few business units. ESM, or Enterprise Systems Management was up 10% for the quarter, 2% LTM. Growth is driven by outstanding performance in our SPECTRUM and eHealth product line as well as good execution selling distributed job scheduling products.

Security was down 8% for the quarter, up 21% LTM. Reasons for the decline included a tough compare with a couple of large security contracts in the prior-year quarter, and the transition of Netegrity from a perpetual up-front model last year to CA's ratable model this year. That said the pipeline for Security is strong and we're optimistic about Q4.

Professional Services were up 34% in the quarter, up 24% LTM. IT service and asset management and project and portfolio management services tied to Clarity Solutions fueled growth in BSO services due in part to continued customer demand for solutions tied to achieving compliance, reducing IT operational costs, and improving service levels. Identity and access management services also contributed to the strong overall services growth.

In Q3, new product sales were affected by our mainframe performance, international operations, and the impact of our ongoing sales force transformation. I'll start with our mainframe performance. At the beginning of the year we projected our mainframe business to be flat, plus or minus a percent or 2. LTM mainframe billings have declined 5%.

While we're proud of our strong distributed billings growth, we need to improve our mainframe performance. We're implementing a five-part strategy to do so. One, we're focusing on competitive replacements.

Two, we're enhancing our product line to exploit new technologies. CA announced Day 1 support for IBM's newest operating environment, z/OS 1.7 for all our products. We've also been enhancing our infrastructure products for DB2 and NetMaster, to support new standards. We are continuing the integration of mainframe storage to Brightstor SRM.

Three, we built a dedicated team of 80 specialists who work with customers to optimize their mainframe investments, help them configure new environments, and enhance and renew legacy environments.

Four, we stepped up our interaction with the user community, spending more time with them to help us shape our mainframe offerings.

And fifth and finally, we're partnering with IBM's hardware group to ensure customers continue to view the mainframe as a competitive platform for their most business-critical data and transaction processing applications.

Now I'll move onto the impact of our performance of our international operations. Although bookings for the third quarter decreased 14% to $832 million, performance was mixed across geographies. North American direct bookings were up 11%, while international bookings were down 36%. We are restructuring our international operations making significant changes to local management, and taking out non-performing sales representatives as we raise the bar in performance. Over the past six months, we've changed the area managers in the UK, Italy, Japan, China, and Korea. These changes are disruptive in the short term, but they're the right things to do to strengthen our sales force capabilities and to meet our long-term growth objectives.

Finally, the impact of the sales force transformation. As you know, we are changing our sales force strategy to drive new product and solution sales versus renewals. We're training our sales force on new products and solution selling, and we've built a compensation plan that encourages both. These changes take time, but we're seeing improvements each quarter.

Now I'd like to talk about Q4 and our expectations for the future. The CA management team has spent considerable time reviewing all geographies, business units, and channels. We have a strong set of deals in the pipeline. Our sales force has been operating with a new focus for about nine months, and we expect deals that we began working on in the early part of the year to come to fruition in Q4.

Our indirect efforts are showing some traction. Year-to-date, CA's indirect business including one-tier bookings has grown 7%. We have new leadership running those efforts and putting new programs in place, and working with our channel partners and VARs. We expect Q4 to deliver double-digit bookings growth. We expect continued momentum in our acquisitions and services business. And looking into next fiscal year, we're slated to release the versions of Unicenter r11, which operate on Microsoft SQL Server and Oracle 10g in early to mid fiscal 2007. We expect these releases to drive incremental billings next year.

Based on these reasons the front log of deals in the pipeline, the continued expected momentum of our channel business, acquisitions, and service business, and the recurring business, which our customers have already committed to, we reiterate mid- to high-single-digit billings growth for the year.

With that I'll pass it on to Bob to go through the financials.

Robert W. Davis, Chief Financial Officer, Principal Accounting Officer, Executive Vice President

Thanks, Jeff. Total revenue for Q3 was 967 million, up 5% over last year, or 8% on a constant-currency basis. Q3 subscription revenue was 713 million, which represented 74% of total revenue. Expenses for the quarter totaled 887 million, compared to 841 million in the prior year. Drivers of the increase included 24 million of additional SG&A from acquisitions and 20 million of additional promotion costs due to our new marketing and branding initiatives. Netting out those items, we've done an excellent job of expense management.

CA's effective non-GAAP tax rate in the third quarter was 29%, compared with 37% in Q3 of 2005. We expect it to be 29% in Q4 and 31% for the full year, compared to 32% for the full fiscal year 2005, the decline being due primarily to tax planning. Q3 non-GAAP EPS was $0.24, and GAAP EPS from continuing operations was $0.09. Both of these results included the impact of our establishment of the Ingres joint venture. We are picking up 25% of their operations. That, along with the gain on the sale of Ingres, resulted in a favorable impact to net income of approximately $4 million.

Cash flow from continuing operations was 422 million this quarter. Adjusted for 11 million of restructuring payments, it was 433 million. For the last 12 months, cash flow from continuing operations was 1.55 billion. Adjusting for restructuring and restitution fund payments and for one-time tax benefits, our last 12 months' adjusted CFFO was 1.46 billion, up 7% over the prior year. Our adjusted cash flow improvement was driven by better working capital management and the aforementioned tax planning. The cash flow reconciliation is available on our earnings slide deck, our supplemental package, and our press release.

Moving on to the balance sheet. We ended the quarter with 1.83 billion in cash and marketable securities, and 1.81 billion in total debt, bringing our net cash level to approximately 22 million. In December, Moody's Investor Service revised its outlook on CA to positive, from stable. This reflects our initiatives to improve our corporate governance profile and remediate internal financial control deficiencies, as well as our stable financial operating performance and conservative financial policies.

The primary uses of cash in the quarter were the repurchase of approximately $107 million of stock and the acquisition of iLumen. We also completed two sale-lease-back transactions that contributed approximately 40 million in investing cash flow.

Let me give you a quick update on the progress of the restructuring we announced in July. The efforts continue on track. Through today we have exited roughly 60% of the affected employees. And when complete, we expect these efforts to generate 75 million of annual savings.

Now I'd like to spend a moment discussing CA's capital allocation strategy, which includes returning money to shareholders through stock buybacks and dividends and making acquisitions. We also continually evaluate our spending levels and investments. All investments, acquisitions, and share repurchases are rigorously analyzed and must meet the Company's financial return on invested capital objectives on a risk-adjusted basis. Our last 12 months' return on invested capital -- defined as adjusted cash flow, divided by invested capital -- was 21%, well above our weighted average cost of capital of approximately 13%. Our last 12 months' operating cash flow margin was 33%, the highest level in recent years.

As I stated, in Q3 CA repurchased approximately $107 million of stock, or 4 million shares. We intend to repurchase up to $600 million of stock by the end of the current year. Since the beginning of fiscal 2006 through today, we have repurchased over $400 million of stock.

Now I'd like to turn to our outlook for Q4. When you think about our performance, there are a few things to consider. Number one, our pending acquisition of Wily, which is expected to close by the end of Q4. Depending on the timing of the close, Wily could be dilutive by up to $0.01 to operating EPS and $0.02 to GAAP EPS, depending on the amount of the purchase price that is allocated to in-process R&D.

Number two, billings over performance. Sales commission expense is tied to billings performance. In a ratable revenue model, a great billings quarter may lead to a lower EPS, due to the fact that revenue is not recognized up front, but over the term of the contract. As a result, paradoxically, if we hit the top end of our 5 to 9% full-year billings guidance, our EPS may be lower, due to increased commission expense in Q4. This was negative to our short-term EPS, strength in billings is clearly great for the company and for shareholders.

Keeping this in mind, for the fourth quarter ending March 31, 2006, we expect revenue of 975 million to $1 billion, reflecting growth of 6% to 9% over the prior year; non-GAAP EPS of $0.23 to $0.24, this range is consistent with the Street consensus of $0.25, when you adjust for the acquisition cost of Wily. Again, please keep in mind my comments about the inverse relationship to the strength of billings. And our GAAP EPS should come in the $0.09 to $0.10 range.

For the full year, we are increasing our full-year adjusted cash flow from operations guidance from 10% growth to 12% to 15% growth, due to strong year-to-date performance and a strong view of our business pipeline in the fourth quarter. We are also reiterating guidance of mid to high-single-digits billing growth. We told you at the beginning of the year, that half our billings growth would be organic and half inorganic. We now expect organic billings growth to contribute less than half of the target, partly due to the performance of our mainframe business, as Jeff discussed previously.

With that, we’d like to open up the lines for Q&A. Operator?

Question-and-Answer Session

Operator

At this time I would like to remind everyone if you like ask a question please press “*�? then the number “1�? on your telephone keypad. We will pause for a moment to compile the Q&A roster. Your first question comes from John Rizzuto from Lazard Capital Markets.

Q - John Rizzuto

Sorry about that. Good afternoon, everyone. A quick question on the billings and the up-front billings payment, is there any incentives or any change in pricing when related to the customer whether or not he is going to pay up-front or pay overtime?

A - Jeff Clarke

Yes, well, it depends, it depends on the deal and John, and it’s often very difficult to split out, the timing versus the normal discount concessions you have on a deal. It’s moving, it’s a moving number. But if you’ve got a deal negotiated for a price of X, and then you are able, which is not always the case, then are you able to negotiate the timing of when the payments will come, at a minimum there will be a time value of money discount to pulling it in. And in our case, that makes sense in a lot of cases because when you want to buyback stock or have cash available, it makes sense to bring that cash forward.

Q - John Rizzuto

Okay, okay perfect. On the mainframe business, Jeff, you clearly feel that there are things that you can do to improve your position in the mainframe business. Can you give us a characterization of the external market for the mainframe? In other words, pricing, competitive pressures and what you’re seeing there beyond what’s in your control?

A - Jeff Clarke

I’m going to let John do that one.

A - John Swainson

Hi, John. It’s John Swainson. Yes, I mean, we think that we are seeing clearly some improvement in the mainframe business overall the macro economic demand but that has not yet obviously fallen through to our topline. We’re clearly doing a number of things and Jeff outlined them in his presentation with respect to beefing up our own mainframe sales teams, which had been sort of neglected in the past in terms of beefing up our own products which also had been neglected in the past; and in terms of ensuring that we work closely with IBM to make sure our products are there on a timely basis. That being said, the mainframe marketplace is a mature market, and there have been some declines in that market as you can see, the decline is a little bit faster than we had anticipated. And frankly, looking at IBM's earnings last week, it would appear that it was faster than they anticipated too. But that being said, we believe that it is not going away, we think that their current round of hardware announcements have not yet translated into the software and we’re quite optimistic that we can improve our position vis-à-vis the overall mainframe marketplace. We think we are gaining share in that market relative to IBM and other competitors.

A - Jeff Clarke

I think there’s another comment, just around some of our sales force execution, and this is a good long-term thing, but not necessarily good short-term thing. Historically, our company would try to forward sell capacities.

Q - John Rizzuto

Right.

A - Jeff Clarke

And when you do that, you do it at a discount. And I think we’re being much more disciplined under Greg Corgan’s leadership in terms of doing less forward selling of capacity at a discount. So when that capacity comes in then you’re able to get a better price for it. Historically you could certainly do well to get a good commission and help a quarter by selling at a fairly large discount, forward capacity that a customer didn’t yet need.

Q - John Rizzuto

Right, okay good. And a quick final question, you said that your sales force strategy, the solution selling, which I imagine goes hand in hand with the EITM strategy is going to really start to, would you expect it to really show benefits in Q4 going forward. What are the things that you look at, the metrics that you look at, what you can share with us, to see whether or not the shift is actually working or meeting your targets and improving?

A - John Swainson

It’s John Swainson again. There are a number. We obviously looked at sales force productivity metrics. And we’re not sure we know how to interpret that data ourselves. So I’m not sure I’m going to share it with you yet. We also look at things like the number of assessments we do using our technical services teams. And that has been a very successful way for us to sell, not only point products but increasingly a broad range of solutions. The point Jeff was trying to make in his remarks is that we’re literally 9 months into this, and our teams are just now seeing the fruits of the solution-based selling that they started at the beginning of this fiscal year. So we’re very optimistic that we’re going to start to see that, and we see it in our forecast now. We’re very optimistic we’ll start to see that in our billings numbers in the fourth quarter.

A - Jeff Clarke

Couple of other comments, I mean clearly we track internally combinations of product sales. So as I’ve, I think we’ve talked about in this call before, when we sell Unicenter, we are much more likely to sell security and particularly some of our recent acquisitions on VSO and on integrity would allow us to sell additional product and how correctly Concord with the network management, which is now very highly attached to Unicenter. These combination sales are an excellent indicator of people wanting to buy more solution. The other thing is if you look at the services growth this year, professional services is up 34% this quarter. That is driving the assessments that John has talked about, the more complex sales.

Q - John Rizzuto

Okay, all right. Great, thanks.

A - Jeff Clarke

Thank you, John. Next question, please.

Operator

Your next question comes from Walter Pritchard from SG Cowen.

Q - Walter Pritchard

Hi just a couple questions for you. Last quarter you gave us a number on new contracts in the bookings. I think it was over $300 million and you gave us a growth rate, I am just wondering if you could provide that same number this quarter?

A - Jeff Clarke

That number, first of all, we’re not going to disclose that on a continual basis for a lot reasons but that number was slightly down on a year-over-year basis this was after being up in the first half and a lot of that had to do with both mainframe business and the European challenges.

Q - Walter Pritchard

Okay. Thanks Jeff, and then just on the visibility in Q4, I think you sound pretty confident on your ability to deliver and improve bookings and billings and cash flow performance. Just wondering if you can give a little bit more insight into what gives you that comfort and how much of that is tied to the Unicenter lease 11 that you just had back here in November?

A - Jeff Clarke

And that is much towards the Unicenter release, that’s really going to be more of play into next fiscal year. It will help, I mean there is lots of assessments and well people are using it, using it today on the Ingress but the sequel server offering on that will move that into the next level. Our confidence is based primarily on, doing reviews of the pipeline, the starting recurring revenue position in the quarter, and the strength of that we’re seeing momentum in certain of our acquisition. So you put those three things together, and we look at a pipeline and we talk about geography. And that’s how we come up with our forecast.

Q - Walter Pritchard

Is it safe to say you have more confidence this quarter going into March when you did in previous March quarters or I am just trying to gauge because it seems the sequential bar is a little bit higher?

A - Jeff Clarke

Well, again I wouldn’t necessarily get tied up on sequential. What I would think of is, look at last year for instance. Last year billings were down 2, up 14, up 7, down 1. I am sorry, I said that wrong, last year was down 10, up 13, up 4, down 3 and so, this year down 2, up 14, down 1. This is going to have some double-digit numbers, and it’s going to have some modest flat numbers. And we looked at the overall numbers, and we’re very comfortable with the fourth-quarter outlook.

Q - Walter Pritchard

Okay, thanks a lot.

A - Jeff Clarke

It will be lumpy.

A - Olivia Bellingham

Thank you. Next question please.

Operator

Your next question comes from Michael Turits with Prudential Equity Group.

Q - Michael Turits

Hi guys good evening.

A - John Swainson

Hi.

Q - Michael Turits

Couple of questions, first back on the mainframe issue, so is it a share issue or is it a market weakness issue? My read was that we are picking up that it seemed like it was across the board that mainframe contracts were slow coming in this quarter for all the major vendors which IBM and possibly Compuware kind of support, so is that it or did you feel you were losing share because as it put you some weakening?

A - John Swainson

We don’t think we’re losing share at all, Michael. In fact as I said earlier, we think we’re gaining share. Every indication is that our performance on the mainframe products is better than our competition. That being said there is some timing issues we are sure with contract renewals. There has been some price pressure, no doubt about that. There has been changes in pricing methodology on the mainframe that are designed to make the platform more competitive vis-à-vis other environments and those have been promoted by IBM, we’ve strongly supported them. So when you take those things together, it has led to a bigger decline in that environment than we had planned for. I don’t see that as being frankly something that could be long term. I do think that stability will kind of return to that market as we see the impacts of the 28% Mips that IBM shipped in the last quarter flowing into the marketplace over, over the next few quarters.

Q - Michael Turits

And then if we adjust out to $59 million in the prepayment for, yes the outsourcer contract, it looks like the cash flow growth is in a range of 8% to 11% versus your prior guidance of 10%, is that, that seem like the right adjustment to make?

A - Jeff Clarke

If you want - just out one deal, we noted that in prior year period there were similar types of deal.

Q - Michael Turits

Okay. How much was it last year, I have in my models like 47 million in the year-ago quarter in prepayments, is that right?

A - Jeff Clarke

Yeah I don’t, I’m not sure at what point we’ve disclosed these historically, I know at some point we listed the number of deals over $15 million and so forth. And I want to remind you on these that these are competitive situations that vary quite a bit in terms of what you have to do in terms of discounting and what you want to do to lock-in contracts overtime, and some it is, is having the opportunity to bring cash in so we can use it to buyback stock and for other reasons.

Q - Michael Turits

Last question if I can is just on solutions, the ship to solution selling, how, what’s the strategy in terms of balancing the use of your unprofessional services versus partners who are there whether they are large or whether they are systems integrators?

A - John Swainson

Well, I think that when you come to solution selling, you’re really thinking about how we sell to our large enterprise customers. And we have both partners and ISV's, sorry that’s our Global Systems Integrators that we work with in that space. Our intent is to work very closely with partners, particularly in the large enterprise, the Global Systems Integrators, Accenture, BearingPoint, Ernst & Young, and they have all signed major agreements with us to do essentially that in the enterprise marketplace over the last quarter. And we see that as being a very important way in which we will sell these more complex solutions, higher value but more complex solutions into the marketplace.

Q - Michael Turits

All right guys, thanks very much.

A - Jeff Clarke

Thanks, Michael.

Q - Olivia Bellingham

Thanks. Next question, please.

Operator

Your next question is coming from Trip Chowdhry from FTN Midwest Securities.

Q - Trip Chowdhry

Congratulations on good execution. Actually you are in a very interesting situation, which I would call is quite cash trendy too. Your sales team executes very well, your billing improves, but it would in a way create some, some hesitation on your EPS side. I was wondering like how can, or when can we see the EPS getting a little bit more improved because of your good sales execution, are we thinking probably within 12 months or may be little bit longer than that?

A - Robert Davis

Hi Trip its Bob Davis. I would say that what we’ve described about earlier, that paradox really doesn’t do, we have a pretty big ramp in the amount of business that Greg Corgan and his team drive throughout the year and so a lot of commission expense rolls up in the back half of the year, especially if we perform well against billings. I think if you look at what’s happened with our margins, you’ll see that our margins are, our cash flow margins at 33% are the best they’ve been in years and they are up 200 BIPS from the prior year and we expect that to continue going on into the future and that of course will filter down into EPS. I think during the current year since I came on board, John and Jeff had asked me to focus lot of attention on reducing costs and I think we’ve done a lot of that. And with the acquisitions we have been driving and the things that Greg’s doing with sales, I’m confident that the growth will begin to kick-in in next year and beyond and that will drive continued margins and obviously EPS improvement into the future.

Q - Trip Chowdhry

Also, you have made some very exciting acquisitions. I think the latest one was Control-F1. I would assume it’s a very bigger company, probably it’s a help Control-F1 for help, I was wondering how does it fix in your overall picture, and from an analyst perspective, how should we think about your acquisition strategy and what are two, three, maybe four key parameters that you think when you identify a company and then acquire a company?

A - John Swainson

Its John, Trip. We look primarily at how well that company helps us fill out our EITM vision or architecture. We’ve defined a very comprehensive view of how enterprises are going to manage their IT from their assets through the people in their enterprise and the applications in their enterprise. And we’re continually looking at how we make it easier for them to do that, how we make it more automated for them to do it, how we reduce the complexity of managing information technology. That acquisition is typically done in a build versus buy kind of analysis. We look at what it would take to do it ourselves, how long it would take and we then compare that to what’s available in the marketplace. And all of the acquisitions that you’ve seen in the last 15 to 18 months have been done with that in mind. Control-F1 specifically is a reasonably small company with whom we had a business partner relationship and as you correctly incurred, the name implies that they provide health facilities for people in a service desk environment. We have over 2,000 customers who use our service desk product and Control-F1 adds to that product to provide a lot of self-help or automated help facilities. As such, it’s a very natural add-on to our product family. We would expect to have a very high percentage of add-on sales to that 2000 customer service desk based. So I hope that to kind of makes sense in terms of how we think about it. Obviously we do rigorous financial analysis we look at the fit of customers and everything else.

Q - Trip Chowdhry

And last question, I know I’m asking too many questions but I never got so much time to get hold of you altogether. Some, of our survey was just telling us that you are gaining some sort of traction and that your EPS product was Symantec. What are you doing right, what have you done over the past three to four months that has given you this kind of advantage?

A - Robert Davis

We compete with Symantec around part of our eTrust product line, but by no means all of it. We compete in the antivirus and anti-spyware marketplaces and we have won some significant business from them particularly around things like AOL where we are now the OEM partner for AOL’s spyware service. On the other hand, I will tell you that our real strength is in the identity and access management space where we don’t really compete with Symantec, we compete more with RSA and Oblix, which is now part of Oracle or even IBM.

Q - Trip Chowdhry

Thanks a lot. Probably I will ring back after the conference call to ask some more questions. Thanks on a good execution. Thank you.

A - John Swainson

Next question, please. Thank you.

Operator

Your next question comes from Sarah Friar from Goldman Sachs.

Q – Sarah Friar

Good afternoon, everyone. John, could you just give us an update on your channel strategy. So you’ve not talked a lot on this call about going out to the indirect channel. Maybe give us a sense for what sort of target in terms of, I don’t know, percentage of revenue that should come through indirect by the end of this year and as we look at it in fiscal year ’07?

A - John Swainson

Yeah, Sarah, our business today is primarily a direct business. We get less than 10% through indirect channels. That is growing. It’s frankly growing a little bit faster through indirect than it is through direct. Our goal in the long-term is to drive it up to, its intermediate goal is to drive it up to 20% in the very long-term to drive it to 30%. Now that’s probably a five-year goal. With a number of channel partners ranging from systems integrators that we discussed through to two-tier VARs they as consumer-based channels for some of our Firewire and other products, and we also have a small OEM business as well. The total business is growing. We’re relatively new at this and putting a lot of efforts and focus into it.

Q – Sarah Friar

Okay, its great and then some Unicenter upgrade, so you’ve already given us a little bit of color there but can you help me understand that as the customers upgrade, does that largely come as part of maintenance or what’s your ability to go out and sell actual products or get new revenue streams from them as they make this upgrade?

A - John Swainson

Well, you’re correct in assuming that many, not all but many of our customers are entitled to believe part of that contract. That is in fact part of our maintenance. That is the vast majority. However, the big opportunity, I believe for us for an up sell more functionality, there are a number of things in this release that are new, number of capabilities in our releases that are new and that will represent, we think attractive upgrades for those customers whether it’s to enhance their network management capabilities with the facilities of Spectrum or eHealth or whether it’s to go to IT asset management and start to really manage, but manage to the asset and financial side of their environment to or to add a service desk. So we really believe here that the growth opportunity for us isn’t necessarily as much re-upping licenses, which is kind of the taking the question you didn’t ask, but not re-upping licenses but more, making us, giving us the ability to sell additional modules or additional capability to those customers.

Q – Sarah Friar

Got it. Can you just remind me of the timeframe for when you will roll out the support of other kind of database environment SQL and Oracle?

A - John Swainson

So the current product is available on Ingress. We are in data for the SQL product and expect it will ship sometime in early fiscal ’07 and the Oracle product immediately thereafter.

Q – Sarah Friar

Okay and I'm assuming that so you have the full database support. It's going to take a while to get customers to really take a look at it seriously.

A - John Swainson

I think that was the message that Jeffrey was trying to send you earlier.

Q – Sarah Friar

Okay, great. Okay thanks a lot, guys.

A - Olivia Bellingham

Thanks.

A - Jeff Clarke

Next question please.

Operator

Your next question comes from Todd Raker from Deutsche Bank.

Q - Todd Raker

Hi guys two questions for you, the first question is, from a cash flow perspective with these guidance, Bob I was wondering if you could quantify the impact on acquisitions on that and the timing the tax rate, but how sustainable is it that in the future poor audio quality

A - Robert Davis

I guess Todd, I’m not sure I picked up, could you repeat the first part of your question again?

Q - Todd Raker

Yeah on the cash flow guidance total of 12% to 15% just trying to quantify the impact on acquisition from acquisitions and the decline in the tax rate, and how steep the tax rate is?

A - John Swainson

Let me take the second part first, which is the decline in the tax rate I think is, we’ve had some, I think, excellent performance this year. I do think the tax rate of 31% will probably go back up slightly next year. I don’t know that if I had to predict, I’d say it would be in the 33% range next year. So we probably won’t go back to the 35% or 36% that we had at the beginning of this past year, when we gave out guidance for the whole year. And then in terms of cash flow around acquisitions, I don’t know that the acquisitions of, the acquisitions have been helping with our billings growth as we had talked about earlier, and that’s clearly I would hope as we go into next year we’re going to be looking for the same sort of mix of more, more organic, some inorganic cash flow. But it hasn’t been dramatic beyond the fact that we have said that we wanted to grow billings in the mid to high single-digits. Obviously acquisitions during the current year have been more responsible than what we had said at the beginning of the year. But if you had to look at the cash flow, I think some of the upside we’ve got this year has been with things that we’ve done with, with working capital management that may not be sustainable. But I don’t, you know we’re not giving guidance for next year but the thought of having double-digit cash flow growth off into the future is not inconceivable.

A - Jeff Clarke

Let me follow up a little bit on that. I think you guys got back into the numbers because it would give you the organic and inorganic. So the acquired billings to-date has been roughly around $150 million. And we certainly had expenses to-date associated with that, certainly well over $100 million. So while billings have contributed to our cash flows, it’s been relatively modest, certainly in that less than 1% year-over-year growth range. Overtime we expect that to be quite a bit more because as you know we did these acquisitions we’re targeting and, and in some of them to-date within the first year, we expect to get you know an eight, in some cases up to 12, in other cases cash flow yield but it’s a modest impact year-to-date for us on cash flows.

Q - Todd Raker

Okay, then higher level question for John maybe, the entire team. You guys have done a very good job of outlining your strategy of reallocating capital against high return, high growth opportunity well to that court mean, have the team in place now for about a year, where are you in terms of a year later, has it harder than you thought, are you back into your expectation and give us go forward

A - John Swainson

Well it’s a hard question to answer in less than about four hours. But given you were asking for a finite answer, I think looking back on this from the perspective of the end of the year, so I’m being a little bit optimistic now but the fact that we will be able to take a company that a year ago was exiting from a deferred prosecution agreement, had no management team to speak of, had no technical strategy to speak of, had a cloud over it, the size of the Empire State Building, and then be able to come out of the year with achieving four quarters of guidance, and mid to high single-digits billings growth and double-digit cash flow growth, I think you guys would have, at the beginning of the year said you guys are nuts. And the fact that we will do it, I think, speaks a lot to the success we’ve had in the transformation. Now as, as I’ve said on a number of occasions, this is not a one-year journey, this is a multi-year journey. We’re running on four or five cylinders, not all eight cylinders at this point in time. We can get this thing working a hell of a lot better and as we do, you’ll see our performance improve.

Q - Todd Raker

Okay. Thanks guys.

A - Robert Davis

Thanks Todd.

Operator

Your next question comes from Jason Maynard from Credit Suisse.

Q - Jason Maynard

Hi, good afternoon guys. Actually one kind of multipart question on the mainframe business. If we just assume for a second that or maybe make the jump that the – sort of the structural growth rate of the mainframe market is more that zero to down 5%, maybe, a) How willing would you be to perhaps look a little more aggressively at the cost structure or the allocation of resources around the mainframe business? And would you be willing to perhaps try in more cash cow that business and refocus those energies on some of your higher growth distributed product lines? And then, b) If that was perhaps the longer-term growth rate, how would that impact or influence your M&A strategy, and would you consider maybe being more aggressive and looking at perhaps slightly larger transactions vis-à-vis kind of the more technology type deals that you've done with Wily?

A - John Swainson

I think we've got a pretty balanced view of the opportunities around the mainframe. I think the current zero to minus five kind of reflects weakness in that business a year ago. I actually think that there is a long-term sustainable business that's stronger than that but I also think that just as you've asserted, we'd actually balanced our resources to where the growth is. So if you look at how our business units are structured, in fact we've taken the high growing parts of our business, whether those be mainframe or otherwise, and put them into business units that have very strong growth targets, and we've taken a collection of products that is intended, that isn't growing as quickly, and we've put it into a mode that we can maintain and sustain those revenue streams for a very long period of time. And I hate the word "Cash cow" because it implies exploitation of customers but the reality is we're making a balance on growth versus the investments and we're trying to do the logical thing relative to where we see our long-term growth. On the acquisitions, our acquisition strategy is driven by many things. It’s driven by our belief in the vision of enterprise IT management, it's driven by the fact we see ourselves in a unique position in the marketplace vis-à-vis our competitors. And we see ourselves having the ability to provide customers with a complete and consistent view of management of IT. We will continue to look for things that enhance that view, and we haven't put a size limit on a transaction that would do that. We've rather said, look, we're trying to give the strongest possible portfolio or tried to build the strongest possible portfolio of products to help enterprises manage and secure their IT environments.

A - Robert Davis

Jason, this is Bob. I guess, if I could just comment on that, but if you look at the product development enhancement process that we have this year versus if you just take Q3 for example where we're spending the 171 this year versus 172 a year ago, I would argue that because of the BU structure that John put in place that we're in charge of the development team, we are actually driving more value to customers today spending less OpEx or incurring less OpEx in the R&D space each quarter. So I think that when you look at our margin expanding 200 BIPS this year over last year and the thought that we can continue that another year or two, it's really being driven by the type of cost optimization that you just referred to a moment ago of mainframe products versus distributed growth areas.

Q - Jason Maynard

Maybe cash cow's the wrong word in this scenario. But just, I think, point three on your five-point plan was to focus like 80 dedicated reps like a swat team or specialist team.

A - John Swainson

That's right.

Q - Jason Maynard

What if you take those -- what if we find in 12 months that that just doesn't move the revenue needle? I mean, that's 80 reps that if you put behind a Wily, I mean, I would assume that would really provide some serious juice to that business?

A - John Swainson

I can guarantee you when the deal close, we’ll have hundreds and hundreds of reps behind Wily. But this -- this 80 is like all our salespeople, they'll be measured on how they deliver but we think there is big opportunity there. These -- we think there's new products to be sold in the mainframe.

Q - Jason Maynard

Okay. Let me -- one quick question if I could shift gears and indulge me on just sort of your commentary around the European market, what you saw and how that bakes into your Q4 expectation?

A - Robert Davis

Let me have a whack at it. As Jeffrey said, we've made a fairly major restructuring of our European operations, we've brought in new senior management. We are in the midst of putting in new area management. We've brought the same level of discipline and focus around solution selling that we have in the Americas, we've brought that to Europe. We are probably six to nine months behind in Europe relative to our implementation in the US but we are very optimistic in the prospects of our business in Europe and we're very optimistic that Andrew Dutton and his team are going to turn this thing around. We're spending a fair bit of senior management time and effort, Jeffrey and I are both going to Europe tonight and will be there until next week. Greg Corrigan head of sales had spent a fair bit of time and effort with the European team, so we clearly believe that it is worth the investment in revamping our European operations. These after all are about 30% of our business.

A - John Swainson

Just -- I think the other point I missed is Andrew Dutton, our head of Europe, and John Ruskin our head of Asia, came to John Greg and I and, really talked about making changes slowly versus rapidly. And we knew that by making a series of deeper changes, more substantive changes, more larger changes to our business on our way of selling, if would have the short-term impact and it did. And we think the brunt of that has been felt this quarter. It will take more than one quarter to - for these things to work out. When we look at the pipeline into Q4, we are substantially more optimistic than we were going into Q3 with these changes happening at that point.

Q - Jason Maynard

No, and I appreciate the restructuring, but I was actually trying to focus more on what was the macro influence and how you were thinking that was going to play out and impact you in the kind of the short and intermediate term as well?

A – Company Speaker

Well, the macro -- the macro economic marketplace in Europe has been a little more difficult than North America, as you know and you see from other vendors. Frankly, one -- that was one of the considerations that led us to believe that we should make these changes now before the market there picks up. We are quite optimistic that the market will pick up, we're seeing signs of it in UK and there are signs that the German market may also be showing signs of life. So it was important for us to get these things done rather than trying to do a major restructuring in a booming market.

Q - Jason Maynard

Okay great.

A - Olivia Bellingham

Thanks, Jason. Next question, please.

Operator

Your next question comes from Gregg Moskowitz from Susquehanna.

Q - Gregg Moskowitz

Thanks very much good afternoon guys, just a couple of questions. On the billing side looking at the BSO segment which have been growing strongly fell 2% year-over-year this quarter and of course a year ago did not have any revenues from Niku. Just wondering if you could talk about some of these sub-segments within BSO, how they fared in the quarter including Niku that would be helpful?

A - Jeff Clarke

Certainly I would, as always on these situations I look at more of a year-to-date or LTM basis. On year-to-date basis it’s up 11, the overall business, we see a very strong front log with our Niku business. And one of the things that – the sales in Niku is a little bit longer, it’s more of a service-led sale, and so I'm -- I'm not surprised that we will have quarters with a little more fluctuation than other quarters. In terms of some segments, in my earlier remarks talked about it, you know the portfolio management part of Niku is clearly that a project management is truly kind of what we lead with, and then we try to upsell from there.

A – Company Speaker

And by the way, it was not an Niku part that was…

A - Jeff Clarke

Niku was particularly strong.

A – Company Speaker

It was very strong. We had a very strong, big mainframe product in this segment, and there was some weakness there.

A - Jeff Clarke

Yes, that’s what we call endeavor product was the weakness that we are experiencing.

Q - Gregg Moskowitz

Right, okay good. And then moving on, you touched briefly earlier, Jeff, on SPECTRUM/eHealth, and I suppose you probably haven’t yet seen a real increase in Concord Unicenter cross selling deals that when you talk about the pipeline and kind of how it looks in that regard?

A - Jeff Clarke

We're actually very excited. We are.

A – Company Speaker

We actually are seeing quite a bit of opportunity for upselling and cross selling of eHealth from spectrum into our Unicenter customer base and our etrust customer base. So that is going particularly well. Again, the same point that we've made before about solution selling, many of those are pilots or assessments or evaluations, and they’ve not yet translated into the full sale, but we're now getting the opportunity to bid a much broader and richer solutions to a customer than we ever had before, which is exactly why we did that Concord expedition.

Q - Gregg Moskowitz

Okay and just one, last one out for Bob. I think in the past I had heard that Sarbanes-Oxley costs are probably tracking in the area of maybe $50 million or so for the year. Just wondering if you can give us an update on where that stands and then also what we might expect for the Q4?

A - Robert Davis

I think I anticipated that question, Greg. I could actually tell you on a fiscal year basis, and we have some lag because a lot of the expenses we incur in the first fiscal quarter relate to the prior year. But if you actually do compare the expense we incurred in fiscal '05 to the current year, last year was $40 million. And this year we expect the number to be to peak at $45 million. And then, going into next year it should drop off pretty significantly. So like in fiscal '07, it should probably drop to $20 million or less.

Q - Gregg Moskowitz

Okay, perfect. Thanks very much.

A - Olivia Bellingham

Thank you. We're going to take one more question. And then John is going to wrap up with a few closing comments.

Operator

Your final question comes from Steve Mahedy from Banc of America Securities.

Q - Stephen Mahedy

Thanks. I think give some details on the security business, you specifically talked about anti-spyware, antivirus, versus some of the identity in access management but I'm wondering given the results and in light of Jeff's comments about some tough compares, was there any unnatural pricing behavior in the marketplace by competitors and -- what is the profitability environment look like for the products going forward?

A - John Swainson

It's John. It was a tough compare, and we saw results down a little bit for the quarter as a result. I would remind you that this last -- last year Netegrity was still in an upfront model. This year they are in a perpetual model, that does account for a good deal of the difference. So year-to-date we're up 21% on a 12-month basis and 17% year-to-date, so I mean this business is doing very well. I cannot speak to and I haven’t seen any undue pricing pressure from any of the spyware or antivirus vendors, again, that's a relatively small part of our total business in the segment.

Q - Stephen Mahedy

Okay, fair enough. Second question would be on the buyback, Bob had laid out some economic hurdles relative to the fact that your net cash position is about $22 million. When you think about the buyback and the 14 million shares that you've done, that $400 million, what would you anticipate when you sit in front of the board and you lay out your fiscal '07 kind of plan as it relates to preceding with continued buyback plan?

A - Robert Davis

Steve, I think probably the best way to think about it is as you go into '07 is that the -- if you take our cash flow that we generate this year and then assume we're going to grow it at some rate next year and we probably done quite a bit of catch-up around acquisitions, I think we’ve said it's unlikely that we would do more than $500 million to $600 million of acquisitions in fiscal ‘07. That leaves roughly $1 billion to either carry as net cash or return to shareholders. So I would envision we still need to go through with the board, but the level that we've done over the past 12 to 15 months that it would continue and probably increase somewhat as we go into next year.

Q- Stephen Mahedy

Okay. Thank you.

A - Olivia Bellingham

Thanks very much.

John Swainson, Chief Executive Officer, and President

Okay, let me just wrap up. I want to reiterate that I'm very proud of the progress that we're making at CA and our goal of becoming the industry’s leading management software company. As I mentioned earlier, I've had hundreds of customer meetings over the last quarter. These customers validate again and again the importance of the management marketplace and CA's opportunity to be a leading player. The action we've taken on many fronts and how we're organized and the products and solutions we're offering, how we go to market, our overall EITM strategy to name just a few are yielding results right now, and as I said before, are going to yield even greater results in the future. I'm even more convinced that CA's putting the right pieces in place to seize the exciting opportunities we see in the management software marketplace. Thank you very much.

Operator

Ladies and gentlemen, this concludes today's conference call, you may now disconnect.

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