Dec 20, 2007
Executives
Bill Lackey - Director of IR Mike Laphen - Chairman and CEO Mike Keane - CFO
Analysts
Moshe Katri - Cowen & Co Adam Frisch - UBS George Price - Stifel Nicolaus David Grossman - Thomas Weisel Partners Rod Bourgeois - Bernstein Abhi Gami - Banc of America Eric Boyer - Wachovia Greg Smith - Merrill Lynch Tien-Tsin Huang -J.P. Morgan Pat Burton - Citi
Operator
Good day everyone and welcome to the Computer SciencesCorporation fiscal year 2008 preliminary first and second earnings call. Today'scall is being recorded.
For opening remarks and introductions, I would like toturn the conference over to Mr. Bill Lackey, Director of Investor Relations.Please go ahead, sir.
Bill Lackey
Thank you, operator, and good afternoon everyone. Welcome toCSC's earnings conference call and today we'll be discussing our preliminaryfirst and second quarter results for fiscal 2008, which were released earlierthis afternoon.
Mike Laphen, Chairman and Chief Executive Officer, will openwith some remarks, and then Mike Keane, Chief Financial Officer, will reviewthe two quarter's and first six months financials. As usual, this call is being webcast live at CSC.com, and wealso welcome those joining us via that process.
Any information we cover that is not directly andexclusively related to historical facts constitutes forward-looking statementsunder Federal Securities laws. For a written description of these factors thatcould cause actual results to vary from those statements.
Please refer to thesection titled Risk Factors of CSC's Form 10-Q for the year ended March 30, 2007. Also on today's call, we will reference certain non-GAAPfinancial measures.
Reconciliation of these non-GAAP financial measures areprovided in the tables attached to the earnings press release and will beposted on the Investor Relations section of CSC.com. The non-GAAP financialmeasures referred to during this conference call are not meant to be consideredin isolation or as a substitute for results prepared in accordance with GAAP.
Finally, we assume no obligation to update the informationpresented on this conference call. And it's now my pleasure to turn the callover to Mike Laphen.
Mike Laphen
Thank you, Bill, and good afternoon, everyone. It's mypleasure to have this opportunity to update you on CSC's current businessposition and our strategic direction.
As I highlighted during our last earningscall, we are focused on ramping up our growth as well as improving ourprofitability and ROIC. Project Accelerate, comprised of five initiatives designedto accomplish these goals over the next several years, is being implemented andwe've made good progress to date.
To briefly review the five initiatives are:one, enhancing our industry specific offerings through the delivery of thedifferentiated business solutions. Two: aggressively growing and leveraging ourNDA capabilities.
Three: expanding our global footprint. Four: repositioningour commercial outsourcing segment including a special emphasis or midsize deals.And five: focusing on high growth segments within the North American publicsector market.
The goal of these initiatives is to achieve a more balancedportfolio of services with both current and prospective clients as well as todeliver longer term revenue growth, operating margins and ROIC of at least 10%. Core business profitability reflects a favorable trend.
Forthe trailing 12 months our global commercial internal operating income margin was9.1%, reflecting an improvement of 130 basis points over the prior comparableperiod. Our North American public sector margin has remained stable in theupper 7% range with the exception of the second quarter non-cash charge thatMike Keane will elaborate on.
Respective margin improvement will be the result of ourcontinuing focus on cost reductions and a change in business mix. We alsocontinue to make progress towards our goal of achieving 10% or greater ROIC.Our emphasis on reducing capital asset intensity and improving working capitalcontinues to be a high priority.
Overall, revenue for the six months grew nearly 10% withpositive growth in all six of our industry verticals. These increases were leadby financial services and healthcare with double-digit gains along with solidgrowth from our North American public sector activities.
Our recent focus on addressing midsize outsourcingopportunities is also delivering results. The restructured sales approach anddedicated sales force have been implemented for midsize deals, which includetotal contract values between $50 million and $350 million.
During the past three quarters, 15 awards have been theresult of this focus, representing nearly $2 billion in awards. The pipelinefor midsize deals has grown ten-fold over the past year and our win rate hasimproved significantly.
The closing of the Covansys acquisition in early Julyrepresented an important step in aggressively growing and leveraging our Indiacapabilities. To-date we are pleased with the progress achieved in theintegration of Covansys and CSC.
Indiais now our second largest country of employment with over 15,000 employees.Those employees, along with approximately 2,500 additional employees in otherlow-cost regions, represent about 27% of our total commercial workforce. Moreimportantly, we can now offer our collective clients a wider range of BPOoutsourcing and business services and solutions.
In order to strengthen our domestic and offshore healthcareexpertise and service offerings, on October 31st, we announced an agreement toacquire First Consulting Group in an all cash transaction for approximately$365 million. Further this project accelerates strategy by enhancing ourcapabilities associated with the key healthcare vertical market and expandingour global delivery, including a new world sourcing location in Ho Chi Minh City, Vietnam.
Importantly thisacquisition will strengthen our core business in all three healthcare markets: healthcareproviders, health plans and life sciences. The transaction is anticipated to be completed in the firstcalendar quarter of 2008.
Our progress on the NHS contract continues. The finalstage of the transition from Accenture occurred in October, when all serviceswere successfully moved in to two new CSC data centers in the South of England.
Additionally, we continue to make strong progress across allregions in terms of appointments. As you are probably aware, iSoft is a keysub-contractor and the acquisition of iSoft by IBA Healthcare was completed atthe end of October.
To ensure the continued successful development of theLorenzo product, we have assumed from iSoft the direct responsibility to managethe resources and processes necessary for the fulfillment of our obligationunder the NHS contract. The commercial step in process was conducted under termsread between iSoft and CSC, and this new approach is expected to be earningsneutral.
As I mentioned earlier, one of the key elements the projectdid accelerate was to achieve market growth with a combination of technologyand electrical property in industry expertise, and providing clients withglobal business solutions delivered in our six vertical industries. For the first half of the year, business solutions greworganically 16% including the contribution of Covansys, the growth was about25% year-over-year.
Business solutions currently constitutes approximately 24%of our total revenue and is anticipated to grow as a percent of total, as wemove towards a more balanced service portfolio. Our North American public sector operations also delivered astrong performance for the first six months.
We experienced good traction inthe six high growth market segments we have identified. And these accounted formore than 50% of the first half North American Public Sector total awards.
Weannounced total awards of $8.5 billion during the first six months, continuingthe strong momentum established in fiscal 2007. A quality and quantity of both our commercial and publicsector pipelines are strong.
We are adding numerous opportunities in bothmarkets over the balance of fiscal year -- we are addressing numerousopportunities in both markets over the balance of fiscal 2008 and anticipateanother solid year of award totals, positioning us well for next year. That's abrief review of our business.
And now, I'll turn the call over to Mike Keane for furtherdetails on our financial results.
Mike Keane
Okay. Thanks, Mike, and thanks, everybody, for joining ustoday.
Let me start providing a general outline. First, we'll cover a number ofitems of interest since our last earnings call.
These include the restatementof the prior year financials, creation of other income line for foreigncurrency translation and non-operating gains and losses within thosestatements, the adoption of FASB interpretation number 48 or otherwise known asFIN 48, our share repurchase status, special items charges and the settlementof the serious contract disputes. After discussing these items, we'll move to our normaldiscussion of income statement balance sheet and cash flow items.
So let's moveon to the first item, the restatement of prior year financials. The restatement stems from a discovery of certain accountingerrors relating to the company's accounting for income taxes and for the effectof foreign currency exchange rate movements on certain intra-company balances.The corrections in accounting for income taxes resulted in a cumulative chargefrom fiscal years 1995 through the end of fiscal 2007 of $303 million.
Of this $303 million, more than half relates to accruals forinterest and penalties. Other significant adjustments relate to errors and taxbasis depreciation and certain transaction between the company's U.S.and foreign entities.
Interest and penalties are a function of both the incorrectcompetition of taxes payable from the errors as well as earlier utilization ofnet operating losses as a result of higher taxable income in prior fiscalyears. Corrections in accounting for currency exchange ratemovements resulted in the recognition of cumulative after tax gains of $193million between fiscal year 1995 through fiscal year 2007.
In the past, the company entered into certain transactionsbetween the parent and its subsidiaries, company's policy was to treat thesetransactions with the foreign entities as long-term net investments. According to an exception provision of FASB 52, in otherwords, the GAAP accounting, the foreign currency gains and losses were recordedin the cumulative translation adjustment on the balance sheet.
On further review the company determined the some of thesetransactions were incorrectly recorded as long-term investments and the foreigncurrency translation movements should have been recorded within the incomestatement. The net effect of the two corrections along with other minoradjustments resulted in a cumulative $110 million charge to retain earningthrough fiscal year 2007.
The company will soon file an amended annual reporton Form 10-KA for the year ended March 30, 2007, which will restate the financialstatements previously filed. As a result of the corrections in accounting for currencyexchange rate movement, we created a new line in our income statement calledother income to capture gains and losses our foreign exchange activity, as wellas other miscellaneous transactions.
Currently many of the intracompany and other balance sheetexposures giving rise to the foreign exchange gains and losses are now beinghedged to minimize the volatility in earnings from exchange rate movements. The third topic is our adoption of a new accounting guidanceon tax FIN 48 and its impact on our financial statements and tax rates goingforward.
FIN 48 clarifies the accounting for uncertain tax positionstaken or to be taken in a tax return. We performed a review of prior taxpositions based on FIN 48 guidelines and as a result the company has recorded$1.4 billion of unrecognized tax benefits or tax liabilities if you will withinthe consolidated balance sheet with no net impact to the consolidatedstatements of income.
Of this amount approximately $163 million was accounted foras a reduction to the March 31, 2007 retained earnings balance, in accordance with theimplementation provisions of FIN 48. Included in our unrecognized tax benefits are $602 millionof uncertain tax positions and $156 million of penalties accrued that wouldpossibly impact our effective tax rate if recognized in the future.
The fourth topic is an update of our share repurchaseprogram. The Board authorized the share repurchases program of up to $2 billionin June of 2006.
At that time we entered into an accelerated share repurchaseup to $1 billion in a purchase agreement under a 10b5-1 plan to acquire anadditional $1 billion worth of common shares once the first phase wascompleted. The final settlement of the accelerated share repurchasetook place in July of 2007.
In August of 2007, we began purchasing sharesthrough daily open market transactions under the 10b5-1plan. During the secondquarter of fiscal 2008, the company repurchased 3.1 million shares for justnearly a $169 million, resulting in an average purchase price $54.45.
We continue to buyback shares based on our pricing grid, andcurrently expect shares to be repurchased over approximately four quartersthrough July of 2008. Our fifth item or special items for the second quartertotaled $26 million and consisted entirely of pretax restructuring charges forthe program we announced last year.
Special items for the first half totaled$75 million and consisted of $53 million pretax restructuring charges and $22million pretax charge related to the retirement of the company's formerchairman and CEO. Remaining pretax restructuring charges expected during fiscal2008 are estimated to be approximately $70 million.
The dispute with Sears has been settled as reflected in thepress release issued on October 22, 2007, and a subsequent timely 8-K filings. Under the agreementSears will pay the company $75 million by January 8th, 2008, to settle all claims andpurchase certain specified equipment.
In addition certain previous paymentsmade by Sears will be retained by the company. The settlement resolves thecompany's net asset position as of as of September 28, 2007 with no material impact toend income.
Before moving on to our customary discussion points, let meoutline the basis of presentation. All data in comparison unless indicatedotherwise will be on a fully restated basis.
Similarly except as indicatedotherwise, quarterly full year and prior year results exclude the impact ofspecial items. So this discussion, we'll be focusing solely on the secondquarter and first half results, so please refer to either the press release tableor Form 10-Q when filed for information related to the first quarter.
Beginning our discussion, total reported revenues increased11% or 8% in constant currency during the second quarter and approximately 10%or 7% in constant currency year-to-date as a result of solid growth in both ofour primary segments. Turning our attention to the segments.
Our North AmericanPublic Sector, which is previously known as our US Federal segment and is nowreferred to as NPS for short, generated $1.4 billion of revenues during thesecond quarter, resulting in a growth rate of 7% compared to the same quarterlast year. Year-to-date, NPS revenues have increased 8% to $2.9 billion versusthe same period last year.
The increases in second quarter and first half revenues weredriven by new programs in the Army and the Air Force, as well as continuedgrowth on our existing contracts for other defense related customers.Additionally, the acquisition of Datatrac completed last December, contributedto growth in NPS of almost 3% for the quarter and the first half of the year. Global commercial revenues increased 14% during the quarterto $2.6 billion and increased 11% year-to-date to $5 billion.
In constantcurrency terms global commercial revenues increased 9% during the quarter and6% on a year-to-date basis. Now, let's look at the individual pieces that make up globalcommercial business to understand the drivers of the performance.
North America commercial outsourcing revenues fell 3%during the quarter and 4% in the first half versus the prior year. While we added several new outsourcing customers, therevenues in the early stage of these contracts were not enough to offset thedecline due to completion of certain other contracts.
North America consulting and systems integration revenues wereessentially flat for the second quarter, but rose 3% year-to-date as higherbilling rates were slightly offset by softer utilization rates. European revenues grew 18% during the quarter and 17%year-to-date.
In constant currency, second quarter and year-to-date revenuesincreased 9%, making Europe our strongestperformer in constant currency. Approximately 7 of the 18 points areattributable to new business wins, with about half of that coming from ourexpanded relationship with National Health Service.
Most of the remaining growth is the result of higherrevenues in our European consulting and systems integration business. Our Asianand Australian operations continue to generate growth in the quarter andyear-to-date.
Revenues in Asia roseapproximately 9% in the second quarter and 13% year-to-date. At constant currency revenues increased 6% during thequarter and 9% year-to-date.
Growth in Asiacontinues to be driven by strengthen in our larger global customer accounts. Australiarevenue increased 20% in both the second quarter and the first half of theyear.
In constant currency revenues increased approximately 8% during thequarter and year-to-date. The growth was mainly due to increases in project work andcontinue to expansion in our local taxes IT recruitment business.
The Covansysacquisition closed in early July and added an incremental 3% to our secondquarter growth in revenues over the same period last year. Now let's look at our awards to date.
Announced awardstotaled $4 billion for the second quarter and $8.5 billion for the first halfof the year. Federal continued the momentum from the record of over $9 billionof federal signings recorded in fiscal 2007.
Our federal pipeline continues tolook strong with $35 billion of opportunities scheduled to be awarded over thenext 15 months and given our normal strong win rate we expect to continue tocapture a sizeable share of this market. Our commercial signings were soft for the second quarter butresults should improve in the future with execution within our existingcommercial pipelines opportunities during the second half, and with ourcomprehensive growth strategy outlined under Project Accelerate.
We have seenconsiderable improvement within our middle market pipeline of opportunities. Moving on to our expenses, cost of services as a percentageof revenue was 81% for the second quarter and 80.8% for the first half offiscal year 2008.
The second quarter and first cost of service ratios were 90and 30 basis points higher versus prior year comparable periods. Despite thebenefits from cost savings initiatives and restructuring activities acrossmultiple business units, costs of services increased mainly due to $42 millionpretax charge recorded within NPS.
Excluding the charge, the second quarter cost of servicesratio would have been approximately 20 basis points favorable versus the prioryear period and the first half ratio would have been approximately 20 basispoints favorable as well. Our NPS operation was adversely impacted in the secondquarter by a near-term customer funding constraint and a related non-cashcharge resulting from a reassessment of recoverability of an asset on the IRSBusiness Systems Modernization Program.
This program represents only about a thirdof our current business generation within the IRS. The reduced asset is relative to the core computinginfrastructure that is applicable to a significant number of future releasesunder the contract.
While our overall business with the IRS is profitable, thecurrent release loss under the modernization program required us take anon-cash charge under developing accounting guidance, equal to $34 million,approximately half of the investment balance. The forward loss recorded in the second quarter related tocurrent release is $8 million.
The total combined $42 million pretax impact isequivalent to about $0.16 of earnings per share. Selling, general and administrative expenses were 6% revenuein the second quarter versus 6.3% a year ago, an improvement of 30 basispoints.
For the first six months of the year, our SG&A costs as a percentof sales improved 23 basis points from 6.3% to 6.1%. The improvement was alsodriven by the effect of restructuring activities as well as more efficientbusiness development costs in our commercial operations, particularly within Europe.
These improvements were partially offset by anincrease in professional fees incurred at corporate headquarters as a result ofthe implementation of FIN-48 and the restatement of prior year financialstatements. Depreciation and amortization expense as a percent ofrevenue improved 11 basis points in the quarter and 8 basis points in the firstsix months to 7.3%.
The improvement was largely due to growth in less capitalintensive businesses. Looking at taxes, the adoption of FIN-48 and therestructuring program have added some complexity that we'll try to describe.The company’s reported effective tax rate for the first half of the year wasapproximately 46%.
Excluding the impact of special items including somenon-deductible restructuring cost, the effective rate would have been 43%versus a previously expected rate in the mid-30% range. Approximately two percentage points of that increase is dueto tax interest charges.
In prior years, before the adoption of FIN-48, wecarried such charges on the interest expense line rather than on the taxprovision line. We feel that the revised presentation gives better transparencyto both lines, but bear in mind though that not the entire two pointsrepresents a year-over-year impact to earnings per share.
Approximately three percentage points of the increase is dueto the reduced benefit of certain permanent tax differences as recognized underFIN-48, as a significant portion of such benefits are reserved for after notmeeting the more likely than not threshold for benefit recognition. In addition, during our second fiscal quarter there werefuture statutory rate decreases announced within two foreign jurisdictions thatresulted in a discreet adverse impact and the valuation of certain foreignsubsidiaries deferred tax assets.
This increased the second quarter and sixmonth effective rate by 7 percentage points respectively and 3 percentagepoints respectively; the 7 for the second quarter, and 3 percentage points forthe six-month. I have some more comments on the tax rates and interest later.
In summary of our earnings before special items, secondquarter diluted earnings per share were $0.54 for continuing operationscompared to $0.68 for the second quarter last year. Notable is that the secondquarter results were adversely impacted $0.12 by the increasing tax rate andanother $0.02 by higher tax interest.
Combined with earnings per share of $0.61for the first quarter, earnings per share increased 6% over the prior yearfirst half. First half diluted earnings were negatively impacted byseveral items, including the $42 million pretax charges related to the IRSprogram.
Higher than expected non-cash amortization charges associated with thepreliminary valuation of purchase intangibles from the Covansys acquisition andhigher than expected consulting and auditing fees for the restatement and FIN48 adoption. Partially offsetting these impacts were foreign exchange gainsrecorded within other income.
Now, an update on our restructuring program. Pretaxrestructuring charges for the second quarter and first half of fiscal year 2008were $26 million and $53 million respectively.
Restructuring charges of $333million were incurred during fiscal year 2007 and we do not expect to exceed$125 million in restructuring charges for the full year of fiscal year 2008. Workforce reductions totaled approximately 800 employees forthe first half of fiscal year 2008, it’s against the plan of approximately2,000 for the full year.
Partially offsetting these reductions were plannedheadcount increases in the lower cost regions of approximately 106 employees atthe half. Under the restructuring plan approximately 800 additional hires inlower cost regions are anticipated for the remainder of the year.
Our increasedused of high value lower cost global resources have helped to improve ourcommercial margins. Now some items to note on our balance sheet.
We ended thesecond quarter with approximately $500 million of cash and cash equivalents.The cash balance decreased by approximately $560 million from year end due tothe use of cash for the Covansys acquisition as well as funding for sharerepurchases in working capital requirements. The increase of $314 million and accounts receivable resultsprimarily from growth within our European and North America public sectorbusinesses as well as the addition of Covansys.
The $1.2 billion increase in goodwill is primarily resultingfrom the Covansys acquisition. The adoption of FIN 48 reclassifiedapproximately $1 billion of current income taxes payable and differed taxassets into differed tax liabilities.
Long-term debt has increased 1.1 billion due primarily tothe funding of the Covansys acquisition. Our day sales outstanding was 103days, three days higher than the comparable period last year as a result ofsome slower cash collection performance within our North American and Europeancommercial business units.
The increase is primarily timing related and accounts specificand we expect our overall DSO measurements to improve by the end of the year.The debt-to-capital ratio at the end of the second quarter was 34% mostly dueto the increased debt from the Covansys acquisition. We plan to initially -- use debt financing to also fund ourinvestment in first consulting group anticipating our close within the firstcalendar quarter 2008.
We expect to use our cash flows to reduce our debt andwe are still targeting our leverage to be in the 25% to 30% range over time. Within NPS the 16 requests for equable adjustment andsubsequent conversion into interest-bearing claims currently totaledapproximately $900 million.
The associated balance sheet assets for theseclaims totaled approximately $825 million of unbilled accounts receivable anddeferred costs related to the contracts. Despite recent government opposition as it claims, we willcontinue to pursue the claim entitlements.
With respect to a larger set ofclaims during the first quarter of fiscal 2008, U.S. Federal ContractingOfficer for the contract of the larger set of claims denied the claims andissued a $42.3 million counterclaim.
The company disagrees with the governmentdenials both factually and contractually and initiated litigation at the ArmedServices Board of Contract Appeal or ASBCA on September 11, 2007 with regards to larger thetwo sets of claims and the counterclaim. During the third quarter of fiscal year 2008, the companyand its litigation team performed a standard review of the value of the claims associatedwith this contract.
Such value is subject to periodic routine adjustment as newfacts are uncovered, because of contract modifications and funding changes,ordinary rate adjustments and our estimated cost that we replace with actualcost. Upon completion of the review, expected during the thirdquarter of fiscal 2008, the company will amend the complaint that filed withASBCA on September 11, 2007and projects it will downward adjust its value with such reductions reflectedin the $900 million total value of both sets of claims above.
This adjustment is fully to the amount claimed, and does notaffect the amounts currently in the company's balance sheet. With respect tothe second set of claims, the government issued a denial on November 15, 2007.
The company isanalyzing this decision and has until February 12, 2008 to initiated litigation in the US Courtof Federal Claims. These denials or claims by the government were somewhatexpected, and do not change our outlook as to our recoverability of costs andassets.
We believe that recovery at least in that balance sheet assets isprobable. We will pursue appeals as necessary and are therefore unable topredict the timing of recovery for these claims.
Moving on to cash flow. Given the trends of our business,our cash flow tends to have significant inner quarter volatility within eachfiscal year and the first half is traditionally a cash utilization period.
Inaddition we mentioned in our fourth quarter call that a significant amount ofcash from the NHS contract was received a quarter earlier than anticipated,thereby lowering this year's reported cash inflow. With that said, free cash flow for the first half of theyear was an outflow of $676 million, and this compares to $357 million outflowfor the first half of last year.
The net cash used in operations of $92 millionfor the first half of fiscal year 2008 is $160 million higher usage than thesame period last year. The main factor driving our working capital increase was$325 million cash outflow from accounts payables and accruals during the firstquarter for capital expenditures made right towards the end of fiscal year2007.
The net cash outflow for investing activities wassignificantly higher in the first half of fiscal 2008 when compared to the sameperiod last year, as a result of the $1.3 billion cash investment for Covansys.In addition, our fiscal year 2007 investing cash flows included $126 millionbeneficial impact from the redemption and accumulated dividends of DynCorp Internationalpreferred stock received as compensation in the previous sale of the business. Before I conclude my remarks, let me take you through ourrevised guidance for fiscal year 2008.
We expect full year revenues to be inthe $16.2 billion to $16.5 billion range, representing between 9% and 11%growth for the year. This does not include any impact for the purchase of FirstConsulting Group.
The tax provision including interest and penalty accruals forfiscal year 2008 is estimated to yield an effective tax rate in the 40% range.In the future, we expect this rate to be volatile as global tax positions areconcluded under tax audits. Taxes deserve a few moments of discussion, has been widelycommented in FIN 48, which is intended to reduce discretion and the recognitionof tax contingencies has accordingly introduced greater volatility.
CSC now has$1.4 billion of unrecognized tax benefits under FIN 48, including approximately$750 million that would benefit the income statement if the tax returnpositions we have taken were to prevail. The potential re-recognition of these benefits that havebeen reserved for under FIN 48 is a potential source of volatility.
Anothersource is interest accruals and potential reversals on a related accrued taxliabilities. For the first half of the year, CSC accrued approximately $47million of interest on tax liabilities.
This figure is before the tax benefitof interest and before interest reversals associated with changes andaccounting methods reported to the IRS. Tax interest represents potential significant adverse impactor earnings and a disposition on liabilities either as repayment or recognitionof the benefits is difficult to forecast.
Currently our guidance treats thisamount as an approximate run rate. We now expect full year earnings per share to be in a $3.70to $3.90 range compared to our prior expectation of $4 to $4.20.
The primaryreasons for the reduction in our outlook include the non-recurring impact ofthe IRS program write-off which was approximately $0.16 and the higher rate intax interest accruals associated with the adoption of FIN 48, which in thecurrent year is approximately another $0.18 impact. Finally, we still expect to be able to meet our two-yearfree cash flow as a percentage of net income ratio of approximately 80% to 90%.
Free cash flow used in the net income ratio excludesrestructuring cost. We do not expect a collection of any of the identified $900million of government contract claims within the current fiscal year.
Well in closing some key take aways from the quarter end andthe first half results include one, we are achieving overall strong growth withour top line revenues. Two, our core commercial operating performance isbenefiting from the restructuring investment begun in the prior fiscal yearparticularly within our European operations.
Three, our North Americapublic sector business continues to achieve a healthy pipeline of businessopportunities and is performing well within its current contracts. And four,the implementation of Project Accelerate initiatives should provide the focusto continue to grow profitably both organically and thorough strategicallyfocused acquisition, while striving to provide the consolidated ROI performanceabove 10%.
I would like to turn that back over to you now Bill.
Bill Lackey
Thank you, Mike. Before we get into Q&A portion, sincewe have covered quite a bit of information we really appreciate your questionsbeing limited to one if you need to get back at the queue.
Please reenter so,we can ensure that we get to everybody's question. Operator, we are ready now to take questions.
Operator
(Operator Instructions) We will take our first question fromMoshe Katri with Cowen & Co.
Moshe Katri - Cowen& Co
Hey, thanks. Thanks for all the clarifications here.
Can yougive us an update in terms of: where do you think you are in Project AccelerateROE basically halfway through? And then also may be you can remind us: whatsort of EBIT margin targets are you looking for by the time the projectbasically is completed?
Thanks.
Mike Laphen
Moshe, this is Mike. It's envisioned to be about a threeyear program, we began at April 1st, so we are about nine months into it.
So wewill continue to roll it out. We haven't talked in terms of EBIT margins, butwe have talked in terms of operating margin and our target there is to be inexcess of 10%.
Moshe Katri - Cowen& Co
So: at this point you think you are basically about a third,you are done with about a third and there is about two-thirds to go?
Mike Laphen
Yeah, we are just shy of a third Moshe.
Moshe Katri - Cowen& Co
Thanks.
Bill Lackey
I am sorry, next question please operator.
Operator
Thank you. So we will go next to Adam Frisch with UBS.
Adam Frisch - UBS
Thank guys, glad to have you back.
Bill Lackey
It’s good to be back.
Adam Frisch - UBS
All the data, kind of sort of, get what [I would] ask for,right. I wanted to ask about free cash flow and restructuring and: how manymore quarters of restructuring charges do you expect if you kind of qualify orquantify that?
And then: what do you expect for free cash flow for the fullyear excluding items?
Mike Keane
Hi Adam. First of on the restructuring, we expect thecharges to stop after the end of the fourth quarter.
At the end of this year wewill be essentially done, because these are small amounts that fall into thefirst quarter but we really don't expect it up next year, but we don’t expectit this time. In terms of free cash flow you have to combine the two years.
So,basically: if you take our net incomes for both years and calculated at times80% to 90%, that will give you the free cash flow over the two years combined.That’s what we expect to be in that range.
Adam Frisch - UBS
Okay. And then
Mike Laphen
And that excludes restructuring.
Adam Frisch - UBS
Got it, okay. And then just a quick follow-up on Covansys:how much is that adding per quarter and for fiscal '08 in general -- in totalrather?
Mike Keane
Well it added about, it was 3% of our growth in terms of thesecond quarter.
Adam Frisch - UBS
It's about $40 million or so from that ballpark there?
Mike Laphen
No, that’s low; it’s about $130 million.
Adam Frisch - UBS
Yeah about a $130 million, okay. You see the one there.
Okay,thank you.
Bill Lackey
Next question please operator.
Operator
We'll go next to George Price with Stifel Nicolaus.
George Price - StifelNicolaus
Thanks very much. I am sorry, maybe you got to it and Imissed it, but Mike: what was in the first half of the year?
And: if you canbreak it up by quarters: What was the restructuring impact to cash flow?Because that's all -- that's not been removed from the 676, correct?
Mike Keane
That’s correct.
George Price- StifelNicolaus
And: did you mention it? If you did, I apologize, but: couldyou repeat it?
Mike Keane
No, I didn’t mention it, but the cash expenditures againstthe accruals in the first half of the year were about $87 million.
George Price- StifelNicolaus
Okay. And: can you give us any sense of your estimation forthe rest of the year?
Mike Keane
I think that, basically, its round about the same rate. Forthe second half year might be a little bit higher.
George Price - StifelNicolaus
Okay. And: if I could just ask you just then also to commentmay be on the broader discretionary commercial environment?
May be U.S. versus Europe?I know that’s a topic I think a lot of people are interested in and thanks verymuch.
Mike Laphen
The European environment, I am pleased to say, has picked upfor us quite nicely both in France and related Belgium and in our, what we callour central market, which as many of you don't know who follows. We'vestruggled to get there but that has bounced back nicely.
So I would say, of course, Europe, with the exception of Italy;we still struggled a bit there. We're seeing good performance there.
NorthAmerican is -- on the project side, the pipeline has picked up significantly.Most recently, our geographic consulting practices are actually doing aboutmid-single digit now in terms of growth. So it was a bit slow the last quarteror so, but what we're -- in North America I amspeaking now.
But it feels better as we're looking forward.
George Price- StifelNicolaus
Great! Thank you.
Bill Lackey
Next question, please, operator.
Operator
And we'll go next to David Grossman with Thomas WeiselPartners.
David Grossman -Thomas Weisel Partners
Thanks. Mike: could you help us maybe on the tax rate alittle bit?
In terms of, understanding: how much of that is a GAAP versus acash tax rate, going forward as we, kind of, look at it?
Mike Keane
The GAAP rate would be higher than the cash rate outflow.And the main reason for that is a couple of items. One is that in order for anitem to be recorded as a benefit it has to reach in more stringent requirementunder FIN 48.
So, therefore, we have more positions that are reserved against,and, therefore, that raises your accrual rates. Another reason is that on these positions, reservepositions, you make the assumption as if you're going to lose your position andyou accrue the related tax, interest and penalties on that at the same time.And you also assume that if all that occurs that any net operating losscoverage that you’ve had before goes away, so these have a compounded effect.As a result of that it's driving the accrual rate higher.
David Grossman -Thomas Weisel Partners
Can you give us an order of magnitude on the 40% for theyear?
Mike Keane
In terms of: relative to cash payments?
David Grossman -Thomas Weisel Partners
Yeah. Exactly.
Mike Keane
Well, its going to be a little lumpy, so basically, we mayhave a single payment but if I -- that just as a catch up adjustment on someareas we identified which is already fixed into our free cash flows from that.And, but, if I remove that basically we are running a rate that's more cashrate that’s going to run closer to the statutory of about 35%.
David Grossman -Thomas Weisel Partners
Alright. And you give a lot of information on the REAs thatare out there, when you could perhaps, it’s, quite frankly, I kind of lost youabout midstream: can you perhaps just give us, the thumbnail summary on…?
Mike Keane
Okay.
David Grossman -Thomas Weisel Partners
You had $900 million they have contested, so…
Mike Keane
Okay I’ll give you the Readers Digest version.
David Grossman -Thomas Weisel Partners
Yeah.
Mike Keane
Basically the government, there has two set of programshere, and on both sets of programs the government has denied our claims, thiswas not a surprise to us, its kind of their first sale though. And, in one ofthe cases, they actually counter claim, but we don't believe it has much meritor basis.
So, that means: we now move on to a litigation phase of the claimsand we believe that our position is very strong, very supportive. But what itreally does is give us less visibility in terms of timing and completion.
Atthe same time we previously had approximately $1 billion estimate in turns, wepreviously had approximately $1 billion estimate in terms of claim coveragethat we submitted. We've basically scrubbed that and now reduced that down to$900 million number, still accruing interest, which we are not booking.
Andthat’s covering our balance sheet, related balance assets of $825 million.
David Grossman -Thomas Weisel Partners
So: what's the next milestone?
Mike Laphen
This is Mike. Well with respect to the larger program, alarge [mod], we expect it to be the first hearing in front of an assigned judgethat takes place in the January-February timeframe of '08.
At that point thejudge has the option to suggest that we and the army move towards alternativedisputes resolution process, as its name would indicate an alternative methodto full litigation. That will be at the judge’s discretion, so if it goes downthat way it could get resolved faster than you would expect it to get resolvedunder a full litigation.
The second program, we don’t think we will be at that stageand probably until this summer of '08.
David Grossman -Thomas Weisel Partners
Okay, I got it. Great, thanks very much.
Bill Lackey
Next question please operator.
Operator
We'll go next to Rod Bourgeois with Bernstein. Please goahead.
Rod Bourgeois -Bernstein
Hey guys, just wanted to clarify the free cash flowtrajectory. If I understood it correctly: in the first half of the year, yourfree cash flow was negative $676 million and: is that accurate?
Mike Laphen
That is correct.
Rod Bourgeois -Bernstein
Okay and the restructuring component of that was $87million?
Mike Laphen
That does not include the $80 million -- $87 million.
Rod Bourgeois -Bernstein
Okay, got it and so, in order toget to a cash flow positive for the year, are you expecting another Marchquarter where you have a sort of huge cash in flow, for…
Mike Keane
We have got a big hockey stick inthe second half of the year.
Rod Bourgeois -Bernstein
Right.
Mike Keane
As we've had traditionally,unfortunately for the last three years or so.
Rod Bourgeois -Bernstein
Alright. And so, given the bigramp that's required, and I know this is an annual “sort of” event for us, butlast year’s big event in Q4 was NHS and the milestones related to that deal.Can you characterize the big milestones needed in order to get to your free cashflow target for fiscal '08?
Because it’s another one of those big ramp years.
Mike Keane
I think its spread evenly, spreadmore evenly. Now, there are some milestone payments, but not as exaggerated asthey were in the prior year and hopefully not on the last day of the fiscalyear as we had last year.
So, it's just a matter of many programs spread acrossboth geography and across business units showing basically the positive cashflow in the second half of the year.
Rod Bourgeois -Bernstein
Right. And: does it require DSO'sto come down to more normalized levels?
Mike Keane
Yes.
Rod Bourgeois -Bernstein
Okay, got it. And then are youseeing the level of restructuring benefits flow through that you would haveexpected at this point in the turn around.
I mean: it's tough to tell with thefinancials, but with the negative cash flow, it leaves a question as to whetherthe restructuring savings are really coming through, but it's tough given someof the noise and the numbers to really figure that out. Are you feeling likeits flowing through at the pace you would have expected at this point?
Mike Keane
Yes, as we had indicated earlier.We thought the positive impact would be about $300 million pretax for this yearand we’re actually running slightly ahead of that rate in the first half of theyear.
Rod Bourgeois -Bernstein
Alright. But: I guess theearnings benefited differently than the, sort of, free cash flow benefit thatyou are seeing from the restructuring?
Mike Keane
Well, the free cash flow as we've always indicated is goingto be extremely lumpy and volatile from quarter-to-quarter. So I don't thinkyou can measure in that regard.
Rod Bourgeois -Bernstein
Okay. Thanks, guys.
Bill Lackey
Next question please, operator.
Operator
And we'll go next to Abhi Gami with Banc of America.
Abhi Gami - Banc of America
Thanks. Back to the REA question: You mentioned that youhave the high probability of recovering claim.
Is that based on priorsituations that are similar to this kind? Can you give some examples?
Or: whatgives you that expectation that's probably look like those?
Mike Keane
No. Historically, we actually haven't gotten into a lot ofclaims.
We know the facts and circumstances that got us into this position andreflecting on those, as well as having outside council review them thoroughlyand go through extensive reviews of the numbers including this, what I'll call,true-up that we just went through. We feel we're well entitled to those fundsand we'll fight aggressively for them.
Abhi Gami - Banc of America
But: was the $100 million true-up? Was that more of aspecific element within one of the REAs that you determine may not be probablyreflected?
What was that, kind of, a discounting of probability?
Mike Keane
No, I think it was a general, if you will, scrubbing of theestimate. And, as I indicated, in certain parts of the claim we had estimatednumbers and as you bring forward and actually fill those with actual numbers,you get better clarity as to what the amount is.
So that's an essence what wasoccurring.
Abhi Gami - Banc of America
And then just to clarify, you mentioned that earlier you areaccruing interest on that, but you haven't actually received any cash againstthe…
Mike Keane
Well, when I say accruing, it's economic accrual. We're notrecording any interest accruals on the claim.
But we are -- the clock isrunning and we are benefiting from an interest accrual now on the $900 million.
Mike Laphen
Yeah, under federal procurement rules, under any kind of claimsituation like this, if the claim is found to be valid we are entitled toaccrued interest from the date that we filed claim.
Abhi Gami - Banc of America
That's all, thank you.
Bill Lackey
Next question please Operator.
Operator
We'll go next to Eric Boyer with Wachovia.
Eric Boyer - Wachovia
Hi, thanks. You are talking working capital improvements inbringing down DSOs: where can you get them struck really?
And: over what timeperiod?
Mike Keane
I think it's a constant effort. Generally, given ourbusiness cycle we tend to see that occur in the second half of the year andalso you would expect that sometimes that occurs because there are incentivesinvolved for that to happen.
But it just so happens that there is a number ofour contracts and number of our business flows that tend to have heavier cashusage in the first part of the year. And then there is a turnaround in thesecond half of the year.
We actually are trying to get that to be more modified andreduce the volatility, but that's not going to occur this year. So, over time,we are pushing for better efficiency in our DSOs, better cash collections.
Andmore importantly away from the working capital, changing our mix of business tobe less capital intensive where it is capital intensive, attempting tostructure the deal that we recover that capital in a shorter time period, interms of receipts from our customers.
Eric Boyer - Wachovia
Is there a number that you are targeting as far as DSO?
Mike Keane
Well, we would like to see the DSO in the low 90s. Nowremember that number in itself is a higher number for us but it also includessome stagnant amounts that are related to these claims.
So there is a largenumber of receivables there that are not turning and when they do you are goingto see that number come down precipitously. But as long as its there in termsof external measurement, we are targeting to get that number down below 90'sand we like to go below that.
Eric Boyer - Wachovia
And finally: are you still expecting high-single digitrevenue growth for you public sector? And: any thoughts on the governmentbudget process?
It’s looking like it’s over now?
Mike Laphen
Yes, we are still expecting high-single digits for ourFederal business. We are very gratified that the omnibus bill was signed thisweek.
That will help us significantly on the civilian side of the spectrum.They have been carrying the most pressure, not that there has been pressureacross the board. So: yeah, we think that will be quite helpful going forward.
Eric Boyer - Wachovia
Thank you.
Bill Lackey
Next question please, operator.
Operator
We'll go next to Greg Smith with Merrill Lynch.
Greg Smith - MerrillLynch
Yeah, hi guys. Can you just talk a little more about theCovansys integration?
Sort of: what steps you've taken? And: what still needsto come on that front?
Mike Laphen
Well we have integrated both our legacy CSC India resources as well as the Covansysresources within India.So that is integrated as one unit. We are doing all the back office activitiesthat are associated with that.
That’s expected to be completed as we roll intothe new fiscal year, April 1st. So, that's operating as single organization.And then we have the go-to-market activity that goes along with that led by RajVattikuti, who came over from Covansys.
So, Raj has both the India direct go-to-market focus whereas, as wellas, all of our offshore resources in India. So, he is both ago-to-market organization and at the same time supports the broader CSC on asupport basis.
Greg Smith - MerrillLynch
Okay. And: have you seen retention tick up at all among thelegacy Covansys employees?
Mike Laphen
Yes, we've seen a drop in turn over and I don’t want tocharacterize it as huge, but we’ve, yes we've seen a drop there. So, we'repleased with that as well.
Greg Smith - MerrillLynch
Okay. Thank you.
Bill Lackey
Next question please, operator.
Operator
We will go next in Tien-Tsin Huang with J.P. Morgan.
Tien-Tsin Huang - J.P. Morgan
Hi, I just had a follow-up on the REA, it’s just to try andbetter understand: why the government is pushing back on the claims? They werejust alleging that they were over charged on our projects and improperlybilled?
I am just trying to better appreciate that.
Mike Laphen
Yes, I don’t want to get into, given these are going intolitigation. I really don’t want to go into too much discussion around all that,not because we're not trying to be transparent.
It is going to litigation. Iwill say that, I think an important perspective here is, we are continuing toperform on both of these programs with both of these customers and I believeand I think you could validate that, we will proceed to be excellent performerson both of those program.
So: yes, we have a contractual dispute. We do not, byany means, have a performance dispute.
We're performing, as I said, I believe:with excellence. And we're continuing to get new contract work and new contractextensions from both these customers.
Tien-Tsin Huang - JP Morgan
Okay. Great!
That's good to know. Then if I could asksomething about free cash flow, just: is it reasonable for us to think that youcan approach breakeven in free cash flow year-to-date in December?
I askbecause, obviously, we're pretty close to the end of December here. So somekind of picture there would be helpful.
Mike Keane
Well, I don't think we'd expect it by the end of our thirdquarter because fourth quarter tends to be a very significant contribution toour free cash flow.
Tien-Tsin Huang - JP Morgan
Okay. Just, as usual, more heavily weighted towardsforecast?
Mike Keane
That's correct.
Tien-Tsin Huang - JP Morgan
All right. Thank you.
Bill Lackey
Operator, I think we have time for one more question please.
Operator
Our next question will come from Pat Burton with Citi.
Pat Burton - Citi
Hi. Thanks.
My question just relates to the balance sheet.Mike, just briefly, go over the rise in prepaid expense from the March toSeptember period. And then, also, on the liability side the drop in the accrued-- other accrued expenses as well as the deferred revenue.
Mike Keane
Okay. The prepaid is actually a natural phenomenon we haveover here.
We have a lot of prepaids that occur in the first quarter. And also,within that line item, we tend to have work-in-process included as well and so,one of the large drivers of our work-in-process accounts is the NHS contract.So that's what you're seeing a little bit there.
Also NHS contract tends to affect deferred revenue wherewe’ve received and from an accounting perspective received advance payments.And we're working against those in recognizing revenue. The reduction inaccrued expenses relates to a comment I made earlier, where we had purchased asignificant amount of capital expenditures program related towards the end ofthe fourth quarter and those ended up getting paid for within the first fiscalquarter this year.
Pat Burton - Citi
Okay. So, on the deferred revenue running down: should weread into that then you are hitting more of your milestones?
Mike Laphen
Now, we are on track, we are meeting our estimates tocompletion and recognizing revenue ratably. So, yes, we are meeting ourmilestones.
Pat Burton - Citi
Okay.
Mike Laphen
(multiple speakers)
Pat Burton - Citi
Thank you. And congratulations on digging out and get mecurrent.
Mike Laphen
Thank you.
Mike Keane
Thank you, operator. Mike?
Mike Laphen
Yeah, this is Mike Laphen, I just want to say it's great tobe back dialoging with all of you. Thanks for joining us today, I apologize forthe short notice that we had, but I hope you can appreciate the situation wewere in, in terms of trying to get to this point.
So thank you for that and Iwant to extend everybody wish for very, very happy holidays and very healthyand successful New Year. Thank you very much.
Operator
And that does conclude today's conference. Thank you foryour participation.
You may disconnect at this time.