UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
__________________________________
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _________.
Commission file number 1-8729
UNISYS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 38-0387840
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
Unisys Way
Blue Bell, Pennsylvania 19424
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (215) 986-4011
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large Accelerated Filer [X] Accelerated Filer [ ] Non-Accelerated Filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act). YES [ ] NO [X]
Number of shares of Common Stock outstanding as of September 30, 2006:
344,577,714.
2
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements.
UNISYS CORPORATION
CONSOLIDATED BALANCE SHEETS
(Millions)
September 30,
2006 December 31,
(Unaudited) 2005
----------- ------------
Assets
------
Current assets
Cash and cash equivalents $ 612.0 $ 642.5
Accounts and notes receivable, net 1,139.9 1,111.5
Inventories:
Parts and finished equipment 100.3 103.4
Work in process and materials 88.4 90.7
Deferred income taxes 112.2 68.2
Prepaid expenses and other current assets 157.0 137.0
-------- --------
Total 2,209.8 2,153.3
-------- --------
Properties 1,346.3 1,320.8
Less-Accumulated depreciation and
amortization 998.8 934.4
-------- --------
Properties, net 347.5 386.4
-------- --------
Outsourcing assets, net 410.6 416.0
Marketable software, net 307.7 327.6
Investments at equity 1.1 207.8
Prepaid pension cost 1,298.0 66.1
Deferred income taxes 138.4 138.4
Goodwill 191.3 192.0
Other long-term assets 137.8 141.3
-------- --------
Total $5,042.2 $4,028.9
======== ========
Liabilities and stockholders' equity
------------------------------------
Current liabilities
Notes payable $ .8 $ 18.1
Current maturities of long-term debt .6 58.8
Accounts payable 377.7 444.6
Other accrued liabilities 1,469.2 1,293.3
-------- --------
Total 1,848.3 1,814.8
-------- --------
Long-term debt 1,049.2 1,049.0
Accrued pension liabilities 353.8 506.9
Other long-term liabilities 662.7 690.8
Stockholders' equity (deficit)
Common stock, shares issued: 2006, 346.6;
2005, 344.2 3.5 3.4
Accumulated deficit (2,408.1) (2,108.1)
Other capital 3,937.7 3,917.0
Accumulated other comprehensive loss (404.9) (1,844.9)
-------- --------
Stockholders' equity (deficit) 1,128.2 (32.6)
-------- --------
Total $5,042.2 $4,028.9
======== ========
See notes to consolidated financial statements.
3
UNISYS CORPORATION
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Millions, except per share data)
Three Months Nine Months
Ended September 30 Ended September 30
------------------ ------------------
2006 2005 2006 2005
---- ---- ---- ----
Revenue
Services $1,217.6 $1,174.0 $3,618.5 $3,517.7
Technology 192.5 213.1 586.7 671.5
-------- -------- -------- --------
1,410.1 1,387.1 4,205.2 4,189.2
Costs and expenses
Cost of revenue:
Services 1,058.9 1,036.0 3,271.7 3,080.8
Technology 92.5 105.1 310.0 324.7
-------- -------- -------- --------
1,151.4 1,141.1 3,581.7 3,405.5
Selling, general and administrative 256.1 261.0 834.2 790.0
Research and development 45.5 61.2 184.7 192.7
-------- -------- -------- --------
1,453.0 1,463.3 4,600.6 4,388.2
-------- ------- -------- --------
Operating loss (42.9) (76.2) (395.4) (199.0)
Interest expense 19.0 17.1 57.9 44.9
Other income (expense), net .4 13.3 153.1 45.8
-------- -------- -------- --------
Loss before income taxes (61.5) (80.0) (300.2) (198.1)
Provision (benefit)
for income taxes 16.0 1,548.2 (.2) 1,502.7
-------- -------- -------- --------
Net loss $ (77.5) $(1,628.2) $ (300.0) $(1,700.8)
======== ======== ======== ========
Loss per share
Basic $ (.23) $ (4.78) $ (.87) $ (5.01)
======== ======== ======== ========
Diluted $ (.23) $ (4.78) $ (.87) $ (5.01)
======== ======== ======== ========
See notes to consolidated financial statements.
4
UNISYS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Millions)
Nine Months Ended
September 30
------------------
2006 2005
-------- --------
Cash flows from operating activities
Net loss $ (300.0) $(1,700.8)
Add (deduct) items to reconcile net loss
to net cash (used for) provided by operating
activities:
Equity loss (income) 4.3 (3.8)
Employee stock compensation 4.8 .2
Depreciation and amortization of properties 88.1 89.7
Depreciation and amortization of outsourcing assets 100.5 96.0
Amortization of marketable software 98.7 91.6
Gain on sale of NUL shares and other assets (153.2) (15.8)
Loss on the tender of debt - 10.7
(Increase) decrease in deferred income taxes, net (44.0) 1,474.5
Decrease in receivables, net 8.0 20.7
Decrease in inventories 5.2 19.6
Increase (decrease) in accounts payable and other
accrued liabilities 69.8 (245.9)
(Decrease) increase in other liabilities (64.8) 199.4
Decrease (increase) in other assets 21.2 (48.8)
Other 22.7 35.2
------- ------
Net cash (used for) provided by operating activities (138.7) 22.5
------- ------
Cash flows from investing activities
Proceeds from investments 5,617.8 5,758.9
Purchases of investments (5,620.7) (5,746.2)
Investment in marketable software (81.2) (93.7)
Capital additions of properties (48.2) (84.9)
Capital additions of outsourcing assets (68.9) (115.7)
Proceeds from sale of NUL shares and
other assets 380.6 23.4
Purchases of businesses - (.5)
------- ------
Net cash provided by (used for)
investing activities 179.4 (258.7)
------- ------
Cash flows from financing activities
Net (reduction in) proceeds from
short-term borrowings (17.3) 3.8
Proceeds from employee stock plans .9 12.8
Payments of long-term debt (57.9) (500.2)
Financing fees (4.6) -
Proceeds from issuance of long-term debt - 541.5
------- ------
Net cash (used for) provided by financing activities (78.9) 57.9
------- ------
Effect of exchange rate changes on
cash and cash equivalents 7.7 (16.1)
------- ------
Decrease in cash and cash equivalents (30.5) (194.4)
Cash and cash equivalents, beginning of period 642.5 660.5
------- -------
Cash and cash equivalents, end of period $ 612.0 $ 466.1
======== =======
See notes to consolidated financial statements.
5
Unisys Corporation
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
In the opinion of management, the financial information furnished herein
reflects all adjustments necessary for a fair presentation of the financial
position, results of operations and cash flows for the interim periods
specified. These adjustments consist only of normal recurring accruals except
as disclosed herein. Because of seasonal and other factors, results for interim
periods are not necessarily indicative of the results to be expected for the
full year.
a. The following table shows how earnings (loss) per share were computed for the
three and nine months ended September 30, 2006 and 2005 (dollars in millions,
shares in thousands):
Three Months Nine Months
Ended September 30 Ended September 30
------------------ ------------------
2006 2005 2006 2005
---- ---- ---- ----
Basic Loss Per Share
Net loss $ (77.5) $ (1,628.2) $ (300.0) $(1,700.8)
======== ========= ======== =========
Weighted average shares 344,182 340,914 343,351 339,736
======== ========= ======== =========
Basic loss per share $ (.23) $ (4.78) $ (.87) $ (5.01)
======== ========= ======== ========
Diluted Loss Per Share
Net loss $ (77.5) $(1,628.2) $ (300.0) $(1,700.8)
======== ========= ======== ========
Weighted average shares 344,182 340,914 343,351 339,736
Plus incremental shares
from assumed conversions
of employee stock plans - - - -
-------- --------- -------- --------
Adjusted weighted average shares 344,182 340,914 343,351 339,736
======== ========= ======== ========
Diluted loss per share $ (.23) $ (4.78) $ (.87) $ (5.01)
======== ========= ======== ========
At September 30, 2006, no shares related to employee stock plans were
included in the computation of diluted earnings per share since inclusion of
these shares would be antidilutive because of the net loss incurred in the
three and nine months ended September 30, 2006.
b. As part of the company's repositioning plan to right size its cost
structure, on March 31, 2006, the company committed to a reduction of
approximately 3,600 employees. This resulted in a pretax charge in the
first quarter of 2006 of $145.9 million, principally related to severance
costs. The charge is broken down as follows: (a) approximately 1,600
employees in the U.S. for a charge of $50.3 million and (b) approximately
2,000 employees outside the U.S. for a charge of $95.6 million. The pretax
charge was recorded in the following statement of income classifications:
cost of revenue-services, $83.4 million; cost of revenue-technology, $2.0
million; selling, general and administrative expenses, $45.4 million;
research and development expenses, $17.6 million; and other income
(expense), net, $2.5 million. The income recorded in other income
(expense), net relates to minority shareholders' portion of the charge
related to majority owned subsidiaries which are fully consolidated by the
company.
As part of the company's continuing repositioning plan to right size its
cost structure, during the three months ended June 30, 2006, the company
committed to an additional reduction of approximately 1,900 employees. This
resulted in a pretax charge in the second quarter of 2006 of $141.2 million,
principally related to severance costs. The charge is broken down as
follows: (a) approximately 650 employees in the U.S. for a charge of $22.1
million and (b) approximately 1,250 employees outside the U.S. for a charge
of $119.1 million. The pretax charge was recorded in the following
statement of income classifications: cost of revenue-services, $101.4
million; selling, general and administrative expenses, $28.3 million;
research and development expenses, $11.8 million; and other income
(expense), net, $.3 million. The income recorded in other income (expense),
net relates to minority shareholders' portion of the charge related to
majority owned subsidiaries which are fully consolidated by the company.
6
During the three months ended September 30, 2006, the company committed to
an additional reduction of approximately 100 employees outside the U.S that
resulted in a pretax charge of $36.4 million, principally related to
severance costs. The pretax charge was recorded in the following statement
of income classifications: cost of revenue-services, $28.1 million and
selling, general and administrative expenses, $8.3 million.
For the nine months ended September 30, 2006, the pretax charge of $323.5
million was recorded in the following statement of income classifications:
cost of revenue-services, $212.9 million; cost of revenue-technology, $2.0
million; selling, general and administrative expenses, $82.0 million;
research and development expenses, $29.4 million; and other income
(expense), net, $2.8 million. The income recorded in other income
(expense), net relates to minority shareholders' portion of the charge
related to majority owned subsidiaries which are fully consolidated by the
company.
Of the total of approximately 5,600 employee reductions announced through
September 30, 2006, approximately 90% are expected to be completed by the
end of 2006 with the remaining reductions targeted for the first half of
2007. Net of increases in offshore resources and outsourcing of certain
internal, non-client facing functions, the company anticipates that these
combined actions will yield annualized cost savings in excess of $340
million by the second half of 2007. The company continues to explore other
approaches to reducing its cost structure, including additional work force
reductions and potential idle facility charges which could result in
additional cost reduction charges in the fourth quarter of 2006.
A further breakdown of the individual components of these costs follows (in
millions of dollars):
Headcount Total U.S. Int'l.
--------- ----- ---- ------
Charge for work force reductions 5,631 $323.5 $72.5 $251.0
Minority interest 2.8 2.8
------ ------ ------ -----
5,631 326.3 72.5 253.8
Utilized (3,237) (98.0) (27.8) (70.2)
Changes in estimates and
revisions (411) (2.4) (1.9) (.5)
Translation adjustments 5.2 5.2
------ ------ ----- -----
Balance at September 30, 2006 1,983 $231.1 $42.8 $188.3
====== ====== ===== ======
Expected future utilization:
2006 remaining three months 1,400 $84.1 $23.2 $ 60.9
2007 and thereafter 583 147.0 19.6 127.4
c. On March 17, 2006, the company adopted changes to its U.S. defined
benefit pension plans effective December 31, 2006, and will increase
matching contributions to its defined contribution savings plan beginning
January 1, 2007.
The changes to the U.S. plans are part of a global effort by the company to
provide a competitive retirement program while controlling the level and
volatility of retirement costs.
7
The changes to the U.S. pension plans affect most U.S. employees and
senior management. They include:
* Ending the accrual of future benefits in the company's defined benefit
pension plans for employees effective December 31, 2006. There will be
no new entrants to the plans after that date.
* Increasing the company's matching contribution under the company savings
plan to 100 percent of the first 6 percent of eligible pay contributed
by participants, up from the current 50 percent of the first 4 percent
of eligible pay contributed by participants. The company match is made
in company common stock.
The changes do not affect the vested accrued pension benefits of current and
former employees, including Unisys retirees, as of December 31, 2006.
As a result of the amendment to stop accruals for future benefits in its
U.S. defined benefit pension plans, the company recorded a pretax
curtailment gain of $45.0 million in the first quarter of 2006. U.S. GAAP
pension accounting rules require companies to re-measure both plan assets
and obligations whenever a significant event occurs, such as a plan
amendment. The company has performed such re-measurement as of March 31,
2006. As a result of the re-measurement, the company's U.S. qualified
defined benefit pension plan is no longer in a minimum liability position
and, accordingly, the company has reclassified its prepaid pension asset
from other comprehensive income to a prepaid pension asset on its balance
sheet. Based on the changes to the U.S. plans, the March 31, 2006 re-
measurement and including the $45.0 million curtailment gain, the company
currently expects its 2006 worldwide pension expense to be approximately
$135 million, down from $181 million in 2005. The expected pension expense
in 2006 is based on actuarial assumptions and on assumptions regarding
interest rates and currency exchange rates, all of which are subject to
change. Accordingly the expected expense amount could change.
Net periodic pension expense for the three and nine months ended September
30, 2006 and 2005 is presented below (in millions of dollars):
Three Months Three Months
Ended September 30, 2006 Ended September 30, 2005
------------------------ ------------------------
U.S. Int'l. U.S. Int'l.
Total Plans Plans Total Plans Plans
----- ----- ----- ----- ----- -----
Service cost $ 26.0 $ 13.9 $ 12.1 $ 28.4 $ 17.3 $ 11.1
Interest cost 91.7 63.0 28.7 91.9 65.8 26.1
Expected return on
plan assets (114.2) (83.1) (31.1) (119.1) ( 90.3) (28.8)
Amortization of prior
service (benefit) cost (.4) (.5) .1 ( 1.7) ( 1.9) .2
Recognized net actuarial
loss 40.3 27.5 12.8 44.7 35.1 9.6
----- ------ ----- ----- ----- ----
Net periodic pension
expense $ 43.4 $ 20.8 $22.6 $ 44.2 $ 26.0 $18.2
====== ====== ===== ====== ====== =====
Nine Months Nine Months
Ended September 30, 2006 Ended September 30, 2005
------------------------ ------------------------
U.S. Int'l. U.S. Int'l.
Total Plans Plans Total Plans Plans
----- ----- ------ ----- ----- ------
Service cost $ 83.2 $ 47.5 $35.7 $ 88.2 $ 52.0 $ 36.2
Interest cost 298.5 215.3 83.2 278.0 197.3 80.7
Expected return on
plan assets (374.8) (284.1) (90.7) (359.9) (270.8) (89.1)
Amortization of prior
service (benefit) cost (.9) (1.5) .6 (4.7) (5.7) 1.0
Recognized net actuarial
loss 130.8 93.9 36.9 135.2 105.2 30.0
Curtailment gain (45.0) (45.0)
------ ------ ----- ------ ----- -----
Net periodic pension
expense $ 91.8 $ 26.1 $65.7 $136.8 $78.0 $ 58.8
====== ====== ===== ====== ===== ======
8
The company currently expects to make cash contributions of approximately
$80 million to its worldwide defined benefit pension plans in 2006 compared
with $71.6 million in 2005. For the nine months ended September 30, 2006
and 2005, $53.3 million and $49.3 million, respectively, of cash
contributions have been made. In accordance with regulations governing
contributions to U.S. defined benefit pension plans, the company is not
required to fund its U.S. qualified defined benefit pension plan in 2006.
Net periodic postretirement benefit expense for the three and nine months
ended September 30, 2006 and 2005 is presented below (in millions of
dollars):
Three Months Nine Months
Ended September 30 Ended September 30
-------------------- -------------------
2006 2005 2006 2005
---- ---- ---- ----
Interest cost $3.2 $3.5 $ 9.6 $10.4
Expected return on assets (.2) (.1) (.3) (.3)
Amortization of prior
service benefit (.5) (.5) (1.5) (1.5)
Recognized net actuarial
loss 1.4 1.6 4.0 4.8
---- ---- ---- -----
Net periodic postretirement
benefit expense $3.9 $4.5 $11.8 $13.4
==== ==== ==== =====
The company expects to make cash contributions of approximately $28 million
to its postretirement benefit plan in 2006 compared with $26.4 million in
2005. For the nine months ended September 30, 2006 and 2005, $19.1 million
and $18.8 million, respectively, of cash contributions have been made.
d. In March 2006, the company sold all of the shares it owned in Nihon Unisys,
Ltd. (NUL), a publicly traded Japanese company. The company received gross
proceeds of $378.1 million and recognized a pretax gain of $149.9 million in
the first quarter of 2006. NUL will remain the exclusive distributor of the
company's hardware and software in Japan.
At December 31, 2005, the company owned approximately 29% of the voting
common stock of NUL. The company accounted for this investment by the
equity method, and, at December 31, 2005, the amount recorded in the
company's books for the investment, after the reversal of a minimum pension
liability adjustment, was $243 million. During the years ended December 31,
2005, 2004 and 2003, and for the nine months ended September 30, 2006 and
2005, the company recorded equity income (loss) related to NUL of $9.1
million, $16.2 million, $18.2 million, $(4.2) million and $3.7 million,
respectively. These amounts were recorded in "Other income (expense), net"
in the company's consolidated statements of income.
e. Under the company's stockholder approved stock-based plans, stock options,
stock appreciation rights, restricted stock and restricted stock units may
be granted to officers, directors and other key employees. At September 30,
2006, 5.5 million shares of unissued common stock of the company were
available for granting under these plans.
As of September 30, 2006, the company has granted non-qualified stock
options and restricted stock units under these plans. Prior to January 1,
2006, the company applied the recognition and measurement principles of APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations in accounting for those plans, whereby for stock options, at
the date of grant, no compensation expense was reflected in income, as all
stock options granted had an exercise price equal to or greater than the
market value of the underlying common stock on the date of grant. Pro forma
information regarding net income and earnings per share was provided in
accordance with Statement of Financial Accounting Standards (SFAS) No.
148, "Accounting for Stock-Based Compensation - Transition and Disclosure"
(SFAS No. 148), as if the fair value method defined by SFAS No. 123,
"Accounting for Stock-Based Compensation" (SFAS No. 123) had been applied to
stock-based compensation. For purposes of the pro forma disclosures, the
estimated fair value of stock options was amortized to expense over the
options' vesting periods.
9
Effective January 1, 2006, the company adopted SFAS No. 123 (revised 2004),
"Share-Based Payment" (SFAS No. 123R), which replaces SFAS No. 123 and
supersedes APB Opinion No. 25. SFAS No. 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the financial statements based on their fair values. The
company adopted SFAS No. 123R using the modified-prospective transition
method, which requires the company, beginning January 1, 2006 and
thereafter, to expense the grant date fair value of all share-based awards
over their remaining vesting periods to the extent the awards were not fully
vested as of the date of adoption and to expense the fair value of all
share-based awards granted subsequent to December 31, 2005 over their
requisite service periods. Stock-based compensation expense for all share-
based payment awards granted after January 1, 2006 is based on the grant-
date fair value estimated in accordance with the provisions of SFAS No.
123R. The company recognizes compensation cost net of a forfeiture rate and
recognizes the compensation cost for only those awards expected to vest on a
straight-line basis over the requisite service period of the award, which is
generally the vesting term. The company estimated the forfeiture rate based
on its historical experience and its expectations about future forfeitures.
As required under the modified-prospective transition method, prior periods
have not been restated. In March 2005, the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107)
regarding the SEC's interpretation of SFAS No. 123R and the valuation of
share-based payments for public companies. The company has applied the
provisions of SAB 107 in its adoption of SFAS No. 123R. The company records
share-based payment expense in selling, general and administrative expenses.
The company's stock option and time-based restricted stock unit grants
include a provision that if termination of employment occurs after the
participant has attained age 55 and completed 5 years of service with the
company, or for directors, the completion of 5 years of service as a
director, the participant shall continue to vest in each of his or her
awards in accordance with the vesting schedule set forth in the applicable
award agreement. For purposes of the pro forma information required to be
disclosed by SFAS No. 123, the company recognized compensation expense over
the vesting period. Under SFAS No. 123R, compensation expense is recognized
over the period through the date that the employee first becomes eligible to
retire and is no longer required to provide service to earn the award. For
grants prior to January 1, 2006, compensation expense continues to be
recognized under the prior method; compensation expense for awards granted
after December 31, 2005 is recognized over the period to the date the
employee first becomes eligible for retirement.
Options have been granted to purchase the company's common stock at an
exercise price equal to or greater than the fair market value at the date of
grant. Options granted before January 1, 2005 generally have a maximum
duration of ten years and were exercisable in annual installments over a
four-year period following date of grant. Stock options granted after
January 1, 2005 generally have a maximum duration of five years and become
exercisable in annual installments over a three-year period following date
of grant. On September 23, 2005, the company accelerated the vesting of all
of its then-issued unvested stock options. On December 19, 2005, the
company granted fully vested stock options to purchase a total of 3.4
million shares of the company's common stock at an exercise price of $6.05,
the fair market value of the company's common stock on December 19, 2005.
Prior to January 1, 2006, restricted stock units had been granted and were
subject to forfeiture upon employment termination prior to the release of
the restrictions. Compensation expense resulting from these awards is
recognized as expense ratably from the date of grant until the date the
restrictions lapse and is based on the fair market value of the shares at
the date of grant.
For stock options issued both before and after adoption of SFAS No. 123R,
the fair value is estimated at the date of grant using a Black-Scholes
option pricing model. As part of its adoption of SFAS No. 123R, for stock
options issued after December 31, 2005, the company reevaluated its
assumptions in estimating the fair value of stock options granted.
Principal assumptions used are as follows: (a) expected volatility for the
company's stock price is based on historical volatility and implied market
volatility, (b) historical exercise data is used to estimate the options'
expected term, which represents the period of time that the options granted
are expected to be outstanding, and (c) the risk-free interest rate is the
rate on zero-coupon U.S. government issues with a remaining term equal to
the expected life of the options. The company recognizes compensation
expense for the fair value of stock options, which have graded vesting, on
the straight-line basis over the requisite service period of the awards.
10
The fair value of stock option awards was estimated using the Black-Scholes
option pricing model with the following assumptions and expected weighted-
average fair values as follows:
Nine Months Ended September 30
------------------------------
2006 2005
---- ----
Weighted-average fair value of grant $2.46 $3.27
Risk-free interest rate 4.35% 3.43%
Expected volatility 45.88% 55.00%
Expected life of options in years 3.67 3.50
Expected dividend yield - -
Prior to January 1, 2006, the company would grant an annual stock option
award to officers, directors and other key employees generally in the first
quarter of a year. For 2006, this annual stock option award has been
replaced with restricted stock unit awards. The company currently expects
to continue to grant stock option awards, principally to newly hired
individuals. The restricted stock unit awards granted in March of 2006
contain both time-based units (25% of the grant) and performance-based units
(75% of the grant). The time-based units vest in three equal annual
installments beginning with the first anniversary of the grant, and the
performance-based units vest in three equal annual installments, beginning
with the first anniversary of the grant, based upon the achievement of
pretax profit and revenue growth rate goals in 2006, 2006-2007, and 2006-
2008, for each installment, respectively. Each performance-based unit will
vest into zero to 1.5 shares depending on the extent to which the
performance goals are met. Compensation expense resulting from these awards
is recognized as expense ratably for each installment from the date of grant
until the date the restrictions lapse and is based on the fair market value
at the date of grant and the probability of achievement of the specific
performance-related goals.
During the nine months ended September 30, 2006, the company recorded $4.8
million of share-based compensation expense, which is comprised of $4.4
million of restricted stock unit expense and $.4 million of stock option
expense.
The adoption of SFAS No. 123R had an immaterial impact to income before
income taxes and net income for the nine months ended September 30, 2006.
A summary of stock option activity for the nine months ended September 30,
2006 follows (shares in thousands):
Weighted-
Weighted- Average Aggregate
Average Remaining Intrinsic
Exercise Contractual Value
Options Shares Price Term (years) ($ in millions)
------- ------ --------- ------------ ---------------
Outstanding at
December
31, 2005 47,536 $16.54
Granted 570 6.29
Exercised (150) 6.25
Forfeited and
expired (3,559) 16.47
------
Outstanding at
Sept. 30, 2006 44,397 16.45 4.4 $ -
======
Vested and
expected to
vest at
Sept. 30, 2006 44,397 16.45 4.4 -
======
Exercisable at
Sept. 30, 2006 43,576 16.65 4.4 -
======
11
The aggregate intrinsic value in the above table reflects the total pretax
intrinsic value (the difference between the company's closing stock price on
the last trading day of the period and the exercise price of the options,
multiplied by the number of in-the-money stock options) that would have been
received by the option holders had all option holders exercised their
options on September 30, 2006. The intrinsic value of the company's stock
options changes based on the closing price of the company's stock. The
total intrinsic value of options exercised for the nine months ended
September 30, 2006 and September 30, 2005 was immaterial. As of September
30, 2006, $1.7 million of total unrecognized compensation cost related to
stock options is expected to be recognized over a weighted-average period of
1.5 years.
A summary of restricted stock unit activity for the nine months ended
September 30, 2006 follows (shares in thousands):
Weighted-
Restricted Average
Stock Grant Date
Units Fair Value
---------- ----------
Outstanding at December 31, 2005 352 $8.89
Granted 1,928 6.55
Vested (128) 7.62
Forfeited and expired (124) 8.11
-----
Outstanding at September 30, 2006 2,028 6.65
=====
The fair value of restricted stock units is determined based on the average
of the high and low trading price of the company's common shares on the date
of grant. The weighted-average grant-date fair value of restricted stock
units granted during the nine months ended September 30, 2006 and 2005 was
$6.55 and $7.55, respectively. As of September 30, 2006, there was $8.1
million of total unrecognized compensation cost related to outstanding
restricted stock units granted under the company's plans. That cost is
expected to be recognized over a weighted-average period of 1.6 years. The
total fair value of restricted share units vested during the nine months
ended September 30, 2006 was $.8 million. No restricted share units vested
during the nine months ended September 30, 2005.
For the nine months ended September 30, 2005, the following table
illustrates the effect on net income and earnings per share if the company
had applied the fair value recognition provisions of SFAS No. 123 (in
millions of dollars, except per share amounts):
Nine Months Ended September 30
------------------------------
2005
-----
Net loss as reported $(1,700.8)
Deduct total stock-based employee
compensation expense determined
under fair value method for all
awards, net of tax (65.2)
---------
Pro forma net loss $(1,766.0)
==========
Loss per share
Basic - as reported $ (5.01)
Basic - pro forma $ (5.20)
Diluted - as reported $ (5.01)
Diluted - pro forma $ (5.20)
Common stock issued upon exercise of stock options or upon lapse of
restrictions on restricted stock units are newly-issued shares. Cash
received from the exercise of stock options for the nine months ended
September 30, 2006 and 2005 was $1.0 million and $.3 million, respectively.
The company did not realize any tax benefits from the exercise of stock
options or upon issuance of stock upon lapse of restrictions on restricted
stock units in light of the company's tax position. Prior to the adoption
of SFAS No. 123R, the company presented such tax benefits as operating cash
flows. Upon the adoption of SFAS No. 123R, tax benefits resulting from tax
deductions in excess of the compensation cost recognized are classified as
financing cash flows.
12
f. The company has two business segments: Services and Technology. Revenue
classifications by segment are as follows: Services - consulting and
systems integration, outsourcing, infrastructure services and core
maintenance; Technology - enterprise-class servers and specialized
technologies.
The accounting policies of each business segment are the same as those
followed by the company as a whole. Intersegment sales and transfers are
priced as if the sales or transfers were to third parties. Accordingly, the
Technology segment recognizes intersegment revenue and manufacturing profit
on hardware and software shipments to customers under Services contracts.
The Services segment, in turn, recognizes customer revenue and marketing
profits on such shipments of company hardware and software to customers.
The Services segment also includes the sale of hardware and software
products sourced from third parties that are sold to customers through the
company's Services channels. In the company's consolidated statements of
income, the manufacturing costs of products sourced from the Technology
segment and sold to Services customers are reported in cost of revenue for
Services.
Also included in the Technology segment's sales and operating profit are
sales of hardware and software sold to the Services segment for internal use
in Services engagements. The amount of such profit included in operating
income of the Technology segment for the three and nine months ended
September 30, 2006 and 2005 was $9.7 million and $3.3 million, and $13.0
million and $13.0 million, respectively. The profit on these transactions
is eliminated in Corporate.
The company evaluates business segment performance on operating income
exclusive of restructuring charges and unusual and nonrecurring items, which
are included in Corporate. All other corporate and centrally incurred costs
are allocated to the business segments based principally on revenue,
employees, square footage or usage.
A summary of the company's operations by business segment for the three and
nine month periods ended September 30, 2006 and 2005 is presented below (in
millions of dollars):
Total Corporate Services Technology
----- --------- -------- ----------
Three Months Ended
September 30, 2006
------------------
Customer revenue $1,410.1 $1,217.6 $ 192.5
Intersegment $ (76.5) 3.6 72.9
-------- -------- -------- -------
Total revenue $1,410.1 $ (76.5) $1,221.2 $ 265.4
======== ======== ======== =======
Operating loss (profit) $ (42.9) $ (42.0) $ (15.6) $ 14.7
======== ======== ======== =======
Three Months Ended
September 30, 2005
------------------
Customer revenue $1,387.1 $1,174.0 $ 213.1
Intersegment $( 57.1) 4.5 52.6
------- -------- -------- -------
Total revenue $1,387.1 $( 57.1) $1,178.5 $ 265.7
======== ======= ======== =======
Operating loss $ (76.2) $ (.4) $ (60.2) $ (15.6)
======== ======= ======== =======
Nine Months Ended
September 30, 2006
----------------
Customer revenue $4,205.2 $3,618.5 $ 586.7
Intersegment $(172.3) 10.8 161.5
-------- ------- -------- -------
Total revenue $4,205.2 $(172.3) $3,629.3 $ 748.2
======== ======= ======== =======
Operating loss $ (395.4) $(330.7) $ (37.7) $ (27.0)
======== ======= ======== =======
Nine Months Ended
September 30, 2005
----------------
Customer revenue $4,189.2 $3,517.7 $ 671.5
Intersegment $( 192.7) 14.2 178.5
-------- -------- -------- -------
Total revenue $4,189.2 $( 192.7) $3,531.9 $ 850.0
======== ======== ======== =======
Operating loss $ (199.0) $ (8.1) $ (181.7) $ (9.2)
======== ======== ======== =======
13
Presented below is a reconciliation of total business segment operating
income (loss) to consolidated loss before income taxes (in millions of
dollars):
Three Months Nine Months
Ended September 30 Ended September 30
------------------ -------------------
2006 2005 2006 2005
---- ---- ---- ----
Total segment operating
profit (loss) $ (.9) $ (75.8) $ (64.7) $(190.9)
Interest expense (19.0) (17.1) (57.9) (44.9)
Other income (expense), net .4 13.3 153.1 45.8
Cost reduction charge (36.4) (323.5)
Corporate and eliminations (5.6) (.4) (7.2) (8.1)
------- ------- ------- -------
Total loss before income
taxes $ (61.5) $ (80.0) $(300.2) $(198.1)
======= ======= ======= =======
Customer revenue by classes of similar products or services, by segment, is
presented below (in millions of dollars):
Three Months Nine Months
Ended September 30 Ended September 30
------------------ ------------------
2006 2005 2006 2005
---- ---- ---- ----
Services
Consulting and systems
integration $ 377.6 $ 392.1 $1,162.9 $1,205.4
Outsourcing 491.0 435.8 1,417.4 1,288.6
Infrastructure services 237.0 220.8 691.5 632.0
Core maintenance 112.0 125.3 346.7 391.7
-------- -------- -------- --------
1,217.6 1,174.0 3,618.5 3,517.7
Technology
Enterprise-class servers 146.2 170.9 459.9 534.8
Specialized technologies 46.3 42.2 126.8 136.7
-------- -------- -------- --------
192.5 213.1 586.7 671.5
-------- -------- -------- --------
Total $1,410.1 $1,387.1 $4,205.2 $4,189.2
======== ======== ======== ========
g. Comprehensive income (loss) for the three and nine months ended September
30, 2006 and 2005 includes the following components (in millions of dollars):
Three Months Nine Months
Ended September 30 Ended September 30
------------------ ------------------
2006 2005 2006 2005
---- ---- ---- ----
Net loss $ (77.5) $(1,628.2) $(300.0) $(1,700.8)
Other comprehensive income
(loss)
Cash flow hedges
Income (loss), net of
tax of $ -, $(.8), -,
and $1.9 (.1) (1.6) (.3) 3.3
Reclassification
adjustments, net of
tax of $ -, $.6, $-
and $- .5 1.3 .5 .3
Foreign currency
translation adjustments 6.0 4.6 (6.2) 21.8
Reversal of U.S. minimum
pension liability - - 1,446.0 -
-------- --------- ------- --------
Total other comprehensive
income (loss) 6.4 4.3 1,440.0 25.4
-------- -------- ------- --------
Comprehensive income (loss) $ (71.1) $(1,623.9) $1,140.0 $(1,675.4)
======== ========= ======== =========
14
Accumulated other comprehensive income (loss) as of December 31, 2005 and
September 30, 2006 is as follows (in millions of dollars):
Cash Minimum
Translation Flow Pension
Total Adjustments Hedges Liability
----- ----------- ------ ---------
Balance at December 31, 2005 $(1,844.9) $(627.3) $ .1 $(1,217.7)
Change during period 1,440.0 (6.2) .2 1,446.0
-------- ------- ------ ---------
Balance at September 30, 2006 $ (404.9) $(633.5) $ .3 $ 228.3
========= ======= ====== =========
h. For equipment manufactured by the company, the company warrants that it will
substantially conform to relevant published specifications for 12 months
after shipment to the customer. The company will repair or replace, at its
option and expense, items of equipment that do not meet this warranty. For
company software, the company warrants that it will conform substantially to
then-current published functional specifications for 90 days from customer's
receipt. The company will provide a workaround or correction for material
errors in its software that prevents its use in a production environment.
The company estimates the costs that may be incurred under its warranties
and records a liability in the amount of such costs at the time revenue is
recognized. Factors that affect the company's warranty liability include
the number of units sold, historical and anticipated rates of warranty
claims and cost per claim. The company quarterly assesses the adequacy of
its recorded warranty liabilities and adjusts the amounts as necessary.
Presented below is a reconciliation of the aggregate product warranty
liability (in millions of dollars):
Three Months Nine Months
Ended September 30 Ended September 30
------------------ ------------------
2006 2005 2006 2005
---- ---- ---- ----
Balance at beginning of
period $ 8.9 $ 9.4 $ 8.0 $ 11.6
Accruals for warranties
issued during the period 2.1 2.1 7.1 6.4
Settlements made during
the period (2.3) (2.6) (7.1) (8.1)
Changes in liability for
pre-existing warranties
during the period,
including expirations (.1) (.5) .6 (1.5)
------- -------- -------- ------
Balance at September 30 $ 8.6 $ 8.4 $ 8.6 $ 8.4
======= ======= ======== ======
i. Cash paid during the nine months ended September 30, 2006 and 2005 for
income taxes was $60.4 million and $32.4 million, respectively.
Cash paid during the nine months ended September 30, 2006 and 2005 for
interest was $60.4 million and $61.7 million, respectively.
15
j. Effective January 1, 2006, the company adopted SFAS No. 151, "Inventory
Costs an amendment of ARB No. 43, Chapter 4" (SFAS No. 151). SFAS No. 151
amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to
clarify the accounting for abnormal amounts of idle facility expense,
handling costs and wasted material (spoilage). Among other provisions, the
new rule requires that such items be recognized as current-period charges,
regardless of whether they meet the criterion of "so abnormal" as stated in
ARB No. 43. Adoption of SFAS No. 151 did not have a material effect on the
company's consolidated financial position, consolidated results of
operations, or liquidity.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an
interpretation of FASB Statement No. 109," (FIN 48). FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken
in a tax return. FIN 48 is effective for fiscal years beginning after
December 15, 2006. The company is currently evaluating what effect, if any,
adoption of FIN 48 will have on the company's consolidated results of
operations and financial position.
In September 2006, the FASB issued Statement of Financial Accounting
Standards No. 157, "Fair Value Measurements," (SFAS No. 157). SFAS No. 157
defines fair value, establishes a framework for measuring fair value and
expands disclosures about fair value measurements. This statement applies
under other accounting pronouncements that require or permit fair value
measurements. Accordingly, SFAS No. 157 does not require any new fair value
measurements. The provisions of SFAS No. 157 are to be applied
prospectively and are effective for financial statements issued for fiscal
years beginning after November 15, 2007. The company is currently
evaluating what effect, if any, adoption of SFAS No. 157 will have on the
company's consolidated results of operations and financial position.
In September 2006, the FASB issued Statement of Financial Accounting
Standards No. 158, "Employers' Accounting for Defined Benefit Pension and
Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106,
and 132(R)," (SFAS No. 158). SFAS No. 158 requires an employer to recognize
in its statement of financial position the funded status of a benefit plan,
measured as the difference between plan assets at fair value and the benefit
obligation. For pension plans, the benefit obligation is the projected
benefit obligation; for any other postretirement benefit plan, such as a
retiree health care plan, the benefit obligation is the accumulated benefit
obligation. If plan assets exceed plan liabilities, an asset would be
recognized, and if plan liabilities exceed plan assets a liability would be
recognized. In addition, SFAS No. 158 requires that changes in the funded
status of a defined benefit postretirement plan be recognized in
comprehensive income in the year in which the changes occur. SFAS No. 158
does not change the amount of expense recorded in a company's statement of
income related to defined benefit postretirement plans. The requirement to
recognize the funded status of a defined benefit postretirement plan and
other disclosure requirements of SFAS No. 158 are effective for fiscal years
ending after December 15, 2006. Adoption of SFAS No. 158 by the company on
December 31, 2006 will result in the recognition of a material charge in the
ending balance of accumulated other comprehensive income. This charge will
have no effect on the company's net income, liquidity, cash flows, or
financial ratio covenants in the company's credit agreements and debt
securities.
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements," (SAB 108). SAB 108 requires companies to evaluate the
materiality of identified unadjusted errors on each financial statement and
related financial statement disclosure using both the rollover approach and
the iron curtain approach. The rollover approach quantifies misstatements
based on the amount of the error in the current year financial statement
whereas the iron curtain approach quantifies misstatements based on the
effects of correcting the misstatement existing in the balance sheet at the
end of the current year, irrespective of the misstatement's year(s) of
origin. Financial statements would require adjustment when either approach
results in quantifying a misstatement that is material. Correcting prior
year financial statements for immaterial errors would not require previously
filed reports to be amended. SAB 108 is effective for interim periods of
the first fiscal year ending after November 15, 2006. The company is
currently evaluating what effect, if any, adoption of SAB 108 will have on
the company's consolidated results of operations and financial position.
16
In September 2006, the Emerging Issues Task Force (EITF) of the FASB,
reached a consensus on Issue 06-4, "Accounting for Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements," (EITF 06-4). EITF 06-4 requires that, for split-dollar life
insurance arrangements that provide a benefit to an employee that extends to
postretirement periods, an employer should recognize a liability for future
benefits in accordance with SFAS No. 106. EITF 06-4 is effective for fiscal
years beginning after December 15, 2007 and it requires that recognition of
the effects of adoption should be either by (a) a change in accounting
principle through a cumulative-effect adjustment to retained earnings as of
the beginning of the year of adoption or (b) a change in accounting
principle through retrospective application to all prior periods. The
company is currently evaluating what effect, if any, adoption of EITF 06-4
will have on the company's consolidated results of operations and financial
position.
In September 2006, the EITF reached a consensus on Issue 06-5, "Accounting
for Purchases of Life Insurance-Determining the Amount That Could Be
Realized in Accordance with FASB Technical Bulletin No. 85-4," (EITF 06-5).
EITF 06-5 requires that a policyholder should consider any additional
amounts included in the contractual terms of the policy in determining the
amount that could be realized under the insurance contract on a policy by
policy basis. EITF 06-5 is effective for fiscal years beginning after
December 15, 2006 and it requires that recognition of the effects of
adoption should be either by (a) a change in accounting principle through a
cumulative-effect adjustment to retained earnings as of the beginning of the
year of adoption or (b) a change in accounting principle through
retrospective application to all prior periods. The company is currently
evaluating what effect, if any, adoption of EITF 06-5 will have on the
company's consolidated results of operations and financial position.
k. In 2002, the company and the Transportation Security Administration (TSA)
entered into a competitively awarded contract providing for the
establishment of secure information technology environments in airports.
The Defense Contract Audit Agency (DCAA), at the request of TSA, reviewed
contract performance and raised some government contracting issues. It is
not unusual in complex government contracts for the government and the
contractor to have issues arise regarding contract obligations. The company
continues to work collaboratively with the DCAA and TSA to try to resolve
these issues. While the company believes that it and the government will
resolve the issues raised, there can be no assurance that these issues will
be successfully resolved or that new issues will not be raised. It has been
publicly reported that certain of these matters have been referred to the
Inspector General's office of the Department of Homeland Security for
investigation. The company has received no investigative requests from the
Inspector General's office or any other government agency with respect to
any such referral. The company does not know whether any such referral will
be pursued or, if pursued, what effect it may have on the company or on the
resolution of the issues with TSA.
l. In June 2006, the company retired at maturity all $57.9 million of its
remaining 8-1/8% senior notes.
During the nine months ended September 30, 2005, the company (a) issued
$400 million 8% senior notes due 2012 and $150 million 8-1/2% senior notes
due 2015, (b) repaid $339.8 million of the company's $400 million 8-1/8%
senior notes due 2006 pursuant to a September 2005 tender offer by the
company and recorded a charge of $10.7 million related to the tender premium
and amortization of deferred costs related to the notes, and (c) in January
2005 retired at maturity all of the company's $150.0 million 7-1/4% senior
notes.
17
The company has a three-year, secured revolving credit facility which
expires in 2009 that provides for loans and letters of credit up to an
aggregate of $275 million. Borrowings under the facility bear interest
based on short-term rates and the company's credit rating. The credit
agreement contains customary representations and warranties, including no
material adverse change in the company's business, results of operations or
financial condition. It also contains financial covenants requiring the
company to maintain certain interest coverage, leverage and asset coverage
ratios and a minimum amount of liquidity, which could reduce the amount the
company is able to borrow. The credit facility also includes covenants
limiting liens, mergers, asset sales, dividends and the incurrence of debt.
Events of default include non-payment, failure to perform covenants,
materially incorrect representations and warranties, change of control and
default under other debt aggregating at least $25 million. If an event of
default were to occur under the credit agreement, the lenders would be
entitled to declare all amounts borrowed under it immediately due and
payable. The occurrence of an event of default under the credit agreement
could also cause the acceleration of obligations under certain other
agreements and the termination of the company's U.S. trade accounts
receivable facility. The credit facility is secured by the company's
assets, except that the collateral does not include accounts receivable that
are subject to the receivable facility, U.S. real estate or the stock or
indebtedness of the company's U.S. operating subsidiaries. As of September
30, 2006, there were letters of credit of $35.9 million issued under the
facility and there were no cash borrowings.
m. During the financial close for the quarter ended September 30, 2005, the
company performed its quarterly assessment of its net deferred tax assets.
Up to that point in time, as previously disclosed in the company's critical
accounting policies section of its Form 10-K, the company had principally
relied on its ability to generate future taxable income (predominately in
the U.S.) in its assessment of the realizability of its net deferred tax
assets.
Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for
Income Taxes" (SFAS No. 109), limits the ability to use future taxable income
to support the realization of deferred tax assets when a company has
experienced recent losses even if the future taxable income is supported by
detailed forecasts and projections. After considering the company's pretax
losses in 2004 and for the nine months ended September 30, 2005, the
expectation of a pretax loss for the full year of 2005, and the company's plans
to restructure its business model by divesting non-core assets, reducing its
cost structure and shifting its focus to high growth markets, the company
concluded that it could no longer rely on future taxable income as the basis
for realization of its net deferred tax asset.
Accordingly, the company recorded a non-cash charge in the third quarter of
2005 of $1,573.9 million to increase the valuation allowance against deferred
tax assets. With this increase the company has a full valuation allowance
against its deferred tax assets for all of the U.S. and certain foreign
subsidiaries. This non-cash charge did not affect the company's compliance with
the financial covenants under its credit agreements. It was recorded in
provision for income taxes in the accompanying consolidated statement of income.
The company expects to continue to record a full valuation allowance on future
tax benefits in such jurisdictions until other positive evidence is sufficient
to justify realization.
The realization of the remaining deferred tax assets is primarily dependent on
forecasted future taxable income within certain foreign jurisdictions. Any
reduction in estimated forecasted future taxable income may require the company
to record an additional valuation allowance against the remaining deferred tax
assets. Any increase or decrease in the valuation allowance would result in
additional or lower income tax expense in such period and could have a
significant impact on that period's earnings.
n. Certain prior year amounts have been reclassified to conform with the 2006
presentation.
18
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.
Overview
For the nine months ended September 30, 2006, the company reported a net loss of
$300.0 million, or $.87 per share, compared with a net loss of $1,700.8 million,
or $5.01 per share, for the nine months ended September 30, 2005. The current
period includes pretax charges of $323.5 million relating to cost reduction
actions and the prior-year period includes a non-cash charge of $1,573.9 million
for the increase in the deferred tax asset valuation allowance discussed below.
During the first nine months of 2006, the company executed against its
previously-announced plan to fundamentally reposition the company for profitable
growth. During the period, the company:
* committed to a reduction of approximately 5,600 employees, which resulted in
pretax charges of $323.5 million. In the first nine months, the company
implemented approximately 3,600 of the employee reductions. See note (b) to
the financial statements.
* adopted changes to its U.S. defined benefit pension plans effective December
31, 2006, and will increase matching contributions to its defined contribution
savings plan beginning January 1, 2007. As a result of stopping the accruals
for future benefits, the company recorded a pretax curtailment gain of $45.0
million. See note (c) to the financial statements.
* began its program to divest non-core assets. In March the company divested
its stake in Nihon Unisys, Ltd. (NUL), a leading IT solutions provider in Japan.
The company sold all of its 30.5 million shares in NUL, generating cash proceeds
of approximately $378 million, which will be used to fund the company's cost
reduction program. A pretax gain of $149.9 million was recorded on the sale.
The company also sold certain assets of its Unigen semiconductor test equipment
business for cash proceeds of $8 million. See note (d) to the financial
statements.
* reached a definitive agreement with its partner banks on renegotiated terms
for its iPSL payment processing joint venture in the United Kingdom. The terms
of the new agreement, which went into effect on January 1, 2006, include new
tariff arrangements that are expected to yield an additional approximately $150
million in revenue to the company over the 2006-2010 timeframe.
* reached a series of alliance agreements with NEC Corporation (NEC) to
collaborate in server technology, research and development, manufacturing, and
solutions delivery. Among the areas included in the agreements, the two
companies will co-design and develop a common high-end, Intel-based server
platform for customers of both companies, and NEC is recognizing the company as
a preferred provider of technology support and maintenance services and managed
security services in markets outside of Japan by offering the company the
opportunity to bid these services.
Results of operations
Company results
For the three months ended September 30, 2006, the company reported a net loss
of $77.5 million, or $.23 per share, compared with a net loss of $1,628.2
million, or $4.78 per share, for the three months ended September 30, 2005. The
prior-year period includes a non-cash charge of $1,573.9 million for the
increase in the deferred tax asset valuation allowance discussed below.
Revenue for the quarter ended September 30, 2006 was $1.41 billion compared with
$1.39 billion for the third quarter of 2005, an increase of 2% from the prior
year. Foreign currency fluctuations had a 2 percentage point positive impact on
revenue in the current period compared with the year-ago period. Services
revenue increased 4% which was offset in part by a decrease of 10% in Technology
revenue. U.S. revenue declined 5% in the quarter compared with the year-ago
period principally in the company's Federal business. Revenue in international
markets increased 8% due to increases in Latin America, Asia and Europe offset
in part by a decline in South Pacific and Japan. On a constant currency basis,
international revenue increased 4% in the three months ended September 30, 2006
compared with the three months ended September 30, 2005.
Pension expense for the three months ended September 30, 2006 was $43.4 million
compared with $44.2 million for the three months ended September 30, 2005. The
company records pension income or expense, as well as other employee-related
costs such as payroll taxes and medical insurance costs, in operating income in
the following income statement categories: cost of sales; selling, general and
administrative expenses; and research and development expenses. The amount
allocated to each category is based on where the salaries of active employees
are charged.
19
Total gross profit margin was 18.3% in the three months ended September 30, 2006
compared with 17.7% in the three months ended September 30, 2005. The current
year period includes a charge of $28.1 million related to cost reduction
actions. Excluding the cost reduction charge, the gross margin improvement was
principally due to operational improvements in several large BPO contracts as
well as the benefits derived from the cost reduction actions.
Selling, general and administrative expenses were $256.1 million for the three
months ended September 30, 2006 (18.2% of revenue) compared with $261.0 million
(18.8% of revenue) in the year-ago period. The current year period includes a
charge of $8.3 million related to cost reduction actions. Excluding the cost
reduction charge, the improvement was principally due to the benefits derived
from the cost reduction actions.
Research and development (R&D) expense in the third quarter of 2006 was $45.5
million compared with $61.2 million in the third quarter of 2005. The company
continues to invest in proprietary operating systems, middleware and in key
programs within its industry practices. The decline in R&D in the quarter was
principally a result of cost reduction actions.
For the third quarter of 2006, the company reported a pretax operating loss of
$42.9 million compared with a pretax operating loss of $76.2 million in the
third quarter of 2005. The current year period includes a charge of $36.4
million related to cost reduction actions.
Interest expense for the three months ended September 30, 2006 was $19.0 million
compared with $17.1 million for the three months ended September 30, 2005,
principally due to higher average debt.
Other income (expense), net, which can vary from period to period, was income of
$.4 million in the third quarter of 2006 compared with income of $13.3 million
in 2005. The difference in 2006 from 2005 was principally due to (a) an
increase in NUL equity income from a loss of $7.8 million in the year-ago
quarter to zero in the current quarter due to the sale of the company's
investment in NUL in March 2006 (see note d), (b) expense of $2.3 million in the
current quarter compared with income of $11.3 million in last year's third
quarter related to minority shareholders' portion of earnings or losses of iPSL,
a 51% owned subsidiary which is fully consolidated by the company, due to
increased profit from iPSL resulting from the renegotiated contract in January
2006, (c) a gain on the sale of property of $15.8 million in the year-ago
period, and (d) a charge of $10.7 million in the year-ago period related to the
debt tender offer discussed below.
During the financial close for the quarter ended September 30, 2005, the company
performed its quarterly assessment of its net deferred tax assets. Up to that
point in time, as previously disclosed in the company's critical accounting
policies section of its Form 10-K, the company had principally relied on its
ability to generate future taxable income (predominately in the U.S.) in its
assessment of the realizability of its net deferred tax assets.
Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for
Income Taxes" (SFAS No. 109), limits the ability to use future taxable income to
support the realization of deferred tax assets when a company has experienced
recent losses even if the future taxable income is supported by detailed
forecasts and projections. After considering the company's pretax losses in
2004 and for the nine months ended September 30, 2005, the expectation of a pre-
tax loss for the full year of 2005, and the company's plans to restructure its
business model by divesting non-core assets, reducing its cost structure and
shifting its focus to high growth markets, the company concluded that it could
no longer rely on future taxable income as the basis for realization of its net
deferred tax asset.
Accordingly, the company recorded a non-cash charge in the third quarter of 2005
of $1,573.9 million to increase the valuation allowance against deferred tax
assets. With this increase the company has a full valuation allowance against
its deferred tax assets for all of the U.S. and certain foreign subsidiaries.
This non-cash charge did not affect the company's compliance with the financial
covenants under its credit agreements. It was recorded in provision for income
taxes in the accompanying consolidated statement of income. The company expects
to continue to record a full valuation allowance on future tax benefits in such
jurisdictions until other positive evidence is sufficient to justify
realization.
20
The realization of the remaining deferred tax assets is primarily dependent on
forecasted future taxable income within certain foreign jurisdictions. Any
reduction in estimated forecasted future taxable income may require the company
to record an additional valuation allowance against the remaining deferred tax
assets. Any increase or decrease in the valuation allowance would result in
additional or lower income tax expense in such period and could have a
significant impact on that period's earnings.
Income (loss) before income taxes for the three months ended September 30, 2006
was a loss of $61.5 million compared with a loss of $80.0 million in 2005. The
provision for income taxes was $16.0 million in the current quarter compared
with a provision for income taxes of $1,548.2 million in the year-ago period.
The prior year provision includes the increase in the deferred tax asset
valuation allowance discussed above. Due to the fact that the company has a
full valuation allowance for all of its U.S. tax assets and certain
international subsidiaries, which was recorded in the third quarter of 2005, the
company no longer has a meaningful effective tax rate. The company will record
a tax provision or benefit for those international subsidiaries that do not have
a full valuation allowance against their deferred tax assets. Any profit or
loss recorded for the company's U.S. operations will have no provision or
benefit associated with it. As a result, the company's provision or benefit for
taxes will vary significantly quarter to quarter depending on the geographic
distribution of income.
For the nine months ended September 30, 2006, the company reported a net loss of
$300.0 million, or $.87 per share, compared with a net loss of $1,700.8 million,
or $5.01 per share, for the nine months ended September 30, 2005. The current
period includes a pretax charge of $323.5 million relating to the cost reduction
actions and the prior-year period includes a non-cash charge of $1,573.9 million
for the increase in the deferred tax asset valuation allowance.
Total revenue for the nine months ended September 30, 2006 was $4.21 billion
compared with $4.19 billion for the nine months ended September 30, 2005.
Foreign currency translations had a negligible impact on revenue in the current
nine months when compared with the year-ago period. In the current nine-month
period, Services revenue increased 3% and Technology revenue decreased 13%.
U.S. revenue declined 4% in the current nine-month period compared with the
year-ago period. Revenue in international markets increased 4% driven by
increases in Europe and Latin America which was partially offset by a decrease
in Pacific/Asia/Japan. On a constant currency basis, international revenue
increased 5% in the nine months ended September 30, 2006.
Pension expense for the nine months ended September 30, 2006 was $91.8 million
compared with $136.8 million of pension expense for the nine months ended
September 30, 2005. The decrease in pension expense in 2006 from 2005 was
principally due to the U.S. curtailment gain of $45.0 million recognized in
March 2006, resulting from the freezing of U.S. plan benefits effective January
1, 2007.
Total gross profit margin was 14.8% in the nine months ended September 30, 2006
compared with 18.7% in the year-ago period. The current period included a
$214.9 million charge related to the cost reduction actions.
For the nine months ended September 30, 2006, selling, general and
administrative expense were $834.2 million (19.8% of revenue) compared with
$790.0 million (18.9% of revenue) for the nine months ended September 30, 2005.
Selling general and administrative expenses for the nine months ended September
30, 2006 included $82.0 million related to the cost reduction actions. Selling,
general and administrative expense in the current nine-month period includes
$19.5 million of pension expense compared with pension expense of $27.1 million
in the year-ago period.
R&D expense for the nine months ended September 30, 2006 was $184.7 million
compared with $192.7 million a year ago. R&D expense in the nine months of 2006
included $29.4 million related to the cost reduction actions. R&D in the
current period includes $4.3 million of pension expense compared with pension
expense of $14.7 million in the year-ago period.
For the nine months ended September 30, 2006, the company reported an operating
loss of $395.4 million compared with an operating loss of $199.0 million for the
nine months ended September 30, 2005. The current period includes a $323.5
million charge related to the cost reduction actions. The current period also
includes pension expense of $91.8 million compared with pension expense of
$136.8 million in the year-ago period.
Interest expense for the nine months ended September 30, 2006 was $57.9 million
compared with $44.9 million for the nine months ended September 30, 2005,
principally due to higher average debt.
21
Other income (expense), net was income of $153.1 million in the current nine-
month period compared with income of $45.8 million in the year-ago period. The
increase in income was principally due to the $149.9 million gain from the sale
of all of the company's shares in NUL (see note (d)), offset in part by (a) a
decline in NUL equity income from $3.7 million in the year-ago period to a loss
of $4.2 million in the current nine month period, (b) an expense of $5.0 million
in the current period compared with income of $27.4 million in the last year's
nine month period related to minority shareholders' portion of earnings or
losses of iPSL, a 51% owned subsidiary which is fully consolidated by the
company, (c) a gain on the sale of property of $15.8 million in the year-ago
period, and (d) a charge of $10.7 million in the year-ago period related to the
debt tender offer.
Income (loss) before income taxes was a loss of $300.2 million in the nine
months ended September 30, 2006 compared with a loss of $198.1 million last
year. The benefit for income taxes was $.2 million in the current period
compared with a provision for income taxes of $1,502.7 million in the year-ago
period.
In 2002, the company and the Transportation Security Administration (TSA)
entered into a competitively awarded contract providing for the establishment of
secure information technology environments in airports. The Defense Contract
Audit Agency (DCAA), at the request of TSA, reviewed contract performance and
raised some government contracting issues. It is not unusual in complex
government contracts for the government and the contractor to have issues arise
regarding contract obligations. The company continues to work collaboratively
with the DCAA and TSA to try to resolve these issues. While the company believes
that it and the government will resolve the issues raised, there can be no
assurance that these issues will be successfully resolved or that new issues
will not be raised. It has been publicly reported that certain of these matters
have been referred to the Inspector General's office of the Department of
Homeland Security for investigation. The company has received no investigative
requests from the Inspector General's office or any other government agency with
respect to any such referral. The company does not know whether any such
referral will be pursued or, if pursued, what effect it may have on the company
or on the resolution of the issues with TSA.
Segment results
The company has two business segments: Services and Technology. Revenue
classifications by segment are as follows: Services - consulting and systems
integration, outsourcing, infrastructure services and core maintenance;
Technology - enterprise-class servers and specialized technologies.
The accounting policies of each business segment are the same as those followed
by the company as a whole. Intersegment sales and transfers are priced as if
the sales or transfers were to third parties. Accordingly, the Technology
segment recognizes intersegment revenue and manufacturing profit on hardware and
software shipments to customers under Services contracts. The Services segment,
in turn, recognizes customer revenue and marketing profit on such shipments of
company hardware and software to customers. The Services segment also includes
the sale of hardware and software products sourced from third parties that are
sold to customers through the company's Services channels. In the company's
consolidated statements of income, the manufacturing costs of products sourced
from the Technology segment and sold to Services customers are reported in cost
of revenue for Services.
Also included in the Technology segment's sales and operating profit are sales
of hardware and software sold to the Services segment for internal use in
Services agreements. The amount of such profit included in operating income of
the Technology segment for the three and nine months ended September 30, 2006
and 2005 was $9.7 million and $3.3 million, and $13.0 million and $13.0 million,
respectively. The profit on these transactions is eliminated in Corporate.
The company evaluates business segment performance on operating income exclusive
of restructuring charges and unusual and nonrecurring items, which are included
in Corporate. All other corporate and centrally incurred costs are allocated to
the business segments, based principally on revenue, employees, square footage
or usage. Therefore, the segment comparisons below exclude the cost reduction
items mentioned above.
22
Information by business segment is presented below (in millions of dollars):
Elimi-
Total nations Services Technology
------- ------- -------- ----------
Three Months Ended
September 30, 2006
------------------
Customer revenue $1,410.1 $1,217.6 $192.5
Intersegment $(76.5) 3.6 72.9
-------- ------- -------- ------
Total revenue $1,410.1 $(76.5) $1,221.2 $265.4
======== ======= ======== ======
Gross profit percent 18.3 % 13.9 % 46.3%
======== ======== ======
Operating (loss)
profit percent (3.0)% ( 1.3)% 5.5%
======== ======== ======
Three Months Ended
September 30, 2005
------------------
Customer revenue $1,387.1 $1,174.0 $213.1
Intersegment $( 57.1) 4.5 52.6
-------- ------- -------- ------
Total revenue $1,387.1 $( 57.1) $1,178.5 $265.7
======== ======= ======== ======
Gross profit percent 17.7% 11.3% 42.4%
======== ======== ======
Operating loss percent (5.5)% (5.1)% (5.9)%
======== ======== ======
Gross profit percent and operating loss percent are as a percent of total
revenue.
In the Services segment, customer revenue was $1.22 billion for the three months
ended September 30, 2006 compared with $1.17 billion for the three months ended
September 30, 2005. Foreign currency translation had a 2 percentage point
positive impact on Services revenue in the current quarter compared with the
year-ago period. Revenue in the third quarter of 2006 increased 4% compared
with 2005, principally due to a 13% increase in outsourcing ($491.0 million in
2006 compared with $435.8 million in 2005), and a 7% increase in infrastructure
services ($237.0 million in 2006 compared with $220.8 million in 2005), offset
in part by a 4% decrease in consulting and systems integration revenue ($377.6
million in 2006 compared with $392.1 million in 2005) and a 11% decrease in core
maintenance ($112.0 million in 2006 compared with $125.3 million in 2005).
Services gross profit was 13.9% in the third quarter of 2006 compared with 11.3%
in the year-ago period. Services operating income (loss) percent was (1.3)% in
the three months ended September 30, 2006 compared with (5.1)% in the three
months ended September 30, 2005. The Services margin improvements were
principally due to operational improvements in several large BPO contracts as
well as the benefits derived from the cost reduction actions.
In the Technology segment, customer revenue was $193 million in the current
quarter compared with $213 million in the year-ago period. Foreign currency
translation had a 1 percentage point positive impact on Technology revenue in
the current period compared with the prior-year period. Revenue in the three
months ended September 30, 2006 was down 10% from the three months ended
September 30, 2005, due to a 14% decrease in sales of enterprise-class servers
($146.2 million in 2006 compared with $170.9 million in 2005) offset in part by
a 10% increase in sales of specialized technology products ($46.3 million in
2006 compared with $42.2 million in 2005). Technology gross profit was 46.3% in
the current quarter compared with 42.4% in the year-ago quarter. Technology
operating income percent was 5.5% in the three months ended September 30, 2006
compared with (5.9)% in the three months ended September 30, 2005. The decline
in revenue in 2006 compared with 2005 primarily reflected the continuing secular
decline in the proprietary mainframe industry. The Technology margin
improvements were principally due to the benefits derived from the cost
reduction actions.
23
New accounting pronouncements
Effective January 1, 2006, the company adopted SFAS No. 151, "Inventory Costs an
amendment of ARB No. 43, Chapter 4" (SFAS No. 151). SFAS No. 151 amends the
guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify the
accounting for abnormal amounts of idle facility expense, handling costs and
wasted material (spoilage). Among other provisions, the new rule requires that
such items be recognized as current-period charges, regardless of whether they
meet the criterion of "so abnormal" as stated in ARB No. 43. Adoption of SFAS
No. 151 did not have a material effect on the company's consolidated financial
position, consolidated results of operations, or liquidity.
Effective January 1, 2006, the company adopted SFAS No. 123 (revised 2004),
"Share-Based Payment" (SFAS No. 123R), which replaces SFAS No. 123 and
supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS
No. 123R requires all share-based payments to employees, including grants of
employee stock options, to be recognized in the financial statements based on
their fair values. The company adopted SFAS No. 123R using the modified-
prospective transition method, which requires the company, beginning January 1,
2006 and thereafter, to expense the grant date fair value of all share-based
awards over their remaining vesting periods to the extent the awards were not
fully vested as of the date of adoption and to expense the fair value of all
share-based awards granted subsequent to December 31, 2005 over their requisite
service periods. During the nine months ended September 30, 2006, the company
recorded $4.8 million of share-based compensation expense. Previous periods
have not been restated. See note (e) for further details.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an
interpretation of FASB Statement No. 109," (FIN 48). FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return. FIN 48 is effective for fiscal years beginning after December 15,
2006. The company is currently evaluating what effect, if any, adoption of FIN
48 will have on the company's consolidated results of operations and financial
position.
In September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, "Fair Value Measurements," (SFAS No. 157). SFAS No. 157 defines fair
value, establishes a framework for measuring fair value and expands disclosures
about fair value measurements. This statement applies under other accounting
pronouncements that require or permit fair value measurements. Accordingly,
SFAS No. 157 does not require any new fair value measurements. The provisions
of SFAS No. 157 are to be applied prospectively and are effective for financial
statements issued for fiscal years beginning after November 15, 2007. The
company is currently evaluating what effect, if any, adoption of SFAS No. 157
will have on the company's consolidated results of operations and financial
position.
In September 2006, the FASB issued Statement of Financial Accounting
Standards No. 158, "Employers' Accounting for Defined Benefit Pension and Other
Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and
132(R)," (SFAS No. 158). SFAS No. 158 requires an employer to recognize in its
statement of financial position the funded status of a benefit plan, measured as
the difference between plan assets at fair value and the benefit obligation.
For pension plans, the benefit obligation is the projected benefit obligation;
for any other postretirement benefit plan, such as a retiree health care plan,
the benefit obligation is the accumulated benefit obligation. If plan assets
exceed plan liabilities, an asset would be recognized, and if plan liabilities
exceed plan assets a liability would be recognized. In addition, SFAS No. 158
requires that changes in the funded status of a defined benefit postretirement
plan be recognized in comprehensive income in the year in which the changes
occur. SFAS No. 158 does not change the amount of expense recorded in a
company's statement of income related to defined benefit postretirement plans.
The requirement to recognize the funded status of a defined benefit
postretirement plan and other disclosure requirements of SFAS No. 158 are
effective for fiscal years ending after December 15, 2006. Adoption of SFAS No.
158 by the company on December 31, 2006 will result in the recognition of a
material charge in the ending balance of accumulated other comprehensive income.
This charge will have no effect on the company's net income, liquidity, cash
flows, or financial ratio covenants in the company's credit agreements and debt
securities.
24
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements," (SAB 108). SAB 108 requires companies to evaluate the materiality
of identified unadjusted errors on each financial statement and related
financial statement disclosure using both the rollover approach and the iron
curtain approach. The rollover approach quantifies misstatements based on the
amount of the error in the current year financial statement whereas the iron
curtain approach quantifies misstatements based on the effects of correcting the
misstatement existing in the balance sheet at the end of the current year,
irrespective of the misstatement's year(s) of origin. Financial statements
would require adjustment when either approach results in quantifying a
misstatement that is material. Correcting prior year financial statements for
immaterial errors would not require previously filed reports to be amended. SAB
108 is effective for interim periods of the first fiscal year ending after
November 15, 2006. The company is currently evaluating what effect, if any,
adoption of SAB 108 will have on the company's consolidated results of
operations and financial position.
In September 2006, the Emerging Issues Task Force (EITF) of the FASB, reached a
consensus on Issue 06-4, "Accounting for Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements," (EITF 06-4). EITF 06-4 requires that, for split-dollar life
insurance arrangements that provide a benefit to an employee that extends to
postretirement periods, an employer should recognize a liability for future
benefits in accordance with SFAS No. 106. EITF 06-4 is effective for fiscal
years beginning after December 15, 2007 and it requires that recognition of the
effects of adoption should be either by (a) a change in accounting principle
through a cumulative-effect adjustment to retained earnings as of the beginning
of the year of adoption or (b) a change in accounting principle through
retrospective application to all prior periods. The company is currently
evaluating what effect, if any, adoption of EITF 06-4 will have on the company's
consolidated results of operations and financial position.
In September 2006, the EITF reached a consensus on Issue 06-5, "Accounting for
Purchases of Life Insurance-Determining the Amount That Could Be Realized in
Accordance with FASB Technical Bulletin No. 85-4," (EITF 06-5). EITF 06-5
requires that a policyholder should consider any additional amounts included in
the contractual terms of the policy in determining the amount that could be
realized under the insurance contract on a policy by policy basis. EITF 06-5 is
effective for fiscal years beginning after December 15, 2006 and it requires
that recognition of the effects of adoption should be either by (a) a change in
accounting principle through a cumulative-effect adjustment to retained earnings
as of the beginning of the year of adoption or (b) a change in accounting
principle through retrospective application to all prior periods. The company
is currently evaluating what effect, if any, adoption of EITF 06-5 will have on
the company's consolidated results of operations and financial position.
Financial condition
Cash and cash equivalents at September 30, 2006 were $612.0 million compared
with $642.5 at December 31, 2005.
During the nine months ended September 30, 2006, cash used for operations was
$138.7 million compared with cash provided of $22.5 million for the nine months
ended September 30, 2005. The current-year period includes $112.5 million,
which represents the final payment from NUL relating to the 2005 grant of a
perpetual license to certain of the company's intellectual property. The prior-
year period included a tax refund of approximately $39 million. Also
contributing to the reduction in operating cash flow was a reduction in the
amount of receivables sold in the company's U.S. securitization. At September
30, 2006 and December 31, 2005, receivables of $120 million and $225 million,
respectively, were sold under the facility and therefore were removed from the
accompanying consolidated balance sheets. Cash expenditures in the current
period related to the current year and prior-year restructuring actions (which
are included in operating activities) were approximately $110.2 million compared
with $49.0 million for the prior-year period. Cash expenditures for the
current-year and the prior-year restructuring actions are expected to be
approximately $88 million for the remainder of 2006, resulting in an expected
cash expenditure of approximately $198 million in 2006 compared with $57.8
million in 2005.
Cash provided by investing activities for the nine months ended September 30,
2006 was $179.4 million compared with $258.7 million of cash used during the
nine months ended September 30, 2005. The principal reason for the increase in
cash provided was that the company received net proceeds of $380.6 million from
the sale of the NUL shares and other assets. Net purchases of investments were
$2.9 million for the nine months ended September 30, 2006 compared with net
proceeds of $12.7 million in the prior-year period. Proceeds from investments
and purchases of investments represent derivative financial instruments used to
manage the company's currency exposure to market risks from changes in foreign
currency exchange rates. In addition, in the current period, the investment in
marketable software was $81.2 million compared with $93.7 million in the year-
ago period, capital additions of properties were $48.2 million in 2006 compared
with $84.9 million in 2005 and capital additions of outsourcing assets were
$68.9 million in 2006 compared with $115.7 million in 2005.
25
Cash used for financing activities during the nine months ended September 30,
2006 was $78.9 million compared with $57.9 million of cash provided during the
nine months ended September 30, 2005. The current period includes a cash
expenditure of $57.9 million to retire at maturity all of the company's
remaining 8-1/8% senior notes. The prior period includes the following: (a)
$541.5 million net proceeds from the September 2005 issuances of $400 million 8%
senior notes due 2012 and $150 million 8-1/2% senior notes due 2015, (b) the
cash expenditure of $349.2 million (including tender premium and expenses of
$9.4 million) for the repayment of $339.8 million of the company's $400 million
8-1/8% senior notes due 2006 pursuant to a September 2005 tender offer by the
company, and (c) the cash expenditure of $150.0 million to retire at maturity
all of the company's 7-1/4% senior notes.
At September 30, 2006, total debt was $1.05 billion, a decrease of $75.3 million
from December 31, 2005.
The company has various lending and funding arrangements as follows:
The company has a three-year, secured revolving credit facility which expires in
2009 that provides for loans and letters of credit up to an aggregate of $275
million. Borrowings under the facility bear interest based on short-term rates
and the company's credit rating. The credit agreement contains customary
representations and warranties, including no material adverse change in the
company's business, results of operations or financial condition. It also
contains financial covenants requiring the company to maintain certain interest
coverage, leverage and asset coverage ratios and a minimum amount of liquidity,
which could reduce the amount the company is able to borrow. The credit
facility also includes covenants limiting liens, mergers, asset sales, dividends
and the incurrence of debt. Events of default include non-payment, failure to
perform covenants, materially incorrect representations and warranties, change
of control and default under other debt aggregating at least $25 million. If an
event of default were to occur under the credit agreement, the lenders would be
entitled to declare all amounts borrowed under it immediately due and payable.
The occurrence of an event of default under the credit agreement could also
cause the acceleration of obligations under certain other agreements and the
termination of the company's U.S. trade accounts receivable facility, discussed
below. The credit facility is secured by the company's assets, except that the
collateral does not include accounts receivable that are subject to the
receivable facility, U.S. real estate or the stock or indebtedness of the
company's U.S. operating subsidiaries. As of September 30, 2006, there were
letters of credit of $35.9 million issued under the facility and there were no
cash borrowings.
In addition, the company and certain international subsidiaries have access to
uncommitted lines of credit from various banks. Other sources of short-term
funding are operational cash flows, including customer prepayments, and the
company's U.S. trade accounts receivable facility.
Under the accounts receivable facility, the company has agreed to sell, on an
on-going basis, through Unisys Funding Corporation I, a wholly owned subsidiary,
interests in up to $300 million of eligible U.S. trade accounts receivable. The
receivables are sold at a discount that reflects a margin based on, among other
things, the company's then-current S&P and Moody's credit rating. The facility
is terminable by the purchasers if the company's corporate rating is below B by
S&P or B2 by Moody's and requires the maintenance of certain ratios related to
the sold receivables. At September 30, 2006, the company's corporate rating was
B+ and B2 by S&P and Moody's, respectively. The facility is renewable annually
at the purchasers' option until November 2008.
At September 30, 2006, the company has met all covenants and conditions under
its various lending and funding agreements. The company expects to continue to
meet these covenants and conditions. The company believes that it will have
adequate sources and availability of short-term funding to meet its expected
cash requirements.
The company may, from time to time, redeem, tender for, or repurchase its
securities in the open market or in privately negotiated transactions depending
upon availability, market conditions and other factors.
The company has on file with the Securities and Exchange Commission a
registration statement covering $650 million of debt or equity securities, which
enables the company to be prepared for future market opportunities.
26
Stockholders' equity increased $1,160.8 million during the nine months ended
September 30, 2006, principally reflecting the reversal of the minimum pension
liability adjustment of $1,446.0 million for the U.S. qualified defined benefit
pension plan, offset in part by the net loss of $300.0 million.
Factors that may affect future results
From time to time, the company provides information containing "forward-looking"
statements, as defined in the Private Securities Litigation Reform Act of 1995.
Forward-looking statements provide current expectations of future events and
include any statement that does not directly relate to any historical or current
fact. Words such as "anticipates," "believes," "expects," "intends," "plans,"
"projects" and similar expressions may identify such forward-looking statements.
All forward-looking statements rely on assumptions and are subject to risks,
uncertainties and other factors that could cause the company's actual results to
differ materially from expectations. Factors that could affect future results
include, but are not limited to, those discussed below. Any forward-looking
statement speaks only as of the date on which that statement is made. The
company assumes no obligation to update any forward-looking statement to reflect
events or circumstances that occur after the date on which the statement is
made.
Statements in this report regarding the company's cost reduction plan are
subject to the risk that the company may not implement the planned headcount
reductions or increase its offshore resources as quickly as currently planned,
which could affect the timing of anticipated cost savings. The amount of
anticipated cost savings is also subject to currency exchange rate fluctuations
with regard to actions taken outside the U.S. Statements in this report
regarding the revenue increases anticipated from the new iPSL tariff
arrangements are based on assumptions regarding iPSL processing volumes and
costs over the 2006-2010 time-frame. Because these volumes and costs are subject
to change, the amount of anticipated revenue is not guaranteed. In addition,
because iPSL is paid by its customers in British pounds, the U.S. dollar amount
of revenue recognized by the company is subject to currency exchange rate
fluctuations.
Other factors that could affect future results include the following:
The company's business is affected by changes in general economic and business
conditions. The company continues to face a highly competitive business
environment. If the level of demand for the company's products and services
declines in the future, the company's business could be adversely affected. The
company's business could also be affected by acts of war, terrorism or natural
disasters. Current world tensions could escalate, and this could have
unpredictable consequences on the world economy and on the company's business.
The information services and technology markets in which the company operates
include a large number of companies vying for customers and market share both
domestically and internationally. The company's competitors include consulting
and other professional services firms, systems integrators, outsourcing
providers, infrastructure services providers, computer hardware manufacturers
and software providers. Some of the company's competitors may develop competing
products and services that offer better price-performance or that reach the
market in advance of the company's offerings. Some competitors also have or may
develop greater financial and other resources than the company, with enhanced
ability to compete for market share, in some instances through significant
economic incentives to secure contracts. Some also may be better able to compete
for skilled professionals. Any of these factors could have an adverse effect on
the company's business. Future results will depend on the company's ability to
mitigate the effects of aggressive competition on revenues, pricing and margins
and on the company's ability to attract and retain talented people.
The company operates in a highly volatile industry characterized by rapid
technological change, evolving technology standards, short product life cycles
and continually changing customer demand patterns. Future success will depend in
part on the company's ability to anticipate and respond to these market trends
and to design, develop, introduce, deliver or obtain new and innovative products
and services on a timely and cost-effective basis. The company may not be
successful in anticipating or responding to changes in technology, industry
standards or customer preferences, and the market may not demand or accept its
services and product offerings. In addition, products and services developed by
competitors may make the company's offerings less competitive.
Future results will also depend in part on the success of the company's focused
investment and sales and marketing strategies. These strategies are based on
various assumptions, including assumptions regarding market segment growth,
client demand, and the proper skill set of and training for sales and marketing
management and personnel, all of which are subject to change.
27
The company's future results will depend in part on its ability to grow
outsourcing and infrastructure services. The company's outsourcing contracts
are multiyear engagements under which the company takes over management of a
client's technology operations, business processes or networks. In a number of
these arrangements, the company hires certain of its clients' employees and may
become responsible for the related employee obligations, such as pension and
severance commitments. In addition, system development activity on outsourcing
contracts may require the company to make significant upfront investments. The
company will need to have available sufficient financial resources in order to
take on these obligations and make these investments.
Recoverability of outsourcing assets is dependent on various factors, including
the timely completion and ultimate cost of the outsourcing solution, and
realization of expected profitability of existing outsourcing contracts. These
risks could result in an impairment of a portion of the associated assets, which
are tested for recoverability quarterly.
As long-term relationships, outsourcing contracts provide a base of recurring
revenue. However, outsourcing contracts are highly complex and can involve the
design, development, implementation and operation of new solutions and the
transitioning of clients from their existing business processes to the new
environment. In the early phases of these contracts, gross margins may be lower
than in later years when an integrated solution has been implemented, the
duplicate costs of transitioning from the old to the new system have been
eliminated and the work force and facilities have been rationalized for
efficient operations. Future results will depend on the company's ability to
effectively and timely complete these implementations, transitions and
rationalizations. Future results will also depend on the company's ability to
effectively address its challenging outsourcing operations through negotiations
or operationally and to fully recover the associated outsourcing assets.
Future results will also depend in part on the company's ability to drive
profitable growth in consulting and systems integration. The company's ability
to grow profitably in this business will depend on the level of demand for
systems integration projects. It will also depend on an improvement in the
utilization of services delivery personnel. In addition, profit margins in this
business are largely a function of the rates the company is able to charge for
services and the chargeability of its professionals. If the company is unable to
attain sufficient rates and chargeability for its professionals, profit margins
will suffer. The rates the company is able to charge for services are affected
by a number of factors, including clients' perception of the company's ability
to add value through its services; introduction of new services or products by
the company or its competitors; pricing policies of competitors; and general
economic conditions. Chargeability is also affected by a number of factors,
including the company's ability to transition employees from completed projects
to new engagements, and its ability to forecast demand for services and thereby
maintain an appropriate head count.
Future results will also depend, in part, on an improvement in the company's
technology business. This will require, in part, an increase in market demand
for the company's high-end enterprise servers and customer acceptance of the new
models announced in the second quarter of 2006. In its technology business, the
company continues to focus its resources on enhancing a common high-performance
platform for both its proprietary operating environments and open standards-
based operating environments such as Microsoft Windows and Linux. In addition,
the company continues to apply its resources to develop value-added software
capabilities and optimized solutions for these server platforms which provide
competitive differentiation. Future results will depend, in part, on customer
acceptance of new ClearPath systems and the company's ability to maintain its
installed base for ClearPath and to develop next-generation ClearPath products
that are purchased by the installed base. In addition, future results will
depend, in part, on the company's ability to generate new customers and increase
sales of the Intel-based ES7000 line. The company believes there is significant
growth potential in the developing market for high-end, Intel-based servers
running Microsoft and Linux operating system software. However, the company's
ability to succeed will depend on its ability to compete effectively against
enterprise server competitors with more substantial resources and its ability to
achieve market acceptance of the ES7000 technology by clients, systems
integrators and independent software vendors. Future results of the technology
business will also depend, in part, on the successful implementation of the
company's new arrangements with NEC.
28
The company frequently enters into contracts with governmental entities. U.S.
government agencies, including the Defense Contract Audit Agency and the
Department of Labor, routinely audit government contractors. These agencies
review a contractor's performance under its contracts, cost structure and
compliance with applicable laws, regulations and standards. The U.S. government
also may review the adequacy of, and a contractor's compliance with, its systems
and policies, including the contractor's purchasing, property, estimating,
accounting, compensation and management information systems. Any costs found to
be overcharged or improperly allocated to a specific contract will be subject to
reimbursement to the government. If an audit uncovers improper or illegal
activities, the company may be subject to civil and criminal penalties and
administrative sanctions, including termination of contracts, forfeiture of
profits, suspension of payments, fines and suspension or prohibition from doing
business with the U.S. government. Other risks and uncertainties associated with
government contracts include the availability of appropriated funds and
contractual provisions that allow governmental entities to terminate agreements
at their discretion before the end of their terms. In addition, if the company's
performance is unacceptable to the customer under a government contract, the
government retains the right to pursue remedies under the affected contract,
which remedies could include termination.
A number of the company's long-term contracts for infrastructure services,
outsourcing, help desk and similar services do not provide for minimum
transaction volumes. As a result, revenue levels are not guaranteed. In
addition, some of these contracts may permit customer termination or may impose
other penalties if the company does not meet the performance levels specified in
the contracts.
Some of the company's systems integration contracts are fixed-price contracts
under which the company assumes the risk for delivery of the contracted services
and products at an agreed-upon fixed price. At times the company has experienced
problems in performing some of these fixed-price contracts on a profitable basis
and has provided periodically for adjustments to the estimated cost to complete
them. Future results will depend on the company's ability to perform these
services contracts profitably.
The success of the company's business is dependent on strong, long-term client
relationships and on its reputation for responsiveness and quality. As a result,
if a client is not satisfied with the company's services or products, its
reputation could be damaged and its business adversely affected. In addition, if
the company fails to meet its contractual obligations, it could be subject to
legal liability, which could adversely affect its business, operating results
and financial condition.
The company has commercial relationships with suppliers, channel partners and
other parties that have complementary products, services or skills. The company
has announced that alliance partnerships with select IT companies are a key
factor in the development and delivery of the company's refocused portfolio.
Future results will depend, in part, on the performance and capabilities of
these third parties, on the ability of external suppliers to deliver components
at reasonable prices and in a timely manner, and on the financial condition of,
and the company's relationship with, distributors and other indirect channel
partners.
More than half of the company's total revenue derives from international
operations. The risks of doing business internationally include foreign currency
exchange rate fluctuations, changes in political or economic conditions, trade
protection measures, import or export licensing requirements, multiple and
possibly overlapping and conflicting tax laws, new tax legislation, and weaker
intellectual property protections in some jurisdictions.
The company cannot be sure that its services and products do not infringe on the
intellectual property rights of third parties, and it may have infringement
claims asserted against it or against its clients. These claims could cost the
company money, prevent it from offering some services or products, or damage its
reputation.
29
Item 4. Controls and Procedures
--------------------------------
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures as of September 30, 2006.
Based on this evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures were effective for gathering, analyzing and disclosing the
information the Company is required to disclose in the reports it files under
the Securities Exchange Act of 1934, within the time periods specified in the
SEC's rules and forms. Such evaluation did not identify any change in the
Company's internal controls over financial reporting that occurred during the
quarter ended September 30, 2006 that has materially affected, or is reasonably
likely to materially affect, the Company's internal control over financial
reporting.
Part II - OTHER INFORMATION
------- -----------------
Item 1A. Risk Factors
------- ------------
See "Factors that may affect future results" in Management's Discussion and
Analysis of Financial Condition and Results of Operations for a discussion of
risk factors.
Item 5. Other Information
------ -----------------
See note (b) of the notes to consolidated financial statements for information
on the restructuring charge taken in the third quarter of 2006.
Effective October 26, 2006, Randall J. Hogan has resigned from the company's
Board of Directors.
Item 6. Exhibits
------- --------
(a) Exhibits
See Exhibit Index
30
SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
UNISYS CORPORATION
Date: October 26, 2006 By: /s/ Janet Brutschea Haugen
-----------------------------
Janet Brutschea Haugen
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)
By: /s/ Joseph M. Munnelly
----------------------
Joseph M. Munnelly
Vice President and
Corporate Controller
(Chief Accounting Officer)
EXHIBIT INDEX
Exhibit
Number Description
------- -----------
3.1 Restated Certificate of Incorporation of Unisys Corporation
(incorporated by reference to Exhibit 3.1 to the registrant's Quarterly
Report on Form 10-Q for the quarterly period ended September 30, 1999)
3.2 Bylaws of Unisys Corporation, as amended through December 1, 2005
(incorporated by reference to Exhibit 3 to the registrant's Current
Report on Form 8-K dated December 1, 2005)
12 Statement of Computation of Ratio of Earnings to Fixed Charges
31.1 Certification of Joseph W. McGrath required by Rule 13a-14(a)
or Rule 15d-14(a)
31.2 Certification of Janet Brutschea Haugen required by Rule 13a-14(a)
or Rule 15d-14(a)
32.1 Certification of Joseph W. McGrath required by Rule 13a-14(b)
or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002,
18 U.S.C. Section 1350
32.2 Certification of Janet Brutschea Haugen required by Rule 13a-14(b)
or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002,
18 U.S.C. Section 1350