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From EDS, Some Scary Silence

By Andrew Park Investors exhaled on Oct. 30 after hearing few unpleasant surprises during the third-quarter earnings announcement by Electronic Data Systems (EDS). The next day, its shares, which had lost 80% of their value in 2002, rose 9.6%, to close at $15.06. (Shares closed at $14.87 on Nov. 1.)One Wall Street analyst summarized his upbeat reaction in the title of his research note: "Not that bad."

Not quite. EDS, which has hit investors with a barrage of bad news this year, left unresolved a host of issues, from the timing of a recovery to its ability to win important new contracts and the future of its withering cash flow. And hovering like a Halloween ghost: a Securities & Exchange Commission inquiry started in the wake of a Sept. 24 revelation that EDS sold put options on its own shares that wound up costing it $225 million. "A lot of question marks are still out there," says UBS Warburg analyst Adam Frisch, who has been bearish on EDS since early 2001.

"NO SUGARCOATING." Indeed, EDS shares have taken a severe beating. After its Sept. 18 warning that earnings might miss estimates by as much as 80%, the stock -- which at $36.46 had already dropped some 50% from the 52-week high of $72.45 -- plummeted 53%, to $17.20. And after EDS disclosed its losing bet on its stock price, shares fell 29%, to close at $11.68. The stock is now trading at less than six times EDS's earnings.

Third-quarter results arrived slightly better than expected: Net income for the tech services giant declined 59%, to $86 million, on sales that were down 3%, to $5.4 billion. These figures were in line with downwardly revised expectations. CEO Richard H. "Dick" Brown says EDS would cut as many as 5,500 jobs, shift at least 1,500 overseas, sell off $500 million in noncore assets, and trim $75 million from its overhead. Says a contrite Brown: "There's no sugarcoating these results."

Problem is, Brown can't rely on results turning sweet for some time to come. Just a year ago, EDS was sailing through the downturn as customers turned to it for help in cutting their technology costs. Now, EDS clients have clamped down on spending for both core outsourcing services as well as lucrative add-ons like management consulting and product-design software.

NEW BILLINGS NEEDED. Revenue from EDS's biggest customer, General Motors (GM), declined 22% in the third quarter, and Brown says GM will continue slashing spending through the end of 2002. Meanwhile, trouble abounds with other EDS clients, including WorldCom (WCOEQ) and US Airways (UAWGQ).

Worse for EDS, it isn't signing up new business to replace what it's losing from existing customers. It signed just $3 billion in contracts in the third quarter, vs. $6.8 billion a year ago, for its lowest quarterly total since 1999. That's bad news because billings are the best predictor of future results for companies like EDS, which rely on long-term service deals to sustain growth. To ensure a revenue recovery in 2003, EDS badly needs to bag many more contracts this quarter, including one of the multibillion-dollar outsourcing projects being floated by Procter & Gamble (PG) and JPMorganChase (JPMCP).

Yet one megadeal has become a megaheadache for EDS -- its $6.9 billion contract to overhaul the U.S. Navy's computer systems. To win the contract in 2000, EDS had to agree to shoulder huge upfront costs and defer profits for years. But technical snags and congressional roadblocks have delayed the timetable and deflated EDS's free cash flow.

"A CURSE." EDS had told investors that the contract would start to generate cash early in 2003, fueling a rebound in its free cash flow. But during its conference call with analysts, Chief Financial Officer James Daley said that won't happen until the end of 2003 because EDS is accelerating work on the project, and profits won't materialize for the foreseeable future.

EDS says it can still hit its goal of $1 billion in free cash flow next year, but some analysts are skeptical. Says Bob Djurdjevic, president of Annex Research: "Sometimes these megadeals turn out to be a curse."

Stung by criticism of the Navy deal, Brown says EDS will be more mindful of cash requirements when it goes after future contracts. But he says, "We are not stepping away from megadeals." Still, Brown acknowledges that overall demand for his company's services won't bounce back until the second half of 2003 at the earliest. Until then, investors may find it harder to breathe easy. Park is based in Dallas for BusinessWeek

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