By Richard Stice, CFA Electronic Data Systems is the largest independent information-technology services provider, with 2002 revenues exceeding $21.5 billion. Despite its leadership in an industry that we think has favorable growth prospects, the shares have declined sharply over the last 18 months, as EDS has lowered financial projections. When Electronic Data Systems (EDS) first revealed its problems after the market close on September 18, 2002, the news caught many analysts and investors by surprise. Following the announcement that revenues and earnings per share for third-quarter 2002 would be lower than previously anticipated, EDS shares fell by more than 50%, to $17.20, the next trading day.
Typically, companies focused on the IT services sector can make relatively good financial projections since the large majority of revenues are recurring and come from long-term contracts. We at S&P believe these built-in expectations contributed to the dramatic one-day move in EDS's stock price. Since the negative preannouncement occurred, it has restructured its management team and business strategy. EDS shares, however, have continued to underperform the broader market.
INITIAL STEPS. We view EDS's naming of Michael H. Jordan as chief executive on Mar. 21 as a positive move, given Jordan's successful track record, most recently as chairman and CEO of CBS Corp. In addition, we like the appointment of an outside leader, since it helps convince investors that EDS is heading in a new direction while simultaneously disassociating itself from previous missteps by management.
On the strategy front, we expect EDS to focus on smaller and shorter-term contracts, which encompass fewer upfront costs and help to expedite profitability. We anticipate that it will reveal a more detailed business outlook at its upcoming analyst day in June.
Though we believe these recent moves are positive initial steps, we think several outstanding issues must be resolved to win back investor confidence. On top of the tough IT-spending environment, EDS has had ongoing difficulties with a few of its largest contracts, including MCI (as the recently renamed WorldCom is now known), the U.S. military, and General Motors (GM), which makes up over 10% revenues.
REVISED AGREEMENT. EDS is the primary provider of data processing and other IT services for the auto giant, including integrated information systems for health and benefits, engineering systems support, office automation, and plant automation functions. Revenues from the GM contract declined 16% in 2002, and EDS expects a further decrease in 2003. In addition, it sees margins edging lower after it recently renegotiated the contract.
EDS provides IT services to MCI, the majority of which are provided under an 11-year services agreement signed in October, 1999. In July, 2002, while still WorldCom, MCI filed for Chapter 11 bankruptcy. Revenues from it represented about $610 million of EDS's 2002 revenues. EDS has revised the terms for these agreements to change its service requirements, reduce certain existing rates, and settle pre-petition amounts owed to EDS. It expects the revised MCI agreements to be approved by the bankruptcy court sometime this quarter.
In October, 2000, EDS was awarded a contract by the U.S. Navy and Marine Corps to provide IT infrastructure services. The contract, which was modified in October 2002, is valued at a minimum of $6 billion in revenues over seven years. However, earlier this month, EDS recorded a $334 million pretax loss associated with it, as a result of adjustments to the pricing and deployment schedule. Moreover, EDS again postponed its forecast regarding when the contract would turn cash-flow-positive. It now does not expect this to occur until mid-2004.
SEC TROUBLE, TOO. We think EDS's exposure to the airline industry is another concern, given its weakened financial condition, ongoing terrorism threats, and the impact of SARS. On March 31, 2003, EDS entered into a new contract with U.S. Airways, which superseded the previous contract that accounted for $190 million of 2002 revenues. The new deal, which has a 10-year term, contains reduced services and pricing. EDS's largest airline contract is an annual $400 million deal with American Airlines (AMR). Other agreements with U.S. and international airline and related travel businesses equate to about $600 million in annual revenues.
Finally, EDS is in the midst of a formal Securities & Exchange Commission investigation. The probe originally focused on the company's purchase and settlement of forward contracts related to its common stock and information regarding events leading up to its third-quarter 2002 earnings pre-announcement. However, following EDS's May 7 first-quarter earnings release, the SEC requested documents related to its Navy and Marine Corps contract.
Although EDS can't predict the investigation's outcome, we think the ongoing uncertainty and recent expansion of the proceedings are negatives for stockholders until the questions are resolved. EDS's shares, which traded at $18.37 on May 20, are flat so far this year, vs. a 4.5% gain for the S&P 500-stock index. We believe the issues surrounding the change in leadership, problem contracts, airline industry exposure, and SEC inspection have hurt the stock.
For 2003, we anticipate EDS's revenues rising about 3% and earnings per share falling 22%, to $1.61, from 2002's $2.06 from continuing operations. On a valuation basis, EDS trades below the broader market on a p-e and p-e-to-growth basis. In addition, the shares are trading below their historical price-to-sales average of about 1.5. However, given the lingering questions with respect to its business, we have a 2-STAR, or avoid, recommendation on the shares and would advise investors to place their funds elsewhere. Analyst Stice follows technology services stocks for Standard & Poor's