On June 20, 2003, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured ratings on Electronic Data Systems (EDS) to 'BBB' from 'A-', lowered its short-term and commercial paper ratings to 'A-3' from 'A-2', and removed the ratings from CreditWatch where they were placed on May 8, 2003. The outlook is negative.
The downgrades reflect weak operational performance in each of EDS' major lines of business because of cost disadvantages, several significant contractual problems, and industry pressures that makes a significant improvement in profit levels over the mid-term challenging, despite announced restructuring efforts.
Plano, Texas-based EDS provides broad-base technology services, including management consulting, systems integration, and systems outsourcing.
The investment-grade ratings for EDS, however, reflect a globally diverse portfolio with deep vertical expertise, a substantial backlog of business, and an improving cash flow outlook over the longer term as $1.7 billion of the unbilled receivables balance (as of March 31, 2003) reverse by 2006.
EDS' first-quarter operating margins were 5%, down sharply from 11% a year earlier, reflecting delivery issues in outsourcing, market pressures in the consulting sector, declines in higher margin discretionary IT services spending, and the renegotiated General Motors Corp. (BBB/Negative/A-2) sector agreements. EDS experienced further slippage in the seat-deployment schedule for the NMCI contract, which also included a decline in the average seat price and a delay in the crossover point to becoming cash-flow positive. In addition, EDS remains exposed to several other problematic contracts, and will continue to be challenged by large telecom and airline customers with weak credit profiles.
To address these issues, EDS management is refocusing on its core business and on execution, which includes improving cost structure and efforts to renew growth and to strengthen the balance sheet. The plan includes cost-reduction actions resulting in a pretax restructuring charge in the $475 million range, organizational realignments, asset sales, and improved risk management procedures. While Standard & Poor's views these actions positively, the associated implementation risks, longer-term investment requirements needed to bolster the business process outsourcing business and other initiatives, and the time frame required to evolve the business profile are unclear, since this occurs against the backdrop of an increasingly competitive environment.
In addition, profit improvement will partly be a function of EDS' ability to garner new contracts and sell more value-added services, along with its ability to reduce costs. In the current environment, cost cuts for all sector participants are needed to offset pricing pressures and may not directly result in expected levels of increased profitability.
Ratings incorporate the expectation that unbilled receivables will wind down and have a positive impact to free cash flow of more than $1.7 billion in 2004-2006. While EDS is expected to pursue new outsourcing contracts requiring less up-front capital, capital expenditure requirements are still expected to remain substantial, in the 6%-9% of revenue range. Pro forma debt to EBITDA is expected to remain under 2.5x, and EBITDA interest coverage is expected to remain over 7x.
Liquidity: At year-end, EDS had $1.5 billion of unrestricted cash and full availability under its $1.25 billion revolving credit facility. The company plans to reduce its credit facility by $250 million in an upcoming renegotiation. Free cash flow in 2003 is expected to be in the $300 million area, which includes $200 million cash used for restructuring, and excludes the $200 million of near-term proceeds from the sale of noncore assets. Liquidity is adequate to fund the $772 million notes due October 2003, dividends requiring $290 million, and near-term cash restructuring actions. Standard & Poor's expects that the company will be able to raise an additional $1 billion-$1.5 billion of capital through asset sales and/or capital market issuance to provide additional flexibility and fund maturities in the 2004 and 2005 time frame. EDS currently has a significant cushion in the minimum tangible net worth covenant of its revolving credit facility and is expected to remain in compliance, even following a substantial charge related to the adoption of accounting pronouncement EITF 00-21.
If ratings fall below 'BBB-', the company's accounts receivable securitization facility (about $360 million outstanding as March 31, 2003) has an unwinding provision, and certain other obligations totaling about $228 million could be triggered if ratings fall to 'BBB-'.
Outlook: The negative outlook reflects Standard & Poor's concerns regarding EDS' ability to realize expected profitability and cash flow improvements in a challenging industry and economic climate. Also, the company is under a formal SEC inquiry, and any potential impact on EDS ratings is not clear at this point.