On April 5, 2004, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured ratings on Plano, Texas-based Electronic Data Systems (EDS) to 'BBB-' from 'BBB', affirmed its 'A-3' commercial paper rating, and removed the company from CreditWatch, where it was placed on February 5, 2004. The outlook is negative.
The downgrade reflects weak operational performance because of cost disadvantages, significant turnaround challenges from underperforming contracts, and industry pressures that make a significant improvement in profit levels over the near-term challenging, despite announced restructuring efforts.
In the current environment, cost cuts for all sector participants are needed to offset pricing pressures. However, Standard & Poor's expects operating margins, currently in the 3% area, will gradually improve as EDS stabilizes its problem contracts, replaces recently lost or divested higher margin business with new contract wins, and sells more value added services into its existing client base.
EDS provides broad based technology services, including systems outsourcing, management consulting, and systems integration.
The investment-grade ratings for EDS reflect a globally diverse portfolio with deep vertical expertise, adequate near-term liquidity following the pending sale of its UGS PLM Solutions unit (the product lifecycle management subsidiary of EDS), and sufficient cash flow protection at current rating levels. Ongoing credit concerns include several large problem contracts, the low level of contract signings, and a relatively high cost structure.
Although EDS has substantially scaled back the revenue and free cash flow assumptions from the Navy Marine Corps Intranet (NMCI) contract, it also has limited its ongoing financial risk from this contract. EDS expects to lose about $1.5 billion in cash flow over the life of this contract. Standard & Poor's still has concerns with ongoing execution issues, but that risk is mitigated by the expected recovery of $800 million to $1 billion of cash flow over the remaining life of this contract.
Financial improvement is expected in other critical-focus accounts because of better execution, renegotiated terms, heightened project management, and enhanced risk management.
Standard & Poor's views the sale of the PLM subsidiary as neutral from a credit perspective. PLM represented only 4% or revenues, and was not driving additional synergies across EDS' other product areas. The $2 billion in proceeds from the divestiture bolsters the balance sheet, and should help alleviate any lingering customer concerns regarding EDS' financial health. However, this business was forecast to contribute about $140 million of EDS' $500 million-$600 million of projected free cash flow in 2004. EDS' cost improvement initiatives and new business signings are expected to offset PLM's lost contribution somewhat.
While EDS will pursue new outsourcing contracts requiring less up-front capital, and continue to use client supported financing transactions (CSFTs), capital expenditure requirements still are expected to remain substantial, in the 9% to 10% of revenue range. At current rating levels, total debt to EBITDA is expected to be managed at under 2.5 times over the intermediate term, and was 2.4 times at December 31, 2003.
Liquidity: Following distribution of the PLM proceeds, EDS will have cash exceeding $4 billion, $1 billion available under its revolving credit facility, and a secured receivable facility with availability of up to $400 million. Pro forma cash of over $4 billion compares with $5.8 billion of debt at Dec. 31, 2003. Free cash flow in 2004 is expected to be $500 million to $600 million, less the effect of the PLM transaction. Liquidity is more than sufficient to fund near-term debt maturities, dividends requiring about $300 million, and near-term restructuring actions. EDS currently has an adequate cushion in the covenants of its revolving credit facility and is expected to remain in compliance. Standard & Poor's expects EDS will retain a significant cash position over the mid-term to support customer confidence.
EDS has commenced an offer to exchange its $1.6 billion of FELINE PRIDES in the form of Income PRIDES in order to strengthen its balance sheet and to reduce its overall debt. EDS is offering to exchange 0.8430 shares of EDS common stock plus $2.53 in cash for each validly tendered Income PRIDES. EDS originally issued the FELINE PRIDES (mandatory convertible debt instruments) in June 2001. The income PRIDE consists of a forward stock purchase contract and a note. The note is owned by the holder but is pledged to EDS to secure the holder's obligations under the purchase contract.
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. Much of the expected improvement in 2004 will come from stabilizing several large contracts that have had a significant negative impact on results over the past two years. If these contracts continue to be substantial drags on cashflow, or if new contract signings remain depressed, ratings may be reviewed for a downgrade. Also, the company is under a formal SEC inquiry, and any potential impact on EDS ratings is not clear at this point.