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No Outsourcing for EDS's Woes

By Olga Kharif For more than a year investors in ailing Electronic Data Systems (EDS) have nurtured hopes of a turnaround even though the technology-services giant's sales kept sliding and it posted loss after quarterly loss. After all, CEO Michael Jordan had righted another messed-up business, CBS (formerly part of Westinghouse Electric) in the mid-1990s. So, when he presented a plan last June to get Plano (Tex.)-based EDS back on its feet, many investors decided to hang in.

Their faith has yet to be rewarded. At $17.50, EDS's shares are trading 76% below their high of $73, hit in 2003. The outlook for EDS, with $21.5 billion in annual sales, remains mired in doubt, most analysts say. On July 15, rating service Moody's downgraded its debt to junk from investment-grade and maintained a negative outlook. The same day, rating agency Standard & Poor's placed EDS on negative credit watch. Both expressed concerns about EDS's liquidity after it decided to delay a $1 billion stock sale. EDS, which had $2 billion in cash and equivalents as of March, on July 15 reduced its full-year cash-flow forecast for the third time this year.

Investors are probably in for more blows in the coming months. EDS is expected to cut its dividend by two-thirds, and the Securities & Exchange Commission is in the midst of a probe into its accounting practices. "The shares look cheap, but there's no positive catalyst to take the stock higher," says Joseph Vafi, an analyst with Jefferies & Co.

MORE PATIENCE NEEDED. On the operating side, EDS's situation appears dark, too. Excluding proceeds from selling a business and asset write-downs, it's girding for a loss of 3 cents a share for the three-month period ended June 30, vs. income of 34 cents a share a year ago. Planning to report second-quarter results on July 28, it expects essentially flat sales of $5.1 billion to $5.2 billion.

To revitalize EDS, a more aggressive restructuring may well be needed, such as shedding more businesses and fine-tuning its sales strategy. EDS will need well into 2005 to stabilize the business, analysts predict, meaning investors will have to be even more patient.

Though some analysts think revenues and profits could begin to rise in the second half of 2004, that's likely wishful thinking. Even EDS's management doesn't foresee growth until 2006. It's currently losing market share to rivals like IBM (IBM), Accenture (ACN), and Computer Sciences (CSC), says Phil Fersht, an analyst with Yankee Group.

FEW BIG DEALS. The recent credit downgrades could exacerbate the market-share slide. Once it wins outsourcing contracts, EDS typically needs to make significant up-front technology investments, but the downgrades will hike borrowing costs. What's more, corporations looking to award long-term outsourcing contracts might prefer rivals with a stellar credit rating such as IBM rather than EDS, says Vafi.

To further stem losses, EDS needs to refocus its sales strategy, analysts say. For months, it has concentrated on grabbing midsize, single-function contracts of less than $1 billion, partly because while "larger contracts look good [on the balance sheet, they] take longer to transact," reasons Michael Boustridge, chief sales officer.

However, companies are moving to larger, multifunction contracts and away from smaller deals. The number of agreements worth more than $1 billion is expected to go from 12 last year up to 20 this year -- while the outsourced-services market overall remains flat, says David Garrity, an analyst with Caris & Co.

IMAGE SPIFFING-UP. EDS needs to focus not only on grabbing these larger contracts but also on convincing potential customers that its current struggles won't hurt its ability to provide solid service. Yankee Group surveys show that large corporations perceive EDS as not stable. Given this, they might hesitate to send it business or could ask for concessions to account for the added risk, Fersht says.

EDS is taking actions to get back on track. It's well on the way to decreasing cost of revenue 20% by 2006, and it's reducing debt. Last December, it hired consumer-marketing guru Sergio Zyman, a former marketing chief at Coca-Cola (KO), to bolster its image.

EDS is also doing a decent job on contract renewals. On July 19, it announced a $1.1 billion, 8-year contract with existing customer Bank of America (BAC). EDS will integrate the bank's communications systems with those of its acquisition Fleet Boston Financial.

HITTING BOTTOM? "EDS is a good, high-return business," says Donald Yacktman, portfolio manager of Yacktman Funds, where EDS is a top-10 holding. "I don't think it's nearly so bad [as some people think]. If this is not the bottom, it's close."

Many investors, however, have adopted a show-me attitude. "It can always get worse," says Alex Vallecillo, senior portfolio manager with Armada Funds, where he oversees $7 billion in investments.

EDS has plenty more work to do. Says Cindy Shaw, an analyst with Schwab Soundview Capital Markets: "It's going to take a long time to right this ship." Kharif is a reporter for BusinessWeek Online in Portland, Ore.

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