Why Eds Is Having Trouble Rebooting

There's lots to fix--and its deal with ex-owner GM won't help

When Electronic Data Systems Corp. officially split from parent General Motors Corp. on June 7, 1996, buttoned-down EDS employees cast aside a longstanding rule against drinking alcohol during the workday. Employees vividly recall the euphoria and popping champagne corks that marked the end of 12 years of ownership by the carmaker.

The party surely started too soon. Instead of soaring, the $14 billion computer-services giant has been stumbling. Once one of Wall Street's high-tech darlings, EDS has had a string of earnings disappointments, sending its stock diving 41%, to $37 9/16 a share, from a high of more than $63 last October. What's more, results so far this year have raised concern about the company's financial controls and long-term growth prospects: Analysts estimate that revenue for 1997 will grow an anemic 3%, while the information-technology markets that EDS serves grow at a robust 14%. Next year, analysts project revenue up 9%, still lagging behind the industry.

Now, EDS execs are racing to right more than a year's worth of wrongs with a top-to-bottom overhaul of the company. First up: cost-cutting, to the tune of some $500 million annually by the end of 1998. And consulting unit A.T. Kearney is helping EDS rethink everything from the way the company evaluates prospective contracts to how it trains employees. "We understand our issues and our challenges," says CEO Lester M. Alberthal Jr. "We understand the marketplace, and we believe we're making the appropriate changes."

SLIM MARGINS. But are they enough? To be sure, EDS is starting to win some big outsourcing contracts after a yearlong dry spell. But investors are still concerned that profits from those deals will be slim and take longer to hit the bottom line. There also are nagging questions about the health of the company's $73 billion backlog of business and whether EDS executives can turn these big wins into fat profits. "EDS hasn't yet seemed to figure out the formula," says R. Gary Helmig, a principal at SoundView Financial Group in Stamford, Conn.

For shareholders, it is results that count, and those don't look promising for awhile. EDS acknowledged in August, after second-quarter earnings fell 22%, that profits this year will decline for the first time since 1976. Analyst Stephen T. McClellan of Merrill Lynch & Co. estimates that EDS will earn $931 million for 1997, excluding restructuring charges, down 7% from more than $1 billion last year. And that's on revenue of $14.9 billion, up only 3%. Next year, he figures the company will earn $1.03 billion, a gain of 11%, on revenue growth of 9%, to $16.3 billion. "You have to change this company around fairly materially to get them off on a new track," says McClellan.

There are rumblings that some investors are losing patience. Sources close to EDS say U.S. Trust Co. of California, the independent trustee of GM's EDS holdings--131 million shares, or 27% of the company--requested an Oct. 9 meeting to discuss its concerns with EDS' outside directors. The pension fund has seen its EDS stake plunge a hefty $3.4 billion. Neither company would comment on the meeting.

Alberthal, a low-key Texan known for his collegial style, vows to jump-start the company he joined nearly 30 years ago. His game plan, dubbed Future By Design, includes an improved warning system to detect problem contracts, accelerated training programs, and new efforts to get his message across to the troops.

The 53-year-old CEO is already trying to cope with customer dissatisfaction and falling employee morale. This year, for instance, he started tying compensation and bonuses for managers to customer satisfaction and leadership ratings, not just profit and sales results. He and his lieutenants also are spending more time on the road listening to employee concerns. The top three execs have held 25 "town hall" meetings with employee groups this year, and 30 more are planned for the next two months. Alberthal's message: EDS must build better relations with customers and meet performance goals.

PAYROLL PURGE. Executives are on a jihad to lower costs. So far, the company has wiped out 8,500 positions and laid off 3,000 people from EDS' 100,000-person workforce. The company is also consolidating business units and paring upper management, with 11 of 150 senior execs already gone and more likely to depart. Other savings will come from reducing the number of vendors EDS uses for such temporary services as clerical and technical work.

But the biggest change may be the reengineering of how EDS goes after large contracts. This year, the company created special corporate teams to land megadeals. In the past, some 50 individual business units were allowed to pursue their own contracts. No more. All bids must now go through the corporate team to allow better control over pricing and profitability. The new approach is getting results, including a $3.8 billion contract with Commonwealth Bank of Australia in September and a $3 billion pact with BellSouth Corp., which is not yet final.

Moreover, the company has won 5 of the 10 largest outsourcing awards so far this year, says McClellan, pushing its total new-contract signings to about $12 billion. Analysts expect a total of $18 billion for the year vs. 1995's $10.1 billion. "That's not the sign of a failing business," says analyst Richard X. Bove of Raymond James & Associates.

True. But the trouble is, these deals aren't likely to show up on the bottom line for a year or more. Up-front costs are considerable, and EDS has adopted more conservative accounting practices: It won't book profits until the heavy lifting on a deal begins, typically six months to a year into the contract. What's more, the big contracts, in which EDS takes over a customer's data-processing centers and absorbs the related employees, are typically less profitable than smaller deals for consulting, applications development, and other higher-margin work.

Stiff competition from giants such as IBM and Computer Sciences Corp. keeps margins on megadeals in the single digits. And with profits on the GM business also shrinking, from an estimated 12% to 14%, analysts say EDS will be hard-pressed to maintain the 12%-plus operating margins it enjoyed in the early 1990s.

"HARDER AND HARDER." Even with new business coming at a record pace, analysts worry that the gains could be wiped out if EDS runs into more trouble on existing deals. Investors were rattled in August by an $80 million pretax writeoff for three problem contracts. EDS also noted that other troubled deals--the company won't identify them--are holding down earnings. "We pressed down harder and harder on the revenue accelerator," says Vice-Chairman Gary J. Fernandes. "I know that led us to some bad decisions."

Nowhere will EDS be tested more sorely than at GM, which still accounts for $4 billion, or nearly 30%, of EDS' revenue. Under the terms of the split-off agreement, GM has the right to put out for competitive bids up to $1 billion worth of business by 2005. GM also negotiated retroactive price cuts for services. Says GM's new chief information officer, Ralph Szygenda: "There's no doubt our goal is efficiency, not only at GM, but in the EDS relationship."

With the GM business likely to shrink, EDS will have to grow its non-GM business at an even faster pace than the industry just to keep up. "I think it would be a mistake to underestimate EDS," warns Fernandes. But he'll have to back up those fighting words with a lot more action. In the meantime, EDS would do well to keep the champagne on ice.