Look Twice At This Bear Market Bargain

KPMG's upcoming computer-consulting IPO will come to investors with something missing: Cisco's billion bucks

"Systems integration" is one of those modern mouthfuls that signifies nothing to most people and megabucks to a few. All it really means is customizing computers and software to a client's needs, a tricky service that Ross Perot quit IBM (IBM) nearly 40 years ago to pioneer with Electronic Data Systems (EDS). Today, such services drive IBM'S growth. With the untold billions still to be invested in e-business, it remains one of Wall Street's most cherished hopes for future gains.

That's why, even in this bleak Wall Street winter, one of the top systems integrators dares to go public. KPMG Consulting is set to sell an estimated $1.9 billion in stock in an initial public offering led by Morgan Stanley Dean Witter (MWD). That's one big deal. But given its parentage (the giant accounting firm KPMG), its partners -- Cisco (CSCO), Oracle (ORCL), and Qwest (Q), among others, and its performance (annual sales growth of 34% in the four fiscal years ended last June), it might have been a lot bigger. In fact, to get the deal done in this subzero IPO climate, the company's indicated value has been slashed to $2.6 billion--44% off the $4.6 billion envisioned just last fall.

CLOSER INSPECTION. Does that look like a bear-market bargain? It did to me, too, until I looked more deeply. KPMG Consulting is not going the way of so many e-businesses. Its 2,500 clients, including such giants as Merrill Lynch (MER), Chevron (CHV), and Johnson & Johnson (JNJ), assure that. But a few recent developments are worth noting, if only to give prospective investors a moment to pause.

Imagine, for example, the near-term outlook for KPMG Consulting's principal business, advising clients about how to make money via the Web. As the economy--and, with it, business investment--slows, so may demand for these easy-to-postpone services. Company executives are keeping quiet on this point, as well as all others, ahead of the IPO. Yet KPMG Consulting's chief marketing partner, Cisco, spoke volumes in January when CEO John Chambers told investors that business conditions have grown "a little more challenging."

Cisco's own actions--detailed in KPMG Consulting's securities filing--are even more telling. A year ago, Cisco gave KPMG Consulting $1.05 billion. In return, it took five million preferred shares, which pay a 6% dividend. The investment stood as a golden endorsement, even though it's separate from the companies' marketing pact. That, while leaving Cisco free to cut similar deals with rivals PricewaterhouseCoopers and Cap Gemini Ernst & Young, limits KPMG Consulting's ability to sell jointly with such Cisco rivals as Nortel Networks.

But here's what really knocks me back: After the IPO, Cisco's investment in KPMG Consulting will be far less than it at first appears. That's because, in a flurry of paperwork to be completed with the IPO, Cisco will get most of its money back. KPMG, the consulting company's parent, will first buy back from Cisco half of its preferred shares at cost, or $525 million. Next, the remaining preferred shares convert to common stock, and KPMG Consulting will then spend $400 million of the $469 million it expects to raise in the IPO to buy back still more of Cisco's stake, which Cisco says is needed to conform to a regulatory ruling.

When the ink dries, Cisco will wind up with 15.1 million common shares in KPMG Consulting, or 9.9%. Its final cost? $125 million, or $8.26 a share. That doesn't include the $63 million in dividends Cisco will have collected on its preferred shares, and it's less than half the indicated IPO price of $17 a share.

KPMG Consulting has disclosed only sketchy results from its December quarter, including the $58 million write-off of a money-losing joint venture with Qwest. But in the 12 months ended Sept. 30, the company posted revenue of $2.5 billion, operating income of $163 million, and earnings per share of 25 cents (table). That means, if the IPO is priced at $17 a share, KPMG Consulting will command 68 times the Sept. 30 earnings.

Although much bigger and slower growing, Electronic Data Systems trades at 32 times what it earned in the year ended last September. As it happens, that's just about the multiple that Cisco, no fool, is set to pay for its piece of KPMG Consulting. The bear-market bargain, in other words, is already gone.

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