EDS: The Turnaround That Wasn't

Big contracts with shaky companies are just one of its problems

In early February, Electronic Data Systems Corp. (EDS ) CEO Richard H. Brown was beaming as he welcomed analysts to the company's sprawling Plano (Tex.) headquarters. Enron Corp.'s collapse and the faltering economy had Corporate America rattled, but Brown had boosted 2001 profits 19%, to $1.36 billion, on a 12% gain in revenues, to $21.5 billion. He pledged this year would be even better, promising 13% to 16% revenue growth. "What other company has that vision, that annuity stream into the future?" he asked.

As it turns out, not even EDS. On Sept. 18, the company said third-quarter profits would fall as much as 84% short of estimates, to $58 million, due to slowing client spending and write-offs from problem contracts. Revenues, which already had been revised downward to a muted 4% to 6% growth rate, will instead decline by as much 5%, to $5.3 billion. The outlook for the fourth quarter was dismal as well, pushing EDS shares down 53%, to $17.20.

Then EDS got whalloped again. On Sept. 24, Merrill Lynch & Co. analyst Stephen T. McClellan revealed that EDS had lost a risky bet on the price of its own stock. In December, 2001, the company began pledging to buy its shares at prices above $60. The gamble would have paid off handsomely if the stock rose and helped defer employee stock-option costs. Instead, it tanked. The maneuver has left EDS $225 million poorer. EDS says it didn't disclose the deals because they were made in the normal course of business. But the news set off fears that EDS could face a cash crunch and have difficulty competing for capital-intensive contracts. EDS shares skidded another 29%, to $11.68.

To be sure, the outsourcing business, EDS's flagship, has been slowing all year. Rivals IBM (IBM ) and Computer Sciences (CSC ) also have seen business slow. Brown insists the culprit is mostly the economy. He says EDS has no liquidity issues. "Our financial condition is strong," he says.

But EDS's woes go beyond a sluggish market. When Brown took over EDS in 1999, he focused on huge outsourcing deals that provide steady revenue growth over their multiyear lifespan. Problem is, the huge startup costs, which involve buying the client's data center and hiring its employees, have deflated EDS's cash flow and profitability on the deals that have been tough to predict. That has some of Brown's former fans wondering if the turnaround is over. "The jury is out," says McClellan, a onetime EDS bull who now rates the stock a sell.

What's more, EDS's method of accounting for those contracts makes any miscalculations costly. EDS uses a method known as percentage-of-completion accounting. Costs and profits are estimated over the life of the deal, and as work is completed the customer is billed on a monthly or quarterly basis. Many rivals, including IBM, use that method too. But under it, when EDS overestimates a contract's profitability, it has to retroactively apply a lower, revised profit margin and take a charge to cover the loss. Critics say the method leaves ample room for errors. "There's more liability to come," says UBS Warburg analyst Adam Frisch.

Indeed, some of EDS's earlier big deals have investors worried. In 2000, EDS was the surprise winner of a $6.9 billion deal to overhaul the U.S. Navy's computer systems. But the contract has sapped EDS's free cash flow, as have the costs of a similar deal with the British government. Together, they reduced EDS's free cash flow by $900 million in 2001, and they'll cut it another $850 million this year. What's more, those deals make it tough for EDS to swallow problems with other clients. EDS has had to write off $101 million from its huge contract with troubled telecom player WorldCom and another $69 million from its deal with bankrupt US Airways Group.

The growing troubles also worry the credit agencies, which have downgraded EDS's debt to A from A+. That could make it tougher to refinance debt and quash some megadeals. After EDS shares began their freefall, Procter & Gamble Co. delayed awarding EDS an expected $8 billion outsourcing contract.

Now, investors are questioning Brown's generous 2001 pay package--$55 million--as well as the costly bet on EDS's stock price. Suddenly, Brown's vision doesn't look so clear.

By Andrew Park in Dallas

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