EDS: What Went Wrong

Did CEO Brown know the extent of its woes months before investors were warned?

On a balmy day last June, some 150 of Electronic Data Systems Corp.'s (EDS ) top executives gathered at the company's Plano (Tex.) campus for its thrice-annual senior leadership meeting. One by one, the heads of its businesses presented grim financial outlooks, say people who were there. EDS looked likely to fall short of its earnings targets for the upcoming third and fourth quarters, in part because of slackening tech spending by corporations. That wasn't what CEO Richard H. "Dick" Brown wanted to hear. Brushing aside the pessimism, he pushed managers to stretch for their targets, as they had in previous quarters. "He said we weren't trying hard enough. We were told there was gold in the hills and to go find it," says a former high-ranking executive.

Now, Brown -- and EDS -- has paid a heavy price for his outsize optimism. Three months after that June meeting, EDS shocked Wall Street by warning that earnings would fall 80% short of projections. That day, Sept. 18, EDS shares fell 53%, to $17.20. Since then, a string of nasty surprises has further sapped investor confidence. Among the concerns: a Securities & Exchange Commission investigation that is focused on events leading up to the earnings miss, as well as on an undisclosed losing bet EDS made on its own stock price that cost the company $225 million. The trail of bad news led to Brown, and on Mar. 20, EDS's board replaced him with former CBS Corp. CEO Michael H. Jordan.

These are grim days in Plano. EDS denies any wrongdoing and will not comment on the SEC probe. Yet barring any findings of malfeasance by the SEC, EDS may still end up as a long-term winner in the $140 billion computer-outsourcing industry. It still has billions worth of multiyear contracts from corporations that have farmed out various technology jobs, such as running computer networks. That's enough recurring revenue to see the company through its current crisis, analysts say. Indeed, investors have driven up EDS shares 12%, to $17.63, since Brown's Mar. 20 ouster. "Dick Brown had lost investors' confidence," says Humberto Andrade, an analyst at Technology Business Research. "It was time to move on." EDS would not comment for this story. Brown, who leaves with a $32 million severance package, could not be reached for comment.

The new CEO faces a daunting job in reestablishing EDS as a dependable powerhouse of tech. While Brown made many necessary changes after he was hired in December, 1998, he failed to address key trends in the rapidly changing tech landscape, say analysts. The company has been slow to address the threat from offshore rivals such as India's Wipro Ltd. (WIT ), which offers many EDS-style services at much lower cost. And EDS is an also-ran in the fast-growing market for business-process outsourcing (BPO). Rather than just taking over a customer's existing computer operation, BPO specialists revamp the entire job, whether it's procurement or human resources. Jordan, who is 66, must also hurry to allay concerns about EDS's future by forming a succession plan.

Investors can only hope that Jordan performs better than Brown did. An inside look at the missteps at EDS shows not only how Brown's unbridled optimism led to troubles, but how his reluctance to confront those problems compounded the woes. After four years on the job, he leaves EDS a weaker and more vulnerable company.

Founded by H. Ross Perot in 1962, EDS had long been famous for its technical competence, steady growth, and Perot's conservative culture, symbolized by crisp white shirts and military-issue haircuts. But by 1998, Brown's gung-ho style seemed just the ticket to revive a company that had grown bureaucratic and inefficient. "The EDS you see one year from now will be very different from the company you know now," Brown declared to securities analysts in April, 1999. Investors drove EDS's stock from about 35 before he was hired to a high of 75 in February, 2000.

Eager for growth, Brown pushed executives to win marquee "megadeals." These were multibillion-dollar contracts in which corporations or government agencies handed over a broader swath of computing jobs. While EDS and its rivals had to make bigger up-front investments in equipment and labor, megadeals ensured a steady stream of dependable new revenues. Brown's efforts seemed to work. EDS inked $24.9 billion in new signings in 1999, up 111% from 1998.

Yet Brown took megarisks to land some of those megadeals. In the fall of 2000, he signed on to overhaul the U.S. Navy's computer systems (page 62), even though former Chief Financial Officer James E. Daley warned that EDS wouldn't make a profit on the deal after inflation was taken into account, say two former senior executives familiar with the deliberations. EDS's winning bid, which beat out offers from IBM and others, carried a thin 4% margin. That's well below the 7% margin typical of EDS's megadeals, says UBS Warburg analyst Adam Frisch. The contract ran into a raft of problems that held up payment. By the end of 2002, the deal had drained $1.9 billion in cash from EDS's coffers. Daley would not comment.

Other big bets turned ugly, too. In June, 1999, Brown signed a $12.4 billion partnership with WorldCom Inc. that required EDS to resell more than $400 million of the telco's services each year to other customers. Even before WorldCom collapsed into Chapter 11 in July, 2002, EDS was struggling to find customers, say two former execs involved with the deal. EDS has renegotiated the contact but has been forced to take $118 million in reserves and write-downs.

The key question for regulators is whether Brown and EDS management should have disclosed bad news sooner. Even as tech spending plummeted, EDS appeared to thrive. In 2001, when Brown earned $55 million in cash, stock, and options, EDS rang up record sales of $21.5 billion. The following February, Brown promised that EDS would grow core revenues by 13% to 16% in 2002, with higher year-over-year margins.

The downdraft, though, was becoming clearer. When EDS closed the books on its first quarter of 2002, core revenues had grown only 8%. Second-quarter results also came in at 8% growth. EDS only met earnings estimates by curtailing bonuses and landing a $200 million prepayment by an unidentified customer, analysts say. Long after rivals IBM (IBM ) and Computer Sciences Corp. (CSC ) had warned of slumps in 2002, Brown remained upbeat, saying frequently: "We're the fastest horse on a muddy track."

By the time of EDS's June leadership summit, the slump was clear to many attendees. Yet execs made little effort to rein in Brown's expectations out of fear of being publicly humiliated, according to former senior executives who were there. Says one: "You'd be singled out as a quitter." Adds another former executive: "Delivering bad news was not a good thing. So you postponed it as long as you could." EDS has said there was no attempt to disregard dissenting opinions.

As investor confidence waned, Brown went on a six-city road show. The purpose of the trip, EDS has said, was to respond to concerns about client bankruptcies and questions about accounting. But Brown faced plenty of questions about market conditions. The CEO insisted that EDS's backlog of signed contracts and pipeline of potential deals would allow the company to meet quarterly expectations, say institutional investors who attended presentations. Brown later said in a conference call that he did not learn about EDS's disappointing earnings until September, 2002, only days before communicating the news.

The stunner came on Sept. 18, when EDS announced that it would earn no more than $74 million in its third quarter -- 80% less than the consensus estimate. A host of unforeseen problems "hit us with a force that was unexpected," Brown said in a conference call with analysts. EDS shares plunged 53%, to $17.20, the next day. A few days later, after a Wall Street analyst revealed that EDS had borrowed $225 million to unwind recent derivatives contracts, shares tumbled 29% more, to $11.68.

All that bad news hurt EDS's business, particularly with its megadeal customers. Procter & Gamble Co. (PG ), for example, backed out of an expected $8 billion deal. By the end of 2002, total signings had plunged 25%.

Some analysts wonder if Jordan and former EDS Vice-Chairman Jeffrey M. Heller, now president and chief operating officer, are going to try to sell the company. At 66 and 63 years old respectively, they're not likely to be in for the long haul. And Jordan is best known for taking over troubled Westinghouse Electric Corp. 10 years ago and dressing up its industrial divisions for sale while merging with CBS.

Finding a buyer for EDS could be tough. Analysts say IBM is well-positioned as is, and that Hewlett-Packard (HPQ ) is still digesting Compaq Computer (CPQ ). Even if those companies go shopping, the EDS Dick Brown built isn't looking like anyone's prize.

By Andrew Park in Dallas

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