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A SPECIAL ANNEX NEWSFLASH

Updated 12/12/03, 12:07 a.m. MST (adds "How the Deal Was Won")

Cap Gemini Ernst & Young Wins $5.2 Billion U.K. Inland Revenue "Megadeal"

Biggest Feather in Cap's Cap

Fujitsu Services Partners with CGE&Y as Subcontractor

PHOENIX, Dec 11 - The Inland Revenue has become the biggest feather in Cap's cap to-date.  The U.K. government's tax authority, roughly equivalent of the IRS in the U.S., announced today that it has decided to award an IT services contract estimated at 3 billion ($5.23 billion) to Cap Gemini Ernst & Young (CGE&Y).  

The deal, which is to become effective on July 1, 2004, is for an initial period of 10 years, with an option to extend it for up to a eight additional years.  There will be a six-month transition period from the incumbent vendors, starting in January 2004.  EDS, the incumbent loser in the bidding process, has been administering the current Inland Revenue megadeal since 1994 (see Annex Bulletin 95-07, 1/30/95).

Naturally, CGE&Y executives gloated, while EDS's sulked. 

"Were delighted to have secured this prestigious contract," said Paul Spence CGE&Y's UK & Ireland CEO, in a release.  

EDS said it was "extremely disappointed" in the decision.  "The company continues to believe that it offered the best solution at the best value," EDS added, also in a release.

The only problem was that EDS's biggest European customer disagreed with that assertion.  In May, chairman of Inland Revenue, Sir Nicholas Montagu, publicly criticized EDS after some tax credits didn't get paid.

Last month, Inland Revenue also told the British Parliament that it may have overpaid up to 2 billion ($3.46 billion) in tax credits due to failures in computer systems.  Now that's a "megaglitch!"  

It was followed by a "megabluster."  Undaunted, EDS took the unusual step of placing advertisements in London newspapers, urging the Treasury to reject the Inland board's recommendation.  It was an act of desperation, kind of like appealing to the crowd and the umpires to override the scoreboard in a sports match.

It didn't work. 

"I am delighted with the outcome of this competition," Sir Montagu said today, according to a Reuters report. "It has been genuinely tough and fair throughout, and we had to decide between extremely strong bids from all three of the consortia whom we originally short-listed."

So you'd think the stock market would have cheered CGE&Y and jeered EDS?  Think again.  CGE&Y shares dropped 1.3% today, while EDS's remained basically flat through the morning (see the chart).

One possible reason for the CGE&Y stock decline is that its shares had already risen in anticipation of today's announcement.  On Monday and Tuesday, after the Financial Times of London first broke the story this weekend of a possible Inland contract award to the Paris-based company, CGE&Y shares rose almost 2% to about $43, before sliding on Wednesday and again today to close at $40.82. 

But another reason for today's CGE&Y stock decline may be more worrisome.  The cold reality of a "megadeal" may be setting in, replacing the initial investor exuberance.  Huge wins may also bring big risks. 

As we have said many times before, "megadeal" contests are like a game of chicken.  The last vendor to say "no" to a deal gets stuck with it (see Annex Bulletin 99-04, 2/04/99, for example).  What follows is often meager profit margins, if not "megalosses," such as the one EDS is now experiencing in its $7 billion U.S. Navy contract (see "Pain Without Gain," Oct 20, 2003, and "EDS Takes Over US Navy," Oct. 10, 2000).

Maybe the investors are finally beginning to understand that winning a "megadeal" can sometimes land a company into a heap of "megatroubles?"  Maybe they are waiting to see what CGE&Y had given up in order to win the Inland deal from EDS?  Hopefully not the store...

Happy Days Are Over at EDS?

Meanwhile, one thing is quite clear.  Happy days are over for EDS, at least when it comes to the U.K. government contracts.  And maybe elsewhere, too.  For,  the loss of the U.K. contract was just the latest in a number of setbacks the second largest IT services vendors in the world has suffered since September 2002.

Besides the U.S. Navy woes, the company has also experienced sharply declining new contracts sales (see "Pain Without Gain," Oct 20, 2003). And it is the subject of a Securities and Exchange Commission investigation into an earnings shortfall and failed stock-hedging strategy last year, and a spate of private lawsuits. 

EDS's reputation has come a long way (down) since we hailed it six years ago as a model government contractor.  Here's an excerpt from this writer's Nov. 6, 1997 letter to the New York Times:

"So why not take a cue from business, and outsource the whole darn federal government?

It's been done before, and successfully at that. EDS, for example, is practically running the British government. Much more efficiently than the civil servants did. And the business is booming.

In the end, everybody wins: The taxpayers are happy because they save money. The EDS shareholders are happy because the company makes money..."

(An excerpt from Annex Bulletin 99-01, 1/02/1999)

As it turned out, neither the U.K. taxpayers nor the EDS shareholders are happy now.  Enter the new contenders...

CGE&Y: Good Timing

"The Inland Revenue demands a partner that can provide a reliable service to their employees, that can help them improve the service they provide to customers and companies and can help them meet the new challenges they will increasingly face in the future," said CGE&Y's Spence. "We have been chosen because of our strong track record of delivery and our strengths in innovation and technology-led change."

Fujitsu Services will be CGE&Y s main partner in delivering the contract.  The Japanese computer vendor will be a subcontractor to CGE&Y, predominantly to manage the data center services. In addition, British Telecom will be subcontracted to provide Wide Area Network (WAN) and Voice Support services. 

CGE&Y's big Inland Revenue win could not have come at a better time.  The company has been thirsting for some good news.

Just last month, for example, CGE&Y disclosed that its third quarter revenues had dropped by 18% (down 13% in constant currency) from a year ago.  CGE&Y also warned that its new contract sales were "below expectations," particularly the September bookings.  This meant that the second half 2003 revenues were expected to be lower than the first half.

Nevertheless, the CGE&Y stock has more than doubled this year, outperforming all of its major competitors (see the chart in "War Is Great," Annex Bulletin 2003-19, Nov 12, 2003).  Clearly, this suggests that the investors have been buying the management line, and giving the company the extra rope and time to turn itself around.  

So is today's stock drop is a mere pause for reflection, or a sign of changing investor attitudes after the biggest feather in Cap's cap?  

Time will tell... Either way, the Paris-based company has now clearly put itself on the map as a major outsourcing vendor.  What it now needs is another big (and profitable) win in the U.S. market to cement such a claim on a global scale.

 Happy bargain hunting!

Bob Djurdjevic

P.S. Separately, IBM dug out a golden nugget today in CGE&Y's back yard - France. Big Blue said it had signed an eight-year deal worth more than 1 billion euros ($1.21 billion) with the French tire company Michelin to manage its European and North American IT operations. 

The announcement comes on the heels of another big IBM win in Europe yesterday, when Zurich Financial Services announced that Big Blue would consolidate and manage all of its employees' electronic workplace technology across five European countries, the United States and Canada.  

So it looks like both CGE&Y and IBM are on a roll in Europe...

How the Deal Was Won

PHOENIX, Dec 12 - How was the Inland Revenue "megadeal" won?  Who would have thought we'd have our answers so soon to this and other rhetorical questions we asked yesterday...  

Maybe the investors are finally beginning to understand that winning a "megadeal" can sometimes land a company into a heap of "megatroubles?"  Maybe they are waiting to see what CGE&Y had given up in order to win the Inland deal from EDS?  Hopefully not the store...

But we do.  They came today from a source in Britain who spoke on condition of anonymity, as one might expect.

"The deal was not won on price," our source said.  "It was won on value added."  And it may become a model for how to compete in future "megadeals," too.

After nearly 10 years of outsourcing experience, Inland Revenue was a savvy customer.  They reportedly never pressured CGE&Y on price, as they did with EDS back in 1994.  This time around, this customer was after more value added then it was getting from EDS.  

The result was a deal twice the size of the original EDS contract (3 billion vs. 1.5 billion).  And a profitable one, too, with "normal margins" for CGE&Y.  Fujitsu Services will receive roughly one-third of the deal.

As the tale of the Inland deal unfolded, it became increasingly clear that EDS's heavy-handed "Texan-style" marketing may have contributed to the Cap Gemini Ernst & Young (CGE&Y) win, and to the Dallas-based vendor's ultimate demise.  EDS not only took out ads in the British media asserting its superiority, thus implying that its British customer was stupid or incompetent (as we pointed out above), the company also brought political pressure to bear at the highest levels.

The pressure tactics backfired.  EDS seemed to lack the sensitivity to realize who the real decision-makers were.  The company's last-ditch efforts to save the deal were "very badly perceived," especially by the British civil servants who actually made the decision. 

"The British don't like to be bullied," our source said.  "They don't like to be seen as 'American poodles'."

Naturally, the EDS arm-twisting made the bid by the Paris-based vendor that much more attractive, without CGE&Y having to stress its local (European) origin.  What CGE&Y did instead, was put its nose to the grindstone, and set out to convince the customer of its competence and capabilities.

  • It designed a whole new architecture for the Inland Revenue project;
  • It re-engineered the back office applications;
  • It drew on its experience with other British government branches, such as with local Councils;
  • It pointed to the new architecture it had designed for the British Defense Ministry;

Best of all, CGE&Y's bid also had zero upfront payment.  This minimized CGE&Y's risks downstream, and increased the profitability of the Inland deal.  

[Upfront payments are expensive, capital-intensive, marketing methods that IT services companies sometimes use in "megadeals" to lure customers into outsourcing (e.g., EDS's U.S.  Navy deal - see "Pain Without Gain," Oct 20, 2003, and "EDS Takes Over US Navy," Oct. 10, 2000)]. 

As a result, the Inland deal will produce about 210 million ($366 million) in 2004 revenues alone, according to Paul Hermelin, CGE&Y's CEO (see the NY Times, Dec 12).  And that's after the six-month ramp-up period, during which CGE&Y will not be collecting the payments at the 100% rate.  

"This contract will position our group for growth next year" after a difficult 2003, Hermelin said.

The stock market investors also seemed to have taken notice of how the deal was won, and what it may mean to CGE&Y in the future.  The CGE&Y stock went up 2% today, closing at $41.64.

For additional Annex Research reports, check out... 

2003 CGE&Y: The 10-year Glitch (May 2003)

A selection from prior years - CGE&Y

Analysis of CGE&Y 2001 Results (Feb 21, 2002), Analysis of Cap Gemini Ernst & Young 2000 ... (2001),  CGG 1999 Preliminary (Mar 10, 2000),  CGG Annual Report 1998 (June 18, 1999),  CGG: The Most Improved (1998)

2003 EDS: Pain Without Gain (Oct 2003)EDS CEO Replaced (Mar 2003)Rebuilding Trust and Confidence (Feb 2003)

2002 EDS: Wall Street Legal Vultures Descend Upon EDS (Sep 27, 2002),  EDS Issues Earnings Warning (Sep 18, 2002),  Wall Street-Main Street Chasm Widens (July 3, 2002),  Analysis of EDS 4Q01 Results (Feb 8, 2002)

A selection from prior years - EDS: Annex Research Analysis of EDS 4Q00 Results (Feb 7, 2001),  EDS Takes Over US Navy (Oct. 10, 2000),  EDS Second Quarter Results (July 28, 2000),  Annex Bulletin - 2000-02 (EDS' e-Price Clubs).

Or just click on and use "financial engineering" or similar  keywords.

Volume XIX, Annex Newsflash No. 2003-13
December 11, 2003

Editor: Bob Djurdjevic
Published by Annex Research, Inc.
e-mail: annex@djurdjevic.com

P.O. Box 97100, Phoenix, Arizona 85060-7100
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