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A SPECIAL ANNEX NEWSFLASH

Updated 5/20/04, 1:35 p.m. PDT (adds "How the Cap/TXU Deal Was Done...")

Analysis of Capgemini's , CSC's Latest News, Results

Capgemini Hits Texas-size Home Run

CSC on a Roll:  Stock Thrives on Strong 4QFY04 Finish; HP Also Hits a Home Run

PHOENIX, May 18 - The state of Texas has always prided itself on bigness.  Now a Paris, France-based company can claim a Texas-size home run.  Capgemini announced this morning that it has signed a $3.5 billion 10-year services deal with TXU Corp., a Texas power company.  In response to the news, Capgemini shares surged by six points on the Paris Bourse today (see the chart below).  

The TXU shares also jumped by over 10%.  Talk about a win-win deal!  

But what especially made this contract a win-win proposition for both companies is the way the deal is structured.  This is no ordinary outsourcing deal.  It's a textbook recipe for procreating the "best of breed" joint ventures, right out of our Holy Grail piece (see IT Industry: Whither Goeth It?, Jan 2004 - see the chart below).  We said in that article that the term "outsourcing" may be obsolete.  

“Outsourcing,” for example, should be abandoned as an outdated type of business relationship.  Outsourcing implies that the customer turns over the responsibility for running its IT to a vendor, and then just yells at him if something goes wrong.  As a parent of a new “adaptive enterprise,” the customer (mother) has a joint custody of the infant with the vendor (father).  Both are responsible for its well-being.  Both should share in risks and benefits of its upbringing.  

(An excerpt from our Holy Grail piece, Jan 2004)

The TXU deal proves out our theory.  The two companies will create a new venture - Capgemini Energy Limited, a limited partnership that will deliver services to TXU, and offer similar services to other energy firms, just as we predicted in our March 1990 Industry Stratification forecast (see the charts below).

We said in our Holy Grail story that it will take creativity, both on the part of IT services firms as "change agents" - fathers, and on the part of the customers - mothers, to create a new corporate species:

So the search for the new Holy Grail – a key to creating successful “adaptive enterprises” - is a bipolar process.  Like procreation, it takes a union of Ñ (chalice – woman - client) and a D (spade – man - vendor) to make it work.  The chalice is the marketplace (customer), the spade is the IT provider (vendor).  

(An excerpt from our Holy Grail piece, Jan 2004)

"The TXU deal is the first of its kind in the United States," according to a Reuters wire reportSo Capgemini and TXU are making history today. 

For Capgemini, that's true in more ways than one.  The TXU deal is also the first "megadeal" won by a foreign-based IT services firm in the United States.  Until now, the French multinational has been struggling to keep up with the  much bigger rivals in the U.S. market (IBM, EDS, HPS, CSC...).  The TXU deal now puts Capgemini not just on the map, but propels it right into the major leagues of the U.S. IT services market.  

The TXU deal is also the second home run Capgemini has hit in the last six months.  The first one was at Inland Revenue in the U.K. - see "Biggest Feather in Cap's Cap," Dec 2003).  It put Capgemini on the map and into the major leagues in European IT services competition.  After the TXU deal, other top IT services vendors can ignore Capgemini's global presence and success only at their peril.

Together with the Inland Revenue contract, the TXU deal will lift the share of outsourcing in Capgemini's total revenue to nearly 35% this year, and to 40%t in 2005, from 28% now, said Paul Hermelin, Capgemini CEO, in this morning's teleconference.  

Hermelin also vowed the Texas deal would be a profitable one.  He said the contract offered good margins and did not consume much cash, according to Reuters.

"It's a contract that has rather good margins," Hermelin said. "The first year is sort of without margins; the second year the margins start to arrive... by the third year, margins would be established."

Under the deal, 2,700 TXU employees will move to Capgemini Energy Limited, the new company, after July 1. Capgemini will be acquiring assets from TXU, but is not spending any cash, a company spokesman told Reuters. The new venture will have a capitalization of $100 million, with Capgemini owning more than 97% of it, while TXU holding less than 3% share.  (If TXU were to own any more than 3% of the partnership, the new entity could be subject to government regulation as a utility).

Despite the 6% surge of Capgemini's stock today, the long-term trend of its Paris Bourse shares is still down (about 17%) this year (see the above chart).  So it remains to be seen if the history-making Texas-size home run that Capgemini hit today will give the French company a long-term boost in the stock market, as it likely will in the U.S. IT services market.

How the Deal Was Done...

PHOENIX, May 20 - John Wilder, 46, has been in the TXU CEO saddle for less than three months, yet he has already turned the $11 billion-Texas utility company upside-down, inside-out and right side up.  That became evident on May 18, when the company ran a full-day show for Wall Street analysts on its new strategy, supported by over 200 (very slick!) slides. 

The upshot was a 14% surge in the TXU shares to a new 12-month high of $39.70.  

What is it that the investors liked so much in Wilder's elaborate "vision statement?"  

Well, a key component was Capgemini Energy Limited, a new company being formed by Capgemini and TXU as the center-piece of a $3.5 billion joint venture.  Its mission will be not only to take over more than half of TXU's Selling General & Administrative (SG&A) expenses (about $450 million per year), and shave off some $175 million from it in 2005, relative to 2003 levels.  The new partnership will generate its own revenues and profits by selling its business process (BPO) and classical (ITO) outsourcing services to other U.S. utility companies, as Capgemini's exclusive channel. 

No wonder the stock market also cheered Capgemini, whose shares got a 6% lift from the TXU deal, possibly reversing the six-month downward trend.

 

In short, Capgemini Energy Limited was exactly the kind of a "deal of the future" that we envisaged when we published the findings of our latest Holy Grail quest last January (see IT Industry: Whither Goeth It?).  In fact, our idea seemed so revolutionary at the time even to some of the more progressive thinkers in America's corporate boardrooms, that one of them wrote to us tongue-in-cheek, in reference to the Holy Grail piece:

"Either you are very wise, or you have had too much coffee!  I enjoyed this! JJJ "  

Evidently, John Wilder wouldn't have had any doubts.  So is this native Missourian, a magna cum laude graduate from Southeast Missouri State University, with a master's degree conferee from the University of Texas at Austin, the epitome of a new breed of visionary CEOs that we dubbed "Chief Creative Officers" in the above Holy Grail piece?

"No question... he is absolutely amazing, a great strategic thinker," confirmed one senior Capgemini executive who was close to the deal.  "He was driving the deal, not we.  He knew what he wanted.  We just asked the question, 'what do you want?'... and listened."

It pays to listen.  Especially to a CEO who is out to change the world of U.S. utilities.  Besides the $3.5 billion-Capgemini deal, Wilder wants TXU to divest itself of $6 billion of "non-core" assets, reduce its debt by $7.3 billion, and create a new trading company (in partnership with Credit Suisse First Boston) to access capital and manage risk.

These are some of the intermediate stops on a road from $2.03 per share to $4.50 per share that the TXU CEO promised investors he would deliver in 2006.

As you can see from the above chart, the Capgemini deal is a 16% stage on this road.

Another amazing thing about the $3.5 billion-deal is that it was done in less than six weeks.  So not only is Wilder a creative, visionary thinker; this 46-year old CEO is also quick on the draw.  And that's another characteristic that's in short supply among the more senior large company CEOs.  Which is why so few of them have embraced real change that creative business process outsourcing can effect.

Of course, the Capgemini leaders had to be no slouches if they were to keep up with Wilder.  For the last two weeks, most of the company's senior executives were camping out in Texas.  Not cooking beans and steak on an open fire as their horses grazed quietly nearby, but cooking up the American deal of a lifetime for this French multinational.

"Our Paris HQ was pretty empty the last two weeks," said one insider, still recovering from jetlag.  "But that's okay.  That's the way it's supposed to be with these big deals."

If the early reactions to the deal are any indication, chances are these Parisians will be earning lots of frequent flyer miles in the next few months, and dining on steaks with corn-on-a-cob and beans.  And not just on account of TXU and its utility industry competitors.  Already, some telecommunications executives are reportedly eyeing the TXU deal as a possible prototype that may work in their industry, too.

And so, finally... more than 14 years after we had first envisaged partnerships between leading-edge customers and top IT vendors that would result in new "best of breed" endeavors, the concept seems to be becoming become a reality (see March 1990 Industry Stratification forecast).  

Hallelujah!  Better late than never...

CSC on a Roll...

Computer Sciences Corp. (CSC) is on a roll.  CSC was another mover and shaker among the IT services stocks today.  Following a strong fourth quarter report card, which the company released after the markets closed yesterday, the CSC stock shot up about 11% in early morning trading. (see the chart below).

That's not surprising.  Here what we said about CSC's prospects in February of this year:

On balance, there seem to be at least as many reasons to cheer the latest CSC report card, as there are to pan them.  Surging sales are bound to translate into growing revenues and profits in the future.  Yet Wall Street has chosen to ignore the good and boo the bad.

Text Box: Some Market Stats    EDS      IBM    Accenture     CSC
Market Cap:	$9.98B	$171.54B	$22.06B	$8.04B
Trailing P/E (ttm):	N/A(Loss)	22.98	21.10	16.05
Current Price:	20.77	99.71	23.46	42.91
PEG Ratio (5 yr fcst):	3.41	2.02	1.36	1.23
Price/Sales (ttm):	0.46	1.92	1.59	0.58
Price/Book (mrq):	1.74	6.09	20.82	1.61
Source: Annex Research

As a result, CSC’s devalued stock price, even if it is still within 10% of its 52-week high, appears a relative bargain compared to its major rivals (see the above table). 

That’s especially evident in terms of the Price/Earnings Growth (PEG) ratio, a forward-looking statistics measuring a stock’s valuation against its projected growth rate (calculated as a P/E Ratio divided by the 5-year expected growth rate).

The PEG Ratio makes the CSC stock look like the best bargain, followed by Accenture, IBM and EDS, in that order.  So anyone still booing CSC may be missing a good play in a global wartime economy.

(An excerpt from "Good Quarter Gets Boos", Feb 2004)

So once again, Wall Street is closing the barn door after the horse has gone.  While we were zigging (re. CSC), Wall Street was zagging.  As you saw from our earlier report on institutional shareholders (see HP, CSC: Keeping Faith, Losing Faith (Apr 2004), 17 of the Top 25 CSC holders sold off their holdings in the last three months of 2003, some quite aggressively.  Now, they are having to buy the CSC shares back at higher prices. It figures...

Summary and Outlook

As to CSC's prospects in the future, we figure that they may be "as good as it gets," for a while. The company may be at a peak right now, it terms of relative business performance.  That's because with the end of the last quarter (4QFY04), favorable comparisons due to CSC's last year's DynCorp acquisition will have run their course.  Also, its outstanding new contracts all-time record ($17.2 billion) during the last fiscal year may be hard to top in the next 12 months.

To their credit, CSC management guidance reflects such views, too.  They expect a revenue growth of 8% to 10% in the current fiscal year, and an even lower (4% to 6%) increase in the current quarter.

So unless the company embarks upon some other sizeable acquisitions, CSC may be coasting for a while.  Since Wall Street institutions have proven that they rarely know which end is up at the companies whose stock they own, stand by for a buying spree of CSC shares now?

Happy bargain hunting!

Bob Djurdjevic

HP Also Hits Home Run

P.S. Hewlett Packard (HP) was another company that seems to have hit a home run today.  But HP did it after the markets closed.  Its second quarter fiscal year 2004 net earnings met Wall Street expectations, while its revenue exceeded it.  

On a non-GAAP basis, HP's second quarter FY04 net earnings were $1.03 billion, up 18% (they were $887 million, up 34% on a GAAP basis).  But its $20.1 billion-revenues, and the company's upward revenue guidance, may be the main reasons for about a 5% surge in HP stock's after-hours trading.  The HP shares had closed at $19.83 today, up 1.7% in the day's trading session.

HP Services (HPS) revenue grew 15% year-over-year to $3.5 billion. This represents record quarterly revenue and the highest quarterly revenue growth since the merger.  

Managed services (outsourcing) grew 50% over the prior year period.  Maintenance revenues grew 9%, while consulting and integration revenue increased 8% year-over-year.  The growth was balanced across HP's geographies, too (see the chart below).

HPS' operating profit was $329 million, or 9.4% of revenue, down from 9.8% in the prior year period, but up 1.2 points sequentially, reflecting improvements in Customer Support and Consulting and Integration margins, HPS said in a statement.

"We feel confident that we will continue to grow at rates in excess of the market," said Carly Fiorina, HP's CEO, in reference to HPS, during a teleconference that followed the earnings release.  She added that HP as a corporation "continues to fire on all cylinders." 

For our detailed HPS analysis and 2004-2005 forecast click here.

For additional Annex Research reports, check out... 

2004 IT Services: HP, CSC: Keeping Faith, Losing Faith (Apr 2004);  EDS: On a Wink and a Prayer (Apr 2004); HPS Wins by a Nose! (Octathlon 2004); Accenture: Burning the Track (Mar 2004);  IGS: "Crown Jewel" Restored? (Mar 2004); HP: Still No Cigar (Feb 2004); Cap Gemini: Another, Smaller Loss (Feb 2004); CSC: Good Quarter Gets Boos (Feb 2004); EDS: "Hot Air Jordan" Flaunts Flop as Feat (Feb 2004); IT Industry: Whither Goeth It? (Jan 2004); Cronyism Is Alive and Well at EDS" (Jan 2004)

2003 Cap:  "Biggest Feather in Cap's Cap," (Dec 2003); The 10-year Glitch (May 2003)

A selection from prior years - CapAnalysis 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)

2004 CSC: "Good Quarter Gets Boos" (Feb 2004); "Five Most and Least Likely Forecasts for 2004" (Jan 2004)

2003 CSC:  "Less Than Meets the Eye" (May 16), "Back to the Future" (Feb 5)

2002 CSC:  Analysis of CSC FY02 results (May 17, 2002), "A Disastrous Quarter!" (Apr 17, 2002), “Tough Times, Soft Deals,” (Apr 25, 2002)

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

Volume XX, Annex Newsflash 2004-11
May 18, 2004

Bob Djurdjevic, Editor
(c) Copyright 2004 by Annex Research, Inc. All rights reserved.
e-mail: annex@djurdjevic.com

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