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A SPECIAL ANNEX NEWSFLASH

Updated 8/10/04, 11:15 A.M. PDT (adds "EDS Prevails in HUD Dispute")

Analysis of EDS Preliminary Second Quarter Results

Moody's Lowers the Boon on EDS

Company Abandons Plan to Raise $1 Billion in Capital

PHOENIX, July 15 - Just over two months ago, we said Moody's seemed to be in the mood to drop Electronic Data Systems' (EDS) credit rating to junk (see EDS: On a Wink and a Prayer, Apr 2004). Well, the leading credit rating agency lowered the boon on EDS today.  Moody's cut EDS credit to junk, scuttling the company's plan to raise $1 billion in additional capital (according to a July 6 shelf registration filing). 

Standard & Poor's said it may also follow suit, while Fitch reaffirmed its 'BBB-' rating for EDS' senior unsecured debt, one notch above junk status.

The EDS stock dropped about 4% in response to the news, a relatively tepid investor reaction given the severity of the downgrade, and considering the stock's rise since mid-May on little more than hot air (see the chart).  

Predictably, the company issued a statement this afternoon protesting Moody's decision. "EDS has significantly reinforced its financial foundation, improved its competitiveness and fully expects to meet its guidance on second quarter 2004 results," the company said in the release.  

Just what EDS was expecting to accomplish with such protest was anybody's guess.  Moody's conducted a review of EDS' financials, reached a conclusion, and published its opinion.  The U.S. Supreme Court ruled eons ago that there is no such thing as "a false opinion," only "a false fact."  So we don't see the point of EDS' protestations?  Letting the facts speak for themselves might be a better tack.  Alas, that may hurt...

Speaking of facts, EDS also released its preliminary second quarter results this afternoon (the "official" numbers are supposed to be released July 28), presumably in the hope of bolstering its protest.  Actually, it may have only given more fuel to the critics' fire.

"EDS anticipates posting... a pro forma loss of three cents per share," the company said in today's release.  "The company expects to post positive free cash flow of approximately $30 million.  Prior guidance was a cash outflow of $200 million - $300 million in the quarter."

Furthermore, EDS warned that it may "lower its full-year 2004 free cash flow estimate to $200 million - $300 million, versus prior guidance of $300 million - $500 million."  The reason, an old familiar plague... the NMCI deal.  Another delay in funding for 40,000 Bureau of Medicine seats is anticipated.

(Actually, the prior guidance was for a full-year cash flow of "$500-$600 million, including NMCI," according to the company's Feb 5, 2004 release, not $300-$500 million.  Is EDS trying to rewrite history to fit the present?)

EDS also boasted that its second quarter contract signings were $4 billion, "up 25% from $3.2 billion in the second quarter last year." Actually, last year's figure was $3.4 billion, making the increase 18%, not 26%.  

To this is yet another example of EDS rewriting history to fit the present.  That's the Big Brother stuff... EDS could hardly afford the Big Brother tactics when it's up to its neck in alligators.

More importantly, last year's new contract sales were among the most dismal in EDS' history.  So they are hardly a yardstick by which to measure success.  The latest new contract sales figure ($4 billion) is actually down 36% compared to that in the second quarter of 2002 ($6.2 billion - see the chart).

Put it all together, and what we see is a company that's struggling to inch its way out of a heap of troubles.  "The harder we work, the 'behinder' we fall," seems to be an apt description of the EDS predicament these days.  We saw it last October (see "Pain without Gain", Oct 2003). Moody's saw it today.  S&P is looking into it.  Fitch is flinching, while EDS is protesting.

"Methinks the lady doeth protest too much," Shakespeare wrote with divine inspiration in "Hamlet" (Act VIII), without realizing that his prescience would also apply to a high tech company almost five centuries later.  

Methinks EDS protests too much and delivers too little.

Stock Rises on 2Q Results, Drops on Dow Chemical, Airlines Woes

PHOENIX, Aug 2 - EDS stock rose last week on the news of second quarter business results, even though they were in line with the previously announced numbers (see above).  It's almost as if investors were bracing for some more bad news, and when it didn't come, they breathed a sigh of relief and bid the stock up.  

But some more bad news did come out this afternoon - at two airlines and at Dow Chemical - sending the EDS shares down almost three points.

There is more to the EDS share prices, however, than meets the eye.  As we pointed out three months ago, "EDS has the highest (91%) instructional holders' share of the Top 8 IT services firms we analyzed" (see EDS: On a Wink and a Prayer, Apr 2004).  And what that means is that relatively few players with large stockholdings can prop up the shares, as they have done in the last several months.

The Wall Street Journal also noted that in its influential Heard on the Street column last Thursday.  Here's an excerpt:

"So why has the stock been climbing lately? Major investors have plowed into the stock, pushing up the share price on the bet that EDS will prove to be the next big turnaround story.  But several obstacles remain, and if the turnaround proves more elusive that these investors are hoping, EDS share could feel the pull of gravity."

Well, EDS sure felt the pull of gravity today (Aug 2), when its shares dropped nearly three points on two bad news stories that broke this afternoon.

First, an EDS software malfunction that lasted for three hours on Sunday morning contributed to 70 cancellations at US Airways, and led to systemwide delays at American Airlines, a division of AMR Corp, the two airlines said on Monday.  American Airlines said it canceled about 130 of its approximately 2,400 daily flights on Sunday because of the computer problem.

Second, "one man's loss is another man's gain," as an old adage goes.  IBM announced this afternoon that it has won a seven-year contract from Dow Chemical to manage its global information technology infrastructure.  The contract to manage e-mail accounts for Dow's more than 50,000 employees and contractors, and support a total 2,800 computer servers, is estimated to be about $1.4 billion.

Dow Chemical is believed to be the "other commercial contract" (in EDS' parlance - besides the Navy) that has been dripping red ink across the company's financial statements.  EDS took a 17-cent charge on it in its latest quarter, saying it was finally able to close out this money-losing deal.  But some EDS obligations will continue until June 2005.  Including those charges, the Dow Chemical deal has cost EDS over $500 million in operating losses, according to an Aug 3 Wall Street Journal report.

So IBM's win can be even seen as a good news story, given that EDS' hemorrhaging at Dow Chemical seems to be coming to an end.  But the company's software glitch at the two airlines only compounds its troubles at what has already been a beleaguered industry segment for EDS.  The fact that the stock dropped only 2.6% despite such news is yet another confirmation of the value of institutional support that EDS seems to be enjoying.  

(EDS shares dropped another 3% in early morning trading on Aug 3).

Bad News Continues... Now U.K. TV Company Announces Lawsuit

PHOENIX, Aug 9 - When it rains, it pours.  Bad news continues to rain on EDS' parade as new details pour out about the company's deals gone sour.  The latest is the British pay-TV company BSkyB.  The operator of the (James) Murdoch-managed Sky TV channel said last week that it "anticipates issuing and serving a claim in the near future for a material amount against an information technology solutions provider," according to a Reuters Aug 9 news wire.

EDS confirmed to Reuters that Sky had "asserted a contractual claim over the deal."  EDS said that Sky took back responsibility for CRM delivery in early 2002, and that EDS had terminated its relationship with Sky at the end of 2002.  The original two-year deal, signed in November 2000, was valued at about 61 million pounds ($112.4 million).

Furthermore, EDS recently reported to the Securities and Exchange Commission staff "a matter involving a transaction between the company and a third party," according to a Wall Street Journal Aug 9 report.  EDS didn't elaborate on the nature of the transaction, but said it "was not material to the company." 

So there you have it... whether these two latest "bad news" stories prove to be material or immaterial to the EDS future, time will tell.  What is already evident, however, is that even the cushion of high institutional shareholdings could not protect the stock from sliding in the last few days (see the chart).

Revenue Boost from "Discretionary Spending"

Another thing that has been perplexing was the EDS revenue growth in the face of sharply declining new contract sales in 2003.  Based on that $10.4 billion shortfall alone, and without any new woes that EDS has encountered this year, we figured that the company had started 2004 about $1.5 billion in the hole at its top line.  

EDS seems to agree.  In its latest (Aug 6) 10Q filing with the SEC, the company said as follows:

The decrease in contract signings in each of 2003 and 2002, relative to prior years, has negatively impacted base organic revenues in 2004 and will continue to impact revenues in the remainder of 2004 and in 2005 as a significant portion of our revenues are generated by long-term IT services contracts that require transition periods of three to 18 months. 

The new contract sales in the first half of 2004 were an improvement over the year before, but they were still down sharply compared to 2002, as you saw above.  Still, if we accept the company's projection of the new contract sales for 2004 of between $17 and $18 billion, the increase in new contract sales from 2003 would amount to about $500 million of additional revenues.  

So the revenue hole gets smaller, but it is still close to $1 billion.  How then could the first half revenues be up 4%? That's a question we posed to EDS on Friday (Aug 6) and again today (Aug 9).

      1H04   Change 1H03
Revenues Actual - as reported $10,436   3.6% $10,078
  Forecast (EDS) $9,574   -5.0%  
Net unexpected revenue boost $446 $416 (est. currency impact)
Est. value of "discretionary spending" $892 (assuming a 1-yr average project length)

A company spokesman agreed with the general drift of our quandary.  He said that the EDS management had also anticipated a 3% to 5% revenue decline this year, according to the guidance it gave the Wall Street analysts in February.  But he credited EDS sales teams with winning enough add-on business ("discretionary spending") from existing clients (about $446 million - our estimate) to offset the anticipated revenue shortfall (see the table).  And, since all of the revenue growth took place overseas, currency translations also played a positive impact (about $416 million - also our estimate).

So that's how a revenue hole supposedly became a mound (a 5% drop turned into a 4% increase), according to EDS.  But we are still at a loss trying to reconcile the above $862 million positive revenue swing in the first half of 2004 with the following disclosure that EDS made to the SEC in its 10Q report:

Base organic revenues in the first six months of 2004 compared to the first six months of 2003 were flat due to a $132 million, or 5%, increase in EMEA and a $7 million, or 1%, increase in Asia Pacific, partially offset by a $94 million, or 3%, decrease in the Americas and a $5 million, or 1%, decrease in A.T. Kearney. Base organic revenues from contracts in the U.S. Government group were flat in the first six months of 2004 compared to the first six months of 2003.

As you can see, the $137 million revenue increases in Europe (EMEA) and Asia Pacific are puny compared to the $862 million positive swing between the forecast and actual revenues (see the above table).  And the differential becomes practically negligible when one deducts from it the $99 million decline in Americas and A.T. Kearney - the only EDS operations that seemed to fit the anticipated trend.

Furthermore, if we look at the second half of this year, we see additional revenue holes forming.  Among some major deals, Texas Medicaid and the Inland Revenue contracts came to an end in the first half of the year.  The Dow Chemical deal is also all but over, as you saw above.  Between these three alone, we figure that's another half a billion dollars of annual revenues gone down the drain.  And God only knows how many other smaller deals may be in the same boat, such as the ailing airlines, for example.

EDS also warned in its second quarter 10Q report about additional negative factors that would affect its revenues this year:

The decrease in base organic revenues in the Americas in the first and second quarters of 2004 was primarily due to the impact of renegotiations of contracts with certain airline clients. The increase in base organic revenues in EMEA was primarily due to contracts with financial services and government clients. Base organic revenues in the U.S. Government group were favorably impacted by growth in our federal business offset by runoff from our state and local business, including the termination of the Medicaid contract with the State of Texas early in the first quarter.

Declining Renewal Rates

Answering a question by an analyst during the second quarter earnings call, the EDS CEO Michael Jordan said that its latest renewal rate was (only) 14% (of new contract sales).  Since that seemed quite a bit lower than what we recalled the company's traditional renewal rates were, we went back to try to reconstruct its recent history.  And here is what we've found:

As you can see from the above charts, the EDS renewal rates are indeed down.  Some analysts on Wall Street have interpreted that as good news, assuming that the rest of the business came from new clients.  Wrong assumption!  Most of the rest of the new contract sales came from add-on business from existing clients.  Jordan said as much during the earnings call.  The EDS spokesman with whom we discussed the subject also confirmed that.

"The primary driver supporting our better than expected (based on our original 04 guidance) revenue performance for the first 6 months of the year was primarily due to selling various services into our existing client base," he wrote in an e-mail.

In the second half of the year, however, EDS will focus on new signings and new clients, the spokesman added.  He cited "new sales rules, tools and processes," as well as the new sales leadership team, as reasons for his optimism. 

So there you have it... Amid all the bad news that seems to be hitting the company these days, EDS is still managing to grow its revenues, at least according to its financial statements.  And despite the losses it had racked up in the first half of 2004, the company still expects to turn a profit of 20 to 30 cents per share for the full year.

Well, maybe some gullible Wall Street analysts or investors are lapping up such rosy forecasts and turning them into their own "feel good" fables.  (The EDS stock moved up 1.2% today despite the "bad news" stories).  But count us out.  Short of deploying some accounting "black magic," we think EDS would be lucky to reach $20 billion in revenues this year, and to turn any profit at all.

Happy bargain hunting!

Bob Djurdjevic

EDS Prevails in HUD Dispute

P.S. EDS announced in the afternoon of August 9 that it had prevailed in a contract dispute with Lockheed Martin over an $860 million deal it was awarded in August 2003 by the federal Department of Housing and Urban Development (HUD).  The new scaled-down version of the original contract is estimated to be worth up to $750 million over 10 years, if all options were exercised.

"It has been a long and arduous process but the new award by HUD reaffirms that EDS offered the superior solution -- twice," said Jim Duffey, EDS' newly appointed vice president, Global Sales and Client Solutions - U.S. Government, in a release. "We all look forward to getting back to the task of providing immediate and sustained modernization to support the HUD mission objectives."

The "HUD win II" is a sorely needed good news-story for a company that has been plagued lately by a plethora of bad news.

For additional Annex Research reports, check out... 

2004 IT Services: Moody's Lowers the Boon on EDS (July 2004); HP: Delivering Value Horizontally (June 2004); Accenture: Revving Up a Notch (June 2004); Beware Your CFO! (May 2004)IBM: Changing of the Guard (May 2004); Capgemini: Texas-size Home Run (May 2004); Following the Money (May 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 EDS: “Biggest Feather in Cap’s Cap,” (Dec 2003); "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: 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 XX, Annex Newsflash 2004-15
July 15, 2004

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

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