Analysis of EDS' 3Q03 Business Results (Oct 30, 2003)

PHOENIX, October 29 – “No pain, no gain,” is what doctors usually say when trying to justify a radical medical procedure. But what if it turns out to be “pain without gain?”

Well, that just about sums up what the Electronic Data Systems’ (EDS) shareholders and employees have been through during the first nine months of 2003. The $2.24 billion accounting charge, announced Monday, quantifies the amount of pain they’ve had to endure.

As a result, EDS has now lost $1.3 billion to-date in 2003, as compared to a $755 million net profit during the comparable period last year. It has announced work force reductions of 5,200 people, or 4% of its total employment. And it has posted a negative free cash flow of $303 million, versus a positive $110 million a year ago.

One thing is for sure… EDS’ shareholders and employees deserve high marks for pain tolerance and are entitled to some powerful painkillers.

Oddly enough, a street that has not been exactly known for awarding masochism did just that. The day EDS announced its “megacharge” (Monday), the company’s shares rose 1.8% to $20.97. The stock continued to climb (to $21.85) before today’s earnings release. And it went up to $22.10 in after-hours trading.

So despite all the pain and red ink, the EDS stock has outperformed both the market and its chief competitor (IBM). And not just in the last few days, but also during the last six months (see the chart on page 2).

Okay, so much for pain. What about gain? There is some good news, although one has to dig deep to find it.

The 13% increase in third quarter new contract signings is one bright spot. The 6% increase in revenue is another, especially considering the 7% decline in GM business.

But the revenues would have dropped 2% as reported, prior to the new EITF-00-21 accounting rule[1].

Furthermore, the 2004 revenue may decline by at least $1.4 billion unless EDS recharges its sales engines and reverses its declining new contracts record. The new contract signings for the first nine months were down 41% ($9.7 billion vs. $16.4 billion).

(Assuming that the new contract sales end up down $10 billion in 2003, and given a seven-year average contract term, the annual negative revenue impact would be about $1.4 billion. Of course, that’s before any expirations, cancellations or “rescoping” – all of which could only exacerbate the EDS growth challenges).

The EDS CEO Michael Jordan, and the CFO Bob Swan, who fielded questions during the post-earning analyst teleconference, agreed with the above logic and math. And they admitted that the company’s results during the first three quarters were disappointing.

“Quality of (new contract) signings continues to improve… (but the) quantity (is) still problematic,” Swan said, referring to an earlier comment by the EDS CEO about the company’s “improving win rates.”

EDS executives also acknowledged that they expected “no dramatic growth” in the sales pipeline. Answering a question by an analyst, they said that future new contract sales growth would come from better win rates, rather than bigger pipeline.

Ouch… For, that implies the market or opportunity is flat or shrinking. Which may be the way EDS executives see the world, but is clearly NOT the case when it comes to their competitors.

As you saw in our recent report on IBM Global Services’ third quarter results, its contract sales were $15.4 billion, the best ever for the third quarter. The backlog was also up, from $112 billion to $115 billion, the highest it has ever been (see “Small Is Now Big at Big Blue,” Oct 16).

A month or so before IBM released its latest results, Accenture reported a 34% jump in its quarterly new contract signings, finishing the August 31 fiscal year end with a $16.1 billion total (see “Strong Finish,” Sep 18, 2003).

Hewlett Packard Services is due to report its latest quarterly results next month. Early indications are this competitor is seeing no slowdown in demand, either.

So the EDS problems are indigenous, not IT services industry or macro-economic in nature. Given that, to what end, we wondered, did the company choose to add to its pain by performing such elective “surgeries” as the EITF-00-21 accounting change?

We wanted to ask the EDS CEO that question during the analyst teleconference that followed the release of EDS’s third quarter results. But we never got a chance. So we posed the question afterward in a phone call to Myrna Vance, EDS’ director of investor relations.

She said that EDS wanted to get its cost structure under control, which would make it more competitive with its rivals. But we pointed out to her that EDS is already by far the leanest competitor among the top IT services vendors. And that it has been winning gold medals for frugality in our annual IT Services Heptathlons for years (with an SG&A expense-to-revenue ratios in the 9% range - see “2003 IT Services Heptathlon,” May 2003).

Nevertheless, EDS’ Jordan said today that his goal is to have a 7% SG&A expense-to-revenue ratio.

To us, it seems that EDS is trying to fix something that isn’t broken. Instead of adding to the sales firepower in order to grow the business, it is reducing it. That’s like rationing ammo to poor marksmen, or removing radars from airplanes and X-rays from hospitals in order to cut costs.

What does seem to be broken at EDS, however, is its low gross margin. At 10.4%, which is what it was in the latest quarter, it is up from 9.8% a year ago (restated). But both figures are pitifully low compared to IBM’s 25% gross margin in the latest quarters, or Accenture’s 36%, for example.

Which means that EDS is either pursuing too many big deals where price competition is intense and margins are low, or is discounting its prices across the board. Or both. Whatever the problem, the solution seems to selling smarter, not cutting costs. What EDS needs to do is develop new and different markets which would yield higher profit margins, not gloat over improving win rates with customers that are already bleeding EDS sales people dry.

EDS’ Vance also said that EDS has been working hard on “tackling the problem accounts.”

Still? We reminded her of our story from July 2000 about all the “pruning” of such problem contracts that the previous EDS management had done. We even did a photo-cartoon for the occasion (see “EDS Contract Pruning,” July 2000):

Over half a billion dollars in revenues is a heck of a lot acreage being “pruned.”

Millions of companies would “kill” for the privilege of being able to grow to the size of the limbs EDS has been severing.

Yet in the global IT services business jungle, eliminating low-margin or unprofitable contracts may be even more important for EDS’s long-term longevity than slashing costs and expenses. It’s kind of like getting rid of bad blood - the medieval doctors’ remedy “for all patients and all seasons.”

Still, more than $500 million in revenues is a heck of a hole to fill with new business just to be flat with prior year’s results… This was no “pruning.” This was evidently a long overdue “slash and burn” activity.

“So what happened?,” this writer wondered. “I thought after all this ‘pruning’ over three years ago, you wouldn’t have any ‘problem contracts’ left anymore.”

Vance replied that regrettably, the company had slackened off in this respect. And so here we are… “pruning” again. But she added that the company has been winning some major new contracts with more to come.

In the third quarter, the biggest percentage of new contract signings came from the U.S. government, which accounted for 41% of the total ($3.4 billion). As with EDS’ major competitors, in today’s global war economy, selling to the federal government appears to be the best bet. Manufacturing sector came second with 20% share of new contracts, with communications accounting for 11% of the total.

Meanwhile, back on the (Plano, Texas) ranch, the Americas and Asia/Pacific regions contracted in the third quarter, while the U.S. government and European business surged ahead. America’s revenues were down 3% in constant currency to $2.28 billion, while the region’s operating profit dropped 34% to $223 million.

As previously noted, the U.S. government revenues were up 39% to $790 million, while its operating profit jumped 195% to $29 million.

European revenues grew 4% in constant currency during the third quarter, while the operating profit on the Old Continent surged 563% to $152 million.

The Asia/Pacific revenues contracted 10% in constant currency to $246 million, while its operating profit jumped 29% to $12 million.

Meanwhile Among the EDS lines of business, an organizational structure left from the previous administration that the new EDS management has now virtually abandoned, outsourcing continues to grow in double digits (up 11%), while AT Kearny (consulting) continued to shrink, also in double digits (down 26%).

The Business Process Outsourcing (BPO), a relatively new concept in outsourcing in which some EDS competitors, like IBM and Accenture are thriving, grew by a modest 4%. The BPO sub-segment now represents about 13% of EDS’ revenues, with the IT (traditional) outsourcing accounting for 56% of the total.

While there are some signs of a gradual recovery evident in the third quarter results, EDS clearly has a long way to go before one can declare that the turnaround is under way. The company’s biggest challenge continues to be increasing new contract sales at higher gross margins than what the company has managed so far this year.

Cutting costs won’t increase revenues. EDS needs new sales leaders who will inspire its own troops and imbue its customers with confidence to do business once again with the company. And it needs to look beyond traditional customers to find new markets and opportunities for profitable growth.

To do that, however, it needs the kind of leaders who share that kind of a vision for the future of the company.

[1] EDS implemented this year new accounting rules governing when revenue is booked on long-term contracts. In the past, EDS booked a percentage of revenue it hadn't received to offset start-up costs, with the assumption the cash would come in later. Now, EDS will book most revenue as it is received. The approach, which more closely matches revenue and cash flow, is expected to shift revenue to future quarters from earlier periods, benefiting future earnings.