Annex Bulletin 2005-16                            May 25, 2005

Confidential Client Edition

IT SERVICES

Analysis of CSC’s Fiscal Fourth Quarter and Full Year 2005 Results

Harvesting Records

Strong Results During Calendar First Quarter, Especially in Europe

PHOENIX, May 25 – What European slump?  Computer Sciences Corp.’s (CSC) fourth quarter of fiscal 2005 results, ended March 31, should dispel any doubts that IBM’s problems in Europe were pervasive. 

CSC European revenues were up 19% (up 14% in constant currency) to $1.3 billion, a new record.  The new business awards from the Old Continent contributed to record new signings (from continuing operations) in the fourth quarter and the full year.  And all that happened during the calendar first quarter of 2005, which was supposed to be weak, based on IBM’s results (see “Slammed and Dunked,” Apr 2005).

CSC’s worldwide net earnings in the latest quarter soared to $412 million, or $2.13 a share, from $191 million, or $1.01 a share, a year ago.  The company’s bottom-line figure was boosted by a one-time net gain of $230 million, or $1.19 a share, related to its sale of some of its DynCorp business units (see “Gearing Down on Purpose, Feb 2005). CSC also booked a special charge of $18.4 million, or 10 cents a share after taxes related to its redemption of $1 billion worth of debt, reducing its debt-to-equity ratio to an enviable 18%. 

Revenue from continuing operations increased to $3.9 billion in the period that ended on Mar 31, up from $3.6 billion a year ago.

CSC’s income from continuing operations, excluding special items, came in at 96 cents a share, while its profit from total operations was $1.04 a share.  On average, Wall Street was expecting EPS of $1.07 on revenue of $3.77 billion, according to a Thomson First Call survey.

No wonder CSC’s shares rose over two points in evening trading, after surging more than three points on Tuesday (May 24).  For the last six months, however, they are down about 21%, since reaching the 12-month high of $58 in December.  And CSC’s overnight gains also fizzled.  The stock was trading early morning today just a shade above its yesterday’s price of $45.78 (see the charts).

Full Year Results

For the full year, CSC reported revenues from continuing operations of just over $14 billion, up 5% from a year ago total.  The main reason for a (mere) single digit growth were the divestitures of two DynCorp units (see “Gearing Down on Purpose, Feb 2005).  But the sale dropped $314 million to CSC’s bottom line, boosting its total net earnings for the year to $810 million, up 56% from a year ago.

CSC also continued its strong sales performance closing $2.7 billion of new business in the fourth quarter.  This lifted the full year’s new contract awards to $16.8 billion, $16 billion of which came from continuing operations.

“We are pleased with our performance for the fourth quarter and the year,” said CSC’s CEO Van Honeycutt in a statement. “Given the re-profiling of our U.S. federal government business due to the divestiture, the redemption of term debt and strong major business awards, we have enhanced our competitive position and financial flexibility.”

The “re-profiling” resulted in a 6% drop in federal government business in FY05.  But Honeycutt said the pipeline of future opportunities in this market is up 31% from a year ago to $33 billion.  “And we intend to win our fair share of that,” he added.  Indeed, the company has already won $820 million in awards in FY06 to-date (meaning in the last six weeks).

In the commercial market, which represents two-thirds of CSC’s business, the company reported double-digit (11%) growth in FY05 to $9.4 billion.  As you saw from the opening paragraphs, the European market was particularly strong, rising 18% for the year.  With revenues of $4.3 billion, CSC Europe is now considerably bigger than its $3.8 billion U.S. commercial market.

Given IBM’s recent problems in Europe, especially in the services area, and Big Blue CEO’s comments that the company would become more aggressive, CSC executives were quizzed about whether or not they saw that being reflected in price-cutting.

Not so, replied Honeycutt.  “We see a lot of activity from them (IBM), but we don’t see irresponsible bidding.”  He added that the pricing has generally stabilized.  And that’s good news for both CSC and other IT services vendors’ shareholders.

“We’re mindful of the consolidating IT market,” said Honeycutt.  “But we don’t see anybody reckless bidding or trying to buy in.”

Strong Balance Sheet – Hint of Acquisitions

The redemption of $1 billion of debt to which the CSC CEO referred above cost the company $18.4 million in after-tax charges in the latest period, but it also significantly enhanced its balance sheet.  The debt-to-total capitalization ratio improved from 30% last year, to 17.6% in the latest period, boasted Leon Level, the CSC’s CFO.

The company also set a record annual free cash flow of $475 million.

So stand by for CSC to put some of the money it saved and it made to work.  “Given the strength of our balance sheet, maybe we’ll enter some market we’re not in yet, probably through acquisition,” hinted Honeycutt in the post-release teleconference with analysts.  He was not any more specific as to what type of an acquisition he had in mind.

Asked about what the best uses of its accumulating capital would be, the CSC CEO replied as if he were with Annex Research.

“If we can invest that cash in some spectacular acquisition, with great revenue and profit growth - that’s the best use of our cash,” Honeycutt said.  “Second to that would be securing new large transactions; and third would be lowering the share base” (i.e., stock buybacks).

It’s refreshing to see that there are some CEOs around who seem immune to the Wall Street stock buyback hype.  Honeycutt evidently believes that minding the store (investing in operations) is more important than greasing Wall Street palms.

Summary & Outlook

During the fiscal year 2005, CSC faced a number of challenges, both internal and external.  Internally, the company digested its 2003 DynCorp acquisition and sold off some of its parts.  Externally, the company faced soft demand for professional services, and a temporary reduction in federal government spending on projects that represent CSC’s sweet spots.

“Despite these challenges, we delivered record revenues, record earnings per share, record new business awards, record free cash flow, and a balance sheet that afford, for all practical purposes, unlimited flexibility,” said Level, the company’s CFO.  He had good reasons to be boastful.  For, it is in hard times that management’s mettle is tested.

So what can we expect in fiscal year 2006?

Honeycutt predicted the company’s fiscal 2006 profit would range between $3.20 and $3.30 a share.  The CEO pegged revenue for the year at between $15 billion and $15.2 billion, up 7% to 8% over the fiscal year 2005 total.

Those are modest goals.  They certainly seem easily achievable under the current market conditions.  Looks like CSC is setting the bar intentionally low so it could harvest a new crop of records a year from now.  Which is not a bad policy given that the company is not trying to buy favors on Wall Street through stock buybacks.

Happy bargain hunting!

Bob Djurdjevic