Confidential Client Edition

IT SERVICES

Analysis of CSC’s Third Fiscal 2005 Quarter Business Results

Gearing Down on Purpose

Revenue, Profit Growth Slows, New Contracts Drop, Following Divestitures

PHOENIX, Feb 9 – After a year of ferocious upward spurt, Computer Sciences Corp.’s (CSC) growth engine is starting the sputter.  Revenue grew by only 5.6% in its third fiscal 2005 quarter that ended Dec 31, while earnings from continuing operations increased even more modestly (70 cents per share vs. 68 cents per share a year ago). 

But at least they were $398 million of bottom line profits, not losses that needed executive tap dancing to be turned into earnings.

Perhaps the most worrying, however, was a slowdown in CSC’s new contract awards, the company’s most impressive business improvement in the last 12 months.  While its third quarter total of $5.3 billion is still the best quarterly sales record this fiscal year, it is down 13% from the $6 billion in the year ago-quarter.  Commercial contracts outpaced the government ones in the quarter by a four-to-one ratio.  The trailing 12 months’ new business awards, however, totaled a strong $17.5 billion, but only $15 billion of it came from continuing operations.

CSC announced in December that it would divest itself of two former DynCorp divisions for $775 million in cash.  The transaction is due to close next week.  The units’ revenues during the first nine months of the current fiscal year were $1.4 billion. 

As a result, CSC estimates that its full fiscal year revenues will decline to $14 billion from $14.8 billion in fiscal 2004.  Which means that Accenture, with calendar year revenues of $14.3 billion, has now again displaced CSC as the world’s third largest IT services firm.  The two companies have been in the neck-and-neck competition for third place for most of the last decade.

Sacrificing Profits for Morals

As for the divested DynCorp businesses, the company disclosed that its revenue growth rate has been higher than that of the rest of CSC, and that its profit margins during the last 15 months have been “high and rising,” according to CSC’s CFO, Leon Level.

Naturally, this raised some analysts’ eyebrows.

“They’ve been higher than the average and rising?” one perplexed analyst repeated the statement during the teleconference that followed the earnings release.

“Yes,” Level confirmed.

“So why would you divest it?”

Good question. 

“Because of what the business has done and the price we have obtained,” Level tried to level with the analyst. 

The answer didn’t sound very convincing.  “Does that suggest that you expect the margins to go down going forward?” the analyst persisted adroitly.

“You’ll have to ask the buyer,” Level replied cagily. 

An uncomfortable pause followed.  That’s when Van Honeycutt, CSC’s CEO, stepped in to help out his tongue-tied CFO.

“We sold the business for several reasons,” he said.  “Most of which is that it’s not a part of our core business.  We’re an IT services company, we’re not a security company; and we’re not a company that basically has casualty reports every day.  So it just didn’t fit with our profile.”

Guess not.  No strangers to financial casualties, taking human casualties every day is not exactly what IT services firms are known for when they take on outsourcing or systems integration contracts.  So even though war may be good for business of other “death merchants,” CSC drew the line when it came to its bottom line. 

“Okay,” is all the stunned analyst could think of saying.

Applying morality to business, even if it hurts, is a refreshing attitude on the part of CSC leaders.  But that seems to have spooked Wall Street, where money talks and nothing else matters.  The CSC stock dropped over three points in after-hours trading.  So it goes…

Business Segment Analysis

On the bright side, CSC’s global commercial revenues increased 11% in the quarter (up 6% in constant currency) to $2.37 billion, led by the same rate of growth in the U.S. market ($994 million).  European revenues rose 15% (5% in constant currency) to $1.07 billion, while the rest of CSC’s international business was essentially flat at $039 million (down 4% in constant currency).

CSC’s federal government business declined 4% to $1.14 billion, not just because of the divestitures, but also due to the completion of a major helicopter maintenance contract.

But the company hailed the federal pipeline of opportunities of nearly $28 billion, even though only $2 billion of which is supposed to be awarded during the current quarter.  So far, the company has won about $1.5 billion in new business this quarter, including commercial contracts.

Outlook

For the full fiscal year 2005, we expect CSC’s federal government business to decline in double digits, while its commercial revenues are likely to rise moderately (in single digits).  Coupled with the four-to-one commercial new contract awards ratio in favor of commercial customers, it seems that we are once again on the doorstep of another reversal in CSC’s business.  

The pendulum seems to be swinging in the direction of commercial customers once again.  Given that bigger competitors, such as IBM, are also experiencing a revival in corporate spending, the timing of CSC’s strategy change seems to be right, whether or not Wall Street sees it just yet.

Happy bargain hunting

Bob Djurdjevic

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