EDS Gets Benefit of Doubt Thanks to Outlook
Ronna Abramson
08/04/05 - 12:01 PM EDT
EDS continued its ride Thursday as two analysts upgraded
their rating on the IT services giant after it issued 2006 guidance late Wednesday that blew away expectations.
Shares of EDS recently soared $2.48, or 11.7%, to $23.77 in
trading that was more than two times average volume.
While expressing concern about revenue growth, Jefferies analyst
Joe Vafi raised his rating to hold from underperform, while J.P. Morgan
analyst Tien-tsin Huang raised his call on EDS to neutral from
underweight.
"Chronic revenue contraction ultimately needs to reverse at some
point," Vafi wrote Thursday morning. "However, we expect that
efficiency gains extracted from what is still extremely depressed P&L
profitability should translate into an earnings-and-cash-flow recovery
story over the next several quarters." His firm has not done banking
with EDS.
Vafi introduced an estimate for 2006 earnings of 93 cents,
representing a 72% increase from his 2005 estimate. However, that was
still slightly short of the company's
surprisingly optimistic outlook from a day earlier,
when EDS said it expects 2006 earnings of at least $1 a share. The
company said it introduced the guidance earlier than usual because it was so
far above the consensus estimate, which sat at 66 cents.
EDS executives, repeatedly peppered late Wednesday with analysts' questions about why they are so confident, attributed their bright outlook to
productivity gains from cost cutting and said improvements in its
massive contract with the U.S. Navy should offset any lost business
from
General Motors.
Vafi said his target of $600 million to $700 million in free cash
flow in 2005 -- flat year over year -- is still "somewhat disappointing"
but called management's view of free cash flow of $800 million to $1
billion next year "more encouraging."
Vafi said he believes it's still too early to have a very accurate
gauge of free cash flow because of the uncertain impact of future business with General Motors. The auto giant, which currently generates about 9% of EDS'
revenue, is opening up its contracts with EDS to competitive bidding,
with final decisions expected at the end of this year or early next
year.
"Overall, we feel that a negative outcome from the GM recompete
process could set back EDS' recovery into the 2007-2008 time period,"
Vafi wrote. "Nevertheless, management's comfort with establishing a
2006 target this early in 2005 suggests a higher degree of confidence
in the business outlook than we have seen in several quarters," he
acknowledged.
J.P. Morgan's Huang, meanwhile, ratcheted up his 2006 earnings
estimate far higher, to $1.20 a share, and estimated free cash flow
would jump to $860 million in 2006 from $600 million in 2005. But he
shared some of Vafi's concerns.
"We remain concerned about anemic revenue growth but expect 2006
free cash flow to be attractive," Huang wrote. "We continue to view
the GM contract as a key risk factor for the stock, but one that we
expect is priced into the stock." EDS is a banking client of J.P. Morgan.
Still, not everyone was swayed by EDS' confidence. "The timing and
precision of the calendar 2006 estimates and the high confidence level
of a team often criticized for missing guidance targets has us
puzzled," wrote UBS analyst Adam Frisch, who maintained his neutral
rating. "There wasn't anything incremental to help us form a more
logical path to EDS' big improvement projected in 2006."
"We can only help but wonder if there are renewed expectations
about potential M&A scenarios in a sector expected to have increased
consolidation in the next few years," he added.
Frisch further highlighted the uncertainty about the Navy and GM
contracts, productivity gains companywide, and also another big
complex contract with the UK Ministry of Defense. And he questioned
why free cash flow is expected to increase 40% to 60% yet net income
is expected to almost double.
Consequently Frisch said he was discounting the company's 2006 projections,
with his estimate for earnings sitting at 80 cents. "If the management
team does succeed, then we would consider it impressive," he said. "We, however, prefer to sit on the sidelines until we get a better
understanding of the drivers of the improvement and are able to make
some sense of the conflicting data points."
But Moors & Cabot analyst Cindy
Shaw said she believes management is actually "setting the bar low to
improve credibility with the Street."
"We believe EDS has turned the corner and its low margins and
restructuring efforts set the stage for superior FCF and earnings
growth over the next few years," she wrote. "In our view EDS has a
long (three years or more) and arduous road ahead, but we believe the
risk/reward is attractive over a 12 to 18 month horizon."
Shaw, who has a buy rating on EDS, raised her '06 earnings
estimate to $1.01 from 77 cents. But she said she believes that could
prove conservative, noting management indicated it expects to spend
$300 million less on growth initiatives next year and EDS has beat the
consensus estimate for four quarters in a row.
However, Shaw still assumes that EDS loses 45% of GM revenue in
July 2006, resulting in a hit of 20 cents to earnings per share. Her
firm hasn't done banking with EDS.
