A losing gamble on its stock price cost

Electronic Data Systems

(EDS)

dearly Tuesday, but the company's hedging pratfalls are far from its biggest worry now.

Enduring its second free-fall in less than a week, EDS tumbled 29% after Merrill Lynch issued a critical report about the company's employee stock option plan. Merrill said EDS' hedging strategy -- which banked heavily on a climbing stock price -- has cost the company $225 million, effectively eliminating all free cash flow for 2002.

Merrill slashed its EDS recommendation to sell and withdrew all earnings guidance for the company after learning of the losses. The firm's action, which sent EDS plunging to a decade low of $11.68 a share, came just days after EDS issued a nightmarish earnings warning that chopped its stock price in half.

In addition, Tuesday's selloff appeared to alert investors that the company could face further problems down the road. Some analysts wondered whether EDS could continue to win big contracts as financial questions loom increasingly over the Plano, Texas, company. Others noted that EDS has been winning fewer big deals recently, an unsettling trend that could further penalize investors.

Caution

"We are now more cautious, even from the current price level," Merrill Lynch analyst Stephen McClellan wrote Tuesday. "The share price is likely to be under pressure as side effects ... surface."

Merrill Lynch raised concerns about EDS' earnings and cash flow, in addition to derivative charges expected to cost the company 21 cents a share.

EDS' derivative losses, paid for with commercial paper issued Friday, resulted from the company's attempt to minimize the costs of its stock option program through the use of derivatives like puts and forward investment contracts. The plan, implemented when EDS' stock was well over $60, has backfired in the wake of EDS' plunge below $20.

"They sold puts on their own stock, never dreaming it would go down this far," one short-seller said. "What they undertook as a profit center has turned into a disaster."

Cliff-Diving
EDS since inception...

And this week

EDS has described its strategy as a "standard hedging technique" against employee stock options that poses no threat to its income statement. But UBS Warburg warned months ago that such an approach carries risks -- as

illustrated by the experience of PC giant

Dell

.

"While many companies choose to hedge their employee stock option exposure via share buybacks, EDS chose to engage in these forward contracts, and is now suffering the consequences resulting from the sharp drop in the stock price during 2002," wrote UBS Warburg analyst Adam Frisch.

That warning -- the second issued by UBS this summer -- came a month before EDS stunned Wall Street with news that it would fall 82% short of third-quarter earnings expectations. After slashing its guidance, EDS saw its stock price spiral to then record lows and the cost of its derivative contracts multiply.

Questions

Since then, analysts have increasingly questioned the credibility of EDS' management team. Even before the latest warning, Frisch said investors have "a lack of conviction in EDS' earnings guidance." Other analysts have since followed Frisch's lead, saying that recent developments create serious doubts about EDS.

Many observers believe EDS still faces incredible challenges going forward. They say the company is increasingly dependent on winning massive contracts to hit sales targets. And they've expressed concern that EDS' precarious financial situation could threaten its ability to compete with industry leader

IBM

.

EDS has expressed confidence in its ability to snag big business, blaming its earnings shortfall on an overall disappearance of corporate spending. But analysts are more pessimistic.

"We do not share EDS' confidence that it is not losing market share," John Jones, an analyst at Soundview Technologies, wrote in a research note last week.

UBS agreed, citing recent shortfalls by the company.

"EDS has failed to win three key mega deals year-to-date," UBS wrote last month. "And in fact, EDS has not won a new billion-dollar-plus outsourcing contract since March 2001."

EDS, ranked second in the computer technology industry, is currently battling for a crucial multibillion-dollar contract with

J.P. Morgan Chase

-- a firm that ironically issued a harrowing earnings warning that coincided with EDS' own. UBS described such contracts as the "lifeblood" of EDS' growth.

But UBS expressed caution about EDS' future, indicating that the company's dry spell could very well continue.

"EDS is still in the running for two large deals in the financial services area," UBS wrote. "But the competition is fierce, and it is difficult to rest an investment thesis on two potential decisions, given the volatile environment."