Updated from Feb. 5

Electronic Data Systems

(EDS)

slid 6% Friday after another weak earnings report spurred a series of negative moves by Wall Street firms and a ratings agency.

On Thursday, EDS saw its fourth quarter wrecked by a troubled Navy contract.

The computer services giant posted a fourth-quarter loss of $354 million, or 73 cents a share, after writing off all the deferred costs -- totaling some $559 million -- stemming from its Navy Marine Corps Intranet, or NMCI, project. The huge Navy contract has been a drain on cash -- and management attention -- since former EDS leaders first landed the "prize" deal more than three years ago.

EDS now expects the project to generate "$800 million to $1 billion in free cash flow through 2007." After numerous missed deadlines, the company had previously said the project would generate positive cash flow this year.

"We have changed our approach to the NMCI program and have developed a more efficient and predictable rollout schedule with our client," explained EDS CEO Mike Jordan. "Our fourth-quarter results, excluding NMCI, met expectations. ... We are continuing to put EDS's house in order."

But some observers didn't quite see it that way. Standard & Poor's put EDS debt on CreditWatch with negative implications, citing reduced cash flow. And both UBS and SG Cowen trimmed their ratings on the stock. On Friday, EDS slid $1.39 to $21.90.

Mixed Messages

Excluding special items, EDS actually managed to beat fourth-quarter earnings estimates of 11 cents a share by a penny. Meanwhile, fourth-quarter revenue of $5.76 billion -- up 8% from a year ago -- came in 6% higher than expected. And fourth-quarter cash flow of $387 million toppled some analyst forecasts.

Contract bookings, totaling $4.3 billion during the quarter, offered some upside surprise as well. Even so, the company managed to attract just over half as much business as it did one year ago. And it offered a darker outlook for 2004 than some had expected.

For the second quarter in a row, EDS lowered its 2004 cash flow projection. It now expects to generate between $500 and $600 million -- down from $600 million to $800 million -- this year. It also issued 2004 earnings guidance of 50 cents to 60 cents a share that falls well shy of the current 98-cent consensus estimate. EDS blamed the NMCI contract for much of the shortfall in both cash flow and earnings per share.

"We believe we have a realistic view of our business prospects for 2004," Swan stated on Thursday.

Some analysts were already braced for the worst. In a detailed research note issued on Wednesday, UBS analyst Adam Frisch predicted that EDS would report a weak fourth quarter and -- more importantly -- "take a rather sober view of top- and bottom-line growth potential in 2004." Frisch, who's been quick to expose EDS's vulnerabilities in the past, offered a laundry list of reasons for his bearish outlook.

He dwelled on weak contract bookings -- and the continued reliance on renewal contracts -- in particular.

"Our expectation for weak fourth-quarter signings represents continuation of a general trend which has persisted for the past two years," noted Frisch, who has a neutral rating on EDS shares. "We believe that significantly weaker bookings over an extended period of time will have a material and longer-term impact to future top-line growth, as existing projects and contracts in backlog will not be sufficient to offset contracts and revenues that either get terminated or expire."

In the meantime, EDS continues to struggle with several major contracts already on its books. Even before Thursday's update, Frisch warned that EDS remained well behind schedule on its huge cash-draining project for the Navy. Although he credited management for making "slow and steady progress" on the Navy deal, he said that even his "best-case scenario" showed EDS missing its own targets. Indeed, he said, the company would have to speed up its progress dramatically -- shifting Navy computers onto the new EDS system at four times its current rate -- in order to meet even low-range targets for completion.

As a result, Frisch was convinced that EDS's 2004 cash flow guidance -- a crucial metric management already lowered in October -- would come down again. Merrill Lynch analyst Jennifer Dugan expressed similar worries in a Wednesday research note as well.

"Our key concern is that EDS's ability to generate sustainable free cash flow will fall below many investors' expectations," wrote Dugan, who recommends selling EDS's stock. "In our view, a significant 2004 cash flow guidance reduction could push the stock back into the mid-high teens, given the investor attention paid to cash flow-based valuation."

Over a Barrel

Because analysts have low visibility -- and wildly varying views -- on EDS's earnings, investors have come to rely more heavily on EDS's cash flow as a measure of the company's health. Dugan predicted on Wednesday that EDS would ultimately deliver $377 million in free cash flow this year, or 37% less than the company's lowest estimate. Frisch, too, warned that EDS's prior 2004 cash flow projections million were too high.

Frisch also cautioned investors to pay more attention to EDS's biggest source of revenue. Sales to

General Motors

(GM) - Get Report

fell 14% to $565 million in the latest period. And Frisch, for one, worries that EDS could lose even more GM business going forward.

"We believe this approximate $2 billion chunk of business will be hotly contested by a variety of other large, leading IT services vendors," Frisch wrote. "In our opinion, potential deterioration in volumes and pricing from this ...

contract renegotiation is a medium-term risk which has not yet been adequately considered by the Street."

Already, Frisch noted, EDS's market position is weakening. And he believes a negative trigger down the road, such as a possible credit downgrade to junk, could cost the company even more business down the road.

Still, he stopped short of predicting that investors would react to Thursday's news -- however disappointing -- with any real panic.

"We recognize the possibility that a new 'vision' and management team will buy EDS more time with the Street to show progress in recovering from its severe operational and financial issues," Frisch wrote. "Although these fundamentals will likely not meet even modest expectations, bullish talk from the recently acquired management team about a 'new EDS' could support the favorable investment case maintained by deep-value investors, who are more focused on the company's earnings power in 2005 and beyond."