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Smooth Sailing Eludes EDS on Navy Deal

The megadeal to end all megadeals continues not to pay off, pressuring cash-flow targets.

Electronic Data Systems

(EDS)

continues to weather hits for its sunny optimism.

Last week -- exactly a year after EDS plunged on a massive profit warning -- Wall Street predicted darker days ahead for the Texas technology giant. Morgan Stanley stepped forward with a new 23-page report casting fresh shadows on EDS's huge, but problematic, contract with the U.S. Navy.

Specifically, analyst David Togut warned that EDS has little chance of seeing the cash it expects from the Navy-Marine Corps Intranet (or NMCI) project in the coming year. His analysis, in fact, gives EDS "less than a 1% probability" of achieving the project goals necessary to hit cash flow targets in 2004. He projects that EDS will instead deliver free cash flow of only $580 million -- 30% less than management guidance -- next year.

Since Wall Street views cash flow as a crucial measure of the company's health, such a shortfall could be crippling.

"The

NMCI ... contract remains EDS's most critical cash flow swing factor," wrote Togut, who has an underweight rating on the shares. It "should continue to drain EDS resources through 2004."

Although EDS believes the NMCI contract will generate positive cash flow by the middle of next year, the company has missed similar targets already. Meanwhile, the thrill of winning that multibillion-dollar contract -- the government's biggest outsourcing deal ever -- has long worn off. Indeed, some industry experts now marvel that they ever applauded the megadeal at all.

"Back in October of 2000, it sounded like a great victory," admitted Bob Djurdjevic of Annex Research in Arizona. "But these so-called megadeals are like a game of chicken. The last company to say 'no' gets stuck."

Under the leadership of Dick Brown -- ousted as CEO in March -- EDS aggressively pursued such deals as a way to grow the company. But the megadeals require huge upfront cash investments that often return just razor-thin profit margins down the road.

The Navy contract, riddled by unexpected challenges and delays, has been particularly expensive. After three years -- and an estimated $2 billion in capital outlays -- EDS still has a long way to go before it can turn a dime of profit on the deal.

Meanwhile, without the strong sales leaders from Brown's regime, EDS has also suffered a sharp decline in the new, less capital-intensive contracts needed to boost current results. Granted, the downturn is somewhat self-inflicted, as EDS steers clear of massive projects -- like NMCI -- that gobble up precious cash the company is now trying to preserve. But with competitors like

IBM

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and

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faring better, EDS can't necessarily blame the rest of the shortfall on the industry.

"There is no generic problem in the industry per se," Djurdjevic said. "But there is an EDS problem ... It all started a year ago."

Crash Landing

By last fall, the Navy project was nearly a year behind schedule and still facing new challenges. But EDS had more immediate concerns. The company was running behind on its profit goals as well. Indeed, it had just two weeks to earn the bulk -- some 80% -- of its quarterly earnings or break its promises to Wall Street.

The company wound up issuing a massive profit warning that battered its shares and triggered a mountain of analyst downgrades. In a single day, the stock -- once a $60 highflier -- plunged 53% to $17 a share and has yet to recover most of that ground. On Friday, EDS added 15 cents to $21.10.

A full year and new management team later, Wall Street remains suspicious. Certainly, Morgan Stanley isn't blindly trusting projections about the company's most important contract. Togut points out that the Navy project has "consistently missed goals set by EDS management due to a combination of EDS management turnover, U.S. military activity and persistent project execution shortfalls." Only if EDS actually slows its progress -- a counterintuitive move that would nevertheless generate rich penalty payments -- does Togut see the company hitting 2004 cash flow targets. And by moving forward at its current rate, EDS could miss those targets by a mile.

"We project that NMCII free cash flow will improve $59 million year-over-year ... less than one-third of management's projected $200 million increase" under such a scenario, Togut said.

Togut believes the Navy deal will dent EDS earnings per share as well. He's projecting an 11-cent hit at least -- and probably double that -- in his 2004 profit forecast of $1.33 a share. On average, Wall Street analysts are expecting EDS to earn a dime more than that.

Rough Sailing

By now, EDS was supposed to be putting the final touches on a huge project that would bring thousands of military computers and servers together on a single Intranet system. But the company was bumped hard as it left the starting gate and, three years later, remains far from the finish line.

The multibillion-dollar project, as it turns out, was even more ambitious than anyone imagined. When EDS aggressively pursued the deal -- paring its bid down to $6.9 billion and hoping for performance bonuses -- the company had no idea it would encounter a massive web of computers entangled by some 100,000 software applications, many of them incompatible with modernized systems. Within months, worried government officials suddenly halted the entire project for rigorous weaponslike testing. Then, after work finally resumed, terrorists struck the Pentagon and destroyed part of the new Intranet system. A year after winning the contract, EDS had taken over only 12% of the Navy's 360,000 computers. And by the middle of this month, Togut calculated, the company had still shifted less than one-third of the Navy's computers onto the new Intranet system.

Still, EDS remains optimistic.

"Total orders are on track," said company spokesman Kevin Lightfoot, "and a key milestone is expected to be reached this fall with an integrated systems test."

But Togut doubts the government will act on that test, giving permission to add even more computers to the NMCI system, until the middle of 2004. In the meantime, he projects that EDS will have moved only 126,000 computers -- less than half the company target -- onto the new system by the end of this year. He is therefore convinced that NMCI will remain a drag on the company's performance throughout 2004.

Meanwhile, EDS itself has acknowledged that NMCI is a critical component of its overall cash flow guidance.

"Half of our improvement next year relative to this year is driven by performance on the Navy contract," CFO Robert Swan told analysts in a July conference call. "So it's a big impact this year and big expectations for it next year on a year-over-year basis."

But Togut questions whether the NMCI project has even advanced as much as EDS claims. He's worried that EDS is counting some computers -- still blocked by the government for complete funding -- as fully operational in the new system.

"We found growing disparities between EDS's management reports and data on the government's web site," he wrote. "This differential has nearly doubled" in the current quarter.

In short, Togut declares the NCMI situation "worse than we thought." But he points to other concerns as well. EDS also has underperforming contracts with

General Motors

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-- its former parent and biggest client -- and struggling companies such as the

American Airlines

unit of

AMR

(AMR)

and

MCI

. Meanwhile, it continues to struggle for the new contracts that once flooded its way.

Last quarter, EDS blamed a hit to total revenue -- which inched up only 2% with help from currency changes -- on dwindling business from GM. But the company's drop-off in new contracts troubled Wall Street far more. In the second quarter, EDS inked only $3.4 billion in new business -- down 45% from a year earlier -- and saw its cash flow plummet 88% to just $25 million.

For its part, EDS has pointed to new contracts, including a $426 million deal with

York International

(YRK)

, as signs of a turnaround.

"We are addressing the challenges around our cost structure, our productivity and our competitiveness," Lightfoot told

TheStreet.com

last week. "Recent wins and contract downselects demonstrate that we are making progress."

As part of its strategy, EDS has pledged to trim its American workforce and hire more cheap labor overseas. But Djurdjevic, for one, believes the company needs to be filling some key positions at home. For example, Djurdjevic says, EDS has yet to find a solid replacement for Doug Frederick -- the senior executive behind major deals like NMCI. Although he applauds the leadership skills of the new management team, Djurdjevic misses the old regime's sizzling sales ability.

"They know how to manage

the company very well," he said of the new leadership team led by CEO Michael Jordan. "But they need -- and still don't have -- strong and inspiring sales leadership."

To Djurdjevic, this weak spot is a huge one that's far more troubling than the Navy contract. Indeed, Djurdjevic has gained enough confidence in EDS's current management team that he's not especially worried about the Navy deal.

"In terms of new business, this is the most important account they have," he said. "I'd be skeptical of being skeptical."

Still, Djurdjevic will not regain his confidence in EDS until he sees new sales leaders -- like the megadeal pushers of old -- to reignite the company. Ultimately, he says, "it will take that and what they're doing already" to turn the company around.