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Walls Starting to Close on EDS

A Moody's downgrade, sagging earnings and a big bond offering suggest all is not well.

Electronic Data Systems


could use a little of what it sells.

The computer services giant, which promises "business solutions" to everyone from the U.S. government on down, desperately needs a way out of a slowly closing trap. In a nutshell, the company's earnings are sagging. Its expenses are soaring. Its debt load is climbing. And its credit is racing toward junk.

Indeed, UBS analyst Adam Frisch -- well-known for his early warnings on the company -- could manage only the slightest reassurance in a dark report issued Wednesday.

"We do not see a near-term bankruptcy crisis looming," Frisch offered, forecasting less dreadful possibilities instead.

Specifically, Frisch predicted that EDS actually could deplete its cash pile -- and turn to peddling assets and borrowing more -- on its risky turnaround journey. In the meantime, he warned that Tuesday's downgrade by Moody's may not be the last.

Moody's lowered EDS' credit to its lowest investment-grade level -- and left the door open for a possible cut to junk -- over concerns about the company's weak cash flow, high severance expenses and future turnaround risks. The downgrade, issued after the market closed Tuesday, took a toll on the company's shares. The stock, which had rallied 50% in recent months, tumbled 4.5% to $21.59 in late afternoon trading.

Surprise Twist

Moody's latest action came despite a huge infusion of fresh cash for EDS.

The one-notch downgrade, issued in anticipation of new capital, was in fact widely expected. But the capital offering itself brought some troubling surprises.

Just last week, EDS told analysts that it planned to raise $500 million to $750 million through capital offerings. But the company actually followed through with two private placements totaling $1.1 billion. And it reportedly promised extra interest -- if its credit falls more -- just to sweeten the deal.

Frisch, for one, was a bit taken aback.

"The offering amounts are higher than we anticipated, possibly indicating greater cash needs than management suggested," wrote Frisch, who has a neutral rating on the stock. "We are concerned that EDS' financial position in the near term is not nearly as good as we thought a few weeks ago."

And Frisch hasn't been terribly optimistic in a while. In comparison, Prudential analyst Bryan Keane was almost jolly after last week's meeting. He proclaimed then that the "positives

were slowly starting to outweigh the negatives" at struggling EDS.

"We believe ... liquidity appears to be under control," wrote Keane, who also rates the stock a hold. "And we were encouraged by the new management team's vigor to turn the business around."

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But even Keane conceded that serious challenges remain. And Moody's helped drive that message home with its latest action.

Moody Blues

To protect its credit -- and dodge a trip to the junkyard -- EDS must pull off three big feats.

It must limit the cash it spends on new mega-deal contracts like the ones that fueled its growth. It must generate cash from old contracts -- particularly a troubling Navy deal -- that have so far been a drain. And it must keep tapping outside sources, such as the capital markets and banks, for extra cash.

But there could be problems. Frisch points with particular concern to the costly Navy deal.

"Based on our conversations with

Navy personnel and contractors ... we continue to believe that the cash flow stability from the ... contract my not be achievable any time soon, given that major milestones have not yet been achieved and the planned seat rollout appears too aggressive," Frisch said.

Meanwhile, Keane acknowledged that big contracts have cost EDS plenty already. And he cautioned that new setbacks would continue to hit the company's earnings and its credibility going forward.

Frisch said the stock is already overvalued. He mentioned the usual lack of earnings visibility. But he also stressed that EDS faces "significant operational and financial issues."

Funny Money

Right now, EDS appears to have plenty of cash. Even Moody's pointed out Tuesday that the company has a $2 billion cushion -- counting borrowing power -- that should protect it going forward.

But the company has plenty of obligations.

There's a $772 million convertible put option that's due in October. There's $290 million in dividends. There's $200 million for restructuring. There's the $227 million vendor payment Moody's just triggered with its downgrade. There's another $360 million receivables account to satisfy if Moody's acts again. And there is, of course, business to fund as usual.

In the meantime, there is a crucial bank facility -- requiring a strict net worth -- still left to negotiate.

Frisch can easily imagine the worst.

"Based on our calculations, EDS would have no cash to run the business net of existing cash obligations" after a downgrade to junk, he wrote. And "we believe EDS could very likely violate the net worth covenant."

For now, Frisch sees EDS shares going nowhere but down.

"We believe sustainable strength will not be possible until these issues subside," he said. "And we expect shares to be weaker on recent news."

Even after Wednesday's dip, EDS continues to trade above Frisch's current 12-month price target of $21 a share.