Electronic Data Systems: Buy or Bye-Bye?

Should you steer clear, or is this an opportunity created by Enron-induced hypersensitivity?
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Not too long ago, Wall Street applauded companies that grew faster than their peers. Now it places them under suspicion. In the case of Electronic Data Systems (EDS) , an information technology giant accused of deteriorating earnings quality and business conditions, the market equivalent of house arrest might well come next.

New studies by two independent and two brokerage-based researchers raise concerns about EDS on three fronts: It faces increased risks that 2002 revenue and earnings could fall short of promises because of lackluster growth in new contracts; a wide-ranging reorganization announced Friday brings new operational risks; and it has allegedly taken advantage of gray areas in accounting rules to make income and cash-flow growth appear more electric than a less-aggressive approach would permit.

The EDS financial story is cross-eyed complicated but worth examining. Its travails are emblematic of firms that grew huge by feeding the appetite among governments and industry for outsourcing -- the practice of taking on data-crunching, transaction-processing and other services that are outside an organization's core competency. As the yen for these projects began to moderate during the recession, EDS and others, such as


(IBM) - Get Report


Computer Sciences


, faced the prospect of negligible growth in bookings from old and new customers alike, as well as a falloff in pricing power.

Investors have already taken note of these issues and hammered EDS' stock down 30% in the past five months, driving it to about $51 on Monday from its November high of $72. Shares now trade at a paltry forward

price-to-earnings ratio of 15 -- a level that Merrill Lynch, in a report on Friday, called as low as it has ever sunk.

That makes the company a poster child for the problem with today's large-cap technology stocks: If you believe the information economy has hit bottom, it's time to take advantage of the palpable panic and start nibbling on EDS shares. Yet the company is still vulnerable to the sort of body blows suffered by

Bristol-Myers Squibb

(BMY) - Get Report

last week or IBM this week when each confirmed widely held fears by steering estimates downward under similar pressure.

To be sure, EDS -- spun out of

General Motors

(GM) - Get Report

in 1996 -- is still a powerhouse in its industry. New management initiated a turnaround in 1999 and reaped rewards by sailing through 2001 without lowering guidance as tech companies elsewhere were crushed.

In just the past few months, it has announced multimillion-dollar deals with the British post office, the Dutch bank

ABM Amro


, electronics maker


(EMR) - Get Report

, the governments of Pennsylvania and Kansas, and many others. And on Friday it announced plans to go after the multibillion-dollar technology consulting business abandoned by Big Five accounting firms such as Arthur Andersen.

But even when you add up all the new business, says Rod Bourgeois, an analyst at the independent research firm Sanford C. Bernstein, it looks as if EDS is headed for the sort of stumble that took its shares down 24% in one day back in June 2000, in the early days of the company's comeback. Although he's still an ardent bull on its long-term prospects and would buy on a wipeout, he says investors "should have concerns" about EDS' ability to meet guidance in the first half of 2002.

So should you stay away or get involved? Let's take a closer look.

When Earnings Growth Outpaces Cash Flow

Camelback Research Alliance, an independent company that provides tools for financial information, says investors should have seen this coming when EDS issued its fourth-quarter earnings report and 2001 annual report earlier in this year. Camelback provides research on earnings quality to institutional clients and raised a red flag when it noticed that while EDS' cash flow appeared to rise in 2001 vs. 2000, it would have fallen if not for a tax bill that came in $327 million lower than the prior year. Additionally, Camelback noted that cash flow has been steadily declining over the past five years -- from $2.2 billion in 1997 to $1.7 billion in 2001 -- at the same time that earnings have been reported as rising from $730 million in 1997 to $1.36 billion in 2001.

Camelback's analysis of historic earnings-quality trends across the market has led it to the belief that when income growth exceeds cash-flow growth over long periods, investors should be concerned because it is much easier for companies to fudge earnings figures than cash-flow figures. Camelback believes that once the quality of a company's earnings and cash-flow stream begins to deteriorate, its stock usually declines over the following 12 to 24 months as investors question their assumptions. In this case, an EDS spokesman said cash flow would pick up the pace in coming years as payments from new contract signings kick in.

There's more to the story than cash-flow trends, however. Donn Vickrey, vice president at Camelback, notes that while EDS' fourth-quarter report shows the company recorded revenue up 12% and income up 19% year over year, much of the difference came from an $814 million increase in what accountants call "unbilled revenues" and, to a lesser extent, restructuring charge reversals.

The Twilight Zone of Accounting

Why is this a big deal? For that, we need to wade into the accounting Twilight Zone. Unbilled revenues represent receipts from long-term consulting contracts that have not been billed to the customer by year- end. When a company books unbilled revenues under "percentage of completion" accounting rules, it is declaring that a portion of contracted services is complete and that it expects the money to be collected later.

Now, it's important to note that there are at least three categories of dollars that can be booked as revenue. The best is cash -- e.g., Company X sells a service to Company Y and receives a check. The next best is accounts receivable -- e.g., Company X sells a service to Company Y and books the value of a credit while awaiting the check. Third best is unbilled revenues -- e.g., Company X sells a service to Company Y, then books the value of the deal before even asking for the check.

Accounting for these unbilled revenues is somewhat subjective. Much of EDS' unbilled revenue in 2001 stems from a contract with the U.S. Navy to build a 400,000-seat intranet site. Under the terms of the deal, EDS must pay for all the construction costs up front; it doesn't get a dime from the Navy until the system goes into testing and operation.

To match revenues with these costs, companies are permitted under accounting rules to estimate the costs and profits of the deal, and book them as if they had already been billed and received, rather than simply promised. While the fixed costs are rarely in dispute, the profit is an educated guess and could be disputed by the client many years later when actually billed. Additionally, companies might ultimately have a hard time actually collecting on the contract if the client runs into financial trouble. While that's not a concern with the U.S. Navy, it could be a problem with other clients. An EDS spokesman says that the firm has booked only costs, not profit, in the Navy deal so far.

In addition to its concerns strictly on the numbers, Camelback doesn't like the fact that EDS' auditor, KPMG, receives almost twice as much for nonaudit services as it does for auditing: $9.4 million vs. $4.8 million, potentially providing motivation for KPMG to accept aggressive accounting methods more readily. Plus, insider trading is overwhelming on the sell side. The only insider purchase reported during the past two years was Frederick Douglas, who purchased 500 shares at $42.56 in July 2000; yet there have been about 140,000 insider shares sold since that date at prices ranging from $57.62 to $70.98.

Also, EDS' debt-to-equity multiple is moderately higher than at rivals IBM and Computer Sciences. And finally, brokerage RBC Capital Markets, among others, notes that the corporate reorganization announced Friday brings "increased management execution risk" at a difficult time.

The Brighter Side

The good news? EDS has an impressive board of directors composed of experienced executives outside the company, including James A. Baker III, former White House chief of staff; Roger Enrico, former chairman of Pepsi; and C. Robert Kidder, chairman of Borden. The board's audit committee is also strong and independent. There is no evidence of questionable related-party transactions, as there were at


. And EDS' debt ratings are strong.

Considering that EDS shares have already fallen 20% since Bourgeois at Sanford Bernstein issued his downgrade in mid-March, and by a third since their November peak, it's possible that investors have already accounted for all of the negative issues in the current price. But history shows that if and when a company confirms suspicions, there is room for further downside. The company has almost two weeks in which it could issue new guidance before earnings are announced on April 22.

The bottom line: EDS has a powerful franchise in a growing field, and its fallen price has brought expectations closer in line with economic reality. When big companies with reasonably decent balance sheets fall to five-year P/E lows, value-oriented investors with a two-year horizon unafraid of considerable risk should take notice. I will add a half position of EDS shares to the SuperModels portfolio if shares fall to $45 or less; stop loss at $37.

At the time of publication, Jon Markman owned or controlled shares in none of the equities mentioned in this column.