EDS Doubters Sit Out Holiday Party

In keeping with the holiday season, investors aretreating EDS' ( EDS) latestmegadeal with the same wonder generally afforded tothe biggest present under the tree.

EDS detractors, banking on unimpressive contents,are still shaking the box for hints of what's inside.But EDS bulls already have celebrated Christmas early,sparking a festive 17% rally during a two-day spikelast week.

The bulls viewed the $4.5 billion Bank ofAmerica ( BAC) contract -- EDS' first megadeal in months-- as sure-fire delivery from an otherwise barrenholiday season. The contract ended a three-month dryspell that began with a September earningswarning that shattered management'scredibility on Wall Street.

Since then, EDS has lostout on highly anticipated megadeals with the likes of Procter & Gamble ( PG) and J.P. Morgan Chase ( JPM).

An EDS spokesman described the Bank of Americadeal as a "vote of confidence" in the company'sfuture.

"This ranks among the top five contracts EDS hasever signed," said John Clendening. "And it's the largestcontract we've signed this year."

Understandably, EDS investors welcomed the Bank ofAmerica deal as the perfect holiday gift. But assplendid as it may appear at first glance, someanalysts caution, that gift has yet to be fullyunwrapped.

Critics also are warning that bullish investors --who have pushed EDS' share price to double itsSeptember lows -- continue to overlook the basicproblems that the company has faced throughout adifficult 2002. Those challenges range from weak cashflow and thinning profit margins to strong competition and potential legalrisks.

Indeed, bears predicted that Bank of America,knowing the recent contract was a must-win for EDS,pounded out favorable terms even on this deal.

EDS described the contract as "a very good dealfor both EDS and Bank of America." But some analystsare holding out for details so they can reach verdictsof their own.

Winter Warmup?
EDS's late-year recovery

"On paper, the deal looks very good, verypromising," said AdamFrisch, a UBS Warburg analyst who has no position inthe stock. "But we don'tknow enough about the deal to determine whether itsignals a turnaround forEDS. It's hard to judge a turnaround on one deal,anyway."

There is a sense among some investors that the EDSturnaround story has gotten ahead of itself, and thatthe company will have to show substantial progress across its businessin coming months justto justify its stock price today. EDS shares slipped 4cents to $19.60 inMonday trading.

Cutting Costs

For EDS, the Bank of America deal is hardlytypical.

Traditionally, EDS pursues blockbuster informationtechnologydeals that score big headlines but devour huge amountsof cash long beforethey reach break-even. In this case, however, EDS willpurchase none of itscounterparty's assets -- a welcome relief to investorsconcerned aboutthe company's dwindling cash flow.

"In the Street's mind, this was like a third-partyverificationthat EDS is here to stay," said Christopher Penny, ananalyst at FriedmanBillings Ramsey with no position in the stock. "Tosome degree, I thinkthis is positive news for investors."

Still, bears note the danger that EDS' smallerupfront investment,estimated at $100 million to $200 million, couldtranslate into asmaller return for the company. The 10-yearoutsourcing contract calls for EDSto manage Bank of America's voice and data networks --probably withassistance from outside vendors -- instead of assumingcontrol of thebank's computer services in a traditional IT deal. Thetrue value ofthat contract, Frisch said, will not become clearuntil EDS reveals how muchof the pie will be sliced off for any telecom vendorslending a hand.

At least one noted short-seller saw minimal valuein the entire $4.5 billion deal.

"This contract represents one week's revenue, wasanticipated andis of dubious economic value," said David Rocker,whose Rocker Partners hedgefund is short the stock. (Rocker Partners owns 9.7% of TheStreet.com Inc., which publishes this Website.) "The market's enthusiasm is unwarranted andwill likely be short-lived."

Pressing the Shorts

Such skepticism is common among the bearishinvestors who'veshorted 18.6 million shares -- some 3.9% -- of EDS' stock. But mainstreamanalysts, even those with tepid ratings on the stock,saw some justification inthe recent rally.

Prudential analyst Bryan Keane, for example,pointed out that theBank of America deal will allow EDS to "at least meet"market expectationsfor $6.5 billion in new fourth-quarter contractbookings. Meanwhile, Keanewrote in a Dec. 12 research note, the contractprovides a "solid win"for EDS' struggling management team.

"Investors had lost confidence in EDS' abilityto sign a largemegadeal," wrote Keane, who has a hold recommendationand a $17 targetprice on the stock. "We think this should helpre-establish some faithin management."

But that hurdle is not the last -- or perhaps eventhe highest --that EDS must clear.


EDS investors, caught up in last week'sjubilation, may haveoverlooked important news about another megadeal.

A bankruptcy judge on Thursday granted a requestfrom USAirways to examine EDS documents related to an ITdeal between the twocompanies. US Airways is seeking to prove that EDSovercharged it for servicesprovided under the $200 million-a-year contract.Frisch, for one,immediately saw reason for concern.

"We recall that EDS was accused earlier this yearof overcharginganother client, the State of Texas, which we believecould havecontributed to Texas' decision to recently award itsMedicaid processing contractto Affiliated Computer Services ( ACS), unseating 25-year incumbent EDS,"Frisch wrote lastweek.

US Airways has essentially accused EDS ofovercharging it by up to$50 million annually under the contract. The airlineplans to use EDSdocumentation, previously confidential, to determinewhether it willmaintain its outsourcing agreement with the computerservices giant.

The loss of that $200 million-a-year contractwould come as a blow to EDS, which already has seencontract bookings plunge by 56% this year.

EDS declined to comment on the matter until itfinishes reviewing the judge's decision.

Triple the Fun

All told, EDS expects to generate $200 million to$400 million infree cash flow this year -- less than half the amountit projected beforeSeptember.

To meet next year's targets, EDS must roughlytriple 2002 cash flowfigures. The company plans to hit its new $1 billioncash flow targetby pushing a money-sapping Navy contract, so farriddled with delays, intopositive territory. But analysts like Keane admit thatEDS's goalscould prove too lofty.

Meanwhile, experts continue to weigh a boatload ofrisks that couldfurther pressure the stock.

For starters, EDS relies on General Motors (GM:NYSE - news - commentary - research - analysis)for 14% of its revenue. That number is expected to slip to 12% next year, somewhat lessening EDS's dependence on a single client. But EDS still remains vulnerable. If GM slashes IT spending -- or, worse yet, severs its outsourcing contract altogether -- EDS could see any top-line growth skid to a halt.

Meanwhile, EDS already faces possible losses fromsome of itsriskier contracts. Nearly half of EDS's accountsreceivable are currentlyunbilled, up from one-third last year. Whilegovernment contracts -- whichessentially guarantee payment -- account for 60% ofthose unbilledreceivables, the rest of the accounts could present atleast somemeasure of collection risk.

In addition, EDS carries international exposure,since 43% of its2001 revenue flowed from outside the country. Thecompany also usedcontroversial "percentage-of-completion" accounting --now shunned bysome investors as unreliable -- to recognize revenueon 40% of itsoutsourcing contracts.

But the biggest threat could be unleashed by thecredit rating agencies. A two-notch credit downgradewould cost EDS$170 million immediately, and a three-notch downgradewould push that amountto $252 million.

EDS stressed that it's a "solid, investment-gradecompany with solid earnings and solid cash flow." Tofurther protect itself, EDS has laid out an officialbackup plan that would allow the company to dodgeserious outlays of cash. Still, the potentialdowngrades -- while are currently viewed as unlikely --could set the company back at the very time it'sstruggling to rebuild its cash flow.

Analysts, who made no changes to their cash flowprojections afterlast week's Bank of America deal, are still waiting onbetter news.

"Investors were looking for any catalyst" for arally, Penny saidof last week's run-up. "But in the long run, we needto see improvement inEDS' cash flow before we really get excited aboutanything."

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