Shares of Computer Sciences ( CSC) shot up Monday on news of a potential buyout of the IT outsourcing firm. The stock jumped as much as $8.21, or 18.1%, to $53.56 before retreating slightly Monday. Shares were most recently up $5.67, or 12.5%, at $51.20. Citing unnamed sources, The Wall Street Journal on Monday named three buyout firms -- Texas Pacific Group, Warburg Pincus and Blackstone Group -- that are actively looking at taking over El Segundo, Calif.-based CSC. William Lackey, the company's director of investor relations, declined to comment, citing the company's policy not to comment on speculation and rumor. CSC, which has 78,000 employees, reported revenue of $14.1 billion in fiscal year 2005, up 4.5% from the previous year. The company's net income from continuing operations rose slightly less -- 4.2%. The company's
growth picked up in the most recent quarter, with earnings per share from continuing operations up 18% on an 8.6% jump in sales. But before Monday's gain, the stock was trading at a discount to its peers. Shares of CSC were trading around 14 times projected earnings for fiscal year 2006, while rival Electronic Data Systems ( EDS), a turnaround story, is trading at 22 times forward earnings. Accenture ( ACN) is trading at 15.5 times forward earnings, and Affiliated Computer Services ( ACS) is trading at 13.6 times forward earnings. The news of a potential buyout of CSC comes at a time when the IT outsourcing market has been showing signs of maturation. Clients are breaking up contracts and signing smaller deals, while at the same time competition is increasing offshore from Indian firms. However, about 50% of CSC's revenue is insulated from competition from India because it's either government- or defense-related, the company has said.
But on the commercial front, one customer, Nortel Networks ( NT), has said it intends to take in-house next year some tech work that CSC has done. CSC said this move will result in it taking an impairment charge of no more than $80 million in fiscal 2006. Another customer, Sears ( SHLD), terminated its master agreement with CSC in May and is now in a dispute with CSC over applicable termination fees. In research notes Monday morning, analysts suggested a transaction could involve breaking up CSC's commercial and federal units. About one-third of CSC's sales come from federal contracts. CSC executives have described the federal sector as "large and stable" and forecast it could grow 4% to 6%. SG Cowen analyst Moshe Katri put a bigger number on the potential growth, estimating the federal segment could generate 5% to 10% of top-line growth for a buyer. His firm hasn't done banking with Computer Sciences. That strong government business, with about 12% in aerospace and defense contracts, could also be of interest to defense contractors looking to replace a drop in revenue from fewer large weapons systems, Deutsche Bank analyst Brandt Sakakeeny wrote. Meanwhile, CSC's commercial business, with a large presence in Europe, could be of interest to Indian outsourcers, EDS, IBM ( IBM) and CapGemini, he wrote. Sakakeeny has a buy rating on CSC and Deutsche Bank has done investment banking and noninvestment banking business with Computer Sciences. The commercial business has a growth rate of 10.9%, or 8% at a constant currency, Sakakeeny noted. Hurdles to a deal, meanwhile, include a lack of free cash flow, uncertainty around the upcoming contract renewal cycle and how CSC values its business given an expected uptick in Europe, Sakakeeny said. He projected free cash flow of $350 million to $450 million in fiscal year 2006.