Computer Sciences Course Tough to Follow

The past six weeks have been a wild ride for Computer Sciences ( CSC), as news of a potential buyout was followed quickly by the talks' collapse.

Now that the dust has settled, enthusiasm for the company and its stock has similarly waned, although the technology services firm's future is not necessarily all doom and gloom. Shares of Computer Sciences are trading around $50, down about 17% from a more than four-year high of $59.90 reached Nov. 1 at the zenith of the takeover rumors. That's still 10% higher than the stock price before news of a potential takeover broke Oct. 24.

"One of the questions probably still out there is, are they still a potential takeover target, or will this go away and they'll just continue on," says Chris Ambrose, a research director for Gartner who covers IT services and outsourcing.

UBS analyst Adam Frisch believes other companies are likely to be interested in acquiring CSC because the extent of the negotiations suggests management wants to sell. Alternatively, if all talks are over, CSC could find other uses for its cash and debt capacity such as an acquisition or share repurchase, which could be accretive to earnings, Frisch wrote in a recent note. (Frisch has a neutral rating on CSC and his firm has done investment banking with CSC.)

Computer Sciences won't comment on takeover speculation.

Other investors and analysts doubt that interested buyers exist. They don't understand why anyone would be interested in CSC's commercial business, which has shown lower growth than the company's more lucrative federal segment.

The Wall Street Journal reported that the negotiations reached a point where buyers -- Lockheed Martin ( LMT) and three private-equity firms -- were discussing a price as high as $65 a share. Three weeks later, the talks stalled because CSC wanted Lockheed to buy its entire business and then sell off the commercial section to the private investors. Lockheed only wanted to buy the federal business and was fearful of taking on the risk of buying the whole company and then selling it off, according to the Journal, which cited unnamed sources in all of its stories.

Banc of America Securities analyst Abhishek Gami believes an acquisition of CSC would be "highly challenging," even at his lower take-out valuation of $53 to $59.

"We maintain that leveraged buyouts of capital-intensive IT outsourcing companies make little sense based on extreme competition, high levels of working capital requirements, the negative impact on vendor competitiveness from a junk bond rating, and long-term contracts that make it difficult to restructure operations," Gami wrote in a recent note. He has a neutral rating on CSC and his firm has done investment banking with CSC.

Moors & Cabot analyst Cindy Shaw echoes that opinion. "I don't view it as a particularly compelling opportunity for private-equity firms," she says of CSC. "They're not challenged in any way, if you will, although they have historically traded at a discount to their peer group because their margins and cash flow tend to be subpar." (Shaw has a neutral rating on CSC and her firm hasn't done banking with the company.)

Several analysts have expressed concern about CSC's negative free cash flow -- $387 million so far for fiscal year 2006, which ends in March. Executives have responded that the company's results are in line with their plans and still on track to meet their target of $350 million to $400 million.

"The bears will come out there and say whatever they want," counters John Hammerschmidt, a portfolio manager with the ( QMCVX) Quaker Mid-Cap Value Fund who bought CSC shares in the mid-$30s. "What made us really attracted to this company was the fact that they have very little debt and consistent earnings."

However, Hammerschmidt liquidated his position during the takeover-rumor run-up at prices up to $57. He believes the stock is worth $52, only 4% higher than the current price.

CSC delivered a 4-cent upside earnings surprise in the second quarter. The company is projected to increase earnings per share 12% in fiscal 2006 and 10% in fiscal 2007, although revenue is expected to be merely flat in '06 and up a modest 6% in '07 amid declining bookings, according to Thomson First Call.

But the company's low debt-to-capital ratio -- at nearly 18% vs. 20% and higher for rivals -- makes it primed to make its own acquisitions, analysts and investors say. Even while takeover rumors were swirling, management talked about its "ample ability" to buy another company that offered long-term revenue and earnings growth.

Ambrose believes acquisitions are very likely in the company's future, particularly given management's stated goal of becoming second only to leader IBM ( IBM) in the IT services market. "I don't know that anybody is going to be able to make that kind of move organically," says Ambrose. Ambrose pegs CSC as No. 4 or 5 in the market currently, with rivals EDS ( EDS), Accenture ( ACN) and Fujitsu also sharing the top spots.

Instead of pursuing vertical plays in industries like insurance or health care, CSC is more likely to make "opportunistic acquisitions" at a good price, Ambrose says. He says CSC is notably weaker than IBM and Accenture in consulting and systems integration but has started to show some strength in applications outsourcing.

But CSC competes well in the infrastructure space and has started to show strength in applications outsourcing -- experience that could ultimately bring the company closer to achieving its goal of becoming No. 2 in the IT services space, according to Ambrose.

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