SAN FRANCISCO -- Wall Street loves to second-guess Hewlett-Packard's ( HPQ) mega-deals. The company's shares plunged 35% in the weeks following the announcement of its intention to acquire Compaq for $25 billion in stock in 2001, as investors questioned the wisdom of combining the two PC makers. And H-P's move to acquire technology services firm EDS ( EDS) for $13.9 billion on Tuesday -- its largest deal since Compaq -- did not play much better among investors. Shares of H-P sank 6.4%, or $2.99, to $43.84 in midday trading. The move will reshape the market for technology consulting and outsourcing services, as H-P turns up the competition on IBM ( IBM), the No.1 player in the services market. H-P said pairing up with EDS will allow it to provide a broader menu of services to business customers around the world that are increasingly looking to outsource various parts of their operations. And in a business where size matters, the two companies' combined revenue of $38 billion creates a clear No.2 player in the market. "If you look at where we were from a market share point of view, if you try and do this organically it just takes too long," said H-P Chief Strategy and Technology Officer Shane Robison in an interview with TheStreet.com. "The opportunity is there today and we want to capture it." But the grand vision was overshadowed by some of the deal's less-appealing details.
"I guess I can see why they're doing it," says Pat Adams, the Chief Investment Officer of Choice Funds, which doesn't currently own H-P shares. "It kind of broadens out the company. But it doesn't really get them into a big growth curve," he says. EDS has grown its sales between 2% and 6% during the past four quarters, while revenue in H-P's services group grew between 6.5% and 11% during the same time frame. "It would be kind of neat for them to lay on something that could really boost the top line," says Adams. The numbers also look disappointing from a profitability standpoint, with EDS posting operating profit margins in the recent quarter that are roughly half the level of H-P's services business. H-P said the acquisition will contribute to adjusted earnings in the next fiscal year, and would add to GAAP earnings in fiscal 2010. But the company did not give investors a sense about how EDS will affect the company's gross profit margin and operating profit margin. "H-P didn't give any kind of guidance or financial impact of this deal on the operating model and I think that is disconcerting," says one large institutional investor, whose firm has stake in H-P. H-P will pay for the deal with a combination of the $9.9 billion in cash on its balance sheet and incremental debt, according to a company spokesperson.
Making the deal work will require integrating two large organizations with different cultures and histories, which presents its own set of challenges. "Clearly there's a group of investors out there that are going to take a wait-and-see approach," says Pacific Crest Securities analyst Brent Bracelin. "There's a lot of risks here. The execution profile goes up." H-P has plenty of experience annexing outside companies and folding them into its operations. The Palo Alto, Calif., tech giant acquired nine companies in 2007, including its $1.7 billion acquisition of Opsware. And CEO Mark Hurd is famous for his focus on increasing efficiency and profitability within the business. Since he took the reins in 2005, H-P has improved its overall operating margin from the mid-5% range to 9.4% in the first quarter of this year, while lopping 15% off of H-P's headcount. Now Hurd will have a chance to try the same tricks on EDS's sagging margins. EDS employs 140,000 workers, while H-P's services business has a staff of 70,000 employees. H-P's Robison said the company will be looking at overhead after the deal is completed, suggesting that layoffs may be in the offing. EDS will continue to operate as its own organization, doing business from its Plano, Texas headquarters under the EDS brand. Robison described the deal as a "reverse merger" with a large portion of H-P's outsourcing business moving to EDS. H-P's technology support business will remain part of a traditional H-P business group.
The move will put H-P ahead of other tech services contenders including Accenture ( ACN), Fujitsu, Computer Sciences Corp ( CSC)and Dell ( DELL). The notion of beefing up H-P's services business is sound, said the H-P institutional investor, noting that the deal is largely an affirmation of the IBM model. But the concern on the Street revolves around whether or not H-P has picked the right company and the right way to go about it. "You have to have your arms around what it's going to take to make this thing work. Nobody wants to buy an experiment," the investor said. H-P was vindicated in its last big experiment, with the Compaq merger ultimately helping to transform H-P into the world's top PC player. Now it will have to prove the Street wrong again.