EDS Gets Benefit of Doubt Thanks to Outlook

Investors suspend near-term concerns and cheer the company's bullish 2006 guidance.
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EDS

(EDS)

continued its ride Thursday as two analysts upgradedtheir rating on the IT services giant after it issued 2006 guidance late Wednesday that blew away expectations.

Shares of EDS recently soared $2.48, or 11.7%, to $23.77 intrading that was more than two times average volume.

While expressing concern about revenue growth, Jefferies analystJoe Vafi raised his rating to hold from underperform, while J.P. Morgananalyst Tien-tsin Huang raised his call on EDS to neutral fromunderweight.

"Chronic revenue contraction ultimately needs to reverse at somepoint," Vafi wrote Thursday morning. "However, we expect thatefficiency gains extracted from what is still extremely depressed P&Lprofitability should translate into an earnings-and-cash-flow recoverystory over the next several quarters." His firm has not done bankingwith EDS.

Vafi introduced an estimate for 2006 earnings of 93 cents,representing a 72% increase from his 2005 estimate. However, that wasstill slightly short of the company's

surprisingly optimistic outlook from a day earlier,when EDS said it expects 2006 earnings of at least $1 a share. Thecompany said it introduced the guidance earlier than usual because it was sofar above the consensus estimate, which sat at 66 cents.

EDS executives, repeatedly peppered late Wednesday with analysts' questions about why they are so confident, attributed their bright outlook toproductivity gains from cost cutting and said improvements in itsmassive contract with the U.S. Navy should offset any lost businessfrom

General Motors

(GM) - Get Report

.

Vafi said his target of $600 million to $700 million in free cashflow in 2005 -- flat year over year -- is still "somewhat disappointing"but called management's view of free cash flow of $800 million to $1billion next year "more encouraging."

Vafi said he believes it's still too early to have a very accurategauge of free cash flow because of the uncertain impact of future business with General Motors. The auto giant, which currently generates about 9% of EDS'revenue, is opening up its contracts with EDS to competitive bidding,with final decisions expected at the end of this year or early nextyear.

"Overall, we feel that a negative outcome from the GM recompeteprocess could set back EDS' recovery into the 2007-2008 time period,"Vafi wrote. "Nevertheless, management's comfort with establishing a2006 target this early in 2005 suggests a higher degree of confidencein the business outlook than we have seen in several quarters," heacknowledged.

J.P. Morgan's Huang, meanwhile, ratcheted up his 2006 earningsestimate far higher, to $1.20 a share, and estimated free cash flowwould jump to $860 million in 2006 from $600 million in 2005. But heshared some of Vafi's concerns.

"We remain concerned about anemic revenue growth but expect 2006free cash flow to be attractive," Huang wrote. "We continue to viewthe GM contract as a key risk factor for the stock, but one that weexpect is priced into the stock." EDS is a banking client of J.P. Morgan.

Still, not everyone was swayed by EDS' confidence. "The timing andprecision of the calendar 2006 estimates and the high confidence levelof a team often criticized for missing guidance targets has uspuzzled," wrote UBS analyst Adam Frisch, who maintained his neutralrating. "There wasn't anything incremental to help us form a morelogical path to EDS' big improvement projected in 2006."

"We can only help but wonder if there are renewed expectationsabout potential M&A scenarios in a sector expected to have increasedconsolidation in the next few years," he added.

Frisch further highlighted the uncertainty about the Navy and GMcontracts, productivity gains companywide, and also another bigcomplex contract with the UK Ministry of Defense. And he questionedwhy free cash flow is expected to increase 40% to 60% yet net incomeis expected to almost double.

Consequently Frisch said he was discounting the company's 2006 projections,with his estimate for earnings sitting at 80 cents. "If the managementteam does succeed, then we would consider it impressive," he said. "We, however, prefer to sit on the sidelines until we get a betterunderstanding of the drivers of the improvement and are able to makesome sense of the conflicting data points."

But Moors & Cabot analyst CindyShaw said she believes management is actually "setting the bar low toimprove credibility with the Street."

"We believe EDS has turned the corner and its low margins andrestructuring efforts set the stage for superior FCF and earningsgrowth over the next few years," she wrote. "In our view EDS has along (three years or more) and arduous road ahead, but we believe therisk/reward is attractive over a 12 to 18 month horizon."

Shaw, who has a buy rating on EDS, raised her '06 earningsestimate to $1.01 from 77 cents. But she said she believes that couldprove conservative, noting management indicated it expects to spend$300 million less on growth initiatives next year and EDS has beat theconsensus estimate for four quarters in a row.

However, Shaw still assumes that EDS loses 45% of GM revenue inJuly 2006, resulting in a hit of 20 cents to earnings per share. Herfirm hasn't done banking with EDS.