Updated from July 30

Hewlett-Packard's

(HPQ) - Get Report

decision to back off an $18 billion acquisition of PricewaterhouseCoopers' consulting business two years ago looks wise after the same outfit sold to

IBM

(IBM) - Get Report

for 1/5th the price Tuesday. Ironically, however, IBM's foray into big-time consulting could force Hewlett-Packard back into acquisition mode.

"It really does change the landscape of competition," says Linda Cohen of Gartner Group. "Now H-P's got to find something upscale to buy, and

Accenture's

(ACN) - Get Report

got to come up with a really strong partnership or maybe make an acquisition in IT outsourcing."

IBM said Tuesday that it will buy the consulting unit for an estimated $3.5 billion in cash and stock. The deal, subject to regulatory approval, is expected to be concluded some time near the end of the third quarter.

Cohen says she predicted two years ago that IBM would have to buy the likes of a PwC or Accenture to complement its technology business. Though it tried to organize its own consulting group focused on enterprise systems and solutions (the BIS, or business innovation services group), the unit simply never got enough traction. "The marketplace perceived IBM as a technology vendor, not a business solutions provider. They needed a brand name in this space," she says.

Long Courtship

IBM CFO John Joyce says IBM had in fact considered buying PwC two years ago but "could not justify the valuation at the time." However, at a multiple of 0.7 times revenue, he says, the buy now qualifies as a "good value."

The purchase price consists of $2.7 billion in cash, $400 million in a convertible note and $400 million in stock. "That will be funded from our strong cash flow and strong balance sheet," says Joyce.

While the price tag is well below what Hewlett-Packard was considering, some analysts suggest IBM will get what it pays for.

"Technology stocks have fallen by 70%," says Prakash Parthasarathy, an analyst at Banc of America Securities, noting that when H-P offered to buy the consulting unit two years ago, the

Nasdaq

was sitting at 3900. "It's a declining market for some service lines, and

PwC also had issues with auditor independence. So it's really three things that you have to factor in."

"It is a dirt-cheap valuation," says Mayank Tandon, an analyst at Jannay Montgomery Scott. "But given the consulting environment and the fact that PwC was running at very low operating margins relative to

KPMG

(KCIN)

and

Accenture

(ACN) - Get Report

, I'm not surprised they're getting it so cheap."

"PwC has been underperforming for a while," Tandon added. "I think they were looking for a partner, and it was hard for it to do an IPO and get a reasonable multiple, so this was the best strategy."

Market Weakness

Under terms of the deal, PwC Consulting, which is expected to post fiscal revenue of about $4.9 billion, will shelve its planned initial public offering and will be integrated into IBM's global services division. PwC has about 30,000 employees, while IBM's global services arm employs 150,0000.

In a conference call, Big Blue says it expects its fourth-quarter earnings to take a hit of about 30 cents a share as a result of the purchase. The deal is expected to be accretive to earnings as of the fourth quarter of 2003, perhaps earlier.

"We think by next year it will be accretive in the second half to EPS," says CFO John Joyce. "But the first half could offset the second half, so it could be break-even relative to EPS in 2003."

By year-end 2004 he predicts the unit should contribute double-digit revenue growth.

Not Cheap Enough?

On the institutional side, some money managers were skeptical. "The fact that they are going to issue $400 million in stock and convertibles, as well as cash -- it's a high hurdle," says Chris Bonavico, manager of the

(TPAGX)

Transamerica Premier Aggressive Growth fund, which doesn't own IBM. "I would have preferred it if it was all cash -- it's always cheaper than stock. Stock has a high required rate of return. Currently, the required rate of return on cash is 2%."

"My main concern is always overpaying. By most metrics I'd say they paid a slight premium," says Bill Schaff, manager of the

(BINVX)

Berger Information Technology fund, which has a stake in IBM.

Accenture trades at around 0.65 times sales, including long-term liabilities, compared with PwC's sale for 0.7 times revenues. But the purchase price is "not out of line," says Schaff.

Strategically, the move makes sense, Schaff believes. "I think it's probably a smart move for IBM to cross-sell. They're catering to Fortune 1000 companies, and this gives them a leg up in that regard. But he acknowledges gains at IBM could cut into business of another holding of his, H-P. "It obviously does take the big business away, and H-P was trying to migrate into that. But I'm not sure they were all that competitive anyway. It's really the small to medium, low-end business that's their sweet spot."

Recently, IBM's services unit has come under heavy pressure amid the weak economy. In its most recent earnings report, the company acknowledged it fell short of its goal of $14 billion in new signings for the department, producing only $10.6 billion.

It also retracted an earlier forecast of double-digit, fourth-quarter sales growth for the unit, which it had made in the previous quarter. Instead, IBM says it expects to see "modest" growth in its services business.

Building Business

Presumably, the acquisition of PwC will lift those expectations in the long term.

"The real key for IBM to get a nice return is to buy the relationships that PwC currently controls and to grow them," adds Bonavico. "So if they execute well and don't lose those relationships, perhaps there's a justification."

Bonavico says he wouldn't buy a services outfit such as IBM's, in any case, because returns aren't high enough. "You can't grow your revenues without adding expenses. A body business will never get the scale to offer attractive returns on capital," he says.

Before the acquisition, IBM drew more than 50% of sales and more than 80% of profits from services and software. Now both are expected to increase.

"We don't use acquisitions to really grow the top line," Joyce said in the conference call. "Traditionally, we depend on R&D capabilities internally to drive revenues. We also don't use acquisitions to solve problems. But this opportunity came along and fit right on our strategy" of focusing more on software and services, he says.

Alluding to accounting regulations, Pricewaterhouse CEO Samuel DiPiazza says in a prepared statement that the deal will "unleash the consulting unit from the regulatory restraints of our industry, and will allow the business to reach its full potential."

IBM says it's been working with PwC and the

Securities and Exchange Commission

to establish procedures to comply with SEC auditor independence rules.

The purchase is the biggest move yet undertaken by IBM chief Samuel Palmisano, who stepped up to his post in March, at a time the company was already suffering from a slowdown in the economy. In an earlier restructuring bid in June, he sold off the company's money-losing hard disk drive business.

Staff writer Rebecca Byrne contributed to this report

.