(Editor's note: This article has been corrected to reflect that it was only Fitch Ratings that lowered EDS's credit rating, and that the rating was lowered to one grade above junk status.)
CNN Moneyline anchor Lou Dobbs rails against Electronic Data Systems (NYSE:EDS) for sending American jobs offshore to India. But there's a better reason to snub the IT outsourcing company -- its stock's prospects. Beaten down already, Electronic Data Systems' stock price has even further to fall.
Shares have slid as credit rating agency Fitch Ratings lowered the company to one grade above junk status at "BBB-minus," raising borrowing costs and worrying potential customers. The sell-off last week of its design-software subsidiary, PLM, for $2.05 billion aims to build up cash to offset debt.
Sure, the sale improves liquidity, but it also removes a valuable business. In 2003, the PML business produced nearly $900 million in revenue and $110 million in profits for Electronic Data Systems. In other words, 20% of EDS's total operating earnings and 35% of its free cash flow vanish as a result of the sale.
Electronic Data Systems has boasted that it could offer whatever technology its clients asked for. But the high cost of supporting numerous software and hardware combinations has made competing with IBM (NYSE:IBM) awfully tough. Electronic Data Systems has lost focus trying to be all things to all customers.
Competition in the IT outsourcing market is getting more intense. Besides IBM, there are plenty of other contenders: Accenture (NYSE:ACN), Computer Sciences (NYSE:CSC), Unisys (NYSE:UIS), BearingPoint (NYSE:BE) , and Hewlett-Packard (NYSE:HPQ). Fierce competition explains why development and call-center work is being sent to India. Electronic Data Systems has to fend off the growing threat from Indian IT outsourcing outfit such as Wipro (NYSE:WIT) and Infosys (NYSE:INFY).
New bookings are sluggish, and several existing contracts -- to the tune of $2.5 billion -- are at risk. Electronic Data Systems' biggest contract, with General Motors (NYSE:GM), is up for renegotiation next year. Then there is the multiyear U.S. Navy Marine Corps Intranet contract. Valued at $8.8 billion, the Navy contract has been a recurring financial and logistics headache for the company, and now its details are part of an ongoing Securities and Exchange Commission investigation of Electronic Data Systems contracts. The company has reduced -- but not eliminated -- the use of percentage-of-completion accounting that books revenue before it actually comes in the door.
The stock has dropped in the last 12 months, but it hasn't hit bottom. Assuming Electronic Data Systems manages to hold on to the General Motors and Navy contracts, the stock trades at a 36 times 2004 earnings and 21 times 2005 earnings. By comparison, EDS peers Accenture, Computer Sciences, Unisys, and BearingPoint trade at an average17 times 2005 earnings. Electronic Data Systems' big premium will be hard to support for long -- even if more work is sent to India.
Fool contributor Ben McClure hails from the Great White North. He doesn't own any shares of companies mentioned here.
