"Everyone deserves a second chance." So goes the cliche. But it's seldom said that one must earn that second chance. And all the glory of your yesteryears will not release you from your recent derelictions.
So it goes for Electronic Data Systems (NYSE:EDS). Its business over the past three years has been atrocious, as the name synonymous with information-technology outsourcing regroups from soured contracts and stiff competition. Some significant changes have edged the firm from red into black, but investors still rightly wonder whether EDS has earned a date with their hard-earned cash.
EDS and the company it keeps
With $20.6 billion in sales during 2004, EDS was the second-largest player in IT outsourcing and consulting services. The top player was IBM Global Services, a division of IBM (NYSE:IBM), with $46.2 billion. After EDS came Accenture (NYSE:ACN), with $15.1 billion, and Computer Sciences (NYSE:CSC), with $14.8 billion.
The sector is also home to many smaller players, from medium-sized firms like Cap Gemini to even tinier firms of just a handful of people. Most of these smaller companies are specialty niche players with unique value propositions.
EDS competes in 60 countries around the world. It offers an array of services, including Internet hosting, running entire computer networks, managing operating services such as human-resources and accounting departments, and providing solutions to various challenges such as supply-chain management and cost centers.
You've lost that lovin' feeling
The past few years have been rough for the company. In November 2001, EDS traded at an all-time high of just over $72 per share. By early 2002, shares were in a free fall and bottomed out at just shy of $11 in October 2002. Recently, the price has meandered in the range of $16 to $25.
What caused the nosedive? In short, several bad deals, and one really bad deal -- the Navy Marine Corps Internet (NMCI) contract that has plagued EDS for three years. The catastrophe began with a poorly written contract that caused several conflicts over deliverables. In 2003, a modified contract ironed out the disputes, but the damage had been done, and the company tallied a loss of $178 million in 2001, $524 million in 2002, $945 million in 2003, and $862 million in 2004. EDS suffered additional losses from other bad contracts, including an unnamed contract that cost EDS $255 million in 2003 and $173 million in 2004.
These losses were a body blow to EDS's finances, while would-be investors and clients shied away. After earning $1.2 billion in net income in 2002, the company lost $1.7 billion in 2003. By 2004, EDS had begun to fully address its problems and posted a modest $158 million gain. Yet to achieve even this pittance, the company had to undergo a great deal of change.
Earning a second chance
EDS has now begun to show a commitment to would-be investors. The company cleaned house among its executive ranks. Turnaround expert Michael Jordan came out of retirement to become CEO, and his old colleagues from PepsiCo filled most of the empty seats. Jordan was best known for his work from 1993 to 1997 at Westinghouse, where, against all odds, he transformed the ailing electronics manufacturer into a successful broadcasting company -- CBS Corp., a division of Viacom. Whether EDS will need such divest-and-reincarnate measures remains to be seen, but Jordan has shown that he will stop at little to win.
What has the new team done so far? One initiative was to sell off several non-core assets and to acquire new ones that fit better into EDS's key service offerings. Another initiative was to form a strategic alliance with Cisco Systems, Motley Fool Stock Advisor pick Dell, EMC, Microsoft, Oracle, SAP, Siebel, Sun Microsystems, and Xerox. The alliance is better able to package solutions specific to customer needs while reducing costs and collaboratively developing new products.
The company has also cut its dividend from $0.15 (3.1%) to $0.05 (1.0%) and was able to reduce its cost of goods sold by $1 billion in 2004 via pink slips and other restructuring efforts. Management, meanwhile, has either terminated or ironed out several troubled contracts, including the undisclosed contract mentioned earlier. Things are even looking better on the NMCI contract. Where it lost $0.59 per share in 2004, the contract is expected to scale down losses in 2005 to $0.15.
They love me, they love me not
EDS is definitely making amends. Recently, it has won some noteworthy contracts with the likes of several state Medicaid programs, the Australian Taxation Office, Dow Corning, and the British armed forces. These wins are meaningful accomplishments in that they show restored faith from highly regarded institutions. Nevertheless, I am waiting to see what happens with the upcoming renegotiation of General Motors' (NYSE:GM) contracts. A financially struggling GM is likely to bargain lean contracts to numerous companies, and that means EDS could lose substantial revenues or even sign on to another bad contract. Although I doubt the latter will happen, GM currently accounts for 9.5% of EDS's revenues. That's a lot of eggs in one basket.
Now let's move on to valuation.
Valuing EDS is like dating over the Internet: The picture you get is not entirely representative. Take the 12-month trailing P/E ratio of 61.3. Assuming future earnings follow those of the past 12 months, EDS is overvalued. However, the sporadic nature of the past 12 months has been mostly reconciled and is not likely to be as influential going forward. So let's try the forward P/E ratio. The analysts' earnings consensus of $0.43 per share in 2005 gives EDS a forward P/E of 44.9. To the extent that those projections are accurate, the company still remains overpriced within an industry whose average is 25.6, at least if P/E is the only course on your analytical plate.
That said, I believe that P/E is not a reliable measure of value for EDS because of several short-term anomalies -- like a $1.42 billion non-cash adjustment from an accounting change and a $27 million charge from a USAir non-payment -- that are distorting the company's income statement. So, for valuation purposes, we want to look at the core business without getting bogged down in accounting conventions. To do that, we can turn to cash flow from operations (net income's distant cousin) for a more reliable multiple. Cash flow -- defined here as cash inflows from operations minus cash outflows from operations -- is a better representation of value in this case, since it derives from actual monies moving through the firm's operations and undistorted by special charges.
The company has a trailing-12-month price-to-cash flow ratio of 7.6, compared with an industry average of 8. In this regard, EDS can be considered fairly priced. However, another issue for shareholders is how the firm uses the cash that it generates. EDS has been investing its cash in restructuring efforts and other expensive projects rather than returning it directly to shareholders. If these projects pay off in the long term, patient shareholders may be rewarded with greater cash flows in the future.
EDS is likely to eliminate many of the anomalies affecting its income statement in the years to come. When it does, the P/E will become a more reliable measure of value. Without so many irregularities eroding earnings, the P/E will then deflate and push the stock into more attractive territory (assuming price stays constant).
In conclusion
While EDS is in its restructuring phase, it's difficult to find value at the current share price. Earnings are being affected by a variety of extraordinary charges that apparently overvalue EDS shares from a P/E perspective. Cash flows are more reliable but only rate the company at fair value. However, I'd argue that shares have good potential for future appreciation, since per-share cash-flow generation is up to industry snuff, the benefits of restructuring have yet to be realized, and the company as a basket of assets may be undervalued -- it sports a relatively low price-to-book ratio of 1.35, compared with an industry average of 1.89.
Now for the big question: Has EDS earned a second chance? No, not yet. I would like to see continued control over costs, more contract wins, and steady positive earnings enabled by efficient operations before I start dating EDS. However, the company has done enough to earn a spot in my little black book.
Fool contributor Cliff Malings is well aware that investing and matters of the heart are not to be approached in the same way. But the parity was too fun to resist. He owns shares of Oracle, but no other companies mentioned. The Motley Fool has a disclosure policy.
