ByWILL SWARTS
The Company
The News
A drumbeat of rumors turned into a steady rhythm of facts Tuesday when
Hewlett-Packard
Electronic Data Systems
IBM
As speculation about the EDS deal mounted H-P's stock slipped 4.7% on Monday, cutting the company's share price by 11% over two days and shaving $12.6 billion from its market cap. EDS shares were up 29% from Friday's close at the end of trading Tuesday.
The merger is expected to be finalized in the second half this year and should more than double H-P's services revenue, which hit $16.6 billion in fiscal 2007, the two companies said in a joint statement.
Their combined services businesses in fiscal 2007 had annual revenues of more than $38 billion. The new IT services group will be called "EDS an HP company," and will be based at EDS's executive offices in Plano, Texas. The merged company will continue to be run by EDS Chief Executive Ronald Rittenmeyer, who will report to H-P CEO Mark Hurd.
"Strategically acquiring EDS fulfills our stated objective of expanding in the services areas," Hurd said on a Tuesday conference call. "It will enhance the global scale of HP's outsourcing service delivery capabilities, particularly in Europe and the Americas. It will expand our offerings in such segments as applications outsourcing, and it will extend our reach in such vertical industries of government and manufacturing."
Analysts at Citigroup, Stifel Nicolaus and Freidman Billings Ramsey & Co. cut their ratings on EDS shares after its 28% jump Monday. Citi lowered the stock to Sell from Hold, Stifel's rating dropped to Hold from Buy, and FBR's rating was reduced to Market Perform from Market Outperform.
The Analysis
This is a good move that makes sense, but Wall Street's showing skepticism between theory and practice, and the execution risks may delay the merger's payoff.
Credit Suisse analyst Bryan Kean summed up the rationale in a Tuesday note.
"By purchasing the No. 2 biggest outsourcing services company, HP is making a somewhat surprising move to further expand in services (about 17% of HP revenues), abandoning its plans to only acquire small 'tuck in' acquisitions," Keane wrote. "In our view, CEO Mark Hurd believes there is plenty of fat to be trimmed from EDS's cost structure and many synergies to be gained. Over the past year, IBM has been very successful in increasing its services margins and the industry has taken note."
CEO Hurd said the merger would start to show results in fiscal 2009. But investors worry that's easier said than done, says Pacific Crest Securities analyst Brent Bracelin.
"I think the sense investors have is that there's risk in the next six months or the next year," he says. "There's execution risk [in the merger], and about half of EDS revenues come from government and financial services verticals. This acquisition will be dilutive to the margin profile of HP, and it will slow revenue growth and means a lower blended profit margin profile. That's a lot for investors to digest."
But Wachovia Securities analyst David Wong argues that HP is finally thinking big enough to make a difference in its acquisition strategy. In the last four quarters, EDS notched revenue of $22 billion, while H-P's services revenue totaled only about $17 billion.
"We have felt that HP's minor acquisitions were too small to make a significant impact on its overall business," he wrote Monday, before the merger was confirmed. "Should HP be able to successfully acquire EDS at a reasonable price, we would view the potential EDS acquisition as being an appropriately decisive step towards building critical mass in services."
The Bottom Line
H-P and EDS are going to need that heft if they want to take on IBM, which owes its 16% year-to-date stock gains to its model of bundling hardware and services, which resulted in record revenue of $98.9 billion in fiscal 2007. H-P's total 2007 revenues including bread-and-butter hardware sales totaled $104.3 billion.
That doesn't mean it will be easy. Both EDS and H-P are trying to cut their work forces, and EDS is grappling with the loss of a high-earning contract with Verizon, notes Robert W. Baird analyst Jayson Noland.
"HP's acquisition of a low-margin, low-growth services organization may raise questions as to strategic direction and could imply HP's 'organic' cost cutting opportunities could be limited," he wrote Tuesday. "Although we view the deal as potentially positive to earnings per share, we believe uncertainty regarding rationale may pressure valuation."
He also wrote that H-P has been a solid performer in its own right. The company on Tuesday announced preliminary fiscal second-quarter earnings of 87 cents a share, ahead of Wall Street's consensus estimate of 84 cents.
For a patient investor, this merger dip is good news, but it may take a while to realize it, says Bracelin at Pacific Crest.
"Three years from now, we'll look back and say this was an acquisition that made strategic sense," he says.
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