H-P to Acquire EDS, Challenge 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.

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."