The winds of change are sweeping through the corridors of EDS since Dick Brown, former CEO at Cable & Wireless, joined the services giant last month. As the company’s new CEO and Chairman, Brown is hell bent on instigating change both in strategic direction and within the company’s own ranks. He is mounting a bid to regain ground lost to market leader, IBM Global Services, which outsold EDS by almost a three-fold margin ($33 billion versus $11.8 billion) in 1998.
First up, Brown is embarking on a highly sensitive corporate cost-cutting exercise which will lessen his popularity within EDS but no doubt curry favor on Wall Street. By dissolving some of the lavish corporate perks that have always been the hallmark of an EDS employee, he believes he can trim operating costs and improve the company’s bottom line. In a leaked memo to 60,000 company employees, Brown said he plans to sell five of nine corporate jets and disband the fleet of company-owned helicopters. We don’t need helicopters. Driving to the airport is OK, was the essence of the message from the company’s new no- nonsense leader.
EDS’s $17.5 billion outsourcing/acquisition agreement with MCIWorldcom is also part of the corporate shake-up. The company is trying to communicate a new message to the market: EDS is getting leaner, more agile and is geared up to providing the outsourcing services needed in today’s corporate landscape by aligning itself with the telecoms and datacoms giant. This is a necessary step given the consolidation in the market and follows AT&T’s $5 billion network-for-services swapout with IBM Global Services in November 1998. The MCIWorldcom deal is being driven by contraction in the market as a whole, says Barry Domber, an outsourcing consultant at Technology Business Integrators.
Part of the deal has EDS buying SHL System House MCIWorldcom’s Canadian-based outsourcing subsidiary. EDS believes it is well- positioned to offer network and systems integration services on top of the application and IT operations outsourcing contracts it already provides. Integrated services are the key to new business. Large enterprise-wide contracts are only won if a client knows he can outsource applications, hardware and networks to one vendor, according to Brown at EDS.
But while the acquisition of SHL played a contributing role in EDS reaching this agreement, it is not believed to be as strategic as EDS may suggest. EDS saw the revenue potential in taking on MCIWorldcom’s outsourcing business and it only bought SHL to sweeten the deal, says Domber.
This theory holds true for a number of reasons. First, EDS has sought to relinquish its dependence on revenues from its former parent, General Motors, ever since the two businesses parted company in 1996. Where EDS derived around 60% of revenues from GM in 1996, GM contract business was down to $4.2 billion in 1998 and is destined to drop a further 7-10% in 1999. The MCIWorldcom outsourcing contract would provide a steady revenue stream of between $5 – $7 billion over the next 10 years and would therefore go some way towards accounting for shrinking revenues from GM.
Analyst estimates vary but there is a common consensus that the MCIWorldcom outsourcing contract will begin to show through in EDS’ numbers next year. EDS will get an $800 million revenue stream hitting its books, half of which will go on stream next year giving the company a 10% growth in revenues, says Keith Ellis, a services analyst at IDC.
Wall Street is more reserved in its estimates. The outsourcing contract and SHL Systemhouse acquisition is a positive move and a major first step in the turnaround process and these two additions will add between $0.05 – $0.10 to EDS earnings per share in 2000, says Steve McClellan at Merrill Lynch. However, the investment bank has not altered its full year EPS estimate of $2.25. Analysts at Lehman Brothers are even more cautious. The bank has raised its 1999 EPS estimate to $1.90 from $1.85 on the basis of cost-cutting measuring Bro
wn is currently instigating which it believes will take effect in the second half of 1999. That said, the investment community is generally reserving judgement on EDS’s future performance until rumors of possible acquisitions and divestitures are cleared up at an analyst meeting in April.
EDS remains bullish and says it’s expecting double-digit revenue growth in 1999 which means non-GM business, which now accounts for three-quarters of the total, will have to rise by at least 17%.
MCIWorldcom has been eager to divest itself of SHL almost from the day the merger took place, according to insiders. This would account for the reason it sold the business for so little and why acquisition rumors have been flying around for so long. EDS paid $1.65 billion in cash for the networking and systems integration business – slightly less than SHL’s last full year revenues of $1.7 billion. Yet MCI is believed to have bought the business for between $3 -$4 billion five years ago. SHL lacked the high margins so coveted in the services market. The company’s margins were down to 7% last year and this will no doubt have a detrimental effect on EDS’ own margins. These have been suffering of late. The company’s gross margins dropped 1.5 points to 17.3% in 1998 – roughly the same level margins were at in 1996 when EDS carried a $500,000 charge associated with the GM demerger.
John Sidgmore has already admitted that his company would not have divested SHL to any company that would not partner with MCIWorldcom and this meant EDS’ hands were effectively tied. If EDS wanted MCIWorldcom’s outsourcing business then it would have to buy SHL. The business is not destined to have much positive impact on the EDS giant bottom line. SHL’s contribution to EDS earnings this year will be minimal. SHL’s net income will be largely offset by foregone interest income and goodwill amortization, says McClellan at Merrill Lynch.
For its part, MCI/Worldcom anticipates receiving between $6 – $8.5 million from EDS over the ten year tenure of the contract. EDS will take responsibility for running MCI/Worldcom’s core IT operations and most of its application development – a somewhat onerous task judging from Sigdmore’s comments. MCI/Worldcom has embarked on a fast-paced acquisition strategy which has left its IT operations in disarray. We’ve made 68 acquisitions over the last couple of years which has left us with some IT integration challenges,’ admits Sidgmore. The MCIWorldcom outsourcing contract is expected to be signed and commence in June and analysts expect little earnings in the first 12 months due to start-up expenses. When fully ramped up at normal profit margins by 2001, the contract should contribute around $0.08 per share, says McClellan.
If the deal is completed, which is by no means certain, the initial challenge will be employee retention. Although both MCIWorldcom and EDS are offering employees attractive stock options there has been some suggestion that the 12,000 network and systems consultants from the SHL side of the house will not want to join the old school culture within EDS. That CEO, Dick Brown, is busy cutting costs will make the move even less appealing. Furthermore, SHL consultants will have seen the second upheaval in just over a year. Having become part of Worldcom and now EDS, and given the dearth of expertise in the industry staff may consider a move elsewhere. That too, could scupper Brown’s plan for future growth.