Why the HP / EDS Deal Is Making The Street Nervous

Clearly, the Street is not crazy about Hewlett-Packard’s (HPQ) plan to acquire Electronic Data Systems (EDS). In two days, the Street has knocked about 10% off HP’s stock price, chopping its market cap by about $12.5 billion, almost equal to the $13.9 billion deal price. The obvious question is, why?

And the answer is, there are several reasons. For starters, this is a large deal - EDS has 135,000 employees - and has the potential to create all kinds of distractions for HP CEO Mark Hurd and his team. Two, $13.9 billion is a lot of cash, and some people wonder if they are overpaying for a company that has not been a good performer in recent years. Three, there is concern about dilution of both revenue growth and margins. And four, there are some who wonder if HP might not have been better off beefing up its software arm, or snapping up an Indian outsourcing firm, rather than adding a U.S.-focused body shop like EDS.

• Toni Sacconaghi, an analyst at Bernstein Research, notes that since 2002, EDS has generated annual revenue growth of just 0.4% versus 8% for HP. And he notes that gross margins at EDS are around 15%, versus 24% for HP. “Given that we do not believe HP will be able to materially improve either revenue growth or gross margins,” he writes, “the acquisition is likely to result in some multiple compression over time even though the deal is accretive and HP has the opportunity to boost EDS’ operating margins from current levels.” Sacconaghi also notes that EDS is heavily weighted to the U.S., with only a third of the company’s workers outside the country. He says that appears inconsistent with HP’s stated goal of building global capacity in its services business. Sacconaghi suggests that for $13 billion, the company could have instead bought Satyam (SAY) or Cognizant (CTSH), which have higher growth and fatter margins. He keeps his Market Weight rating on the stock.
• Louis Miscioscia, Cowen: “Now is a good time to buy given the recent hit due to the announced deal with EDS,” he writes. “We would not have recommended that HP acquire EDS, and are concerned about opportunity costs, but we do believe that HP can make it work, that is with a lot of heavy lifting. Financially the deal is about a push, strategically this should actually help HP’s positioning in services and finally operationally one has to decide if Mark Hurd can run EDS better than EDS running itself. We think he can.” He keeps his Outperform rating.
• Richard Gardner, Citigroup: “We would be aggressive buyers of HPQ shares on today’s pullback,” he writes. Gardner says the sell-off is “a clear overreaction.” Gardner says that HP faces slower industry growth, more stable component pricing and a more stable dollar going forward, but that “these factors are more than fairly reflect in consensus estimates” and the stock price.
• Doug Reid, Thomas Weisel Partners: Reid writes that he is “incrementally more negative on HPQ” for three reasons: EDS’s “comparatively weak” margins and revenue profile and “significant integration risk.” He maintains a Market Weight rating.
• Richard Krugele, Needham: He contends that “investor sentiments appear to be overdone.”
• Scott Craig, Bank of America: Likewise, he says that “the stock price decline over the past 2 days…is an overreaction and a good buying opportunity for the stock.” He says that the deal “makes strategic long-term sense, even if the price paid is a little aggressive.” He says the reasons investors are nervous about the deal include lack of detail on potential cost and revenue synergies and “EDS’s challenging history.”

Comments

[xz1]

i dont think mark hurd had a choice, his magic was cost control and optimize the operation. he pretty much squeeze everything he can out of the old hpq and need a new battlefield to replicate the trick. EDS is a good target but I'd rather see him do a stock deal than cash. Now hpq -3B on their balance sheet. though long term it most likely work out well, the short term integration and financial risk is just too high, i sold out all my position and will stay away from the stock. There are just too many cheap options available on this market today.

[Ali K]

HP historically is able to integrate new companies extremely well. The caveat is that the positive record is generally for many smaller companies - and the Compaq acquisition (much larger than others) was a total nightmare for HP. THe questions are whether they can integrate well, and whether they can manage EDS to better performance. Overall, as a long term play they really can't lose - either EDS/HP has a smooth transition and HP ends up being near dominant over IBM - or HP still maintains such share by using EDS resources and relationships after dismantling the company. Long term - strong buy.

[p. smith]

lots of heavy lifting and margin compression, too much uncertainty for many years to come.