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EDS downplays WorldCom impact

After a significant stock drop, Electronic Data Systems says that WorldCom's accounting scandal and possible bankruptcy will not impact the bottom line of the IT services company.

3 min read
After a significant stock drop, Electronic Data Systems said Monday that WorldCom's accounting scandal and possible bankruptcy will not impact the bottom line of the information technology services company, despite several multibillion-dollar contracts they have with WorldCom.

Since the WorldCom accounting scandal came to light last week, shares in EDS have fallen more than 35 percent. Shares were $47.50 a week ago--the day before the WorldCom news broke--and were down $6.70, or 18.03 percent, to $30.45 at the close of trading Monday.

EDS has two major contracts with WorldCom, both 11-year deals signed in 1999. One is an IT services contract worth $6.4 billion; the other is a separate network services contract valued at $6 billion.

"Although in certain downside scenarios these developments could be material to (EDS') results of operations in 2002, in most events they are not, and in any event they are not material to EDS' financial position," the company said in a press release.

EDS is expected to report earnings of $3.62 a share and revenue of $23.2 billion for 2002, according to consensus estimates from First Call, though several analysts lowered those numbers slightly Monday.

EDS said the IT services contract with WorldCom is likely to continue. Under the deal, WorldCom is expected to contribute $160 to $175 million in revenue and three to four cents a share to EDS' earnings in each of the last two quarters of 2002, the company said.

"WorldCom will continue to require substantial IT services in its ongoing operations," the company said. Even if it doesn't, the company said it should easily be able to re-deploy the 1 percent of its staff and $90 million worth of equipment dedicated to WorldCom.

Analysts agree that as a customer, WorldCom's impact on EDS should be minimal. WorldCom's revenue only makes up about 2 percent of EDS' overall revenue of $550 million a year.

"In our view, the concerns over the WorldCom contract are exaggerated. An outright contract termination is unlikely," Lehman Brothers analyst Karl Keirstead said Monday.

Keirstead also pointed out that most of EDS' business with WorldCom is for managing things like data centers and billing operations, essential services WorldCom will still need even if it declares bankruptcy or is sold off in pieces.

The network services agreement is more controversial. The deal requires EDS to buy telecommunications network services from WorldCom over an 11-year period.

However, the deal isn't exclusive and EDS said it works with other telecom service providers. While it is "closely monitoring" the situation, EDS believes the WorldCom network will continue to operate.

More significant, analysts say, is that the agreement requires EDS to meet increasing revenue payments to WorldCom; if it fails to do so, EDS could be required to pay WorldCom a percentage of the shortfall.

EDS said Monday that it can meet the terms of the deal for 2002, but may have trouble going forward because of WorldCom's troubles. However, the company believes it should be able to renegotiate the terms of the deal--something analysts say should be possible.

But some analysts said investors are still skittish over the close ties between the companies, particularly regarding the fine print of the deals. Many companies with outsourcing-based business models have seen their accounting practices come under scrutiny because it is typically "impossible to know the 'real' profitability and cash-flow characteristics," of such deals, Keirstead said.

Deutsche Bank analyst William Zinsmeister also suggested that concern about how the deals are "tied together" is one of the biggest causes of the stock's decline. Zinsmeister suggests EDS should try to terminate its contracts with the company.

Ending the deals "would do much toward improving the psychology on the shares and could send a positive signal. Failure to sever the relationship, however, could continue to invite lingering concerns," Zinsmeister wrote in a research note.

Ending the contracts with WorldCom would result in lost revenue, but would only be around 2 percent per year on both companies' revenue and earnings.

Regardless of EDS' relationship with WorldCom, its stock may have a hard time recovering based on tough times for all companies in the IT services industry.

A slowdown in IT spending prompted UBS Warburg analyst Adam Frisch to lower estimates on the stock Monday. He said the ratio of the company's new contracts signed to renewals has declined 22 percent, 72 percent and 35 percent on a year-over-year basis for the last three quarters.