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Analysts: EDS faces uphill climb

EDS is downgraded by Salomon Smith Barney as the consulting and computer systems integration giant continues to see its revenues fall.

    Electronic Data Systems was downgraded by influential investment bank Salomon Smith Barney as the world's second-largest consulting and computer systems integration company continues to see its revenues from its largest client fall.

    Salomon analyst Richard Weingarten lowered his outlook for EDS to "neutral" from "outperform," saying the company is a "strong franchise" with an inherent value greater than its current stock price, but that "there are still several bumps left in the road before EDS realizes that value."

    Indeed, other analysts also agree that EDS faces an uphill climb as it tries to generate profits amid declining revenues and contracts from General Motors, its largest client. The giant automaker has steadily been allowing EDS's competitors to bid on an increasing percentage of the work EDS has been doing since the company was spun off from GM, in accordance of a master services agreement (MSA) between the two. GM will be able to place another $200 million-plus up for competitive bidding in 1999.

    "This will obviously have a negative impact on EDS's revenues," said an industry analyst. "Additionally, the MSA calls for further cost reductions into the contracts with GM going from 1998 to 1999 and onward."

    As outlined in the MSA, EDS must pass along to GM a 10 percent reduction in communications rates which is estimated at more than $50 million pretax, and another $50 million in "good faith" cost reductions are expected.

    While EDS has been winning contracts elsewhere, including the deals in the past year with regional phone company Bell South and Australia's Commonwealth Bank, and even a few contracts in open bidding from GM, analysts still point to the importance of EDS's continued revenue stream from GM.

    For the third quarter ended September 30, EDS saw its revenues from GM decline $32.1 million or 2 percent to about $1 billion. For the nine months ended September 30, revenues from GM fell $148 million or 5 percent to about $3.1 billion.

    In its 10-Q form filed on Friday with the Securities and Exchange Commission, the company said that the slide was "primarily from reduced discretionary spending by GM" for IT services. However, analysts say that the automaker may also be shunning EDS to some degree.

    "[GM] thinks they are paying too much for the work EDS is doing and they are looking for ways to pay less," said Gary Helmig, an analyst at SoundView Financial Group. "While EDS would call it conegotiations as they negotiate new contracts, it sounds to me more like GM is telling them 'we won't pay this much for that set of services."

    "EDS has to accept the terms," added Helmig.

    Another major problem analysts point to is EDS's falling gross margin [revenues minus the cost of revenues divided by revenues]. EDS saw its gross margin slide to 18 percent for both the three and nine months periods which ended September 30, which were 21 percent and 20 percent for those periods a year-ago, respectively.

    Analysts say that EDS is a victim of having too rosy an outlook for its gross margins.

    "What happens is that when they sign up these new contracts, there is a gross margin assumption at the time the contract is setup," said Helmig. "The problem is that EDS's gross margin assumptions tend to be aggressive and they take more profit than they should.

    "And as they have done with at least six contracts, they have to adjust their figures which brings them back to the ground," added Helmig.

    Analysts say that EDS has improved its ability to accurately forecast their costs but that they still need to do an even better job on that front.

    Shares of EDS were trading at 38.50, down 0.625 for the day. The stock has traded as high as 50.88 and as low as 30.44 during the past 52 weeks.

    EDS's competitors include Cambridge Technology Partners (which was also downgraded to "neutral'' from "buy'' by analyst Karl Keirstead at Lehman Brothers), Keane and Computer Science Corporation.

    EDS must move quickly to secure a CEO and CFO to bring confidence to investors and clients, analysts agree. Its current CEO, Les Alberthal, informed the company in August that he planned to retire.

    "We believe the near-term lack of both a CEO and a CFO poses a near-term risk to results, particularly new business signings," wrote Weingarten in his report adding that potential customers might be wary to partner up with EDS not knowing who will ultimately be at the helm.

    "When the new management gets in--which will happen someday--I think we would be looking at what the new management is doing to manage the GM contracts," said Helmig. "They will either manage them to profitability or obscurity."