HP’s Acquisition of EDS Makes Sense

Tuesday morning Hewlett-Packard (HPQ) announced a deal to acquire Electronic Data Systems Corp. (EDS) for $13.9 billion dollars or $25 per share. HP offered almost a 30% premium to the pre-deal-price of EDS stock. The offer has been approved by both companies’ boards and now awaits EDS shareholder approval. Clearly, the intent of the deal is to challenge IBM’s supremacy in IT services. IBM claims the largest share of the international IT services market with 7.2%, according to Gartner Inc. EDS is second with a 3% share, and HP is fifth with 2.3%. As with any large scale merger there will be organizational difficulties and differences of corporate culture, but this merger should provide much upside for HP.

The HP technology solutions group is already the largest division within HP and accounted for 16% of sales last year. The deal will effectively double the size of this unit in one fell swoop. The IT service group is obviously a focal point for HP CEO Mark Hurd’s growth strategy and many analysts foresee the industry as a whole growing at a steady 8% clip of the next 5 years. Mr. Hurd wants to claim more of that growth for HP as opposed to industry leader and rival IBM. The other reason HP is eager to grow its IT services group is because—unlike their Personal Computer business segment—the IT service group is very resistant to business cycle fluctuations. The deal will greatly enhance HP’s presence and versatility in the industry; up until now HP’s IT services have mostly been limited to support for its own products.

If the deal does in fact get approval to proceed--which seems quite likely--it will be a big step in the right direction for HP. EDS has just started to see the benefits of a turnaround instigated by former CEO Michael Jordan and current CEO Ronald Rittenmeyer. EDS had lost over $1 billion in 2002 and 2003, but by streamlining operations and off-shoring jobs to India the company has returned to profitability.

The turnaround was necessary as global competition in IT services has intensified greatly, a trend which we believe will continue in years to come. The combination of HP and EDS will help HP greatly strengthen its IT services and consulting business and will allow it to compete more ably with not only IBM but other emerging-market players in the field.

Disclosure: No positions

Comments

[User 49180]

The acquisition of EDS may prove valuable to HPQ in the long run but could lead to p/e compression and a lower than otherwise HPQ stock price in the near term. HPQ's Gross margin was just under 25% last year compared to just under 42.5% for IBM which has shed lower margin business segments like PC's over the last several years. EDS' gross margin was just under 14% last year and adding another relatively low margin book of business to HPQ's big PC business should keep HPQ Gross Margin sub 25%.

In addition, many big EDS customers use IBM hardware and may want to transition to IBM's new Power6 equipment. The acquisition may provide marketing opportunities for IBM to characterize HPQ/EDS as a "middleman".

[deaverb]

The article underscores the long term strategic advantages of this merger that so many have missed. EDS is a top brand in consulting, especially "wring out the costs by eliminating the complexity and 'your' people, turning them over to us (whew)."

As with a re-energized Avis with Robert Townsend many years ago, that ironically benefited Hertz as much or more than Avis, now IT buyers have two strong shops to choose between. If one doesn't work, you have Avis try harder over at HP, or #1 at IBM.

Any CEO of a major Fortune 500 company will take a sigh of relief knowing that the "other" guy is a safe fall back position. IBM has hardware; HP has hardware. Sweet deal for everyone.

Smart move.