HP and EDS Will Face Integration Challenges

Includes: EDS, HPQ
by: Research Recap

Hewlett-Packard’s (NYSE: HPQ) planned $12.6-billion takeover of Electronic Data Systems (NYSE: EDS) is drawing mixed reviews.

The $25 a share all cash price represents a 25 percent premium to EDS’ closing sharing price on Friday.

Shares of H-P were down 6.6% in trading Tuesday, following a 4.7% drop in shares Monday, when the news was first reported by the Wall Street Journal.

The rapid revaluation of H-P shares at a level 11% lower than Friday’s close has motivated some analysts to urge investors to jump in, the WSJ reports. “HPQ has lost more market cap over the past 24 hours than the total purchase price of EDS, a clear overreaction,” writes Richard Gardner, Citigroup analyst (the company owns 10% or more of the common shares of HPQ, it should be noted).

For other analysts, this isn’t enough. Goldman Sachs analysts suggest that this buy “introduces operational risk to what has been one of the strongest and most consistent margin expansion stories in tech,” and Cowen & Co. analysts worry that this acquisition, like the company’s buy of Compaq in 2002, will prove to be a long, frustrating merger that costs plenty of money.

“In order to gain the buy-in from investors, Hewlett-Packard will have to adequately explain how its going to offset the higher percentage of total revenues being driven by lower margin business segments,” UBS analyst Adam Frisch told Dow Jones Newswires.

The Financial Times says the acquisition of EDS could help to push HP into higher-value parts of the services business and help support sales of existing products. “It gives them a place higher up the services food chain, against IBM,” one Silicon Valley investment banker said.

The FT’s Lex is underwhelmed:

Hewlett Packard will find it hard convincing its own shareholders that it can successfully integrate a different business and that it is worth paying a premium in order to try.

The move is a complicated strategic gambit for H-P Chief Executive Mark Hurd, according to The Wall Street Journal. “H-P already is a sprawling conglomerate that is the world’s largest maker of personal computers, with a market capitalization of $115 billion. Now it would have to digest a large company with a starkly different culture than its own.”

Lehman Brothers initiated coverage of H-P on April 21 with an Overweight rating and a target price of $59.

We believe HP continues to have solid momentum in industry standard servers & blades; success is helping HP gain traction in high margin areas like storage & software. We think HP is a winner in the “Utilization Era.”

On April 14, Merrill Lynch added H-P to its “US1” list with a price target of $56.

HP is one of our top picks in the IT Hardware sector because it is a defensive, large-cap, diversified (both geographically and product portfolio) play, with significant margin improvement remaining from ongoing cost initiatives.

Merrill was neutral on EDS on April 25:

While 1Q results were good, we think 2008 is still a transition year with ‘09 starting to look like an inflection point. Given the uncertainties hovering over ‘08 including filling the Verizon hole and tightened IT budgets, we are maintaining Neutral as we expect the shares to mark time pending better visibility.

Likewise, Jefferies and Co was cautious on EDS prior to the deal:

While better bookings are encouraging, headwinds including flat free cash flow and the Verizon contract termination could continue to hinder share performance.

Fitch, Moodys and Standard & Poor’s all reiterated H-P’s debt ratings, following announcement of the deal. Fitch and S&P put EDS on watch positive.

A transcript of H-P’s conference call is available here.

24/7 Wall Street’s Doug McIntyre wonders why Dell (NASDAQ: DELL)didn’t snap up EDS. “It would not be hard to make the case that Dell needs EDS much more than Hewlett-Packard.”

The EDS deal says more about Dell than it does Hewlett-Packard. Under CEO Mark Hurd, HPQ has been opportunistic and nimble. None of that can be said for Dell.

One thing that should not be too much of a challenge: integrating the two companies’ logos, which are almost the same shade of blue.