HP/EDS Merger: How Will It Affect the Tech Sector?

by: Zacks Investment Research

Headline-grabbing news last week regarding the Hewlett-Packard (NYSE:HPQ) buyout of Electronic Data Systems (NASDAQ:EDS) prompted us to check in with Zacks senior technology analyst Steve Biggs, CFA, who covers both companies. We also found out which tech stocks he rates the strongest for the near term.

Does Hewlett-Packard's buying out of EDS have any immediate impact on the tech sector overall, or does it mostly just make HP a bigger competitor versus IBM (NYSE:IBM)?

With the addition of EDS, HP will have triple the size of its services business and become a much closer competitor to IBM. We had a Sell rating on EDS prior to the announcement of HP's acquisition due to declining contract signings, which don't bode well for future results.

In fact, I have been somewhat negative on most of the IT services industry. I believe large scale outsourcing, such as what EDS and IBM do, is on the decline with enterprises choosing to bring more IT infrastructure management back in-house and outsource to smaller specialty providers that focus on certain aspects of the business, such as account statements, human resources, etc.

Given my view on EDS, I believe this could be a major disruption for Hewlett-Packard as it is battling a deteriorating top-line. HP believes that it can take out $1 billion in expenses, so profitability may be able to meet expectations, although this will take time. CEO Mark Hurd is known for organizational skills and his ability to cut costs, which helped HP realize benefits from the Compaq acquisition.

EDS is also a partner of Opsware, which HP acquired last year, and had tried to buy the company in the past. My belief is that over the next year or so, investors will look at likely revenue disappointments which could hurt the shares. Five years down the road, we might be able to look at this acquisition and see how it helped HP's competitive position, much like the Compaq acquisition.

How has The Street reacted to the news in the couple days since this announcement?

As expected, EDS was up based on the cash value of HP's offer and HP was down due to concerns over risks associated with the acquisition. The increased merger and acquisition activity we have seen over the past few quarters is probably a good sign for technology stocks in general, as acquirers perceive value in these companies. A number of companies in my universe have been acquired or have agreed to acquisitions over the past months. The majority of acquisition targets have been poorly performing companies that are near long-term lows in market capitalization, such as EDS, ChoicePoint (NYSE:CPS), Yahoo (YHOO), 3Com (COMS), meaning the acquirer (or hopeful acquirer) must have confidence in the business environment going forward.

Has earnings season in tech gone pretty much as expected, or have there been some noteworthy surprises?

The big surprise is how strong results have been. With many people looking for signs of an economic slowdown, most companies with a March quarter end have posted very strong results. I would say that the economy in the first quarter was much stronger than we thought. As a result, the market has rallied over the past month. Companies with an April quarter-end have begun to report and some of the results are not so positive, meaning that things could be slowing down, but it took until March for it to happen.

However, there have only been a few data points, with many large companies yet to report April quarters. I am still somewhat cautious in spite of strong results thus far, as we could still see slower IT spending.

Which stocks under coverage are your top Buy recommendations at this time?

I continue to like IBM as a defensive technology play. It gets more than half its revenue from overseas, insulating the company in the event of a domestic slowdown, and it could benefit from any disruptions at HP as it integrates EDS.

I also still like long-term buys Hittite Microwave (NASDAQ:HITT) and Salesforce.com (NYSE:CRM). Hittite is broadly diversified with good international exposure and sells into some defensive markets. Salesforce.com has a strong product cycle with new applications and its subscription model requires little up-front commitment from customers, which is an easier sell in uncertain times.

Steve Biggs, CFA is a senior analyst covering industries within the technology sector for Zacks Equity Research.