HP More Than Doubles Services Biz with EDS Acquisition

Published: May 13, 2008

by Timothy Prickett Morgan

To say that Hewlett-Packard has wanted to be a powerhouse in IT services is a bit of an understatement. Almost straight out of the gate in 2000, then-new chief executive officer Carly Fiorina, the first non-HPer to run the company, tried to do a $17 billion deal with the IT consultancy arm of accountant PriceWaterhouse Coopers and failed, which IBM accomplished two years later with $3.5 billion just as HP had taken a left turn and acquired Compaq for $20 billion in 2001. The Compaq deal gave HP enterprise servers, storage, and some services. But nothing like the $13.9 billion acquisition today of Electronic Data Systems.

Given HP's aspirations in the IT sector, and the fact that it already dominates PCs and X64 servers and probably cannot increase its share very much in these areas, the real question is what took HP so long to come around to trying to acquire EDS? There are a bunch of factors that have caused HP to not go after EDS, which was founded by former presidential candidate Ross Perot four decades ago after he left Big Blue, until now. First and foremost, it took HP about five years to recover from its Compaq acquisition--which turns out to have been a great deal, despite the weeping and gnashing of teeth of critics--and the downturn in IT spending that started just after HP announced the Compaq deal in 2000. Only in the past year or so is HP bringing in the kinds of revenues and profits that it said the Compaq deal could bring. Moreover, it took a special tax break from the U.S. government that allowed HP to move $14.5 in cash back to the States to help fill its coffers to do deals.

Perhaps more importantly, EDS was too expensive between 1999 and 2002, when it had a market capitalization that ranged from three to four times the value EDS had before the deal was announced. As recently as March 17, shares of EDS were trading at a 52-week low of $15.71, giving it a market capitalization of $6.1 billion. That is not a lot of market confidence for a company that is the number two services provider in the world, which EDS already was behind IBM, and brought in $22.1 billion in its last fiscal year. EDS had a rough 2003 through 2005, when sales stagnated and the company was losing money. EDS started getting more black ink in its financial reports in 2005, and revenues have been growing some in 2006 and 2007, with profits on the rise a bit. Still, Wall Street is not exactly happy with EDS because it only brought $716 million to the bottom line on that $22.1 billion in sales in fiscal 2007 ended in December. IBM's margins in services are roughly twice that.

So you may be asking yourself, why does HP want to buy a company with 137,000 employees that doesn't make a lot of money right now? And why would it spend $13.9 billion--some of which will come from debt, not cash--to acquire a company that won't even add to HP's bottom line until fiscal 2010, according to Mark Hurd, HP's chairman and chief executive officer, who hosted a conference call with Wall Street analysts on Tuesday morning.

For one thing, EDS, despite the criticisms that all service companies face as they mess up an account and get a customer furious (it happens to all the services players), has a $10.4 billion services businesses in the Americas region, driven by state, local, and federal government contracts as much as by big business deals, and is a key player in application hosting ($6.4 billion in sales worldwide in 2007) and infrastructure services ($11.5 billion, which is more than twice the size of HP's $4.8 billion in outsourcing services deals). EDS also has a $3.1 billion business process outsourcing (BPO) business that will nestle in to HP's own consulting and integration business, and brings in another $1.1 billion in other services. And HP has a huge break-fix Technology Services unit that raked in $8.7 billion in HP's fiscal 2007 ended last October. When you add it all up and project some growth for HP's fiscal 2008, you get a services business that is going to be north of $40 billion, which should push HP to around $137 billion or so in fiscal 2008. That makes HP the undisputed IT giant, well ahead of Big Blue, and gives it a services business that is nipping at the heels of the $44.1 billion behemoth that is Global Services. But HP won't be nipping that hard at IBM. If IBM grows Global Services at 12 percent in 2008--the same rate it attained last year thanks partly to a weak dollar and IBM's global reach--then it will crest above $49 billion in sales.

That is a lot of ground to make up--like enough that HP would have to buy CDC (ranked sixth just behind HP prior to the EDS deal) to make up the difference. As it stands, HP estimates that IBM has about 10 percent of the $500 billion to $550 billion addressable market for IT services, compared to around 7 percent for the combined EDS and HP; Fujitsu and Accenture have about 4 percent of the addressable market share each (a little less than EDS), followed by the 3 percent or so held by HP and CSC independently. After the deal goes through, which HP expects to happen in the second half of 2008 after it jumps through regulatory hurdles and wins shareholder approval, HP will have around 20 percent of the application outsourcing space (the top position), around 10 percent of the IT outsourcing business, and around 5 percent of the BPO business globally.

Hurd got on the call with Wall Street and probably had an inkling that not all analysts would be happy with the deal, considering that this is a lot of cash to shell out for a company that, while improving, is not yet firing on all cylinders. But Hurd explained that the deal would make HP "the leading force in the IT services industry," and added that the combination of the two companies was "compelling strategically, financially, and operationally." While not being terribly specific about where HP might be able to cut costs to get EDS margins in line with its own and those at IBM in services, he said that the EDS unit, which will inherit the outsourcing business inside HP's Technology Solutions Group and which will be called EDS and run by the company's current chairman and chief executive officer, Ron Rittenmeyer, after the deal is done. Rittenmeyer will very likely be given a parallel post (executive vice president) to that held by Ann Livermore, who will remain in charge of the other bits of TSG--including services, storage, software, support services, and systems integration services. Based on 2007's financials, the proposed EDS unit would have had approximately $27 billion in sales compared to approximately $28 billion for TSG (minus outsourcing services).

One of the reasons why EDS has been successful over the many years of its operations is that it was not a services company that was captive to a particular IT vendor--making EDS a kind of Switzerland. The reason why HP is keeping EDS at arm's length from the rest of TSG seems obvious enough: HP wants to continue to benefit from the perception that EDS is making IT decisions independently of its parent's desire to sell its own platform. This is something that IBM has had to wrestle with as Global Services, which used to be legally separated from IBM as ISSC thanks to an antitrust settlement from 1969, has been merged back into the Big Blue collective and then extended out from and embraced other IT suppliers' hard and soft wares.

There are nonetheless some pretty significant platform plays that will now be possible, once HP takes control of EDS. For one thing, EDS manages over 65,000 servers worldwide and remotely supports more than 3 million desktops; the company manages over 1 million applications and over 2.6 billion lines of code on behalf of customers. There is a lot of IBM mainframe and Sun Microsystems iron in that mix, and HP will be able to make a compelling case among some of those customers to switch, for economic reasons, to iron that it can give to customers at cost if it so desires. While no one has ever been able to prove such a thing, it is intuitively obvious that IBM Global Services is one of the largest (if not the largest) mainframe customers in the world, and you can bet Sam Palmisano's last dollar that Global Services has helped smooth out mainframe sales here and there from time to time. HP will now be able to do much the same with its own iron inside EDS accounts that use HP-UX, Windows, or Linux on Integrity and Windows or Linux on ProLiant iron. To a lesser extent in terms of economic effects, EDS also gives HP a place to park some iron made by competitors as it does takeout deals when it boots out that iron as it wins a deal to put its own iron in. This is a far better option than letting that iron loose on the open market, where it can compete again.

There are also some synergies between HP's Opsware systems management business--HP acquired Opsware for $1.6 billion last summer--and EDS, too, since EDS was an early investor in Opsware and by far its largest customer.

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