HP – EDS: A good deal, actually

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Is the EDS deal bad for HP shareholders? The market’s initial reaction suggests so, with HP losing several billion dollars in market cap because the deal introduces operational risk to what has been a remarkable turnaround / margin expansion story for HP investors.

A more in-depth look though at the likely strategic rationale, potential alternative targets and possible financial rationale leads us to conclude that the deal may not be so bad if you take a longer term perspective.

SITUATION

First off, though, let’s establish a common understanding of the IT services market taxonomy and where HP Services plays today.

Basically, there are 3 layers of IT services to consider: those relevant to infrastructure, applications, and business processes. Within each, some services targeted the front-end of the IT life cycle (i.e., design, build), while others target the back-end (i.e., deploy, manage & operate).

The bottom infrastructure layer includes services such as IT architecture and strategy consulting, as well as the building, integration and running of data centers and networks (the latter is often called IT infrastructure outsourcing).

The middle application layer essentially includes five types of services:

  • IT solutions and applications consulting (e.g., applications strategy and selection, application architecture design, functional design, project mgt)
  • Applications development (e.g., application detailed functional design, application development and testing)
  • Solution integration (e.g., application deployment, application integration)
  • Outsourced application support (e.g., help desk)
  • Outsourced application management (e.g., monitoring, maintenance, optimization, applications hosting)

Finally, the top business layer includes business process consulting and business process outsourcing. (There is also business strategy consulting but that is less directly related to IT, though IT can obviously be an enabler.)

In general, and at the risk of oversimplifying, the higher growth higher margin services are those in the business process layer as well as those in the front-end of the life cycle (i.e., consulting and integration) across the layers.

HP’s services business clearly has its origins in the infrastructure layer and – we suspect – is still characterized mostly by small product-attach services deals sold to middle management in IT rather than larger solutions-oriented deals sold to the C-suite. Moreover, we suspect that HP’s current front-end infrastructure consulting and integration services don’t do much for the company overall in terms of pulling other HP products or larger managed service deals.

We know that application level services have been a stated area of focus for the company but suspect that today fewer than half its services resources are dedicated to that area. More importantly, we estimate that HP’s bench strength in application level services is one order of magnitude smaller than that of Accenture or arch-rival IBM, and is also outranked by players such as Cap Gemini Ernst & Young and Deloitte.

Hence, HP seems to lack scale, breadth, and a market leading position in the higher value added parts of the IT services stack.

STRATEGIC OBJECTIVES

We are convinced that a deal would make strategic sense in principle if it helped HP achieve much of the following:

  • Allows HP to tap into higher growth and higher margin lines of business, potentially during a cyclical downturn in the economy when multiples are depressed
  • Positions HP as a solutions provider to the enterprise, promising higher margins through customized service bundles that aim to address IT or business problems in more of an end-to-end manner. This would also cater towards enterprise customers with a preference for one-stop shopping
  • Provides deeper C-level customer relationships, coupled with greater domain expertise in functional processes or industry-specific applications required for these more consultative relationships
  • Leverages a strong consulting & integration capability to pull through more of the broader HP product and services portfolio in the enterprise
  • Ideally, utilizes a deeper offshore talent pool to improve margins in the onshore business
  • Furthermore, a deal might provide targeted vertical, business process and applications expertise to drive further optimization of complex multi-vendor environments
  • On the margin, a deal might also enhance the appeal of HP’s Adaptive Enterprise messaging by providing more of the transmission mechanism between business strategy & processes and the enabling “HP Adaptive Infrastructure”

We see the first 4 factors as key to a deal, while the latter 3 obviously do not warrant a double-digit billion price tag on their own.

It is clear that accomplishing these goals in an organic fashion would not have been a viable option for HP, given the magnitude of the gap and considering the maturation and consolidation of the market.

Hence, the question boils down to which target would best meet HP’s presumed needs. HP could have gone in a few different directions here:

  • Acquire an Indian-based player such as Infosys, Tata, Wipro. Pro = good off-shore (and growing on-shore/near-shore) talent pool, presence in higher growth and higher margin businesses. Con = this is reflected in higher multiples. Biggest con is that their onshore go to market talent and set of C-level relationships is dwarfed by many of the on-shore players
  • Acquire a consulting and integration company such as Accenture, Cap Gemini Ernst & Young. Biggest pro is the ability to assemble solutions and pitch to the C-level. Accenture would also have brought a large business process off-shoring presence, seen as a large and high growth market. Con is that jumping from infrastructure to the business level still potentially leaves gaps at the application level. Moreover, similar ‘one stop shop’ attempts in the past, notably EDS acquisition and subsequent divestiture of management consulting firm A.T.Kearney, were widely seen as failures due to widely divergent cultures and minimal realization of cross-sell
  • Acquire a series of mid-sized players focused on specific industries (e.g., Booz & Co, the government consulting arm that is currently being spun off by Booz Allen & Hamilton) or geographies (e.g., Atos Origin, long mooted as a target for larger players). Whether this would achieve HP’s goals in principle depends on the targets. The biggest con is that HP is not exactly known to be an acquisition integration machine, unlike Cisco, so this option holds a lot of execution risk as well as a longer time to assemble
  • And finally, acquire one of the large IT outsourcing behemoths, notably EDS, CSC, and Unisys. So a fair debate would center more on the merits of these kinds of players

FINANCIAL RATIONALE

  • Of the 4 top IT outsourcing companies, EDS is the biggest, with 2007 revenues of $22bn, vs. CSC $16bn, CapGemini Euro 9bn, ACS $6bn, Unisys $6bn, Perot Systems $3bn. So HPQ would be buying the biggest asset in the IT outsourcing space, and…
  • HP is getting fairly good ‘value for money’. At a proposed price of $25, HP would be paying a multiple of 5.1 times Enterprise Value to estimated 2009 EBITDA. This is right in line with the peer group average. Also, at $25 per share, HP is acquiring EDS at a price / 2009 free cash flow multiple of 14.0x. This is higher than the peer group multiple of 11.4x but we see this justified in principle by the expected synergies, notably HP product pull
  • Accenture would undoubtedly have been a much more ‘high quality’ asset overall – a well run firm, strong in consulting & integration which is key to selling bigger solutions-oriented deals at the C-level, and with a very strong and attractive BPO franchise. However, we suppose HP management did not have appetite for a deal 3 times the size of EDS, given Accenture’s current market cap of $31bn (before any takeover premium) vs. EDS’s $12bn (incl. takeover premium). Such a deal would have been much more dilutive to HP shareholders (market cap $115bn) and potentially much harder to pull off given Accenture’s more complex governance model (i.e., more than a hundred partners which jointly control the voting rights)
  • We think the deal is fair and generous to EDS shareholders, given EDS’ poor growth and margins as well as absence of any other obvious strategic buyers

ORGANIZATIONAL CHALLENGES AHEAD

  • EDS has made progress in its turnaround but clearly needs to continue the push for higher growth and higher profitability. We do not know how much progress the company has made in shifting its resource base offshore but think that a 50/50 onshore / offshore staff mix should be the target for this kind of business. (Cap Gemini, which is slightly more weighted towards EMEA, has publicly stated a 40% offshore target)
  • Goldman Sachs analyst David Bailey summed up the challenges in a note to clients on May 12: “We think that HP’s acquisition of EDS could offer a number of positives for the company. The addition of EDS’s recurring revenue would provide more balance to HP’s revenue mix and help offset some the volatility stemming from the company’s more transactional and consumer exposure. Moreover, the deal should provide HP with opportunities to introduce the company’s hardware and software to a broader set of enterprise customers that currently outsource their datacenters with EDS.”
  • While HP has not traditionally been an ‘acquisition integration’ machine, CEO Hurd has led a successful turnaround at HP, with HP expenses as a percentage of revenue declining from 16.7% in the January quarter of 2005 to 14.5% in the January quarter of 2008 (a 13% decline), while gross margin improved by roughly 155 bps. This should give investors hope that he can succeed in trimming at least 5% from EDS operating expenses and increase gross margins by half a percentage point within 2 years

THE NET OF IT

  • HP is more than doubling the size of its current $17bn IT services business, bringing the combined entity to a run rate of $39bn in revenue
  • HP is buying the leading standalone IT outsourcing company at a pretty reasonable price
  • While the space HP is buying into is not very exciting overall (low margins, low growth, reflected in the fact that HP only pays 0.6x EDS revenue), it’s a fairly obvious adjacent market for HP. HP should be able to achieve decent synergies assuming moderate or better success with integration
  • Besides purely financial synergies (e.g., SG&A reduction), we believe the deal will bring deeper CIO-level customer relationships and enable HP to sell bigger, solutions-oriented deals
  • We look at this deal similar to HP’s acquisition of Compaq – a focus on operational synergies to drive upside for investors. Investors should be reasonably pleased that this deal makes sense based just on the financial synergies that Hurd will most likely be able to deliver on, before counting any possible additional upside from more strategic synergies
  • While no other target company would have been perfect either, the deal does fall short of several other criteria we would have judged important, notably a stronger presence in consulting and integration, business process outsourcing, and an offshore-based delivery model. Accenture would have been a better target for meeting these objectives, though note our concerns on price / dilution, feasibility of a deal with Accenture, and Accenture’s weaker presence in the ‘natural adjacent space’ to pull HP products (i.e., IT outsourcing)

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