EDS Rides Out a Storm

It was an imperfect storm.

On Sept. 18, Electronic Data Systems slashed its forecasted third-quarter earnings, from 74 cents to no more than 15 cents per share. Soon thereafter, a Merrill Lynch analyst warned investors EDS faced a cash crunch. Stephen McClellan noted that EDS had issued $225 million of commercial paper to cover costs of employee stock options, after a failed bet that the company’s own stock would rise in value. That $225 million, he said, would wipe out the company’s “free cash flow” for the year.

EDS stock fell 53% on the earnings warning; and another 29% on McClellan’s note, to $11.68. By the middle of January, the company’s stock had climbed back up to $20. But then, the Securities and Exchange Commission said it had begun a formal investigation of EDS’ ill-fated cost-hedging strategy. It ended the month at $16.53.

But all is not as it seems in this set of “facts.” That’s why it makes it so hard for technology managers to do their due diligence on the financial condition of a potential partner in the deployment of information systems, such as EDS.

Take the assertion by seasoned analyst McClellan that the $225 million could wipe out the company’s “free cash flow” for the year.

Not so. Not all cash coming into a company flows from the same sources or is used for the same purposes.

Free cash flow is the lifeblood of a company, day-to-day. Essentially, it is the cash generated by operations that is free to be put back into operations. Excluded from the count is cash used in investing activities, such as covering the costs of stock option plans, making acquisitions or purchasing marketable securities.

McClellan mixed up the two. The payment for the commercial paper was an investing activity. EDS’ free cash flow would be unaffected.

In September, EDS said free cash flow for the year would likely be between $200 million and $40o million. In the third quarter, free cash flow was $118 million. In the fourth quarter, it reached $863 million. For the year, $1 billion.

McClellan, who had spent 18 years at Merrill Lynch covering companies such as EDS and Computer Sciences Corp., wound up out of a job. His last day was Jan. 15.

If a veteran analyst like McClellan can get a fundamental piece of cash analysis so wrong, what hope is there for the nonprofessional analyst trying to make sense of what is happening at a technology supplier?

First, think long-term. You want your deployment partner to be around for years to come. So check out the debt.

“Debt is at a peak level,” says Rod Bourgeois, the senior analyst at independent research firm Sanford C. Bernstein. Bourgeois notes and correctly says that EDS’ obligation to purchase shares because its hedging failed would have “no impact” on free cash flow. And he said so in July.

But take a look at EDS’ long-term debt, which Bourgeois says “stretches” the company’s balance sheet. At the end of 1998, the company had $1.2 billion of long-term debt. At the end of 2001, that had mushroomed to $4.7 billion.

If the company had been borrowing money to pay its bills, then such a surge would be truly alarming. As it was, Bourgeois notes, the money paid for a slew of company acquisitions that coincided with the arrival of new chief executive Richard Brown. “The reality is that the company has never really needed to raise debt to finance the ongoing operations of the company,” Bourgeois says.