Taking Stock: EDS Looks Like A Bargain Despite Its Relationship With WorldComTaking Stock: EDS Looks Like A Bargain Despite Its Relationship With WorldCom

The second age of McCarthyism is upon us. This time, the targets of the witch hunt are American businesses. Most prominent U.S. companies are being scrutinized for telltale signs of accounting irregularities or fraud. One of the latest victims is EDS. So what are the alleged fishy issues?

EDS (EDS--NYSE), one of the world's largest IT outsourcing and consulting firms with more than $21 billion in revenue last year, was founded in 1962 and functioned as an independent IT consulting firm until General Motors acquired it in 1984. EDS was spun off from GM in 1996 but didn't perform very well until Dick Brown came aboard as CEO in 1999 and began to turn things around.

EDS has four lines of business: information solutions ($16.2 billion, or 71% of revenue last year), business-process management ($3.0 billion, 14% of revenue), consulting ($2.4 billion, 16% of revenue), product life-cycle management solutions ($700 million, 3% of revenue), and other (an $800 million, or 4%, loss last year).

One key concern for EDS is its contract with WorldCom. In 1999, the telecom carrier outsourced its billing systems and other IT services in a $6.4 billion, 11-year contract. A worst-case scenario in which all WorldCom-related business disappears would lead to a decline of 16 cents per share, according to management. That's 4% to 5% of this year's earnings per share, so it's not that significant. EDS would also lose about $600 million in revenue--3% to 4% of total annual revenue going forward. In addition, EDS owns $90 million worth of equipment that's specific to WorldCom. Not great, but not a disaster. Finally, WorldCom owes EDS $150 million for services already provided. So far, WorldCom has paid every bill. EDS is looking to renegotiate its commitment to buy a certain amount of telecom services each year from WorldCom but is accounting for the expense as if no change for the better is going to occur and accruing a penalty for buying less than what's stipulated in the contract. That's a nice sign of conservative accounting.

Another issue concerns revenue recognition and an increase in accounts receivable. Questions have been raised about EDS's revenue-recognition policy for long-term IT outsourcing contracts. According to generally accepted U.S. accounting principles, EDS must use what's called the percentage of completion method when recognizing revenue. This is a requirement because EDS has a relatively clear sense of the total cost of each outsourcing contract. Revenue is recognized as certain milestones are achieved, and if cash isn't collected, the money is booked as accounts receivable to be collected later.

Take its contract with the Navy: EDS has spent more than $500 million building infrastructure dedicated to this contract and has achieved certain milestones. Some revenue and expenses have been recognized, but no cash has been collected and won't be until further testing is completed satisfactorily. The amount owed is accumulated as an account receivable.

This also helps explain why EDS reported $1.4 billion in net income last year but had free cash flow of only about $200 million. But cash flow is expected to rise dramatically over the next couple of years as some big contracts move from the implementation phase to the cash-collection phase. Free cash flow should be $700 million to $900 million this year, and $1 billion to $1.5 billion next year.

But EDS must deliver on these numbers. If not, it's an indication that customers aren't satisfied with the quality of the company's work and are refusing to pay until fixes are made.

Of the doubts surrounding EDS, only its WorldCom contracts appear to have a real--though relatively small--impact on the business. That's not to say free cash-flow generation isn't important. But there are good reasons why the divergence between cash flow and net income exists. Combined with a conservative management team, it looks as if EDS has been unfairly targeted. The stock has been driven down to levels only seen in times of crisis such as after the GM spin-off. EDS is trading at 10.5 times this year's earnings estimate, which makes it a bargain in my book.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the information 100 Stock Index. Reach him at [email protected].

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