EDS: What went Wrong?

On a balmy day last June, some 150 of Electronic Data Systems Corp’s top
executives gathered at the company’s Plano campus for its thrice-annual senior
leadership meeting. One by one, the heads of its businesses presented grim
financial outlooks, say people who were there.

EDS looked likely to fall short of its earnings targets for the upcoming
third and fourth quarters, in part because of slackening tech spending by
corporations. That wasn’t what CEO Richard H "Dick" Brown wanted to
hear. Brushing aside the pessimism, he pushed managers to stretch for their
targets, as they had in previous quarters. "He said we weren’t trying
hard enough. We were told there was gold in the hills and to go find it,"
says a former high-ranking executive.

Now, Brown–and EDS–has paid a heavy price for his outsize optimism. Three
months after that June meeting, EDS shocked Wall Street by warning that earnings
would fall 80% short of projections. That day, Septermber 18, EDS shares fell
53%, to $17.20. Since then, a string of nasty surprises has further sapped
investor confidence. Among the concerns–a Securities & Exchange Commission
investigation that is focused on events leading up to the earnings miss, as well
as on an undisclosed losing bet EDS made on its own stock price that cost the
company $225 million. The trail of bad news led to Brown, and on March 20, EDS’
board replaced him with former CBS Corp. CEO Michael H Jordan.

These are grim days in Plano. EDS denies any wrongdoing and will not comment
on the SEC probe. Yet barring any findings of malfeasance by the SEC, EDS may
still end up as a long-term winner in the $140-billion computer outsourcing
industry. It still has billions worth of multiyear contracts from corporations
that have farmed out various technology jobs, such as running computer networks.
That’s enough recurring revenue to see the company through its current crisis,
analysts say. Indeed, investors have driven up EDS shares 12%, to $17.63, since
Brown’s March 20 ouster.

The new CEO faces a daunting job in reestablishing EDS as a dependable
powerhouse of tech. While Brown made many necessary changes after he was hired
in December, 1998, he failed to address key trends in the rapidly changing tech
landscape, say analysts. The company has been slow to address the threat from
offshore rivals such as India’s Wipro Ltd, which offers many EDS-style
services at much lower cost. And EDS is an also-ran in the fast-growing market
for business process outsourcing. Rather than just taking over a customer’s
existing computer operation, BPO specialists revamp the entire job, whether it’s
procurement or human resources. Jordan, who is 66, must also hurry to allay
concerns about EDS’s future by forming a succession plan.

Investors can only hope that Jordan performs better than Brown did. An inside
look at the missteps at EDS shows not only how Brown’s unbridled optimism led
to troubles, but how his reluctance to confront those problems compounded the
woes. After four years on the job, he leaves EDS a weaker and more vulnerable
company.

Founded by H Ross Perot in 1962, EDS had long been famous for its technical
competence, steady growth, and Perot’s conservative culture, symbolized by
crisp white shirts and military-issue haircuts. But by 1998, Brown’s gung-ho
style seemed just the ticket to revive a company that had grown bureaucratic and
inefficient. "The EDS you see one year from now will be very different from
the company you know now," Brown declared to securities analysts in April,
1999. Investors drove EDS’s stock from about 35 before he was hired to a high
of 75 in February, 2000.

Eager for growth, Brown pushed executives to win marquee "megadeals."
These were multibillion-dollar contracts in which corporations or government
agencies handed over a broader swath of computing jobs. While EDS and its rivals
had to make bigger up-front investments in equipment and labor, megadeals
ensured a steady stream of dependable new revenues. Brown’s efforts seemed to
work. EDS inked $24.9 billion in new signings in 1999, up 111% from 1998. Yet
Brown took megarisks to land some of those megadeals. In the fall of 2000, he
signed on to overhaul the US Navy’s computer systems, even though former Chief
Financial Officer James E Daley warned that EDS wouldn’t make a profit on the
deal after inflation was taken into account, say two former senior executives
familiar with the deliberations. EDS’s winning bid, which beat out offers from
IBM and others, carried a thin 4% margin. That’s well below the 7% margin
typical of EDS’s megadeals, says UBS Warburg analyst Adam Frisch. The contract
ran into a raft of problems that held up payment. By the end of 2002, the deal
had drained $1.9 billion in cash from EDS’ coffers. Daley would not comment.
Other big bets turned ugly, too. In June, 1999, Brown signed a $12.4 billion
partnership with WorldCom Inc. that required EDS to resell more than $400
million of the telco’s services each year to other customers. Even before
WorldCom collapsed in July, 2002, EDS was struggling to find customers, say two
former execs involved with the deal. EDS has renegotiated the contact but has
been forced to take $118 million in reserves and write-downs. The key question
for regulators is whether Brown and EDS management should have disclosed bad
news sooner. Even as tech spending plummeted, EDS appeared to thrive. In 2001,
when Brown earned $55 million in cash, stock, and options, EDS rang up record
sales of $21.5 billion. The following February, Brown promised that EDS would
grow core revenues by 13% to 16% in 2002, with higher year-over-year margins.

The downdraft, though, was becoming clearer. When EDS closed the books on its
first quarter of 2002, core revenues had grown only 8%. Second-quarter results
also came in at 8% growth. Long after rivals IBM and Computer Sciences Corp had
warned of slumps in 2002, Brown remained upbeat, saying frequently–yet execs
made little effort to rein in Brown’s expectations out of fear of being
publicly humiliated, according to former senior executives who were there.

As investor confidence waned, Brown went on a six-city road show. The purpose
of the trip, EDS has said, was to respond to concerns about client bankruptcies
and questions about accounting. But Brown faced plenty of questions about market
conditions. The CEO insisted that EDS’ backlog of signed contracts and
pipeline of potential deals would allow the company to meet quarterly
expectations, say institutional investors who attended presentations. Brown
later said in a conference call that he did not learn about EDS’ disappointing
earnings until September, 2002, only days before communicating the news. The
stunner came on Sept. 18, when EDS announced that it would earn no more than $74
million in its third quarter – 80% less than the consensus estimate. A host of
unforeseen problems "hit us with a force that was unexpected," Brown
said in a conference call with analysts. EDS shares plunged 53%, to $17.20, the
next day. A few days later, after a Wall Street analyst revealed that EDS had
borrowed $225 million to unwind recent derivatives contracts, shares tumbled 29%
more, to $11.68. Some analysts wonder if Jordan and former EDS vice-chairman
Jeffrey M Heller, now president and chief operating officer, are going to try to
sell the company. Finding a buyer for EDS could be tough. Analysts say IBM is
well-positioned as is, and that Hewlett-Packard is still digesting Compaq
Computer. Even if those companies go shopping, the EDS Dick Brown built isn’t
looking like anyone’s prize.

By Andrew Park in Dallas in BusinessWeek. Copyright 2003 by The McGraw-Hill Companies, Inc