Update: HP buys EDS for $13.9 billion

Deal will greatly expand HP's IT services business and catapult it to the No. 2 spot close behind IBM

HP said Tuesday morning that it has signed a deal to acquire IT outsourcer EDS for $13.9 billion, or $25 per share.

The deal has been approved by both companies' boards of directors, and is expected to close in the second half of this year.

HP said it will more than double its services revenue. It plans to fold its outsourcing business into a new unit to be called "EDS -- an HP company," which will be based in Plano, Texas, where EDS has its headquarters.

"This is about us putting our outsourcing business into EDS," said HP Chairman and CEO Mark Hurd, in a conference call with analysts.

[ For complete coverage of the EDS acquisition and its ramifications for HP, see InfoWorld's special report. ]

The EDS division will be led by EDS Chairman, President and Chief Executive Officer Ronald A. Rittenmeyer, who will report directly to Hurd.

That will take control of some of HP's services activities away from Ann Livermore, executive vice president of HP's Technology Solutions Group (TSG). Services, including outsourcing, contribute almost half of that group's revenue: the other half comes from storage, servers and software. Livermore "has got a big job," said Hurd, adding that much of HP's services activity will remain with TSG.

Rittenmeyer's appointment raised at least one analyst's eyebrows.

"It's interesting that he has been put into this spot, as there were questions about how he was going since taking over as CEO at EDS," said Gartner analyst Ben Pring.

The deal will greatly expand HP's IT services business and catapult it to the number two spot close behind IBM, whose Global Technology Services division has long been a strong profit generator for the company.

"I see [the acquisition] as an attempt by HP to really go head to head with IBM in a much more meaningful way, especially in technology services and IT outsourcing," Dana Stiffler, research director with AMR Research, said Monday, while the two companies were still in talks.

The worldwide market for IT services was worth $748 billion in 2007, an increase of 10.5 percent from the year before, according to recent figures from Gartner. IBM led the market with about $54 billion in revenue, followed by EDS with $22 billion. HP was in fifth place with revenue of $17 billion, behind Accenture and Fujitsu.

Buying a services business in a faltering economy is a good investment, because that's when customers are keenest to cut their costs by outsourcing, said Hurd.

"Services is countercyclical, the tougher things get, the better services does," he said.

Rittenmeyer said that EDS has a "strong pipeline" of contracts ahead of it.

There is little overlap in the channels by which the two companies reach customers, said Hurd, since HP's services business primarily targets small and medium-size businesses. Nevertheless, Hurd sees other areas where the companies can realize "significant synergies" and reduce operational costs.

The pending deal should not adversely impact HP partners who are authorized to sell services for its products, Hurd insisted.

"It’s good for HP, so it’s going to be good for our channel partners," Hurd said. "If you look at our outsourcing business today, we try to make it very complementary to our partners."

EDS will remain hardware-agnostic following the acquisition despite the presence of HP’s hardware business, Hurd said.

"While this is a popular question because of our product portfolio, in the services industry you have to work with all kinds of [products]," he said.

The acquisition will enable EDS to begin offering lower-priced services to customers, Hurd said.

"There’s a tremendous leverage you get from scale," he said. "We’re spreading our cost structure across a much larger revenue base. We expect to bring that capability to EDS. With many of the functions they do today, we can help them take advantage of that scale."

Buying EDS will grow HP's services business and allow it to offer a wider range of services to attract large business customers. EDS is strong in infrastructure management services and also custom application services, where it helps companies to design, integrate and manage applications.

EDS is less strong in providing services for packaged applications, however, and the acquisition will not give HP a big lift in the type of business consulting services delivered to line managers and business executives either, Stiffler said Monday.

HP has been keen to expand its services business for years, and EDS is not its first attempt to do so. In 2000 HP dropped plans to acquire PricewaterhouseCoopers Consulting, which was ultimately scooped up by IBM two years later, for $3.5 billion.

HP's services business generated only 16 percent of its total 2007 revenue of $104.3 billion, while IBM makes more than half of its annual revenue from services. The company increased its revenue estimate for fiscal year 2008 on Tuesday morning, saying it now expects revenue of between $114.2 billion and $114.4 billion, up from a previous estimate of $113.5 billion to $114 billion.

The company also reported preliminary results for its second fiscal quarter, ended April 30. It made revenue of $28.3 billion for the quarter, compared with $25.5 billion a year earlier. The figure beat estimates of analysts polled by Thomson Financial, who had expected $27.98 billion. HP also said estimated earnings per share for the quarter were $0.80, up from $0.65 one year earlier. Excluding acquisition related costs, EPS was $0.87, beating the analyst estimate of $0.84.

It expects to announce final results on May 20.

Buying EDS will give HP the muscle it needs to become a serious threat to IBM's services business, said Kathryn Hale, research vice president at Gartner, also speaking before the companies confirmed the deal. HP has the resources and the wherewithal to acquire EDS and improve its business results, she added.

EDS reported revenue of $22.1 billion for its fiscal year 2007, which was up only a fraction from 2006. Net income was $716 million, up from $470 million.

EDS and its subsidiaries employ about 137,000 people worldwide, around 90,000 of them overseas. About 45,000 of the overseas employees work in what EDS calls "best shore" countries, affording high service quality and low cost. EDS aims to boost the number of overseas workers in the "best shore" countries to around 55,000, said Rittenmeyer. HP ended its 2007 fiscal year with about 172,000 workers.

The $25 per share offer is a $6.14 premium above EDS' closing share price of $18.86 Friday. Rumors of the acquisition drove up EDS' share price to $24.13 by the close of trading Monday. Within two hours of trading Tuesday, EDS shares were at $24.45, up by $0.37, and HP shares were down by $2.95 to $43.88. The share price of buying companies often drops on the day an acquisition is announced, as traders calculate that big acquisitions usually have a dilutive effect on earnings, at least initially.

(Chris Kanaracus in Boston contributed to this report.)

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