Market Share: EDS struggles to get cash flowing in the right direction

Bill Loomis

Investors in the federal and commercial information technology space have watched Electronic Data Systems Corp. go from high flying to struggling. One issue EDS is tackling is the eight-year, $6.9 billion Navy-Marine Corps Intranet contract awarded in October 2000.

The rollout of the network has been delayed because of additional testing requirements and thousands of unexpected legacy applications that either have to be made compliant to NMCI standards, run on a separate system or eliminated.

The impact on EDS has been higher capital investment and lower cash flow from the program. We estimate EDS will have invested nearly $1 billion in the program this year. It has accumulated a similar amount of unbilled account receivables, which represent revenue EDS has recognized on the program but cannot yet bill --and therefore receive cash payment -- until certain contractual terms are met.

EDS expects the unbilled account receivables to continue to grow until the first quarter or early in the second quarter of 2003. Then, following successful results from testing and EDS performing well on its service-level agreement terms, the contract will turn cash-flow positive.

The Navy recently completed its second milestone test of the network, which has more than 33,000 seats up and running out of an eventual 400,000 seats. From then on, EDS will be measured by -- and the contract profitability will be subject to -- its performance relative to the service-level agreements negotiated with the Navy.

EDS has many other challenges it needs to surmount, including a Securities and Exchange Commission investigation, the impact of bankrupt clients, slowing revenue growth, declining profit margins and reduced contract awards. But investors are particularly focused on cash flow. Turning NMCI into a cash-producing contract rather than one of the largest cash-using contracts is very important to restoring investor confidence.

Certainly, the NMCI contract is new ground for both the Navy and EDS, given its large scope and security requirements. Other agencies seem to be taking a more modular, manageable and less risky approach to outsourcing, which we believe would benefit the contractor as well.

However, there is clearly a push in government, civilian and defense, to move more risk to the private sector through fixed price and performance-based contracting. On outsourcing initiatives, industry will likely be called upon more to buy (or build and own, such as NMCI) the outsourced infrastructure, similar to the private sector. While this generally should mean higher profit margins for the industry, it also means higher risk if you do not have contingencies for unknowns, such as finding thousands of noncompliant applications that have to be fixed.

Contractors are sometimes quite reliant on customer-provided data in determining their bid and cost structure, and therefore should have contract language to protect them if the information is inaccurate. Performance-based contracting has been used extensively by the states, and we are aware of contracts where the contractor used a state's estimates for future volumes and was hurt when actual volumes varied materially.

While performance-based contracting seems to be a growing trend, contractors need to be much more careful in their due diligence and contract language than with traditional cost plus to time and material engagements. *

Bill Loomis is a managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. For additional information and current disclosures for the companies discussed herein, please write to: Legg Mason Wood Walker Inc., 100 Light Street, P.O. Box 1476, Baltimore, MD 21203, Attn: Research Department.

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