Tuesday we learned that HP (chart here) is buying EDS (chart here) (read press release here, read Reuters article here). So is this a good deal? The reasons to be pessimistic outweigh the reasons to be optimistic.
What we know is that the market for computer outsourcing has slowed dramatically. Companies are realizing that the benefits of IT outsourcing are easier to talk about than achieve. Additionally, we know the margin has dropped for a decade, as very efficient and low cost competitors offshore have driven down prices while raising delivery standards. EDS almost went broke after 2000 trying to compete for new projects by pricing to market - which was money losing. And HP has struggled to grow profitably.
We also know that this is a highly fragmented market, where no one has enough share to affect price, with market leader IBM having only 7% share - and the combined EDS/HP will have only about 5% share as the #2 player. So we tie growth or profitability to size. In fact, the fastest growing and most profitable competitors are not the largest (Infosys, TCS, Cognizant, WiPro). Those making money are using global delivery models with aggressive new approaches to services - not cost cutting - to raise returns for themselves and customers. While the market is growing at maybe 10%/year, IBM, HP, EDS and CSC have not matched market growth. But the leaders are growing at more than 20% per quarter! And while the U.S. behemoths are earning margins of 2-20%, the leaders are earning over 40%! So obviouslyl success relies on utlizing innovation and new approaches to deliver higher value. Not just cost cutting.
The signs of a good acquisition are when the buyer says (a) this will change our way of doing business (b) we will operate this in a seperate environment so it can develop its own market approach (c) we will monitor progress and look to adopt learning from this new acquisition in our existing business. But the press release says the primary benefits of this acquistion are (1) size - merging revenues and (b) lower cost by cutting overhead and people. Meanwhile the business will remain headquartered in its existing location and will maintain the existing CEO from EDS as well as existing reporting structure. Ugh. Not optimistic sounding.
A year from now what are we likely to hear? HP will say that it has grown revenue by more than 10% - which will merely be the fact that they bought EDS, not that there was any "real" growth. EDS will no longer be a competitor. Cost reductions will not have occurred as quickly as hoped, thus there will be negative P&L implications that are planned to improve (given more time). Revenue growth will not meet expectations, as some customers will leave after the merger (as people leave) and some offerings will be deleted as part of the cost savings. The total market share of HP will be less than today's combined share of HP and EDS, as the share of Infosys, TCS, WiPro and Cognizant continues growing. But HP will declare a victory, and the CEO will expect more pay, because HP will be bigger!
HP has done very well for investors since Mr. Hurd replaced Ms. Fiorina as CEO. But fixing old investments isn't enough. HP needs to return to innovation for growth. Once HP was a market leader with its products. And it needs to be an innovator in services if it wants to grow faster than the market and earn higher margings. And that will require using more White Space with different leaders for the services business. Increasingly, HP has been improving profitability by merely being a market follower, using conventional tools to Defend & Extend businesses its already in. That does not bode well for earning above average rates of return going forward - and thus is not good news for investors who have already lost more than 10% of their equity value - and could lose more purchasing EDS and its poorly performing Success Formula.