Hewlett-Packard: Deutsche Bank Pees on EDS Merger, Deal "Dilutive"

Hewlett-Packard (HPQ) announced its buyout of Electronic Data Systems (EDS) today, paying $25 per share for the technology services provider. The move will catapult HPQ into second place in the technology service sector, behind IBM. Management was, of course, quick to rave about all kinds of synergies and efficiencies that the merger will produce, but Deutsche Bank is holding its nose, and insists that the deal will be dilutive. In notes released prior to this mornings announcement, DB tore holes in the then prospective merger:

our preliminary analysis of the transaction suggests modest dilution, low returns and significant opportunity cost. This deal appears to be a cost‐cutting / restructuring play (benefits from existing program largely realised) that will dilute HP’s overall growth rate and margin/return profile.

As highlighted all stock transaction with synergy assumptions ranging from zero to 100M would be $0.06‐$0.09 dilutive to HPQ’s ’08 earnings. In addition, as highlighted in Fig 2 a 50/50 cash/stock deal would be ~$0.01‐$0.05 dilutive. We estimate the deal would garner ~7% ROI (x‐charges) and reduce HP’s operating margin by ~80bps. EDS has struggled with revenue growth (only a 2% CAGR over the past 5 years) due to its reliance on the most mature segment of Services, its high‐cost footprint, share losses and re‐scoping of major contracts.

In the short term, the deal will threaten sales growth at Dell (DELL) and Sun Microsystems (JAVA) as HPQ cross-sells its hardware into EDS’ customer base. IBM, however, will benefit from “dislocations” as a result of the merger and subsequent restructuring:

Beyond heavy restructuring initiatives, we would expect HPQ to cross‐sell its hardware offerings into EDS’s customer base. This is likely incrementally negative for JAVA and DELL hardware sales (EDS is a large partner). This threat will likely be mitigated somewhat as competing integrators seek to diversify hardware allocations away from HP‐EDS. We believe this deal would be beneficial to IBM in the near‐term as it would likely benefit from dislocation associated with EDS’s integration and restructuring. Longer‐term (2‐3 years+), HP–EDS could evolve into a more significant challenger to IBM (Buy, $125.2).

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