HP in talks to buy Electronic Data Systems to compete with IBM

HP shares fell nearly 5 percent amid some skepticism that slow-growing EDS, still considered in turnaround mode, would provide more than a one-time boost, and might not be worth a premium of as much as 37 percent.

A source briefed on the matter told Reuters about the talks and that the plan was to announce a deal by the close of Tuesday. The Wall Street Journal first reported the discussions, and later HP and EDS both said they were in talks about a business combination but gave no details.

"While Hewlett-Packard has over time built up its own outsourcing practice, this clearly is a move by Mark Hurd to challenge IBM in the services area," said David Garrity, director of research at Dinosaur Securities, referring to HP's chief executive.

A bigger HP could compete better against International Business Machines Corp in going after large clients and help it keep costs in line, analysts said. If HP completes the acquisition, it would be by far the largest under CEO Hurd.

"It would put Hewlett-Packard in the sweet spot of an IT spending trend. It would definitely improve their position against IBM," said CRT Capital Group analyst Ashok Kumar.

SKEPTICISM ABOUT TARGET

HP has long considered an acquisition to beef up its tech services business, a sector that offers relatively stable income and high margins even in an economic downturn.

Worldwide computer services revenue rose 10.5 percent to $748 billion in 2007, according to data released on Monday by market research firm Gartner Inc.

IBM continued to be the leader, with 7.2 percent share. EDS weighed in at No. 2, with 3.0 percent of the market, while HP was No. 5, with 2.2 percent market share.

Together HP and EDS would have roughly $39.4 billion in services revenue, compared with IBM's $54.1 billion last year.

"HP gains a very strong No. 2 position in total services market share and professional services market share behind IBM," said Gartner analyst Allie Young.

If EDS were to remain independent it would have a tough time holding on to its number 2 slot in IT services market, Young said.

EDS brings to HP a strong base in infrastructure outsourcing, Young said. But neither HP nor EDS is strong in high-end consulting, which is a strong suit for IBM.

Yet there was some skepticism about HP's target, EDS.

"Unless HP has some synergies where they can dramatically impact earnings growth of EDS, I'm not sure why they'd want to buy it," said Jim Huguet, co-chief executive at Great Companies LLC. He noted that EDS's earnings growth has averaged 2.8 percent.

"EDS is trading at about half its historical PE, so they're obviously seeing it as a value, which it is if you can generate earnings growth at 15-20 percent. But my question is whether it will become a drain on Hewlett-Packard?"

In April, EDS reported a 62 percent decline in first quarter profit, though the results had topped Wall Street expectations. Despite the beat, analysts said EDS faced intense competition from Indian rivals and saw little catalyst for growth.

"Growth could temporarily stall but then the opportunity is for the merged operations to be extremely strong and competitive," Young said.

Besides HP and IBM, EDS also competes with Accenture Ltd (ACN.N: Quote, Profile, Research) and Computer Sciences Corp in the United States, as well as Indian companies Infosys Technologies Ltd, Tata Consultancy Services Ltd and Cognizant Technology Solutions Corp.

"EDS has been relatively stagnant over the past few years. HP has been trying to promote themselves as a major services organization over the past few years. This will certainly help them with that," said Chad Hersh, an analyst at Novarica.

EDS has cut thousands of jobs to boost profits, and also is generating revenue from contracts including a lucrative deal last year with the U.S. Navy.

"We believe that Hewlett would be acquiring a fairly clean book of business, at least one that has been well scrubbed. So there shouldn't be any untoward surprises," Garrity said.

In 2000, HP pulled out of talks to buy the consulting business of PricewaterhouseCoopers for as much as $18 billion. IBM in October 2002 closed its $3.5 billion acquisition of PricewaterhouseCoopers' consulting division.