EDS Shares Plummet Again

Electronic Data Systems

Merrill Lynch analyst Stephen McClellan downgraded his rating for EDS to "sell" from "hold," saying the Plano, Texas, technology services company faces a loss from derivatives deals. The settlement could wipe out the company's free cash flow for 2002, the analyst said.

Separately, Sanford Bernstein analyst Rod Bourgeois said he expects the Securities and Exchange Commission to begin an informal inquiry into EDS' accounting. Bourgeois said the high-profile nature of last week's profit warning could draw SEC scrutiny. But it's possible the informal inquiry wouldn't lead to a formal probe, he said.

EDS officials couldn't immediately be reached. An SEC spokesman declined to comment.

EDS shares traded midday Tuesday at $10.70, down $5.82, or 35 percent. Volume was 39 million shares, compared with the daily average of 6.5 million.

According to Merrill's McClellan, EDS has entered a series of options contracts and forward-purchase agreements that could result in a charge against earnings of up to 21 cents a share. He didn't specify when the expected charge would occur. The moves also "effectively eliminate" EDS' free cash flow for 2002, he said.

EDS last week lowered its forecast of 2002 free cash flow to a range of $200 million to $400 million, compared with an earlier target of $600 million to $800 million.

Reduced free cash flow could hurt EDS' ability to compete for tech services contracts, McClellan said. That raises questions about EDS' bids for outsourcing contracts with companies such as Procter and Gamble and J.P. Morgan Chase, McClellan said. Both companies are considering outsourcing large chunks of their operations.

Among other concerns, McClellan said EDS could be hurt by downgrades of its debt ratings, as well as contracts with unstable customers like WorldCom and US Airways Group, both of which are in bankruptcy court.

"In our view, there remains great uncertainty surrounding EDS' near term earnings and cash flow generation," McClellan wrote in a research note.

Merrill Lynch has an investment-banking relationship with EDS.

Although Bourgeois of Sanford Bernstein raised concerns about a possible SEC investigation into EDS, he was cautiously optimistic on other issues. He said he doubted EDS faces a liquidity crisis because it has historically been able to fund its operations without the need to raise capital. Also, he believes EDS can exceed its reduced earnings expectations.

Bernstein has no investment banking relationship with EDS.

EDS said last week it expected earnings of 12 cents to 15 cents a share for the quarter ending Sept. 30, well below its previous target of 74 cents a share. It also expects lower revenue than previously targeted. The company blamed cutbacks in tech spending by existing and prospective customers.

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