OVUM. Phil Codling
For the full year, revenue growth for 2006 was 4% and operating margin was 3.8%, compared to 2.7% in 2005. Free cash flow for the full year improved from $619m to $887m. The outlook for 2007 is 4% revenue growth and an operating margin at 6.3%.
This was an excellent end to a positive year for EDS. Having underlined its return to growth and ability to raise margins in the first three quarters, the business accelerated in Q4 against key metrics, including top line, bottom line, contract signings, operating margin and free cash flow. Wall Street analysts on the call with Mike Jordan and his team last night sounded suitably impressed by this expectation-beating performance, and EDS's stock has gained 4% on the NYSE in after hours trading.
There's no magic formula behind EDS's return to form. Its key ingredients are the rationalisation of the cost base (including headcount reductions in expensive locations and inorganic/organic growth offshore) and improved contract execution, helped by smarter partnering and a shift towards standardised processes and service templates. IT outsourcing has always delivered slow returns on investment and change, and these ingredients have been, and remain, long-term strategic projects under Jordan's 4-year-old recovery strategy. EDS has played the long game, and it's starting to pay off.
EDS's cash generation is particularly impressive and significant. Creating free cash flow has been a challenge for large outsourcers, since ITO eats up capital expenditure, particularly on asset-heavy deals. This has acted as a natural break on the ability of outsourcers to improve cash flow through revenue growth.
In 2006, EDS actually reported higher capex than in the previous year ($1.0bn vs $700m), but its free cash flow went up because of its improved profit performance. Going forward, however, its capex requirements should diminish. That's because it is using less capital-intensive standardised processes, such as the Service Delivery Automation (SDA) and Business Management Transformation (BMT) now employed on two major accounts, the UK government department DWP and General Motors, and scheduled for other customers in 2007. It's also because it is pushing more into applications outsourcing and BPO, as opposed to capex-hungry ITO. All this suggests that EDS's cash generation should continue to accelerate. Indeed, it is estimating free cash flow of $1.0bn to $1.1bn for 2007.
This discussion of cash flow hasn't been for the sake of purely financial analysis. Cash has the power to drive growth. It enables service providers to invest in new services and even acquisitions. In other words, EDS is now getting itself into something of a virtuous circle, where growth begets more growth. Therefore, we should expect a more aggressive push by the company into applications and BPO in the year ahead, coupled with targeted M&A.
CSC Q3: no growth but outlook positive
CSC has announced its results for the third quarter of FY 2007. Reported revenue growth was in line with expectations at just 2%, or down 1% in constant currency. The operating margin before interest and special items fell from 7.0% in Q3 last year to 6.7%. Contracts signed in the quarter amounted to $1.6 billion, taking the nine-month total to $12.6 billion.
CSC continues its recovery from the difficulties and uncertainties that plagued it during 2006. The Q3 numbers - no growth, low contract signings, margin slightly down - are hardly impressive in themselves. But looking ahead, there are clear signs that things are improving.
Let's take the signings tally. CSC has signed more contract value in the first three quarters of FY 2007 than in the whole of FY 2006 ($12.6 billion vs $12.1 billion). And the pipeline looks healthy - it's 15% bigger than a year ago. So in terms of contracted revenue and future prospects, a return to growth appears imminent.
The NHS will start to help soon too. CSC should hit some milestones in its two new NHS clusters towards the end of Q4, and under NPfIT rules would then get an instant revenue hit. Management were, however, keen to emphasise to analysts the risk of these milestone slipping into April and the revenue take thus falling. As we've said before, the increased scope of CSC's NHS commitments brings great opportunities for the company but undeniable risks. For this reason, the Q4 milestones will be watched with particular interest.
As for the beleaguered operation in continental Europe, there are signs of improvement. Total European revenues again disappointed, with a constant currency decline of 7% in the quarter. But CSC is now pointing to progress in its French and German consulting and SI businesses, which concurs with our view of the improving market conditions in these geographies.
The foreseeable pick-up in CSC's growth should benefit margins. The Q3 operating margin fell partly because of growth in lower margin US federal business and the costs of CSC's ongoing review of stock related compensation (which contributed to a 38 basis point rise in SG&A to 6.3% of revenue). But we are also now seeing the effect of CSC's painful restructuring process on its bottom line. It claims $130 million of savings year-to-date following 4,000 'separations' and other rationalisations around property and data centres. That's in line with previous projections, and the total benefit to the bottom in FY 2008 should be some $300 million. Meanwhile, offshore headcount keeps growing, with 7,100 people now stationed in India and capacity for 4,500 more planned by December.
So CSC is executing its restructuring programme to plan, and thus becoming a leaner company. We think it's important that it doesn't rely on a lowered cost base to improve competitiveness and drive growth. CSC operates in a highly competitive IT outsourcing market that is prone to commoditisation. It must seek out new growth opportunities and differentiate itself. So we're pleased to see it talking of initiatives designed at the mid-market, including 'Offshore Direct' - India-led offerings slated for formal launch in April. CSC has a good record of competing for and growing smaller accounts (take Whitbread for example) and a concerted push into the mid-market looks sensible and timely. Financial services BPO that leverages its in-house software assets, especially in the UK and Europe, is another untapped opportunity for the company.