Consulting
References Practices Case
October 20, 1991
Why E.D.S. Loves a Recession
Lester M. Alberthal Jr., who took over the computer services company from H. Ross Perot, aims to triple sales to $25 billion by 2000.
But its confidence was well placed. The Houston-based natural gas company thinks it is on its way to saving at least that much, equal to 20 percent of its computing expenses, by 1999. "We're out of the how-to-do-it part of the computing business," said Jack I. Tompkins, the Enron senior vice president who bargained with E.D.S. on the deal. "We consider E.D.S. the technology experts."
A network command center in Plano, Tex., manages global communications. (Electronic Data Systems Corp.)
This growth is expected despite the fact that the number of companies in the business is increasing. The key is an explosion in demand. One recent survey showed that 40 percent of all corporations are seriously considering hiring computer services companies to manage all or part of their data processing operations. Overall, worldwide spending on computer services, which range from a narrow task like managing automated teller accounts for banks to taking full control of a company's entire computing operations and staff, are expected to hit $1.3 trillion in 1995, according to researchers.
E.D.S and the other biggest computer service companies have gained leverage in demanding price breaks when buying computers for their customers. In fact, with pressure on their profit margins, the big computer makers have started to look at the computer services business with envy. In May, the International Business Machines Corporation, for one, entered the business, and it is expected to give E.D.S. a stiff challenge.
"Customers have had so much hardware jammed down their throats for so long that they are now going outside for help," said Stephen T. McClellan, a data processing analyst at Merrill Lynch in New York. "The service companies are squarely positioned between the computer hardware companies and the end users. That is starting to change the landscape of the industry."
Bolstered by the urgency of some customers to raise money to ride out the recession, the computer services business did more managing of existing systems and offering advice and purchasing equipment under "outsourcing" contracts with corporations. Now, E.D.S. and a few of its well-heeled competitors have the cash to buy outright the computing operations of large companies as well as hire the employees of those operations.
To help sustain healthy growth, E.D.S. has also been prospecting for business abroad. Last summer, Lester M. Alberthal Jr., the scholarly looking chairman and chief executive at E.D.S. since late 1986, flexed E.D.S.'s financial muscle in Europe, where it has been a laggard. In the company's first hostile takeover battle, he put up more than $250 million and came away with control of a British-based computer services firm, SD-Scicon P.L.C.
Turning over a corporate computing department to a service company, however well known, is not easy. Traditionalists argue that, for one thing, no team of outside experts can know the details of their businesses as intimately as their own staffs.
Sometimes they are correct. E.D.S. manages computer systems for several savings institutions in Texas controlled by the Resolution Trust Corporation. A few months ago, having misinterpreted data from those sources, it sent inaccurate reports to credit agencies that 1,800 homeowners were delinquent in their mortgage payments. E.D.S. eventually caught the error.
Still, aversion to outsourcing is gradually breaking down. "We are moving away from the end of the scale that says 'build everything yourself,' " conceded Bill T. Houghton, president of the information systems subsidiary at the Chevron Corporation in San Ramon, Calif. "If we aren't cost-effective in some area, we try to improve it. If we can't, then using outside suppliers is an alternative."
Some senior computing executives in big corporations acknowledge that they have allowed the service companies to get a foot inside their camp as wholesalers of personal computers and packaged software and suppliers of nationwide and global telecommunication networks. Those deals can often lead to bigger contracts.
In a recession, signing up a computer services company to manage all aspects of information systems "moves the risk and capital investments onto someone else's shoulders," said Robert S. Sullivan, dean of the Graduate School of Industrial Administration at Carnegie Mellon University in Pittsburgh.
Like Enron, Continental Bank and Eastman Kodak have turned all of their computing problems and all of their computing employees over to service companies in the last few years and signed long-term contracts with those companies to operate their information systems.
Financially weakened companies like Cummins Engine, Greyhound Lines and the Southland Corporation have also gone to service companies to cut their computing costs.
In the biggest deal yet, the General Daynamics Corporation, which has been forced to scale back its arms business since the collapse of Communism, agreed to pay the Computer Sciences Corporation of El Segundo, Calif., about $3 billion over the next 10 years to manage all of its computing operations. In turn Computer Sciences agreed to pay $200 million for all of General Dynamics's computer equipment and will hire all of its computing employees. E.D.S. may soon sign an even-bigger deal with the McDonnell Douglas Corporation.
In this atmosphere, E.D.S. has flourished. Its 1990 revenues rose to $6.1 billion from less than $800 million when G.M. bought it for $2.55 billion in cash and stock in 1984. The company earned $496.9 million last year, a 14 percent increase over 1989, and profits were up another 12 percent in the first half of 1991, to $139.8 million.
G.M., which accounted for more than 80 percent of E.D.S. revenues in the first years after the marriage, should account for less than half this year. Analysts expect that orders booked by G.M. for manufacturing software, car-order systems for dealers, health-care administration and other services will be fairly flat as the auto maker struggles with weak car sales in the next few years.
But orders from a growing list of 7,200 other customers in 28 countries should rise at annual rates of nearly 20 percent, analysts said. The company posted an 11 percent sales increase for the first half of the year and will approach $7 billion in revenues for the year. The Yankee Group, a research firm in Boston, projects that revenues for E.D.S. will reach $13.3 billion in 1995, with more than $10 billion coming from customers other than G.M.
Today, E.D.S. accounts for 4.9 percent of the sales of General Motors, up from 3.5 percent just six years ago. Along with E.D.S.'s healthy rise in earnings, that provides at least a small measure of help for a company whose core business has stagnated.
Mr. Alberthal, who is 47, wants his executives reaching toward a yearly sales target of $25 billion, which some analysts think is possible by the end of the decade.
E.D.S., which was founded in 1962, already has lower costs and the best profit margins in the industry compared with a handful of other systems integrators like I.B.M., Andersen Consulting and Computer Sciences.
This advantage stems in part from its position as one of the nation's largest buyers of computers, software and telecommunications services for the insurers, credit unions and health plans that are its non-G.M. customers. And because it is one of the world's largest private operators of data processing centers, capable of handling six billion computer instructions a second, E.D.S. uses dozens of mainframes at 110 sites in the United States, Europe and Asia.
E.D.S. by itself has put pressure on profit margins at I.B.M. It is Big Blue's biggest customer for mainframes, buying more than 50 a year, and it can command bargain prices in small computers as well. If E.D.S. thinks I.B.M.'s price for an order of thousands of personal computers is too steep, it will simply turn to Dell, Compaq, Apple, Digital Equipment and dozens of other suppliers.
To counter inroads made by E.D.S. and other systems companies, I.B.M. in May formed the Integrated Systems Solutions Corporation, even though some rivals contend that the step violated a 1956 consent decree by the computer giant to stay out of the services business. The Justice Department is investigating, but it could be years before action is taken.
I.B.M. is ignoring the fuss. "It is our focus and catalyst for I.B.M. to become a more services-oriented rather than a product-oriented company," said Dennie Welsh, president of the subsidiary.
I.B.M. executives are telling Wall Street that computer services will eventually become a significant profit producer in a company that currently derives 70 percent of its sales from the slowing hardware business.
E.D.S. has other challenges. Its payroll has ballooned to more than 60,000 employees, and a bureaucracy that customers said had slowed the company's response time and made it rigid in its problem solving. In response, Mr. Alberthal last year organized the company into 38 different business units, each dealing with a different industry. The idea was to speed decisions and push them closer to customers.
Earlier, Mr. Alberthal had softened the rigid edges of the military-style culture created by Mr. Perot by, among other things, easing dress codes that banned facial hair and striped shirts.
Flush with more than $700 million in cash, little debt and a yearly revenue stream of more than $3 billion from G.M., Mr. Alberthal is chasing growth in different ways to extend E.D.S.'s vital dominance in economies of scale in computing power, telecommunications networks and other technology.
E.D.S. has a stake in Hitachi's National Advanced Systems and can sell mainframes assembled by National as an alternative to I.B.M. models. And it is hawking a recently developed system for transmitting engineering documents between Macintosh computers.
As for how it all works, executives at Enron, whose former staff of 550 computing specialists are now employees of E.D.S., have some insight.
"It's almost three years and were satisfied," said Mr. Tompkins. "I don't think we've lost control of anything."
Therein is a question. "I would not want anyone to think that by outsourcing your information system that it's suddenly a life of ease," Mr. Tompkins said. " You can delegate, but you can't abrogate."
Analysts say his Perot Systems Corporation, based in Herndon, Va., should exceed $150 million in sales this year. The outspoken Mr. Perot has boasted that annual revenues will reach $1 billion by the year 2000. "I'm working with the best and brightest people I've ever known," he said.
Mr. Perot founded Electronic Data Systems in 1962 when his supervisors at I.B.M. in Dallas rebuffed his urgings to add programming and consulting services for companies buying big I.B.M. mainframes.
Perot Systems pales in size next to E.D.S., but Mr. Perot does not seem to mind. He has taken some hits -- Epic Healthcare Group Inc. in Dallas did not renew a $3 million contract last year. But he has also on occasion defeated E.D.S. and other established giants in bidding wars. NCNB and First American Bancshares are two clients in the financial services business. And Kelsey-Hayes, a maker of auto parts, chose Perot over E.D.S. last spring.
Mr. Perot, who is 61 years old, bankrolled the company with $20 million from his personal fortune, which is estimated at $3 billion. He said he spends about one-third of his time on Perot Systems business. He also has land development operations and is popular on the lecture circuit.
More than half of his top 50 employees followed him from E.D.S., but these days he has nothing but praise for the industry leader, and even for G.M., at least when speaking with reporters. "They're doing a great job, and I'm proud of them," he said.
The rapid growth of E.D.S. and its biggest competitors raises the intriguing question of how much of the nation's computing capicity will one day end up in the hands of a few computer services giants.
The biggest deal so far was put together last month, when the Computer Sciences Corporation of El Segundo, Calif., agreed to pay $200 million for the computing operations of General Dynamics, a hobbled military supplier. General Dynamics will transfer 2,600 employees to Computer Sciences and pay about $300 million annually for 10 years to Computer Sciences for managing the operations.
But E.D.S. is close to an even-bigger deal with McDonnell Douglas. The two have signed a letter of intentunder which E.D.S. would acquire the contractor's systems-integration unit, with revenues of $398 million last year. But E.D.S.'s head, Lester M. Alberthal Jr., does not rule out buying McDonnell's entire computing operations, which would expand the deal enormously.
Graphs: "EDS" tracks total EDS revenues, and breakdown of revenues from General Motors and non-General Motors, 1986-1992 (1991 and 1992, estimates) (Source: Company reports); graph shows a breakdown of total sales for EDS. (Source: Company reports) (pg. 6)