HP Buying EDS. Time to Buy HP.

One big piece of business news of the past couple days is Hewlett-Packard’s announcement that it will be purchasing IT services company EDS for a total of $13.9 billion in cash. As a result, HP’s stock has been battered, falling about 13% from its Monday afternoon highs, just before news leaked out about the purchase, to its Tuesday lows. While large acquisitions invariably run the risks of integration, I believe now is the time to buy HPQ. If anything, the purchase of EDS will be more reason to buy HP than not.

HP’s purchase of EDS, as many analysts have daftly pointed out, will certainly be a step in IBM’s direction, where services revenues make up about 60% of its business. However, services only make up about 15% of HP’s revenues. Both IBM and HP are able to achieve approximately 10% operating margins from their services segment, while EDS has only been able to pull a 5% operating margin.

Since taking the reigns in early 2005, Mark Hurd has done a fantastic job of cutting costs, boosting growth, and as a result, has increased operating margins considerably, across HP’s market segments. The following is just one example of operating margin growth, in the Personal Systems Group (otherwise known as the PC segment). Numbers were calculated from HP’s annual and quarterly reports:

  • 2004 – 0.8%
  • 2005 – 2.5%
  • 2006 – 3.9%
  • 2007 – 5.3%
  • Q1 2008 – 5.8%

That’s quite an improvement. I can only imagine that the plan is to boost EDS’ margins more inline with the rest of HP’s services division. An extra 4% improvement in operating margins at EDS would boost operating income by close to $1 billion annually. That’s assuming no growth in revenues. This is probably the ‘significant synergies’ that HP expects from the combination. I’m confident Mark Hurd will be able achieve his goals, given his track record.

Also taking into consideration that EDS has over $3 billion in cash, the net $10.9 billion cash outlay doesn’t sound so bad for an additional $2 billion in operating income, if operating margins at EDS can be expanded to ~9%. That’s not evening mentioning any revenue growth in other segments from cross-selling through services.

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