25-HP and EDS: The Cost Case

Two strong industry leaders, both highly successful in other markets, decide to combine their subsidiaries in one market in order to gain market share and improve economies of scale. This made some good sense a few years ago. It didn’t turn out quite the way they hoped, though. We cover the story and four separate blogs, numbers 23 – 26.

Posted 6/2/08

This entry is the third in our series of four entries on the HP/EDS deal.

The Setting

Hewlett Packard has proposed a take-over of EDS, in order to improve its services, revenues and profits. EDS is #2 to IBM in the computer services industry. Hewlett Packard is #5. The combined company, at $38 billion In revenues, would have only a 5% share of the market. IBM has $54 billion in services revenues and 7% market share. The reaction in the stock market has been mixed. Hewlett Packard stockholders don’t like it. Its share price fell. The EDS shareholders like it a lot better, as their shares increased in value.

A company undertakes an acquisition to achieve one or more of these three objectives: first, acquire a product that it does not have; second, acquire customers that it otherwise could not service; and third, establish a new lower unit cost through the combination of the two companies. We will look at each of these, in turn, in the current HP and EDS deal and then summarize our conclusions in the last entry.

The Cost Case

The cost outlook for this acquisition is surely positive. The cost reduction opportunities are plentiful.

EDS was slow to shift some of its infrastructure to lower cost countries, such as India, so it starts out with high operating costs. EDS has operating margins of 6%, which are half those of IBM, and lower than those of HP in the services business. The combination of the two companies will have enough overhead overlap to allow significant cost savings.

HP, as the acquirer, is better positioned to reduce costs. HP’s CEO has proven himself to be an effective cost manager. The HP management group has been fire-tried in the hardware business. The hardware business is much tougher than the services business because it is closer to a commodity with standard features. Cost is always an important element of the hardware business. The combined company is virtually certain to see significant reductions in unit costs.

In our fourth and last entry, we will summarize our conclusions on this combination.

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Update 2022:

The combination of HP plus EDS is likely to have reduced the cost of the combined company, as it increased the combined company’s market share and economies of scale.

Born out of HP’s split, HPE focuses on enterprise products and services. Hewlett Packard Enterprise (HPE) was created in 2015 when HP split its operation into two. On one side is HP Inc, the printer and PC arm of the company, while HPE deals with enterprise products and services.

As of early 2022, DXC Technology, which contains much of the old EDS, had sales of $4 billion, down 11.6% from the previous quarter. The company was operating at a net loss. At the same time, IBM reported quarterly sales of $16.7 billion, an increase of 6.5%. IBM was profitable.

In 2016, IBM held 7% of the IT services business, excluding consulting and business process outsourcing.  Accenture was second with 4% with HPE a close third at 4%.   In this fragmented market, the top ten competitors held only 30% of the market.  There are segments available for consolidation in this market. The first segmentation in any market should be by customer size and then by role within the customer size. See HERE and HERE for how to do this. The reason to put the emphasis on size is that the long term potential low-cost position (ie., other than the ownership of the customer relationship) is directly related to the relative size of the competitor.

Acquisitions, when done effectively, are very helpful in reducing costs. See, HERE and HERE for some thoughts on successful acquisitions to reduce costs.

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Update 9/25

The 2025 computer services business includes three key services: the provision of IT infrastructure, managed as well as cloud services and consulting. The three leading market share holders: AWS from Amazon (30% share), Azure from Microsoft (20% share) and Google cloud (13% share). Together, they hold 63% of the industry’s market share. Other competitors hold low single-digit shares.

These three leaders completely reimagined the computer services business. The original business leaders, IBM and HP, were selling their own hardware and the proprietary software that accompanied the hardware. They were superseded by today’s leaders who innovated with cloud computing (a Function), digital transformation (a Function) and pay-as-you-go (Price) tech models. These three leaders are examples of Next Leader Transformer competitors.

The three leaders have developed extensive networks of global data centers for cloud computing, specialized cloud utilization products and advanced machine learning toolkits. These Function innovations offered turnkey solutions and rapid scalability to all customers (Function and Convenience). They also have produced superb economies of scale for the leaders.

Direct competitors will have a very difficult time competing with these leaders with their solid economies of scale. The leaders of the industry seem to have reached a high level of penetration of the Very Large and Large customers. These customers view their computer services providers as strategic partners. These partnerships focus on broader business goals rather than straightforward costs. Once a supplier establishes such a customer relationship that relationship becomes extremely difficult to flip to another supplier. Hence, volatility in the market is low with these customers. In search of continued growth, the industry leaders are now adapting their products to serve the Medium and Small customers.

Customers found pay-per-use pricing attractive because it allowed them to experiment without a long-term commitment. This pricing scheme provided for easy scale increases or decreases as the customers’ business needs required.

Globalization and digital networking allows customers to source computer services from anywhere. These trends plus procurement systems that allow customers to compare various vendors’ complex offerings has resulted in the development of more uniform pricing and vendor consolidation for security and efficiency. Still, the dominance of the industry leaders along with their entrenched relationships with the industries Very Large and Large customers ensure that their profits are attractive and sustainable.

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