HP and EDS: The Cost Case

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 on 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.

Posted 6/2/08

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