NEW YORK (Reuters) - Hewlett-Packard Co (HPQ.N) plans to buy technology outsourcing company Electronic Data Systems Corp EDS.N to better compete against IBM (IBM.N), but Wall Street questioned whether the $12.6 billion deal for a slow-growing company was overpriced.
HP shares fell 5.28 percent after the deal was announced on Tuesday, on top of a 5 percent drop on Monday in anticipation of the news. The declines have wiped about $12 billion off HP's market value, taking it to $109 billion.
Owning EDS, one of the pioneers of the outsourcing of managed computer services, would vault HP to second place in the global technology services industry, behind International Business Machines Corp. Analysts said the merged company would be better-equipped to go after large clients and cap costs.
Neither EDS nor HP, however, are strong in the high-end consulting business that is a strong suit of IBM, they said.
Brent Bracelin, an analyst at Pacific Crest Securities, said EDS gets half of its revenue from government and financial services customers, which are not high-growth clients.
"What investors are worried about now is what happens over the next six months," he said. "I think there are still some concerns around extracting value out of the deal."
The acquisition would be HP's biggest since its $19 billion purchase of Compaq in 2002 and the most ambitious under Chief Executive Mark Hurd.
It values EDS at $25 per share, a 33 percent premium to its closing price on Friday. Including debt, the deal's enterprise value was $13.9 billion, the companies said.
HP said it would pay for the deal with a mixture of cash and debt, without giving the breakdown. HP ended its last fiscal quarter with nearly $10 billion in cash.
"I would say the deal, in my view, is a little pricey, but we'd have to look at the details," said Jeff Embersits, chief investment officer of Shareholder Value Management, which owns HP shares.
He said the key was how EDS would be integrated to make it a more profitable business.
"Mark's working with a five-year plan. So this will probably look a lot smarter in two or three years, but it could be a tough year," he said.
HP expects the deal to close in the second half of 2008 and boost its adjusted fiscal 2009 earnings and fiscal 2010 net earnings.
The company also reported better-than-expected preliminary quarterly results on Tuesday and raised its fiscal 2008 outlook, which it said did not include any potential impact from the EDS deal.
"We would be aggressive buyers of (HP) shares on today's pullback," Citi analyst Richard Gardner wrote in a report, calling the share fall "a clear overreaction."
"The EDS acquisition was unexpected, but strategically and financially compelling, in our view," he said, adding there was minimal overlap between HP and EDS's service offerings and customers. "The deal should create cross-selling opportunities and boost confidence in EDS as a service provider."
LUCRATIVE SERVICES BUSINESS
HP has long considered an acquisition to beef up its tech services business, a sector that offers relatively stable income and high margins, even in an economic downturn.
Technology services include specialization in consulting on how to build systems, providing computer and software resources for companies, which is broadly called outsourcing, and managing and maintaining technology.
Worldwide computer services revenue rose 10.5 percent to $748 billion in 2007, according to market research firm Gartner Inc. IBM led with a 7.2 percent market share, EDS was second with 3.0 percent, while HP was fifth with 2.2 percent.
"The acquisition is estimated to more than double HP's services business and creates a leading force in the global IT services industry," Hurd told analysts on a conference call.
The combined company will have annual services revenue of more than $38 billion and 210,000 employees, HP said. That compared to IBM's $54.1 billion in services revenue last year.
Analysts said the deal would likely spark a round of consolidation as suddenly much-smaller rivals such as Infosys Technologies Ltd (INFY.BO), Tata Consultancy Services Ltd (TCS.BO), Wipro Ltd (WIPR.BO) (WIT.N) and Cognizant Technology Solutions Corp (CTSH.O) scramble to stay competitive.
EDS also competes against U.S. companies such as Accenture Ltd (ACN.N), Computer Sciences Corp (CSC.N) and Affiliated Computer Services Inc (ACS.N).
"We're going to start seeing more, I believe, of these strategic deals where it's not private equity coming, but it's big companies -- such as Microsoft (MSFT.O) trying to go after Yahoo (YHOO.O) -- who have cash on their books and see beaten- down stock prices," said Matt McCall, president of Penn Financial Group.
HP plans to form a new business group called EDS that will be headquartered at EDS's existing office in Plano, Texas, and led by EDS CEO Ronald Rittenmeyer, who will report to Hurd.
EDS shares ended up 1.08 percent at $24.34 after gaining nearly 28 percent on Monday in anticipation of the deal.