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Daily Trouble
How Did it Find Trouble?
Ross Perot is part folk hero, part presidential candidate, part Larry King buddy, part family man, part business tycoon. And for a few weeks in February, it appeared he would also be part Internet billionaire. Oh, well.
Perot had the good fortune to take his Perot Systems public on February 1 amidst a rousing market rally that was sending all things Internet into gaga land. As a information technology (IT) services provider, Perot gets most of its revenues from systems integration and major infrastructure outsourcing contracts. Yet, a small but growing chunk of its business comes from helping companies deal with Internet/e-commerce issues.
That was enough to send Perot Systems flying. Its 7.5 million share offering was priced at $16, but it soon touched $85. The giant sucking sound heard since then were speculators getting flushed out of the stock.
The five underwriters were too honest to help matters. With the shares at $43, lead underwriter Morgan Stanley initiated coverage March 1 with a "neutral" rating, which more than made up for Hambrecht & Quist's "buy" rating the same day. A week later, with the stock still around $38, underwriter Bear Stearns also started coverage with a "neutral" rating. "Neutral" tends to be code for "this sucker's overvalued, but I'm not allowed to say that."
The last leg of this Trouble followed the August 1 end to the lock-up period. Some 25 million shares owned by insiders and others became freely tradable at that date, and a spate of top executives have since cashed out part of their holdings. The stock is down 25% since these shares started hitting the market.
Business Description
Financial Facts
How Could You Have Seen it Coming?
Perot Systems has grown mightily in recent years, with revenues jumping from $292 million in FY94 to $994 million last year, a 36% compound annual growth rate (CAGR). Over this same period, the company has become increasingly profitable, with operating income soaring from $10.9 million to $61.3 million (a 54% CAGR).
Nonetheless, analysts have been looking for Perot Systems to deliver just 24% long-term growth. IT services companies traditionally trade at a slight premium to their growth rates, but 30x forward earnings estimates should have seemed like a more than ample valuation for what's still a second-tier player. Even at $40 a share, the stock changed hands at 70x FY99 estimates.
Where to From Here? Ironically, Perot System's slide has come on the heels of strong quarterly earnings. Second quarter results announced August 3 had revenues up 18% to $282.3 million, thanks mostly to add-on work from UBS and 63% year-over-year growth in still small Internet services revenues. That total was slightly below analysts' projections, but the company more than made up for the shortfall by improved pricing on short-term projects and by managing expenses, despite a tight market for IT services professionals. Gross margins improved to 22.4% from 20.4% a year ago, and operating margins jumped to 8.4% from 6.4% as selling, general, and administrative (SG&A) expenses remained flat as a percent of revenues. Earnings per share (EPS) shot up 50% to $0.15, beating the $0.13 consensus estimate. For the first half of the year, revenues have risen 23% to $556.6 million while operating income has soared 59% to $50.6 million from $31.8 million a year ago. First quarter EPS of $0.15 crushed the $0.11 consensus estimate, so year-to-date earnings of $0.29 have leaped 45% versus the first half of FY98. Although the backlog is up 15%, the company will need to adjust to the loss of business from EME. Also, a couple of major contracts that the company thought would be signed in Q2 have spilled into the second half of the year. Such deals can take 6 to 9 months to start showing up in the revenue stream. Moreover, remaining Y2K fears could muck up the start of new IT projects in Q4. Still, the company's last eight major engagements have come with fixed gross margins around 30%. The company is also competing on six major new Internet and e-commerce projects, which generally come with gross margins in the same range. Perot Systems also struck a pact in July with Atos, a billion dollar IT services firm based in Paris. Under this agreement, the two firms will work together to provide multinational clients with IT services. Atos should complement Perot thanks to its strong presence in France and other European countries where Perot has little penetration. Yet, the Street's now looking for FY99 earnings of no more than $0.58 per share and FY00 earnings of $0.70. So the stock trades for 26.6 times earnings some five quarters away. Moreover, despite the insider selling that's helped punish the stock of late, more such shares could hit the market. Some analysts think market psychology will turn more favorable for Perot and other IT services firms once year-end issues are out of the way. That could push the stock back into the low to mid $20s. However, in this business a few unsigned contracts can mean the difference between making a quarter's earnings target or not. Also, it's simply hard for most individual investors to dissect and track competitive advantage in this kind of corporate services market. As a result, it's easy to get blind-sided. Of course, Perot Systems could also suffer from another year 2000 bug. Though Ross has scratched his itch for politics a couple of times now, CEOs of IT services companies just don't generally get to spend as much time on the talk show circuit as do presidential candidates. And rumor has it that Ross doesn't mind the limelight.
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