Commercial Practices Illuminate Path to Government Activities

August 1999
By Michael A. Robinson

Pursuing federal information system projects causes no strain to a company flush with business experience and acquisitions.

Dealing with the Byzantine operations of the Internal Revenue Service leaves a lot of executives feeling taxed—but not Van B. Honeycutt.  Instead, the chairman, president and chief executive officer of Computer Sciences Corporation, El Segundo, California, says his company’s lead role in a 10- to 15-year contract to overhaul the federal tax agency’s information infrastructure underscores a series of dramatic changes he helped plan 10 years ago. They include more work with Fortune 500 companies and rapid growth through acquisitions.

The largest contract in Computer Sciences Corporation’s (CSC’s) 40-year history spans more than a decade and will run into several billion dollars (SIGNAL, February, page 31). Honeycutt does not provide estimates of the contract’s total price tag for all the companies involved, but he does not quarrel with a range of $2 billion to $5 billion. More importantly, however, the Internal Revenue Service (IRS) work will almost certainly cement CSC’s reputation as one of the world’s leading information technology (IT) companies.

Not only is the IRS contract important for the sheer number of end users it will affect, but also more than any other award, it represents the deep diversification CSC has undergone in the past decade.

CSC has had a string of major commercial contract awards in the past several years that have kept revenues growing at a compound rate approaching 20 percent. Honeycutt says that experience with commercial bids proved decisive in winning the Internal Revenue Service (IRS) contract. Already armed with decades of experience in federal work, CSC approached the project as though it were bidding on a major corporate account complete with best commercial practices.

“Quite frankly, I think the IRS is very interested in improving services, and by partnering with us, we are going to improve the service,” Honeycutt maintains. “We are very mindful of the performances under the contract—the IRS, taxpayers, Congress; there are going to be a lot of people watching this thing unfold.”

Indeed, the contract could involve CSC’s highest profile IT work to date. The company is in charge of a team called the Prime Alliance that includes some of the world’s leading technology companies: IBM, KPMG Peat Marwick, Lucent Technologies, Northrop Grumman, SAIC and Unisys.

Already, the IRS contract, granted last December, has increased CSC’s visibility with the public, enhanced its standing on Wall Street, and could lead to greater name recognition with Congress and even a broad swath of the tax-paying public.

This is because CSC is working with an agency that affects the lives of every taxpayer in America. At the same time, the agency depends on Congress for its funding, and when citizens complain, as they have in the past year about the way the IRS does business, they often write or call their elected representatives in Washington, D.C.

Although the potential for a public relations bonanza exists for CSC, performance is the key, Honeycutt notes. Good performance will mean continued funding and will make the IRS an ultra-modern manager of information and data. For instance, CSC may help the IRS develop an online archive that allows taxpayers to access their records via the World Wide Web as well as find information about relevant tax codes and how certain changes can affect someone’s tax status.

Currently, taxpayers cannot get this information online, and when they telephone the IRS to ask for assistance, they often get contradictory answers.

“If you look at the past, the one thing that hasn’t been done well at the IRS is modernizing the tax system,” Honeycutt adds. “Now we’re on the hook [at CSC] to do it. But we feel up to the challenge, and I think it is going to be a very good contract for us.”

But this contract is far from being CSC’s only recent major win. In fact, the company has an extensive pipeline of both commercial and government IT work that also includes consulting and systems integration.

“In the past several years the company has made excellent progress towards expanding its business with commercial clients, winning several, high-profile megacontracts,” Brian Maimone, a financial analyst with ING Baring Furman Selz, said in a recent report on CSC. The analyst noted CSC’s ability to leverage its reputation “as a provider of project management and high-tech engineering services to the federal government to build a brand name in the commercial systems integration and IT outsourcing markets.”

So far this year, CSC won a five-year, $1.2 billion outsourcing contract with Pratt & Whitney; a 10-year, $320 million outsourcing contract with Republic Services Corporation, a division of one of the nation’s largest financial services firms; and a 10-year, $300 million contract with AT&T Consumer Services.

“One of the reasons for our momentum in the case of large outsourcing contracts is that it has become an acceptable way for commercial clients to do this kind of work,” Honeycutt says.

At the same time, the steady stream of new work represents a carefully orchestrated strategy of diversification from CSC’s roots as a government contractor. It worked. CSC is a much different company than it was a decade ago. Back then, more than 75 percent of its revenues stemmed from federal agencies, much of it in defense-related work. Today, CSC stands in stark reversal of its dependence on federal contracts. For fiscal year 2000, only 20 to 22 percent of its revenues will come from federal work.

Honeycutt says that he and the previous chief executive officer, William Hoover, who retired in 1995, were dissatisfied with the company’s stock price and the fact that CSC shares traded as low as nine times earnings, an anemic performance in the great stock market boom of the mid-1990s. But because CSC had consistent earnings growth, it was a sure money maker and was one of the world’s few big-scale IT companies capable of handling the Fortune 500 companies and federal agencies that would obviously need help, Honeycutt and Hoover believed the stock had greater inherent value than the price reflected. But Wall Street did not agree. Thus, the two took action.

“We decided that if we really wanted to grow the company and get the growth rate stimulated and get involved in higher margin business that would [positively] affect our P/E [price-earnings ratio], we had to diversify,” Honeycutt recalls. “We decided to do that through acquisitions of IT service companies in North America and Europe.”

So, CSC embarked on a major acquisition binge. In the past 10 years, the company has purchased some 60 companies, about one-third of those since the 1996 fiscal year. 

All 60 were privately held firms. Most of the more recent acquisitions occurred overseas. For instance, last February CSC acquired 51 percent of Singapore-based CSA Holdings Limited, one of the largest information technology services companies in Asia. The following month, the company bought Informatica Group SpA, an Italian firm providing a full range of services to the Italian banking, finance, industrial, telecommunications, insurance and public sectors and expanded into Italy with the acquisitions of four IT services companies.

Wall Street financial analysts clearly have noticed the changes at CSC. Of the 19 analysts who cover the company on a regular basis, not one has it listed as a stock to sell. The rest are essentially evenly divided between suggesting the stock as either a hold or a buy.

In a recent report on CSC, Gregory Gould and Matthew Glasofer of Goldman Sachs in New York wrote, “The two most important growth drivers for CSC are: one, the ramp-up of a record number of new contracts won in fiscal year 1999; and two, continued rapid growth (and a possible acceleration) in the U.S. systems integration business (approximately $1 billion, or 10 percent of revenue).”

The report also noted that, “The systems integration business has an operating margin almost double the corporate average, so despite its small relative size, [it] will be an important contributor to earnings. Management is optimistic on revenue growth in U.S. systems integration and consulting possibly accelerating from e-commerce and front office automation. CSC’s outsourcing pipeline is robust.”

Karl Keirstead, an analyst with Lehman Brothers in New York, said he considers CSC stock undervalued. The company’s common shares command a P/E multiple of only about 25 times earnings per share (EPS). That compares with a P/E of 31 for Electronic Data Systems and a multiple of 37 for Automatic Data Processing.

“The key attribute of the CSC story is the high degree of EPS predictability and visibility, resulting from strong internal execution and a diversified revenue mix,” Keirstead wrote in a report last April. “CSC has met or exceeded Street EPS expectations every quarter for the last few years.”

Meanwhile, considering the tough criteria the company adopted in its acquisition plan, it seems surprising that the company found so many opportunities. To acquire a company, CSC decided it had to be a good fit for the parent company, have good management, a long-term customer base, positive earnings, be in a market in which CSC wanted to operate, contribute positive earnings within the first year, and be a friendly transaction.

Honeycutt acknowledged that many companies growing quickly through acquisitions stumble because they run into roadblocks integrating so many disparate elements. Culture clashes, surprises in the balance sheet, personnel departures, and underperforming products are some of the many problems that can catch corporate buyers by surprise.

But in CSC’s case, Honeycutt explains, the company treated the acquisitions as though they were the type of large integration projects for which CSC is well known. Not only has the company avoided the growing pains typical of a buying binge, but it intends to acquire even more companies, Honeycutt says.

“I don’t think we will buy 60 companies in the next five years, but a third of our revenues will come from acquisitions, which means we will make fewer acquisitions but they will be a lot larger than the ones we have made in the past.

“Because they will be a lot larger, they’ll probably be more publicly traded companies than privately held [ones]. Will we use our stock to acquire a company? Absolutely. When you get to any level, your currency is your stock price, the money you can borrow or the money you can generate from earnings. And we will use a combination of all three sources as we plan for how we are going to finance acquisitions.”

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