10-K 1 d10k.htm FORM 10-K Form 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

 

Commission File No. 01-11779

 

LOGO

 


 

ELECTRONIC DATA SYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware   75-2548221

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

5400 Legacy Drive, Plano, Texas 75024-3199

(Address of principal executive offices, including ZIP code)

 

Registrant’s telephone number, including area code: (972) 604-6000

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class   Name of each exchange on which registered

Common Stock, $.01 Par Value

7.125% Notes due 2009

7.45% Notes due 2029

Zero-Coupon Convertible Senior Notes due October 10, 2021

6.0% Senior Notes due 2013, Series B

3.875% Convertible Senior Notes due 2023

 

New York, London

Luxembourg

Luxembourg

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No ¨.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No þ.

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨.

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer þ Accelerated Filer ¨ Non-accelerated filer ¨.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ.

 

As of June 30, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant (based on the closing price on such date as reported on the New York Stock Exchange Composite Transactions) was approximately $9,950,000,000.

 

There were 514,513,517 shares of the registrant’s common stock outstanding as of March 1, 2006.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held on April 18, 2006 are incorporated by reference in Part III.

 



PART I

 

ITEM 1. BUSINESS

 

Overview

 

Electronic Data Systems Corporation, or EDS, is a leading global technology services company that delivers business solutions. EDS founded the information technology outsourcing industry more than 40 years ago. Today, we deliver a broad portfolio of information technology and business process outsourcing services to clients in the manufacturing, financial services, healthcare, communications, energy, transportation, and consumer and retail industries and to governments around the world.

 

As of February 28, 2006, we employed approximately 117,000 persons in the United States and 57 other countries around the world. Our principal executive offices are located at 5400 Legacy Drive, Plano, Texas 75024, telephone number: (972) 604-6000.

 

Our predecessor was incorporated in Texas under the name Electronic Data Systems Corporation in 1962. In 1984, General Motors Corporation, or GM, acquired all of the capital stock of our predecessor, and we remained a wholly owned subsidiary of GM until our split-off in June 1996. As a result of the split-off, we became an independent, publicly held Delaware corporation. Unless the context otherwise requires, references to EDS include its predecessor and subsidiaries.

 

EDS Services

 

Infrastructure Services. EDS Infrastructure Services delivers hosting, workplace (desktop), storage, security and privacy, and communications services that enable clients to drive down their total cost of ownership and increase the productivity of their information technology (“IT”) environment across the globe. Infrastructure Services include:

 

    Data Center Services. EDS Data Center Services address the business and technology needs of our clients in the area of hosting and storage services. These services establish the client’s infrastructure using a set of highly granular, standard components that can be provisioned quickly and easily, serving as the base to build an integrated business support model from business processes down to application and infrastructure. Data Center Services is composed of 4 principal offerings:

 

    Managed Server. This service suite combines midrange hosting, application hosting and Web hosting into packaging that spans the data center. Managed Server Hosting offers multiple levels of packaging allowing a client to utilize its current technology within an EDS data center to advance the fundamentals of traditional IT by providing leveraged, high-value services such as standardization, increased automation and virtualization in a utility model.

 

    Managed Mainframe. These entry level services include migration to a leveraged EDS Service Management center with processing environments for dedicated or shared logical partitions. Higher value services include the z/OS platform which provides the client standardization and increased automation in a utility model.

 

    Data Center Modernization. These transformational state packages rationalize, consolidate, automate and virtualize IT infrastructure and the applications environment for maximum use through server consolidation, mainframe consolidation and migration services.

 

    Storage Services. We provide a fully managed suite of enterprise-wide services for storage management, information protection (backup and recovery) and information optimization (archival services) from the data center to the desktop.

 

    EDS Workplace Services. EDS Workplace Services delivers expert management and support of the end user’s work environment from the software applications that support the client’s business practices to the supporting network communications infrastructure. Workplace services include:

 

    Workplace Management Services. We offer comprehensive management of a client’s total workplace environment. We support PCs, laptops and hand-held computing devices, as well as associated support services such as helpdesks, asset management of hardware and software, and administration of the servers and networks that tie it all together.

 

    Mobile Workplace Services. EDS Mobile Workplace Services provide an end-to-end managed mobility solution that delivers voice and enterprise data regardless of a user’s locality, device, network or application.


    Workplace Migration Services. Provides an end-to-end solution for automating the deployment/version upgrades of desktop and server operating systems, including the associated packaging required to migrate a client’s enterprise applications, to computers across an organization quickly and reliably.

 

    Workplace Messaging and Collaboration Services. Messaging solutions provide mailbox service as a base service to users through a hosted, locally or remotely managed messaging system. This service includes Antivirus and Security, and also includes migrating to more current releases and/or consolidating e-mail systems. Collaboration Services secure Instant Messaging and virtual team workspace to enable an organization to improve collaboration.

 

    Workplace Support Services. Provides the single point of contact for resolving IT issues in the desktop environment. Help desk services may be accessed by various channels including telephone, the Web, e-mail and facsimile.

 

    Security and Privacy. We offer defined security, privacy and business continuity features embedded at the onset in every EDS offering. These features are the people, tools, processes and controls used by EDS across all portfolio offerings to meet clients’ expectations and industry-specific standards and regulations for security, privacy, business continuity management and risk management.

 

    Communications Services. EDS Communications Services delivers comprehensive, secure, flexible network services on a global basis ranging from network support to management of an entire client network. EDS designs, builds, deploys and manages a single seamless network that integrates voice, video and data; improves the effectiveness of data exchange in the supply chain; and delivers secure connectivity and smooth operations over a wired or wireless platform. These services are designed to help clients manage the complexities of aligning their communications and network needs with their overall IT outsourcing strategies.

 

Applications Services. EDS Applications Services helps organizations plan, develop, integrate and manage custom applications, packaged software and industry-specific solutions. We offer applications development and management services on an outsourced or project basis. Services range from outsourcing of all applications development and systems integration to the management and implementation of EDS-owned or third-party industry applications. Benefits to clients for these services can include reduced costs, extended value of technology investments, information sharing and enhanced ability to adapt to market changes. Our Applications Services include the following:

 

    Applications Development Services. We create new applications, providing full lifecycle support through delivery. We define the application requirements, analyze application characteristics, implement to a production environment and monitor performance for a warranted time. Services include custom application development, application testing, mobile applications, workforce enhancement, and enterprise application integration.

 

    Application Management Services. We offer outsourcing support for specific applications or entire applications portfolios, both custom and packaged, including services for enterprise applications and support for SAP®, Oracle® and PeopleSoft® software. We assess the specified applications, plan the transition and provide ongoing management to improve client productivity and operating efficiency. We also provide applications rationalization, content management integration and legacy application migration services.

 

    Integrated Applications Services. We engineer offerings such as Business Intelligence Services, Portals and Dashboards Services, Web Services and Enterprise Applications Integration Services to support the overall integration of the client’s architecture or our own Agile Application Architecture. These services integrate and extend existing packaged and legacy applications.

 

    Industry-Specific Application Solutions. These solutions are designed to support industry-specific needs. Our industry solutions span eight vertical industry segments: communications, energy, financial, government, healthcare, manufacturing, retail and transportation.

 

Applications Services offerings and capabilities are available via the EDS Global Delivery Model, including the EDS Best ShoreSM delivery approach which offers clients the ability to develop and manage applications in one or more of our solution centres strategically located in cost-effective countries. The delivery of our services offers a lifecycle approach to on-shore, near-shore and offshore applications development and management with globally integrated, consistent work processes and tools and project-sharing at multiple facilities on a 24 hours a day, seven days a week basis.

 

2


Business Process Outsourcing Services. Business Process Outsourcing (BPO) continues to be one of the fastest growing market segments in the IT services industry and an important element of our strategy to enlarge our business services footprint and grow our revenue base. BPO services help clients to achieve economies of scale and improve business performance. By leveraging a shared-services operating model, clients reduce operational risk and control costs.

 

Enterprise Services are or will be sold across multiple industries and include Customer Relationship Management (CRM), Human Resources (HR), and Finance and Accounting services. For each of these services, EDS manages all components from technology, administration and customer service to business intelligence and third-party relationships. Our integrated solutions combine best-practice business processes, leading technologies and experienced professionals along with skilled domain partners.

 

EDS also delivers industry-specific offerings and provides industry experts to assist clients in key process improvement redesign. One example is our suite of Government BPO Services. For more than forty years EDS has provided Medicare and Medicaid claims processing to the U.S. federal and state governments helping to lower program costs while increasing efficiency and performance. EDS’ offerings to governments also include: fiscal agent services; decision support services; fraud, waste and abuse protection services; integrated pharmacy services; Health Insurance Portability and Accountability Act (HIPAA) compliance services; immunization registry and tracking services; and case management services. We also offer Internet-based enrollment and eligibility inquiry capabilities.

 

Other industries supported by our industry-specific BPO offerings include financial services, manufacturing, healthcare, transportation, communications, energy and consumer/retail.

 

Many BPO services are supported by our reusable, multi-client utility platform. This platform is comprised of key components of the BPO portfolio, including: customer relationship management (CRM) and call center services; financial process services such as credit services and insurance services, payment and settlement, card processing and billing and clearing transactions and content management services.

 

ExcellerateHRO LLP, our 85% owned joint venture with Towers Perrin, offers a comprehensive set of HR outsourcing solutions on a global basis across the core areas of benefits administration, compensation administration, payroll, recruitment and staffing, relocation, work force administration and work force development.

 

EDS Agile Enterprise

 

A key component of our multi-year plan is the development of the EDS Agile Enterprise technology platform, a network-based utility architecture intended to create a more flexible, open and cost effective technology foundation for the delivery of a significant portion of our infrastructure outsourcing, applications, and BPO services. As part of this strategy, we have established alliance relationships with a number of leading technology companies to develop the Agile Enterprise technology platform. We refer to this “federation” of technology companies as the EDS Agility Alliance. EDS Agility Alliance members currently include Cisco Systems, Dell, EMC, Microsoft, Oracle, SAP, Sun Microsystems, Towers Perrin and Xerox.

 

See “Risk Factors” below for a discussion of certain risks relating to our multi-year plan.

 

Revenues

 

Our fees are generally paid pursuant to contracts with our clients. These contracts may provide for both fixed and variable fee arrangements. The terms of our infrastructure outsourcing contracts generally range from 5 to 7 or more years, and contracts for applications and BPO services generally have shorter terms. We refer you to Note 12 in the notes to our consolidated financial statements for a summary of certain financial information related to our reportable segments for 2005, 2004 and 2003, as well as certain financial information related to our operations by geographical regions for such years.

 

No one client accounted for more than 10 percent of our total revenues in 2005. Approximately one-half of our 2005 revenues were generated outside the United States. GM accounted for 9.1%, 9.5% and 10.5% of our revenues in 2005, 2004 and 2003, respectively. We expect GM to account for approximately 8% of our revenues in 2006.

 

Certain IT outsourcing agreements contain third-party benchmarking provisions which generally permit contractual rates to be compared to a range of market rates for comparable services on a periodic basis over the term of the agreement. We refer you to “Risk Factors” below for a discussion of these provisions.

 

3


Approximately $1.9 billion of our 2005 revenues were attributable to the U.S. federal government, including our Navy Marine Corps Intranet (“NMCI”) contract discussed under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Contracts with the U.S. federal government have various attributes that differ from our other commercial contracts, including provisions for modifications in scope of work due to changing customer requirements, annual funding constraints of the federal government and, in some cases, the indefinite delivery/indefinite quantity characteristics of the contracts.

 

Strategic Alliances

 

We maintain multiple technology practices and platforms to enable us and our clients to select the right vendor for specific needs. The EDS Alliance Program focuses on building and managing global alliances that enable us to realize our strategic objectives and deliver competitive differentiation for our clients’ businesses. We believe our strategic alliances help us provide clients with the best solutions at a superior value.

 

The EDS Agility Alliance referred to above is our most strategically significant set of alliance relationships. In addition to the EDS Agility Alliance, we have alliance relationships with companies selected to provide specific, focused expertise within certain horizontal or industry segments and solution alliance relationships that support a specific solution or offering in our portfolio.

 

Competition

 

The IT services market remains fragmented and highly competitive. We face competition from companies providing infrastructure, applications and BPO services. Our principal competitors in the infrastructure services market are IBM Global Services, Computer Sciences Corporation (“CSC”), Hewlett-Packard Services, T-Systems and Fujitsu. Our principal competitors in the applications services market are Accenture Ltd., BearingPoint, Capgemini, CSC, Deloitte Consulting and Keane Consulting. Our principal competitors in the BPO market are Accenture Ltd., Affiliated Computer Services, Convergys, Hewitt, and IBM Global Services. In addition, we experience significant competition from telecommunications providers in our network services and other businesses, including applications development and hosting. In recent years we have also experienced significant competition from offshore providers in our infrastructure, applications and BPO businesses, including in particular from India-based competitors such as Infosys Technologies Ltd., Tata Consultancy Services Ltd. and Wipro Ltd.

 

EDS is the second largest provider of IT outsourcing services in the world. We believe we are positioned to compete effectively based on our technology and systems capabilities, full range of service offerings available on a global scale and the value proposition for our service offerings. However, technology and its application within the business enterprise are in a rapid and continuing state of change as new technologies continue to be developed, introduced and implemented. We believe that in order to continue to compete effectively we must develop and market offerings that meet changing user needs and respond to technological changes on a timely and cost-effective basis.

 

Patents and Proprietary Rights

 

We hold a number of patents and pending patent applications in the United States and other countries. Our policy generally is to pursue patent protection we consider necessary or advisable for the patentable inventions and technological improvements of our business. We also significantly rely on trade secrets, copyrights, technical expertise and know-how, continuing technological innovations and other means, such as confidentiality agreements with employees, consultants and clients, to protect and enhance our competitive position.

 

Some of our business areas, including in particular our BPO services, are highly patent-intensive. Many of our competitors have obtained, and may obtain in the future, patents that cover or affect services or products directly or indirectly related to those we offer. We routinely receive communications from third parties asserting patent or other rights covering our products and services. We may not be aware of all patents containing claims that may pose a risk of infringement by our products and services. In general, if one or more of our products or services infringe patents held by others, we would be required to cease developing or marketing those products or services, obtain licenses from the holders of the patents, or redesign our products or services to avoid infringing the patent claims. There is no assurance that we would be able to take any of such remedial actions or, if we are able to do so, that the costs incurred would not be significant.

 

We are not aware of any pending patent or proprietary right disputes that would have a material adverse effect on our consolidated financial position or results of operations.

 

4


Regulation

 

Various aspects of our business are subject to governmental regulation in the United States and other countries in which we operate. Failure to comply with such regulation may, depending upon the nature of the noncompliance, result in the suspension or revocation of any license or registration at issue, the termination or loss of any contract at issue or the imposition of contractual damages, civil fines or criminal penalties. We have experienced no material difficulties in complying with the various laws and regulations affecting our business.

 

Our Web Site and Availability of Information

 

We make available free of charge on our Web site at www.eds.com/investor our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission, or SEC. We also make available on our Web site other reports filed with, or furnished to, the SEC under the Securities Exchange Act of 1934, including our proxy statements and reports filed by officers and directors under Section 16(a) of that Act. We do not intend for information contained on our Web site to be part of this Form 10-K.

 

ITEM 1A. RISK FACTORS

 

Because of the following factors, as well as other variables affecting our operating results, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods.

 

Our engagements with clients may not be profitable. The pricing and other terms of our client contracts, particularly our long-term IT outsourcing agreements, require us to make estimates and assumptions at the time we enter into these contracts that could differ from actual results. These estimates reflect our best judgments regarding the nature of the engagement and our expected costs to provide the contracted services. Any increased or unexpected costs or unanticipated delays in connection with the performance of these engagements, including delays caused by factors outside our control, could make these contracts less profitable or unprofitable, which would have an adverse effect on our profit margin. Our exposure to this risk increases generally in proportion to the scope of the client contract. In addition, a majority of our IT outsourcing contracts contain some fixed-price, incentive-based or other pricing terms that condition our fee on our ability to meet defined goals. Our failure to meet a client’s expectations in any type of contract may result in an unprofitable engagement.

 

Our ability to recover significant capital investments in certain construct contracts is subject to risks. Some of our client contracts require significant investment, including asset purchases and operating losses, in the early stages which is recovered through billings over the life of the respective contract. These contracts often involve the construction of new computer systems and communications networks and the development and deployment of new technologies. Substantial performance risk exists in each contract with these characteristics, and some or all elements of service delivery under these contracts are dependent upon successful completion of the development, construction and deployment phases. Contracts with ongoing construct activities had assets, including receivables, prepaid expenses, deferred costs, equipment and software, of approximately $1.3 billion at December 31, 2005, including approximately $0.9 billion associated with the NMCI contract (net of impairment charges associated with this contract in previous years). Some of these contracts, including the NMCI contract, have experienced delays in their development and construction phases, and certain milestones have been missed. We refer you to the discussion of the NMCI contract under “Overview – 2005 Highlights” below for further information regarding our risks under such contracts. Remaining long-lived assets and lease receivables associated with the NMCI contract totaled $240 million and $408 million, respectively, at December 31, 2005. In addition, we refer you to the discussion under “Overview – 2005 Highlights” below for further information regarding our risks under a commercial contract for which we recognized a $37 million non-cash impairment charge in 2005.

 

Our exposure to certain industries and financially troubled customers has adversely affected our financial results. Our exposure to certain industries and financially troubled customers has had, and could in the future have, a material adverse effect on our financial position and our results of operations. For example, we are a leading provider of IT outsourcing services to the United States automobile industry, which sector has been experiencing significant financial difficulties. We refer you to the discussion under “Overview” below of our revenues from GM and reserves recorded in 2005 with respect to our receivables from Delphi, which filed for bankruptcy in October 2005. In addition, we are the leading IT outsourcing provider to the airline industry, which has also faced significant financial challenges. We have a long-term IT outsourcing agreement with American Airlines and recently entered into a long-term IT outsourcing agreement with United Airlines. We also provide IT services to US Airways, which filed for bankruptcy in September 2004. We refer you to the discussion in Note 5 of the notes to our consolidated financial statements below of the write-down of our investment in an aircraft leasing partnership due to uncertainties regarding the recoverability of the partnership’s investments in aircraft leased to Delta Air Lines, which filed for bankruptcy in September 2005.

 

5


A decline in revenues from or loss of significant clients could reduce our revenues and profitability. Our success is to a significant degree dependent on our ability to retain our significant clients and maintain or increase the level of revenues from these clients, including in particular revenues from certain “mega-deal” long-term IT outsourcing agreements. We may lose clients due to their merger or acquisition, business failure, contract expiration, conversion to a competing service provider or conversion to an in-house data processing system. We may not be able to retain or renew relationships with our significant clients in the future. As a result of business downturns or for other business reasons, we are also vulnerable to reduced processing volumes from our clients, which can reduce the scope of services provided and the prices for those services.

 

Impact of Rating Agency downgrades. Any adverse action by Moody’s, S&P or Fitch with respect to our long-term credit ratings could materially adversely impact our ability to compete for new business, our cost of capital and our ability to access capital.

 

Some of our contracts contain benchmarking provisions that could decrease our revenues and profitability. Some of our long-term IT outsourcing agreements contain pricing provisions that permit a client to request a benchmark study by a mutually acceptable third-party benchmarker. Typically, benchmarking may not be conducted during the initial years of the contract term but may be requested by a client periodically thereafter, subject to restrictions which limit benchmarking to certain groupings of services and limit the number of times benchmarking may be elected during the term of the contract. Generally, the benchmarking compares the contractual price of our services against the price of similar services offered by other specified providers in a peer comparison group, subject to agreed upon adjustment and normalization factors. Generally, if the benchmarking study shows that our pricing has a difference outside a specified range, and the difference is not due to the unique requirements of the client, then the parties will negotiate in good faith any appropriate adjustments to the pricing. This may result in the reduction of our rates for the benchmarked services. Due to the enhanced focus of our clients on reducing IT costs, as well as the uncertainties and complexities inherent in benchmarking comparisons, our clients may increasingly attempt to obtain additional price reductions beyond those already embedded in our contract rates through the exercise of benchmarking provisions. Such activities could negatively impact our results of operations or cash flow in 2006 or thereafter to a greater extent than has been our prior experience.

 

An ongoing SEC investigation could adversely affect us or the market value of our securities. The SEC staff is conducting a formal investigation of some of our activities and contracts. We refer you to the discussion of “Pending Litigation and Proceedings” under Note 15 of the notes to our consolidated financial statements below for a description of this investigation. The investigation is ongoing, and we will continue to cooperate with the SEC staff. We are unable to predict the outcome of the investigation, the scope of matters that the SEC may choose to investigate in the course of this investigation or in the future, the SEC’s views of the issues being investigated, or any action that the SEC might take, including the imposition of fines, penalties, or other available remedies. Any adverse development in connection with the investigation, including any expansion of the scope of the investigation, could have a material adverse effect on us, including diverting the efforts and attention of our management team from our business operations, and could negatively impact the market value of our securities.

 

Pending litigation could have a material adverse effect on our liquidity and financial condition. We are defendants in various claims and pending actions arising in the ordinary course of business or otherwise. We recently agreed upon the terms of a settlement regarding certain shareholder class action suits and remain a party to certain other litigation related to such matters. We refer you to the discussion of “Pending Litigation and Proceedings” under Note 15 of the notes to our consolidated financial statements below for a description of certain of these matters. We are not able to determine the actual impact of these matters on us or our consolidated financial statements. However, we may be required to pay judgments or settlements and incur expenses in aggregate amounts that could have a material adverse effect on our liquidity and financial condition.

 

The markets in which we operate are highly competitive, and we may not be able to compete effectively. The markets in which we operate include a large number of participants and are highly competitive. Our primary competitors are IT service providers, large accounting, consulting and other professional service firms, application service providers, telecommunications companies, packaged software vendors and resellers and service groups of computer equipment companies. We also experience competition from numerous smaller, niche-oriented and regionalized service providers. Our business is experiencing rapid changes in its competitive landscape. We increasingly see our competitors moving operations offshore to reduce their costs as well as increasing direct competition from niche offshore providers, primarily India-based competitors. The competition from India-based companies is growing in intensity due to the abundance of highly skilled workers in the country, a pro-business regulatory environment and significantly lower costs of labor, which may allow these competitors to offer lower prices than we are able to offer. In addition, negative publicity from our pending litigation or SEC staff investigation could have a negative effect on our competitive position. Any of these factors may impose additional pricing pressure on us, which could have an adverse effect on our revenues and profit margin.

 

6


Market changes may result in decreased profitability. The IT outsourcing market is commoditizing, which is shrinking margins on many of our core offerings. In addition, that market has experienced slower growth and lower margins in recent years. We are continuing to invest in new service offerings in the higher-margin segments such as Business Process Outsourcing and applications development. However, if we are unable to implement our strategies to more effectively compete in such markets, our margins and profitability could be adversely affected.

 

We may not achieve the benefits we expect from our multi-year plan. Management has implemented a multi-year plan designed to make significant changes in the way we do business. This plan includes the development of a new technology platform for the delivery of our services which we refer to as the “Agile Enterprise” as well as other initiatives intended to substantially reduce our cost structure. We invested significant capital in the implementation of the multi-year plan in 2005 and will invest additional capital in 2006. Although management believes this plan will enable us to achieve sustainable, profitable growth over the longer term, there can be no assurance as to the acceptance of our technology initiatives in the marketplace or our ability to recognize a return on our investment. Our ability to achieve the anticipated cost savings and other benefits from these initiatives on a timely basis is subject to many estimates and assumptions, including assumptions regarding the costs and timing of activities in connection with these initiatives. These estimates and assumptions are subject to significant economic, competitive and other uncertainties some of which are beyond our control. In addition, service pricing contained in certain contracts signed since early 2005, including our new contracts with GM and the U.K. Government’s Department of Works and Pension, and other contracts expected to be signed in 2006, assume successful completion of our EDS Agile Enterprise initiatives on a timely basis. If these assumptions are not realized and we experience delays beyond those already experienced with respect to certain segments of these initiatives, or if other unforeseen events occur, our business and results of operations could be adversely affected and there could be a material adverse effect on the price of our securities.

 

Unanticipated changes in our tax provisions or exposure to additional tax liabilities could affect our profitability. We are subject to income taxes in the United States and numerous foreign jurisdictions. We are subject to ongoing tax audits in various jurisdictions. Tax authorities may disagree with our intercompany charges or other matters and assess additional taxes. Our provision for income taxes and cash tax liability in the future could be adversely affected by numerous factors including, but not limited to, income before taxes being lower than anticipated in countries with accumulated tax losses and higher than anticipated in countries with higher statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in tax laws, regulations, accounting principles or interpretations thereof, and the discovery of new information in the course of our tax return preparation process, which could adversely impact our results of operations and financial condition in future periods. In particular, the carrying value of deferred tax assets is dependent on our ability to generate future taxable income over the expiration period of the tax asset. An impairment of deferred tax assets would result in an increase in our effective tax rate and related tax expense in the period of impairment and could affect our profitability.

 

Risks associated with our international operations could negatively affect our earnings. International operations accounted for approximately one-half of our revenues in 2005 and will continue to represent a significant opportunity for growth in the IT industry. Our results of operations are affected by our ability to manage risks inherent in doing business abroad. These risks include exchange rate fluctuation, regulatory concerns, terrorist activity, restrictions with respect to the movement of currency, access to highly skilled workers, political and economic instability and our ability to protect our intellectual property. Any of these risks could impede our ability to increase our presence in certain jurisdictions or enter new jurisdictions. In addition, these risks could result in increased costs which could materially adversely affect our results of operations.

 

Our services or products may infringe upon the intellectual property rights of others. We cannot be sure that our services and products, or the products of others that we offer to our clients, do not infringe on the intellectual property rights of third parties, and we may have infringement claims asserted against us. These claims may harm our reputation, cost us money and prevent us from offering some services or products. We generally agree in our contracts to indemnify our clients for any expenses or liabilities they may incur resulting from claimed infringements of the intellectual property rights of third parties. In some instances, the amount of these indemnities may be greater than the revenues we receive from the client. Any claims or litigation in this area, whether we ultimately win or lose, could be time-consuming and costly, injure our reputation or require us to enter into royalty or licensing arrangements. We may, in limited cases, be required to forego rights to the use of intellectual property we help create, which limits our ability to also provide that intellectual property to other clients. Any limitation on our ability to provide a service or product could cause us to lose revenue-generating opportunities and require us to incur additional expenses to develop new or modified solutions for future projects.

 

A material weakness in our internal controls could have a material adverse effect on us. Effective internal controls are necessary for us to provide reasonable assurance with respect to our financial reports and to effectively prevent fraud. If we cannot provide reasonable assurance with respect to our financial reports and effectively prevent fraud, our reputation and operating results could be harmed. Pursuant to the Sarbanes-Oxley Act of 2002, we are required to furnish a report by management on internal control over financial reporting, including management’s assessment of the effectiveness of such control. Internal control over financial reporting may not prevent or detect misstatements because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud. Therefore, even effective internal controls can provide only

 

7


reasonable assurance with respect to the preparation and fair presentation of financial statements. In addition, projections of any evaluation of effectiveness of internal control over financial reporting to future periods are subject to the risk that the control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. If we fail to maintain the adequacy of our internal controls, including any failure to implement required new or improved controls, or if we experience difficulties in their implementation, our business and operating results could be adversely impacted, we could fail to meet our reporting obligations, and there could be a material adverse effect on our stock price. In connection with their review of our third quarter 2004 results and the ongoing procedures related to their audit of internal controls over financial reporting as of December 31, 2004, our independent auditors identified material weaknesses in our internal controls related to our NMCI contract and revenue recognition. Although such material weaknesses were corrected by December 31, 2004, we may identify one or more material weaknesses in our internal control over financial reporting from time to time in the future.

 

Cautionary Statement Regarding Forward-Looking Statements

 

The statements in this Report that are not historical statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements regarding estimated revenues, earnings, free cash flow, total contract value (“TCV”) of new contract signings, operating margins, cost savings and other forward-looking financial information. In addition, we have made in the past and may make in the future other written or oral forward-looking statements, including statements regarding future financial and operating performance, short- and long-term revenue, earnings and free cash flow, the timing of the revenue, earnings and free cash flow impact of new and existing contracts, liquidity, estimated future revenues from existing clients, the TCV of new contract signings, business pipeline, industry growth rates and our performance relative thereto, the impact of acquisitions and divestitures, and the impact of client bankruptcies. Any forward-looking statement may rely on a number of assumptions concerning future events and be subject to a number of uncertainties and other factors, many of which are outside our control, that could cause actual results to differ materially from such statements. In addition to the factors outlined above, these factors include, but are not limited to, the following: the performance of current and future client contracts in accordance with our cost, revenue and cash flow estimates, including our ability to achieve any operational efficiencies in our estimates; for contracts with U.S. Federal government clients, including our NMCI contract, the government’s ability to cancel the contract or impose additional terms and conditions due to changes in government funding, deployment schedules, military action or otherwise; our ability to access the capital markets, including our ability to obtain capital leases, surety bonds and letters of credit; the impact of third-party benchmarking provisions in certain client contracts; the impact on a historical and prospective basis of accounting rules and pronouncements; the impact of claims, litigation and governmental investigations; the success of our multi-year plan and cost-cutting initiatives and the timing and amount of any resulting benefits; the impact of acquisitions and divestitures; a reduction in the carrying value of our assets; the impact of a bankruptcy or financial difficulty of a significant client on the financial and other terms of our agreements with that client; with respect to the funding of pension plan obligations, the performance of our investments relative to our assumed rate of return; changes in tax laws and interpretations and failure to obtain treaty relief from double taxation; failure to obtain or protect intellectual property rights; fluctuations in foreign currency, exchange rates and interest rates; the impact of competition on pricing, revenues and margins; and the degree to which third parties continue to outsource IT and business processes.

 

We disclaim any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise, except as may be required by law.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

8


ITEM 2. PROPERTIES

 

As of February 28, 2006, we operated approximately 233 locations in 41 states in the United States and 423 locations in 45 countries outside the United States. At such date, we owned approximately 3.2 million square feet of space and leased from third parties approximately 20.5 million square feet of space.

 

We operate 16 large scale Service Management Centers, or SMCs, to service our IT outsourcing operations in locations throughout the United States and in Australia, Brazil, Canada, France, Germany, the Netherlands and the United Kingdom. In addition, we provide applications services from our Solution Centres located throughout the world. We also operate service delivery centers, or SDCs, at customer-owned sites or EDS-owned or leased facilities throughout the world. SDCs usually support a single or small number of clients with more specialized requirements than those supported at the large scale, multiple customer SMCs or our Solution Centres. Our leased properties consist primarily of office, warehouse, Solutions Centre, SDC and non-U.S. SMC facilities. Lease terms are generally five years or, for leases related to a specific client contract, generally have a term concurrent with that contract. We do not anticipate any difficulty in obtaining renewals or alternative space upon expiration of our existing leases. In addition to our owned and leased properties, we occupy office space at client locations throughout the world. Such space is generally occupied pursuant to the terms of the relevant client contract.

 

In connection with our efforts to improve our cost competitiveness and enhance workplace capacity usage, we completed the sale of 16 domestic and international real estate properties during the third quarter of 2005. Some of the properties involved in the sale were leased back under various terms. We will continue to review space requirements and efficiency on an ongoing basis.

 

ITEM 3. LEGAL PROCEEDINGS

 

The information set forth below under the heading “Pending Litigation and Proceedings” in Note 15 of the “Notes to Consolidated Financial Statements” in this Annual Report on Form 10-K is incorporated herein by reference.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None submitted.

 

9


EXECUTIVE OFFICERS OF EDS

 

The following sets forth certain information with respect to the executive officers of EDS, and persons chosen to become executive officers of EDS, as of March 1, 2006:

 

Michael H. Jordan, 69, has been Chairman and Chief Executive Officer of EDS since March 2003. He was Chairman and Chief Executive Officer of CBS Corporation (formerly Westinghouse Electric Corporation) from July 1993 until December 1998. Prior to joining Westinghouse, Mr. Jordan was a principal with the investment firm of Clayton, Dubilier and Rice from September 1992 through June 1993, Chairman of PepsiCo International from December 1990 through July 1992 and Chairman of PepsiCo World-Wide Foods from December 1986 to December 1990. Mr. Jordan has been chairman of the board of directors of eOriginal, Inc. (electronic document services) since June 1999. He is also a director of Aetna Inc.

 

Jeffrey M. Heller, 66, has been President and a director since he rejoined EDS in March 2003, and was also Chief Operating Officer until October 2005. He retired from EDS in February 2002 as Vice Chairman, a position he had held since November 2000. Mr. Heller served as President and Chief Operating Officer of EDS from 1996 to November 2000, Senior Vice President from 1984 to 1996, and Chairman of Unigraphics Solutions Inc. (then a subsidiary of EDS) from January 1999 to February 2001. He joined EDS in 1968 and has served in numerous technical and management capacities. Mr. Heller is also a director of Trammell Crow Company, Temple Inland Corp. and Mutual of Omaha.

 

Charles S. Feld, 63, has been Executive Vice President, Portfolio Development of EDS since January 2004. Mr. Feld has oversight responsibility for the development and strategic direction of our service offerings. From 1992 to January 2004, he served as Chief Executive Officer and President of The Feld Group, Inc., a technology management firm founded by him and acquired by EDS in January 2004. During that period, Mr. Feld served in technology positions at numerous Feld Group clients, including as Chief Information Officer at First Data Resources, a division of First Data Corp., from 2000 to 2002 and Chief Information Officer of Delta Air Lines from 1997 to 2000. Prior to establishing The Feld Group, Mr. Feld had served as Chief Information Officer of the Frito-Lay subsidiary of PepsiCo, Inc. since 1981. His association with that company began in 1970 as a systems engineer for International Business Machines Corporation.

 

Storrow M. Gordon, 53, has been Executive Vice President, General Counsel and Secretary of EDS since September 2005. Ms. Gordon has oversight responsibility for our legal affairs on a global basis and is responsible for our Office of Ethics and Compliance. She served as Deputy General Counsel of EDS from 2000 to September 2005. Prior to joining EDS in 1991, Ms. Gordon was a shareholder in a Dallas law firm specializing in corporate and general business law.

 

Ronald A. Rittenmeyer, 58, has been Co-Chief Operating Officer and Executive Vice President, Global Service Delivery of EDS since October 2005 and was Executive Vice President, Global Service Delivery of EDS from July to October 2005. He has oversight responsibility for EDS’ delivery capabilities on a global basis and, as Co-Chief Operating Officer, shares joint responsibility for EDS’ business development, functional alignment and change through EDS’ operating structure. Prior to joining EDS, he was Managing Director of The Cypress Group, a private equity firm, from July 2004 to June 2005, Chairman, Chief Executive Officer and President of Safety-Kleen, Inc., a hazardous waste management company, from August 2001 to July 2004, and Chief Executive Officer and President of AmeriServe, a food services company, from February 2000 to December 2001. Prior to that time Mr. Rittenmeyer had held executive positions with RailTex, Inc., Ryder TRS, Inc., Burlington Northern Railroad, Frito-Lay, Inc., PepsiCo Food International and Merisel.

 

Stephen F. Schuckenbrock, 45, has been Co-Chief Operating Officer and Executive Vice President, Global Sales & Client Solutions of EDS since October 2005 and was Executive Vice President, Global Sales & Client Solutions from January 2004 to October 2005. He has oversight responsibility for EDS’ sales organizations and centers of industry expertise and, in his role as Co-Chief Operating Officer, shares joint responsibility for EDS’ business development, functional alignment and change through EDS’ operating structure. Prior to joining EDS, he had served as Chief Operating Officer of The Feld Group, Inc., a technology management firm acquired by EDS in January 2004, since July 2000. Before joining The Feld Group in July 2000, Mr. Schuckenbrock led several technology organizations within PepsiCo, Inc., including serving as Chief Information Officer of PepsiCo from April 1998 to June 2000 and Chief Information Officer of its Frito-Lay subsidiary from June 1995 to April 1998. Before joining PepsiCo, he was a partner of The Feld Group from 1993 to 1995. Mr. Schuckenbrock began his career at International Business Machines Corporation in 1983, where he was employed in a variety of sales and technology management positions for 10 years.

 

10


Tina M. Sivinski, 49, has been Executive Vice President, Human Resources of EDS since October 2003 and served as Senior Vice President, Human Resources from October 2002 to October 2003. She has oversight responsibility for our compensation and benefits, diversity, center of learning, and HR business partner functions. Prior to that time, she was President of EDS’ Global Energy Industry Solutions group from August 2001 to October 2002. Before joining EDS, Ms. Sivinski was Vice President of Strategic Marketing, Sales and Business Development for GrandBasin, a Halliburton Company, from November 2000 to May 2001, a Vice President of Science Applications International from January 2000 to November 2000 and was employed by Data General Corp from 1980 to December 1999, most recently as a Vice President.

 

Robert H. Swan, 45, has been Executive Vice President and Chief Financial Officer of EDS since February 2003. Mr. Swan has had oversight responsibility for our treasury, financial analysis, tax, controller, administration, global supply chain management, merger and acquisition, investor relations and audit functions. Prior to joining EDS, he was Executive Vice President and Chief Financial Officer of TRW Inc. from July 2001 to December 2002. Mr. Swan served in executive positions at Webvan Group, Inc. from 1999 to 2001, including Chief Executive Officer from April to July 2001, Chief Operating Officer from September 2000 to July 2001 and Chief Financial Officer from October 1999 to July 2001. (Webvan filed a voluntary petition for Chapter 11 bankruptcy in July 2001.) He held various financial positions in General Electric Company from 1985 to 1999, including Chief Financial Officer, GE Lighting, from May 1998 to October 1999, Vice President, Finance, GE Medical Systems Europe, from January 1997 to May 1998 and Chief Financial Officer, GE Transportation Systems from October 1994 to January 1997.

 

Executive officers serve at the discretion of our Board of Directors.

 

Mr. Swan will resign from EDS effective March 15, 2006. The Board of Directors has appointed Thomas A. Haubenstricker and Ronald P. Vargo to serve as interim co-chief financial officers effective as of that date. Such persons will also retain their current positions.

 

Mr. Haubenstricker, 43, has been Vice President for Finance Administration of EDS since January 2003 with responsibility for EDS’ corporate business development and corporate planning and financial analysis organizations. He was Vice President of Strategic Planning and Business Development from January 2002 to January 2003 and Managing Director of Financial Planning and Reporting from 2000 to January 2002. Mr. Haubenstricker joined EDS’ finance organization in 1985 and has held various financial accounting, planning and reporting positions in the United States and EMEA (EDS’ Europe, Middle East and Africa region).

 

Mr. Vargo, 51, joined EDS as Vice President and Treasurer in January 2004. In that role, he has responsibility for EDS’ global treasury, corporate finance, and risk management operations as well as pension and corporate investment activities. Prior to joining EDS, he was Vice President and Treasurer of TRW Inc., now part of Northrop Grumman, from 1999 to 2003, a position he also held between 1991 and 1994. In addition, he held various financial and management positions at TRW Inc., The Standard Oil Company (subsequently British Petroleum p.l.c.) and General Electric Company.

 

11


PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

Our common stock is listed on the New York Stock Exchange (the “NYSE”) under the symbol “EDS.” The table below shows the range of reported per share sales prices on the NYSE Composite Tape for the common stock for the periods indicated.

 

Calendar Year


   High

   Low

2004

             

First Quarter

   $ 25.44    $ 18.30

Second Quarter

     20.66      15.62

Third Quarter

     20.43      16.43

Fourth Quarter

     23.38      19.01

2005

             

First Quarter

   $ 23.35    $ 19.59

Second Quarter

     21.11      18.59

Third Quarter

     23.95      19.00

Fourth Quarter

     24.82      21.16

 

The last reported sale price of the common stock on the NYSE on March 1, 2006 was $27.27 per share. As of that date, there were approximately 108,976 record holders of common stock.

 

EDS declared quarterly dividends on the common stock at the rate of $0.15 per share for the first and second quarters of 2004, and at the rate of $0.05 per share for the third and fourth quarters of 2004 and each quarter in 2005.

 

EDS did not purchase any common stock during the year ended December 31, 2005 and did not have any authorized share repurchase program in effect during that period.

 

12


ITEM 6. SELECTED FINANCIAL DATA

(in millions, except per share amounts)

 

     As of and for the Years Ended December 31,

 
     2005(1)

    2004(2)

    2003(2)

    2002(2)(3)

    2001(2)(3)(4)

 

Operating results

                                        

Revenues

   $ 19,757     $ 19,863     $ 19,758     $ 19,538     $ 19,272  

Cost of revenues

     17,422       18,224       18,261       16,352       15,653  

Selling, general and administrative

     1,819       1,571       1,577       1,532       1,544  

Restructuring and other

     (26 )     170       175       (2 )     (17 )

Other income (expense)(5)

     (103 )     (272 )     (262 )     (331 )     121  

Provision (benefit) for income taxes

     153       (103 )     (205 )     451       782  

Income (loss) from continuing operations

     286       (271 )     (312 )     874       1,431  

Income (loss) from discontinued operations

     (136 )     429       46       242       (44 )

Cumulative effect on prior years of changes in accounting principles, net of income taxes

     —         —         (1,432 )     —         (24 )

Net income (loss)

   $ 150     $ 158     $ (1,698 )   $ 1,116     $ 1,363  

Per share data

                                        

Basic earnings per share of common stock:

                                        

Income (loss) from continuing operations

   $ 0.55     $ (0.54 )   $ (0.65 )   $ 1.82     $ 3.04  

Net income (loss)

     0.29       0.32       (3.55 )     2.33       2.90  

Diluted earnings per share of common stock:

                                        

Income (loss) from continuing operations

     0.54       (0.54 )     (0.65 )     1.79       2.95  

Net income (loss)

     0.28       0.32       (3.55 )     2.28       2.81  

Cash dividends per share of common stock

     0.20       0.40       0.60       0.60       0.60  

Financial position

                                        

Total assets

   $ 17,087     $ 17,744     $ 18,616     $ 18,880     $ 16,353  

Long-term debt, less current portion

     2,939       3,168       4,148       4,148       4,692  

Shareholders’ equity

     7,512       7,440       7,022       7,022       6,446  

 

(1) We adopted a new method of accounting for share-based payments as of January 1, 2005. This change in accounting resulted in the recognition of pre-tax compensation expense of $160 million ($110 million net of tax) for the year ended December 31, 2005.
(2) Operating results for each of the years in the four year period ended December 31, 2004 have been restated to conform to the current presentation to reflect certain activities as discontinued operations during 2005.
(3) We adopted a new method of accounting for revenue recognition on long-term contracts effective January 1, 2003. Amounts for prior years are reported in accordance with our previous method of accounting for revenue recognition. Revenues for the years ended December 31, 2002 and 2001 were $18,311 million and $18,175 million, respectively, on a comparable pro forma basis as if the aforementioned accounting change had been applied to all contracts at inception. Net income for the years ended December 31, 2002 and 2001 were $460 million and $932 million, respectively, on a comparable pro forma basis as if the aforementioned accounting change had been applied to all contracts at inception.
(4) Effective January 1, 2002, we fully adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Intangible Assets. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized. Operating results, including those related to discontinued operations, include goodwill amortization in the pre-tax amount of $173 million for the year ended December 31, 2001.
(5) Other income (expense) includes net investment gains (losses) in the pre-tax amounts of $(41) million, $6 million, $6 million, $(119) million, and $344 million for the years ended December 31, 2005, 2004, 2003, 2002 and 2001, respectively.

 

13


ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with the consolidated financial statements and related notes that appear elsewhere in this document.

 

Overview

 

We are a leading provider of information technology (“IT”) and business process outsourcing (“BPO”) services to corporate and government clients around the world. This section provides an overview of the principal factors and events that impacted our 2005 results and the principal risks and opportunities that could impact our future.

 

2005 Highlights

 

Progress on Initiatives

 

At the beginning of 2005, we stated our priorities were to shift our focus from improving our core business and strengthening our balance sheet to a longer-term strategy, which contemplated significant new investments in our infrastructure and in new service offerings intended to improve our cost competitiveness and generate future growth. This discussion outlines our progress on these initiatives. Investments in these initiatives, including our upfront investment in the U.K. Ministry of Defence contract referred to below, reduced our earnings by approximately $0.36 per share during 2005.

 

Investments in Infrastructure. The principal focus of our investments in infrastructure during the year was the development of our “Agile Enterprise” platform, a network-based utility architecture designed to create a flexible, open and cost-effective technology foundation for the delivery of a significant portion of our IT outsourcing and BPO services. This platform includes the build-out of a global secure infrastructure, which is expected to be completed during 2006, as well as the modernization of legacy systems. As part of this strategy we have established alliance relationships with leading industry providers, which we refer to as the “EDS Agility Alliance.” We believe the technology vision behind the Agile Enterprise platform represents a key market differentiator for EDS and contributed to our increased level of new business signings in 2005 and year-to-date in 2006.

 

Investments in New Service Offerings. Our 2005 investments included a significant expansion of our human resources (“HR”) BPO capabilities, principally through the creation in the first quarter of ExcellerateHRO LLP, our 85% owned joint venture with Towers Perrin. ExcellerateHRO combines our payroll and related HR outsourcing business with the pension, health and welfare administration services business formerly operated by Towers Perrin as its Towers Perrin Administrative Services (“TPAS”) business. The new company enables us to offer a comprehensive set of HR outsourcing solutions across the core areas of benefits, payroll, compensation management, workforce administration and relocation, recruitment and staffing, and workforce development. The $417 million in cash we paid at closing of the transaction (which principally represented the purchase price for the business and the right to use the Towers Perrin brand, net of Towers Perrin’s interest in the new company and its share of the cash capital contribution (approximately $50 million) to the venture) was funded from cash on hand. We invested additional amounts in ExcellerateHRO and other BPO offerings during the year and will continue to focus on expanding our BPO offerings in 2006.

 

Cost Competitiveness. We continued to focus on improving our cost competitiveness in 2005 as part of our long-term goal to reduce our cost of revenue by approximately 20% over the four-year period commencing with 2005. During 2005, we reduced our cost of revenue by approximately $1 billion principally through the following:

 

    improvements in our supply chain, including increased usage of centralizing sourcing, competitive bidding, advanced sourcing tools and automation and improvements in demand planning, logistics and fulfillment;

 

    labor cost management through increased productivity, investment in automation and monitoring tools, and acceleration of our Best ShoreSM initiatives by increasing our capabilities in lower cost geographies;

 

    enterprise process improvements, including greater standardization and consolidation, more regimented contract start-up processes and service delivery automation; and

 

    production process improvements, including automation and process redesign enabling improved utilization of data center capacity.

 

In addition, during 2005 we sold sixteen domestic and international real estate properties in connection with our efforts to improve our cost competitiveness and enhance workplace capacity usage. Net proceeds from the sale were $178 million. Fourteen properties involved in the sale have been leased back for various extended periods. A deferred net gain of $14 million has been allocated to various leased properties and will be recognized over the respective term of each lease. We recognized a net gain of $3 million on the sale of the remaining properties which is included in other income in the 2005 consolidated statement of operations.

 

14


General Motors Recompete

 

GM is our largest single client, accounting for approximately $1.8 billion, or 9.1%, of our total revenue in 2005. Our ten-year Master Service Agreement, or MSA, with GM expires in June 2006. The MSA serves as a framework for the negotiation and operation of service agreements for certain “in-scope” IT services (as defined in the MSA) we provide to GM on a worldwide basis. These “in-scope” services account for a substantial majority of our revenues from GM. In February 2006, GM announced the results of a recompete process which covered substantially all of the work we perform under the MSA, including applications maintenance, infrastructure operations and integration management. We were awarded approximately 70% of the contracts we bid on with a total contract value of approximately $3.8 billion over five years. See “Priorities and Expectations for 2006 and Beyond” below for a discussion of the financial impact of the GM recompete in 2006 and thereafter.

 

A.T. Kearney

 

During 2005, we approved a plan to proceed with a transaction to sell 100% of our ownership interest in our A.T. Kearney management consulting business. That subsidiary, the sale of which was completed on January 20, 2006, is classified as “held for sale” at December 31, 2005 and 2004 and its results for the years ended December 31, 2005, 2004 and 2003 are included in income (loss) from discontinued operations. A.T. Kearney’s 2005 results include a pre-tax impairment charge of $118 million to write-down the carrying value of its long-lived assets, including tradename intangible, to estimated fair value less cost to sell. The estimated fair value was determined based on the terms of the sale. The impairment charge is partially offset by the recognition of $8 million previously unrecognized tax assets that will be realized as a result of the sale. We refer you to Notes 17 and 20 in the accompanying Notes to Consolidated Financial Statements.

 

Third-Party Bankruptcies

 

We provide IT services to Delphi Corporation (“Delphi”) through a long-term agreement. On October 8, 2005, Delphi filed for protection under Chapter 11 of the United States Bankruptcy Code. Due to uncertainties regarding the recoverability of certain pre-bankruptcy receivables associated with the Delphi contract, we recorded receivable reserves of $17 million which is reflected in cost of revenues in our 2005 consolidated statement of operations. The remaining assets associated with our services agreement with Delphi are expected to be recovered through collection or future operations.

 

During 2005, we recorded write-downs of our investment in an aircraft leasing partnership due to uncertainties regarding the recoverability of the partnership’s investments in aircraft leased by Delta Air Lines, which filed for bankruptcy on September 14, 2005, and the proposed sale of certain lease investments in the partnership. These write-downs were partially offset by the accelerated recognition of previously deferred investment tax credits associated with the investment. These write-downs totaled $35 million and are reflected in other expense in our 2005 consolidated statement of operations.

 

Client Contract Payment

 

During 2005, we reached an agreement with a government client to consolidate and extend our multiple IT services agreements with that client into a single extended agreement. As a result of this contract realignment, we received a non-refundable payment of $307 million from the client in the third quarter of 2005. A similar payment will be received from this client in the second quarter of 2006 which will be used to fund the incremental capital requirements in 2006 necessitated by the service delivery transformational requirements for this new contract. These payments will be recognized as revenue as we provide services over the five-year term of the new contract and resulted from the revision of contract pricing and delivery standards of numerous existing IT service contracts prior to their contractual end dates.

 

Accounting Change

 

We adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as of January 1, 2005. This statement requires the recognition of compensation expense when an entity obtains employee services in share-based payment transactions. This change in accounting resulted in the recognition of compensation expense of $160 million ($110 million net of tax) in 2005. The effect of all share-based payments on earnings per share (both basic and dilutive) would have been $0.33 and $0.44, respectively, during the years ended December 31, 2004 and 2003 if we had applied the provisions of SFAS 123R. The effect of share-based payments (both basic and dilutive) on earnings per share during the year ended December 31, 2005 was $0.29. In addition, effective with our March 2005 long-term incentive award grant, we significantly limited the use of annual stock option grants and instead provided annual grants of performance-vesting restricted stock units (“Performance RSUs”). Although we continue to use stock options as a component of the long-term incentive compensation of our senior executives along with Performance RSUs, we have completely replaced the use of stock options in favor of Performance RSUs for all other incentive plan participants. The vesting of the Performance RSUs is tied to our performance as measured by operating margin, net asset utilization and organic revenue growth over multiple year periods.

 

15


Prior to January 1, 2005, we recognized compensation cost associated with stock-based awards under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, the difference between the quoted market price as of the date of the grant and the contractual purchase price of shares was charged to operations over the vesting period on a straight-line basis. No compensation cost was recognized for fixed stock options with exercise prices equal to the market price of the stock on the dates of grant and shares acquired by employees under the EDS Stock Purchase Plan or Nonqualified Stock Purchase Plan. The primary difference in the accounting under SFAS 123R is that compensation expense for share-based awards is now recognized when we obtain employee services. Using the fair value approach required by SFAS 123R, compensation expense is recognized based on the fair value of the award on the date of grant. Prior to January 1, 2005, pro forma compensation expense using the fair value approach was disclosed in the notes to the financial statements in accordance with SFAS 123. Beginning January 1, 2005, compensation expense for stock options was recognized using the same methodology used to determine pro forma expense for disclosure purposes under SFAS 123.

 

We record a tax benefit related to share-based payments, recognizing a deferred tax asset based on an effective tax rate of 35%. The excess of the market value of our stock over the exercise price at the date of exercise represents the tax deduction to be received. If this deduction is equal to the amount of compensation expense recorded for that option, the entire tax asset is realized. If the deduction is greater than the compensation expense recognized, we will record an increase in additional paid-in capital. However, if the deduction is less than the expense recognized, a portion of the deferred tax asset will not be realized, and the deficiency will be reported as deferred tax expense in the period that options expire, are exercised or forfeited. There are numerous factors that influence the portion of the deferred tax asset that will be realized, including exercise behavior of the employees, future market price of the stock, and the volatility used in calculating the fair value of options on the grant date. At this time, we cannot predict the actual realization of our deferred tax assets.

 

NMCI

 

We provide end-to-end IT infrastructure on a seat management basis to the Department of Navy (the “DoN”), which includes the U.S. Navy and Marine Corps, under a contract that has been extended through September 2007. Seats are ordered on a governmental fiscal year basis, which runs from October 1 through September 30. Amounts to be billed per seat are based on the type of seat ordered. In addition, certain milestones must be met before we can bill at a price equal to the full seat price included in the pricing schedule. According to that schedule, seats under management are generally billed at a price of 85% of the associated full seat price until certain service performance levels as defined in the contract are satisfied. Upon meeting such service levels, seats operating under the NMCI environment are billed at a price equal to 100% of the full seat price while those operating under the pre-existing, or “legacy”, network environment continue to be billed at a price equal to 85% of the full seat price. At December 31, 2005, we had approximately 318,000 computer seats under management that were then billable, and approximately 81% of these seats were operating under the NMCI environment.

 

Long-lived assets and lease receivables associated with the contract totaled approximately $240 million and $408 million, respectively, at December 31, 2005. If we do not maintain or exceed current monthly seat cutover rates, or if we do not meet service performance and customer satisfaction levels in accordance with anticipated timelines, estimates of future contract cash flows will decline. We continue to pursue several opportunities to improve the financial performance of this contract, including efforts to increase the average seat price; qualify for performance and customer satisfaction incentives under the contract; improve productivity; extend the contract term through the DoN’s optional three-year extension period; and seek additional business with this client. We also are seeking to obtain compensation for significant amounts related to services required by and provided to the client in addition to contractual requirements, including services related to legacy applications, and for amounts related to the minimum order obligations under the contract. In addition, we expect to recover a significant portion of our investment in this contract through the sale of NMCI infrastructure and desktop assets to the client at the end of the contract term.

 

We reported revenues of $817 million, operating losses of $(75) million and free cash flow of $125 million associated with the NMCI contract in 2005, compared with revenues of $761 million, operating losses of $(487) million and free cash flow usage of $(423) million in 2004. The 2004 results are exclusive of the $375 million asset impairment charge taken in the third quarter of 2004 and the $522 million repurchase of financial assets from a securitization trust in the fourth quarter of 2004. The securitization trust had been used to finance the purchase of capital assets for the contract. The increase in revenue in 2005 compared to 2004 is attributable to a greater number of seats under management and recognition of seats billed at 100% of the full seat price, offset in part by a decline in product sales. The decrease in operating losses in 2005 compared to 2004 is due to increased productivity, reduced depreciation and amortization expense as a result of the impairment of NMCI-related long lived assets in the third quarter of 2004, additional seats under management and recognition of seats billed at 100% of the full seat price. The increase in free cash flow in 2005 is due to the aforementioned operational improvements, as well as our repurchase in the fourth quarter of 2004 of assets associated with the NMCI securitization facility. See “Off Balance Sheet Arrangements and Contractual Obligations” below. Although we continue to have a number of opportunities to improve the performance of the NMCI contract over the longer-term, we also face a number of significant risks, including the factors that resulted in the impairment of assets in the third quarter of 2004.

 

16


U.K. Ministry of Defence

 

In March 2005, a consortium led by us was awarded a ten-year contract for the first increment of the U.K. Ministry of Defence (MoD) project to consolidate numerous existing information networks into a single next-generation infrastructure (the Defence Information Infrastructure Future project). The total contract value of this contract was approximately $3.9 billion over ten years. Billings under the contract are initially based upon the achievement of milestones during the initial development and subsequently on the number of seats deployed. Our upfront expenditure and capital investment requirements for this contract during 2005 adversely impacted our free cash flow and earnings for the year. Many of the services and service delivery challenges required by this contract are similar to those required by the NMCI contract discussed above, and accordingly, many of the risks are the same. We have applied lessons learned from our experience with the NMCI contract to this contract, including contract terms with clearly defined client and EDS accountability and improved program management. We have met client expectations regarding key deliverables under this contract despite program changes and inability to achieve certain related dependencies that have extended the initial development timeline. This contract provides for adjustments to reflect the financial impact to EDS of client driven program changes and inability to achieve dependencies. We are working with the client to agree upon the appropriate adjustments provided for under the contract. If we do not reach satisfactory resolution with respect to these matters or for any future delays in the development timeline or seat deployment schedule our revenues, earnings and free cash flow for this contract, or the timing of the recognition thereof, could be adversely impacted.

 

Settlement of Consolidated Securities Class Action

 

On November 1, 2005, we entered into a memorandum of understanding regarding a settlement of the consolidated securities class action filed in late 2002, subject to certain conditions, including final approval of the settlement by the U.S. District Court for the Eastern District of Texas. See Note 15 of Notes to our Consolidated Financial Statements. The terms of the settlement provide for a cash payment of $137.5 million. We estimate approximately one-half of such payment will be made by our insurers and have recognized the cost of our portion of the settlement in our financial statements as of December 31, 2005.

 

Other

 

On March 1, 2005, we launched ExcellerateHRO LLP, our 85% owned joint venture with Towers Perrin, to deliver a comprehensive range of HR BPO services. ExcellerateHRO combines EDS’ payroll and related HR outsourcing business with the pension, health and welfare administration services business formerly operated by Towers Perrin as its TPAS business. The new company enables us to offer a comprehensive set of HR outsourcing solutions across the core areas of benefits, payroll, compensation management, workforce administration and relocation, recruitment and staffing, and workforce development. The $417 million in cash we paid at closing of the transaction was funded from cash on hand. This payment principally represented the purchase price for the acquisition by ExcellerateHRO of Towers Perrin’s benefits administration business and the right to use the Towers Perrin brand name, net of Towers Perrin’s interest in ExcellerateHRO and its share of the cash capital contribution (approximately $50 million) to the venture.

 

During 2005, we identified deterioration in the projected performance of one of our commercial contracts based, among other things, on a change in management’s judgment regarding the amount and likelihood of achieving anticipated benefits from contract-specific productivity initiatives, primarily related to the length of time necessary to achieve cost savings from planned infrastructure optimization initiatives. We determined that the estimated undiscounted cash flows of the contract over its remaining term were insufficient to recover the contract’s deferred contract costs. As a result, we recognized a non-cash impairment charge of $37 million in the second quarter of 2005 to write-off the contract’s deferred contract costs. The impairment charge is reported as a component of cost of revenues in the 2005 consolidated statements of operations and is included in the results of the Outsourcing segment. Remaining long-lived assets associated with this contract totaled $143 million at December 31, 2005. The current estimate of cash flows includes cost reductions resulting from the expected optimization of the contract’s service delivery infrastructure based on project plans and anticipated vendor rate reductions based on historical and industry trends. Some of the project plans have near-term milestones that are critical to meeting overall cost reduction goals. It is reasonably possible that these milestones may not be met or actual cost savings from these and other planned initiatives may not materialize in the near-term and, as a result, remaining long-lived assets associated with the contract will become fully impaired. We continue to pursue several opportunities to improve the financial performance of this contract, including leveraging the infrastructure through the addition of new business opportunities with the client.

 

17


Priorities and Expectations for 2006 and Beyond

 

We have substantially completed the transformation outlined in 2003 to “stabilize, fix and invest to grow” our business. Our priorities for 2006 and beyond are focused on achieving profitable growth through continued focus on cost competitiveness and service quality. We will continue initiatives to reduce our cost of revenues by approximately $1 billion in 2006 following a reduction of approximately $1 billion in each of the past two years. These initiatives include continued reengineering of our supply chain, labor cost management, enterprise process improvement and production process improvement. In addition, we will seek to build on our service excellence initiatives, which efforts resulted in increased client loyalty and innovation metrics in 2005.

 

We expect 2006 revenues of approximately $20.0-$20.5 billion, which would represent an increase in organic revenues of 2-4% from 2005. This reflects an anticipated increase in revenues from new business signed during 2005, including the U.K. MoD contract, offset by a decrease in GM revenues discussed above. We refer you to “Results of Operations” below for a definition of organic revenues.

 

We currently expect 2006 earnings per share of approximately $1.05-$1.15, excluding the impact of expensing stock options and Performance RSUs, and discontinued operations. Such forecasted increase in 2006 earnings is due to several factors, including the positive impact of the productivity initiatives described above, improvements in the performance of our NMCI and U.K. MoD contracts, revenue growth, and certain extraordinary items that adversely impacted 2005 earnings, such as the pension charge related to the termination of our U.K. Inland Revenue contract and litigation and settlement expenses. The incremental impact of such items on our 2006 earnings will be partially offset by the second-half impact of the expiration of our MSA with GM, additional investments in technology and infrastructure, increased sales costs associated with higher levels of new contract signings, and expenses associated with the acceleration of our offshore initiatives.

 

On February 21, 2006 we announced that the Board of Directors had authorized a $1 billion share repurchase program over 18 months. On February 23, 2006 we entered into a $400 million accelerated share repurchase agreement (see Note 20 in the accompanying Notes to Consolidated Financial Statements). Our expectations regarding 2006 earnings per share referred to above reflects the impact of the shares acquired through the accelerated share repurchase agreement and other shares that may be repurchased in 2006, which will be somewhat offset by the impact of anticipated issuances of additional shares upon option exercises and other compensation programs.

 

We expect free cash flow in 2006 of $800 million to $1 billion, compared to $619 million in 2005, with the forecasted improvement driven principally by our expected improvements in operating margins and improvements in working capital. Such improvements would be somewhat offset by an increase in net capital expenditures due to the benefit of our sale of real estate assets in 2005.

 

GM is our largest single client, accounting for approximately $1.8 billion, or 9.1%, of our total revenue in 2005. Our ten-year MSA with GM expires in June 2006. In February 2006, GM announced the results of a recompete process which covered substantially all of the work we perform under the MSA, including applications maintenance, infrastructure operations and integration management. We were awarded approximately 70% of the contracts we bid on with a total contract value of approximately $3.8 billion over five years (see “Total Contract Value of Contract Signings” below). We expect annualized revenue from GM of approximately $1.2-$1.4 billion over the next five years, including the business recently awarded as well as other GM business not part of the recompete. We expect 2006 revenue from GM, which will include the MSA through June 7, will be approximately $1.6 billion. We do not expect a significant change in our operating margins attributable to GM revenue compared to 2005. We refer you to the discussion in “Risk Factors” above of our exposure to certain industries, including the United States automobile industry, that have been experiencing financial difficulties. Such exposure has had, and could in the future have, a material adverse effect on our financial position and results of operations.

 

We continue to work with the DoN with respect to our efforts to improve the performance of our NMCI contract and expect that client to extend the contract term through its optional three-year extension period, which would run through September 30, 2010. We also expect continued improvement in the operational performance of the contract in 2006, which lost $75 million in 2005, through an increase in average seat prices as well as additional opportunities with this client. As a result of such operational improvement and anticipated extension of the contract term, we expect this contract, which has used approximately $3.2 billion of free cash flow since inception, to generate significant free cash flow during 2006 and thereafter, including free cash flow generated from the extended contract and through the expected sale of NMCI infrastructure and desktop assets to the client at the end of the contract term. We continue to face a number of risks under this contract, however, as described under “2005 Highlights” above.

 

See “Total Contract Value of Contract Signings” below for a discussion of our expectations for new contract signings for 2006.

 

18


The estimates for 2006 financial performance set forth in this Management’s Discussion and Analysis of Financial Condition and Results of Operations rely on management’s current assumptions, including assumptions concerning future events, and are subject to a number of uncertainties and other factors, many of which are outside the control of management, that could cause actual results to differ materially from such estimates. For a discussion of certain of these factors, we refer you to the discussion under “Risk Factors” in Item 1A of this Form 10-K as well as additional assumptions related to our 2006 financial guidance referred to under “Income Taxes” below.

 

Total Contract Value of Contract Signings

 

A key metric used by management to monitor new business activity is the total contract value, or TCV, of our contract signings. There are no third-party standards or requirements governing the calculation of TCV. The TCV of a client contract represents our estimate at contract signing of the total revenue expected over the term of that contract. Contract signings include contracts with new clients and renewals, extensions and add-on business with existing clients. TCV does not include potential revenues that could be earned from a client relationship as a result of future expansion of service offerings to that client, nor does it reflect option years under non-governmental contracts that are subject to client discretion. TCV reflects a number of management estimates and judgments regarding the contract, including assumptions regarding demand-driven usage, scope of work and client requirements. In addition, our contracts may be subject to currency fluctuations and, for contracts with the U.S. federal government, annual funding constraints and indefinite delivery/indefinite quantity characteristics. Accordingly, the TCV we report should not be considered firm orders or predictive of future operating results.

 

Following is a summary of the TCV of contract signings, excluding contracts signed by our former A.T. Kearney and UGS PLM Solutions subsidiaries, by quarter for the last five years (in billions):

 

    

First

Quarter


  

Second

Quarter


  

Third

Quarter


  

Fourth

Quarter


   Year

2001

   $ 7.1    $ 6.6    $ 6.2    $ 9.7    $ 29.6

2002

     6.7      5.6      2.6      7.6      22.5

2003

     2.6      3.0      3.1      3.9      12.6

2004

     3.6      3.8      2.9      3.7      14.0

2005

     6.9      2.6      5.3      5.3      20.1

 

The TCV of contract signings can fluctuate significantly from year to year depending on a number of factors, including the timing of significant new and renewal contracts and the length of those contracts.

 

Our TCV of contract signings increased to $20.1 billion in 2005 compared to $14.0 billion in 2004, reflecting an increase in average contract size as well as a greater impact from new and add-on business compared to 2004. The significant decrease in 2003 and 2004 compared to the prior years has negatively impacted our revenues since 2003, as a significant portion of our revenue is generated by long-term IT services contracts. Our ability to achieve revenue growth in the future will be dependent on our ability to increase the TCV of contract signings to a level higher than that of recent years. We expect TCV of contract signings in 2006 to be in excess of $23 billion. We refer you to the discussion of revenues in “Results of Operations” below.

 

Results of Operations

 

Revenues. Following is a summary of revenues from contracts with base (non-GM) clients and revenues from GM, excluding revenues from our former A.T. Kearney and UGS PLM Solutions subsidiaries which are reported as discontinued operations, for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

   2004

   2003

Revenues:

                    

Base

   $ 17,952    $ 17,907    $ 17,589

GM

     1,805      1,956      2,169
    

  

  

Total

   $ 19,757    $ 19,863    $ 19,758
    

  

  

 

19


Following is a summary of our revenue growth percentages calculated using revenues reported in the consolidated statements of operations, and adjusted for the impact of foreign currency translation, acquisitions and those divestitures not accounted for as discontinued operations (“organic revenue growth”):

 

     Total

    Base

    GM

 
     2005

    2004

    2005

    2004

    2005

    2004

 

As reported revenue growth

   (1 )%   1 %   —       2 %   (8 )%   (10 )%

Impact of foreign currency changes

   (1 )%   (5 )%   (1 )%   (5 )%   (1 )%   (2 )%
    

 

 

 

 

 

Fixed U.S. dollar revenue growth

   (2 )%   (4 )%   (1 )%   (3 )%   (9 )%   (12 )%

Impact of acquisitions

   (1 )%   —       (1 )%   —       —       —    

Impact of divestitures

   —       —       —       —       —       —    
    

 

 

 

 

 

Organic revenue growth

   (3 )%   (4 )%   (2 )%   (3 )%   (9 )%   (12 )%
    

 

 

 

 

 

 

Fixed U.S. dollar revenue growth is calculated by removing from as reported revenues the impact of the change in exchange rates between the local currency and the U.S. dollar from the current period and the comparable prior period. Organic revenue growth further excludes revenue growth due to acquisitions in the period presented if the comparable prior period had no revenues from the same acquisition, and revenue decreases due to businesses divested in the period presented or the comparable prior period.

 

2005 vs. 2004. The 2% decrease in base organic revenues in 2005 was primarily attributable to a $416 million, or 2%, decrease in our Outsourcing segment which excludes the results of our NMCI contract. The decrease in our Outsourcing segment was attributable to a $101 million, or 1%, decrease in the Americas unit, a $295 million, or 5%, decrease in Europe, Middle East and Africa (EMEA), and a $107 million, or 5%, decrease in the U.S. Government unit, offset by a $88 million, or 7%, increase in Asia Pacific. The decrease in revenues in EMEA was primarily due to the termination of our contract with the U.K. Government’s Inland Revenue department effective June 30, 2004, offset by an increase in revenue from other government and commercial clients, including our contract with the U.K. Ministry of Defence. The decrease in the Americas was primarily due to the termination of our “other commercial contract” effective August 1, 2004 (see Note 3 in the accompanying Notes to Consolidated Financial Statements). The decrease in U.S. Government was primarily attributable to the completion of a large federal contract in early 2005.

 

2004 vs. 2003. The 3% decrease in base organic revenues in 2004 was primarily attributable to a $236 million, or 1%, decrease in our Outsourcing segment and a $256 million, or 25%, decrease in our NMCI segment. The decrease in the Outsourcing segment was attributable to a $288 million, or 4%, decrease in EMEA and a $35 million, or 2%, decrease in the U.S. Government unit, offset by a $71 million, or 1%, increase in the Americas and a $15 million, or 1%, increase in Asia Pacific. The decrease in revenues in the NMCI segment was associated with lower product sales which were partially offset by increased service revenue. The decrease in base organic revenues in EMEA in 2004 was primarily due to the termination of our contract with the U.K. Government’s Inland Revenue department effective June 30, 2004, and was offset by an increase in revenues from financial services and other government clients. The U.S. Government business experienced reduced revenues in 2004 due to runoff from our state and local business, including the termination of the Medicaid contract with the State of Texas early in the first quarter of 2004. The decrease in revenues from our state and local business was offset by an increase in revenues from U.S. federal government contracts.

 

The decrease in organic revenues from GM in 2005 and 2004 was primarily attributable to reduced pricing under our MSA with GM, which expires in June 2006, as well as GM’s move toward a multi-vendor strategy. We expect revenues from GM of approximately $1.6 billion in 2006 and annualized revenues of approximately $1.2 to $1.4 billion beginning in 2007. We refer you to “Overview” above for a discussion of the recent GM recompete.

 

Gross margin. Our gross margin percentages [(revenues less cost of revenues)/revenues] were 11.8%, 8.3% and 7.6% in 2005, 2004 and 2003, respectively. Our gross margins in all periods were adversely affected by the performance of the NMCI contract, including asset write-downs in 2004 and 2003. The NMCI contract had a 90 basis point, 480 basis point and 530 basis point negative impact on our gross margin percentages in 2005, 2004 and 2003, respectively. Other items affecting our 2005 gross margin include a pension obligation settlement loss associated with the termination of the Inland Revenue contract (40 basis points), an increase in compensation expense attributable to the change in accounting for share-based payments (50 basis points), a deferred cost impairment charge associated with a large IT commercial contract (20 basis points) and litigation costs (20 basis points). These items were partially offset by favorable resolution of certain customer contract matters that permitted recognition of previously deferred revenue (40 basis points). Our gross margins in 2005 were also adversely affected by the investments discussed in “2005 Highlights” above and the decrease in organic revenues discussed above, including the termination of our contract with the U.K. Government’s Inland Revenue department. An additional item affecting our 2004 gross margin was operating losses and other charges on our “other commercial contract” (150 basis points). Other items affecting our 2003 gross margin include operating losses on our “other commercial contract” (140 basis points) and a $98 million (50 basis point) reversal of MCI receivable reserves.

 

20


We expect our gross margin to improve in 2006 as a result of our continued cost competitiveness initiatives, improved execution on our client contracts, and decrease in the level of investments compared to 2005.

 

Selling, general and administrative. SG&A expenses as a percentage of revenues were 9.2%, 7.9% and 8.0% in 2005, 2004 and 2003, respectively. The increase in our SG&A percentage in 2005 was primarily attributable to an increase in compensation expense resulting from the change in accounting for share-based payments, and performance-based RSUs (30 basis points) and incremental legal and regulatory costs (20 basis points). Our SG&A expense in 2005 was also impacted by higher sales and marketing costs, including commissions associated with increasing TCV of new business signings (40 basis points), and by certain investment initiatives discussed in “2005 Highlights” above (10 basis points).

 

Restructuring and other. Following is a summary of restructuring and other for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

Restructuring and other employee reduction activities:

                        

Employee separation, early retirement and exit costs, net

   $ 68     $ 276     $ 232  

Asset write-downs

     —         —         36  

CEO severance

     —         —         48  

Other activities:

                        

Pre-tax gain on disposal of businesses:

                        

European wireless clearing

     (93 )     —         —    

U.S. wireless clearing

     —         (35 )     —    

Automotive Retail Group

     —         (66 )     —    

Credit Union Industry Group

     —         —         (139 )

Other

     (1 )     (5 )     (2 )
    


 


 


Total

   $ (26 )   $ 170     $ 175  
    


 


 


 

We refer you to Note 19 in the accompanying Notes to Consolidated Financial Statements for a further discussion of the components of restructuring and other activities.

 

Other income (expense). Other income (expense) includes interest expense, interest and dividend income, investment gains and losses, minority interest expense, and foreign currency transaction gains and losses. Following is a summary of other income (expense) for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

Other income (expense):

                        

Interest expense

   $ (241 )   $ (321 )   $ (301 )

Interest income and other, net

     138       49       39  
    


 


 


Total

   $ (103 )   $ (272 )   $ (262 )
    


 


 


 

The decrease in interest expense in 2005 was primarily due to the extinguishment of debt resulting from our debt exchange offer completed in 2004 and other scheduled debt repayments. See “Financial Position” and “Liquidity and Capital Resources” for a further discussion of our outstanding debt balance. Interest expense in 2004 includes $36 million in expenses resulting from our debt exchange offer. See Note 8 to our consolidated financial statements for a further discussion of the exchange offer. The increase in interest income and other in 2005 was primarily due to interest income on increased levels of cash and marketable securities, and foreign currency transaction gains. Interest income and other in 2005 includes net investment losses of $41 million, including a write-down of $35 million relating to our leveraged lease investments, and interest and other income of $171 million. Interest income and other in 2004 includes net investment losses of $28 million, including a write-down of $34 million relating to our leveraged lease investments, and interest and other income of $77 million. Interest income and other in 2003 includes net investment gains of $6 million and other income of $33 million.

 

21


Income taxes. Our effective tax rates on income (loss) from continuing operations were 34.9%, 27.5% and 39.7% for the years ended December 31, 2005, 2004 and 2003, respectively. The tax rate in 2005 was significantly impacted by (i) recognition of additional valuation allowances of $115 million for losses incurred in certain foreign tax jurisdictions due to underperforming operations, and (ii) reversal of certain tax contingency accruals of $40 million due to progress made in jurisdictional tax audits. Our effective tax rate will fluctuate also in the future as a result of our adoption of SFAS 123R as discussed in “Overview” above. As we record expense under SFAS 123R, a deferred tax asset is recorded. The realization of that asset is dependent upon the intrinsic value of an option on the date of exercise. Any unrealized deferred tax asset is charged to tax expense in the period of exercise or expiration and, accordingly, would result in a higher effective tax rate in such period. See “Application of Critical Accounting Policies” below for a discussion of factors affecting income tax expense.

 

The U.S. research and development tax credit expired as of December 31, 2005. A retroactive extension of the credit is contained in legislation that has been passed by both the House and Senate and is currently in reconciliation conference. The Company has determined its 2006 guidance on the basis that the credit will be extended with retroactive effect to January 1, 2006. In the event that the legislation is not passed in its current form, full year guidance could be impacted and in the event the legislation is not passed and signed by the President by March 31, 2006, quarterly results could be adversely impacted until the extension of the credit is signed and can be reflected in the full year effective tax rate.

 

On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004. The Act created a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. Management determined that the incremental cost of the repatriation did not produce a corresponding economic benefit, and as a result, we did not make a repatriation under this provision.

 

Discontinued operations. Income (loss) from discontinued operations, net of income taxes, was $(136) million, $429 million and $46 million, respectively, for the years ended December 31, 2005, 2004 and 2003. Income (loss) from discontinued operations is comprised primarily of the net results of A.T. Kearney which is classified as “held for sale” at December 31, 2005, and UGS PLM Solutions which was sold during the second quarter of 2004. Discontinued operations also includes our European Technology Solutions and subscription fulfillment businesses sold during 2003. Income from discontinued operations includes net gains (losses) of $(92) million, $433 million and $(9) million, net of income taxes, in 2005, 2004 and 2003, respectively.

 

Net income (loss). Income (loss) from continuing operations was $286 million, or $0.55 per basic share and $0.54 per diluted share, in 2005 compared with $(271) million, or $(0.54) per basic and diluted share, in 2004 and $(312) million, or $(0.65) per basic and diluted share in 2003. Net income (loss) was $150 million in 2005 compared with $158 million in 2004 and $(1,698) million in 2003. Basic earnings (loss) per share was $0.29 in 2005 compared with $0.32 in 2004 and $(3.55) in 2003. Diluted earnings (loss) per share was $0.28 in 2005 compared with $0.32 in 2004 and $(3.55) in 2003.

 

During the third quarter of 2003, we adopted the provisions of Emerging Issues Task Force (“EITF”) Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, on a cumulative basis as of January 1, 2003. The adoption of EITF 00-21 resulted in a non-cash adjustment of $1.42 billion, net of tax, resulting primarily from the reversal of unbilled revenue associated with our IT service contracts which we had been accounting for using the percentage-of-completion method of revenue recognition. The adjustment also reflects the deferral and subsequent amortization of system construction costs which were previously expensed as incurred and included in the percentage-of-completion model for the respective contracts.

 

In addition, we adopted SFAS No. 143, Accounting for Asset Retirement Obligations, effective January 1, 2003. SFAS No. 143 requires that the fair value of the liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The majority of our retirement obligations relate to leases which require the facilities be restored to original condition at the expiration of the leases. The adoption of SFAS No. 143 resulted in a reduction of income reported as a cumulative effect of a change in accounting principle of $25 million ($17 million after tax). Additionally, the fair value of the liability recorded on January 1, 2003 was $48 million.

 

Segment information. We refer you to Note 12 in the notes to our consolidated financial statements for a summary of certain financial information related to our reportable segments for 2005, 2004 and 2003, as well as certain financial information related to our operations by geographic region and by service line for such years.

 

22


Financial Position

 

At December 31, 2005, we held cash and marketable securities of $3.2 billion, had working capital of $3.5 billion, and had a current ratio (current assets/current liabilities) of 1.68-to-1. This compares to cash and marketable securities of $3.6 billion, working capital of $3.4 billion, and a current ratio of 1.64-to-1 at December 31, 2004. Approximately 6% of our cash and cash equivalents and marketable securities at December 31, 2005 were not available for debt repayment due to various commercial limitations on the use of these assets. The decrease in cash and marketable securities in 2005 is due principally to cash payments of $417 million associated with the purchase of Towers Perrin’s benefits administration business in the first quarter of 2005, $135 million associated with the purchase of the outstanding interest in our Australian subsidiary in the second quarter of 2005 and debt payments of $560 million in 2005, offset by free cash flow of $619 million (see “Liquidity and Capital Resources” below for the definition of free cash flow).

 

Days sales outstanding for trade receivables were 58 days at December 31, 2005 compared to 56 days at December 31, 2004. Days payable outstanding were 19 days at December 31, 2005 and 2004.

 

Total debt was $3.3 billion at December 31, 2005 versus $3.8 billion at December 31, 2004. Total debt consists of notes payable and capital leases. The total debt-to-capital ratio (which includes total debt and minority interests as components of capital) was 30% at December 31, 2005 compared to 33% at December 31, 2004.

 

Off-Balance Sheet Arrangements and Contractual Obligations

 

In connection with certain service contracts, we may arrange a client supported financing transaction (“CSFT”) with our client and an independent third-party financial institution or its designee. The use of these transactions enables us to offer clients more favorable financing terms. These transactions also enable the preservation of our capital and allow us to avoid client credit risk relating to the repayment of the financed amounts. Under these transactions, the independent third-party financial institution finances the purchase of certain IT-related assets and simultaneously leases those assets for use in connection with the service contract. The use of a CSFT on a service contract results in lower contract revenue and expense to EDS over the contract term.

 

In CSFTs, client payments are made directly to the financial institution providing the financing. If the client does not make the required payments under the service contract, under no circumstances do we have an ultimate obligation to acquire the underlying assets unless our nonperformance under the service contract would permit its termination, or we fail to comply with certain customary terms under the financing agreements, including, for example, covenants we have undertaken regarding the use of the assets for their intended purpose. We consider the possibility of our failure to comply with any of these terms to be remote.

 

At December 31, 2005, the estimated future asset purchases to be financed under existing arrangements were $72 million. The aggregate dollar values of assets purchased under our CSFT arrangements were $8 million, $65 million and $72 million during 2005, 2004 and 2003, respectively. As of December 31, 2005, there were outstanding an aggregate of $241 million under CSFTs yet to be paid by our clients. In the event a client contract is terminated due to nonperformance, we would be required to acquire only those assets associated with the outstanding amounts for that contract. Net of repayments, the estimated future maximum amount outstanding under existing financing arrangements is not expected to exceed $250 million. We believe we have sufficient alternative sources of capital to directly finance the purchase of capital assets to be used for our current and future client contracts without the use of these arrangements.

 

During 2001, we established a securitization facility under which we financed the purchase of capital assets for our NMCI contract. Under the terms of the facility, we sold certain financial assets resulting from that contract to a trust (“Trust”) classified as a qualifying special purpose entity for accounting purposes. During 2004, we completed agreements with the Trust’s lenders to repurchase financial assets for $522 million in cash. Upon completion of the transaction, we recognized current lease receivables of $286 million and non-current lease receivables of $236 million associated with this purchase. Such receivables are being collected over the remaining term of the NMCI contract.

 

Performance guarantees. In the normal course of business, we may provide certain clients, principally governmental entities, with financial performance guarantees, which are generally backed by standby letters of credit or surety bonds. In general, we would be liable for the amounts of these guarantees in the event our nonperformance permits termination of the related contract by our client, the likelihood of which we believe is remote. We believe we are in compliance with our performance obligations under all service contracts for which there is a performance guarantee.

 

23


Following is a summary of the estimated expiration of financial guarantees outstanding as of December 31, 2005 (in millions):

 

          Estimated Expiration Per Period

     Total

   2006

   2007

   2008

   Thereafter

Performance guarantees:

                                  

CSFT transactions

   $ 241    $ 88    $ 86    $ 37    $ 30

Standby letters of credit, surety bonds and other

     521      282      21      18      200

Other guarantees

     32      18      10      4      —  
    

  

  

  

  

Total

   $ 794    $ 388    $ 117    $ 59    $ 230
    

  

  

  

  

 

Contractual obligations. Following is a summary of payments due in specified periods related to our contractual obligations as of December 31, 2005 (in millions):

 

          Payments Due by Period

     Total

   2006

   2007-2008

   2009-2010

  

After

2010


Long-term debt, including current portion and interest(1)

   $ 4,958    $ 525    $ 509    $ 1,748    $ 2,176

Operating lease obligations

     1,370      316      453      236      365

Purchase obligations(2)

     3,388      976      1,435      899      78
    

  

  

  

  

Total(3)

   $ 9,716    $ 1,817    $ 2,397    $ 2,883    $ 2,619
    

  

  

  

  

 

(1) Amounts represent the expected cash payments (principal and interest) of our long-term debt and do not include any fair value adjustments or bond premiums or discounts. Amounts also include capital lease payments (principal and interest).
(2) Purchase obligations include material agreements to purchase goods or services, principally software and telecommunications services, that are enforceable and legally binding on EDS and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Purchase obligations also exclude our obligation to repurchase minority interests in joint ventures, including our obligation to repurchase Towers Perrin’s minority interest in ExcellerateHRO. See Note 16 of the accompanying consolidated financial statements.
(3) Minimum pension funding requirements are not included as such amounts are zero for our U.S. pension plans and have not been determined for foreign pension plans. See Note 13 of the accompanying consolidated financial statements.

 

24


Liquidity and Capital Resources

 

Following is a summary of our cash flows for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

Cash flows:

                        

Net cash provided by operating activities

   $ 1,296     $ 1,278     $ 1,495  

Net cash used in investing activities

     (797 )     (758 )     (809 )

Net cash used in financing activities

     (681 )     (663 )     (71 )

Free cash flow

     619       304       221  

 

Operating activities. The increase in net cash provided by operating activities in 2005 compared to 2004 was due to a $150 million increase in earnings, adjusted to exclude non-cash operating items, offset by a $132 million change in operating assets and liabilities. The change in operating assets and liabilities resulted primarily from a decrease in receivables collections and an increase in tax payments, offset by an increase in deferred revenue (see “Client Contract Payment” in the “Overview” section above). The decrease in net cash provided by operating activities in 2004 compared to 2003 was due to a $393 million decrease in earnings, adjusted to exclude non-cash operating items, offset by a $176 million change in operating assets and liabilities. The change in operating assets and liabilities resulted primarily from a decrease in prepayments to vendors, a decrease in construction costs related to our active construct contracts and a reduction in tax payments, offset by restructuring payments, a decrease in accounts receivable collections and a one-time pension payment of $119 million associated with the termination of the Inland Revenue contract. Operating cash flows in 2005 were comprised of $1,211 million in cash provided by our core IT outsourcing and consulting businesses (excluding NMCI), and $85 million in cash provided by our NMCI contract. Operating cash flows in 2004 were comprised of $1,557 million in cash provided by our core IT outsourcing and consulting businesses offset by $279 million in cash used by our NMCI contract.

 

Investing activities. The change in net cash used in investing activities in 2005 compared to 2004 was primarily due to a decrease in proceeds from divestitures in 2005, and an increase in acquisition payments related to 2005 acquisitions (see Notes 16, 17 and 19 in the accompanying Notes to Consolidated Financial Statements). In addition, we realized net proceeds of $178 million in 2005 resulting from sales of real estate (see “Real Estate Initiatives” in the “Overview” section above). Net cash used in investing activities in 2004 includes the proceeds from the divestitures of our U.S. wireless clearing business, UGS PLM Solutions and ARG. Divestiture proceeds were somewhat offset by net purchases of marketable securities. Net cash used in investing activities in 2004 also includes a $522 million cash payment related to the purchase of financial assets associated with the NMCI securitization facility. Excluding this purchase, net proceeds from investments and other assets decreased in 2004 compared to 2003 due primarily to lower securitization proceeds and equipment purchases associated with the NMCI contract.

 

Financing activities. The increase in net cash used in financing activities in 2005 compared to 2004 was primarily due to proceeds from our common stock issuance associated with a debt exchange in 2004. The increase in net cash used in financing activities in 2004 was primarily due to an increase in net payments on long-term debt and capital lease obligations, partially offset by proceeds from our common stock issuance associated with a debt exchange and by a reduction in dividend payments.

 

Free cash flow. We define free cash flow as net cash provided by operating activities, less capital expenditures. Capital expenditures is the sum of (i) net cash used in investing activities, excluding proceeds from sales of marketable securities, proceeds related to divested assets and non-marketable equity investments, payments related to acquisitions, net of cash acquired, and non-marketable equity investments, and payments for purchases of marketable securities, and (ii) capital lease payments. During 2004, we sold our UGS PLM Solutions subsidiary and repurchased financial assets outstanding under the NMCI contract securitization facility. Due to the significance of these transactions, the calculation of free cash flow for 2004 was adjusted to exclude $14 million in transaction fees paid during 2004 related to the UGS PLM Solutions disposition, and the $522 million cash payment related to the repurchase of financial assets associated with the NMCI securitization facility. The calculation of free cash flow for 2004 was also adjusted to include $85 million in cash generated through utilization of operating tax credits, predominantly related to 2004, to offset income tax associated with the UGS PLM Solutions disposition (such tax credits would otherwise have been available to offset future taxable income generated by operations). Free cash flow is a non-GAAP measure and should be viewed together with our consolidated statements of cash flows.

 

25


Following is a reconciliation of free cash flow to the net change in cash and cash equivalents for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

Net cash provided by operating activities

   $ 1,296     $ 1,278     $ 1,495  

Capital expenditures:

                        

Proceeds from investments and other assets

     310       68       43  

Net proceeds from real estate sales

     178       —         —    

Payments for purchases of property and equipment

     (718 )     (666 )     (703 )

Payments for investments and other assets

     (27 )     (556 )     (25 )

Payments for purchases of software and other intangibles

     (300 )     (302 )     (494 )

Other investing activities

     29       28       25  

Capital lease payments

     (149 )     (167 )     (120 )
    


 


 


Total capital expenditures

     (677 )     (1,595 )     (1,274 )

Adjustments:

                        

Utilization of tax credits related to the UGS PLM Solutions disposition

     —         85       —    

Transaction fees related to the UGS PLM Solutions disposition

     —         14       —    

Payment related to the repurchase of financial assets associated with the NMCI securitization facility

     —         522       —    
    


 


 


Free cash flow

     619       304       221  

Other investing and financing activities:

                        

Proceeds from sales of marketable securities

     1,434       956       548  

Net proceeds from divested assets and non-marketable equity securities

     160       2,129       233  

Payments for acquisitions, net of cash acquired, and non-marketable equity securities

     (552 )     (78 )     11  

Payments for purchases of marketable securities

     (1,311 )     (2,337 )     (447 )

Proceeds from long-term debt

     5       6       1,869  

Payments on long-term debt

     (560 )     (561 )     (1,312 )

Net decrease in borrowings with original maturities less than 90 days

     —         —         (235 )

Proceeds from issuance of common stock

     —         198       —    

Employee stock transactions

     107       76       47  

Dividends paid

     (105 )     (200 )     (287 )

Other financing activities

     21       (15 )     (33 )

Effect of exchange rate changes on cash and cash equivalents

     (21 )     48       (60 )

Adjustments:

                        

Utilization of tax credits

     —         (85 )     —    

Transaction fees

     —         (14 )     —    

Payment related to the repurchase of financial assets associated with the NMCI securitization facility

     —         (522 )     —    
    


 


 


Net increase (decrease) in cash and cash equivalents

   $ (203 )   $ (95 )   $ 555  
    


 


 


 

Our gross capital requirement in 2005 was approximately $1.2 billion including equipment and real estate leases and the use of CSFTs. Free cash flow of $125 million for the NMCI contract for 2005 reflects net cash provided by operating activities of $85 million and a net cash inflow of capital expenditures of $40 million.

 

Credit facilities. During 2004, we entered into a $550 million Three-and-One-Half Year Multi Currency Revolving Credit Agreement with a bank group including Citibank, N.A., as Administrative Agent, and Bank of America, N.A., as Syndication Agent. The new facility replaced our five-year $550 million revolving credit facility, which expired in September 2004. The new facility may be used for general corporate borrowing purposes and the issuance of letters of credit. The aggregate availability under the new facility, together with our $450 million Three-Year Multi Currency Revolving Credit Agreement entered into in 2003, is $1.0 billion. As of December 31, 2005, there were no amounts outstanding under either of these facilities and we had issued letters of credit totaling $160 million under the $550 million Three-and-One-Half Year Multi Currency Revolving Credit Agreement, thereby reducing the availability under these facilities to $840 million at such date. The new facility includes financial and other covenants of the general nature contained in the facility it replaced and the $450 million Three-and-One-Half Year Multi Currency Revolving Credit Facility was amended and restated to include financial and other terms similar to the new facility.

 

26


Our unsecured credit facilities contain certain financial and other restrictive covenants and representations and warranties that would allow any amounts outstanding under the facilities to be accelerated, or restrict our ability to borrow thereunder, in the event of noncompliance. The financial covenants of our unsecured credit facilities were modified in September 2004 in connection with the replacement of our $550 million credit facility as discussed above, and include a minimum net worth covenant, a fixed charge coverage requirement and a leverage ratio requirement. The leverage ratio cannot exceed 2.25-to-1 through December 2005, and 2.00-to-1 thereafter. The fixed charge coverage covenant requires us to maintain a fixed charge ratio of no less than 1.15-to-1 through December 2005, and 1.25-to-1 thereafter. We were in compliance with all covenants at December 31, 2005.

 

Following is a summary of the financial covenant requirements under our unsecured credit facilities and the calculated amount or ratios at December 31, 2005 (dollars in millions):

 

     As of and for the
Year Ended
December 31, 2005


     Covenant

   Actual

Minimum net worth

   $ 6,420    $ 7,512

Leverage ratio

     2.25      1.67

Fixed charge coverage ratio

     1.15      2.37

 

Credit ratings. Following is a summary of our senior long-term debt credit ratings by Moody’s Investor Services, Inc. (“Moody’s”), Standard & Poor’s Rating Services (“S&P”) and Fitch Ratings (“Fitch”) at December 31, 2005:

 

    

Moody’s


  

S&P


  

Fitch


Senior long-term debt

  

Ba1

  

BBB–

  

BBB–

Outlook

  

Stable

  

Negative

  

Stable

 

On September 15, 2005, Moody’s revised our rating outlook to stable from negative. On November 2, 2005, Fitch revised our rating outlook to stable from negative. At December 31, 2005, we had no recognized or contingent material liabilities that would be subject to accelerated payment due to a ratings downgrade. We do not believe a negative change in our credit rating would have a material adverse impact on us under the terms of our existing client agreements.

 

Liquidity. At December 31, 2005, we had total liquidity of $3.9 billion, comprised of unrestricted cash and marketable securities of $3.0 billion and availability under our unsecured credit facilities of $840 million. During 2005, we terminated our secured A/R facility, a revolving secured financing arrangement collateralized by certain trade receivables with availability of up to $400 million. We elected to terminate the facility in order to more closely align our liquidity with our minimum targeted levels referred to below. We have maintained in effect our unsecured credit agreements which provide for aggregate availability of $1.0 billion for issuances of letters of credit and general corporate borrowing.

 

Based on our improved free cash flow performance in 2005 and forecasted free cash flow improvements, we have moved our minimum targeted liquidity from 18 months of forecasted capital expenditures (as defined under “Free Cash Flow” above), interest payments, debt maturities and dividend payments to 12 months of forecasted capital expenditures, interest payments, debt maturities and dividend payments. Accordingly, in February 2006 our Board of Directors authorized us to repurchase up to $1 billion of our common shares in open market or other purchases over the next 18 months. We completed $400 million of such authorized repurchase through an Accelerated Share Repurchase arrangement in February 2006 (see Note 20 in the accompanying Notes to Consolidated Financial Statements).

 

Change in dividend rate. On July 27, 2004, our Board of Directors reduced the quarterly dividend on our common stock from $0.15 to $0.05 per share.

 

Application of Critical Accounting Policies

 

The preparation of our financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates. Areas in which significant judgments and estimates are used include, but are not limited to, revenue recognition, accounts receivable collectibility, accounting for long-lived assets, deferred income taxes, retirement plans, performance guarantees and litigation.

 

27


Revenue recognition and associated cost deferral. We provide IT and business process outsourcing services under time-and-material, unit-price and fixed-price contracts, which may extend up to 10 or more years. Services provided over the term of these arrangements may include one or more of the following: IT infrastructure support and management; IT system and software maintenance; application hosting; the design, development, or construction of software and systems (“Construct Service”); transaction processing; and business process management.

 

If a contract involves the provision of a single element, revenue is generally recognized when the product or service is provided and the amount earned is not contingent upon any future event. If the service is provided evenly during the contract term but service billings are irregular, revenue is recognized on a straight-line basis over the contract term. However, if the single service is a Construct Service, revenue is recognized under the percentage-of-completion method using a zero-profit methodology. Under this method, costs are deferred until contractual milestones are met, at which time the milestone billing is recognized as revenue and an amount of deferred costs is recognized as expense so that cumulative profit equals zero. If the milestone billing exceeds deferred costs, then the excess is recorded as deferred revenue. When the Construct Service is completed and the final milestone met, all unrecognized costs, milestone billings and profit are recognized in full. If the contract does not contain contractual milestones, costs are expensed as incurred and revenue is recognized in an amount equal to costs incurred until completion of the Construct Service, at which time any profit would be recognized in full. If total costs are estimated to exceed revenue for the Construct Service, then a provision for the estimated loss is made in the period in which the loss first becomes apparent.

 

If a contract involves the provision of multiple service elements, total estimated contract revenue is allocated to each element based on the relative fair value of each element. The amount of revenue allocated to each element is limited to the amount that is not contingent upon the delivery of another element in the future. Revenue is then recognized for each element as described above for single-element contracts, except revenue recognized on a straight-line basis for a non-Construct Service will not exceed amounts currently billable unless the excess revenue is recoverable from the client upon any contract termination event. If the amount of revenue allocated to a Construct Service is less than its relative fair value, costs to deliver such service equal to the difference between allocated revenue and the relative fair value are deferred and amortized over the contract term. If total Construct Service costs are estimated to exceed the relative fair value for the Construct Service contained in a multiple-element arrangement, then a provision for the estimated loss is made in the period in which the loss first becomes apparent.

 

In the rare event that fair value is not determinable for each service element of a multiple-element contract, the contract is considered one accounting unit, and revenue is recognized using the proportional performance method. Under this method, contract revenue is recognized for each service element based on the proportional performance of each service element to the total expected performance of each service element over the life of the contract.

 

We also defer and subsequently amortize certain set-up costs related to activities that enable the provision of contracted services to the client. Such activities include the relocation of transitioned employees, the migration of client systems or processes, and the exit of client facilities. Deferred contract costs, including set-up costs, are amortized on a straight-line basis over the remaining original contract term unless billing patterns indicate a more accelerated method is appropriate. The recoverability of deferred contract costs associated with a particular contract is analyzed whenever events or circumstances indicate that their carrying value may not be recoverable using the undiscounted estimated cash flows of the whole contract over its remaining contract term. If such undiscounted cash flows are insufficient to recover the long-lived assets and deferred contract costs, including contract concessions paid to the client, the deferred contract costs and contract concessions are written down by the amount of the cash flow deficiency. If a cash flow deficiency remains after reducing the balance of the deferred contract costs and contract concessions to zero, any remaining long-lived assets are evaluated for impairment. Any such impairment recognized would equal the amount by which the carrying value of the long-lived assets exceeds the fair value of those assets.

 

Accounts receivable. Reserves for uncollectible trade receivables are established when collection of amounts due from clients is deemed improbable. Indicators of improbable collection include client bankruptcy, client litigation, industry downturns, client cash flow difficulties or ongoing service or billing disputes. Receivables more than 180 days past due are automatically reserved unless persuasive evidence of probable collection exists. Our allowances for doubtful accounts as a percentage of total gross trade receivables were 2.0%, and 3.5% at December 31, 2005 and 2004, respectively. The increase in the allowance in 2004 resulted primarily from the recognition of reserves in connection with the US Airways bankruptcy. Excluding those reserves, the allowance percentage was 2.7% at December 31, 2004.

 

Long-lived assets. Our property and equipment, software and definite-lived intangible asset policies require the amortization or depreciation of assets over their estimated useful lives. An asset’s useful life is the period over which the asset is expected to contribute directly or indirectly to our future cash flows. The useful lives of property and equipment are limited to the standard depreciable lives or, for certain assets dedicated to client contracts, the related contract term. The useful lives of capitalized software are limited to the shorter of the license period or the related contract term. The estimated useful lives of definite-lived intangible assets are based on the expected use of the asset and factors that may limit the use of the asset. We may utilize the assistance of a third-party appraiser in the assessment of the useful life of an intangible asset.

 

28


Goodwill is not amortized, but instead tested for impairment at least annually. The first step of the goodwill impairment test is a comparison of the fair value of a reporting unit to its carrying value. The fair value of a reporting unit is the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties. We conducted an annual goodwill impairment test as of December 1, 2005. The goodwill impairment test requires us to identify our reporting units and obtain estimates of the fair values of those units as of the testing date. Our reporting units are comprised of the geographic components of our operating segments that share similar economic characteristics. We estimate the fair values of our reporting units using discounted cash flow valuation models. Those models require estimates of future revenues, profits, capital expenditures and working capital for each unit. We estimate these amounts by evaluating historical trends, current budgets, operating plans and industry data. We utilize our weighted-average cost of capital to discount the estimated expected future cash flows of each unit. The estimated fair value of each of our reporting units exceeded its respective carrying value in 2005 indicating the underlying goodwill of each unit was not impaired.

 

We plan to conduct our annual impairment test as of December 1st of each year when our budgets and operating plans for the forthcoming year are expected to be finalized. The timing and frequency of additional goodwill impairment tests are based on an ongoing assessment of events and circumstances that would more than likely reduce the fair value of a reporting unit below its carrying value. We will continue to monitor our goodwill balance for impairment and conduct formal tests when impairment indicators are present. A decline in the fair value of any of our reporting units below its carrying value is an indicator that the underlying goodwill of the unit is potentially impaired. This situation would require the second step of the goodwill impairment test to determine whether the unit’s goodwill is impaired. The second step of the goodwill impairment test is a comparison of the implied fair value of a reporting unit’s goodwill to its carrying value. An impairment loss is required for the amount which the carrying value of a reporting unit’s goodwill exceeds its implied fair value. The implied fair value of the reporting unit’s goodwill would become the new cost basis of the unit’s goodwill.

 

Deferred income taxes. We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. We must assess the likelihood that we will be able to recover our deferred tax assets. In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and adjust the valuation allowances accordingly. Factors considered in making this determination include the period of expiration of the tax asset, planned use of the tax asset, and historical and projected taxable income as well as tax liabilities for the tax jurisdiction in which the tax asset is located. Valuation allowances will be subject to change in each future reporting period as a result of changes in one or more of these factors. A majority of the tax assets are associated with tax jurisdictions in which we have a large scale of operations and long history of generating taxable income, thereby reducing the estimation risk associated with recoverability analysis. However, in smaller tax jurisdictions in which we have less historical experience or smaller scale of operations, the assessment of recoverability of tax assets is largely based on projections of taxable income over the expiration period of the tax asset and is subject to greater estimation risk. Accordingly, it is reasonably possible the recoverability of tax assets in these smaller jurisdictions could be impaired as a result of poor operating performance over extended periods of time or a future decision to reduce or eliminate operating activity in such jurisdictions. Such an impairment would result in an increase in our effective tax rate and related tax expense in the period of impairment.

 

Liabilities for tax contingencies. We have recorded liabilities for tax contingencies related to positions we have taken that could be challenged by taxing authorities. These potential exposures result from the uncertainties in application of statutes, rules, regulations and interpretations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether and the extent to which additional taxes will be due. Our estimate of the ultimate tax liability contains assumptions based on past experiences, judgments about potential actions by taxing jurisdictions as well as judgments about the likely outcome of issues that have been raised by taxing jurisdictions. Although we believe our reserves for tax contingencies are reasonable, they may change in the future due to new developments with each issue. We record an additional charge or benefit in our provision for taxes in the period in which we determine that the recorded tax liability is more or less than we expect the ultimate assessment to be.

 

Retirement plans. We offer pension and other postretirement benefits to our employees through multiple global pension plans. Our largest pension plans are funded through our cash contributions and earnings on plan assets. We use the actuarial models required by SFAS No. 87, Employers’ Accounting for Pensions, to account for our pension plans. Two of the most significant actuarial assumptions used to calculate the net periodic pension benefit expense and the related pension benefit obligation for our defined pension benefit plans are the expected long-term rate of return on plan assets and the discount rate assumptions.

 

SFAS No. 87 requires the use of an expected long-term rate of return that, over time, will approximate the actual long-term returns earned on pension plan assets. We base this assumption on historical actual returns as well as anticipated future returns based on our investment mix. Given our relatively young workforce, we are able to take a long-term view of our pension

 

29


investment strategy. Accordingly, plan assets are weighted heavily towards equity investments. Equity investments are susceptible to significant short-term fluctuations but have historically outperformed most other investment alternatives on a long-term basis. At December 31, 2005, 84% of pension assets were invested in public and private equity and real estate investments with the remaining assets being invested in fixed income securities. Such mix is consistent with that assumed in determining the expected long-term rate of return on plan assets. Rebalancing our actual asset allocations to our planned allocations based on actual performance has not been a significant issue.

 

An 8.6% weighted-average expected long-term rate of return on plan assets assumption was used for the pension plan actuarial valuations in 2005 and 2004. A 100 basis point increase or decrease in this assumption results in an estimated pension expense decrease or increase, respectively, of $64 million in the subsequent year’s pension expense (based on the most recent pension valuation and assuming all other variables are constant).

 

An assumed discount rate is required to be used in each pension plan actuarial valuation. This rate reflects the underlying rate determined on the measurement date at which the pension benefits could effectively be settled. High-quality bond yields on our measurement date, October 31, 2005, with maturities consistent with expected pension payment periods are used to determine the appropriate discount rate assumption. For the countries with the largest pension plans, actual participant data is used by our actuaries to determine the maturity of the benefit obligation which is matched to bonds available at the measurement date. In other countries, we use the average age of the participants to determine the maturity of the benefit obligation. A 5.4% weighted-average discount rate assumption was used for the 2005 pension plan actuarial valuations. The methodology used to determine the appropriate discount rate assumption has been consistently applied. A 100 basis point increase in the discount rate assumption will result in an estimated decrease of approximately $156 million in the subsequent year’s pension expense, and a 100 basis point decrease in the discount rate assumption will result in an estimated increase of approximately $222 million in the subsequent year’s pension expense (based on the most recent pension valuation and assuming all other variables are constant).

 

Our long-standing policy of making consistent cash pension plan contributions provided some protection against negative short-term market returns. In addition, positive investment returns from 2003 to 2005 resulted in our actual pension plan asset returns exceeding expected returns reflected in our assumptions. However, the impact of contributions and positive returns has been offset by declining discount rates over the last several years. Our pension plans’ funded status, as of October 31, 2005 reflected total plan assets of $6.4 billion and total accumulated benefit obligations under all plans of $7.5 billion. As a result, under the requirements of SFAS No. 87, we have an additional minimum pension plan liability of $855 million at December 31, 2005 with a corresponding reduction, net of tax, in the accumulated other comprehensive loss component of shareholders’ equity of $552 million. Such liability is slightly higher than the liability at December 31, 2004.

 

Our weighted-average long-term rate of return assumption for plan assets as of January 1, 2006 is 8.5%. Our 2006 net periodic pension cost is expected to decrease from 2005 after excluding the impact in 2005 of the $77 million settlement loss related to the Inland Revenue contract discussed in “Results of Operations” above. Our required minimum amount of 2006 contributions will not exceed actual contributions made in 2005.

 

Stock-based compensation. We estimate the fair value of stock options using a Black-Scholes-Merton pricing model. The outstanding term of an option is estimated based on the vesting term and contractual term of the option, as well as expected exercise behavior of the employee who receives the option. Expected volatility during the estimated outstanding term of the option is based on historical volatility during a period equivalent to the estimated outstanding term of the option. Expected dividends during the estimated outstanding term of the option are based on recent dividend activity. Risk-free interest rates are based on the U.S. Treasury yield in effect at the time of the grant. We estimate the fair value of restricted stock units based on the market value of our stock on the date of grant, adjusted for any restrictive provisions affecting fair value, such as required holding periods after the date of vesting. Compensation expense for share-based payment is charged to operations over the vesting period of the award, and includes an estimate for the number of awards expected to vest. The initial estimate is based on historical results, and compensation expense is adjusted for actual results. If vesting of such an award is conditioned upon the achievement of performance goals, compensation expense during the performance period is estimated using the most probable outcome of the performance goals, and adjusted as the expected outcome changes.

 

Other liabilities. In the normal course of business, we may provide certain clients, principally governmental entities, with financial performance guarantees, which are generally backed by standby letters of credit or surety bonds. In general, we would only be liable for the amounts of these guarantees in the event that our nonperformance permits termination of the related contract by our client, the likelihood of which we believe is remote. At December 31, 2005, we had $521 million of outstanding standby letters of credit and surety bonds relating to these performance guarantees. In addition, we had $241 million outstanding under CSFT and securitization transactions that are supported by performance guarantees. We believe we are in compliance with our performance obligations under all service contracts for which there is a performance guarantee. In addition, we had $32 million of other financial guarantees outstanding at December 31, 2005 relating to indebtedness of others.

 

30


There are various claims and pending actions against EDS arising in the ordinary course of our business. See Note 15 to the consolidated financial statements for a discussion of current litigation. Certain of these actions seek damages in significant amounts. In determining whether a loss accrual or disclosure in our consolidated financial statements is required, we consider, among other things, the degree to which we can make a reasonable estimate of the loss, the degree of probability of an unfavorable outcome, and the applicability of insurance coverage for a loss. The degree of probability and the loss related to a particular claim are typically estimated with the assistance of legal counsel.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are exposed to market risk from changes in interest rates, equity prices and foreign currency exchange rates. We enter into various hedging transactions to manage this risk. We do not hold or issue derivative financial instruments for trading purposes. A discussion of our accounting policies for financial instruments, and further disclosure relating to financial instruments, are included in the notes to the consolidated financial statements.

 

Interest rate risk. Interest rate risk is managed through our debt portfolio of fixed- and variable-rate instruments including interest rate swaps. Risk can be estimated by measuring the impact of a near-term adverse movement of 10% in short-term market interest rates. If these rates average 10% more in 2006 than in 2005, there would be no material adverse impact on our results of operations or financial position. During 2005, had short-term market interest rates averaged 10% more than in 2004, there would have been no material adverse impact on our results of operations or financial position.

 

Equity price sensitivity. Our financial position is affected by changes in equity prices as a result of certain investments. Risk can be estimated by measuring the impact of a near-term adverse movement of 10% in the value of our equity security investments. If the market price of our investments in equity securities in 2006 were to fall by 10% below the level at the end of 2005, there would be no material adverse impact on our results of operations or financial position. During 2005, declines in the market price of our equity securities did not have a material adverse impact on our results of operations or financial position.

 

Foreign exchange risk. We conduct business in the United States and around the world. Our most significant foreign currency transaction exposures relate to Canada, Mexico, the United Kingdom, Western European countries that use the euro as a common currency, Australia and New Zealand. The primary purpose of our foreign currency hedging activities is to protect against foreign currency exchange risk from intercompany financing and trading transactions. We enter into foreign currency forward contracts and currency options with durations of generally less than 30 days to hedge such transactions. We have not entered into foreign currency forward contracts for speculative or trading purposes.

 

Generally, foreign currency forward contracts are not designated as hedges for accounting purposes and changes in the fair value of these instruments are recognized immediately in earnings. In addition, since we enter into forward contracts only as an economic hedge, any change in currency rates would not result in any material gain or loss, as any gain or loss on the underlying foreign-denominated balance would be offset by the loss or gain on the forward contract. Risk can be estimated by measuring the impact of a near-term adverse movement of 10% in foreign currency rates against the U.S. dollar. If these rates average 10% more in 2006 than in 2005, there would be no material adverse impact on our results of operations or financial position. During 2005, had foreign currency rates averaged 10% more than in 2004, there would have been no material adverse impact on our results of operations or financial position.

 

Accelerated Stock Repurchase. Pursuant to an accelerated share repurchase agreement entered into in February 2006, we are subject to equity price risk due to the repurchase of common stock through that program (see Part II, Item 5). At the end of the program, we are required to receive or pay a price adjustment based on the difference between the average price paid by Credit Suisse for our stock over the life of the program and the initial purchase price of $26.61 per share for 15 million shares. At our election, any payments we are required to make pursuant to the settlement of the forward contract could either be in cash or in shares of our common stock. Changes in the fair value of our common stock will impact the final settlement of the program. Settlement is expected to occur in the second quarter of 2006, depending upon the timing and pace of purchases.

 

31


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

MANAGEMENT REPORT

 

MANAGEMENT RESPONSIBILITY FOR FINANCIAL INFORMATION

 

Responsibility for the objectivity, integrity, and presentation of the accompanying financial statements and other financial information presented in this report rests with EDS management. The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The financial statements include amounts that are based on estimates and judgments which management believes are reasonable under the circumstances.

 

KPMG LLP, independent auditors, is retained to audit EDS’ consolidated financial statements and management’s assessment of the effectiveness of the company’s internal control over financial reporting. Its accompanying report is based on audits conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States).

 

The Audit Committee of the Board of Directors is composed solely of independent, non-employee directors, and is responsible for recommending to the Board the independent auditing firm to be retained for the coming year. The Audit Committee meets regularly and privately with the independent auditors, with the company’s internal auditors, and with management to review accounting, auditing, internal control and financial reporting matters.

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Management of EDS is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934. Those rules define internal control over financial reporting as a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. EDS’ internal control over financial reporting includes those policies and procedures that:

 

    pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of EDS;

 

    provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America;

 

    provide reasonable assurance that receipts and expenditures of EDS are being made only in accordance with authorization of management and directors of EDS; and

 

    provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of EDS’ assets that could have a material effect on the consolidated financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

EDS management assessed the effectiveness of EDS’ internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria described in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included an evaluation of the design of EDS’ internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting. Management reviewed the results of its assessment with the Audit Committee of our Board of Directors.

 

Based on this assessment and those criteria, management believes that EDS maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005.

 

KPMG LLP, independent registered public accounting firm, who audited and reported on EDS’ consolidated financial statements included in this report, has issued an attestation report on management’s assessment of internal control over financial reporting.

 

Michael H. Jordan

CHAIRMAN OF THE BOARD AND

CHIEF EXECUTIVE OFFICER

March 8, 2006

 

Robert H. Swan

EXECUTIVE VICE PRESIDENT AND

CHIEF FINANCIAL OFFICER

March 8, 2006

 

32


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors

Electronic Data Systems Corporation:

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Electronic Data Systems Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control – Integrated Framework issued by COSO. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by COSO.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Electronic Data Systems Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005, and the related financial statement schedule, and our report dated March 8, 2006 expressed an unqualified opinion on those consolidated financial statements and schedule.

 

KPMG LLP

Dallas, Texas

March 8, 2006

 

33


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors

Electronic Data Systems Corporation:

 

We have audited the accompanying consolidated balance sheets of Electronic Data Systems Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005. In connection with our audits of the consolidated financial statements, we have also audited the related financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Electronic Data Systems Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

As discussed in Note 1 to the consolidated financial statements, during 2005, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, and, during 2003, the Company adopted the provisions of Emerging Issues Task Force Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, and SFAS No. 143, Accounting for Asset Retirement Obligations.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Electronic Data Systems Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 8, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

KPMG LLP

Dallas, Texas

March 8, 2006

 

34


ELECTRONIC DATA SYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per share amounts)

 

     Years Ended December 31,

 
     2005

    2004

    2003

 

Revenues

   $ 19,757     $ 19,863     $ 19,758  
    


 


 


Costs and expenses

                        

Cost of revenues

     17,422       18,224       18,261  

Selling, general and administrative

     1,819       1,571       1,577  

Restructuring and other

     (26 )     170       175  
    


 


 


Total costs and expenses

     19,215       19,965       20,013  
    


 


 


Operating income (loss)

     542       (102 )     (255 )

Interest expense

     (241 )     (321 )     (301 )

Interest income and other, net

     138       49       39  
    


 


 


Other income (expense)

     (103 )     (272 )     (262 )
    


 


 


Income (loss) from continuing operations before income taxes

     439       (374 )     (517 )

Provision (benefit) for income taxes

     153       (103 )     (205 )
    


 


 


Income (loss) from continuing operations

     286       (271 )     (312 )

Income (loss) from discontinued operations, net of income taxes

     (136 )     429       46  
    


 


 


Income (loss) before cumulative effect of changes in accounting principles

     150       158       (266 )

Cumulative effect on prior years of changes in accounting principles, net of income taxes

     —         —         (1,432 )
    


 


 


Net income (loss)

   $ 150     $ 158     $ (1,698 )
    


 


 


Basic earnings per share of common stock

                        

Income (loss) from continuing operations

   $ 0.55     $ (0.54 )   $ (0.65 )

Income (loss) from discontinued operations

     (0.26 )     0.86       0.09  

Cumulative effect on prior years of changes in accounting principles

     —         —         (2.99 )
    


 


 


Net income (loss)

   $ 0.29     $ 0.32     $ (3.55 )
    


 


 


Diluted earnings per share of common stock

                        

Income (loss) from continuing operations

   $ 0.54     $ (0.54 )   $ (0.65 )

Income (loss) from discontinued operations

     (0.26 )     0.86       0.09  

Cumulative effect on prior years of changes in accounting principles

     —         —         (2.99 )
    


 


 


Net income (loss)

   $ 0.28     $ 0.32     $ (3.55 )
    


 


 


 

See accompanying notes to consolidated financial statements.

 

As discussed in Note 1, the Company adopted EITF 00-21 during 2003 on a cumulative basis as of January 1, 2003 resulting in a change in the Company’s method of recognizing revenue on long-term contracts, and SFAS No. 123R as of January 1, 2005 resulting in a change in the Company’s method of recognizing stock-based compensation to employees.

 

35


ELECTRONIC DATA SYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(in millions, except share and per share amounts)

 

     December 31,

 
     2005

    2004

 

ASSETS

                

Current assets

                

Cash and cash equivalents

   $ 1,899     $ 2,102  

Marketable securities

     1,321       1,453  

Accounts receivable, net

     3,311       3,161  

Prepaids and other

     848       874  

Deferred income taxes

     778       602  

Assets held for sale

     345       479  
    


 


Total current assets

     8,502       8,671  

Property and equipment, net

     1,967       2,181  

Deferred contract costs, net

     638       708  

Investments and other assets

     684       1,059  

Goodwill

     3,832       3,635  

Other intangible assets, net

     640       624  

Deferred income taxes

     824       866  
    


 


Total assets

   $ 17,087     $ 17,744  
    


 


LIABILITIES AND SHAREHOLDERS’ EQUITY

                

Current liabilities

                

Accounts payable

   $ 492     $ 472  

Accrued liabilities

     2,430       2,773  

Deferred revenue

     1,329       1,061  

Income taxes

     208       58  

Current portion of long-term debt

     314       658  

Liabilities held for sale

     275       267  
    


 


Total current liabilities

     5,048       5,289  

Pension benefit liability

     1,173       1,132  

Long-term debt, less current portion

     2,939       3,168  

Minority interests and other long-term liabilities

     415       715  

Commitments and contingencies

                

Shareholders’ equity

                

Preferred stock, $.01 par value; authorized 200,000,000 shares; none issued

     —         —    

Common stock, $.01 par value; authorized 2,000,000,000 shares; 526,199,617 and 522,748,596 shares issued at December 31, 2005 and 2004, respectively

     5       5  

Additional paid-in capital

     2,682       2,433  

Retained earnings

     5,371       5,492  

Accumulated other comprehensive loss

     (367 )     (59 )

Treasury stock, at cost, 2,913,605 and 7,443,650 shares at December 31, 2005 and 2004, respectively

     (179 )     (431 )
    


 


Total shareholders’ equity

     7,512       7,440  
    


 


Total liabilities and shareholders’ equity

   $ 17,087     $ 17,744  
    


 


 

See accompanying notes to consolidated financial statements.

 

36


ELECTRONIC DATA SYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)

(in millions)

 

     Common Stock

  

Additional

Paid-In

Capital


   

Retained

Earnings


   

Accumulated

Other

Comprehensive

Loss


    Treasury Stock

   

Share-

holders’

Equity


 
    

Shares

Issued


   Amount

        

Shares

Held


    Amount

   

Balance at December 31, 2002

   496    $ 5    $ 901     $ 7,951     $ (689 )   19     $ (1,146 )   $ 7,022  
    
  

  


 


 


 

 


 


Comprehensive loss:

                                                          

Net loss

   —        —        —         (1,698 )     —       —         —         (1,698 )

Currency translation adjustment

   —        —        —         —         466     —         —         466  

Unrealized losses on securities, net of tax effect of $(1), and reclassification adjustment

   —        —        —         —         (3 )   —         —         (3 )

Change in minimum pension liability, net of tax effect of $61

   —        —        —         —         95     —         —         95  
                                                      


Total comprehensive loss

                                                       (1,140 )

Dividends

   —        —        —         (287 )     —       —         —         (287 )

Stock award transactions

   —        —        16       (154 )     —       (4 )     257       119  
    
  

  


 


 


 

 


 


Balance at December 31, 2003

   496    $ 5    $ 917     $ 5,812     $ (131 )   15     $ (889 )   $ 5,714  
    
  

  


 


 


 

 


 


Comprehensive income:

                                                          

Net income

   —        —        —         158       —       —         —         158  

Currency translation adjustment, net of tax effect of $75

   —        —        —         —         256     —         —         256  

Unrealized losses on securities, net of tax effect of $(3), and reclassification adjustment

   —        —        —         —         (5 )   —         —         (5 )

Change in minimum pension liability, net of tax effect of $(101)

   —        —        —         —         (179 )   —         —         (179 )
                                                      


Total comprehensive income

                                                       230  

Dividends

   —        —        —         (200 )     —       —         —         (200 )

Issuance of common stock

   27      —        1,601       —         —       —         —         1,601  

Stock award transactions

   —        —        (85 )     (278 )     —       (8 )     458       95  
    
  

  


 


 


 

 


 


Balance at December 31, 2004

   523    $ 5    $ 2,433     $ 5,492     $ (59 )   7     $ (431 )   $ 7,440  
    
  

  


 


 


 

 


 


Comprehensive loss:

                                                          

Net income

   —        —        —         150       —       —         —         150  

Currency translation adjustment, net of tax effect of $(75)

   —        —        —         —         (293 )   —         —         (293 )

Unrealized losses on securities, net of tax effect of $(3), and reclassification adjustment

   —        —        —         —         (1 )   —         —         (1 )

Change in minimum pension liability, net of tax effect of $(17)

   —        —        —         —         (14 )   —         —         (14 )
                                                      


Total comprehensive loss

                                                       (158 )

Dividends

   —        —        —         (105 )     —       —         —         (105 )

Stock award transactions

   3      —        249       (166 )     —       (4 )     252       335  
    
  

  


 


 


 

 


 


Balance at December 31, 2005

   526    $ 5    $ 2,682     $ 5,371     $ (367 )   3     $ (179 )   $ 7,512  
    
  

  


 


 


 

 


 


 

See accompanying notes to consolidated financial statements.

 

37


ELECTRONIC DATA SYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

 

     Years Ended December 31,

 
     2005

    2004

    2003

 

Cash Flows from Operating Activities

                        

Net income (loss)

   $ 150     $ 158     $ (1,698 )
    


 


 


Adjustments to reconcile net income (loss) to net cash provided by operating activities:

                        

Depreciation and amortization and deferred cost charges

     1,456       1,974       2,529  

Deferred compensation

     224       42       62  

Cumulative effect on prior years of changes in accounting principles

     —         —         1,432  

Other long-lived asset write-downs

     164       537       36  

Other (including pre-tax gains on sales of businesses of $844 and $131 in 2004 and 2003, respectively

     8       (859 )     (116 )

Changes in operating assets and liabilities, net of effects of acquired companies:

                        

Accounts receivable

     (310 )     97       440  

Prepaids and other

     20       153       (90 )

Deferred contract costs

     (161 )     (126 )     (540 )

Accounts payable and accrued liabilities

     (207 )     (466 )     31  

Deferred revenue

     299       (51 )     (116 )

Income taxes

     (347 )     (181 )     (475 )
    


 


 


Total adjustments

     1,146       1,120       3,193  
    


 


 


Net cash provided by operating activities

     1,296       1,278       1,495  
    


 


 


Cash Flows from Investing Activities

                        

Proceeds from sales of marketable securities

     1,434       956       548  

Proceeds from investments and other assets

     310       68       43  

Net proceeds from divested assets and non-marketable equity securities

     160       2,129       233  

Net proceeds from real estate sales

     178       —         —    

Payments for purchases of property and equipment

     (718 )     (666 )     (703 )

Payments for investments and other assets

     (27 )     (556 )     (25 )

Payments for acquisitions, net of cash acquired, and non-marketable equity securities

     (552 )     (78 )     11  

Payments for purchases of software and other intangibles

     (300 )     (302 )     (494 )

Payments for purchases of marketable securities

     (1,311 )     (2,337 )     (447 )

Other

     29       28       25  
    


 


 


Net cash used in investing activities

     (797 )     (758 )     (809 )
    


 


 


Cash Flows from Financing Activities

                        

Proceeds from long-term debt

     5       6       1,869  

Payments on long-term debt

     (560 )     (561 )     (1,312 )

Net decrease in borrowings with original maturities less than 90 days

     —         —         (235 )

Capital lease payments

     (149 )     (167 )     (120 )

Proceeds from issuance of common stock

     —         198       —    

Employee stock transactions

     107       76       47  

Dividends paid

     (105 )     (200 )     (287 )

Other

     21       (15 )     (33 )
    


 


 


Net cash used in financing activities

     (681 )     (663 )     (71 )
    


 


 


Effect of exchange rate changes on cash and cash equivalents

     (21 )     48       (60 )
    


 


 


Net increase (decrease) in cash and cash equivalents

     (203 )     (95 )     555  

Cash and cash equivalents at beginning of year

     2,102       2,197       1,642  
    


 


 


Cash and cash equivalents at end of year

   $ 1,899     $ 2,102     $ 2,197  
    


 


 


 

See accompanying notes to consolidated financial statements.

 

38


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Description of Business

 

Electronic Data Systems Corporation is a professional services firm that offers its clients a portfolio of related services worldwide within the broad categories of traditional information technology (“IT”) outsourcing, business process outsourcing and solutions consulting services. The Company also provided management consulting services through its A.T. Kearney subsidiary which was sold in January 2006 (see Note 20). Services include the design, construction or management of computer networks, information systems, information processing facilities and business processes. As used herein, the terms “EDS” and the “Company” refer to Electronic Data Systems Corporation and its consolidated subsidiaries.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of EDS and its controlled subsidiaries. The Company defines control as a non-shared, non-temporary ability to make decisions that enable it to guide the ongoing activities of a subsidiary and the ability to use that power to increase the benefits or limit the losses from the activities of that subsidiary. Subsidiaries in which other shareholders effectively participate in significant operating decisions through voting or contractual rights are not considered controlled subsidiaries. The Company’s investments in entities it does not control, but in which it has the ability to exercise significant influence over operating and financial policies, are accounted for under the equity method. Under such method, the Company recognizes its share of the subsidiaries’ income (loss) in other income (expense). If EDS is the primary beneficiary of variable interest entities, the consolidated financial statements include the accounts of such entities. No variable interest entities were consolidated during the periods presented.

 

Earnings Per Share

 

Basic earnings per share of common stock is computed using the weighted-average number of common shares outstanding during the period. Diluted earnings per share amounts reflect the incremental increase in common shares outstanding assuming the exercise of all employee stock options and stock purchase contracts and the issuance of shares in respect of restricted stock units that would have had a dilutive effect on earnings per share. Diluted earnings per share also assumes that any dilutive convertible debt outstanding was converted at the later of the date of issuance or the beginning of the period, with related interest and outstanding common shares adjusted accordingly. Following is a reconciliation of the number of shares used in the calculation of basic and diluted earnings per share for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

   2004

   2003

Basic earnings per share of common stock:

              

Weighted-average common shares outstanding

   519    501    479

Effect of dilutive securities (Note 11):

              

Restricted stock units

   2    —      —  

Stock options

   5    —      —  
    
  
  

Diluted earnings per share of common stock:

              

Weighted-average common and common equivalent shares outstanding

   526    501    479
    
  
  

 

In the computation of diluted earnings per share for 2004 and 2003, all common stock options, restricted stock units, the assumed conversion of convertible debt and the effect of forward purchase contracts were excluded because their inclusion would have been antidilutive. Securities that were outstanding but were not included in the computation of diluted earnings per share because their effect was antidilutive are as follows for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

   2004

   2003

Common stock options

   42    75    58

Restricted stock units

   —      7    2

Convertible debt and forward purchase contracts

   20    28    36

 

39


Accounting Changes

 

The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as of January 1, 2005, using the modified prospective application method. This statement requires the recognition of compensation expense when an entity obtains employee services in stock-based payment transactions. This change in accounting resulted in the recognition of compensation expense of $160 million ($110 million net of tax) for the year ended December 31, 2005. Compensation expense presented in the 2005 consolidated statement of operations includes $94 million in cost of revenues, $40 million in selling, general and administrative, and $26 million in income (loss) from discontinued operations.

 

Prior to January 1, 2005, the Company recognized compensation cost associated with stock-based awards under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, the difference between the quoted market price as of the date of the grant and the contractual purchase price of shares was charged to operations over the vesting period on a straight-line basis. No compensation cost was recognized for fixed stock options with exercise prices equal to the market price of the stock on the dates of grant and shares acquired by employees under the EDS Stock Purchase Plan or Nonqualified Stock Purchase Plan.

 

Pro forma net loss and earnings per share disclosures as if the Company recorded compensation expense based on fair value for stock-based awards have been presented in accordance with the provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, and are as follows for the year ended December 31, 2005 (in millions, except per share amounts):

 

     2004

    2003

 

Net income (loss):

                

As reported

   $ 158     $ (1,698 )

Stock-based compensation costs included in reported net income (loss), net of related tax effects

     27       40  

Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects

     (165 )     (209 )
    


 


Pro forma

   $ 20     $ (1,867 )
    


 


Basic earnings per share of common stock:

                

As reported

   $ 0.32     $ (3.55 )

Pro forma

     0.04       (3.90 )

Diluted earnings per share of common stock:

                

As reported

   $ 0.32     $ (3.55 )

Pro forma

     0.04       (3.90 )

 

During the third quarter of 2003, the Company adopted the provisions of Emerging Issues Task Force (“EITF”) Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, on a cumulative basis as of January 1, 2003. EITF 00-21 modified the application of existing contract accounting literature followed by the Company prior to January 1, 2003. EITF 00-21 governs how to identify whether goods or services, or both, that are to be delivered separately in a bundled sales arrangement should be accounted for separately. In most circumstances, EITF 00-21 also limits the recognition of revenue in excess of amounts billed (e.g., unbilled revenue) to the amount that would be received if the client contract was terminated for any reason. The adoption of EITF 00-21 resulted in a non-cash adjustment reported as a cumulative effect of a change in accounting principle of $1.42 billion ($2.24 billion before tax). The adjustment resulted primarily from the reversal of unbilled revenue associated with the Company’s IT service contracts which had been accounted for as a single unit using the percentage-of-completion method of revenue recognition. Such reversal resulted from the fact that typical termination provisions of an IT service contract do not provide for the recovery of unbilled revenue in the event the contract is terminated for the Company’s nonperformance. The adjustment also reflects the deferral and subsequent amortization of system construction costs. Such costs were previously expensed as incurred and included in the percentage-of-completion model for the respective contracts.

 

During the years ended December 31, 2005, 2004 and 2003, the Company recognized revenues of approximately $250 million, $360 million and $345 million, respectively, which had been recognized prior to January 1, 2003 and reversed in the cumulative effect adjustment recognized upon adoption of EITF 00-21. These amounts were estimated as the amount for which unbilled revenue would have been reduced in those periods for those contracts impacted by the cumulative adjustment based on the most recent percentage-of-completion models prepared for each contract during 2003. Such revenues have been offset by deferred cost amortization and charges recognized by the Company since January 1, 2003 associated with costs that had been recognized prior to January 1, 2003 and deferred in the cumulative effect adjustment.

 

40


The impact of the EITF 00-21 accounting change in 2003, excluding the effect of the cumulative accounting change, was to decrease the loss from continuing operations and net loss by $725 million ($1.51 per share). Because EDS’ accounting records for the second half of 2003 were prepared under EITF 00-21, percentage-of-completion calculations for the period were not subject to EDS’ percentage-of-completion accounting controls and procedures in place in previous periods. Accordingly, the impact of the accounting change referred to above is an estimate.

 

Effective January 1, 2003, the Company adopted SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires that the fair value of the liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The majority of the Company’s retirement obligations relate to leases which require the facilities be restored to original condition at the expiration of the leases. The adoption of SFAS No. 143 resulted in a reduction of income reported as a cumulative effect of a change in accounting principle of $25 million ($17 million after tax). Additionally, the fair value of the liability recorded on January 1, 2003 was $48 million. Changes in the liability from the date of adoption of SFAS No. 143 and the pro forma impact of adoption on prior periods were not material.

 

Accounts Receivable

 

Reserves for uncollectible trade receivables are established when collection of amounts due from clients is deemed improbable. Indicators of improbable collection include client bankruptcy, client litigation, industry downturns, client cash flow difficulties, or ongoing service or billing disputes. Receivables more than 180 days past due are automatically reserved unless persuasive evidence of probable collection exists. Accounts receivable are shown net of allowances of $69 million and $114 million at December 31, 2005 and 2004, respectively.

 

Marketable Securities

 

Marketable securities at December 31, 2005 and 2004 consist of government and agency obligations, corporate debt and corporate equity securities. The Company classifies all of its debt and marketable equity securities as trading or available-for-sale. All such investments are recorded at fair value. Changes in net unrealized holding gains (losses) on trading securities are recognized in income, whereas changes in net unrealized holding gains (losses) on available-for-sale securities are reported as a component of other comprehensive income (loss), net of tax, in shareholders’ equity until realized.

 

Investments in marketable securities are monitored for impairment and written down to fair value with a charge to earnings if a decline in fair value is judged to be other than temporary. The Company considers several factors to determine whether a decline in the fair value of an equity security is other than temporary, including the length of time and the extent to which the fair value has been less than carrying value, the financial condition of the investee, and the intent and ability of the Company to retain the investment for a period of time sufficient to allow a recovery in value.

 

Property and Equipment

 

Property and equipment are carried at cost. Depreciation of property and equipment is calculated using the straight-line method over the shorter of the asset’s estimated useful life or the term of the lease in the case of leasehold improvements. The ranges of estimated useful lives are as follows:

 

     Years

Buildings

   40-50

Facilities

   5-20

Computer equipment

   3-5

Other equipment and furniture

   5-20

 

The Company reviews its property and equipment for impairment whenever events or changes in circumstances indicate the carrying values of such assets may not be recoverable. For property and equipment to be held and used, impairment is determined by a comparison of the carrying value of the asset to the future undiscounted net cash flows expected to be generated by the asset. If such assets are determined to be impaired, the impairment recognized is the amount by which the carrying value of the assets exceeds the fair value of the assets. Property and equipment to be disposed of by sale is carried at the lower of then current carrying value or fair value less cost to sell.

 

Investments and Other Assets

 

Investments in non-marketable equity securities are monitored for impairment and written down to fair value with a charge to earnings if a decline in fair value is judged to be other than temporary. The fair values of non-marketable equity securities are determined based on quoted market prices. If quoted market prices are not available, fair values are estimated based on an evaluation of numerous indicators including, but not limited to, offering prices of recent issuances of the same or similar

 

41


equity instruments, quoted market prices for similar companies and comparisons of recent financial information, operating plans, budgets, market studies and client information to the information used to support the initial valuation of the investment. The Company considers several factors to determine whether a decline in the fair value of a non-marketable equity security is other than temporary, including the length of time and the extent to which the fair value has been less than carrying value, the financial condition of the investee, and the intent and ability of the Company to retain the investment for a period of time sufficient to allow a recovery in value.

 

Goodwill and Other Intangibles

 

The cost of acquired companies is allocated to the assets acquired and liabilities assumed based on estimated fair values at the date of acquisition. Costs allocated to identifiable intangible assets with finite lives, other than purchased software, are generally amortized on a straight-line basis over the remaining estimated useful lives of the assets, as determined by underlying contract terms or appraisals. Such lives range from one to 14 years. Identifiable intangible assets with indefinite useful lives are not amortized but instead tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Intangible assets with indefinite useful lives are impaired when the carrying value of the asset exceeds their fair value.

 

The excess of the cost of acquired companies over the net amounts assigned to assets acquired and liabilities assumed is recorded as goodwill. Goodwill is not amortized but instead tested for impairment at least annually. The first step of the impairment test is a comparison of the fair value of a reporting unit to its carrying value. Reporting units are the geographic components of its reportable segments that share similar economic characteristics. The fair value of a reporting unit is estimated using the Company’s projections of discounted future operating cash flows of the unit. Goodwill allocated to a reporting unit whose fair value is equal to or greater than its carrying value is not impaired and no further testing is required. A reporting unit whose fair value is less than its carrying value requires a second step to determine whether the goodwill allocated to the unit is impaired. The second step of the goodwill impairment test is a comparison of the implied fair value of a reporting unit’s goodwill to its carrying value. The implied fair value of a reporting unit’s goodwill is determined by allocating the fair value of the entire reporting unit to the assets and liabilities of that unit, including any unrecognized intangible assets, based on fair value. The excess of the fair value of the entire reporting unit over the amounts allocated to the identifiable assets and liabilities of the unit is the implied fair value of the reporting unit’s goodwill. Goodwill of a reporting unit is impaired when its carrying value exceeds its implied fair value. Impaired goodwill is written down to its implied fair value with a charge to expense in the period the impairment is identified. As this impairment test is based on the Company’s assessment of the fair value of its reporting units, future changes to these estimates could also cause an impairment of a portion of the Company’s goodwill balance.

 

The Company conducts an annual impairment test for goodwill as of December 1st. The Company determines the timing and frequency of additional goodwill impairment tests based on an ongoing assessment of events and circumstances that would more than likely reduce the fair value of a reporting unit below its carrying value. Events or circumstances that might require the need for more frequent tests include, but are not limited to: the loss of a number of significant clients, the identification of other impaired assets within a reporting unit, the disposition of a significant portion of a reporting unit, or a significant adverse change in business climate or regulations. The Company also considers the amount by which the fair value of a particular reporting unit exceeded its carrying value in the most recent goodwill impairment test to determine whether more frequent tests are necessary.

 

Purchased or licensed software not subject to a subscription agreement is capitalized and amortized on a straight-line basis, generally over two to five years. Costs of developing and maintaining software systems incurred primarily in connection with client contracts are considered contract costs. Purchased software and certain development costs for computer software sold, leased or otherwise marketed as a separate product or as part of a product or process are capitalized and amortized on a product-by-product basis over their remaining estimated useful lives at the greater of straight-line or the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product. Estimated useful lives of software products to be sold, leased or otherwise marketed range from three to seven years. Software development costs incurred to meet the Company’s internal needs are capitalized and amortized on a straight-line basis over three to five years. Software under subscription arrangements, whereby the software provider makes available current software products as well as products developed or acquired during the term of the arrangement, are executory contracts and expensed ratably over the subscription term.

 

Sales of Financial Assets

 

The Company accounts for the sale of financial assets when control over the financial asset is relinquished. No financial assets were sold by the Company during 2005. The Company sold $51 million and $668 million of financial assets, primarily lease receivables, during 2004 and 2003, respectively. In most cases, the Company sold lease receivables to a legally isolated securitization trust. If a trust is not used, the receivables are sold to an independent substantive financial institution. None of these transactions resulted in any significant gain or loss, or servicing asset or servicing liability.

 

42


Revenue Recognition and Deferred Contract Costs

 

The Company provides IT and business process outsourcing services under time-and-material, unit-price and fixed-price contracts, which may extend up to 10 or more years. Services provided over the term of these arrangements may include one or more of the following: IT infrastructure support and management; IT system and software maintenance; application hosting; the design, development, and/or construction of software and systems (“Construct Service”); transaction processing; business process management and consulting services.

 

If a contract involves the provision of a single element, revenue is generally recognized when the product or service is provided and the amount earned is not contingent upon any future event. If the service is provided evenly during the contract term but service billings are irregular, revenue is recognized on a straight-line basis over the contract term. However, if the single service is a Construct Service, revenue is recognized under the percentage-of-completion method using a zero-profit methodology. Under this method, costs are deferred until contractual milestones are met, at which time the milestone billing is recognized as revenue and an amount of deferred costs is recognized as expense so that cumulative profit equals zero. If the milestone billing exceeds deferred costs, then the excess is recorded as deferred revenue. When the Construct Service is completed and the final milestone met, all unrecognized costs, milestone billings, and profit are recognized in full. If the contract does not contain contractual milestones, costs are expensed as incurred and revenue is recognized in an amount equal to costs incurred until completion of the Construct Service, at which time any profit would be recognized in full. If total costs are estimated to exceed revenue for the Construct Service, then a provision for the estimated loss is made in the period in which the loss first becomes apparent.

 

If a contract involves the provision of multiple service elements, total estimated contract revenue is allocated to each element based on the relative fair value of each element. The amount of revenue allocated to each element is limited to the amount that is not contingent upon the delivery of another element in the future. Revenue is then recognized for each element as described above for single-element contracts, except revenue recognized on a straight-line basis for a non-Construct Service will not exceed amounts currently billable unless the excess revenue is recoverable from the client upon any contract termination event. If the amount of revenue allocated to a Construct Service is less than its relative fair value, costs to deliver such service equal to the difference between allocated revenue and the relative fair value are deferred and amortized over the contract term. If total Construct Service costs are estimated to exceed the relative fair value for the Construct Service contained in a multiple-element arrangement, then a provision for the estimated loss is made in the period in which the loss first becomes apparent. If fair value is not determinable for all elements, the contract is treated as one accounting unit and revenue is recognized using the proportional performance method.

 

The Company also defers and subsequently amortizes certain set-up costs related to activities that enable the provision of contracted services to the client. Such activities include the relocation of transitioned employees, the migration of client systems or processes, and the exit of client facilities. Deferred contract costs, including set-up costs, are amortized on a straight-line basis over the remaining original contract term unless billing patterns indicate a more accelerated method is appropriate. The recoverability of deferred contract costs associated with a particular contract is analyzed on a periodic basis using the undiscounted estimated cash flows of the whole contract over its remaining contract term. If such undiscounted cash flows are insufficient to recover the long-lived assets and deferred contract costs, including contract concessions paid to the client, the deferred contract costs and contract concessions are written down by the amount of the cash flow deficiency. If a cash flow deficiency remains after reducing the balance of the deferred contract costs and contract concessions to zero, any remaining long-lived assets are evaluated for impairment. Any such impairment recognized would equal the amount by which the carrying value of the long-lived assets exceeds the fair value of those assets.

 

The Company’s software licensing arrangements typically include multiple elements, such as software products, post-contract customer support, consulting and training. The aggregate arrangement fee is allocated to each of the undelivered elements in an amount equal to its fair value, with the residual of the arrangement fee allocated to the delivered elements. Fair values are based upon vendor-specific objective evidence. Fees allocated to each software element of the arrangement are recognized as revenue when the following criteria have been met: a) a written contract for the license of software has been executed, b) the Company has delivered the product to the customer, c) the license fee is fixed or determinable, and d) collectibility of the resulting receivable is deemed probable. If evidence of fair value of the undelivered elements of the arrangement does not exist, all revenue from the arrangement is deferred until such time evidence of fair value does exist, or until all elements of the arrangement are delivered. Fees allocated to post-contract customer support are recognized as revenue ratably over the support period. Fees allocated to other services are recognized as revenue as the service is performed.

 

Deferred revenue of $1,329 million and $1,061 million at December 31, 2005 and 2004, respectively, represented billings in excess of amounts earned on certain contracts.

 

43


Currency Translation

 

Assets and liabilities of non-U.S. subsidiaries whose functional currency is not the U.S. dollar are translated at current exchange rates. Revenue and expense accounts are translated using an average rate for the period. Translation gains and losses are not included in determining net income (loss), but are reflected in the comprehensive income (loss) component of shareholders’ equity. Cumulative currency translation adjustment gains (losses) included in shareholders’ equity were $189 million, $482 million (net of deferred tax of $75 million) and $226 million at December 31, 2005, 2004 and 2003, respectively. Net currency transaction gains (losses), net of income taxes, are included in determining net income (loss) and were $4 million, $(13) million and $(32) million, respectively, for the years ended December 31, 2005, 2004 and 2003.

 

Financial Instruments and Risk Management

 

Following is a summary of the carrying amounts and fair values of the Company’s significant financial instruments at December 31, 2005 and 2004 (in millions):

 

     2005

    2004

 
    

Carrying

Amount


   

Estimated

Fair Value


   

Carrying

Amount


   

Estimated

Fair Value


 

Available-for-sale marketable securities (Note 2)

   $ 1,321     $ 1,321     $ 1,453     $ 1,453  

Investments in securities, joint ventures and partnerships, excluding equity method investments (Note 5)

     23       23       15       15  

Long-term debt (Note 8)

     (3,253 )     (3,351 )     (3,826 )     (4,025 )

Foreign currency forward contracts, net liability

     (5 )     (5 )     (19 )     (19 )

Interest rate swap agreements, net liability

     (70 )     (70 )     (37 )     (37 )

 

Current marketable securities are carried at their estimated fair value based on current market quotes. The fair values of certain long-term investments are estimated based on quoted market prices for these or similar investments. For other investments, various methods are used to estimate fair value, including external valuations and discounted cash flows. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues or based on the current rates offered to the Company for instruments with similar terms, degree of risk and remaining maturities. The fair value of foreign currency forward and interest rate swap contracts represents the estimated amount to settle the contracts using current market exchange or interest rates. The carrying values of other financial instruments, such as cash equivalents, accounts and notes receivable, and accounts payable, approximate their fair value.

 

The Company makes investments, receives revenues and incurs expenses in many countries and has exposure to market risks arising from changes in interest rates, foreign exchange rates and equity prices. The Company has also invested in start-up companies to gain access to technology and marketplaces in which the Company intended to grow its business. The Company’s ability to sell these investments may be constrained by market or other factors. Derivative financial instruments are used to hedge against these risks by creating offsetting market positions. The Company does not hold or issue derivative financial instruments for trading purposes.

 

The notional amounts of derivative contracts, summarized below as part of the description of the instruments utilized, do not necessarily represent the amounts exchanged by the parties and thus are not necessarily a measure of the exposure of the Company resulting from its use of derivatives. The amounts exchanged by the parties are normally calculated on the basis of the notional amounts and the other terms of the derivatives.

 

Foreign Currency Risk

 

The Company has significant international sales and purchase transactions in foreign currencies. The Company hedges forecasted and actual foreign currency risk with purchased currency options and forward contracts that expire generally within 30 days. These derivative instruments are employed to eliminate or minimize certain foreign currency exposures that can be confidently identified and quantified. Generally, these instruments are not designated as hedges for accounting purposes, and changes in the fair value of these instruments are recognized immediately in other income (expense). The Company’s currency hedging activities are focused on exchange rate movements, primarily in Canada, Mexico, the United Kingdom, Western European countries that use the euro as a common currency, Australia and New Zealand. At December 31, 2005 and 2004, the Company had forward exchange contracts to purchase various foreign currencies in the amount of $1.9 billion and $1.9 billion, respectively, and to sell various foreign currencies in the amount of $1.2 billion and $1.5 billion, respectively.

 

44


Securities Price Risk

 

The Company has used derivative instruments to eliminate or reduce market price risk associated with strategic equity investments. Securities selected for hedging are determined after considering market conditions, up-front hedging costs and other relevant factors. Once established, hedges are generally not removed until maturity. The Company was not party to any such instruments at December 31, 2005.

 

Interest Rate Risk

 

The Company enters into interest rate swap agreements that convert fixed-rate instruments to variable-rate instruments to manage interest rate risk. The derivative financial instruments are designated and documented as fair value hedges at the inception of the contract. Changes in fair value of derivative financial instruments are recognized in earnings as an offset to changes in fair value of the underlying exposure which are also recognized in other income (expense). The impact on earnings from recognizing the fair value of these instruments depends on their intended use, their hedge designation, and their effectiveness in offsetting the underlying exposure they are designed to hedge.

 

The Company had interest rate swap fair value hedges outstanding in the notional amount of $1.8 billion in connection with its long-term notes payable at December 31, 2005 and 2004 (see Note 8). Under the swaps, the Company receives fixed rates ranging from 6.0% to 7.125% and pays floating rates tied to the London Interbank Offering Rate (“LIBOR”). The weighted-average floating rates were 6.39% and 4.40% at December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, the Company had $700 million of swaps and related debt which contained the same critical terms. Accordingly, no gain or loss relating to the change in fair value of the swap and related hedged item was recognized in earnings. At December 31, 2005 and 2004, $1.1 billion of the interest rate swaps contained different terms than the related underlying debt. Accordingly, the Company recognized in earnings the change in fair value of the interest rate swap and underlying debt which amounted to gains of $5.5 million and $1.5 million during 2005 and 2004, respectively. Such gains are included in interest expense and other, net in the accompanying consolidated statements of operations.

 

Comprehensive Income (Loss) and Shareholders’ Equity

 

Comprehensive income (loss) includes all changes in equity during a period, except those resulting from investments by and distributions to owners. For the years ended December 31, 2005, 2004 and 2003, reclassifications from accumulated other comprehensive loss to net income (loss) of net gains (losses) recognized on marketable security transactions were $(3) million, $1 million and $4 million, net of the related tax expense (benefit) of $(1) million, $0.4 million and $1 million, respectively.

 

Following is a summary of changes within each classification of accumulated other comprehensive loss for the years ended December 31, 2005 and 2004 (in millions):

 

    

Cumulative

Translation

Adjustments


   

Unrealized

Gains
(Losses) on
Securities


    Minimum
Pension
Liability
Adjustment


   

Accumulated
Other
Comprehensive

Loss


 

Balance at December 31, 2003

   $ 226     $ 2     $ (359 )   $ (131 )

Change

     256       (5 )     (179 )     72  
    


 


 


 


Balance at December 31, 2004

     482       (3 )     (538 )     (59 )

Change

     (293 )     (1 )     (14 )     (308 )
    


 


 


 


Balance at December 31, 2005

   $ 189     $ (4 )   $ (552 )   $ (367 )
    


 


 


 


 

In connection with its employee stock incentive plans, the Company issued 4.5 million, 7.6 million and 3.7 million shares of treasury stock at a cost of $252 million, $458 million and $257 million during 2005, 2004 and 2003, respectively. The difference between the cost and fair value at the date of issuance of such shares has been recognized as a charge to retained earnings of $166 million, $278 million and $154 million in the consolidated statements of shareholders’ equity and comprehensive income (loss) during 2005, 2004 and 2003, respectively.

 

45


Income Taxes

 

The Company provides for deferred taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be reversed. The deferral method is used to account for investment tax credits. Valuation allowances are recorded to reduce deferred tax assets to an amount whose realization is more likely than not. Income taxes payable are recorded whenever there is a difference between amounts reported by the Company in its tax returns and the amounts the Company believes it would likely pay in the event of an examination by taxing authorities. The Company accrues interest on such amounts and includes the associated expense in provision (benefit) for income taxes in the accompanying consolidated statements of operations. Income taxes payable are classified in the accompanying consolidated balance sheets based on their estimated payment date.

 

Statements of Cash Flows

 

The Company considers the following asset classes with original maturities of three months or less to be cash equivalents: certificates of deposit, commercial paper, repurchase agreements and money market funds.

 

Use of Estimates

 

The preparation of the consolidated financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates. Areas in which significant judgments and estimates are used include, but are not limited to, cost estimation for Construct Service elements, projected cash flows associated with recoverability of deferred contract costs, contract concessions and long-lived assets, liabilities associated with pensions and performance guarantees, receivables collectibility, and loss accruals for litigation, exclusive of legal fees which are expensed as services are received. It is reasonably possible that events and circumstances could occur in the near term that would cause such estimates to change in a manner that would be material to the consolidated financial statements.

 

Concentration of Credit Risk

 

Accounts receivable, net, from General Motors (“GM”) and its affiliates totaled $256 million and $292 million as of December 31, 2005 and 2004, respectively. In addition, the Company has several large contracts with major U.S. and foreign corporations, each of which may result in the Company carrying a receivable balance between $50 million and $100 million at any point in time. At December 31, 2005 and 2004, the Company had net operating receivables of $162 million and $152 million, respectively, and investments in leveraged leases of $55 million and $99 million, respectively, associated with travel-related industry clients, primarily airlines. Other than operating receivables from GM and aforementioned contracts, concentrations of credit risk with respect to accounts receivable are generally limited due to the large number of clients forming the Company’s client base and their dispersion across different industries and geographic areas.

 

The Company is exposed to credit risk in the event of nonperformance by counterparties to derivative contracts. Because the Company deals only with major commercial banks with high-quality credit ratings, the Company believes the risk of nonperformance by any of these counterparties is remote.

 

Reclassifications

 

The Company purchases assets to be sold in sales-type lease transactions under certain contracts with customers and occasionally sells lease receivables associated with these transactions to third parties. Payments for assets to be sold to customers under sales-type leases and proceeds from associated lease receivables related to these transactions were reported as payments for and proceeds from investments and other assets in the investing section of the statement of cash flows in previous periods. During 2005, the Company began to report cash flows related to these transactions as changes in prepaid and other assets in the operating section of the statement of cash flows in accordance with guidance recently issued by the SEC. Cash flows associated with reacquired sales-type lease receivables and their subsequent collection continue to be classified as payments for and proceeds from investments and other assets in the investing section of the statement of cash flows. The respective amounts contained in the consolidated statements of cash flows for 2004 and 2003 have been reclassified to conform to the 2005 presentation.

 

Certain other reclassifications have been made to the 2004 and 2003 consolidated financial statements to conform to the 2005 presentation, including reclassification of balances associated with discontinued operations.

 

46


NOTE 2: MARKETABLE SECURITIES

 

Following is a summary of current available-for-sale marketable securities at December 31, 2005 and 2004 (in millions):

 

     2005

    

Amortized

Cost


  

Gross

Unrealized

Gains


  

Gross

Unrealized

Losses


   

Estimated

Fair Value


Government and agency obligations

   $ 192    $ —      $ (1 )   $ 191

Obligations of states and political subdivisions

     19      —        —         19

Corporate debt securities

     319      —        (2 )     317

Mortgage-backed securities

     306      —        (4 )     302

Asset-backed securities

     454      —        (4 )     450
    

  

  


 

Total debt securities

     1,290      —        (11 )     1,279

Equity securities

     43      —        (1 )     42
    

  

  


 

Total current available-for-sale securities

   $ 1,333    $ —      $ (12 )   $ 1,321
    

  

  


 

     2004

    

Amortized

Cost


  

Gross

Unrealized

Gains


  

Gross

Unrealized

Losses


   

Estimated

Fair Value


Government and agency obligations

   $ 226    $ —      $ —       $ 226

Obligations of states and political subdivisions

     12      —        —         12

Corporate debt securities

     359      —        (1 )     358

Mortgage-backed securities

     381      —        (2 )     379

Asset-backed securities

     438      —        (3 )     435
    

  

  


 

Total debt securities

     1,416      —        (6 )     1,410

Equity securities

     42      1      —         43
    

  

  


 

Total current available-for-sale securities

   $ 1,458    $ 1    $ (6 )   $ 1,453
    

  

  


 

 

The amortized cost and estimated fair value of current available-for-sale debt securities at December 31, 2005, by contractual maturity, are shown below (in millions). Expected maturities may differ from contractual maturities because the issuers of the securities may have the right to repay obligations without prepayment penalties.

 

    

Amortized

Cost


  

Estimated

Fair Value


Debt securities:

             

Due in one year or less

   $ 257    $ 256

Due after one year through five years

     258      256

Due after five years through ten years

     2      2

Due after ten years

     13      13

Mortgage-backed securities

     306      302

Asset-backed securities

     454      450
    

  

Total debt securities

   $ 1,290    $ 1,279
    

  

 

Following is a summary of sales of available-for-sale securities for the years ended December 31, 2005, 2004 and 2003 (in millions). Specific identification was used to determine cost in computing realized gain or loss.

 

     2005

    2004

    2003

 

Proceeds from sales

   $ 1,434     $ 956     $ 548  

Gross realized gains

     1       3       3  

Gross realized losses

     (8 )     (4 )     (3 )

 

47


NOTE 3: PROPERTY AND EQUIPMENT

 

Following is a summary of property and equipment at December 31, 2005 and 2004 (in millions):

 

     2005

    2004

 

Land

   $ 86     $ 118  

Buildings and facilities

     1,599       1,792  

Computer equipment

     4,620       4,938  

Other equipment and furniture

     424       440  
    


 


Subtotal

     6,729       7,288  

Less accumulated depreciation

     (4,762 )     (5,107 )
    


 


Total

   $ 1,967     $ 2,181  
    


 


 

During 2005, the Company sold sixteen domestic and international real estate properties in connection with its efforts to improve its cost competitiveness and enhance workplace capacity usage. Net proceeds from the sale were $178 million. Fourteen properties involved in the sale have been leased back by the Company for various extended periods. A deferred net gain of $14 million has been allocated to the various leased properties and will be recognized by the Company over the respective term of each lease. The Company recognized a net gain of $3 million on the sale of the remaining properties which is included in other income in the 2005 consolidated statement of operations.

 

The Company recorded a non-cash impairment charge of $375 million in 2004 to write-down long-lived assets used on the Company’s Navy Marine Corps Intranet (“NMCI”) contract to estimated fair value. The impairment charge is reported as a component of cost of revenues in the consolidated statement of operations and is reflected in the results of the NMCI segment. Fair value was measured by probability weighting future contract pre-tax cash flows discounted at a pre-tax risk free discount rate. The decline in the fair value of these assets is primarily a result of lower estimates of future revenues as a result of several events occurring during 2004. Such events include the failure to meet seat cutover schedules, a revision of the timeline for meeting performance service levels contained in a contract amendment signed September 30, 2004, a deceleration in customer satisfaction improvement rates, and delays in signing certain anticipated contract modifications and additions. Remaining long-lived assets and lease receivables associated with the contract totaled approximately $240 million and $408 million, respectively, at December 31, 2005.

 

The Company had a significant commercial contract under which it provided various IT services using the legacy IT systems acquired from the client while developing and deploying a new IT system dedicated to that client. This contract experienced delays in its development and construction phases, and milestones in the contract had been missed. Throughout the contract period, the Company negotiated with the client to resolve critical issues, including those associated with the pricing and technical specifications for the new IT system. In July 2004, the Company and the client reached an agreement to terminate the existing contract effective as of August 1, 2004, provide transition services for a limited period thereafter and settle each party’s outstanding claims. During 2004, the Company recognized impairment charges of $128 million to write-down certain assets to fair value. In addition, the Company recognized $14 million of shutdown costs during 2004 to record contract-related vendor commitments and employee severance obligations associated with the contract. All of the aforementioned amounts associated with this contract are included in cost of revenues in the consolidated statements of operations and are reflected in the results of the Outsourcing segment.

 

NOTE 4: DEFERRED CONTRACT COSTS

 

The Company defers certain costs relating to construction and set-up activities on client contracts. Following is a summary of deferred costs for the years ended December 31, 2005 and 2004 (in millions):

 

    

Gross

Carrying

Amount


   

Accumulated

Amortization


    Total

 

Balance at December 31, 2003

   $ 1,528     $ (658 )   $ 870  

Additions

     126       (298 )     (172 )

Other

     158       (148 )     10  
    


 


 


Balance at December 31, 2004

     1,812       (1,104 )     708  

Additions

     161       (138 )     23  

Other

     (56 )     (37 )     (93 )
    


 


 


Balance at December 31, 2005

   $ 1,917     $ (1,279 )   $ 638  
    


 


 


 

48


During 2005, the Company identified deterioration in the projected performance of one of its commercial contracts based on, among other things, a change in management’s judgment regarding the amount and likelihood of achieving anticipated benefits from contract-specific productivity initiatives, primarily related to the length of time necessary to achieve cost savings from planned infrastructure optimization initiatives. The Company determined that the estimated undiscounted cash flows of the contract over its remaining term were insufficient to recover the contract’s deferred contract costs. As a result, the Company recognized a non-cash impairment charge of $37 million in the second quarter of 2005 to write-off the contract’s deferred contract costs. The impairment charge is reported as a component of cost of revenues in the 2005 consolidated statement of operations and is included in the results of the Outsourcing segment. Remaining long-lived assets associated with this contract totaled $143 million at December 31, 2005. The current estimate of cash flows includes cost reductions resulting from the expected optimization of the contract’s service delivery infrastructure based on project plans and anticipated vendor rate reductions based on historical and industry trends. Some of the project plans have near-term milestones that are critical to meeting overall cost reduction goals. It is reasonably possible that these milestones may not be met or actual cost savings from these and other planned initiatives may not materialize in the near-term and, as a result, remaining long-lived assets associated with this contract will become fully impaired. The Company continues to pursue several opportunities to improve the financial performance of this contract, including leveraging the infrastructure through the addition of new business opportunities with the client.

 

The “other” line item in the table above includes asset write-downs, including the write-off associated with a commercial contract in 2005 referred to above, and changes associated with foreign currency translation adjustments. Estimated amortization expense related to deferred costs at December 31, 2005 for each of the years in the five-year period ending December 31, 2010 and thereafter is (in millions): 2006 – $211; 2007 – $121; 2008 – $96; 2009 – $77; 2010 – $51; and thereafter – $82.

 

NOTE 5: INVESTMENTS AND OTHER ASSETS

 

Following is a summary of investments and other assets at December 31, 2005 and 2004 (in millions):

 

     2005

    2004

 

Lease contracts receivable (net of principal and interest on non-recourse debt)

   $ 52     $ 58  

Estimated residual values of leased assets (not guaranteed)

     22       22  

Unearned income, including deferred investment tax credits

     (25 )     (29 )
    


 


Total investment in leveraged leases (excluding deferred taxes of $18 million at December 31, 2005 and 2004)

     49       51  

Leveraged lease partnership investment

     55       99  

Investments in equipment for lease

     182       411  

Investments in joint ventures and partnerships

     58       50  

Deferred pension costs

     72       59  

Other

     268       389  
    


 


Total

   $ 684     $ 1,059  
    


 


 

The Company holds interests in various equipment leases financed with non-recourse borrowings at lease inception accounted for as leveraged leases. The Company’s investment in leveraged leases is comprised of a fiber optic equipment leveraged lease with a subsidiary of MCI signed in 1988. For U.S. federal income tax purposes, the Company receives the investment tax credit (if available) at lease inception and has the benefit of tax deductions for depreciation on the leased asset and for interest on the non-recourse debt. All non-recourse borrowings have been satisfied in relation to these leases.

 

The Company holds an equity interest in a partnership which holds leveraged aircraft lease investments. The Company accounts for its interest in the partnership under the equity method. During 2005, the Company recorded write-downs of its investment in the partnership due to uncertainties regarding the recoverability of the partnership’s investments in aircraft leased to Delta Air Lines which filed for bankruptcy on September 14, 2005, and the proposed sale of certain lease investments in the partnership. These write-downs were partially offset by the accelerated recognition of previously deferred investment tax credits associated with the investment. These write-downs total $35 million and are reflected in other income (expense) in the Company’s 2005 consolidated statement of operations. During 2004, the Company recorded a write-down of $34 million of its investment in the partnership due to a reduction in the expected cash flows from the partnership. This reduction included a renegotiation of leases with a U.S. airline. These write-downs are reflected in other income (expense) in the Company’s 2004 consolidated statement of operations. The carrying amount of the Company’s remaining equity interest in the partnership was $55 million at December 31, 2005. The partnership’s remaining leveraged lease investments, subsequent to the proposed sale, will include leases with American Airlines and one international airline. The Company’s ability to recover its remaining investment in the partnership is dependent upon the continued payment of rentals by the lessees and the realization of expected future aircraft values. In the event such lessees are relieved from their obligation to pay such rentals as a result of bankruptcy, the investment in the partnership would be partially or wholly impaired.

 

49


Investments in securities, joint ventures and partnerships includes investments accounted for under the equity method of $35 million at December 31, 2005 and 2004. The Company recognized impairment losses totaling $1 million in 2005 and 2004 due to other than temporary declines in the fair values of certain non-marketable equity securities. These losses are reflected in other income (expense) in the Company’s consolidated statements of operations.

 

Investments in equipment for lease is comprised of equipment to be leased to clients under long-term IT contracts and net investment in leased equipment associated with such contracts. The net investment in leased equipment associated with the NMCI contract was $408 million and $717 million at December 31, 2005 and 2004, respectively. Future minimum lease payments to be received under the NMCI contract were $358 million at December 31, 2005. In addition, the unguaranteed residual values accruing to the Company were $78 million, and unearned interest income related to these leases was $28 million at December 31, 2005. The net lease receivable balance is classified as components of prepaids and other and investments and other assets in the consolidated balance sheets. Future minimum lease payments to be received at December 31, 2005 were as follows: 2006 – $250 million; 2007 – $108 million.

 

NOTE 6: GOODWILL AND OTHER INTANGIBLE ASSETS

 

Following is a summary of changes in the carrying amount of goodwill for the Outsourcing segment for the years ended December 31, 2005 and 2004 (in millions):

 

     Outsourcing

 

Balance at December 31, 2003

   $ 3,448  

Additions

     54  

Deletions

     (11 )

Other

     144  
    


Balance at December 31, 2004

     3,635  

Additions

     416  

Deletions

     (45 )

Other

     (174 )
    


Balance at December 31, 2005

   $ 3,832  
    


 

Goodwill additions resulted from acquisitions completed in 2005 and 2004 (see Note 16) and include adjustments to the preliminary purchase price allocations. Goodwill deletions resulted from divestitures completed in 2005 and 2004 (see Notes 17 and 19). Other changes to the carrying amount of goodwill were primarily due to foreign currency translation adjustments. The Company conducted its annual goodwill impairment tests as of December 1, 2005 and 2004. No impairment losses were identified as a result of these tests.

 

Intangible assets with definite useful lives are amortized over their respective estimated useful lives to their estimated residual values. Intangible assets with indefinite useful lives are not amortized but instead tested for impairment at least annually. All of the Company’s intangible assets at December 31, 2005 and 2004 had definite useful lives. Following is a summary of intangible assets at December 31, 2005 and 2004 (in millions):

 

     2005

    

Gross

Carrying

Amount


  

Accumulated

Amortization


    Total

Software

   $ 2,101    $ (1,665 )   $ 436

Customer accounts

     192      (90 )     102

Other

     393      (291 )     102
    

  


 

Total

   $ 2,686    $ (2,046 )   $ 640
    

  


 

     2004

    

Gross

Carrying

Amount


  

Accumulated

Amortization


    Total

Software

   $ 2,093    $ (1,662 )   $ 431

Customer accounts

     294      (174 )     120

Other

     300      (227 )     73
    

  


 

Total

   $ 2,687    $ (2,063 )   $ 624
    

  


 

 

50


Amortization expense related to intangible assets, including amounts pertaining to discontinued operations, was $445 million and $591 million for the years ended December 31, 2005 and 2004, respectively. Estimated amortization expense related to intangible assets subject to amortization at December 31, 2005 for each of the years in the five-year period ending December 31, 2010 and thereafter is (in millions): 2006 – $317; 2007 – $171; 2008 – $72; 2009 – $22; 2010 – $14; and thereafter – $44.

 

NOTE 7: ACCRUED LIABILITIES

 

Following is a summary of accrued liabilities at December 31, 2005 and 2004 (in millions):

 

     2005

   2004

Accrued liabilities relating to:

             

Contracts

   $ 609    $ 789

Payroll

     694      565

Restructuring activities

     66      208

Property, sales and franchise taxes

     266      363

Other

     795      848
    

  

Total

   $ 2,430    $ 2,773
    

  

 

NOTE 8: LONG-TERM DEBT

 

Following is a summary of long-term debt at December 31, 2005 and 2004 (in millions):

 

     2005

    2004

 
     Amount

   

Weighted-

Average

Rate


    Amount

   

Weighted-

Average

Rate


 

Senior notes due 2013

   $ 1,087     6.50 %   $ 1,085     6.50 %

Senior notes due 2009

     700     7.12 %     700     7.12 %

Convertible notes due 2023

     690     3.88 %     690     3.88 %

Notes payable due 2006 to 2029

     497     7.01 %     1,047     6.93 %

Other, including capital lease obligations

     279     —         304     —    
    


       


     

Total

     3,253             3,826        

Less current portion of long-term debt

     (314 )           (658 )      
    


       


     

Long-term debt

   $ 2,939           $ 3,168        
    


       


     

 

In June 2003, the Company completed a private offering of $1.1 billion aggregate principal amount of 6.0% unsecured Senior Notes due 2013. Interest on the notes is payable semiannually. In the event the credit ratings assigned to the notes fall to below the Baa3 rating of Moody’s or the rating BBB– of S&P, the interest rate payable on the notes will be increased to 6.5%. On July 15, 2004, Moody’s lowered the Company’s long-term credit rating to Ba1 from Baa3. As a result of Moody’s rating action, the interest rate payable on $1.1 billion of the Company’s senior unsecured debt was increased from 6.0% to 6.5%. Further downgrades in the Company’s credit rating will not affect this rate. However, in the event the Company’s credit rating is subsequently increased to Baa3 or above by Moody’s and its S&P credit rating remains at or above BBB–, this rate will return to 6.0%. The Company may redeem some or all of the notes at any time prior to maturity. In conjunction with the issuance of the Senior Notes, the Company entered into interest rate swaps with a notional amount of $1.1 billion under which the Company receives fixed rates of 6.0% and pays floating rates equal to the six-month LIBOR (4.70% at December 31, 2005) plus 2.275% to 2.494%. These interest rate swaps are accounted for as fair value hedges (see Note 1).

 

In June 2003, the Company completed a private offering of $690 million aggregate principal amount of 3.875% unsecured Convertible Senior Notes due 2023. Interest on the notes is payable semiannually. Contingent interest is payable during any six-month period beginning July 2010 in which the average trading price of a note for the applicable five trading day reference period equals or exceeds 120% of the principal amount of the note as of the day immediately preceding the first day of the applicable six-month period. The five trading day reference period means the five trading days ending on the second trading day immediately preceding the relevant six-month interest period. The notes are convertible by holders into shares of the Company’s common stock at an initial conversion rate of 29.2912 shares of common stock per $1,000 principal amount, representing an initial conversion price of $34.14 per share of common stock, under the following circumstances: a) during any calendar quarter, if the last reported sale price of EDS common stock for at least 20 trading days during the period of 30 consecutive trading days ending on the last trading day of the previous calendar quarter is greater than or equal to 120% or, following July 15, 2010, 110% of the conversion price per share of EDS common stock on such last trading day; b) if the notes have been called for redemption;

 

51


c) during any period in which the credit ratings assigned to the notes by either Moody’s or S&P is lower than Ba2 or BB, respectively, or the notes are no longer rated by at least one of these rating services or their successors; or d) upon the occurrence of specified corporate transactions. The Company may redeem for cash some or all of the notes at any time on or after July 15, 2010. Holders have the right to require the Company to purchase the notes at a price equal to 100% of the principal amount of the notes plus accrued interest, including contingent interest and additional amounts, if any, on July 15, 2010, July 15, 2013 and July 15, 2018, or upon a fundamental change in the Company’s ownership, control or the marketability of the Company’s common stock prior to July 15, 2010.

 

In June 2001, the Company completed the public offering of 32.2 million units of a security, initially referred to as Income PRIDES, each with a stated price of $50 before underwriting discount. Each unit initially consisted of $50 principal amount of EDS senior notes due August 2006 and a purchase contract which obligated the investor to purchase $50 of EDS common stock no later than August 17, 2004 at a price ranging from $59.31 to $71.47 per share. On May 12, 2004, the Company completed an offer to exchange 0.843 shares of EDS common stock plus $1.58 in cash for each validly tendered and accepted Income PRIDES. The Company accepted all of the 28.2 million Income PRIDES tendered pursuant to the offer and issued 23.8 million shares plus $45 million in cash to the holders. The notes relating to the 4.0 million units not tendered totaling $198 million were remarketed on May 12, 2004 at an interest rate of 6.334% per annum and mature on August 17, 2006. Investors who did not tender their Income PRIDES in the exchange offer were obligated to purchase EDS common stock on August 17, 2004. On that date, the Company issued 3.3 million shares of common stock for consideration of $198 million.

 

As a result of the exchange, the Company increased shareholders’ equity by $1,403 million in 2004 for the fair value of the purchase contracts and the fair value of the common stock issued. The remaining consideration was accounted for as an extinguishment of debt. Accordingly, the Company decreased liabilities by $1,418 million for the carrying value of the notes exchanged and the unpaid portion of contract adjustment payments that were recorded when the units were originally issued. In addition, the Company paid cash of $50 million and recognized a loss on debt extinguishment of $36 million in interest expense as a result of the exchange in 2004.

 

In December 2002, EDS Information Services, LLC, a wholly owned subsidiary of EDS, contributed to the capital of and sold certain trade receivables to Legacy Receivables, LLC, a limited liability company of which it is the sole member (the “LLC”), which then entered into a $500 million revolving secured financing arrangement collateralized by those trade receivables. The secured A/R facility was reduced to $400 million during 2003. There were no amounts outstanding under this facility at December 31, 2004. During 2005, the Company elected to terminate this facility.

 

During September 2004, the Company entered into a $550 million Three-and-One-Half Year Multi Currency Revolving Credit Agreement with a bank group including Citibank, N.A., as Administrative Agent, and Bank of America, N.A., as Syndication Agent. The facility replaced the Company’s five year $550 million revolving credit facility, which expired in September 2004. The new facility may be used for general corporate borrowing purposes and the issuance of letters of credit. The aggregate availability under the new facility, together with the Company’s $450 million Three-Year Multi Currency Revolving Credit Agreement entered into in September 2003, is $1.0 billion. There were no amounts outstanding under either of these facilities at December 31, 2005 and 2004. The Company had issued letters of credit totaling $160 million under the $550 million Three-and-One-Half Year Multi Currency Revolving Credit Agreement at December 31, 2005. The new facility includes financial and other covenants of the general nature contained in the facility it replaced, and the $450 million Three-Year Multi Currency Revolving Credit Agreement was amended and restated to include financial and other terms similar to the new facility. The Company pays annual commitment fees of 0.35% of the $450 million facility and 0.30% of the $550 million facility.

 

The Company’s unsecured credit facilities and the indentures governing its long-term notes contain certain financial and other restrictive covenants that would allow any amounts outstanding under the facilities to be accelerated, or restrict the Company’s ability to borrow thereunder, in the event of noncompliance. The financial covenants of the Company’s unsecured credit facilities were modified in September 2004 with the renewal of its $550 million credit facility discussed above, and include a minimum net worth covenant, a fixed charge coverage requirement and a leverage ratio requirement. The leverage ratio requirement limits the Company’s leverage ratio to not exceed 2.25-to-1 from July 2005 through December 2005, and 2.00-to-1 thereafter. The fixed charge coverage covenant requires the Company to maintain a fixed charge ratio of no less than 1.15-to-1 from July 2005 through December 2005, and 1.25-to-1 thereafter. The Company was in compliance with all covenants at December 31, 2005.

 

In addition to compliance with these financial covenants, it is a condition to the Company’s ability to borrow under its unsecured credit facilities that its representations and warranties under those facilities, including among others its representation regarding no material adverse change in its business, be true and correct as of the date of the borrowing. The Company’s unsecured credit facilities, the indentures governing its long-term notes and certain other debt instruments also contain cross-default provisions with respect to a default in any payment under, or resulting in the acceleration of, indebtedness greater than $50 million.

 

52


Expected maturities of long-term debt for years subsequent to December 31, 2005 are as follows (in millions):

 

2006

   $ 314

2007

     82

2008

     53

2009

     733

2010

     698

Thereafter

     1,373
    

Total

   $ 3,253
    

 

NOTE 9: MINORITY INTERESTS AND OTHER LONG-TERM LIABILITIES

 

Other long-term liabilities were $337 million and $531 million at December 31, 2005 and 2004, respectively. Other long-term liabilities include liabilities related to the Company’s purchased or licensed software, tax liabilities and interest rate swap agreements. Minority interests were $78 million and $184 million at December 31, 2005 and 2004, respectively. The decrease in minority interests in 2005 was primarily due to the Company’s purchase of the outstanding minority interest in its Australian subsidiary (see Note 16).

 

NOTE 10: INCOME TAXES

 

Following is a summary of income tax expense for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

Income (loss) from continuing operations

   $ 153     $ (103 )   $ (205 )

Income (loss) from discontinued operations

     (38 )     329       66  

Cumulative effect on prior years of changes in accounting principles

     —         —         (829 )

Shareholders’ equity

     (101 )     (20 )     68  
    


 


 


Total

   $ 14     $ 206     $ (900 )
    


 


 


 

Following is a summary of the provision (benefit) for income taxes on income (loss) from continuing operations for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     United States

             
     Federal

    State

    Non-U.S.

    Total

 

2005

                                

Current

   $ 127     $ 13     $ 87     $ 227  

Deferred

     (233 )     (29 )     188       (74 )
    


 


 


 


Total

   $ (106 )   $ (16 )   $ 275     $ 153  
    


 


 


 


2004

                                

Current

   $ (377 )   $ 2     $ 145     $ (230 )

Deferred

     31       (7 )     103       127  
    


 


 


 


Total

   $ (346 )   $ (5 )   $ 248     $ (103 )
    


 


 


 


2003

                                

Current

   $ 72     $ 13     $ (193 )   $ (108 )

Deferred

     (339 )     (71 )     313       (97 )
    


 


 


 


Total

   $ (267 )   $ (58 )   $ 120     $ (205 )
    


 


 


 


 

Following is a summary of the components of income (loss) from continuing operations before income taxes for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

U.S. income

   $ (170 )   $ (814 )   $ (782 )

Non-U.S. income

     609       440       265  
    


 


 


Total

   $ 439     $ (374 )   $ (517 )
    


 


 


 

53


Following is a reconciliation of income tax expense using the statutory U.S. federal income tax rate of 35.0% to actual income tax expense for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

    2004

    2003

 

Statutory federal income tax

   $ 154     $ (131 )   $ (181 )

State income tax, net

     (10 )     (3 )     (30 )

Foreign losses

     75       64       43  

Research tax credits

     (54 )     (45 )     (46 )

Other

     (12 )     12       9  
    


 


 


Total

   $ 153     $ (103 )   $ (205 )
    


 


 


Effective income tax rate

     34.9 %     27.5 %     39.7 %
    


 


 


 

Following is a summary of the tax effects of significant types of temporary differences and carryforwards which result in deferred tax assets and liabilities as of December 31, 2005 and 2004 (in millions):

 

     2005

   2004

     Assets

    Liabilities

   Assets

    Liabilities

Leasing basis differences

   $ —       $ 178    $ —       $ 186

Other accrual accounting differences

     429       21      423       19

Employee benefit plans

     337       18      309       33

Depreciation/amortization differences

     337       257      365       270

Net operating loss and tax credit carryforwards

     996       —        876       —  

Employee-related compensation

     233       —        215       —  

Other

     294       269      271       250
    


 

  


 

Subtotal

     2,626       743      2,459       758

Less valuation allowances

     (281 )     —        (233 )     —  
    


 

  


 

Total deferred taxes

   $ 2,345     $ 743    $ 2,226     $ 758
    


 

  


 

 

The net changes in the valuation allowances for the years ended December 31, 2005 and 2004 were increases of $48 million and $87 million, respectively. Of the net change in 2005, $92 million was an increase in valuation allowances for prior years’ losses incurred in certain foreign tax jurisdictions, which increased current year income tax expense from continuing operations. The remaining change in the valuation allowance in 2005 was primarily due to the sale of A.T. Kearney in January 2006 (see Notes 17 and 20) and foreign currency translation adjustments. Approximately one-half of the Company’s net operating loss and tax carryforwards expire over various periods from 2006 through 2025, and the remainder are unlimited.

 

In assessing the realizability of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and adjusts the valuation allowance accordingly. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Based on the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, the Company believes it is more likely than not it will realize the benefits of the deductible differences, net of existing valuation allowances at December 31, 2005. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.

 

U.S. income taxes have not been provided for $587 million of undistributed earnings of certain foreign subsidiaries, as such earnings have been permanently reinvested in the business. As of December 31, 2005, the unrecognized deferred tax liability associated with these earnings amounted to approximately $86 million.

 

On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004. The Act created a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. The Company determined that the incremental cost of the repatriation did not produce a corresponding economic benefit, and as a result, it did not make a repatriation under this provision.

 

54


NOTE 11: STOCK PURCHASE AND INCENTIVE PLANS

 

Stock Purchase Plan

 

Under the Stock Purchase Plan, eligible employees may purchase EDS common stock at the end of each fiscal quarter at a purchase price equal to 85% of the lower of the market price on the first or last trading day of the quarter, through payroll deductions of up to 10% of their compensation, not to exceed $25,000 per year in market value. Shares of EDS common stock purchased under the plan may not be sold or transferred within one year of the date of purchase. The number of shares originally authorized for issuance under this plan is 57.5 million. Total compensation expense recognized under this plan was $6 million during the year ended December 31, 2005. See Note 1 for pro forma expense associated with stock-based incentive compensation for the years ended December 31, 2004 and 2003.

 

PerformanceShare and EDS Global Share Plans

 

PerformanceShare and Global Share are “broad-based” plans that permit the grant of stock options to any eligible employee of EDS or its participating subsidiaries other than executive officers. As of December 31, 2005, options for 16.0 million shares had been granted under PerformanceShare (principally in a broad-based grant in May 1997) and options for 25.9 million shares had been granted under Global Share (principally in two broad-based grants in July 2000 and February 2002). The number of shares originally authorized for issuance under PerformanceShare and Global Share is 20 million and 27 million, respectively. As of December 31, 2005, no shares were available for future issuance under these plans.

 

Incentive Plan

 

The Incentive Plan is authorized to issue up to 136.5 million shares of common stock. The Incentive Plan permits the granting of stock-based awards in the form of stock grants, restricted shares, restricted stock units, stock options or stock appreciation rights to eligible employees and non-employee directors. A restricted stock unit is the right to receive shares. The exercise price for stock options granted under this plan must be equal to or greater than the fair market value on the date of the grant.

 

Transition Incentive Plan

 

The Transition Incentive Plan permits the grant of nonqualified stock options to eligible employees. This plan was intended to be used exclusively for the grant of stock options to former employees of Structural Dynamics Research Corporation (“SDRC”), which was acquired in August 2001, and UGS PLM Solutions Inc., which became a wholly owned subsidiary in September 2001, and has been used exclusively for that purpose. UGS PLM Solutions (which was the successor by merger to SDRC) was sold by the Company in May 2004. Such options have an exercise price equal to the fair market value per share of common stock on the grant date, vested in May 2004 in connection with the sale of UGS PLM Solutions, and are exercisable for two years from the date of such sale. The number of options originally authorized for issuance under this plan is 3.7 million.

 

Transition Inducement Plan

 

The Transition Inducement Plan permits awards in the form of nonqualified stock options, stock appreciation rights, restricted stock units, restricted stock awards or stock grants to eligible employees. This plan was adopted in October 2002 in anticipation of then proposed New York Stock Exchange rules which provide that awards issued to induce new employment or in exchange for awards under an “acquired” plan are not subject to shareholder approval. All options granted under this plan must have an exercise price not less than the fair market value per share of common stock on the grant date. The maximum number of shares that can be issued under this plan is 7.0 million, of which not more than 2.0 million are available for awards other than in the form of stock options.

 

Stock Options

 

The fair value of each stock option award is estimated on the date of grant using the Black-Scholes-Merton valuation model that uses the assumptions noted below. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by employees who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company under SFAS 123R. The Company uses historical data to estimate the expected volatility for the term of new options and the outstanding period of the option for separate groups of employees that have similar historical exercise behavior. The risk-free rate used to estimate fair value is based on the U.S. Treasury yield curve in effect at the time of grant. The weighted-average fair values of options granted were $10.46, $8.60 and $4.70 for the years ended December 31, 2005, 2004 and 2003, respectively. The fair value of each option was estimated at the date of grant, with the following weighted-average assumptions for the years ended December 31, 2005, 2004 and 2003, respectively: dividend yields of 1.0%, 2.9% and 3.6%; expected volatility of 60.3%, 61.7% and 45.9%; risk-free interest rate of 4.1%, 2.7% and 2.7%; and

 

55


expected lives of 5.0 years, 4.8 years and 4.2 years. The total intrinsic value of options exercised during the years ended December 31, 2005, and 2004 were $23 million and $13 million, respectively, resulting in tax deductions of $8 million and $5 million, respectively. No options were exercised during the year ended December 31, 2003. During 2005, the Company issued new shares and utilized treasury shares to satisfy share option exercises and the vesting of restricted share awards. The Company plans to utilize treasury shares acquired under the repurchase program authorized in February 2006 to satisfy future share option exercises and the vesting of restricted share awards (see Note 20).

 

Following is a summary of options activity under the Company’s various stock-based incentive compensation plans during the years ended December 31, 2005, 2004 and 2003:

 

    

Shares

(millions)


   

Weighted-

Average

Exercise

Price


Fixed options:

            

Outstanding at December 31, 2002

   73.9     $ 53

Granted

   22.5       17

Exercised

   —         —  

Forfeited and expired

   (46.1 )     52
    

     

Outstanding at December 31, 2003

   50.3       38

Granted

   33.7       20

Exercised

   (2.9 )     16

Forfeited and expired

   (10.2 )     34
    

     

Outstanding at December 31, 2004

   70.9       31

Granted

   1.5       20

Exercised

   (4.7 )     17

Forfeited and expired

   (15.8 )     51
    

     

Outstanding at December 31, 2005

   51.9       26
    

     

Exercisable

   26.0       29
    

     

 

At December 31, 2005, the weighted-average remaining contractual terms of outstanding and exercisable options were 5.2 years and 4.0 years, respectively, and the aggregate intrinsic values of these options were $211 million and $99 million, respectively. Total compensation expense recognized for stock options was $154 million during the year ended December 31, 2005. See Note 1 for pro forma expense associated with stock-based incentive compensation, including stock options for the years ended December 31, 2004 and 2003. As of December 31, 2005, there was approximately $136 million of unrecognized compensation cost related to nonvested options, which is expected to be recognized over a weighted-average period of 1.6 years.

 

Certain stock option grants contain market conditions that accelerate vesting if the Company’s stock reaches target prices. At December 31, 2005, approximately 3.3 million, 4.3 million and 4.3 million options were outstanding that will become exercisable if the price of the Company’s stock at the close of the trading day is above $24.31, $24.93 and $28.76 per share, respectively, for ten consecutive trading days (see Note 20).

 

Restricted Stock Units

 

The Company began using restricted stock units as its primary stock-based incentive compensation in March 2005. Prior to such time, stock options were primarily used for stock-based incentive compensation. Restricted stock units granted are generally scheduled to vest over periods of three to ten years. The March 31, 2005 grant consisted of performance-vesting restricted stock units. The number of awards that vest is dependent upon the Company’s performance over a three-year period with vesting thereafter.

 

The fair value of each restricted stock unit is generally the market price of the Company’s stock on the date of grant. However, if the shares have a mandatory holding period after the date of vesting, a discount is provided based on the length of the holding period. A discount was applied in determining the fair value of all restricted stock unit awards to adjust for the present value of foregone dividends during the period the award is outstanding and unvested. An additional discount of 15% was applied in determining the fair value of all units subject to transfer restrictions for a one-year period following vesting. This transferability discount was derived based on the value of a one-year average-strike lookback put option.

 

56


Following is a summary of the status of the Company’s nonvested restricted stock units as of December 31, 2005, and changes during the years ended December 31, 2005, 2004 and 2003:

 

    

Shares

(millions)


   

Weighted-

Average

Grant Date

Fair Value


Nonvested restricted stock units:

            

Nonvested at December 31, 2002

   5.7     $ 43

Granted

   1.0       19

Vested

   (1.5 )     42

Forfeited

   (0.4 )     42
    

     

Nonvested at December 31, 2003

   4.8       38

Granted

   1.2       22

Vested

   (2.1 )     38

Forfeited

   (0.4 )     41
    

     

Nonvested at December 31, 2004

   3.5       33

Granted

   7.3       19

Vested

   (1.5 )     34

Forfeited

   (0.4 )     18
    

     

Nonvested at December 31, 2005

   8.9       22
    

     

 

As of December 31, 2005, there was approximately $115 million of total unrecognized compensation cost related to nonvested restricted stock units. Such cost is expected to be recognized over a weighted-average period of 2.2 years. Total compensation expense for restricted stock units was $64 million ($42 million net of tax), $42 million ($27 million net of tax) and $62 million ($40 million net of tax), respectively, for the years ended December 31, 2005, 2004 and 2003. The aggregate fair value of shares vested during the years ended December 31, 2005, 2004 and 2003 were $33 million, $41 million and $26 million, respectively, at the date of vesting, resulting in tax deductions to realize benefits of $12 million, $14 million and $9 million, respectively, as compared to aggregate fair values of $52 million, $80 million and $59 million, respectively, on the dates of their grants.

 

Executive Deferral Plan

 

The Executive Deferral Plan is a nonqualified deferred compensation plan established for a select group of management and highly compensated employees which allows participants to contribute a percentage of their cash compensation and restricted stock units into the plan and defer income taxes until the time of distribution. The plan is a nonqualified plan for U.S. federal income tax purposes and as such, its assets are part of the Company’s general assets. The Company makes matching contributions on a portion of amounts deferred by plan participants that are invested in EDS stock units. Matching contributions vest upon contribution. The fair market price of common stock on the date of matching contributions is charged to operations in the period made. The Company also makes discretionary contributions that vest over periods up to five years as determined by the Board of Directors. The fair market price of common stock on the date of discretionary contributions is charged to operations over the vesting period. No employer contributions were made to the plan during the year ended December 31, 2005. Employer contributions to the plan during the years ended December 31, 2004 and 2003 were 37 thousand and 584 thousand shares, respectively.

 

57


NOTE 12: SEGMENT INFORMATION

 

The Company uses operating income (loss), which consists of segment revenues less segment costs and expenses (before restructuring and other), to measure segment profit or loss. Segment information for non-U.S. operations is measured using fixed currency exchange rates in all periods presented. The Company adjusts its fixed currency exchange rates if and when the statutory rate differs significantly from the fixed rate to better align the two rates. Prior period segment information presented below has been restated to reflect a change in the fixed exchange rates of certain non-U.S. currencies and other segment attribute changes in 2005. Total segment assets and depreciation and amortization expense as of and for the year ended December 31, 2003 is not readily available under the current reporting structure and has been estimated to conform with the 2005 and 2004 presentation. The “all other” category is primarily comprised of corporate expenses, including stock-based compensation, and also includes differences between fixed and actual exchange rates. Operating segments that have similar economic and other characteristics have been aggregated to form the Company’s reportable segments. The accompanying segment information excludes the net results of A.T. Kearney which are included in discontinued operations in the consolidated statements of operations (see Note 17).

 

Following is a summary of certain financial information by reportable segment, including components of the Outsourcing segment, as of and for the years ended December 31, 2005, 2004 and 2003 (in millions):

 

     2005

     Revenues

   

Operating

Income

(Loss)


   

Total

Assets


Americas

   $ 9,239     $ 1,433     $ 4,283

EMEA

     5,935       819       3,558

Asia Pacific

     1,377       103       529

U.S. Government

     2,025       375       519

Other

     1       (752 )     1,307
    


 


 

Total Outsourcing

     18,577       1,978       10,196

NMCI

     817       (75 )     922

All other

     363       (1,361 )     5,969
    


 


 

Total

   $ 19,757     $ 542     $ 17,087
    


 


 

     2004

     Revenues

   

Operating

Income

(Loss)


   

Total

Assets


Americas

   $ 9,251     $ 1,113     $ 3,783

EMEA

     6,247       911       3,388

Asia Pacific

     1,289       107       532

U.S. Government

     2,132       374       520

Other

     2       (560 )     829
    


 


 

Total Outsourcing

     18,921       1,945       9,052

NMCI

     761       (862 )     1,097

All other

     181       (1,185 )     7,595
    


 


 

Total

   $ 19,863     $ (102 )   $ 17,744
    


 


 

     2003

     Revenues

   

Operating

Income

(Loss)


   

Total

Assets


Americas

   $ 9,589     $ 1,170     $ 3,100

EMEA

     6,517       851       3,411

Asia Pacific

     1,274       78       390

U.S. Government

     2,167       479       1,317

Other

     —         (465 )     2,710
    


 


 

Total Outsourcing

     19,547       2,113       10,928

NMCI

     1,017       (948 )     1,071

All other

     (806 )     (1,420 )     6,617
    


 


 

Total

   $ 19,758     $