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8/16/2002
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Taking Stock: This IT Workhorse Plows Steadily Through The Rocky Economy

It may be easy to ignore Unisys, but it's not a good idea.

What's priced at a six-year low and still makes money in technology? Hint: It also has a 115-year history that started with adding machines. Answer: It's that workhorse of the IT landscape, the technology services and hardware company Unisys.

Unisys (UIS --- NYSE) reported reasonable second-quarter earnings this year, unlike many other technology companies. Although revenue was $1.4 billion, down 7% year over year, the vendor reported earnings per share in line with expectations of 13 cents. Overall gross margin and operating margins for the quarter were 29.7% and 7.1%, respectively, up from 27.2% and 3.1% last year. These numbers were also up from the first quarter of this year, which saw gross and operating margins of 28.6% and 5.8%, respectively. Most of the older IT managers will recognize Unisys' name, but I'm not sure that investors appreciate the role the company plays in the IT industry.

It's easy to ignore Unisys. Its past is littered with earning disappointments, an unpredictable mainframe product cycle, and migration to an unknown services business. But today, most of its revenue comes from services -- more than 76% in the latest quarter -- and the business is stabilizing along with it.

In the second quarter, services revenue declined 4% year over year to $1.0 billion, but gross margins expanded to 21.9% from 19.2% last year and 21.7% last quarter. Operating margins were a much healthier 5.8% in the latest quarter, up from 1.6% last year and 4.9% last quarter.

Because this represents the largest portion of business for the company, this upward trend is very meaningful. I look forward to seeing this trend continue and project that service operating margins will be close to 6% for the full year, with potential to reach 7% next year. Outsourcing revenue grew 8% year over year but was offset by declines in systems integration and managed networking revenue, as at many other IT-services companies.

Overall, the technology division was down 15% year over year to $320 million. Its gross margins were 46.8% in the second quarter, up from 43.5% last year and 42.5% last quarter. Operating margins grew to 12.2% from 10.5% last year and 7.7% in the first quarter. The weakness in ES7000 server sales (down more than 20% year over year) could not be offset by the growth in ClearPath large enterprise server revenue (up 5% year over year). Operating profit margins are unlikely to stay as high as 12% for the rest of the year, and on an annualized basis, they're likely to get closer to 10%.

Unisys' problems remain the same as in the past. It's heavily dependent on IT spending. Orders were down 10% year over year. With new orders weakening, the forward outlook remains fuzzy.

The equity market capitalization of its 322 million shares at $7.93 per share is $2.6 billion. Wall Street expects Unisys to earn about 70 cents per share in 2002, up from 48 cents last year, on about $5.7 billion to $5.8 billion of revenue.

Unfortunately, about 30 cents of earnings per share in 2002 come from pension income tied to an overfunded pension plan. This earnings-per-share benefit could also work against Unisys in future years by the amount of underfunding if the fund doesn't meet its current assumption of 9.5% return, which is very likely in the near future. Therefore, the 30 cents should be subtracted to get a better picture of true ongoing operating earnings.

I project that operating margins will be between 7% to 7.5% for 2002. Depending on the assumptions of revenue growth rates (very low) and operating margin expansion (flat in my base case), on a discounted cash-flow model, I get a valuation between $10 and $13. At the low end of my valuation range, I see upside of 25% and, potentially, as high as 62%. Downside is probably close to $6 on a fundamental basis. This seems like a reasonable risk/reward scenario for a company that will likely benefit greatly from an uptick in IT spending.


William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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