HP Smacked in EDS Suit, Highlighting the Risks of Service Businesses

(MoneyWatch)  Many high tech companies get into consulting because it is profitable and a natural adjunct to selling products. IBM (IBM) made an amazing business recovery in the 1990s by heavily moving into IT services and consulting and away from a product-centric focus. Last fall, Dell (DELL) announced that it would buy Perot Systems.

For a number of quarters, EDS proved a smart purchase by HP because the company's service division was the only growing business line. But the acquisition came with some baggage, including a law suit, as HP explains in a company press release about why it is revising earnings:

EDS and one of EDS's subsidiaries are defendants in litigation filed in the United Kingdom by Sky Subscribers Services Limited and British Sky Broadcasting Limited (BSkyB) in 2004 relating to a customer relationship management project that was awarded to EDS in 2000. At a court hearing held on March 1, 2010, the court ordered EDS to make an interim payment to BSkyB of ?£70 million, or approximately $112 million, which is in addition to an interim payment of ?£200 million, or approximately $320 million, that HP made voluntarily to BSkyB in February 2010. Following that March 1 hearing, HP determined that it was appropriate to increase the contingency reserve. HP will continue to evaluate the reserve pending final resolution of the litigation.

HP plans to appeal the decision if possible, and did dodge a worse problem when a British court in January dismissed most of BSkyB's claims. But for now, HP is reserving an additional amount for the payment that will reduce earnings for the first quarter, which ended on January 31, by $73 million.

Had the dispute been over a hardware problem, HP might have replaced equipment or provided a refund and recovered the hardware for another use. However, once a company provides a service, the time of the consultant employees is gone forever, and there is nothing to reuse or recycle. Although the margins of the work are attractive, the potential risk can be higher.