Initiating ACS: Neutral

We are initiating coverage of Affiliated Computer Services Inc. (ACS - Analyst Report) with a Neutral rating.

Headquartered in Dallas , Texas , ACS delivers IT-based services and solutions globally to commercial and government clients in the U.S. The company is a leading provider of business process outsourcing (BPO), information technology (IT) services and system integration services.

With growing revenue, increased earnings momentum, strong bookings, cost-control initiatives and substantial free cash flow, we remain positive on the company’s long term prospects. Moreover, we are encouraged by the ramp of new business signings, which were a record for fiscal 2009 at $1 billion of annual recurring revenue (ARR), a substantial increase of 27% from fiscal 2008. Total contract value is estimated at $4.5 billion.

While acquisitions have enabled revenue to grow at a considerable rate, the pace of acquisitions is aggressive and raises the risk of integration.

The company’s cash flow is strong. Operating cash flow of $877.1 million (13.4% of total revenue) in 2009 is an increase of 6.1% from 2008. However, the high level of debt is a threat to the stock.

As of June 2009, Affiliated’s net cash position (cash less debt, including current portion) was a significant deficit of $1.61 billion or about $16.45 per share (long-term debt to total capitalization ratio of 49%). Moreover, the company has $250 million in senior notes due in June 2010, which will further reduce cash.

The company announced its acquisition by Xerox Corporation for a total of $6.4 billion ($63.11 per ACS share). This represents a 33.6% premium to the closing price of ACS following the announcement. We expect the transaction to close soon, which should be accretive to fiscal 2010 earnings. As a subsidiary of Xerox, Affiliated will operate independently. Trading currently below the acquisition price, we believe the deal to be beneficial for Affiliated.

Thus we set a six-month price target of $63.00, close to the acquisition price. Our target price is 15.1x our 2010 EPS estimate, a discount to the industry.