Hewitt (HEW) Worth a Second Look

File this one under “The Best Laid Plans.” No sooner than we develop a watch list - one of the goals of which being to help us focus on a smaller portion of the stock market universe (100 or so rather than 10,000 or so stocks) - but we get a blast from the past in the form of a stock alert. This one told us that Hewitt (HEW) had fallen below $21. At some time (we think it was when the stock fell on their second-quarter earnings report) we decided that was the price it would have to penetrate in order for us to take a closer look.

The reason we chose the $21 figure was not very scientific. It gives them an enterprise value of $2.3 billion, which is essentially 10x their FY2005 (fiscal year ends September) free cash flow. Our reasoning is, if the stock trades at a 10 percent free cash flow yield we can earn a decent long-term rate of return even if the company doesn’t grow. Shrinking is another story, so the first thing we did this morning after getting the alert was check the most recent 10Q. It showed that in the first six months of FY2006 operating cash flow is higher and capital expenditures are lower than they were for the same period in 2005. Net result: free cash flow appears to be going up, not down.

The next thing we did was try to figure out why the shares had fallen to our target. That too was easy - last week the long-time CEO announced he is retiring at the end of this year and that the previous earnings guidance for the remainder of this year was no longer good. As they say - the markets dislike uncertainty, so the fact that there is not new guidance (it is to be given when they announce third quarter results) is something especially disliked.

Hewitt said it is reviewing guidance in connection with a review of its human resources business-process outsourcing contract portfolio. The company records revenue on a percentage of completion basis, which means that if they were incorrect in estimating the costs and revenues of contracts there could be a substantial revision to make up for over-estimating revenue in past periods. Plus, with the costs re-estimated it is probable that future revenue on the contracts will result in no profit, hurting margins. That now looks likely to happen.
So clearly, the stock has fallen for good reasons.  With the CEO leaving, the former head of the HR outsourcing business forced to resign, and uncertainty not only over future numbers but whether even the past reported numbers can be relied upon, a low apparent valuation has to be taken with a grain (or a bucket) of salt.

But we’re going to take that second look anyway. For one thing, it is quite possible the Street is overestimating the severity of the necessary restatement. For another, with the long-tenured CEO retiring Hewitt may now be “in play.” We have said before that as much as any company hates doing HR we can’t understand why companies like HEW would want to do it for other companies, but there is no shortage of firms getting into the business. One of these may be tempted by the opportunity to grab a leading firm while it is down.

As the chart below indicates, Hewitt is trading at a much lower P/E than it has historically mustered. With the “E” in doubt, that may well be justified. A big enough restatement could also invalidate the 10 percent free cash flow yield we targeted. But on the other hand - it may not. And we’d hate to miss this one if things turn out not to be so bad.

Like this article? Why not try out:

•  RSS or email subscription to my free content

• Or buy my book: Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements