The following article is a reprint of my February 6, 2008 RealMoney column

Hewitt (HEW) is a leading global provider of human resource benefits, outsourcing and consulting services. On Tuesday the company reported $0.59 in earnings per share, beating analyst estimates by a full $0.20 per share. Given that it currently sports a healthy 9.1% free cash flow yield, I thought it was worth a further look.

Unfortunately, the full year guidance given was that Hewitt is “maintaining our fiscal 2008 guidance despite absorbing what we expect will be about six cents per share in dilution from the divestiture of Cyborg over the balance of the year.” After a $0.20 beat in the first quarter, ideally estimates would be raised by $0.14 (or more) despite absorbing a $0.06 per share dilution.

Hewitt’s surprise was largely driven by the fact that its Human Resources Business Process Outsourcing (HR BPO) business, which accounts for 20% of total revenue, lost less money in the company’s fiscal first quarter 2008 than it did in the prior year. Still, there are contracts that the company is trying to restructure to achieve profitability that are in “sensitive” stages.

Given how much most companies hate the human resources function, one would think that those willing to take on others’ headaches would be able to earn high profits. Unfortunately, there are a surprisingly large number of companies willing to take on those headaches. In the latest 10K, management says that “The principal competitors in our HR BPO segment are technology consultants and integrators such as Accenture (ACN), Affiliated Computer Services (ACS - Annual Report, EDS/ExcellerateHRO (EDS) and IBM (IBM - Annual Report) and; companies that have extended their services into human resources outsourcing such as Automatic Data Processing (ADP) and Convergys (CVG).

On the conference call, management indicated that the outsourcing business was counter-cyclical, with customers outsourcing more in downturns in order to reduce costs. Yet they seemed to contradict this statement by saying that the current market environment was causing their new contract signing pace to be behind schedule. Hewitt’s Zacks rank declined last week from 1 (best) to 2. Although the current rank still puts Hewitt in the top 20% of companies measured for earnings momentum, the cautious guidance and talk of a light pipeline are likely to result in some estimate reductions for the remainder of the year.

Despite the lower sales pipeline and ongoing restructuring of unprofitable contracts, Hewitt paid higher performance-based compensation in the fourth quarter. This resulted in first quarter free cash flow being $4 million lower than last year. The company also expects to spend more on capital expenditures this year, which will dampen free cash flow generation.

Furthermore, while earnings are improving the quality of those earnings is not. To gauge earnings quality, I measured the accrual ratio (change in net operating assets as a percentage of net operating assets) over the past several years. The accrual ratio gives an indication of the extent that earnings are driven by cash flows versus accounting choices. The closer the ratio is to zero, the better. Hewitt’s has been declining.

Source: Zacks Research Wizard, compiled by William A. Trent

So, after looking under the hood, I see a company with falling earnings momentum, falling free cash flow yield and falling earnings quality. The only thing rising in recent quarters has been the share price. As a value oriented investor, I’d rather it was the other way around.

Disclosures: None

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

Cognizant’s recent slowdown in net hiring has taken the wind out of its sails, and we have said several times that the biggest threat to the offshore IT providers is sustaining the employee growth that will be needed to sustain revenue growth - especially given the industry’s high employee turnover rates.

With several of the earnings reports from leading IT outsourcers and offshorers now in, we thought it an opportune time to peruse the conference call transcripts for clues.

First off, it is clear that demand remains strong.

George Price - Stifel Nicolaus

Where are we in terms of headcount in India? And then targets going forward by the end of the fiscal year?

Bill Green

I think I mentioned that we were in the mid-50s, in terms of total numbers. I think we were at 35,000 or targeting 35,000 by the end of the fiscal year. You know, the growth just continues, George, to expand there now with the management consulting expansion. We’re just going to see more substantive growth there. So we’re still on-target to hit the end of the fiscal year number that we’ve been throwing around.

(Excerpt from full ACN conference call transcript)

However, the demand is also putting pressure on wages.

We are increasing the offshore wages by somewhere between 13% to 15% and onsite wages for people outside India by 5% to 6%.

Overall, the impact on the margins because of the wage increases is something around 300 basis points, and we are assuming the rupee/dollar rate at 43.10. The average for fiscal ‘07 was 45. So, that could have an impact of something around 150 to 160 basis points on the margin.

(Excerpt from full INFY conference call transcript)

Margins are under pressure due to a rising rupee as well.

Now, this quarter our operating margin dropped by 100 basis points. This is primarily on account of rupee appreciation. But as we look forward, we have given guidance where we expect the profitability to be maintained at the same percentage level next year.

(Excerpt from full INFY conference call transcript)

Cognizant even claims that the slower hiring pace is just to protect margins:

And in the end, why are we slowing down hiring, because we want to stay within our target margin range, which we feel we can do without disrupting the business at all, because we are running such a low utilization today.

(Excerpt from full CTSH conference call transcript)

This explanation, however, doesn’t hold water with us. For one thing, low utilization has been the norm as the companies bring hires through the training program and prepare for expected turnover. Whether the margin impact is due to rising wages, currency issues or anything else is not the point as they are all symptoms of competition for workers. Instead, the point is whether the employees will add productivity or will allow revenue to grow only in line with employee count. We don’t see why it would be any more important to protect margin now than it would have been a year ago. To some extent it appears Infosys agrees.

S. D. Shibulal

Well, a higher utilization actually creates stress within the system because it’s like having a manufacturing plant and you cannot have people come just in time all the time. So, it made sense for us to have some amount of strategic bench, especially when you are bidding for large deals. And when large deals come into picture, there is one-time investment of people acquired. And today, on an average, every quarter we close some large deals, some multimillion dollar multiyear deal gets closed in every quarter.

So, it was important for us to build a strategic bench. At the same time, at this point in time, we have the fleet transferring too in the bench without impacting the business — including the utilization, without impacting the business.

(Excerpt from full INFY conference call transcript)

One key to continuing growth as the headcount increases is to reduce turnover. Some progress has been made here.

During the quarter, our annualized employee attrition declined to 15% from 17% in Q4. While we are pleased with our sequential progress in this area, attrition remains above historical levels. We continue to monitor employee attrition carefully and take necessary short and long-term steps to manage it.

(Excerpt from full CTSH conference call transcript)

Given Cognizant’s 43,000 employee count, a 2% reduction in annual turnover offers the same benefit as hiring 860 employees in a year. They also seem to be focusing on hiring the real revenue generators:

The increase in cost of revenues was due to additional technical staff for on-site and offshore required to support our revenue growth. We increased our technical staff by over 4,300 during the quarter and ended the quarter with approximately 40,800 technical staffs. This is a net increased of almost 15,750 technical staff from March 31, 2006.

(Excerpt from full CTSH conference call transcript)

Because of the ability to focus the hiring, because of increased productivity as employees gain experience and because of the low current utilization there is certainly some room for the companies to grow faster than they add employees. However, this ability is somewhat temporary. Long term, more sales will require more bodies. The question is whether those bodies can be found and retained.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Large Cap Watch List (Track at Marketocracy).

Though less than the Small Cap Watch List and Mid Cap Watch List (Track at Marketocracy), there was still relatively high turnover in this list. 14 of the original 33 names made the cut for the new list (which was trimmed to just 26 names.) Part of the reason for the turnover was to reduce overlap between the lists. One third of the Mid Cap Watch List (Track at Marketocracy) names appear on each of the Small Cap and Large Cap Watch List (Track at Marketocracy)s, but there is no longer any overlap between small and large.
So without further ado, the names on the chopping block from the previous list are:

3M (MMM); Continental (CTTAY.PK); Mitsui (MITSY); Anheuser-Busch (BUD); ConocoPhillips (COP); Helix Energy (HELX); IndyMac Bancorp (NDE - Annual Report); Barr Pharmaceutical (BRL - Annual Report); Quest Diagnostics (DGX); Public Storage (PSA); ITT Educational Services (ESI); Equifax (EFX); Rent-a-Center (RCII); Kroger (KR); Ricoh (RICOY); First Data Corp. (FDC); Expeditors International (EXPD); and Keyspan (KSE).

The new list is:

Accenture Reports Strong Second-Quarter Fiscal 2007 Financial Results: Financial News - Yahoo! Finance

Accenture (ACN) reported strong financial results for the second quarter of fiscal 2007, ended Feb. 28, with net revenues of $4.75 billion, a year-over-year increase of 16 percent in U.S. dollars and 10 percent in local currency. Consulting and outsourcing revenues both grew by double digits in U.S. dollars.GAAP diluted earnings per share were $0.47, compared with $0.11 in the same period last year. EPS of $0.47 increased 27 percent over adjusted EPS of $0.37 in the second quarter last year, reflecting the items described below under Financial Review.

The adjustment from last year relates to a provision taken due to the loss of a major contract. Analysts were expecting the company to earn $0.42 on $4.7 billion in revenues. The outlook was also fairly strong:

Third Quarter Fiscal 2007

Accenture expects net revenues for the third quarter of fiscal 2007 to be in the range of $4.9 billion to $5.1 billion.

Fiscal Year 2007

For the full fiscal year 2007, Accenture now expects net revenue growth to be at the high end of its previously communicated range of 9 percent to 12 percent in local currency. The company has revised its outlook for diluted EPS upward to the range of $1.88 to $1.93, which is $0.08 higher than its previously communicated range of $1.80 to $1.85.

The company continues to expect operating cash flow to be $1.95 billion to $2.15 billion; property and equipment additions to be $335 million; and free cash flow to be in the range of $1.6 billion to $1.8 billion. The company now expects its annual effective tax rate to be in the range of 34 percent to 36 percent. Accenture continues to target new bookings for fiscal 2007 in the range of $22 billion to $24 billion.

Although the company raised its estimates for the year, analyst estimates were already above the previous guidance range, at $1.87. Since Accenture beat by a nickel in the current quarter, the $1.88-$1.93 guidance actually would appear to indicate that earnings per share in the second half will be lower than analysts were forecasting.

The board of directors of Large Cap Watch List (Track at Marketocracy) member Accenture (ACN) approved a $1.5 billion share buyback authorization. The only question we have is: Why so little?

The amount is consistent with the company’s share repurchases in each of the last two years, so the amount was probably already factored into street expectations. The company generated $2.7 billion in cash from operations in its August 2006 fiscal year, and only needed $300 million to invest in new equipment given the knowledge-based (rather than asset-based) nature of its business.

So it would seem the company should be able to afford something more like $2 billion. But even that would cause cash to pile up further on the balance sheet, which already shows a $2.7 billion hoard against virtually no debt. And speaking of debt, maybe they should consider taking some on to recapitalize (use for share repurchases.) It seems like a reasonable value at 9x free cash flow, which by our reckoning values the company as though it will not grow - and the strong cash flow should be sufficient to support a reasonable amount of debt.

The board should certainly be considering all of these options. If they don’t do it, a private equity buyer might.

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Large Cap Watch List (Track at Marketocracy) (to be measured against the S&P 500) follows.

Astute observers will notice less overlap between this watch list and the names in the Small Cap Watch List and Mid Cap Watch List. This was not for lack of overlap, as the smallest S&P 500 name has a market capitalization of $600 million, which would allow for complete overlap with the Mid Caps if we chose. Instead we selected an arbitrary low of $2 billion for large-cap names, which cuts off five names that are actually in the S&P 500.
In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.

We have discussed Oracle’s (ORCL - Annual Report) acquisition strategy several times, and believe it is the correct path for the company. However, the devil is always in the details, and with an acquisition strategy the details include making sure customers of both the parent and the acquired company remain satisfied. As ComputerWorld reports, Oracle is having mixed success on that front.

Some Siebel CRM users interviewed at the Oracle OpenWorld user conference here last week said Oracle has been slow to provide details on its pledge to integrate Siebel and Oracle products and to reveal its long-term plans for its CRM product lines.

She said Oracle executives have given mixed messages about the future of the Siebel middleware products. Depending on Oracle’s plans, EDS may have to replace the Siebel middleware with software from Oracle, [Julie Reeves, CRM leader for the office of the CIO at Electronic Data Systems Corp.] noted. “It’s an open question for the future,” she said.

Reeves said she hopes that Oracle moves to ease the migration to new versions of its tools. The process is now quite costly, mostly because EDS has to customize each new version, she said.

“Easing that migration and helping customers upgrade without significant financial drain is very important,” Reeves said.

At this point, it sounds like they aren’t so much ready to switch vendors as anxious to learn what improvements may be planned and how that might affect their own implementation plans. However, integrating software is a complicated process (IBM, Accenture and others make billions each year helping companies do it) and it may be unfair to expect a detailed roadmap so quickly. On the day-to-day service front, Oracle appears to be doing a much better job.

A couple of Siebel users said that Oracle’s services operation has equaled and in some cases exceeded that of the former Siebel Systems Inc.

Richard Napier, business development manager at InFact Group, a software consulting firm and systems integrator in Plano, Texas, said software patches and upgrades are easier to locate on the Oracle Web site than they had been on Siebel’s.

“In all our dealings with Oracle, we notice better communication, more efficiently handled service requests and basically more information” than Siebel offered, he said.

As long as the integration road map is worth the wait, Oracle should manage to pull everything together.

Summary: Services are holding up fairly well in the current market.
PPI data for telecom shows that recent mergers have resulted in a less hostile pricing environment:

Watch List News

National Geospatial-Intelligence Agency Awards $69 Million Contract over five years to Accenture for Human Capital Management.

Leading customer care and billing solutions provider CSG Systems (CSGS) reported an upside earnings surprise and promoted Mike Scott to executive vice president and chief operating officer.

Credit reporting agency Equifax (EFX) earned $69.6 million, or 53 cents per share, up 11 percent from $62.6 million, or 47 cents per share, during the same period a year ago. Excluding certain items, the company earned 51 cents per share. Sales rose 7 percent to $387.7 million from last year’s $363.4 million. Analysts were looking for earnings of 50 cents per share on sales of $388.4 million. Shares fell on concerns of slowing growth in the face of declining mortgage applications.
Fidelity National Information Services, Inc. (FIS), a leading global provider of technology services to financial institutions, announced financial results for the second quarter of 2006. Consolidated revenue increased to $1.02 billion, Net earnings increased to $66.0 million and Net earnings per diluted share was $0.34. “FIS generated another quarter of solid operating performance. Year-to- date pro forma revenue growth of 6.2% and EBITDA growth of 10.4% are in line with our original full year expectations,” stated FIS Chairman William P. Foley, II. “With strong sales growth in the first half of the year and the recent launch of our new item processing and BPO operation in Brazil, we are increasing our full year outlook to reflect pro forma revenue growth of 5% to 7% percent, EBITDA growth of 10% to 12% and cash earnings per diluted share of $2.06 to $2.12.”

Rent-A-Center, Inc. (RCII), the nation’s largest rent-to-own operator, announced a messy quarter but the stock rallied sharply on an increase to guidance. The Company reported total revenues for the quarter ended June 30, 2006 of $583.6 million, a $3.0 million increase from $580.6 million for the same period in the prior year. Reported net earnings for the quarter ended June 30, 2006 were $39.8 million, or $0.56 per diluted share, representing an increase of 7.7% from the $0.52 per diluted share, or net earnings of $39.6 million for the same period in the prior year, when excluding the benefit of the 2005 tax audit reserve credit. “Our second quarter same store sales continued a positive trend in 2006,” commented Mark E. Speese, the Company’s Chairman and Chief Executive Officer. “Our same store sales increased 1.1% for the quarter, which is primarily related to changes in our promotional activities as well as an increase in the number of units on rent,” Speese continued. “In addition, we believe our customer has adjusted to the current level of fuel costs. As a result of these factors, we are raising our fiscal 2006 guidance to $2.08 to $2.15 diluted earnings per share from $2.00 to $2.10,” Speese stated.

Other News

Standard & Poors downgraded Convergys (CVG) on fears that it will lose major customers.

The Watch List names lost 4.37 percent this week, worse than any of the benchmarks. Again, not surprisingly given the median market cap of Watch List members, the performance was closest to the small-cap indices and it is still slightly ahead of them since inception.

It was a busy week, with earnings warnings from Borders Group (BGP), BJ’s Wholesale (BJ) and Yankee Candle (YCC), and an earnings disappointment from Journal Register (JRC). Ceradyne made its nuclear ambitions concrete, but will have a tough time fighting an Armored competitor. Hansen Natural (HANS) got kudos from Fortune.

Other news, that was fit to print but didn’t fit, includes:

Starbucks to up noncoffee merchandise for holidays - Yahoo! News

The holiday line-up will feature a glittery snow globe on a gold-colored base, at least three kinds of Christmas ornaments, a reusable Advent calendar that turns into a miniature chest of drawers at the end of the season and a dessert plate reading “Cookies for Santa.”

NTT DoCoMo going Super 3G

NTT DoCoMo, Inc. announced that starting today it will accept proposals from suppliers for development of equipment for Super 3G base stations and handsets.DoCoMo will select one or more suppliers for each of these categories around October and aims to complete the technology with the selected suppliers before the end of 2009.

The Super 3G standard is expected to provide superfast downlink data rates of over 100Mbps and uplink data rates of over 50Mbps, low-latency data transmission, and improved spectrum efficiency.

Accenture Acquiring Advantium and Meridian Informed Purchasing, Two Companies Specializing in Profit Recovery and Analytics

The two companies use sophisticated processes and proprietary software to analyze clients’ procurement and payables data to prevent, detect and recover the lost profits, or erroneous payments, which can result from human error, system-integration issues, contract non-compliance and fraud.

Cognizant (CTSH) forms digital media center of excellence.

Statoil’s Valkyrie well disappoints.

Travelzoo continues its growth in the UK.

Brunswick sneezed and MarineMax caught a cold.

KCS Energy acquisition by Petrohawk closed.

Pinnacle (PNCL) asked to place additional aircraft lease deposits.

In September 2005, Northwest Airlines, Inc. requested that Pinnacle Airlines, Inc., a wholly-owned subsidiary of Pinnacle Airlines Corp. (collectively, “Pinnacle”), pay $21,700,000 in additional aircraft sublease security deposits by March 1, 2006. Pinnacle has disputed Northwest’s right to seek additional security deposits at this time. Northwest has extended its deadline to August 14, 2006 while the parties continue ongoing discussions regarding their future business relationship.

Gabelli to Pay $130 Mln to Settle With US on Cell Licenses.

Campbell Soup to sell UK, Irish units for $845 mln. That’s a cash infusion equal to five percent of the market cap.

Disclosure: Author is long Starbucks (SBUX) at time of publication.

Consulting firm Accenture (ACN), which is on our Watch List,  reported strong earnings Thursday after the market close. The outsourcing market appears to remain strong, which has positive implications for other Watch List names including IBM and Cognizant (CTSH).
Fiscal third-quarter net income advanced 2.5 percent to $496.1 million, or $0.56 per share, from $484 million, or $0.51 per share, in the year-ago period. Analysts were expecting $0.46. The year-ago results included a benefit of $66 million, or 8 cents per share, related to the company’s 2001 reorganization into a corporation from groups of partnerships. Revenue rose 6.8 percent to $4.81 billion from $4.5 billion last year and compared favorably to analyst estimates of $4.43 billion. Consulting revenue rose 6 percent to $2.66 billion, and outsourcing revenue gained 11 percent to $1.75 billion.

Accenture shares have tumbled about 11 percent in the three months since its last earnings report on March 28, when the company surprised investors with a $450 million charge for losses expected on a computer system project for the British health care system. The Standard & Poor’s 500 Index fell 4 percent during the same period.

New bookings, a key indicator of future revenue, were $5.57 billion in the third quarter, the highest in nine quarters, Accenture said.

Accenture said it now expects full-year 2006 revenue growth at the upper end of its earlier forecast of 9 percent to 12 percent. It expects full-year net income per share of $1.55 to $1.57, including a $140 million tax benefit recorded in June.

For the fourth quarter, Accenture forecast revenue of $4.2 billion to $4.35 billion and net income of 52 to 54 cents per share. Analysts are forecasting profit of 38 cents per share, before items, and revenue of $4.27 billion.