Human resources is a complex and time-consuming task for most companies. Although HR ultimately works as a major determinant of success or failure, the function itself is usually seen as a cost center. As a result, many companies would prefer to pay someone else to do it for them. The potential business opportunity is quite large.

Within the HR outsourcing arena, Hewitt is well positioned as an objective provider. Most of its competition comes from firms that do benefits administration in order to gather assets for their investment business or that have extended a basic payroll function. By offering the full range of services and not being conflicted by ties to a particular benefit provider, Hewitt has an advantage when competing for clients suspicious of others’ motives.

The company is unwinding its relationship with FORE holdings, which presented conflicts of interest between shareholders and management.

Cash flow from Operating Activity rose considerably more than net income year-to-date. However, this may be temporary as there was a large increase in accrued compensation (relative to the previous year) that will ultimately be paid.

Summary: In light of the ongoing audit it is difficult to interpret past results as a guide to future activity.

Income statement analysis

Sales growth accelerated from 11.3% in 2004 to 28.8% in 2005 on the back of the exult acquisition. However, in the first six months of 2006 sales declined 2%.

Sales quality – the need for a restatement and write-off related to contract costs suggests that sales were of poor quality and inadequate diligence was done regarding estimating future possibility. It is possible the market has become too competitive to be very profitable.

Revenue recognition – the percentage of completion method used carries the potential risk that costs and revenues will be (intentionally or unintentionally) estimated incorrectly, resulting in exactly the type of write-down the company is now quantifying. As they say in the 10K: “Our accounting for our long-term contracts requires using estimates and projections that may change over time; such changes may have a significant or adverse effect on our reported results of operations or consolidated balance sheet.

Projecting contract profitability on our long-term Outsourcing contracts requires us to make assumptions and estimates of future contract results. All estimates are inherently uncertain and subject to change to correct inaccurate assumptions and reflect changes in circumstances. In an effort to maintain appropriate estimates, we review each of our long-term Outsourcing contracts, the related contract reserves and intangible assets on a regular basis. If we determine that we need to change our estimates for a contract, we will change the estimates in the period in which the determination is made. These assumptions and estimates involve the exercise of judgment and discretion, which may also evolve over time in light of operational experience, regulatory direction, developments in accounting principles, and other factors. Further, initially foreseen effects could change over time as a result of changes in assumptions, estimates or developments in the business or the application of accounting principles related to long-term Outsourcing contracts. Application of, and changes in, assumptions, estimates and policies may adversely affect our financial results.”

· Customer financing – N/A

· Other

Seasonality – none apparent.

Earnings quality

· Capitalization of expenses – certain expenses are capitalized at the beginning of the contract to be recognized over the contract terms ($91 million in 2005), along with certain deferred revenue items. In addition, some software development costs are capitalized ($25 million in 2005).

· Operating margins – were declining even before the recent write-off announcement. A huge increase in “other operating expense” accounted for the deterioration. The company’s explanation was higher 3^rd-party BPO services and higher “client service delivery expense.”

· Stock options – company accelerated vesting of out-of-money options to avoid expensing them, so the $0.35 per share pro-forma information reported is not a good guide to future expense.

· Pensions –Recurring (service + interest) costs exceed amount recorded on income statement by $6 million per year.

· Anomalous tax rates – no

· Other – following the Exult merger, certain expenses were reclassified from the consulting to the outsourcing segment, impairing comparability.

Balance sheet analysis

Debt load and maturity schedule

Exotic debt instruments “Subsequent to our merger with Exult, Hewitt became the sole obligor and assumed obligations on $110 million of 2.50% Convertible Senior Notes due October 1, 2010. The notes rank equally with all of our existing and future senior unsecured debt and are effectively subordinated to all liabilities of each of our subsidiaries. We recorded the notes at their estimated fair value of $102 million at the merger date and are accreting the value of the discount over the remaining term of the notes to their stated maturity value using a method that approximates the effective interest method. As of September 30, 2005 the outstanding balance on the notes was $104 million.

The notes are convertible into shares of Hewitt Class A common stock at any time before the close of business on the date of their maturity, unless the notes have previously been redeemed or repurchased, if (1) the price of Hewitt’s Class A common stock issuable upon conversion of a note reaches a specified threshold, (2) the notes are called for redemption, (3) specified corporate transactions occur or (4) the trading price of the notes falls below certain thresholds. The initial conversion rate is 17.0068 shares of Hewitt Class A common stock per each $1,000 principal amount of notes, subject to adjustment in certain circumstances. This is equivalent to an initial conversion price of approximately $58.80 per share. Based upon this conversion price, the notes if converted, would be convertible into 1,870,748 shares of Hewitt Class A common stock.

On or after October 5, 2008, we have the option to redeem all or a portion of the notes that have not been previously converted or repurchased at a redemption price of 100% of the principal amount of the notes plus accrued interest and liquidated damages owed, if any, to the redemption date. Similarly, the convertible debt note holders have the option, subject to certain conditions, to require Hewitt to repurchase any notes held by the holders on October 1, 2008 or upon a change in control at a price equal to 100% of the principal amount of the notes plus accrued interest and liquidated damages owed, if any, to the date of purchase.”

Value of unexercised options

Pension funding – unfunded liability of $65 million, of which only half is currently recognized on the balance sheet.

Accruals

· Doubtful accounts – rose by 10% compared to a 14% rise in receivables and a 29% rise in sales. Held at the same percentage of receivables would have reduced operating income by nearly $1 million.

· Other – substantial increase in cash flow from operations largely due to stock-option related tax deferrals

Receivables trends (DSO) – Declining

Long-term or unbilled receivables – stable

SPEs and other off-balance sheet items – $500 mm PV of operating leases, $150 mm in contractual obligations.

Cash flow analysis

Operating cash flow and net income trends – CFFO rose $90 million on a $2 million decline in net income for the first 6 months of 2006, primarily due to increased accrued compensation.

Growth indicators – out the window until the results of the restatement are known.

The proxy statement and other issues

Director independence – Three of 11 directors are employees and two have ties to Sara Lee.

Related party transactions – “In May and July 2005, FORE Holdings, our former parent company and a related party, sold properties and its rights as lessor for a number of the properties in which the Company leases space. As a result, our operating leases are all with third parties and there are no remaining operating leases with related parties (see Note 13 to the consolidated financial statements for additional information). In exchange for certain waivers and covenant changes stemming from the property sale, we received $3 million which is being amortized as a reduction of our rent expense over the remainder of the related leases.”

Other – multiple classes of stock: “As of September 30, 2005, our initial stockholders and their assignees owned shares of Class B and Class C common stock representing approximately 45% of the voting interest in Hewitt. Pursuant to the terms of our amended and restated certificate of incorporation, the Class B and Class C common stock are voted together in accordance with a majority of the votes cast by the holders of such stock, voting together as a group. As long as our initial stockholders continue to own or control a significant block of shares, our initial stockholders have a significant influence over the voting process. This will enable our initial stockholders, to have a significant influence over the election of the Board of Directors, control of management policies and determination of the outcome of most corporate transactions or other matters submitted to all the stockholders for approval, including mergers, consolidations or the sale of substantially all of our assets.

In addition, most of our initial stockholders are our employees and they may act in their own interest as employees, which may conflict with or not be the same as the interests of stockholders who are not employees.”

In Part 1 we discussed Hewitt’s (HEW) business and strategy. Here we take a look at some of the other companies doing the same thing, and how it affects Hewitt.

Looking through the lens of Porter’s Five Forces, we find:

Customer bargaining power is weak. As mentioned in Part 1, Hewitt has 2,400 clients and none represent more than 10% of Hewitt’s revenue. While there is typically a good deal of competition for the initial contract and renewals, contract terms are typically 3-5 years and include early exit penalties. Furthermore, once a customer is on a particular system switching can be painful.

Supplier bargaining power is mixed. In a consulting business, the suppliers are employees. There is typically a give-and-take for key employees, and previous partners became shareholders when the firm went public. Unfortunately, Hewitt has squandered several of the retention levers it had at its disposal: goodwill shares are now fully vested, out-of-money stock options were given accelerated vesting so as to avoid expensing them under new accounting rules, restricted shares issued at the time of the Exult merger have vested, and so on. The company may have to step up retention efforts in coming quarters.

The threat of new entrants is limited. The large number of existing competitors and the level of expertise needed to be successful are barriers to entry.

Substitute products are available. The primary being in-house human resources management.  In addition, software packages are available that perform some HR tasks. In fact, part of Hewitt’s consulting business is to help clients choose such software.

Competitive rivalry is intense. Gartner breaks out the competitive landscape as follows:

In their 10K, Hewitt describes it thusly:

We operate in a highly competitive and rapidly changing global market and compete with a variety of organizations. In addition, a client may choose to use its own resources rather than engage an outside firm for human resources solutions.

 

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Outsourcing. The principal competitors in our human resources outsourcing business are outsourcing divisions of large financial institutions such as CitiStreet, Fidelity Investments, Merrill Lynch, Putnam

Investments, T. Rowe Price and the Vanguard Group; companies that extended their services into human resources outsourcing such as Automatic Data Processing, Ceridian, Convergys and Paychex and technology consultants and integrators such as Accenture, Affiliated Computer Services, Electronic Data Systems and IBM.

 

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Consulting. The principal competitors in our consulting business are consulting firms focused on broader human resources, such as Mercer Human Resource Consulting, Towers Perrin and Watson Wyatt Worldwide. We also face competition from smaller benefits and compensation firms, as well as from public accounting, consulting and insurance firms offering human resources services.

 

We promised a while back we would give Hewitt (HEW) a second look. Our only follow-up since then was this post rehashing some old news. Well, now we are delivering – a second look in a five-part series!

According to their 10K, Hewitt is one of the leading global providers of human resources outsourcing and consulting services. These range from 401(k) enrollment to defined benefit plan administration, to health care administration, talent recruiting – basically everything that a human resources (HR) department would do. Unlike many of its competitors Hewitt does not manage assets, which allows it to offer objective advice. It also offers a complete range of consulting and outsourcing services. In its own words:

Our global human resources outsourcing and consulting experience and expertise complement and strengthen each other. For example, our outsourcing clients benefit from our expertise in creating strategies and program designs that meet business objectives while being administered cost-effectively and efficiently. Our consulting clients benefit from our outsourcing capabilities in two ways. First, our ability to extract detailed design, demographic and plan data from our extensive outsourcing databases, and to aggregate and analyze the data to provide unique insights that we use to create strategies and program designs that best meet business needs. Second, our deep understanding of operational realities ensures that our consulting solutions are practical and operationally effective. We believe that this integration creates a competitive advantage by enabling us to provide our clients with more effective total human resources solutions across the full range of their workforce-related business challenges.

In their fiscal year 2005 the company’s revenue generation was 29% consulting and 71% outsourcing. The company had more than 2,400 clients, none of whom accounted for more than 10% of company sales. The company believes its position offers competitive advantage:

As a leader in human resources outsourcing, we have achieved the size and scale that enhances our continued innovation and flexibility to help our clients meet their changing business challenges. We employ new technologies as well as standardized proprietary technologies when existing technologies do not meet our clients’ needs or our requirements. This integrated combination of technologies provides the necessary economies of scale and balance of customization versus standardization to be flexible enough to adapt to a broad range of program complexity and to accommodate the needs of clients ranging in size from less than 1,000 to well over 500,000 employees.

It sounds to us like a difficult balance to strike, and we wonder if it can truly be managed.

Their HR Business Process Outsourcing (BPO) unit got much bigger with the October 2004 acquisition of Exult. This acquisition has led to many of the company’s current problems.

Some post-merger financial effects that we expect to see in future results include changes in business mix relating to the expansion of the HR BPO business. When we bring on new HR BPO clients, we typically assume their existing cost structure, including personnel and third party subcontractors, and work to transform the processes, systems and service delivery to reduce costs over time. As the HR BPO business grows within our Outsourcing segment, we expect near-term negative impacts on our firmwide and Outsourcing segment margins as we make investments in our HR BPO business infrastructure and upfront investments to implement new contracts and transform the underlying client processes. Margins are expected to improve as the initial HR BPO contracts mature and the average age of our HR BPO client contract portfolio increases.

You may recall that Hewitt’s recent blowup started with the company 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.