Stock Market Beat » Hewitt Associates (HEW)

HEW: Hewitt Doesn’t Look as Good Under the Hood

Trent — Wed, 13 Feb 2008 11:32:28 +0000

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.

Conference Calls Confirm Trendless Employment Growth

Trent — Thu, 16 Aug 2007 11:00:36 +0000

When it comes to reading financial statements and government statistics, it is a good practice to follow Ronald Reagan’s admonition to “trust, but verify” whenever possible. Many have pointed out the high percentage of US job growth generated by the “birth/death model” in recent years, and I have noted that despite headlines to the contrary even the government’s statistics on job growth look sluggish.

So today I am trying to verify. By looking at what companies that are related to the job market are saying, perhaps I can see whether there is more strength or weakness than is otherwise apparent. The companies I chose were Paychex (PAYX) and Automatic Data Processing (ADP), both of which manage payrolls for a large number of businesses, and Hewitt Associates (HEW), which is an outsourcing firm providing benefits management. I reviewed their recent conference calls to collect their thoughts on the job market.

Paychex, for one, is doing its own part to help the employment market.

As of May 31, 2007 our number of employees increased 7% from 10,900 employees one year ago, to 11,700 employees today.

(Excerpt from full PAYX conference call transcript). While that doesn’t say much for the overall economy, it is certainly a start. On the bigger picture, management said:

When we look at the specifics of the things that we have a visibility to and the main number that we look at is the new hire transactions per client and the change in that from a growth year-to-year basis. Night of 2007 ended up at 4.2% for the full year and 5.1% for the fourth quarter. So, those are two very healthy numbers. Last year as an example was 3.1% on the full year.

So, John has often talked about it has been the economy stuck in a good place and the stuck that we, the elements of the equation that we see specifically new hire transactions because we do the compliance reporting.

Bonuses paid is other one that we look at and at the year end the bonus is paid by our clients to their employees were also up. And we look at checks per client, that was also up on a year-to-year basis, although modestly. So, the things that we look at suggest to us that the economy at least the one that we’re addressing, seems to be okay and it doesn’t seem to be moving dramatically one way or the other.

(Excerpt from full PAYX conference call transcript)

ADP does not think things are slowing significantly.

Liz Grausam – Goldman Sachs

Okay. And your pay per control has decelerated a little bit from 3Q into 4Q. Are you seeing anything kind of broad based across your client base one direction or the other in terms of what their hiring trends have been across the year?

Gary Butler

No, we’re not, and you can’t it’s hard to look at it quarter-to-quarter. Now, if you look at the trends for the past year, we were as low as 1.7, and as high as 3%. You have got to really look at it on the full year basis, and we aren’t seeing anything that would lead us just believe that’s decelerating.

(Excerpt from full ADP conference call transcript)

In case things do start to slow, ADP also helps us figure out how to spot it.

Typically in economic slowdowns in the past, what becomes more difficult is selling new business because people stop expending capital or the time to convert the business, et cetera. So, the thing that would probably be the most visible would be a slight slowing of new sales bookings.

Additionally, in severe downturns in the past we’ve seen some clients cancel ancillary reports or supplemental kinds of things that we were doing for them to try to get the bill down a little bit. And certainly if you had a major slowdown you would see some abatement in the pay growth that we’ve enjoyed at the 2% plus level over the last three years.

(Excerpt from full ADP conference call transcript)

Hewitt also appears to see things as solid.

The HR BPO business reported strong top line growth in the third quarter. Overall, after adjusting for the decline in third party revenue and currency, revenues grew 14%, driven primarily by growth of existing clients, including an increase in the project work as well as by contracts that went live in the twelve-month period.

(Excerpt from full HEW conference call transcript)

All in all, the conference calls seem to verify what I had been seeing from the government statistics – a fairly trendless situation.

Hewitt: Another Miss, Still Not Cheap Enough

Trent — Mon, 13 Nov 2006 11:02:27 +0000

We have looked at benefits outsourcing firm Hewitt Associates (HEW) several times, and each time we come away feeling like there is more risk than reward. For example, back in August we said:

Furthermore, the lack of profitability shows that Hewitt was too aggressive in pursuing contracts. As a result, investors should not expect the company to grow as fast as the historic results would suggest. This is already showing, with consulting revenues down 3% year-to-date.

And lo and behold, Hewitt misses again, according to Reuters.com

Human resources services company Hewitt Associates Inc. (HEW.N: Quote, Profile, Research) on Friday reported weaker-than-expected quarterly earnings on higher expenses and investment in new services, sending shares down 2.3 percent.Earnings fell 43.3 percent to $22.9 million, or 21 cents per share, in Hewitt’s fiscal fourth quarter, compared with $40.5 million, or 37 cents per share a year earlier.

Analysts, on average, expected profit of 26 cents per share, according to Reuters Estimates.

Revenue edged 0.9 percent lower to $727.6 million, compared with Wall Street forecasts for sales of $720 million.

Hewitt cited higher performance-based compensation in its outsourcing and consulting segments, and said the weaker-than-expected results reflected a “deteriorating” profit outlook for its human resources business process outsourcing (HR-BPO) contracts.

Morningstar Takes on HR Outsourcing

Trent — Thu, 31 Aug 2006 12:03:53 +0000

We recently profiled the travails of Human Resources outsourcing firm Hewitt (HEW). Although the stock price had triggered a buy alert we previously set, the uncertainty regarding past revenue (which now is being restated) caused us to remain on the sidelines.

Then yesterday we read an interesting article from Morningstar called Four Top HR Outsourcing Stocks. In many ways, Morningstar appears to share our views.

One caveat though–the one-stop-shop HR outsourcing model has struggled. Often termed human resource business process outsourcing, this new offering focuses on large corporations–usually with more than 10,000 employees–and handles nearly every HR function. Although it has great potential to cut costs for clients, the benefits are much less evident for the service provider.

That sounds quite a bit like our own comment, “One of the things we like about the HR Outsourcing business is that the complexity of the HR function makes many companies prefer not to do it themselves. For the same reason, we wonder why there are so many companies willing to do it for others.” The high competition drove Hewitt to price contracts too aggressively, and was the source of their latest slip.

Still, Morningstar lists Hewitt as one of their fab four, saying:

Hewitt’s position as both a consulting and outsourcing firm creates valuable synergies. With the information accumulated from its benefits outsourcing experience, Hewitt consults for firms that need help with benefit programs but aren’t willing to take the outsourcing leap. Through its 60-year history, Hewitt has gained expertise that keeps more than 90% of its clients coming back every year.

Recently, Hewitt’s stock has been hurt by troubles in its HR business process outsourcing service. Unfortunately, Hewitt swam too deep before the waters in this complicated business had been tested. Still, Hewitt’s non-HR business process outsourcing business (80% of revenue) continues to perform and generates more than enough value to support our opinion that Hewitt’s stock is cheap.

On this we disagree. Our previous conclusion still holds:

Furthermore, the lack of profitability shows that Hewitt was too aggressive in pursuing contracts. As a result, investors should not expect the company to grow as fast as the historic results would suggest. This is already showing, with consulting revenues down 3% year-to-date.

So what we’ve got here are shares that are pricing in no growth on an EV/FCF basis, an assumption that seems appropriate given the circumstances. We’ve also got a company with what we estimate as sustainable earnings power of $1.00 per share – on which a share price of $20+ appears on the high side in the current market.

Hewitt Revisited

Trent — Mon, 14 Aug 2006 13:03:52 +0000

Back in June when Hewitt Associates (HEW) shares plummeted on news that they would have to re-evaluate the profitability of their outsourcing contracts, we said the company’s enterprise value relative to its free cash flow merited a second look. We pointed out that we had viewed their previous Dutch auction share buyback as a paradoxical warning signal. And last week we presented a five-part series detailing the pluses and minuses for the stock.

Today they provided us with some of the meat we need to really make an investment decision.

The operating loss for the third quarter was $207.6 million, compared with operating income of $56.0 million in the prior-year quarter.

This quarter’s results include $249 million of non-cash pretax charges related to the Company’s review of its HR BPO contract portfolio, comprised of the following:

$172 million of goodwill impairment reflecting lower expected profitability of the overall existing portfolio, as well as lower future new contract expectations;

$70 million of contract loss provisions reflecting the Company’s revised profitability expectations for several existing contracts; and

$7 million of intangible asset impairment, primarily resulting from reduced demand for an acquired software asset.

While the company stressed that the charges were “non-cash” there is clearly a cost associated. The goodwill resulted from acquisitions of companies they expected would be more profitable than they are. The goodwill impairment tells us they gave up $172 million worth of stock they shouldn’t have given up when those acquisitions were made. The available earnings for shareholders are diluted by those erroneously issued shares.

But the real issue relates to the contract loss provisions. When Hewitt books a long-term contract, they estimate the total costs over the life of the project using what is known as the percentage of completion method. Then, as costs are realized they recognize the percentage of contractual revenues associated with those costs. By matching the revenue recognition to the cost recognition, the financial statements smooth out any differences between when the company incurs a cost and receives the related payment.

The problem with the percentage of completion method is the reliance on estimating the total costs over a three-to-five year contract. Even the most skilled and honest management team can make a mistake. And a less skilled or honest management team could be prone to underestimating the costs. If the company discovers that its costs will exceed contractual revenues it must take a charge for the amount the costs will exceed revenue. Subsequent contract revenue will equal costs and result in no profit or loss. For Hewitt, this represents a significant portion of their existing contracts.

As a result of our comprehensive and rigorous review of the business, we took charges in the quarter, reflecting our conclusion that the performance — primarily of the 2005 class of contracts — will fall significantly short of our prior expectations.

The 2005 class of contracts likely constitutes about a quarter (assumes a three-to-five year life and reflects the lack of growth this year over 2005) of the company’s total outsourcing contracts, which in turn account for more than two thirds of total company revnue. So for the remaining two-to-three years of the contracts there will be no profit recognized on about 18 percent of the company’s revenue. If we assume the remainder of their contracts generate the historic 8.2% margins, future operating margins look likely to fall in the 6.7 percent range.

Furthermore, the lack of profitability shows that Hewitt was too aggressive in pursuing contracts. As a result, investors should not expect the company to grow as fast as the historic results would suggest. This is already showing, with consulting revenues down 3% year-to-date.

So what we’ve got here are shares that are pricing in no growth on an EV/FCF basis, an assumption that seems appropriate given the circumstances. We’ve also got a company with what we estimate as sustainable earnings power of $1.00 per share – on which a share price of $20+ appears on the high side in the current market.

Hewitt (Part 5) – What We Don’t Like

Trent — Fri, 11 Aug 2006 11:52:04 +0000

One of the things we like about the HR Outsourcing business is that the complexity of the HR function makes many companies prefer not to do it themselves. For the same reason, we wonder why there are so many companies willing to do it for others.
Hewitt’s multi-class stock structure is a relic of a partnership that was unwilling to give up control to financial owners. We believe such companies should remain privately held.

The idea that contracts can be priced anticipating improved cost management over time appears ~~unrealistic~~ optimistic in light of the recent announcements.

Attributing of increased “other operating expense” partially to “client service delivery expense” gives us concern that some project implementations were not working well. If customer service has been suffering it may result in higher than normal levels of turnover at contract renewal.

The need to adjust contract profitability presents a conundrum: will employees receive the performance pay to which they are accustomed. If they are they will be rewarded for going after unprofitable contracts, but if they aren’t it could increase employee turnover. Either is unpalatable. The company has contributed to this being an issue by the fact that out-of-money options received accelerated vesting and that goodwill shares are also now fully vested, removing many of the incentives to stay. Two senior employees (Brian Doyle, President of HR Consulting and Dale Gifford, CEO) have already left or announced plans to leave, though the timing of the resignations may suggest they are partly related to the recent problems.

In a related issue, the company said in the latest 10Q that:

This year, we are recognizing a higher level of performance-based compensation than in the prior year based on our performance against internal targets to date.

Ay, ay ay. Given the shrinking profitability (even before the contracts needed to be restated) their internal targets appear awfully low.

They also say:

During the second quarter of fiscal 2006, we continued to focus heavily on making progress toward achieving more profitable growth, while continuing to invest in the implementation of our early stage HR BPO outsourcing contracts.

Translation: We have not achieved profitable growth, nor have we made any progress toward doing so. However, we continue to focus on doing so. Our take: if recent results are an indicator of what focus can do we’d prefer they stop.

Hewitt (Part 4) Things We Like

Trent — Thu, 10 Aug 2006 11:44:17 +0000

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.

Hewitt (Part 3) – The Fundies

Trent — Wed, 09 Aug 2006 11:34:33 +0000

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.”

	YTD 06	FY05	FY04	FY03
Operating margin	7.1	8.1	9.9	8.8

· 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

Amount	Interest Rate	Terms
$ 15,000	7.93	Repayable in June 2007
6,000	7.94	Repayable in five annual installments which began in March 2003
30,000	7.45	Repayable in five annual installments which began in May 2004
10,000	8.11	Repayable in June 2010
15,000	7.90	Repayable in October 2010
35,000	8.08	Repayable in five annual installments beginning in March 2008
$111,000

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.”

Hewitt (Part 2) – The Competitive Environment

Trent — Tue, 08 Aug 2006 11:12:05 +0000

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.

• 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.

• 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.

Hewitt (Part 1) – What They Do

Trent — Mon, 07 Aug 2006 11:41:46 +0000

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.