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

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