Hewitt Associates: Expecting Improvement, Encouraged By Recent Results

Hewitt Associates (HEW) provides human resources outsourcing and consulting services. Clients consist primarily of businesses with more than 10,000 employees.

About 78% of fiscal 2006 revenues were generated in the United States. Remaining revenues came from Europe, Canada, the Asia-Pacific region, and Latin America.

The outsourcing business consists of Benefits Outsourcing [BO] and Human Resource Business Process Outsourcing [HR BPO]. BO contracts are generally for periods of three to five years. They accounted for 50.3% of first half fiscal 2007 revenues. Services include administration of health and welfare plans, defined contribution plans, and defined benefit plans. HR BPO contracts typically last seven to ten years. They produced 18.3% of first half fiscal 2007 revenues. Services include talent management such as recruiting, training, performance management, and succession planning; workforce management such as compensation administration, records management, relocation services, leave management, and travel; and core process management, which administers transactions involving payrolls, benefits, and payments. HEW can either build on a client’s existing HR operations or convert it completely to HEW’s proprietary systems.

The Consulting business produced 31.4% of first half fiscal 2007 revenues. HEW advises clients on developing and managing employee retirement and healthcare plans. It also offers offers advice to companies that are undergoing organizational restructurings such as mergers, acquisitions, and divestitures. Consulting engagements are usually short term.

Contracts are accounted for on a proportional-performance basis, which requires an initial estimation of expected costs. The company ran into problems in the early part of 2006 when its accounting of charges came into question. The stock hit a bottom when HEW simultaneously announced the retirement of its long time CEO and a review of its portfolio of contracts. The ultimate result was a $249 million pretax non-cash charge and $208 million in net operating losses for fiscal Q3 2006.

Management has since ramped up cost-cutting initiatives while taking a more disciplined approach to its HR BPO business. Operating profit margins for the BO and Consulting businesses improved to 26.6% and 17.0%, respectively, in fiscal Q3. HR BPO’s operating loss margin improved dramatically thanks to contract stabilization and effective cost controls. The company’s overall pro forma operating profit margin improved to 10.98% from 7.61% in the prior year quarter. Total Q3 revenues rose 3.9% year-over-year to $742.3 million. Net income was $47.51 million or 43 cents per share, which compares to a net loss of $202 million or $1.88 per share in the year earlier quarter.

Investment concerns include additional charges as HEW continues to review and renegotiate contracts. Future results might be negatively impacted if new contracts prove to be less profitable than expected. And a slowing economy could hurt business if clients cut payrolls. However, HEW will benefit as more businesses outsource HR functions to save money and focus on core competencies.

We are encouraged by recent financial results and expect improvements to continue as management stabilizes the HR BPO business and pursues further cost reductions.