Hewitt Associates F2Q08 (Qtr End 3/31/08) Earnings Call Transcript

Hewitt Associates, Inc. (HEW)

F2Q08 Earnings Call

May 5, 2008 8:30 am ET

Executives

Sean McHugh - Investor Relations

Russell P. Fradin - Chairman of the Board, Chief Executive Officer

John J. Park - Chief Financial Officer

Analysts

Ashwin Shirvaikar - Citigroup

Bhavan Suri - William Blair & Company

Tien-tsin Huang - JP Morgan

Mark Marcon - Robert W. Baird

Shlomo Rosenbaum - Stifel Nicolaus

Todd Van Fleet - First Analysis

Cynthia Houlton - RBC Capital Markets

Liz Grausam - Goldman Sachs

Jason Kupferberg - UBS

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Hewitt Associates second quarter fiscal 2008 earnings conference call. (Operator Instructions) I’d now like to turn the conference over to your host, Mr. Sean McHugh. Please go ahead.

Sean McHugh

Good morning and thank you for joining us. On the call today are Russ Fradin, our Chairman and CEO, and John Park, our CFO.

Before we get started, let me highlight that when we discuss revenues, we are referring to net revenues, or revenues before reimbursements. And during this call, we will discuss underlying operating income, earnings per share, and adjusted EBITDA amounts. These are non-GAAP financial measures that provide a better understanding of our underlying performance. Please refer to this morning’s press release in the investor relations section of our website to obtain a full reconciliation of these measures to U.S. GAAP.

On this call, we may make forward-looking statements. Forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Please refer to our most recent SEC filings for more information on risk factors that could cause actual results to differ. Hewitt disclaims any obligation to update or revise any forward-looking statements made on this call.

At the conclusion of the call, we’ll conduct a question-and-answer session. During the Q&A session, we ask that as a courtesy to others, you please limit yourself to one question.

Now I will turn the call over to Russ.

Russell P. Fradin

Thank you, Sean and good morning, everyone. Thanks for joining us today. Since our last call, we’ve continued to execute against our key priorities, delivering great service to our clients, investing in growth opportunities in our benefit outsourcing and consulting businesses, further stabilizing our human resource BPO business and controlling our cost structure.

John will speak to our results in greater detail but let me just quickly touch on the highlights. We are pleased with our overall second quarter performance. All of our businesses generated solid revenue growth and our operating margin saw a meaningful year-over-year gain. In our benefit outsourcing business, revenue momentum continued as we saw a nice mix of increased project work and new clients going live and we also provided additional services to existing clients. Margins improved over last year, although they were impacted by several large, complex client projects that went live during the quarter. We also added sales resources to help accelerate our growth.

Human resource BPO’s loss narrowed further thanks to a combination of revenue growth and expense efficiency related to offshoring and infrastructure cost management. Importantly, we restructured one of our outsourcing contracts during the quarter and we are pleased to have been able to extend our relationship with this client on the benefits and consulting side.

In addition, we recognized in the quarter that it is likely that we will terminate services with another client. While our current portfolio appears to be more stable compared to previous quarters, I want to remind everyone that a few sensitive client situations still remain. We will continue to work hard to address these situations in ways that balance the needs of both these clients and our shareholders.

The consulting business delivered good top line growth but margins were somewhat lower than last year, mainly due to investments in our associates and time spent on knowledge development. As I mentioned last call, we are increasing our hiring to meet current and future demand, investing in knowledge building, all while ensuring that our associates are properly compensated.

In terms of our broader cost initiatives, we continue to implement our plans in the areas of global sourcing, operations productivity, technology, overhead, and real estate. As you may have seen in this morning’s release, we took some charges consistent with our stated plan to rationalize our real estate portfolio.

I’ve talked about the fact that M&A is an important component of our growth plans and we made good progress during the quarter. First, we acquired New Bridge Street Consultants in the quarter, one of the leading executive compensation firms in the United Kingdom. This investment expands our global consulting footprint and can help us accelerate regional growth in a critical practice area.

Second, we announced the acquisition of CSI, an Australian consulting firm that specializes in salary and benefit survey data and analytics. This transaction improves our compensation analysis capabilities and strengthens our overall service offering in our fast-growing Asia-Pacific region. This deal closed at the beginning of the third quarter.

Third, just last week we announced an agreement to acquire LCG, a recognized expert in employee absence management. Our clients have expressed interest in the growing area of integrated disability, leave, and absence management, particularly as it contributes to improved workforce productivity.

We are excited to add another critical capability to our complement of HR solutions in our benefit outsourcing business. We expect this deal to close within the next several months. These businesses build our HR services capabilities in key areas and will benefit greatly from Hewitt's distribution capabilities.

Related to M&A, I’d like to remind everyone that during the second quarter, we sold our Cyborg licensed software and payroll business in January as part of our plan to streamline our HR BPO service offering. Given our focus on managed end-to-end payroll, we saw no need to own a software licensing business.

Before I turn the call over to John, I wanted to address the question -- are we seeing any signs of a downturn or recession in our business? As before, the short answer is still no, we’ve seen no impact on our business. This doesn’t mean we are not concerned. We are. We read the papers. We talk to our clients frequently. We closely monitor our metrics for signs of deterioration. We just simply haven’t seen anything to date.

I do want to acknowledge that there are meaningful portions of our business that could be impacted by a recession. A significant portion of our business is tied to overall client employment levels, particularly in benefit outsourcing. Additionally, much of the project revenue component of our outsourcing business is discretionary in nature, as is a notable portion of our consulting business. That being said, we could perhaps be a lagging indicator due to the nature of our business.

Looking at where we stand today, we are pleased with our year-to-date performance and our overall operating fundamentals. With all these factors in mind, we feel positive about the balance of the year and feel good about raising our guidance for fiscal 2008. John will provide more detail in the guidance in just a few minutes.

So with that, I will turn the call over to John.

John J. Park

Thanks, Russ and good morning, everyone. Before I begin, I want to take you through the items that should be adjusted for when looking at our underlying results. Number one, we took $19 million in net pretax charges related to the resolution of an HR BPO contract and the likely termination of another, which Russ mentioned. This is the net of $11 million of revenue recognition and $30 million in expenses. As we mentioned last quarter, many of our BPO contracts include benefits outsourcing services and the March contract resolution impacted both our benefits outsourcing and HR BPO segments.

Second, this year included a $35 million pretax net gain related to the divestiture of the Cyborg business at the end of January.

Third, this year’s results also include an $8 million pretax charge related to the rationalization of our real estate portfolio.

Fourth, recall that last year’s quarter included pretax charges totaling $19 million related to the restructuring of an HR BPO contract, the resolution of a legal dispute, and a non-cash asset impairment. Last year’s quarter also included $4 million in benefits related to comparable Cyborg operations in February and March and an unrelated accrued severance adjustment.

With these in mind, let me start by recapping the highlights of our consolidated results. In the second quarter, consolidated net revenues grew 7% on an underlying basis. This includes $15 million in currency benefit and $4 million in growth from acquisitions. Consolidated operating income excluding one-time items grew 77% to $60 million in the second quarter compared to $34 million last year.

Our effective tax rate was 36.2% for the quarter compared to 41.6% in the second quarter last year. The lower rate is mostly due to our mix of income among various jurisdictions and the recognition of a deferred tax asset. On an underlying basis, our effective tax rate was 39% for the quarter.

Our reported net income for the second quarter increased to $44 million, or $0.43 per diluted share compared with net income of $13 million, or $0.12 per diluted share last year. On a normalized basis, we recorded earnings of $0.37 per diluted share in the second quarter as compared to $0.20 per diluted share last year.

I would like to point out that today’s press release contains an underlying operating income and EPS reconciliation to GAAP schedule, as well as information related to currency translation, acquisition and divestitures, and third-party supplier revenue.

Cash flow from operations was $37 million for the six-month period compared to $78 million in the prior year period. Free cash flow was negative $19 million, which compared to $36 million in the prior six month period. The decrease in free cash flow was driven primarily by higher performance based compensation and other employee benefits paid in the current year for fiscal 2007 performance, increased capital expenditures, and deferred compensation payments related to an acquisition. These items were partially offset by higher net income driven by increased revenue.

To better understand the underlying cash flow generating capabilities of our business, we introduced an adjusted EBITDA metric at the end of fiscal 2007. Adjusted EBITDA for the six-month period increased over $90 million from prior year to $273 million. It is important to note that the majority of the year-over-year six-month improvement came from our HR BPO business.

Capital expenditures increased to $33 million in the second quarter and $57 million for the six-month period versus $21 million and $42 million in the prior year respectively. This increased was driven by technology investments as well as spending related to our real estate rationalization.

Regarding our share repurchase program, we bought back $228 million of stock at an average of $37.60 per share. For the six-month period, we bought back $398 million of stock at an average price of $37.34 per share. As of May 2nd, we have $168 million remaining, which we intend to complete within the authorization period, which ends in January of 2009.

It is worth noting that we have not repurchased any shares since the end of the quarter. Decisions around our repurchase activity were influenced by the illiquidity of our short-term investments, which I’ll address more specifically in just a few minutes.

Now let me provide some color on the performance of our business segments. In benefits outsourcing, second quarter segment revenues grew 4% after adjusting for the previously noted one-time item, acquisitions and currency. The growth was driven primarily by increased project work and participant growth. End user participant counts increased by 6% to $19.6 million.

Excluding one-time items, second quarter benefits margins improved about 240 basis points year over year, mostly due to project revenue growth and infrastructure cost reductions. This was partly offset by higher compensation and client service delivery expenses related to several large and complex clients that when live during the quarter.

We did see a sequential decline in benefits margins. Typically the second quarter is a seasonally softer margin quarter than the first and the first quarter was one where almost everything broke in our favor. Going forward, we are still comfortable with our medium term view of benefit outsourcing margins in the low to mid 20s and we are certainly targeting the upper end of that range.

The HR BPO business reported strong top line growth in the second quarter. Adjusting for one-time items, currency and excluding third-party revenue, segment revenues grew 13% over last year, driven primarily by several contracts that went live, project work, and higher transactional volume.

Excluding one-time items, HR BPO operating loss improved to $32 million compared to a loss of $49 million in the second quarter last year. The improvement reflects strong revenue performance, staffing leverage, and infrastructure savings.

As I noted earlier, a significant part of our strong year-over-year growth in cash earnings came from HR BPO, reflecting not only the operating loss reduction but also lower net deferred implementation costs and revenues.

Turning to our outsourcing sales prospects, in benefits outsourcing we are seeing reasonably strong activity in the marketplace across all services and in both mid and large market segments. We are particularly pleased with our ability to capitalize on the mid-market opportunities through our real-life HR acquisition.

Additionally, our investment in our sales force and the revamping of sales incentive is driving results across our benefits outsourcing business.

Our sales outlook in HR BPO remains unchanged from the first quarter. There are a few new deals in the marketplace. We remain very selective in our pursuit of new opportunities, focusing on a core set of services that we can provide with quality and under the right financial profile.

Now a look at our consulting business, consulting reported solid top line growth at organic constant currency revenue increased 7%. Both talent and organization consulting and health management grew in the low double-digits. Retirement and financial management grew in the low single digits and communication declined by mid-single digits, mostly due to the timing of client projects.

Regionally, North America and Asia-Pacific contributed the most to revenue growth. In North America, we continue to see a healthy market for retirement and financial management services, driven by pension funding legislation and ongoing pension accounting changes. In Asia-Pacific, we continue to be pleased with our very strong growth, driven by demand for our talent and organizational consulting services.

It is important to note that seasonally the second quarter was typically a soft margin period for consulting. This quarter, underlying margins declined by one percentage point compared to last year, mostly due to investments in our people and in knowledge development. Recall that investing in retention productivity and knowledge development has been a key priority in consulting to support long-term top line growth.

Finally for the second quarter, unallocated shared services costs as a percentage of net revenue increased by 40 basis points on an underlying basis, mainly due to some one-time favorabilities in the prior year.

Turning to our outlook for the remainder of the year, as Russ mentioned, we have made good progress in the first half of 2008. Given this progress and improved visibility into the balance of the year, we are raising our full-year guidance. To be clear, this guidance reflects our performance expectations on an underlying basis after excluding unusual items in both fiscal 2008 and 2007.

We now expect the following: total company net revenue growth in the mid to high single digits; underlying operating income of approximately $315 million to $330 million, up from $300 million to $315 million; and underlying diluted earnings per share of $1.85 to $1.95, up from our previous guidance of $1.70 to $1.80.

It is important to note that this guidance includes approximately $0.06 per share of earnings dilution due to the loss of the Cyborg business for the last eight months of fiscal 2008, in addition to some modest incremental dilution from our recent acquisitions.

We are also expecting growth in our adjusted EBITDA metric to slightly lag EPS growth, again on an underlying basis. This guidance also assumes continued execution of our share repurchase program and a normalized effective tax rate of 39%. The guidance excludes unusual items as well as anticipated full year real estate charges of approximately $35 million to $45 million previously communicated and right now are trending towards the upper end of that range.

Before I turn the call back over to Russ, I’d like to comment briefly on some balance sheet items. Given recent issues in the global credit and capital markets, specifically those related to auction rate securities, we’ve taken the following actions.

First, on the balance sheet we’ve reclassified all of our auction rate securities from short-term investments to long-term investments.

Second, we have concluded that we have a reduction in fair value of our auction rate security portfolio due to the current illiquidity of these securities. As a result, we have recorded a temporary fair value adjustment of $4 million resulting in a value of $135 million on our balance sheet. This adjustment is reflected in other comprehensive income, a component of stockholders’ equity on the balance sheet.

We believe this is a temporary market liquidity issue, not a credit quality issue that will not have a meaningful impact on our operations.

Now before we take your questions, I would like to turn the call back to Russ.

Russell P. Fradin

Thanks, John. In summary, overall we had a good second quarter and we are very pleased with our progress in the first half of the year. We’ve developed some good momentum and we see it continuing in the back half of the year. We’ve taken action to reposition our business to better capitalize on growth opportunities. We’ve invested for growth both organically and through acquisitions to drive our more established benefit outsourcing and consulting businesses. We continue to stabilize our HR BPO business as it moves towards an improved long-term financial profile.

Finally, we are working to improve our productivity and cost effectiveness while also emphasizing service quality. While we are encouraged by our progress, we recognize there’s a lot more work to do. We look forward to updating you on our continued progress on future calls. I thank you for joining us today.

Operator, we are ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Ashwin Shirvaikar of Citigroup. Please go ahead.

Ashwin Shirvaikar - Citigroup

Thank you. Appreciate the higher guidance. It is certainly a positive here. My question is going forward, how do you balance further acquisitions and the ongoing buy-back? Can you do both or is it a choice between the two?

Russell P. Fradin

Let me first talk to the acquisitions and let John comment on the buy-back. What I think you’ve seen is that when we look at the acquisition agenda, for the most part we are looking at what I call tuck-in deals. These are smaller deals, very often with private companies that we think can enhance our ability to offer services to our clients, and that’s really the question we ask -- what is it that the clients are looking for in terms of Hewitt and Hewitt's ability to provide services. And very often, the acquisition itself is saving the company money where they would have had to invest to build a product or to hire a group of consultants, like the New Bridge example or the CSI example, or we are getting some intellectual property like the CSI example.

So we are not looking to go crazy here, and that’s why I use the term small tuck-in acquisitions and it creates a nice balance with the internal growth capability. I don’t think given the cash flow generation capability of the company that it really has an impact on the stated buy-back program but I’ll let John comment more specifically on the buy-back program and our cash use in general.

John J. Park

Yes, Ash, I would say that with the cash that we have or we anticipate to be on our balance sheet, our access to credit, there’s no reason to think that we are necessarily facing a trade-off between completing the share repurchase under the current authorization and making acquisitions that are consistent with what we’ve said before, which is small tuck-in acquisition. But obviously the attractiveness of the opportunities will always be weighted against the use of cash and we’ll also keep you informed if at one point we see opportunities that may impact actually our ability to execute the share buy-back but right now, we don’t necessarily see any issues where we are forced to make those trade-offs.

Russell P. Fradin

And that’s a good point, just to elaborate a little bit further on that. The fact that we kind of did these three deals in rapid succession, that’s very unusual. They were opportunistic. One of the deals was really a small deal, even by our standards. And so I wouldn’t expect, if your question is are we going to be doing three a quarter, this was a very unusual quarter and I would say that we are going to take some time to digest at this point as opposed to seeing a whole lot more acquisitions in the back half of the year. So if that helps as well, this was very unusual.

And I also think we are not afraid to do divestitures like you saw with the Cyborg thing, that if we see an asset that we think is a better asset with another own -- and that provided, by the way, some of the cash for some of these acquisitions, which was a good thing.

Ashwin Shirvaikar - Citigroup

Okay. Is there some way you can quantify the forward benefits or timing of some these charges you are taking, particularly the real estate and some of the other restructuring?

John J. Park

You know, Ashwin, when we originally talked about the real estate charges, we had said that the gross savings we estimate on these real estate charges is about half on a full run-rate basis of the charges. There is no reason to change that expectation but again, that’s a gross savings. There’s some investment that we certainly anticipate utilizing those savings against.

Ashwin Shirvaikar - Citigroup

Okay, great. Congratulations.

Operator

Thank you. And the next question comes from the line of Bhavan Suri of William Blair & Company. Please go ahead.

Bhavan Suri - William Blair & Company

Great quarter. Just have a couple of quick questions for you guys; on the consulting business, especially around retirement and the financial side, much of that seems to be driven by macro changes, the accounting changes, the pension protection act, things like that. How long have you guys thought about how much -- how long do you expect that to keep driving growth in the United States in that business? Could you provide a little color around how you think about that?

Russell P. Fradin

I was going to say it’s a question we ask ourselves every day, both at the corporate level and in the consulting business. And I’d say from our standpoint, we’re very comfortable that there is certainly no cliff here. We see these services being required for a long period of time. Did the pension protection act produce some extra juice and those sort of things that helped accelerate the growth? Absolutely, but we do see this as an area that is going to require the kinds of services we provide for a long period of time, and so I see it as a very long tail item.

Part of what you are seeing and part of the reason for the reduced margins in the consulting business, and this is very important to understand, is we are investing very heavily now in practice areas that are related to the normal actuarial valuations that we believe have a much longer life and additional growth. And you will see us over the next six to 12 months making announcements and offering services in the marketplace that we believe are going to continue the growth that you would expect in these businesses. So we are not waiting for the pension plans to run out. We are taking proactive actions to get into closely related practice areas that are going to extend that growth for a long period of time, in our belief, or we wouldn’t be making the investments.

Bhavan Suri - William Blair & Company

Sure, sure. And then I guess, Russ, just as a quick follow-up; how do you think of the health management opportunity? Obviously it’s been a very nice kind of growth opportunity but with potential political changes coming along and some change happening in that space, how do you think we should think about that going forward?

Russell P. Fradin

Well, again it’s one of those areas that we believe is going to offer a whole lot of growth for the future and in many ways, if you look out in a five to 10 year timeframe as opposed to a one to two year timeframe, may be one of those offsets to declining actuarial work. But the one great thing about our business is change is almost always good and so I’m not going to give you my commentary on the democrats versus the republicans on this one, or Clinton versus Obama. I have my personal views but what I will tell you is any level of change in the health management area will end up being a very good thing for us and the others that compete in this space and we are very actively now investing both in hiring more people and in the practice knowledge in health management to make sure that we remain a leader in that whole area.

Bhavan Suri - William Blair & Company

Great. Turning to the HR BPO business, you said there were still a couple of contracts that were still in a sensitive area. I remember the last time we talked it was probably in that less than five contracts range and I was wondering how we could think of quantifying the ones that are sensitive or when we might think of the business becoming break-even.

Russell P. Fradin

I am actually glad you asked that question and I’ll let John provide his own commentary as well, but I guess one of the issues coming relatively new into a job, you learn some things. And one of the things that I think we’ve learned is this issue of sensitive contracts and all that is not a static pool -- meaning we’ve had some clients move in and move out of that designation over time, so I wouldn’t view it the way we originally did saying there’s X amount of them and as soon as we work them off, all will be good. We’ve learned to let more and the good news here is you are right -- the number of sensitive contracts is dramatically lower than 18 months ago and that’s the good news. But it is apparent that over time, these are very complex beasts and some situations will move in and out of there.

By the way, sometimes having nothing to do with the service we are providing, meaning companies get acquired or companies go private or things like that happen that affects the nature of the contract and what the client is looking for, even when we are providing good service.

So I’d say the overall message that we want you to hear is that we are getting the book of business to a much better place and it is much more stable than it was 18 months ago and there aren’t eight or more of these contracts which are in flux and causing us great pain but there are still some sensitive situations that remain.

John J. Park

What I would add, Russ, is that on your question regarding anticipated break-even, we are still doing a lot of work around not only the infrastructure costs that we are taking out that directly the HR BPO business but also the variety of scenarios that could play out around all of the contracts that are currently in some form or restructuring. And throwing out a number on break-even right now would probably be premature. What I will tell you is that we are very pleased with the reduction in not only the operating loss but the gains in adjusted EBITDA or cash earnings, and our future anticipated reductions in terms of the loss of that business will be reflected in the guidance that we put out but we are very pleased to see the progress that we are making in terms of our ability to reduce the operating loss of the business.

Bhavan Suri - William Blair & Company

Great. Thanks, John. Great quarter, guys.

Operator

(Operator Instructions) The next question comes from the line of Tien-tsin Huang, JP Morgan. Please go ahead.

Tien-tsin Huang - JP Morgan

Thanks. One question -- maybe I can ask it a few ways. Project work first; you’ve had a couple of quarters of pretty strong project work in outsourcing. Can you help quantify the contribution there and how sustainable it is? And the second, I was hoping to get a feel for the raised guidance. Can you help rank the items that drove the increase in your guidance? Thanks.

John J. Park

We do not want to disclose the specific amount of project work. What I will tell you is that the vast majority of the revenue that we generate in our human resource outsourcing business is recurring in nature, it’s contractual. However, obviously the piece that is much more volatile is the project work piece and as we said earlier, we think that the fact that the project work is at a healthy pace over the last couple of quarters is really reflective of the fact that we are doing good work for our clients, number one. You don’t get project work if your underlying operations are suffering, and particularly in the HR BPO side of the business. The fact that clients are feeling better about their service levels we believe is a factor in driving the higher project work.

And secondly, it’s also an indication that there’s a lot of activity going on in the marketplace. Even though the economy may be soft, there is a lot of activity going around in terms of clients wanting to look at different ways to run their benefits administrative program. So we will just keep it at that. It is meaningful. We’ll try to highlight the priority of magnitude, which we often do when we talk about the causes that drive revenue within any segment, but we are going to leave it at that.

Russell P. Fradin

Just a couple of comments on the question of the project work, and that is that remember a lot of this work, we use the term project work, is we are serving for the most part larger companies that are continually changing and updating their benefit programs. And they change them in good economic times to enhance the benefits for their employees, and in leaner times they also change them sometimes to reduce the nature of the benefits available. And that’s what the project work is, meaning it’s okay, I want to add options or reduce options to my health program or my retirement program or things like that.

And second, remember that participant count is by far the vast majority of what we get paid on. So I don’t want to dismiss that without disclosing how much was each. Remember the vast majority of what we are getting paid for is in fact the participant count.

Regarding the question on guidance, I would have to say that the primary driver behind our improved outlook is simply better visibility into the second half. We certainly didn’t see anything that was shockingly different in the second quarter than what we had anticipated in the first quarter, but as we’ve talked about these are interesting times. These are volatile times in the economy and we just have improved visibility into our second half performance.

Operator

Thank you. The next question comes from the line of Mark Marcon of Robert W. Baird. Please go ahead.

Mark Marcon - Robert W. Baird

Good morning and continued nice progress. I’ve got questions that I’m going to try to weave together -- looking at the overall outsourcing area, two things -- one, within benefits outsourcing, it looks like you are seeing some nice improvement with regard to the organic revenue growth rate, even when we strip out the current acquisitions. And I’m wondering if you can give us a little bit of color in terms of what that is due to -- is it because your organization has become more focused on selling the traditional benefits administration outsourcing while you’ve de-emphasized HR BPO? Is it because of the market dynamics where both vendors as well as clients seem to be pulling back? Or maybe just a combination of all of the above?

And then secondly on the HR BPO side, you mentioned that there’s one more client that is -- that might be discontinued. Do you anticipate that there are others above and beyond that, or do you think things will stabilize after these two? Thank you.

Russell P. Fradin

Let me speak to the first question -- clearly we are putting a greater emphasis on growth in the benefit outsourcing business, and you heard me mention at the beginning of the call that we have significantly added to the number of sales people. We’ve put in place different compensation plans. We have some very strong management overseeing that area and so it’s a real point of emphasis for us to be able to do that.

When you look at the growth profile, you grow A by adding new clients and you can tell by the participant count and the substantial jump this quarter that we are clearly doing that. And so that feels pretty good.

Second, you grow by selling additional services to your current client base and so when you look further out in the future, you know, two, three, four, five years, the reason you make acquisitions like LCG is that we believe our clients will benefit from additional services like absent management and leaves management. And so we are putting greater emphasis on cross-selling some new services and some services that have been around for a while that we hadn’t emphasized quite as much.

Third, interestingly enough you grow the benefit outsourcing business by reducing your losses of clients and so the reason why we are so focused on the quality we provide in that business and investing in our quality in that business is that the growth is heavily, heavily dependent on not losing clients and on make sure that our client base is what we call referenceable, so when a new client looks to come on board the current clients will speak highly of us.

And the last thing that I would add is that I do think that our competitive position in the benefit outsourcing business as compared to 18 months ago is strong. We are feeling stronger. We’ve seen -- I don’t want to say some hiccups but we’ve seen a little bit of weakness in some of our competitors and that has certainly helped us.

So a whole bunch of factors, but you are right -- it really is a headline issue for us.

There was an add-on to your question and now I can’t remember it.

Mark Marcon - Robert W. Baird

It was on HR BPO.

John J. Park

On HR BPO, obviously we are pleased with the resolution that we had previously announced and we felt that we were far enough along in terms of resolving another sensitive contract that we provided for in the quarter. As it relates to specifically trying to predict another event that may occur in the next quarter or two, I think it’s, as Russ said earlier, we are discovering that there is a lot of change in this space and some of that change is not entirely due to anything that we do. And so we don’t think it’s necessarily prudent to try to predict whether or not there’s going to be other major contract resolutions within any timeframe.

But suffice it to say, it’s something that we are working on across several contracts within our portfolio where we think it could be of mutual benefit for both the customer and ourselves if we restructure some more contracts.

Russell P. Fradin

And in terms of anticipating where the profile of that business is going in the next one to two years, which I presume is part of what you are trying to get at here, I presume you’ve gleaned from our comments that in some areas we’ve agreed to transition services with some clients and as you can tell from John’s comments, the sales pipeline is slower in that business. So if you look at continuing to bring clients lives and transitioning services, again I wouldn’t expect the growth profile of that business to remain at the level you are seeing it at right now, if that’s your question.

Mark Marcon - Robert W. Baird

I was just trying -- well, I mean I know that you are trying to determine what the long-term profile is because it’s a dynamic situation in that you also have other competitors within the space that are having issues. It’s possible that a number of other players end up dropping out of this space, in which case the space may end up actually being an economically attractive one.

Russell P. Fradin

I was going to say, you and I think alike. It’s really music to my ears because we feel like we’ve gone through some painful times here and I really do believe that for the commitments we are making and negotiating now, they will be very good commitments for us, given all that we’ve learned. And if the market moves in our direction, boy, that would only be further upside to what we are thinking about now. So we want to be cautious. We don’t want to overstep our bounds again but I tell you it’s an area that you’re right -- it could have real long-term benefit for us.

Mark Marcon - Robert W. Baird

Thank you.

Operator

Thank you. The next question comes from the line of Shlomo Rosenbaum of Stifel Nicolaus. Please go ahead.

Shlomo Rosenbaum - Stifel Nicolaus

Thank you very much for taking my questions. You guys have done a good job and raised EPS guidance. One thing that I wanted to understand a little bit better, just on the numbers, was a little bit how to think about the free cash flow. I think this was the first time looking back in my model that I could see two quarters of sequential negative free cash flow. Historically you’ve generated very good free cash flow. How should we think about that through the year?

And if I could also just sneak in another type of housekeeping question, I wanted to ask how much -- the various acquisitions that you’ve announced fiscal year to date, how much annual revenue are we talking about here? Thanks.

John J. Park

On your first question regarding free cash flow, let me first remind everyone on that call that seasonally, we are very much skewed towards the second half of the year in terms of our cash flow generation. It has to do with the seasonal pattern of our business and also the fact that incentive compensation is a significant amount of expense for us, and that occurs in the first quarter.

You are right in that this year our free cash flow has been somewhat behind last year specifically, and that’s being driven by the fact that frankly, we had a good year last year and we paid out significant bonuses related to that in this fiscal year, from a cash view point for last year’s performance. And secondly, there’s a lot of activity going on in terms of capital expenditures where we are fairly comfortable now that there’s key areas that have tremendous payback potential, particularly in some technology that enhances our client’s experience and also some internal technology that will significantly improve our productivity. And then also you are seeing some capital expenditures related to the real estate restructurings that are going on.

All of that being said, we feel comfortable that on a full-year basis, this will be another year where we generate a very healthy level of free cash flow despite all of the investments that we are going through. And while we do not specifically guide to free cash flow, we’ve said in the past that this is a business that on a sustainable basis, given -- excluding anything really unusual that might happen, free cash flow will be nicely in excess of net income and there’s no reason to believe that this won’t be another year where we won’t generate a nice excess in free cash flow above our net income expectations.

Shlomo Rosenbaum - Stifel Nicolaus

Thanks, and the second question just on the annualized revenue you are adding with the acquisitions you’ve announced this year?

John J. Park

We’re not going to be specific on that but I want to say that -- I want to reiterate again these are relatively small tuck-in acquisitions that hold a tremendous amount of strategic value and that provide very robust technology platforms for us. So near-term, we didn’t make these acquisitions to necessarily really juice our revenue growth rate. It’s going to have some impact but these are businesses that two to three years down the line, you know, we think have the potential to be a meaningful part of not only growth within those acquired businesses but benefits that will also spread to our core businesses.

So I don’t necessarily think that in the near-term you should be thinking of adjusting your model so that there’s a significant impact. Perhaps just a modest impact in terms of our revenue growth.

Shlomo Rosenbaum - Stifel Nicolaus

Thanks.

Operator

Thank you. The next question comes from the line of Todd Van Fleet of First Analysis. Please go ahead.

Todd Van Fleet - First Analysis

Good morning, guys. I wanted to see if I could get my arms around where you are at on the consulting business at this stage. I think the margin in Q2 was lower than what we would have expected, even given the seasonally soft quarter. John, I think you had that maybe 100 basis points of that compression year over year was from some investments that you’ve been making in personnel. So I’m wondering, the company’s philosophy at this stage in growing the consulting business just generally speaking, are you recruiting for the most part kind of rainmakers in various portions of the business so that you wouldn’t see necessarily a significant lag between the time you bring people on board and the time you start realizing some significant revenue generation from those new headcount additions?

And then in the context of the margin depression as well in Q2, I’m wondering how much of that is due to the bonus accrual methodology. You had talked about switching from kind of a lumpy accrual approach to more of a straight-lining over the course of the year. I’m just trying to get a sense for what the impact is of both of those aspects on the consulting margin here and expected margin moving ahead. Thanks.

Russell P. Fradin

Let me mention one factor that you didn’t raise, which is important in thinking about our consulting business, and that is we are very focused on staff retention and making sure that we minimize our turnover because if you have good staff and they both have client relationships and the capability to do the work, the lower your turnover the less you are going to be -- and I will tell you that in this quarter, one of the good news things we didn’t talk about is that our turnover in consulting was the most dramatic drop I think we’ve ever seen. And so our turnover was very low in this, and that’s part of what drove the compensation expense being higher, in addition to the things you’re talking about of adding staff and gosh, if we can find the rainmakers, that would be terrific. We are focused on people that can do quality work and usually work finds them, and that’s always been my belief in consulting.

But I also just wanted to mention, since people hadn’t asked about it. That the turnover is dramatically lower in the consulting business than it has been in the past.

In terms of the specific margin point decline, let me ask John to --

John J. Park

Yeah, let me make a few comments. Good questions, Todd. First of all, I do want to reemphasize that the second quarter is seasonally a soft quarter from a margin point of view for consulting. And a hundred basis point decline for us is not something that we are overly concerned about. I think you can have normal fluctuations in margin given patterns of hiring, patterns of specific project spend, and sometimes timing of revenue. And I think it’s a combination of all of those things that led to a modest decline in margin year over year.

But to think about us being in a mode where we are probably investing more than reaping the benefits of investments in the past in consulting at this time period is probably accurate, and particularly as it relates to the staffing, bringing on new people, making investments in knowledge management, some of the transformational or development work on our services that Russ mentioned a few minutes ago, those are definitely expenses that will have a lagging benefit.

So yes, clearly we think that there are better times ahead in terms of consulting margins. In fact, there is no reason to believe that we are not going to realize the medium term margin targets that we had put out earlier around mid-teens to perhaps upper teens as we start reaping the benefits of some of the investments that we are making at this point.

Finally, to address another element of your question, you asked about bonus methodology; no, the bonus methodology did not have a meaningful impact in terms of historical comparisons on margins this quarter.

Todd Van Fleet - First Analysis

Thanks. John, if I could sneak another one in and get you to identify whereabouts in the P&L the one-time items are showing up, such as the real estate charge and the HR BPO restructuring charge?

John J. Park

Those charges are spread throughout the P&L, Todd, and rather than go through the specifics of the accounting right now, perhaps if you are really interested in that, that’s something that you can follow-up on.

Todd Van Fleet - First Analysis

Thanks.

Operator

Thank you. The next question comes from the line of Cynthia Houlton of RBC Capital Markets. Please go ahead.

Cynthia Houlton - RBC Capital Markets

Just a question on the hiring and firing trends within your benefits; are you seeing it -- I mean, obviously your overall growth rate has shown -- you said some addition of new clients, but could you talk about kind of within your customer base what you are seeing on hiring and firing trends within your core mid markets or core benefits base?

Russell P. Fradin

Do you mean in terms of participant count? Is that the question?

Cynthia Houlton - RBC Capital Markets

Yeah.

Russell P. Fradin

No substantial changes in the trending -- meaning we certainly didn’t see any declines, if that’s the question. We saw steady eddy as she goes and the bulk of the increase was actually adding new clients as opposed to huge growth. And again, remember in that overall participant count, there’s M&A activity is reflected, so sometimes somebody buys a company that’s a client, sometimes a company gets divested but it all flows through. There was nothing unusual in this quarter, other than the adding of the new clients.

Cynthia Houlton - RBC Capital Markets

Okay. Thank you.

Operator

Thank you. The next question comes from the line of Liz Grausam of Goldman Sachs. Please go ahead.

Liz Grausam - Goldman Sachs

Thank you. I just want to talk a little bit more about your HR BPO contract restructuring renewals; first, are there any comment elements you can share with us, for those clients that chose through restructuring stay with you versus those clients that have chosen to move on and you guys will part ways going forward. And on the second part on those clients that are going to be deconverting from parts of your HR BPO practice, can you share with us the impact, both in timing as to when we should expect some of the revenue impact to hit but also will those clients moving away, will that actually be accretive to your margin in that your operating loss will decline as a result of those contracts deconverting? Thank you.

Russell P. Fradin

In terms of the first question, I think it is fair to say that if you look at the trending of where in essence we’ve restructured a contract and everyone knows this quarter we had one where in essence, we’re terminating the HR BPO services, but we are continuing the benefits and the consulting for the long-term. And we’ve had several now where we are very pleased that that’s been the outcome. And I’d say these are clients that we’ve had longstanding relationships with where there’s been some tough negotiating but a meeting of the minds in terms of where they want to head and how we can help them get there.

In terms of, for example, the likely termination that we are anticipating and others that might trend in that direction, for the most part you are looking at companies that are undergoing some sort of restructuring. So in this case, it was a company that went private in a private equity transaction, where there are others that are in the retail industry and are having difficult times -- those are the ones where frankly, even if the contract had not been difficult for both of us, it’s unclear whether given the change in control or other things like that, whether the relationship would have continued anyway.

So that’s been the primary differentiator of, you know, in my words, who’s stayed and who’s gone to date.

In terms of when we will see the effects of that, I’ll look at John and see if he wants to comment on that.

John J. Park

Well, I think the first part of that question was around the revenue drop-off and while I don’t want to comment on any specific client situations, recognize that these are not in general simple relationships. These are complex relationships that have quite a bit of operational implementation complexity related to them. So in general, when you hear an announcement, you are not going to see the revenue fall off next quarter. In most cases it’s I would say a minimum a year that there is some type of an ongoing relationship and in many cases, it’s actually going to be longer than that. You know, once the decision is made, it really is almost a reverse of the implementation and we’ve talked about how long some of these implementations can take on the HR BPO side.

And as it relates to your question on impact on margins, certainly we are targeting the restructuring of these relationships in ways that enhance our margin. I mean, we think NPV first but the natural outcome of that is that generally in most if not all of these cases, you are going to see an enhancement in margin once we are past the decommissioning stage.

Liz Grausam - Goldman Sachs

Thank you.

Operator

Thank you. The final question comes from the line of Jason Kupferberg of UBS. Please go ahead.

Jason Kupferberg - UBS

Thanks for squeezing me in, guys. Just a clarification to start -- I’m trying to sort a bunch of these one-time items but the HR BPO charges are in the guidance or are not in the guidance?

John J. Park

The charges are excluded from the guidance.

Jason Kupferberg - UBS

The HR BPO charges are excluded? Okay. That’s what I thought. I just wanted to confirm that. And then, coming back to the balance sheet, obviously the buy-back program has been one of the investment highlights behind the stock for a period of time and there is not a lot left on the current authorization. I guess you have at least some temporary impairment related to the auction rate security. Can you give us some thoughts on whether or not there could be some additional buy-back authorization introduced, perhaps even prior to January of ’09? I mean, there’s not a heck of a lot left on the current plan to carry through for whatever that would be, you know, nine months out from now.

John J. Park

I obviously don’t want to comment on specifics here, Jason, but certainly we do have a substantial amount that’s left to finish and no, we have not ruled out further share repurchase at some point in the future, but I obviously want to be careful about comment on anything more specific than that.

Jason Kupferberg - UBS

Okay, and then just a last one on free cash flow -- can’t help but ask a little bit more on that. You mentioned it should be comfortably or nicely in excess of net income this year. Which net income number is that? Is that the adjusted net income number you were referring to?

John J. Park

Yes.

Jason Kupferberg - UBS

Okay, and the reasons why we are kind of weak year-to-date here? I mean, are there any one-time things that you would call out or is this more timing related?

John J. Park

Well, there’s a variety of factors. You know, I did talk about the incentive payout, which was a significant part of this. Higher CapEx overall. There were also some things related to some of the acquisitions that we’ve made where we’ve held back from deferred compensation, which actually comes out of free cash flow. But I would say that the primary drivers are around the expense, or the actual cash outflow of the higher expense related to incentive comp from prior year.

Jason Kupferberg - UBS

Okay, and then you still have some investments to make in benefits outsourcing, I’m assuming? I didn’t hear that called out as a source of the quarter-over-quarter margin decline in benefits, but that was a theme you were talking about earlier in the year, reinvesting in the business and having that being more back-end loaded. Is that still the plan?

John J. Park

Absolutely. In fact, I would say that that’s one of the top priorities for the business, is to invest, particularly as it relates to continuing the top line momentum in benefits into the future years.

Jason Kupferberg - UBS

Okay. Thank you.

Russell P. Fradin

I want to thank everyone for joining us today and we look forward to the quarter ahead.

Operator

Thank you. And that does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference service. You may now disconnect.

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