Hewitt Associates, Inc. F3Q08 (Qtr End 06/30/08) Earnings Call Transcript

Hewitt Associates, Inc. (HEW)

F3Q08 Earnings Call

August 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

Todd Van Fleet - First Analysis

Shlomo Rosenbaum - Stifel Nicolaus

Tien-tsin Huang – JP Morgan

Mark Marcon – Robert W. Baird

Jason Kupferberg – UBS

[Scott Sharer – Globus Capital]

Bhavar Suri – William Blair & Company

Presentation

Operator

Welcome to the Hewitt Associates fiscal 2008 third quarter earnings conference call. (Operator Instructions) At this time I’d like to turn the conference over to Sean McHugh.

Sean McHugh

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’re referring to net revenues or revenues before reimbursements. And during this call we will discuss underlying operating income, net 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 of our web site to obtain a reconciliation of US GAAP to these measures.

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’ll turn it over to Russ.

Russell P. Fradin

I’m pleased to say we had another good quarter and we made important progress in many areas. In particular I want to highlight four points. First, demand for our services remains strong. Second, we’ve taken a number of actions to invest in future growth and strengthen our leadership team. Third, we’re seeing meaningful improvement in our HRBPO business. Fourth, we are in the process of securing $0.5 billion of new financing that will give us real flexibility in these turbulent times. Let me spend a minute on each of these points.

First, in terms of the market we continue to see strong demand and good sales results in pipelines. This is something we track pretty closely and we’re not seeing a meaningful impact on our demand. This is true across all geographies. Of course, with the current economic backdrop we’re keeping a sharp eye on any developments in this area and I want you to know that there are areas of our business that could be susceptible to a downturn. We have not seen any real indications at this point. Our revenue growth was quite healthy this quarter. Consulting growth was positive mainly due to demand for retirement and financial management services in Europe and North America. Benefit outsourcing also grew at a decent pace on higher participant counts and increased project work. Our pipelines remain healthy. Just remember that given the complex contracting and implementation cycles this revenue won’t appear in our financial results for at least 12 to 18 months.

Second, we’re making significant investments to grow the business. Our recent acquisitions are part of this plan and also contributed to our top line growth. New Bridge Street, UKs leading executive compensation firm, and CSI a compensation analytic specialist in Australia together added about 300 basis points to our overall consulting growth. Real Life HR which we renamed Core Benefits Administration provides health and welfare outsourcing to the middle market and added about 100 basis points to our benefit outsourcing growth. Our acquisition of LCG a leading [leaves] management firm was completed July 1 and will add to our future growth.

We’re also making internal investments, restructuring our costs and strengthening our leadership team. The practical implication of these steps resulted in a dip in benefit outsourcing margins though still well within our medium term guidance. Our investment in benefits included bringing several large and complex clients live this year and these large contracts are in the early stages of margin maturity curves that improve over time.

In consulting we took some restructuring actions to better align the business for future growth and invest in the build-out of new practices. And we’ve had severance for the leadership change and other personnel actions we’ve taken. Last week we named co-leaders of our consulting business. Eric Fiedler most recently led the Asia Pacific consulting business, our fastest growing region with leading market positions in the growing markets of China and India. Yvan Legris most recently led our UK consulting and benefit outsourcing operations, another fast growing business that is one of Hewitt’s real crown jewels. These two highly capable executives have demonstrated great leadership and results during their careers and I’m confident that they will lead our already successful consulting business to the next level of performance.

Third, we’re really pleased with the progress in HRBPO. It’s year-over-year operating loss improved for a fifth consecutive quarter due to our success in renegotiating some contracts in our cost management efforts. With most of the sensitive contract situations resolved, the overall portfolio situation continues to improve and we intend to address the few sensitive situations that remain. While we see the growth prospects in this business as more modest than once envisioned, we feel real good about our progress to date.

Finally, we’re about to close some financing in order to continue our progress in improving our capital structure and supporting our growth agenda. Specifically we’re in the process of arranging $500 million of new debt financing. This will give us real flexibility in these challenging economic times to both look at appropriate acquisitions and improve our capital structure. Our finance team deserves a lot of credit for getting this done under current market conditions.

With that I will turn the call over to John to provide more detail on our third quarter results, the financing and the outlook for the balance of the fiscal year.

John J. Park

In the third quarter reported consolidated net revenues grew 7%. Adjusting for currency acquisitions and divestitures and third party revenue, revenues increased 6%. Reported consolidated operating income grew 12% to $81 million in the third quarter compared to $72 million last year. Our underlying operating income grew 4% to $83 million in the third quarter compared to $81 million last year. These results include $9 million in net severance and $4 million in net litigation charges but exclude the following one-time items. In the quarter a $2 million pre-tax charge related to the rationalization of our real estate portfolio; in last year’s quarter $12 million in pre-tax charges related to severance mostly in our HRBPO business; the restructuring of an HRBPO contract; and the resolution of a legal dispute. Last year’s underlying results also exclude a favorable pre-tax contribution of $3 million related to our Cyborg operations which we sold in the second quarter of this year.

Our effective tax rate was 43.5% for the quarter compared to 36.6% in the third quarter last year. The higher rate is principally due to discreet items in both years. On an underlying basis our effective tax rate was 39% for the quarter.

Our reported net income for the third quarter remained relatively flat at $48 million or $0.48 per diluted share compared with net income of $48 million or $0.43 per diluted share last year. Adjusting for the one-time items and normalizing the tax rates, we recorded underlying earnings of $0.53 per diluted share in the third quarter as compared to $0.46 per diluted share last year. This is an increase of 16%.

Cash flow from operations was $161 million for the nine-month period compared to $258 million in the prior year period. Free cash flow was $81 million which compared to $195 million in the prior nine-month period. The decrease in the free cash flow was driven primarily by higher performance-based compensations paid in the current year for fiscal 2007 performance, higher tax payments and increased receivables. Payments related to previously disclosed HRBPO client settlements also contributed to the decline. These items were partially offset by the higher net income.

Capital expenditures increased to $23 million in the third quarter and $80 million for the nine month period versus $21 million and $63 million in the prior year respectively. The year-to-date increase was driven by technology investments and spending related to our real estate rationalization. Adjusted EBITDA for the nine month period increased by $89 million over the prior year to $395 million based almost entirely on gains in our HRBPO business.

Regarding our share repurchase program, during the third quarter we bought back $13 million of stock at an average of $38.39 per share. From the end of the quarter to yesterday’s market close, we bought back an additional $72 million of stock at an average price of $36.36 per share leaving us with $83 million remaining on the existing $750 million program.

Now let me provide you some color on the performance of our business segments. Benefits outsourcing reported third quarter segment revenues grew 5%. Adjusting for acquisitions and currency, revenues increased 3%. Growth was driven primarily by new client participant growth and increased project work partially offset by client losses. End user participant accounts increased by 9% to $19.7 million. Reported third quarter benefits outsourcing margins declined approximately 170 basis points to 24.8%. Excluding one-time items third quarter underlying benefit outsourcing margins declined 215 basis points to 25.2% mostly due to higher compensation and client service delivery expenses related to several large and complex clients that recently went live, higher provisions for legal settlements, and higher performance based compensation. These higher costs were partially offset by a notable improvement in our European operations as that business has stabilized nicely.

In HRBPO reported revenue declined 5%. However, when adjusting for one-time items, currency and excluding third party revenue, segment revenues grew 4% over last year. Growth was driven primarily by several contracts that went live partially offset by planned service reductions with certain clients and favorable one-time adjustments in the prior year. Reported HRBPO segment loss was $16 million for the quarter compared to a loss of $37 million last year. Excluding one-time items the underlying operating loss improved to $16 million compared to a loss of $33 million in the third quarter last year. The improvement reflects staffing leverage and infrastructure savings related to our lean productivity program and the successful renegotiation of some contracts. The business continues to stabilize and as a result we expect to share more specific profitability outlook during our fourth quarter call.

Let me make a few comments on our outsourcing sales prospects. In benefits outsourcing we’re seeing good activity across the market place and our pipeline remains strong. In particular we’re seeing strong demand for our new core benefits administration offering which is the branding for our middle market platform based on our acquisition of Real Life HR last year. This business continues to perform above our expectations and we are excited about its growth prospects. The LCG leaves administration pipeline was very solid at closing and we have supplemented it since then. With respect to HRBPO, while there are a few new deals in the market place, we are seeing a slight uptick in activity. Some companies are beginning to explore smaller bundles of services which is squarely in line with our strategy.

Now a look at our consulting business. Consulting reported strong top line growth with reported net revenues increasing by 18%. Excluding currency revenues grew 15% reflecting organic growth of 12% and another 3% of growth from acquisitions. From a practice perspective retirement and financial management grew in the mid-teens, talent and organization consulting grew in the low teens, health management grew modestly, and communication declined in the low single digits.

Regionally Europe and North America counted for most of the overall segment revenue growth. In Europe and North America we continue to see a healthy market for retirement and financial management services driven by legislative and accounting changes and our expansion of services to current clients, new client wins and project work. Our strong growth in Asia Pacific continued again this quarter driven by demand for our talent and organizational consulting services and made a notable contribution to the year-over-year segment increase.

Reported third quarter consulting margin was 11.5% and excluding one-time items underlying margin was 11.7% which was a decline of about 500 basis points from last year. Reported and underlying third quarter consulting margins clearly fell below our medium term targets primarily due to higher compensation costs. Included in that is $6 million in severance charges related to the leadership change and other restructuring activities. We also continued our investments to build out new practices during the quarter. Overall we remain comfortable with our medium margin targets of mid to high teens.

Finally for the third quarter unallocated shared services costs as a percentage of net revenues increased slightly to 6.3% on both a reported and underlying basis mainly due to higher performance based compensation, legal fees, and the timing of some one-time favorabilities of the prior year.

Turning to our outlook for the remainder of the year, we are updating our full year guidance based on the good progress we’ve made through the first three quarters of fiscal 2008. This guidance reflects our performance expectations on an underlying basis after excluding the previously disclosed unusual items in both fiscal 2008 and 2007. We now anticipate the following: Total company net revenue growth in the mid to high single digits, underlying operating income of approximately $320 million to $335 million, and underlying diluted earnings per share of $1.90 to $2.00 with the higher likelihood of falling in the upper half of that range. We see our solid revenue growth trends continuing for the balance of the year. The broad EPS guidance range for the fourth quarter gives us flexibility in the timing of our restructuring actions and reflects our desire to remain cautious given the current economic backdrop. We’re also expecting strong growth in our adjusted EBITDA metric but slightly lagging diluted EPS growth again on an underlying basis. As a reminder of how much progress we’ve made in the course of this year, 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 and some modest incremental dilution from our recent acquisitions as well as a significant amount of severance.

This guidance also assumes continued execution of our share repurchase program and a normalized effective tax rate of 39%. It also reflects the likelihood of additional severance charges related to continued work force restructuring. Our guidance excludes the previously disclosed unusual items as well as anticipated full year real estate charges of approximately $35 million to $45 million as previously communicated. Right now we’re trending towards the upper end of that range. I’ll remind everyone that year to date we’ve taken $10 million in real estate charges leaving a balance of $25 million to $35 million in the fourth quarter.

Before I turn the call back over to Russ, I’d like to give you some more color on our recent financing activities. As Russ mentioned, later this month we intend to close on two financing transactions totaling $500 million. The financing will consist of a $270 million five-year syndicated senior unsecured term loan and $230 million in privately placed senior unsecured notes with most maturing in seven years and some maturing in 10. The notes are not being offered publicly and will not be registered. The weighted average pre-tax cost of financing is expected to be approximately 6%. The financing will give us the flexibility to optimize our debt, pursue focused M&A opportunities as they arise, and improve our capital structure.

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

Russell P. Fradin

In summary, we had a good overall third quarter and we’re very pleased with our progress this year. We’ve developed some nice momentum and we see it continuing through the fourth quarter. Our four strategic priorities of keeping clients first, creating a rewarding work experience for our associates, growing with intention, and getting lean remain unchanged and will continue to guide our future actions. Our plans for the balance of 2008 are intended to position us for continued success in fiscal 2009 and beyond. We’re encouraged by our progress and we plan on continuing the hard work required to achieve our objectives.

At this point we’re ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Ashwin Shirvaikar - Citigroup.

Ashwin Shirvaikar - Citigroup

I can understand that given the turnaround situation every quarter you have unusual charges of severance and so on. When will you be past this call it turnaround and then at that point what levels of segment profitability do you expect?

John J. Park

I think there are two parts to that question. One is you’re asking about some of the restructuring actions and when those might potentially abate. What I will tell you is obviously we are going through changes in our organization. I think we will always be going through changes in terms of our organization. To what extent it’s difficult to comment on. I think we’re dealing with a business in a business environment that’s always changing. So I don’t’ want to tell you that this is it or next quarter will be it. All I can tell you is that we’ll continue to make the right decisions for the business and we’ll be very transparent in terms of what we’re doing and what it’s costing us within the business.

In terms of margins for the business, we do feel like we’re being consistent here and we’re comfortable with the medium targets that we’ve laid out for our more established businesses and we’re very pleased with the amount of momentum that we have in reducing the loss in the HRBPO business. And as we signaled just a few minutes ago I think we’ll be ready to talk about some potentially longer term targets on the HRBPO business in next quarter’s call.

Russell P. Fradin

The other thing that’s worth noting is a change in reporting that maybe was a little bit subtle this time. And that is if you notice, when we were restructuring the HRBPO business and it was clear that that was troublesome and had some contracts to renegotiate and all that, we did call those out as more unusual one-time items. If you notice this time around, to the extent that for example we’re taking large severance charges in the consulting business, we’re not “normalizing” for that. We are disclosing it because we think it’s important information. I don’t expect to be changing business unit presidents very often on the one hand. On the other hand, from the standpoint of “normalizing” for that, we’re not asking for any free passes or special consideration based on that. So we’re just going to report it as business as usual if it’s within those kinds of operations and it’s not part of some special restructuring like the real estate or the HRBPO business.

Ashwin Shirvaikar - Citigroup

As I look at your cash flow performance, you have pretty good EBITDA but seem to be hurt by deferred contract costs and other long-term liabilities. Can you go into some detail into what those are and to what extent are those a timing element? In other words, at what point should we expect that to be reversible?

John J. Park

I’ll just make a broad comment on the relationship between adjusted EBITDA and our cash flow. Obviously there are major definitional differences and in this particular case working capital fluctuations are obviously not captured in adjusted EBITDA. Tax payments are also not captured in adjusted EBITDA. And I would say that one of the reasons why we provide both cash flow and adjusted EBITDA is we feel that adjusted EBITDA gives you a better sense for the underlying, a little bit more of a smooth view of what our pre-tax cash flow generating capability is. And obviously cash flow is affected by timing related items. As in this quarter we really feel like the working capital and the tax payments were somewhat timing related.

Operator

Our next question comes from Todd Van Fleet - First Analysis.

Todd Van Fleet - First Analysis

On the severance payments for this quarter, can you give us some sense as to what the expected savings will be as a result of those severance payments looking out over the course of a year? And then if you can help us understand the magnitude of the severance that we might expect in Q4 and the corresponding savings related to those payments?

John J. Park

In total we took about $9 million of severance for the quarter and as we said earlier about $6 million was in the consulting business. There was a meaningful portion of that $6 million that was related to the senior leadership change and I think that’s a transition cost; it’s not necessarily a cost that’s going to drive savings in the future. I would say that the balance of the severance that was both in the consulting business and in the outsourcing business was more of your work force restructuring expenses and obviously that’s going to have some positive effects on the business in the future. We try not to be too specific because each of these situations is different, but we obviously do these from a value optimization point of view. So you could expect that we are getting the kind of returns that you would typically find in these kinds of actions. There’s nothing unusual in terms of the mix of people that are involved outside of the piece that was for the leadership change within the consulting business.

In terms of Q4, obviously we’ve provided a fairly broad range in terms of the specific full year guidance and the implications for Q4 earnings and one of the reasons why we’ve done that is we want the flexibility to execute further restructuring in the right way and not necessarily be pushed by having to push it into one week versus another week or sometimes one day versus another day. So we’re going to stay flexible there but I think one of the reasons why we did provide that broad range was so that we could actually accommodate a significant range of severance outcomes within the quarter. So I think to be narrower than that at this point is probably not going to be helpful because we do want to keep that flexibility.

Todd Van Fleet - First Analysis

So John, ignoring the senior leadership changes, is the proper rule of thumb every dollar of severance buys $4 of savings? Is it a 3 to 1 relationship or can you help us kind of calibrate that?

John J. Park

I don’t necessarily want to get that specific. That seems a little bit on the high side.

Operator

Our next question comes from Shlomo Rosenbaum - Stifel Nicolaus.

Shlomo Rosenbaum - Stifel Nicolaus

One of the things I want to focus on which I think is probably the most positive part is the HRBPO loss is coming down. Could you just talk about more specifics and what drove the sharp year-over-year losses? If you can give a certain number to the sensitive contracts? It seems like last quarter they spiked up when we talked about it and then this quarter they seemed to come down. Were there three or four contracts that got renegotiated? If you could just give us some more color on that.

Russell P. Fradin

In terms of the contract situations I don’t recall last quarter that they spiked up. I think we just highlighted that there were still a few stragglers that were unresolved. But I think from our perspective at this point, you’re beginning to see a bunch of things. One, we’re not at this point struggling the way we were 18 months ago with more than a handful of problematic situations. We’ve pretty much resolved them and I hope you can tell that, that we’re not whining about that at this point. From the standpoint of more ongoing, at this point we’re getting some benefit from that. We’re also getting very big benefit from productivity. We really have gone in and we’ve restructured the operations that a lot of the charges we took were related to that, and that’s been very helpful to us because once we’re able to get common facilities and get a little more in terms of common process, we can really drive productivity. And that’s what you’re beginning to see now. You’re really beginning to see that we’re getting what I’d call more than normal life cycle impact. We’re through the toughest part of a lot of these contracts and we’re able to get the productivity and that’s really what you’re seeing. But in terms of talking about this or that troubled contract, at this point I don’t want to say in business as usual but more a mode of things will crop up like they will in any large outsourcing business. But there’s nothing that we’re anticipating at this point causing what I’ll call a huge hiccup. So that’s not to say new stuff won’t develop because as soon as you say that, I need to touch wood somewhere, but I do think we’re just in a better position in that position as you can tell.

Shlomo Rosenbaum - Stifel Nicolaus

If I could just sneak in one other one about cash flow. Year-over-year we talked a little bit about the cash flow being less this year over last year. Can you talk a little bit more about what we should expect just for the whole year and how to think of the cash flow of this business now that it looks like it’s a lot more stabilized on the HRBPO side, what we should think about on an ongoing basis?

Russell P. Fradin

We have said fairly consistently that we feel that this is a business that can generate free cash flow in excess of net income and we think that speaking in terms of a medium term perspective that’s still something we’re very comfortable with. This particular year we’re shading the guidance towards consistent with net income or in excess of net income just because we do have some timing unfavorablilities on task payments. But, it’s certainly something we are working on pretty aggressively in terms of making sure that the cash flow this year is something that we feel very comfortable with but, we want to provide ourselves with a little bit of a range giving we have had some timing issues with tax payments.

Shlomo Rosenbaum - Stifel Nicolaus

And the fact that you already have almost $420 million in debt and the debt is going to $500 million, is the fact that you didn’t go for more debt because you’re comfortable in the cash flow of the business or how should we think about that as just the credit environment? It’s only like one times EBITDA for you guys.

John J. Park

Well, yes certainly we didn’t maximize the debt that we could take on. We did take on an amount of debt that we thought was optimum and for that we think through all the possible options that we have for use of cash and we also do incorporate internal cash flow generating capabilities. I think it’s important to emphasize we don’t see anything underlying our business performance that leads us to believe that our fundamental cash flow generating capabilities has lessened.

Operator

Our next question comes from Tien-tsin Huang – JP Morgan.

Tien-tsin Huang – JP Morgan

In consulting I had a couple of quick questions there if you don’t mind. First, you typically see a sequential growth performance in consulting in the fourth quarter versus the third quarter, any reason why this year it would be different? Then secondly, I’m not sure I caught this but the leadership changes, can you give us more detail there, what’s driving it and what kind of strategic changes should we expect in light of the changes?

Russell P. Fradin

Let me address the margin piece.

Tien-tsin Huang – JP Morgan

Actually the margin and revenues, sorry.

Russell P. Fradin

First of all, we’re not in the practice of giving specifically quarterly guidance and we certainly don’t want to comment on one particular segment. But, certainly I think what you see in the consulting business is we do have very healthy revenue momentum and I think you could probably read in to our comments that we don’t necessarily see anything at this point that impacts that. Now obviously, we are cautious about the economy but there’s nothing that we’re seeing that leads us to believe at this point that those trends are going to change. In terms of margins performance, again we’re not going to be specific about a quarter and about a particular segment but just keep in mind that across all of our businesses we are anticipating that we will continue to pursue restructuring activities as they make sense.

John J. Park

In terms of the second part of the question, I think that from a leadership standpoint a) I just want to put out there in terms of both [Perry Brandorf] and [Roger Parkin] that I have enormous, enormous respect for them both personally and professionally. So, it really is what I would call more in the judgment normal course of business, there was no iceberg we hit or anything like that, that caused this, you are just always faced as leadership with questions about what’s really best for the future. And I think, in this standpoint I would view it as normal course of business as opposed to there is something lurking or anything more than that, that we just felt the transition would be better for the business and that you’re really looking for what kind of leadership is going to take you in to the future and it is nothing more than that.

Operator

Our next question is from the line of Mark Marcon – Robert W. Baird.

Mark Marcon – Robert W. Baird

I was wondering with regards to the guidance, what are you using? For the fiscal year guidance we’re looking at $1.92, within that what are you using for the third quarter number?

John J. Park

We’re using the numbers we’ve actually laid out in the earnings release and I would just focus you –

Mark Marcon – Robert W. Baird

So the $0.53?

John J. Park

Yes, I would focus you at looking at the normalized underlying results and what we’re basing our forecast on does not, for instance adjust for some of the items that we specifically said were significant in the quarter but were not identified as usual items. Of course, the biggest piece being the severance but also there being some significant legal charges. Those are included in the guidance but please exclude the items that we specifically listed as one-time items that we normalize for.

Mark Marcon – Robert W. Baird

So the third quarter number would be the $0.53 which obviously the underlying performance was significantly better than that and your expectation with regards to the magnitude of the severance cost as we go out towards the fourth quarter would be what exactly?

John J. Park

We don’t want to give an estimate of that. What we want to tell you is that it is likely that we will incur some restructuring cost in the fourth quarter and therefore, given the uncertainty around the amount, we’re providing what is a relatively large range for one quarter.

Russell P. Fradin

I think from our perspective and I think John covered this already but just to reiterate, you can see that we’re frankly saying that the higher end of that range is more likely and if you look at everything we absorbed within the guidance this year whether it’s the $0.06 dilution around Cyborg, the acquisitions which frankly in this year were mildly dilutive and the fact that we’re not calling out the severance charges and other things like that as special items to be considered, we feel like we’ve built a lot of momentum that we feel very positive about. So again, looking out I think as John said in the economic environment and seeing what’s happening to so many companies, we want to be a little bit cautious as John said as well as give ourselves the flexibility that we are looking at how do you get the cost structure best position for 09 and beyond? We just want to make sure that we’re managing this for the long term and not just the quarter-to-quarter. That’s why frankly we’ve been much more focused on the annual guidance than the quarterly guidance and that’s probably caused a little bit of the hiccups quarter-to-quarter in terms of the analysis.

Mark Marcon – Robert W. Baird

I completely agree, it looks to me like the underlying performance is much better than what the optics in terms of the surface level numbers would suggest so I was just trying to clarify there might be some people who on the surface might interpret the guidance for the fourth quarter as being somewhat weak and what I was trying to highlight was it appears to me that you’re excluding certain severance charges which – I was just trying to get a feel for whether or not you thought those severance or restructuring charges could be of equal or greater magnitude to what we saw during the third quarter just to kind of triangulate in terms of what you thought the underlying operating performance might be like during the fourth quarter when we stripe out all of the various unusual elements which I think are a better reflection of the ongoing earnings and free cash flow power of the business.

John J. Park

Mark, as I said, we’re certainly not ready to be more specific than what we said on the potential restructuring costs in Q4 but one of the things that you can think about is that if the actions we take result in dollars on the lower end of what you would typically find in this type of situation then certainly that would help us think more towards the upper end of the guidance and if it was larger towards the lower end of the guidance. That may be obviously but that’s the way we were thinking about the guidance.

Mark Marcon – Robert W. Baird

Let me ask the question a different way, is there any reason why you would expect the underlying operating profit margins exclusive of restructuring charges across any of the three divisions to decline in the fourth quarter relative to the third quarter? Traditionally, they would all go up?

John J. Park

I think we’re getting in to too much detail given that we do like to talk about full year guidance, we don’t like to talk about specific segments by quarter. But again, I think you can pick up from our comments that we feel very comfortable with the underlying trends within our business both in terms of revenue and margins.

Operator

Our next question comes from Jason Kupferberg – UBS.

Jason Kupferberg – UBS

Just to pick up on the margin question a little bit and make sure I have some numbers right, the underlying margin the quarter was 10.7%. I think it was down 50 bibs year-over-year and in the earlier part of fiscal 08 you actually had some nice year-over-year improvement. It looks like Q4 based on the guidance the adjusted margins according to your guidance definition will be kind of flattish year-over-year and so should we think about go forward incremental year-over-year improvements as being relatively modest or is there more significant pick up here? I’m just trying to get a sense of how much restructuring is really left to be done? And then really what we’re kind of left with on the other side of that?

John J. Park

I think the best way to address that is just by talking about the three segments because there is a little bit of a different story in the three. Clearly, in the case of HRBPO, we’re on a nice track in terms of improving the margin. We’ll be in a better position to talk about longer term next quarter, certainly we feel pretty comfortable that we’re on a nice track here in terms of significantly improving the margins. I would say that on the consulting business just to go back and recast some of the comments we had made, the consulting business is really in a condition where we are really happy with the regained top line growth. What comes with that though is you need to invest in order to get that top line growth and I really feel like we’re at a point where we’re investing a little bit ahead of what we’re realizing on the revenue line so we’re very much in investment mode in terms of hiring, in terms of making sure that we’re retaining our very best people. I think in this particular quarter you want to layer on top of it the fact that we did incur some restructuring charges as we accelerated some of the changes that we’re making to sort of optimize the mix of people that we have.

I would say that on the benefit side of the business again, we’re very pleased with the regained revenue growth. We are in a mode though in benefits also where we are investing in the business and that not only is coming from the fact that we have brought on some very large complex clients and when they do go live you’re generally at the front end of the profit curve which tends to improve as the contracts mature. Also, we’ve talked about some exciting new markets that we’re starting to penetrate which certainly at the beginning will cost you a little bit in terms of margin. So, summing it all up I would say that on a segment-by-segment basis we still feel very comfortable with our medium term targets and those medium term targets we’ve always said are ones where we strive to be on the upper end of that and if we feel at some point in the future that we have the opportunity to go beyond them we will certainly advise you of that.

Jason Kupferberg – UBS

Just on HRBPO I know you’re going to talk about more longer term specific next quarter but if we think about rates of continued improvement going forward, it seems like you took a bit of a step function down in terms of a lower loss this quarter. How should we think about that? Presumably some of the contract renegotiation kicked in to help so from here with the improvements be more kind of incremental quarter-by-quarter? Anything you can shade light on there?

John J. Park

I’d rather not comment on that right now. I think that’s probably a topic that is best for when we discuss annual guidance which will be next year. I just want to remind you that we do like to think in terms of full year and so we’ll provide you with a better perspective of where the trajectory of HRBPO will be next quarter.

Jason Kupferberg – UBS

Will you also give the cash versus non-cash losses potentially? I know you’ve talked in the past about possibly disclosing that?

John J. Park

We’ll try to give you some color on that also Jason.

Russell P. Fradin

The only thing I would add Jason, to the extent it’s helpful is our jobs you could argue sometimes they’re complicated and sometimes they’re pretty simple but it’s the continual tug between growth and margins and from our standpoint we want to make sure we’re ensuring the future of the business, that we really are making the right investments to grow the top line and grow the top line in a way that’s going to lead to the kind of margin structures that John’s outlined over time and that’s why we keep emphasizing around the fourth quarter that really we need to make that tradeoff appropriately to make sure that we continue to improve that top line growth and improve the margin structure and we want to give ourselves that flexibility. But, there’s nothing underlying within the businesses that’s changing other than what you see in HRBPO. Meaning, what you see in HRBPO is clearly now we’re turning the corner and from that standpoint we’re feeling pretty good about that but in the other businesses it’s more normal the tug between growth and margin and trying to make the right set of tradeoffs there.

Operator

Our next question comes from the line [Scott Sharer – Globus Capital].

[Scott Sharer – Globus Capital]

A quick question, John on the debt you said you’ll have that done by the end of the month. Should I assume that the initial proceeds will be used to pay off the short term debt and possibly take the converts out?

John J. Park

We don’t want to be locked in to anything at this point but certainly optimization of our overall debt cost is one of the priorities that we’ll be considering. Yes, I would say that one of the reasons why we finance at this point is in anticipation of the convert which we feel will be converted at the end of this fiscal year.

[Scott Sharer – Globus Capital]

Two more quick ones, you had 102 average shares, what was the period ending share count?

Sean McHugh

It looks like shares outstanding ending at the balance sheet that’s there is 97.4.

[Scott Sharer – Globus Capital]

97.4 on a basic basis or fully diluted?

Sean McHugh

That would just be on shares outstanding.

[Scott Sharer – Globus Capital]

I need to clarify that because it was 101.9 on a fully diluted basis. I want to know what the period end was because you bought back some more stock, but okay. The next question, in terms of the real estate savings you guys talked about next year getting maybe I don’t know it was like 50% of your target that you had. So this year the charges are going to be about $40 million in total so are you still expecting that the real estate savings as they flow through overtime will kind of come in at a 40% to 50% rate in terms of what you spend?

John J. Park

The short answer is yes but, we want to remind you Scott that we always talked about that savings being a gross savings. There is some portion of that, that we need to reinvest back in to our facilities and also some of course that we want to reinvest in terms of our overall business.

[Scott Sharer – Globus Capital]

That $4 million litigation charge, that was one-time, right? You wouldn’t expect that to happen again. I know you said there might be some more severance but you wouldn’t expect that to happen again, right?

Russell P. Fradin

It was actually the net of a bunch of little things that we accumulated and we just saw the opportunity to clean them up so we did. We thought it was a good business practice but, no I sure hope it’s not the start of some new wave, if that’s the question.

[Scott Sharer – Globus Capital]

Well it looks like you had $9 million of severance and $4 million of litigation which is basically $13 million pre-tax which after tax looks to be about $0.07 to $0.08 a share that flowed through the numbers in the quarter.

Operator

Our next question comes from Todd Van Fleet - First Analysis.

Todd Van Fleet - First Analysis

Just one clarification, John I think you had said that your comfortable on the consulting side with the margins, your medium term outlook on the margins for that business. I guess medium term looks beyond the current fiscal year so we shouldn’t think about a return to kind of mid to upper teens here in the final quarter of the year for consulting or for the full year I guess, for fiscal 2008?

John J. Park

We really want to remind everyone that we’re much more comfortable talking about full year guidance. We don’t want to be constrained to manage the business on a quarter-by-quarter basis. We’ve always thought about our medium term outlook as what we’re able to achieve in the two to three year period and we are comfortable with the mid to high teens as a margin target on consulting.

Operator

Our next question comes from Bhavar Suri – William Blair & Company.

Bhavar Suri – William Blair & Company

Just a quick question, you mentioned that there was some activity in the HRBPO space, a slight uptick in demand. Could that possibly be, or have you explored that with customers, because of the weakening economy people are looking to outsource a little more or to outsource offshore a little more because of that? Could you provide a little color around that?

Russell P. Fradin

I think in the HRBPO business one of the things that we’ve talked about which I’m hoping is coming to a little bit of fruition is that we’re trying to narrow the scope and the statement of work and I think a lot of the initial HRBPO deals, the statement of work had been very, very broad both in terms of what we call domains, the number of areas in the company that are outstourcing as well as geography. What we’re seeing now is that us as well as a number of our competitors have become more experienced in the market. I think the customers have become more experience, and so we’re beginning to see sort of a glimpse of some clients coming to market with what I’ll call narrower statements of work and narrower scope. And yes, when you look underlying at what’s causing some of that, there are really a couple factors. One is what you point out is the economy. The economy in general causes people to look at how they can bring their costs down and outsourcing is sort of a natural thing they look at. And by the way, that can be for benefits as well. But second, there are also companies that come up on discontinuities and when they need to replace an underlying HR system or something like that that’s a major capital expense, they do tend to relook at the whole situation. So what we’re seeing there is a combination of both, both the economic situation and various individual situations where prospects have to revisit their HR infrastructure.

Bhavar Suri – William Blair & Company

One real quick one on the Real Life or I guess the core benefits platform. Could you provide a little more color in terms of number of customers or relative growth? I know you said 100 basis points of the growth came from that but just a little more color on that?

Russell P. Fradin

I think that from our standpoint we were really looking to take the Hewitt brand into what we call the mid market, and for us that’s clients call it somewhere between 4,000 or 5,000 employees and 15,000 employees. And those are areas where we’ve always had a good and strong consulting base but we haven’t had quite the activity just because our total benefit outsourcing platform takes a lot of effort to get that implemented, so it kind of restricts the size clients you can implement it in. So in taking call it the Hewitt brand more into the mid market in the outsourcing space, we’ve just seen really a pent up demand and so we’ve put a dedicated sales force on the street and we just found that the reception to Hewitt entering that mid market has been just more than even we would have predicted. And that’s what you’re seeing. So we’re adding client names at a more rapid clip. They’re all brand name companies that you would recognize. And they’re all in that sort of 5,000 to 15,000 employee segment. So we’ll be talking about that and highlighting it a bit more on some of these future calls but you can assume that we’re well in excess of the business case that we use to justify the economics of Real Life HR.

And by the way, as long as folks are listening, I just want to congratulate our management team because we really have some dedicated folks in Hunt Valley and some folks running that business that have just had a spectacular year. And I want to congratulate them on that.

Operator

Our next question comes from Mark Marcon - Robert W. Baird.

Mark Marcon - Robert W. Baird

On the core benefits, can you give us a sense for what the longer term margin profile of that might be? It sounds to me like that might be a more standardized offering and that might be kind of in line with your previous experiences over at ADP which obviously there’ve been tremendous margin discipline over there. I’m wondering if you can comment a little bit about that in terms of how we should think about the margins.

John J. Park

Well, good news bad news. I think the good news is exactly what you say that the margin profile there is more predictable, more stable, and it’s more contained. The bad news is that because you are looking at smaller clients, their plans tend to be simpler so the revenue per participant tends to be a bit lower. So good news on the margins but the revenue is probably not quite as robust as you’d see in the large market.

Mark Marcon - Robert W. Baird

The opportunity set though in terms of potential clients is much larger.

John J. Park

Absolutely.

Mark Marcon - Robert W. Baird

With regard to consulting, what are you seeing on the PPA side? And can you talk a little bit with the exception of the management transitions which are clearly understood, can you talk a little bit about would there be any reason for severance on the consulting side given that it seems, and please correct me if I’m wrong, that we’ve stabilized the higher than normal turnover in that division and that things are kind of normalizing there. So I’m trying to understand where severance changes?

Russell P. Fradin

Great question. Actually if you look at what’s going on, on the first question on PPA, we continue to see nice growth. And I will also add, people talk about PPA but let’s face it. In the extreme volatility we’ve seen in all the capital markets causes pension trustees and plan sponsors to want to take call it more frequent peeks at the performance side. So that helps us a bit. So it’s not just PPA; it’s beyond PPA that it’s just the extreme volatility in the markets causes a lot of people to look at their overall asset liability situation a bit more frequently, so that’s helpful. And so you are seeing some of that and you’re seeing some really nice growth really on a worldwide basis in the [inaudible] practice.

In terms of the margin and the restructuring, you’re right. We’ve seen the turnover within consulting calm down a whole lot and that was true again this quarter and so we feel good about that. Part of what we’re trying to drive here and I know people internally are tired of hearing me a bit like a broken record, but we really are moving to a real performance based corporation and it really is from our standpoint you need to perform at certain levels. And as the two new guys come in and sort of take a look at what needs to be done and we look at the long-term margin structure that we want to get to, any actions we might take would be more related to individual situations or some smaller practices that are under performing and things like that. I think both John and I want to give them the flexibility as we’ve said. You’ve got a new set of eyes and you want to make sure they have the flexibility to do what they need to do. It’s really nothing more than that but we feel that the consulting business from a top line standpoint is performing pretty nicely. We obviously want to improve the margin situation a bit and that relates to individual actions that we need to take within specific practices and offices. And it’ll be more that kind of clean up that you’ll see.

Mark Marcon - Robert W. Baird

That sounds like it could actually help improve the voluntary turnover in that you’re no longer carrying dead wood and that should be encouraging to all the producers.

Russell P. Fradin

I might choose to speak a little bit differently of that internally but I appreciate the commentary.

Mark Marcon - Robert W. Baird

On the HR BPO loss, you’re still carrying some of those clients that are being separated, right? In other words, if we were to look at the clients that would still be part of the equation on a longer-term basis, the underlying margins would actually be even better or the improvement would be even better?

Russell P. Fradin

I just want to use that question to not only answer it but to reinforce a basic principle that’s very important to us because we talk about this client’s first principle. And that is that in all of these renegotiations, and I think it’s clear that some of them were a bit tense and we use the word sensitive situation, we really did try to look across the enterprise. Because all of these clients are not only HR BPO clients but they’re also consulting clients and benefit outsourcing clients. And I think I can say that in virtually every situation we preserved the client relationship. So even where we may have reduced or eliminated the scope of services in the HR BPO segment, to my knowledge in every case we preserved the relationship in consulting and in benefit outsourcing. And we’re very proud of that that we feel the clients were very professional, they understood, it was very business-like, and that’s what we were worried about. We were worried about not wanting to burn bridges with clients and create situations where frankly they were using us in other areas that are very mutually beneficial and we didn’t want to have that. So we feel that the bulk of that tenseness is over and it’s a bit more business as usual and that’s what we’re seeing in all of the businesses.

Operator

That does end the Q&A portion of our call today.

Sean McHugh

From our standpoint I want to thank everyone for the attentiveness and the questions as usual. We look forward to giving you updates as necessary and speaking to you at the end of the fourth quarter.

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