Description

Summary of the Investment Opportunity

Hewitt Associates Inc. (“HEW”, “Hewitt” or the “Company”) is a human resource outsourcing and consulting company with three different business lines: benefits administration, human resource business process outsourcing (“HRBPO”) and consulting. Hewitt’s financials have been obscured in the last two years due to large losses in its recently acquired HRBPO business unit and, as a result, the Company trades at a discount to its peer group.  I believe the losses from the HRBPO business are peaking and profitability will improve dramatically going forward.  Investment in Hewitt is an opportunity to own an industry leading company with good growth prospects and solid cash flow at a discounted valuation relative to its peer group.

In my view Hewitt’s current valuation understates the intrinsic value of the Company. On a sum-of-the-parts, Hewitt trades at a discount to its peers. Inclusive of the losses from HRBPO, the Company trades at 9.0x CY06 EBITDA while the peer group is at 10.6x – representing a 15% discount on a depressed EBITDA.  If you value the HRBPO business at zero, which is $602MM less than the old management paid for it two years ago, and exclude these losses from EBITDA (without assigning any corporate expense to HRBPO), you are effectively paying 6.9x CY06 EBITDA for consulting and benefits administration.  This represents a 35% valuation discount relative to the peer group for two businesses that are widely recognized as leaders in their respective fields.  I also believe that the new management has ample opportunity to improve profitability in the core business as they have suffered from lack of focus during the last two years.

In FY06 HEW generated $196MM of FCF which is remarkable given $149MM of operating losses in the HRBPO business (even more remarkably, I estimate that HRBPO was $200MM overall cash drain in FY06).  Hewitt’s current valuation implies an unrealistic trajectory for HRBPO.  The Company’s solid cash flow generating ability should provide the margin of safety that will enable the newly appointed management to turn around the HRBPO business and crystallize the intrinsic sum-of-the-parts valuation for investors.  HEW also represents an attractive acquisition candidate either for a strategic or a financial buyer.

I feel 2007 will be the year in which results in HRBPO will start to improve, and the core business will also improve.  HEW has earnings power of over $2.50 per share implicit in its current business, with a moderate assumption of growth.  HEW is a leader in its industry and the average of comparable companies trade at approximately 20x PE’s implying HEW could be worth north of $50 per share in the next eighteen months.

Business Description

I have included a more detailed description of the HEW’s businesses than is typical for these write-ups. Some readers may want to skip this section and perhaps return to it later for reference. 

Hewitt has three different business lines: benefits administration, human resource business process outsourcing (“HRBPO”) and consulting. U.S., U.K., and ROW represent 79%, 12% and 9% of total revenues, respectively.  Hewitt operates in two reportable segments, outsourcing and consulting.  Outsourcing segment consists of the legacy benefits administration business as well as HRBPO, which Hewitt acquired in October 2004.  The two legacy businesses, benefits outsourcing and consulting, are both solid businesses with stable margins, good growth prospects and high level of recurring revenues.  The recently acquired HRBPO business has driven the decline in Hewitt’s margins in the last two years.  

Outsourcing ($2.0Bn and $171MM, in FY06 Sales and Segment Level EBIT)

Hewitt’s Benefits outsourcing segment consists of two businesses: Benefits Administration and HRBPO.

Benefits Administration ($1.5Bn and $320MM in FY06 Sales and Segment Level EBIT)

Hewitt provides benefits administration services primarily to companies with 10,000+ employees. These contracts average 3-5 years in length and have historically posted renewal rates in excess of 80% (resulting in ~95% recurring revenue base).  In a typical deal, Hewitt takes over the client’s internal benefits function and often imports it to its own model which is optimized to reflect current best practices while standardized to achieve economies of scale.  HEW records and manages transactions directed by clients’ employees, provides web-based tools for self-management of benefits and has call centers that answer benefits related questions that clients’ employees may have.  HEW also integrates the clients’ benefits data with the relevant external resources including health plans, trustees, investment managers and payroll processors (if the service is not provided by HEW). The Company also offers various financial consulting services to all of the clients of its retirement plan services.

Benefits administration is a relatively mature (though growing) and profitable business for HEW.  HEW competes in this market with companies like ADP, ACS/Mellon, Fidelity, Citistreet, Mercer, and EDS/ExcellerateHRO (JV with EDS and Towers Perrin). Hewitt is most known for this service and is widely considered as the premium provider (10-15% pricing premium) with the best quality solutions.  Organic growth in this segment is expected to be in the mid-single digit range.  NelsonHall, an industry specialist consulting firm, estimates the size of the benefits administration market at $10.6Bn in 2005. This would imply ~14% market share for Hewitt.

HRBPO ($457MM and $(149)MM  in FY06 Sales and Segment Level EBIT)

While every HRBPO contract is different, the basic principle is that HEW takes over a bundle of clients’ HR related functions as opposed to just a standalone benefits administration contract.  HEW then integrates all these functions in an attempt to deliver a seamless solution for the client while realizing cost savings through economies of scale and scope.  Generally HRBPO providers bid for these contracts assuming 20% operating cost savings for the client while they expect to realize 30% - difference being the profit margin that the provider gets from the value added service. These contracts are generally long-lived (5-10 years in length with 7 years average life) and are expected to turn cash flow positive towards the end of the contract life due to high level of upfront implementation spend and time required for process standardization and ultimate realization of the projected cost savings (including moving functions offshore, etc.).  In addition to the benefits administration, HEW offers a selection of other HR related services including: payroll processing; payments, including accounts receivable, accounts payable, travel and expense; talent management; recruiting; learning and development; succession planning; flexible staffing; compensation administration; leave administration; and workforce relocation.  HEW currently has a portfolio of 30 contracts each of which is a bundled combination of the aforementioned services. Almost all of the contracts contain the core benefits administration piece, which was the cornerstone of HEW’s aggressive growth strategy into this business.

The HRBPO market is immature and has only recently grown in scale. Due to its immaturity it is difficult to get reliable information on current market statistics (I have seen market size estimates ranging from $8.9Bn by Gartner to $3.6Bn by NelsonHall in 2005).  However, most industry observers agree that Hewitt is by far the largest player in the market. While the growth opportunities for the HRBPO business are significant, it remains unclear whether providers can establish profitability in this market in the long-term (at least in its current form).  As a result, there has been a drought in contract signings in 2006 as most of the HRBPO providers are in digestion mode from the heavy 2005 signings.

Consulting ($843MM and $162MM, in FY06 Sales and Segment Level EBIT)

Hewitt has three principal consulting practices: retirement, health care, and talent and organization consulting.

Retirement (~60% of consulting revenues). HEW’s particular strength in consulting lies in the pension arena where it is a clear leader.  It assists clients in three primary activities: developing overall retirement program strategies and designs aligned with the needs of companies and their employees; provides analysis and financial strategies to support clients in their management of pension issues like the Pension Protection Act of 2006; and consulting on asset allocation, investment policies and investment manager evaluation.  The HEW actuarial consultants also assist clients in due diligence investigations and analyses of proposed mergers, acquisitions, asset sales and other corporate restructurings to help clients understand the implications of such transactions on the liabilities and funded status of the plan, and also on the future cash contribution and expense trends. In the medium-term, this business has solid prospects driven by the recent legislative changes around pension accounting in the U.S. and in the U.K. as well as the recent surge in M&A activity. HEW will also benefit from the transition from defined benefit to defined contribution plans as companies need consulting services when they restructure their retirement benefits. Over the long-term, however, the decline in the number of defined benefit plans will be a retractor.

Health and Welfare (~20% of consulting revenues).  HEW consultants help clients design health and welfare strategies. The offered services include assisting clients in their selection of health plans and helping them determine optimal funding approaches (insured, self-insured or risk adjusted insured). Demand drivers for these services include general corporate focus on containing escalating healthcare costs, changes among health care providers due to M&A, and recent Medicare changes (such as Medicare Part D).

Talent and Organizational (~20% of consulting revenues). HEW offers consulting services to help its clients in people-related workforce challenges including hiring, retention, motivation, compensation, managing a global workforce, etc.

HEW’s key competitors in the HR consulting market are Mercer (a subsidiary of Marsh McLennan with $3.8Bn in revenues), Aon (~$1.0Bn in revenues), Watson Wyatt (~$1.0Bn in revenues) and TowersPerrin.  HEW also competes with the divisions of the Big Four accounting firms such as Deloitte, PWC, and E&Y and to a lesser extent with larger consulting firms like Accenture. In consulting, HEW is also considered to be a premium provider with 5-10% price premium relative to competitors.

Background on the HRBPO Business

In October 2004, Hewitt acquired Exult Inc. from General Atlantic in a 100% stock deal valued at $602MM.  Exult forms the base of Hewitt’s current HRBPO business.  The rationale for this acquisition was defensive.  The old management feared that Exult, if owned by a competitor, would attack Hewitt’s core benefits outsourcing business as this service would be bundled with a broader outsourcing offering provided by Exult.  With the benefit of hindsight, these concerns have proven largely exaggerated.  In 2005, in an attempt to build the HRBPO business, Hewitt’s old management signed up 13 new contracts at overly aggressive terms.  Consequently, Hewitt’s financials have been obscured due to large losses in its HRBPO business unit and the Company trades at a discount to its peer group.  Hewitt has only recently started to disclose selected HRBPO numbers separately allowing investors to value this business separately.  I believe the losses from the HRBPO business are peaking and profitability will improve significantly going forward as the newly appointed CEO implements his restructuring plan in 2007.  

Investment Strengths

Inexpensive valuation relative to peers – On a sum-of-the-parts basis, HEW appears inexpensive.  If you apply the peer group median multiple of 10.6x TEV/EBITDA to HEW’s consulting and benefits businesses, the $30.00 stock price implies negative valuation of $1.8Bn (or $16 per share) for HRBPO, which is extremely bearish, in my view.  Assuming a peer group EBITDA multiple of 10.6x and zero value for HRBPO would imply a current stock price of $45.66.

Excluding the HRBPO loss, HEW currently trades at 6.9x LTM EBITDA (9.0x including the loss).  On EBIT basis, HEW trades at 9.4x LTM (excluding the HRBPO loss) while the peer group is at 13.3x.  On a LTM P/E basis (excluding the HRBPO loss), HEW trades at 15.8x.  However, if we adjust earnings for the recently announced $750MM share repurchase program, the multiple accretes to 13.8x (well below peer group median of 21.3x).

Mixed sell-side sentiment – Analyst opinions on HEW vary a great deal.  For instance, on November 2, Goldman Sachs published a report re-iterating their sell recommendation and assigned HEW as one of their “least favorite picks” (though they recently took HEW off the list).  Goldman has a $21 price target which they base on their proprietary “regression-based valuation framework”, which, in my view, does not incorporate the hidden value of the core business that is being masked by the HRBPO losses.  On the other hand, Citigroup has a $32.50 price target and the analyst is bullish on the turnaround story.  In my view the lack of analyst consensus has driven the stock price down and is part of the reason why this investment opportunity exists.

Bulk of the HRBPO losses should be behind already – Based on my discussions with the Company, I believe that the bulk of the cash spending related to the HRBPO problem contracts has already incurred as the high level of implementation spend supporting the 2005 contract signings is declining.  Based on my estimates the cumulative HRBPO cash losses in FY05-FY06 were $363 million of which $200MM was incurred in FY06.  According to management, the bulk of these losses were related to the 2005 problem contracts.  Based on management guidance, the cumulative losses from the eight problem contracts are ~$220MM over their total life.  As a result, I believe that the bulk of the cash losses are behind at this point.

The management categorizes the HRBPO contracts in three buckets: (i) 10 of contracts that are highly profitable, (ii) 12 contracts that are roughly break-even and (iii) eight contracts that are very unprofitable and a large cash drain.  The profitability within the contract base is highly skewed, i.e., eight of the contracts generate large losses while ten of them are very profitable.  This skewness increases returns from successful restructurings of the problem contracts but also adds to the difficulty of making accurate forecasts (HEW did not give guidance on 1Q07 conference call).  Management is actively renegotiating the problem contracts.  They have displayed willingness to be assertive and aggressive in contract renegotiations in order to achieve the goals that the Board has set for them (especially the CEO). For obvious reasons, as a service company, the management needs to publicly display a more measured approach to contract renegotiations.

I believe HEW’s management recently conducted overall client profitability reviews whereby they reviewed each of the problem accounts in detail in order to determine the overall financial contribution for each client.  The intent of this review was to understand the overall profitability of each client before engaging in aggressive negotiations.  Management should be currently in the middle of these renegotiations.  Consulting has approximately 2,300 clients while benefits administration client base is roughly 350.  The HRBPO clients tend to be larger than the average.  If you conservatively assume that each of these “problem clients” are 2x the average size, their revenue contribution should be roughly 6% of benefits administration and less than 1% of consulting (due to more fragmented customer base).  Assuming overall segment level EBIT margin on these revenues would yield roughly $20MM EBIT contribution from these clients.  Because of the high level of customer fragmentation, HEW should be in a decent position to renegotiate the problem contracts because little of its profits are at risk with these clients.

To further highlight the returns from the HRBPO restructuring, I have broken out the roughly $140MM LTM EBIT loss into four components.  My estimation of the loss composition is as follows: (i) profit from the performing contracts (+30), (ii) cash loss from the eight problem contracts (-70), (iii) unutilized overhead cost (-70), and (iv) non-cash amortization of the capitalized implementation spending (-30).  We believe that the unutilized overhead, which mainly consists of the staff that was previously hired to support 2x the size of the current contract base, can be easily cut through severance.  The management is currently fiercely re-negotiating the problem contracts which should start bearing fruit as well (but will have a longer payback).  If we assume management is successful in cutting the unutilized overhead and reduces the variable losses on the contracts by half, the ongoing cash loss bridges from the estimated -$110MM to roughly break-even.  Simultaneously, management is working on margin improvements on the break-even contracts through moving functions off-shore, etc. I believe HRBPO will turn out to be an attractive and profitable business once restructured but view this purely as an incremental upside to the investment case laid out herein.

Management compensation is geared towards turnaround – I believe the CEO is incentivized to turn the business around. His compensation depends largely on meeting the FY07 targets set by the Board.  While his overall compensation package is not excessive, the portion dependent on FY07 forms the largest portion of it.

Solid core businesses with good growth prospects and stable/defensible margins – Hewitt’s core businesses, consulting and benefits administration, are solid growth businesses with stable margins and high returns on capital.  In FY06, segment level EBIT margins were 19.3% and 21.0% for consulting and benefits administration, respectively (16.0% and 14.3% after corporate allocation).  Both of these segments have a long history of steady margins with five-year average segment level EBIT margins of 20.5% for benefits and 19.2% for consulting.  HEW’s consulting margins are high relative to comparables that have EBIT margins in the low teens (Watson Wyatt has 11.0% margins after corporate; Mercer has 11.9% before corporate). Some of the margin delta relates to accounting methodologies for corporate allocations.  Nevertheless, HEW has consistently posted higher margins than its peers.  Comparisons across the benefits peer group are difficult as none of the public peers break out the benefits administration separately.  ADP employment services, which includes payroll processing and benefits administration, had segment level EBIT margins of 22.7% in 2005.  The five-year average margin for ADP employment services segment is 22.6% which is reflective of the stable profitability in this business.  ROIC for HEW was significantly depressed as a result of the Exult acquisition and was 14.9% in FY06.  However, average ROIC during FY00-FY04, before Exult, is 25.9%, which I believe to be a more realistic number for the core businesses given the large goodwill burden from Exult.

According to my channel checks (which included client interviews and discussions with contract intermediaries like Equaterra) HEW is regarded as the premium provider.  It should also be noted that the competitive environment in this market has changed little in the last five years.  I believe benefits administration should experience a rebound in growth as Hewitt is no longer signing up new benefits clients in its bundled HRBPO offering.  While consulting has recently experienced some turmoil amid increased associate turnover, the franchise has a good reputation and current market demand for these services is strong.  The CEO’s recent actions of repositioning consulting internally within Hewitt have been well received by the consultants and the mood is changing for the better.

Franchise value provides safety in case private or strategic acquisition of Hewitt is possible – I believe that HEW represents an attractive acquisition candidate either for a strategic or a financial buyer.  There are several buyers that could realize significant synergies through Hewitt.  ADP, for instance, would benefit from further integrating its payroll processing with Hewitt’s benefits administration as the two companies’ systems are already integrated to a lesser extent.  Accenture would likely be interested in the consulting franchise and the integration between the benefits administration function with the consulting group (Accenture’s transformation business).  While IBM currently has a small HRO offering, acquisition of HEW would bring them significant scale quickly.  IBM currently uses Mercer for benefits consulting and could potentially drive synergies from that perspective as well. Other potential strategic partners could include HP and GenPact who already have a presence in the Information Technology and Finance and Accounting verticals but lack HRO.  From the perspective of a financial buyer, HEW represents an ideal buy-out candidate.  It is a misunderstood growth story with a contained/fixable set of problems; cyclically defensive and robust cash flow that can be used to pay down debt; and high level of recurring revenue contributing to the stability of the business.  I believe a financial sponsor would construct a highly transparent turnaround plan for the HRBPO business and raise significant debt financing against the cash flows of the core businesses.  We all have witnessed businesses not too dissimilar to HEW being financed with >7x Debt/EBITDA (e.g., SunGard).  According to the management, engaging in a public-to-private transaction during the HRBPO restructuring would not maximize shareholder value and their plan is “not to steal the company from the public shareholders”.  The management is clearly focused on fixing the HRBPO business which would dramatically strengthen HEW’s negotiating position should it decide to pursue a strategic/financial sale to maximize value.

Investment Concerns

Weak disclosure standard – The Company has only recently started to break out the operating losses in the HRBPO segment and has not even provided exact revenue breakdown for HRBPO separately.  Hewitt’s guidance has been spotty and the Company does not give complete and accurate disclosure.   

Management and turn-around execution – As part of my diligence, I have conducted several channel checks including discussions with Hewitt’s previous clients, current clients, and contract intermediaries.  It has been evident to me that the old management team took their focus off the core business in FY05 when they were busy chasing HRBPO and integrating Exult.  This resulted in service delivery issues and increased customer dissatisfaction in benefits administration as well as unfairly compensated consultants.  I believe that the new management team has started an aggressive turnaround and the decades old franchise reputation should be restored as a result.  As execution is the key to any turnaround, and given new CEO’s mixed success at his previous Company, I conducted extensive reference checks on him.  The general perception is that he is very well regarded and Bisys had a set of legacy issues that were out of his control.   

Consulting turnover – As mentioned above, Hewitt did not properly compensate its consultants in 2005.  HEW used to have a firm wide compensation policy whereby all employees would benefit from the success of the overall franchise.  Because of the large losses from HRBPO in FY05, HEW consultants did not get their bonuses despite record profits for the consulting segment.  This underpayment coincided with the vesting of the locked up IPO shares.  As a result, consulting turnover increased dramatically in FY06.  Immediately after joining the Company in September, Russ Fradin changed the compensation policy and decoupled consultants’ compensation from the firm wide system.  Hewitt now pays bonuses based on segment results.  Fradin also decided to pay the consultants extra compensation in order to stop turnover and make up for the past underpayment.  While there has been significant turnover in other firms as well (typical when the market is booming), one of HEW’s competitive advantages in the past has been its ability to retain talent.  Ironically, HEW has a consulting practice focused on this specific area.  At this point it is unclear how extensively the turnover has impacted the franchise.  Based on my channel checks, however, the turnover has been manageable and was the first focus area for the new CEO when he joined.  The new CEO spent 18 years at McKinsey as a consultant, which should give him credibility within Hewitt.

Catalyst

Mostly negative sell-side community upgrading their views as the new CEO lays out his plans.
The Company should start showing dramatic improvement in HRBPO losses in FY07 as it implements layoffs in the division.
Increased disclosure around HRBPO and potentially breaking out the detailed financials for that segment.