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Monday, August 14, 2006

Hewitt Revisited

By William Trent, CFA of Stock Market Beat

Back in June when Hewitt Associates (HEW) shares plummeted on news that they would have to re-evaluate the profitability of their outsourcing contracts, we said the company’s enterprise value relative to its free cash flow merited a second look. We pointed out that we had viewed their previous Dutch auction share buyback as a paradoxical warning signal. And last week we presented a five-part series detailing the pluses and minuses for the stock.

Today they provided us with some of the meat we need to really make an investment decision.
The operating loss for the third quarter was $207.6 million, compared with operating income of $56.0 million in the prior-year quarter.

This quarter’s results include $249 million of non-cash pretax charges related to the Company’s review of its HR BPO contract portfolio, comprised of the following:

$172 million of goodwill impairment reflecting lower expected profitability of the overall existing portfolio, as well as lower future new contract expectations;

$70 million of contract loss provisions reflecting the Company’s revised profitability expectations for several existing contracts; and

$7 million of intangible asset impairment, primarily resulting from reduced demand for an acquired software asset.

While the company stressed that the charges were “non-cash” there is clearly a cost associated. The goodwill resulted from acquisitions of companies they expected would be more profitable than they are. The goodwill impairment tells us they gave up $172 million worth of stock they shouldn’t have given up when those acquisitions were made. The available earnings for shareholders are diluted by those erroneously issued shares.

But the real issue relates to the contract loss provisions. When Hewitt books a long-term contract, they estimate the total costs over the life of the project using what is known as the percentage of completion method. Then, as costs are realized they recognize the percentage of contractual revenues associated with those costs. By matching the revenue recognition to the cost recognition, the financial statements smooth out any differences between when the company incurs a cost and receives the related payment.

The problem with the percentage of completion method is the reliance on estimating the total costs over a three-to-five year contract. Even the most skilled and honest management team can make a mistake. And a less skilled or honest management team could be prone to underestimating the costs. If the company discovers that its costs will exceed contractual revenues it must take a charge for the amount the costs will exceed revenue. Subsequent contract revenue will equal costs and result in no profit or loss. For Hewitt, this represents a significant portion of their existing contracts.

As a result of our comprehensive and rigorous review of the business, we took charges in the quarter, reflecting our conclusion that the performance — primarily of the 2005 class of contracts — will fall significantly short of our prior expectations.

The 2005 class of contracts likely constitutes about a quarter (assumes a three-to-five year life and reflects the lack of growth this year over 2005) of the company’s total outsourcing contracts, which in turn account for more than two thirds of total company revnue. So for the remaining two-to-three years of the contracts there will be no profit recognized on about 18 percent of the company’s revenue. If we assume the remainder of their contracts generate the historic 8.2% margins, future operating margins look likely to fall in the 6.7 percent range.
Furthermore, the lack of profitability shows that Hewitt was too aggressive in pursuing contracts. As a result, investors should not expect the company to grow as fast as the historic results would suggest. This is already showing, with consulting revenues down 3% year-to-date.

So what we’ve got here are shares that are pricing in no growth on an EV/FCF basis, an assumption that seems appropriate given the circumstances. We’ve also got a company with what we estimate as sustainable earnings power of $1.00 per share - on which a share price of $20+ appears on the high side in the current market.

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