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Thursday, August 31, 2006

Morningstar Takes on HR Outsourcing

By William Trent, CFA of Stock Market Beat

We recently profiled the travails of Human Resources outsourcing firm Hewitt (HEW). Although the stock price had triggered a buy alert we previously set, the uncertainty regarding past revenue (which now is being restated) caused us to remain on the sidelines.

Then yesterday we read an interesting article from Morningstar called Four Top HR Outsourcing Stocks. In many ways, Morningstar appears to share our views.

One caveat though–the one-stop-shop HR outsourcing model has struggled. Often termed human resource business process outsourcing, this new offering focuses on large corporations–usually with more than 10,000 employees–and handles nearly every HR function. Although it has great potential to cut costs for clients, the benefits are much less evident for the service provider.

That sounds quite a bit like our own comment, “One of the things we like about the HR Outsourcing business is that the complexity of the HR function makes many companies prefer not to do it themselves. For the same reason, we wonder why there are so many companies willing to do it for others.” The high competition drove Hewitt to price contracts too aggressively, and was the source of their latest slip.

Still, Morningstar lists Hewitt as one of their fab four, saying:

Hewitt’s position as both a consulting and outsourcing firm creates valuable synergies. With the information accumulated from its benefits outsourcing experience, Hewitt consults for firms that need help with benefit programs but aren’t willing to take the outsourcing leap. Through its 60-year history, Hewitt has gained expertise that keeps more than 90% of its clients coming back every year.

Recently, Hewitt’s stock has been hurt by troubles in its HR business process outsourcing service. Unfortunately, Hewitt swam too deep before the waters in this complicated business had been tested. Still, Hewitt’s non-HR business process outsourcing business (80% of revenue) continues to perform and generates more than enough value to support our opinion that Hewitt’s stock is cheap.

On this we disagree. Our previous conclusion still holds:

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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