Hewitt's "Learning" Experience Weighs on Earnings

August 14, 2006 (PLANSPONSOR.com) - The calendar may say 2006, but it looks like 2005 is a year that Hewitt Associates would just as soon forget.

Today the Lincolnshire, Illinois-based consultant and Human Resources Outsourcing (HRO) provider reported that net revenues declined 2%, to $698.2 million from the comparable prior-year quarter.   The culprit appeared to be the firm’s outsourcing business, where outsourcing revenues declined 3%. In a conference call, chairman and chief executive officer Dale L. Gifford cited higher implementation and ongoing servicing costs associated with taking on a “large number of contracts in a short period of time,” specifically fiscal 2005. 

The firm noted that the current quarter was impacted by a previously anticipated $44 million decline in third-party supplier revenues (specifically, the termination of a contract with Bank of America, which moved its account to Fidelity), and the net favorable effects of foreign currency translation of $3 million.   Consulting revenues rose 4%.  

In a press release, Hewitt said that the quarterly results include $249 million of pretax non-cash charges related to the firm’s HR BPO business, as well as higher performance-based compensation versus the prior-year quarter of $44 million.  In a conference call discussing the results, Gifford acknowledged the challenges of taking on too much business too fast, particularly in view of the complex issues, and the new technologies involved.  However, “despite issues encountered in the HR BPO business, we remain encouraged by the performance of our more established businesses, Benefits Outsourcing and Consulting, which make up roughly 80% of our total revenues,” Gifford said.

Facing Challenges

In May, the firm acknowledged it might win fewer new business process outsourcing (BPO) contracts this year, and said it was facing “challenges” in implementing an early 2005 HR BPO contract, resulting in a $7 million loss reserve.   At the time, Chief Executive Dale Gifford said the firm was “leveraging our learnings from this contract, and are working through issues that we’ve identified primarily related to the implementation of some of our 2005 contracts.”   Less than six weeks later, the firm announced that Bryan J. Doyle, a long-time leader in Hewitt’s HR outsourcing unit (and president of the unit since last year), had resigned to pursue other opportunities – and that Dale L. Gifford, Hewitt’s CEO since 1992, planned to retire at year’s end (see  Hewitt Announces CEO Retirement ).  

Last week, Hewitt Associates named BISYS leader Russell Fradin as its new chairman and chief executive officer, replacing Gifford (see  Hewitt Names BISYS Leader as CEO and Chairman ).

In today’s earnings release, Gifford noted, “Given recent challenges implementing some of our HR BPO contracts, an important focus for us in the quarter was to revisit our assumptions related to the expected future performance of our HR BPO portfolio. 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.”   Chief Financial Officer John Park said the firm now expects these 13 contracts will be break-even, rather than profitable, over a five-year period.  

"We are highly disappointed by these findings, and are aggressively addressing the issues, having already implemented key process improvements to drive future performance," Gifford said.  

The $249 million of non-cash pretax charges related to Hewitt's review of its HR BPO contract portfolio was comprised of the following:

  • $172 million of goodwill impairment (primarily related to the acquisition of Exult in 2004 - see  Hewitt Absorbs Exult ) 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.

Revised Expectations

"Although we continue to expect contracts signed this year and in the future to generate acceptable levels of profitability, the diminished economics of our portfolio, at this point in time, no longer supports the value of the goodwill associated with the HR BPO business," said Park, in a press release. "As a result, we have written off a significant portion of the goodwill, and recorded loss provisions reflecting our revised expectations primarily for our 2005 class of contracts." 

Asked to speak to the difference between the profitability of the 2005 contracts versus more current arrangements, Park said that there wasn't a "bright line" of differentiation, but acknowledged specific challenges with payroll and recruiting, as well as contracts that were "more global" in nature.  However, he cautioned that there were other factors, and that it was difficult to generalize the differences.  "We were pioneers in this business," he explained; "we were estimating costs of things that had never been done."

The quarter's results also reflect higher performance-based compensation, with some component of that increase attributed to "discretionary decisions made by management and the Board of Directors to better recognize the individual contributions of associates across the business and progress made addressing challenges in HR BPO," according to the release.   In a conference call, Park noted that "consultant retention remains a challenge," and that the firm was making efforts to ensure that compensation policies took this into account.

Hewitt noted that while outsourcing segment revenues declined 3% in the third quarter, after adjusting for the expected significant decline in third-party supplier revenues, and the favorable effects of acquisitions and foreign currency translation of approximately $2 million each, Outsourcing revenues increased 5%.   Hewitt said that growth was driven primarily by increased services to new and existing HR BPO clients, organic growth of existing benefits outsourcing clients, and one-time project work in benefits outsourcing.

The firm said it now has more than $160 million of annualized Outsourcing revenue in backlog (defined as a signed contract or letter of intent), of which more than 50% is related to HR BPO services, with the remainder for stand-alone benefits services. Additionally, Hewitt said it has more than $135 million of annualized Outsourcing revenue in the pipeline (defined as a formal proposal outstanding), of which more than 55% is related to HR BPO.

For fiscal 2006, Hewitt says it expects total net revenue to be flat to slightly down, comprised of a low-single digit decrease in Outsourcing, and mid-single digit growth in Consulting. Including the charges, Hewitt now expects a core loss in fiscal 2006 of about $100 million to $105 million.

As of June 30, 2006, Hewitt said it was "live with 18.7 million end-user benefits participants and approximately 742,000 client employees with HR BPO services."