An HR Stock that Could Rebound as America Gets Back to Work

The U.S. unemployment rate hit the dreaded 10% mark in late 2009. As bad as this has been for firms and their underlying employees, it has been even more difficult for companies that help other companies with human resources. On the flip side, these firms will be among the first to benefit once employment trends accelerate. And seeing as unemployment has already fallen back to the single digits, a recovery may very well already be underway.

A prime beneficiary of this recovery could very well turn out to be Illinois-based Hewitt Associates (NYSE: HEW). Founded by Ted Hewitt in 1940 as a one-man insurance operation, the company has evolved from an actuarial benefits manager to a broad-based benefits outsourcing firm. Over time it has developed a reputation and integrity that has allowed it to grow into one of the largest human resources (HR) consulting and outsourcing firms in the world. Hewitt now has operations in 33 countries and serves more than 3,000 clients, including two thirds of Fortune 500 firms.

Hewitt operates three primary business segments, many of which it has pioneered. Benefits outsourcing is its largest segment and also happens to be the most lucrative, with operating margins close to 25%. The unit brings in just over half of total revenue and helps clients outsource key human resource functions, including defined benefit and contribution retirement plans and health care programs that serve employees while protecting the bottom lines of the client. The company lays claim to having created the first large-employer 401(k) plan, now commonplace in the industry.

Consulting has been core to Hewitt since its founding and accounted for a third of last year’s revenue. The segment is also quite profitable, and boasts an operating margin of about 14%. The unit helps clients design HR programs and strategies, including designing retirement plans, helping firms determine compensation levels for hiring and maintaining employees, and finding ways to lower healthcare costs.

A newer division is human resource business process outsourcing (HR BPO), which was created just as Hewitt was going public and accounted for 16% of last year’s revenue. HR BPO also helps clients perform HR functions but focuses on tackling more detailed administrative tasks, such as payroll services, determining employee compensation levels and recruiting outside talent. HR BPO has yet to turn a profit, though losses have been stemmed to negligible amounts after posting nearly $500 million in losses in 2007.

Total company operating margins were greater than 14% last year and have averaged in the double digits during the past few years. Net margins are trending toward double digits despite the economic downturn. A stable top line also defines Hewitt’s ability to weather economic storms: 95% of clients have been with Hewitt for more than five years and it handles benefits for 5% of the American workforce. Stability combined with a steady stream of new clients and bolt-on acquisitions has resulted in mid-single digit sales growth during the past five years.

Sales should accelerate as clients begin hiring again and net margins should also improve as Hewitt continues to control costs and see a boost in demand. This should also positively impact returns on invested capital, which are already in excess of 20%. High returns stem from a stellar reputation as a human resources provider and a service model that doesn’t require much capital to operate. As an added wild card, HR BPO could juice the bottom line further once consistent profitability is achieved.

Hewitt’s shares trade for a very reasonable low teens multiple off forward earnings — at the low end of its P/E range since going public. Hewitt is also unique as one of the only publicly-traded pure-play human resource service providers. The stock has the potential to double if the valuation returns to IPO-era levels, but should see at least +50% upside during the next couple years as improved profit prospects will combine to benefit shareholders.