Even with big wins, providers face operating losses initially, and making a profit will depend on execution.
In looking back, 2005 looks like a banner year. There were 38 new major HRO deals announced—an annual jump of 41 percent. And two of the stars of 2005—Hewitt and Convergys—won 17 deals between them, or 45 percent of new deals and a whopping 80 percent of the total contract value (TCV).
Recently, both Hewitt and Convergys broke out the revenue and operating margins for their HRO practices. Hewitt announced FY2005 revenues of $615 million and an operating loss of $101 million for a return of -16.4 percent. And Convergys announced Employee Care FY2005 revenues of $163 and an operating loss of $50 million for a return of -30.7 percent.
How should we make sense of this apparent disconnect? More importantly, as a current or potential client, should there be any impact on the timing and magnitude of your actions?
HRO Finance 101: A Primer
Let’s examine the financial dynamics of an HRO deal from the supplier perspective. First, a seven-year deal actually occurs over at least eight to nine years. There is year -1 in which selection and contracting occurs, and year 0 in which design and implementation takes place.
Year -1 represents an investment in people and dollars in RFI and RFP responses, site visits and facility tours, and a number of meetings and discussions to explore trade-offs with the goal of agreeing on the optimal solution design and deal terms. It is common for an HRO supplier to spend more than $3 million to be selected as one of three finalists. With odds of 1-in-3 of winning, that translates to nearly $10 million invested for every client won.
Year 0 is an investment-heavy phase in which the HRO supplier staffs a team of experts to perform detailed blue printing, design, and implementation of all aspects of the people, process, and technology components of service delivery platform. Costs for this phase are roughly 10 percent of TCV, or about $15 million to $18 million, with a growing portion of this borne by the supplier.
Finally, in year 1, recognition of revenues can begin. Suppliers that do not take immediate ownership of the complete HR process are limited in the revenues they can recognize until delivery actually begins. For suppliers that assume the complete HR process at the time of contract signing, they will be able to recognize revenues immediately (i.e., no year 0), but they will be burdened with rationalizing the people and assets that come from the buyer organization. For either business model, service efficiency usually is not optimized the first year, so the year 1 operating margin will be below what is achievable later in the contract term.
All told, in a typical HRO deal, the supplier will have invested close to $20 million in a typical deal. And while most HRO suppliers report that a given deal is profitable overall and that the up-front investment often is recouped sometime by year 3, the dynamics of the financial model can appear dubious until delivery is stabilized and the full operating margin is realized.
What This Means for Clients
What will the 2006 numbers look like for Hewitt and Convergys? With 17 wins in 2005, they will incur a significant implementation investment in 2006 before they can recognize revenues. Hewitt is forecasting an operating loss of $128 million in FY2006 in support of its 12 wins, while Convergys projects an operating loss of $25 million in FY2006. However, both also are projecting that these investments today will pay off and that they each will break even by early 2008.
Revenue and operating margins are a measure of past performance. Success needs to be measured against execution fundamentals: on-time and on-budget delivery against 2005 client wins.
This article is not meant to scare readers; in fact we have been talking about this issue for quite some time. The only difference today is that we have actual financial facts to back up what suppliers have been telling us all along. There is no doubt that suppliers are investing heavily in winning market share and developing their technology and operating platforms. The real challenge is simultaneously improving the overall quality of the HR experience. Will these investments be rewarded? It’s too soon to say. Nobody claimed this is a market for the timid.