Six significant developments are altering the landscape of the big market. Look for smaller and shorter contracts in the years ahead.
Aside from its newness and rapid growth rate, the HRO market was largely unremarkable until 2006. Many fundamental drivers changed very little from year to year.
However, beginning in 2006, many market characteristics that industry observers took for granted changed. In fact, the large-company segment (buyers with more than 15,000 employees) changed drastically. Here are six major changes affecting this segment.
• Demand outstripping supply. The HRO market still demonstrates a distinct lack of capacity from providers. Nearly every major provider has cut back on the number of large deals it is willing to sign this year. This has temporarily reduced market capacity, possibly up to 25 percent compared with 2005, the record year in terms of number of deals signed. There were approximately 40 large HRO deals signed in 2005. The range for 2007 could be as low as 30, but anything approaching 50 is highly unlikely.
Mature HRO providers have cut back on capacity as a result of a shortage of high-quality transition resources and problem contracts. As companies restructure troubled contracts and continue to train and hire transition resources, the capacity shortage will lessen by the end of the year and into 2008.
• Prices are increasing. From 2000 through 2005, the per employee per year fell steadily—15 percent a year. In 2005, we saw HRO pricing finally begin to level out. Pricing in 2006 increased slightly, and we expect HRO pricing to increase modestly again this year.
Why? There are multiple factors at play, each of which has a tendency to drive prices higher. First, the lack of capacity mentioned earlier. Getting providers to bid on quality business is more difficult now than ever before. Second, there is less competition on pursuits. In fact, there are many sole-source deals in play now—the most since 2002. Third, HRO providers are exhibiting better discipline in selecting their prospective clients.
• HRO providers profitability is improving. As a result of restructuring unprofitable deals, a capacity shortage, higher pricing, and less competition, it is no surprise that provider profitability is improving. This is a very healthy development for the industry as a whole, and profitability should continue to improve in the latter half of this year and into 2008.
• Fewer large, global HRO deals. It was not unusual in the first few years of the HRO market to see agreements routinely exceed $500 million in total contract value (TCV). In 2005, DuPont signed an agreement with Convergys in excess of $1 billion that covered 60,000 employees in 70 countries. Recently, Johnson & Johnson signed a 10-year, $1 billion HRO agreement, also with Convergys. It is quite possible that this may be the last $1 billion HRO agreement signed in 2007.
Why? Except for certain unique HRO buyers, getting a single HRO provider to step up to a global deal is almost impossible. This kind of deal imposes enormous challenges to a provider’s service delivery model. For most buyers, focusing their attention on a handful of core countries is an ideal first deployment, both economically and from a change management perspective. Adding other countries with smaller employee populations to a global HRO agreement is usually not profitable for an HRO provider. Therefore, these non-core countries are often put on hold.
• Contracts are smaller and shorter in duration. EquaTerra has witnessed HRO deals become smaller not only in terms of TCV but also in the number of in-scope HR processes. Whereas historically most large HRO deals included 10-plus HR processes (many had more than 15 HR processes), it is not unusual to see deals focus on clusters of three to five or five to 10 HR processes. This is due to the market’s better understanding of providers’ strengths and weaknesses.
Contract lengths have also dropped. Ten-year contracts used to be common. Seven-year contracts are more prevalent now, and the number of five-year agreements has begun to increase.
• New HRO providers are still entering the market. Another major development is that new HRO providers are still entering the market. Yes, there have been a number of acquisitions in the HRO market, but that should not be characterized as consolidation. There is little danger of a “Big Three” HRO industry. In fact, there are more HRO providers today than ever before. ADP and Fidelity have increased their capabilities in the large HRO market. Northgate has notched some large contract wins recently. Newcomers include Caliber Point and Raytheon. There will be others. This phenomenon also points to a healthy HRO market, even though the market fundamentals have drastically changed.