Industria y Construcción

Paychex 401,000 ADP 165,000 Gevity HR 135,500 Administaff 112,496 Oasis Outsourcing 70,000 SCI 30,000

Barrett Business Services 25,300 Sources: Company reports

NAPEO estimates that there are approximately 700 professional employer organizations total in the U.S., with the largest five serving roughly one-third of total WSEs. The industry’s core potential market, businesses with less than 50 employees, employ roughly 50 million workers total, with another 45 million employed by companies with 50-499 employees, according to the BLS. Utilizing NAPEO’s estimated average gross pay of a PEO worksite employee of $31,000/year, the market is approximately $1.5-3.0 trillion in gross revenue. However, as noted in prior sections, much of the gross revenue for a PEO comes in the form of pass-through payroll wages and thus is an unreliable measure of revenue. Rather, if we use a net revenue (which is devoid of wages) of approximately $1,000 per employee, the market size is a more conservative, but still significant, potential market of $50-95 billion. That said, some PEOs exclude struggling businesses and those with significant employment risks from their target markets. Currently, the market is less than 5% penetrated, which should change rapidly over the next decade as more small companies gain a better understanding of the advantages of PEOs.

Competitive Advantages

The shakeup within the industry during the last recession forced the exit of many small PEO firms that lacked either quality client bases or the financial savvy to survive a difficult market. On the flip side of the coin, stricter regulations have also limited the number of new entrants into the market. Among the 700 existing players, the top 10 (in terms of worksite employees) have clearly differentiated themselves from smaller participants in three areas: (1) the economics of benefits administration, (2) their adeptness at dealing with compliance issues, and (3) the superior technological platform. The first two topics have been covered thoroughly, though it is worth noting that the largest PEOs have been the most aggressive and influential entities in designing and implementing PEO laws. Not surprisingly, the new restrictions

The last advantage that large PEOs have is their sophisticated technological platform. Some of the larger PEOs are investing millions of dollars in multi-functional, web-based tools, powerful back-office databases, and other related automation software. This is creating new opportunities for these firms, as they can grow faster, provide more services, and generate superior value by using completely automated systems to handle the needs of hundreds of clients with tens of thousands of employees (NAPEO). Evidence suggests that customers generally stay with their PEO partners as retention rates for the top firms often exceed 70%, and in some cases exceed 80% (which are significant higher if client losses due to M&A activity and bankruptcies are excluded). Reasons for stickiness include: (1) the cost of switching (exiting the old system and implementing a new one) would be too great, (2) PEOs generally offer homogeneous products, and (3) the original contracts are long term in nature. Ultimately, we expect PEOs will compete mostly on price, which would further help the large players that have already built scale into their operations, but acknowledge that service quality is also an important factor.

Positioning for the Future

With solid demand driven by a compelling value proposition, we believe that professional employer organization services will be one of the fastest growing areas within human capital services for established players. We conservatively project that the largest PEO players will grow revenue at an annual pace of 10-15% for the next five years.

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Leading Companies

Notable HR consulting companies include Watson Wyatt Worldwide, Mercer, Hewitt Associates, Towers Perrin, Affiliated Computer Services, Hay Group, and Aon.

Description

Like many of the other sub-segments in the HR marketplace, defining an HR consulting firm is complicated. HR consulting firms tend to offer services that address the following strategic and tactical issues:

• Leadership;

• Workforce planning and development; • Health care management;

• Pension actuarial valuation; • HR administration;

• Retirement administration; • Performance management; • Compensation management; • Global HR services; and • Organizational design.

For example, a client company may want a consultant to help improve its recruiting process. As a result, the consultant will review the demographics of the company’s employee base, suggest strategies for improving hiring, and assist in the development of an enterprise recruiting solution or recommend another third-party provider.

HR consulting firms and HR outsourcers sometimes operate across an ambiguous line since some firms offer both services. Some HR consulting firms offer discrete outsourced HR services much like comprehensive HR outsourcers. For instance, Hewitt Associates is a well-regarded HR consulting company and is also a well-regarded benefits outsourcer.

Revenue Model

Consulting services are usually arranged on a project-by-project basis. HR consultants are paid in a variety of ways, depending on the type of services provided. For consulting services, consultants typically bill by the hour or have a fixed fee for a specific deliverable. For outsourcing solutions, fees are generally levied on a per-employee, per-month basis or on a cost-plus basis.

General Trends

The HR consulting market grew steadily throughout the 2000s, powered by an overall increase in human capital spending. Because of high international exposure and service diversification, the largest players within the group fared particularly well through the recession and subsequent recovery. We remain optimistic about the overall health of the HR consulting market due to the recurring nature of certain projects as well as constant changes in rules, regulations, demographics and technology that require outside expertise. Revenue growth has recently benefited from several legislative/regulatory changes, which we discuss below. Figure 11.1 depicts this trend by showing the revenue growth of Mercer, Watson Wyatt, and Hewitt Consulting.

0 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 7,000,000 R e ven u e ( $ 000 s) 2001 2002 2003 2004 2005 2006

Mercer Consult. WW HEW

FIGURE 11.1:

Source: Annual reports of HEW, WW, and MMC

One specific example of recent legislation impacting pension plans was the passage of the much- anticipated Pension Protection Act of 2006 in August 2006 following a prolonged revision process. The 907-page report outlines several important changes to existing pension laws:

(1) All companies must fund 100% of their pension plan targets by 2011, albeit at a staggered pace: 92% in 2008, 94% in 2009, 96% in 2010, and 100% thereafter;

(2) The new laws established thorough disclosure rules that require companies to report pension- related financials and/or projections; and

(3) Non-traditional (e.g., cash-balance) plans are properly defined and legalized.

The third point is in response to the August 7, 2006 decision of the 7th Circuit Court which reversed an earlier District Court ruling that struck down the legality of IBM’s cash balance pension plans. A cash balance pension plan features elements of both traditional employer-funded defined benefit plans and 401(k) plans. A cash balance plan is a defined benefit plan that defines the benefit in terms of a hypothetical account balance, which is more characteristic of a defined contribution plan. In a typical cash balance plan, a participant's account is credited each year with a pay credit (a percentage of compensation from the employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the balances of the participants’ accounts. Thus, the investment risks and rewards on plan assets are borne solely by the employer. Another key difference between a cash balance plan and a traditional defined benefit plan is that participants in a cash balance plan generally have the option to transfer at least a portion of their account balance to an IRA or to a new employer’s plan if they change jobs. The original court ruling stated that the credit system used in a cash balance plan discriminated against seniors because younger employees have more time to accumulate credits. However, the new decision dismissed the notion of discrimination on the basis of the time value of money.

In our opinion, these reforms represent a monumental shift in the government’s view towards market forces. It is widely speculated that the new pension laws will open inroads for consumer-directed healthcare. Consequently, pension and healthcare plans will be more subject to market forces which should promote more efficient plan administration. We believe that these policy overhauls will create new catalysts for HR consulting firms that are broadly exposed to the retirement and healthcare plan services. Specifically, as firms move towards fully funding their pension plan targets (as required by the new law), demand for actuarial services at HR consulting firms should increase significantly.

Industry Drivers

Similar to discrete and comprehensive HR outsourcing, demand for consulting services is highly dependent on the nature of the services. For example, HR consulting related to health and welfare is growing rapidly due to the reasons mentioned previously whereas more discretionary consulting services (particularly people-related consulting) are experiencing weaker demand in the current economic climate. We expect HR consulting to experience continued growth from a long-term perspective. Aside from pent- up demand, we believe demand for consulting services will increase due to the need by companies to increase the efficiency and effectiveness of their human capital programs. At many companies, the HR department is staffed by administrators who are not familiar with best practices; therefore, they turn to consultants to assist with their strategic and tactical issues.

Many of the demand drivers for the outsourced solutions provided by HR consulting firms are the same as those for discrete and comprehensive HR outsourcers. Specifically, employers are seeking new ways to optimize their HR function in order to reduce cost, increase service levels, and focus less on the day- to-day administration of HR and more on strategic functions such as recruiting and employee retention.

Economics of Business

For the most part, HR consulting is a head count business with low capital requirements. We temper this by noting that the larger HR consultants in the industry develop products (software, studies, etc.) that, once developed, can be leveraged by selling to new parties. Similar to other consulting businesses, HR consulting can generate high margins provided that the utilization of consultants is high. Current operating margins for the industry typically run in the 10-20% range.

Market Size and Structure

The HR consulting market is one of the most established in the HCS space. Many reputable players (such as Hewitt, Towers Perrin, and Mercer) can trace their roots back to the early 20th century. The larger, global HR consulting firms have traditionally billed themselves as HR consultants (Mercer, Watson Wyatt, Hewitt, etc.). Other firms such as the Big Four and IT outsourcers (EDS, PricewaterhouseCoopers/IBM, etc.) have moved into the HR fray by offering either consulting or outsourcing solutions. Overall, the HR consulting marketplace is bifurcated into large, national and international consulting firms and hundreds of small, regional or boutique consulting firms. The larger consulting firms tend to offer some outsourcing solutions (such as health benefits or 401(k) administration) in addition to strategic HR consulting services.

Currently, we believe that benefits and HR consulting is a $14-18 billion market, with the top three generating $6.6 billion alone (Figure 11.1). While we anticipate 4-6% annual revenue growth in a normal operating environment, recent regulatory changes could drive above-trend growth in the near term.

Competitive Advantages

Large HR consulting firms tend to compete on a number of fronts. Reputation is often a powerful guiding force behind a client’s selection of a consulting partner as some consultants have very well-developed franchises in certain areas (e.g., benefits administration or actuarial work). In addition, large consulting firms tend to have broader geographical presence which allows them to address the needs of even the largest multinational companies. Furthermore, some consulting firms offer a broad array of services within HR as well as across other, non-HR areas such as finance, accounting, or logistics. On the other hand, small HR consulting practices tend to compete on the basis of price or regional expertise. These firms may have a strong regional presence or a narrow focus in a particular HR segment.

A few large HR consultants such as Hewitt Associates offer outsourced solutions due to their ability to leverage their HR expertise into an outsourced solution. HR consulting firms have been designing and

HR is a source of competitive advantage within the HR outsourcing marketplace. Experience in systems design and integration is an additional source of competitive advantage for consulting firms. Consulting firms that possess this expertise are better able to facilitate the smooth consolidation and integration of disparate HR applications.

Since 2001, multinational companies have been expanding globally much more so than they did ten years ago. In our opinion, this is a trend that will likely continue. As a result, multinational companies are increasingly looking for service providers with geographic footprints large enough to meet their global demands. As such, HR consulting firms that have a wide geographic footprint are likely to have an advantage.

Finally, as the provisions of the Pension Protection Act go into effect, consulting firms that excel in this area will benefit the most from the changes. As a result, we expect retirement and healthcare plan specialists such as Watson Wyatt, Hewitt, and Towers Perrin have the potential to modestly increase their market share.

Positioning for the Future

We believe that blue chip HR consulting firms can be attractive investments given the combination of solid growth and high margins. Furthermore, we project that demand for HR consulting services will enjoy a strong secular upturn as the pension plan legislation runs its course.

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Leading Companies

Notable human capital point solutions providers include ADP (Employease), OneClickHR, Saba, SHPS, Skillsoft, and Workscape.

Description

Human capital point solutions (“point solutions”) are an amalgamation of various segments of the HR continuum that do not neatly fit into the other HCM categories. Generally speaking, point solutions are applications or processes that automate key business activities, streamline decision-making processes, or make these processes more effective through the automatic dissemination of best practices. Examples of point solutions can include the following:

• Human capital deployment; • Performance management; • Compensation management;

• Employee Relationship Management (ERM); • Professional services automation; and • eLearning/eTraining modules.

While some of these solutions are enterprise applications, the majority of these point solutions are increasingly offered under a SaaS model.

Revenue Model

The human capital point solution providers derive revenue through various channels including: subscription and hosting fees; software licensing; software maintenance; professional services related to software implementation, customization and training; and per-usage fees related to certain programs (eLearning materials, for example). For example, customers at Workscape typically pay for an implementation fee for its compensation management module ($250k-400k). Additionally, they will be expected to pay service and support fees that range from 150 to 200% of the licensing fee. Other services, such as e-learning programs, may be obtained on a per-curriculum basis. Contract duration is typically one to three years of service with monthly billing. In cases where professional services are rendered, vendors generally bill clients on a per-contractor and per-time basis.

General Trends

In terms of recent trends, performance management has been one of the hottest areas within HCM and has garnered a lot of attention recently. More generally speaking, consolidation has been a recurring theme within the entire HCS space, but has been particularly pertinent within point solutions. Two of the largest players within this sector, eBenefits and eBenx, were bought out by healthcare providers HUB International and SHPS, respectively. OneClickHR, the leading European e-HR company, has also restructured internally in an attempt to turn around disappointing earnings. The heightened M&A activity is a sign of maturation within the industry; however, and we believe that the leaders emerging from the wave of consolidations will be in a position to produce sustained growth.

Industry Drivers

Historically, point solutions have fallen within the domain of HR and IT consulting firms that offer strategic consulting services and/or custom enterprise solutions for a client’s particular needs. With the advent of the web, numerous other players, including startups and previously smaller niche firms, have begun to combine HR best practices with sophisticated web technology to create solutions that add significant

benefits and efficiencies at lower cost per employee and are easily scalable between large and small organizations. This has enabled some point solution providers to enter previously under penetrated markets (small to mid-size companies).

There are several distinguishing features of point solutions. First, these services are often ready “out of the box”, which translates into lower start-up costs and quicker implementation. Second, point solutions are often built on the premise of employee self-service where employees have access to manage their own benefits and personal information online. This is appealing to employers because it usually results in the need for less back-office support. Finally, point solutions often have the potential to heighten the level of connectivity and communication between employers and employees. A good example of this is Workscape, which offers a comprehensive employee portal solution that serves as the desktop interface connecting employees to self-service benefits administration, employer news and communications, online payroll administration, and a myriad of other products and services.

Economics of Business

Similar to web-based HCS vendors, the operations of point solutions firms often exhibit high amounts of leverage. Designing software results in large initial costs; however, once the software is designed it can be deployed repeatedly on-demand with few additional costs (occasional upgrades and repairs). Moreover, once established with a meaningful client base, these firms can leverage their infrastructure to achieve higher margins. In some situations, the point solutions tools have gained enough traction such that they are viewed as industry standards, similar to what ERP providers have done.

Market Size and Structure

Given that human capital point solutions is a very broadly defined market, estimates of market size vary widely depending on which solutions are included. The revenue of the largest publicly traded player in the space, Skillsoft, is approximately $225 million. However, there are a large number of smaller firms that specialize in specific service/product segments. Furthermore, most of the companies in HCPS are privately held.

Competitive Advantages

Point solutions derive their competitive advantage primarily by providing best-of-breed solutions. Many of the companies within this category offer unique products that are technologically advanced or make unique use of the technology.

Positioning for the Future

Point solutions offer best-of-breed services that often are cutting edge and offer a unique value proposition. We believe several companies in this space will emerge as attractive long-term investments, due to the potential for rapid growth, combined with highly scalable business models. However, some of these solutions may need to partner with other major solution providers in order to gain traction in a consolidating HR marketplace.

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Human Capital Separation is the final portion of the human capital continuum and includes retirement benefits administration and outplacement.

Source: Baird

Given the overall investment thesis, we are not providing a detailed discussion of this area; however, later we do profile three outplacement firms (Right Management Consultants, Lee Hecht and Harrison, and Drake Beam Morin). Many of the companies providing retirement benefits administration services in this area are HR consultants and outsourcers and have been discussed previously in other parts of the