Description

Willis Towers Watson (WLTW) is an attractive business - stable and defensive with opportunities for growth. It’s run by a management team with a strong track record and trades at a reasonable valuation. Krusty75 posted a great write-up in December and I would refer you to that report (as well the thread), especially for a background on the business segments and merger developments. Since that time, the price has moved a bit lower and there have been a few new events. As such, I’m re-posting this idea for the VIC community because I think it’s a compelling one.

WLTW is a global advisory, broking and solutions provider. The current business was created as the result of a merger of equals between Willis Group and Towers Watson that was announced in June of 2015 and closed at the beginning of January. The deal has striking similarities to the successful Aon/Hewitt marriage from 2010 and presents a number of opportunities going forward.

The new WLTW looks identical to its two peers, AON and MMC - just smaller. WLTW’s sales and EBITDA of $8b and $2b, make it the #3 player in the insurance brokerage and benefits consulting business. AON and MMC have $13-$14b in sales and ~$3b in EBITDA. All of three players have a roughly 50/50 split between “risk” and “benefits” and all derive about 50% of sales from OUS. The main difference is that WLTW has much greater exposure to private healthcare exchanges, small today but a high growth future opportunity. Industry reports have pegged the WLTW opportunity at $2b (~25% of current sales) vs. $1b for AON and MMC (<10% of their current sales). This is why Towers traded a growthy multiple pre-merger.

Despite better opportunities for growth, WLTW trades at a discount to AON and MMC and an attractive absolute valuation. This is because insurance analysts had come to view stand-alone Willis as under-performer due to a subpar acquisition in 2008, and ongoing restructuring efforts that entailed big margin promises but have been to slow to show any results. Burned in the past, analysts are yet to fully appreciate the benefits of the merger going forward, and management is too conservative to fully voice them.

WLTW today trades at 14x cash EPS on 2016 (or 10x EBITDA and 15x NOPAT). In comparison, AON and MMC trade at 13x and 12x EBITDA. While I would argue that WLTW should trade at a premium, you don’t need to believe that for this idea to be interesting. If WLTW was merely valued in-line with peers it would suggest a price of $150-$165, up 27-39%.

The thesis for WLTW is as follows:

1. The merger creates a mini-AON/MMC - a stable and defensive business.

2. The combined entity will have better growth prospects than peers as each standalone entity was already in the early innings of its own growth story.

3. In addition, the merger enhances these company-specific growth stories and adds three additional legs to the thesis: cost synergies, tax rate & capital allocation improvements.

4. Management has a strong track record of creating value and good success integrating.

5. Finally, as noted above, the absolute valuation is attractive for a staples-like business and I think the stock should trade closer to 16-20x cash EPS (11-13x EBITDA). That equates to $135-$165 on 2016 and $160-$200 on 2017.

The new WLTW should be a much stronger third player in an otherwise slow moving oligopolistic market. This will be an entity with durable, low-to-mid single digit type revenue growth (before the impact of healthcare exchanges). Indeed, all three players in the market have consistently exhibited non-cyclical organic growth. In a world seemingly starved for predictable cash flows, this appears to be a good candidate.

The insurance brokerage side is particularly attractive because it’s a tollbooth business. In fact, since coming public in 2001, Willis has only seen 1 down year (in terms of organic sales growth). That year was 2005 when organic growth was down 1% and that was due to a Spitzer-led crackdown on contingent commissions (ex-contingent commissions, revenue would have been up mid-single digits).

The Towers side is similarly stable. Since the 2010 merger of Towers Perrin and Watson Wyatt, organic growth has averaged 3-4% (with 2010 being the only down year at -2%). This past merger obscures what Towers did in 2008 and 2009 but looking at Aon’s HR Solutions segment should give a sense for stability. Aon’s HR/consulting segment saw organic sales up 3% in 2008 and down 5% in 2009.

In addition to being defensive, WLTW has opportunities for growth. While I won’t get into all the details now, Towers has a leading position in the still nascent, but fast growing healthcare exchange market. This is viewed by many as the future of how health care benefits will be delivered by employers. Exchange solutions sales totaled $446m for 2015 and estimates peg the future opportunity for Towers at north of $2b over the next 5-7 years (for those interested, see the Jefferies report from 1/6/15). Clearly, this has the opportunity to be a meaningful growth driver going forward.

Exchange solutions sales were up 36% in 2015 but comprised only 10% of Tower’s sales. As a combined entity, the exchange piece is even smaller (6% of total WLTW 2015 sales and growing to 7.5% in 2016 by my estimates). This is what upset Towers bulls (largely growth investors) about the merger - most of whom have since dumped the stock. While the merger has indeed diluted the impact of the exchange story, it’s still a growth story nonetheless and is now priced at a value multiple. Prior to the deal, TW traded at 17-23x cash earnings while Willis was at 14-16x. Today, the new entity trades at the low-end of a more Willis-like multiple at 14x.  

In addition to exchanges, organic growth should benefit from cross-selling (both in risk and HR consulting). This will particularly benefit Willis on the insurance brokerage side. Willis’ current market share is below 10% vs. 25% each for Aon and Marsh. This because Willis has been primarily a mid-market broker unable to penetrate large corporates (much like Aon was pre-Hewitt). Towers offers strong inroads to larger clients and the merger has the potential to make Willis a much more formidable competitor. Likewise, Willis offers Towers important inroads to the middle market where private exchange adoption is stronger and only MMC has a good position. Towers is already the dominant leader in the retiree segment (with ~60% share) and the merger should enhance its active market share (currently ~25%). In short, the merger has the potential to make Towers the clear leader in what looks to be a three horse race.

The other element to this story is that each standalone entity was already in the early innings of its own growth story. Tower’s story being revenue driven via its leading position in the emerging private exchange business. Willis’ story being margin driven via its cost-cutting and relocation initiative, titled the operational improvement plan.

The Willis margin story could be particularly compelling and seems to be largely dismissed by investors and analysts. Coming into the merger, Willis’ margins were sitting near all-time lows. Adjusted EBITDA margins were 23% in 2015 down from as high as 27% in 2011. In fact, 2013 was the first year on record that Willis’ margins fell below those of Aon and MMC. This is an important point because Willis is a structurally higher margin business given its greater exposure to more profitable reinsurance and specialty business. There are a number of theories as to why margins have eroded but chief among them is the tough environment in reinsurance, and investments in people and technology following the hire of Dominic Casserley in late 2012.   

In the beginning of 2014, Dominic introduced a multi-year plan to realize $300m in annualized savings by 2018 at a cost of $410m. This is a bold goal: 3x the size of any past plan and implies 700-800bps of margin improvement if all of the savings fell to earnings. These savings would come from role relocation (70%) and real estate & IT optimization (30%), and Willis has said that it would expect the majority of such savings to fall to the bottom-line.

While this is exciting, investors have been skeptical because the program is still early days and Willis' results to date have been middling. Savings started rolling in during 2015 but adjusted EBITDA was only up 4%. That said, it’s still early. Cumulative savings realized to date are $123m compared to what I estimate will ultimately be over $600m by the end of 2017. So this is really just getting started and Willis recently upped the target to $325m in annualized savings. If I assume 65% of that falls to EBIT, it would imply 250bps of margin potential on the new post-merger sales base.    

In addition to all of these company-specific elements, the merger provides some pretty straight forward opportunities for growth. File these under financial engineering if you wish. Namely, cost synergies, tax rate optimization, and capital allocation improvements.

On the cost synergies, they are saying $100-$125m over 3 years. If you compare this though to the Aon/Hewitt deal or Towers Perrin/Watson Wyatt, the synergy estimate seem very low and John Haley (who will lead the new company) has been known to sandbag in the past (see Krusty’s 2010 write-up on Towers). Based on my analysis I think $180m+ is more realistic and think you could argue for as high as $250m. Moreover, if you look back at those prior deals, they realized almost all of the synergies in year one (70% to 80% of the total).

Further, the tax rate is expected to come down to “mid 20s” thanks to Willis’ Irish domicile. This is especially important for Towers where the tax rate was 34% in FY15. There was clearly some worry about this given the recent inversion news but the company filed an 8K last Friday reiterating their guidance. This “tax rate” story has been a significant driver of earnings growth at Aon.

Finally, there’s an important capital allocation story (again, very similar to what has driven Aon’s shares higher). Pro forma leverage today stands at 1.7x and management has openly said that they would like to get that ratio up to 2.4-3x. Given the incremental debt capacity and strong FCF, I think the company could easily (and will likely) repurchase $3-$4 billion in stock over the next two years.

When you put this all together, I think it is very likely that WLTW will have better growth than peers. I estimate EBITDA growing 17% in 2016 and 11% in 2017, resulting in cash EPS of $8.25 and $10.50, an attractive valuation of 14x 2016 eps and 11x 2017 eps.

What makes this idea all that more appealing though is when you look past the financial metrics and evaluate management at the helm. John Haley, who was the former CEO at Towers, will be taking the lead as the CEO of WLTW. This is Haley’s third merger of equals since 2005 and he has had excellent success integrating prior deals. The Towers-Perrin/Watson Wyatt merger achieved 150% of the targeted synergies (83% in year one) and increased consolidated margins 400bps in two years. More importantly, he has created significant value for shareholders over his 15 year tenure, overseeing a 15% CAGR for Tower’s stock since its IPO vs. 5% for the S&P over that same time frame. He has an actuarial reputation of being conservative, and under-promising and over-delivering (and that reflected in the current guidance imo). Finally, Haley has skin in the game and a recently released comp plan that strongly incentives him to focus on TSR (see HTC’s post from 3/1 for further details on this).

In summary, I like WLTW given what I view as safe business with under-appreciated opportunities for growth. At today’s price, I think the valuation is attractive and there’s a reasonable case to a $160 to $200 stock over the next 1-2 years. 

Catalyst

Earnings revisions driven by merger synergies, Willis' OIP plan and growth in Tower's exchange business.