December 03, 2015 - 10:56am EST by
2015 2016
Price: 135.00 EPS 0 0
Shares Out. (in M): 69 P/E 0 0
Market Cap (in $M): 9,315 P/FCF 0 0
Net Debt (in $M): -405 EBIT 0 0
TEV ($): 8,910 TEV/EBIT 0 0

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Towers Watson (TW)
Towers Watson (TW), soon to be Willis Towers Watson, is a rare opportunity to buy a stable and steadily
growing collection of businesses at roughly 11x CY2017 cash earnings. The opportunity is driven by a
misunderstood and under-appreciated merger transaction between TW, a leading human resources
consulting firm, and Willis (WSH), a top global insurance broker. The deal is highly accretive relative to
existing expectations for TW’s earnings power. Based solely on high confidence cost and tax synergies,
we think that the pro forma entity can earn $12.20 in EPS in 2018. Adding in the benefit of capital
deployment and revenue synergies, 2018 EPS climbs to nearly $14. TW currently trades at around $135,
or $125 net of a $10 special dividend to be paid out when the transaction closes. 16x our 2018 EPS
estimate of nearly $14 implies a share price of $224, almost 80% higher than the current ex-dividend
price of $125.
TW/WSH merger
There are three key drivers of accretion in the deal: cost synergies, tax, and revenue synergies/de-risked
revenue growth.
Cost synergies
Management has guided to cost synergies of $100-125mm. We think that by 2018, cost savings are
likely to reach $175mm. Our target is based on conversations with industry participants, and implies a
similar synergy “beat” in percentage terms to the one delivered by TW in the Watson Wyatt/Towers
Perrin deal in 2009. At just 1.2-1.5% of PF revenue, TW’s guidance range is conservative. Note that when
Aon and Hewitt merged, targeted cost savings were 7.5-8.5% of revenue.
WSH is an Irish domiciled company, and management expects a tax rate on the pro forma entity of 25%.
In addition, TW’s international cash balance of ~$800mm will become available. We think the tax rate
target is conservative: it is in-line with WSH’s current rate, and well above that of competitor Aon. Tax
considerations also drove the choice of transaction structure. WSH is the acquirer, and WSH will own
50.1% of the new entity. The pro forma ownership structure minimizes regulatory questions around the
viability of the tax strategy, as WSH/TW is not an inversion.
Revenue synergies
Revenue savings are inevitably more slippery, so we give credit for just $250mm out of management’s
target range of $375 675mm. Some revenue opportunities are quantifiable, such as the potential for
WSH to make modest market share gains in P&C brokerage with TW’s client base. Less readily
quantifiable, but probably just as important, are the tailwinds to growth that the combination provides.
The two companies have complementary client bases, with TW focused on Fortune 500 types, while
WSH is more middle market. For the first time, TW will have a dedicated sales channel into the middle
market. This is especially valuable for products early in their adoption cycle, most notably, TW’s
healthcare exchange business.
Overall accretion, other considerations
TW and WSH released a proxy filing with forward projections for their standalone operations. Taking
their forward estimates of cash net income, adding management’s high-end synergy target of $125mm,
and reducing TW’s tax rate to 25%, the implied 2017 EPS is $9.90. This is ~38% higher than the current
consensus estimate of TW’s 2017 EPS.
Beyond this, the re-domicile will allow the combined entity full access to its cash flows. This opens the
door to accretive capital deployment, likely through a combination of share repurchases and M&A. In a
recent press release, management noted its intention to return capital to shareholders in order to
increase pro forma leverage to a level similar to that of WSH within the next 6-12 months. We assume
2x ND/EBITDA, which would imply an incremental turn of EBITDA in leverage from current pro forma. As
such, the combined entity could spend more than $2bn on share repurchases in the 12 months after
closing. In the out years, maintaining leverage will provide significant capital for further buybacks and
Last but not least, TW management will be running the new entity. Since going public in 2000, TW (fka
Watson Wyatt) has seen its share price compound at approximately 17%. All of this has come under the
leadership of CEO John Haley. TW’s CFO Roger Millay has worked with Haley since 2008, and as a team
they have executed several highly successful transactions, most notably Towers Perrin and Extend
Recent developments
Since the deal announcement, market commentators have had an odd fixation on valuing TW in terms
of WSH. At 2.65 shares of WSH for each TW holder, plus $4.87 in the original special dividend, the value
based on WSH’s pre-deal share price was $125, 9% below TW’s unaffected price of $138. The stock
quickly traded down to that level, and commentators complained that TW had subjected itself to a take-
under. The market apparently failed to appreciate that TW drove the negotiations and would control
management of the new entity. Even more significantly, it ignored the previously described EPS
accretion. In the days after the deal announcement, as TW’s shares fell by around 10%, its implied
multiple fell by more than 40%.
TW’s shareholder base has likely added to the inefficiency. TW’s profile has shifted in the past two years
from a slow but steady consulting business to a play on the evolution of health benefits management
towards private healthcare exchanges. Healthcare exchanges are benefits management platforms
administered by consulting firms like TW (and AON and MMC) to streamline the employee experience
and to coordinate buying of services from the large healthcare companies. Given its SaaS-like business
model and enormous potential market, some investors have assumed huge growth rates, high
incremental margins, and point to aggressive valuation metrics for similar businesses. For the healthcare
exchange bulls, the deal announcement was disappointing on two levels. First, it dilutes exposure to the
healthcare exchange business by approximately half. Second, the equity-based deal perhaps implied
that TW management’s perspective on the potential value of the healthcare exchange business is a bit
more sober than some investors might have hoped. Therefore, the deal likely contributed to an exodus
of its healthcare exchange focused, more growth-driven investors.
Inefficiency has persisted. A dissident event-driven investor acquired shares of TW after the deal
announcement and started agitating for a higher deal consideration. His communications have been
characterized by what we believe is a myopic focus on the deal’s value in terms of WSH’s share price, an
overly optimistic appraisal of the exchange business’s prospects, and, most unfortunately, spurious attacks
on TW’s longstanding and highly effective CEO.
Prior to the scheduled shareholder vote on 11/18/15, ISS and Glass Lewis advised TW owners to oppose
the deal. They noted the attractiveness of the merger, but insisted that TW shareholders should hold
out for a bigger split of the value. In response to these demands, TW and WSH management postponed
the vote and came to an agreement on an increased special dividend of $10 per share, and a
commitment for more aggressive capital deployment going forward. Both ISS and the dissident holder
have continued to demand a marginally higher dividend. Both seem to be ignoring the significance of
the capital allocation commitment, and both are arguing for relatively tiny changes from here: it appears
to be a classic example of “penny-wise, pound-foolish” behavior. The vote on the revised terms is now
scheduled for 12/11/15.
The underlying businesses
The legacy Towers Watson business offers a variety of actuarial and human resource consulting services. The largest
of these focuses on pension benefits, but it also encompasses consulting on risks specific to the insurance
industry, “talent and rewards” (compensation), investment consulting, and healthcare benefits
including the aforementioned private exchange product.
Investors new to the story might be wary of the pension benefits consulting, given that defined benefit
pensions are gradually dying off. This is a legitimate concern, but it tends to get overblown. First, TW’s
revenue in this area is hourly or project based not per capita, so there isn’t a direct link between a
shrinking plan participant count and TW revenue. Given the actuarial nature of the product, TW also has
good visibility into activity levels. Further, TW has an exceptional market position. After the merger of
Watson Wyatt and Towers Perrin in 2009, TW has been larger than the rest of the pension benefits
consulting industry combined. Not surprisingly, margins have steadily increased since then: clients have
essentially nowhere else to go, and the same is true for the actuarial consultants that TW employs. With
pricing power and moderate cost pressure due to lack of competition for talent, the bottom line has
expanded. Despite the growth worries, revenue in this segment has grown at an organic CAGR of 3.7%
since 2006.
Risk and Financial Services encompasses specialized actuarial work primarily for life insurance firms, as
well as investment consulting. While not exciting, growth has been moderate and margins have
expanded. Talent and Rewards has grown revenue and margins nicely, though it is the most cyclical of
TW’s businesses. The most exciting area is the Exchange segment, as previously mentioned. In this
business, TW earns a recurring per capita fee to provide a healthcare benefits management portal for
clients’ employees. TW also coordinates buying of services from the major healthcare providers,
hopefully increasing competition and containing costs. The broader concept is that exchanges give
corporate clients a vehicle to gradually transition towards healthcare benefit programs that are more
“defined contribution” than “defined benefit.” In other words, employers provide employees with a
fixed dollar amount to use as they see fit, rather than providing an open ended obligation. This business
is early stage, but it is growing at 30+% and should see high incremental margins as it matures.
Willis is the third largest global insurance broker after Marsh and Aon. Insurance brokerage is a business
with an unusually stable growth profile. Revenue generally comes in the form of a commission or fee on
premiums purchased by the corporate client. Global P&C premiums have risen in 48 out of the past 50
years. Over the past few years, commissions/fees as a percent of premiums have been stable or
increasing. There has been little change in the competitive environment for years: the market for large
corporate clients has been dominated by Marsh, Aon, and Willis. In the midst of the Spitzer investigation
into contingent commissions and other improprieties, there was speculation that Marsh would be
unseated and upstart competitors would gain traction. Nothing of the sort happened. The big three
have continued to get larger and more dominant than ever.
Relative to Aon and Marsh, Wills has been the laggard of the group in certain respects, especially
margins. The roots of this lie in the acquisition of HRH in 2008, an ill-timed effort to gain share in the US
market. HRH was itself a messy roll-up, and WSH struggled to integrate it, especially in the midst of the
financial crisis. More recently, WSH has been going through an extensive restructuring aimed at
rationalizing back office and IT expenses. While some skepticism is warranted here, we have learned
nothing to suggest that WSH shouldn’t be able to reach a margin profile similar to its peers.
Earnings build
Multiple selection and valuation
This is an unusually resilient collection of businesses. TW has a-cyclical elements most notably the
pension benefits consulting business, in which activity tends to pick up during times of asset price
volatility. WSH, and its global insurance brokerage peers, have been able to keep growing during
virtually all economic environments. To the negative, the topline growth potential is mostly unexciting
(healthcare exchange being the exception). A multiple roughly in line the market seems appropriate: call
it 16x. 16x our 2018 EPS estimate of nearly $14 implies a share price of $224, almost 80% higher than the
current ex-dividend price of $125.
Other considerations
Why buy the pro forma entity through TW, rather than WSH? There is still a risk that the deal falls apart.
We think the risk is low, but it is difficult to quantify with confidence. Therefore, in making the decision
between TW and WSH, we focus more on the question of which standalone business would we feel
more comfortable owning, rather than which security creates the pro forma ownership at a slightly
cheaper price. Having owned TW in the past, we have studied it over an extended period of time and
feel comfortable with the franchise’s value.
Deal goes through: the TW vote is 12/11/15
Sell-side estimates are updated for the pro forma entity; market realizes how cheap TW is
Buyback program to reach leverage target accelerates upward valuation correction
Disclaimer: We and our affiliates are long TW. We may buy or sell shares without notification. This is not
a recommendation to buy or sell shares.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


 Deal goes through: the TW vote is 12/11/15
 Sell-side estimates are updated for the pro forma entity; market realizes how cheap TW is
 Buyback program to reach leverage target accelerates upward valuation correction
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