Description

Here we go again: WTW (formerly known as Willis Towers Watson) has reported another set of mixed results, slashed its outlook, and conducted a confounding conference call.  Management has now cut guidance three times in less than a year, erasing most of its credibility with investors.  The stock is down 13% in 2023 vs. the S&P 500 up 19% and Marsh and Aon up 16% and 13%, respectively (all including dividends).  WTW’s 2024 P/E multiple has shriveled to 13x, a huge discount to both the market and its peer group.  For a good business with modest leverage and decent long-term prospects, this is – in a word – pathetic.  Nevertheless, I believe that now is the time to buy the stock.  Since the company has been written up on VIC twice before, in 2016 and 2021, I’m going to skip the usual business overview and cut to the chase of why I think it’s interesting.  If you like good companies available at value prices, read on.  If you own the stock currently (as I do), this might trigger PTSD, so consider skipping ahead to the next write-up.

How did we get here?  As anyone who follows the insurance brokerage sector knows, Aon agreed to acquire WTW in early 2020.  The deal was ultimately stuffed by regulators in mid-2021, leaving WTW in an awkward spot.  The company’s longtime CEO, John Haley, wanted to retire (immediately as it turned out), which left a leadership vacuum.  Meanwhile, many of the company’s producers, particularly on the insurance brokerage side of the business, had departed in anticipation of Aon integration.  Thus, when the deal fell through, the company had to move quickly to arrest any further management/producer losses and to hold a group of activist investors with ideas about the company’s standalone future at bay.  To what I suspect was the activists’ dismay, the board appointed two insiders to the positions of CEO and CFO.  Further, the company followed through on its plan to sell its reinsurance brokerage business to Arthur J. Gallagher, which had been a remedy for the Aon deal.  The $1 billion termination fee paid by Aon was used to repurchase stock and new management immediately restarted hiring in insurance brokerage. 

But the road since then has been choppy.  Management first cut guidance when the Ukraine war forced the company to jettison its highly profitable Russian operation.  Then the company dropped its long-term free cash flow guidance in early 2023, largely because of issues that took place in 2022.  Inexplicably, management waited another quarter to provide more detail on the company’s free cash flow trajectory.  And today management gutted its prior 2024 guidance.  This time the culprit was lower pension income (which is non-cash) and additional margin pressure associated with new hires.  The street estimate for 2024 EPS was already well below management’s original 2024 guide as the pension income loss was anticipated, so the ultimate change in estimates is likely to be small (~4%), but there is a palpable sense of frustration among both the buy-side and sell-side with WTW.  I think this provides a good opportunity.

To keep this simple, I’d highlight a few key thesis points:

1. 2024 estimates are now cleaned up and realistic.  At the mid-point of the range, management is now guiding to $16.20 of EPS, down from $19.00 (Q3-22) and $19.50 (September 2021 investor day).  $1.65 of this reduction came from an expected decline in pension income.  Notably, earnings quality is much higher now.  Pension income as a percent of EPS in 2024 will be ~4% compared to ~16% in 2021.  The remaining reductions from the original target include the loss of Russia (~50c) and another ~$1.15 per share from incremental investments in hiring producers and other costs.  To sanity check the 2024 estimate, I look at the CAGR vs. 2021 EPS.  $16.20 is a ~12% EPS CAGR.  Within this figure, there’s net income CAGR of ~8%, FDSO reduction CAGR of ~8%, and a ~4% CAGR headwind from lower pension income.  This strikes me as reasonable for this business, which is a MSD organic grower with margin leverage and ample free cash flow to deploy.  Relative to 2023, the 2024 guide implies similar growth in net income (~HSD), which seems achievable.  Despite the attention paid to pension income on yesterday's call, it will be a much smaller hit to EPS in 2024 than in 2023.
2. The stock is very cheap.  WTW currently trades at 13x 2024 P/E.  This is a 30% discount to the S&P 500 and a 40% discount to peers Marsh and Aon.  Should WTW trade at a discount?  Sure, management is screwing things up right now.  But I don’t think a discount this steep this makes much sense in the medium to long term, especially if management can continue to drive attractive organic growth, which was overlooked during today’s orgy of selling, and get margins and free cash flow generation to promised levels.  (Note: before I am harangued in the Q&A about differences in accounting influencing multiples in the sector – yes, I know.  There are some puts and takes across the different players.  But much of the delta was from WTW’s income from an overfunded pension, and that’s mostly gone now.  Big picture, the differences are small whereas the magnitude of the valuation differential is now huge.)  Regardless of where you think different companies in the sector should trade, 13x is quite low for a modestly levered, growing business services company that is returning substantial capital to shareholders.
3. Management’s targets for margin expansion and accelerating free cash flow growth seem reasonable.  Management is now targeting 2024 adjusted operating margins of 22.5-23.5%, well below its initial targets of 24-25%.  This target is also far below the level at which Marsh and Aon operate, in the mid/high-20’s and 30%+ range, respectively.  Even allowing for some modest structural differences among the businesses, this is a large gap that WTW should be able to partially close.  Meanwhile, the improvement in free cash generation is even more straightforward.  Relative to a free cash flow “margin” of 12% in 2023, management is targeting 16%+ in (around) 2025.  Two drivers of this are just mathematical: the dropping out of heavy restructuring charges by 2024 and the maturation of the Tranzact business, which consumes cash as it grows and pays out down the road.  A similar sized bucket of improvement is simply improved margins, which seem doable per above.
4. Maybe an activist put?  There was considerable activist noise in late 2021 after the Aon deal blew up, though much of that subsided after WTW’s board acted quickly to replace management and return a sizable amount of capital to shareholders.  Should the stock continue to languish, I think it’s likely that one or more of the firms that previously owned shares and/or had sharpened their pencils on the company return.  What might attract an activist at this point?  Well, replacing management jumps to mind rather too easily.  More dramatically, an activist could probably make a convincing argument that the Towers Watson-Willis Group merger from 2016 has failed to live up to its potential and should be unwound.  Both of those businesses might be better run as independent companies or as divisions of other companies.

So, what are we playing for?  Lets underwrite a subdued scenario to be conservative: 5% organic revenue growth + 1% growth from margin leverage = 6% net income growth + 4% EPS growth from share repurchases = 10% EPS growth.  If we start with the midpoint of management’s new guidance of $16.20 in 2024, this results in 2028 EPS of nearly $24.  Applying a 15x P/E multiple, the stock is worth >$350 per share, or nearly 70% upside.  The 4.5-year IRR including dividends is ~14%.  I don’t think this is crazy.  The same earnings math using a P/E of 18x implies ~100% upside in the share price and an IRR of ~18%.  In a bear case, I candidly don’t think there’s material downside from here given (a) EPS is almost certainly going to be higher irrespective of the macro environment, and (b) the starting multiple is low.  Could the stock trade for 10x 2024 EPS of ~$16?  Sure, given enough investor loathing, but that would be an unduly punitive valuation compared to just about any relevant marker.  But if that’s your risk, we’re still talking about a roughly 3:1 up/down in a (sad) base case and about 4:1 in the same operating case but with a market multiple.  That seems…good?  I happen to think EPS growth will be a little faster than 10%, but we don’t need that to make this a nice investment.

In terms of risk, I think the most likely one is that WTW turns into a value trap.  Maybe EPS growth turns out to be MSD and the stock languishes at a low teens P/E multiple.  This could certainly happen.  I don’t think there are meaningful threats to the business itself, however.  The legacy Towers Watson piece of the company is a boring, slow growth consulting business.  The legacy Willis piece is a bit less staid, particularly given recent personnel changes, but even here we’re talking about one of the biggest players in insurance brokerage, which is generally a pretty good business.  There is more scope for adverse surprises in WTW’s health benefits administration business, notably Tranzact, but this is a small profit pool.  Practically, I think the risk is that management execution remains sloppy and that investors decide not to bother. 

Catalyst

1. Management stops cutting guidance every quarter.
2. The market decides a 13x P/E is too low for a company in a sector that trades >20x.
3. Activists smell blood in the water and force change.