Towers Watson (TW) is a high quality business that generates substantial free cash flow, has a net cash balance sheet and trades for less than 12x current year EPS.  Using conservative assumptions, we believe EPS will increase nearly 50% over the next several years while additional cash accumulates on the balance sheet.  A variety of factors that collectively put TW in the "special situation" bucket seem to be obscuring value here, a situation that we suspect will not persist for long.

TW is the product of the January 2010 merger between Watson Wyatt (formerly publicly traded under the ticker "WW") and Towers Perrin (formerly private).  TW provides consulting and outsourced services for major corporations worldwide.  The company's primary businesses include: 

• Benefits (59% of revenues). The bulk of this segment is retirement consulting, which is mostly focused on actuarial and related work on defined benefit pension plans. TW is the #1 provider of actuarial services worldwide. This segment also contains TW's health care consulting practice and its tech outsourcing operation. About 80% of the benefits segment's revenues are recurring and pre-bonus margins are in the 27-30% range. Mgmt expects a MSD revenue growth rate over time.

• Risk & Financial Services (24% of revenues). The RFS segment includes TW's risk consulting business, which provides a variety of services to the life insurance industry, and investment consulting operation, which provides investment advisory services to pension plan sponsors, primarily in the UK. TW is also the world's 4^th largest reinsurance broker. About two-thirds of the RFS segment's revenues are recurring and pre-bonus margins are around 25%. Mgmt expects a M-to-HSD revenue growth rate over time.

• Talent & Rewards (17 of revenues). The T&R segment includes three businesses, all of which are similarly sized: executive compensation consulting, rewards and talent consulting and data, surveys and technology. Not surprisingly, about 80% of T&R revenue is non-recurring and tied to discretionary corporate spending. Consequently, margins can fluctuate meaningfully, ranging from zero to 25% (pre-bonus) in recent years. Over time mgmt expects 10-15% pre-bonus margins and M-to-HSD revenue growth.

We believe that TW possesses an industry-leading consulting franchise with significant BTEs, good pricing power and stable revenues (overall, roughly two-thirds are recurring).  The core business, providing actuarial work to pension and health plans and complex actuarial/reporting services to insurers, is highly defensive (even exhibiting some counter-cyclicality), yet TW offers upside in the form of unrealized merger cost synergies, a net cash balance sheet and discretionary businesses (about one-third of revenues) operating at trough levels.  Mgmt also has a good reputation for execution, capital deployment and conservatism (no surprise given their actuarial backgrounds).  Overall, we think the WW-TP merger created a superior franchise, and that TW's current price offers a very attractive risk-reward proposition.

In terms of valuation, TW is cheap relative Watson Wyatt's historical trading range (10-20x P/E ratio range, ~16x average forward P/E ratio over the last five years) and to the broader opportunity set. Deal-related inefficiencies are likely contributors to this depressed price level.  We believe that a 14x P/E ratio more appropriately reflects TW's earnings power and growth profile. Applying this multiple to our FY-13 (June 2012) EPS estimate of about $5.30 yields a stock price of $74. This excludes nearly $7 per share in net cash that accumulates in the interim (note that we assume moderate stock buyback activity).  Meanwhile, we struggle to see a scenario in which TW earns less than $4.00. Even if business conditions deteriorate, the company has at least 50c of EPS coming from incremental (i.e. post-FY-11) cost synergies in addition to copious free cash flow available for stock buybacks. 

Investment Thesis

• Significant Latent Earning Power. Substantial unrealized cost synergies from the WW-TP merger, discretionary businesses operating at trough levels, net cash on the balance sheet and significant free cash flow generation (well in excess of earnings) set the stage for significant earnings growth over the next few years. The margin expansion opportunity looks substantial, even relative to expectations. Since the merger, mgmt has already increased its long-term EBITDA margin target from "at least 17%" to "at least 18%". We think this highlights mgmt's low-balled synergy guidance. In the Aon-Hewitt merger, which involves comparable businesses, mgmt's cost synergy target is ~10% of the pro forma cost base; at TW, the comparable figure is 4-5%. We'd also note that TW mgmt's new incentive compensation plan (based on FY-13 figures) has a high end payout triggered at a 19% or better EBITDA margin. It's possible this is a real stretch target, but that seems unlikely.

• Interesting Special Situation Inefficiencies. Prior to the merger, WW was a publicly traded small cap company ($1.7 billion pre-deal valuation), while TP was private. The limited available historical data on TP is borderline useless given significant differences in reporting. Post-deal, numerous TP partners retired, which led mgmt to launch two tender offers and a recent secondary offering. Additional vesting events over the next four years create a continuing, though declining overhang. Furthermore, TW's financials are confusing given substantial non-cash charges, namely stock-based compensation associated with restricted shares offered to TP non-partners in the merger. It's important to point out that these shares are already in TW's share count.

• Insiders Seem to Think Stock is Cheap. TW mgmt has been eager to reduce the company's share count since the merger, and as time has passed, holders of TW stock (mainly former TP partners) seem less inclined to sell. Immediately following the merger (Jan-10), TW repurchased $400 million in shares from retiring TP partners (upsized from $200 million originally) at ~$42 per share. By Jun-10, however, when TW mgmt tendered for another $200 million at $43 per share, only 50% of eligible sellers accepted. In Sep-10, TW launched a secondary for holders of shares that otherwise unlock in Jan-11. At the $46 price point, the participation rate declined further to about 45%. Interestingly, a significant number of eligible sellers were TP retirees who no longer have any connection to the business and have been seeking a monetization event for years.

• Attractive Industry Dynamic. Our conversations with industry participants highlighted the stickiness of actuarial work for pension plans and insurers. Similar to the bulge-bracket investment banks, the top few actuarial firms enjoy a comfortable oligopoly perpetuated by the risk aversion of corporate managers. Reflecting their clients' preference for brand names over bargain prices, TW's primary businesses have shown strong inflationary pricing for the past 10-15 years. Recent industry consolidation, namely AON-HEW and WW-TP, should only support these trends.

• Revenue Growth Tailwinds. Despite low current revenue growth expectations, over a longer time frame TW should benefit from the tailwind of ever more complex regulations governing pension and health plans. Regardless of your opinion on ObamaCare, the avalanche of new rules should provide incremental revenue opportunities to TW's health care consulting business for many years. Heightened regulatory scrutiny and reporting requirements for insurers, especially in Europe, will be a further boon. And to the extent that we see a general economic recovery, TW's discretionary businesses will obviously benefit.

Financials

June FYE

                                                           FY-10     FY-11     FY-12     FY-13     FY-14

Revenue                                              3,181     3,209     3,320     3,466     3,620

Adjusted EBITDA                                   503         556        585         627         654

Adjusted EBIT                                       n/a         476         505         547         574

Adjusted EPS                                       3.52        4.20        4.60        5.28        5.91

Consensus EPS                                      n/a         3.98       4.55        4.50        n/a

Adjusted EBITDA Margin                        n/a        17.3%    17.6%    18.1%    18.1%

Adjusted EBIT Margin                           n/a         14.8%    15.2%    15.8%    15.9%

FCF / Share                                          n/a         4.57        5.18        5.89        6.53

Net Cash / Share                                 1.62        3.16        5.39        6.83        8.54

Valuation

P/E Ratio                                                              11.9x     10.9x     9.5x        8.5x

EV/EBITDA Ratio                                                 6.5x        6.1x        5.7x        5.5x

FCF / Share Yield                                               9.1%      10.4%    11.8%    13.1%

Risks

• Some of TW's businesses face a weak revenue environment as companies curtail spending levels on more discretionary projects. It is possible that investors will not re-rate TW's multiple until revenue growth accelerates.

• TW's major businesses are affected by changes in governmental regulation and tax policy. While historically (and prospectively) these policies have tended to boost revenues, any changes that simplify regulations or taxes (honestly, how likely is this?) would be negative.

• A large portion of TW's business relates to defined benefit pension plans. Some large corporations have been taking action to freeze their plans, but volume reductions to TW have been offset by higher pricing and increased complexity. The demise of the traditional pension has been much heralded, but we seem no closer to it today than fifteen years ago.

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.

• Implementation of significant regulatory and accounting changes over the next few years, particularly those applying to financial companies. Incremental future changes, which we think are likely, could be an additional tailwind.
• Pick-up in M&A activity, particularly in the insurance industry.
• Additional stock buybacks. We think it's likely that the unlocking of TP shares over the next four years puts added pressure on mgmt to repurchase some of those shares, which they have already demonstrated.
• Pick-up in discretionary corporate spending. TW's Talent and Rewards segment is most levered to this type of spending, but the other businesses would see some benefit from looser corporate budgets as well.