Description

WSH has been written up three times, but it is currently at it cheapest valuation yet.  It is an excellent business with sticky customers and very high returns on capital.  It is cheap on every metric, with a 12% free cash flow yield, 8.5x eps, and 7.5x EBITDA.  The CEO bought $5.5 mm of stock last year, and he has huge incentive comp tied to achieving financial targets that are above consensus estimates before he retires in 2010.  It is mis-priced because it had liquidity risk at the height of the financial crisis that it has since resolved.  But, it is still "tainted" because it is more levered than peers at about 3x debt/EBITDA.  I expect WSH will continue its history of large buybacks now that the liquidity issues are behind it.    

The prior write-ups do a good job describing the business, so just to summarize:

• WSH is a global insurance broker for large and mid-size companies. 60% of revenue is outside the US. It was acquired by KKR in 1998 and IPO'd in 2001.
• It is a mature and stable professional services business. WSH takes no underwriting risk.
• "Have-to-have" product; 92% customer retention rate every year.
• 26% EBITDA margins; low capital requirements with an 85% ROIC.
• Buffett has said he wished he owned an insurance broker.
• Moderate, but stable growth.
• Favorable competitive position: WSH is the third player in a 3-player oligopoly globally.

 Valuation: 50% upside

• WSH is trading at 8.5x 2010 cash EPS (i.e. net income before amortization), and it is trading at close to lowest price since going public in 2001. Historically insurance brokers trade at 13-15x forward EPS during "soft markets" and higher during "hard markets."
• The historical P/E range implies a mid-$40's fair value.
• M&A multiples of 10x EBITDA imply mid-$40's.
• DCF implies mid-$40's value with conservative assumptions.

 Why is it cheap/What is the market missing?:

1. Liquidity concerns since resolved:

a. WSH closed a large acquisition on 9/30/08, partially financed with a one year bridge loan for $1bn. The deal coincided with the collapse of the financial markets, creating re-financing risk. The stock dropped from the mid 30's to the mid 20's in September 2008. They have since repaid/refinanced the bridge loan, albeit by borrowing $500 mm from Goldman at 13%. This resolved the issue, but the stock price has not recovered. The Goldman paper is currently trading at 147% of par.

b. The outside shareholders of a small partially-owned French subsidiary, Gras Savoy, have a contractual right to put their ownership to WSH at any point between 2001 and 2011 relating to a deal struck in 1997. The put value is $350mm, which is based on a formula. There was a concern that the put could be exercised in 2010, the same year as a large debt maturity. This would have used almost all of WSH's available liquidity, assuming the debt market was closed. This is now a mute point because WSH just refi'd its 2010 debt maturity.  WSH has repeatedly said publicly that the put holders do not wish to exercise the put. In fact, the put holders recently increased their ownership by buying in a 4% stake from another minority shareholder. WSH has announced that it is negotiating to sell a portion of its stake to a French private equity firm as part of a transaction that would terminate the put rights altogether.

c. WSH is levered at about 3x debt/EBITDA while its peers have <1x debt. Most of its debt matures between 2015 and 2017, but it has $390 mm of debt maturing in 2010. There used to be concern if they could refinance this, which they just did with a $300mm debt issue at 7%. Regardless, they comfortably had the resources to meet the maturity. I expect they will have well over $200mm of cash at the end of 2009, plus they will accumulate over $300mm cash in 2010, after paying dividends. In addition they have $200 mm un-drawn on their revolver.

2. The sell-side has reduced consensus EPS forecasts by 20% since the beginning of the year which has been a negative catalyst for the stock. The consensus reductions are due to two factors: (i) WSH discontinued a $1bn stock buyback plan after the financial market turmoil, and resultant liquidity concerns, which would have significantly reduced the share count; and (ii) forecasts for organic growth have dropped from 4% to 2% due to the weaker economy. Due to the resolution of the liquidity issues, I believe WSH will resume buybacks which should lead to positive earnings revisions.

3. WSH has significant non-cash amortization related to the HRH acquisition and nobody on the sell-side adds it back to earnings. This understates the true earnings and distorts comparisons to peers. I believe WSH is considering starting to report a non-GAAP cash EPS figure which would significantly increase consensus estimates.

4. WSH is perceived to have overpaid for the large September 2008 acquisition of HRH (adds 30% to revenue), the 9^th largest broker, for 10x EBITDA. While 10x is consistent with historical transactions, it was viewed as high given the environment and given that it was higher than WSH's multiple of ~8x at the time. The reality is that even at 10x EBITDA the acquisition generates a mid-teens cash-on-cash return when factoring the cost savings.

 Management:

• KKR hired the current CEO, Joe Plumeri, before to the IPO in 2001.
• The CEO bought $5.5 mm of stock in the market in October 2008 at $22 per share.
• ­ For context, he owns 3.2 mm shares in total which is worth $83mm. He exercised options in 2005 cashing out $50mm.
• The CEO has a good record for capital allocation having bought back $1.4bn of stock in the last 5 years.
• CEO is 66 and has a contract through 2010 when he is expected to retire. His contract gives him options on 1.7 mm shares (in other words, the upside on $45mm of stock) if he hits certain targets including getting the operating margin to 27% vs. current margin of 22% and getting 2010 EPS to $4.10 vs. consensus of $2.85. These targets were set by the board relatively recently in October 2008, but consensus estimates are now much lower because of the discontinued buybacks and slower economy.
• ­ The CEO wants to retire on a strong note, and there is still significant upside to EPS estimates given that WSH could resume buybacks. In addition, the CEO is aggressively managing costs to offset the slower top-line growth. So, the EPS targets in his contract maybe more achievable than current consensus implies.

Catalyst

Very cheap, plus resumption of buybacks, and upside to EPS estimates because CEO wants to hit his comp targets and retire next year on a strong note.