Willis Group Holdings WSH
September 16, 2003 - 2:40pm EST by
2003 2004
Price: 30.69 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 5,200 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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How about a well-run company, in a great industry, with 28% operating margins, 33% ROEs, tons of cash flow, on track for 35% EPS growth this year? You can buy it for under 14x this year’s earnings and under 12x next. Better yet, its market cap is $5.2 billion. This one really has no warts. I run the risk here of being labeled a GARP investor by fellow club members, but hey, I’m not afraid of four-letter words.

History: Willis is the world’s third largest insurance broker, behind Marsh and Aon. Its history is quite relevant to the story today, so let me bore you with a paragraph on that. KKR took this firm private in 1998. At the time, it was a sleepy, undermanaged company consisting of two great franchises, Willis in London and Corroon & Black in the U.S., that were run separately even though they had merged back in 1990. KKR sang the usual LBO tune to management and employees – we’ll make you rich in a few years if you work your butt off, save your paper clips, quit those lunch martinis, and pound the pavement for new business. Surprise, surprise, it worked! WSH earned $1 per share in 2001, the year it was IPO’d, and it’s on track for $2.20 this year. Pretax margins of 15% were one of the worst in the industry, but now are among the best at 28%. Net debt-to-cap has been reduced from over 50% to 23%. And it’s not all cost-cutting. Revenues have grown from $1.4bil to $2.0bil during that time, on industry-leading 18% organic annual growth.

OK, great, you say. You’ve missed the boat. The stock’s more than doubled since the IPO two years ago, why invest now? The simple answer is that the company can grow profits at a mid-high-teens annual rate, yet trades at less than 12x next year’s EPS. But for details, here are three good reasons, followed by valuation.

1) Industry: Insurance broking is an inherently wonderful industry to invest in. It’s not capital intensive, it’s only mildly cyclical (and not correlated with the economy), and it’s consolidating to the benefit of the larger, public players. It’s a “tollbooth” business, receiving commissions for selling a product (property and casualty insurance) that is essentially a required, recurring purchase for businesses. And it takes on no underwriting risk, so you can sleep at night. There’ve been other insurance brokers posted on VIC (Aon and Hub International come to mind), so you can read up on those for more color. WSH is highly profitable with a return on equity of 33% and operating margins of 28%, but that’s actually not that unusual among the well-run brokers.

2) Management: In 2000, KKR brought in a real top-notch exec who had just retired from Citigroup, Joe Plumeri, as the CEO. Plumeri was one of Sandy Weill’s chief lieutenants for 30 years, and he’s got a great team of managers around him. He just recently extended his contract through 2008. He’s an energetic sales guy, which is perfect for insurance broking, but has plenty of financial discipline, too. Joe and KKR have really inculcated the firm with a shareholder value mantra (to the point where you wonder if it’s not excessive, actually). Over 70% of employees own stock, and executives own 4.4% of the shares. Managers are “encouraged” not to sell any stock. Most are in it for the long haul. This was not one of those cut-expenses-to-the-bone and pretty-it-up for the IPO type of LBO. This has the potential to go on a multi-year run a la Safeway, although there is a big difference in that I don’t see KKR remaining invested in this for that long.

3) Growth: The growth potential is big. WSH will post $2bil in revenues this year, good enough to be almost twice the size of 4th place A.J. Gallagher, but still less than a third of 2nd place Aon. It’s had the best internal growth of all the public players for a couple of years now, and it should be able to outgrow the others for a few more years at least. The main source of momentum is that WSH is in the sweet spot from a size perspective – it’s big enough to service global customers but small enough to cater to the mid-market customer. Now that WSH has integrated its London and American operations, it’s become a viable third alternative to Marsh and Aon in the global account segment. Marsh and Aon dominate that segment, so customers are quite happy to have another choice. It’s not just clients that like having a third choice, but the insurance carriers, too – in fact, six insurers invested in the LBO along with KKR, and although they’ve sold their stakes, it underscores the interest that insurers have in helping WSH succeed. Acquisitions will add to growth also. This industry is still extremely fragmented (the U.S. alone has 30,000 brokers), but it’s getting more and more top heavy each year as smaller players are selling out. Globalization trends and increasing risk management complexity make it tougher to compete without a larger platform. WSH is still small enough that buying up mid-market brokers still matters to the financials. There’s no reason why WSH can’t get a couple of points of profitable top-line growth each year buying up small $0.5-5mil revenue brokers.

Valuation and Financials: Of the 18% internal revenue growth this past year and a half, only 5 points came from premium price hikes. WSH should do just fine without a hard market. My best guess is that it can do 13-16% sales growth and 15-18% earnings growth for a few years. WSH will earn $2.20-2.25 in 2003, and $2.60-2.70 in 2004 (these are my back-of-the-envelope estimates; consensus is $2.20 and $2.56). The P/E is <14x 2003, and 11-12x 2004. Its competitors HRH, AJG, BRO, MMC, and AOC trade for 14x, 16x, 21x, 17x, and 11x respectively, on 2003 estimates. None are perfect comps, as they all have their unique characteristics, but the gist remains unchanged – WSH is the cheapest broker aside from troubled AOC, even though WSH has one of the best growth prospects. The median P/Es for the public brokers during the past decade have ranged from 15x to 19x. WSH shares really should trade at a minimum of a 16x P/E, or $40/share, and 18-19x, or $45+/share, is reasonable. WSH converts most of its net income to free cash, so the free cash flow multiple is similar to the P/E, maybe a point or two higher.

It’s paid down $400mil of debt since the IPO. It announced a $100mil share repurchase program in July, although I suspect that debt paydown and acquisitions might remain a priority for now. The company is still just below investment grade, due to its LBO legacy, but I’m sure the rating agencies will catch up soon with the progress the company’s made, and kick up WSH a notch or two. It’s not a major catalyst for the stock, but every bit helps, and WSH should refi when it gets upgraded. The stock pays a 2% dividend.

Compensation: One thing that’ll stand out if you look at the proxy is that Plumeri has options worth over $130mil. These were all granted to him during the LBO, at a strike price of $3.2/share, which is why they’re worth so much now. All the LBO options granted, of which there were around 35mil given to 400 employees, including to Plumeri, were given out only in direct proportion to the amount of stock actually purchased by that employee. So while Plumeri and some others made off like a bandit, at least it’s somewhat justifiable and won’t be repeated. These options are why fully diluted shares have increased so much recently; it should top out at 175mil by next year, compared to the 169mil reported in the most recent quarter. This is all included in the earnings estimates.

Risks: The one on most people’s minds is the end of the P&C hard cycle. My view is that as long as it’s not an extreme, prolonged soft cycle, WSH should be able to grow at a decent rate. If you look back to the soft market of the 1990s, you’ll see that most of the major insurance brokers performed pretty well. The main risk aside from the cycle is that of people retention. The equity handed out for the LBO has made a lot of WSH managers well off. Those options began to vest last year, and most will vest by early 2005. After inquiring around, I haven’t found any significant exodus of newly minted WSH millionaires, but it’s something to watch out for.


Continued solid earnings – consensus is probably too low
Free cash flow usage – share buybacks, acquisitions, debt paydown
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