Description

I am recommending the purchase of Willis Group Holdings Ltd., (NYSE: WSH), the third largest insurance broker in the world.  The stock is trading at $35.88/share.

It has about 7.8% of the worldwide market, compared to 31% of the market for Marsh & Mclennan and 20% for Aon.  Its market share is basically unchanged since 2005.  This company has been written up twice on VIC over the past 5 years, and these write-ups can be reviewed for further detail.

The following characterize WSH’s business:

1)      negative working capital,

2)       margins between 20% and 30%,

3)       generally limited capital expenditures,

4)      operating profit of $620mm last year against $345mm of fixed assets,

5)      26% ROE but no tangible equity in the business or required,

6)      $1.4bn of debt against a $5.1bn equity market cap,

7)      90% client retention rate,

8)      a 2.88% dividend yield,

9)      a willingness to buy back shares that has reduced shares outstanding from 168mm in ’04 to currently 141mm,

10)   perhaps about $700mm (out of a market cap of $5.1bn) remaining on its current buy-back authorization,

11)   majority of the business overseas,

12)   business hedged to inflation, and

13)   high switching costs for customers.

Finally, the company is forecasting the following EPS figures:

2008: $2.85-$2.95

2009: $3.30-$3.40

2010: $4.00-$4.10

The stock is basically unchanged since the previous recommendations, trading at $36.  Earnings per share last year and in ’06 were $2.78 and $2.84.  The stock may be going nowhere because earnings will have been basically unchanged for 3 years, and insurance premiums are down a lot, the latter which is what the industry’s commissions and fees are substantially based on. 

In making the above projections, the company “include(s) minimal accretion in 2008 from share buybacks increasing to $.30 by 2010”.  It also includes roughly $.35 from cost saves and “Shaping Our Future” changes in 2009 and beyond. 

I guess the market is skeptical about the projections.  The stock is trading at 13x times trailing EPS, 12.5 times projected ’08, and 9x 2010 projected earnings.

It seems to me that if the targets are met, this stock will be up a lot.  In terms of target, WSH seems likely to trade at the roughly 13x at which it has been trading.  While I think this too low, if it were to trade there and meet the $4.00 target, WSH would trade at $52 a share.

So what are the issues that could be of concern to the market and my responses to these issues? 

1)      While the industry is undergoing organic growth, as mentioned above, insurance premium pricing is down substantially.  This provides a huge head-wind to earnings.  My response to this is that the broker industry continues to do well which shows the basic strength of the industry.  Also, with interest rates down a lot and insurance companies facing asset quality issues in their portfolio holdings, my view would be that premium pricing may have to firm going forward to offset lower asset returns and write-offs. 

2)      WSH holds $1.7bn of fiduciary funds.  It is earning about 5% on these holdings.  This return is simply too high.  Either EPS will need to come down by $.18 to account for 200 basis points of lower rates or there is risk to this portfolio.  This takes EPS in 2010 down to $3.82.  I would point out that all the assets are Level 1 assets (but, now after pointing it out, I will say so what).  So there is risk here. 

3)      Even though WSH’s defined benefit pension plans are technically over funded by $400mm and now closed to new employees, WSH has made very substantial cash contributions to the pension funds over the past few years.  It will pay out about $1.2bn over the next 10 years, an amount equal to roughly half its assets.  It will also further fund the plans by $175mm in ’08, a roughly similar amount in ’09 and $49mm in 2010.  The further fundings reduce cash from operations, and the market may be accounting for them.  The company now only offers defined contribution plans.  However, the rates of returns on the existing plans’ assets are expected to be roughly 8%.  This is too high and compares with expected compensation expense of about 4% and discount rates of about 5%.  The plans are heavily in equities.  To be conservative, if the company lost 20% of its plans’ assets (about $500mm), this might require additional contributions of $500mm, the interest expense of which would reduce EPS by another $.18 a share, taking 2010 earnings down to about $3.64.  So whether from additional contributions or lower expected returns, the market could be looking at the pension category and penalizing the company.   This may be valid. 

4)      Capital expenditures continue to run well in excess of D&A given new headquarter expenditures.  Hopefully these will start to come back into line as the new headquarters is now fully occupied.  There could be some skepticism here however. 

5)      WSH may buy in the 48% of voting rights that it does not own of Gras Savoye, a French broker.  This would cost north of $300mm and could further dilute earnings by $.05.  Now we are at about $3.59. 

6)      While the industry is showing organic growth, in the first quarter, WSH saw 1% pricing pressure, which it said it expected to see continue on larger clients.  My view is that this industry behaves like a strong oligopoly and that there has and will continue to be much discipline.  The cost of switching is very high for customers, for once a risk manager gets comfortable that a broker has really helped him or her to take care of protecting against the risks that are of concern—and many of the risks are complex--, switching to save 1% on a premium which is generally not a big percent of the risk insured doesn’t make a lot of sense.  It is a little like Cisco’s (CSCO) dominance.  In the case of CSCO, network reliability is more important than pricing.  At the end of the day, the risk manager’s job is to manage risk, first and foremost.  Once there is comfort with a broker and a policy, a small price change doesn’t tend to move the business, and thus the 90% renewal rate.  Also, with margins as high as they are, some pricing pressure doesn’t destroy margins as would be the case with lower margin businesses, leading to a nice margin of safety.

7)      The company is targeting 28% operating margins in 2010.   Operating margins were 20% in 2005 and lower before.  Over the past 10 years, WSH has gone from the worst margins in the industry to the best margins.  If, instead of reaching 28% as projected (not counting the above considerations but operating considerations), the company’s operating margin remains the 24% that it was last year, this would hurt earnings by roughly $.50, taking earnings down to $3.09 share.  If the company’s margin declined to the 20% it was in 2005, this would take another $.40-$.50 off earnings, depending upon revenue, and bring EPS down to $2.59. 

If all of these things came to pass, the company would be trading at roughly 14x 2010 earnings.  However, I doubt all of these things would come to pass.  And if they were to come to pass, we are likely talking about a low interest rate scenario, in which case a PE of 14x does not seem too expensive for this type of company.  At 12x the $2.59, the stock would be $31, 14% down from the current level, compared to my up target of 13x $4.00 or $52 a share.  So I see a very attractive win-to-lose, with the support of a solid dividend and big buy-back,

Finally, in terms of businesses that are long-term hedges against inflation, WSH and other brokers are fantastic.  Capital needs are modest, but as asset values go up, risks insured tend to go up in lock-stop, or close to in lock-stop.  And as a toll-road on the insurance business (to use  Buffett’s term), and a low-cost one at that in relation to values insured, WSH’s commissions and fees should be able to move up concurrently.   

Catalyst