WLTW: A turnaround story or the continuation of prior challenges?

AON announced its acquisition of WLTW in early 2020, and the merger was set to close in 2H21, before the DOJ stepped in to block the deal. Shortly afterwards, AON and WLTW terminated their merger agreement, setting the stage for WLTW to turn around its business as a stand-alone company.

WLTW operates the 3rd largest insurance brokerage globally behind MMC and AON, as well as a leading consulting business focused on human capital management. In 2020 WLTW generated $9.4bn of revenue and $1.9bn of operating income with Insurance brokerage and risk management accounting for ~50% of revenue, and benefits consulting accounting for the remaining 50%. WLTW serves clients in more than 140 countries, with 53% of revenue generated in North America, and 47% generated internationally.

WLTW also benefits from substantial diversification across customers and insurance carriers. Specifically, no single client accounts for a significant percentage of revenue and WLTW places insurance with more than 2,500 insurance carriers, none of which individually accounted for a significant concentration of the total premiums for its clients. In both segments WLTW focuses on large enterprises, serving 91% of the Fortune 1000, 91% of the Fortune 500, and 93% of the FTSE 100.

In terms of the layout for this write up, I will focus on:

• Business Segment Analysis

• Recent management changes

• Capital allocation priorities

• Key risks

• Financial Model

• Valuation Analysis

Business Segment Analysis

WLTW currently operates four business segments: Human Capital & Benefits (HCB), Corporate Risk & Broking (CRB), Investment, Risk & Reinsurance (IRR), and Benefits Delivery & Administration (BDA). In 2022 WLTW will transition to two business segments: Risk & Broking, made up of CRB and IRR, and Health, Wealth & Career, comprised of HCB and BDA.

Risk & Broking Segment

Insurance brokerage is an attractive industry for many reasons. Insurance brokers operate as intermediaries between enterprises who need commercial insurance, and insurance underwriters who provide the coverage. Brokers help their clients better understand their risk exposures, how best to manage those risks, and by negotiating and placing insurance with insurance carriers. Enterprises purchase commercial insurance regardless of the operating environment, and for almost all businesses commercial insurance is a requirement to operate. This is important, as purchasing insurance is largely non-discretionary. Brokers primarily focus on placing property and casualty insurance, as well as health insurance. Key types of insurance coverage include commercial property, commercial auto, workers compensation, directors and officer liability, etc.

There is also minimal risk of disruption to the sector, as insurance broking is a relationship-based industry, with brokers providing a valuable service to their clients. Brokers generate revenue by charging commissions based on a percentage of premiums placed. WLTW’s commission rate was ~12% for 2020 based on $25bn of premiums placed. Additionally, commercial insurance policies are highly customized based on the unique needs of the insured, further minimizing disruption risk. If disruption were to occur it would likely occur for smaller accounts, which may have more homogenous insurance needs.

There has been substantial consolidation in this sector over the past decade, with 5 major public brokers remaining (MMC, AON, WLTW, AJG, and BRO), with three focused on serving large enterprises (MMC, AON, and WLTW). Given the global scale of the incumbents, I believe there are very significant barriers to entry to compete for large accounts. Additionally, buyers and insurance carriers are highly fragmented. In the U.S. alone there 2,496 P&C insurance carriers as of 2019. As a result of the industry structure, client retention rates are typically quite high, usually between 90-95% (WLTW is at 92% as of 1H21). This is driven by the fact that incumbents have the historical data and knowledge of the account and switching to a new broker is likely an unnecessary hassle, as well as the fact that there aren’t many competitors left to switch to. Even if premium rates increase upon contract renewal, customers tend to stay with the same insurance broker.

Insurance brokers also have modest capital needs. Unlike insurers, insurance brokers don’t take any underwriting or investment risk directly, so there are no regulatory capital requirements for brokers to hold capital against insurance reserves or against an investment portfolio. Additionally, brokers have very modest capex needs, leading to strong FCF generation.

The last thing to note on the sector before discussing WLTW’s broking operations, is the cyclicality of commercial insurance premium rates. Premium rates exhibit cyclicality as shown below driven by underwriting losses and inflows and outflows of capital into the sector. Typically, when insurers face large losses, such after Hurricane Katrina in 2005 ($65bn of insured losses), premium rates increase substantially. This leads to large capital inflows, and declining premium rates. And the cycle continues from there. However, despite the cyclicality of premiums, the brokers themselves show very minimal cyclicality in their revenue. Most of the large brokers have generated low-mid single digit organic revenue growth over the past decade. This is driven by the fact that brokers can sell additional coverage in a soft market, or clients may reduce their exposure during a hard market.

WLTW’s broking operations are currently housed in two segments: CRB and IRR. CRB focuses on providing broking services to large enterprises, as well as to middle market business, where WLTW faces additional from brokers such as AJG and BRO. WLTW focuses on providing broking and risk management services to several sectors including Real Estate, Healthcare, Retail, Aerospace, Construction, and Natural Resources, among others. Additionally, WLTW provides broking and risk management services aimed at financial, executive, and professional risks such as professional liability, cyber insurance, and M&A related insurance, to a range of clients across sectors.

IRR will be a small contributor to Risk & Broking going forward as WLTW has agreed to sell its reinsurance business to AJG for $3.25bn, closed on the sale of its wholesale insurance brokerage for $808mn, and moved its investment consulting operations to Health, Wealth & Career segment. What’s left of IRR includes several businesses focused on insurers/reinsurers such as insurance consulting & technology, capital markets services for insurers and reinsurers, and Innovisk which helps insurers with product development, marketing & distribution, and claims management.

WLTW has guided to mid-single digit revenue growth in CRB through 2024, in-line with the 4% revenue CAGR from 2016-2020. A key focus is expanding WLTW’s large account business in North America, by hiring additional sales talent focused on the region, as well as by leveraging its client relationships from its Health, Wealth, and Career segment, to take market share. WLTW already has a strong middle market presence in North America and plans on doubling down on those capabilities. All together these initiatives should $100mn+ of incremental revenue over the next four years. Management has also guided to a 500bps margin improvement by YE24 in CRB, compared to 300bps of margin improvement from 2016-2020. WLTW expects digitization to drive 300bps of operating margin improvement, with the remainder from real estate rationalization, and right shoring operations, discussed further below.

Health, Wealth & Career Segment

WLTW’s two consulting businesses contribute the remaining 50% of revenue, comprised of HCB and BDA. While benefits consulting is not quite as attractive as insurance brokerage, given greater competition, and less discretionary, I view this segment favorably. Specifically, WLTW sports a higher retention rate in most of its consulting businesses (95+%) than in brokerage, as well as the fact that revenue is largely backed by long-term contracts that are typically 3-5 years in length. The strong retention rate is likely driven by the fact that WLTW offers both insurance brokerage and consulting services to clients, increases client retention rates.

HCB helps clients provide comprehensive retirement and health benefits, and talent and rewards, to help attract and retain employees. Services include actuarial support, plan design, and administration for pension and retirement savings plans. WLTW receives fees for its consulting services, with many based on long-term contracts, and similarly focused on the needs of large enterprises. Additionally, WLTW has very strong client retention in this business as well, generally 95+% in the Retirement subsegment and the Health and Benefits subsegment. WLTW’s consulting relationships are long-term in nature, especially within its retirement consulting business driven by the heavily regulated nature of employee benefit plans and our clients’ annual needs for these services.

BDA is a unique offering for WLTW relative to its peers and is primarily focused on U.S. based employers. BDA’s Individual Marketplace business provides Medicare to consumers through employers or direct to consumer, as well as life insurance and supplemental insurance. BDA also provides health, and welfare benefits administration for large U.S. companies. Finally, BDA provides benefits accounts such as Health Reimbursement Accounts, Health Savings Accounts, and other account-based benefits to its Individual Marketplace and Benefit Outsourcing clients. A significant portion of BDA’s revenue is also recurring driven by commissions from policies sold, or from long-term service contracts that typically range from three to five years.

During its Investor Day presentation, management guided to mid-single digit organic revenue growth for HCB, driven by high single digit growth in Health & Benefits, mid-single digit growth in Talent & Rewards and mid-single digit growth in Investments. Additionally, WLTW is focused on bundling capabilities to better distinguish the company against competitors, and to make client relationships stickier. Management also highlighted margin improvement in HCB driven by real estate rationalization, and reduced tech spend, but did not guide to a specific improvement in margins.

Management discussed significant opportunities to grow in BDA, WLTW’s fastest growing business, with 7% annual organic revenue growth from 2016-2020. Specifically, within its Individual Marketplace business, Medicare represents a $28bn premium opportunity and non-Medicare health insurance a $6bn premium opportunity. This represents a $1bn revenue opportunity at a 3% commission rate, and $1.7bn opportunity at a 5% commission rate.

Recent Management Changes

Recently WLTW appointed a new CEO, Carl Hess, and a new CFO, Andrew Krasner. Mr. Hess will assume the CEO role on 1/1/2022 when John Haley retires and has an extensive track record at WLTW. Mr. Hess has led the IRR segment since October 2016 and has been with WLTW and predecessor companies since 1989. Mr. Hess has a strong track record at WLTW, improving IRR’s operating margins by 540bps from FY17-20, and led the Americas region which experienced 6.5% annual revenue growth over his tenure as well.

Additionally, Andrew Krasner was just named CFO. Mr. Krasner held senior finance roles at WLTW from 2009-2021 including Head of M&A, and Global Treasurer, and was briefly CFO of AssuredPartners in early 2021, before being tapped as the new CFO of WLTW.

The key question is, are these the right executives to carry out WLTW’s new plan?

While clearly a positive that both individuals have extensive experience at WLTW, there are some drawbacks. Specifically, WLTW has lagged its peers in operating margins for years, with minimal margin expansion from 2013-2020. There are some legitimate questions about whether this management team is the right team to turn around WLTW, although I believe these concerns are already reflected in the significant difference in multiples between WLTW and its peers (discussed further below). Additionally, Carl Hess was the CEO of one of WLTW’s smallest segments, IRR, which accounted for 18% of WLTW’s revenue in 2020.

Historically, Long-Term Incentive awards were granted based on WLTS’s three-year TSR Compounded Annual Growth Rate (CAGR) relative to the S&P 500. Going forward, I hope to see executive compensation tied to WLTW achieving their recently announced financial targets, such as adjusted operating margin expansion and EPS growth. Management was asked about future executive compensation at its Investor Day and alluded to the fact that the board would take into consideration the company’s new financial targets.

Capital Allocation

At its recent Investor Day, WLTW laid out its capital allocation priorities for 2H21-2024 with $10-11bn of cash available to deploy. WLTW plans to repurchase $4bn of shares through 2022, with $3.5bn of net proceeds from the AON termination fee ($1bn pre-tax) and the sale of Willis Re to AJG ($3.25bn pre-tax), as well as from excess cash on WLTW’s balance sheet.

Additionally, WLTW expects to generate $5-6bn of FCF from FY22-FY24. WLTW can also issue $1.5-2bn of debt to maintain leverage in the 2-2.5x range, which is not included in the below chart. As a result, WLTW can repurchase $10bn of shares through 2024, equivalent to 34% of its market cap, in addition to paying $1.3bn in dividends. Given the depressed stock price, management noted that share repurchases represent the most attractive option for capital currently.

Historically, WLTW has been active on the M&A front. The most notable acquisition was the $18bn acquisition of Towers Watson in 2016, doubling the size of the organization. WLTW also acquired TRANZACT, a D2C healthcare company that connects consumers to health insurers for $1.2bn in 2019, which is now part of BDA. Besides those deals, WLTW typically spends $100-$200mn/yr. of bolt-on acquisitions. Management noted at its recent investor day, that they do not expect to pursue large scale M&A and will continue to make tuck-in acquisitions, such as the recent acquisition of Israeli firm Leaderim. Acquisitions would likely be focused on expanding WLTW’s geographic footprint, or adding additional capabilities in its Health, Wealth, and Career segment.

Additionally, management laid out their FY24 financial targets which include achieving >$10bn in revenue, 24-25% operating margins (up from ~20% currently) and Adjusted EPS of $18-21 (up from $11.70 in FY20).

In terms of revenue growth, management guided to mid-single digit organic revenue growth through 2024 slightly above the 3.4% annual organic revenue growth from 2015-2020. The key drivers were discussed above, and WLTW expects to drive mid-single digit revenue growth in both segments.

On the margin side, management expects to increase margins by 400-500bps by 2024, with 100-200bps from operating leverage and 300bps from expense reduction. The key areas of expense reduction include real estate rationalization, technology modernization, right-shoring operations, and better utilization of global platforms. WLTW expects to achieve $30mn of savings by YE22, $120mn by YE23, and $300mn by YE24 with $750mn of additional costs to achieve the plan.

The $300mn of run-rate cost savings compares to $800mn of expense reduction AON had planned to take out of the combined companies and doesn’t feel overly aggressive at roughly 3% of revenue. Management noted during its recent investor day, that discussions with AON during the proposed merger helped management identify key areas for expense reduction.

Finally, 11-16% annualized EPS growth through 2024 will be driven by the factors just discussed: mid-single digit revenue growth, 400-500bps of margin expansion, and upwards of $10bn of share repurchases.

Risks

Poor capital allocation under new CEO/failing to achieve margin expansion

The biggest risk facing WLTW over the next couple years is poor capital allocation and failure to achieve its margin expansion targets. In terms of capital allocation, management has identified share buybacks as the most attractive investment option currently. The concern would be if management pursues a large acquisition with overly aggressive synergy targets, like the Towers Watson acquisition in 2016. Luckily insurance brokerage is already too concentrated for WLTW to make any large acquisitions. WLTW would need to pursue an acquisition in its consulting business. However, management was very explicit in its investor day comments that WLTW only look at bolt-on M&A and would not pursue transformational M&A.

In terms of failing to achieve its financial targets, the key question is whether WLTW can improve its operating margins when historically it has failed to do so. WLTW’s adjusted operating margins currently trail MMC by 300bps and AON by 850bps respectively:

From 2013-2020, WLTW increased its operating margins by 170bps compared to 540bps for MMC and 950bps for AON. The difference in performance can partially be explained by greater operating leverage at MMC (84% larger than WLTW) and AON (18% larger than WLTW) given their greater scale. Additionally, AON and MMC experienced stronger revenue growth in their Insurance Brokerage businesses, which generate higher margins than Consulting. Finally, AON and MMC have focused more on bolt-on acquisitions, while WLTW spent several years integrating its large acquisition of Towers Watson.

Willis Group’s acquisition of Towers Watson also negatively impacted its ROIC and has been a key contributor to WLTW’s lagging stock price relative to its peers. Specifically, since the Towers Watson acquisition was announced in June 2015, WLTW has generated a total return of 107% compared to 215% for MMC and 219% for AON. Willis Group likely would have generated much stronger shareholder returns had it not purchased Towers Watson and instead repurchased shares, or used some debt financing instead of financing the deal entirely with equity.

As a result of the acquisition, WLTW experienced a 550bps drop in ROIC from 13.4% in 2014 to 7.9% in 2017. However, I see WLTW’s ROIC improving going forward driven by stronger earnings as discussed below.

In its merger presentation, Willis Group guided to $100-$125mn of cost synergies and $375-$675mn of revenue synergies. However, Willis Group’s guidance was significantly too aggressive. Specifically, Willis Group guided to FY18 revenue of $10.25bn, compared to actual FY18 revenue of $8.5bn, $2.5bn of FY18 EBITDA compared to actual FY18 EBITDA of $1.8bn, and FY18 Adjusted Net Income of $1.6bn compared to actual FY18 Adjusted Net Income of $1.3bn.

Source: https://www.sec.gov/Archives/edgar/data/1470215/000119312515353276/d98270d425.htm

Now that Towers Watson has been fully integrated, and with no major M&A expected going forward, WLTW can focus entirely on reducing costs and right sizing its business. Additionally, management is highly focused on its capital allocation policies, and share repurchases in particular to drive shareholder value.

Increased employee attrition

Finally, WLTW has experienced modest employee attrition over the past 12 months, due to the uncertainty surrounding the AON acquisition. WLTW’s voluntary attrition rate increased from 11% in 2020 to 13.4% LTM, although WLTW has lost many key executives. However, Management noted that WLTW has already hired back 100 colleagues since the AON merger was cancelled, and the company is focused on hiring additional talent. Additionally, management expects client retention to improve back to levels prior to the announced merger from 92% back to 94% over the next few quarters.

I expect it’ll take time WLTW to improve employee attrition and client retention rates, but I don’t believe increased employee attrition represents a large risk to WLTW given the company’s proactive stance in rehiring many colleagues who left, and its focus on adding additional talent.

Financials

Assumptions:

Revenue: Mid-single digit revenue growth in line with management’s expectations and slightly above the 3.4% organic revenue growth WLTW has achieved from 2015-2020. Revenue growth assumptions for each segment are discussed above.

Adjusted Operating Margin: WLTW generates 300bps of margin improvement compared to 400-500bps target. I gave the company credit for Real Estate rationalization, some IT expense reduction and very modest operating leverage.

Repurchases: I expect WLTW to repurchase $3bn of shares in 2022, $3bn in 2023 driven by $1.7bn of FCF generation and $1bn of debt issuance, and $2bn in 2024 driven by $1.9bn of FCF generation. As a result, I expect WLTW’s diluted average shares to decline from 130 in 2020 to 95 in 2024.

M&A: I expect $150mn/yr. of bolt-on M&A in-line with WLTW’s pace of acquisitions over time.

Valuation

WLTW currently trades at 16x consensus ‘22 EPS, a steep discount compared to 23x for AON, 24x for MMC, 27x for AJG, and 26x for BRO. The valuation discount reflects the market’s skepticism of WLTW’s ability to drive margin expansion, and concerns around increased employee attrition/client retention rates and the subsequent impact on revenue growth. However, I believe WLTW should be able to close that valuation gap through margin expansion, as well as more prudent capital allocation policies going forward. Given the large repurchase program over the next few years, WLTW should be able to grow EPS at a much higher rate than peers from FY22-FY24. Using a 20x forward P/E multiple, WTLW would be worth $407/share by YE23, a 74% premium to the current stock price of $233/share. At an 18x forward P/E, WLTW would be worth $366/share, a 57% premium to the current stock price. I view WLTW as an attractive investment, taking into consideration the substantial upside, and minimal downside risk, based on my analysis.

Disclaimer

This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions. You can follow Enlightened Capital on twitter here!