By Mark S. Basham As a leading human-resources consulting firm, Watson Wyatt & Co. (WW) is benefiting from the need for consulting services by companies that are increasingly scrutinizing their employee-benefit plans in light of disappointing plan performance in recent years. And while many companies have delayed spending on this type of technology projects recently, Standard & Poor's believes that such spending has been only temporarily delayed and is likely to perk up once the economy and corporate balance sheets grow healthier.
Watson Wyatt provides consulting services to organizations to help them design, implement, and maintain employee benefit plans. Such services accounted for 59% of revenues in fiscal 2002 (ended June). The Washington (D.C.) outfit also offers advice on ways to use technology to improve service levels and reduce costs to administer benefits (16% of revenues), and helps companies develop compensation strategies to attract, retain, and motivate employees (7%). About 10% of revenues were derived from operations in Latin America and the Asia-Pacific region, with the remaining 8% from ancillary communications and data services.
WW is part of the global Watson Wyatt Worldwide alliance, which operates 87 offices in 30 countries. WW owns 25% of the alliance's European operations, and the rest is owned by an employee partnership. It's is one of the four major human-capital consulting firms, along with William M. Mercer, Towers Perrin, and Hewitt Associates (HEW). The industry's structure is hour-glass shaped, with these four accounting for about 40% of total revenue and the remaining 60% divided among a fragmented group of approximately 950 other firms.
NEW OPPORTUNITIES. WW's relationships with its clients have been established over many years, creating a significant barrier to competition. S&P believes that a growing corporate need for proper pension-plan design, which has been highlighted by increased accounting scrutiny, is creating an opportunity for WW to win over competitors' clients that are dissatisfied with the performance of their sponsored plans. Rising costs for health-care plans are also fueling demand for consulting services in this area. That's confirmed by the 10% year-over-year increase in benefit-consulting revenues in the September, 2002, quarter, despite a relatively flat market.
Large companies typically view human-capital management as a core corporate activity. They usually don't dramatically curtail spending in this area during economic downturns, as has been the case in other strategic areas such as technology, which requires large capital outlays.
S&P also thinks that corporate spending on human-capital management is likely to grow at a somewhat faster rate than the overall U.S. economy for the next few years. Still, spending in this area, particularly for new or upgraded programs involving capital outlays, is subject to the economic cycle. Also, when unemployment rises and slack arises in the labor force, companies see less need to augment compensation strategies. This is reflected in WW's relatively cautious near-term outlook for its technology and compensation practices.
KEEPING COSTS IN CHECK. WW has recently recruited several managers for key positions amid the variance in performance among its three primary business segments. It also plans to eliminate 38 positions, primarily in its technology group, and take a $1.5 million charge for severance and restructuring during the December quarter. The firm has carefully weighed these actions to avoid hurting its competitive position once growth returns to its long-term trend. S&P sees this occurring in the second half of 2003.
We at S&P estimate that revenues will increase 4% in fiscal 2003 vs. 2002, as revenues in the largest division, benefits consulting, will grow by a high single-digit rate, while revenue at the other groups will be flat or increase slightly. Reflecting the small severance charge, as well as the recent key hires, we expect salaries, benefits, and bonuses -- the largest cost component in WW's business model -- will rise 6%. The firm has stated its intention to tightly control and monitor discretionary spending, such as the use of outside professional services.
Previous restructurings in WW's international offices should result in higher income from affiliates, despite weak economies overseas. We have accordingly trimmed our earnings-per-share forecast to $1.48 from $1.50 to reflect the inclusion of severance expense.
FINANCIALLY STRONG. In fiscal 2004, S&P expects revenue growth to more closely approximate WW's long-term potential of about 7% a year. In the absence of the severance charge, and with the benefit of the permanent cost reductions resulting from the job cuts, operating income is projected to increase by 13%, to $1.65 per share.
WW's financial position is strong, with $64 million in cash and $100 million available under a revolving line of credit (as of Sept. 30). The firm has no debt. It sponsors a defined-benefit pension plan, and although this plan has had a negative return on assets in the last two fiscal years, the firm has stepped up cash contributions.
It's important to note that the plan's fairly balanced discount rate and return assumptions have not masked this deterioration in performance, meaning that it has stepped up pension-obligation accruals to reflect this obligation on its balance sheet. In regard to stock-based compensation, its pro forma effect was only 2 cents per share and 1 cent per share in the most recent two fiscal years.
ROOM TO GROW. S&P uses
discounted cash-flow analysis as its primary valuation technique with WW (peer group comparisons is the secondary method). Free cash-flow generation in recent fiscal years has been somewhat erratic due to WW's change from a partnership to the stock form of ownership in fiscal 2001. The effects of this change on cash flow should be minimal going forward, and we expect WW to generate fairly consistently cash-flow margins.
Our discounted cash-flow analysis assumes a below-market beta of 0.80, reflecting the noncyclical nature of WW's benefits-consulting practice. Reflecting the cyclical nature of its other practice groups, we incorporate two economic cycles into our long-term growth assumptions (in years 6 and 12). Discounted cash-flow analysis using these assumptions gives an intrinsic value of $28 to $30 for WW's shares.
The stock now trades at about $22.15, or 16 times trailing 12-month EPS. At our target price, WW would trade at approximately 20 times our fiscal 2003 EPS estimate of $1.48 a share, compared with the current p-e ratio of 28 for peer Hewitt Associates. The price-to-sales ratio of WW is approximately 1.0, compared to Hewitt's 1.7. Analyst Basham follows emerging growth stocks for Standard & Poor's