BRO - Willis Towers Watson: More Macro Risk But Also More Room For Improvement

Summary

• Willis Towers Watson had a better than expected fourth quarter, with the company returning to inline organic growth performance with its peer group and beating on margins.
• Insurance brokerage should remain healthy in 2023, particularly on the consulting side, and while a recession would threaten the HWC business, I don't expect significant layoffs.
• The proposed-then-failed AON bid significantly disrupted WTW's operations, but the company seems back on track and I like the opportunities to grow both sides of the business.
• Mid-single-digit/high-single-digit revenue/FCF growth and an 18x multiple to 2023 earnings can drive a fair value of $268-$285.

The insurance brokerage space looks kind of flat now in the sense that the major players are somewhat bunched together in terms of revenue growth and their outlook for 2023, and there aren’t a lot of obvious bargains in the space. Willis Towers Watson ( WTW ) (“Willis”) may be an exception. This broker and benefits consultant seems to have regained its footing after underperforming in the wake of the breakdown of AON’s ( AON ) failed attempt to acquire the company, and there seems to be more “low-hanging fruit” in terms of margin-driving operational improvement over the next few years.

Of course, there are risks here as well. Like Brown & Brown ( BRO ), Willis doesn’t have the attractive reinsurance brokerage exposure of AON, Arthur J Gallagher ( AJG ), or Marsh & McLennan ( MMC ), and the benefits business would likely be more vulnerable if there’s a typical full-on recession that sees meaningful unemployment. I understand some degree of caution in assigning a robust multiple to a business that’s only just started catching up to peers, but since further rerating is more of a possibility here than with other brokerages, I think this might be a relative value name to consider.

Fourth Quarter Results Show Improvement

Willis didn’t blow off the doors with fourth quarter results, but they were better than expected and showed some important signs of progress that I believe can carry forward into 2023.

Revenue rose 1% as reported, 5% in organic terms, and 6% in adjusted organic terms that account for business sales gains and other items, and that was good for a small beat. Both the Health, Wealth, and Career (or HWC) business and Risk & Broking (or R&B) business grew 6% in those adjusted terms. Within those segments, Willis saw flat results in HWC’s Health operations, 5% growth in Wealth, 9% growth in Career, and 6% growth in Benefits Delivery and Outsourcing. Within Risk & Broking, Corporate Risk & Broking was up 3%, while Insurance Consulting & Technology was up 17%.

Adjusted EBITDA fell about 1% (with margin down 80bp to 37.1%), while adjusted operating earnings rose 1%, with margin up 20bp to 32.4%. Operating earnings in HWC rose 4% (margin up 80bp to 39%) and in R&B they fell 7%, with margin down 180bp to 28.3%. While this may look unimpressive next to operating margin improvements at other brokers, Willis is seeing opex pressure from aggressive hiring and the company still beat expectations by about $0.10/share.

Relative to other insurance brokers, Willis finally caught up this quarter, as the 6% adjusted growth in the R&B business was in line with the peer group average for the quarter – since the announcement of the AON deal there had been elevated attrition that contributed to organic growth at an average rate roughly half that of the peer group. That said, I would expect bears to point to the weaker Corporate Risk & Broking growth as a sign that Willis still isn’t truly back in line with its peers.

Steady As She Goes In Brokerage

Despite fears of the end of a hard commercial insurance market, growth in 2023 should still be relatively healthy. Ongoing increases in loss expense are supporting premium growth and commercial insurers continue to push for higher premiums. At the same time, insurance buyers are increasingly turning to brokers like Willis to avail themselves of their consulting services to figure out ways to offset higher premiums (changing coverage limits and so on).

I don’t see much to threaten the brokerage business in the short term. A slower economy is usually worse for insurance demand, and there have been some areas of weakness (like professional liability), but thus far the slowdown doesn’t seem likely to lead to meaningful employment losses or business shrinkage. Moreover, higher prices and more regulatory complexity are increasing the perceived value that brokers like Willis offer, so I’m not really concerned about a falloff.

More specific to Willis, the company added around 10,000 new employees in 2022 and has seen turnover return to more normal levels. With better staffing I expect that Willis will be in a position to play more offense than defense in 2023 and 2024 and regain some of the share it lost due to the AON deal disruptions.

One other Willis-specific note that isn’t as supportive – like Brown & Brown, the company doesn’t have a presence in the red-hot reinsurance market. This will deprive the company of some of the attractive growth that AON, AJG, and MMC can look forward to in 2023, but it’s not as if this is a new development.

HWC Is More Macro Sensitive, But Also Has More Potential Growth Opportunities

Given that Willis’s HWC business is tied very explicitly to employment (they provide a range of advice and services in the employee benefits space), it would make sense to expect this business to be more sensitive to the macro outlook.

Thus far employment has been exceptionally strong, and I think this may be a rare economic slowdown that doesn’t see a significant move in unemployment – many companies report still being understaffed relative to their preferred levels, and I think these last few years have been eye-opening with respect to just how difficult it can be to hire workers after previously shedding payroll. Likewise, given that workers have been flexing a little more power of late, I would think that enhancing benefit programs (or looking for ways to cut costs without cutting benefits) would at least be on the radars of some companies, and an opportunity for Willis.

Beyond this, I still see opportunities for growth in the Benefits Delivery & Outsourcing space. Private medical exchanges have become increasingly popular, and Willis is one of the leading players here, as well as in pension outsourcing. On top of that, the TRANZACT business is a way for Willis to leverage the ongoing growth in direct-to-consumer marketing for Medicare plans.

The Outlook

I’m looking for around 5% long-term revenue growth from Willis, and that may actually be a little light given the opportunity for Willis to leverage its post-deal restructuring plan to regain some share in the market. At this point I’m modeling Willis as if it basically just keeps pace with its peer group and that could be a bit conservative, particularly with management actively looking for deals. On the margin side I am giving the company credit for its restructuring efforts, but I still expect the company to trail its peers (as it has in the past).

With those assumptions (around 5% long-term revenue growth and 8% FCF growth), Willis looks undervalued below $285, and that’s with a slightly higher discount rate than its peers to reflect marginally higher operating/execution risk.

Multiples-based valuation approaches are much more subjective, but I’d note that Willis’s main peers/rivals trade closer to the high end of their historical ranges (P/E and EBITDA) than Willis does. Maybe some discount is appropriate, and I’m going with 10%, but even then 18x my 2023 adjusted EPS number gets me to a fair value of almost $268, while 13x my adjusted 2023 EBITDA estimate gets me to around $268 as well.

The Bottom Line

Willis’s trailing performance relative to its peers does argue for some valuation discount, but I think today’s discount may be too large. There has been evidence of the company closing that gap, including fourth quarter results, and I think there will be more evidence of “business back to normal” as 2023 plays out. Willis does have more macro exposure risk than many of its peers, but I don’t think that will matter too much through this next phase of the cycle and while I don’t think Willis is “super cheap” the relative value case looks interesting for investors who want exposure to what has traditionally been a more conservative market segment.

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