At the end of his tirade, he drops a pearl of wisdom that can be transplanted into almost any situation: “the first step in solving any problem is recognizing there is one”.
Willis Towers Watson has seemingly taken this advice to heart following the failed merger attempt, acknowledging the gaps in its strategy and setting out its proposed path forward at a September investor day.
In an industry based on human connection and relationships, the firm’s most pressing issue has been employee retention and the hiring standstill during the merger process.
Management acknowledged the issue and noted that Willis has made progress in managing its employee retention problem in its corporate risk and broking segment (CRB), noting the company’s core CRB headcount is only down 1% from the third quarter of last year. CRB is the biggest beneficiary of the favorable commercial pricing environment, but the merger distraction led to missed opportunities.
Management noted third-quarter departures were also lower than in the second quarter, suggesting that the firm is past the peak of employee attrition.
In what many have taken to calling the brokerage “talent war”, Willis is up against arguably better-positioned competitors in fighting for talent. The firm is already spending more than competitors on salaries as a percent of revenue, a challenging position to be in given the current wage inflation environment.
But with the stock up 3.4% since the call, and 9.8% since the investor day, analysts and investors appear to be buying into the good news.
When Willis announced that an internal candidate, Carl Hess, was to succeed John Haley as CEO, we expressed doubts that he would be able to buck old habits and push the firm in a new direction. And it seems like it is playing out this way. So instead of the Great Reset, we are seeing management position the firm as a New & Improved Version of what already existed.
Starboard Value’s presentation last week pointed to meaningful value creation if the company can meet its targets.
The activist investor believes Willis will significantly close the stock multiple gap with its competitors if the firm reaches its 2024 targets, including total revenue of over $10bn, operating margins of 24%-25% and an EPS of $18-$21. In addition to Willis’ stated goals, Starboard Value also believes that, through utilizing capital efficiency initiatives to improve free cash flow, the firm should be able to return $10bn to shareholders through stock buybacks and dividends by the end of 2023.
This all sounds great in theory and, of course, can be expected to focus Hess' mind as he prepares to take the CEO job at year end, with the presence of Elliott Management and the TCI on the shareholder register likely to do the same.
However, sustaining growth above the long-term 3%-5% brokers have typically delivered, while delivering significant margin expansion and delivering the dramatic capital return requested by Starboard, will be challenging.
Overall, third-quarter results were broadly in line with expectations (EPS of $1.73 vs. Street consensus of $1.59). Below we highlight the key points on which Willis has to deliver.
Although organic growth rates appear to have peaked, Willis’s $10bn revenue growth remains attainable.
Brokers’ organic growth seems to have (broadly) rounded the corner and begun to slow. As we had previously discussed, high commercial pricing rates and the economic recovery created a brokerage super-cycle and spurred high levels of growth over the past year.
Slowing organic growth reflects the slowing of the economy and early and uneven signs of moderation in commercial lines pricing.
Management acknowledged it is lagging peers given its lost talent during merger talks. Marsh was able to broadly maintain growth this quarter, with AJ Gallagher recording organic growth rise for the quarter, versus clear declines at Brown & Brown and Truist.
Willis has set itself the long-term target of achieving mid-single-digit organic growth to help it to reach $10bn of revenues by the end of 2024. The firm’s third-quarter organic growth of 7% sits above targeted growth levels and implies 6% organic growth for the fourth quarter to meet the full-year 6% expectation.
The human capital and benefits segment’s organic growth increased from 5% in Q2 to 6% in Q3. Corporate risk and broking organic growth slowed in Q3, down to 6% in Q3 from 8% in Q2. The investment, risk, and reinsurance segment also slowed from 15% of organic growth in Q2 to 20% in Q3.
Third-quarter margin expansion is not indicative of trend.
On profitability, the broker reported 120bps expansion on adjusted operating margin to 13.4%, with higher profitability across the segments (with the exception of benefit delivery and administration segment).
The year-to-date adjusted operating margin is 14.6%, up 210bps from the first nine months of 2020. The company’s 2020 target of 19.5%-20% is still well below its 2024 target of 24%-25%.
While the quarter showed incremental improvement YoY, Q3 is typically the least informative quarter in the year (it’s the broker’s seasonally lowest on sales, least profitable, and cash-poor period). Therefore, we believe it's too early to predict margin expansion based on this quarter’s improvement.
Capital management actions are unlikely to meet investors’ hopes.
Activist investors, including Starboard Value, are counting on Willis to improve its free cash flows metric to return value to shareholders.
For the first nine months of the year, free cash flow was up 73% YoY, with $1.77bn through September in 2021 compared to $1.02bn in 2020. Much of this jump in free cash flow came from the termination fee of the failed merger with Aon, which netted the firm $942mn.
Without these, free cash flows for the first nine months of 2021 would have been $1.2bn, up only 17% YoY. The company has targeted $5bn-$6bn of free cash flow generation by 2024.
Starboard’s presentation pointed to Willis returning up to $10bn to shareholders by 2023. Year to date, the company has returned $1bn in share repurchases and $275mn in dividends. This appears exceptionally ambitious given the current pace.
In summary, Willis’ results were largely in line with expectations. The firm’s ability to continue its slow but steady progress towards 2024 targets will be tested by the competitive hiring environment, alongside potential pricing headwinds.