Tuesday morning, August 12, Towers Watson reported solid fiscal fourth-quarter results. While there were a variety of puts and takes, the overall results and outlook were generally in line with our expectations. Thus, we will make relatively minor changes to our estimates. We are increasing our fiscal 2015 EPS estimate by $0.01, to $5.86, and reducing our fiscal 2016 EPS estimate by $0.01, to $6.54.
In comparing our estimates with fiscal 2014, we note that fiscal 2014 EPS included about $0.15 of dilution from the Liazon acquisition; about $20 million (or $0.20 per share) of severance and restructuring expenses; a $10 million charge in the fiscal first quarter ($0.10 per share); and $27 million ($0.27 per share) of investments in TAS, the exchange, and health and group benefits consulting and brokerage. At the profit margin line, those factors represent an aggregate drag of almost 200 basis points. Those factors were somewhat offset by an abnormally low tax rate (which helps earnings in fiscal 2014 by about $0.35) and lower-than-normal bonus accruals.
As described in more detail in the next section, our fiscal 2015 projection assumes that 1) nonexchange revenue growth will improve, to 2%; 2) the healthcare exchanges (including retirees and actives) will add net new lives of about 500,000; 3) EBITDA margins will improve by 50 basis points; and 4) the tax rate will normalizes to 33%-34%. While we are not changing our estimates much, we were encouraged by these results. The core consulting business appears back on track to deliver the 2%-5% long-term revenue growth that we expect, we see solid room to leverage some investment spending during the next few years, and the overall exchange business is growing quickly. The exchange growth came in a little different than expected (driven more by Liazon than we expected) and will still not dramatically change the company’s profits in fiscal 2015, but the business continues to progress nicely and will have an increasingly significant impact on fiscal 2016 and beyond.
Given the favorable commentary about cost savings that exchange clients are seeing, the strong client interest in these solutions, and Towers Watson’s strong growth in this sector, we remain convinced that Towers Watson’s exchange business will grow significantly during the next several years. Shares of Towers Watson trade at 18 times our next-12-months’ EPS estimate, compared with an average of 19.8 times the next-12-months’ earnings projections for the other consulting firms that we cover and an average of 16.4 times for Aon (AON $84.98; Outperform) and Marsh & McLennan (MMC $51.44; Market Perform).
Given the challenges with breaking out the profitability of active exchange, we believe the best way to evaluate the company’s earnings is to look at its overall earnings. Based on our assumptions, if we apply a 15-17 times P/E to the core consulting business, the exchange business is trading at 4-7 times revenue and a P/E of 29-49 times. Overall, we believe that the valuation is fair, and we remain optimistic that the company’s legacy consulting operations can drive moderate growth while exponential growth for the exchange business can drive strong overall growth for the company during the next few years. Our rating thus remains Outperform.