TOWERS WATSON & CO. – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Executive Overview
General
We are a global consulting firm focusing on providing human capital and financial consulting services.
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We help our clients enhance business performance by improving their ability to attract, retain and motivate qualified employees. We focus on delivering consulting services that help organizations anticipate, identify and capitalize on emerging opportunities in human capital management. We also provide independent financial advice regarding all aspects of life insurance and general insurance, as well as investment advice to help our clients develop disciplined and efficient strategies to meet their investment goals. We operate the largest privateMedicare exchange inthe United States . Through this exchange, we help our clients to move to a more sustainable economic model by capping and controlling the costs associated with retiree healthcare benefits. As leading economies worldwide become more service-oriented, human resources and financial management have become increasingly important to companies and other organizations. The heightened competition for skilled employees, unprecedented changes in workforce demographics, regulatory changes related to compensation and retiree benefits, and rising employee-related costs have increased the importance of effective human capital management. Insurance and investment decisions have become increasingly complex and important in the face of changing economies and dynamic financial markets.Towers Watson helps its clients address these issues by combining expertise in human capital and financial management with consulting and technology solutions, to improve the design and implementation of various human resources and financial programs, including compensation, retirement, health care, and insurance and investment plans. The human resources consulting industry, although highly fragmented, is highly competitive. It is composed of major human capital consulting firms, specialty firms, consulting arms of accounting firms and information technology consulting firms. In the short term, our revenue is driven by many factors, including the general state of the global economy and the resulting level of discretionary spending, the continuing regulatory compliance requirements of our clients, changes in investment markets, the ability of our consultants to attract new clients or provide additional services to existing clients, the impact of new regulations in the legal and accounting fields and the impact of our ongoing cost saving initiatives. In the long term, we expect that our financial results will depend in large part upon how well we succeed in deepening our existing client relationships through thought leadership and a focus on developing cross-practice solutions, actively pursuing new clients in our target markets, cross selling and making strategic acquisitions. We believe that the highly fragmented industry in which we operate offers us growth opportunities, because we provide a unique business combination of benefits and human capital consulting, as well as risk and capital management and strategic technology solutions.
Segments
We provide services in four business segments: Benefits, Risk and Financial Services, Talent and Rewards, and Exchange Solutions.
Benefits Segment. The Benefits segment is our largest and most established segment. This segment has grown through business combinations as well as strong organic growth. It helps clients create and manage cost-effective benefits programs that help them attract, retain and motivate a talented workforce.
The Benefits segment provides benefits consulting and administration services through four primary lines of business:
• Retirement; • Health and Group Benefits; • Technology and Administration Solutions; and •International Consulting . Retirement supports organizations worldwide in designing, managing, administering and communicating all types of retirement plans. Health and Group Benefits provides advice on the strategy, design, financing, delivery, ongoing plan management and communication of health and group benefit programs. Through our Technology and Administration Solutions line of business, we deliver cost- 31
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effective benefit outsourcing solutions.The International Consulting Group provides expertise in dealing with international human capital management and related benefits and compensation advice for corporate headquarters and their subsidiaries. A significant portion of the revenue in this segment is from recurring work, driven in large part by the heavily regulated nature of employee benefits plans and our clients' annual needs for these services. For the fiscal year endedJune 30, 2012 , the Benefits segment contributed 58% of our segment revenue. For the same period, approximately 43% of the Benefits segment's revenue originates from outsidethe United States and is thus subject to translation exposure resulting from foreign exchange rate fluctuations.
Risk and Financial Services Segment. Within the Risk and Financial Services segment, our second largest segment, we have three primary lines of business:
•Risk Consulting and Software ("RCS"); •Investment Consulting and Solutions ("Investment"); and • Reinsurance and Insurance Brokerage ("Brokerage"). The Risk and Financial Services segment accounted for 25% of our total revenue for the fiscal year endedJune 30, 2012 . Approximately 68% of the segment's revenue originates from outsidethe United States and is thus subject to translation exposure resulting from foreign exchange rate fluctuations. The segment has a strong base of recurring revenue, driven by long-term client relationships in reinsurance brokerage services, retainer investment consulting relationships, consulting services on financial reporting, and actuarial opinions on property/casualty loss reserves. Some of these relationships have been in place for more than 20 years. A portion of the revenue is related to project work, which is more heavily dependent on the overall level of discretionary spending by clients. This work is favorably influenced by strong client relationships, particularly related to mergers and acquisitions consulting. Major revenue growth drivers include changes in regulations, the level of mergers and acquisitions activity in the insurance industry, growth in pension and other asset pools, and reinsurance retention and pricing trends.
Talent and Rewards Segment. Our third largest segment, Talent and Rewards, is focused on three primary lines of business:
• Executive Compensation; • Rewards, Talent and Communication; and • Data, Surveys and Technology. The Talent and Rewards segment accounted for approximately 17% of our total revenue for the fiscal year endedJune 30, 2012 . Few of the segment's projects have a recurring element. As a result, this segment is most sensitive to changes in discretionary spending due to cyclical economic fluctuations. Approximately 47% of the segment's revenue originates from outsidethe United States and is thus subject to translation exposure resulting from foreign exchange rate fluctuations. Revenue for Talent and Rewards consulting has minimal seasonality, with a small degree of heightened activity in the second half of the year during the annual compensation, benefits and survey cycles. Major revenue growth drivers in this group include demand for workforce productivity improvements and labor cost reductions, focus on high performance culture, globalization of the workforce, changes in regulations and benefits programs, mergers and acquisitions activity, and the demand for universal metrics related to workforce engagement.
Exchange Solutions Segment.Our fourth largest segment, Exchange Solutions has one line of business:
•Extend Health . We established our fourth segment, Exchange Solutions, when we acquiredExtend Health onMay 29, 2012 and as a result, one month of operations was included in our fiscal year 2012 results. Exchange Solutions operates the largest privateMedicare insurance exchange inthe United States . Our core solution enables employers to transition their retirees to individual, defined contribution health plans at an annual cost that the employer controls - versus group-based, defined benefit health plans, which have uncertain annual costs. By moving to a defined contribution approach, our clients can provide their retirees with the same or better health care benefits at a lower overall cost. Most Exchange Solutions revenues come from the commissions we receive from insurance carriers for enrolling individuals into their health plans. This revenue increases as the number of enrolled members grows. Exchange Solutions experiences seasonality due to the majority of policies beginning onJanuary 1 following corporations' open enrollment periods. In addition, the annual enrollment period forMedicare -eligible individuals coincides with this period. It is expected that the majority of enrollments will occur in our second quarter and we will hire additional seasonal benefits advisors to supplement our full-time benefit advisors and incur higher costs. The associated commission revenue with these new enrollments is deferred until the policy effective date in our third quarter and is spread over the policy period. 32
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Financial Statement Overview
Shown below are
Fiscal Year Geographic Region 2012 2011 2010 United States 48 % 49 % 52 % United Kingdom 23 22 22 Canada 6 6 6 Germany 5 4 4 Netherlands 3 3 3 We derive the majority of our revenue from fees for consulting services, which generally are billed at standard hourly rates and expense reimbursement, which we refer to as time and expense, or on a fixed-fee basis. Management believes the approximate percentages for time and expense and fixed-fee basis engagements are 60% and 40%, respectively. Clients are typically invoiced on a monthly basis with revenue generally recognized as services are performed. No single client accounted for more than 1% of our consolidated revenues for any of our most recent three fiscal years. Our most significant expense is compensation to associates, which typically comprises approximately 70% of total costs of providing services. We compensate our directors and select executives with incentive stock-based compensation plans from time to time. When granted, awards are governed by theTowers Watson & Co. 2009 Long Term Incentive Plan, which provides for the awards to be valued at their grant date fair value which is amortized over the expected term of the awards, generally three years. In connection with the issuance ofTowers Watson restricted Class A common stock to Towers Perrin RSU holders in the Merger, we expect the total non-cash compensation expense relating toTowers Watson restricted Class A common stock for the three year period to be$158.7 million . This estimate was determined assuming a 10% annual forfeiture rate based on actual and expected attrition and the graded method of expense methodology. This expense methodology assumes that the restricted shares were issued to Towers Perrin RSU holders in equal amounts of shares that vest over one year, two years and three years giving the effect of more expense in the first year than the second and third. In the event that an associate is involuntarily terminated other than for cause, vesting is accelerated and expense is recorded immediately.
Salaries and employee benefits are comprised of wages paid to associates, related taxes, severance, benefit expenses such as pension, medical and insurance costs, and fiscal year-end incentive bonuses.
Professional and subcontracted services represent fees paid to external service providers for employment, marketing and other services. For the three most recent fiscal years, approximately 40 to 60% of the professional and subcontracted services were directly incurred on behalf of clients and were reimbursed by them, with such reimbursements being included in revenue. For the fiscal year endedJune 30, 2012 forTowers Watson , approximately 31% of professional and subcontracted services represent these reimbursable services.
Occupancy includes expenses for rent and utilities.
General and administrative expenses include legal, marketing, supplies, telephone and networking costs to operate office locations as well as insurance, including premiums on excess insurance and losses on professional liability claims, non-client-reimbursed travel by associates, publications and professional development. This line item also includes miscellaneous expenses, including gains and losses on foreign currency transactions.
Depreciation and amortization includes the depreciation of fixed assets and amortization of intangible assets and internally-developed software.
Transaction and integration expenses include fees and charges associated with the Merger and with our other acquisitions. Transaction and integration expenses principally consist of investment banker fees, regulatory filing expenses, integration consultants, as well as legal, accounting, marketing, and information technology integration expenses.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted inthe United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses 33
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during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates. The areas that we believe are critical accounting policies include revenue recognition, valuation of billed and unbilled receivables from clients, discretionary compensation, income taxes, pension assumptions, incurred but not reported claims, and goodwill and intangible assets. The critical accounting policies discussed below involve making difficult, subjective or complex accounting estimates that could have a material effect on our financial condition and results of operations. These critical accounting policies require us to make assumptions about matters that are highly uncertain at the time of the estimate or assumption. Different estimates that we could have used, or changes in estimates that are reasonably likely to occur, may have a material effect on our financial condition and results of operations.
Revenue Recognition
We recognize revenue when it is earned and realized or realizable which is when there is persuasive evidence of an arrangement with a client, there is a fixed or determinable price, services have been rendered or products delivered or available for use, and collectability is reasonably assured. The majority of our revenue consists of fees earned from providing consulting services. We recognize revenue from these consulting engagements when hours are worked, either on a time-and-expense basis or on a fixed-fee basis, depending on the terms and conditions defined at the inception of an engagement with a client. We have engagement letters with our clients that specify the terms and conditions upon which the engagements are based. These terms and conditions can only be changed upon agreement by both parties. Individual associates' billing rates are principally based on a multiple of salary and compensation costs. Revenue for fixed-fee arrangements that span multiple months is based upon the percentage of completion method. We typically have three types of fixed-fee arrangements: annual recurring projects, projects of a short duration, and non-recurring system projects. Annual recurring projects and the projects of short duration are typically straightforward and highly predictable in nature. As a result, the project manager and financial staff are able to identify, as the project status is reviewed and bills are prepared monthly, the occasions when cost overruns could lead to the recording of a loss accrual. We have non-recurring system projects that are longer in duration and subject to more changes in scope as the project progresses. We evaluate at least quarterly, and more often as needed, project managers' estimates-to-complete to assure that the projects' current statuses are accounted for properly. Certain software contracts generally provide that if the client terminates a contract, we are entitled to payment for services performed through termination. Revenue recognition for fixed-fee engagements is affected by a number of factors that change the estimated amount of work required to complete the project such as changes in scope, the staffing on the engagement and/or the level of client participation. The periodic engagement evaluations require us to make judgments and estimates regarding the overall profitability and stage of project completion that, in turn, affect how we recognize revenue. We recognize a loss on an engagement when estimated revenue to be received for that engagement is less than the total estimated direct and indirect costs associated with the engagement. Losses are recognized in the period in which the loss becomes probable and the amount of the loss is reasonably estimable. We have experienced certain costs in excess of estimates from time to time. Management believes it is rare, however, for these excess costs to result in overall project losses. We have developed various software programs and technologies that we provide to clients in connection with consulting services. In most instances, such software is hosted and maintained by us and ownership of the technology and rights to the related code remain with us. Software developed to be utilized in providing services to a client, but for which the client does not have the contractual right to take possession, is capitalized during the implementation stage. Revenue associated with the related contract, together with amortization of the related capitalized software, is recognized over the service period. As a result, we do not recognize revenue during the implementation phase of an engagement. We deliver software under arrangements with clients where the maintenance associated with the initial software fees is a fixed percentage, and we are able to determine the stand-alone value of the delivered software separate from the maintenance. We recognize the initial software fees as software is delivered, and recognize the maintenance ratably over the contract period based on each element's relative fair value. For software arrangements in which initial fees are received in connection with mandatory maintenance for the initial software license to remain active, we determined that the initial maintenance period is substantive. Therefore, we recognize the fees for the initial license and maintenance bundle ratably over the initial contract term., which is generally one year. Each subsequent renewal fee is recognized ratably over the contractually stated renewal period. We collect, analyze and compile data in the form of surveys for our clients who have the option of participating in the survey. The surveys are published online via a web tool which provides simplistic functionality. We have determined that the web tool is inconsequential to the overall arrangement. We record the survey revenue when the results are delivered online and made available to our clients that have a contractual right to the data. If the data is updated more frequently than annually, we recognize the survey revenue ratably over the contractually stated period. 34
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In our capacity as a reinsurance broker, we collect premiums from our reinsurance clients and, after deducting our brokerage commissions, we remit the premiums to the respective reinsurance underwriters on behalf of our reinsurance clients. In general, compensation for reinsurance brokerage services is earned on a commission basis. Commissions are calculated as a percentage of a reinsurance premium as stipulated in the reinsurance contracts with our clients and reinsurers. We recognize brokerage services revenue on the later of the contract's inception or billing date as fees become known or as our services are provided for premium processing. In addition, we hold cash needed to settle amounts due reinsurers or our reinsurance clients, net of any commissions due to us, pending remittance to the ultimate recipient. We are permitted to invest these funds in high quality liquid instruments. As an insurance exchange, we generate revenue from commission paid to us by insurance carriers for health insurance policies issued through our enrollment services. Under our contracts with insurance carriers, once an application has been accepted by an insurance carrier and a policy has been issued, we will receive commission payments from the policy effective date until the end of the annual policy period as long as the policy is not cancelled by the insured or the carrier. We defer upfront fees and recognize revenue ratably from the policy effective date over the policy period, generally one year. The commission fee per policy placed with a carrier could vary by whether the insured was previously aMedicare participant and whether the policy is in its first or subsequent year. Due to the uncertainty of the commission fee per policy, we don't recognize revenue until the policy is accepted by the carrier, the policy is effective and a communication is received from the carrier of the fee per insured. As the commission fee is cancellable on a pro rata basis related to the underlying insurance policy which we are not party to, we recognize the commission fee ratably over the policy period. Our carrier contracts entitle us to receive commission fees per policy for the life of the policy unless limited by legislation or cancelled by the carrier or insured. We estimate that these commission fees generally continue for five or more years once placed. As a result, the majority of the revenue is recurring in nature and grows in direct proportion to the number of new policies added each year.
Revenue recognized in excess of billings is recorded as unbilled accounts receivable. Cash collections and invoices generated in excess of revenue recognized are recorded as deferred revenue until the revenue recognition criteria are met. Client reimbursable expenses, including those relating to travel, other out-of-pocket expenses and any third-party costs, are included in revenue, and an equivalent amount of reimbursable expenses are included in professional and subcontracted services as a cost of revenue.
Valuation of Billed and Unbilled Receivables from Clients
We maintain allowances for doubtful accounts to reflect estimated losses resulting from the clients' failure to pay for the services after the services have been rendered, including allowances when customer disputes may exist. The related provision is recorded as a reduction to revenue. Our allowance policy is based on the aging of the billed and unbilled client receivables and has been developed based on the write-off history. Facts and circumstances such as the average length of time the receivables are past due, general market conditions, current economic trends and our clients' ability to pay may cause fluctuations in our valuation of billed and unbilled receivables.
Discretionary Compensation
Our compensation program includes a discretionary bonus that is determined by management and has historically been paid once per fiscal year in the form of cash and/or deferred stock units after our annual operating results are finalized. An estimated annual bonus amount is initially developed at the beginning of each fiscal year in conjunction with our budgeting process. Estimated annual operating performance is reviewed quarterly and the discretionary annual bonus amount is then adjusted, if necessary, by management to reflect changes in the forecast of pre-bonus profitability for the year.
Income Taxes
We account for income taxes in accordance with Accounting Standards Codification ("ASC") 740, Income Taxes, which prescribes the use of the asset and liability approach to the recognition of deferred tax assets and liabilities related to the expected future tax consequences of events that have been recognized in our financial statements or income tax returns. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established, when necessary, to reduce deferred tax assets when it is more likely than not that a portion or all of a given deferred tax asset will not be realized. In accordance with ASC 740, income tax expense includes (i) deferred tax expense, which generally represents the net change in the deferred tax asset or liability balance during the year plus any change in valuation allowances and (ii) current tax expense, which represents the amount of tax currently payable to or receivable from a taxing authority plus amounts accrued for expected tax contingencies (including both tax and interest). ASC 740 prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those positions to be recognized in the financial statements. We continually review tax laws, regulations and related guidance in order to properly record any uncertain tax positions. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits. 35
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Incurred But Not Reported (IBNR) Claims
We accrue for IBNR professional liability claims that are probable and estimable, and for which we have not yet contracted for insurance coverage. We use actuarial assumptions to estimate and record a liability for IBNR professional liability claims. Our estimated IBNR liability is based on long-term trends and averages, and considers a number of factors, including changes in claim reporting patterns, claim settlement patterns, judicial decisions, and legislation and economic decisions. Our estimated IBNR liability does not include actuarial projections for the effect of claims data for large cases due to the insufficiency of actuarial experience with such cases. Our estimated IBNR liability will fluctuate if claims experience changes over time. As ofJune 30, 2012 , we had a$202.2 million IBNR liability, net of recoverable receivables of our captive insurance companies. This net liability decreased from$208.5 million as ofJune 30, 2011 as the result of known and improved claims experience. To the extent our captive insurance companies, PCIC and SMIC, expect losses to be covered by a third party, they record a receivable for the amount expected to be recovered. This receivable is classified in other current or other noncurrent assets in our consolidated balance sheet.
Pension Assumptions
Towers Watson sponsors both qualified and non-qualified defined benefit pension plans and other post-retirement benefit plan ("OPEB") plans inNorth America andEurope . As ofJune 30, 2012 , these funded and unfunded plans represented 98 percent ofTowers Watson's pension and OPEB obligations and are disclosed herein.Towers Watson also sponsors funded and unfunded defined benefit pension plans in certain other countries, representing an additional$80.9 million in projected benefit obligations,$54.9 million in assets and a net liability of$26.0 million . Under the legacyWatson Wyatt plans inNorth America , benefits are based on the number of years of service and the associate's compensation during the five highest paid consecutive years of service. The non-qualified plan provides for pension benefits that would be covered under the qualified plan but are limited by the Internal Revenue Code. The non-qualified plan is unfunded. In theU.K. , benefits earned prior toJanuary 2008 are based on the number of years of service and the associate's compensation during the three years before leaving the plan. Benefits earned afterJanuary 2008 are based on the number of years of service and the associate's average compensation during the associate's term of service since that date. The plan liabilities inGermany represent the grandfathered pension benefit for employees hired prior toJuly 1991 . The pension plan for associates hired afterJuly 1991 is a defined contribution arrangement. The legacy Towers Perrin pension plans in the U.S. accrue benefits under a cash-balance formula for associates hired or rehired after 2002 and for all associates for service after 2007. For associates hired prior to 2003 and active as ofJanuary 2003 , benefits prior to 2008 are based on a combination of a cash balance formula, for the period after 2002, and a final average pay formula based on years of plan service and the highest five consecutive years of plan compensation prior to 2008. Under the cash balance formula, benefits are based on a percentage of the associate's plan compensation each year. The Canadian Retirement Plan provides a choice of a defined benefit or a defined contribution. The non-qualified plans inNorth America provide for the additional pension benefits that would be covered under the qualified plan in the respective country were it not for statutory maximums. The non-qualified plans are unfunded. TheU.K. Plan provides predominantly lump sum benefits. Benefit accruals under theU.K. plan ceased onMarch 31, 2008 . The plans inGermany mostly provide benefits under a cash balance benefit formula. Benefits underthe Netherlands plan accrue on a final pay basis on earnings up to a maximum amount each year. EffectiveDecember 31, 2010 , the existing U.S. qualified and non-qualified pension plans were closed to new participants, and benefit accruals were frozen under the current benefit formulas effectiveDecember 31, 2011 . BeginningJanuary 1, 2012 , U.S. associates, including U.S. named executive officers, began accruing qualified and non-qualified benefits under a new stable value pension design. Retiree medical benefits provided under our U.S. postretirement benefit plans were closed to new hires effectiveJanuary 1, 2011 . Life insurance benefits under the same plans were frozen with respect to service, eligibility and amounts as ofJanuary 1, 2012 for active associates. The determination ofTowers Watson's obligations and annual expense under the plans is based on a number of assumptions that, given the longevity of the plans, are long-term in focus. A change in one or a combination of these assumptions could have a material impact onTowers Watson's pension benefit obligation and related cost. Any difference between actual and assumed results is amortized intoTowers Watson's pension cost over the average remaining service period of participating associates.Towers Watson considers several factors prior to the start of each fiscal year when determining the appropriate annual assumptions, including economic forecasts, relevant benchmarks, historical trends, portfolio composition and peer company comparisons.
Funding is based on actuarially determined contributions and is limited to amounts that are currently deductible for tax purposes. Since funding calculations are based on different measurements than those used for accounting purposes, pension contributions are not equal to net periodic pension cost.
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OnJanuary 1, 2012 , the legacy Watson Wyatt U.S. pension plan merged into the legacy Towers Perrin U.S. pension plan and it was renamed theTowers Watson pension plan. Prior to the plan merger, the legacy Towers Perrin and legacyWatson Wyatt plans had different accounting policies related to the determination of the market-related value of plan assets that is used to calculate expected return on plan assets, a component of net periodic benefit cost. However as a result of the merger of the two plans, the company was required to adopt a single method, resulting in a change in accounting principle. Previously, the legacy Towers Perrin plans inNorth America used a calculated value for the non-fixed income portion of the portfolio and fair value for the fixed income investments. The legacyWatson Wyatt plan used fair value for all investments in determining the market-related value of plan assets. The company elected to adopt the fair value method in determining the market-related value of plan assets of the merged plans and the legacy Towers Perrin pension plan inCanada . The company considers the fair value method for determining market-related value of plan assets to be a preferable method of accounting because asset-related gains and losses are subject to amortization into pension cost immediately. We evaluated the effect of this change in accounting method and deemed it immaterial to the historical and current financial statements and therefore did not account for the change retrospectively. Accordingly, the company calculated the cumulative difference of using a calculated value to determine market-related value of plan assets versus the fair value method for the legacy Towers Perrin plans over the period of time from the date of the merger between Towers Perrin andWatson Wyatt throughJanuary 1, 2012 to determine the cumulative impact of this accounting change. The cumulative effect of the change, as ofJanuary 1, 2012 , resulted in an increase to salary and employee benefit expense of$9.5 million , a reduction in income tax expense of$3.7 million and a reduction to net income of$5.8 million for the fiscal year endedJune 30, 2012 and an increase to accumulated other comprehensive income of$5.8 million . The cumulative effect of the change in accounting method decreased diluted earnings per share by$0.08 for the fiscal year endedJune 30, 2012 . Related to the change in accounting method, the$9.5 million expense is offset by a benefit of$6.6 million for the six months endedJune 30, 2012 .
Assumptions Used in the Valuations of the Defined Benefit Pension Plans
The following assumptions were used in the valuations ofTowers Watson's defined benefit pension plans. The assumptions presented for the North American plans represent the weighted-average of rates for all U.S. and Canadian plans. The assumptions presented forTowers Watson's European plans represent the weighted-average of rates for theU.K. ,Germany andNetherlands plans. In relation to the acquisition of Towers Perrin onJanuary 1, 2010 , the legacy plans of Towers Perrin have been included in the assumptions as of and for the years endedJune 30, 2010 and 2011.
The assumptions used to determine net periodic benefit cost for the fiscal years ended
Year Ended June 30, 2012 2011 2010 North North North America Europe America Europe America Europe Discount rate 5.79 % 5.59 % 5.80 % 5.25 % 6.43 % 6.03 % Expected long-term rate of return on assets 8.14 % 6.78 %
8.16 % 6.79 % 8.11 % 6.48 % Rate of increase in compensation levels
3.82 % 3.93 %
3.88 % 3.88 % 3.93 % 5.09 %
The following table presents the assumptions used in the valuation to determine the projected benefit obligation for the fiscal years endedJune 30, 2012 and 2011: June 30, 2012 June 30, 2011 North North America Europe America Europe Discount rate 4.86 % 4.80 % 5.79 % 5.62 % Rate of increase in compensation levels 4.35 % 3.93 %
3.82 % 3.93 %
As a result of plan changes adopted during the first quarter of fiscal year 2011, the legacy Watson Wyatt U.S. Pension Plans were remeasured as ofSeptember 30, 2010 . Upon remeasurement the discount rate assumption was changed for these plans and the net periodic benefit cost for the remainder of fiscal year 2011 was calculated using a weighted average discount rate of 5.79%.Towers Watson's discount rate assumptions were determined by matching expected future pension benefit payments with current AA corporate bond yields from the respective countries for the same periods. Inthe United States , specific bonds were selected to match plan cash flows. InCanada , yields were taken from a corporate bond yield curve. InEurope , the discount rate was set based on yields on European AA corporate bonds at the measurement date. TheU.K. is based on theU.K. AA corporate bonds, whileGermany andthe Netherlands are based on European AA corporate bonds. 37
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The expected rates of return assumptions for
The following information illustrates the sensitivity to a change in certain assumptions for the North American pension plans for fiscal year 2013:
Effect on FY 2013 Change in Assumption Pre-Tax Pension Expense 25 basis point decrease in discount rate +$8.9
million
25 basis point increase in discount rate -$8.5
million
25 basis point decrease in expected return on assets +$5.3
million
25 basis point increase in expected return on assets -$5.3
million
The above sensitivities reflect the impact of changing one assumption at a time. Economic factors and conditions often affect multiple assumptions simultaneously and the effects of changes in key assumptions are not necessarily linear.
The following information illustrates the sensitivity to a change in certain assumptions for the European pension plans for fiscal year 2013:
Effect on FY 2013 Change in Assumption Pre-Tax Pension Expense 25 basis point decrease in discount rate +$3.9
million
25 basis point increase in discount rate -$3.0
million
25 basis point decrease in expected return on assets +$1.6
million
25 basis point increase in expected return on assets -$1.6
million
The sensitivities reflect the effect of assumption changes occurring after acquisition accounting has been applied. The differences in the discount rate and compensation level assumption used for the North American and European plans above can be attributed to the differing interest rate environments associated with the currencies and economies to which the plans are subject. The differences in the expected return on assets are primarily driven by the respective asset allocation in each plan, coupled with the return expectations for assets in the respective currencies.
Goodwill and Intangible Assets
In applying the acquisition method of accounting for business combinations, amounts assigned to identifiable assets and liabilities acquired were based on estimated fair values as of the date of acquisition, with the remainder recorded as goodwill. Intangible assets are initially valued at fair market value using generally accepted valuation methods appropriate for the type of intangible asset. Intangible assets with definite lives are amortized over their estimated useful lives and are reviewed for impairment if indicators of impairment arise. Intangible assets with indefinite lives are tested for impairment annually as ofApril 1 , and whenever indicators of impairment exist. The fair value of the intangible assets is compared with their carrying value and an impairment loss would be recognized for the amount by which the carrying amount exceeds the fair value. Goodwill is tested for impairment annually as ofApril 1 , and whenever indicators of impairment exist. Goodwill is tested at the reporting unit level which is one level below our operating segments. The Company had nine reporting units onApril 1 , and added a tenth reporting unit with the acquisition ofExtend Health, Inc. onMay 29, 2012 (see Note 2 of the accompanying consolidated financial statements for further information regarding the acquisition ofExtend Health, Inc. ), however this was presumed to be a transaction at arm's length and therefore was not included in the annual impairment test. During fiscal 2012, the Company early adopted ASU 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment ("ASU 2011-08"), which gives entities testing goodwill for impairment the option of performing a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. During this assessment, we first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Qualitative factors we consider include, but are not limited to, macroeconomic conditions, industry and market conditions, company specific events, changes in circumstances, after tax cash flows and market capitalization. If the qualitative factors indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we perform the two step process to assess our goodwill for impairment. During fiscal 2012, the Company determined each reporting unit had a fair value that was substantially in excess of the carrying value, and therefore that we had no reporting units with carrying values that were more likely than not to exceed their fair value. As a result, we did not perform Steps 1 or 2 of the two-step impairment test. 38
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When the Company performs Step 1 of the two-step impairment test, we use Level 3 valuation techniques to estimate the fair value of a reporting unit that fall under income or market approaches. Under the discounted cash flow method, an income approach, the business enterprise value is determined by discounting to present value the terminal value which is calculated using debt-free after-tax cash flows for a finite period of years. Key estimates in this approach are internal financial projection estimates prepared by management, business risk, and expected rate of return on capital. The guideline company method, a market approach, develops valuation multiples by comparing our reporting units to similar publicly traded companies. Key estimates and selection of valuation multiples rely on the selection of similar companies, obtaining estimates of forecasted revenue and EBITDA estimates for the similar companies and selection of valuation multiples as they apply to the reporting unit characteristics. Under the similar transactions method, a market approach, actual transaction prices and operating data from companies deemed reasonably similar to the reporting units is used to develop valuation multiples as an indication of how much a knowledgeable investor in the marketplace would be willing to pay for the business units. If the Company was required to perform Step 2, we would determine the implied fair value of the reporting unit used in step one to all the assets and liabilities of that reporting unit (including any recognized or unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. Then the implied fair value of goodwill would be compared to the carrying amount of goodwill to determine if goodwill is impaired.
Results of Operations
The table below sets forth our consolidated statements of operations and data as a percentage of revenue for the periods indicated. The consolidated statement of operations ofTowers Watson for the fiscal year endedJune 30, 2010 includes the results of Towers Perrin's operations beginningJanuary 1, 2010 , or six months of the twelve-month period. Consolidated Statements of Operations (Thousands of U.S. dollars) Fiscal Year Ended June 30, 2012 2011 2010 Revenue $ 3,417,736 100 % $ 3,259,451 100 % $ 2,387,829 100 % Costs of providing services: Salaries and employee benefits 2,067,689 60 %
2,043,063 63 % 1,540,417 65 % Professional and subcontracted services
285,063 8 %
246,348 8 % 163,848 7 % Occupancy
141,053 4 %
144,191 4 % 109,454 5 % General and administrative expenses 284,994 8 % 281,576 9 % 220,937 9 % Depreciation and amortization
152,891 4 % 130,575 4 % 101,084 4 % Transaction and integration expenses 86,130 3 % 100,535 3 % 87,644 4 % 3,017,820 88 % 2,946,288 90 % 2,223,384 93 % Income from operations 399,916 12 % 313,163 10 % 164,445 7 % Income/(loss) from affiliates 262 - % 1,081 - % (1,274 ) - % Interest income 3,860 - % 5,523 - % 2,950 - % Interest expense (9,156 ) - % (12,475 ) - % (7,508 ) - % Other non-operating income 11,350 - % 19,349 1 % 11,304 - % Income before income taxes 406,232 12 % 326,641 10 % 169,917 7 % Provision for income taxes 145,756 4 % 129,916 4 % 50,907 2 % Net income before non-controlling interests 260,476 8 % 196,725 6 % 119,010 5 % Net income/(loss) attributable to non-controlling interests 263 - % 2,288 - % (1,587 ) - % Net income attributable to controlling interests $ 260,213 8 % $ 194,437 6 % $ 120,597 5 % 39
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Table of Contents Results of Operations for the Fiscal Year EndedJune 30, 2012 Compared to Fiscal Year EndedJune 30, 2011
Revenue
Revenue for the fiscal year endedJune 30, 2012 was$3.4 billion , an increase of$158.3 million , or 5%, compared to$3.3 billion for the fiscal year endedJune 30, 2011 . Our revenue growth reflects the good opportunities and strong teams we have developed in our business as well as from the addition of our three recent acquisitions,Extend Health , Aliquant and EMB. On an organic basis, which excludes the effects of acquisitions and currency, revenue increased 3% for the fiscal year endedJune 30, 2012 compared to the fiscal year endedJune 30, 2011 . All of our segments experienced organic growth in fiscal year 2012. We experienced challenges in our fourth quarter of fiscal 2012, including the impact of our ERP transition inNorth America , an economic slow-down in EMEA, and reduced demand for economy-driven discretionary services such as that in our Talent and Rewards segment. Despite these challenges at the end of our fiscal year 2012, we see signs of continued growth and strengthening of our business in fiscal year 2013. The average exchange rate used to translate our revenues earned in British pounds sterling increased to 1.5898 for fiscal year 2012 from 1.5878 for fiscal year 2011, and the average exchange rate used to translate our revenues earned in Euros decreased to 1.3457 for fiscal year 2012 from 1.3637 for fiscal 2011. Constant currency is calculated by translating prior year revenue at the current year average exchange rate. In fiscal year 2012, we experienced significant billing delays related to our ERP transition, which increased reserves for our receivables. We have a phased deployment, and the U.S. business impacts were identified and mitigated in the early stages of the EMEA roll-out.
A comparison of segment revenue for the fiscal year ended
• Benefits revenue increased
fiscal year 2012 compared to
constant currency basis, our Benefits segment revenue increased 4% due to
revenue growth in all of our practices. Our Retirement practice revenue,
which represents the majority of the segment's revenue, increased 1% on a
constant currency basis. This growth was strongest in
experienced growth in pension administration for new clients. Our
Technology and Administration Solutions practice experienced low double
digit constant currency growth largely due to the addition of Aliquant and
due to demand for system modifications and new call center clients.
Revenue increased in our Health and Group Benefits practice in the U.S.
driven by an increase in client demand for our strategy work, particularly
in the plan management and product sales. The health benefits consulting
environment continues to be strong with regulatory uncertainty, market
change and cost pressure. Our International practice, with high single
digit revenue growth, helps to address the issues multinationals face in
their compensation and benefit programs. We anticipate that our Benefits
segment revenue will show modest growth with sustained momentum in our Technology and Administration Solutions practice and in our Health and Group Benefits practice, as well as with project activity in our Retirement practice. Revenue in our Benefits segment increased 3% on an organic basis, which excludes the effects of acquisitions and currency. • Risk and Financial Services revenue increased 10% and was$817.6 million
for fiscal year 2012 compared to
increase was due to revenue growth in all of practices. Our Risk
Consulting and Software practice experienced low double digit constant
currency revenue growth due to the addition of EMB. In addition, regulatory changes and merger and acquisition activity continue to drive demand. Our revenue in EMEA was impacted by a decrease in demand and a
delay of Solvency II implementation. Revenue from property and casualty
consulting increased in the fourth quarter of fiscal year 2012. We
experienced continued growth in our Brokerage practice revenue due to mid
single digit growth in the
favorable pricing conditions and high retention rates drove growth. Our
Investment practice experienced mid single digit growth due to solid
demand worldwide for advice on investment strategy, delegated services and
alternative assets and has a good global pipeline. We remain cautious
about
Risk and Financial Services to maintain a positive momentum. Revenue in
our Risk and Financial Services segment increased 4% on an organic basis.
• Talent and Rewards revenue increased 5% and was
year 2012 compared to
organic growth in all regions and in all lines of business of Talent and
Rewards. We experienced high single digit revenue growth in our Executive
Compensation consulting practice this year. The Executive Compensation
consulting environment continued focus on pay-performance alignment,
increased focus on risk mitigation and efforts to gauge shareholders'
opinions have driven demand for our services globally. Rewards, Talent and
Communication practice revenue increased in the high single digits in all
regions, led by the
benefits open enrollment period, where we assist clients in helping their
employees understand the value of their health and benefit packages.
Merger and acquisition activity globally has created demand for change management support and reward program design. We experienced low single digit growth in Data, Surveys and Technology revenue from the rationalization 40
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of our legacy product platforms over the past year. We saw a decrease in
European sales in the fourth quarter. We expect to see mixed result in
fiscal year 2013, with the tightening in
growth in activity in the
experienced 6% organic revenue growth. • We established our fourth segment, Exchange Solutions, when we acquired
private
solution enables employers to transition their retirees to individual,
defined contribution health plans at an annual cost that the employer
controls. We generate revenue from the commissions we receive from
insurance carriers for enrolling individuals into their health plans. This
revenue increases as the number of enrolled members grows. For the quarter
and fiscal year ended
revenue was
consolidated operations. As a result of purchase accounting, we will not
realize
commissions paid by carriers per policy placed prior to the acquisition as
there is no subsequent performance obligation.
Salaries and Employee Benefits
Salaries and employee benefits were$2.1 billion for fiscal year 2012 compared to$2.0 billion for fiscal year 2011, an increase of$24.6 million , or 1%. This increase was primarily driven by an increase in base salary of$96.0 million attributed to an 8% increase in headcount and a 4% increase in base salary. Our EMEA and APAC operations accounted for 56% of our headcount increase as ofJune 30, 2012 compared toJune 30, 2011 as a result of our acquisition of EMB inJanuary 2011 and also as we have increased resources in certain of our practices in response to new business opportunities. We expect to continue hiring new associates to address pockets of opportunities as they arise throughout our business. Our discretionary annual bonus decreased by$19.2 million for fiscal year 2012 compared to fiscal year 2011 and is based on pre-bonus profitability and can fluctuate based on the operating results of the Company. Our stock-based compensation decreased$23.5 million in the current year primarily due to our use of the graded-vesting method of recording expense related to the restricted stock units issued to employees of Towers Perrin in the Merger. Our pension and other employee benefits expense decreased$23.9 million due to the remeasurement of our U.S. pension and post-retirement plans inSeptember 2010 . The plan changes substantially reduced plan obligations associated with future pay and health care cost increases. In addition, our fringe benefits and taxes were reduced by$10.8 million . As a percentage of revenue, salaries and employee benefits decreased to 60% for the fiscal year 2012 from 63% for fiscal year 2011.
Professional and Subcontracted Services
Professional and subcontracted services for fiscal year 2012 were$285.1 million , compared to$246.3 million for fiscal year 2011, an increase of$38.7 million , or 16%. The increase is due to an increase of$32.7 million of external service provider fees to supplement our day-to-day operations including information technology consultants and recruiting fees. We also experienced an increase in$6.0 million of pass-through expenses, which are reimbursable under our contracts. As a percentage of revenue, professional and subcontracted services were 8% for fiscal year 2012 and 2011.
Occupancy
Occupancy expense for fiscal year 2012 was$141.1 million compared to$144.2 million for fiscal year 2011, a decrease of$3.1 million , or 2%. We experienced decreases in base rent related to consolidating locations and eliminating leases and for amortization of the fair value of acquired lease intangibles and tenant improvement allowances. As a percentage of revenue, occupancy expense was 4% for fiscal years 2012 and 2011.
General and Administrative Expenses
General and administrative expenses for fiscal year 2012 were$285.0 million , compared to$281.6 million for fiscal year 2011, an increase of$3.4 million , or 1%. The increase was principally due to increased non-billable travel costs and general office expenses to support an expanded employee base. As a percentage of revenue, general and administrative expenses decreased to 8% for fiscal year 2012 from 9% for fiscal year 2011.
Depreciation and Amortization
Depreciation and amortization expense for fiscal year 2012 was$152.9 million , compared to$130.6 million for fiscal year 2011, an increase of$22.3 million , or 17%. The increase is primarily due to amortization of intangible assets related to our three new acquisitions,Extend Health in fiscal year 2012 and EMB and Aliquant in fiscal year 2011. In addition, we accelerated amortization for a software application that we acquired in the merger as management determined that its use would be discontinued in the next three to four years. A portion of the increase is also attributable to increased depreciation on the computer hardware that has been placed in service in fiscal years 2011 and 2012. As a percentage of revenue, depreciation and amortization expenses were 4% for fiscal year 2012 and 2011. 41
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Transaction and Integration Expenses
Transaction and integration expense for fiscal year 2012 was$86.1 million , compared to$100.5 million for fiscal year 2011, a decrease of$14.4 million , or 14%. The decrease was principally due to fees paid in fiscal year 2011 to terminate our external information technology service provider relationship and to terminate leases for our office integration, offset by increased expenses associated with information technology integration projects in the current year. As a percentage of revenue, transaction and integration expenses were 3% for fiscal years 2012 and 2011. Income from Affiliates Income from affiliates for fiscal year 2012 was$0.3 million compared to income from affiliates of$1.1 million for fiscal year 2011. In the second quarter of fiscal year 2012, we purchased a majority ownership inFifth Quadrant Actuaries and Consultants Holdings (Pty) Ltd. ("Fifth Quadrant") and began to consolidate its operations. Fifth Quadrant has historically been the primary source of income from affiliates.
Interest Income
Interest income was
Interest Expense
Interest expense was
Other Non-Operating Income
Other non-operating income for fiscal year 2012 was$11.4 million , compared to$19.3 million for fiscal year 2011. In fiscal year 2012, we recorded a$2.8 million gain resulting from the fair value adjustment to our investment in Fifth Quadrant upon the purchase of a controlling interest. We acquired an additional ownership in Fifth Quadrant and consolidated our former equity investee in our results of operations beginning in the second quarter of fiscal year 2012. Included in fiscal year 2011 is$9.4 million received for a deferred payment on the sale of an investment. In both fiscal years 2012 and 2011, we also recorded deferred payments from divestitures.
Provision for Income Taxes
Provision for income taxes for fiscal year 2012 was$145.8 million , compared to$129.9 million for fiscal year 2011. The effective tax rate was 35.9% for fiscal year 2012 compared to 39.8% for fiscal year 2011. Our effective tax rate decreased for fiscal year 2012 as compared to fiscal year 2011 primarily due to a change in the mix of income between foreign and U.S. operations, and the release of valuation allowance in foreign jurisdictions, offset by the reduction of tax loss carryforwards that cannot be utilized following legal entity restructurings. Beginning in fiscal year 2012, the Company no longer provides deferred taxes on current or future earnings with respect to the acquired Towers Perrin Canadian subsidiary. If future events, including material changes in estimates of cash, working capital and long-term investments requirements, necessitate that foreign earnings be distributed, an additional provision for U.S. income and foreign withholding taxes, net of foreign tax credits, may be necessary.
Net Income Attributable to Controlling Interests
Net income attributable to controlling interests for the fiscal year ended
Earnings Per Share
Diluted earnings per share for fiscal year 2012 was
Results of Operations for the Fiscal Year Ended
Compared to Fiscal Year EndedJune 30, 2010 Revenue for the fiscal year endedJune 30, 2011 was$3.3 billion , an increase of$871.6 million , or 37%, compared to$2.4 billion for the fiscal year endedJune 30, 2010 . The increase was the result of purchase accounting of the Merger, which in fiscal year 2010 provided for the consolidation of a full year ofWatson Wyatt's operating results but only six months of Towers Perrin's results. 42
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Salaries and employee benefits were 63% of revenue for the fiscal year endedJune 30, 2011 , a decrease of 2% from 65% of revenue for the fiscal year endedJune 30, 2010 . Transaction and integration expenses related to the Merger were 3% of revenue for fiscal year 2011, a decrease 1%, from 4% of revenue for fiscal year 2010. The provision for income taxes for fiscal year 2011 is 39.8% compared with 30.0% in fiscal year 2010. Our effective tax rate increased for fiscal year 2011 as compared to fiscal year 2010 primarily due to a change in the mix of income between foreign and U.S. operations and an increase in the valuation allowance for foreign jurisdictions for fiscal year 2011. The effective tax rate in fiscal year 2010 was significantly lower due to a valuation allowance release on U.S. foreign tax credits as we determined that it was more likely than not that these foreign tax credits would be realized within the carryforward period.
Net Income Attributable to Controlling Interests
Net income attributable to controlling interests for the fiscal year ended
Earnings Per Share
Diluted earnings per share for the fiscal year ended
There were no other significant increases or decreases of more than one percent comparing the statements of operations line items as a percent of revenue period over period for the fiscal years endedJune 30, 2011 and 2010. 43
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UNAUDITED SUPPLEMENTAL PRO FORMA CONDENSED COMBINED STATEMENTS OF OPERATIONS
The consolidated statement of operations ofTowers Watson for the fiscal year endedJune 30, 2010 includes the results of Towers Perrin's operations beginningJanuary 1, 2010 , or six months of the twelve-month period. As a result, the consolidated statement of operations for the fiscal year endedJune 30, 2011 as compared to the unaudited supplemental pro forma combined financial information for fiscal year endedJune 30, 2010 is prepared and presented to aid in explaining the results of operations of the mergedTowers Watson . The pro forma unaudited consolidated statement of operations ofTowers Watson for the fiscal year endedJune 30, 2010 is prepared as if the Merger occurred onJuly 1, 2009 . The pro forma consolidated statement of operations for the fiscal year endedJune 30, 2010 combinesTowers Watson's historical unaudited consolidated statement of operations for the six months endedJune 30, 2010 withWatson Wyatt's and Towers Perrin's historical unaudited consolidated statements of operations for the six months endedDecember 31, 2009 .Watson Wyatt's fiscal year ended onJune 30 while Towers Perrin's fiscal year ended onDecember 31 . Towers Perrin's financial information has been recast to conform toWatson Wyatt's fiscal year end. Towers Perrin's historical unaudited consolidated statement of operations for the six months endedDecember 31, 2009 was derived by subtracting Towers Perrin's unaudited consolidated statement of operations for the six months endedJune 30, 2009 from Towers Perrin's audited consolidated statement of operations for the year endedDecember 31, 2009 . The unaudited pro forma combined financial statements should be read together with the respective historical financial statements and related notes of Towers Perrin andWatson Wyatt and the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The unaudited pro forma condensed combined statements of operations give effect to the Merger including:
• related Merger consideration; • adjustments made to record the assets and liabilities of Towers Perrin at their estimated fair values; • reclassifications made to conform Towers Perrin's andWatson Wyatt's historical financial statement presentation toTowers Watson's ; and • the consolidation ofProfessional Consultants Insurance Company, Inc. ,
which we refer to as "PCIC."
Pro forma earnings per share reflect the impact of significant non-cash and non-recurring expenses resulting from the Merger, including compensation expense incurred as a result of the issuance of Towers Watson Restricted Class A common stock to Towers Perrin restricted stock unit ("RSU") holders and the incremental amortization of acquired intangible assets. The following unaudited pro forma condensed combined statements of operations for the fiscal year endedJune 30, 2010 is provided for informational purposes only. It does not purport to represent whatTowers Watson's results of operations would have been had the Merger been completed as of the date indicated and do not purport to be indicative of the results of operations thatTowers Watson may achieve in the future. 44
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Table of Contents Unaudited Supplemental Pro Forma Combined Statement of Operations Year Ended June 30, 2010 Year Ended Six Months Ended Year Ended June 30, 2010 December 31, 2009 June 30, 2010 As Reported Historical Pro Forma Towers Watson Towers Perrin PCIC Adjustments As Adjusted (In thousands,
except share and per share data)
Revenue $ 2,387,829 $ 798,131 $ 12,750 $ (9,404 )H $ 3,180,916 (8,390 )K Costs of providing services: Salaries and employee benefits 1,540,417 558,855 107 46,832 B 2,146,211 Professional and subcontracted services 163,848 79,421 483 243,752 Occupancy 109,454 35,406 - 1,835 A 146,695 General and administrative expenses 220,937 40,351 16,924 (9,404 )H 268,808 Depreciation and amortization 101,084 19,007 - 11,508 A 131,599 Transaction and integration expenses 87,644 15,734 - (103,378 )E - 2,223,384 748,774 17,514 (52,607 ) 2,937,065 Income from operations 164,445 49,357 (4,764 ) 34,813 243,851 (Loss)/income from affiliates (1,274 ) (164 ) - 353 J (1,085 ) Interest income 2,950 530 1,517 (266 )C 4,731 Interest expense (7,508 ) (1,536 ) - (2,000 )D (11,991 ) (947 )G
Other non-operating income 11,304 5,281 - 16,585 Income before income taxes 169,917 53,468 (3,247 ) 31,953 252,091 Provision for income taxes 50,907 9,779 (1,187 ) 8,419 F 67,918 Net income before non-controlling interests 119,010 43,689 (2,060 ) 23,534 184,173 Net loss attributable to non-controlling interests (1,587 ) - - (559 )I (2,146 ) Net income/(loss) attributable to controlling interests $ 120,597 $ 43,689 $ (2,060 ) $ 24,093 $ 186,319 Earnings per share: Net income-Basic $ 2.04 M $ 3.14 Net income-Diluted $ 2.03 M $ 3.14 Weighted average shares of common stock, basic (000) 59,257 M 59,257 Weighted average shares of common stock, diluted (000) 59,372 M 59,372 45
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Pro Forma Adjustments
The pro forma adjustments reflected in the unaudited supplemental pro forma condensed combined financial information are as follows:
A) Reflects estimated amortization of Towers Perrin's acquired intangible assets
on an accelerated amortization basis over their estimated useful lives.
Customer-related intangible assets are amortized over a 12-year estimated
life and developed technology intangible assets are amortized over a
weighted-average four-year estimated life. The trademark and trade names
intangible asset has an indefinite life. Also reflects an adjustment to rent
expense to approximate fair value of acquired leases. B) Reflects non-cash compensation expense in connection with the issuance of
the Merger. The graded method of expense methodology assumes that the
restricted shares were issued to Towers Perrin RSU holders in equal amounts
of shares which vest over one year, two years and three years. The current
estimate of total non-cash compensation expense relating to
restricted Class A common stock for the three-year period is
This estimate was determined assuming a 10% annual forfeiture rate based on
actual and expected attrition. C) Reflects interest income forgone as a result of the cash consideration of
the redemption of Towers Watson Class R common stock.
D) Reflects interest accrued on
Notes issued to Towers Perrin Class R Participants. Interest on the Towers
Watson Notes accrued at a 2.0% fixed rate per annum, compounded annually.
E) Reflects the elimination of Merger-related transaction costs (including
financial advisory, legal and valuation fees). Because transaction costs will
not have a continuing impact, they are not reflected in the unaudited pro
forma condensed combined statement of operations.
F) Reflects the provision for taxes as a result of the Merger. A U.S. statutory
rate of 40.0% was used for fiscal year 2011, except for adjustments related
to PCIC for which a 34% statutory rate was used since PCIC would not be
included in the U.S. consolidated tax return. For the fiscal year 2010 the
U.S. statutory rate of 39.6% was used. For purposes of determining the
estimated income tax expense for the adjustments reflected in the unaudited
pro forma condensed combined statement of operations, taxes were determined
by applying the applicable statutory tax rate for jurisdictions where each
pro forma adjustment is expected to be reported. Although not reflected in
these unaudited pro forma condensed combined statements of operations, the
effective tax rate of the combined company could be significantly different
depending on post-acquisition activities, including repatriation decisions,
the geographic mix of income, and post-Merger restructuring activities.
G) Reflects one year of amortization of
with theTowers Watson credit facility, which will be amortized over a three-year period.
H) Reflects the elimination of premium revenue and unearned revenues from Watson
Wyatt and Towers Perrin as recorded by PCIC, as well as related expense recorded byWatson Wyatt and Towers Perrin. I) Reflects the 27.14% non-controlling interest in PCIC of the remaining minority shareholder.
J) Reflects the elimination of
PCIC as recorded under the equity method. K) Reflects the reduction to Towers Perrin's software revenue attributable to performance obligations completed prior to the Merger. This reduction is
required to reflect the acquired deferred software revenue at fair value as
of the date of the Merger.
L) Reflects the elimination of merger-related deferred payment on the sale of an
investment. Because this deferred payment will not have a continuing impact,
it is not reflected in the unaudited pro forma condensed consolidated statement of operations.
M) Earnings per share calculations for the fiscal years ended
2010 and 2009 are based on
as ofJune 30, 2011</chron>, 2010 and 2009, respectively. 46
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Statement of Operations for the Fiscal Year Ended
Compared to Pro Forma Financial Information for the Fiscal Year Ended June 30,
2010 RevenueTowers Watson revenue for the fiscal year endedJune 30, 2011 was$3.3 billion , an increase of$78.5 million , or 2%, from pro forma revenue of$3.2 billion for the fiscal year endedJune 30, 2010 . Our revenue growth reflected increased revenue from both new and existing clients. In addition, revenue from two acquisitions, Aliquant and EMB, contributed to the increase in revenue in the second half of fiscal year 2011. We use constant currency to evaluate our results of operations because we are a global company subject to foreign currency translation fluctuations in our year-over-year comparisons. Constant currency is calculated by translating prior year revenue at the current year average exchange rate. The average exchange rate used to translate our revenues earned in British pounds sterling increased to 1.5878 for fiscal 2011 from 1.4749 for fiscal year 2010, and the average exchange rate used to translate our revenues earned in Euros increased to 1.3637 for fiscal year 2011 from 1.2211 for fiscal 2010.
A comparison of segment revenue for the fiscal year ended
• Benefits revenue increased 2% and was
compared to
basis, our Retirement practice revenue remained consistent, which represents the majority of the segment's revenue. The growth in the Retirement practice is from the developing markets inAsia andLatin America which is driven by new legislation and client demand. The
Retirement practice in
revenue in fiscal year 2011 compared to the same period in fiscal year
2010 because of a strong prior year comparable from project work related
to regulatory changes. Revenue increased on a constant currency basis in
our Technology and Administration Solutions practice, with revenue growth
in the U.S. and a slight decline in
due to the addition of Aliquant, a health and welfare benefits
administration outsourcing firm that we acquired during the second quarter
of fiscal year 2011. Revenue increased in our Health and Group Benefits
practice as health care reform deadlines approach. Revenue in our Benefits
segment increased 1% on an organic basis which excludes the effects of
acquisitions and currency effects. • Risk and Financial Services revenue increased 2% and was$740.7 million
and
respectively. Revenue increased on a constant currency basis in our Risk
Consulting and Software practice primarily due to the addition of EMB, a non-life consulting and software company, that we acquired during our third quarter of fiscal year 2011. Revenue for ourRisk Consulting and Software practice, without the inclusion of EMB, decreased due to a decrease in project activity. Revenue from our Brokerage practice decreased on a constant currency basis from decreases in pricing and
volume as a result of overall market conditions in the U.S. property and
casualty insurance marketplace, which were only partially offset from new
client activity in
on a constant currency basis compared to fiscal year 2010 due to less
activity in
strong Investment practice comparable in the prior year. Revenue in our
Risk and Financial Services segment decreased 2% on an organic basis which
excludes the effects of acquisitions and currency.
• Talent and Rewards revenue remained consistent and was
respectively. Revenues from our Executive Compensation practice continued
to decrease as work moved to a new Board-focused Executive Compensation
boutique firm, Pay Governance, to help some of our clients address
perceived independence issues. After adjusting for the revenue that was
transferred to Pay Governance and for two small acquisitions in
Sweden , Talent and Rewards experienced 7% constant currency revenue growth. On an organic basis, revenues in all practices, Executive Compensation; Rewards, Talent and Communication; and Data, Surveys and
Technology, increased. The organic increase in revenue for Executive
Compensation is due to increased project activity inNorth America in both management and compensation committee consulting and strong growth inAsia Pacific . Increases in revenue inAsia Pacific , particularlyChina , is attributed to local companies expanding nationally, regionally and globally and implement executive pay plans to support growth. Organic
revenue growth in Reward, Talent and Communication was due to significant
increases in all geographic regions especially in
experienced organic revenue growth in our Data, Surveys and Technology
practice due to growth in data and surveys in all geographic regions,
especially in
Salaries and Employee Benefits
Salaries and employee benefits were$2.0 billion for the fiscal year endedJune 30, 2011 compared to$2.1 billion for the fiscal year ended 2010, a decrease of$103.1 million , or 5%. The decrease is principally due to decreases in discretionary compensation, pension and employer related taxes partially offset by an increase in other employee benefits. As a percentage of revenue, salaries and employee benefits decreased to 63% for fiscal year 2011 from 67% for fiscal year 2010.
Professional and Subcontracted Services
Professional and subcontracted services used in consulting operations for the fiscal year endedJune 30, 2011 were$246.3 million , compared to$243.8 million for the fiscal year endedJune 30, 2010 , an increase of$2.6 million , or 1%. The increase was principally due to increased use of external service providers to supplement our day-to-day operations. Professional and subcontracted services were 8% of revenue for fiscal year 2011 and 2010. 47
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Occupancy
Occupancy expense for the fiscal year endedJune 30, 2011 was$144.2 million compared to$146.7 million for the fiscal year endedJune 30, 2010 , a decrease of$2.5 million , or 2%. This decrease is principally due to the reduction of leased office space resulting from the Merger. As a percentage of revenue, occupancy expense decreased to 4% for fiscal year 2011 from 5% for fiscal year 2010.
General and Administrative Expenses
General and administrative expenses for the fiscal year endedJune 30, 2011 were$281.6 million , compared to$268.8 million for the fiscal year endedJune 30, 2010 , an increase of$12.8 million , or 5%. This increase is primarily due to increases in travel and entertainment expenses, general office costs as well as increases in promotions offset by decreases in professional liability expense as a result of a reduction in reserves for specific claims. As a percentage of revenue, general and administrative expenses increased to 9% for fiscal year 2011 from 8% for fiscal year 2010.
Depreciation and Amortization
Depreciation and amortization expense for the fiscal year endedJune 30, 2011 was$130.6 million , compared to$131.6 million for the fiscal year endedJune 30, 2010 , a decrease of$1.0 million , or 1%. The decrease results primarily from the change in the average exchange rates used to translate our expenses incurred in British pounds sterling and the Euro. On a constant currency basis, depreciation and amortization expense increased principally due to an increase in amortization of intangibles related to the Aliquant and EMB acquisitions in fiscal year 2011, partially offset by a decrease in depreciation of fixed assets. As a percentage of revenue, depreciation and amortization expense was 4% for fiscal years 2011 and 2010.
Transaction and Integration Expenses
Transaction and integration expenses incurred related to the Merger were$100.5 million for the fiscal year endedJune 30, 2011 compared to$103.4 million for the fiscal year endedJune 30, 2010 , a decrease of$2.8 million , or 3%. Transaction and integration expenses principally consist of investment banker fees, regulatory filing expenses, integration consultants, as well as legal, accounting, marketing, and IT integration expenses. As a percentage of revenue, transaction and integration expenses were 3% for fiscal year 2011 and 4% for fiscal year 2010. Transaction and integration expenses are eliminated in the pro forma condensed combined statements of operations because these costs will not have a continuing impact.
Income / (Loss) From Affiliates
Income from affiliates for the fiscal year endedJune 30, 2011 was$1.1 million compared to loss from affiliates of$1.1 million for the fiscal year endedJune 30, 2010 , an increase of$2.2 million , or 200%. During fiscal year 2011, we increased our effective ownership interest in Fifth Quadrant from 20% to 40%. As a result, 40% of Fifth Quadrant's operating results are included in our income from affiliates. Loss from affiliates for fiscal year 2010 includes our share of our affiliates' losses as well as an asset write-down of an equity affiliate.
Interest Income
Interest income for the fiscal year endedJune 30, 2011 was$5.5 million , compared to$4.7 million for the fiscal year endedJune 30, 2010 . The increase is mainly due to a higher average cash balance in the current period compared to the prior period, combined with higher short-term interest rates inCanada andEurope . Interest Expense
Interest expense for the fiscal year ended
Other Non-Operating Income
Other non-operating income for the fiscal year endedJune 30, 2011 was$19.3 million , compared to$16.6 million for the fiscal year endedJune 30, 2010 . Included in fiscal year 2011 is a gain on the sale of eValue, a financial modeling software acquired from Towers Perrin in the Merger. Included in historical other non-operating income for fiscal 2011 is a$9.4 million deferred payment we received related to a divestiture by Towers Perrin inJune 2009 before the closing of the Merger and a gain on divestiture of a technology. The first nine months of fiscal 2010 included$5.0 million of payments received from the licensing of a brand name in conjunction with the sale of an investment. 48
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Explanatory Note Regarding Pro Forma Financial Information
The unaudited pro forma combined statements of operations and pro forma analysis above have been provided to present illustrative combined unaudited statements of operations for the fiscal year endedJune 30, 2010 , giving effect to the business combination as if it had been completed onJuly 1, 2009 . This presentation was for illustrative purposes only and is not indicative of the results of operations that might have occurred had the business combination actually taken place as of the dates specified, or that may be expected to occur in the future.
Historical Results of
The following sections of Management's Discussion and Analysis are based on actual results of the business and do not contain pro forma information.
Liquidity and Capital Resources
Our most significant sources of liquidity are funds generated by operating activities, available cash and cash equivalents, and our credit facility. Consistent with our liquidity position, management considers various alternative strategic uses of cash reserves including acquisitions, dividends and stock buybacks, or any combination of these options.
We believe that we have sufficient resources to fund operations beyond the next 12 months. The key variables that we manage in response to current and projected capital resource needs include credit facilities and short-term borrowing arrangements, working capital and our stock repurchase program. Our cash and cash equivalents atJune 30, 2012 totaled$478.2 million , compared to$528.9 million atJune 30, 2011 . The decrease in cash fromJune 30, 2011 toJune 30, 2012 was principally attributable to the cash payment of$435.9 million for the acquisition ofExtend Health, Inc. and the maturity and repayment of the$100.8 million principal and compounded interest for the subordinated notes issued inJune 2010 in connection with our tender offer. Both of these payments were offset by borrowings under the Senior Credit Facility and a new$250.0 million term loan facility (the "Term Loan").
Our cash and cash equivalents balance includes
Our restricted cash atJune 30, 2012 totaled$171.4 million , compared to$153.2 million atJune 30, 2011 , of which$166.9 million is available for payment of reinsurance premiums on behalf of reinsurance clients and an additional$4.5 million is held for payment of health and welfare premiums on behalf of our clients. Our non-U.S. operations are substantially self-sufficient for their working capital needs. As ofJune 30, 2012 ,$385.9 million ofTowers Watson's total cash and cash equivalents balance of$478.2 million was held outside ofthe United States . Should we require more capital in the U.S. than is generated by our U.S. operations, we may decide to make additional borrowings under our Senior Credit Facility, repatriate funds held in foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates or increased interest expense. We do not expect restrictions or taxes on repatriation of cash held outside the U.S. to have a material effect on the Company's overall liquidity, financial condition or results of operations. As ofJune 30, 2012 , we have not provided U.S. federal income taxes on undistributed foreign earnings of our foreign subsidiaries, because such earnings are considered indefinitely reinvested outsidethe United States . It is not practicable to estimate the U.S. federal income tax liability that might be payable if such earnings are not reinvested indefinitely. If future events, including material changes in estimates of cash, working capital and long-term investment requirements necessitate that these earnings be repatriated, an additional provision for U.S. income and foreign withholding taxes, net of foreign tax credits, may be necessary. Assets and liabilities associated with non-U.S. entities have been translated into U.S. dollars as ofJune 30, 2012 , at U.S. dollar rates that fluctuate compared to historical periods. As a result, cash flows derived from changes in the consolidated balance sheets include the impact of the change in foreign exchange translation rates. Events that could change the historical cash flow dynamics discussed above include significant changes in operating results, potential future acquisitions, material changes in geographic sources of cash, unexpected adverse impacts from litigation or future pension funding during periods of severe downturn in the capital markets. 49
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Cash Flows From/(Used in) Operating Activities.
Cash flows from operating activities were$316.1 million for fiscal year 2012 compared to cash flows from operating activities of$541.2 million for fiscal year 2011. This decrease of$225.1 million is primarily attributable additional net income from operations of$63.8 million offset by the following:
• Our billed and unbilled accounts receivable balances increased $105.4
million from
revenue growth, and partially due to an increased focus on ERP deployment
activities in
approximately 81% of our revenue is operating on the new Oracle system. We
expect that we may experience elevated levels of accounts receivable for
the next few quarters while we continue deployments around the world.
• Our bonus payments for fiscal 2012 and 2011 are relatively consistent
while half of the bonus payments for fiscal 2010 were made prior to the
fiscal year end due to the Merger betweenWatson Wyatt and Towers Perrin. • A$75.0 million decrease in our professional liability claims reserves
primarily as a result of known and improved claims experience.
The allowance for doubtful accounts increased
Cash Flows Used in Investing Activities.
Cash flows used in investing activities for fiscal year 2012 were$542.3 million , compared to$200.9 million of cash flows from investing activities for fiscal year 2011. The increase in cash used is due to$435.9 million of cash paid for the acquisitions ofExtend Health, Inc. in fiscal 2012 less$7.0 million cash acquired in the acquisitions plus an additional$59.3 million spent on the purchase of fixed assets in fiscal 2012.
Cash Flows From/(Used in) Financing Activities.
Cash flows from financing activities for fiscal year 2012 were$188.8 million , compared to cash flows used in financing activities of$272.7 million for fiscal year 2011. The increase was due to a net increase in total borrowings of$357.2 million in fiscal 2012 as compared to fiscal 2011. This was partially offset by an additional$78.3 million of cash repurchases of common stock during fiscal 2012.
During fiscal 2012, the average outstanding balance on our Senior Credit Facility was
Capital Commitments
Expenditures of capital were$123.7 million for fiscal year 2012. Additionally, during fiscal 2012, we spent$34.9 million for internally-developed capitalized software for external use by our clients.
Dividends
During the fiscal year endedJune 30, 2012 , our board of directors approved the payment of a quarterly cash dividend in the amount of$0.10 per share. Total dividends paid in fiscal yearJune 30, 2012 and 2011 were$26.4 million and$21.6 million , respectively.
Off-Balance Sheet Arrangements and Contractual Obligations
Remaining payments
by fiscal year due as of
Less than More Than Contractual Cash Obligations (in thousands) Total 1 Year 1-3 Years 3-5 Years 5 Years Revolving credit facility $ 208,000 $ - $ - $ 208,000 $ - Term loan 250,000 - 50,000 200,000 - Lease commitments 611,039 106,079 188,115 131,981 184,864 $ 1,069,039 $ 106,079 $ 238,115 $ 539,981 $ 184,864 50
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Operating Leases. We lease office space under operating lease agreements with terms typically averaging 10 years. We have determined that there is not a large concentration of leases that will expire in any one fiscal year. Consequently, management anticipates that any increase in future rent expense on leases will be mainly market driven. Intangible assets and liabilities were recognized for the difference between the contractual cash obligations shown above and the estimated market rates at the time of the acquisitions. The resulting intangibles will amortize to rent expense but do not impact the amounts shown above since there is no change to our contractual cash obligations.
Pension Contribution. Contributions to our various pension plans for fiscal year 2013 are projected to be
Uncertain Tax Positions. The table above does not include liabilities for uncertain tax positions under ASC 740, Income Taxes. The settlement period for the$39.3 million liability, which excludes interest and penalties, cannot be reasonably estimated since it depends on the timing and possible outcomes of tax examinations with various tax authorities. Contingent Consideration from Acquisitions. The table above does not include liabilities for contingent consideration for our EMB acquisitions in fiscal year 2011. As ofJune 30, 2012 , we still expect to pay out £2.4 million per year for fiscal year 2013 through fiscal year 2016 related to these contingent consideration provisions in our agreements and subject to performance requirements on behalf of the sellers.
Indebtedness
OnNovember 7, 2011 ,Towers Watson and certain subsidiaries entered into a five-year,$500 million revolving credit facility, which amount may be increased by an aggregate amount of$250 million , subject to the satisfaction of customary terms and conditions, with a syndicate of banks (the "Senior Credit Facility"), replacing a previous facility due to expire inDecember 2012 . Borrowings under the Senior Credit Facility bear interest at a spread to either LIBOR or the Prime Rate. During fiscal 2012, the weighted-average interest rate on the Senior Credit Facility and the previous facility was 1.97%. We are charged a quarterly commitment fee, currently 0.175% of the Senior Credit Facility, which varies with our financial leverage and is paid on the unused portion of the Senior Credit Facility. Obligations under the Senior Credit Facility are guaranteed byTowers Watson and all of its domestic subsidiaries (other than our captive insurance companies). The Senior Credit Facility contains customary representations and warranties and affirmative and negative covenants. The Senior Credit Facility requiresTowers Watson to maintain certain financial covenants that include a minimum Consolidated Interest Coverage Ratio and a maximum Consolidated Leverage Ratio (which terms in each case are defined in the Senior Credit Facility). In addition, the Senior Credit Facility contains restrictions on the ability ofTowers Watson to, among other things, incur additional indebtedness; pay dividends; make distributions; create liens on assets; make acquisitions; dispose of property; engage in sale-leaseback transactions; engage in mergers or consolidations, liquidations and dissolutions; engage in certain transactions with affiliates; and make changes in lines of businesses. As ofJune 30, 2012 , we were in compliance with our covenants.
As of
Previous Senior Credit Facility
Prior to entering into the Senior Credit Facility onNovember 7, 2011 ,Towers Watson and certain subsidiaries had entered into a three-year,$500 million revolving credit facility with a syndicate of banks (the "Old Senior Credit Facility"). Borrowings under the Old Senior Credit Facility bore interest at a spread to either LIBOR or the Prime Rate. We were charged a quarterly commitment fee, 0.5% of the Old Senior Credit Facility, which varied with our financial leverage and was paid on the unused portion of the Old Senior Credit Facility. Obligations under the Old Senior Credit Facility were guaranteed byTowers Watson and all of its domestic subsidiaries (other than PCIC and SMIC) and were secured by a pledge of 65% of the voting stock and 100% of the non-voting stock of Towers Perrin Luxembourg Holdings S.A.R.L.
Letters of Credit under the Senior Credit Facility
As ofJune 30, 2012 ,Towers Watson had standby letters of credit totaling$24.9 million associated with our captive insurance companies in the event that we fail to meet our financial obligations. Additionally,Towers Watson had$2.2 million of standby letters of credit covering various other existing or potential business obligations. The aforementioned letters of credit are issued under the Senior Credit Facility, and therefore reduce the amount that can be borrowed under the Senior Credit Facility by the outstanding amount of these standby letters of credit. 51
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Additional Borrowings, Letters of Credit and Guarantees not part of the Senior Credit Facility
Towers Watson Consultoria Ltda. (Brazil ) has a bilateral credit facility with a major bank totaling Brazilian Real (BRL) 6.5 million (U.S.$3.2 million ). As ofJune 30, 2012 , a total of BRL$5.9 million (U.S.$2.9 million ) was outstanding under this facility.Towers Watson has also provided a$5.0 million Australian dollar-denominated letter of credit (U.S.$5.1 million ) to an Australian governmental agency as required by the local regulations. The estimated fair market value of these letters of credit is immaterial because they have never been used, and we believe that the likelihood of future usage is remote.
Term Loan Agreement Due
OnJune 1, 2012 , the Company entered into a five-year$250 million amortizing term loan facility ("the Term Loan") with a consortium of banks. The interest rate on the term loan is based on the Company's choice of one, three or six month LIBOR plus a spread of 1.25% to 1.75%, or alternatively the bank base rate plus 0.25% to 0.75%. The spread to each index is dependent on the Company's consolidated leverage ratio. The interest rate elected on the Term Loan duringJune 2012 was 1.51%. The Term Loan amortizes at a rate of$6.25 million per quarter, beginning in September of 2013, with a final maturity ofJune 1, 2017 . The company has the right to prepay a portion or all of the outstanding Term Loan balance on any interest payment date without penalty.
This agreement contains substantially the same terms and conditions as our existing Senior Credit Facility dated
The Company entered into the Term Loan as part of the financing of our acquisition of
Subordinated Notes due
OnJune 15, 2010 , in connection with an offer to exchange shares of Class B-1 Common Stock for unsecured subordinated notes,Towers Watson entered into an indenture with the trustee for the issuance of Towers Watson Notes dueMarch 2012 in the aggregate principal and compounded interest amount of$100.8 million as ofMarch 15, 2012 . The Towers Watson Notes were issued onJune 29, 2010 , bearing interest fromJune 15, 2010 at a fixed per annum rate, compounded quarterly on the "interest reset dates," equal to the greater of (i) 2.0%, or (ii) 120.0% of the short-term applicable federal rate listed under the quarterly column, in effect at the applicable "interest reset date." OnMarch 15, 2012 ,Towers Watson repaid the aggregate principal and compounded interest amount of the Towers Watson Notes which was funded in part by borrowings under our Senior Credit Facility.
Subordinated Notes due
OnDecember 30, 2009 , in connection with the Merger and the ClassR Elections as described in Note 2,Towers Watson entered into an indenture with the trustee for the issuance of Towers Watson Notes dueJanuary 2011 in the aggregate principal amount of$200 million . The Towers Watson Notes dueJanuary 2011 were issued onJanuary 6, 2010 , bearing interest fromJanuary 4, 2010 at a fixed per-annum rate of 2.0%, and matured onJanuary 1, 2011 . The indenture contained limited operating covenants, and obligations under the Towers Watson Notes dueJanuary 2011 were subordinated to and junior in right of payment to the prior payment in full in cash of all Senior Debt (as defined in the indenture) on the terms set forth in the Indenture. OnJanuary 3, 2011 (the first business day following the note maturity date),Towers Watson repaid both principal and interest on the Notes which was funded in part by a$75 million borrowing under our Senior Credit Facility. 52
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Non-U.S. GAAP Measures In order to assist readers of our financial statements in understanding the core operating results that the Company's management uses to evaluate the business and for financial planning, we present (1) Adjusted EBITDA, (2) Adjusted Net Income Attributable to Controlling Interests, and (3) Adjusted Diluted Earnings Per Share (which are all non-U.S. GAAP measures), to eliminate the effect of acquisition-related expenses from the financial results of our operations. We use Adjusted Net Income Attributable to Controlling Interests (the numerator) for the purpose of calculating Adjusted Diluted Earnings Per Share. The Company believes that Adjusted EBITDA and Adjusted Diluted Earnings Per Share are relevant and useful information widely used by analysts, investors and other interested parties in our industry to provide a baseline for evaluating and comparing our operating results. Since the Merger inJanuary 2010 , we have incurred significant acquisition-related expenses related to our merger and integration activities necessary to combineWatson Wyatt and Towers Perrin. These acquisition-related expenses include transaction and integration costs, severance costs, non-cash charges for amortization of intangible assets and merger-related stock-based compensation costs from the issuance of merger-related restricted shares. Included in our acquisition-related transaction and integration costs are integration consultant fees and legal, accounting, marketing and information technology integration expenses. We expect that during the first three years following the merger, these activities and the related expenses will be incurred and be significant, although amortization will continue over the estimated useful lives of the related intangibles. Acquisition-related gains include a gain resulting from the fair value adjustment to our investment in Fifth Quadrant upon the purchase of a controlling interest. We consider Adjusted EBITDA and Adjusted Diluted Earnings Per Share to be important financial measures, which we use to internally evaluate and assess our core operations, and benchmark our operating results against our competitors. We use Adjusted EBITDA to evaluate and measure our performance-based compensation plans. Adjusted EBITDA and Adjusted Diluted Earnings Per Share are important in illustrating what our operating results would have been had we not incurred these acquisition-related expenses. We define Adjusted EBITDA as net income before non-controlling interests adjusted for provision for income taxes, interest, net, depreciation and amortization, transaction and integration expenses, stock-based compensation, change in accounting method for pension,Extend Health stock-based compensation and other non-operating income. These non-U.S. GAAP measures are not defined in the same manner by all companies and may not be comparable to other similarly titled measure of other companies. Non-U.S. GAAP measures should be considered in addition to, and not as a substitute for, the information contained within our financial statements.
Reconciliation of Adjusted EBITDA to net income before non-controlling interests, Adjusted Net Income Attributable to Controlling Interests to net income attributable to controlling interests and Adjusted Diluted Earnings Per Share to diluted earnings per share are included in the tables below.
Year Ended June 30, 2012 2011 2010 (in thousands) Reconciliation of net income before non-controlling interests to Adjusted EBITDA is as follows: Net income before non-controlling interests $ 260,476 $ 196,725 $ 119,010 Provision for income taxes 145,756 129,916 50,907 Interest, net 5,296 6,952 4,558 Depreciation and amortization 152,891 130,575 101,084 Transaction and integration expenses 86,130 100,535 87,644 Stock-based compensation (a) 31,152 71,715 48,006 Change in accounting method for pension (b) 2,963 - - Extend Health stock-based compensation (c) 931 Other non-operating income (d) (11,612 )
(20,430 ) (10,030 )
Adjusted EBITDA $ 673,983 $ 615,988 $ 401,179
(a) Stock-based compensation is included in salary and employee benefits expense
and relates to Towers Watson Restricted Class A shares held by our current
associates which were awarded to them in connection with the Merger.
(b) The Company had a net impact of
result of the cumulative effect of the change in accounting method of $6.2
million offset by a reduction in net periodic cost of
(c) Extend Health stock-based compensation is included in salary and employee
benefits expense and relates to stock options held by our current associates
which were assumed by the Company in connection with the acquisition.
(d) Other non-operating income includes income from affiliates and other
non-operating income. 53
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Table of Contents Year EndedJune 30, 2012 (In thousands, except share and per share amounts) Net income attributable to controlling interests $
260,213
Adjusted for certain Merger-related items (e):
Amortization of intangible assets
42,393
Transaction and integration expenses including severance (f)
54,110
Stock-based compensation (g)
20,577
Change in accounting method for pension
1,859
Gain on investment in Fifth Quadrant
(1,779 )
Gain on investment inExtend Health
(727 )
Release of acquisition related liability
(601 )
Other merger-related tax items
(698 )
Extend Health stock-based compensation
615
Adjusted net income attributable to controlling interests $ 375,962
Weighted average shares of common stock-diluted (000)
72,542
Earnings per share-diluted, as reported $
3.59
Adjusted for certain Merger-related items:
Amortization of intangible assets
0.59
Transaction and integration expenses including severance
0.74
Stock-based compensation
0.28
Change in accounting method for pension
0.03
Gain on investment in Fifth Quadrant
(0.03 )
Gain on investment inExtend Health
(0.01 )
Release of acquisition related liability
(0.01 )
Other merger-related tax items
(0.01 )
Extend Health stock-based compensation
0.01
Adjusted earnings per share-diluted $ 5.18
(e) The adjustments to net income attributable to controlling interests and
diluted earnings per share of certain Merger-related items are net of tax. In
calculating the net of tax amounts, the effective tax rate for; amortization
of intangible assets was 35.4%, transaction and integration expenses
including severance was 37.2%, stock-based compensation and
stock-based compensation was 34.0%, gain on Fifth Quadrant was 28.0%, change
in accounting method for pension was 37.3%, gain on investment in Extend
Health was 39.9%, and release of acquisition related liability was 39.9%.
Included in other tax items is a
restructurings in
provision for income taxes.
(f) Included in transaction and integration expenses including severance is
approximately
(g) Stock-based compensation relates to shares of Restricted Class A common stock
held by our current associates which were awarded to them as former Towers
Perrin employees in connection with the Merger.
Risk Management
As a part of our risk management program, we purchase customary commercial insurance policies, including commercial general liability and claims-made professional liability insurance. Our professional liability insurance currently includes a self-insured retention of$1 million per claim, and covers professional liability claims against us, including the cost of defending such claims. EffectiveJuly 1, 2010 throughJuly 1, 2011 ,Stone Mountain Insurance Company ("SMIC"), a wholly-owned captive insurance company, provided us with$50 million of professional liability insurance coverage per claim and in the aggregate, including the cost of defending such claims, above the$1 million self-insured retention. SMIC secured$25 million of reinsurance coverage from unaffiliated reinsurance companies in excess of the$25 million SMIC retained layer. Excess insurance attaching above the SMIC coverage is provided by various unaffiliated commercial insurance companies. Because we have a self-insured retention for each claim and because Stone Mountain is wholly-owned by us, our primary errors and omissions risk is borne byTowers Watson or the subsidiary SMIC. As stated above, commencingJuly 1, 2010 ,Towers Watson obtained primary insurance for errors and omissions professional liability risks from SMIC on a claims-made basis. SMIC has issued a policy of insurance substantially similar to the policies historically issued by PCIC. 54
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For the policy period beginningJuly 1, 2011 and endingJuly 1, 2012 , certain changes were made to our professional liability insurance program. These changes remain in-force for the policy period beginningJuly 1, 2012 , and endingJuly 1, 2013 . Our professional liability insurance includes a self-insured retention of$1 million per claim.Towers Watson also retains$10 million in the aggregate above the$1 million self-insured retention per claim. SMIC provides us with$40 million of coverage per claim and in the aggregate, above these retentions. SMIC secured$25 million of reinsurance from unaffiliated reinsurance companies in excess of the$15 million SMIC retained layer. Excess insurance attaching above the SMIC coverage is provided by various unaffiliated commercial insurance companies. Because of the$1 million self-insured retention per claim and the additional$10 million aggregate retention above, and because Stone Mountain is wholly-owned by us, our primary errors and omissions risk is borne byTowers Watson and the subsidiary SMIC. We reserve for contingent liabilities based on ASC 450, Contingencies, when it is determined that a liability, inclusive of defense costs, is probable and reasonably estimable. The contingent liabilities recorded are primarily developed actuarially. Before the Merger,Watson Wyatt and Towers Perrin each obtained substantial professional liability insurance from an affiliated captive insurance company,Professional Consultants Insurance Company ("PCIC"). A limit of$50 million per claim and in the aggregate was provided by PCIC subject to a$1 million per claim self-insured retention. PCIC secured reinsurance of$25 million attaching above the$25 million PCIC retained layer. In addition, both legacy companies carried excess insurance from unaffiliated commercial insurance companies above the self-insured retention and the coverage provided by PCIC. Our ownership interest in PCIC is 72.86% post-Merger. As a consequence, PCIC's results of operations are consolidated into our results of operations. Although the PCIC insurance policies forTowers Watson's fiscal year 2010 continue to cover professional liability claims above a$1 million per claim self-insured retention, the consolidation of PCIC will effectively net PCIC's premium income against our premium expense for the first$25 million of loss above the self-insured retention for each legacy company. Accordingly, the impact of PCIC's reserve development may result in fluctuations in our earnings. PCIC ceased issuing insurance policies effectiveJuly 1, 2010 and at that time entered into a run-off mode of operation. Our shareholder agreements with PCIC could require additional payments to PCIC if development of claims significantly exceeds prior expectations. We provide for the self-insured retention where specific estimated losses and loss expenses for known claims are considered probable and reasonably estimable. Although we maintain professional liability insurance coverage, this insurance does not cover claims made after expiration of our current policies of insurance. Generally accepted accounting principles require that we record a liability for incurred but not reported ("IBNR") professional liability claims if they are probable and reasonably estimable, and for which we have not yet contracted for insurance coverage. We use actuarial assumptions to estimate and record our IBNR liability. As ofJune 30, 2012 , we had a$202.2 million IBNR liability, net of recoverable receivables of our captive insurance companies. This net liability decreased from$208.5 million as ofJune 30, 2011 as the result of known and improved claims experience. To the extent our captive insurance companies, PCIC and SMIC, expect losses to be covered by a third party, they record a receivable for the amount expected to be recovered. This receivable is classified in other current or other noncurrent assets in our consolidated balance sheet. Insurance market conditions for us and our industry have varied in recent years, but the long-term trend has been increasing premium cost. Although the market for professional liability insurance is presently reasonably accessible, trends toward higher self-insured retentions, constraints on aggregate excess coverage for this class of professional liability risk and financial difficulties which have, over the past few years, been faced by several longstanding E&O carriers, are anticipated to recur periodically, and to be reflected in our future annual insurance renewals. As a result, we will continue to assess our ability to secure future insurance coverage, and we cannot assure that such coverage will continue to be available in the event of adverse claims experience, adverse loss trends, market capacity constraints or other factors. In light of increasing litigation worldwide, including litigation against professionals, we have a policy that all client relationships be documented by engagement letters containing specific risk mitigation clauses that were not included in all historical client agreements. Certain contractual provisions designed to mitigate risk may not be legally enforceable in litigation involving breaches of fiduciary duty or certain other alleged errors or omissions, or in certain jurisdictions. We may incur significant legal expenses in defending against litigation.
Recent Accounting Pronouncements
Adopted
OnDecember 17, 2010 , theFinancial Accounting Standards Board (FASB) issued ASU 2010-28, Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (a consensus of theFASB Emerging Issues Task Force ), which (1) does not prescribe a specific method of calculating the carrying value of a reporting unit in the performance of step 1 of the goodwill impairment test and (2) requires entities with a zero or negative carrying value to assess, considering qualitative factors such as but not limited to those listed in ASC 350-20-35-30 whether it is more likely than not that a goodwill impairment exists. If an entity concludes that it is more likely than not that an impairment of goodwill exists, the entity must perform step 2 of the goodwill impairment test. These provisions are effective for impairment tests performed 55
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during the fourth quarter in our current fiscal year. During that impairment test, if any of our reporting units have a zero or negative carrying value, we will assess, on the basis of current facts and circumstances, whether it is more likely than not that an impairment of our goodwill exists. If so, we will perform step 2 of the goodwill impairment test and record the impairment charge, if any, as a cumulative-effect adjustment through beginning retained earnings. At this time, there is no impact on our financial statements as a result of adopting this provision. OnSeptember 15, 2011 , the FASB issued ASU 2011-08, Intangibles - Goodwill and Other (Topic 350):Testing Goodwill for Impairment, which gave entities testing goodwill for impairment the option of performing a qualitative assessment before calculating the fair value of a reporting unit in Step 1 of the goodwill impairment test. If entities determine, on the basis of qualitative factors, that the fair value of a reporting unit is more likely than not less than the carrying amount, the two-step impairment test would be required. Otherwise, further testing is not needed. The ASU was effective for all entities for annual and interim goodwill impairment tests performed for fiscal years beginning afterDecember 15, 2011 . Early adoption was permitted and the Company implemented this guidance in our fiscal 2012 impairment test performed during the fourth quarter. The adoption did not have any impact to our financial statements as a result of adopting this provision. Not yet adopted OnJune 16, 2011 , the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, which revised the manner in which entities present comprehensive income in their financial statements. The new guidance removes the presentation options in ASC 220, Comprehensive Income, and requires entities to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. The ASU does not change the items that must be reported in other comprehensive income. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning afterDecember 15, 2011 , with early adoption permitted. At this time, there is no impact expected to our financial statements as a result of the change in presentation and the Company will adopt the new presentation in our fiscal year 2013 filings. OnDecember 23, 2011 , the FASB issued ASU 2011-12, "Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05," which defers certain provisions of ASU 2011-05 including the indefinite deferral until further deliberation of the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented (for both interim and annual financial statements). The FASB also decided that during the deferral period, entities would be required to comply with all existing requirements for reclassification adjustments in ASC 220, which indicates that "an entity may display reclassification adjustments on the face of the financial statement in which comprehensive income is reported, or it may disclose reclassification adjustments in the notes to the financial statements." The effective date for public entities is for fiscal years, and interim periods within those fiscal years, beginning afterDecember 15, 2011 . In light of this deferral, we will continue to disclose certain reclassifications out of accumulated other comprehensive income as proscribed by the existing literature and we will adopt the other provisions of ASU 2011-05 within our fiscal year 2013 filings. OnJuly 27, 2012 , the FASB issued ASU 2012-02, "Intangibles - Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment" which amended the guidance in ASC 350-30 on testing indefinite-lived intangible assets, other than goodwill, for impairment. The FASB issued the ASU in response to feedback on ASU 2011-08 which amended the goodwill impairment testing requirements by allowing an entity to perform a qualitative impairment assessment before proceeding to the two-step impairment test. Similarly, under ASU 2012-02, an entity testing an indefinite-lived intangible asset for impairment has the option of performing a qualitative assessment before calculating the fair value of the asset. If the entity determines, on the basis of qualitative factors, that the fair value of the indefinite-lived intangible asset is not more likely than not (i.e., a likelihood of more than 50 percent) impaired, the entity would not need to calculate the fair value of the asset. The ASU did not revise the requirement to test indefinite-lived intangible assets annually for impairment. In addition, the ASU does not amend the requirement to test these assets for impairment between annual tests if there is a change in events or circumstances; however, it does revise the examples of events and circumstances that an entity should consider in interim periods. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning afterSeptember 15, 2012 . Early adoption is permitted and the Company plans to adopt this ASU as part of its fiscal 2013 annual impairment test. The Company does not expect to have any impact to our financial statements as a result of adopting this provision.
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