The popularity of outsourcing has created niche markets for businesses that provide specific functions essential to the operating process. Companies that specialize in precise areas, such as shipping or payroll, can attract a wide variety of corporate customers by adding convenience and lowering operating costs. In this regard, recently formed Towers Watson (TW) has developed a strong base of clients thanks to its specialization and efficiency in human resources (HR) management. The HR consulting industry is a well developed and rapidly growing sector, with a total market exceeding $20 billion a year, and average annual compounded growth rates in the high-single digits.

The company formed at the start of 2010 with the merger of Watson Wyatt and Towers Perrin. Watson Wyatt was a Virginia-based public company that specialized in managing employee benefit services. Towers Perrin started as an insurance underwriting firm that grew to concentrate on a number of professional and consulting services. Before the merger, Watson Wyatt was historically the third largest HR consultant and Towers Perrin was the sixth largest. The combination made Towers Watson more or less the biggest human resources-based professional services business in the world, jumping ahead of powerful competitors Mercer (owned by Marsh & McLennan (MMC)) and Deloitte Consulting in terms of overall market share. The deal was big enough to draw attention from antitrust agencies, such as the European Commission. Accordingly, Watson Wyatt was forced to sell some of its assets to comply with regulations before the merger was completed.

The company’s largest segment is its benefits management division, which comprised 64% of revenue in fiscal 2010 (ended June 30th). This segment concentrates on a number of areas, including insurance and administrative solutions. However, the primary area of focus of late has been retirement management. This topic has become increasingly important, as the age of the average employee rises and selective Baby Boomers leave the workforce in the near future with substantial pensions and benefits to be paid. Companies that have defined benefit plans typically hire Towers Watson to strategize on the best ways to tackle these obligations, including how to deal with the associated financial risks and time constraints. Current pension concerns require a substantial degree of expertise, which Towers Watson provides. Besides giving advice, the company also administers and manages retirement plans for the companies and organizations it serves. Moreover, it has the technological capabilities to manage large employee bases, allowing it to retain sizable multinational corporations and government agencies as clients. We expect demand for Towers Watson’s retirement-based consulting services to remain strong, as the company can ultimately preserve solvency for many struggling businesses over the long haul.

Towers Watson also has a significant presence in healthcare management, a relatively complex area in the workplace today. The rising costs of benefits and insurance payments has forced many companies to look for new alternatives to existing plans. Towers Watson advises clients on specific strategies involving the impact of healthcare legislation. The company also uses collective purchasing agreements, which cut costs on doctors, pharmaceuticals, and other health benefits for many employers.

At this point, Towers Watson’s cost efficiency lags some of its competitors. Its pro-forma operating margin (excluding depreciation and amortization) was 11.8% in fiscal 2010, below HR consultant Hewitt Associates (HEW) and a similar but diversified competitor in Aon Corp. (AON), both of which had operating margins closer to 20% in calendar 2009. However, we believe the company’s profitability will improve over the next few years as Towers further consolidates its operations and generates cost savings. Moreover, the company’s increased market share should bolster revenues and pricing, resulting in greater fixed cost leverage.

Towers Watson’s capital structure is comparable to, or healthier than, many of its peers. It has a relatively low debt burden, with no long-term obligations outstanding. In comparison, Hewitt is over 40% leveraged and Aon is more than 20% leveraged, with $2 billion in outstanding debt. Towers Watson’s predecessors also had a good history of generating operating cash flow. This should give it the flexibility to increase its market presence through global expansion, as well as pursue other investment opportunities.

Still, the stock, which has been trading around $45 a share of late, has below-average appreciation potential to the 2013-2015 timeframe, based on our projected 10% to 15% annual bottom-line growth over that period. The biggest concern right now is the threat of further industry consolidation. Most recently, Aon has agreed to acquire Hewitt. This would make Aon’s HR consulting business comparable in size to other market leaders, and may curb some of Towers Watson’s success over the next few years.

At the time of this article’s writing, the author did not have any positions in the companies mentioned.