** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

 

**FORM 10-Q**

(Mark One)

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OFTHE SECURITIES EXCHANGE ACT OF 1934

 

**For the quarterly periodended September 30, 2006**

*** ***

**OR**

** **

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OFTHE SECURITIES EXCHANGE ACT OF 1934

 

**For the transition period from                   to                   **

** **

**CommissionFile Number: 001-16159**

**WATSON WYATT WORLDWIDE, INC.**

(Exact name of Registrantas specified in its charter)

| **Delaware**                                                    |   | **52-2211537**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **901 N.  Glebe Road  Arlington, VA**                           |   | **22203**                             |
| (Address of  principal executive offices)                       |   | (zip code)                            |

 

**(703) 258-8000**

(Registrant’s telephone number, including area code)

** **

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

                                                                                        Yes   x            No   o

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. 

| Large accelerated filer   x |   | Accelerated filer   o |   | Non-accelerated filer   o |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

                                                                                        Yes   o            No   x

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as ofOctober 31, 2006.

| Class                                           |   | Outstanding at  October 31, 2006 |
|-------------------------------------------------|--------|----------------------------------|
| Class A Common  Stock, $.01 par value per share |   | 42,381,532  shares               |

 

 

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**WATSON WYATT WORLDWIDE, INC.INDEX TO FORM 10-Q****For the Three Months Ended September 30, 2006
|                | ** ** | ** **                                                                                                 | ** ** | ** ** | ** ** |
|----------------|------------|------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| PART  I.       |       | FINANCIAL INFORMATION                                                                                      |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item  1.       |       | Financial Statements  (Unaudited)                                                                          |       |       |       |
|           |       |                                                                                                       |       |       |       |
|           |       | Consolidated Statements of Operations—Three Months Ended  September 30, 2006 and 2005                 |       |       |       |
|           |       |                                                                                                       |       |       |       |
|           |       | Consolidated  Balance Sheets—September 30, 2006 and June 30, 2006                                     |       |       |       |
|           |       |                                                                                                       |       |       |       |
|           |       | Consolidated Statements of Cash Flows—Three Months Ended  September 30, 2006 and 2005                 |       |       |       |
|           |       |                                                                                                       |       |       |       |
|           |       | Consolidated Statement of Changes in Stockholders’  Equity—Three Months Ended September 30, 2006 |       |       |       |
|           |       |                                                                                                       |       |       |       |
|           |       | Notes to the Consolidated Financial Statements                                                             |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 2.        |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 3.        |       | Quantitative and Qualitative Disclosures About Market  Risk                                                |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 4.        |       | Controls and Procedures                                                                                    |       |       |       |
|           |       |                                                                                                       |       |       |       |
| PART  II.      |       | OTHER  INFORMATION                                                                                         |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item  1.       |       | Legal  Proceedings                                                                                         |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item  1A.      |       | Risk  Factors                                                                                              |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 2.        |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                               |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 3.        |       | Defaults Upon Senior Securities                                                                            |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 4.        |       | Submission of Matters to a Vote of Security Holders                                                        |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item  5.       |       | Other  Information                                                                                         |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Item 6.        |       | Exhibits                                                                                                   |       |       |       |
|           |       |                                                                                                       |       |       |       |
| Signatures     |       |                                                                                                       |       |
|           |       |                                                                                                       |       |
| Certifications |       |                                                                                                       |       |

 

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**WATSONWYATT WORLDWIDE, INC.Consolidated Statements of Operations**(Thousands of U.S. Dollars,Except Per Share Data)
| ** **                                                                                                                                | ** ** | **Three months ended September 30** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                                                                                                | ** ** | **(Unaudited)**                                         | ** ** |
|                                                                                                                                      |       |                                                    |       |   |   |
| Revenue                                                                                                                                   |       | $                                                       | 336,004    |   | $ | 265,886 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Costs of providing  services:                                                                                                             |       |                                                    |       |   |   |
| Salaries and  employee benefits                                                                                                           |       | 185,595                                                 |       | 147,550 |   |
| Professional and  subcontracted services                                                                                                  |       | 20,035                                                  |       | 19,011 |   |
| Occupancy,  communications and other                                                                                                      |       | 40,951                                                  |       | 32,853 |   |
| General and  administrative expenses                                                                                                      |       | 38,099                                                  |       | 31,389 |   |
| Depreciation and  amortization                                                                                                            |       | 12,751                                                  |       | 9,677 |   |
|                                                                                                                                      |       | 297,431                                                 |       | 240,480 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Income from operations                                                                                                                    |       | 38,573                                                  |       | 25,406 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| (Loss)/income from  affiliates                                                                                                            |       | (229                                                    | )          | 1,351 |   |
| Interest expense                                                                                                                          |       | (443                                                    | )          | (876 | ) |
| Interest income                                                                                                                           |       | 1,450                                                   |       | 788 |   |
| Other non-operating  income/(loss)                                                                                                        |       | 36                                                      |       | (1,862 | ) |
|                                                                                                                                      |       |                                                    |       |   |   |
| Income from continuing  operations before income taxes                                                                                    |       | 39,387                                                  |       | 24,807 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Provision for income  taxes                                                                                                               |       | 14,573                                                  |       | 10,915 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Income from continuing  operations                                                                                                        |       | 24,814                                                  |       | 13,892 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Discontinued  operations:                                                                                                                 |       |                                                    |       |   |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Sublease income from  discontinued operations, less applicable income tax expense for the three  months ended September 30, 2006 and 2005 |       | —                                                  |       | 9 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Net income                                                                                                                                |       | $                                                       | 24,814     |   | $ | 13,901 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Basic earnings per  share:                                                                                                                |       |                                                    |       |   |   |
| Income from  continuing operations                                                                                                        |       | $                                                       | 0.59       |   | $ | 0.36 |   |
| Income from  discontinued operations                                                                                                      |       | —                                                  |       | — |   |
| Net income                                                                                                                                |       | $                                                       | 0.59       |   | $ | 0.36 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Diluted earnings per  share:                                                                                                              |       |                                                    |       |   |   |
| Income from  continuing operations                                                                                                        |       | $                                                       | 0.56       |   | $ | 0.36 |   |
| Income from  discontinued operations                                                                                                      |       | —                                                  |       | — |   |
| Net income                                                                                                                                |       | $                                                       | 0.56       |   | $ | 0.36 |   |
|                                                                                                                                      |       |                                                    |       |   |   |
| Weighted average shares  of common stock, basic (000)                                                                                     |       | 42,396                                                  |       | 38,841 |   |
| Weighted average shares of common stock, diluted (000)                                                                                    |       | 44,388                                                  |       | 39,095 |   |

 

See accompanyingnotes to theconsolidated financial statements

1

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**WATSONWYATT WORLDWIDE, INC.Consolidated Balance Sheets**(Thousands of U.S. Dollars,Except Share and Per Share Data)
| ** **                                                                                                      | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                      | ** ** | **2006**               | ** ** | **2006**          | ** ** |
| ** **                                                                                                      | ** ** | **(unaudited)**        | ** ** | ** **        | ** ** |
| **Assets**                                                                                                      | ** ** | ** **             | ** ** | ** **        | ** ** |
| Cash and cash  equivalents                                                                                      |       | $                      | 63,394     |              | $          | 165,345 |   |
| Receivables from  clients:                                                                                      |       |                   |       |              |       |
| Billed, net of  allowances of $6,570 and $3,678                                                                 |       | 177,052                |       | 180,533           |       |
| Unbilled, at  estimated net realizable value                                                                    |       | 140,588                |       | 123,044           |       |
|                                                                                                            |       | 317,640                |       | 303,577           |       |
| Deferred income taxes                                                                                           |       | 4,366                  |       | 567               |       |
| Other current assets                                                                                            |       | 46,847                 |       | 24,158            |       |
| Total current  assets                                                                                           |       | 432,247                |       | 493,647           |       |
|                                                                                                            |       |                   |       |              |       |
| Investment in  affiliates                                                                                       |       | 8,224                  |       | 8,564             |       |
| Fixed assets, net                                                                                               |       | 152,568                |       | 147,738           |       |
| Deferred income taxes                                                                                           |       | 75,300                 |       | 70,417            |       |
| Goodwill                                                                                                        |       | 328,526                |       | 324,041           |       |
| Intangible assets                                                                                               |       | 187,115                |       | 187,075           |       |
| Other assets                                                                                                    |       | 8,707                  |       | 8,877             |       |
| **Total Assets**                                                                                                |       | $                      | 1,192,687  |              | $          | 1,240,359 |   |
| ** **                                                                                                      | ** ** | ** **             | ** ** | ** **        | ** ** |
| **Liabilities**                                                                                                 | ** ** | ** **             | ** ** | ** **        | ** ** |
| Accounts payable and  accrued liabilities, including discretionary compensation                                 |       | $                      | 206,261    |              | $          | 288,396 |   |
| Deferred income taxes                                                                                           |       | —                 |       | 168               |       |
| Income taxes payable                                                                                            |       | 16,434                 |       | 7,771             |       |
| Total current liabilities                                                                                       |       | 222,695                |       | 296,335           |       |
|                                                                                                            |       |                   |       |              |       |
| Note payable                                                                                                    |       | 25,000                 |       | 30,000            |       |
| Accrued retirement  benefits                                                                                    |       | 165,370                |       | 162,505           |       |
| Deferred rent and  accrued lease losses                                                                         |       | 28,864                 |       | 28,982            |       |
| Deferred income taxes                                                                                           |       | 443                    |       | 480               |       |
| Other noncurrent  liabilities                                                                                   |       | 77,619                 |       | 73,296            |       |
| **Total Liabilities**                                                                                           |       | 519,991                |       | 591,598           |       |
|                                                                                                            |       |                   |       |              |       |
| Commitments and  contingencies                                                                                  |       |                   |       |              |       |
|                                                                                                            |       |                   |       |              |       |
| **Stockholders’ Equity**                                                                                   |       |                   |       |              |       |
| Preferred Stock - No  par value:                                                                                |       |                   |       |              |       |
| 1,000,000 shares  authorized; none issued and outstanding                                                       |       | —                 |       | —            |       |
| Class A Common Stock -  $.01 par value:                                                                         |       |                   |       |              |       |
| 99,000,000  shares authorized; 42,513,451 and 42,463,451 issued and 42,329,814 and 42,385,513  outstanding |       | 425                    |       | 425               |       |
| Additional paid-in  capital                                                                                     |       | 387,344                |       | 386,392           |       |
| Treasury stock, at cost  - 183,637 and 77,938 shares                                                            |       | (7,329                 | )          | (2,134            | )          |
| Retained earnings                                                                                               |       | 264,237                |       | 242,599           |       |
| Accumulated other  comprehensive income                                                                         |       | 28,019                 |       | 21,479            |       |
| **Total Stockholders’ Equity**                                                                             |       | 672,696                |       | 648,761           |       |
|                                                                                                            |       |                   |       |              |       |
| **Total Liabilities and  Stockholders’ Equity**                                                            |       | $                      | 1,192,687  |              | $          | 1,240,359 |   |

 

See accompanyingnotes to theconsolidated financial statements

2

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**WATSONWYATT WORLDWIDE, INC.Consolidated Statements of Cash Flows**(Thousands of U.S. Dollars)
| ** **                                                                     | ** ** | **Three months ended September 30** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                                     | ** ** | **(Unaudited)**                                         | ** ** |
| Cash flows used in  operating activities:                                      |       |                                                    |       |   |   |
| Net income                                                                     |       | $                                                       | 24,814     |   | $ | 13,901 |   |
| Adjustments to  reconcile net income to net cash used in operating activities: |       |                                                    |       |   |   |
| Loss on foreign  currency forward contract                                     |       | —                                                  |       | 3,602 |   |
| Income from  discontinued operations, net of income tax expense                |       | —                                                  |       | (9 | ) |
| Provision for  doubtful receivables from clients                               |       | 8,187                                                   |       | 5,832 |   |
| Depreciation                                                                   |       | 10,460                                                  |       | 8,157 |   |
| Amortization of  intangible assets                                             |       | 2,291                                                   |       | 1,520 |   |
| Provision for  deferred income taxes                                           |       | (8,576                                                  | )          | (281 | ) |
| Income from  affiliates                                                        |       | 229                                                     |       | (1,351 | ) |
| Distributions  from affiliates                                                 |       | —                                                  |       | 1,639 |   |
| Other, net                                                                     |       | 216                                                     |       | (1,070 | ) |
| Changes in  operating assets and liabilities (net of discontinued operations): |       |                                                    |       |   |   |
| Receivables from  clients                                                      |       | (20,509                                                 | )          | (2,398 | ) |
| Other current  assets                                                          |       | (23,457                                                 | )          | (21,919 | ) |
| Other assets                                                                   |       | 178                                                     |       | (517 | ) |
| Accounts payable  and accrued liabilities                                      |       | (71,987                                                 | )          | (59,457 | ) |
| Income taxes  payable                                                          |       | 9,463                                                   |       | (1,488 | ) |
| Accrued  retirement benefits                                                   |       | 2,112                                                   |       | 8,878 |   |
| Deferred rent  and accrued lease losses                                        |       | (119                                                    | )          | (13 | ) |
| Other noncurrent  liabilities                                                  |       | 4,138                                                   |       | 3,361 |   |
| Cash flows used  in operating activities:                                      |       | (62,560                                                 | )          | (41,613 | ) |
| Cash flows used in  investing activities:                                      |       |                                                    |       |   |   |
| Acquisitions and  contingent consideration payments                            |       | (1,118                                                  | )          | (133,169 | ) |
| Purchases of  fixed assets                                                     |       | (9,018                                                  | )          | (7,823 | ) |
| Capitalized  software costs                                                    |       | (5,528                                                  | )          | (8,736 | ) |
| Proceeds from  divestitures                                                    |       | 36                                                      |       | 1,740 |   |
| Cash flows used  in investing activities:                                      |       | (15,628                                                 | )          | (147,988 | ) |
| Cash flows (used in)  from financing activities                                |       |                                                    |       |   |   |
| Borrowings                                                                     |       | 35,000                                                  |       | 102,000 |   |
| Repayment on  borrowings                                                       |       | (40,000                                                 | )          | — |   |
| Foreign currency  forward contract                                             |       | —                                                  |       | (8,405 | ) |
| Dividends paid                                                                 |       | (3,176                                                  | )          | (3,156 | ) |
| Repurchases of  common stock                                                   |       | (20,065                                                 | )          | — |   |
| Tax benefit on  exercise of stock options and employee stock purchase plan     |       | 832                                                     |       | 192 |   |
| Issuances of  common stock - exercises of stock options                        |       | 1,349                                                   |       | 356 |   |
| Issuances of  common stock - employee stock purchase plan                      |       | 1,463                                                   |       | 1,647 |   |
| Cash flows (used  in) from financing activities                                |       | (24,597                                                 | )          | 92,634 |   |
| Effect of exchange  rates on cash                                              |       | 834                                                     |       | 1,079 |   |
| Decrease in cash and  cash equivalents                                         |       | (101,951                                                | )          | (95,888 | ) |
| Cash and cash  equivalents at beginning of period                              |       | 165,345                                                 |       | 168,076 |   |
| Cash and cash  equivalents at end of period                                    |       | $                                                       | 63,394     |   | $ | 72,188 |   |

 

See accompanyingnotes to theconsolidated financial statements

3

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** **

**WATSON WYATT WORLDWIDE, INC.Consolidated Statement of Changes in Stockholders’ Equity**(Thousands of U.S.Dollars)
| ** **                                                       | ** ** | **Class A**       | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|------------------|------------|----------------|------------|------------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                       | ** ** | **Common**             | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Stock**              | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Outstanding**        | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **(number**            | ** ** | **Class A** | ** ** | **Additional** | ** ** | **Treasury**     | ** ** | ** **   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **of shares,**    | ** ** | **Common**       | ** ** | **Paid-in**    | ** ** | **Stock,**       | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **in thousands)** | ** ** | **Stock**        | ** ** | **Capital**    | ** ** | **at Cost** | ** ** | **Earnings** | ** ** | **Income**        | ** ** | **Total**  | ** ** |
| Balance at June  30, 2006                                        |       | 42,386                 |       | $                | 425        |           | $          | 386,392          |       | $            | (2,134     | )                 | $          | 242,599    |       | $ | 21,479 |   | $ | 648,761 |   |
|                                                             |       |                   |       |             |       |           |       |             |       |         |       |              |       |       |       |
| Comprehensive  income:                                           |       |                   |       |             |       |           |       |             |       |         |       |              |       |       |       |
| Net income                                                       |       |                   |       |             |       |           |       |             |       | 24,814       |       |              |       | 24,814     |       |
| Additional minimum pension liability, net of tax                 |       |                   |       |             |       |           |       |             |       |         |       | (21               | )          | (21        | )          |
| Foreign currency translation adjustment, net of tax              |       |                   |       |             |       |           |       |             |       |         |       | 6,561             |       | 6,561      |       |
| Total  comprehensive income                                      |       |                   |       |             |       |           |       |             |       |         |       |              |       | 31,354     |       |
| Cash dividends  declared                                         |       |                   |       |             |       |           |       |             |       | (3,176       | )          |              |       | (3,176     | )          |
| Repurchases of  common stock                                     |       | (500                   | )          |             |       |           |       | (20,065          | )          |         |       |              |       | (20,065    | )          |
| Issuances of common stock - employee stock purchase  plan shares |       | 43                     |       |             |       | 61             |       | 1,402            |       |         |       |              |       | 1,463      |       |
| Issuances of common stock - deferred stock units                 |       | 295                    |       |             |       | 2,160          |       | 9,765            |       |         |       |              |       | 11,925     |       |
| Issuances of  common stock to outside directors                  |       | 7                      |       |             |       | 59             |       | 194              |       |         |       |              |       | 253        |       |
| Issuances of  common stock - stock options                       |       | 99                     |       |             |       | (2,160         | )          | 3,509            |       |         |       |              |       | 1,349      |       |
| Tax benefit of  exercises of stock options                       |       |                   |       |             |       | 832            |       |             |       |         |       |              |       | 832        |       |
|                                                             |       |                   |       |             |       |           |       |             |       |         |       |              |       |       |       |
| Balance at September 30,  2006 (unaudited)                       |       | 42,330                 |       | $                | 425        |           | $          | 387,344          |       | $            | (7,329     | )                 | $          | 264,237    |       | $ | 28,019 |   | $ | 672,696 |   |

 

See accompanyingnotes to theconsolidated financial statements

4

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**WATSON WYATT WORLDWIDE, INC.Notes to the Consolidated Financial Statements**(Tabular amounts are in thousands, except per share data)(Unaudited)

**Note 1 —Basis of Presentation.**

The accompanyingunaudited quarterly consolidated financial statements of Watson WyattWorldwide, Inc. and our subsidiaries (collectively referred to as “we,” “WatsonWyatt,” “Watson Wyatt Worldwide” or the “company”) are presented in accordancewith the rules and regulations of the Securities and Exchange Commission(“SEC”) for quarterly reports on Form 10-Q. In the opinion of management, these consolidated financial statementsreflect all adjustments, consisting only of normal recurring adjustments,  which are necessary for a fair presentationof the consolidated financial statements and results for the interimperiods.  The consolidated financialstatements should be read together with the audited consolidated financialstatements and notes thereto contained in the company’s Annual Report on Form10-K for the fiscal year ended June 30, 2006, which is filed with the SEC andmay be accessed via EDGAR on the SEC’s web site at www.sec.gov.  The year-end balance sheet data was derivedfrom audited financial statements, but does not include all disclosuresrequired by U.S. generally accepted accounting principles.

The results of operationsfor the three months ended September 30, 2006 are not necessarily indicative ofthe results that can be expected for the entire fiscal year ending June 30,2007.  The results reflect certain  estimates and assumptions made by managementincluding estimated bonuses and anticipated tax liabilities that affect theamounts reported in the consolidated financial statements and relatednotes.  Certain prior year amounts havebeen reclassified to conform to the current year’s presentation.

**Note 2 —Business Combination.**

On July 31, 2005, the company acquired substantiallyall of the assets and assumed most liabilities of Watson Wyatt LLP (“WWLLP”)(the “business combination”), a leading United Kingdom-based actuarial,benefits and human resources consulting partnership. The company and WWLLP hadjointly offered services since 1995 pursuant to alliance agreements and as aresult, have business segments that are very similar in nature.  See Note 3 for further information regardingthe related accounting and operating segments of the combined company.

We believe the European business has strengthenedWatson Wyatt’s global market presence. The purchase price of $437.0 millionconsisted of £88.3 million in cash, or $156.1 million at the exchange rate ineffect at August 1, 2005, the issuance of 9,090,571 shares of the company’scommon stock valued at $238.7 million, transaction costs of $20.5 million andadditional consideration including debt forgiveness and investmentelimination.  The shares paid were valuedat $26.26 per share, which was the average of the closing market prices of thecompany’s stock over five business days beginning with two business days priorto the announcement date of January 18, 2005 and ending with the two businessdays following the announcement date.  Inaddition, a further 1,950,000 shares may be paid to the former partners ofWWLLP as additional consideration after June 30, 2007, contingent upon theachievement by the acquired business of certain agreed-upon financialperformance goals.  If the contingentshares are issued they will be accounted for as goodwill.

5

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*Purchase Price Allocation*

The business combinationhas been accounted for using the purchase method of accounting as prescribed inStatement of Financial Accounting Standards No. 141, “Business Combinations”(FAS 141), where the assets acquired and liabilities assumed are recorded attheir respective fair values as of the combination date.  As of the business combination date, thecompany determined the following estimated fair values for the proportionateassets purchased and liabilities assumed. The determination of estimated fair value requires management to makesignificant estimates and assumptions. The company hired an independent thirdparty to assist in the valuation of assets.

|                                         | ** ** | **August 1, 2005  (in thousands)** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------|------------|
| Total purchase  price                   |       |                                              |       | $ | 437,042 |   |
| Less net assets acquired:               |       |                                              |       |   |   |
| Trademark and trade name                |       | $                                                 | 108,000    |   |   |   |
| Customer related intangibles            |       | 60,600                                            |       |   |   |
| Core/developed technology               |       | 17,500                                            |       |   |   |
| Cash and cash equivalents               |       | 31,230                                            |       |   |   |
| Client receivables and unbilled revenue |       | 111,305                                           |       |   |   |
| Other current assets                    |       | 47,153                                            |       |   |   |
| Fixed assets                            |       | 13,068                                            |       |   |   |
| Other assets                            |       | 3,795                                             |       |   |   |
| Current liabilities                     |       | (154,854                                          | )          |   |   |
| Accrued retirement benefits             |       | (49,046                                           | )          |   |   |
| Other non current liabilities           |       | (33,657                                           | )          |   |   |
|                                    |       |                                              |       | 155,094 |   |
| Goodwill                                |       |                                              |       | $ | 281,948 |   |
|                                         |            |                                                   |            |  |  |  |  |

 

The allocation of the purchase price resulted in theallocation of $281.9 million to goodwill, which has been assigned to oursegments as follows:

|                                                | ** ** | **Goodwill** | ** ** |
|------------------------------------------------|------------|--------------|------------|
| Benefits                                       |       | $            | 136,463    |   |
| Technology and  Administration Solutions Group |       | 40,037       |       |
| Human Capital  Group                           |       | 16,071       |       |
| Insurance &  Financial Services Group      |       | 52,160       |       |
| Investment  Consulting Group                   |       | 37,217       |       |
| Allocation of goodwill  to business segments   |       | $            | 281,948    |   |

 

The majority of the goodwill will be deductible fortax purposes in the U.K. over a period not exceeding 25 years.

6

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*Hedge Treatment*

During the third quarter of fiscal year 2005, thecompany entered into a foreign currency forward contract to offset the riskassociated with the foreign exchange (British Pound) exposure inherent in thecombination.  The forward contractprovided for the purchase of £88 million at a fixed price of $164.5 million,with a settlement date of July 29, 2005. In accordance with Statement of Financial Accounting Standards Board No.133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133),as amended and interpreted, since the forward contract was associated with abusiness combination that is subject to the provisions of FAS 141 and thecombination involves an equity method investment, the forward contract did notqualify for hedge accounting.  As aresult, changes in fair value associated with the forward contract wererequired to be recognized in the Consolidated Statement of Operations during thefirst quarter of fiscal year 2006. Consequently, a loss of $3.6 million has been recognized during thefirst quarter of fiscal year 2006 and included in other non-operatingincome.  Total losses recognized underthis forward contract were $8.4 million.

*Pro Forma Financial Information*

The following unaudited pro forma combined statementof operations has been provided to present an illustrative combined unauditedstatement of operations for the three month period ended September 30, 2005,giving effect to the combination as if it had been completed on July 1, 2005.The unaudited combined statement of operations for the three month period endedSeptember 30, 2006 reflects the actual financial results of Watson Wyatt as acombined company. The unaudited pro forma combined statement of operations forthe three month period ended September 30, 2005 combines the actual financialresults for the combined company from August 1, 2005, the dated of combination,through September 30, 2005 with the historical financial results of WatsonWyatt for July 2005 and the pro forma historical financial results of WWLLP forJuly 2005.   The diluted earnings pershare calculation in this pro forma analysis assumes that the 1,950,000 sharesrelated to the business combination had been issued at the beginning of eachperiod.

The unaudited pro forma combined financial informationshows the impact of the combination with WWLLP on Watson Wyatt’s historicalresults of operations.  The unaudited proforma combined income statements are presented for illustrative purposes onlyand are not indicative of the results of operations that might have occurredhad the combination actually taken place as of the dates specified, or that maybe expected to occur in the future.  Theydo not assume any benefits from any cost savings or synergies and do notreflect any integration costs that the combined company realized or incurredafter the combination.

7

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**Pro Forma Combined Statements of Operations**(in thousands, exceptper share data)
| ** **                                              | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | **Historical**                                          | ** ** | **Pro forma** | ** ** |
| ** **                                              | ** ** | **(Unaudited)**                                         | ** ** |
| Revenue                                                 |       | $                                                       | 336,004    |   | $ | 302,329 |   |
|                                                    |       |                                                    |       |   |   |
| Costs of  providing services:                           |       |                                                    |       |   |   |
| Salaries and employee benefits                          |       | 185,595                                                 |       | 170,221 |   |
| Professional and subcontracted services                 |       | 20,035                                                  |       | 19,695 |   |
| Occupancy, communications and other                     |       | 40,951                                                  |       | 37,950 |   |
| General and administrative expenses                     |       | 38,099                                                  |       | 36,817 |   |
| Depreciation and amortization                           |       | 12,751                                                  |       | 10,983 |   |
|                                                    |       | 297,431                                                 |       | 275,666 |   |
|                                                    |       |                                                    |       |   |   |
| Income from  operations                                 |       | 38,573                                                  |       | 26,663 |   |
| (Loss)/income  from affiliates                          |       | (229                                                    | )          | 828 |   |
| Interest  income/(expense), net                         |       | 1,007                                                   |       | (838 | ) |
| Other  non-operating income                             |       | 36                                                      |       | 1,740 |   |
|                                                    |       |                                                    |       |   |   |
| Income from  continuing operations before income taxes  |       | 39,387                                                  |       | 28,393 |   |
| Provision for  income taxes                             |       | 14,573                                                  |       | 12,493 |   |
|                                                    |       |                                                    |       |   |   |
| Income from  continuing operations                      |       | $                                                       | 24,814     |   | $ | 15,900 |   |
|                                                    |       |                                                    |       |   |   |
| Basic earnings  per share:                              |       | $                                                       | 0.59       |   | $ | 0.38 |   |
| Diluted earnings  per share:                            |       | $                                                       | 0.56       |   | $ | 0.36 |   |
|                                                    |       |                                                    |       |   |   |
| Weighted average  shares of common stock, basic (000)   |       | 42,396                                                  |       | 41,871 |   |
| Weighted average shares  of common stock, diluted (000) |       | 44,388                                                  |       | 44,075 |   |

 

The pro forma information for the quarter endedSeptember 30, 2005 excludes, in Other non-operating income, a loss of $3.6million on a foreign exchange forward contract entered into in conjunction withthe business combination with WWLLP.

8

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**Note 3 —Segment Information.**

Watson Wyatt is organizedand managed through a matrix form of organization.  During fiscal year 2006, we substantiallycompleted the global implementation of our financial systems which has enabledsegment reporting around the world.  As aresult, beginning fiscal year 2007, the Asia-Pacific and Latin America operationshave been reported on a practice basis and are included in our operatingsegments listed below. We now have five reportable operating segments orpractice areas as follows:

(1)      BenefitsGroup

(2)      Technologyand Administration Solutions Group

(3)      HumanCapital Group

(4)      Insurance& Financial Services Group

(5)      InvestmentConsulting Group

Management evaluates the performance of its segmentsand allocates resources to them based on net operating income on a pre-bonus,pre-tax basis.  The category previouslyreported as “other” has been reclassified as “All other segments” in thereconciliation of reportable segments to consolidated amounts as prescribed inStatement of Financial Accounting Standards No. 131 “Disclosures about Segmentsof an Enterprise and Related Information”, (FAS 131).  This includes communication and changemanagement implementation support services. Prior period amounts have been restated to conform to the currentclassification.

The table below presentsspecified information about reported segments as of and for the three monthsended September 30, 2006:
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  &  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|--------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 185,355    |                                                  | $          | 37,201                    |       | $                                                | 39,579     |                              | $          | 26,383    |       | $ | 27,368 |   | $ | 315,886 |   |
| Net operating  income                   |       | 44,922              |       | 8,395                                                 |       | 5,054                     |       | 5,069                                            |       | 6,566                             |       | 70,006    |       |
| Receivables                             |       | 199,466             |       | 19,975                                                |       | 41,161                    |       | 28,873                                           |       | 19,794                            |       | 309,269   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                  |            |                                   |            |           |            |  |  |  |  |  |  |

 

The table belowpresents specified information about reported segments as of and for the threemonths ended September 30, 2005 as restated to reflect the elimination of the“Asia-Pacific/Latin America” and “other” segments.  The segment information below includes theconsolidated results from Watson Wyatt Limited from August 1, 2005, the date ofcombination, through September 30, 2005:
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  &  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|--------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 156,983    |                                                  | $          | 25,176                    |       | $                                                | 31,478     |                              | $          | 15,355    |       | $ | 16,348 |   | $ | 245,340 |   |
| Net operating  income                   |       | 39,212              |       | 5,462                                                 |       | 1,626                     |       | 2,692                                            |       | 1,699                             |       | 50,691    |       |
| Receivables                             |       | 178,497             |       | 14,791                                                |       | 31,544                    |       | 19,945                                           |       | 13,628                            |       | 258,405   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                  |            |                                   |            |           |            |  |  |  |  |  |  |

 

9

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Information aboutinterest income and tax expense is not presented as a segment expense becausesuch items are not considered a responsibility of the segments’ operatingmanagement.  Prior year data has beenrestated to be consistent with current classifications for comparative purposes.

Reconciliationsof the information reported by segment to the historical consolidated amountsfollow for the three month periods ended September 30, 2006 and 2005:
| ** **                                                                                  | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                                                                        |       |                                                    |       |   |   |
| Revenue:                                                                                    |       |                                                    |       |   |   |
| Total segment revenue                                                                       |       | $                                                       | 315,886    |   | $ | 245,340 |   |
| Reimbursable expenses not included in total segment  revenue                                |       | 10,504                                                  |       | 10,160 |   |
| All other segments                                                                          |       | 9,834                                                   |       | 12,449 |   |
| Other, net                                                                                  |       | (220                                                    | )          | (2,063 | ) |
| Consolidated revenue                                                                        |       | $                                                       | 336,004    |   | $ | 265,886 |   |
|                                                                                        |       |                                                    |       |   |   |
| Net Operating  Income:                                                                      |       |                                                    |       |   |   |
| Total segment net operating income                                                          |       | $                                                       | 70,006     |   | $ | 50,691 |   |
| Income from affiliates                                                                      |       | (229                                                    | )          | 1,351 |   |
| Differences in allocation methods for depreciation,  G&A, medical and  pension costs(1) |       | (2,231                                                  | )          | (1,950 | ) |
| Gain on sale of business units                                                              |       | 36                                                      |       | 1,740 |   |
| Loss on hedge                                                                               |       | —                                                  |       | (3,602 | ) |
| Discretionary compensation                                                                  |       | (29,920                                                 | )          | (21,320 | ) |
| All other segments                                                                          |       | (1,395                                                  | )          | 552 |   |
| Other, net                                                                                  |       | 3,120                                                   |       | (2,655 | ) |
| Consolidated income before income taxes                                                     |       | $                                                       | 39,387     |   | $ | 24,807 |   |
|                                                                                        |       |                                                    |       |   |   |
| Receivables:                                                                                |       |                                                    |       |   |   |
| Total segment receivables - billed and unbilled                                             |       | $                                                       | 309,269    |   | $ | 258,405 |   |
| All other segments                                                                          |       | 8,270                                                   |       | 9,752 |   |
| Net valuation differences(2)                                                                |       | 101                                                     |       | 3,449 |   |
| Total billed and unbilled receivables                                                       |       | 317,640                                                 |       | 271,606 |   |
| Assets not reported by segment(3)                                                           |       | 875,047                                                 |       | 901,319 |   |
| Consolidated  assets                                                                        |       | $                                                       | 1,192,687  |   | $ | 1,172,925 |   |

 

----

(1)Depreciation, general and administrative, pension, and medical costs areallocated to our segments based on budgeted expenses determined at thebeginning of the fiscal year as management believes that these costs arelargely uncontrollable to the segment. To the extent that the actual expense base upon which allocations aremade differs from the forecast/budget amount, a reconciling item will becreated between internally allocated expenses and the actual expense that wereport for GAAP purposes.

(2)Total segment receivables, which reflects the receivable balances used bymanagement to make business decisions, are included for management reportingpurposes net of deferred revenues — cash collections and invoices generated inexcess of revenue recognized in the segment revenues.

(3)Assets not reported by segment for management reporting purposes includegoodwill and intangible assets of $515.6 million.

10

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**Note 4 —Share-based Compensation.**

TheFinancial Accounting Standards Board (FASB) issued FAS123(R), “Share-basedPayment” as a  revision to Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation.”  FAS 123(R) requirescompanies to account for share-based payment transactions with employees usinga fair-value based method, thereby eliminating the disclosure-only provisionsof FAS 123.  FAS 123(R) became effective for the company as of July 1,2005.

Thecompany has four share-based compensation plans, which are describedbelow.  These compensation plans includethe 2001 Employee Stock Purchase Plan, the 2001 Deferred Stock Unit Plan forSelected Employees, the Compensation Plan for Outside Directors and the 2000Long-Term Incentive Plan.  All four planshave been approved by stockholders.

*2001Employee Stock Purchase Plan*

Theemployee stock purchase plan enables employees to purchase shares of thecompany’s stock.  No compensation expensewas recognized as a result of this plan during the first three months of fiscalyear 2007 or 2006.

##### *2001 Deferred Stock Unit Plan for Selected Employees*

DeferredStock Units - The2001 Deferred Stock Unit Plan for Selected Employees is intended to provideselected associates of the company with additional incentives by permitting thecompany to grant them an equity interest in the company in the form ofrestricted stock units, in lieu of a portion of their annual fiscal year endbonus.  Shares under this plan areawarded during the first quarter of each fiscal year.  During the first quarter of fiscal year 2007,300,552 shares of common stock, at an average market price of $40.48 wereawarded for a total fair value of $12.2 million.  During the first quarter of fiscal year 2006,177,300 shares of common stock, at a market price of $26.94 were awarded, for atotal fair value of $4.8 million.

11

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SBIProgram  — On November 19, 2004, the company’s Boardof Directors approved a long-term bonus arrangement pursuant to the company’s2001 Deferred Stock Unit Plan for Selected Employees.  The arrangement,called the Performance Share Bonus Incentive Program (the “SBI Program”), is along-term stock bonus arrangement for senior executives of the company and itsaffiliates that is designed to strengthen incentives and align behaviors togrow the business in a way that is consistent with the strategic goals of thecompany.

Incentivesunder the SBI Program are provided through grants of deferred stock unitspursuant to the company’s 2001 Deferred Stock Unit Plan for SelectedEmployees.  Grants of deferred stock units are based on the value of thecash portion of the eligible participant’s fiscal year-end bonus target and amultiplier, which is then converted into a target number of deferred stockunits based upon the company’s stock price as of the fiscal year-end prior togrant.  Participants may vest between zero and 170% of the target numberof deferred stock units based on the extent to which financial and strategicperformance metrics are achieved over a three fiscal year period.  Thefinancial and strategic performance metrics are established at the beginning ofeach performance period.  For the fiscal year 2005 through 2007performance period, the vesting criteria are based upon earnings per sharegrowth, market penetration and cross-selling ratios.  For the fiscal year 2006 through 2008performance period, the vesting criteria are based upon growth in earnings pershare and revenue.

Compensationexpense of $0.3 million was recorded pursuant to these plans for the firstquarter of fiscal year 2007 compared to no compensation expense for the firstquarter of fiscal year 2006.  Expensesfor these plans will be recognized when awards are both probable and reasonablyestimable.  If applicable, compensationexpense will be recognized as a component of the discretionary annual bonusrecorded in salaries and employee benefits.

##### *Amended Compensation Plan for Outside Directors*

TheAmended Compensation Plan for Outside Directors (the “Outside Director’s Plan”)provides for the cash and stock compensation of outside Directors.  Under the Outside Director’s Plan, outsideDirectors are initially paid in shares of the company’s common stock, or in acombination of cash and shares, quarterly for services provided during thepreceding quarter.  In addition, outsidedirectors receive shares with a grant date market value of $45,000 at the endof each fiscal year for services performed during the preceding fiscal year.Approximately $0.3 million of compensation expense was recorded relative tothis plan during the first quarter of fiscal year 2007 compared to $0.2 millionin the first quarter of fiscal year 2006.

##### *2000 Long-Term Incentive Plan*

Thecompany issued non-qualified stock options under the 2000 Long-Term IncentivePlan (the “Stock Option Plan”) in conjunction with its initial public offeringin fiscal year 2001.  No options havebeen granted under the stock option plan since fiscal year 2001 and the companydoes not currently intend to issue further stock options under the Stock OptionPlan. For the first quarter of fiscal year 2007, the company recognized lessthan $0.1 million in compensation expense related to the Stock Option Plan, inaccordance with FAS 123(R).  For thefirst quarter of fiscal year 2006, the company recognized compensation expenseof $0.2 million, related to the Stock Option Plan.

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**Note 5 —Retirement Benefits.**

*DefinedBenefit Plans*

We sponsor both qualifiedand non-qualified, non-contributory defined benefit pension plans coveringsubstantially all of our associates. Under our plans in North America, benefits are based on the number ofyears of service and the associates’ compensation during the five highest paidconsecutive years of service.  Under ourplan in the U.K., benefits are based on the number of years of service and theassociates’ compensation during the three years before leaving the plan. Thenon-qualified plan, included only in North America, provides for pensionbenefits that would be covered under the qualified plan but are limited by theInternal Revenue Code.  The non-qualifiedplan has no assets and therefore is an unfunded arrangement.  The benefit liability is reflected on thebalance sheet.  The measurement datefor  each of  the plans is June 30.

*Components of Net PeriodicBenefit Cost for Defined Benefit Pension Plans*

The followingtable sets forth the components of net periodic benefit cost for the company’sdefined benefit pension plan for North America for the three month periodsended September 30, 2006 and 2005, and for the U.K. defined benefit pensionplan for the three month period ended September 30, 2006 and for the two monthsended September 30, 2005:
| ** **                             | ** ** | **September 30**  | ** ** | **September 30** | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **North America** | ** ** | **U.K.**              | ** ** |
|                                   |       |                   |       |                  |       |   |   |   |   |
| Service Cost                           |       | $                      | 7,387      |                  | $          | 7,109 |   | $ | 2,895 |   | $ | 2,090 | ** ** |
| Interest Cost                          |       | 9,236                  |       | 9,025                 |       | 3,405 |   | 2,351 |   |
| Expected return on plan  assets        |       | (10,994                | )          | (10,930               | )          | (3,202 | ) | (2,213 | ) |
| Amortization of  transition obligation |       | (10                    | )          | (9                    | )          | **—** |   | **—** | ** ** |
| Amortization of net  loss              |       | 4,051                  |       | 3,776                 |       | **—** |   | **—** |   |
| Amortization of prior  service cost    |       | (429                   | )          | (412                  | )          | **—** |   | **—** | ** ** |
| Net periodic benefit cost              |       | $                      | 9,241      |                  | $          | 8,559 |   | $ | 3,098 |   | $ | 2,228 | ** ** |

 

The fiscal year 2007 netperiodic benefit cost is based, in part, on the following rate assumptions asof June 30, 2006 for the North America and U.K. plans:

|                                              | ** ** | **North America** | ** ** | **U.K.** | ** ** |
|----------------------------------------------|------------|------------------------|------------|----------|------------|
| Discount rate                                |       | 6.25%                  |       | 5.10%    |       |
| Expected long-term  rate of return on assets |       | 8.75%                  |       | 5.69%    |       |
| Rate of increase in  compensation levels     |       | 3.84%                  |       | 4.75%    |       |

 

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*Employer contributions*

The company made $700,000in contributions to the North America plans during the first quarter of fiscalyear 2007 and anticipates making $17.0 million in contributions over theremainder of the fiscal year.

The company made $2.1million in contributions to the U.K. plans during the first quarter of fiscalyear 2007 and anticipates making $8.3 million in contributions over the remainderof the fiscal year.

*Defined Contribution Plans*

In the U.S., we sponsor a savings plan that providesbenefits to substantially all U.S. associates. The company matches employeecontributions at a rate of 50 percent of the first 6 percent up to $60,000 ofassociates’ eligible compensation.  Thecompany may also make an annual profit sharing contribution to the plan in anamount that is dependant upon the company’s financial performance during thefiscal year.

In the U.K., we sponsor a savings plan that providesbenefits to substantially all U.K. associates. The company provides a basic contribution and a match to employeecontributions both of which depend on age and base salary.  The maximum employer contribution is up to10% of associates base salary up to $180,000.

*HealthCare Benefits*

In the U.S., wesponsor a contributory health care plan that provides hospitalization, medicaland dental benefits to substantially all U.S. associates.  We accrue a liability for estimated incurredbut unreported claims based on projected use of the plan as well as prior planhistory.

In the U.K., wesponsor a non-contributory medical insurance plan that provides hospitalizationand medical benefits and a contributory dental plan that provides dentalbenefits to substantially all U.K. associates.

*PostretirementBenefits*

We provide certainhealth care and life insurance benefits for retired associates.  The principal plans cover associates in theU.S. and Canada who have met certain eligibility requirements. Our principalpost-retirement benefit plans are unfunded. We accrue a liability for these benefits.

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*Components of Net PeriodicBenefit Cost for Other Postretirement Plans*

The followingtable sets forth the components of net periodic benefit cost for the company’spost-retirement plans for the three months ended September 30, 2006 and 2005:

|                                        | ** ** | **Three Months Ended September 30** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                   |       |                                                    |       |   |   |
| Service cost                           |       | $                                                       | 432        |   | $ | 452 |   |
| Interest cost                          |       | 589                                                     |       | 603 |   |
| Expected return  on plan assets        |       | —                                                  |       | — |   |
| Amortization of  transition obligation |       | —                                                  |       | — |   |
| Amortization of  net loss/(gain)       |       | 3                                                       |       | (82 | ) |
| Amortization of  prior service cost    |       | (165                                                    | )          | (165 | ) |
| Net periodic  benefit cost             |       | $                                                       | 859        |   | $ | 808 |   |

 

*Employer contributions*

The company madecontributions in the form of premiums and medical claim payments to itshealthcare and post-retirement plans of $800,000 and $1.1 million in the threemonths ended September 30, 2006 and 2005, respectively.  We plan to make additional payments estimatedto total $2.5 million through the end of June 30, 2007.

*Recent Pronouncement*

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) publishedStatement of Financial Accounting Standards No. 158, “Employers’ Accounting forDefined Benefit Pension Plans and Other Postretirement Plans” (FAS 158), whichis an amendment to FAS 87, “Employers’ Accounting for Pensions”; FAS 88, “Employers’Accounting for Settlements and Curtailments of Defined Benefit Pension Plansand for Termination Benefits”; and FAS 132(R), revision to FAS132, “Employers’Disclosures about Pensions and Other Postretirement Benefits”.  FAS 158 requires companies to recognize thefunded status of defined benefit pension and postretirement plans as an assetor liability in its statement of financial position and to recognize changes inthat funded status in the year in which the changes occur through comprehensiveincome. The provisions of FAS 158 are effective for fiscal years ending afterDecember 15, 2006 and the transition method is prospective.  As a result, the company will adopt theprovisions of FAS 158 for the period ending June 30, 2007.  The company is currently evaluating theimpact that adoption of FAS 158 will have on the financial statements.

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**Note 6 —Goodwill & Intangible Assets.**

Goodwilland intangible assets are outlined below for the three months ended September30, 2006:
| ** **                         | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  &  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **All Other  Segments** | ** ** | **Total** | ** ** |
|------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|--------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|-----------|------------|
| Balance as of  June 30, 2006  |       | $                   | 167,538    |                                                  | $          | 43,168                    |       | $                                                | 18,990     |                              | $          | 54,351                       |       | $         | 38,780     |   | $ | 1,214 |   | $ | 324,041 |   |
| Goodwill acquired  during the year |       | 125                 |       | —                                                |       | 993                       |       | —                                           |       | —                            |       | —                       |       | 1,118     |       |
| Impairment losses                  |       | —              |       | —                                                |       | —                    |       | —                                           |       | —                            |       | —                       |       | —    |       |
| Other                              |       | (117                | )          | (34                                                   | )          | (14                       | )          | (45                                              | )          | (32                               | )          | —                       |       | (243      | )          |
| Translation  adjustment            |       | 1,691               |       | 499                                                   |       | 307                       |       | 650                                              |       | 463                               |       | —                       |       | 3,610     |       |
| Balance as of September  30, 2006  |       | $                   | 169,237    |                                                  | $          | 43,633                    |       | $                                                | 20,276     |                              | $          | 54,956                       |       | $         | 39,211     |   | $ | 1,214 |   | $ | 328,526 |   |

 

The following tablereflects changes in the net carrying amount of the components of intangibleassets for the three months ended September 30, 2006:
| ** **                                  | ** ** | **Pension** | ** ** | **Trademark  & trade  name** | ** ** | **Customer  related  intangible** | ** ** | **Core/  developed  technology** | ** ** | **Non-  compete  agreements** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|-------------|------------|---------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|-------------------------------|------------|-----------|------------|
| Balance as of  June 30, 2006                |       | $           | 569        |                                  | $          | 112,966                           |       | $                                | 58,546     |                          | $          | 14,973    |       | $ | 21 |   | $ | 187,075 |   |
| Intangible  assets acquired during the year |       | —      |       | —                                |       | —                            |       | —                           |       | —                        |       | —    |       |
| Amortization  expense                       |       | —      |       | —                                |       | (1,338                            | )          | (942                             | )          | (11                           | )          | (2,291    | )          |
| Translation  adjustment                     |       | —      |       | 1,411                                 |       | 732                               |       | 188                              |       | —                        |       | 2,331     |       |
| Balance as of September  30, 2006           |       | $           | 569        |                                  | 114,377    |                              | $          | 57,940                           |       | $                             | 14,219     |      | $          | 10 |   | $ | 187,115 |   |
|                                             |            |             |            |                                       |            |                                   |            |                                  |            |                               |            |           |            |  |  |  |  |  |  |

 

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Thefollowing table reflects the carrying value of intangible assets at September30, 2006 and June 30, 2006:
| ** **                                            | ** ** | **September 30, 2006** | ** ** | **June 30, 2006** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                            | ** ** | **Gross**                        | ** ** | ** **                  | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                            | ** ** | **Carrying**                     | ** ** | **Accumulated**             | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                                            | ** ** | **Amount**                       | ** ** | **Amortization**            | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Intangible assets and intangible pension asset:       |       |                             |       |                        |       |   |   |   |   |
| Trademark & trade name                            |       | $                                | 114,377    |                        | $          | — |   | $ | 112,966 |   | $ | — |   |
| Customer related intangibles                          |       | 61,896                           |       | 3,956                       |       | 64,210 |   | 5,664 |   |
| Core/developed technology                             |       | 16,976                           |       | 2,757                       |       | 18,443 |   | 3,470 |   |
| Non-compete                                           |       | 421                              |       | 411                         |       | 672 |   | 651 |   |
| Intangible pension asset                              |       | 569                              |       | —                      |       | 569 |   | — |   |
| Total intangible  assets and intangible pension asset |       | $                                | 194,239    |                        | $          | 7,124 |   | $ | 196,860 |   | $ | 9,785 |   |

 

A component of the changein the gross carrying amount of trademark & trade name, customer relatedintangibles, core/developed technology and the intangible pension asset reflects translationadjustments between June 30, 2006 and September 30, 2006.  These intangible assets are denominated inthe currencies of our subsidiaries outside the United States, and aretranslated into our reporting currency, the U.S. dollar, based on exchangerates at the balance sheet date.

The weightedaverage remaining life of amortizable intangible assets at September 30, 2006, was9.5 years.  Future estimated amortizationexpense is as follows:

| Fiscal year ending June 30: | ** ** | ** ** | ** ** | **Amount** | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                            |       | $          | 6,803      |       |
| 2008                                            |       | 9,058      |       |
| 2009                                            |       | 9,058      |       |
| 2010                                            |       | 9,058      |       |
| 2011                                            |       | 5,657      |       |
| Thereafter                                      |       | 32,535     |       |
| Total                                           |       | $          | 72,169     |       |

 

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**Note 7 —Earnings Per Share.**

Basic earnings pershare is calculated on the basis of the weighted average number of commonshares outstanding during the three months ended September 30, 2006 and2005.  Diluted earnings per share iscalculated by dividing net income by the weighted average number of commonshares outstanding, plus the dilutive effect of outstanding stock options andemployee stock purchase plan shares using the “treasury stock” method over thesame measurement period.  The componentsof basic and diluted earnings per share are as follows:
| ** **                                                                                              | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                                                                                    |       |                                                    |       |   |   |
| Income from  continuing operations                                                                      |       | $                                                       | 24,814     |   | $ | 13,892 |   |
| Discontinued  operations                                                                                |       | —                                                  |       | 9 |   |
| Net income                                                                                              |       | $                                                       | 24,814     |   | $ | 13,901 |   |
|                                                                                                    |       |                                                    |       |   |   |
| Weighted average  outstanding shares of common stock                                                    |       | 42,396                                                  |       | 38,841 |   |
| Dilutive effect  of employee stock options, employee stock purchase plan shares, and  contingent shares |       | 1,992                                                   |       | 254 |   |
| Common stock and  stock equivalents                                                                     |       | 44,388                                                  |       | 39,095 |   |
|                                                                                                    |       |                                                    |       |   |   |
| Basic earnings  per share:                                                                              |       |                                                    |       |   |   |
| Income from  continuing operations                                                                      |       | $                                                       | 0.59       |   | $ | 0.36 |   |
| Discontinued  operations                                                                                |       | —                                                  |       | — |   |
| Net income                                                                                              |       | $                                                       | 0.59       |   | $ | 0.36 |   |
|                                                                                                    |       |                                                    |       |   |   |
| Diluted earnings  per share:                                                                            |       |                                                    |       |   |   |
| Income from  continuing operations                                                                      |       | $                                                       | 0.56       |   | $ | 0.36 |   |
| Discontinued  operations                                                                                |       | —                                                  |       | — |   |
| Net income                                                                                              |       | $                                                       | 0.56       |   | $ | 0.36 |   |

 

The three monthperiod ended September 30, 2006 diluted earnings per share calculation assumesthat the 1,950,000 contingent shares related to the business combination hadbeen issued and outstanding for the entire quarter.

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**Note 8 —Variable Interest Entities.**

FASB Interpretation No.46, “Consolidation of Variable Interest Entities,” as revised (FIN 46(R)),expands existing accounting guidance about when a company should include in itsconsolidated financial statements the assets, liabilities, and activities ofanother entity.  In general, FIN 46(R)requires a variable interest entity (VIE), as defined by FIN 46(R), to beconsolidated by its primary beneficiary. The primary beneficiary is defined as the company that will absorb amajority of the VIE’s expected losses or residual returns if they occur.

We have evaluated underFIN 46(R) our consolidated subsidiaries and believe that our accounting anddisclosure is in compliance with the pronouncement.  Therefore, the adoption of FIN 46(R) had noeffect on the company.

The company’s Investmentin affiliates has historically consisted of investments in three entities:  WWLLP, Watson Wyatt Holdings (Europe) Limited(WWHE) and Professional Consultants Insurance Company, Inc. (PCIC).  As a result of our acquisition ofsubstantially all of the assets and most liabilities of WWLLP, effective August1, 2005, the company owns 100% of the operations of WWLLP and WWHE.  For the quarter ended September 30, 2005 thecompany has accounted for its share of earnings from WWLLP and WWHE for themonth of July 2005 under the equity method and has consolidated results fromWatson Wyatt Limited for the months of August and September, 2005.

As of September 30, 2006,our Investment in affiliate consists solely of an equity investment in PCIC,which will continue to be accounted for under the equity method.  The company evaluated this investment inorder to determine the applicability of FIN 46(R).  Since the company is not obligated to absorba majority of expected losses or residual returns in this entity, the companyis not required to consolidate this entity.

PCIC was organized in1987 as a captive insurance company under the laws of the State ofVermont.  PCIC provides professionalliability insurance on a claims-made basis to Watson Wyatt and two otheractuarial and management consulting firms, all of which participate in theprogram as both policyholders and stockholders. The company currently owns 34.15 percent of PCIC.  Capital contributions to PCIC are requiredwhen approved by a majority of its stockholders.  Management believes that the company’smaximum financial statement exposure to loss is limited to the carrying valueof the company’s investment in PCIC of $8.2 million, combined with letters ofcredit totaling $8.0 million for which PCIC has been designated as beneficiary,for a total maximum exposure of $16.2 million.

**Note 9 —Comprehensive Income.**

Comprehensive incomeincludes net income, changes in the additional minimum pension liabilityresulting from translation adjustments and changes in the cumulativetranslation adjustment gain or loss.  Forthe three months ended September 30, 2006, comprehensive income totaled $31.4million, compared with $12.4 million for the three months ended September 30,2005.

**Note 10 —Restricted Shares.**

In conjunctionwith our business acquisition of WWLLP on July 31, 2005, we issued 9,090,571Class A shares, 4,749,797 of which are subject to sale restrictions.  Sale restrictions expired on 2,339,761 shareson July 31, 2006 and will expire on 2,410,036 shares on July 31, 2007.  The payment of up to an additional 1,950,000Class A shares after June 30, 2007 is contingent upon achievement bythe acquired business of certain financial performance goals.  Sale of these shares, if issued, will berestricted until July 31, 2009.  See Note2 of this report for further information regarding the business combination ofWWLLP.

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**Note 11 — Guarantees.**

The company historicallyhas provided guarantees on an infrequent basis to third parties in the ordinarycourse of business.  The guaranteesdescribed below are currently in effect and could require the company to makepayments to third parties under certain circumstances.

*Business combination*.  OnJuly 31, 2005, the company acquired substantially all of the assets and assumedmost liabilities of WWLLP, the company’s long-time alliance partner.  The company entered into indemnityarrangements with WWLLP relating to the acquisition and also agreed thatcertain indemnity obligations relating to the alliance arrangements willcontinue after the acquisition.  In thebusiness combination agreement, Watson Wyatt Limited, the company’s principalU.K. subsidiary, has agreed to indemnify WWLLP against liabilities arising withrespect to certain liabilities assumed in the business combination by WatsonWyatt Limited and also with respect to certain tax liabilities.

Aspart of the original alliance arrangements in 1995, the company sold itsthen-existing businesses in the U.K. and Europe to the predecessor of WWLLP orits subsidiaries.  The company agreed toindemnify the buyers against liabilities arising with respect to prior acts oromissions of the businesses transferred. Furthermore, the company agreed to indemnify WWLLP against liabilitiesarising with respect to acts or omissions of the company and its subsidiariesduring the alliance arrangements.  Theseindemnities will continue following the business combination.

Thecompany is unable to estimate an amount of any potential future payments underthese arrangements because the occurrence of any of the events to which theindemnities apply is entirely speculative and the amount of any payment woulddepend upon the nature of the event triggering such indemnity. Managementbelieves that any potential for payment under such indemnities should declinewith the passage of time.  The companyhas insurance to cover liabilities arising from acts or omissions by thecompany and its subsidiaries, and such insurance may cover some or all of itsindemnity obligations relating to prior acts or omissions.  Except for such insurance, there are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that the company as indemnitor can liquidate to recover amounts paid undersuch indemnities.

Inconnection with our business combination, payment of an additional 1,950,000shares of the company’s common stock to the former partners of WWLLP after June30, 2007, is contingent upon the achievement by the acquired business of agreed-uponfinancial performance goals. The value of all the contingent stock was $88.0million based on the NYSE closing price on October 31, 2006. The contingentconsideration is payable by Watson Wyatt Limited and the payment obligationsare guaranteed by Watson Wyatt Worldwide, Inc.

Underthe business combination agreement, Watson Wyatt Limited is obligated to makepayments to members of WWLLP representing profits and tax payments relating toperiods before the closing date of the transaction. The company has guaranteedthese obligations and has properly reflected them on the company’s consolidatedfinancial statements as of September 30, 2006.

*Letters of Credit*.  The company has outstanding letters of creditto three beneficiaries totaling $14.3 million to guarantee payment in the event that the company fails to meetits financial obligations to these beneficiaries.  One letter of credit for $2.6 million willexpire in April 2007, while the second letter of credit totaling $8.0 millionwill remain outstanding as long as we retain an ownership share of ouraffiliated captive insurance company, PCIC. The company has also provided a $5.0 million Australiandollar-denominated letter of credit (US $3.7 million) to an Australiangovernmental agency as required by local regulations. The estimated fair marketvalue of these letters of credit is immaterial because they have never beenused, and the company believes that future usage is remote.

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*Indemnification Agreements*.  The company has various agreements that providethat it may be obligated to indemnify the other party with respect to certainmatters.  Generally, theseindemnification clauses are included in contracts arising in the normal courseof business and in connection with the purchase and sale of certainbusinesses.  Although it is not possibleto predict the maximum potential amount of future payments under theseindemnification agreements due to the conditional nature of the company’sobligations and the unique facts of each particular agreement, the company doesnot believe that any potential liability that might arise from such indemnityprovisions is probable or material. There are no provisions for recourse to third parties, nor are anyassets held by any third parties that any guarantor can liquidate to recoveramounts paid under such indemnities.

*Wellspring Leases*.  We continue to guarantee three leases foroffice premises for Wellspring Resources, LLC (“Wellspring”), the benefitsadministration outsourcing business that we exited from in fiscal year1998.  At September 30, 2006, minimumremaining payments guaranteed under these leases, which expire at various datesthrough 2007, total $2.5 million, excluding anticipated future sublease income.  All income or expense associated with theguaranteed leases is reflected in discontinued operations in the Statement ofOperations.

**Note 12 —Contingent Liabilities.**

*LegalProceedings*:  From time to time, we are a party to variouslawsuits, arbitrations or mediations that arise in the ordinary course of business.  We have received subpoenas and requests forinformation in connection with government investigations. The matters reportedon below involve the most significant pending or potential claims against us.

Wecarry substantial professional liability insurance with a self-insuredretention of $1 million per occurrence, which provides coverage forprofessional liability claims including the cost of defending such claims. Wereserve for contingent liabilities based on Statement of Financial AccountingStandards No. 5, “Accounting for Contingencies” (FAS 5) when it is determinedthat a liability, inclusive of defense costs, is probable and reasonablyestimable. Management believes, based on currently available informationincluding the existence of professional liability insurance, that the resultsof all pending claims against the company will not have a material adverseeffect on the results of operations, but litigation is subject to many factorswhich are difficult to predict so there can be no assurance that in the eventof a material unfavorable result in one or more of such matters, we will notincur material costs.

*Iron Workers Local 25 et al. v. Watson Wyatt & Co. *On July 8, 2004, Watson Wyatt was served with an amended complaintfiled by a former client in the United States District Court for the EasternDistrict of Michigan.  The complaintalleged malpractice, breach of contract, and related misrepresentation andfraud claims in the performance of actuarial consulting.  The complaint stated that the plaintiff’spension fund is underfunded as a result of alleged deficiencies in our workwhich caused the trustees to adopt benefit improvements in 1997 and 1999 whichwere unaffordable. In response to a discovery request, in January 2005 theplaintiffs disclosed that their minimum damage claim was $53.7 million.  Plaintiff’s initial expert witness reportsincluded allegations of gross negligence and damage estimates of $100 million.Supplemental expert reports prepared prior to recent discussion of alternativemeans of resolving the case have contended that Watson Wyatt must restore thepension fund to the position it would have been in 2002 had the allegednegligence not taken place, with damage allegations in amounts substantiallygreater than earlier damage estimates. Watson Wyatt vigorously disputes allallegations of negligence and all related claims as well as the purporteddamages.  Watson Wyatt’s expert witnessreports conclude that the company was not negligent and dispute such purporteddamages.  Discovery is continuing. WatsonWyatt has filed a Motion for Summary Judgment as to the 1997 benefitimprovements on the basis of the Michigan Statute of Limitations.  That motion is pending and will be argued inDecember 2006.  Though the parties havepursued alternative means of resolving the case, settlement has not beenachieved. The trial date is now scheduled for April 2007.

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*SBC Holdings, Inc. *On July 23, 2004, we received a demand letter from counsel for a clientalleging that errors in valuations for 2001 and subsequent years understatedthe liabilities of its pension plan and overstated the company’s networth.  As a result, the client claimedit did not annuitize its defined benefit plan and redeemed its stock at aninflated price.  Watson Wyatt filed apetition to compel arbitration of the matter on April 15, 2006 in the U.S.District Court for the Eastern District of Michigan.  On May 5, 2005, the Stroh Companies filed ananswer and counterclaim, alleging damages in excess of $46 million.

On June 30, 2006, the Courtpartially granted and partially denied our motion to compel arbitration byruling that only claims arising from events that occurred after our engagementletter with the client were subject to arbitration.  We filed a notice of appeal to the SixthCircuit on August 1, 2006.  Mediationdiscussions required by Sixth Circuit rules were held on September 11 and 21,2006.  To date, mediation has beenunsuccessful and we are proceeding with the appeal.

**Note 13 — Recent Accounting Pronouncements.**

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) publishedStatement of Financial Accounting Standards No. 158, “Employers’ Accounting forDefined Benefit Pension Plans and Other Postretirement Plans” (FAS 158), whichis an amendment to FAS 87, “Employers’ Accounting for Pensions”; FAS 88,“Employers’ Accounting for Settlements and Curtailments of Defined BenefitPension Plans and for Termination Benefits”; and FAS 132(R), revision toFAS132, “Employers’ Disclosures about Pensions and Other PostretirementBenefits”.  FAS 158 requires companies torecognize the funded status of defined benefit pension and postretirement plansas an asset or liability in its statement of financial position and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income. The provisions of FAS 158 are effective forfiscal years ending after December 15, 2006 and the transition method isprospective.  As a result, the companywill adopt the provisions of FAS 158 for the period ending June 30, 2007.  The company is currently evaluating theimpact that adoption of FAS 158 will have on the financial statements.

In September 2006, the U.S.Securities and Exchange Commission staff issued Staff Accounting Bulletin No.108, “ Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements” (SAB 108).   SAB 108 eliminates the diversity of practicesurrounding how public companies quantify financial statement misstatements. Itestablishes an approach that requires quantification of financial statementmisstatements based on the effects of the misstatements on each of thecompany’s financial statements and the related financial statement disclosures.SAB 108 must be applied to our annual financial statements for the year endingJune 30, 2007. The company is currently evaluating the impact of SAB 108 on itsfinancial statements.

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes - aninterpretation of FASB Statement No. 109”, which clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FAS No. 109, “Accounting for Income Taxes.”  ThisInterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return.  This Interpretation also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure, and transition.  This Interpretation iseffective for fiscal years beginning after December 15, 2006.  The companyis currently evaluating the effects, if any, that this Interpretation may haveon its consolidated financial statements.

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**ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

**ExecutiveOverview**

**General**

Watson Wyatt is a globalconsulting firm focusing on providing human capital and financial consultingservices. We provide services in five principal practice areas: Benefits,Technology and Administration Solutions, Human Capital Consulting, Insuranceand Financial Services, and Investment Consulting, operating from 94 offices in30 countries throughout North America, Europe, Asia-Pacific and Latin America.The company employs 6,360 associates as follows: 

| Benefits Group                                 |   | 2,700 |   |
|------------------------------------------------|--------|-------|--------|
| Technology and  Administration Solutions Group |   | 750   |   |
| Human Capital  Group                           |   | 800   |   |
| Insurance &  Financial Services Group      |   | 370   |   |
| Investment  Consulting Group                   |   | 370   |   |
| Other (including  Communication)               |   | 740   |   |
| Corporate                                      |   | 630   |   |
| Total                                          |   | 6,360 |   |

 

We help our clientsenhance business performance by improving their ability to attract, retain, andmotivate qualified employees. We focus on delivering consulting services thathelp our clients anticipate, identify and capitalize on emerging opportunitiesin human capital management.  We alsoprovide independent financial advice regarding all aspects of life assuranceand general insurance, as well as investment advice to assist our clients indeveloping disciplined and efficient investment strategies to meet theirinvestment goals.  Our target marketclients include those companies in the fortune 1000, Pension & Investments(P&I) 1000, the FTSE 100, and locally-defined equivalent organizations.

As leading economiesworldwide become more services-oriented, human capital and financial managementhas become increasingly important to companies and other organizations. Theheightened competition for skilled employees, unprecedented changes inworkforce demographics, regulatory changes related to compensation and retireebenefits and rising employee-related costs have increased the importance ofeffective human capital management. Insurance and investment decisions becomeincreasingly complex and important in the face of changing economies anddynamic financial markets.  We help ourclients address these issues by combining our expertise in human capital andfinancial management with consulting and technology, to improve the design andimplementation of various human resources and financial programs, includingcompensation, retirement, health care, insurance and investment plans.

The human resourcesconsulting industry, although highly fragmented, is highly competitive and iscomprised of major human capital consulting firms, specialist firms, consultingarms of accounting firms and information technology consulting firms.  We believe we have successfully managed coststhroughout the company by leveraging our variable compensation cost structure,initiating targeted job reductions and controlling discretionary spending. Webelieve we are well positioned to take advantage of an improvement in theoverall economy.

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In the short term, ourrevenues are driven by many factors including the general state of the globaleconomy and the resulting level of discretionary spending by our clients, theability of our consultants to attract new clients or cross-sell to existingclients, and the impact of new regulations in the legal and accounting fieldsthat most recently increased demand for our executive compensation and benefitspractices.  In the long term, benefitsspending is expected to continue to be the largest component of U.S. corporatespending.  We believe that the agingworkforce, the projected shortfall in workers over the next decade and changingregulations will translate into opportunities for us.  We expect that the company’s financialresults will depend in large part upon how well we succeed in deepening ourexisting client relationships through thought leadership and focus oncross-practice solutions, actively pursuing new clients in our target markets,cross selling and strategic acquisitions. We believe that the highly fragmented industry in which we operaterepresents tremendous growth opportunities for us, because we offer a uniquecombination of benefits and human capital consulting as well as strategictechnology solutions.

**PrincipalServices**

We design, develop andimplement human resource and risk management strategies and programs throughthe following closely-interrelated practice areas:

**Benefits Group-**The Benefits Group, accountingfor 55 percent of our total first quarter fiscal year 2007 revenues, is thefoundation of our business.  Retirement,the core of our Benefits Group business, is less impacted by discretionaryspending reductions than our other segments, mainly due to the recurring natureof client relationships.  Our corporateclient retention rate within our target market has remained very high. Revenuefor our retirement practice is seasonal, with the third and fourth quarters ofeach fiscal year being the busier periods. Major revenue growth drivers in this practice include changes inregulations, particularly those affecting pension plans in the U.K., leveragefrom other practices, an improving economy, increased global demand andincreased market share.   Servicesprovided through the Benefits Group include the following:**

**·**                 Retirementplans, including pension, 401(k) and executive benefit plans

**·**                 Healthcare, disability and other group benefit plans

**·**                 Compensation,benefits, expatriate and human resources practice strategy, implementation andadministration

**·**                 Actuarialservices

**·**                 Strategicworkforce planning

**Technology and AdministrationSolutions Group -**Our Technology and AdministrationSolutions Group (TAS), accounting for 11 percent of our total first quarterfiscal year 2007 revenues, provides information technology services to ourcustomers.  Services provided through TASinclude the following:

**·**                 Web-basedapplications for health and welfare, pension and compensation administration

**·**                 Administrationoutsourcing solutions for health and welfare and pension benefits

**·**                 Callcenter strategy, design and tools

**·**                 Strategichuman resource technology and service delivery consulting

**·**                 Targetedonline compensation and benefits statements, content management and call centercase management solutions

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**Human CapitalGroup** - Our**Human CapitalGroup (HCG), accounting for 12 percent of our total first quarter fiscal year2007 revenues, generally encompasses short-term projects and as a result ismost sensitive to economic conditions. Services provided through HCG include the following:

**·**                 Compensationplans, including broad-based and executive compensation,  stock and other long-term incentive programs

**·**                 Strategiesto align workforce performance with business objectives

**·**                 Organizationeffectiveness consulting, including talent management

**·**                 Strategiesfor attracting, retaining and motivating employees

**·**                 Dataservices

**Insurance & FinancialServices Group** - Our Insurance & Financial ServicesGroup (I&FS) accounts for 8 percent of our total first quarter fiscal year2007 revenues. This business is characterized by ongoing relationships with ourclients who will typically use our skills on a number of differentprojects.  Services provided throughI&FS include the following:

**·**                 Independentactuarial and strategic advice

**·**                 Assessmentand advice regarding financial condition and risk management

**·**                 Financialmodeling software tools for product design and pricing, planning andprojections, reporting, valuations and risk management

**Investment Consulting Group -**OurInvestment Consulting Group, accounts for 8 percent of our total first quarterfiscal year 2007 revenues.  Thisbusiness, although relationship based, can be impacted by volatility ininvestment returns, particularly as clients look to us for assistance inmanaging that volatility.  Servicesprovided through our Investment Consulting Group include the following:

**·**                 Investmentconsulting services to pension plans and other institutional funds

**·**                 Inputon governance and regulatory issues

**·**                 Analysisof asset allocation and investment strategies

**·**                 Investmentstructure analysis, selection and evaluation of managers, and performancemonitoring

While we focus ourconsulting services in the areas described above, management believes that oneof our primary strengths is our ability to draw upon consultants from ourdifferent practices to deliver integrated services to meet the needs of ourclients.  This includes communication andchange management implementation support services.

Our clients include manyof the world’s largest corporations as well as emerging growth companies,public institutions and nonprofit organizations.

**Financial Statement Overview**

Watson Wyatt’s fiscalyear ends June 30. The financial statements contained in this quarterly reportreflect Consolidated Balance Sheets as of the end of the first quarter offiscal year 2007 (September 30, 2006) and as of the end of fiscal year 2006(June 30, 2006), Consolidated Statements of Operations for the three monthperiods ended September 30, 2006 and 2005, Consolidated Statements of CashFlows for the three month periods ended September 30, 2006 and 2005 and aConsolidated Statement of Changes in Stockholders’ Equity for the three monthperiod ended September 30, 2006.

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The company’s acquisitionof substantially all of the assets and assumption of most liabilities of WWLLPwas completed July 31, 2005 and as a result, our financial statements reflectthe consolidation of the European operations through Watson Wyatt Limitedbeginning August 1, 2005.  Prior to July31, 2005, or for one month of the first quarter, the company recorded its shareof the results of WWLLP and WWHE using the equity method of accounting.  This income is reflected in the “Income fromaffiliates” line on our income statement. Our share of the results of our affiliated captive insurance company,PCIC, continues to be recorded using the equity method of accounting, and isalso reflected in the “Income from affiliates” line.

Wederive substantially all of our revenue from fees for consulting services,which generally are billed based on time and materials or on a fixed-feebasis.  Clients are typically invoiced ona monthly basis with revenue generally recognized as services are performed.Before the company’s business combination, for the most recent three fiscalyears, revenue from U.S. consulting operations has comprised approximately 80percent of consolidated revenue.  For thefirst quarter of fiscal year 2007, U.S. Consulting operations comprised approximately50 percent of consolidated revenue. Before and after the business combination, no single client accountedfor more than 2 percent of our consolidated revenue for any of the most recentthree fiscal years.

In delivering consultingservices, our principal direct expenses relate to compensation of personnel.Salaries and employee benefits are comprised of wages paid to associates,related taxes, benefit expenses such as pension, medical and insurance costsand fiscal year-end incentive bonuses.

Professionaland subcontracted services represent fees paid to external service providersfor employment, marketing and other services. Before the company’s business combination, for the most recent threefiscal years, approximately 60 to 70 percent of these professional andsubcontracted services were directly incurred on behalf of our clients and werereimbursed by them, with such reimbursements being included in revenue.  For the first quarter of fiscal year 2007, approximately50 percent of professional and subcontracted services represent thesereimbursable services.

Occupancy, communicationsand other expenses represent expenses for rent, utilities, supplies andtelephone to operate office locations as well as non-client-reimbursed travelby associates, publications and professional development. This line item alsoincludes miscellaneous expenses, including gains and losses on foreign currencytransactions.

General andadministrative expenses include the operational costs, professional fees andinsurance paid by corporate management, general counsel, marketing, humanresources, finance, research and technology support.

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**CriticalAccounting Policies and Estimates**

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, disclosures of contingent assets and liabilities atthe date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Our estimates, judgments and assumptionsare 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 arecritical accounting policies include revenue recognition, valuation of billedand unbilled receivables from clients, discretionary compensation, incometaxes, pension assumptions, Incurred But Not Reported claims, and goodwill andintangible assets. The critical accounting policies discussed below involvesmaking difficult, subjective or complex accounting estimates that could have amaterial effect on our financial condition and results of operations. Thesecritical accounting policies require us to make assumptions about matters thatare highly uncertain at the time of the estimate or assumption and differentestimates that we could have used or changes in the estimate that arereasonably likely to occur may have a material impact on our financialstatements and results of operations.

*  **Revenue Recognition***

Revenue includes feesprimarily generated from consulting services provided in the areas of employeebenefits, human capital strategies, technology and administration solutions andfinancial management.  We recognizerevenue from these consulting engagements when hours are worked, either on atime-and-materials basis or on a fixed-fee basis, depending on the terms andconditions defined at the inception of an engagement with a client.  The terms of our contracts with clients are fixed and determinable andcan only be changed based on agreement of both parties. Individual consultants’billing rates are principally based on a multiple of salary and compensationcosts.

Revenue for fixed-feearrangements, which span multiple months, is based upon the percentage ofcompletion method.* *Thecompany typically has three types of fixed-fee arrangements:  annual recurring projects, projects of ashort duration, and non-recurring system projects.  Annual recurring projects and the projects ofshort duration are typically straightforward and highly predictable in nature.  As a result, the project manager andfinancial staff are able to identify, as the project status is reviewed andbills are prepared monthly, the occasions when cost overruns could lead to therecording of a loss accrual.

Our non-recurring systemprojects are typically found in our Technology and Administration SolutionsGroup.  They tend to be more complexprojects that are longer in duration and subject to more changes in scope asthe project progresses than projects undertaken in other segments. We evaluateat least quarterly, and more often as needed, project managers’estimates-to-complete to assure that the projects’ current status is accountedfor properly.  Our Technology andAdministration Solutions Group contracts generally provide that if the client terminates a contract,the company is entitled to payment for services performed through termination.

Revenue recognition forfixed-fee engagements is affected by a number of factors that change theestimated amount of work required to complete the project such as changes inscope, the staffing on the engagement and/or the level of clientparticipation.  The periodic engagementevaluations require us to make judgments and estimates regarding the overallprofitability and stage of project completion that, in turn, affect how werecognize revenue.  The company recognizesa loss on an engagement when estimated revenue to be received for thatengagement is less than the total estimated direct and indirect costsassociated with the engagement.  Lossesare recognized in the period in which the loss becomes probable and the amountof the loss is reasonably estimable.  Thecompany has experiencedcertain costs in excess of estimates from time to time.  Management believes that it is rare, however,for these excess costs to result in overall project losses.

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The company has developed various software programsand technologies that we provide to clients in connection with consultingservices.  In most instances, suchsoftware is hosted and maintained by the company and ownership of the technologyand rights to the related code remain with the company.  Software developed to be utilized inproviding services to a client, but for which the client does not have thecontractual right to take possession, is capitalized in accordance with the AICPA’sStatement of Position 98-1 “Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use.” Revenue associated with the related contract, together with amortizationof the related capitalized software, is recognized over the serviceperiod.  As a result we do not recognizerevenue during the implementation phase of an engagement.

Revenue recognized in excess of billings is recordedas unbilled accounts receivable.  Cashcollections and invoices generated in excess of revenue recognized are recordedas deferred revenue until the revenue recognition criteria are met.  Client reimbursable expenses, including thoserelating to travel, other out-of-pocket expenses and any third-party costs, areincluded in revenue, and an equivalent amount of reimbursable expenses are includedin 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 estimatedlosses resulting from our clients’ failure to pay for our services after theservices have been rendered, including allowances when customer disputes mayexist.  The related provision isgenerally recorded as a reduction to revenue. Our allowance policy is based on the aging of our billed and unbilledclient receivables and has been developed based on our write-off history.  Facts and circumstances such as the averagelength of time the receivables are past due, general market conditions, currenteconomic trends and our clients’ ability to pay may cause fluctuations in ourvaluation of billed and unbilled receivables.

* **Discretionary Compensation***

The company’s compensation program includes a discretionary annualbonus that is determined by management and paid once per fiscal year in theform of cash and/or deferred stock units after the company’s annual operatingresults are finalized.

An estimated annual bonus amount is initially developed at thebeginning of each fiscal year in conjunction with our budgeting process.  Quarterly, estimated annual operatingperformance is reviewed by the company and the discretionary annual bonusamount is then adjusted, if necessary, by management to reflect changes in theforecast of pre-bonus profitability for the year. In those quarters where theestimated annual bonus level changes, the remaining estimated annual bonus isaccrued over the remaining quarters as a constant percentage of estimatedfuture pre-bonus profitability.  Annualbonus levels may vary from current expectations as a result of changes in thecompany’s forecast of pre-bonus profitability and competitive employment marketconditions.

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***Income Taxes***

Determining the consolidated provision for income tax expense, deferredtax assets and liabilities and the related valuation allowance involvesjudgment.  As a global company, we arerequired to calculate and provide for estimated income tax liabilities for eachof the tax jurisdictions in which we operate. This process involves estimating current tax obligations and exposuresin each jurisdiction as well as making significant judgments regarding thefuture recoverability of deferred tax assets. The company does not provide deferred taxes on cumulative earnings offoreign subsidiaries that have been reinvested indefinitely as asserted underAccounting Principles Board (APB) 23. Due to the availability of foreign tax credits, it is not practicable toestimate the company’s income tax liability that might be payable if suchearnings were not reinvested indefinitely, however, deferred taxes are providedfor earnings of foreign subsidiaries which the company plans to remit.  Tax costs can involve complex issues and mayrequire an extended period to resolve. Changes in the geographic mix or estimated level of annual pre-taxincome, limitations on the use of the company’s foreign subsidiary losses,changes in tax laws and changes resulting from tax audits can all affect theoverall effective income tax rate which, in turn, impacts the overall level ofincome tax expense and net income.

***Pension Assumptions***

We sponsor both qualified and non-qualified, non-contributory definedbenefit pension plans covering substantially all of our associates.  Under our plans in North America, benefitsare based on the number of years of service and the associates’ compensationduring the five highest paid consecutive years of service.  Under our plan in the U.K., benefits arebased on the number of years of service and the associates’ compensation duringthe three years before leaving the plan. The non-qualified plan, included onlyin North America, provides for pension benefits that would be covered under thequalified plan but are limited by the Internal Revenue Code.  The non-qualified plan is an unfundedarrangement and therefore has no assets. The benefit liability is reflected on the balance sheet.  The measurement date for each of the plans isJune 30.

Determination of ourobligations and annual expense under the plans is based on a number ofassumptions that, given the longevity of the plans, are long-term infocus.  A change in one or a combinationof these assumptions could have a material impact on our pension benefitobligation and related expense.  For thisreason, management employs a long-term view so that assumptions do not changefrequently in response to short-term volatility in the economy.  Any difference between actual and assumedresults is amortized into our pension expense over the average remainingservice period of participating employees. We consider several factors prior to the start of each fiscal year whendetermining the appropriate annual assumptions, including economic forecasts,historical trends, portfolio composition and peer comparisons.

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*NorthAmerica*

The followingassumptions were used at the end of the past three fiscal years in thevaluation of our North American plans:
| ** **                                   | ** ** | **Year Ended June 30** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount rate                                |       | 6.25%                                 |       | 5.25% |   | 6.25% |   |
| Expected  long-term rate of return on assets |       | 8.75%                                 |       | 9.00% |   | 9.00% |   |
| Rate of increase in  compensation levels     |       | 3.84%                                 |       | 3.34% |   | 3.34% |   |

 

The 6.25 percentdiscount rate assumption used at the end of fiscal year 2006 represents a 100basis point increase from the 5.25 percent discount rate used at the end offiscal year 2005 and the same as the discount rate used at the end of fiscalyear 2004.  The company’s 2006 discountrate assumption was determined by matching future pension benefit payments withexpected future U.S. AA corporate bond yields for the same periods.

The expectedlong-term rate of return on assets assumption was 8.75 percent per annum at theend of fiscal year 2006 and represents a 25 basis point reduction from the rateof return used in fiscal years 2005 and 2004. Selection of the returnassumption at 8.75 percent per annum was supported by an analysis performed bythe company of the weighted average yield expected to be achieved with theanticipated makeup of investments.  Theinvestment makeup is heavily weighted towards equities.  The return on assets through the firstquarter of fiscal year 2007 has been 4.1 percent, compared to a return of 1.0percent in the first quarter of fiscal year 2006.

The following information illustrates thesensitivity to a change in certain assumptions for the U.S. pension plans:

| Change in Assumption                        | ** ** | **Effect on FY2007   Pre-Tax Pension Expense** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| 25 basis point  decrease in discount rate             |       | +$3.3  million                                                          |       |
| 25 basis point  increase in discount rate             |       | -$3.2  million                                                          |       |
| 25 basis point  decrease in expected return on assets |       | +$1.0  million                                                          |       |
| 25 basis point increase  in expected return on assets |       | -$1.0 million                                                           |       |

 

Theabove sensitivities reflect the impact of changing one assumption at a time. Itshould be noted that economic factors and conditions often affect multipleassumptions simultaneously and the effects of changes in key assumptions arenot necessarily linear. The company’s U.S. Other Postretirement EmployeeBenefits Plan is relatively insensitive to discount rate changes due to theplan provisions that have been established to control costs and as such nosensitivity results are shown in the table above.

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*United Kingdom*

The followingassumptions were used in the valuation of our U.K. plan at June 30, 2006, July31, 2005, the date of the business combination and April 30, 2005, the formerWWLLP fiscal year end: 
| ** **                                   | ** ** | **Period Ended** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **June 30,**     | ** ** | **July 31,** | ** ** | **April 30,** | ** ** |
| ** **                                   | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount rate                                |       | 5.10%                 |       | 5.00% |   | 5.30% |   |
| Expected  long-term rate of return on assets |       | 5.69%                 |       | 5.63% |   | 5.76% |   |
| Rate of increase in  compensation levels     |       | 4.75%                 |       | 4.75% |   | 4.75% |   |

 

The 5.10 percentdiscount rate assumption used at the end of July 30, 2006 represents a 10 basispoint increase from the discount rate at July 31, 2005. The discount rate isset having regard to yields on European AA corporate bonds at the measurementdate and this increase reflects the change in yields between these two dates.

The expectedlong-term rate of return on assets assumption remained the same from July, 312005 to June 30, 2006 and was supported by an analysis performed by the companyof the weighted average return expected to be achieved given the anticipatedmakeup of investments, which is heavily weighted towards bonds. The return onassets through the first quarter of fiscal year 2007 has been 3.6 percent,compared to a return of 3.0 percent in the first quarter of fiscal year 2006.

The followinginformation illustrates the sensitivity to a change in certain assumptions forthe U.K. pension plans:

| Change in Assumption                        | ** ** | **Effect on FY2007   Pre-Tax Pension Expense** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| 25 basis point  decrease in discount rate             |       | +$1.3  million                                                          |       |
| 25 basis point  increase in discount rate             |       | -$1.2  million                                                          |       |
| 25 basis point  decrease in expected return on assets |       | +$0.5  million                                                          |       |
| 25 basis point increase  in expected return on assets |       | -$0.5 million                                                           |       |

 

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***  Incurred But Not Reported Claims***

The company uses actuarial assumptions to estimate and record aliability for incurred but not reported (IBNR) professional liability claimsand engaged an external actuarial firm to assist in the calculation of theseestimates.  Our estimated IBNR liabilityis 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, but excludes theeffect of claims data for large cases due to the insufficiency of actualexperience with such cases.  Managementdoes not currently expect significant fluctuations in the IBNR liability, basedon the company’s historical claims experience. However, our estimated IBNR liability will fluctuate if claimsexperience changes over time.

**Resultsof Operations**

The table belowsets forth our historical Consolidated Statements of Operations data forcontinuing operations as a percentage of revenue for the periods indicated:

**Consolidated Statementsof Operations**
| ** **                                      | ** ** | **Three months ended September 30** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| Revenue                                         |       | $                                                       | 336,004    |   | $ | 265,886 |   | 100 | % | 100 | % |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| Costs of providing services:                    |       |                                                    |       |   |   |   |   |   |   |
| Salaries and employee benefits                  |       | 185,595                                                 |       | 147,550 |   | 55.2 |   | 55.5 |   |
| Professional and subcontracted services         |       | 20,035                                                  |       | 19,011 |   | 6.0 |   | 7.2 |   |
| Occupancy, communications and other             |       | 40,951                                                  |       | 32,853 |   | 12.2 |   | 12.4 |   |
| General and administrative expenses             |       | 38,099                                                  |       | 31,389 |   | 11.3 |   | 11.8 |   |
| Depreciation and amortization                   |       | 12,751                                                  |       | 9,677 |   | 3.8 |   | 3.6 |   |
|                                            |       | 297,431                                                 |       | 240,480 |   | 88.5 |   | 90.5 |   |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| Income from operations                          |       | 38,573                                                  |       | 25,406 |   | 11.5 |   | 9.5 |   |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| (Loss)/income from affiliates                   |       | (229                                                    | )          | 1,351 |   | (0.1 | ) | 0.5 |   |
| Interest expense                                |       | (443                                                    | )          | (876 | ) | (0.1 | ) | (0.3 | ) |
| Interest income                                 |       | 1,450                                                   |       | 788 |   | 0.4 |   | 0.3 |   |
| Other non-operating income/(loss)               |       | 36                                                      |       | (1,862 | ) | — |   | (0.7 | ) |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| Income from continuing operations before  taxes |       | 39,387                                                  |       | 24,807 |   | 11.7 |   | 9.3 |   |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| Provision for income taxes                      |       | 14,573                                                  |       | 10,915 |   | 4.3 |   | 4.1 |   |
|                                            |       |                                                    |       |   |   |   |   |   |   |
| Income from continuing operations               |       | $                                                       | 24,814     |   | $ | 13,892 |   | 7.4 | % | 5.2 | % |

 

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**ThreeMonths Ended September 30, 2006 Compared to the Three Months Ended September30, 2005**

As a result of the August1, 2005 effective date of our acquisition of WWLLP, the quarter ended September30, 2006 reflects the consolidated operating results of the combined companyfor all three months of the quarter, whereas the operating results for thethree months ended September 30, 2005 includes the consolidated operatingresults of Watson Wyatt Limited for the months of August and September 2005.  The analysis below highlights the changesbetween the consolidated statements of operations for the quarters endedSeptember 30, 2006 and 2005 and segregates the effects of the acquisition fromthe company’s results without the impact of Watson Wyatt Limited’s consolidatedresults (the historical company). Following this analysis is a pro formaanalysis which assumes that the combination and consolidation had occurred atthe beginning of each period presented. Management believes that the pro forma analysis provides a moremeaningful comparison of financial results.

*   **Revenue.***

Revenues for the firstquarter of fiscal year 2007 were $336 million, an increase of $70 million, or26 percent, from $266 million in the first quarter of fiscal year 2006.  The business combination was completed onJuly 31, 2005, and therefore, the first quarter of fiscal year 2006 onlyincludes two months of our European operations. Additionally, the British Pound appreciated during the first quarter offiscal year 2007, accounting for $4 million of the revenue increase.  The average exchange rate used to translateour revenues earned in the United Kingdom increased to 1.8735 for the firstquarter of fiscal year 2007 from 1.779 in the first quarter of fiscal year2006. The impact of the U.S. dollar depreciating against other foreigncurrencies resulted in an additional $1 million of revenue.

The increases in thehistorical company segment revenue for the first quarter of fiscal year 2007 ascompared to the first quarter of fiscal year 2006 are due to the additionalmonth of European operations as well as the following:

·                  Benefitsincreased revenues $28.4 million, or 18 percent, over the first quarter offiscal year 2006 due to increased demand from existing clients around plandesign and administration as well as revenues from new clients.

·                  Technologyand Administration Solutions increased revenues $12.0 million, or 48 percent,over the first quarter of fiscal year 2006, largely due to an increase in thenumber of projects that went into service during the fiscal year.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), the company beginsrecognizing revenue after projects go into service.  No revenues are recognized during projectimplementation.  At September 30, 2006,the company had 58 projects in service and 65 projects in implementation.  At September 30, 2005, the company had 18projects in service and 48 projects in implementation.

·                  HumanCapital Group increased revenues $8.1 million, or 26 percent, over the firstquarter fiscal year 2006 primarily due to continuing strong demand forexecutive compensation consulting.

·                  Insuranceand Financial Services increased revenues $11.0 million, or 72 percent, overfirst quarter fiscal year 2006 primarily due to an increase in project work aswell as an expansion of our operations in Amsterdam.

·                  InvestmentConsulting increased revenues $11.0 million, or 67 percent, over the firstquarter of fiscal year 2006 due to an increase in the number of associatesworking in this practice combined with an overall strong demand for ourservices, especially advice related to structured products.

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***Salariesand Employee Benefits*.**

Salaries and employeebenefit expenses for the first quarter of fiscal year 2007 were $185.6 millioncompared to $147.6 million for the first quarter of fiscal year 2006, anincrease of $38.0 million or 25.8 percent. The increase was mainly due to the additional salary and benefitexpenses of $28.5 million related to the business combination.  The increase in the historical company wasdue to higher salaries and benefits of $6.5 million, higher accrual fordiscretionary compensation of $1.2 million, and increased benefit expense of$1.3 million. Also included is less capitalization of $3.3 million related tothe capitalization of time spent customizing in-house administration systems inaccordance with AICPA’s Statement of Position 98-1, “Accounting for the Costsof Computer Software Developed or Obtained for Internal Use”. Additionally, adecrease in pension expense of $2.9 million partially offsets the increase insalaries and employee benefits. As a percentage of revenue, salaries andemployee benefits decreased to 55.2 percent from 55.5 percent.

*** Professional and Subcontracted Services*.**

Professional andsubcontracted services used in consulting operations for the first quarter offiscal year 2007 were $20.0 million, compared to $19.0 million for the first quarterof fiscal year 2006, an increase of $1.0 million or 5.4 percent.  The increase is attributable to higherreimbursable expenses related to the business combination of $2.7 million,partially offset by a decrease of $1.7 million of reimbursable expenses relatedto the historical company. As a percentage of revenue, professional andsubcontracted services decreased to 6.0 percent from 7.2 percent.

*** Occupancy, Communications and Other.***

Occupancy, communicationsand other expenses for the first quarter of fiscal year 2007 were $41.0 millioncompared to $32.9 million for the first quarter of fiscal year 2006, anincrease of $8.1 million or 24.6 percent. The increase is principallyattributable to additional occupancy, communication, and other expense of $7.6million related to the business combination. The increase of $0.5 million in the historical company is due to increasesin miscellaneous expenses such as travel, repairs and maintenance, and dues,offset by decreases in rent and utilities, business tax, equipment rental, andgeneral office.  As a percentage ofrevenue, occupancy, communications and other decreased to 12.2 percent from12.4 percent.

*** General and Administrative Expenses.***

General andadministrative expenses for the first quarter of fiscal year 2007 were $38.1million, compared to $31.4 million for the first quarter of fiscal year 2006,an increase of $6.7 million or 21.4 percent. The increase is mainly due to additional general and administrative expensesof $7.9 million related to the business combination.  The overall decrease in the historicalcompany is primarily due to higher professional services of $0.8 million andincreased salaries and benefits of $0.3 million, offset by a decrease in rentand utilities of $0.4 million and a decrease of $1.8 million in insuranceexpense.  As a percentage of revenue,general and administrative expense decreased to 11.3 percent from 11.8 percent.

*** Depreciation and Amortization.***

Depreciation andamortization for the first quarter of fiscal year 2007 was $12.8 million,compared to $9.7 million for the first quarter of fiscal year 2006, an increaseof $3.1 million or 31.8 percent.  Theincrease is due to additional expense of $1.3 million related to the businesscombination, a $1.1 million increase due to depreciation of internallydeveloped software used to support our Benefits Group and Technology andAdministration Solutions Group, and $0.7 million increase in depreciation onfixed assets.  As a percentage ofrevenue, depreciation and amortization increased to 3.8 percent from 3.6percent.

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*** (Loss)/Income From Affiliates.***

Loss from affiliates forthe first quarter of fiscal year 2007 was $0.2 million, compared to income of$1.4 million for the first quarter of fiscal year 2006, a decrease of $1.6million.  The loss in the first quarterof fiscal year 2007 reflects our portion of PCIC’s results for thequarter.  Income recognized in the firstquarter of fiscal year 2006 includes not only our share of PCIC’s results, butalso our share of results from our European affiliates for the month of July2005, after which time the business combination was consummated.

*** Interest Expense.***

Interest expense for thefirst quarter of fiscal year 2007 was $0.4 million, compared to $0.9 millionfor the first quarter of fiscal year 2006. The decrease in the current period was due to a lower average debtbalance during the first quarter of fiscal year 2007 compared to the sameperiod in fiscal year 2006.

***InterestIncome.***

Interest incomefor the first quarter of fiscal year 2007 was $1.5 million, compared to $0.8million for the first quarter of fiscal year 2006. The increase is mainly dueto a higher average cash balance in the current period compared to the priorperiod.

***OtherNon-Operating Income/(Loss).***

Other non-operating income/(loss) in the first quarter offiscal year 2006 includes a $1.7 million gain recognized by the company on thesale of its New Zealand operations, netted against a loss of $3.6 million on aforeign exchange forward contract entered into in conjunction with the businesscombination.

*** Provision for Income Taxes.***

Provision for incometaxes for the first three months of fiscal year 2007 was $14.6 million,compared to $10.9 million for the first three months of fiscal year 2006. Oureffective tax rate was 37.0 percent for the first three months of fiscal year2007 and 44.0 percent for the first three months of fiscal year 2006.  The tax rate decrease is due to the geographicmix of income and the release of tax reserves. The company has not provided U.S. deferred taxes on cumulative earningsof foreign subsidiaries that have been reinvested indefinitely, which alsoincludes foreign subsidiaries affiliated with our recent combination withWWLLP.  We record a tax benefit onforeign net operating loss carryovers and foreign deferred expenses only if itis more likely than not that a benefit will be realized.

*** Income From Continuing Operations.***

Income from continuingoperations for the first quarter of fiscal year 2007 was $24.8 million,compared to $13.9 million for the first quarter of fiscal year 2006.  As a percentage of revenue, income fromcontinuing operations increased to 7.4 percent from 5.2 percent.

*** Earnings Per Share, Income From ContinuingOperations.***

Diluted earnings pershare, income from continuing operations for the first quarter of fiscal year2007 was $0.56, compared to $0.36 for the first quarter of fiscal year2006.    The diluted earnings per sharecalculation for the quarter ended September 30, 2006 assumes that the 1,950,000contingent shares related to the business combination had been issued andoutstanding for the entire quarter.

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**Pro FormaStatement of Operations**

For a more meaningful comparison of financial results,the following table presents the company’s unaudited results for the threemonths ended September 30, 2006 compared with the unaudited pro forma resultsfor the three months ended September 30, 2005, as if the combination andconsolidation had occurred at the beginning of each period.  The diluted earnings per share calculation inthis pro forma analysis assumes that the 1,950,000 shares related to thebusiness combination had been issued at the beginning of each period.

In our opinion,information for the three months ended September 30, 2006 and the pro formaresults for the three months ended September 30, 2005 contain all adjustments,consisting only of normal recurring adjustments necessary to fairly presentthis information. Operating results for any period are not necessarilyindicative of results for any future periods. The unaudited pro forma combinedincome statement is presented for illustrative purposes only and is notindicative of the results of operations that might have occurred had thecombination actually taken place as of the dates specified, or that may beexpected to occur in the future.

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** **

**Pro FormaCombined Statements of Operations**(in thousands, except per share data)
| ** **                                              | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                              | ** ** | **2006  Historical**                                    | ** ** | **2005  Pro forma** | ** ** | **Increase  (Decrease)** | ** ** | **%** | ** ** |
| ** **                                              | ** ** | **(Unaudited)**                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                 |       | $                                                       | 336,004    |   | $ | 302,329 |   | $ | 33,675 |   | 11.1 | % |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Costs of  providing services:                           |       |                                                    |       |   |   |   |   |   |   |
| Salaries and employee benefits                          |       | 185,595                                                 |       | 170,221 |   | 15,373 |   | 9.0 |   |
| Professional and subcontracted services                 |       | 20,035                                                  |       | 19,695 |   | 339 |   | 1.7 |   |
| Occupancy, communications and other                     |       | 40,951                                                  |       | 37,950 |   | 3,001 |   | 7.9 |   |
| General and administrative expenses                     |       | 38,099                                                  |       | 36,817 |   | 1,282 |   | 3.5 |   |
| Depreciation and amortization                           |       | 12,751                                                  |       | 10,983 |   | 1,768 |   | 16.1 |   |
|                                                    |       | 297,431                                                 |       | 275,666 |   | 21,764 |   | 7.9 |   |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Income from  operations                                 |       | 38,573                                                  |       | 26,663 |   | 11,910 |   | 44.7 |   |
| (Loss)/income  from affiliates                          |       | (229                                                    | )          | 828 |   | (1,057 | ) | (127.7 | ) |
| Interest income  (expense), net                         |       | 1,007                                                   |       | (838 | ) | 1,845 |   | 220.2 |   |
| Other  non-operating income                             |       | 36                                                      |       | 1,740 |   | (1,704 | ) | (97.9 | ) |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Income from continuing  operations before income taxes  |       | 39,387                                                  |       | 28,393 |   | 10,994 |   | 38.7 |   |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Provision for income  taxes                             |       | 14,573                                                  |       | 12,493 |   | 2,080 |   | 16.6 |   |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Income from continuing  operations                      |       | $                                                       | 24,814     |   | $ | 15,900 |   | $ | 8,914 |   | 56.1 | % |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Basic earnings per share:                               |       | $                                                       | 0.59       |   | $ | 0.38 |   | $ | 0.21 |   | 55.3 | % |
| Diluted earnings per  share:                            |       | $                                                       | 0.56       |   | $ | 0.36 |   | $ | 0.20 |   | 55.6 | % |
|                                                    |       |                                                    |       |   |   |   |   |   |   |
| Weighted average  shares of common stock, basic (000)   |       | 42,396                                                  |       | 41,871 |   | 525 |   | 1.3 | % |
| Weighted average shares  of common stock, diluted (000) |       | 44,388                                                  |       | 44,075 |   | 313 |   | 0.7 | % |

 

The pro forma informationfor the quarter ended September 30, 2005 excludes, in Other non-operatingincome, a loss of $3.6 million on a foreign exchange forward contract enteredinto in conjunction with the business combination with WWLLP.

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*   **Revenue.***

Revenuesfor the first quarter of fiscal year 2007 were $336 million, an increase of $34million, or 11 percent, from $302 million in the first quarter of fiscal year2006. The British Pound appreciated during the first quarter of fiscal year2007 and resulted in $6 million of the revenue increase. The average exchangerate used to translate our revenues earned in the United Kingdom increased to1.8735 for the first quarter of fiscal year 2007 from 1.779 in the firstquarter of fiscal year 2006. The impact of the U.S. dollar depreciating againstother foreign currencies resulted in an additional $1 million of revenues.

Theincreases in our segment revenue for the first quarter of fiscal year 2007 ascompared to the first quarter of fiscal year 2006 are as follows:

·                  Benefitsincreased revenues $9.6 million, or 5 percent, over the first quarter of fiscalyear 2006 due to increased demand from existing clients around plan design andadministration as well as revenues from new clients.

·                  Technologyand Administration Solutions increased revenues $7.4 million, or 25 percent,over the first quarter of fiscal year 2006, largely due to an increase in thenumber of projects that went into service during the fiscal year.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), the company beginsrecognizing revenue after projects go into service.  No revenues are recognized during projectimplementation.  At September 30, 2006,the company had 58 projects in service and 65 projects in implementation.  At September 30, 2005, the company had 18projects in service and 48 projects in implementation.

·                  HumanCapital Group increased revenues $5.9 million, or 17 percent, over the firstquarter of fiscal year 2006 primarily due to continuing strong demand forexecutive compensation consulting.

·                  Insuranceand Financial Services increased revenues $3.5 million, or 15 percent, over thefirst quarter of fiscal year 2006 primarily due to an increase in project workas well as an expansion of our operations in Amsterdam.

·                  InvestmentConsulting increased revenues $7.3 million, or 36 percent, over the firstquarter of fiscal year 2006 due to an increase in the number of associatesworking in this practice combined with an overall strong demand for ourservices, especially advice related to structured products.

***Salariesand Employee Benefits*.**

Salaries and employeebenefit expenses for the first quarter of fiscal year 2007 were $185.6 millioncompared to $170.2 million for the first quarter of fiscal year 2006, anincrease of $15.4 million or 9.0 percent. The increase is mainly due to additional salary expense of $8.8 million,higher bonus expense of $4.5 million, higher benefits expense of $1.6 million,the impact of an appreciating British Pound and a decrease in capitalization of$3.3 million related to the capitalization of time spent customizing in-houseadministration systems in accordance with AICPA’s Statement of Position 98-1, “Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use”partially offset by a decrease in pension expense of $4.4 million. As apercentage of revenue, salaries and employee benefits decreased to 55.2 percentfrom 56.3 percent.

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*** Professional and Subcontracted Services*.**

Professional andsubcontracted services expense for the first quarter of fiscal year 2007 were$20.0 million compared to $19.7 million for the first quarter of fiscal year2006, an increase of $0.3 million or 1.7 percent.  As a percentage of revenue, professional andsubcontracted services decreased to 6.0 percent from 6.5 percent.  The increase is mainly due to higher reimbursableexpenses incurred on behalf of clients.

 ***Occupancy, Communicationsand Other.***

Occupancy, communicationsand other expenses for the first quarter of fiscal year 2007 were $41.0 millioncompared to $38.0 million for the first quarter of fiscal year 2006, anincrease of $3.0 million or 7.9 percent. The increase is mainly due to increases in dues, rent and utilities,repairs and maintenance expenses, as well as the impact of an appreciatingBritish Pound, offset by a decrease in business tax expense, duplicating, andequipment rental expense.  As apercentage of revenue, occupancy, communications and other decreased to 12.2percent from 12.6 percent.

*** General and Administrative Expenses.***

General andadministrative expenses for the first quarter of fiscal year 2007 were $38.1million, compared to $36.8 million for the first quarter of fiscal year 2006,an increase of $1.3 million or 3.5 percent. The increase is due to higher professional services fees of $1.5million, increased salaries and benefits of $2.1 million, and an increase in rentexpense of $1.0 million, offset by a decrease of $1.9 million in insurance, a decreasein miscellaneous expenses such as general office and office supplies of $1.4million, as well as the impact of an appreciating British Pound. As apercentage of revenue, general and administrative expenses decreased to 11.3percent from 12.2 percent.

***Depreciationand Amortization.***

Depreciation andamortization for the first quarter of fiscal year 2007 was $12.8 millioncompared to $11.0 million for the first quarter of fiscal year 2006, anincrease of $1.8 million or 16.1 percent. The increase is mainly due todepreciation of internally developed software used to support our Benefits andTechnology and Adminstration Solutions Group. As a percentage of revenue, depreciation and amortization increased to3.8 percent from 3.6 percent.

*** (Loss)/Income From Affiliates.***

Loss from affiliates forthe first quarter of fiscal year 2007 was $0.2 million, compared to income of$0.8 million for the first quarter of fiscal year 2006, a decrease of $1.0million. The decrease was due to our share of operating loss of PCIC.

*** Interest Income/(Expense), net.***

Net interest income forthe first quarter of fiscal year 2007 was $1.0 million compared to net interestexpense of $0.8 million for the first quarter of fiscal year 2006.  The increase in net interest income in thecurrent period was due an increased net investment balance.

*** Other Non-Operating Income.***

Other non-operating income in the first quarter of fiscalyear 2006 includes a $1.7 million gain recognized by the company on the sale ofits New Zealand operations.

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*** Provision for Income Taxes.***

Provision for incometaxes for the first three months of fiscal year 2007 was $14.6 million,compared to $12.5 million for the first three months of fiscal year 2006. Oureffective tax rate was 37.0 percent for the first three months of fiscal year2007 and 44.0 percent for the first three months of fiscal year 2006.  The tax rate decrease is due to thegeographic mix of income and the release of tax reserves. The company has notprovided U.S. deferred taxes on cumulative earnings of foreign subsidiariesthat have been reinvested indefinitely, which also includes foreignsubsidiaries affiliated with our recent combination with WWLLP.  We record a tax benefit on foreign netoperating loss carryovers and foreign deferred expenses only if it is morelikely than not that a benefit will be realized.

*** Income From Continuing Operations.***

Income from continuingoperations for the first quarter of fiscal year 2007 was $24.8 million,compared to $15.9 million for the first quarter of fiscal year 2006.  As a percentage of revenue, income fromcontinuing operations increased to 7.4 percent from 5.3 percent.

*** Earnings Per Share, Income From ContinuingOperations.***

Diluted earnings pershare, income from continuing operations for the first quarter of fiscal year2007 was $0.56, compared to $0.36 for the first quarter of fiscal year 2006. The diluted earnings per share calculationassumes that the 1,950,000 contingent shares related to the businesscombination have been issued and outstanding since the beginning of each fiscalyear presented.

**Liquidity and Capital Resources**

The followinganalysis is based on the company’s historical consolidated financialstatements.

Our cash and cashequivalents at September 30, 2006 totaled $63.4 million, compared to $165.3million at June 30, 2006.  The decreasein cash from June 30, 2006 to September 30, 2006 was mainly attributable to thepayment of previously accrued discretionary compensation which totaledapproximately $85 million during the first three months of fiscal year 2007. Wealso paid $13.0 million in corporate taxes, $9.0 million in capitalexpenditures and $3.2 million in dividends during the quarter.  These outflows of cash were funded by cashflow from current consulting operations, from existing cash balances and fromborrowings under our revolving credit facility. Consistent with the company’s liquidity position, management considersvarious alternative strategic uses of cash reserves including acquisitions,dividends and stock buybacks, or any combination of these options. The companybelieves that it has sufficient resources to fund operations through the nexttwelve months.

Our non U.S. operationsare substantially self-sufficient for their working capital needs.  At September 30, 2006, $48.7 million of thetotal cash balance of $63.4 million was held outside of North America, which wehave the ability to utilize, if necessary. There are no significantrepatriation restrictions other than local or U.S. taxes associated withrepatriation.

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*** Cash Used in Operating Activities.***

Cash used in operatingactivities for the first three months of fiscal year 2007 was $62.6 million,compared to cash used in operating activities of $41.6 million for the firstthree months of fiscal year 2006.  The differenceis primarily attributable to accrued discretionary compensation and to anincrease in our accounts receivable balance.

The allowance fordoubtful accounts increased $2.9 million from June 30, 2006 to September 30,2006. The number of days of accounts receivable and work in process outstandingwas 86 at September 30, 2006, compared to 83 at June 30, 2006.

*** Cash Used in Investing Activities.***

Cash used in investingactivities for the first three months of fiscal year 2007 was $15.6 million,compared to $148.0 million used in investing activities for the first threemonths of fiscal year 2006.  Thedifference can be primarily attributed to acquisition and contingentconsideration payments of $133.2 million in the first quarter of fiscal year2006.

Expenditures of capitalfunds were $9.0 million for the first three months of fiscal year 2007.  Anticipated commitments of capital funds areestimated at $40 million for the remainder of fiscal year 2007. We expect cashfrom operations to adequately provide for these cash needs.

***  Cash (Used in)/From Financing Activities.***

Cash used in financingactivities for the first quarter of fiscal year 2007 was $24.6 million,compared to cash from financing activities of $92.6 million for the firstquarter of fiscal year 2006.  This changeis primarily attributable to activity under our credit facility which includedborrowings of $102 million in the first quarter of fiscal year 2006 compared toa net repayment of $5 million in the first quarter of fiscal year 2007.  Additionally, during the first quarter offiscal year 2007, the company repurchased $20 million of common stock, whereasno common stock was repurchased during the same period in fiscal year 2006, andthe company made a one-time payment of $8.4 million under a forward contract infiscal year 2006.

**Off-BalanceSheet Arrangements and Contractual Obligations**
| ** **                                                          | ** ** | **Remaining payments due by fiscal year as of September 30, 2006** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| **Contractual Cash Obligations (in thousands)** | ** ** | **Total**                                                                                                            | ** ** | **Remaining  2007** | ** ** | **2008  through  2009** | ** ** | **2010  through  2011** | ** ** | **Thereafter** | ** ** |
| Lease  commitments                                                  |       | $                                                                                                                    | 365,546    |   | $ | 41,164 |   | $ | 97,566 |   | $ | 80,401 |   | $ | 146,415 |   |
| Revolving Credit  Facility                                          |       | 25,000                                                                                                               |       | 25,000 |   | — |   | — |   | — |   |
| Total                                                               |       | $                                                                                                                    | 390,546    |   | $ | 66,164 |   | $ | 97,566 |   | $ | 80,401 |   | $ | 146,415 |   |

 

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***OperatingLeases.***  We leaseoffice space, furniture and selected computer equipment under operating leaseagreements with terms ranging from one to ten years. Management has determinedthat there is not a large concentration of leases that will expire in any onefiscal year.  Consequently, managementanticipates that any increase in future rent expense will be mainly marketdriven.

***CreditAgreement. ***The company has a credit facility provided bya syndicate of banks in an aggregate principal amount of $300 million.  Interest rates associated with this facilityvary with LIBOR and/or the Prime Rate and are based on our leverage ratio, asdefined by the credit agreement.  We arecharged a quarterly commitment fee, currently 0.15 percent of the facility,which varies with our financial leverage and is paid on the unused portion ofthe credit facility.  Borrowings underthis facility were $25 and $102 million as of September 30, 2006 and 2005,respectively.  Credit under the facilityis available upon demand, although the credit facility requires us to observecertain covenants (including requirements for minimum net worth, which act torestrict dividends, cash flow leverage ratio and a fixed coverage charge) andis collateralized with a pledge of stock of material subsidiaries.  We were in compliance with all covenantsunder the credit facility as of September 30, 2006. This facility is scheduledto mature on June 30, 2010.

Aportion of the revolving facility is used to support required letters of creditissued under the credit line.  As aresult, $10.6 million of the facility was unavailable for operating needs as ofSeptember 30, 2006.  We are also chargeda fee for outstanding letters of credit that also fluctuates based on ourleverage ratio.

***PensionContributions.*** Contributions to our various pension plans for fiscal year 2007 areprojected to be approximately $28.0 million.

***Guarantees***

*Wellspring Leases*.  The company continues to guarantee threeleases for office premises for Wellspring. At September 30, 2006, minimum remaining payments guaranteed under theseleases, which expire at various dates through 2007, totaled $2.5 million,excluding anticipated future sublease income. All income or expense associated with the guaranteed leases is reflectedin discontinued operations in the Statement of Operations.

*Business Combination*.  OnJuly 31, 2005, the company acquired substantially all the assets and assumedmost liabilities of WWLLP, the company’s long-time alliance partner.  The company entered into indemnityarrangements with WWLLP relating to the acquisition and also agreed thatcertain indemnity obligations relating to the alliance arrangements willcontinue after the business combination. In the business combination agreement, Watson Wyatt Limited, the company’sprincipal U.K. subsidiary, has agreed to indemnify WWLLP against liabilitiesarising with respect to certain liabilities assumed in the business combinationby Watson Wyatt Limited and also with respect to certain tax liabilities.

Aspart of the original alliance arrangements in 1995, the company sold itsthen-existing businesses in the U.K. and Europe to the predecessor of WWLLP orits subsidiaries.  The company agreed toindemnify the buyers against liabilities arising with respect to prior acts oromissions of the businesses transferred. Furthermore, the company agreed to indemnify WWLLP against liabilitiesarising with respect to acts or omissions of the company and its subsidiariesduring the alliance arrangements.  Theseindemnities will continue following the business combination.

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Thecompany is unable to estimate an amount of any potential future payments underthese arrangements because the occurrence of any of the events to which theindemnities apply is entirely speculative and the amount of any payment woulddepend upon the nature of the event triggering such indemnity. Managementbelieves that any potential for payment under such indemnities should declinewith the passage of time.  The companyhas insurance to cover liabilities arising from acts or omissions by thecompany and its subsidiaries, and such insurance may cover some or all of itsindemnity obligations relating to prior acts or omissions.  Except for such insurance, there are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that the company as indemnitor can liquidate to recover amounts paidunder such indemnities.

Inconnection with our business combination, payment of an additional 1,950,000shares of the company’s common stock to the former partners of WWLLP after June30, 2007, is contingent upon the achievement by the acquired business ofagreed-upon financial performance goals. The value of all the contingent stockwas $88.0 million based on the NYSE closing price on October 31, 2006. Thecontingent consideration is payable by Watson Wyatt Limited and the paymentobligations are guaranteed by Watson Wyatt Worldwide, Inc.

Underthe business combination agreement, Watson Wyatt Limited is obligated to makepayments to members of WWLLP representing profits and tax payments relating toperiods before the closing date of the transaction. The company has guaranteedthese obligations and has reflected them on the company’s consolidatedfinancial statements as of September 30, 2006.

**RiskManagement**

Asa part of our overall risk management program, we carry customary commercialinsurance policies, including commercial general liability, employmentpractices liability, and claims-made professional liability insurance with aself-insured retention of $1 million per claim, which provides coverage forprofessional liability claims of the company and its subsidiaries, includingthe cost of defending such claims.  Ourprimary insurance coverage beyond this retention is written by an affiliatedcaptive insurance company (PCIC) owned by us and two other professionalservices firms.

Informulating its premium structure, PCIC estimates the amount it expects to payfor losses (and loss expenses) for all the members as a whole and thenallocates that amount to the member firms based on the individual member’sexpected losses.  PCIC bases premiumcalculations, which are determined annually based on experience through Marchof each year, on relative risk of the various lines of business performed byeach of the owner companies, past claim experience of each owner company,growth of each of those companies, industry risk profiles in general and theoverall insurance markets.  As of July 1,2006, the captive insurance company carries reinsurance for 90% of losses it insuresabove $25 million.

Ouragreements with PCIC could require additional payments to PCIC in the eventthat the company decided to exit PCIC and adverse claims significantly exceedprior expectations.  If thesecircumstances were to occur, the company would record a liability at the timeit becomes estimable and probable.

Thecompany will continue to provide for the self-insured retention where specificestimated losses and loss expenses for known claims in excess of $1 million areconsidered probable and reasonably estimable.

Althoughthe company maintains professional liability insurance coverage, this insurancedoes not cover claims made after expiration of our current insurancecontracts.  Generally accepted accountingprinciples require that we record a liability for incurred but not reported(IBNR) professional liability claims if they are estimable and probable, andfor which we have not yet contracted for insurance coverage.  The company uses actuarial assumptions toestimate and record its IBNR liability and has a $34.3 million IBNR liabilityrecorded as of September 30, 2006.

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Recentinsurance market conditions for our industry include increases in overallpremium cost, higher self-insured retentions and constraints on aggregateexcess coverages, trends that are anticipated to continue.  We expect these recent conditions to recurperiodically and to be reflected in our future annual insurance renewals.  As a result, we will continue to assess ourability to secure future insurance coverage and we cannot assure that suchcoverage will continue to be available indefinitely in the event of specificadverse claims experience, adverse loss trends, market capacity constraints orother factors.  In anticipation of thepossibility of future reductions in risk transfer from PCIC to re-insurers, aswell as the hardening insurance market conditions in recent years, the firmsthat own PCIC, including the company, have increased PCIC’s capital over thepast couple of years, with the most recent capital contributions being made inJuly 2005 in the form of $1.5 million in cash and a letter of credit for $3.1million.

Inlight of increasing worldwide litigation, including litigation againstprofessionals, the company has implemented a requirement that all clientrelationships be documented by engagement letters containing specific riskmitigation clauses that were not included in all historical clientagreements.  Nearly 100 percent of thecompany’s U.S.****and U.K.****corporateclients have signed engagement letters including mitigation clauses, andinitiatives to maintain that process in the United States and the UnitedKingdom and complete it elsewhere are underway. The company has disengaged from certain client relationships wheresatisfactory engagement terms could not be achieved.

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**DisclaimerRegarding Forward-looking Statements**

This filingcontains certain statements that are “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995, including, butnot limited to the following: Note 5 -  Retirement Benefits; Note 6 — Goodwill andIntangible Assets; Note 11 — Guarantees; Note 12 — Contingent Liabilities; theExecutive Overview; Critical Accounting Policies and Estimates; the discussionof our capital expenditures; Off-Balance Sheet Arrangements and ContractualObligations; Risk Management; and Part II, Item 1 “Legal Proceedings”.  You can identify these statements and otherforward-looking statements in this filing by words such as “may”, “will,”, “expect”,“anticipate”, “believe”, “estimate”, “plan”, “intend”, “continue”, or similarwords, expressions or the negative of such terms or other comparableterminology. You should read these statements carefully because they containprojections of our future results of operations or financial condition, orstate other “forward-looking” information. A number of risks and uncertaintiesexist which could cause actual results to differ materially from the resultsreflected in these forward-looking statements. Such factors include but are not limited to:

·              ourability to integrate the business of WWLLP into our own business, processes andsystems, and achieve the anticipated results;

·              ourcontinued ability to recruit and retain qualified associates;

·              thesuccess of our marketing, client development and sales programs after thebusiness combination;

·              ourability to maintain client relationships and to attract new clients after thebusiness combination;

·              declinesin demand for our services;

·              outcomesof pending or future litigation and the availability and capacity ofprofessional liability insurance to fund the outcome of pending cases or futurejudgments or settlements;

·              theability of the Company to obtain professional liability insurance;

·              asignificant decrease in the demand for the consulting, actuarial and otherservices we offer as a result of changing economic conditions or other factors;

·              actionsby competitors offering human resources consulting services, including publicaccounting and consulting firms, technology consulting firms and Internet/intranetdevelopment firms;

·              ourability to achieve cost reductions after the business combination;

·              foreigncurrency exchange and interest rate fluctuations;

·              exposureto WWLLP liabilities that have not been expressly assumed;

·              generaleconomic and business conditions that adversely affect us or our clients;

·              thelevel of capital resources required for future acquisitions and businessopportunities;

·              regulatorydevelopments abroad and domestically that impact our business practice;

·              legislativeand technological developments that may affect the demand for or costs of ourservices;

and other factorsdiscussed under “Risk Factors” in the company’s 2006 Annual Report on Form 10-Kfiled with the SEC on September 1, 2006. These statements are based on assumptions that may not come true.  All forward-looking disclosure is speculativeby its nature.  The Company undertakes noobligation to update any of the forward-looking information included in thisreport, whether as a result of new information, future events, changedexpectations or otherwise.

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**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

We are exposed to market risks in the ordinary course ofbusiness.  These risks include interestrate risk, foreign currency exchange and translation risk.

**Interest Rate Risk**

The primary objective of our investment activities is topreserve principal while at the same time maximizing yields without significantlyincreasing risk. To achieve this objective, we maintain our portfolio in mainlyshort term securities that are recorded on the balance sheet at fair value.

**ForeignCurrency Risk**

International net revenues result from transactions byour foreign operations and are typically denominated in the local currency ofeach country. These operations also incur most of their expenses in the localcurrency. Accordingly, our foreign operations use the local currency, as theirfunctional currency and our primary international operations use the Britishpound. Our international operations are subject to risks typical ofinternational operations, including, but not limited to, differing economicconditions, changes in political climate, differing tax structures, otherregulations and restrictions, and foreign exchange rate volatility.Accordingly, our future results could be adversely impacted by changes in theseor other factors.

**TranslationExposure**

Foreign exchange rate fluctuations may adversely impactour consolidated financial position as well as our consolidated results ofoperations and may adversely impact our financial position as the assets andliabilities of our foreign operations are translated into U.S. dollars inpreparing our consolidated balance sheet. Additionally, foreign exchange ratefluctuations may adversely impact our consolidated results of operations asexchange rate fluctuations on transactions denominated in currencies other thanour functional currencies result in gains and losses that are reflected in our consolidatedstatement of income.

We consolidate our international subsidiaries byconverting them into U.S. dollars in accordance with Statement of FinancialAccounting Standards No. 52, “Foreign Currency Translation” (FAS 52). Theresults of operations and our financial position will fluctuate when there is achange in foreign currency exchange rates.

**ITEM4.  CONTROLS AND PROCEDURES.**

**Evaluationof Disclosure Controls and Procedures**

An evaluation was performed under the supervision andwith the participation of our management, including the chief executiveofficer, or CEO, and chief financial officer, or CFO, of the effectiveness ofthe design and operation of our disclosure controls and procedures. Based onthat evaluation, our management, including the CEO and CFO, concluded that ourdisclosure controls and procedures were effective as of September 30, 2006.

**Changes in Internal Control OverFinancial Reporting**

There were no significantchanges in our internal control over financial reporting in the quarter endedSeptember 30, 2006 that materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

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**Limitations on the Effectiveness of Controls**

Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures will necessarily prevent all error and all fraud.  However, our management does expect that the control system provides reasonable assurance that its objectives will be met.  A control system, no matter how well designed and operated, cannot provide absolute assurance that the control system’s objectives will be met.   In addition, the design of such internal controls must take into account the costs of designing and maintaining such a control system.  Certain inherent limitations exist in control systems to make absolute assurances difficult, including the realities that judgments in decision-making can be faulty, that breakdowns can occur because of a simple error or mistake, and that individuals can circumvent controls.  The design of any control system is based in part upon existing business conditions and risk assessments. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Over time, controls may become inadequate because of changes in business conditions or deterioration in the degree of compliance with policies or procedures.  As a result, they may require change or revision.  Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and may not be detected.  Nevertheless, the disclosure controls and procedures are designed to provide reasonable assurance of achieving their stated objectives, and the CEO and CFO have concluded that the disclosure controls and procedures are effective at a reasonable assurance level.

**PARTII.  OTHER INFORMATION**

**ITEM1.  LEGAL PROCEEDINGS.**

From time to time, we area party to various lawsuits, arbitrations or mediations that arise in the ordinarycourse of business. The disclosure called for by Part II, Item 1, regarding ourlegal proceedings is incorporated by reference herein from Note 12 “ContingentLiabilities,” of the Notes to the Consolidated Financial Statements in thisForm 10-Q for the quarter ending September 30, 2006.

**ITEM1A.  RISK FACTORS.**

There are no materialchanges from risk factors as previously disclosed in our 2006 Annual Report onForm 10-K (File No. 001-16159) filed on September 1, 2006.

**ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS.**

The company did not engage in any unregistered sales of equitysecurities during the quarter.

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**Issuer Purchases of Equity Securities**

The table below presents specified information aboutthe company’s stock repurchases and repurchase plans:
| **Period**                                         | ** ** | **Total Number of  Shares Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of  Shares Purchased  as Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum Number of  Shares that May Yet  Be Purchased Under  the Plans or Programs** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1, 2006  through July 31, 2006                |       | —                                               |       | $                                                | —     |                                                                                                                             | —     |                                                                                                                                    | 413,534    |   |
| August 1, 2006  through August 31, 2006            |       | 36,800                                               |       | 38.23                                            |       | 36,800                                                                                                                           |       | 376,734                                                                                                                                 |       |
| September 1,  2006 through September 30, 2006 |       | 463,200                                              |       | 40.28                                            |       | 463,200                                                                                                                          |       | 1,413,534                                                                                                                               |       |
| Total                                              |       | 500,000                                              |       |                                             |       | 500,000                                                                                                                          |       |                                                                                                                                    |       |
|                                                    |            |                                                      |            |                                                  |            |                                                                                                                                  |            |                                                                                                                                         |            |  |

 

In addition, during thefirst quarter of fiscal year 2007, the company’s Board of Directors approvedthe repurchase of up to 1,500,000 shares of our Class A common stock. Sharesthat the company repurchases are primarily issued in connection with thecompany’s employee benefit plans.

**ITEM3.  DEFAULTS UPON SENIOR SECURITIES.**

**None.**

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.**

None.

**ITEM 5.OTHER INFORMATION.**

None.

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**ITEM 6.EXHIBITS.**
| 21   |   | Subsidiaries of Watson Wyatt Worldwide, Inc.                                                                                                                                      |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1 |   | Certification of Chief Executive Officer Pursuant to  Securities Exchange Act Rules 13a-14 and 15d-14, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1)        |
| 31.2 |   | Certification of Chief Financial Officer Pursuant to  Securities Exchange Act Rules 13a-14 and 15d-14, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1)        |
| 32   |   | Certification of Chief Executive Officer and Chief  Financial Officer Pursuant to Title 18, U.S.C. Section 1350, adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002(1) |

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(1)   Filed with this Form 10-Q

 

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**Signatures**

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

Watson Wyatt Worldwide,Inc.(Registrant)
| /s/ John J. Haley   |   | November 9, 2006        |
|---------------------|--------|-------------------------|
| Name:               |   | John J. Haley           |   | Date |
| Title:              |   | President and           |   |   |
|                |   | Chief Executive Officer |   |   |
|                |   |                    |   |   |
|                |   |                    |   |   |
| /s/ Carl D. Mautz   |   | November 9, 2006        |
| Name:               |   | Carl D. Mautz           |   | Date |
| Title:              |   | Vice President and      |   |   |
|                |   | Chief Financial Officer |   |   |
|                |   |                    |   |   |
|                |   |                    |   |   |
| /s/ Peter L. Childs |   | November 9, 2006        |
| Name:               |   | Peter L. Childs         |   | Date |
| Title:              |   | Controller              |   |   |

 

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