**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

 

**FORM 10-Q**

**(Mark One)**

 

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

 

**                                                Forthe quarterly period ended December 31, 2006**

** **

**OR**

 

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

 

**                                                Forthe transition period from                         to                        **

** **

**Commission File Number:001-16159**

** **

**WATSON WYATT WORLDWIDE, INC.**

(Exact name of Registrant as 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 ofJanuary 31, 2007.

|                                                 | Class  |               |   |   | Outstanding at January  31, 2007 |   |
|-------------------------------------------------|--------|--------------------|--------|--------|----------------------------------|--------|
| Class A Common  Stock, $.01 par value per share |   | 42,367,956  shares |

 

 

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**WATSONWYATT WORLDWIDE, INC.INDEX TO FORM 10-Q****For the Three and Six Months Ended December 31, 2006
| PART I.        |   | FINANCIAL INFORMATION                                                                                    |   |   |   |
|----------------|--------|----------------------------------------------------------------------------------------------------------|--------|--------|--------|
|           |   |                                                                                                     |   |   |   |
| Item  1.       |   | Consolidated Financial  Statements (Unaudited)                                                           |   |   |   |
|           |   |                                                                                                     |   |   |   |
|           |   | Consolidated Statements of Operations—Three and Six  Months Ended  December 31, 2006 and 2005       |   | 1      |   |
|           |   |                                                                                                     |   |   |   |
|           |   | Consolidated  Balance Sheets—December 31, 2006 and June 30, 2006                                    |   | 2      |   |
|           |   |                                                                                                     |   |   |   |
|           |   | Consolidated Statements of Cash Flows—Six Months Ended  December 31, 2006 and 2005                  |   | 3      |   |
|           |   |                                                                                                     |   |   |   |
|           |   | Consolidated Statement of Changes in Stockholders’  Equity—Six Months Ended  December 31, 2006 |   | 4      |   |
|           |   |                                                                                                     |   |   |   |
|           |   | Notes to the Consolidated Financial Statements                                                           |   | 5      |   |
|           |   |                                                                                                     |   |   |   |
| Item 2.        |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations              |   | 23     |   |
|           |   |                                                                                                     |   |   |   |
| Item 3.        |   | Quantitative and Qualitative Disclosures About Market  Risk                                              |   | 48     |   |
|           |   |                                                                                                     |   |   |   |
| Item 4.        |   | Controls and Procedures                                                                                  |   | 48     |   |
|           |   |                                                                                                     |   |   |   |
| PART  II.      |   | OTHER  INFORMATION                                                                                       |   |   |   |
|           |   |                                                                                                     |   |   |   |
| Item  1.       |   | Legal  Proceedings                                                                                       |   | 49     |   |
|           |   |                                                                                                     |   |   |   |
| Item  1A.      |   | Risk  Factors                                                                                            |   | 49     |   |
|           |   |                                                                                                     |   |   |   |
| Item 2.        |   | Unregistered Sales of Equity Securities and Use of  Proceeds                                             |   | 49     |   |
|           |   |                                                                                                     |   |   |   |
| Item 3.        |   | Defaults Upon Senior Securities                                                                          |   | 50     |   |
|           |   |                                                                                                     |   |   |   |
| Item 4.        |   | Submission of Matters to a Vote of Security Holders                                                      |   | 50     |   |
|           |   |                                                                                                     |   |   |   |
| Item  5.       |   | Other  Information                                                                                       |   | 53     |   |
|           |   |                                                                                                     |   |   |   |
| Item 6.        |   | Exhibits                                                                                                 |   | 54     |   |
|           |   |                                                                                                     |   |   |   |
| Signatures     |   |                                                                                                     |   | 55     |   |
|           |   |                                                                                                     |   |   |   |
| Certifications |   |                                                                                                     |   | 60     |   |

 

----

 

**WATSONWYATT WORLDWIDE, INC.Consolidated Statements of Operations**(Thousands of U.S. Dollars,Except Per Share Data)

(Unaudited)
| ** **                                                                                                                                            | ** ** | **Three months ended December 31** | ** ** | **Six months ended December 31** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                            | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                                                            | ** ** | ** **                                             | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                                                                                               |       | $                                                      | 366,425    |                                                 | $          | 315,764 |   | $ | 702,429 |   | $ | 581,650 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Costs of providing  services:                                                                                                                         |       |                                                   |       |                                                 |       |   |   |   |   |
| Salaries and  employee benefits                                                                                                                       |       | 201,045                                                |       | 175,207                                              |       | 386,640 |   | 322,757 |   |
| Professional and  subcontracted services                                                                                                              |       | 26,130                                                 |       | 19,595                                               |       | 46,165 |   | 38,606 |   |
| Occupancy,  communications and other                                                                                                                  |       | 45,682                                                 |       | 43,687                                               |       | 86,633 |   | 76,540 |   |
| General and  administrative expenses                                                                                                                  |       | 39,461                                                 |       | 37,206                                               |       | 77,560 |   | 68,595 |   |
| Depreciation and  amortization                                                                                                                        |       | 13,923                                                 |       | 11,132                                               |       | 26,674 |   | 20,809 |   |
|                                                                                                                                                  |       | 326,241                                                |       | 286,827                                              |       | 623,672 |   | 527,307 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Income from operations                                                                                                                                |       | 40,184                                                 |       | 28,937                                               |       | 78,757 |   | 54,343 |   |
| (Loss)/income from  affiliates                                                                                                                        |       | (638                                                   | )          | 71                                                   |       | (867 | ) | 1,422 |   |
| Interest expense                                                                                                                                      |       | (589                                                   | )          | (1,482                                               | )          | (1,032 | ) | (2,359 | ) |
| Interest income                                                                                                                                       |       | 762                                                    |       | 508                                                  |       | 2,212 |   | 1,297 |   |
| Other non-operating  income/(loss)                                                                                                                    |       | 68                                                     |       | (288                                                 | )          | 104 |   | (2,150 | ) |
| Income from continuing  operations before income taxes                                                                                                |       | 39,787                                                 |       | 27,746                                               |       | 79,174 |   | 52,553 |   |
| Provision for income  taxes                                                                                                                           |       | 13,793                                                 |       | 10,571                                               |       | 28,366 |   | 21,486 |   |
| Income from continuing  operations                                                                                                                    |       | 25,994                                                 |       | 17,175                                               |       | 50,808 |   | 31,067 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Discontinued  operations:                                                                                                                             |       |                                                   |       |                                                 |       |   |   |   |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Sublease income from  discontinued operations, less applicable income tax expense for the three and  six months ended December 31, 2006 and 2005 |       | —                                                 |       | 8                                                    |       | — |   | 17 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Net income                                                                                                                                            |       | $                                                      | 25,994     |                                                 | $          | 17,183 |   | $ | 50,808 |   | $ | 31,084 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic earnings per share:                                                                                                                             |       |                                                   |       |                                                 |       |   |   |   |   |
| Income from  continuing operations                                                                                                                    |       | $                                                      | 0.61       |                                                 | $          | 0.41 |   | $ | 1.20 |   | $ | 0.77 |   |
| Income from  discontinued operations                                                                                                                  |       | —                                                 |       | —                                               |       | — |   | — |   |
| Net income                                                                                                                                            |       | $                                                      | 0.61       |                                                 | $          | 0.41 |   | $ | 1.20 |   | $ | 0.77 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Diluted earnings per  share:                                                                                                                          |       |                                                   |       |                                                 |       |   |   |   |   |
| Income from  continuing operations                                                                                                                    |       | $                                                      | 0.58       |                                                 | $          | 0.41 |   | $ | 1.14 |   | $ | 0.76 |   |
| Income from  discontinued operations                                                                                                                  |       | —                                                 |       | —                                               |       | — |   | — |   |
| Net income                                                                                                                                            |       | $                                                      | 0.58       |                                                 | $          | 0.41 |   | $ | 1.14 |   | $ | 0.76 |   |
|                                                                                                                                                  |       |                                                   |       |                                                 |       |   |   |   |   |
| Weighted average  shares of common stock, basic (000)                                                                                            |       | 42,407                                                 |       | 42,147                                               |       | 42,401 |   | 40,494 |   |
| Weighted average shares  of common stock, diluted (000)                                                                                          |       | 44,525                                                 |       | 42,391                                               |       | 44,545 |   | 40,748 |   |

 

See accompanying notes 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)

(Unaudited)
| ** **                                                                                                     | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                     | ** ** | **2006**              | ** ** | **2006**          | ** ** |
| **Assets**                                                                                                     |       |                  |       |              |       |
| Cash and cash  equivalents                                                                                     |       | $                     | 68,471     |              | $          | 165,345 |   |
| Receivables from  clients:                                                                                     |       |                  |       |              |       |
| Billed, net of allowances of $6,277 and $3,678                                                                 |       | 212,834               |       | 180,533           |       |
| Unbilled, at estimated net realizable value                                                                    |       | 120,566               |       | 123,044           |       |
|                                                                                                           |       | 333,400               |       | 303,577           |       |
|                                                                                                           |       |                  |       |              |       |
| Deferred income  taxes                                                                                         |       | 3,107                 |       | 567               |       |
| Other current  assets                                                                                          |       | 51,816                |       | 24,158            |       |
| Total current assets                                                                                           |       | 456,794               |       | 493,647           |       |
|                                                                                                           |       |                  |       |              |       |
| Investment in  affiliates                                                                                      |       | 7,573                 |       | 8,564             |       |
| Fixed assets,  net                                                                                             |       | 156,569               |       | 147,738           |       |
| Deferred income  taxes                                                                                         |       | 68,329                |       | 70,417            |       |
| Goodwill                                                                                                       |       | 341,669               |       | 324,041           |       |
| Intangible  assets                                                                                             |       | 193,236               |       | 187,075           |       |
| Other assets                                                                                                   |       | 8,291                 |       | 8,877             |       |
| **Total  Assets**                                                                                              |       | $                     | 1,232,461  |              | $          | 1,240,359 |   |
| ** **                                                                                                     | ** ** | ** **            | ** ** | ** **        | ** ** |
| **Liabilities**                                                                                                | ** ** | ** **            | ** ** | ** **        | ** ** |
| Accounts payable  and accrued liabilities, including discretionary compensation                                |       | $                | 218,610    |              | $     | 288,396 |   |
| Deferred income  taxes                                                                                         |       | —                |       | 168               |       |
| Income taxes  payable                                                                                          |       | 13,960                |       | 7,771             |       |
| Total current liabilities                                                                                      |       | 232,570               |       | 296,335           |       |
|                                                                                                           |       |                  |       |              |       |
| Note payable                                                                                                   |       | —                |       | 30,000            |       |
| Accrued  retirement benefits                                                                                   |       | 168,685               |       | 162,505           |       |
| Deferred rent  and accrued lease losses                                                                        |       | 28,230                |       | 28,982            |       |
| Deferred income  taxes                                                                                         |       | 445                   |       | 480               |       |
| Other noncurrent  liabilities                                                                                  |       | 78,943                |       | 73,296            |       |
| **Total  Liabilities**                                                                                         |       | 508,873               |       | 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 42,430,316 and 42,385,513 outstanding |       | 425                   |       | 425               |       |
| Additional  paid-in capital                                                                                    |       | 386,776               |       | 386,392           |       |
| Treasury stock,  at cost — 83,135 and 77,938 shares                                                       |       | (3,318                | )          | (2,134            | )          |
| Retained  earnings                                                                                             |       | 287,048               |       | 242,599           |       |
| Accumulated  other comprehensive income                                                                        |       | 52,657                |       | 21,479            |       |
| **Total  Stockholders’ Equity**                                                                           |       | 723,588               |       | 648,761           |       |
| **Total  Liabilities and Stockholders’ Equity**                                                           |       | $                     | 1,232,461  |              | $          | 1,240,359 |   |

 

See accompanying notes to theconsolidated financial statements

2

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**WATSONWYATT WORLDWIDE, INC.Consolidated Statements of Cash Flows**(Thousands of U.S. Dollars)

 
| ** **                                                                                 | ** ** | **Six months ended December 31** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                                                                                 | ** ** | **(Unaudited)**                                      | ** ** |
| Cash flows (used  in)/from operating activities:                                           |       |                                                 |       |   |   |
| Net income                                                                                 |       | $                                                    | 50,808     |   | $ | 31,084 |   |
| Adjustments to reconcile net income to net cash  (used in)/from operating activities: |       |                                                 |       |   |   |
| Loss on foreign currency forward contract                                                  |       | —                                               |       | 3,602 |   |
| Provision for doubtful receivables from clients                                            |       | 10,191                                               |       | 4,014 |   |
| Depreciation                                                                               |       | 22,025                                               |       | 17,099 |   |
| Amortization of intangible assets                                                          |       | 4,649                                                |       | 3,710 |   |
| Provision for deferred income taxes                                                        |       | (657                                                 | )          | 11,337 |   |
| Loss/(income) from affiliates                                                              |       | 867                                                  |       | (1,422 | ) |
| Distributions from affiliates                                                              |       | —                                               |       | 1,599 |   |
| Other, net                                                                                 |       | 188                                                  |       | (670 | ) |
| Changes in operating assets and liabilities, net of  business combination                  |       |                                                 |       |   |   |
| Receivables from clients                                                                   |       | (40,013                                              | )          | (14,395 | ) |
| Other current assets                                                                       |       | (18,454                                              | )          | (10,101 | ) |
| Other assets                                                                               |       | 585                                                  |       | (605 | ) |
| Accounts payable and accrued liabilities                                                   |       | (57,618                                              | )          | (33,750 | ) |
| Income taxes payable                                                                       |       | (3,015                                               | )          | (4,181 | ) |
| Accrued retirement benefits                                                                |       | 6,180                                                |       | (3,472 | ) |
| Deferred rent and accrued lease losses                                                     |       | (752                                                 | )          | 1,570 |   |
| Other noncurrent liabilities                                                               |       | 5,950                                                |       | 2,099 |   |
| Cash flows (used in)/from operating activities:                                            |       | (19,066                                              | )          | 7,518 |   |
|                                                                                       |       |                                                 |       |   |   |
| Cash flows used  in investing activities:                                                  |       |                                                 |       |   |   |
| Acquisitions and contingent consideration payments                                         |       | (1,322                                               | )          | (134,137 | ) |
| Purchases of fixed assets                                                                  |       | (18,586                                              | )          | (14,397 | ) |
| Capitalized software costs                                                                 |       | (10,672                                              | )          | (14,982 | ) |
| Proceeds from divestitures                                                                 |       | 104                                                  |       | 1,452 |   |
| Cash flows used in investing activities:                                                   |       | (30,476                                              | )          | (162,064 | ) |
|                                                                                       |       |                                                 |       |   |   |
| Cash flows (used  in)/from financing activities:                                           |       |                                                 |       |   |   |
| Borrowings                                                                                 |       | 35,000                                               |       | 102,000 |   |
| Repayment on borrowings                                                                    |       | (65,000                                              | )          | (27,000 | ) |
| Foreign currency forward contract                                                          |       | —                                               |       | (8,405 | ) |
| Dividends paid                                                                             |       | (6,358                                               | )          | (6,318 | ) |
| Repurchases of common stock                                                                |       | (20,065                                              | )          | (2,470 | ) |
| Tax benefit on exercise of stock options and  employee stock purchase plan                 |       | 1,497                                                |       | 453 |   |
| Issuances of common stock — exercises of stock  options                               |       | 2,030                                                |       | 1,380 |   |
| Issuances of common stock — employee stock purchase  plan                             |       | 3,287                                                |       | 3,333 |   |
| Cash flows (used in)/from financing activities:                                            |       | (49,609                                              | )          | 62,973 |   |
| Effect of exchange  rates on cash                                                          |       | 2,277                                                |       | 3,319 |   |
| Decrease in cash  and cash equivalents                                                     |       | (96,874                                              | )          | (88,254 | ) |
| Cash and cash  equivalents at beginning of period                                          |       | 165,345                                              |       | 168,076 |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                    | 68,471     |   | $ | 79,822 |   |

 

See accompanyingnotes to theconsolidated financial statements

 

3

----

 

**WATSON WYATT WORLDWIDE, INC.Consolidated Statement of Changes in Stockholders’ Equity**(Thousands of U.S.Dollars)

(Unaudited)
| ** **                                                            | ** ** | **Class A**                 | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|------------------|------------|----------------|------------|------------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                            | ** ** | **Common**                       | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Stock**                        | ** ** | ** **       | ** ** | ** **     | ** ** | ** **       | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Outstanding**                  | ** ** | **Class A** | ** ** | **Additional** | ** ** | **Treasury**     | ** ** | ** **   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **(number 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                                                           |       |                             |       |             |       |           |       |             |       | 50,808       |       |              |       | 50,808     |       |
| Additional  minimum pension liability, net of tax                     |       |                             |       |             |       |           |       |             |       |         |       | (236              | )          | (236       | )          |
| Foreign  currency translation adjustment, net of tax                  |       |                             |       |             |       |           |       |             |       |         |       | 31,414            |       | 31,414     |       |
| Total comprehensive  income                                           |       |                             |       |             |       |           |       |             |       |         |       |              |       | 81,986     |       |
| Cash dividends declared                                               |       |                             |       |             |       |           |       |             |       | (6,359       | )          |              |       | (6,359     | )          |
| Repurchases of common  stock                                          |       | (500                             | )          |             |       |           |       | (20,065          | )          |         |       |              |       | (20,065    | )          |
| Issuances of common  stock — employee stock purchase plan shares |       | 87                               |       |             |       | 120            |       | 3,167            |       |         |       |              |       | 3,287      |       |
| Issuances of common  stock — deferred stock units                |       | 301                              |       |             |       | 2,166          |       | 10,000           |       |         |       |              |       | 12,166     |       |
| Issuances of common  stock to outside directors                       |       | 8                                |       |             |       | 60             |       | 225              |       |         |       |              |       | 285        |       |
| Issuances of common  stock — stock options                       |       | 149                              |       |             |       | (3,459         | )          | 5,489            |       |         |       |              |       | 2,030      |       |
| Tax benefit of exercises  of stock options and other                  |       |                             |       |             |       | 1,497          |       |             |       |         |       |              |       | 1,497      |       |
|                                                                  |       |                             |       |             |       |           |       |             |       |         |       |              |       |       |       |
| Balance at December 31, 2006 (Unaudited)                              |       | 42,431                           |       | $                | 425        |           | $          | 386,776          |       | $            | (3,318     | )                 | $          | 287,048    |       | $ | 52,657 |   | $ | 723,588 |   |

 

See accompanying notes 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.  Inthe opinion of management, these consolidated financial statements reflect alladjustments, consisting only of normal recurring adjustments,  which are necessary for a fair presentationof the consolidated financial statements and results for the interimperiods.  All intercompany accounts andtransactions have been eliminated in consolidation. 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.

Our fiscal year 2007began July 1, 2006 and ends June 30, 2007.

The results of operationsfor the six months ended December 31, 2006 are not necessarily indicative ofthe results that can be expected for the entire fiscal year.  The results reflect certain estimates andassumptions made by management including estimated bonuses and anticipated taxliabilities that affect the amounts reported in the consolidated financialstatements and related notes.  Certainprior year amounts have been reclassified to conform to the current year’spresentation.

**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.

The purchase price of $437.0 million consisted of£88.3 million in cash, or $156.1 million at the exchange rate in effect at July 31,2005, the issuance of 9,090,571 shares of the company’s common stock valued at$238.7 million, transaction costs of $20.5 million and additional considerationincluding debt forgiveness and investment elimination.  The shares paid were valued at $26.26 pershare, which was the average of the closing market prices of the company’sstock over five business days beginning with two business days prior to theannouncement date of January 18, 2005 and ending with the two business daysfollowing the announcement date.  Inaddition, a further 1,950,000 shares may be paid as additional considerationafter June 30, 2007, contingent upon the achievement by the acquired businessof certain agreed-upon financial performance goals.  If the contingent shares are issued they willbe accounted for as goodwill.

5

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* *

*Purchase Price Allocation*

The business combination has been accounted for usingthe purchase method of accounting as prescribed in Statement of FinancialAccounting Standards No. 141, “Business Combinations” (“FAS 141”), where theassets acquired and liabilities assumed are recorded at their respective fairvalues as of the combination date.  As ofthe business combination date, the company determined the following estimatedfair values for the proportionate assets purchased and liabilitiesassumed.  The determination of estimatedfair value requires management to make significant estimates and assumptions.The company hired an independent third party to assist in the valuation ofassets.

|                                         | ** ** | **July 31, 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 Group                                 |       | $            | 136,463    |   |
| Technology and  Administration Solutions Group |       | 40,037       |       |
| Human Capital  Group                           |       | 16,071       |       |
| Insurance and  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 a result,changes in fair value associated with the forward contract were required to berecognized in the Consolidated Statement of Operations during the first quarterof fiscal year 2006.  Consequently, aloss of $3.6 million was recognized during the first quarter of fiscal year2006 and included in other non-operating income.

*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 and six month periods ended December 31,2005, giving effect to the combination as if it had been completed on July 1,2005. The unaudited combined statements of operations for the three and sixmonths period ended December 31, 2006 and the three month period ended December31, 2005 reflect the actual financial results of Watson Wyatt as a combinedcompany. The unaudited pro forma combined statements of operations for the sixmonth period ended December 31, 2005 combine the actual financial results forthe combined company from August 1, 2005, the date of combination, throughDecember 31, 2005 with the historical financial results of Watson Wyatt forJuly 2005 and the pro forma historical financial results of WWLLP for July2005. The diluted earnings per share calculation in this pro forma analysisassumes that the 1,950,000 contingent shares related to the businesscombination had been issued at the beginning of each period.

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-FormaCombined Statements of Operations**(in thousands, except per share data)
| ** **                                              | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                              | ** ** | **Historical**                                          | ** ** | **Historical**                                        | ** ** | **%** | ** ** | **Historical** | ** ** | **Pro Forma** | ** ** | **%** | ** ** |
| ** **                                              | ** ** | **2006**                                                | ** ** | **2005**                                              | ** ** | **Change** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                              | ** ** | **(Unaudited)**                                         | ** ** | ** **                                            | ** ** | **(Unaudited)** | ** ** | ** ** | ** ** |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Revenue                                                 |       | $                                                       | 366,425    |                                                  | $          | 315,764 |   | 16.0 | % | $ | 702,429 |   | $ | 618,093 |   | 13.6 | % |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Costs of  providing services:                           |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                          |       | 201,045                                                 |       | 175,207                                               |       | 14.7 |   | 386,640 |   | 345,428 |   | 11.9 |   |
| Professional and subcontracted services                 |       | 26,130                                                  |       | 19,595                                                |       | 33.4 |   | 46,165 |   | 39,290 |   | 17.5 |   |
| Occupancy, communications and other                     |       | 45,682                                                  |       | 43,687                                                |       | 4.6 |   | 86,633 |   | 81,637 |   | 6.1 |   |
| General and administrative expenses                     |       | 39,461                                                  |       | 37,206                                                |       | 6.1 |   | 77,560 |   | 74,023 |   | 4.8 |   |
| Depreciation and amortization                           |       | 13,923                                                  |       | 11,132                                                |       | 25.1 |   | 26,674 |   | 22,115 |   | 20.6 |   |
|                                                    |       | 326,241                                                 |       | 286,827                                               |       |   |   | 623,672 |   | 562,493 |   |   |   |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Income from  operations                                 |       | 40,184                                                  |       | 28,937                                                |       | 38.9 |   | 78,757 |   | 55,600 |   | 41.6 |   |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| (Loss)/income  from affiliates                          |       | (638                                                    | )          | 71                                                    |       | (998.6 | ) | (867 | ) | 899 |   | (196.4 | ) |
| Interest  income/(expense), net                         |       | 173                                                     |       | (974                                                  | )          | 117.8 |   | 1,180 |   | (1,812 | ) | 165.1 |   |
| Other  non-operating income/(loss)                      |       | 68                                                      |       | (288                                                  | )          | 123.6 |   | 104 |   | 1,452 |   | (92.8 | ) |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations before income taxes  |       | 39,787                                                  |       | 27,746                                                |       | 43.4 |   | 79,174 |   | 56,139 |   | 41.0 |   |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Provision for income  taxes                             |       | 13,793                                                  |       | 10,571                                                |       | 30.5 |   | 28,366 |   | 23,064 |   | 23.0 |   |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Income from continuing  operations                      |       | $                                                       | 25,994     |                                                  | $          | 17,175 |   | 51.3 | % | $ | 50,808 |   | $ | 33,075 |   | 53.6 | % |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Basic earnings per  share:                              |       | $                                                       | 0.61       |                                                  | $          | 0.41 |   |   |   | $ | 1.20 |   | $ | 0.82 |   |   |   |
| Diluted earnings per  share:                            |       | $                                                       | 0.58       |                                                  | $          | 0.41 |   |   |   | $ | 1.14 |   | $ | 0.77 |   |   |   |
|                                                    |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Weighted average shares  of common stock, basic (000)   |       | 42,407                                                  |       | 42,147                                                |       |   |   | 42,401 |   | 40,494 |   |   |   |
| Weighted average shares  of common stock, diluted (000) |       | 44,525                                                  |       | 42,391                                                |       |   |   | 44,545 |   | 42,698 |   |   |   |

 

The pro forma information for the six months endedDecember 31, 2005 excludes, in Other non-operating income/(loss), a loss of$3.6 million on a foreign exchange forward contract entered into in conjunctionwith the 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 Americaoperations have been reported on a practice basis and are included in ouroperating segments listed below. We now have five reportable operating segmentsor practice areas as follows:

(1)   BenefitsGroup

(2)   Technologyand Administration Solutions Group

(3)   HumanCapital Group 

(4)   Insuranceand Financial Services Group 

(5)   Investment Consulting 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 reclassified to conform to the currentclassification.

The table below presentsspecified information about reported segments as of and for the three monthsended December 31, 2006:
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  and  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 196,709    |                                                  | $          | 41,504                    |       | $                                              | 45,536     |                              | $          | 26,985    |       | $ | 32,558 |   | $ | 343,291 |   |
| Net operating  income                   |       | 47,923              |       | 10,689                                                |       | 8,322                     |       | 3,261                                          |       | 10,118                            |       | 80,313    |       |
| Receivables                             |       | 208,726             |       | 21,953                                                |       | 45,644                    |       | 28,393                                         |       | 23,526                            |       | 328,242   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                |            |                                   |            |           |            |  |  |  |  |  |  |

 

The table belowpresents specified information about reported segments as of and for the threemonths ended December 31, 2005 as reclassified to reflect the elimination ofthe “Asia-Pacific/Latin America” and “Other” segments:
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  and  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 176,605    |                                                  | $          | 37,017                    |       | $                                              | 38,232     |                              | $          | 22,616    |       | $ | 21,282 |   | $ | 295,752 |   |
| Net operating  income                   |       | 39,190              |       | 10,423                                                |       | 5,021                     |       | 3,021                                          |       | 1,859                             |       | 59,514    |       |
| Receivables                             |       | 180,315             |       | 19,833                                                |       | 38,429                    |       | 23,365                                         |       | 13,572                            |       | 275,514   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                |            |                                   |            |           |            |  |  |  |  |  |  |

 

9

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The table below presentsspecified information about reported segments as of and for the six monthsended December 31, 2006:
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  and  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 382,064    |                                                  | $          | 78,705                    |       | $                                              | 85,115     |                              | $          | 53,368    |       | $ | 59,925 |   | $ | 659,177 |   |
| Net operating  income                   |       | 92,845              |       | 19,084                                                |       | 13,376                    |       | 8,330                                          |       | 16,684                            |       | 150,319   |       |
| Receivables                             |       | 208,726             |       | 21,953                                                |       | 45,644                    |       | 28,393                                         |       | 23,526                            |       | 328,242   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                |            |                                   |            |           |            |  |  |  |  |  |  |

 

The table belowpresents specified information about reported segments as of and for the sixmonths ended December 31, 2005 as reclassified to reflect the elimination ofthe “Asia-Pacific/Latin America” and “Other” segments.  The segment information below includes theconsolidated results from Watson Wyatt Limited, formerly WWLLP, from August 1,2005, the date of combination, through December 31, 2005:
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  and  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 333,588    |                                                  | $          | 62,193                    |       | $                                              | 69,710     |                              | $          | 37,971    |       | $ | 37,630 |   | $ | 541,092 |   |
| Net operating  income                   |       | 78,402              |       | 15,885                                                |       | 6,647                     |       | 5,713                                          |       | 3,558                             |       | 110,205   |       |
| Receivables                             |       | 180,315             |       | 19,833                                                |       | 38,429                    |       | 23,365                                         |       | 13,572                            |       | 275,514   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                |            |                                   |            |           |            |  |  |  |  |  |  |

 

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 forcomparative purposes.

10

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Reconciliations ofthe information reported by segment to the historical consolidated amountsfollow for the three and six month periods ended December 31, 2006 and 2005:
| ** **                                                                                  | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                                | ** ** | **2005**                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                        |       |                                                    |       |                                                  |       |   |   |   |   |
| Revenue:                                                                                    |       |                                                    |       |                                                  |       |   |   |   |   |
| Total segment  revenue                                                                      |       | $                                                       | 343,291    |                                                  | $          | 295,752 |   | $ | 659,177 |   | $ | 541,092 |   |
| Reimbursable  expenses not included in total segment revenue                                |       | 13,831                                                  |       | 12,831                                                |       | 24,335 |   | 22,991 |   |
| All other  segments                                                                         |       | 10,453                                                  |       | 8,727                                                 |       | 20,287 |   | 21,176 |   |
| Other, net                                                                                  |       | (1,150                                                  | )          | (1,546                                                | )          | (1,370 | ) | (3,609 | ) |
| Consolidated  revenue                                                                       |       | $                                                       | 366,425    |                                                  | $          | 315,764 |   | $ | 702,429 |   | $ | 581,650 |   |
|                                                                                        |       |                                                    |       |                                                  |       |   |   |   |   |
| Net Operating Income:                                                                       |       |                                                    |       |                                                  |       |   |   |   |   |
| Total segment  net operating income                                                         |       | $                                                       | 80,313     |                                                  | $          | 59,514 |   | $ | 150,319 |   | $ | 110,205 |   |
| (Loss)/income  from affiliates                                                              |       | (638                                                    | )          | 71                                                    |       | (867 | ) | 1,422 |   |
| Differences in  allocation methods for depreciation, G&A, medical and pension costs (1) |       | (5,031                                                  | )          | (4,437                                                | )          | (7,262 | ) | (6,387 | ) |
| Gain/(loss) on  sale of business units                                                      |       | 68                                                      |       | (288                                                  | )          | 104 |   | 1,452 |   |
| Loss on hedge                                                                               |       | —                                                  |       | —                                                |       | — |   | (3,602 | ) |
| Discretionary  compensation                                                                 |       | (36,460                                                 | )          | (25,912                                               | )          | (66,380 | ) | (47,232 | ) |
| All other  segments                                                                         |       | (2,361                                                  | )          | (2,551                                                | )          | (3,756 | ) | (1,999 | ) |
| Other, net                                                                                  |       | 3,895                                                   |       | 1,349                                                 |       | 7,016 |   | (1,306 | ) |
| Consolidated  income before income taxes                                                    |       | $                                                       | 39,786     |                                                  | $          | 27,746 |   | $ | 79,174 |   | $ | 52,553 |   |
|                                                                                        |       |                                                    |       |                                                  |       |   |   |   |   |
| Receivables:                                                                                |       |                                                    |       |                                                  |       |   |   |   |   |
| Total segment  receivables - billed and unbilled                                            |       | $                                                       | 328,242    |                                                  | $          | 275,514 |   | $ | 328,242 |   | $ | 275,514 |   |
| All other  segments                                                                         |       | 7,159                                                   |       | 1,845                                                 |       | 7,159 |   | 1,845 |   |
| Net valuation  differences (2)                                                              |       | (2,001                                                  | )          | 8,315                                                 |       | (2,001 | ) | 8,315 |   |
| Total billed and  unbilled receivables                                                      |       | 333,400                                                 |       | 285,674                                               |       | 333,400 |   | 285,674 |   |
| Assets not  reported by segment                                                             |       | 899,061                                                 |       | 880,903                                               |       | 899,061 |   | 880,903 |   |
| Consolidated assets                                                                         |       | $                                                       | 1,232,461  |                                                  | $          | 1,166,577 |   | $ | 1,232,461 |   | $ | 1,166,577 |   |

----

(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 $534.9 million.

11

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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 Amended Compensation Plan for Outside Directors and the2000 Long-Term Incentive Plan.  All fourplans have been approved by the 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 six months of fiscalyears 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.

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 2008 and2007 through 2009 performance periods, the vesting criteria are based upongrowth in earnings per share and revenue.

12

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Compensationexpense of $1.0 million and $1.4 million was recorded pursuant to these plansfor the second quarter and first six months of fiscal year 2007, respectively,compared to no compensation expense for the first six months of fiscal year2006.  Expenses for these plans will berecognized when awards are both probable and reasonably estimable.  If applicable, compensation expense will berecognized as a component of the discretionary annual bonus recorded insalaries 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, or non-employee,Directors.  Under the Outside Director’sPlan, outside Directors are initially paid in shares of the company’s commonstock, or in a combination of cash and shares, quarterly for services providedduring the preceding calendar quarter. In addition, outside Directors receive shares with a grant date marketvalue of $45,000 at the end of each fiscal year for services performed duringthe preceding fiscal year. Approximately $0.3 million of compensation expensewas recorded relative to this plan during the first six months of each offiscal years 2007 and 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 six months 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).  Compensationexpense of $0.1 million and $0.3 million was recorded pursuant to the StockOption Plan for the second quarter and first six months of fiscal year 2006,respectively.

**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 date foreach of the plans is June 30.

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*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 and six monthperiods ended December 31, 2006 and 2005, and for the U.K. defined benefitpension plan for the three and six month periods ended December 31, 2006 andthe three and five month periods ended December 31, 2005:
| ** **                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                | ** ** | **2005**                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **North  America**                                      | ** ** | **U.K.**                                              | ** ** | **North  America** | ** ** | **U.K.** | ** ** | **North  America** | ** ** | **U.K.** | ** ** | **North  America** | ** ** | **U.K** | ** ** |
| Service Cost                           |       | $                                                       | 6,490      |                                                  | $          | 3,277 |   | $ | 7,564 |   | $ | 3,136 |   | $ | 12,714 |   | $ | 6,451 |   | $ | 14,673 |   | $ | 5,226 |   |
|                                   |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest Cost                          |       | 10,076                                                  |       | 4,173                                                 |       | 9,340 |   | 3,527 |   | 20,045 |   | 8,217 |   | 18,365 |   | 5,878 |   |
| Expected Return  on Plan Assets        |       | (11,803                                                 | )          | (4,043                                                | )          | (10,937 | ) | (3,320 | ) | (23,534 | ) | (7,960 | ) | (21,866 | ) | (5,533 | ) |
| Amortization of  Transition Obligation |       | (10                                                     | )          | —                                                |       | (9 | ) | — |   | (20 | ) | — |   | (19 | ) | — |   |
| Amortization of  Net Loss              |       | 2,270                                                   |       | (219                                                  | )          | 4,287 |   | — |   | 4,328 |   | (431 | ) | 8,063 |   | — |   |
| Amortization of  Prior Service Cost    |       | (735                                                    | )          | —                                                |       | (448 | ) | — |   | (1,469 | ) | — |   | (860 | ) | — |   |
| Net Periodic Benefit  Cost             |       | $                                                       | 6,288      |                                                  | $          | 3,188 |   | $ | 9,797 |   | $ | 3,343 |   | $ | 12,064 |   | $ | 6,277 |   | $ | 18,356 |   | $ | 5,571 |   |

 

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%    |       |

 

*Employer Contributions*

The company made $700,000in contributions to North American plans during the first six months of fiscalyear 2007.  An additional pensioncontribution of $15.0 million was made during January 2007.  We anticipate that $700,000 will becontributed by the company to the North American pension plans during theremainder of fiscal year 2007.

The company made $7.3million in contributions to the U.K. plans during the first six months offiscal year 2007 and anticipates making $6.3 million in contributions over theremainder of the fiscal year. Discussions are currently underway with the pension trustee regardingthe appropriate level of future contributions.

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*Defined Contribution Plans*

In the U.S., we sponsor a savings plan that providesbenefits to substantially all U.S. associates with a match to 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 to12% of an associate’s 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.

*Componentsof Net Periodic Benefit Cost for Other Postretirement Plans*

The followingtable sets forth the components of net periodic benefit cost for the company’shealthcare and post-retirement plans for the three and six months ended December31, 2006 and 2005:
| ** **                             | ** ** | **Three Months Ended December 31, ** | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                      | ** ** | **2005**                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost                           |       | $                                                             | 406        |                                                  | $          | 456 |   | $ | 811 |   | $ | 908 |   |
| Interest cost                          |       | 649                                                           |       | 606                                                   |       | 1,297 |   | 1,209 |   |
| Expected return  on plan assets        |       | —                                                        |       | —                                                |       | — |   | — |   |
| Amortization of  transition obligation |       | —                                                        |       | —                                                |       | — |   | — |   |
| Amortization of  net loss              |       | (39                                                           | )          | (81                                                   | )          | (78 | ) | (164 | ) |
| Amortization of  prior service cost    |       | (165                                                          | )          | (165                                                  | )          | (330 | ) | (330 | ) |
| Net periodic benefit  cost             |       | $                                                             | 851        |                                                  | $          | 816 |   | $ | 1,700 |   | $ | 1,623 |   |

 

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*Employer Contributions*

The company madecontributions in the form of premiums and medical claim payments to itshealthcare and post-retirement plans of $900,000 and $700,000 in the threemonths ended December 31, 2006 and 2005, respectively, and contributions of$1.7 million and $1.6 million in the six months ended December 31, 2006 and2005, respectively.  We plan to makeadditional payments estimated to total $1.8 million through June 30, 2007.

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

Goodwilland intangible assets are presented below by segment for the six months endedDecember 31, 2006:
| ** **                            | ** ** | **Benefits  Group** | ** ** | **Technology and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance  and 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                 |       | —                                                    |       | 1,197                     |       | —                                             |       | —                            |       | —                       |       | 1,322     |       |
|                                  |       |                |       |                                                      |       |                      |       |                                               |       |                              |       |                         |       |      |       |
| Impairment losses                     |       | —              |       | —                                                    |       | —                    |       | —                                             |       | —                            |       | —                       |       | —    |       |
|                                  |       |                |       |                                                      |       |                      |       |                                               |       |                              |       |                         |       |      |       |
| Other                                 |       | (157                | )          | (40                                                       | )          | (16                       | )          | (52                                                | )          | (37                               | )          | —                       |       | (303      | )          |
|                                  |       |                |       |                                                      |       |                      |       |                                               |       |                              |       |                         |       |      |       |
| Translation  adjustment               |       | 7,894               |       | 2,381                                                     |       | 1,017                     |       | 3,103                                              |       | 2,214                             |       | —                       |       | 16,609    |       |
|                                  |       |                |       |                                                      |       |                      |       |                                               |       |                              |       |                         |       |      |       |
| Balance as of December 31,  2006 |       | $                   | 175,400    |                                                      | $          | 45,509                    |       | $                                                  | 21,188     |                              | $          | 57,402                       |       | $         | 40,957     |   | $ | 1,214 |   | $ | 341,669 |   |

 

The followingtable reflects changes in the net carrying amount of the components ofintangible assets for the six months ended December 31, 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                        |       | —      |       | —                                |       | (2,719                            | )          | (1,909                           | )          | (21                           | )          | (4,649    | )          |
| Translation adjustment                      |       | (17         | )          | 6,640                                 |       | 3,362                             |       | 825                              |       | —                        |       | 10,810    |       |
| Balance as of December 31, 2006             |       | $           | 552        |                                  | $          | 119,606                           |       | $                                | 59,189     |                          | $          | 13,889    |       | $ | — |   | $ | 193,236 |   |

 

 

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Thefollowing table reflects the carrying value of intangible assets at December31, 2006 and June 30, 2006:
| ** **                                            | ** ** | **December 31, 2006** | ** ** | **June 30, 2006** | ** ** |
|-------------------------------------------------------|------------|---------------------------------|------------|-----------------------------|------------|
| ** **                                            | ** ** | **Gross**                       | ** ** | ** **                  | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                            | ** ** | **Carrying**                    | ** ** | **Accumulated**             | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                                            | ** ** | **Amount**                      | ** ** | **Amortization**            | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Intangible  assets and intangible pension asset:      |       |                            |       |                        |       |   |   |   |   |
| Trademark and  trade name                             |       | $                               | 119,606    |                        | $          | — |   | $ | 112,966 |   | $ | — |   |
| Customer related  intangibles                         |       | 64,526                          |       | 5,337                       |       | 64,210 |   | 5,664 |   |
| Core/developed  technology                            |       | 17,613                          |       | 3,724                       |       | 18,443 |   | 3,470 |   |
| Non-compete                                           |       | 421                             |       | 421                         |       | 672 |   | 651 |   |
| Intangible  pension asset                             |       | 552                             |       | —                      |       | 569 |   | — |   |
| Total intangible assets  and intangible pension asset |       | $                               | 202,718    |                        | $          | 9,482 |   | $ | 196,860 |   | $ | 9,785 |   |

 

A component of the change in the gross carrying amountof trademark and trade name, customer related intangibles,core/developed technology and the intangible pension asset reflects translation adjustmentsbetween June 30, 2006 and December 31, 2006. These intangible assets are denominated in the currencies of oursubsidiaries outside the United States, and are translated into our reportingcurrency, the U.S. dollar, based on exchange rates at the balance sheet date.

The weighted average remaining life of amortizableintangible assets at December 31, 2006, was 9.3 years.  Future estimated amortization expense is asfollows:

| Fiscal year ending June 30: | ** ** | **Amount** | ** ** |
|-------------------------------------------------|------------|------------|------------|
| 2007                                            |       | $          | 4,734      |   |
| 2008                                            |       | 9,469      |       |
| 2009                                            |       | 9,469      |       |
| 2010                                            |       | 9,469      |       |
| 2011                                            |       | 5,916      |       |
| Thereafter                                      |       | 34,021     |       |
| Total                                           |       | $          | 73,078     |   |

 

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**Note 7 –Earnings Per Share.**

Basic earnings pershare are calculated on the basis of the weighted average number of commonshares outstanding during the three and six month periods ending December 31,2006 and 2005.  Diluted earnings pershare is calculated by dividing net income by the weighted average number ofcommon shares outstanding, plus the dilutive effect of outstanding stockoptions and employee stock purchase plan shares using the “treasury stock”method over the same measurement period. The components of basic and diluted earnings per share are as follows:
| ** **                                                                         | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                | ** ** | **2005**                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                               |       |                                                    |       |                                                  |       |   |   |   |   |
|                                                                               |       |                                                    |       |                                                  |       |   |   |   |   |
| Income from  continuing operations                                                 |       | $                                                       | 25,994     |                                                  | $          | 17,175 |   | $ | 50,808 |   | $ | 31,067 |   |
| Discontinued  operations                                                           |       | —                                                  |       | 8                                                     |       | — |   | 17 |   |
| Net income                                                                         |       | $                                                       | 25,994     |                                                  | $          | 17,183 |   | $ | 50,808 |   | $ | 31,084 |   |
|                                                                               |       |                                                    |       |                                                  |       |   |   |   |   |
| Weighted average  outstanding shares of  common stock                              |       | 42,407                                                  |       | 42,147                                                |       | 42,401 |   | 40,494 |   |
| Dilutive effect  of employee stock options and employee stock purchase plan shares |       | 2,118                                                   |       | 244                                                   |       | 2,144 |   | 254 |   |
| Common stock and  stock equivalents                                                |       | 44,525                                                  |       | 42,391                                                |       | 44,545 |   | 40,748 |   |
|                                                                               |       |                                                    |       |                                                  |       |   |   |   |   |
| Basic earnings  per share:                                                         |       |                                                    |       |                                                  |       |   |   |   |   |
| Income from  continuing operations                                                 |       | $                                                       | 0.61       |                                                  | $          | 0.41 |   | $ | 1.20 |   | $ | 0.77 |   |
| Discontinued  operations                                                           |       | —                                                  |       | —                                                |       | — |   | — |   |
| Net income                                                                         |       | $                                                       | 0.61       |                                                  | $          | 0.41 |   | $ | 1.20 |   | $ | 0.77 |   |
|                                                                               |       |                                                    |       |                                                  |       |   |   |   |   |
| Diluted earnings  per share:                                                       |       |                                                    |       |                                                  |       |   |   |   |   |
| Income from  continuing operations                                                 |       | $                                                       | 0.58       |                                                  | $          | 0.41 |   | $ | 1.14 |   | $ | 0.76 |   |
| Discontinued  operations                                                           |       | —                                                  |       | —                                                |       | — |   | — |   |
| Net income                                                                         |       | $                                                       | 0.58       |                                                  | $          | 0.41 |   | $ | 1.14 |   | $ | 0.76 |   |

 

In calculatingearnings per share for the three and six month periods ended December 31, 2006,we assume that the 1,950,000 contingent shares related to the businesscombination have been issued and outstanding for the entire period.

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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. Theadoption of FIN 46(R) had no effect 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 on July 31, 2005,the company owns 100% of the operations of WWLLP and WWHE.  For the six months ended December 31, 2005the company 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 thru December, 2005.

As of August 1, 2005, ourInvestment in affiliate consists solely of an equity investment in PCIC, whichwill 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 $7.6 million, combined with letters ofcredit totaling $8.0 million for which PCIC has been designated as beneficiary,for a total maximum exposure of $15.6 million.

**Note 9 –Comprehensive Income.**

Comprehensive incomeincludes net income, changes in the additional minimum pension liabilityresulting from translation adjustments and revaluations, and changes in thecumulative translation adjustment gain or loss. For the three months ended December 31, 2006, comprehensive incometotaled $50.6 million, compared with $6.6 million for the three months endedDecember 31, 2005.  For the six monthsended December 31, 2006, comprehensive income totaled $82.0 million comparedwith $19.0 million for the six months ended December 31, 2005.

**Note 10 –Restricted Shares.**

In conjunctionwith our business combination of WWLLP on July 31, 2005, we issued 9,090,571Class A common stock shares, 4,749,797 of which were subject tocontractual transfer restrictions. Transfer restrictions expired on 2,339,761 of these shares on July 31,2006 and will expire on the remaining 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 andCommitments.**

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 will continueafter the acquisition.  In the businesscombination agreement, Watson Wyatt Limited, the company’s principal U.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 the indemnitiesapply is entirely speculative and the amount of any payment would depend uponthe nature of the event triggering such indemnity. Management believes that anypotential for payment under such indemnities should decline with the passage oftime.  The company has insurance to coverliabilities arising from acts or omissions by the company and its subsidiaries,and such insurance may cover some or all of its indemnity obligations relatingto prior acts or omissions.  Except forsuch insurance, there are no provisions for recourse to third parties, nor areany assets held by any third parties that the company as indemnitor canliquidate to recover amounts paid under such indemnities.

Inconnection with our business combination, payment of an additional 1,950,000shares of the company’s common stock after June 30, 2007, is contingent uponthe achievement by the acquired business of agreed-upon financial performancegoals. The value of all the contingent stock was $87.1 million based on theNYSE closing price on January 31, 2007. The contingent consideration is payableby Watson Wyatt Limited and the payment obligations are guaranteed by WatsonWyatt 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 December 31, 2006.

*Letters of Credit*.  The company has outstanding letters of creditto three beneficiaries totaling $14.5 million to guarantee payment in the eventthat the company fails to meet its financial obligations to thesebeneficiaries.  One letter of credit for$2.6 million will expire in April 2007, while the second letter of credittotaling $8.0 million will remain outstanding as long as we retain an ownershipshare of our affiliated captive insurance company, PCIC.  The company has also provided a $5.0 millionAustralian dollar-denominated letter of credit (US $3.9 million) to anAustralian governmental agency as required by local regulations. The estimatedfair market value of these letters of credit is immaterial because they havenever been used, and the company believes that future usage is remote.

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*Indemnification Agreements*.  The company has various agreements thatprovide that it may be obligated to indemnify the other party with respect tocertain matters.  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 these indemnificationagreements due to the conditional nature of the company’s obligations and theunique facts of each particular agreement, the company does not believe thatany potential liability that might arise from such indemnity provisions isprobable or material.  There are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that any guarantor can liquidate to recover amounts paid under suchindemnities.

*Wellspring Leases*.  We continue to guarantee two leases foroffice premises for Wellspring Resources, LLC (“Wellspring”), the benefitsadministration outsourcing business that we exited from in fiscal year1998.  Based on our analysis and thelimited duration of the remaining lease obligations, the company no longerrecords an obligation. Based on our analysis and the limited duration of theremaining lease obligations, the company believes that payment under theselease guarantees is remote.

**Note 12 –Contingent Liabilities.**

*LegalProceedings*:  From time to time, we are a party to variouslawsuits, arbitrations or mediations that arise in the ordinary course ofbusiness. The matters reported on below involve the most significant pending orpotential claims against us.  We alsohave received subpoenas and requests for information in connection withgovernment investigations.

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 No. 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. Facilitated discussions regarding resolution of the claimhave occurred throughout January 2007, and are pending.  Certaindiscovery matters have been suspended pending an outcome of thosediscussions.  A Watson Wyatt motion for partial Summary Judgment is alsopending.

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***Watson Wyatt v.SBC Holdings, Inc. (Stroh Brewery Company):**** *On July 23, 2004, wereceived a demand letter from Stroh’s counsel alleging that errors in valuations for 2001 and subsequent yearsunderstated the liabilities of its pension plan and overstated the company’snet worth.  As a result, Stroh claimed itdid not annuitize its defined benefit plan and redeemed its stock at aninflated price.  On April 15, 2005,Watson Wyatt filed a petition in the federal court to compel arbitration of thematter. Subsequently, Stroh filed an answer and counterclaim, alleging damagesin excess of $46 million.  The courtgranted in part and denied in part our motion for summary judgment, and we havefiled an appeal to the Sixth Circuit Court of Appeals that is pending.

***Department of Labor Investigation:*** On November 17, 2006, Watson WyattInvestment Consulting Inc. (“WWIC”) received a subpoena from the United StatesDepartment of Labor (“DOL”) in connection with its investigation into thecompensation of consultants and other investment advisers.  WWIC has responded to the subpoena andcontinues to cooperate with the DOL.

**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 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 fiscal year ending June 30, 2007.  The company is currently evaluating theimpact that adoption of FAS 158 will have on the consolidated financialstatements.

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 statement misstatementsbased on the effects of the misstatements on each of the company’s financialstatements and the related financial statement disclosures. SAB 108 must beapplied to our annual financial statements for the year ending June 30, 2007.The company is currently evaluating the impact, if any, of SAB 108 on itsconsolidated financial statements.

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes —an interpretation of FASB Statement No. 109” (“FAS 109”), which clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FAS No. 109, “Accounting for IncomeTaxes.”  FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return.  ThisInterpretation also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning afterDecember 15, 2006.  The company is currently evaluating the effects thatthis Interpretation may have on its consolidated financial statements.

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**Note 14 – Acquisition of Watson Wyatt Brans & Co.**

OnFebruary 1, 2007, the company acquired the net assets of Watson Wyatt Brans& Co., its long-time alliance partner in the Netherlands, for a combinationof cash and stock.  Watson Wyatt Brans& Co. has approximately 180 associates in five offices throughout theNetherlands and had revenues of approximately $37 million (Euro 28 million) in2006. The business combination will be accounted for using the purchase methodof accounting as prescribed in Statement of Financial Accounting StandardsBoard No. 141, “Business Combinations” (SFAS 141).

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

**ExecutiveOverview**

**General**

Watson Wyatt is aglobal consulting firm focusing on providing human capital and financialconsulting services. We provide services in five principal practice areas:Benefits, Technology and Administration Solutions, Human Capital Consulting,Insurance and Financial Services and Investment Consulting, operating from 94offices in 30 countries throughout North America, Europe, Asia-Pacific andLatin America. The company employs approximately 6,340 associates as follows: 

| Benefits Group                                 |   | 2,680 |   |
|------------------------------------------------|--------|-------|--------|
| Technology and  Administration Solutions Group |   | 750   |   |
| Human Capital  Group                           |   | 790   |   |
| Insurance and  Financial Services Group        |   | 370   |   |
| Investment  Consulting Group                   |   | 370   |   |
| Other (including  Communication)               |   | 790   |   |
| Corporate                                      |   | 590   |   |
| Total                                          |   | 6,340 |   |

 

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 their investmentgoals.  Our target market clients includethose companies in the fortune 1000, Pension & Investments (P&I) 1000,the FTSE 100, and equivalent organizations in markets around the world.

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 havebecome increasingly 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, including compensation,retirement, health care, insurance and investment plans.

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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 continued improvement inthe overall economy.

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 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 54 percent of our total second 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 and increasedmarket share.   Services provided throughthe Benefits Group include the following:**

·                  Servicesrelated to the design of retirement plans, including pension, 401(k) andexecutive benefit plans

·                  Healthcare, disability and other group benefit plans

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

·                  Actuarialservices

·                  Strategicworkforce planning

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**Technology and AdministrationSolutions Group -**Our Technology and AdministrationSolutions Group (TAS), accounting for 11 percent of our total second 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

**HumanCapital Group** - Our Human Capital Group (HCG),accounting for 12 percent of our total second quarter fiscal year 2007revenues, generally encompasses short-term projects. As a result this segmentis most sensitive to current economic conditions.  Services provided through HCG include thefollowing:

·                  Compensationplans, including broad-based and executive compensation, stock and otherlong-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 7 percent of our total second quarter fiscal year2007 revenues. This business is characterized by ongoing relationships with ourclients that will typically utilize our services 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-**Our Investment Consulting Group accounts for 9 percent of our totalsecond quarter fiscal year 2007 revenues. This business, although relationship based, can be affected byvolatility in investment returns, particularly as clients look to us forassistance in managing that volatility. Services provided through our Investment Consulting Group include thefollowing:

·                  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 capability includescommunication and change management implementation support services.

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

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**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 second quarter offiscal year 2007 (December 31, 2006) and as of the end of fiscal year 2006(June 30, 2006), Consolidated Statements of Operations for the three and sixmonth periods ended December 31, 2006 and 2005, Consolidated Statements of CashFlows for the six month periods ended December 31, 2006 and 2005 and aConsolidated Statement of Changes in Stockholders’ Equity for the six monthperiod ended December 31, 2006.

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 of Watson Wyatt Limited beginningAugust 1, 2005.  Prior to July 31, 2005,or for one month of the first quarter of fiscal year 2006, the company recordedits share of the results of WWLLP and WWHE using the equity method ofaccounting.  This prior year income isreflected in the “Income from affiliates” line on our income statement.  Our share of the results of our affiliatedcaptive insurance company, PCIC, continues to be recorded using the equitymethod of accounting, and is also 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 thesecond quarter of fiscal year 2007, U.S. consulting operations comprisedapproximately 50 percent of consolidated revenue.  Before and after the business combination, nosingle client accounted for more than 2 percent of our consolidated revenue forany of the most recent three 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 costs,and 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 second quarter of fiscal year 2007,approximately 50 percent of professional and subcontracted services representthese reimbursable 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.

***RevenueRecognition***

Revenue includes feesprimarily generated from consulting services provided.  We recognize revenue from these consultingengagements when hours are worked, either on a time-and-materials basis or on afixed-fee basis, depending on the terms and conditions defined at the inceptionof an engagement with a client.  The terms of our contracts with clients arefixed and determinable and may change based upon agreement by both parties.Individual consultants’ billing rates are principally based on a multiple of salaryand compensation costs.

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 a shortduration, and non-recurring system projects. Annual recurring projects and the projects of short duration aretypically 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-completeto assure that the projects’ current status is accounted for properly.  Our Technology and Administration SolutionsGroup contracts generallyprovide that if the client terminates a contract, the company is entitled topayment 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 companyrecognizes a loss on an engagement when estimated revenue to be received forthat engagement 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 thetechnology and 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 theAICPA’s Statement of Position 98-1 “Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use.”  Revenue associated with the related contract,together with amortization of the related capitalized software, is recognizedover the service period.  As a result wedo not recognize revenue 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 areincluded in professional and subcontracted services as a cost of revenue.

***Valuation of Billed and UnbilledReceivables 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 the futurerecoverability 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, “Accounting for Income Taxes — SpecialAreas”.  Due to the availability offoreign tax credits, it is not practicable to estimate the company’s income taxliability that might be payable if such earnings were not reinvestedindefinitely, however, deferred taxes are provided for earnings of foreignsubsidiaries which the company plans to remit. Tax costs can involve complex issues and may require an extended periodto resolve.  Changes in the geographicmix or estimated level of annual pre-tax income, limitations on the use of thecompany’s foreign subsidiary losses, changes in tax laws and changes resultingfrom tax audits can all affect the overall effective income tax rate which, inturn, impacts the overall level of income 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.

*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 | % |

 

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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 discount rateassumption 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 first sixmonths of fiscal year 2007 has been 9.7 percent, compared to a return of 1.0percent in the first six months 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 are notnecessarily linear. The company’s U.S. Other Postretirement Employee BenefitsPlan is relatively insensitive to discount rate changes due to the planprovisions that have been established to control costs and as such nosensitivity results are shown in the table above.

*UnitedKingdom*

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** | ** ** | **2005** | ** ** |
| 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 | % |

 

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The 5.10 percent discountrate assumption used at the end of June 30, 2006 represents a 10 basis pointincrease from the discount rate at July 31, 2005. The discount rate is sethaving regard to yields on European AA corporate bonds at the measurement dateand 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 six months of fiscal year 2007 has been 5.3 percent,compared to a return of 8.2 percent in the first five months of fiscal year2006.

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  |       |

 

***IncurredBut 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.

***Goodwill and Intangible Assets***

In applying the purchasemethod of accounting for business combinations, amounts assigned toidentifiable assets and liabilities acquired have been based on estimated fairvalues as of the date of the acquisitions, with the remainder recorded asgoodwill. Estimates of fair value have been based primarily upon future cashflow projections discounted to present value using a risk adjusted discountrate. We evaluate our goodwill for impairment annually and whenever indicatorsof impairment exist. The evaluation is based upon a comparison of the estimatedfair value of the reporting unit to which the goodwill has been assigned to thesum of the carrying value of the net assets for that reporting unit. The fairvalues used in this evaluation are estimated based upon a multiple of revenuefor the reporting unit. This revenue multiple is based on our experience andknowledge. Intangible assets are initially valued at fair market value usinggenerally accepted valuation methods appropriate for the type of intangibleasset. Intangible assets with definite lives are amortized over their estimateduseful lives and are reviewed for impairment if indicators of impairment arise.The evaluation of impairment would be based upon a comparison of the carryingamount of the intangible asset to the estimated future undiscounted net cashflows expected to be generated by the asset. If estimated future undiscountednet cash flows are less than the carrying amount of the asset, the asset wouldbe considered impaired. The impairment expense would be determined by comparingthe estimated fair value of the intangible asset to its carrying value, withany shortfall from fair value recognized as an expense in the current period.

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**Resultsof Operations**

The table belowsets forth our historical Consolidated Statements of Operations data forcontinuing operations as a percentage of change between periods indicated:  

**Consolidated Statements of Operations**

(in thousands, except per share data)
| ** **                                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                             | ** ** | ** **                                              | ** ** | ** **                                            | ** ** | **%** | ** ** | ** ** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                                             | ** ** | **2006**                                                | ** ** | **2005**                                              | ** ** | **Change** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                                         | ** ** | ** **                                            | ** ** | **(Unaudited)** | ** ** | ** ** | ** ** |
|                                                   |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Revenue                                                |       | $                                                       | 366,425    |                                                  | $          | 315,764 |   | 16.0 | % | $ | 702,429 |   | $ | 581,650 |   | 20.8 | % |
|                                                   |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Costs of  providing services:                          |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                         |       | 201,045                                                 |       | 175,207                                               |       | 14.7 |   | 386,640 |   | 322,757 |   | 19.8 |   |
| Professional and subcontracted Services                |       | 26,130                                                  |       | 19,595                                                |       | 33.4 |   | 46,165 |   | 38,606 |   | 19.6 |   |
| Occupancy, communications and Other                    |       | 45,682                                                  |       | 43,687                                                |       | 4.6 |   | 86,633 |   | 76,540 |   | 13.2 |   |
| General and administrative expenses                    |       | 39,461                                                  |       | 37,206                                                |       | 6.1 |   | 77,560 |   | 68,595 |   | 13.1 |   |
| Depreciation and amortization                          |       | 13,923                                                  |       | 11,132                                                |       | 25.1 |   | 26,674 |   | 20,809 |   | 28.2 |   |
|                                                   |       | 326,241                                                 |       | 286,827                                               |       |   |   | 623,672 |   | 527,307 |   |   |   |
|                                                   |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Income from  operations                                |       | 40,184                                                  |       | 28,937                                                |       | 38.9 |   | 78,757 |   | 54,343 |   | 44.9 |   |
| Income from  affiliates                                |       | (638                                                    | )          | 71                                                    |       | (998.6 | ) | (867 | ) | 1,422 |   | (161.0 | ) |
| Interest expense                                       |       | (589                                                    | )          | (1,482                                                | )          | 60.3 |   | (1,032 | ) | (2,359 | ) | 56.3 |   |
| Interest income                                        |       | 762                                                     |       | 508                                                   |       | 50.0 |   | 2,212 |   | 1,297 |   | 70.5 |   |
| Other  non-operating income/(loss)                     |       | 68                                                      |       | (288                                                  | )          | 123.6 |   | 104 |   | (2,150 | ) | 104.8 |   |
| Income from  continuing operations before income taxes |       | 39,787                                                  |       | 27,746                                                |       | 43.4 |   | 79,174 |   | 52,553 |   | 50.7 |   |
| Provision for income  taxes                            |       | 13,793                                                  |       | 10,571                                                |       | 30.5 |   | 28,366 |   | 21,486 |   | 32.0 |   |
| Income from  continuing operations                     |       | $                                                       | 25,994     |                                                  | $          | 17,175 |   | 51.3 | % | $ | 50,808 |   | $ | 31,067 |   | 63.5 | % |

 

**Three andSix Months Ended December 31, 2006 Compared to the Three and Six Months EndedDecember 31, 2005**

As a result of the July31, 2005 acquisition of WWLLP, the three and six month periods ended December31, 2006 and the three month period ended December 31, 2005 include theconsolidated operating results of the business acquired from WWLLP for theentire period, whereas the operating results for the six months ended December31, 2005 includes the acquired business for the months August 2005 throughDecember 2005.  The analysis belowhighlights the changes between the consolidated statements of operations forthe quarters ended December 31, 2006 and 2005 and segregates the effects of theacquisition from the historical company’s results. Following this analysis is apro forma analysis which assumes that the acquisition and consolidation of theacquired business had occurred at the beginning of each period presented.  Management believes that the pro formaanalysis provides a more meaningful comparison of financial results.

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***Revenue.***

Revenues for the secondquarter of fiscal year 2007 were $366 million, an increase of $50 million, or16 percent, from $316 million in the second quarter of fiscal year 2006.  The overall increase in revenues is dueprimarily to growth in our business, but also includes the impact of changes inforeign currency exchange rates.  TheBritish Pound appreciated during the second quarter of fiscal year 2007 andresulted in $12 million of the revenue increase.  The average exchange rate used to translateour revenues earned in the U.K. increased to 1.9439 for the second quarter offiscal 2007 from 1.7400 in the second quarter of fiscal year 2006.  The impact of the U.S. dollar depreciatingagainst other foreign currencies resulted in an additional $1 million ofrevenue.

The increases in our segment revenue for second quarter fiscal year2007 as compared to the second quarter of fiscal year 2006 are due to thefollowing:

·                  Benefitsincreased revenues $20.1 million, or 11 percent, over the second quarter offiscal year 2006 due primarily to increased demand for our services fromexisting clients, including plan design, valuation and administration in theU.S. and plan design and valuation in Europe. The appreciation of the British Pound accounted for 3 percentage pointsof the increase.

·                  Technologyand Administration Solutions increased revenues $4.5 million, or 12 percent,over the second quarter of fiscal year 2006, largely due to an increase in thenumber of projects that went into service during the fiscal year.  The appreciation of the British Poundaccounted for 4 percentage points of the increase. In accordance with EITF00-3, “Application of AICPA Statement of Position 97-2 to Arrangements thatInclude the Right to Use Software Stored on Another Entity’s Hardware” (EITF00-3), the company begins recognizing revenue after projects go intoservice.  No revenues are recognizedduring project implementation.  AtDecember 31, 2006, the company had 75 projects in service and 60 projects inimplementation.  At December 31, 2005,the company had 25 projects in service and 51 projects in implementation. 

·                  HumanCapital Group increased revenues $7.3 million, or 19 percent, over the secondquarter of fiscal year 2006 primarily due to strong demand for compensationconsulting, including executive compensation, sales effectiveness and strategicrewards.  The appreciation of the BritishPound accounted for 3 percentage points of the increase.

·                  Insuranceand Financial Services increased revenues $4.4 million, or 19 percent, over thesecond quarter of fiscal year 2006 primarily due to an increase in lifeinsurance consulting projects.  Theappreciation of the British Pound accounted for 10 percentage points of theincrease.

·                  InvestmentConsulting increased revenues $11.3 million, or 53 percent, over the secondquarter of fiscal year 2006 due to an increase in demand for our services,especially investment strategy advice. The appreciation of the British Pound accounted for 6 percentage pointsof the increase.

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Revenues for the sixmonths ended December 31, 2006 were $702 million, an increase of $120 million,or 21 percent, from $582 million for the six months ended December 31,2005.  The business combination wascompleted on July 31, 2005, and therefore, the six months ended December 31,2005 only includes five months of our European operations.  A discussion of pro forma revenue is providedon page 41.  Additionally, the BritishPound appreciated during the six months ended December 31, 2006 and resulted in$16 million of the revenue increase.  Theaverage exchange rate used to translate our revenues earned in the UnitedKingdom increased to 1.9036 for the six months ended December 31, 2006 from1.7623 for the six months ended December 31, 2005.

The increase in oursegment revenue for the six months ended December 31, 2006 as compared to thesix months ended December 31, 2005 is due to the additional month of Europeanoperations as well as the following:

·                  Benefitsincreased revenues $48.5 million, or 15 percent, over the six months endedDecember 31, 2005 due to increased demand from existing clients for plandesign, valuation and administration services. The appreciation of the British Pound accounted for 3 percentage pointsof the increase.

·                  Technologyand Administration Solutions increased revenues $16.5 million, or 27 percent,over the six months ended December 31, 2005, largely due to an increase in thenumber of projects that went into service during the fiscal year.  The appreciation of the British Pound accountedfor 3 percentage points of the increase. In accordance with EITF 00-3, “Application of AICPA Statement ofPosition 97-2 to Arrangements that Include the Right to Use Software Stored onAnother Entity’s Hardware” (EITF 00-3), the company begins recognizing revenueafter projects go into service.  Norevenues are recognized during project implementation.  At December 31, 2006, the company had 75projects in service and 60 projects in implementation.  At December 31, 2005, the company had 25projects in service and 51 projects in implementation.

·                  HumanCapital Group increased revenues $15.4 million, or 22 percent, over the sixmonths ended December 31, 2005 primarily due to increased demand forcompensation consulting, including executive compensation, sales effectivenessand strategic rewards.  The appreciationof the British Pound accounted for 2 percentage points of the increase.

·                  Insuranceand Financial Services increased revenues $15.4 million, or 41 percent, overthe six months ended December 31, 2005 primarily due to an increase in projectwork, including life insurance consulting projects.  The appreciation of the British Poundaccounted for 8 percentage points of the increase.

·                  InvestmentConsulting increased revenues $22.3 million, or 59 percent, over the six monthsended December 31, 2005 due to an increase in demand for our services,especially investment strategy advice. The appreciation of the British Pound accounted for 5 percentage pointsof the increase.

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*** ***

***Salariesand Employee Benefits*.**

Salaries and employeebenefit expenses for the second quarter of fiscal year 2007 were $201.0 millioncompared to $175.2 million for the second quarter of fiscal year 2006, anincrease of $25.8 million or 14.7 percent. The increase is mainly due to additional salary expense of $15.7million, higher bonus expense of $10.3 million, higher benefits expense of $3.9million, a decrease in capitalization of $1.0 million related to thecapitalization 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”, partially offsetby a decrease in pension expense of $5.0 million. As a percentage of revenue,salaries and employee benefits decreased to 54.9 percent from 55.5 percent.

Salaries and employeebenefit expenses for the first six months of fiscal year 2007 were $386.6 millioncompared to $322.8 million for the first six months of fiscal year 2006, anincrease of $63.9 million or 19.8 percent. The increase was mainly due to additional salary expenses of $41.2million related to the acquisition of the European business. The increase inthe historical company was due to higher salaries of $16.1 million, higheraccrual for discretionary compensation of $4.3 million, and increased benefitexpense of $4.0 million. Also included is less capitalization of $4.3 millionrelated to time spent customizing in-house administration systems in accordancewith AICPA’s Statement of Position 98-1, “Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use”.  Additionally, a decrease in pension expenseof $6.2 million partially offset the increases outlined above.  As a percentage of revenue, salaries andemployee benefits decreased to 55.0 percent from 55.5 percent.

***Professionaland Subcontracted Services*.**

Professional andsubcontracted services expense for the second quarter of fiscal year 2007 were$26.1 million compared to $19.6 million for the second quarter of fiscal year2006, an increase of $6.5 million or 33.4 percent.  As a percentage of revenue, professional andsubcontracted services increased to 7.1 percent from 6.2 percent.  The increase is mainly due to higherreimbursable expenses incurred on behalf of clients and increased costs inEurope for temporary staff, consulting fees, and legal reserves.

Professional andsubcontracted services used in consulting operations for the first six monthsof fiscal year 2007 were $46.2 million, compared to $38.6 million for the firstsix months of fiscal year 2006, an increase of $7.6 million or 19.6percent.  The increase was mainly due toadditional expenses of $8.8 million related to the acquisition of WWLLPpartially offset by a decrease of $1.2 million of reimbursable expenses relatedto the historical company. As a percentage of revenue, professional andsubcontracted services remained at 6.6 percent for both periods.

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

Occupancy, communicationsand other expenses for the second quarter of fiscal year 2007 were $45.7million compared to $43.7 million for the second quarter of fiscal year 2006,an increase of $2.0 million or 4.6 percent. The increase is mainly due to increases in travel, promotion,professional development, repairs and maintenance, and postage as well as theimpact of an appreciating British Pound, offset by a decrease in duplicatingand general office, rent and utilities, and contributions expense.  As a percentage of revenue, occupancy,communications and other decreased to 12.5 percent from 13.8 percent.

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Occupancy, communicationsand other expenses for the first six months of fiscal year 2007 were $86.6million compared to $76.5 million for the first six months of fiscal year 2006,an increase of $10.1 million or 13.2 percent. The increase was mainly due to additional expenses of $9.7 million relatedto the acquisition of WWLLP. The increase of $0.4 million associated with thehistorical company was principally attributable to increases in expenses suchas travel, repairs and maintenance, dues and entertainment, promotion, anappreciating British Pound, and telephone expense partially offset by decreasesin expenses such as rent, business tax, equipment rental expense and generaloffice expense.  As a percentage ofrevenue, occupancy, communications and other decreased to 12.3 percent from13.2 percent.

***Generaland Administrative Expenses.***

General andadministrative expenses for the second quarter of fiscal year 2007 were $39.5million, compared to $37.2 million for the second quarter of fiscal year 2006,an increase of $2.3 million or 6.1 percent. The increase is primarily due tohigher professional services of $2.2 million from costs associated withcompliance with the Sarbanes-Oxley Act of 2002 as well as technologyconsultants in the U.K., increased salaries and benefits of $2.1 million,increased rent and utilities of $1.4 million, and increased miscellaneousexpenses such as postage, travel, dues and general office expense of $0.5million partially offset by decreases in insurance expense of $3.5 million andpromotion expense of $0.6 million.  As apercentage of revenue, general and administrative expense decreased to 10.8percent from 11.8 percent.

General andadministrative expenses for the first six months of fiscal year 2007 were $77.6million, compared to $68.6 million for the first six months of fiscal year2006, an increase of $9.0 million or 13.0 percent.  The increase is mainly due to additionalexpenses of $8.9 million related to the acquisition of WWLLP. The increase of$0.1 million in the historical company is mainly due to higher professionalservices expense of $1.9 million, and higher miscellaneous expenses such asrent, travel, duplicating, and postage of $0.6 million partially offset bydecreased insurance expense of $2.4 million. As a percentage of revenue, general and administrative expense decreasedto 11.0 percent from 11.8 percent.

***Depreciationand Amortization.***

Depreciation andamortization for the second quarter of fiscal year 2007 was $13.9 million,compared to $11.1 million for the second quarter of fiscal year 2006, anincrease of $2.8 million or 25.1 percent. The increase is mainly due to a $2.0million increase in depreciation of internally developed software used tosupport our Benefits Group and Technology and Administration Solutions Group,and $0.8 million increase in depreciation on fixed assets and intangibles.  As a percentage of revenue, depreciation andamortization increased to 3.8 percent from 3.5 percent.

Depreciation andamortization for the first six months of fiscal year 2007 was $26.7 million,compared to $20.8 million for the first six months of fiscal year 2006, anincrease of $5.9 million or 28.2 percent. The increase is due to additional expense of $1.3 million related to theacquisition of WWLLP. The increase of $4.6 million in the historical company isdue to $3.2 million of depreciation of internally developed software used tosupport our Benefits Group and Technology and Administration Solutions Groupand $1.4 million higher depreciation expense on fixed assets andintangibles.  As a percentage of revenue,depreciation and amortization increased to 3.8 percent from 3.6 percent.

***(Loss)/IncomeFrom Affiliates.***

Loss from affiliates forthe second quarter of fiscal year 2007 was $0.6 million, compared to income of$0.1 million for the second quarter of fiscal year 2006, a decrease of $0.7million.  The gain or loss recognizedreflects our portion of PCIC’s results for the quarter.

36

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Loss from affiliates forthe first six months of fiscal year 2007 was $0.9 million compared to income of$1.4 million for the first six months of fiscal year 2006.  The income in fiscal year 2006 includes notonly our share of income from PCIC but also our share of results from ourEuropean affiliates for the month of July 2005, after which time the businesscombination was consummated.

***InterestExpense.***

Interest expense for thesecond quarter of fiscal year 2007 was $0.6 million, compared to $1.5 million forthe second quarter of fiscal year 2006. Interest expense for the first six months of fiscal year 2007 was $1.0million, compared to $2.4 million for the first six months of fiscal year 2006.  The decrease in both periods was due to alower average debt balance.

***InterestIncome.***

Interest incomefor the second quarter of fiscal year 2007 was $0.8 million, compared to $0.5million for the second quarter of fiscal year 2006. Interest income for thefirst six months of fiscal year 2007 was $2.2 million, compared to $1.3 millionfor the first six months of fiscal year 2006. The increase is mainly due to a higher average cash balance in thecurrent period compared to the prior period combined with higher short-terminterest rates in the United States and Europe.

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

Other non-operating income/(loss) in the first six months 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.

***Provisionfor Income Taxes.***

Provision for incometaxes for the first six months of fiscal year 2007 was $28.4 million, comparedto $21.5 million for the first six months of fiscal year 2006. Our effectivetax rate was 35.8 percent for the first six months of fiscal year 2007 and 40.9percent for the first six 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.

***IncomeFrom Continuing Operations.***

Income from continuingoperations for the second quarter of fiscal year 2007 was $26.0 million,compared to $17.2 million for the second quarter of fiscal year 2006.  As a percentage of revenue, income fromcontinuing operations increased to 7.1 percent from 5.4 percent. Income fromcontinuing operations for the first six months of fiscal year 2007 was $50.8million, compared to $31.1 million for the first six months of fiscal year2006.  As a percentage of revenue, incomefrom continuing operations increased to 7.2 percent from 5.3 percent.

***EarningsPer Share, Income From Continuing Operations.***

Diluted earnings pershare, income from continuing operations for the second quarter of fiscal year2007 was $0.58, compared to $0.41 for the second quarter of fiscal year2006.   Diluted earnings per share,income from continuing operations for the first six months of fiscal year 2007was $1.14, compared to $0.76 for the first six months of fiscal year 2006. Thediluted earnings per share calculation for the three and six months of fiscalyear 2007 assumes that the 1,950,000 contingent shares related to the businesscombination had been issued and outstanding for the entire three and sixmonths.

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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 six monthsended December 31, 2006 compared with the unaudited pro forma results for thesix months ended December 31, 2005, as if the business combination had occurredat the beginning of each period.  Thediluted earnings per share calculation in this pro forma analysis assumes thatthe 1,950,000 shares related to the business combination had been issued at thebeginning of each period.  The comparisonof financial results for the three month period ended December 31, 2006compared with the three month period ended December 31, 2005 is comparable anddiscussion is provided beginning on page 33.

In our opinion,information for the six months ended December 31, 2006 and the pro formaresults for the six months ended December 31, 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 December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                               | ** ** | **Historical**                                          | ** ** | **Historical**                                        | ** ** | **%** | ** ** | **Historical** | ** ** | **Pro Forma** | ** ** | **%** | ** ** |
| ** **                                               | ** ** | **2006**                                                | ** ** | **2005**                                              | ** ** | **Change** | ** ** | **2005** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                               | ** ** | **(Unaudited)**                                         | ** ** | ** **                                            | ** ** | **(Unaudited)** | ** ** | ** ** | ** ** |
|                                                     |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Revenue                                                  |       | $                                                       | 366,425    |                                                  | $          | 315,764 |   | 16.0 | % | $ | 702,429 |   | $ | 618,093 |   | 13.6 | % |
|                                                     |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Costs of  providing services:                            |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                           |       | 201,045                                                 |       | 175,207                                               |       | 14.7 |   | 386,640 |   | 345,428 |   | 11.9 |   |
| Professional and subcontracted Services                  |       | 26,130                                                  |       | 19,595                                                |       | 33.4 |   | 46,165 |   | 39,290 |   | 17.5 |   |
| Occupancy, communications and Other                      |       | 45,682                                                  |       | 43,687                                                |       | 4.6 |   | 86,633 |   | 81,637 |   | 6.1 |   |
| General and administrative expenses                      |       | 39,461                                                  |       | 37,206                                                |       | 6.1 |   | 77,560 |   | 74,023 |   | 4.8 |   |
| Depreciation and amortization                            |       | 13,923                                                  |       | 11,132                                                |       | 25.1 |   | 26,674 |   | 22,115 |   | 20.6 |   |
|                                                     |       | 326,241                                                 |       | 286,827                                               |       |   |   | 623,672 |   | 562,493 |   |   |   |
|                                                     |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Income from  operations                                  |       | 40,184                                                  |       | 28,937                                                |       | 38.9 |   | 78,757 |   | 55,600 |   | 41.6 |   |
| (Loss)/income  from affiliates                           |       | (638                                                    | )          | 71                                                    |       | (998.6 | ) | (867 | ) | 899 |   | (196.4 | ) |
| Interest  expense, net                                   |       | 173                                                     |       | (974                                                  | )          | 117.8 |   | 1,180 |   | (1,812 | ) | 165.1 |   |
| Other  non-operating (loss)/income                       |       | 68                                                      |       | (288                                                  | )          | 123.6 |   | 104 |   | 1,452 |   | (92.8 | ) |
| Income from  continuing operations before income taxes   |       | 39,787                                                  |       | 27,746                                                |       | 43.4 |   | 79,174 |   | 56,139 |   | 41.0 |   |
| Provision for income  taxes                              |       | 13,793                                                  |       | 10,571                                                |       | 30.5 |   | 28,366 |   | 23,064 |   | 23.0 |   |
| Income from continuing  operations                       |       | $                                                       | 25,994     |                                                  | $          | 17,175 |   | 51.3 | % | $ | 50,808 |   | $ | 33,075 |   | 53.6 | % |
|                                                     |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Basic earnings per  share:                               |       | $                                                       | 0.61       |                                                  | $          | 0.41 |   |   |   | $ | 1.20 |   | $ | 0.82 |   |   |   |
| Diluted earnings per share:                              |       | $                                                       | 0.58       |                                                  | $          | 0.41 |   |   |   | $ | 1.14 |   | $ | 0.77 |   |   |   |
|                                                     |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Weighted average shares  of common  stock, basic (000)   |       | 42,407                                                  |       | 42,147                                                |       |   |   | 42,401 |   | 40,494 |   |   |   |
| Weighted average shares  of common  stock, diluted (000) |       | 44,525                                                  |       | 42,391                                                |       |   |   | 44,545 |   | 42,698 |   |   |   |

 

The pro forma informationfor the six months ended December 31, 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 six monthsendedDecember 31, 2006 were $702 million, an increase of $84 million, or 14 percent,from $618 million for the six months ended December 31, 2005.  The British Pound appreciated during the sixmonths ended December 31, 2006 and resulted in $19 million of the revenueincrease.  The average exchange rate usedto translate our revenues earned inthe U.K. increased to 1.9036 for the six months ended December 31, 2006 from1.7623 for the six months ended December 31, 2005.

The increases in our segment revenue for thesix months ended December 31, 2006 as compared to the six months ended December31, 2005 are as follows:

·                  Benefitsincreased revenues $29.7 million, or 8 percent, over the six months endedDecember 31, 2005 due to increased demand from existing clients for plandesign, valuation and administration services. The appreciation of the British Pound accounted for 3 percentage pointsof the increase.

·                  Technologyand Administration Solutions increased revenues $11.9 million, or 18 percent,over the six months ended December 31, 2005, 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.  The appreciation of theBritish Pound accounted for 3 percentage points of the increase.

·                  HumanCapital Group increased revenues $13.2 million, or 18 percent, over the sixmonths ended December 31, 2005, primarily due to continuing strong demand forexecutive compensation consulting.  Theappreciation of the British Pound accounted for 2 percentage points of theincrease.

·                  Insuranceand Financial Services increased revenues $8.0 million, or 18 percent, over thesix months ended December 31, 2005, primarily due to an increase in projectwork, including life insurance consulting projects.  The appreciation of the British Poundaccounted for 8 percentage points of the increase.

·                  InvestmentConsulting increased revenues $18.6 million, or 45 percent, over the six monthsended December 31, 2005 due to an increase in the number of associates workingin this practice combined with an overall strong demand for our services,especially structured products.  Theappreciation of the British Pound accounted for 5 percentage points of theincrease.

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*** ***

***Salariesand Employee Benefits*.**

Salaries and employeebenefit expenses for the first six months of fiscal year 2007 were $386.6million, compared to $345.4 million for the first six months of fiscal year2006, an increase of $41.2 million or 11.9 percent.   The increase was mainly due to highersalaries of $24.5 million, a higher accrual for discretionary compensation of$14.8 million, higher benefits of $5.6 million, the impact of an appreciatingBritish Pound and a decrease in capitalization of time spent customizingin-house administration systems of $4.3 million, in accordance with AICPA’sStatement of Position 98-1, “Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use” partially offset by a decrease inpension expense of $9.4 million.  As apercentage of revenue, salaries and employee benefits decreased to 55.5 percentfrom 55.9 percent.

***Professionaland Subcontracted Services*.**

Professional andsubcontracted services used in consulting operations for the first six monthsof fiscal year 2007 were $46.2 million, compared to $39.3 million for the firstsix months of fiscal year 2006, an increase of $6.9 million or 17.5 percent. Asa percentage of revenue, professional and subcontracted services increased to6.6 percent from 6.4 percent.  Theincrease is principally attributable to higher reimbursable expenses incurredon behalf of clients and increased costs in Europe for temporary staff,consulting fees, and legal reserves.

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

Occupancy, communicationsand other expenses for the first six months of fiscal year 2007 were $86.6million compared to $81.6 million for the first six months of fiscal year 2006,an increase of $5.0 million or 6.1 percent. The increase is mainly due to increases in rent and utilities, repairsand maintenance expenses, travel, promotion, professional development, dues, aswell as the impact of an appreciating British Pound, partially offset by adecrease in miscellaneous expenses such as duplicating, general office, andbusiness tax expense.  As a percentage ofrevenue, occupancy, communications and other decreased from 12.3 percent to13.2 percent.

***Generaland Administrative Expenses.***

General andadministrative expenses for the first six months of fiscal year 2007 were $77.6million, compared to $74.0 million for the first six months of fiscal year2006, an increase of $3.5 million or 4.8 percent.   The increase is mainly due to increases insalaries expense of $4.2 million, professional services expense of $3.7million, rent and utilities expense of $2.5 million partially offset by adecrease in professional indemnity insurance of $5.4 million and decreases inmiscellaneous expenses such as office supplies, promotion, and dues totaling$1.6 million.  As a percentage ofrevenue, general and administrative expenses decreased to 11.0 percent from12.0 percent.

***Depreciationand Amortization.***

Depreciation andamortization for the first six months of fiscal year 2007 was $26.7 millioncompared to $22.1 million for the first six months of fiscal year 2006, anincrease of $4.6 million or 20.8 percent. The increase is mainly due to depreciationof internally developed software used to support our Benefits and Technologyand Administration Solutions Group of $3.2 million and amortization ofintangibles of $1.4 million.  As apercentage of revenue, depreciation and amortization increased to 3.8 percentfrom 3.6 percent.

***(Loss)/IncomeFrom Affiliates.***

Loss from affiliates forthe first six months of fiscal year 2007 was $0.9 million compared to income of$0.9 million for the first six months of fiscal year 2006.  The amount of income or loss recognizedreflects our share of PCIC’s earnings for the relative period.

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*** ***

***InterestIncome/(Expense), net.***

Net interest income forthe first six months of fiscal year 2007 was $1.2 million compared to netinterest expense of $1.8 million for the first six months of fiscal year2006.  The increase in net interestincome in the current period was due to an increased net investment balance anda decreased average debt balance.

***OtherNon-Operating Income.***

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

***Provisionfor Income Taxes.***

Provision for incometaxes for the first six months of fiscal year 2007 was $28.4 million, comparedto $23.1 million for the first six months of fiscal year 2006. Our effectivetax rate was 35.8 percent for the first six months of fiscal year 2007 and 40.9percent for the first six 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 foreign subsidiariesaffiliated 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 six months of fiscal year 2007 was $50.8 million,compared to $33.1 million for the first six months of fiscal year 2006.  As a percentage of revenue, income from continuingoperations increased to 7.2 percent from 5.4 percent.

***EarningsPer Share, Income From Continuing Operations.***

Diluted earnings pershare, income from continuing operations for the first six months of fiscalyear 2007 was $1.14, compared to $0.77 for the first six months of fiscal year 2006.The diluted earnings pershare calculation assumes that the 1,950,000 contingent shares related to thebusiness combination have been issued and outstanding since the beginning ofeach fiscal year presented.

**Liquidity and Capital Resources**

Our cash and cashequivalents at December 31, 2006 totaled $68.5 million, compared to $165.3million at June 30, 2006.  The decreasein cash from June 30, 2006 to December 31, 2006 was mainly attributable to thepayment during the first quarter of fiscal year 2007 of $96.5 million ofpreviously accrued discretionary compensation. We also paid $29.9 million incorporate taxes, $18.6 million in capital expenditures and $6.4 million individends during the first six months of fiscal year 2007.  These payments were funded by cash flow fromcurrent consulting operations, from existing cash balances and from borrowingsunder 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 company utilized$6.4 million from its credit facility and cash on hand toward the cashconsideration payment to be made in connection with the acquisition ofsubstantially all the assets of Watson Wyatt Brans Co. (“Brans Acquisition”).  The company believes that it has sufficientresources to fund operations through the next twelve months.

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Our non U.S. operationsare substantially self-sufficient for their working capital needs.  At December 31, 2006, $42.6 million of thetotal cash balance of $68.5 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.

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

Cash used in operatingactivities for the first six months of fiscal year 2007 was $19.1 million,compared to cash from operating activities of $7.5 million for the first sixmonths of fiscal year 2006.  Thedifference is primarily attributable to the payment of bonuses and an increasein accounts receivable in fiscal year 2007.

The allowance fordoubtful accounts increased $2.6 million from June 30, 2006 to December 31,2006. The number of days of accounts receivable and work in process outstandingwas 85 at December 31, 2006, compared to 83 at June 30, 2006.

***CashUsed in Investing Activities.***

Cash used in investingactivities for the first six months of fiscal year 2007 was $30.5 million,compared to $162.1 million used in investing activities for the first sixmonths of fiscal year 2006.  Thedifference can be primarily attributed to acquisition and contingent considerationpayments of $134.1 million in the first six months of fiscal year 2006.

Expenditures of capitalfunds were $18.6 million for the first six months of fiscal year 2007.  Anticipated commitments of capital funds areestimated at $30 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 six months of fiscal year 2007 was $49.6 million,compared to cash from financing activities of $63.0 million for the first sixmonths of fiscal year 2006.  This changeis primarily attributable to activity under our credit facility which includednet borrowings of $75 million in the first six months of fiscal year 2006compared to a net repayment of $30 million in the first six months of fiscalyear 2007.  Additionally, during thefirst six months of fiscal year 2007, the company repurchased $20 million ofcommon stock, compared to $2.5 million of common stock during the same periodin fiscal year 2006. The company also made a one-time payment of $8.4 millionunder a forward contract in fiscal year 2006.

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**Off-BalanceSheet Arrangements and Contractual Obligations**

The followingtable summarizes our contractual arrangements at December 31, 2006, andthe timing and effect that such commitments are expected to have on ourliquidity and cash flow in future periods.
| ** **                                                      | ** ** | **Remaining payments due by fiscal year as of December 31, 2006** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| **Contractual Cash  Obligations (in thousands)** | ** ** | ** **                                                                                                          | ** ** | **Total** | ** ** | **Remaining  2007** | ** ** | **2008  through  2009** | ** ** | **2010  through  2011** | ** ** | **Thereafter** | ** ** |
| Lease commitments                                               |       | $                                                                                                                   | 363,449    |   | $ | 27,993 |   | $ | 102,781 |   | $ | 84,112 |   | $ | 148,563 |   |
|                                                                 |            |                                                                                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***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 0.125 percent of the facility,which varies with our financial leverage and is paid on the unused portion ofthe credit facility.  There were noborrowings under this facility as of December 31, 2006, compared to netborrowings of $75 million as of December 31, 2005.  On February 1, 2007, the company accessed$6.4 million under its credit facility in connection with the BransAcquisition. Credit under the facility is available upon demand, although thecredit facility requires us to observe certain covenants (includingrequirements for minimum net worth, which act to restrict dividends, cash flowleverage ratio and a fixed coverage charge) and is collateralized with a pledgeof stock of material subsidiaries.  Wewere in compliance with all covenants under the credit facility as of December31, 2006. This facility is scheduled to 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 ofDecember 31, 2006.  We are also charged afee for outstanding letters of credit that also fluctuates based on ourleverage ratio.

***PensionContributions.***  We’vemade pension contributions of $8.0 million during the first six months offiscal year 2007.  We also made a $15.0million pension contribution in January 2007. We anticipate contributing an additional $7.0 million to various plans overthe remainder of the fiscal year.

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*** ***

***Guarantees***

*Wellspring Leases*.  We continue to guarantee two leases foroffice premises for Wellspring Resources, LLC (“Wellspring”), the benefitsadministration outsourcing business that we exited from in fiscal year1998.  Based on our analysis and thelimited duration of the remaining lease obligations, the company believes thatpayment under these lease guarantees is remote.

*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.

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 after June 30, 2007, is contingent uponthe achievement by the acquired business of agreed-upon financial performancegoals. The value of all the contingent stock was $87.1 million based on theNYSE closing price on January 31, 2007. The contingent consideration is payableby Watson Wyatt Limited and the payment obligations are guaranteed by WatsonWyatt 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 December 31, 2006.

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** **

**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 professional liability insurance coverage beyond our self-insured retentionamount is written by an affiliated captive insurance company (PCIC) owned by usand two other professional services 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 itinsures above $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 probable and reasonably estimable.

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 insurance contracts. Generally accepted accounting principlesrequire that we record a liability for incurred but not reported (IBNR)professional liability claims if they are probable and reasonably estimable,and for which we have not yet contracted for insurance coverage.  The company uses actuarial assumptions toestimate and record its IBNR liability and has a $34.7 million IBNR liabilityrecorded as of December 31, 2006.

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.

Inlight of increasing worldwide litigation, including litigation againstprofessionals, the company has implemented a requirement that all clientrelationships be documented by engagement letters containing specific risk mitigationclauses that were not included in all historical client agreements.  Nearly 100 percent of the company’s U.S.****andU.K.****corporate clients havesigned engagement letters including mitigation clauses, and initiatives tomaintain that process in the United States and the United Kingdom and completeit elsewhere are underway.  The companyhas disengaged from certain client relationships where satisfactory engagementterms 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 — Goodwilland Intangible Assets; Note 11 — Guarantees; Note 12 — Contingent Liabilities;the Executive Overview; Critical Accounting Policies and Estimates; thediscussion of our capital expenditures; Off-Balance Sheet Arrangements andContractual Obligations; Risk Management; and Part II, Item 1 “LegalProceedings”.  You can identify thesestatements and other forward-looking statements in this filing by words such as“may”, “will,”, “expect”, “anticipate”, “believe”, “estimate”, “plan”, “intend”,“continue”, or similar words, expressions or the negative of such terms orother comparable terminology. You should read these statements carefullybecause they contain projections of our future results of operations orfinancial condition, or state other “forward-looking” information. A number ofrisks and uncertainties exist which could cause actual results to differmaterially from the results reflected in these forward-looking statements.  Such factors include but are not limited to:

·              ourability to integrate acquired businesses, including the Brans business, intoour own business, processes and systems, and achieve the anticipated results;

·              ourcontinued ability to recruit and retain qualified associates;

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

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

·              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;

·              ourability 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 andInternet/intranet development firms;

·              ourability to achieve cost reductions after our recent acquisitions;

·              foreigncurrency exchange and interest rate fluctuations;

·              exposureto liabilities that have not been expressly assumed in our acquisitiontransactions;

·              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 DISCLOSURESABOUT MARKET RISK**

We are exposed to market risksin the ordinary course of business. These risks include interest rate risk, foreign currency exchange andtranslation risk.

**Interest Rate Risk**

The primary objective of ourinvestment activities is to preserve principal while at the same timemaximizing yields without significantly increasing risk. To achieve thisobjective, we maintain our portfolio in mainly short term securities that arerecorded on the balance sheet at fair value.

**ForeignCurrency Risk**

International net revenuesresult from transactions by our foreign operations and are typicallydenominated in the local currency of each country. These operations also incurmost of their expenses in the local currency. Accordingly, our foreignoperations use the local currency, as their functional currency and our primaryinternational operations use the British pound. Our international operationsare subject to risks typical of international operations, including, but notlimited to, differing economic conditions, changes in political climate,differing tax structures, other regulations and restrictions, and foreignexchange rate volatility. Accordingly, our future results could be adversely impactedby changes in these or other factors.

**TranslationExposure**

Foreign exchange ratefluctuations may adversely impact our consolidated financial position as wellas our consolidated results of operations and may adversely impact ourfinancial position as the assets and liabilities of our foreign operations aretranslated into U.S. dollars in preparing our consolidated balance sheet.Additionally, foreign exchange rate fluctuations may adversely impact ourconsolidated results of operations as exchange rate fluctuations ontransactions denominated in currencies other than our functional currenciesresult in gains and losses that are reflected in our consolidated statement ofincome.

We consolidate our internationalsubsidiaries by converting them into U.S. dollars in accordance with Statementof Financial Accounting Standards No. 52, “Foreign Currency Translation” (“FAS52”). The results of operations and our financial position will fluctuate whenthere is a change in foreign currency exchange rates.

**ITEM 4.  CONTROLS AND PROCEDURES.**

**Evaluation of Disclosure Controls and Procedures**

An evaluation was performedunder the supervision and with the participation of our management, includingthe chief executive officer, or CEO, and chief financial officer, or CFO, ofthe effectiveness of the design and operation of our disclosure controls andprocedures as such term is defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934. Based on that evaluation, our management,including the CEO and CFO, concluded that our disclosure controls andprocedures were effective as of December 31, 2006.

**Changes in Internal Control OverFinancial Reporting**

There were no significantchanges in our internal control over financial reporting in the quarter endedDecember 31, 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**

**ITEM 1.  LEGAL PROCEEDINGS.**

From time to time, we area party to various lawsuits, arbitrations or mediations that arise in theordinary course of business. The disclosure called for by Part II, Item 1,regarding our legal proceedings is incorporated by reference herein from Note12 “Contingent Liabilities,” of the Notes to the Consolidated FinancialStatements in this Form 10-Q for the quarter ending December 31, 2006.

**ITEM 1A.  RISK FACTORS.**

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

**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS.**

The company did notengage in any unregistered sales of equity securities during the quarter.  See Item 5 below, however, with respect toour unregistered issuance of shares in connection with an off-shore acquisitionafter the interim reporting period.

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** **

**Issuer Purchases of EquitySecurities**

The table belowpresents specified information about the company’s stock repurchases andrepurchase 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** | ** ** |
|---------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 1, 2006 through  October 31, 2006   |       | —     |       | $                                                | —     |                                             | —     |                                                                                                                             | 1,413,534  |                                                                                                                                    |
| November 1, 2006 through  November 31, 2006 |       | —     |       | —                                           |       | —                                           |       | 1,413,534                                                                                                                        |       |
| December 1, 2006 through  December 31, 2006 |       | —     |       | —                                           |       | —                                           |       | 1,413,534                                                                                                                        |       |
| Total                                       |       | —     |       |                                             |       | —                                           |       |                                                                                                                             |       |
|                                             |            |            |            |                                                  |            |                                                  |            |                                                                                                                                  |            |                                                                                                                                         |            |  |

 

During the firstquarter of fiscal year 2007, the company’s Board of Directors approved therepurchase of up to 1,500,000 shares of our Class A common stock. Shares thatthe company repurchases are primarily issued in connection with the company’semployee benefit plans.

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.**

**None.**

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.**

At the seventh annualmeeting of the stockholders of the Company, held on November 17, 2006, thefollowing matters were submitted to a vote of stockholders:

(1)                     a proposal toapprove amendments to the Amended and Restated Certificate of Incorporation toeliminate the classification of the Board of Directors;

(2)                     the electionof ten members of the Board of Directors;

(3)                     a proposal toapprove amendments to the Amended and Restated Certificate of Incorporation toeliminate the Class B Stock; and

(4)                     a proposal toapprove an increase in the number of shares which may be issued under the 2001Deferred Stock Unit Plan for Selected Employees.

Proxies representing 36,739,089 shares were received(total shares outstanding as of the Record Date were  42,285,798) and theresults of the meeting are as follows with respect to each matter submitted toa vote of stockholders.

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*Amendments to the Amendedand Restated Certificate of Incorporation to Eliminate the Classification ofthe Board of Directors*

Up until the date of the Annual Meeting, held onNovember 17, 2006, under the Company’s Amended and Restated Certificate ofIncorporation, Directors were separated into three classes, serving staggeredterms.  Each year, the stockholders wereasked to elect the Directors comprising one of the classes for a three-yearterm. At the time of the Annual Meeting, the term for four Directors was set toexpire in 2006 (this year’s Annual Meeting). The term of three other Directors was set to expire in 2007 and the termof the other four Directors was set to expire in 2008.  Because of the classified Board structure,stockholders had the opportunity to elect one class of the Directors (orapproximately one-third of the Directors) each year.

The Board of Directors adopted resolutions settingforth proposed amendments to the Amended and Restated Certificate ofIncorporation (the “Declassification Amendments”) to eliminate the classifiedBoard structure, to permit removal of Directors by stockholders with or withoutcause in accordance with Delaware law and to make technical, conformingchanges.  The Board declared the DeclassificationAmendments advisable, and unanimously resolved to submit the DeclassificationAmendments to the Company’s stockholders for consideration.

On November 17, 2006, the stockholders of the Companyapproved this proposal.  Therefore theterms of all Directors will expire at the annual meeting of stockholders eachyear and their successors will be elected for one-year terms that will expireat the next annual meeting.

Of the proxies received,the votes were as follows:

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|---------------------------|------------|
| 35,675,783 |       | 326,913     |       | 736,393     |       | 0                         |       |

 

*Election of Directors*

The stockholders approved the proposal to eliminatethe classification of the Board of Directors, and upon effectiveness of theDeclassification Amendments, the Board of Directors was no longerclassified.  All ten of the Company’sDirectors therefore stood for election to serve a one-year term expiring at the2007 Annual Meeting of Stockholders, and until his or her successor shall havebeen elected and qualified.

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Of the proxies received,the votes were as follows:

| Nominees for Directors                              | ** ** | ** ** | ** ** | **For**   | ** ** | **Withheld** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------|------------|--------------|------------|
|                                                          |       |       |       |      |       |
| Term expiring at the  annual meeting of stockholders in 2007: |       |       |       |      |       |
|                                                          |       |       |       |      |       |
| John J. Gabarro                                               |       | 34,616,578 |       | 2,122,511 |       |
| John J. Haley                                                 |       | 34,703,575 |       | 2,035,514 |       |
| R. Michael McCullough                                         |       | 34,811,124 |       | 1,927,964 |       |
| Brendan R. O’Neill                                       |       | 35,786,396 |       | 952,692   |       |
| Linda D. Rabbitt                                              |       | 35,436,024 |       | 1,303,065 |       |
| Chandrasekhar  Ramamurthy                                     |       | 34,520,944 |       | 2,218,144 |       |
| Gilbert T. Ray                                                |       | 34,650,826 |       | 2,088,263 |       |
| Roger C. Urwin                                                |       | 33,751,615 |       | 2,987,473 |       |
| Gene H. Wickes                                                |       | 34,419,440 |       | 2,319,648 |       |
| John C. Wright                                                |       | 34,019,784 |       | 2,719,304 |       |

 

*Approval of a proposal toapprove amendments to the Amended and Restated Certificate of Incorporation toEliminate the Class B Stock*

At the time of the Annual Meeting, Article 4 of theCompany’s Amended and Restated Certificate of Incorporation authorized theissuance of up to 15,000,000 shares of Class B-1 Common Stock, par value $.01per share, and 15,000,000 shares of Class B-2 Common Stock, par value $.01 pershare (collectively, the “Class B Common Stock”).  There are no shares of Class B CommonStock outstanding.  In October 2001, allthe Class B-1 shares automatically converted to Class A shares, and in October2002, all the Class B-2 shares automatically converted to Class A shares.  The Company has no intention to issue anyshares of Class B Common Stock.  OnSeptember 29, 2006, the Board of Directors determined that it is in the bestinterests of the Company and the Company’s stockholders that the Amended andRestated Certificate of Incorporation be restated to eliminate the Class BCommon Stock.  As a result, the Boardadopted proposed amendments to Article 4 of the Amended and Restated Certificateof Incorporation, declared such amendments advisable and unanimously resolvedto submit such amendments to the Company’s stockholders for consideration.   On November 17, 2006, the stockholders ofthe Company approved amendments to the Company’s Amended and RestatedCertificate of Incorporation to eliminate the Class B stock.

Of the proxies received, the votes were as follows:

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|---------------------------|------------|
| 34,646,060 |       | 93,911      |       | 1,999,117   |       | 0                         |       |

 

*Approval of a proposal toapprove an increase in the number of shares which may be issued under the 2001Deferred Stock Unit Plan for Selected Employees.*

On November 17, 2006, the stockholders of the Companyapproved an amendment to the 2001 Deferred Stock Unit Plan for SelectedEmployees (the “DSU Plan”) to increase the number of shares of common stockavailable for issuance under the DSU Plan to 2,700,000, subject to adjustmentsfor stock splits, stock dividends and similar transactions, includingextraordinary distributions of cash or stock.  The board of directorsapproved this amendment on September 19, 2006. No grants or awards have beenmade in connection with this amendment to the principal executive officer,principal financial officer or a named executive officer.

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The DSU Plan was originally approved on November 5,2001 at the annual meeting of stockholders.  The DSU Plan is intended toprovide senior associates of the Company with additional incentives bypermitting the Company to grant them an equity interest in the Company in theform of deferred stock units, in lieu of a portion of their annual fiscalyear-end bonus, typically paid in September of each year. Each stock unitrepresents one share of common stock.  The initial total number of sharesauthorized for issuance in payment of deferred stock units under the DSU Planwas 1,500,000 shares.

Of the proxies received, the votes were as follows:

| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|---------------------------|------------|
| 25,245,203 |       | 2,740,186   |       | 1,996,671   |       | 6,757,029                 |       |

 

**ITEM 5. OTHERINFORMATION.**

Thecompany previously announced the dismissal of PricewaterhouseCoopers LLP (“PwC”)as the company’s independent registered public accounting firm on December 7,2006, and approved Deloitte & Touche LLP (“Deloitte”) as its new independentregistered public accounting firm, effective upon completion of Deloitte’scustomary client acceptance procedures which were completed on December 12,2006.  Details of the event were filedunder Item 4.01 of Form 8-K on December 13, 2006.

 On February 1, 2007, the Company issued252,285 shares of the Company’s class A common stock under Regulation S of theSecurities Act of 1933 in connection with the Brans Acquisition.

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**ITEM 6. EXHIBITS.**
| 3.1  |   | Amended and Restated Certificate of Incorporation of  Watson Wyatt Worldwide, Inc.(1)                                                                                             |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  |   | Amended and Restated Bylaws of Watson Wyatt  Worldwide, Inc.(1)                                                                                                                   |
| 10.1 |   | 2001 Deferred Stock Unit Plan for Selected Employees(1)                                                                                                                                |
| 10.2 |   | FY07 Performance Share Bonus Incentive Program (1)                                                                                                                                     |
| 21   |   | Subsidiaries of Watson Wyatt Worldwide, Inc.(1)                                                                                                                                        |
| 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 withthis 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 WyattWorldwide, Inc.(Registrant)
| /s/  John J. Haley  |   | February 9, 2007        |   |   |
|---------------------|--------|-------------------------|--------|--------|
| Name:               |   | John J. Haley           |   | Date   |
| Title:              |   | President and           |   |   |
|                |   | Chief Executive Officer |   |   |
|                |   |                    |   |   |
|                |   |                    |   |   |
| /s/ Carl D. Mautz   |   | February 9, 2007        |   |   |
| Name:               |   | Carl D. Mautz           |   | Date   |
| Title:              |   | Vice President and      |   |   |
|                |   | Chief Financial Officer |   |   |
|                |   |                    |   |   |
|                |   |                    |   |   |
| /s/ Peter L. Childs |   | February 9, 2007        |   |   |
| Name:               |   | Peter L. Childs         |   | Date   |
| Title:              |   | Controller              |   |   |
|                     |        |                         |        |        |  |  |  |

 

 

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