**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 

**(Mark One)**

 

| **ý**                                  | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                               |
|---------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                  | ** **                                                                                                                                                                                                                                  |
| ** **                                  | **For the  quarterly period ended September 30, 2004**                                                                                                                                                                                      |
| ** **                                  | ** **                                                                                                                                                                                                                                  |
| **OR**                                      |
| ** **                                  | ** **                                                                                                                                                                                                                                  |
| **o**                                       | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                              |
| ** **                                  | ** **                                                                                                                                                                                                                                  |
| ** **                                  | **For the  transition period from                    to                  ** |
| ** **                                  | ** **                                                                                                                                                                                                                                  |
| **Commission File Number:  001-16159** |

 

| **WATSON WYATT & COMPANY HOLDINGS**                         |
|-----------------------------------------------------------------|
| (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.) |

** **

**1717 H Street NWWashington, D.C. 20006-3900**(Address of principal executive offices, including zipcode)

**(202) 715-7000**(Registrant’s telephone number, including area code)

 

Indicate by check mark whetherthe Registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the Registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days:

 

Yes ý    No o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes ý    No o

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of October 31,2004.

 
| **Class**                             |   | **Number of Shares** |
|---------------------------------------|--------|----------------------|
|                                  |   |                 |
| Class A  Common Stock, $.01 par value |   | 32,437,920           |

 

 

----

 

**WATSON WYATT & COMPANY HOLDINGSINDEX TO FORM 10-Q**

 

For the Three Months Ended September 30, 2004

 
| PART I.        | FINANCIAL  INFORMATION                                                                                     |   |
|----------------|------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                       |   |
| Item 1.        | Financial  Statements (Unaudited)                                                                          |   |
|           |                                                                                                       |   |
|           | Consolidated Statements of Operations—Three  months ended September 30, 2004 and 2003                 |   |
|           |                                                                                                       |   |
|           | Consolidated Balance Sheets—September 30, 2004 and June 30, 2004                                      |   |
|           |                                                                                                       |   |
|           | Consolidated Statements of Cash Flows—Three  months ended September 30, 2004 and 2003                 |   |
|           |                                                                                                       |   |
|           | Consolidated Statement of Changes in  Stockholders’ Equity—Three months ended September 30, 2004 |   |
|           |                                                                                                       |   |
|           | Notes to the Consolidated Financial  Statements                                                            |   |
|           |                                                                                                       |   |
| Item 2.        | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                |   |
|           |                                                                                                       |   |
| Item 3.        | Quantitative and Qualitative Disclosures About  Market Risk                                                |   |
|           |                                                                                                       |   |
| Item 4.        | Controls and Procedures                                                                                    |   |
|           |                                                                                                       |   |
| PART II.       | OTHER INFORMATION                                                                                          |   |
|           |                                                                                                       |   |
| Item 1.        | Legal Proceedings                                                                                          |   |
|           |                                                                                                       |   |
| Item 2.        | Unregistered Sales of Equity Securities,  Use of Proceeds and Issuer Purchases of Equity Securities        |   |
|           |                                                                                                       |   |
| Item 3.        | Defaults Upon Senior Securities                                                                            |   |
|           |                                                                                                       |   |
| Item 4.        | Submission of Matters to a Vote of Security  Holders                                                       |   |
|           |                                                                                                       |   |
| Item 5.        | Other Information                                                                                          |   |
|           |                                                                                                       |   |
| Item  6.       | Exhibits  and Reports on Form 8-K                                                                          |   |
|           |                                                                                                       |   |
| Signatures     |                                                                                                       |   |
|           |                                                                                                       |   |
| Certifications |                                                                                                       |   |

 

----

** **

**WATSON WYATT & COMPANY HOLDINGS**

**Consolidated Statements of Operations**

(Thousandsof U.S. Dollars, Except Per Share Data)

 
| ** **                                                                                                                                | ** ** | **Three months ended September 30** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
|                                                                                                                                      |       | **2004**                            | ** ** | **2003** |   |
|                                                                                                                                      |       | **(Unaudited)**                     |       |
|                                                                                                                                      |       |                                |       |   |   |
| Revenue                                                                                                                                   |       | $                                   | 175,391    |   | $ | 170,983 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Costs of providing services:                                                                                                              |       |                                |       |   |   |
| Salaries and employee benefits                                                                                                            |       | 97,076                              |       | 105,073 |   |
| Professional and subcontracted services                                                                                                   |       | 11,979                              |       | 9,086 |   |
| Occupancy, communications and other                                                                                                       |       | 24,100                              |       | 23,518 |   |
| General and administrative expenses                                                                                                       |       | 16,888                              |       | 15,601 |   |
| Depreciation and amortization                                                                                                             |       | 4,683                               |       | 4,652 |   |
|                                                                                                                                      |       | 154,726                             |       | 157,930 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Income from operations                                                                                                                    |       | 20,665                              |       | 13,053 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Income from affiliates                                                                                                                    |       | 2,206                               |       | 1,790 |   |
| Interest income, net                                                                                                                      |       | 455                                 |       | 214 |   |
| Other non-operating income                                                                                                                |       | 28                                  |       | 6,125 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Income from continuing operations before  income taxes                                                                                    |       | 23,354                              |       | 21,182 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Provision for income taxes                                                                                                                |       | 9,603                               |       | 8,685 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Income from continuing operations                                                                                                         |       | 13,751                              |       | 12,497 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Discontinued operations:                                                                                                                  |       |                                |       |   |   |
|                                                                                                                                      |       |                                |       |   |   |
| Sublease income from discontinued  operations, less applicable income tax expense for the three months ended  September 30, 2004 and 2003 |       | 2                                   |       | 10 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Net income                                                                                                                                |       | $                                   | 13,753     |   | $ | 12,507 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Basic earnings per share:                                                                                                                 |       |                                |       |   |   |
| Income from continuing operations                                                                                                         |       | $                                   | 0.42       |   | $ | 0.38 |   |
| Income from discontinued operations                                                                                                       |       | —                              |       | — |   |
| Net income                                                                                                                                |       | $                                   | 0.42       |   | $ | 0.38 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Diluted earnings per share:                                                                                                               |       |                                |       |   |   |
| Income from continuing operations                                                                                                         |       | $                                   | 0.42       |   | $ | 0.37 |   |
| Income from discontinued operations                                                                                                       |       | —                              |       | — |   |
| Net income                                                                                                                                |       | $                                   | 0.42       |   | $ | 0.37 |   |
|                                                                                                                                      |       |                                |       |   |   |
| Weighted average shares of common stock, basic  (000)                                                                                     |       | 32,358                              |       | 33,078 |   |
| Weighted average shares of common stock, diluted  (000)                                                                                   |       | 32,679                              |       | 33,424 |   |

 

See accompanying notes to theconsolidated financial statements

 

1

----

** **

**WATSON WYATT & COMPANY HOLDINGS**

**ConsolidatedBalance Sheets**

(Thousandsof U.S. Dollars, Except Share and Per Share Data)

 
|                                                                                                                                              |       | **September  30,  2004** | ** ** | **June 30,  2004** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------|------------|
|                                                                                                                                              |       | **(unaudited)**          | ** ** | ** **         |       |
| **Assets**                                                                                                                                        | ** ** | ** **               | ** ** | ** **         | ** ** |
| Cash and cash equivalents                                                                                                                         |       | $                        | 107,125    |               | $          | 156,940 |   |
| Receivables from clients:                                                                                                                         |       |                     |       |               |       |
| Billed, net of allowances of $3,145 and  $1,241                                                                                                   |       | 91,420                   |       | 86,726             |       |
| Unbilled, net of allowances of $1,241 and  $456                                                                                                   |       | 66,062                   |       | 63,108             |       |
|                                                                                                                                              |       | 157,482                  |       | 149,834            |       |
|                                                                                                                                              |       |                     |       |               |       |
| Deferred income taxes                                                                                                                             |       | 7,079                    |       | 15,052             |       |
| Other current assets                                                                                                                              |       | 39,361                   |       | 11,388             |       |
| Total current assets                                                                                                                              |       | 311,047                  |       | 333,214            |       |
|                                                                                                                                              |       |                     |       |               |       |
| Investment in affiliates                                                                                                                          |       | 30,834                   |       | 30,235             |       |
| Fixed assets, net                                                                                                                                 |       | 65,410                   |       | 65,438             |       |
| Deferred income taxes                                                                                                                             |       | 54,988                   |       | 55,240             |       |
| Goodwill and intangible assets                                                                                                                    |       | 21,272                   |       | 20,909             |       |
| Other assets                                                                                                                                      |       | 9,482                    |       | 7,132              |       |
|                                                                                                                                              |       |                     |       |               |       |
| **Total Assets**                                                                                                                                  |       | $                        | 493,033    |               | $          | 512,168 |   |
| ** **                                                                                                                                        | ** ** | ** **               | ** ** | ** **         | ** ** |
| **Liabilities**                                                                                                                                   | ** ** | ** **               | ** ** | ** **         | ** ** |
| Accounts payable and accrued liabilities,  including discretionary compensation                                                                   |       | $                        | 80,047     |               | $          | 113,233 |   |
| Income taxes payable                                                                                                                              |       | 10,515                   |       | 12,526             |       |
| Total current liabilities                                                                                                                         |       | 90,562                   |       | 125,759            |       |
|                                                                                                                                              |       |                     |       |               |       |
| Accrued retirement benefits                                                                                                                       |       | 100,960                  |       | 97,984             |       |
| Deferred rent and accrued lease losses                                                                                                            |       | 10,239                   |       | 10,199             |       |
| Deferred income taxes                                                                                                                             |       | 365                      |       | 628                |       |
| Other noncurrent liabilities                                                                                                                      |       | 31,261                   |       | 32,414             |       |
|                                                                                                                                              |       |                     |       |               |       |
| **Total Liabilities**                                                                                                                             |       | 233,387                  |       | 266,984            |       |
|                                                                                                                                              |       |                     |       |               |       |
| 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: 69,000,000  shares authorized; 33,372,880 and 33,372,880 issued and 32,419,031 and  32,317,156 outstanding |       | 334                      |       | 334                |       |
| Additional paid-in capital                                                                                                                        |       | 149,387                  |       | 149,508            |       |
| Treasury stock, at cost - 953,849 and  1,055,724 shares                                                                                           |       | (23,711                  | )          | (26,149            | )          |
| Retained earnings                                                                                                                                 |       | 137,007                  |       | 125,669            |       |
| Accumulated other comprehensive loss                                                                                                              |       | (3,371                   | )          | (4,178             | )          |
| **Total Stockholders’ Equity**                                                                                                               |       | 259,646                  |       | 245,184            |       |
|                                                                                                                                              |       |                     |       |               |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                               |       | $                        | 493,033    |               | $          | 512,168 |   |

 

See accompanying notes to theconsolidated financial statements

 

2

----

 

**WATSON WYATT & COMPANY HOLDINGS**

**Consolidated Statements of Cash Flows**

(Thousandsof U.S. Dollars)

** **
| ** **                                                                     | ** ** | **Three months ended September 30** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **(Unaudited)**                     | ** ** |
| Cash flows used in operating activities:                                       |       |                                |       |   |   |
| Net income                                                                     |       | $                                   | 13,753     |   | $ | 12,507 |   |
| Adjustments to reconcile net income to net  cash used in operating activities: |       |                                |       |   |   |
| Other non-operating gain related to PCIC                                       |       | —                              |       | (5,600 | ) |
| Income from discontinued operations, net of  income tax expense                |       | (2                                  | )          | (10 | ) |
| Provision for doubtful receivables from  clients                               |       | 3,463                               |       | 2,586 |   |
| Depreciation                                                                   |       | 4,610                               |       | 4,570 |   |
| Amortization of intangible assets                                              |       | 73                                  |       | 82 |   |
| Provision for deferred income taxes                                            |       | (6,717                              | )          | 5,998 |   |
| Income from affiliates                                                         |       | (2,206                              | )          | (1,790 | ) |
| Distributions from affiliates                                                  |       | 1,491                               |       | 1,065 |   |
| Other, net                                                                     |       | 43                                  |       | (544 | ) |
| Changes in operating assets and liabilities  (net of discontinued operations)  |       |                                |       |   |   |
| Receivables from clients                                                       |       | (11,110                             | )          | (9,926 | ) |
| Other current assets                                                           |       | (13,294                             | )          | (7,487 | ) |
| Other assets                                                                   |       | (2,350                              | )          | 600 |   |
| Accounts payable and accrued liabilities                                       |       | (28,938                             | )          | (22,022 | ) |
| Income taxes payable                                                           |       | (2,013                              | )          | (14,687 | ) |
| Accrued retirement benefits                                                    |       | 2,976                               |       | 8,128 |   |
| Deferred rent and accrued lease losses                                         |       | 40                                  |       | 561 |   |
| Other noncurrent liabilities                                                   |       | (1,134                              | )          | 433 |   |
| Net cash used in operating activities                                          |       | (41,315                             | )          | (25,536 | ) |
|                                                                           |       |                                |       |   |   |
| Cash flows used in investing activities:                                       |       |                                |       |   |   |
| Purchases of fixed assets                                                      |       | (4,504                              | )          | (3,593 | ) |
| Proceeds from divestitures                                                     |       | 28                                  |       | 525 |   |
| Acquisitions and contingent consideration  payments                            |       | (41                                 | )          | (43 | ) |
| Net cash used in investing activities                                          |       | (4,517                              | )          | (3,111 | ) |
|                                                                           |       |                                |       |   |   |
| Cash flows (used in) from financing  activities:                               |       |                                |       |   |   |
| Issuances of common stock - exercises of  stock options                        |       | 424                                 |       | 305 |   |
| Issuances of common stock - employee stock  purchase plan                      |       | 1,793                               |       | 1,608 |   |
| Dividends paid                                                                 |       | (2,424                              | )          | — |   |
| Repurchases of common stock                                                    |       | (4,188                              | )          | — |   |
| Net cash (used in) from financing  activities                                  |       | (4,395                              | )          | 1,913 |   |
|                                                                           |       |                                |       |   |   |
| Effect of exchange rates on cash                                               |       | 412                                 |       | 663 |   |
|                                                                           |       |                                |       |   |   |
| Decrease in cash and cash equivalents                                          |       | (49,815                             | )          | (26,071 | ) |
|                                                                           |       |                                |       |   |   |
| Cash and cash equivalents at beginning of  period                              |       | 156,940                             |       | 144,374 |   |
|                                                                           |       |                                |       |   |   |
| Cash and cash equivalents at end of period                                     |       | $                                   | 107,125    |   | $ | 118,303 |   |

 

See accompanying notes to theconsolidated financial statements

 

3

----

 

**WATSON WYATT & COMPANY HOLDINGS**

**Consolidated Statement of Changes in Stockholders’ Equity**

(Thousandsof U.S. Dollars)

** **
| ** **                                                       | ** ** | **Class A  Common  Stock Outstanding  (number of  shares)** | ** ** | **Class A  Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Treasury  Stock,  at Cost** | ** ** | **Retained  Earnings  (Accumulated  Deficit)** | ** ** | **Accumulated  Other  Comprehensive  (Loss)/Income** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|----------------------------|------------|----------------------------------|------------|-------------------------------|------------|------------------------------------------------|------------|------------------------------------------------------|------------|-----------|------------|
| Balance at June 30, 2004                                         |       | 32,317                                                      |       | $                          | 334        |                             | $          | 149,508                       |       | $                                              | (26,149    | )                                                    | $          | 125,669   |       | $ | (4,178 | ) | $ | 245,184 |   |
|                                                             |       |                                                        |       |                       |       |                             |       |                          |       |                                           |       |                                                 |       |      |       |
| Comprehensive income:                                            |       |                                                        |       |                       |       |                             |       |                          |       |                                           |       |                                                 |       |      |       |
| Net income                                                       |       |                                                        |       |                       |       |                             |       |                          |       | 13,753                                         |       |                                                 |       | 13,753    |       |
| Additional minimum pension liability                             |       |                                                        |       |                       |       |                             |       |                          |       |                                           |       | 27                                                   |       | 27        |       |
| Foreign currency translation adjustment                          |       |                                                        |       |                       |       |                             |       |                          |       |                                           |       | 780                                                  |       | 780       |       |
| Total comprehensive income                                       |       |                                                        |       |                       |       |                             |       |                          |       |                                           |       |                                                 |       | 14,560    |       |
| Cash dividends declared                                          |       |                                                        |       |                       |       |                             |       |                          |       | (2,415                                         | )          |                                                 |       | (2,415    | )          |
| Repurchases of common stock                                      |       | (165                                                        | )          |                       |       |                             |       | (4,188                        | )          |                                           |       |                                                 |       | (4,188    | )          |
| Issuances of common stock - employee stock purchase  plan shares |       | 81                                                          |       |                       |       | (206                             | )          | 1,999                         |       |                                           |       |                                                 |       | 1,793     |       |
| Issuances of common stock - deferred stock units                 |       | 151                                                         |       |                       |       | 276                              |       | 3,769                         |       |                                           |       |                                                 |       | 4,045     |       |
| Issuances of common stock to outside  directors                  |       | 2                                                           |       |                       |       | 3                                |       | 46                            |       |                                           |       |                                                 |       | 49        |       |
| Issuances of common stock - stock options                        |       | 33                                                          |       |                       |       | (388                             | )          | 812                           |       |                                           |       |                                                 |       | 424       |       |
| Tax benefit of exercises of stock options                        |       |                                                        |       |                       |       | 194                              |       |                          |       |                                           |       |                                                 |       | 194       |       |
|                                                             |       |                                                        |       |                       |       |                             |       |                          |       |                                           |       |                                                 |       |      |       |
| Balance at September 30, 2004                                    |       | 32,419                                                      |       | $                          | 334        |                             | $          | 149,387                       |       | $                                              | (23,711    | )                                                    | $          | 137,007   |       | $ | (3,371 | ) | $ | 259,646 |   |

 

See accompanying notes to the consolidated financial statements

 

4

----

 

**WATSON WYATT & COMPANY HOLDINGS**

 

**Notes to the Consolidated Financial Statements**(Tabular amounts are in thousands, except per sharedata)

(Unaudited)

**Note 1 – Basisof Presentation.**

 

The accompanying unauditedquarterly consolidated financial statements of Watson Wyatt & CompanyHoldings and our subsidiaries (collectively referred to as “we,” “Watson Wyatt”or the “Company”) are presented in accordance with the rules and regulations ofthe Securities and Exchange Commission (“SEC”) for quarterly reports on Form10-Q.  In the opinion of management,these financial statements reflect all adjustments, consisting only of normalrecurring adjustments, which are necessary for a fair presentation of theconsolidated financial statements for the interim periods.  The consolidated financial statements shouldbe read in conjunction with the audited consolidated financial statements andnotes thereto contained in the Company’s Annual Report on Form 10-K for thefiscal year ended June 30, 2004, which is filed with the SEC and may beaccessed via EDGAR on the SEC’s web site at www.sec.gov.

The results of operations forthe three months ended September 30, 2004 are not necessarily indicative of theresults that can be expected for the entire fiscal year ending June 30,2005.  The results reflect certainestimates, including estimated bonuses and anticipated tax liabilities.

 

**Note 2 –Company Background.**

 

Watson Wyatt is an internationalcompany engaged in the business of providing professional consultative serviceson a fee basis, primarily in the human resource areas of employee benefits andcompensation, but also in other areas of specialization such as human capitalconsulting and human resource-related technology consulting.

** **

**Note 3 –Segment Information.**

 

In North America, the Companyis primarily organized and managed by practice. Although our consultants in our international offices provide servicesin these same practice areas, our international operations as a whole aremanaged geographically and comprise a single operating segment.  Therefore, we have five reportable operatingsegments or practice areas:

 

(1)           BenefitsGroup

 

(2)           TechnologySolutions Group

 

(3)           HumanCapital Group

 

(4)           International

 

(5)           Other(including Data Services and Communication)

 

5

----

 

The Company evaluates theperformance of its segments and allocates resources to them based on netoperating income on a pre-bonus, pre-tax basis.

 

The table below presentsspecified information about reported segments as of and for the three monthsended September 30, 2004:

 
| ** **                             | ** ** | **Benefits  Group** | ** **    | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** **   | **Other** | ** ** | **Total**    | ** ** |
|----------------------------------------|------------|---------------------|---------------|----------------------------------|------------|---------------------------|------------|-------------------|--------------|-----------|------------|--------------|------------|
| Revenue (net of reimbursable expenses) |       | $                   |  104,911 |                             | $          | 17,182                    |       | $                 |  13,062 |      | $          |  21,053 |       | $ |  11,510 |   | $ |  167,718 | ** ** |
| Net operating income/(loss)            |       | 23,291              |          | 2,726                            |       | 2,967                     |       | 618               |         | 2,399     |       | 32,001       |       |
| Receivables                            |       | 111,694             |          | 8,959                            |       | 13,284                    |       | 17,455            |         | 3,953     |       | 155,345      |       |
|                                        |            |                     |               |                                  |            |                           |            |                   |              |           |            |              |            |  |  |  |  |  |  |

 

The table below presentsspecified information about reported segments as of and for the three monthsended September 30, 2003:

 
| ** **                             | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of reimbursable expenses) |       | $                   | 103,868    |                             | $          | 20,269                    |       | $                 | 10,166     |      | $          | 18,945    |       | $ | 11,693 |   | $ | 164,941 |   |
| Net operating income/(loss)            |       | 22,041              |       | 1,413                            |       | (256                      | )          | (66               | )          | 687       |       | 23,819    |       |
| Receivables                            |       | 92,141              |       | 14,928                           |       | 8,764                     |       | 16,800            |       | 7,221     |       | 139,854   |       |
|                                        |            |                     |            |                                  |            |                           |            |                   |            |           |            |           |            |  |  |  |  |  |  |

 

Information about interestincome and tax expense is not presented as a segment expense because such itemsare not considered a responsibility of the segments’ operating management.

 

6

----

 

Reconciliations of theinformation reported by segment to the consolidated amounts follow for thethree month periods ended September 30, 2004 and 2003:

 
| ** **                                                                              | ** ** | **Three Months Ended September 30** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Revenue:                                                                                |       |                                |       |   |   |
| Total segment revenue                                                                   |       | $                                   | 167,718    |   | $ | 164,941 |   |
| Reimbursable expenses not included in total  segment revenue                            |       | 8,241                               |       | 5,959 |   |
| Other, net                                                                              |       | (568                                | )          | 83 |   |
| Consolidated revenue                                                                    |       | $                                   | 175,391    |   | $ | 170,983 |   |
|                                                                                    |       |                                |       |   |   |
| Net Operating Income:                                                                   |       |                                |       |   |   |
| Total segment net operating income                                                      |       | $                                   | 32,001     |   | $ | 23,819 |   |
| Income from affiliates                                                                  |       | 2,206                               |       | 1,790 |   |
| Differences in allocation methods for depreciation,  G&A, medical and pension costs |       | (1,300                              | )          | 1,435 |   |
| Gain on sale of business units                                                          |       | 28                                  |       | 525 |   |
| Discretionary compensation                                                              |       | (11,000                             | )          | (13,500 | ) |
| PCIC non-operating gain                                                                 |       | —                              |       | 5,600 |   |
| Other, net                                                                              |       | 1,419                               |       | 1,513 |   |
| Consolidated income before income taxes                                                 |       | $                                   | 23,354     |   | $ | 21,182 |   |
|                                                                                    |       |                                |       |   |   |
| Receivables:                                                                            |       |                                |       |   |   |
| Total segment receivables - billed and  unbilled                                        |       | $                                   | 155,345    |   | $ | 139,854 |   |
| Net valuation differences                                                               |       | 2,137                               |       | 6,408 |   |
| Total billed and unbilled receivables                                                   |       | 157,482                             |       | 146,262 |   |
| Assets not reported by segment                                                          |       | 335,551                             |       | 352,687 |   |
| Consolidated assets                                                                     |       | $                                   | 493,033    |   | $ | 498,949 |   |

** **

**Note 4 –Targeted Job Reductions.**

 

We implemented job reductionsin our North American region during the first quarter of fiscal year 2004.  This resulted in the elimination ofapproximately 100 positions.  Theestimated $2.6 million charge to earnings related to these reductions wasincluded in the Company’s financial results for the quarter ended September 30,2003. Of the $2.6 million severance charge, $2.5 million was included inSalaries and employee benefits and $0.1 million was included in Professionaland subcontracted services.

 

7

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**Note 5 –PCIC Other Non-operating Gain.**

 

On July 9, 2003, the Board ofDirectors of PCIC, a captive insurance company of which we own 34.8 percent,decided to pass on to each of its owners a credit in their 2003-04 policy yearin connection with benefits received from an aggregate stop loss insurancepolicy entered into by PCIC.  PCIC’sBoard determined in July 2003 that this credit would be used to offset all or aportion of each insureds’ obligation to PCIC for historical lossexperience.   As a result, the Companyrecorded a $5.6 million pre-tax non-operating gain in the first quarter offiscal year 2004 and included this gain in “Other non-operating income” in theConsolidated Statements of Operations.

 

As a result of this gain, theCompany also recorded a $5.6 million supplemental bonus accrual in the firstquarter of fiscal year 2004 that was incremental to the Company’s fiscal yearend bonus, and was paid in September 2004 with the regular bonus cycle.  This supplemental bonus was included inSalaries and employee benefits for the first quarter of fiscal year 2004.

** **

**Note 6 –Stock-based Compensation.**

 

We have elected to followAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees” (APB 25), for stock options issued under the 2000 Long-termIncentive Plan, and the 2001 Employee Stock Purchase Plan.  Compensation expense for the 2000 Long-termIncentive Plan, if any, would be recorded and measured as the differencebetween the fair market value of the stock at the date of the grant and theoption price.  The compensation expensewould be recognized over the five-year vesting period identified in theplan.  For any cash-based, non-stockawards, such as stock appreciation rights, compensation expense will berecognized over the vesting period to the extent that the market price of thestock increases.  We have elected thedisclosure-only provisions of Statement of Financial Accounting Standards No.123, “Accounting for Stock-based Compensation” (FAS 123).

 

As required by FAS 123, theCompany has determined pro forma net income and earnings per share as if theCompany had accounted for its stock compensation plans under the fair valuemethod of FAS 123.   The Companyestimated compensation expense for its Stock Purchase Plan based on the 15percent discounted purchase price offered to employees enrolled in the plan,which approximates fair value.  For theStock Option Plan, the Company uses the Black-Scholes option valuation model tocalculate the fair value of options granted for pro forma disclosure purposes.

 

8

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The table below reflects thepro forma effect on net income and earnings per share for the three monthsended September 30, 2004 and 2003 as if the Company were to recognizecompensation expense under the fair-value-based method of FAS 123:

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended September 30** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                                                                                                          |       |                                |       |   |   |
| Net income, as reported                                                                                                                       |       | $                                   | 13,753     |   | $ | 12,507 |   |
| Add: Stock-based compensation expense  included in reported net income, net of related tax effects                                            |       | 34                                  |       | 46 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair-value-based method for all awards,  net of related tax effects |       | (382                                | )          | (406 | ) |
| Pro forma net income                                                                                                                          |       | $                                   | 13,405     |   | $ | 12,147 |   |
|                                                                                                                                          |       |                                |       |   |   |
| **Earnings per share:**                                                                                                                       |       |                                |       |   |   |
| Basic - as reported                                                                                                                           |       | $                                   | 0.42       |   | $ | 0.38 |   |
| Basic - pro forma                                                                                                                             |       | $                                   | 0.41       |   | $ | 0.37 |   |
|                                                                                                                                          |       |                                |       |   |   |
| Diluted - as reported                                                                                                                         |       | $                                   | 0.42       |   | $ | 0.37 |   |
| Diluted - pro forma                                                                                                                           |       | $                                   | 0.41       |   | $ | 0.36 |   |

 

**Note 7 –Retirement Benefits.**

* *

*DefinedBenefit Plans*

 

We sponsor both qualified andnon-qualified, non-contributory defined benefit pension plans coveringsubstantially all of our associates. Under our principal plans (United States, Canada, Hong Kong and U.K.),benefits are based on the number of years of service and the associates’compensation during the five highest paid consecutive years of service.  The non-qualified plan 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 which benefit liabilityis reflected on the balance sheet. Included in the results is our U.K. plan, which is inactive but is partof the additional minimum pension liability reported on the ConsolidatedBalance Sheets.  The measurement date forthe plans is June 30.

 

9

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*Componentsof Net Periodic Benefit Cost for Defined Benefit Pension Plans*

 

The following table sets forththe components of net periodic benefit cost for the Company’s U.S. and non-U.S.defined benefit pension plans for the three months ended September 30, 2004 and2003:

 
| ** **                            | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
| ** **                            | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                  |       |                                |       |   |   |
| Service Cost                          |       | $                                   | 6,439      |   | $ | 6,669 |   |
| Interest Cost                         |       | 8,744                               |       | 8,372 |   |
| Expected return on plan assets        |       | (10,138                             | )          | (8,958 | ) |
| Amortization of transition obligation |       | (1                                  | )          | (1 | ) |
| Amortization of net loss              |       | 1,737                               |       | 2,851 |   |
| Amortization of prior service cost    |       | (541                                | )          | (542 | ) |
| Net periodic benefit cost             |       | $                                   | 6,240      |   | $ | 8,391 |   |

* *

*Employercontributions*

 

The company made nocontributions to the U.S. plan and $780,000 in contributions to the non-U.S.plans during the first three months of the fiscal year.  We anticipate making contributions of $10.0million to the U.S. plan and $800,000 in contributions to the non-U.S. plans inthe second quarter of this fiscal year.

* *

*DefinedContribution Plans*

 

We sponsor a savings plan that providesbenefits to substantially all U.S. associates. Prior to July 1, 2003, wematched employee contributions at 50 percent of the first 6 percent of totalpay, which included base salary, overtime and annual performance-basedbonuses.  Vesting of the Company matchoccurs after three years for new employees and is 100 percent for all employeeshired before January 1, 1997.  TheCompany match was suspended from July 1, 2003 through June 30, 2004.  However, effective July 1, 2004, the companyreinstituted a match to employee contributions at a rate of 50 percent of thefirst 6 percent up to $60,000 of associates’ eligible compensation.  The company will also make an annual profitsharing contribution to the plan in an amount that is dependent upon thecompany’s financial performance during the fiscal year.

* *

*Health CareBenefits*

 

We sponsor a contributoryhealth care plan that provides hospitalization, medical and dental benefits tosubstantially all U.S. associates.  Weaccrue a liability for estimated incurred but unreported claims based onprojected use of the plan as well as prior plan history.

* *

*PostretirementBenefits*

 

We provide certain health careand 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.

 

10

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*Componentsof Net Periodic Benefit Cost for Other Postretirement plans*

 

The following table sets forththe components of net periodic benefit cost for the Company’s healthcare andpost-retirement plans for the three months ended September 30, 2004 and 2003:

 
| ** **                            | ** ** | **Three Months Ended September 30** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
|                                  |       | **2004**                            | ** ** | **2003** | ** ** |
|                                  |       |                                |       |   |   |
| Service cost                          |       | $                                   | 413        |   | $ | 422 |   |
| Interest cost                         |       | 605                                 |       | 575 |   |
| Expected return on plan assets        |       | —                              |       | — |   |
| Amortization of transition obligation |       | 12                                  |       | 12 |   |
| Amortization of net gain              |       | (143                                | )          | (68 | ) |
| Amortization of prior service cost    |       | (105                                | )          | (156 | ) |
| Net periodic benefit cost             |       | $                                   | 782        |   | $ | 784 |   |

* *

*Employercontributions*

 

The Company made contributionsin the form of premiums and medical claim payments to its healthcare andpost-retirement plans of $600,000 in each of the three months ended September30, 2004 and 2003.  We plan to makeadditional payments estimated to total $1.9 million through the end of June 30,2005.

 

**Note 8 –Goodwill & Intangible Assets.**

 

The changes in the carryingamount of goodwill for the three months ended September 30, 2004, are asfollows: 

 
| ** **                        | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Balance as of June 30, 2004       |       | $                   | 16,331     |                             | $          | 1,449                     |       | $                 | 70         |      | $          | 1,084     |       | $ | 1,214 |   | $ | 20,148 |   |
| Goodwill recorded during the year |       | —              |       | —                           |       | —                    |       | —            |       | —    |       | —    |       |
| Impairment losses                 |       | —              |       | —                           |       | —                    |       | —            |       | —    |       | —    |       |
| Translation adjustment            |       | 298                 |       | —                           |       | 4                         |       | 42                |       | —    |       | 344       |       |
| Balance as of September 30, 2004  |       | $                   | 16,629     |                             | $          | 1,449                     |       | $                 | 74         |      | $          | 1,126     |       | $ | 1,214 |   | $ | 20,492 |   |

 

11

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The following table reflectschanges in the net carrying amount of the components of intangible assets forthe three months ended September 30, 2004:

 
| ** **                                 | ** ** | **Non-contractual  customer  relationships** | ** ** | **Non-compete  agreements** | ** ** | **Purchased  software** | ** ** | **Pension** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|-------------|------------|-----------|------------|
|                                       |       |                                         |       |                        |       |                    |       |        |       |      |       |
| Balance as of June 30, 2004                |       | $                                            | 459        |                        | $          | 176                     |       | $           | 2          |      | $          | 124 |   | $ | 761 |   |
| Intangible assets recorded during the year |       | 41                                           |       | —                      |       | —                  |       | —      |       | 41        |       |
| Amortization expense                       |       | (50                                          | )          | (23                         | )          | —                  |       | —      |       | (73       | )          |
| Translation adjustment                     |       | 51                                           |       | —                      |       | —                  |       | —      |       | 51        |       |
| Balance as of September 30, 2004           |       | $                                            | 501        |                        | $          | 153                     |       | $           | 2          |      | $          | 124 |   | $ | 780 |   |

 

The following table reflectsthe carrying value of intangible assets at September 30, 2004 and June 30,2004:

 
| ** **                                            | ** ** | **September 30, 2004**      | ** ** | **June 30, 2004**             | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                                            | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated   Amortization** | ** ** |
| Intangible  assets and intangible pension asset:      |       |                        |       |                          |       |   |   |   |   |
| Non-contractual  customer relationships               |       | $                           | 1,097      |                          | $          | 596 |   | $ | 962 |   | $ | 503 |   |
| Non-compete  agreements                               |       | 672                         |       | 519                           |       | 672 |   | 496 |   |
| Purchased  software                                   |       | 125                         |       | 123                           |       | 125 |   | 123 |   |
| Intangible  pension asset                             |       | 124                         |       | —                        |       | 124 |   | — |   |
| Total  intangible assets and intangible pension asset |       | $                           | 2,018      |                          | $          | 1,238 |   | $ | 1,883 |   | $ | 1,122 |   |

 

A component of the changein the gross carrying amount of non-contractual customer relationships reflectstranslation adjustments between June 30, 2004 and September 30, 2004.  This intangible asset is denominated in thecurrencies of our subsidiaries outside the United States, and is translatedinto our reporting currency, the U.S. dollar, based on exchange rates at thebalance sheet date.

 

The weighted average remaininglife of amortizable intangible assets at September 30, 2004, was 3.4years.  Estimated amortization expensefor the remainder of 2005 and thereafter are as follows:

 
| **Fiscal year ending June 30:** | ** ** | **Amount** | ** ** |
|---------------------------------|------------|------------|------------|
| 2005                            |       | $          | 253        |   |
| 2006                            |       | 170        |       |
| 2007                            |       | 60         |       |
| 2008                            |       | 39         |       |
| Thereafter                      |       | 134        |       |
|                                 |            |            |            |  |

 

12

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**Note 9 –Earnings Per Share.**

 

Basic earnings per share iscalculated on the basis of the weighted average number of common sharesoutstanding during the three months ended September 30, 2004 and 2003.  Diluted earnings per share is calculated onthe basis of the weighted average number of common shares outstanding plus theeffect of outstanding stock options and employee stock purchase plan sharesusing the “treasury stock” method.  Thecomponents of basic and diluted earnings per share are as follows:

 
| ** **                                                                         | ** ** | **Three Months Ended September 30** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                                               |       |                                |       |   |   |
| Income from continuing operations                                                  |       | $                                   | 13,751     |   | $ | 12,497 |   |
| Discontinued operations                                                            |       | 2                                   |       | 10 |   |
|                                                                               |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 13,753     |   | $ | 12,507 |   |
|                                                                               |       |                                |       |   |   |
| Weighted average outstanding shares of common  stock                               |       | 32,358                              |       | 33,078 |   |
| Dilutive effect of employee stock options and  employee stock purchase plan shares |       | 321                                 |       | 346 |   |
|                                                                               |       |                                |       |   |   |
| Common stock and stock equivalents                                                 |       | 32,679                              |       | 33,424 |   |
|                                                                               |       |                                |       |   |   |
| Basic earnings per share:                                                          |       |                                |       |   |   |
| Income from continuing operations                                                  |       | $                                   | 0.42       |   | $ | 0.38 |   |
| Discontinued operations                                                            |       | —                              |       | — |   |
|                                                                               |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 0.42       |   | $ | 0.38 |   |
|                                                                               |       |                                |       |   |   |
| Diluted earnings per share:                                                        |       |                                |       |   |   |
| Income from continuing operations                                                  |       | $                                   | 0.42       |   | $ | 0.37 |   |
| Discontinued operations                                                            |       | —                              |       | — |   |
|                                                                               |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 0.42       |   | $ | 0.37 |   |

 

13

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**Note 10 –Investment in Affiliates.**

 

In January 2003, the FASBissued FASB Interpretation No. 46, “Consolidation of Variable InterestEntities,” which was later revised in December 2003 (FIN 46R) and effectiveMarch 31, 2004 for the Company.  Thisinterpretation of Accounting Research Bulletin No. 51, “Consolidated FinancialStatements,” addresses consolidation by business enterprises of variableinterest entities.  FIN 46R introducesthe concept of a variable interest entity and requires consolidation by theprimary beneficiary where there is a controlling financial interest in avariable interest entity or where the variable interest entity does not havesufficient equity at risk to finance its activities without additional subordinatedfinancial support from other parties.

 

Investment in Affiliatesconsists of equity investments in three entities, Watson Wyatt Holdings(Europe) Limited (WWHE), Watson Wyatt LLP (WWLLP) and Professional ConsultantsInsurance Company Inc. (PCIC), each of which is accounted for under the equitymethod.  The Company evaluated each ofthese entities based on FIN 46R’s criteria in order to determine theapplicability of FIN 46R and the Company’s current assessment is that of thethree entities, WWHE and PCIC are considered to be variable interestentities.  The Company has concluded,however, that it does not have a controlling financial interest in WWHE or PCICand, as a result, the Company is not the primary beneficiary and is notrequired to consolidate their results.

 

On April 1, 1995, the Companytransferred its United Kingdom (“U.K.”) operations to WWLLP, an actuarialpartnership based in the U.K., and received a beneficial interest in WWLLP anda 10% interest in a defined profit pool of WWLLP.  The Company also transferred its ContinentalEuropean operations to WWHE as a newly-formed holding company, jointly ownedand controlled by the Company and WWLLP, in exchange for 50.1% of its shares.Effective July 1, 1998, the Company sold one-half of its investment in WWHE toWWLLP.  WWHE is now jointly owned andcontrolled by the Company (25%) and WWLLP (75%).  While Watson Wyatt & Company, WWLLP, andWWHE remain separate legal entities, the companies have marketed their servicesglobally under the Watson Wyatt Worldwide brand, sharing resources,technologies, processes and business referrals. Management believes that the Company’s maximum financial statementexposure to loss is limited to the carrying value of the Company’s investmentin WWHE of $6.8 million as of September 30, 2004.

 

PCIC was organized in 1987 as acaptive insurance company under the laws of the State of Vermont.  PCIC provides professional liabilityinsurance on a claims-made basis to three actuarial and management consultingfirms, all of which participate in the program as both policyholders andstockholders.  The Company currently owns34.8 percent of PCIC.  Capitalcontributions to PCIC are required when approved by a majority of itsstockholders.  Management believes thatthe Company’s maximum financial statement exposure to loss is limited to thecarrying value of the Company’s investment in PCIC of $6.7 million, combinedwith letters of credit totaling $4.9 million for which PCIC has been designatedas beneficiary, for a total maximum exposure of $11.6 million.

 

**Note 11 –Comprehensive Income.**

 

Comprehensive income includesnet income, the additional minimum pension liability and changes in thecumulative translation adjustment gain or loss. For the three months ended September 30, 2004, comprehensive incometotaled $14.6 million, compared with $12.6 million for the three months endedSeptember 30, 2003.

 

**Note 12 –Restricted Shares.**

 

In conjunction with our initialpublic offering in October 2000, we entered into agreements providing foradditional transfer restrictions with major stockholders, executive officersand employee directors.  As a result ofthese agreements, 1,665,400 Class A shares were restricted as of September 30,2004.  These shares became freelytransferable in October 2004.

 

14

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**Note 13 –Guarantees.**

 

The Company historically hasprovided 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.

 

*Letters ofCredit*.  TheCompany has two outstanding letters of credit totaling $7.5 million under ourexisting credit facility to guarantee payment to beneficiaries in the eventthat the Company fails to meet its financial obligations to thesebeneficiaries.  One letter of credit for$2.6 million will expire in October 2006, while the second letter of credit for$4.9 million will remain outstanding as long as we retain an ownership share ofour affiliated captive insurance company, PCIC. The estimated fair market value of these letters of credit is nominalbecause they have never been used, and the Company believes that future usageis remote.

* *

*AffiliateAgreements*.  In1995, we entered into an alliance agreement with R. Watson & Sons, a UnitedKingdom-based actuarial, benefits and human resources consulting partnership(now WWLLP), the predecessor of which was founded in 1878.  Included in the agreements between theCompany and WWLLP (the “Alliance Agreements”) are various indemnities andguarantees relating to the performance of the Company and its subsidiaries,some of which became part of WWHE, as to such matters as tax liabilities,liabilities for prior acts or omissions arising from the operation of the UKand European businesses prior to the alliance and failure to perform variousobligations under the Alliance Agreements. In addition, certain events, such as a sale of material parts of ourbusiness, could require the Company to either purchase from or sell to WWLLP aninterest in our European business and/or repurchase the shares of the Company’sstock currently held by WWLLP.  TheCompany is unable to estimate an amount of any potential future payments underthese contractual arrangements because the potential occurrence of any of theevents to which the indemnities apply is entirely speculative, there is nohistory of payments and the dollar amount, if any, would be dependent upon thenature of the event triggering such indemnity. Management believes that anypotential for payment under such indemnities and guarantees should decline withthe passage of time.  There are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that the Company as guarantor can liquidate to recover amounts paidunder such indemnities.

 

The Company owns 25 percent ofWWHE and WWLLP owns the remaining 75 percent. Additional capital for WWHE, if required, may be provided by both ownersbased on their respective ownership interests. If either the Company or WWLLP does not provide its pro rata share ofany additional capital invested in WWHE, that party’s respective ownershipinterest will be reduced accordingly.

 

In connection with the establishmentof our alliance with Watson Wyatt LLP in 1995, the company agreed to guaranteeWatson Wyatt LLP’s performance under a lease for office space in London thatexpires in 2015.  Payments by WatsonWyatt LLP under the lease total £1.4 million (or approximately $2.5 millionbased on the September 30, 2004, exchange rate) per year.  We also granted Watson Wyatt LLP an option toreturn the leased space to our UK subsidiary in 2009.  If Watson Wyatt LLP were to exercise thisoption, the company would attempt to sublease the space at the then-currentmarket rates.

* *

*IndemnificationAgreements*.  TheCompany has various agreements that provide that it may be obligated toindemnify the other party with respect to certain matters.  Generally, these indemnification clauses areincluded in contracts arising in the normal course of business and inconnection with the purchase and sale of certain businesses.  Although it is not possible to predict themaximum 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.

 

15

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*WellspringLeases*.  We continueto guarantee three leases for office premises for Wellspring Resources, LLC(“Wellspring”), the benefits administration outsourcing business that we exitedfrom in fiscal year 1998.  At September30, 2004, minimum remaining payments guaranteed under these leases, whichexpire at various dates through 2007, total $16.5 million, excludinganticipated future sublease income.  SeeNote 15 for more information regarding our obligation to guarantee Wellspring’sleases.

 

**Note 14 –Contingent Liabilities.**

 

From time to time, we are aparty to various lawsuits, arbitrations or mediations that arise in theordinary course of business. These disputes typically involve claims relatingto the rendering of professional services or employment matters.  Management believes, based on currentlyavailable information, that the results of all pending claims against us willnot have a material adverse effect on the company.  The matters reported on below involve themost significant pending or potential claims against us.

* *

*Iron Workers Local 25 et al. v. Watson Wyatt& Co. *OnJuly 8, 2004, Watson Wyatt & Co. was served with an amended complaint filedby a former client in the United States District Court for the Eastern Districtof Michigan.  The complaint allegedmalpractice, breach of contract, and related claims in the performance ofactuarial consulting.  The Complaintstated that the plaintiff’s Pension Fund is underfunded as a result of thealleged deficiencies in our work.   Theamount of damages sought were not specified. We filed an answer denying theallegations and the court has set a discovery schedule.

* *

*SECExamination of Investment Advisers. *InDecember 2003, the Securities and Exchange Commission (SEC) formally asked manyof the major investment consulting firms, Watson Wyatt Investment Consulting(WWIC) among them, to provide detailed information on their business structuresand practices in order to determine if conflicts of interest with moneymanagers exist.  In March 2004, WWICcompleted its responses to the SEC staff’s requests for information.  WWIC has received no further inquiry from theSEC staff on this topic since that time.

* *

*Departmentof Justice Antitrust Investigation. *InMarch 2004, the United States Department of Justice (DOJ) issued a CivilInvestigative Demand (CID) to Watson Wyatt and other companies in the employeebenefits industry.  The DOJ is seeking todetermine whether firms which have entered into agreements with their clientslimiting liability have done so in violation of U.S. antitrust laws. WatsonWyatt has been providing information to DOJ in response to the CID.

* *

*ClientDemand Letter. *OnJuly 23, 2004, we received a demand letter from counsel for a client allegingthat errors in valuations for 2001 and subsequent years understated theliabilities of its pension plan and overstated its net worth.  As a result, the client claimed it did notannuitize its defined benefit plan and redeemed its stock at an inflated price.  The letter claimed damages “in excess of $35million.”  We plan to meet with counselfor the client to discuss the basis of these claims.

** **

**Note 15 –Discontinued Operations.**

 

As discussed in Note 13, theCompany continues to guarantee three leases for office premises forWellspring.  Through the first threemonths of fiscal year 2005, the Company received sublease income ofapproximately $4,000 in excess of lease payments related to this business.  Since the second quarter of fiscal year 2003,the leases have been generating positive cash flows of less than $0.1 millionper fiscal year.

 

16

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**Note 16 – RecentAccounting Pronouncements.**

 

In January 2003, the FinancialAccounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46),“Consolidation of Variable Interest Entities,” which clarifies the financialreporting guidance associated with the consolidation of another entity.  In December 2003, the FASB revised andsuperceded FIN 46 with the issuance of FIN 46R in order to address certainimplementation issues.  The companyadopted FIN 46R effective March 31, 2004 and has included appropriatedisclosure in this Form 10-Q.  Adoptionof the FIN 46R has not resulted in a change in our accounting.  See Note 10 of the Consolidated FinancialStatements for further information regarding the impact of adopting FIN 46R.

 

Emerging Issues Task ForceIssue 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21),was effective for the company beginning July 1, 2003.  There was no change in revenue recognized inthe current portfolio of client engagements due to our adoption of EITF 00-21.

 

In December 2003, the Securities and ExchangeCommission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), “RevenueRecognition,” which supercedes Staff Accounting Bulletin No. 101 (SAB 101),“Revenue Recognition in Financial Statements.” SAB 104’s primary purpose is to rescind accounting guidance contained inSAB 101 related to multiple element revenue arrangements, superceded as aresult of the issuance of EITF 00-21. While the wording of SAB 104 has changed to reflect the issuance of EITF00-21, the revenue recognition principles of SAB 101 remain largely unchangedby the issuance of SAB 104.  The issuanceof SAB 104 has not had an effect on our revenue recognition policies as theyare in accordance with SAB 104.

 

In May 2004, the FinancialAccounting Standards Board issued FASB Staff Position (FSP) No. 106-2“Accounting and Disclosure Requirements Related to the Medicare PrescriptionDrug Improvement and Modernization Act of 2003” (the Act) (FAS 106-2), whichwas effective as of the first quarter beginning after June 15, 2004. The Actincludes a prescription drug benefit under Medicare Part D as well asa federal subsidy to sponsors of retiree health care benefit plans that providea benefit that is at least actuarially equivalent (as defined in the Act) toMedicare Part D.  The adoption of FAS106-2 has not had a material effect on the financial condition or results ofoperations of the company.

 

In December 2003, the FinancialAccounting Standards Board (FASB) published revisions to Statement of FinancialAccounting Standards No. 132, “Employers’ Disclosures about Pensions and OtherPostretirement Benefits” (FAS 132).  FAS132 revisions retain the original disclosures but require additional annualdisclosures about assets, obligations, cash flows and interim disclosures aboutnet periodic benefit costs of defined benefit pension plans and otherpostretirement plans.   The statement waseffective for fiscal years ending after December 15, 2003.  The company has adopted FAS 132 as revisedand included appropriate disclosure in this Form 10-Q.

 

In June 2004, the EmergingIssues Task Force (EITF) issued EITF 02-14****“Whether anInvestor Should Apply the Equity Method of Accounting to Investments Other ThanCommon Stock if the Investor Has the Ability to Exercise Significant InfluenceOver the Operating and Financial Policies of the Investee.”  This EITF indicates that an investor shouldonly apply the equity method of accounting when it has investments in eithercommon stock or in-substance common stock of a corporation, provided that theinvestor has the ability to exercise significant influence over the operatingand financial policies of the investee. The issuance of EITF 02-14 has not had an effect on our accounting forequity investments which has been in accordance with EITF 02-14.

** **

**Note 17 –Sale of U.S.-based Public Sector Retirement Business.**

 

In fiscal year 2002, we soldour U.S.-based public sector retirement business to Gabriel, Roeder, Smith& Company (“GRS”).  The futureconsideration from the sale of the U.S.-based public sector retirement businessis contingent upon the successful transition of certain clients to GRS and upontheir retention by GRS.

 

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In accordance with the terms of thesale, GRS paid the Company a $0.5 million contingent payment in the firstquarter of fiscal year 2004.  The amountof additional contractual cash payments over the upcoming two fiscal years isalso contingent upon the successful transition of certain clients to GRS andupon their retention by GRS.

 

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

** **

**Overview**

 

Watson Wyatt & Company Holdings,including its subsidiaries, is a global human capital consulting firm. We helpour clients enhance business performance by improving their ability to attract,retain and motivate qualified employees. We focus on delivering value-addedconsulting services that help our clients anticipate, identify and capitalizeon emerging opportunities in human capital management.  We implement this strategy through 3,850associates in 61 offices located in 18 countries.

 

As leading economies worldwidebecome more services-oriented, human capital has become increasingly importantto companies and other organizations. The heightened competition for skilledemployees, unprecedented changes in workforce demographics, regulatory changesrelated to compensation and retiree benefits and rising employee-related costshave increased the importance of effective human capital management. We helpour clients address these issues by combining our expertise in human capitalmanagement with consulting and technology, to improve the design andimplementation of various human resources, or HR, programs, includingcompensation, retirement and health care plans.

 

**General**

 

As of September 30, 2004, weemployed 3,850 associates as follows:

 

| Benefits  Group                                      |   | 1,650 |   |
|------------------------------------------------------|--------|-------|--------|
| Technology  Solutions Group                          |   | 310   |   |
| Human  Capital Group                                 |   | 160   |   |
| International                                        |   | 955   |   |
| Other  (including Data Services & Communication) |   | 550   |   |
| Corporate                                            |   | 225   |   |
| Total                                                |   | 3,850 |   |

 

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**PrincipalServices**

 

We design, develop andimplement HR strategies and programs through the following closely-interrelatedpractice areas:

 
| **Benefits Group**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Technology Solutions Group**                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **Human Capital Group**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| •      Retirement plans, including pension,  401(k) and executive benefits plans

•      Health care, disability and other group  benefit plans

•      Investment consulting services to  pension plans

•      Global compensation, benefits,  expatriate and HR practice strategy, implementation and administration

•      Actuarial services

•      Strategic workforce planning

  |       | •      Web-based applications for health and  welfare, pension and compensation administration

•      Call center strategy, design and tools

•      Strategic, research-based HR technology  and service delivery consulting

•      Targeted online compensation and  benefits statements, content management and call center case management  solutions |       | •     Compensation plans,  including broad-based and executive compensation,  stock and other long-term incentive  programs

•      Strategies to align workforce performance  with business objectives

•      Organization effectiveness consulting,  including talent management, through organization and employee research

•      Strategies for attracting, retaining and  motivating employees

•      Performance management |

 

Our clients include many of theworld’s largest corporations as well as emerging growth companies, publicinstitutions and nonprofit organizations.

 

**InternationalOperations**

 

Outside of North America, ourconsultants, working in Asia-Pacific and Latin America, operate on a geographicbasis from 25 offices in 16 countries and provide consulting services in thepractice areas described above.

 

**Other**

 

While we focus our consultingservices in the areas described above, management believes that one of ourprimary strengths is our ability to draw upon consultants from our differentpractices to deliver integrated services to meet the needs of our clients.

 

**WatsonWyatt Worldwide Alliance**

 

Recognizing our clients’ needfor consulting services worldwide, in the late 1970s we established operationsthroughout Europe by acquiring local firms and opening new offices.  In 1995, in response to the rapidlyincreasing globalization of the world economy, we made a strategic decision tostrengthen our European capabilities significantly and extend our global reach.We entered into an alliance with R. Watson & Sons (which subsequentlybecame Watson Wyatt Partners, now Watson Wyatt LLP), a leading UnitedKingdom-based actuarial, benefits and human resources consulting partnershipfounded in 1878. Since 1995, we have marketed our services globally under theWatson Wyatt Worldwide brand, sharing resources, technologies, processes andbusiness referrals with Watson Wyatt LLP.

 

The Watson Wyatt Worldwidealliance maintains 88 offices in 30 countries and employs close to 6,000associates. Watson Wyatt & Company Holdings operates 61 offices in 18countries in North America, Latin America and Asia-Pacific. Watson Wyatt LLPoperates 10 offices in the United Kingdom and 

 

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Ireland, and also operates oneoffice engaged in the insurance and financial services business in the UnitedStates. The alliance operates 16 offices in 10 continental European countries,principally through a jointly-owned holding company, Watson Wyatt Holdings(Europe) Limited.  Watson Wyatt &Company owns 25 percent of the holding company; Watson Wyatt LLP owns 75percent.

 

**Executive Overview**

 

Watson Wyatt & CompanyHoldings is a global provider of human capital consulting services.  We provide services in three principalpractice areas: Benefits, Technology Solutions and Human Capital consulting,operating from 61 offices in 18 countries throughout North America,Asia-Pacific and Latin America.  We alsooperate through our affiliates in Europe: Watson Wyatt LLP – which conductsoperations in the United Kingdom and Ireland and in which we hold a 10 percentinterest in a defined distribution pool – and Watson Wyatt Holdings (Europe)Limited, a holding company through which we conduct Continental Europeanoperations.  We own 25 percent of WatsonWyatt Holdings (Europe) Limited and Watson Wyatt LLP owns the remaining 75percent.  We collectively market ourservices globally under the Watson Wyatt Worldwide brand, sharing resources,technologies, processes and business referrals with our alliance partners.

 

We design, develop andimplement HR strategies and programs through the following closely-interrelatedpractice areas:

 

*BenefitsGroup –*The Benefits Group, accounting for 60 percentof our total first quarter 2005 revenues, is the foundation of ourbusiness.  Retirement, the core of ourBenefits business, is less impacted by discretionary spending reductions thanour other segments, mainly due to the recurring nature of many projects.  Our corporate client retention rate withinour target market has remained very high, averaging over 95 percent over thepast two years. Revenue for our retirement practice is seasonal, with the thirdand fourth quarters of each fiscal year being the busier periods.  Major revenue growth drivers in this practiceinclude changes in regulations, particularly those affecting pension plans,leverage from other practices, an improving economy, increased global demandand increased market share.  Revenue fromthe Benefits Group for the first quarter of fiscal year 2005 increased $1.0million or 1 percent during the first quarter of fiscal year 2005 due to aslight increase in ongoing work for existing clients as well as new clientwins.  Revenue for our Health Care consultingpractice, which is also part of the Benefits Group, increased 6% during thequarter due to an increased number of projects related to health careconsumerism, data analysis and strategic benefit planning.

 

*TechnologySolutions Group –*Our Technology Solutions Group,accounting for 10 percent of our total first quarter fiscal year 2005 revenues,provides information technology services to our customers.  In fiscal year 2004, delays in discretionarytechnology spending resulted in lower revenues, but the backlog of work, whichis a fairly accurate indicator of future revenues, has improved over the pastthree quarters.  Revenue from ourTechnology Solutions Group decreased $3.1 million or 15 percent during the firstquarter of fiscal year 2005, however this includes $2.6 million in time spentcustomizing administration systems. Related revenue will be recognized as these systems go intoservice.  In general, we are seeing particularacceptance of our scalable benefits administration solutions as an alternativeto total business process outsourcing. Enhancing our applications and leveraging our other segments are vitalto our growth strategy.

 

*HumanCapital Group –*Our**Human CapitalGroup, accounting for 7 percent of our total first quarter fiscal year 2005revenues, generally encompasses short-term projects and as a result is mostsensitive to economic conditions.  Growthslowed significantly in the second half of fiscal year 2001 and continued tocontract in fiscal years 2002, 2003 and 2004. However, revenue grew by 28% over the prior-year first quarter due tosignificant demand for consulting in the areas of executive compensation, salescompensation and organization effectiveness.

 

In the short term, our revenuesare driven by many factors including the general state of the economy and 

 

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the resulting level ofdiscretionary spending by our clients, the ability of our consultants toattract new clients or cross-sell to existing clients, and the impact of newregulations in the legal and accounting fields that most recently increaseddemand for our executive compensation and benefits practices.

 

The human resources consultingindustry, although highly fragmented, is highly competitive and is comprised ofmajor human capital consulting firms, specialist firms, consulting arms ofaccounting firms and information technology consulting firms.  Our overall revenues have been flat over thepast three years, and it is clear that the competitive environment will remainchallenging until the economy fully rebounds and companies are committed tospending on human capital projects.  Tomitigate the pressures faced by the economic downturn, we have successfullymanaged costs throughout the company by leveraging our variable compensationcost structure, initiating targeted job reductions and controllingdiscretionary spending.  We believe weare well-positioned to take advantage of an improvement in the overall economy.

 

In the long term, we believethat benefits spending will continue to be the largest component of U.S.corporate spending.  We believe that theaging workforce, the projected shortfall in workers over the next decade andchanging regulations will translate into opportunities for us.  We believe 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 our highly fragmented industry represents tremendousgrowth opportunities for us, because we are the only firm to offer acomprehensive line of benefits and human capital consulting as well asstrategic technology solutions.

 

**FinancialStatement Overview**

 

Watson Wyatt’s fiscal year endsJune 30. The financial statements contained in this quarterly report reflectConsolidated Balance Sheets as of the end of the first quarter of fiscal year2005 (September 30, 2004) and as of the end of fiscal year 2004 (June 30,2004), Consolidated Statements of Operations for the three-month periods endedSeptember 30, 2004 and 2003, Consolidated Statements of Cash Flows for thethree-month periods ended September 30, 2004 and 2003 and a ConsolidatedStatement of Changes in Stockholders’ Equity for the three-month period endedSeptember 30, 2004.

 

We operate globally as analliance with our affiliates.  However,the revenues and operating expenses in the Consolidated Statements ofOperations reflect solely the results of operations of Watson Wyatt &Company Holdings. Our share of the results of our affiliates, recorded usingthe equity method of accounting, is reflected in the “Income from affiliates”line. Our affiliates are Watson Wyatt LLP, Watson Wyatt Holdings (Europe)Limited and Professional Consultants Insurance Company, Inc. (PCIC), ourcaptive insurance company.

 

We derive substantially all ofour revenue from fees for consulting services, which generally are billed basedon time and materials or on a fixed-fee basis. Clients are typically invoiced on a monthly basis with revenue generallyrecognized as services are performed. For the most recent three fiscal years,revenue from U.S. consulting operations has comprised approximately 80 percentof consolidated revenue. No single client accounted for more than 4 percent ofour consolidated revenue for any 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 costsand fiscal year-end incentive bonuses.

 

Professional and subcontractedservices represent fees paid to external service providers for employment,marketing and other services.  For themost recent three fiscal years, approximately 60 to 70 percent of theseprofessional and subcontracted services were directly incurred on behalf of ourclients and were reimbursed by them, with such reimbursements being included inrevenue.

 

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Occupancy, communications andother expenses represent expenses for rent, utilities, supplies and telephoneto operate office locations as well as non-client-reimbursed travel byassociates, publications and professional development.

 

General and administrativeexpenses include the operational costs and professional fees paid by corporatemanagement, general counsel, marketing, human resources, finance, research andtechnology support.

 

**CriticalAccounting Policies and Estimates**

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, disclosures ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reporting period.  Our estimates, judgments and assumptions arecontinually evaluated based on available information and experience.  Because of the use of estimates inherent inthe financial reporting process, actual results could differ from thoseestimates.  The accounting policiesdiscussed below are critical to the understanding of the use of estimates inthe company’s financial statements.

 

*   **Revenue Recognition***

 

Revenue includes fees primarilygenerated from consulting services provided in the areas of employee benefits,human capital strategies and related technology solutions.  We recognize revenue from these consultingengagements either on a time-and-materials basis or on a fixed-fee basis,depending on the terms and conditions defined at the inception of an engagementwith a client.

 

Revenue is recognized ontime-and-materials engagements based on billable rates times hours worked plusexpenses incurred.  For fixed-feearrangements, revenue is also recognized based on billable rates times hours workedplus expenses incurred.  However, forsignificant fixed-fee engagements in our Technology Solutions Group, weperiodically review ongoing engagements through the preparation of anestimate-to-complete.  Revenuerecognition for fixed-fee engagements is affected by a number of factors thatchange the estimated amount of work required to complete the project such aschanges in scope, the staffing on the engagement and/or the level of clientparticipation.  These periodic engagementreviews require us to make judgments and estimates regarding the overallprofitability and stage of project completion which, 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.

 

The company has developed various softwareprograms and technologies that we provide to clients in connection withconsulting services.  In most instances,such software is hosted and maintained by 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.

 

Revenue recognized in excess of billings isrecorded as unbilled accounts receivable. Cash collections and invoices generated in excess of revenue recognizedare recorded as deferred revenue until the revenue recognition criteria aremet.  Client reimbursable expenses,including those relating to travel, other out-of-pocket expenses and anythird-party costs, are included in revenue, and an equivalent amount ofreimbursable expenses are included in professional and subcontracted servicesas a cost of revenue.

 

In December 2003, theSecurities and Exchange Commission (SEC) issued Staff Accounting Bulletin No.104 (SAB 104), “Revenue Recognition,” which supercedes Staff AccountingBulletin No. 101 (SAB 101), “Revenue Recognition in Financial Statements.”  The primary purpose of SAB 104 is to rescind 

 

22

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accounting guidance containedin SAB 101 related to multiple element revenue arrangements, superceded as aresult of the issuance of EITF 00-21. While the wording of SAB 104 has changed to reflect the issuance of EITF00-21, the revenue recognition principles of SAB 101 remain largely unchangedby the issuance of SAB 104.  The issuanceof SAB 104 has not had an effect on our revenue recognition policies as theyare in accordance with SAB 104.

 

***   Valuation of Billed and Unbilled Receivablesfrom Clients***

 

We maintain allowances fordoubtful accounts to reflect estimated losses resulting from our clients’failure to pay for our services after the services have been rendered,including allowances when customer disputes may exist.  The related provision is generally recordedas a reduction to revenue.  Our allowancepolicy is based on the aging of our billed and unbilled client receivables andhas 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 compensationprogram includes a discretionary annual bonus that is determined by managementand paid once per fiscal year in the form of cash and/or deferred stock unitsafter the company’s annual operating results are finalized.

 

An estimated annual bonusamount is initially developed at the beginning of each fiscal year in conjunctionwith our budgeting process.  Quarterly,estimated annual operating performance is reviewed by the company and thediscretionary annual bonus amount is then adjusted, if necessary, by managementto reflect changes in the forecast of pre-bonus profitability for theyear.   After determining the estimatedannual bonus amount, the bonus is then allocated to remaining quarterlyreporting periods as a constant percentage of estimated pre-bonusprofitability.  In those quarters wherethe estimated annual bonus level changes, the remaining estimated annual bonusis accrued 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.

 

As a result of a $5.6 millionpre-tax non-operating gain recorded in the first quarter of fiscal year 2004,the company recorded a $5.6 million supplemental bonus accrual in the firstquarter of fiscal year 2004 that was incremental to the company’s fiscal yearend bonus.  This supplemental bonusamount, which was paid out in September 2004 with the regular bonus cycle, isincluded in salaries and employee benefits. Management does not expect this charge to recur.

 

***   Income Taxes***

 

Determining the consolidatedprovision for income tax expense, deferred tax assets and liabilities and therelated valuation allowance involves judgment. As a global company with offices in 18 countries, we are required tocalculate and provide for estimated income tax liabilities for each of the taxjurisdictions in which we operate.  Thisprocess involves estimating current tax obligations and exposures in eachjurisdiction as well as making judgments regarding the future recoverability ofdeferred tax assets.  Tax costs caninvolve complex issues and may require an extended period to resolve.  Changes in the geographic mix or estimatedlevel of annual pre-tax income, limitations on the use of the company’s foreignsubsidiary losses, changes in tax laws and changes resulting from tax auditscan all affect the overall effective income tax rate which, in turn, impactsthe overall level of income tax expense and net income.

 

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*** ***

***   Pension Assumptions***

 

We sponsor both qualified andnon-qualified, non-contributory defined benefit pension plans coveringsubstantially all of our associates. Under our principal plans (United States, Canada, Hong Kong and theUnited Kingdom), benefits are based on our associates’ years of service andcompensation during the five highest-paid consecutive years of service.

 

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 remaining serviceperiod of participating employees.  Weconsider 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.

 

The following assumptions wereused at the end of the past three fiscal years in the valuation of our U.S.plan, which comprises the majority of the principal defined benefit pensionplans:

 
| ** **                                  | ** ** | **Year Ended June 30** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| ** **                                  | ** ** | **2004**               | ** ** | **2003** | ** ** | **2002** | ** ** |
| Discount rate                               |       | 6.25                   | %          | 6.00 | % | 7.25 | % |
| Expected long-term rate of return on assets |       | 9.00                   | %          | 9.00 | % | 10.00 | % |
| Rate of increase in compensation levels     |       | 3.34                   | %          | 3.09 | % | 4.34 | % |

 

The 6.25 percent discount rateassumption used at the end of fiscal year 2004 represents a 25 basis pointincrease from the 6.00 percent discount rate used at the end of fiscal year2003 and represents a 100 basis point reduction from the 7.25 percent discountrate used at the end of fiscal year 2002. The Company’s 2004 discount rate assumption was determined by matchingfuture pension benefit payments with expected future AA bond yields for thesame periods.

 

The expected long-term rate ofreturn on assets assumption remained at 9.00 percent for fiscal year 2004. Therate of return was lowered in fiscal year 2003 from 10.00 percent at the end offiscal year 2002.  Selection of the 9.00percent return assumption was supported by an analysis performed by the Companyof the weighted average yield expected to be achieved with the anticipatedmakeup of investments.  The investmentmakeup is heavily weighted towards equities. The return on assets through the first three months of fiscal year 2005has been (1.0)%, compared to a return of 1.9% in fiscal year 2004.

 

Thefollowing information illustrates the sensitivity to a change in certainassumptions for the U. S. pension plans:

 
| **Change in Assumption**                              | ** ** | **Effect on FY2005  Pre-Tax Pension Expense** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|
|                                                  |       |                                          |       |
| 25 basis  point decrease in discount rate             |       | +$2.8 million                                 |       |
| 25 basis  point increase in discount rate             |       | -$2.6 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                                 |       |

 

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The above sensitivities reflectthe impact of changing one assumption at a time. It should be noted that economicfactors and conditions often affect multiple assumptions simultaneously and theeffects of changes in key assumptions are not necessarily linear.

 

Thesechanges in assumptions would have no effect on the company’s fundingrequirements. In addition, at June 30, 2004, a 25 basis point decrease in thediscount rate would cause the accumulated benefit obligation to exceed thevalue of plan assets, thereby necessitating the recording of a minimum pensionliability.  As a result, we would berequired to record an increase in the pension liability of $53.5 million, anon-cash charge to stockholders’ equity of $32.4 million and an increase indeferred tax assets of $21.1 million.  A25 basis point increase in the discount rate would have no impact on the liability,stockholders’ equity or deferred tax assets since there is no unfundedaccumulated benefit obligation when using either a 6.25 percent or 6.50 percentdiscount rate.

 

The company's U.S. OtherPostretirement Employee Benefits plan is relatively insensitive to discountrate changes due to the plan provisions that have been established to controlcosts and as such no sensitivity results are shown in this display.

 

***   Incurred But Not Reported Claims***

 

The company uses actuarial assumptions to estimate and record aliability for incurred but not reported (IBNR) professional liability claimsand engaged an external actuarial firm to assist in the calculation of theseestimates.  Our estimated IBNR liabilityis based on long-term trends and averages, and considers a number of factors,including changes in claim reporting patterns, claim settlement patterns,judicial decisions, and legislation and economic decisions, but excludes theeffect of claims data for large cases due to the insufficiency of actual experiencewith such cases.  Management does notcurrently expect significant fluctuations in the IBNR liability, based on thecompany’s historical claims experience. However, our estimated IBNR liability will fluctuate if claimsexperience changes over time.

 

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** **

**Results ofOperations.**

 

The table below sets forthConsolidated Statements of Operations data for continuing operations as apercentage of revenue for the periods indicated:

 
| ** **                                             | ** ** | **Three Months Ended September 30** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                   |       |                                |       |   |   |
| Revenue                                                |       | 100.0                               | %          | 100.0 | % |
|                                                   |       |                                |       |   |   |
| Costs of providing services:                           |       |                                |       |   |   |
| Salaries and employee benefits                         |       | 55.4                                |       | 61.5 |   |
| Professional and subcontracted services                |       | 6.8                                 |       | 5.3 |   |
| Occupancy, communications and other                    |       | 13.7                                |       | 13.8 |   |
| General and administrative expenses                    |       | 9.6                                 |       | 9.1 |   |
| Depreciation and amortization                          |       | 2.7                                 |       | 2.7 |   |
|                                                   |       | 88.2                                |       | 92.4 |   |
|                                                   |       |                                |       |   |   |
| Income from operations                                 |       | 11.8                                |       | 7.6 |   |
|                                                   |       |                                |       |   |   |
| Income from affiliates                                 |       | 1.2                                 |       | 1.1 |   |
| Interest income, net                                   |       | 0.3                                 |       | 0.1 |   |
| Other non-operating income                             |       | —                              |       | 3.6 |   |
|                                                   |       |                                |       |   |   |
| Income from continuing operations before  income taxes |       | 13.3                                |       | 12.4 |   |
|                                                   |       |                                |       |   |   |
| Provision for income taxes                             |       | 5.5                                 |       | 5.1 |   |
|                                                   |       |                                |       |   |   |
| Income from continuing operations                      |       | 7.8                                 | %          | 7.3 | % |

 

**ThreeMonths Ended September 30, 2004, Compared to the Three Months Ended September30, 2003**

 

*   **Revenue*****.**

 

Revenue from operations for thefirst quarter of fiscal year 2005 was $175.4 million, an increase of 3 percentfrom $171.0 million in the prior period.

 

The Benefits Group increasedrevenue $1.0 million or 1 percent during the first quarter of fiscal year 2005due to a slight increase in ongoing work for existing clients as well as newclient wins.  Revenue from our HumanCapital Group increased $2.9 million or 28 percent during the first quarter offiscal year 2005, reflecting significant demand for consulting in the areas ofexecutive compensation, sales compensation and organization effectiveness.  Our international segment finished thequarter with revenue growth of $2.1 million or 11 percent.  However, revenue increased 8 percent on aconstant currency basis.  Revenue fromour Technology Solutions Group decreased $3.1 million or 15 percent, reflecting$2.6 million in time spent customizing administration systems.  Revenue for other practice areas in NorthAmerica decreased $0.2 million or 2 percent during the first quarter of fiscalyear 2005.

 

***   Salaries and Employee Benefits*.**

 

Salaries and employee benefitexpenses for the first quarter of fiscal year 2005 were $97.1 million, adecrease of 8 percent from $105.1 million in the prior period.  Salaries and employee benefit expenses forthe first quarter of fiscal year 2004 include severance charges of $2.5 millionrelated to job reductions in 

 

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North America and the $5.6million supplemental bonus related to PCIC. The net change, exclusive of these charges, was due to a higher accrualfor discretionary compensation of $3.3 million, net of the exclusion of timespent customizing administration systems of $2.3 million, and lower pension andpost retirement expenses of $2.5 million. As a percentage of revenue, salariesand employee benefit expenses decreased to 55.4 percent from 61.5 percent.

 

***   Professional and Subcontracted Services*.**

 

Professional and subcontractedservices used in consulting operations for the first quarter of fiscal year2005 were $12.0 million, an increase of 32 percent from $9.1 million in theprior period.  The increase was mainlydue to higher reimbursable expenses from clients.  As a percentage of revenue, professional andsubcontracted services increased to 6.8 percent from 5.3 percent.

 

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

 

Occupancy, communications andother expenses for the first quarter of fiscal year 2005 were $24.1 million, anincrease of 3 percent from $23.5 million in the prior period.  The increase was mainly due to slightlyhigher costs in categories such as dues, general office and travel, net oflower rent expenses of $0.6 million.  Asa percentage of revenue, occupancy, communications and other decreased to 13.7percent from 13.8 percent.

 

***   General and Administrative Expenses.***

 

General and administrativeexpenses for the first quarter of fiscal year 2005 were $16.9 million, anincrease of 8 percent from $15.6 million in the prior period.  The increase is mainly due to higherinsurance costs.  As a percentage ofrevenue, general and administrative expenses increased to 9.6 percent from 9.1percent.

 

***   Depreciation and Amortization.***

 

Depreciation and amortizationfor the first quarter of fiscal year 2005 and 2004 was $4.7 million.  As a percentage of revenue, depreciation andamortization remained at 2.7 percent.

 

***   Income From Affiliates.***

 

Income from affiliates for thefirst quarter of fiscal year 2005 was $2.2 million, an increase of 22 percentfrom $1.8 million in the prior period. The increase was due to improved operations of Watson Wyatt LLP of $0.4million.

 

***   Interest Income, Net.***

 

Interest income, net for thefirst quarter of fiscal year 2005 was $0.5 million, compared to $0.2 million inthe prior period.  The increase wasmainly due to an increase in the rate of interest earned on investments, ahigher average cash balance during the first quarter of fiscal year 2005 andlower costs associated with our new credit agreement.

 

***   Other Non-operating Income.***

 

During fiscal years 2005 and 2004,the company received cash payments of $28,000 and $0.5 million, respectively,in connection with the fiscal year 2002 sale of our U.S.-based publicretirement business to GRS.  All paymentsreceived in connection with the sale of our U.S.-based public retirementpractice were contingent upon the successful transition of certain clients toGRS and upon their retention by GRS. During the first quarter of fiscal year 2004, the company also recordeda $5.6 million non-operating gain related to PCIC, our captive insurancecompany.

 

27

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***   Provision for Income Taxes.***

 

Provision for income taxes forthe first quarter of fiscal year 2005 was $9.6 million, compared to $8.7million for the first quarter of fiscal year 2004. Our effective tax rate was41.1 percent for the first three months of fiscal year 2005 and 41.0 percentfor the first three months of fiscal year 2004. We record a tax benefit on foreign net operating loss carryovers andforeign deferred expenses only if it is more likely than not that a benefitwill be realized.

 

***   Income From Continuing Operations.***

 

Income from continuingoperations for the first quarter of fiscal year 2005 was $13.8 million, anincrease of 10% from $12.5 million in the prior period.  As a percentage of revenue, income fromcontinuing operations increased to 7.8 percent from 7.3 percent.

 

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

 

Diluted earnings per share,income from continuing operations for the first quarter of fiscal year 2005 was$0.42, compared to $0.37 for the first quarter of fiscal year 2004.

 

   ***Discontinued Operations.***

 

In the first quarter of fiscalyear 2005, the Company received sublease income of approximately $4,000 inexcess of lease payments related to Wellspring, compared to $17,000 in theprior period.

 

**Liquidityand Capital Resources**

 

Our cash and cash equivalentsat September 30, 2004, totaled $107.1 million, compared to $156.9 million atJune 30, 2004.  The decrease in cash fromJune 30, 2004 to September 30, 2004, follows a typical pattern of cash flow forthe company that is attributable to the payment of previously accrueddiscretionary compensation.  During thefirst quarter of fiscal year 2005, we paid $34.8 million in previously accrueddiscretionary compensation, $18.5 million in corporate taxes, $4.2 million forthe repurchase of the company’s stock, $4.5 million in capital expenditures and$2.4 million in dividends.  Theseoutflows of cash were offset by positive cash flow from consultingoperations.  Consistent with thecompany’s liquidity position, management considers various alternativestrategic uses of cash reserves including acquisitions, dividends and stockbuybacks, or any combination of these options.

 

Our non U.S. operations do notmaterially impact liquidity or capital resources as they are substantiallyself-sufficient for their working capital needs.  At September 30, 2004, $33.4 million of thetotal cash balance of $107.1 million was held outside of North America, whichwe have the ability to utilize, if necessary. There are no significantrepatriation restrictions other than local or U.S. taxes associated withrepatriation.

 

*   **Cash Used in OperatingActivities.***

 

Cash used in operatingactivities**for the first three months of fiscalyear 2005 was $41.3 million, compared to cash used in operating activities of$25.5 million for the first three months of fiscal year 2004.  The variance is mainly due to the prepaymentof taxes during the first quarter of fiscal year 2005.  The allowance for doubtful accounts increased$1.9 million and the allowance for work in process increased $0.8 million fromJune 30, 2004 to September 30, 2004. The number of days of accounts receivableand work in process outstanding increased to 83 at September 30, 2004, comparedto 78 at June 30, 2004 and 2003.

 

*   **Cash Used in InvestingActivities.***

 

Cash used in investingactivities for the first quarter of fiscal year 2005 was $4.5 million, comparedto $3.1 million for the first quarter of fiscal year 2004.  The increase can be primarily attributed tohigher 

 

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purchases of fixed assets of$0.9 million.

 

Expenditures of capital fundswere $6.9 million for the first three months of fiscal year 2005.  Anticipated commitments of capital funds areestimated at $31.2 million for the remainder of fiscal year 2005, mainly forcomputer hardware purchases, office relocations and renovations, developmentand upgrade of financial and retirement systems and acquisition-relatedpayments. We expect cash from operations to adequately provide for these cashneeds.

 

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

 

Cash used in financingactivities for the first quarter of fiscal year 2005 was $4.4 million, comparedto cash from financing activities of $1.9 million for the first quarter offiscal year 2004.  The difference can beattributed to common stock repurchases of $4.2 million and dividends paidduring the first quarter of fiscal year 2005. In May 2004, the Board of Directors of the company approved theinitiation of a quarterly cash dividend in the amount of $0.075 per share.  The first quarterly dividend payment of $2.4million was made on July 15, 2004 to shareholders of record as of June 30,2004.  The second quarterly dividendpayment was made shareholders of record as of September 30, 2004 and wasaccrued in these financial statements.

 

**Off-BalanceSheet Arrangements and Contractual Obligations**

 

***Operating Leases***.  We lease office space, furniture and selectedcomputer equipment under operating lease agreements with terms ranging from oneto ten years.  Future expected paymentsare as follows:

 
| ** **                        | ** ** | **Remaining payments due by fiscal year as of September 30, 2004** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------|------------|
| **Contractual Cash  Obligations** | ** ** | **Total**                                                          | ** ** | **2005** | ** ** | **2006  through  2007** | ** ** | **2008  through  2009** | ** ** | **Thereafter** | ** ** |
| Lease commitments                 |       | $                                                                  | 258,246    |   | $ | 30,177 |   | $ | 63,163 |   | $ | 51,678 |   | $ | 113,228 |   |
|                                   |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Management has determined thatthere is not a large concentration of leases that will expire in any one fiscalyear.  Consequently, managementanticipates that any increase in future rent expense will be mainly marketdriven.

 

***Guarantees***

 

*WellspringLeases*.  TheCompany continues to guarantee certain leases for office premises and equipmentfor Wellspring.  At September 30, 2004,minimum remaining payments guaranteed under these leases, which expire atvarious dates through 2007, totaled $16.5 million, excluding anticipatedsublease income.  The leases arecurrently generating positive cash flows of less than $0.1 million per fiscalyear.  Management will continue toevaluate the adequacy of these provisions and make adjustments as appropriate.  See Notes 13 and 15 of the Notes to theConsolidated Financial Statements for more information related to Wellspring.

 

*AffiliateAgreements*.  Inconnection with the establishment of our alliance with Watson Wyatt LLP in1995, the company agreed to guarantee Watson Wyatt LLP’s performance under alease for office space in London that expires in 2015.  Payments by Watson Wyatt LLP under the leasetotal £1.4 million (or approximately $2.5 million based on the September 30,2004, exchange rate) per year.  We alsogranted Watson Wyatt LLP an option to return the leased space to our UKsubsidiary in 2009.  If Watson Wyatt LLPwere to exercise this option, the company would attempt to sublease the spaceat the then-current market rates.

 

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**CreditAgreement**

 

In June 2004, we reduced thesize of our revolving credit facility to $50 million from $100 million in orderto better align it with our business needs. The facility is provided by a syndicate of banks.  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 0.20 percent of the facility,that varies with our financial leverage and is paid on the unused portion ofthe credit facility.  No amounts wereoutstanding under the company’s revolving credit facility as of September 30,2004 or June 30, 2004.  Credit under thefacility is available upon demand, although the credit facility requires us toobserve certain covenants (including requirements for a fixed coverage charge,cashflow leverage ratio and asset coverage) and is collateralized with a pledgeof stock of material subsidiaries.  Wewere in compliance with all covenants under the credit facility as of September30, 2004.

 

A portion of the revolvingfacility is used to support required letters of credit issued under the creditline.  As a result, $7.5 million of thefacility is currently unavailable for operating needs.  We are also charged a fee for outstandingletters of credit that also fluctuates based on our leverage ratio.  The credit facility is scheduled to mature onJune 29, 2009.

 

**RiskManagement**

 

**As a part of our overall risk management program, we carrycustomary commercial insurance policies, including commercial generalliability, employment practices liability, and claims-made professionalliability insurance with a self-insured retention of $1 million per claim,which provides coverage for professional liability claims including the cost ofdefending such claims.  Our primaryinsurance coverage beyond this retention is written by an affiliated captiveinsurance company owned by us and two other professional services firms.  Prior to July 1, 2003, the first $5 millionof coverage had a premium structure which provided that the captive insurancecompany would recover from the firm defending the claim approximately 75percent of any loss up to $5 million. This recovery occurred through insurance premium payments in subsequentyears.  The company recorded an accrualfor this liability.  The remaining 25percent of any loss up to $5 million was a risk borne by the captive insurancecompany, which carried reinsurance in the commercial markets for most lossesabove $5 million.**

** **

**As of July 1, 2003, PCIC has attempted to recover throughits premium structure the amounts it expects to pay out for member companies inclaims losses, continuing the loss sharing formula whereby 75% of the lossesincurred by PCIC with respect to each member are incorporated in the member’s futurepremium charges, and will increase such member’s premium by approximately alike amount over the next five years. PCIC now bases premium calculations,which are determined annually based on experience through March of each year,on relative risk of the various lines of business performed by each of theowner companies, past claim experience of each owner company, growth of each ofthose companies, industry risk profiles in general and the overall insurancemarkets.  As of July 1, 2004, the captiveinsurance company carries reinsurance for a substantial portion of losses above$25 million.**

** **

**Our agreements with PCIC could require additional paymentsto PCIC in the event that the company decided to exit PCIC and adverse claimssignificantly exceed prior expectations. If these circumstances were to occur, the company would record aliability at the time it becomes estimable and probable.**

** **

**The company will continue to provide for the self-insuredretention where specific estimated losses for known claims in excess of $1million are considered probable and reasonably estimable.**

** **

**Although the company maintains professional liabilityinsurance coverage, this insurance does not cover claims made after expirationof our current insurance contracts. Generally accepted accounting principles require that we record aliability for incurred but not reported (IBNR) professional liability claims ifthey are estimable and probable, and for which we have not yet contracted forinsurance coverage.  The company usesactuarial assumptions to estimate and record its IBNR liability and has a $13.4million**

** **

**30**

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** **

**IBNR liability recorded as of September 30, 2004.**

** **

**Current insurance market conditions for our industryinclude increases in overall premium cost, higher self-insured retentions andreductions in aggregate excess coverages, trends that are anticipated tocontinue.  We expect these trends to bereflected in our future annual insurance renewals and, as a result, we willcontinue to assess our ability to secure future insurance coverage.  In anticipation of the possibility of futurereductions in risk transfer from PCIC to reinsurers, as well as the trendtoward a generally hardening insurance market, the firms that own PCIC, includingthe company, increased PCIC’s capital in fiscal years 2002 and 2003.  No capital contribution was provided duringfiscal year 2004 or the first quarter of fiscal year 2005.**

** **

**In light of increasing worldwide litigation, includinglitigation against professionals, the company has been implementing arequirement that all client relationships be documented by engagement letterscontaining specific risk mitigation clauses that were not included in allhistorical client agreements.  Nearly 100percent of the company’s U.S. corporate clients have signed engagement lettersincluding mitigation clauses, and initiatives to complete that process both inthe United States and elsewhere are underway. The company has disengaged fromcertain client relationships where satisfactory engagement terms could not beachieved.**

** **

**Recent AccountingPronouncements**

** **

In January 2003, the FinancialAccounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46),“Consolidation of Variable Interest Entities,” which clarifies the financialreporting guidance associated with the consolidation of another entity.  In December 2003, the FASB revised andsuperceded FIN 46 with the issuance of FIN 46R in order to address certainimplementation issues.  The companyadopted FIN 46R effective March 31, 2004 and has included appropriatedisclosure in this Form 10-Q.  Adoptionof the FIN 46R has not resulted in a change in our accounting.  See Note 10 of the Consolidated FinancialStatements for further information regarding the impact of adopting FIN 46R.

 

Emerging Issues Task ForceIssue 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21),was effective for the company beginning July 1, 2003.  There was no change in revenue recognized inthe current portfolio of client engagements due to our adoption of EITF 00-21.

 

In December 2003, the Securities and ExchangeCommission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), “RevenueRecognition,” which supercedes Staff Accounting Bulletin No. 101 (SAB 101), “RevenueRecognition in Financial Statements.” SAB 104’s primary purpose is to rescind accounting guidance contained inSAB 101 related to multiple element revenue arrangements, superceded as aresult of the issuance of EITF 00-21. While the wording of SAB 104 has changed to reflect the issuance of EITF00-21, the revenue recognition principles of SAB 101 remain largely unchangedby the issuance of SAB 104.  The issuanceof SAB 104 has not had an effect on our revenue recognition policies as theyare in accordance with SAB 104.

 

In May 2004, the FinancialAccounting Standards Board issued FASB Staff Position (FSP) No. 106-2“Accounting and Disclosure Requirements Related to the Medicare PrescriptionDrug Improvement and Modernization Act of 2003” (the Act) (FAS 106-2), whichwas effective as of the first quarter beginning after June 15, 2004. The Actincludes a prescription drug benefit under Medicare Part D as well as a federalsubsidy to sponsors of retiree health care benefit plans that provide a benefitthat is at least actuarially equivalent (as defined in the Act) to MedicarePart D.  The adoption of FAS 106-2 hasnot had a material effect on the financial condition or results of operationsof the company.

 

In December 2003, the FinancialAccounting Standards Board (FASB) published revisions to Statement of FinancialAccounting Standards No. 132, “Employers’ Disclosures about Pensions and OtherPostretirement Benefits” (FAS 132).  FAS132 revisions retain the original disclosures but require additional annualdisclosures about assets, obligations, cash flows and interim disclosures aboutnet periodic benefit costs of defined benefit pension plans and otherpostretirement plans.   The statement was

 

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effective for fiscal yearsending after December 15, 2003.  Thecompany has adopted FAS 132 as revised and included appropriate disclosure inthis Form 10-Q.

 

In June 2004, the EmergingIssues Task Force (EITF) issued EITF 02-14****“Whether anInvestor Should Apply the Equity Method of Accounting to Investments Other ThanCommon Stock if the Investor Has the Ability to Exercise Significant InfluenceOver the Operating and Financial Policies of the Investee.”  This EITF indicates that an investor shouldonly apply the equity method of accounting when it has investments in eithercommon stock or in-substance common stock of a corporation, provided that theinvestor has the ability to exercise significant influence over the operatingand financial policies of the investee. The issuance of EITF 02-14 has not had an effect on our accounting forequity investments which has been in accordance with EITF 02-14.

 

**DisclaimerRegarding Forward-looking Statements**

 

This filing contains certainstatements that are “forward-looking statements” within the meaning of thePrivate Securities Litigation Reform Act of 1995, including, but not limited tothe following: Note 7 -  RetirementBenefits on page 9 through 11; Note 8 – Goodwill and Intangible Assets on pages11 and 12; Note 13 – Guarantees on page 15; Note 14 – Contingent Liabilities onpage 16; the Executive Overview on pages 20 and 21; Critical AccountingPolicies and Estimates on pages 22 through 25; the discussion of our capitalcommitments on page 29; Off-Balance Sheet Arrangements and ContractualObligations on page 29; Risk Management on page 30 and 31; and Part II, Item 1“Legal Proceedings” on page 33 and 34. In some cases, you can identify these statements and otherforward-looking statements in this filing by words such as “may,” “will,”“expect,” “anticipate,” “believe,” “estimate,” “plan,” “intend,” “continue,” orsimilar words. You should read these statements carefully because they containprojections of our future results of operations or financial condition, or stateother “forward-looking” information. A number of risks and uncertainties existwhich could cause actual results to differ materially from the resultsreflected in these forward-looking statements. Such factors include, but arenot limited to, our continued ability to recruit and retain highly qualifiedassociates, outcomes of litigation, a significant decrease in the demand forthe consulting services we offer as a result of changing economic conditions orother factors, actions by competitors offering human resources consultingservices, including public accounting and consulting firms, technologyconsulting firms and internet/intranet development firms, regulatory,legislative and technological developments that may affect the demand for orcosts of our services and other factors discussed under “risk factors” in ourAnnual Report on Form 10-K for the fiscal year ended June 30, 2004, which wasfiled with the SEC on August 17, 2004, and may be accessed via EDGAR on theSEC’s web site at www.sec.gov. These statements are based on assumptions thatmay not come true. All forward-looking disclosure is speculative by its nature.The Company undertakes no obligation to update any of the forward-lookinginformation included in this report, whether as a result of new information,future events, changed expectations or otherwise.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK.**

 

We are exposed to market risksin the ordinary course of business. These risks include interest rate risk andforeign currency exchange risk. We have examined our exposure to these risksand concluded that none of our exposures in these areas are material to fairvalues, cash flows or earnings*.*

 

**ITEM4.  CONTROLS AND PROCEDURES.**

 

**Evaluationof Disclosure Controls and Procedures**

 

Thechief executive officer (CEO) and chief financial officer (CFO) of the companyevaluated our disclosure controls and procedures as of the end of the firstquarter of fiscal year 2005.  They haveconcluded that, as of September 30, 2004, such controls and procedures havebeen effectively designed to

 

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ensurethat information required to be disclosed in reports that the company fileswith or submits to the SEC is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and isaccumulated and communicated to management, including the CEO and CFO, asappropriate, to allow timely decisions regarding such disclosure.

 

**Changesin Internal Control Over Financial Reporting**

 

Nochanges to our internal control over financial reporting have occurred duringthe first quarter that have come to management’s attention that have materiallyaffected or are reasonably likely to materially affect our internal controlover financial reporting.

 

**Compliancewith Section 404 of the Sarbanes-Oxley Act of 2002**

 

Our company is required tocomply with Section 404 of the Sarbanes-Oxley Act of 2002 and SEC rules andPublic Company Accounting Oversight Board (PCAOB) standards for implementingSection 404 by June 30, 2005.  Withregards to the company’s continuing compliance efforts, the company hascompleted all documentation of financial and company-wide controls.  We began testing certain key controls in thefourth quarter of fiscal year 2004 in preparation for compliance with Section404 and plan to continue testing through the first half of fiscal year 2005 inpreparation for management’s assessment in the second half of fiscal year 2005.

 

**Limitations on the Effectiveness of Controls**

 

Our management, including the CEO and CFO, does not expect that our internal controls 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, management believes that the company’s internal controls over financial reporting for the first quarter of fiscal year 2005 were adequate.

 

**PART II.  OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

From time to time, we are aparty to various lawsuits, arbitrations or mediations that arise in theordinary course of business. These disputes typically involve claims relatingto the rendering of professional services or employment matters.  Management believes, based on currentlyavailable information, that the results of all pending claims against us willnot have a material adverse effect on the company.  The matters reported on below involve themost significant pending or potential claims against us.

 

*Iron Workers Local 25 et al. v. Watson Wyatt& Co. *OnJuly 8, 2004, Watson Wyatt & Co. was served with an amended complaint filedby a former client in the United States District Court for the Eastern Districtof Michigan.  The complaint allegedmalpractice, breach of contract, and related claims in the performance ofactuarial consulting.  The Complaintstated that the plaintiff’s Pension Fund is underfunded as a result of the allegeddeficiencies in our work.   The amount ofdamages sought were not 

 

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specified. We filed an answer denying theallegations and the court has set a discovery schedule.

 

*SECExamination of Investment Advisers. *InDecember 2003, the Securities and Exchange Commission (SEC) formally asked manyof the major investment consulting firms, Watson Wyatt Investment Consulting(WWIC) among them, to provide detailed information on their business structuresand practices in order to determine if conflicts of interest with moneymanagers exist.  In March 2004, WWICcompleted its responses to the SEC staff’s requests for information.  WWIC has received no further inquiry from theSEC staff on this topic since that time.

 

*Departmentof Justice Antitrust Investigation. *InMarch 2004, the United States Department of Justice (DOJ) issued a CivilInvestigative Demand (CID) to Watson Wyatt and other companies in the employeebenefits industry.  The DOJ is seeking todetermine whether firms which have entered into agreements with their clientslimiting liability have done so in violation of U.S. antitrust laws. WatsonWyatt has been providing information to DOJ in response to the CID.

 

*ClientDemand Letter. *OnJuly 23, 2004, we received a demand letter from counsel for a client allegingthat errors in valuations for 2001 and subsequent years understated theliabilities of its pension plan and overstated its net worth.  As a result, the client claimed it did notannuitize its defined benefit plan and redeemed its stock at an inflatedprice.  The letter claimed damages “inexcess of $35 million.”  We plan to meetwith counsel for the client to discuss the basis of these claims.

 

**ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

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

 

**Issuer Purchases of Equity Securities**

 

The table below presents specified information about the Company’sstock repurchases and repurchase plans:

 
| **Period**                                    | ** ** | **Total Number   of Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** **   | **Total Number of  Shares Purchased  as Part of Publicly  Announced Plans   or Programs** | ** ** | **Maximum Number of   Shares that May Yet  Be Purchased Under  the Plans or Programs** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------|--------------|-------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| July 1, 2004 through July 31, 2004            |       | —                                  |       | $                                 |  — |                                                                                      | —     |                                                                                   | 928,934    | ** ** |
| August 1, 2004 through August 31, 2004        |       | 88,000                                  |       | 25.37                             |         | 88,000                                                                                    |       | 840,934                                                                                |       |
| September 1, 2004 through September 30,  2004 |       | 77,000                                  |       | 25.40                             |         | 77,000                                                                                    |       | 763,934                                                                                |       |
| Total                                         |       | 165,000                                 |       | $                                 | 25.38        |                                                                                      | 165,000    |                                                                                   |       |   |

 

**ITEM3.  DEFAULTS UPON SENIOR SECURITIES.**

** **

**None.**

** **

**34**

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** **

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

 

None.

 

I**TEM 5. OTHER INFORMATION.**

 

None.

 

**ITEM 6. EXHIBITS****.**

** **
|   | 3.1    | Amended and Restated Certificate of Incorporation of Watson Wyatt  & Company Holdings(1)                                                                                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                    |
|   | 3.2    | Amended and Restated Bylaws of Watson Wyatt & Company Holdings(2)                                                                                                                                   |
|   |   |                                                                                                                                                                                                    |
|   | 4      | Form of Certificate Representing Common Stock(1)                                                                                                                                                        |
|   |   |                                                                                                                                                                                                    |
|   | 10.1   | Credit Agreement Among Suntrust Bank and Others dated June 30,  2004(8)                                                                                                                                 |
|   |   |                                                                                                                                                                                                    |
|   | 10.2   | Senior Officer Deferred Compensation Plan(4)                                                                                                                                                            |
|   |   |                                                                                                                                                                                                    |
|   | 10.3   | Form of agreement among Watson Wyatt & Company, Watson Wyatt  & Company Holdings and employee directors, executive officers and  significant stockholders restricting the transfer of shares(3) |
|   |   |                                                                                                                                                                                                    |
|   | 10.4   | 2001 Deferred Stock Unit Plan for Selected Employees(5)                                                                                                                                                 |
|   |   |                                                                                                                                                                                                    |
|   | 10.5   | Compensation Plan for Outside Directors(6)                                                                                                                                                              |
|   |   |                                                                                                                                                                                                    |
|   | 10.6   | Lease between Watson Wyatt & Company and Arlington Office,  L.L.C., dated April 27, 2004(7)                                                                                                         |
|   |   |                                                                                                                                                                                                    |
|   | 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(9)                         |
|   |   |                                                                                                                                                                                                    |
|   | 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(9)                         |
|   |   |                                                                                                                                                                                                    |
|   | 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(9)                  |

 

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(1)               Incorporatedby reference from Registrant’s Form S-3/A, Amendment No. 1 (File No.33-394973), filed on March 17, 2000

(2)               Incorporatedby reference from Registrant’s Form 10-Q, filed on May 2, 2001

(3)               Incorporatedby reference from Registrant’s Form S-3/A, Amendment No. 5 (File No.33-394973), filed on September 14, 2000

(4)               Incorporatedby reference from Registrant’s Form 10-K, filed on August 15, 2001

(5)               Incorporatedby reference from Registrant’s Form DEF14A, filed on October 17, 2003

(6)               Incorporatedby reference from Registrant’s Form DEF14A, filed on October 15, 2004

(7)               Incorporatedby reference from Registrant’s Form 10-Q, filed on May 7, 2004

(8)               Incorporatedby reference from Registrant’s Form 10-K, filed on August 17, 2004

(9)               Filedwith this form 10-Q

 

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**Signatures**

 

Pursuant to the requirements ofthe Securities and Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

Watson Wyatt & CompanyHoldings(Registrant)

 

 
| /s/ John J.  Haley   |                     |   | November 9,  2004 |   |
|----------------------|--------------------------|--------|-------------------|--------|
| Name:                | John J.  Haley           | Date   |
| Title:               | President  and           |   |
|                 | Chief  Executive Officer |   |
|                 |                     |   |
|                 |                     |   |
| /s/ Carl D.  Mautz   |                     |   | November 9,  2004 |   |
| Name:                | Carl D.  Mautz           | Date   |
| Title:               | Vice  President and      |   |
|                 | Chief  Financial Officer |   |
|                 |                     |   |
|                 |                     |   |
| /s/ Peter L.  Childs |                     |   | November 9,  2004 |   |
| Name:                | Peter L.  Childs         | Date   |
| Title:               | Controller               |   |
|                      |                          |        |                   |        |  |  |  |

 

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