**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

 

**FORM 10-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 December 31, 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 & COMPANYHOLDINGS**(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 zip code)

 

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

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days:

 

| Yes | ý |   | No | o |
|-----|--------|--------|----|---|

 

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

 

| Yes | ý |   | No | o |
|-----|--------|--------|----|---|

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of January 31, 2005.

 
| **Class**                            | ** ** | **Number of Shares** | ** ** |
|--------------------------------------|------------|----------------------|------------|
| Class A Common Stock, $.01 par value |       | 32,572,186           |       |

 

 

----

 

**WATSON WYATT & COMPANYHOLDINGSINDEX TO FORM 10-Q**

 

For the Three and Six MonthsEnded December 31, 2004

 
| PART I.        | FINANCIAL INFORMATION                                                                                    |   |
|----------------|----------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                     |   |
| Item 1.        | Financial Statements (Unaudited)                                                                         |   |
|           |                                                                                                     |   |
|           | Consolidated  Statements of Operations—Three and six months ended December 31, 2004 and  2003       |   |
|           |                                                                                                     |   |
|           | Consolidated Balance Sheets—December  31, 2004 and June 30, 2004                                    |   |
|           |                                                                                                     |   |
|           | Consolidated  Statements of Cash Flows—Six months ended December 31, 2004 and 2003                  |   |
|           |                                                                                                     |   |
|           | Consolidated  Statement of Changes in Stockholders’ Equity—Six months ended December 31,  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 and Use of Proceeds                                             |   |
|           |                                                                                                     |   |
| Item 3.        | Defaults Upon  Senior Securities                                                                         |   |
|           |                                                                                                     |   |
| Item  4.       | Submission  of Matters to a Vote of Security Holders                                                     |   |
|           |                                                                                                     |   |
| Item 5.        | Other Information                                                                                        |   |
|           |                                                                                                     |   |
| Item 6.        | Exhibits                                                                                                 |   |
|           |                                                                                                     |   |
| Signatures     |                                                                                                     |   |
|           |                                                                                                     |   |
| Certifications |                                                                                                     |   |

 

----

 

**WATSONWYATT & COMPANY HOLDINGS**

**ConsolidatedStatements of Operations**

(Thousands of U.S. Dollars, Except Per Share Data)

 
| ** **                                                                                                                              | ** ** | **Three months ended December 31** | ** ** | **Six months ended December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                              | ** ** | **(Unaudited)**                    | ** ** | **(Unaudited)**                  | ** ** |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Revenue                                                                                                                                 |       | $                                  | 175,849    |                             | $          | 170,353 |   | $ | 351,240 |   | $ | 341,336 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Costs of  providing services:                                                                                                           |       |                               |       |                             |       |   |   |   |   |
| Salaries and  employee benefits                                                                                                         |       | 95,194                             |       | 94,374                           |       | 192,270 |   | 199,447 |   |
| Professional and  subcontracted services                                                                                                |       | 11,544                             |       | 12,613                           |       | 23,523 |   | 21,699 |   |
| Occupancy,  communications and other                                                                                                    |       | 27,901                             |       | 25,921                           |       | 52,001 |   | 49,439 |   |
| General and  administrative expenses                                                                                                    |       | 19,481                             |       | 14,990                           |       | 36,369 |   | 30,591 |   |
| Depreciation and  amortization                                                                                                          |       | 4,810                              |       | 5,395                            |       | 9,493 |   | 10,047 |   |
|                                                                                                                                    |       | 158,930                            |       | 153,293                          |       | 313,656 |   | 311,223 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Income from  operations                                                                                                                 |       | 16,919                             |       | 17,060                           |       | 37,584 |   | 30,113 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Income from  affiliates                                                                                                                 |       | 2,724                              |       | 1,048                            |       | 4,930 |   | 2,838 |   |
| Interest income,  net                                                                                                                   |       | 407                                |       | 170                              |       | 862 |   | 384 |   |
| Other  non-operating (expense)/income                                                                                                   |       | (56                                | )          | 27                               |       | (28 | ) | 6,152 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Income from  continuing operations before income taxes                                                                                  |       | 19,994                             |       | 18,305                           |       | 43,348 |   | 39,487 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Provision for income  taxes                                                                                                             |       | 8,939                              |       | 7,503                            |       | 18,542 |   | 16,188 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Income from  continuing operations                                                                                                      |       | 11,055                             |       | 10,802                           |       | 24,806 |   | 23,299 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Discontinued  operations:                                                                                                               |       |                               |       |                             |       |   |   |   |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Sublease income  from discontinued operations, less applicable income tax expense for the  three and six months ended December 31, 2004 |       | 6                                  |       | 16                               |       | 8 |   | 26 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Net income                                                                                                                              |       | $                                  | 11,061     |                             | $          | 10,818 |   | $ | 24,814 |   | $ | 23,325 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Basic earnings  per share:                                                                                                              |       |                               |       |                             |       |   |   |   |   |
| Income from  continuing operations                                                                                                      |       | $                                  | 0.34       |                             | $          | 0.33 |   | $ | 0.76 |   | $ | 0.70 |   |
| Income from  discontinued operations                                                                                                    |       | —                             |       | —                           |       | — |   | — |   |
| Net income                                                                                                                              |       | $                                  | 0.34       |                             | $          | 0.33 |   | $ | 0.76 |   | $ | 0.70 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Diluted earnings  per share:                                                                                                            |       |                               |       |                             |       |   |   |   |   |
| Income from  continuing operations                                                                                                      |       | $                                  | 0.34       |                             | $          | 0.32 |   | $ | 0.76 |   | $ | 0.70 |   |
| Income from  discontinued operations                                                                                                    |       | —                             |       | —                           |       | — |   | — |   |
| Net income                                                                                                                              |       | $                                  | 0.34       |                             | $          | 0.32 |   | $ | 0.76 |   | $ | 0.70 |   |
|                                                                                                                                    |       |                               |       |                             |       |   |   |   |   |
| Weighted average  shares of common stock, basic (000)                                                                                   |       | 32,516                             |       | 33,143                           |       | 32,437 |   | 33,111 |   |
| Weighted average  shares of common stock, diluted (000)                                                                                 |       | 32,807                             |       | 33,474                           |       | 32,737 |   | 33,453 |   |

 

See accompanying notes to theconsolidated financial statements

 

1

----

 

**WATSONWYATT & COMPANY HOLDINGS**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                 | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                                                                                 | ** ** | **2004**         | ** ** | **2004**     | ** ** |
| ** **                                                                                                 | ** ** | **(unaudited)**  | ** ** | ** **   | ** ** |
| **Assets**                                                                                                 | ** ** | ** **       | ** ** | ** **   | ** ** |
| Cash and cash  equivalents                                                                                 |       | $                | 135,082    |         | $          | 156,940 |   |
| Receivables from  clients:                                                                                 |       |             |       |         |       |
| Billed, net of  allowances of $2,523 and $1,241                                                            |       | 90,678           |       | 86,726       |       |
| Unbilled, net of  allowances of $1,037 and $456                                                            |       | 53,880           |       | 63,108       |       |
|                                                                                                       |       | 144,558          |       | 149,834      |       |
| Deferred income  taxes                                                                                     |       | 11,224           |       | 15,052       |       |
| Other current  assets                                                                                      |       | 36,407           |       | 11,388       |       |
| Total current  assets                                                                                      |       | 327,271          |       | 333,214      |       |
| Investment in  affiliates                                                                                  |       | 33,386           |       | 30,235       |       |
| Fixed assets,  net                                                                                         |       | 75,343           |       | 65,438       |       |
| Deferred income  taxes                                                                                     |       | 55,098           |       | 55,240       |       |
| Goodwill and  intangible assets                                                                            |       | 22,054           |       | 20,909       |       |
| Other assets                                                                                               |       | 6,148            |       | 7,132        |       |
|                                                                                                       |       |             |       |         |       |
| **Total  Assets**                                                                                          |       | $                | 519,300    |         | $          | 512,168 |   |
| ** **                                                                                                 | ** ** | ** **       | ** ** | ** **   | ** ** |
| **Liabilities**                                                                                            | ** ** | ** **       | ** ** | ** **   | ** ** |
| Accounts payable  and accrued liabilities, including discretionary compensation                            |       | $                | 90,098     |         | $          | 113,233 |   |
| Income taxes  payable                                                                                      |       | 10,232           |       | 12,526       |       |
| Total current  liabilities                                                                                 |       | 100,330          |       | 125,759      |       |
| Accrued  retirement benefits                                                                               |       | 102,403          |       | 97,984       |       |
| Deferred rent  and accrued lease losses                                                                    |       | 10,402           |       | 10,199       |       |
| Deferred income  taxes                                                                                     |       | 347              |       | 628          |       |
| Other noncurrent  liabilities                                                                              |       | 31,512           |       | 32,414       |       |
|                                                                                                       |       |             |       |         |       |
| **Total  Liabilities**                                                                                     |       | 244,994          |       | 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:                                                                    |       |             |       |         |       |
| 99,000,000  shares authorized; 33,372,880 and 33,372,880 issued and 32,562,318 and  32,317,156 outstanding |       | 334              |       | 334          |       |
| Additional  paid-in capital                                                                                |       | 148,780          |       | 149,508      |       |
| Treasury stock,  at cost - 810,562 and 1,055,724 shares                                                    |       | (20,148          | )          | (26,149      | )          |
| Retained  earnings                                                                                         |       | 145,626          |       | 125,669      |       |
| Accumulated  other comprehensive gain/(loss)                                                               |       | (286             | )          | (4,178       | )          |
| **Total  Stockholders’ Equity**                                                                       |       | 274,306          |       | 245,184      |       |
|                                                                                                       |       |             |       |         |       |
| **Total  Liabilities and Stockholders’ Equity**                                                       |       | $                | 519,300    |         | $          | 512,168 |   |

 

See accompanying notes to theconsolidated financial statements

 

2

----

 

**WATSON WYATT& COMPANY HOLDINGS**

**ConsolidatedStatements of Cash Flows**

(Thousands of U.S. Dollars)

 
| ** **                                                                     | ** ** | **Six months ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **(Unaudited)**                   | ** ** |
| Cash flows from  (used in) operating activities:                               |       |                              |       |   |   |
| Net income                                                                     |       | $                                 | 24,814     |   | $ | 23,325 |   |
| Adjustments to  reconcile net income to net cash used in operating activities: |       |                              |       |   |   |
| Other  non-operating gain related to PCIC                                      |       | —                            |       | (5,600 | ) |
| Provision for  doubtful receivables from clients                               |       | 3,841                             |       | 3,741 |   |
| Depreciation                                                                   |       | 9,344                             |       | 9,883 |   |
| Amortization of  intangible assets                                             |       | 149                               |       | 164 |   |
| Provision for  deferred income taxes                                           |       | 3,689                             |       | 5,451 |   |
| Income from  affiliates                                                        |       | (4,930                            | )          | (2,838 | ) |
| Distributions  from affiliates                                                 |       | 3,069                             |       | 2,285 |   |
| Other, net                                                                     |       | 200                               |       | (536 | ) |
| Changes in  operating assets and liabilities (net of discontinued operations)  |       |                              |       |   |   |
| Receivables from  clients                                                      |       | 1,435                             |       | (1,749 | ) |
| Other current  assets                                                          |       | (11,598                           | )          | (4,209 | ) |
| Other assets                                                                   |       | 984                               |       | 1,100 |   |
| Accounts payable  and accrued liabilities                                      |       | (18,566                           | )          | (21,330 | ) |
| Income taxes  payable                                                          |       | (15,715                           | )          | (15,156 | ) |
| Accrued retirement  benefits                                                   |       | 4,419                             |       | 1,764 |   |
| Deferred rent  and accrued lease losses                                        |       | 203                               |       | 1,535 |   |
| Other noncurrent  liabilities                                                  |       | (887                              | )          | (1,266 | ) |
| Net cash from  (used in) operating activities                                  |       | 451                               |       | (3,436 | ) |
|                                                                           |       |                              |       |   |   |
| Cash flows used  in investing activities:                                      |       |                              |       |   |   |
| Purchases of  fixed assets                                                     |       | (12,057                           | )          | (7,806 | ) |
| TSP Capitalized  software costs                                                |       | (6,727                            | )          | — |   |
| Contingent  payments for divestitures                                          |       | (28                               | )          | 552 |   |
| Acquisitions and  contingent consideration payments                            |       | (517                              | )          | (113 | ) |
| Net cash used in  investing activities                                         |       | (19,329                           | )          | (7,367 | ) |
|                                                                           |       |                              |       |   |   |
| Cash flows used  in financing activities:                                      |       |                              |       |   |   |
| Issuances of  common stock - exercises of stock options                        |       | 1,148                             |       | 1,179 |   |
| Issuances of  common stock - employee stock purchase plan                      |       | 3,632                             |       | 3,278 |   |
| Dividends paid                                                                 |       | (4,857                            | )          | — |   |
| Repurchases of  common stock                                                   |       | (4,188                            | )          | (9,776 | ) |
| Net cash used in  financing activities                                         |       | (4,265                            | )          | (5,319 | ) |
|                                                                           |       |                              |       |   |   |
| Effect of  exchange rates on cash                                              |       | 1,285                             |       | 3,361 |   |
|                                                                           |       |                              |       |   |   |
| Decrease in cash  and cash equivalents                                         |       | (21,858                           | )          | (12,761 | ) |
|                                                                           |       |                              |       |   |   |
| Cash and cash  equivalents at beginning of period                              |       | 156,940                           |       | 144,374 |   |
|                                                                           |       |                              |       |   |   |
| Cash and cash  equivalents at end of period                                    |       | $                                 | 135,082    |   | $ | 131,613 |   |

 

See accompanying notes to theconsolidated financial statements

 

3

----

 

**WATSON WYATT & COMPANY HOLDINGS**

**ConsolidatedStatement of Changes in Stockholders’ Equity**

(Thousands of U.S. Dollars)

 
| ** **                                                       | ** ** | **Class A**     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|----------------|------------|--------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                       | ** ** | **Common**      | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Stock**       | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Outstanding** | ** ** | **Class A** | ** ** | **Additional** | ** ** | **Treasury** | ** ** | ** **   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **(number of**  | ** ** | **Common**  | ** ** | **Paid-in**    | ** ** | **Stock,**   | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **shares)**     | ** ** | **Stock**   | ** ** | **Capital**    | ** ** | **at Cost**  | ** ** | **Earnings** | ** ** | **(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                                                       |       |            |       |        |       |           |       |         |       | 24,814       |       |              |       | 24,814     |       |
| Additional  minimum pension liability                            |       |            |       |        |       |           |       |         |       |         |       | (362              | )          | (362       | )          |
| Foreign currency  translation adjustment                         |       |            |       |        |       |           |       |         |       |         |       | 4,254             |       | 4,254      |       |
| Total comprehensive  income                                      |       |            |       |        |       |           |       |         |       |         |       |              |       | 28,706     |       |
| Cash dividends                                                   |       |            |       |        |       |           |       |         |       | (4,857       | )          |              |       | (4,857     | )          |
| Repurchases of  common stock                                     |       | (165            | )          |        |       |           |       | (4,188       | )          |         |       |              |       | (4,188     | )          |
| Issuances of  common stock - employee stock purchase plan shares |       | 166             |       |        |       | (468           | )          | 4,100        |       |         |       |              |       | 3,632      |       |
| Issuances of  common stock - deferred stock units                |       | 151             |       |        |       | 276            |       | 3,769        |       |         |       |              |       | 4,045      |       |
| Issuances of  common stock to outside directors                  |       | 4               |       |        |       | 7              |       | 105          |       |         |       |              |       | 112        |       |
| Issuances of  common stock - stock options                       |       | 89              |       |        |       | (1,067         | )          | 2,215        |       |         |       |              |       | 1,148      |       |
| Tax benefit of  exercises of stock options                       |       |            |       |        |       | 524            |       |         |       |         |       |              |       | 524        |       |
|                                                             |       |            |       |        |       |           |       |         |       |         |       |              |       |       |       |
| Balance at  December 31, 2004                                    |       | 32,562          |       | $           | 334        |           | $          | 148,780      |       | $            | (20,148    | )                 | $          | 145,626    |       | $ | (286 | ) | $ | 274,306 |   |

 

See accompanying notes to theconsolidated financial statements

 

4

----

 

**WATSON WYATT & COMPANYHOLDINGS**

 

**Notes to the ConsolidatedFinancial Statements**(Tabular amounts are in thousands, except per share data)

(Unaudited)

 

**Note 1 – Basis of Presentation.**

 

The accompanying unaudited quarterly consolidated financial statementsof Watson Wyatt & Company Holdings and our subsidiaries (collectivelyreferred to as “we,” “Watson Wyatt”, “Watson Wyatt Company” or the “company”)are presented in accordance with the rules and regulations of the Securitiesand Exchange Commission (“SEC”) for quarterly reports on Form 10-Q.  In the opinion of management, these financialstatements reflect all adjustments, consisting only of normal recurringadjustments, which are necessary for a fair presentation of the consolidatedfinancial statements for the interim periods. The consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and notes thereto contained inthe company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2004,which is filed with the SEC and may be accessed via EDGAR on the SEC’s web siteat www.sec.gov.

 

The results of operations for the six months ended December 31, 2004are not necessarily indicative of the results that can be expected for theentire fiscal year ending June 30, 2005. The results reflect certain estimates, including estimated bonuses andanticipated tax liabilities.

 

**Note 2 – Company Background.**

 

Watson Wyatt is an international company engaged in the business ofproviding professional consultative services on a fee basis, primarily in thehuman resource areas of employee benefits and compensation, but also in otherareas of specialization such as human capital consulting and humanresource-related technology consulting.

 

**Note 3 – Business Combination.**

 

On January 18,2005, the company and Watson Wyatt LLP (WWLLP) announced the signing of aletter of intent to combine the two firms. Watson Wyatt & Company currently owns approximately 20 percent ofWWLLP and will acquire substantially all of the assets and certain liabilitiesof WWLLP for a purchase price of approximately $451 million in cash andstock.  The purchase price consists ofapproximately 11 million shares of Watson Wyatt & Company Holdings commonstock and cash of approximately $158 million from existing cash reserves andborrowings.  The business combinationwill be accounted for using the purchase method of accounting as prescribed inFASB 141, “Business Combinations.”  Thecompany is in the process of securing a valuation of WWLLP.

 

The letter ofintent is non-binding and the transaction is subject to a number of conditions,including the signing of a definitive agreement, approval by stockholders ofWatson Wyatt & Company Holdings and by the voting partners of WWLLP,regulatory review and customary closing conditions.  The transaction is currently scheduled toclose on or before the end of the company’s fiscal year on June 30, 2005.

 

5

----

 

**Note 4 – Segment Information.**

 

In North America, the company is primarily organized and managed bypractice.  Although our consultants inour international offices provide services in these same practice areas, ourinternational operations as a whole are managed geographically and comprise asingle operating segment.  Therefore, wehave five reportable operating segments or practice areas:

 

(1)    Benefits Group

(2)    Technology Solutions Group

(3)    Human Capital Group

(4)    International

(5)    Other (including Data Services andCommunication)

 

The company evaluates the performance of its segments and allocatesresources to them based on net operating income on a pre-bonus, pre-tax basis.

 

The table below presents specified information about reported segmentsas of and for the three months ended December 31, 2004:

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 99,810     |                             | $          | 19,573                    |       | $                 | 14,303     |      | $          | 22,244    |       | $ | 11,218 |   | $ | 167,148 |   |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Net operating  income                   |       | 15,786              |       | 5,376                            |       | 4,000                     |       | 1,193             |       | 1,114     |       | 27,469    |       |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Receivables                             |       | 93,815              |       | 9,253                            |       | 12,747                    |       | 20,163            |       | 5,956     |       | 141,934   |       |
|                                         |            |                     |            |                                  |            |                           |            |                   |            |           |            |           |            |  |  |  |  |  |  |

 

The table below presents specified information about reported segmentsas of and for the three months ended December 31, 2003:

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 98,428     |                             | $          | 21,871                    |       | $                 | 11,622     |      | $          | 19,387    |       | $ | 10,942 |   | $ | 162,250 |   |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Net operating  income/(loss)            |       | 16,722              |       | 4,042                            |       | 2,144                     |       | (1,181            | )          | (53       | )          | 21,674    |       |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Receivables                             |       | 82,599              |       | 11,418                           |       | 9,963                     |       | 17,368            |       | 5,671     |       | 127,019   |       |
|                                         |            |                     |            |                                  |            |                           |            |                   |            |           |            |           |            |  |  |  |  |  |  |

 

 

6

----

 

The table below presents specified information about reported segmentsas of and for the six months ended December 31, 2004:

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 204,721    |                             | $          | 36,755                    |       | $                 | 27,365     |      | $          | 43,297    |       | $ | 22,728 |   | $ | 334,866 |   |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Net operating  income                   |       | 39,077              |       | 8,102                            |       | 6,967                     |       | 1,811             |       | 3,513     |       | 59,470    |       |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Receivables                             |       | 93,815              |       | 9,253                            |       | 12,747                    |       | 20,163            |       | 5,956     |       | 141,934   |       |
|                                         |            |                     |            |                                  |            |                           |            |                   |            |           |            |           |            |  |  |  |  |  |  |

 

The table below presents specified information about reported segmentsas of and for the six months ended December 31, 2003:

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of reimbursable  expenses) |       | $                   | 202,296    |                             | $          | 42,140                    |       | $                 | 21,788     |      | $          | 38,332    |       | $ | 22,635 |   | $ | 327,191 |   |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Net operating income/(loss)             |       | 38,763              |       | 5,455                            |       | 1,888                     |       | (1,247            | )          | 634       |       | 45,493    |       |
|                                    |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Receivables                             |       | 82,599              |       | 11,418                           |       | 9,963                     |       | 17,368            |       | 5,671     |       | 127,019   |       |
|                                         |            |                     |            |                                  |            |                           |            |                   |            |           |            |           |            |  |  |  |  |  |  |

 

Information about interest income and tax expense is not presented as asegment expense because such items are not considered a responsibility of thesegments’ operating management.

 

7

----

 

Reconciliations of the information reported by segment to theconsolidated amounts follow for the three and six-month periods ended December31, 2004 and 2003:

 
| ** **                                                                                  | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                  | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                        |       |                                |       |                              |       |   |   |   |   |
| Revenue:                                                                                    |       |                                |       |                              |       |   |   |   |   |
| Total segment  revenue                                                                      |       | $                                   | 167,148    |                              | $          | 162,250 |   | $ | 334,866 |   | $ | 327,191 |   |
| Reimbursable  expenses not included in total segment revenue                                |       | 8,038                               |       | 8,889                             |       | 16,279 |   | 14,848 |   |
| Other, net                                                                                  |       | 663                                 |       | (786                              | )          | 95 |   | (703 | ) |
| Consolidated  revenue                                                                       |       | $                                   | 175,849    |                              | $          | 170,353 |   | $ | 351,240 |   | $ | 341,336 |   |
|                                                                                        |       |                                |       |                              |       |   |   |   |   |
| Net Operating  Income:                                                                      |       |                                |       |                              |       |   |   |   |   |
| Total segment  net operating income                                                         |       | $                                   | 27,469     |                              | $          | 21,674 |   | $ | 59,470 |   | $ | 45,493 |   |
| Income from  affiliates                                                                     |       | 2,724                               |       | 1,048                             |       | 4,930 |   | 2,838 |   |
| Differences in  allocation methods for depreciation, G&A, medical and pension costs (1) |       | (2,712                              | )          | 1,925                             |       | (4,012 | ) | 3,360 |   |
| (Loss)/Gain on  sale of business units                                                      |       | (56                                 | )          | 27                                |       | (28 | ) | 552 |   |
| Discretionary  compensation                                                                 |       | (9,413                              | )          | (5,970                            | )          | (20,413 | ) | (19,470 | ) |
| PCIC  non-operating gain                                                                    |       | —                              |       | —                            |       | — |   | 5,600 |   |
| Other, net                                                                                  |       | 1,982                               |       | (399                              | )          | 3,401 |   | 1,114 |   |
| Consolidated  income before income taxes                                                    |       | $                                   | 19,994     |                              | $          | 18,305 |   | $ | 43,348 |   | $ | 39,487 |   |
|                                                                                        |       |                                |       |                              |       |   |   |   |   |
| Receivables:                                                                                |       |                                |       |                              |       |   |   |   |   |
| Total segment  receivables - billed and unbilled                                            |       | $                                   | 141,934    |                              | $          | 127,019 |   | $ | 141,934 |   | $ | 127,019 |   |
| Net valuation  differences (2)                                                              |       | 2,624                               |       | 9,911                             |       | 2,624 |   | 9,911 |   |
| Total billed and  unbilled receivables                                                      |       | 144,558                             |       | 136,930                           |       | 144,558 |   | 136,930 |   |
| Assets not  reported by segment                                                             |       | 374,742                             |       | 359,573                           |       | 374,742 |   | 359,573 |   |
| Consolidated  assets                                                                        |       | $                                   | 519,300    |                              | $          | 496,503 |   | $ | 519,300 |   | $ | 496,503 |   |

 

----

(1) Depreciation, general and administrative,pension, and medical costs are allocated to our segments based on budgetedexpenses determined at the beginning of the fiscal year as management believesthat these costs are largely uncontrollable to the segment.  To the extent that the actual expense baseupon which allocations are made differs from the forecast/budget amount, areconciling item will be created between internally allocated expenses and theactual expense that we report for GAAP purposes.  The decrease in the reconciling item in thesecond quarter of fiscal year 2005 was mainly due to an under allocation ofgeneral and administrative expenses to our segments.

 

(2) Total segment receivables, which reflectsthe receivable balances used by management to make business decisions, areincluded for management reporting purposes net of deferred revenues – cashcollections and invoices generated in excess of revenue recognized in thesegment revenues and cash held in suspense.

 

8

----

 

**Note 5 – Targeted Job Reductions.**

 

We eliminated approximately 100 positions in our North American regionduring the first quarter of fiscal year 2004. A charge to earnings of $2.6 million related to these reductions wasincluded in the company’s financial results for the quarter ended September 30,2003.  We eliminated an additional 22positions in our North American region during the second quarter of fiscal year2004, resulting in a charge to earnings of $0.7 million in the company’sfinancial results for the quarter ended December 31, 2003.  Of the $3.3 million total severance charge,$3.2 million was included in Salaries and employee benefits and $0.1 millionwas included in Professional and subcontracted services.

 

**Note 6 – Professional Consultants Insurance CompanyInc. (PCIC) Other Non-operating Gain.**

 

On July 9, 2003, the Board of Directors of PCIC, a captive insurancecompany of which we own 34.8 percent, decided to pass on to each of its ownersa credit in their 2003-04 policy year in connection with benefits received froman aggregate stop loss insurance policy entered into by PCIC.  PCIC’s Board determined in July 2003 thatthis credit would be used to offset all or a portion of each insureds’ obligationto PCIC for historical loss experience. As a result, the company recorded a $5.6 million pre-tax non-operatinggain in the first quarter of fiscal year 2004 and included this gain in “Othernon-operating income” in the Consolidated Statements of Operations.

 

As a result of this gain, the company also recorded a $5.6 millionsupplemental bonus accrual in the first quarter of fiscal year 2004 that wasincremental to the company’s fiscal year end bonus, and was paid in September2004 during the regular bonus cycle. This supplemental bonus amount was included in Salaries and employeebenefits for the first quarter of fiscal year 2004.

 

**Note 7 – Stock-based Compensation.**

 

We have elected to follow Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (APB 25), for stock options issued under the2000 Long-term Incentive 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 the plan.  For any cash-based, non-stock awards, such asstock appreciation rights, compensation expense will be recognized over thevesting period to the extent that the market price of the stock increases.  We have elected the disclosure-onlyprovisions of Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-based Compensation” (FAS 123).

 

As required by FAS 123, the company has determined pro forma net incomeand earnings per share as if the company had accounted for its stockcompensation plans under the fair value method of FAS 123.  The company estimated compensation expensefor its Stock Purchase Plan based on the 15 percent discounted purchase priceoffered to employees enrolled in the plan, which approximates fair value.  For the Stock Option Plan, the company usesthe Black-Scholes option valuation model to calculate the fair value of optionsgranted for pro forma disclosure purposes.

 

9

----

 

The table below reflects the pro forma effect on net income andearnings per share for the three and six months ended December 31, 2004 and 2003as if the company were to recognize compensation expense under thefair-value-based method of FAS 123:

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                          |       |                                |       |                              |       |   |   |   |   |
| Net income, as  reported                                                                                                                      |       | $                                   | 11,061     |                              | $          | 10,818 |   | $ | 24,814 |   | $ | 23,325 |   |
| Add: Stock-based  compensation expense included in reported net income, net of related tax  effects                                           |       | 33                                  |       | 31                                |       | 67 |   | 77 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair-value-based  method for all awards, net of related tax effects |       | (358                                | )          | (383                              | )          | (728 | ) | (798 | ) |
| Pro forma net  income                                                                                                                         |       | $                                   | 10,736     |                              | $          | 10,466 |   | $ | 24,153 |   | $ | 22,604 |   |
|                                                                                                                                          |       |                                |       |                              |       |   |   |   |   |
| **Earnings  per share:**                                                                                                                      |       |                                |       |                              |       |   |   |   |   |
| Basic - as  reported                                                                                                                          |       | $                                   | 0.34       |                              | $          | 0.33 |   | $ | 0.76 |   | $ | 0.70 |   |
| Basic - pro  forma                                                                                                                            |       | $                                   | 0.33       |                              | $          | 0.32 |   | $ | 0.74 |   | $ | 0.68 |   |
|                                                                                                                                          |       |                                |       |                              |       |   |   |   |   |
| Diluted - as  reported                                                                                                                        |       | $                                   | 0.34       |                              | $          | 0.32 |   | $ | 0.76 |   | $ | 0.70 |   |
| Diluted - pro  forma                                                                                                                          |       | $                                   | 0.33       |                              | $          | 0.31 |   | $ | 0.74 |   | $ | 0.68 |   |

 

**Note 8 – Retirement Benefits**

 

*Defined Benefit Plans*

 

We sponsor both qualified and non-qualified, non-contributory definedbenefit pension plans covering substantially all of our associates.  Under our principal plans (United States,Canada, Hong Kong and U.K.), benefits are based on the number of years ofservice and the associates’ compensation during the five highest paidconsecutive years of service.  Thenon-qualified plan provides for pension benefits that would be covered underthe qualified plan but are limited by the Internal Revenue Code.  The non-qualified plan has no assets andtherefore is an unfunded arrangement. The benefit liability is reflected on the balance sheet.  Included in the results is our U.K. plan,which is inactive but is part of the additional minimum pension liability reportedon the Consolidated Balance Sheets.  Themeasurement date for the plans is June 30.

 

10

----

 

*Components of Net Periodic Benefit Cost for DefinedBenefit Pension Plans*

 

The following table sets forth the components of net periodic benefitcost for the company’s U.S. and non-U.S. defined benefit pension plans for thethree and six months ended December 31, 2004 and 2003:
| ** **                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                             | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                                |       |                              |       |   |   |   |   |
| Service Cost                           |       | $                                   | 6,173      |                              | $          | 6,669 |   | $ | 12,612 |   | $ | 13,337 |   |
| Interest Cost                          |       | 8,919                               |       | 8,372                             |       | 17,663 |   | 16,745 |   |
| Expected return  on plan assets        |       | (10,541                             | )          | (8,958                            | )          | (20,679 | ) | (17,916 | ) |
| Amortization of  transition obligation |       | (2                                  | )          | (1                                | )          | (3 | ) | (2 | ) |
| Amortization of  net loss              |       | 1,662                               |       | 2,851                             |       | 3,398 |   | 5,703 |   |
| Amortization of  prior service cost    |       | (540                                | )          | (542                              | )          | (1,081 | ) | (1,084 | ) |
| Net periodic  benefit cost             |       | $                                   | 5,671      |                              | $          | 8,391 |   | $ | 11,910 |   | $ | 16,783 |   |

 

The fiscal year 2005 net periodic benefit cost is based, in part, onthe following rate assumptions as of June 30, 2004:

 
| ** **                                   | ** ** | **Year Ended June 30, 2004** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|
| Discount rate                                |       | 6.25                         | %          |
| Expected  long-term rate of return on assets |       | 9.00                         | %          |
| Rate of increase  in compensation levels     |       | 3.34                         | %          |

 

*Employer contributions*

 

The company made no contributions to the U.S. plan and $900,000 incontributions to the non-U.S. plans during the second quarter of fiscal year2005.  We may make a contribution of upto $10 million to the U.S. plan during the remainder of the fiscal year andanticipate making $3 million in contributions to the non-U.S. plans in the lasttwo quarters of fiscal year 2005.

 

*Defined Contribution Plans*

 

We sponsor asavings plan that provides benefits to substantially all U.S. associates. Priorto July 1, 2003, we matched employee contributions at 50 percent of the first 6percent of total pay, which included base salary, overtime and annualperformance-based bonuses.  Vesting ofthe company match occurs after three years for new employees and is 100 percentfor all employees hired before January 1, 1997. Effective July 1, 2004, the company reinstituted a match to employeecontributions at a rate of 50 percent of the first 6 percent up to $60,000 ofassociates’ eligible compensation.  Thecompany may also make an annual profit sharing contribution to the plan in anamount that is dependant upon the company’s financial performance during thefiscal year.

 

*Health Care Benefits*

 

We sponsor a contributory health care plan that provideshospitalization, medical and dental benefits to substantially all U.S.associates.  We accrue a liability forestimated incurred but unreported claims based on projected use of the plan aswell as prior plan history.

 

11

----

 

*Postretirement Benefits*

 

We provide certain health care and life insurance benefits for retiredassociates.  The principal plans coverassociates in the U.S. and Canada who have met certain eligibilityrequirements. Our principal post-retirement benefit plans are unfunded.  We accrue a liability for these benefits.

 

*Components of Net Periodic Benefit Cost for OtherPostretirement plans*

 

The following table sets forth the components of net periodic benefitcost for the company’s healthcare and post-retirement plans for the three and sixmonths ended December 31, 2004 and 2003:

 
| ** **                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                             | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                                |       |                              |       |   |   |   |   |
| Service Cost                           |       | $                                   | 423        |                              | $          | 422 |   | $ | 836 |   | $ | 843 |   |
| Interest Cost                          |       | 614                                 |       | 575                               |       | 1,219 |   | 1,150 |   |
| Expected return  on plan assets        |       | —                              |       | —                            |       | — |   | — |   |
| Amortization of  transition obligation |       | 13                                  |       | 12                                |       | 25 |   | 24 |   |
| Amortization of  net loss              |       | (141                                | )          | (68                               | )          | (284 | ) | (137 | ) |
| Amortization of  prior service cost    |       | (106                                | )          | (156                              | )          | (212 | ) | (312 | ) |
| Net periodic  benefit cost             |       | $                                   | 803        |                              | $          | 785 |   | $ | 1,584 |   | $ | 1,568 |   |

 

*Employer contributions*

 

The company made contributions in the form of premiums and medicalclaim payments to its healthcare and post-retirement plans of $700,000 and$400,000 in the three months ended December 31, 2004 and 2003, respectively,and contributions of $1.3 million and $1.0 million in the six months endedDecember 31, 2004 and 2003, respectively. We plan to make additional payments estimated to total $1.3 millionthrough the end of June 30, 2005.

 

**Note 9 – Goodwill & Intangible Assets.**

 

The changes in the carrying amount of goodwill for the six months endedDecember 31, 2004, are as follows:

 
| ** **                         | ** ** | **Benefits  Group** | ** ** | **Technology  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **International** | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------------|------------|-------------------|------------|-----------|------------|-----------|------------|
| Balance as of  June 30, 2004       |       | $                   | 16,331     |                             | $          | 1,449                     |       | $                 | 70         |      | $          | 1,292     |       | $ | 1,214 |   | $ | 20,356 |   |
|                               |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Goodwill  recorded during the year |       | —              |       | —                           |       | —                    |       | 517               |       | —    |       | 517       |       |
|                               |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Impairment  losses                 |       | —              |       | —                           |       | —                    |       | —            |       | —    |       | —    |       |
|                               |       |                |       |                             |       |                      |       |              |       |      |       |      |       |
| Translation  adjustment            |       | 581                 |       | —                           |       | 8                         |       | 147               |       | —    |       | 736       |       |
| Balance as of  December 31, 2004   |       | $                   | 16,912     |                             | $          | 1,449                     |       | $                 | 78         |      | $          | 1,956     |       | $ | 1,214 |   | $ | 21,609 |   |

 

12

----

 

The following table reflects changes in the net carrying amount of thecomponents of intangible assets for the six months ended December 31, 2004:

 
| ** **                                  | ** ** | **Non-contractual** | ** ** | ** **      | ** ** | ** **    | ** ** | ** **  | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|---------------------|------------|-----------------|------------|---------------|------------|-------------|------------|------------|------------|
| ** **                                  | ** ** | **customer**        | ** ** | **Non-compete** | ** ** | **Purchased** | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **relationships**   | ** ** | **agreements**  | ** ** | **software**  | ** ** | **Pension** | ** ** | **Total**  | ** ** |
|                                        |       |                |       |            |       |          |       |        |       |       |       |
| Balance as of  June 30, 2004                |       | $                   | 253        |            | $          | 176           |       | $           | 2          |       | $          | 124 |   | $ | 555 |   |
| Intangible  assets recorded during the year |       | —              |       | —          |       | —        |       | —      |       | —     |       |
| Amortization  expense                       |       | (102                | )          | (46             | )          | (1            | )          | —      |       | (149       | )          |
| Translation  adjustment                     |       | 32                  |       | —          |       | —        |       | 7           |       | 39         |       |
| Balance as of  December 31, 2004            |       | $                   | 183        |            | $          | 130           |       | $           | 1          |       | $          | 131 |   | $ | 445 |   |

 

The following table reflects the carrying value of intangible assets atDecember 31, 2004 and June 30, 2004:

 
| ** **                                           | ** ** | **December 31, 2004** | ** ** | **June 30, 2004** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **Gross**             | ** ** | ** **        | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | **Carrying**          | ** ** | **Accumulated**   | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                                           | ** ** | **Amount**            | ** ** | **Amortization**  | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Intangible assets and intangible pension asset:      |       |                  |       |              |       |   |   |   |   |
| Non-contractual customer relationships               |       | $                     | 879        |              | $          | 696 |   | $ | 962 |   | $ | 503 |   |
| Non-compete agreements                               |       | 672                   |       | 542               |       | 672 |   | 496 |   |
| Purchased software                                   |       | 125                   |       | 124               |       | 125 |   | 123 |   |
| Intangible pension asset                             |       | 131                   |       | —            |       | 124 |   | — |   |
| Total intangible assets and intangible pension asset |       | $                     | 1,807      |              | $          | 1,362 |   | $ | 1,883 |   | $ | 1,122 |   |

 

A component of thechange in the gross carrying amount of non-contractual customer relationshipsreflects translation adjustments between June 30, 2004 and December 31, 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 remaining life of amortizable intangible assets atDecember 31, 2004, was 1.2 years.  Estimatedamortization expense for the remainder of 2005 and thereafter is as follows:
| **Fiscal  year ending June 30:** | ** ** | **Amount** | ** ** |
|----------------------------------|------------|------------|------------|
| 2005                             |       | $          | 158        |   |
| 2006                             |       | 136        |       |
| 2007                             |       | 20         |       |
| 2008                             |       | —     |       |
|                                  |            |            |            |  |

 

13

----

 

**Note 10 – Earnings Per Share.**

 

Basic earnings per share is calculated on the basis of the weightedaverage number of common shares outstanding during the three and six monthsended December 31, 2004 and 2003. Diluted earnings per share is calculated on the basis of the weightedaverage number of common shares outstanding plus the effect of outstandingstock options and employee stock purchase plan shares using the “treasury stock”method.  The components of basic anddiluted earnings per share are as follows:
| ** **                                                                         | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                               |       |                                |       |                              |       |   |   |   |   |
| Income from  continuing operations                                                 |       | $                                   | 11,055     |                              | $          | 10,802 |   | $ | 24,806 |   | $ | 23,299 |   |
| Discontinued  operations                                                           |       | 6                                   |       | 16                                |       | 8 |   | 26 |   |
| Net income                                                                         |       | $                                   | 11,061     |                              | $          | 10,818 |   | $ | 24,814 |   | $ | 23,325 |   |
|                                                                               |       |                                |       |                              |       |   |   |   |   |
| Weighted average  outstanding shares of common stock                               |       | 32,516                              |       | 33,143                            |       | 32,437 |   | 33,111 |   |
| Dilutive effect  of employee stock options and employee stock purchase plan shares |       | 291                                 |       | 331                               |       | 300 |   | 342 |   |
|                                                                               |       |                                |       |                              |       |   |   |   |   |
| Common stock and  stock equivalents                                                |       | 32,807                              |       | 33,474                            |       | 32,737 |   | 33,453 |   |
|                                                                               |       |                                |       |                              |       |   |   |   |   |
| Basic earnings  per share:                                                         |       |                                |       |                              |       |   |   |   |   |
| Income from  continuing operations                                                 |       | $                                   | 0.34       |                              | $          | 0.33 |   | $ | 0.76 |   | $ | 0.70 |   |
| Discontinued  operations                                                           |       | —                              |       | —                            |       | — |   | — |   |
| Net income                                                                         |       | $                                   | 0.34       |                              | $          | 0.33 |   | $ | 0.76 |   | $ | 0.70 |   |
|                                                                               |       |                                |       |                              |       |   |   |   |   |
| Diluted earnings  per share:                                                       |       |                                |       |                              |       |   |   |   |   |
| Income from  continuing operations                                                 |       | $                                   | 0.34       |                              | $          | 0.32 |   | $ | 0.76 |   | $ | 0.70 |   |
| Discontinued  operations                                                           |       | —                              |       | —                            |       | — |   | — |   |
| Net income                                                                         |       | $                                   | 0.34       |                              | $          | 0.32 |   | $ | 0.76 |   | $ | 0.70 |   |

 

14

----

 

**Note 11 – Variable Interest Entities.**

 

In January 2003, the FASB issued FASB Interpretation No. 46,“Consolidation of Variable Interest Entities,” which was later revised inDecember 2003 (FIN 46R) and effective March 31, 2004 for the company.  FIN 46(R) expands existing accountingguidance about when a company should include in its consolidated financialstatements the assets, liabilities, and activities of another entity.  In general, FIN 46(R) requires a variableinterest entity (VIE), as defined by FIN 46(R), to be consolidated by itsprimary beneficiary.  The primarybeneficiary is defined as the company that will absorb a majority of the VIE’sexpected losses or residual returns if they occur.

 

We have evaluated under FIN 46(R) our consolidated subsidiaries aslisted in Exhibit 21 of the Form 10-K for the year ended June 30, 2004, all ofour affiliates as listed in Note 4 of the same Form 10-K, and both Wellspringand Gabriel, Roeder, Smith & Company (“GRS”), and believe that ouraccounting and disclosure is in compliance with the pronouncement.

 

Investment in Affiliates consists of equity investments in threeentities, Watson Wyatt Holdings (Europe) Limited (WWHE), WWLLP and PCIC, eachof which is accounted for under the equity method.  The company evaluated each of these entitiesbased onFIN 46(R)’s criteria in order to determine the applicability of FIN 46(R).

 

Since the company is not obligated to absorb a majority of expectedlosses or residual returns in the entities it determined to be variableinterest entities, the company is not required to consolidate theseentities.  Therefore, the adoption of FIN46(R) had no effect on the company.

 

On April 1, 1995, the company transferred its United Kingdom (“U.K.”)operations to WWLLP, an actuarial partnership based in the U.K., and received a20% interest in the working capital of WWLLP and a 10 percent interest in adefined profit pool of WWLLP.  Thecompany also transferred its Continental European operations to WWHE as anewly-formed holding company, jointly owned and controlled by the company andWWLLP, in exchange for 50.1 percent of its shares. Effective July 1, 1998, thecompany sold one-half of its investment in WWHE to WWLLP.  WWHE is now jointly owned and controlled bythe company (25 percent) and WWLLP (75 percent).  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 $7.3 million as of December 31, 2004.  See Note 3 for additional informationregarding the company’s potential transaction with WWLLP.

 

PCIC was organized in 1987 as a captive insurance company under thelaws of the State of Vermont.  PCICprovides professional liability insurance on a claims-made basis to threeactuarial and management consulting firms, all of which participate in theprogram as both policyholders and stockholders. The company currently owns 34.8 percent of PCIC.  Capital contributions to PCIC are requiredwhen approved by a majority of its stockholders.  Management believes that the company’smaximum financial statement exposure to loss is limited to the carrying valueof the company’s investment in PCIC of $7.2 million, combined with letters ofcredit totaling $4.9 million for which PCIC has been designated as beneficiary,for a total maximum exposure of $12.1 million.

 

**Note 12 – Comprehensive Income.**

 

Comprehensive income includes net income, changes in the additionalminimum pension liability resulting from translation adjustments and changes inthe cumulative translation adjustment gain or loss.  For the three months ended December 31, 2004,comprehensive income totaled $14.1 million, compared with $14.6 million for thethree months ended December 31, 2003. For the six months ended December 31, 2004, comprehensive income totaled$28.7 million, compared with $27.2 million for the six months ended December31, 2003.

 

15

----

 

**Note 13 – Restricted Shares.**

 

In conjunction with our initial public offering in October 2000, weentered into agreements providing for additional transfer restrictions withmajor stockholders, executive officers and employee directors.  At each of the first four anniversaries ofour initial public offering, a portion of these shares became freelytransferable.  The final 1,665,400 ClassA shares became freely transferable in October, 2004.  All of these agreements expired as ofDecember 31, 2004.

 

**Note 14 – Guarantees.**

 

The company historically has provided guarantees on an infrequent basisto third parties in the ordinary course of business.  The guarantees described below are currentlyin effect and could require the company to make payments to third parties undercertain circumstances.

 

*Letters of Credit*.  The company has two outstanding letters ofcredit totaling $7.5 million under our existing credit facility to guaranteepayment to beneficiaries in the event that the company fails to meet itsfinancial obligations to these beneficiaries. One letter of credit for $2.6 million will expire in October 2006, whilethe second letter of credit for $4.9 million will remain outstanding as long aswe retain an ownership share of our affiliated captive insurance company,PCIC.  The estimated fair market value ofthese letters of credit is nominal because they have never been used, and the companybelieves that future usage is remote.

 

*Affiliate Agreements*.  In 1995, we entered into an alliance agreementwith R. Watson & Sons, a United Kingdom-based actuarial, benefits and humanresources consulting partnership (now WWLLP - See Note 3 for additional information regarding the company’s potentialtransaction with WWLLP), the predecessor of which was founded in1878.  Included in the agreements betweenthe company 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.  The companyis unable to estimate an amount of any potential future payments under thesecontractual arrangements because the potential occurrence of any of the eventsto which the indemnities apply is entirely speculative, there is no history ofpayments and the dollar amount, if any, would be dependent upon the nature ofthe event triggering such indemnity. Management believes that any potential forpayment under such indemnities and guarantees should decline with the passageof time.  There are no provisions forrecourse to third parties, nor are any assets held by any third parties thatthe company as guarantor can liquidate to recover amounts paid under suchindemnities.

 

The company owns 25 percent of WWHE and WWLLP owns the remaining 75percent.  Additional capital for WWHE, ifrequired, may be provided by both owners based on their respective ownershipinterests.  If either the company orWWLLP does not provide its pro rata share of any additional capital invested inWWHE, that party’s respective ownership interest will be reduced accordingly.

 

In connection with the establishment of our alliance with Watson WyattLLP in 1995, the company terminated its then existing office space in Londonand a new lease was entered into by WWLLP that expires in 2015.  The company agreed to guarantee Watson WyattLLP’s performance under this new lease. Payments by Watson Wyatt LLP under the lease total £1.4 million (orapproximately $2.7 million based on the December 31, 2004, exchange rate) peryear.  The company also entered into twooption agreements with WWLLP with respect to the leased space.  One option agreement provides WWLLP with theright to require the company to accept a sublease of two floors of the leasedspace upon any termination of the alliance. The second option agreement provides WWLLP with the right to assign theentire lease to the company on or after December 25, 2009. If Watson Wyatt LLPwere to exercise either

 

16

----

 

of these options, the company would attempt to sublease the space atthe then-current market rates.

 

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

 

*Wellspring Leases*.  We continue to guarantee three leases foroffice premises for Wellspring Resources, LLC (“Wellspring”), the benefitsadministration outsourcing business that we exited from in fiscal year1998.  At December 31, 2004, minimumremaining payments guaranteed under these leases, which expire at various datesthrough 2007, total $14.8 million, excluding anticipated future subleaseincome.  See Note 16 for more informationregarding our obligation to guarantee Wellspring’s leases.

 

**Note 15 – Contingent Liabilities.**

 

From time to time, we are a party to various lawsuits, arbitrations or mediationsthat arise in the ordinary course of business.  We have received subpoenas and requests forinformation in connection with government investigations.  The matters reported on below involve themost significant pending or potential claims against us.

 

We reserve for contingent liabilities basedon Statement of Financial Accounting Standards No. 5, “Accounting forContingencies” (SFAS 5) when it is determined that a liability is probable andreasonably estimable.  Managementbelieves, based on currently available information, that the results of allpending claims against us will not have a material adverse effect on thecompany.

 

*Government Investigations:*

 

*SEC Examination of InvestmentAdvisers. *In December 2003, the Securities and ExchangeCommission (SEC) formally asked many of the major investment consulting firms,Watson Wyatt Investment Consulting (WWIC) among them, to provide detailedinformation on their business structures and practices in order to determine ifconflicts of interest with money managers exist.  In March 2004, WWIC completed its responsesto the SEC staff’s requests for information.

 

*Department of Justice AntitrustInvestigation. *In March 2004, the United States Departmentof Justice (DOJ) issued a Civil Investigative Demand (CID) to Watson Wyatt andother companies in the employee benefits industry.  On January 20, 2005, we received asupplementary CID.  The DOJ is seeking todetermine whether firms that 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 CIDs.

 

*New York State AttorneyGeneral*.  On December 17, 2004, the New York StateAttorney General issued a subpoena to Watson Wyatt seeking information about “override”and other insurance placement compensation. Preliminary data indicate that such payments accounted for less than 0.2percent of Watson Wyatt's revenue over the past four years.  Watson Wyatt has provided information to theNew York State Attorney General in response to the subpoena and will continueto cooperate in the investigation.

 

*ProfessionalLiability Claims:*

 

*IronWorkers Local 25 et al. v. Watson Wyatt & Co. *On July 8, 2004, Watson Wyatt was served with an amended complaintfiled by a former client in the United States District Court for the EasternDistrict of

 

17

----

 

Michigan.  The complaint alleged malpractice, breach ofcontract, and related claims in the performance of actuarial consulting.  The complaint stated that the plaintiff’s pensionfund is underfunded as a result of the alleged deficiencies in our work.  In response to a discovery request, inJanuary the plaintiffs disclosed that their minimum damage claim is $53.7million. Aside from defense costs, at this time, we are unable toreasonably estimate the possibility of loss or range of possible loss.

 

*Client Demand Letter. *On July 23, 2004, we received a demand letter from counsel for a clientalleging that errors in valuations for 2001 and subsequent years understatedthe liabilities of its pension plan and overstated 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.”  Aside fromdefense costs, at this time, we are unable to reasonably estimate thepossibility of loss or range of possible losses.  We have met and plan to meet again withcounsel for the client to discuss the basis of these claims.

 

*OtherMatters:*

 

*Wyatt Bode Grabner (GmbH)*.  In October 2004, Watson Wyatt was served witha lawsuit by our joint venture partners, Karl Bode and Edwin Grabner.  We jointly own a business known as Wyatt BodeGrabner GmbH, which was founded in 1981 and previously conducted pensionconsulting in certain markets in Germany. Drs. Bode and Grabner alleged that Watson Wyatt & Company breachednon-compete provisions in the 1981 agreements as a result of WWLLP setting upits own subsidiary in Germany in 2003. They are seeking what they allege to be the value of the business,approximately €10 million plus, or in the alternative, substantial pensionspurportedly due under the 1981 agreements. We have denied any such liability and filed our defense to the claims inNovember 2004.  A hearing scheduled forJanuary 2005 has been deferred until April as the matter has been assigned toanother court.  Aside from defense costs,at this time, we are unable to reasonably estimate the possibility of loss orrange of possible losses.  This is not aprofessional liability claim, and therefore we do not believe this is coveredby our insurance.

 

**Note 16 –Discontinued Operations.**

 

As discussed in Note 14, the company continues to guarantee threeleases for office premises for Wellspring. In accordance with the contractual arrangements pursuant to which WatsonWyatt divested its interest in Wellspring, Watson Wyatt agreed to share withState Street either costs or benefits arising from these facilities leased byWellspring.  Since one of the threeWellspring leases is currently sub-leased at rates in excess of the lease rate,the company is contractually entitled to a share of the benefit of the excesscash flow from the sub-leases.  Throughthe first six months of fiscal year 2005, the company received sublease incomeof approximately $14,000 in excess of lease payments related to thisbusiness.  Since the second quarter offiscal year 2003, the leases have been generating positive cash flows of lessthan $0.1 million per fiscal year.  The company’scurrent assessment is that the positive cash flow from the sub-leases willcontinue until they expire in December 2006.

 

**Note17 – Recent Accounting Pronouncements.**

** **

In January 2003, the Financial Accounting Standards Board (FASB) issuedFASB Interpretation No. 46 (FIN 46), “Consolidation of Variable InterestEntities,” which clarifies the financial reporting guidance associated with theconsolidation of another entity.  InDecember 2003, the FASB revised and superceded FIN 46 with the issuance of FIN46R in order to address certain implementation issues.  The company adopted FIN 46R effective March31, 2004 and has included appropriate disclosure in this Form 10-Q.  Adoption of FIN 46R has not resulted in achange in our accounting.  See Note 11 ofthe Consolidated Financial Statements for further information regarding theimpact of adopting FIN 46R.

 

Emerging Issues Task Force Issue 00-21, “Revenue Arrangements withMultiple Deliverables” (EITF 00-21), was effective for the company beginningJuly 1, 2003.  There was no change inrevenue recognized in the current portfolio of client engagements due to ouradoption of EITF 00-21.

 

In December 2003,the Securities and Exchange Commission (SEC) issued Staff Accounting BulletinNo. 104 (SAB 104), “Revenue Recognition,” which supercedes Staff AccountingBulletin No. 101 (SAB 101),

 

18

----

 

“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 Financial Accounting Standards Board issued FASB StaffPosition (FSP) No. 106-2 “Accounting and Disclosure Requirements Related to theMedicare Prescription Drug Improvement and Modernization Act of 2003” (the Act)(FAS 106-2), which was effective as of the first quarter beginning after June15, 2004. The Act includes a prescription drug benefit under Medicare Part D aswell as a federal subsidy to sponsors of retiree health care benefit plans thatprovide a benefit that is at least actuarially equivalent (as defined in theAct) to Medicare Part D.  The adoption ofFAS 106-2 has not had a material effect on the financial condition or resultsof operations of the company.

 

In December 2003, the Financial Accounting Standards Board (FASB)published revisions to Statement of Financial Accounting Standards No. 132, “Employers’Disclosures about Pensions and Other Postretirement Benefits” (FAS 132).  FAS 132 revisions retain the originaldisclosures but require additional annual disclosures about assets,obligations, cash flows and interim disclosures about net periodic benefitcosts of defined benefit pension plans and other postretirement plans.  The statement was effective for fiscal yearsending after December 15, 2003.  Thecompany has adopted FAS 132 as revised and included appropriate disclosure inthisForm 10-Q.

 

In June 2004, the Emerging Issues Task Force (EITF) issued EITF 02-14****“Whether an Investor Should Apply the Equity Method ofAccounting to Investments Other Than Common Stock if the Investor Has theAbility to Exercise Significant Influence Over the Operating and FinancialPolicies of the Investee.”  This EITFindicates that an investor should only apply the equity method of accountingwhen it has investments in either common stock or in-substance common stock ofa corporation, provided that the investor has the ability to exercisesignificant influence over the operating and financial policies of theinvestee.  The issuance of EITF 02-14 hasnot had an effect on our accounting for equity investments which has been inaccordance with EITF 02-14.

 

In December 2004, the Financial Accounting Standards Board (FASB)published revisions to Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation” (FAS 123). The revised FAS 123 requires companies to account for share-basedpayment transactions with employees using a fair-value based method, therebyeliminating the disclosure-only provisions of FAS123.  The revised FAS123 is effective for allpublic entities as of the beginning of the first interim or annual reportingperiod beginning after June 15, 2005. The company is currently evaluating the impact on our financialcondition and results of operations.  Thecompany currently elects the disclosure-only provisions of Statement of FAS123.

 

On October 22, 2004, the American Jobs Creation Act was signed intolaw.  The AJCA includes a one-time election to exclude 85% of its foreignunrepatriated earnings in either fiscal year 2005 or 2006.  The Companyhas started evaluating the effect of the repatriation provision; however, theCompany will not be able to complete the analysis until after Congress orTreasury provides additional guidance on key elements of the provision.  Asa result, it is currently not practical to estimate the range of income taxesassociated with repatriation.

 

**Note 18 – Sale of U.S.-based Public SectorRetirement Business.**

 

In fiscal year 2002, we sold our U.S.-based public sector retirementbusiness to Gabriel, Roeder, Smith & Company (“GRS”).  The future consideration from the sale of theU.S.-based public sector retirement business is contingent upon the successfultransition of certain clients to GRS and upon their retention by GRS.

 

19

----

 

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 DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

**Overview**

 

Watson Wyatt & Company Holdings, including its subsidiaries, is aglobal human capital consulting firm. We help our clients enhance businessperformance by improving their ability to attract, retain and motivatequalified employees. We focus on delivering value-added consulting servicesthat help our clients anticipate, identify and capitalize on emergingopportunities in human capital management. We implement this strategy through 3,700 associates in 60 officeslocated in 18 countries.

 

As leading economies worldwide become more services-oriented, humancapital has become increasingly important to companies and other organizations.The heightened competition for skilled employees, unprecedented changes inworkforce demographics, regulatory changes related to compensation and retireebenefits and rising employee-related costs have increased the importance ofeffective human capital management. We help our clients address these issues bycombining our expertise in human capital management with consulting andtechnology, to improve the design and implementation of various humanresources, or HR, programs, including compensation, retirement and health careplans.

 

**General**

 

As of December 31, 2004, we employed 3,700 associates as follows:

 

| Benefits Group                                       |   | 1,615 |   |
|------------------------------------------------------|--------|-------|--------|
| Technology  Solutions Group                          |   | 290   |   |
| Human Capital  Group                                 |   | 165   |   |
| International                                        |   | 900   |   |
| Other (including  Data Services & Communication) |   | 500   |   |
| Corporate                                            |   | 230   |   |
| Total                                                |   | 3,700 |   |

 

20

----

 

**Principal Services**

 

We design, develop and implement HR strategies and programs through thefollowing closely-interrelated practice 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 the world’s largest corporations as well asemerging growth companies, public institutions and nonprofit organizations.

 

**International Operations**

 

Outside of North America, our consultants, working in Asia-Pacific andLatin America, operate on a geographic basis from 24 offices in 16 countriesand provide consulting services in the practice areas described above.

 

**Other**

 

While we focus our consulting services in the areas described above,management believes that one of our primary strengths is our ability to drawupon consultants from our different practices to deliver integrated services tomeet the needs of our clients.

 

**Watson Wyatt Worldwide Alliance**

 

Recognizing our clients’ need for consulting services worldwide, in thelate 1970s we established operations throughout Europe by acquiring local firmsand opening new offices.  In 1995, inresponse to the rapidly increasing globalization of the world economy, we madea strategic decision to strengthen our European capabilities significantly andextend our global reach. We entered into an alliance with R. Watson & Sons(which subsequently became Watson Wyatt Partners, now Watson Wyatt LLP), aleading United Kingdom-based actuarial, benefits and human resources consultingpartnership founded in 1878. Since 1995, we have marketed our services globallyunder the Watson Wyatt Worldwide brand, sharing resources, technologies,processes and business referrals with Watson Wyatt LLP.

 

The Watson Wyatt Worldwide alliance maintains 88 offices in 30countries and employs close to 5,900 associates. Watson Wyatt & CompanyHoldings operates 60 offices in 18 countries in North America, Latin Americaand Asia-Pacific. Watson Wyatt LLP operates 10 offices in the United Kingdomand

 

21

----

 

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

 

See Note 3 for additional information regardingthe company’s potential transaction with WWLLP.

 

**ExecutiveOverview**

 

Watson Wyatt 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 60 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 and implement HR strategies and programs through thefollowing closely-interrelated practice areas:

 

*Benefits Group –*The BenefitsGroup, accounting for 57 percent of our total second quarter 2005 revenues, isthe foundation of our business. Retirement, the core of our Benefits business, is less impacted bydiscretionary spending reductions than our other segments, mainly due to therecurring nature of client relationships. Our corporate client retention rate within our target market hasremained very high, averaging over 95 percent over the past two years. Revenuefor our retirement practice is seasonal, with the third and fourth quarters ofeach fiscal year being the busier periods. Major revenue growth drivers in this practice include changes inregulations, particularly those affecting pension plans, leverage from otherpractices, an improving economy, increased global demand and increased marketshare.  Revenue from the Benefits Group forthe second quarter of fiscal year 2005 increased $1.4 million or 1 percent dueto retirement work for new clients.

 

*Technology Solutions Group –*OurTechnology Solutions Group, accounting for 11 percent of our total second quarterfiscal year 2005 revenues, provides information technology services to ourcustomers.  In fiscal year 2004, delaysin discretionary technology spending resulted in lower revenues, but thebacklog of work, which is a fairly accurate indicator of future revenues, hasimproved over the past three quarters.  Revenuefrom our Technology Solutions Group decreased $2.3 million or 11 percent duringthe second quarter of fiscal year 2005. However, this decrease includes timespent customizing administration systems. Related revenue will be recognized as these systems go into service.  Results for the group continue to be betterthan anticipated by management due to more strategic consulting work and fasterimplementation periods than planned.

 

*Human Capital Group –*Our**Human Capital Group, accounting for 8 percent of our totalsecond quarter fiscal year 2005 revenues, generally encompasses short-termprojects and as a result is most sensitive to economic conditions.  Growth slowed significantly in the second halfof fiscal year 2001 and continued to contract in fiscal years 2002, 2003 and2004.  However, revenue grew by 23percent over the prior-year second quarter.  As corporate governance and Sarbanes-Oxleycontinue to have high visibility in boardrooms, demand for executivecompensation work has driven increased revenues.

 

22

----

 

In the short term, our revenues are driven by many factors includingthe general state of the economy and the resulting level of discretionaryspending by our clients, the ability of our consultants to attract new clientsor cross-sell to existing clients, and the impact of new regulations in thelegal and accounting fields that most recently increased demand for ourexecutive compensation and benefits practices.

 

The human resources consulting industry, although highly fragmented, ishighly competitive and is comprised of major human capital consulting firms,specialist firms, consulting arms of accounting firms and informationtechnology consulting firms.  Our overallrevenues have been flat over the past three years, and it is clear that thecompetitive environment will remain challenging until the economy fully reboundsand companies are committed to spending on human capital projects.  To mitigate the pressures faced by the economy,we have successfully managed costs throughout the company by leveraging ourvariable compensation cost structure, initiating targeted job reductions andcontrolling discretionary spending.  Webelieve we are well-positioned to take advantage of an improvement in theoverall economy.

 

In the long term, we believe that benefits spending will continue to bethe largest component of U.S. corporate spending.  We believe that the aging workforce, theprojected shortfall in workers over the next decade and changing regulationswill translate into opportunities for us. We believe that the company’s financial results will depend in largepart upon how well we succeed in deepening our existing client relationshipsthrough thought leadership and focus on cross-practice solutions, activelypursuing new clients in our target markets, cross selling and strategicacquisitions.  We believe that the highlyfragmented industry in which we operate represents tremendous growth opportunitiesfor us, because we are the only firm to offer a comprehensive line of benefitsand human capital consulting as well as strategic technology solutions.

 

**Financial Statement Overview**

 

Watson Wyatt’s fiscal year ends June 30. The financial statementscontained in this quarterly report reflect Consolidated Balance Sheets as ofthe end of the second quarter of fiscal year 2005 (December 31, 2004) and as ofthe end of fiscal year 2004 (June 30, 2004), Consolidated Statements ofOperations for the three and six-month periods ended December 31, 2004 and2003, Consolidated Statements of Cash Flows for the six-month periods endedDecember 31, 2004 and 2003 and a Consolidated Statement of Changes inStockholders’ Equity for the six-month period ended December 31, 2004.

 

We operate globally as an alliance with our affiliates.  However, the revenues and operating expensesin the Consolidated Statements of Operations reflect solely the results ofoperations of Watson Wyatt & Company Holdings. Our share of the results ofour affiliates, recorded using the equity method of accounting, is reflected inthe “Income from affiliates” line. Our affiliates are Watson Wyatt LLP, WatsonWyatt Holdings (Europe) Limited and Professional Consultants Insurance Company,Inc. (PCIC), our captive insurance company.

 

We derive substantially all of our revenue from fees for consultingservices, which generally are billed based on time and materials or on afixed-fee basis.  Clients are typicallyinvoiced on a monthly basis with revenue generally recognized as services areperformed. For the most recent three fiscal years, revenue from U.S. consultingoperations has comprised approximately 80 percent of consolidated revenue. Nosingle client accounted for more than 4 percent of our consolidated revenue forany of the most recent three fiscal years.

 

In delivering consulting services, our principal direct expenses relateto compensation of personnel. Salaries and employee benefits are comprised ofwages paid to associates, related taxes, benefit expenses such as pension,medical and insurance costs and fiscal year-end incentive bonuses.

 

Professional and subcontracted services represent fees paid to externalservice providers for employment, marketing and other services.  For the most recent three fiscal years,approximately 60 to 70 percent of these professional and subcontracted serviceswere directly incurred on behalf of our clients and were

 

23

----

 

reimbursed by them, with such reimbursements being included in revenue.

 

Occupancy, communications and other expenses represent expenses forrent, utilities, supplies and telephone to operate office locations as well asnon-client-reimbursed travel by associates, publications and professional development.This line item also includes miscellaneous expenses, including gains and losseson foreign currency transactions.

 

General and administrative expenses include the operational costs andprofessional fees paid by corporate management, general counsel, marketing,human resources, finance, research and technology support.

 

**Critical Accounting Policies and Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, disclosures of contingent assets and liabilities atthe date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated basedon available information and experience. Because of the use of estimates inherent in the financial reportingprocess, actual results could differ from those estimates.  The accounting policies discussed below arecritical to the understanding of the use of estimates in the company’sfinancial statements.

 

***   Revenue Recognition***

 

Revenue includes fees primarily generated from consulting servicesprovided in the areas of employee benefits, human capital strategies andrelated technology solutions.  Werecognize revenue from these consulting engagements when hours are worked, eitheron a time-and-materials basis or on a fixed-fee basis, depending on the termsand conditions defined at the inception of an engagement with a client.  The terms of our contracts with clients are fixed and determinable andcan only be changed based on agreement of both parties.  Individual consultants’ billing rates areprincipally based on a multiple of salary and compensation costs.

 

Revenue for fixed-fee arrangements, which span multiple months, isbased upon the percentage of completion method.* *The company typically has threetypes of fixed-fee arrangements:  annualrecurring projects, projects of a short duration, and non-recurring systemprojects.  Annual recurring projects andthe projects of short duration are typically straightforward and highlypredictable in nature.  As a result, theproject manager and financial staff are able to identify, as the project statusis reviewed and bills are prepared monthly, the rare occasion when costoverruns could lead to the recording of a loss accrual.

 

Our non-recurring system projects are typically found in our TechnologySolutions Group.  They tend to be morecomplex, to incur changes in scope as the project progresses and to be longer-termprojects.  We evaluate, at leastquarterly, and more often as needed, project managers’ estimates to complete toassure that the projects’ current status is properly accounted for.  Contracts are written such that, in the unexpected event that thecustomer terminates a contract, the company gets paid for work performedthrough termination.

 

Revenue recognition for fixed-fee engagements is affected by a number offactors that change the estimated amount of work required to complete theproject such as changes in scope, the staffing on the engagement and/or thelevel of client participation.  Theperiodic engagement evaluations require us to make judgments and estimatesregarding the overall profitability and stage of project completion that, inturn, affect how we recognize revenue. The company recognizes a loss on an engagement when estimated revenue tobe received for that engagement is less than the total estimated direct andindirect costs associated with the engagement. Losses are recognized in the period in which the loss becomes probableand the amount of the loss is reasonably estimable.  The company has experienced certain costs in excess ofestimates from time to time.  Managementbelieves that it is rare, however, for these excess costs to result in overallproject losses.

 

24

----

 

The company hasdeveloped various software programs and technologies that we provide to clientsin connection with consulting services. In most instances, such software is hosted and maintained by the companyand ownership of the technology and rights to the related code remain with thecompany.  Software developed to beutilized in providing services to a client, but for which the client does nothave the contractual right to take possession, is capitalized in accordancewith the AICPA’s Statement of Position 98-1 “Accounting for the Costs ofComputer Software Developed or Obtained for Internal Use.”  Revenue associated with the related contract,together with amortization of the related capitalized software, is recognizedover the service period.  As a result,and in accordance with EITF 00-3, we do not recognize revenue during the customizationphase of an engagement.

 

Revenue recognizedin excess of billings is recorded as unbilled accounts receivable.  Cash collections and invoices generated inexcess of revenue recognized are recorded as deferred revenue until the revenuerecognition criteria are met.  Clientreimbursable expenses, including those relating to travel, other out-of-pocketexpenses and any third-party costs, are included in revenue, and an equivalentamount of reimbursable expenses are included in professional and subcontractedservices as a cost of revenue.

 

In December 2003, the Securities and Exchange Commission (SEC) issuedStaff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition,” whichsupercedes Staff Accounting Bulletin No. 101 (SAB 101), “Revenue Recognition inFinancial Statements.”  The primarypurpose of SAB 104 is to rescind accounting guidance contained in SAB 101related to multiple element revenue arrangements, superceded as a result of theissuance of EITF 00-21.  While thewording of SAB 104 has changed to reflect the issuance of EITF 00-21, therevenue recognition principles of SAB 101 remain largely unchanged by theissuance of SAB 104.  The issuance of SAB104 has not had an effect on our revenue recognition policies as they are inaccordance with SAB 104.

 

***   Valuation of Billed andUnbilled Receivables from Clients***

 

We maintain allowances for doubtful accounts to reflect estimatedlosses resulting from our clients’ failure to pay for our services after theservices have been rendered, including allowances when customer disputes mayexist.  The related provision is generallyrecorded as a reduction to revenue.  Ourallowance policy is based on the aging of our billed and unbilled clientreceivables and has been developed based on our write-off history.  Facts and circumstances such as the averagelength of time the receivables are past due, general market conditions, currenteconomic trends and our clients’ ability to pay may cause fluctuations in ourvaluation of billed and unbilled receivables.

 

***   Discretionary Compensation***

 

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

 

An estimated annual bonus amount is initially developed at thebeginning of each fiscal year in conjunction with our budgeting process.  Quarterly, estimated annual operatingperformance is reviewed by the company and the discretionary annual bonusamount is then adjusted, if necessary, by management to reflect changes in theforecast of pre-bonus profitability for the year.   After determining the estimated annual bonusamount, the bonus is then allocated to remaining quarterly reporting periods asa constant percentage of estimated pre-bonus profitability.  In those quarters where the estimated annualbonus level changes, the remaining estimated annual bonus is accrued over theremaining quarters as a constant percentage of estimated future pre-bonusprofitability.  Annual bonus levels mayvary from current expectations as a result of changes in the company’s forecastof pre-bonus profitability and competitive employment market conditions.

 

As a result of a $5.6 million pre-tax non-operating gain recorded inthe first quarter of fiscal year 2004, the company recorded a $5.6 millionsupplemental bonus accrual in the first quarter of fiscal year 2004 that wasincremental to the company’s fiscal year end bonus.  This supplemental bonus amount, which

 

25

----

 

was paid out in September 2004 during the regular bonus cycle, isincluded in salaries and employee benefits. Management does not expect this charge to recur.

 

***   Income Taxes***

 

Determining the consolidated provision for income tax expense, deferredtax assets and liabilities and the related valuation allowance involvesjudgment.  As a global company withoffices in 18 countries, we are required to calculate and provide for estimatedincome tax liabilities for each of the tax jurisdictions in which weoperate.  This process involvesestimating current tax obligations and exposures in each jurisdiction as wellas making judgments regarding the future recoverability of deferred taxassets.  Tax costs can involve complexissues 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.

 

***   Pension Assumptions***

 

We sponsor both qualified and non-qualified, non-contributory defined benefitpension plans covering substantially all of our associates.  Under our principal plans (United States,Canada, Hong Kong and the United Kingdom), benefits are based on our associates’years of service and compensation during the five highest-paid consecutiveyears of service.

 

Determination of our obligations and annual expense under the plans isbased on a number of assumptions that, given the longevity of the plans, arelong-term in focus.  A change in one or acombination of these assumptions could have a material impact on our pensionbenefit obligation and related expense. For this reason, management employs a long-term view so that assumptionsdo not change frequently in response to short-term volatility in theeconomy.  Any difference between actualand assumed results is amortized into our pension expense over the averageremaining service period of participating employees.  We consider several factors prior to thestart of each fiscal year when determining the appropriate annual assumptions, includingeconomic forecasts, historical trends, portfolio composition and peercomparisons.

 

The following assumptions were used at the end of the past three fiscalyears in the valuation of our U.S. plan, which comprises the majority of theprincipal defined benefit pension plans:

 
| ** **                                   | ** ** | **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 rate assumption used at the end of fiscalyear 2004 represents a 25 basis point increase from the 6.00 percent discountrate used at the end of fiscal year 2003 and represents a 100 basis pointreduction from the 7.25 percent discount rate used at the end of fiscal year2002.  The company’s 2004 discount rateassumption was determined by matching future pension benefit payments withexpected future AA bond yields for the same periods.

 

The expected long-term rate of return on assets assumption remained at9.00 percent per annum for fiscal year 2004. The rate of return was lowered infiscal year 2003 to 9.00 percent from 10.00 percent at the end of fiscal year2002.  Selection of the return assumptionat 9.00 percent per annum 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 six months of fiscal year 2005has been 7.8 percent, compared to a return

 

26

----

 

of 13.0 percent in the first six months of fiscal year 2004.

 

The following information illustrates thesensitivity to a change in certain assumptions 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                                |       |

 

The above sensitivities reflect the impact ofchanging one assumption at a time. It should be noted that economic factors andconditions often affect multiple assumptions simultaneously and the effects ofchanges in key assumptions are not necessarily linear.

 

The company’s U.S. Other PostretirementEmployee Benefits plan is relatively insensitive to discount rate changes dueto the plan provisions that have been established to control costs and as suchno sensitivity results are shown in this display.

 

***   Incurred But Not ReportedClaims***

 

Thecompany uses actuarial assumptions to estimate and record a liability forincurred but not reported (IBNR) professional liability claims and engaged anexternal actuarial firm to assist in the calculation of these estimates.  Our estimated IBNR liability is based onlong-term trends and averages, and considers a number of factors, includingchanges in claim reporting patterns, claim settlement patterns, judicialdecisions, and legislation and economic decisions, but excludes the effect ofclaims data for large cases due to the insufficiency of actual experience withsuch 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.

 

27

----

 

**Results of Operations.**

 

The table below sets forth Consolidated Statements of Operations datafor continuing operations as a percentage of revenue for the periods indicated:

 
| ** **                                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                             | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Revenue                                                |       | 100.0                               | %          | 100.0                             | %          | 100.0 | % | 100.0 | % |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Costs of  providing services:                          |       |                                |       |                              |       |   |   |   |   |
| Salaries and  employee benefits                        |       | 54.1                                |       | 55.4                              |       | 54.7 |   | 58.3 |   |
| Professional and  subcontracted services               |       | 6.6                                 |       | 7.4                               |       | 6.7 |   | 6.4 |   |
| Occupancy,  communications and other                   |       | 15.9                                |       | 15.2                              |       | 14.8 |   | 14.5 |   |
| General and  administrative expenses                   |       | 11.1                                |       | 8.8                               |       | 10.4 |   | 9.0 |   |
| Depreciation and  amortization                         |       | 2.7                                 |       | 3.2                               |       | 2.7 |   | 2.9 |   |
|                                                   |       | 90.4                                |       | 90.0                              |       | 89.3 |   | 91.1 |   |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Income from  operations                                |       | 9.6                                 |       | 10.0                              |       | 10.7 |   | 8.9 |   |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Income from  affiliates                                |       | 1.5                                 |       | 0.6                               |       | 1.4 |   | 0.8 |   |
| Interest income,  net                                  |       | 0.2                                 |       | 0.1                               |       | 0.2 |   | 0.1 |   |
| Other  non-operating income                            |       | —                              |       | —                            |       | — |   | 1.8 |   |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Income from  continuing operations before income taxes |       | 11.3                                |       | 10.7                              |       | 12.3 |   | 11.6 |   |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Provision for  income taxes                            |       | 5.0                                 |       | 4.4                               |       | 5.2 |   | 4.8 |   |
|                                                   |       |                                |       |                              |       |   |   |   |   |
| Income from  continuing operations                     |       | 6.3                                 | %          | 6.3                               | %          | 7.1 | % | 6.8 | % |

 

**Three and Six Months Ended December 31, 2004,Compared to the Three and Six Months Ended December 31, 2003**

 

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

 

Revenue from operations for the second quarter of fiscal year 2005 was$175.8 million, an increase of 3 percent from $170.4 million in the priorperiod.

 

The Benefits Group increased revenue $1.4 million or 1 percent duringthe second quarter of fiscal year 2005 due to retirement work for new clients.  Revenue from our Human Capital Groupincreased $2.7 million or 23 percent during the second quarter of fiscal year2005, reflecting increased demand for executive compensation work.  Our international segment finished thequarter with revenue growth of $2.9 million, or 15 percent, as a result ofimproving economic conditions, particularly in our Japan and Taiwan offices.  However, revenue increased 11 percent on aconstant currency basis.  Revenue fromour Technology Solutions Group decreased $2.3 million or 11 percent, reflecting,in part, time spent customizing administration systems.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements That Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), revenue for certaincontracts for which the company provides a hosting arrangement is recognizedover the hosting period.  Revenue forother practice areas in North America increased $0.3 million or 3 percentduring the second quarter of fiscal year 2005.

 

Revenue from operations for the first six months of fiscal year 2005was $351.2 million, an increase of 3 percent from $341.3 million in the priorperiod.

 

28

----

 

The Benefits Group increased revenue $2.4 million or 1 percent duringthe first six months of fiscal year 2005 due to retirement work for new clients.  Revenue from our Human Capital Groupincreased $5.6 million or 26 percent during the first six months of fiscal year2005, reflecting increased demand for executive compensation work.  Our international segment finished the sixmonths with revenue growth of $5.0 million or 13 percent, as a result ofimproving economic conditions, particularly in our Japan and Taiwan offices.  However, revenue increased 9 percent on aconstant currency basis.  Revenue fromour Technology Solutions Group decreased $5.4 million or 13 percent, reflecting$5.6 million in time spent customizing administration systems.  In accordance with EITF 00-3, revenue forcertain contracts for which the company provides a hosting arrangement isrecognized over the hosting period. Revenue for other practice areas in North America increased $0.1 millionduring the first six months of fiscal year 2005.

 

***   Salaries and Employee Benefits*.**

 

Salaries and employee benefit expenses for the second quarter of fiscalyear 2005 were $95.2 million, compared to $94.4 million for the second quarterof fiscal year 2004, an increase of $0.8 million or 1 percent.  Salaries and employee benefit expenses forthe second quarter of fiscal year 2004 include severance charges of $0.7million related to job reductions in North America.  The increase, exclusive of this charge, wasmainly due to a higher accrual for discretionary compensation of $3.7 million,higher salaries of $1.4 million, and higher profit sharing expenses of $0.6million, which reflects the re-instatement of the company’s 401(k) match,partially offset by the capitalization of time spent customizing in-house administrationsystems of $2.6 million, in accordance with AICPA’s Statement of Position 98-1,“Accounting for the Costs of Computer Software Developed or Obtained forInternal Use”, and lower pension and post-retirement costs of $1.5 million.  As a percentage of revenue, salaries andemployee benefits decreased from 55.4 percent to 54.1 percent.

 

Salaries and employee benefit expenses for the first six months offiscal year 2005 were $192.3 million, compared to $199.4 million for the firstsix months of fiscal year 2004, a decrease of $7.1 million or 4 percent.  Salaries and employee benefit expenses forthe first six months of fiscal year 2004 include severance charges of $3.2million related to job reductions in North America and the $5.6 millionsupplemental bonus related to PCIC.  The increase,exclusive of these charges, was mainly due to a higher accrual fordiscretionary compensation of $7.0 million, increased salaries of $2.2 millionand higher profit sharing expenses of $1.0 million , partially offset by thecapitalization of time spent customizing in-house administration systems of$4.9 million, in accordance with AICPA’s Statement of Position 98-1, and lowerpension and post-retirement costs of $3.5 million.  As a percentage of revenue, salaries andemployee benefits decreased from 58.3 percent to 54.7 percent.

 

***   Professional and SubcontractedServices*.**

 

Professional and subcontracted services used in consulting operationsfor the second quarter of fiscal year 2005 were $11.5 million, compared to$12.6 million for the second quarter of fiscal year 2004, a decrease of $1.1million or 9 percent.  As a percentage ofrevenue, professional and subcontracted services decreased from 7.4 percent to 6.6percent.

 

Professional and subcontracted services used in consulting operationsfor the first six months of fiscal year 2005 were $23.5 million, compared to$21.7 million for the first six months of fiscal year 2004, an increase of $1.8million or 8 percent.  As a percentage ofrevenue, professional and subcontracted services increased from 6.4 percent to 6.7percent.

 

***   Occupancy, Communications andOther.***

 

Occupancy, communications and other expenses for the second quarter offiscal year 2005 were $27.9 million compared to $25.9 million for the secondquarter of fiscal year 2004, an increase of $2.0 million or 8 percent.  As a percentage of revenue, occupancy,communications and other increased from 15.2 percent to 15.9 percent.

 

29

----

 

Occupancy, communications and other expenses for the first six monthsof fiscal year 2005 were $52.0 million, compared to $49.4 million for the firstsix months of fiscal year 2004, an increase of $2.6 million or 5 percent.  The increase in both periods is mainly due tomiscellaneous expenses, including promotional expenses and office supplies.  As a percentage of revenue, occupancy,communications and other increased from 14.5 percent to 14.8 percent.

 

***   General and AdministrativeExpenses.***

 

General and administrative expenses for the second quarter of fiscalyear 2005 were $19.5 million, compared to $15.0 million for the second quarterof fiscal year 2004, an increase of $4.5 million or 30 percent.  The increase is mainly due to higherinsurance costs of $1.7 million, increased legal expenses of $0.9 million, increasedsalaries and benefits of $0.4 million and increases in miscellaneous expenses,including expenses associated with compliance with the Sarbanes-Oxley Act of2002 and related SEC rules.  As apercentage of revenue, general and administrative expenses increased from 8.8percent to 11.1 percent.

 

General and administrative expenses for the first six months of fiscalyear 2005 were $36.4 million, compared to $30.6 million for the first sixmonths of fiscal year 2004, an increase of $5.8 million or 19 percent.  As a percentage of revenue, general andadministrative expenses increased from 9.0 percent to 10.4 percent.  The increase is mainly due to higher insurancecosts of $3.1 million, increased legal expenses of $0.9 million, increasedsalaries and benefits of $0.3 million and increases in miscellaneous expenses,including expenses associated with compliance with the Sarbanes-Oxley Act of2002 and related SEC rules.

 

***   Depreciation and Amortization.***

 

Depreciation and amortization for the second quarter of fiscal year2005 was $4.8 million, compared to $5.4 million for the second quarter offiscal year 2004, a decrease of $0.6 million or 11 percent.  As a percentage of revenue, depreciation andamortization decreased from 3.2 percent to 2.7 percent.

 

Depreciation and amortization for the first six months of fiscal year2005 was $9.5 million, compared to $10.0 million for the first six months offiscal year 2004, a decrease of $0.5 million or 5 percent.  As a percentage of revenue, depreciation andamortization decreased from 2.9 percent to 2.7 percent.

 

***   Income From Affiliates.***

 

Income from affiliates for the second quarter of fiscal year 2005 was $2.7million, compared to $1.0 million for the second quarter of fiscal year 2004, anincrease of $1.7 million.  The increasewas due to higher operating results of Watson Wyatt LLP of $0.7 million, improvedoperations of Watson Wyatt Holdings (Europe) Limited (WWHE) of $0.4 million andhigher equity income of our affiliated captive insurance company, ProfessionalConsultants Insurance Company (PCIC), of $0.6 million.

 

Income from affiliates for the first six months of fiscal year 2005 was$4.9 million, compared to $2.8 million for the first six months of fiscal year2004, an increase of $2.1 million or 75 percent.  The increase was due to higher operatingresults of Watson Wyatt LLP of $1.2 million, improved operations of WWHE of$0.3 million and higher equity income of our affiliated captive insurancecompany, PCIC, of $0.6 million.

 

***   Interest Income, Net.***

 

Interest income, net for the second quarter of fiscal year 2005 was $0.4million, compared to $0.2 million for the second quarter of fiscal year 2004, anincrease of $0.2 million.  Interestincome, net for the first six months of fiscal year 2005 was $0.9 million,compared to $0.4 million for the first six months of fiscal year 2004, an increaseof $0.5 million.  The increase in bothperiods was due to a higher rate earned on

 

30

----

 

our investments and lower expenses due to the company’s new creditagreement.

 

***   Other Non-operating Expenses.***

 

Other non-operating expenses for thefirst six months of fiscal year 2005 were negligible, compared to $6.2 millionfor the first six months of fiscal year 2004. The decrease is mainly due to the $5.6 million non-operating gain the companyrecorded in the first quarter of fiscal year 2004 related to PCIC.  See Note 6 of the Notes to the ConsolidatedFinancial Statements for more information about this non-operating gain.  During the first six months of fiscal year2004, the company also received cash payments of $0.6 million in connectionwith the fiscal year 2002 sale of our U.S.-based public retirement business toGRS.  All payments received in connectionwith this sale were contingent upon the successful transition of certainclients to GRS and upon their retention by GRS.

 

***   Provision for Income Taxes.***

 

Provision for income taxes for the first six months of fiscal year 2005was $18.5 million, compared to $16.2 million for the first six months of fiscalyear 2004. Our effective tax rate was 42.8 percent for the first six months offiscal year 2005 and 41.0 percent for the first six months of fiscal year 2004. The change in rate was due to anincrease in the effective rate on foreign income.  We record a tax benefit on foreign netoperating loss carryovers and foreign deferred expenses only if it is morelikely than not that a benefit will be realized.

 

***   Income From ContinuingOperations.***

 

Income from continuing operations for the second quarter of fiscal year2005 was $11.1 million, compared to $10.8 million for the second quarter offiscal year 2004, an increase of $0.3 million or 3 percent.  As a percentage of revenue, income fromcontinuing operations remained at 6.3 percent. Income from continuing operations for the first six months of fiscalyear 2005 was $24.8 million, compared to $23.3 million for the first six monthsof fiscal year 2004, an increase of $1.5 million or 6 percent.  As a percentage of revenue, income fromcontinuing operations increased from 6.8 percent to 7.1 percent.

 

***   Earnings Per Share, IncomeFrom Continuing Operations.***

 

Diluted earnings per share, income from continuing operations for thesecond quarter of fiscal year 2005 were $0.34, compared to $0.32 for the secondquarter of fiscal year 2004.  Dilutedearnings per share, income from continuing operations for the first six monthsof fiscal year 2005 were $0.76, compared to $0.70 for the first six months offiscal year 2004.

 

   ***DiscontinuedOperations.***

 

The company received sublease income through the first six months offiscal year 2005 of approximately $14,000 in excess of lease payments relatedto Wellspring .  See Note 16 of the Notesto the Consolidated Financial Statements for more information related toWellspring.

 

**Liquidity and Capital Resources**

 

Our cash and cash equivalents at December 31, 2004, totaled $135.1million, compared to $156.9 million at June 30, 2004.  The decrease in cash from June 30, 2004 to December31, 2004, follows a typical pattern of cash flow for the company that isattributable to the payment of previously accrued discretionarycompensation.  During the first sixmonths of fiscal year 2005, we paid $34.8 million in previously accrueddiscretionary compensation, $30.4 million in corporate taxes, $4.2 million forthe repurchase of the company’s stock, $16.6 million in capital expendituresand $4.9 million in dividends.  Theseoutflows of cash were funded by cash flow from consulting operations and bycash on hand.  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.

 

31

----

 

Our non U.S. operations do not materially impact liquidity or capitalresources as they are substantially self-sufficient for their working capitalneeds.  At December 31, 2004, $30.4 millionof the total cash balance of $135.1 million was held outside of North America,which we have the ability to utilize, if necessary. There are no significantrepatriation restrictions other than local or U.S. taxes associated withrepatriation.

 

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

 

Cash from operating activities**for the firstsix months of fiscal year 2005 was $0.4 million, compared to cash used inoperating activities of $3.4 million for the first six months of fiscal year2004.

 

The allowance for doubtful accounts increased $1.3 million and theallowance for work in process increased $0.6 million from June 30, 2004, toDecember 31, 2004. The number of days of accounts receivable and work inprocess outstanding was 76 at December 31, 2004, compared to 78 at June 30,2004 and 72 at December 31, 2003.

 

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

 

Cash used in investing activities for the first six months of fiscalyear 2005 was $19.3 million, compared to $7.4 million for the first six monthsof fiscal year 2004.  The increase can beprimarily attributed to higher purchases of fixed assets of $4.3 million andcash outflows associated with the capitalization of time spent customizingin-house administration systems of $6.7 million, in accordance with AICPA’sStatement of Position 98-1.

 

Expenditures of capital funds were $23.6 million for the first sixmonths of fiscal year 2005.  Anticipatedcommitments of capital funds are estimated at $21.1 million for the remainderof fiscal year 2005, mainly for computer hardware purchases, office relocationsand renovations, development and upgrade of financial and retirement systemsand acquisition-related payments. We expect cash from operations to adequatelyprovide for these cash needs.  The companyanticipates that future annual commitments of capital funds will includeapproximately $13 million in dividends and $24 to $27 million in purchases offixed assets.  Capital of approximately$158 million required for our combination with WWLLP (see Note 13 of Notes tothe Consolidated Financial Statements) will come from existing cash reservesand borrowing under our revolving credit facility.

 

***   Cash Used in FinancingActivities****.*

 

Cash used in financing activities for the second quarter of fiscal year2005 was $4.3 million, compared to cash used in financing activities of $5.3million for the second quarter of fiscal year 2004.  The difference can be attributed to $5.6million in common stock repurchases and $4.9 million in quarterly dividendspaid during the first six months of fiscal year 2005.

 

**Off-Balance Sheet Arrangements and ContractualObligations**

 

***Operating Leases***. We lease office space, furniture and selected computer equipment underoperating lease agreements with terms ranging from one to ten years.  Future expected payments are as follows:

 
| ** **                         | ** ** | **Remaining payments due by fiscal year as of December 31, 2004** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------|------------|
| **Contractual  Cash  Obligations** | ** ** | **Total**                                                         | ** ** | **2005** | ** ** | **2006  through  2007** | ** ** | **2008  through  2009** | ** ** | **Thereafter** | ** ** |
| Lease  commitments                 |       | $                                                                 | 255,328    |   | $ | 20,555 |   | $ | 66,756 |   | $ | 54,301 |   | $ | 113,716 |   |
|                                    |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

32

----

 

Management has determined that there is not a large concentration ofleases that will expire in any one fiscal year. Consequently, management anticipates that any increase in future rentexpense will be mainly market driven.

 

***Guarantees.***

 

*Wellspring Leases*.  The company continues to guarantee certainleases for office premises and equipment for Wellspring.  At December 31, 2004, minimum remainingpayments guaranteed under these leases, which expire at various dates through2007, totaled $14.8 million, excluding anticipated sublease income.  The leases are currently generating positivecash flows of less than $0.1 million per fiscal year.  Management will continue to evaluate theadequacy of these provisions and make adjustments as appropriate.  See Notes 14 and 16 of the Notes to theConsolidated Financial Statements for more information related to Wellspring.

 

*Affiliate Agreements*.  In connection with the establishment of ouralliance with WWLLP in 1995, the company terminated its then existing officespace in London and a new lease was entered into by WWLLP that expires in2015.  The company agreed to guarantee WWLLP’sperformance under this new lease.  Paymentsby WWLLP under the lease total £1.4 million (or approximately $2.7 millionbased on the December 31, 2004, exchange rate) per year.  The company also entered into two optionagreements with WWLLP with respect to the leased space.  One option agreement provides WWLLP with theright to require the company to accept a sublease of two floors of the leasedspace upon any termination of the alliance. The second option agreement provides WWLLP with the right to assign theentire lease to the company on or after December 25, 2009. If WWLLP were toexercise either of these options, the company would attempt to sublease thespace at the then-current market rates.

 

**Credit Agreement**

 

In June 2004, we reduced the size of our revolving credit facility to$50 million from $100 million in order to better align it with our businessneeds.  The facility is provided by asyndicate of banks.  Interest ratesassociated with this facility vary with LIBOR and/or the Prime Rate and arebased on our leverage ratio, as defined by the credit agreement.  We are charged a quarterly commitment fee,currently 0.20 percent of the facility that varies with our financial leverageand is paid on the unused portion of the credit facility.  No amounts were outstanding under the company’srevolving credit facility as of June 30, 2004 or December 31, 2004.  Credit under the facility is available upondemand, although the credit facility requires us to observe certain covenants(including requirements for a fixed coverage charge, cashflow leverage ratio andasset coverage) and is collateralized with a pledge of stock of materialsubsidiaries.  We were in compliance withall covenants under the credit facility as of December 31, 2004.

 

A portion of the revolving facility is used to support required lettersof credit issued under the credit line. As a result, $7.5 million of the facility is currently unavailable foroperating needs.  We are also charged afee for outstanding letters of credit that also fluctuates based on ourleverage ratio.  The credit facility isscheduled to mature on June 29, 2009.

 

**Risk Management**

 

**As a part of our overall riskmanagement program, we carry customary commercial insurance policies, includingcommercial general liability, employment practices liability, and claims-madeprofessional liability insurance with a self-insured retention of $1 millionper claim, which provides coverage for professional liability claims includingthe cost of defending such claims.  Ourprimary insurance coverage beyond this retention is written by an affiliatedcaptive insurance company owned by us and two other professional servicesfirms.  Prior to July 1, 2003, the first$5 million of coverage had a premium structure which provided that the captiveinsurance company would recover from the firm defending the claim approximately75 percent of any loss up to $5 million. This recovery occurred through insurance**

 

33

----

 

**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 hasattempted to recover through its premium structure the amounts it expects topay out for member companies in claims losses, continuing the loss sharingformula whereby 75 percent of the losses incurred by PCIC with respect to eachmember are incorporated in the member’s future premium charges, and willincrease such member’s premium by approximately a like amount over the nextfive years. PCIC now bases premium calculations, which are determined annuallybased on experience through March of each year, on relative risk of the variouslines of business performed by each of the owner companies, past claimexperience of each owner company, growth of each of those companies, industryrisk profiles in general and the overall insurance markets.  As of July 1, 2004, the captive insurancecompany carries reinsurance for a substantial portion of losses above $25million.**

** **

**Our agreements with PCIC couldrequire additional payments to PCIC in the event that the company decided toexit PCIC and adverse claims significantly exceed prior expectations.  If these circumstances were to occur, thecompany would record a liability at the time it becomes estimable and probable.**

** **

**The company will continue toprovide for the self-insured retention where specific estimated losses forknown claims in excess of $1 million are considered probable and reasonablyestimable.**

** **

**Although the company maintainsprofessional liability insurance coverage, this insurance does not cover claimsmade after expiration of our current insurance contracts.  Generally accepted accounting principlesrequire that we record a liability for incurred but not reported (IBNR)professional liability claims if they are estimable and probable, and for whichwe have not yet contracted for insurance coverage.  The company uses actuarial assumptions toestimate and record its IBNR liability and has a $13.6 million IBNR liabilityrecorded as of December 31, 2004.**

** **

**Current insurance market conditionsfor our industry include increases in overall premium cost, higher self-insuredretentions and reductions in aggregate excess coverages, trends that areanticipated to continue.  We expect thesetrends to be reflected in our future annual insurance renewals and, as aresult, we will continue to assess our ability to secure future insurancecoverage.  In anticipation of thepossibility of future reductions in risk transfer from PCIC to reinsurers, aswell as the trend toward a generally hardening insurance market, the firms thatown PCIC, including the company, increased PCIC’s capital in fiscal years 2002and 2003.  No capital contribution wasprovided during fiscal year 2004 or the first six months of fiscal year 2005.**

** **

**In light of increasing worldwidelitigation, including litigation against professionals, the company has beenimplementing a requirement that all client relationships be documented byengagement letters containing specific risk mitigation clauses that were notincluded in all historical client agreements. Nearly 100 percent of the company’s U.S. corporate clients have signedengagement letters including mitigation clauses, and initiatives to completethat process both in the United States and elsewhere are underway. The companyhas disengaged from certain client relationships where satisfactory engagementterms could not be achieved.**

** **

**RecentAccounting Pronouncements**

** **

In January 2003, the Financial Accounting Standards Board (FASB) issuedFASB Interpretation No. 46 (FIN 46), “Consolidation of Variable InterestEntities,” which clarifies the financial reporting guidance associated with theconsolidation of another entity.  InDecember 2003, the FASB revised and superceded FIN 46 with the issuance of FIN46R in order to address certain implementation issues.  The company adopted FIN 46R effective March31, 2004 and has included appropriate disclosure in this Form 10-Q.  Adoption of the FIN 46R has not resulted in achange in our accounting.  See Note 11 ofthe Consolidated Financial Statements for further information regarding theimpact of adopting FIN 46R.

 

34

----

 

Emerging Issues Task Force Issue 00-21, “Revenue Arrangements withMultiple Deliverables” (EITF 00-21), was effective for the company beginningJuly 1, 2003.  There was no change inrevenue recognized in the current portfolio of client engagements due to ouradoption of EITF 00-21.

 

In December 2003,the Securities and Exchange Commission (SEC) issued Staff Accounting BulletinNo. 104 (SAB 104), “Revenue Recognition,” which supercedes Staff AccountingBulletin No. 101 (SAB 101), “Revenue Recognition in Financial Statements.”  SAB 104’s primary purpose is to rescindaccounting guidance contained in SAB 101 related to multiple element revenuearrangements, superceded as a result of the issuance of EITF 00-21.  While the wording of SAB 104 has changed toreflect the issuance of EITF 00-21, the revenue recognition principles of SAB101 remain largely unchanged by the issuance of SAB 104.  The issuance of SAB 104 has not had an effecton our revenue recognition policies as they are in accordance with SAB 104.

 

In May 2004, the Financial Accounting Standards Board issued FASB StaffPosition (FSP) No. 106-2 “Accounting and Disclosure Requirements Related to theMedicare Prescription Drug Improvement and Modernization Act of 2003” (the Act)(FAS 106-2), which was effective as of the first quarter beginning after June15, 2004. The Act includes a prescription drug benefit under Medicare Part D aswell as a federal subsidy to sponsors of retiree health care benefit plans thatprovide a benefit that is at least actuarially equivalent (as defined in theAct) to Medicare Part D.  The adoption ofFAS 106-2 has not had a material effect on the financial condition or resultsof operations of the company.

 

In December 2003, the FASB published revisions to Statement ofFinancial Accounting Standards No. 132, “Employers’ Disclosures about Pensionsand Other Postretirement Benefits” (FAS 132). FAS 132 revisions retain the original disclosures but require additionalannual disclosures about assets, obligations, cash flows and interimdisclosures about net periodic benefit costs of defined benefit pension plansand other postretirement plans.  Thestatement was effective for fiscal years ending after December 15, 2003.  The company has adopted FAS 132 as revisedand included appropriate disclosure in thisForm 10-Q.

 

In June 2004, the Emerging Issues Task Force (EITF) issued EITF 02-14****“Whether an Investor Should Apply the Equity Method ofAccounting to Investments Other Than Common Stock if the Investor Has theAbility to Exercise Significant Influence Over the Operating and FinancialPolicies of the Investee.”  This EITFindicates that an investor should only apply the equity method of accountingwhen it has investments in either common stock or in-substance common stock ofa corporation, provided that the investor has the ability to exercisesignificant influence over the operating and financial policies of theinvestee.  The issuance of EITF 02-14 hasnot had an effect on our accounting for equity investments which has been inaccordance with EITF 02-14.

 

In December 2004, the FASB published revisions to Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation” (FAS 123).  The revised FAS123 requires companies to account for share-based payment transactions withemployees using a fair-value based method, thereby eliminating the disclosure-onlyprovisions of FAS 123.  The revised FAS 123is effective for all public entities as of the beginning of the first interimor annual reporting period beginning after June 15, 2005.  The company is currently evaluating theimpact on our financial condition and results of operations.  The company currently elects thedisclosure-only provisions of Statement of FAS 123.

 

On October 22, 2004, the American Jobs Creation Act (AJCA) was signedinto law.  The AJCA includes a one-time election to exclude 85 percent ofits foreign unrepatriated earnings in either fiscal year 2005 or 2006. The company has started evaluating the effect of the repatriation provision;however, the company will not be able to complete the analysis until afterCongress or Treasury provides additional guidance on key elements of theprovision.  As a result, it is currently not practical to estimate therange of income taxes associated with repatriation.

 

35

----

 

**Disclaimer Regarding Forward-looking Statements**

 

This filing contains certain statements that are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, including, but not limited to the following: Note 8 -  Retirement Benefits on page 10 through 12;Note 9 – Goodwill and Intangible Assets on pages 12 and 13; Note 14 –Guarantees on page 16 and 17; Note 15 – Contingent Liabilities on page 17 and18; the Executive Overview on pages 22 and 23; Critical Accounting Policies andEstimates on pages 24 through 27; the discussion of our capital commitments onpage 32; Off-Balance Sheet Arrangements and Contractual Obligations on page 32and 33; Risk Management on page 33 and 34; and Part II, Item 1 “LegalProceedings” on page 37 and 38.  In somecases, you can identify these statements and other forward-looking statementsin this filing by words such as “may,” “will,” “expect,” “anticipate,” “believe,”“estimate,” “plan,” “intend,” “continue,” or similar words. You should readthese statements carefully because they contain projections of our futureresults of operations or financial condition, or state other “forward-looking”information. A number of risks and uncertainties exist which could cause actualresults to differ materially from the results reflected in theseforward-looking statements. Such factors include, but are not limited to, ourcontinued ability to recruit and retain highly qualified associates, outcomesof litigation, a significant decrease in the demand for the consulting serviceswe offer as a result of changing economic conditions or other factors, actionsby competitors offering human resources consulting services, including publicaccounting and consulting firms, technology consulting firms andinternet/intranet development firms, regulatory, legislative and technologicaldevelopments that may affect the demand for or costs of our services and otherfactors discussed under “risk factors” in our Annual Report on Form 10-K forthe fiscal year ended June 30, 2004, which was filed with the SEC on August 17,2004, and may be accessed via EDGAR on the SEC’s web site at www.sec.gov. Thesestatements are based on assumptions that may not come true. All forward-lookingdisclosure is speculative by its nature. The company undertakes no obligationto update any of the forward-looking information included in this report,whether as a result of new information, future events, changed expectations orotherwise.

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.**

 

We are exposed to market risks in the ordinary course of business.These risks include interest rate risk and foreign currency exchange risk. Wehave examined our exposure to these risks and concluded that none of ourexposures in these areas are material to fair values, cash flows or earnings*.*

 

**ITEM 4. CONTROLS AND PROCEDURES.**

 

**Evaluation of Disclosure Controls and Procedures**

 

The chief executive officer(CEO) and chief financial officer (CFO) of the company evaluated our disclosurecontrols and procedures as of the end of the second quarter of fiscal year2005.  They have concluded that, as ofDecember 31, 2004, such controls and procedures were effectively designed toensure that information required to be disclosed in reports that the companyfiles with or submits to the SEC is recorded, processed, summarized andreported within 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.

 

36

----

 

**Changes in Internal Control Over FinancialReporting**

 

No changes to our internalcontrol over financial reporting have occurred during the second quarter thathave come to management’s attention that have materially affected or arereasonably likely to materially affect our internal control over financialreporting.

 

**Compliance with Section 404 of the Sarbanes-OxleyAct of 2002**

 

Our company is required to comply with Section 404 of theSarbanes-Oxley Act of 2002 and SEC rules and Public Company AccountingOversight Board (PCAOB) standards for implementing Section 404 by June 30,2005.  With regards to the company’scontinuing compliance efforts, the company has completed all documentation offinancial and company-wide controls.  We continueto test certain key controls in preparation for compliance with Section 404 andas the basis for management’s assessment of the adequacy and effectiveness ofinternal controls at the end of our 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 second quarter of fiscal year 2005 were effective.

 

**PART II.  OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

From time to time, we are a party to various lawsuits, arbitrations ormediations that arise in the ordinary course of business.  We have received subpoenas and requests forinformation in connection with government investigations.  The matters reported on below involve themost significant pending or potential claims against us.

 

We reserve for contingent liabilities basedon Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies”(SFAS 5) when it is determined that a liability is probable and reasonablyestimable.  Management believes,based on currently available information, that the results of all pendingclaims against us will not have a material adverse effect on the company.

 

*GovernmentInvestigations:*

 

*SEC Examination of InvestmentAdvisers. *In December 2003, the Securities and ExchangeCommission (SEC) formally asked many of the major investment consulting firms,Watson Wyatt Investment Consulting (WWIC) among them, to provide detailedinformation on their business structures and practices in order to determine ifconflicts of interest with money managers exist.  In March 2004, WWIC completed its responsesto the SEC staff’s requests for information.

 

37

----

 

*Department of Justice AntitrustInvestigation. *In March 2004, the United States Departmentof Justice (DOJ) issued a Civil Investigative Demand (CID) to Watson Wyatt andother companies in the employee benefits industry.  On January 20, 2005, we received asupplementary CID.  The DOJ is seeking todetermine whether firms that 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 CIDs.

 

*New York State AttorneyGeneral*.  On December 17, 2004, the New York StateAttorney General issued a subpoena to Watson Wyatt seeking information about “override”and other insurance placement compensation. Preliminary data indicate that such payments accounted for less than 0.2percent of Watson Wyatt’s revenue over the past four fiscal years.  Watson Wyatt has provided information to theNew York State Attorney General in response to the subpoena and will continueto cooperate in the investigation.

 

*ProfessionalLiability Claims:*

 

*IronWorkers Local 25 et al. v. Watson Wyatt & Co. *On July 8, 2004, Watson Wyatt was served with an amended complaintfiled by a former client in the United States District Court for the EasternDistrict of Michigan.  The complaintalleged malpractice, breach of contract, and related claims in the performanceof actuarial consulting.  The complaintstated that the plaintiff’s pension fund is underfunded as a result of the allegeddeficiencies in our work. In response to a discovery request, in January theplaintiffs disclosed that their minimum damage claim is $53.7 million. Asidefrom defense costs, at this time, we are unable to reasonably estimate thepossibility of loss or range of possible loss.

 

*Client Demand Letter. *On July 23, 2004, we received a demand letter from counsel for a clientalleging that errors in valuations for 2001 and subsequent years understatedthe liabilities of its pension plan and overstated its net worth.  As a result, the client claimed it did notannuitize its defined benefit plan and redeemed its stock at an inflatedprice.  Aside from defense costs,at this time, we are unable to reasonably estimate the possibility of loss orrange of possible losses.  The letter claimed damages “in excess of $35million.”    We have met and plan to meetagain with counsel for the client to discuss the basis of these claims.

 

*OtherMatters:*

 

*Wyatt Bode Grabner (GmbH)*.  In October 2004, Watson Wyatt was served witha lawsuit by our joint venture partners, Karl Bode and Edwin Grabner.  We jointly own a business known as Wyatt BodeGrabner GmbH, which was founded in 1981 and previously conducted pensionconsulting in certain markets in Germany. Drs. Bode and Grabner allege that Watson Wyatt breached non-competeprovisions in the 1981 agreements as a result of WWLLP setting up its ownsubsidiary in Germany in 2003.  They areseeking what they allege to be the value of the business, approximately €10million plus, or in the alternative, substantial pensions purportedly due underthe 1981 agreements.  We haved denied anysuch liability and filed our defense to the claims in November 2004.  A hearing scheduled for January 2005 has beendeferred until April as the matter has been assigned to another court.  Aside from defense costs, at this time, weare unable to reasonably estimate the possibility of loss or range of possiblelosses.  This is not a professionalliability claim, and therefore we do not believe this is covered by ourinsurance.

 

38

----

 

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

 

The company did notengage in any unregistered sales of equity securities during the quarter.

 

**Issuer Purchases of EquitySecurities**

 

The company did not repurchaseits own stock during the second quarter of fiscal year 2005.  The maximum number of shares that may yet bepurchased under our Board of Director approved plan is 763,934.  Repurchsed stock is generally issued inconnection with the company’s employee benefit plans.

 

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

 

**None.**

** **

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

** **

At the fifth annual meeting of thestockholders of the company, held on November 19, 2004, the following matterswere submitted to a vote of stockholders: (1) the election of two Class Imembers of the Board of Directors; and (2) a proposal to increase the number ofshares that may be issued under the Compensation Plan for Outside Directors.

 

Proxies representing 27,801,482 shares werereceived (total shares outstanding as of the Record Date were 32,419,031), andthe results of the meeting were as follows with respect to each mattersubmitted to a vote of stockholders.

 

Election of Class I Directors

 

Pursuant to the company’s Amended andRestated Certificate of Incorporation, the directorships are divided into threeclasses, Class I, Class II and Class III. The directorships in Class I expiredas of the annual stockholders’ meeting in 2004 and will expire every threeyears thereafter; the directorships in Class II will expire as of the annualstockholders’ meeting in 2005 and every three years thereafter; and thedirectorships in Class III will expire as of the annual stockholders’ meetingin 2006 and every three years thereafter. As the term of each of the classes ofdirectors expires, directors of the company will be elected to serve for athree-year period and until their respective successors have been duly electedand qualified.  Voting results were asfollows:

 
| **Nominees  for Class I Directors**                            | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|--------------|------------|
| *Term  expiring at the annual meeting of stockholders in 2004* |       |       |       |         |       |
| R. Michael  McCullough                                         |       | 26,636,638 |       | 1,164,844    |       |
| Paul N. Thornton                                               |       | 27,297,061 |       | 504,421      |       |

 

39

----

 

The directors serving in Class II and ClassIII and their remaining terms are as follows:

 
| **Class II Directors**                                         |
|----------------------------------------------------------------|
| *Term expiring at the annual  meeting of stockholders in 2005* |
| John J. Gabarro                                                |
| John J. Haley                                                  |
| Linda D. Rabbitt                                               |
| Gene H. Wickes                                                 |
| John C. Wright                                                 |

 
| **Class III Directors**                                        |
|----------------------------------------------------------------|
| *Term expiring at the annual  meeting of stockholders in 2006* |
| Gilbert T. Ray                                                 |
| John B. Shoven                                                 |

 

Approval of a proposal to increase the numberof shares that may be issued under the Compensation Plan for Outside Directors

 

The Compensation Plan for Outside Directorsis intended to provide compensation for the company’s outside directors througha combination of cash and stock grants.  Under the plan, outside directorsare paid a quarterly retainer, committee and meeting fees and receive an annualstock grant for services rendered as directors. An additional 25,000 shares of common stock were authorized and reservedfor issuance under the Compensation Plan for Outside Directors at the 2004Annual Meeting of Stockholders.

 

Of the proxies received, the votes were asfollows:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** |
|------------|------------|-------------|------------|-------------|------------|----------------------|
| 21,040,972 |       | 2,106,287   |       | 50,211      |       | 4,604,012            |

 

**ITEM 5. OTHER INFORMATION.**

 

None.

 

40

----

 

**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)                                                                                                         |
|   |   |                                                                                                                                                                                                    |
| 10.7   |   | Watson Wyatt & Company  Performance Share Bonus Incentive Program(9)                                                                                                                                |
|   |   |                                                                                                                                                                                                    |
| 21     |   | Subsidiaries of Watson Wyatt & Company Holdings(9)                                                                                                                                                  |
|   |   |                                                                                                                                                                                                    |
| 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)                  |

 

----

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

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

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

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

(5)          Incorporated byreference from Registrant’s Form DEF14A, filed on October 17, 2003

(6)          Incorporated byreference from Registrant’s Form DEF14A, filed on October 15, 2004

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

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

(9)          Filed with this form10-Q

 

41

----

 

**Signatures**

 

Pursuant to the requirements of the Securities and Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 

Watson Wyatt & Company Holdings(Registrant)

 

 
| /s/ John J. Haley   |                    |   | February 9, 2005 |
|---------------------|-------------------------|--------|------------------|
| Name:               | John J. Haley           |   | Date             |
| Title:              | President and           |   |             |
|                | Chief Executive Officer |   |             |
|                |                    |   |
| /s/ Carl D. Mautz   |                    |   | February 9, 2005 |
| Name:               | Carl D. Mautz           |   | Date             |
| Title:              | Vice President and      |   |             |
|                | Chief Financial Officer |   |             |
|                |                    |   |
| /s/ Peter L. Childs |                    |   | February 9, 2005 |
| Name:               | Peter L. Childs         |   | Date             |
| Title:              | Controller              |   |             |
|                     |                         |        |                  |  |

 

42

----