Welcome, thank you all for standing by. At this time, all participants are in listen-only mode until the question and answer session. For any questions, please press star then one. This call is being recorded. If you have any objections, you may disconnect at this time. Now we'll turn the meeting over to the Director of Investor Relations, Mr. Peter Poillon. Sir, you may begin.
Thank you, welcome to our third quarter 2014 earnings conference call, which is being hosted by Dominic Casserley, Chief Executive Officer of Willis Group Holdings. A webcast replay of the call, along with the slide presentation to which we'll be referring, can be accessed through our website. If you have any questions after the call, my direct line is +1-212-915-8084. Please note that we may make certain statements relating to future results, which are forward-looking statements as that term is defined by the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those estimated or anticipated. These statements reflect our opinions only as of today's date, and we undertake no obligation to revise or publicly update them in light of new information or future events.
Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2013, and subsequent filings, as well as our earnings press release for a more detailed discussion of the risk factors that may affect our results. Copies may be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we use on the call are expressed on a non-GAAP basis. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our press release and slides associated with this call. I'll now turn the call over to Dominic.
Welcome, thank you for joining our quarterly conference call. With me today are John Greene, our Chief Financial Officer, Steve Hearn, our Deputy CEO and Head of Willis Global, Tim Wright, Head of Willis International, and Todd Jones, Head of Willis North America. By now, you've had a chance to read the news release that we put out last night announcing our third quarter earnings. On this call, John and I will give our prepared remarks, and we'll move to Q&A. To begin, I'd like to provide some comments on this quarter's results, primarily on our organic commissions and fees growth and our underlying expense growth. Through the first half of 2014, we had grown our commissions and fees organically by 4.3%. This quarter, growth for the group slowed to 2.5%, which is disappointing as it is below our first half results.
It is important, however, to get below this headline number to see that the decline is isolated in a few areas and that many of our regions and practices continue to grow well. For example, a theme you will hear across segments is weaker construction practice revenues this quarter. This is a result of timing of projects and the fact that last year's quarter had some significant project revenues that have impacted the current comparison. Looking at revenues on a segment-by-segment basis, Willis International led the way, contributing 6.3%. Willis North America added 3.4%, and Willis Global, where most of the negative factors were at play, came in very slightly down at 0.4%. Let me provide a little more detail on each of the segments in turn. First, Willis International. Our international operations grew 6.3% in the quarter, bringing our organic growth rate year-to-date to 6.5%.
Once again, this is a really strong result from the segment. Latin America and Eastern Europe grew double digits, while Western Europe saw mid-single-digit growth in the quarter. Asia was about flat as growth in China and global wealth solutions was offset by a decline in Hong Kong. If you think about economic growth rates around the globe, it is clear that Willis International's organic growth has outpaced the nominal economic growth of many of the geographies in which it operates. That includes both Western Europe and many of the emerging markets. We believe that this is evidence of our strong market position in those international markets and our strategic initiatives to actively invest in the fastest-growing markets and take share in developed markets. On to Willis North America, which continues to generate solid new business while maintaining strong retention levels.
As I said, we delivered 3.4% organic growth in North America. We saw mid-single-digit organic growth across several of our geographic regions, with the Midwest and Atlantic leading the way. Rates in general in North America continue to moderate with, of course, variances across different products and lines of business. We've recently published our Marketplace Realities report for those interested in a deep dive into our view of 2015 rates in North America. It is available on our website. Looking at our results by practice, importantly, North America's largest practice, Human Capital, grew mid-single digits. While I'm discussing Human Capital, let me provide a brief update on our health care exchange strategy, which includes our own exchange offering, The Willis Advantage. I believe when we last updated you, we had 16 current and committed exchange clients in total. We now have 31, and that includes Willis in North America.
The pipeline remains strong, more than 700 prospects in various stages of discussions. We remain optimistic about the growth opportunity of this important business. Our second largest practice in North America, construction, as I mentioned earlier, was down mid-single digits in the quarter as a number of projects in the prior year quarter did not recur. That is simply the nature of this project-oriented business. Quarter-to-quarter, results can be uneven. Importantly, year-to-date, this practice is up mid-single digits, so it continues to be a growing practice. On to Willis Global, which is comprised of Willis Re, Willis Insurance UK, Facultative, risk, and Willis Capital Markets & Advisory. Global's organic commissions and fees decreased by 0.4% in the quarter. This result reflected a blend of differing results across its major component businesses.
Willis Re grew low single digits in a seasonally small quarter by continuing to innovatively serve our clients and win new business. This was achieved against the backdrop of perhaps the most competitive market condition the reinsurance industry has seen in more than a decade. Within the reinsurance business, Willis North America grew strongly, supported by new business wins, and Willis International grew modestly. However, the prevailing market conditions took their toll on the specialties reinsurance division, which was down modestly in the quarter. Moving on to Willis Insurance UK, which combines our U.K. retail unit and global specialty businesses. Willis Insurance UK declined mid-single digits in the quarter, with the majority of the weakness isolated in the specialty construction business, which was up against a very difficult comparison due to large project revenues recorded in last year's quarter that did not recur.
Meanwhile, natural resources saw strong growth and transportation grew low single digits as aerospace saw some rate improvement. The U.K. retail business was up modestly year-over-year. This business continues to be in turnaround mode but has been steadily improving. To conclude on revenues, as you can see, the majority of our business continued to grow well in the quarter, but our overall growth rate of 2.5% was pulled down by some specific issues in the specialty division of Willis Re and in selected specialty businesses. With that, let me turn to expenses. I want to make a few brief observations about expenses, and then John will provide the appropriate level of details in his remarks.
We told you last quarter when we reported underlying expense growth of 6.1%, that we expected the rate of expense growth to decline over the second half of the year as the rate of increase in headcounts slowed and our expense management initiatives took hold. In that context, our underlying expense growth in the current quarter was 4.1%, an improvement relative to the first half of the year. Two points of importance I would like to make about our expense growth rate. First, to date, we have received very little benefit in our expenses from our Operational Improvement Program. Therefore, we achieved this expense growth moderation through our expense management initiatives that we briefly discussed last quarter. Second, as we are achieving this moderation expense growth, we continue to invest in talent in value-added areas and in our higher growth markets to drive future growth.
We are demonstrating progress in our expense growth rate. To be clear, we obviously will not be pleased with any level of overall expense growth that exceeds our overall revenue growth. John will discuss the financial results of operations in greater detail. He will also provide an update on our Operational Improvement Program, which is off to a good start, and we are pleased with the progress we're making. When he is finished, I'll come back to wrap up and discuss our inorganic growth before we turn to Q&A. With that, I'll hand it to John.
Thank you, Dominic. I'll be working off the third quarter slide deck posted on our website, starting at slide three. This is a walkthrough showing the major earnings component in terms of both reported and underlying EPS from the third quarter 2013 through to third quarter 2014. From 3Q13 reported on the left-hand side, we adjust for $0.34 related to the debt extinguishment charge to give us an underlying 3Q13 EPS of $0.19. Moving across the slide, you can see increased commissions and fees for 3Q14 at a $0.09 positive impact and increased expenses had a $0.13 negative impact. The net of those items, a $0.04 reduction represents the company's underlying business performance. Continuing across, you can see a net $0.01 negative impact from several items.
Higher quarter-over-quarter interest expense and a higher tax rate, partially offset by better results in our associate line and an increase from the non-controlling interest line. The net impact of these gets us to third quarter underlying EPS of $0.14 per share. Let me remind you that we defined underlying as reported, excluding non-operating items and the impact of foreign exchange movement. To get from underlying EPS to reported, we have $0.10 of adverse movements in foreign currency and $0.08 of cost from the Operational Improvement Program. Drilling down into foreign exchange, we saw about $24 million of unfavorable movement. That breaks down as $3 million in commissions and fees and $7 million in operating expenses, which gives us a total of $10 million of foreign exchange translation impacts, or $0.04 per share.
Of that, the most significant year-over-year currency movement for us was the relative strengthening of the pound against the dollar. We also had $14 million, or $0.06 per share, of unfavorable foreign currency impacts to our other income line, which is below operating income. This was primarily a change in foreign currency gains and losses on revaluation of our non-functional currency assets and liabilities. The Operational Improvement charge in the quarter amounted to $17 million. You can find a breakdown of the charge by segment and expense category in the press release. I would note that we've achieved savings of about $2 million from the program in the third quarter, primarily from headcount reductions. Let's turn to slide four on underlying EBITDA and net cash flow from operations. You'll recall that we view underlying EBITDA as a decent proxy for cash flow.
You can see from this slide that underlying EBITDA was $636 million, down about $10 million year-to-date, which is a reduction of less than 2%. Our net cash flows from operations over the first nine months of the year were down $85 million over the same period last year. The decrease was driven primarily by the non-reoccurrence of the closeout of derivative contracts in the third quarter last year, plus increased cash payments this year from our long-term incentive plans. Slide five shows our reported and organic commission and fee growth by segment. I would add three things to what Dominic said. First, there was no impact on our international results from the China revenue recognition issue from the fourth quarter of last year. Second, overall reported growth in our international segment was lower than organic growth due to the negative impact of foreign exchange movement.
This was partially offset by acquired revenues, primarily Charles Monat. North America's reported commission and fee growth was below organic growth because of the sale of some small, slower growth businesses. We expect to close on the sale of a few more small offices in North America in the fourth quarter. Moving on to the total expense walk on slide six. From the left, we adjust the prior year reported balance for $7 million of adverse foreign currency movements experienced in the current quarter, and 1 million of fees related to the debt extinguishment cost that we incurred within other operating expenses in the third quarter last year. As a side note, we also paid a $65 million tender premium related to the refi, but that flowed through interest expense on a net basis in last year's results.
That gets us to an underlying amount of $731 million of total expenses in last year's quarter. Moving across, underlying expenses grew by $30 million, or 4.1%. Salaries and benefits accounted for $22 million of the growth, other operating expenses 7, and the last 1 million from depreciation and amortization. That gets you to $761 million of total underlying operating expenses in the current quarter. When you add in the $17 million charge related to the Operational Improvement Program, you get to the reported total expense of $778 million for 3Q14. Slide seven provides more details on salaries and benefits. The primary driver of salary and benefit expense growth over the past several quarters has been our investment in new talent.
We told you last quarter that the growth in our salary and benefits line item would decline over the remainder of the year as a result of a slowdown in net headcount additions in 2014. In the second quarter of 2014, S&B increased 6.3% year-over-year. This quarter, the rate of growth declined to 4%. FTEs are up 2% since September 2013, so increased headcount accounted for about half of the S&B growth. The remainder was largely due to salary increases, which are essentially in line with inflation. Headcount growth through the first nine months of 2014 was 1.7%. More than half of the growth is in our low-cost operations in Mumbai. To be clear, the increase is not part of our Operational Improvement Program, but rather part of the move to low-cost operations that we had been implementing before we announced the program.
As we have said, the program in large part involves the significant acceleration of movements already well underway for many years, building on the skills and experience we have developed over those years. Turning to slide eight. Let me give you input on some of the non-operating line items. Other income and expenses, which is below operating income, includes the revaluation foreign currency loss. This is a $14 million year-over-year change. The primary currency drivers of this change were movements in the Venezuelan bolivar, the euro, and the pound sterling against the U.S. dollar. Taxes in the quarter were impacted by a $4 million adjustment reflecting an increased proportion of U.S. earnings relative to the U.K. As you know, the U.S. corporate tax rate is almost double that of the U.K. Our associate line showed improvement in the quarter, driven by Gras Savoye.
Let's turn to the balance sheet and uses of cash at slide nine. As you can see, we ended the third quarter with $656 million of cash, up over $30 million from a year ago. The decreased cash balance relative to the year-end was driven primarily by the share buyback program and increased cash dividend. This was partially offset by the non-reoccurrence of the third quarter 2013 tender premium paid on our debt refinancing. Regarding our uses of cash, I would highlight that we repurchased almost 2 million shares of stock for about $82 million during the quarter. Earlier this month, we completed our announced buyback program, having repurchased a little over 5 million shares in total at a cost of about $213 million. CapEx is up a little due to investments in systems and infrastructures.
Dividends are 9% higher, we've been more active in M&A, including the Charles Monat acquisition that closed in the second quarter. Let's turn to slide 10, the update on the Operational Improvement Program we promised back in April. You've read in our press release that we have updated our estimated savings based on the actions we were taking in 2014 or will take in 2015. We've also provided saving of our projected spend. Starting with the updated savings, we are now estimating that we will achieve savings of at least $8 million on actions we've taken in 2014. That's $3 million ahead of our original estimate. The majority of the savings flowing through this year are from headcount reductions, primarily in our U.K. operations. For 2015, we're now estimating at least $60 million of in-year savings. That's $15 million ahead of the original estimate.
Our 2014 and 2015 actions will result in an estimated $120 million of annualized savings by the end of the program. That is 40% of our $300 million estimated total annual savings. We still expect program cost savings of $135 million in 2016 and $235 million in 2017. That's unchanged from our original estimate. Turning to the cost side, we expect to spend about $40 million in 2014. Some of that, of course, was preparatory work, we expect to spend about $130 million in 2015. That gives us about $170 million of the total $410 million we anticipate on spending over the life of the program. The remaining $240 million will be spent in 2016 and 2017.
Let me note that spend, as we've defined the term here, is total Operational Improvement Program-related payments for items that will flow directly through our income statement or for items that are capitalized and run through depreciation over time. It's a combination of expense and CapEx. We've made a good start to the program. To help you track our progress, we'll provide you with three metrics indexed to March of this year. They are the ratio of FTEs in higher-cost geographies to lower-cost nearshore and offshore centers, which stood at a ratio of 80/20. Plus, the square footage of real estate per FTEs and desk per FTEs, both indexed to 100. We believe these metrics will be helpful to you in measuring our progress on middle-office and back-office transition and real estate efficiency. With that, I'll hand it back over to Dominic.
Thank you, John. I'd like to conclude with an update on our M&A activity. Last quarter, we told you about the investment we made in our Human Capital and benefits capabilities in the Nordics, specifically our acquisition of a controlling stake in Max Matthiessen in Sweden. That transaction closed earlier this month, and we're delighted to welcome the Max Matthiessen team into our worldwide Human Capital and benefits practice. Additionally, we're pleased to have announced the acquisition of SurePoint Reinsurance Advisors. That will meaningfully expand our capabilities in the accident and health reinsurance market in North America. We also acquired a range of Irish pension and financial advisory businesses from IFG, which nicely complement our global Human Capital and benefits practice. Finally, we announced last week that Willis is in advanced, exclusive talks with Miller Insurance Services LLP to take a majority interest in that leading independent specialist program.
Under the proposed transaction, we would combine wholesale businesses to trade under the Miller brand. When we are able to, we will update you on the progress of these discussions. Let me leave you with these thoughts about three planks of our strategy. First, I'm convinced that our strategy to grow revenues organically through our global presence by Connecting Willis together to deliver better solutions for our clients and through innovation, will continue to drive new business and increase our share of wallet from existing clients. Despite some isolated negative items this quarter, we exhibited good organic growth in most of the business. Second, our measured acquisition strategy that is focused on high-quality, specialized firms with leading market positions is proceeding well. We believe this strategy will further increase our growth rate and support our organic positioning.
Third, you are starting to see the results of our disciplined approach to controlling expense growth and the early encouraging actions from our Operational Improvement Program. Together, these three items of organic growth, focused M&A, and expense management give all of us at Willis great confidence that we are heading in the right direction to achieve earnings growth, margin expansion, and improved cash flow. With that, operator, may we please begin with the Q&A session?
Yes, sir. Thank you. We will now begin the question and answer session. For any questions, please press star then one. Please unmute your phone and record your name clearly when prompted. To cancel your request, press star then zero. The first question comes from the line of Steve Gallant of Nomura. Sir, your line's open.
Good morning. Thank you for your comments about the organic growth slowing in the quarter. I wanted just to clarify. What is the outlook for Willis Insurance in the U.K. in the fourth quarter? Should we continue to expect a little underperformance there offsetting the areas of strength?
Well, let me. I'm going to have, obviously, Steve Hearn, who oversees Willis Insurance U.K., which is part of Willis Global. Obviously, with the providers, we don't provide quarter to quarter earnings or revenue or cost specific guidance. With that, let me have Steve just to give a sense of how we're doing.
Thanks, Dominic. Thanks for the question. I'll remind you, of course, that our U.K. insurance business is a sum of its parts. We have some, as we pointed out in the script, some businesses that have performed well in Q3 and, in fact, have performed well throughout the year for us, and some businesses that continue to drive significant growth for the organization. We've had some challenges, as we've declared. U.K. retail has been a challenge for us for a period of time, some years. That's something that I've been working on very hard over the course of this year in terms of a turnaround program for our U.K. retail business. As I say, we continue to drive strong growth in many parts of the organization. Within it as well are our global specialty operations, which continue to be market leading businesses.
We're very proud of our position as market leader with some strong margin contribution and profit from those businesses. I'm afraid I can't get to the specific, as Dominic said, of giving you some guidance around what will happen in Q4.
Okay. As a follow-up on the U.S. construction, you discussed how the year-to-date number was up mid-single digit. I just wanted to clarify, that's what you see as the trend, not the decline you saw in the third quarter.
Well, I'm going to hand over to Todd Jones to talk about U.S. construction. Clearly, I think we've tried to indicate to you that we're obviously looking, when we think about our revenues generically, we're looking at how they've been performing during the course of the year as much as what's happened in this particular quarter. Todd, why don't you talk about construction in the U.S.?
Yeah, I think Dominic said it well, that if you look at how the business has performed sort of quarter-over-quarter and then year-to-date, obviously our Q2 performance, which was sort of mid-teens, was a bit of an outlier in terms of growth. The expectation is the business continues to perform well. We continue to see a tremendous amount of activity on both the project space and the surety side. Our expectations is we're going to continue to perform in that space as we have year-to-date.
Okay. Thank you.
Thank you. The next question comes from the line of Jay Gelb of Barclays. Sir, your line is open.
Thank you. I realize the third quarter is seasonally a light quarter for revenue. We're just trying to get a handle on when we might see some stabilization at adjusted pre-tax margin. I know third quarter may not be the best indicator of that, but as earnings estimates keep coming down, I think that'll be a headwind on the stock. Any insight you can help us with there would be helpful initially. Thanks.
Well, again, I'm not going to give you specific guidance. Obviously the things you have to analyze is a sense of our revenue momentum on an ongoing basis versus where we see cost momentum. I think you're starting to see the cost momentum, cost growth come down both pre the Operational Improvement Program, which hasn't really kicked in yet. We'll see an acceleration of the impact of the Operational Improvement Program. Obviously our plan is to continue to have strong organic growth, to supplement that with M&A growth, and to see the combination of our normal expense management, which you started to see the impact of, combined with the Operational Improvement Program, to see the crossover into and the increase in margin expansion. Those were the points I made at the end of my remarks. We can see all the ingredients for that happening.
That's helpful. Do you think that crossover point, you think that's 2015 or 2016?
Again, I hope it's as soon as we can possibly make it. You're going to have to analyze what you see the numbers going through in terms of our revenue momentum and the deceleration of our organic expense growth, and how that's going to play out. John Greene took you through, for instance, the trend lines in our salary and benefits over the last few quarters, and you can see that it's actually been flat, and the impact of the Operational Improvement Program. We would obviously expect if those trends continue, that we'll be able to see performance improve in good time.
Okay. On a separate topic with the potential use of free cash for the Miller deal, what impact, if any, does that have on the potential acquisition of the remainder of Gras Savoye in 2015.
Very good question. We remain very confident of our ability to fund both a Miller transaction and Gras Savoye through our normal cash on hand and debt capacity.
Thank you.
Thank you. The next question comes from the line of Michael Nannizzi of Goldman Sachs. Sir, your line is open.
Thank you. The one slide on the OIP, on the operational expense program, you talked about savings being better than the April announcement, or at least the trajectory of them. Is there any difference to the costs that you outlined or that you expected when you originally outlined the plan versus now? In other words, are you investing more now than you anticipated back in April? Thanks.
Well, we didn't give you the details back then, if you remember, of how we expected to phase our expense growth. I think you
Yeah, I know
Naturally expect that in our ability to accelerate savings, of course, that does mean you're going to see some slight acceleration of expenses. Let's talk about what are in the expenses. Expenses are parallel running costs, some redundancy costs, some specific system investments you might make to simplify a process, and obviously building out of capability to absorb more people in a lower cost location. You've got to have somewhere for them to sit, for instance. Obviously, as we have accelerated our expectation of where our savings will come, we obviously will incur, for obvious reasons, costs a bit earlier.
Got it. Okay. I'm just curious, just going a little bit deeper operationally, what sort of actions are you taking to make sure that the program doesn't negatively impact morale in the areas that you're looking to retain folks?
Yeah, very good question. All the leaders of this program, or the people heavily involved in it, are focused on a number of metrics. Obviously, a critical issue about staff morale is actually how is this affecting client service. As we advance every single project, we are also measuring client service metric to make sure that as we make changes, not only are clients well informed, understand what we're doing, but of course, at the end of the day, we actually want client service metrics to go up. We are, first of all, very firmly focusing on client service as much as operational improvement or cost improvement as we do this. Secondly, you should understand this is a program which is highly involving everybody who's doing the change. These programs are not from some outside element doing the change.
These are Willis-driven programs with people heavily involved in the operational improvements. That is the process we're going through.
Got it. Just on that, have you also incorporated into your expectation when you talk about declining year-over-year increase in expenses, any potential for higher retention costs or to the extent that becomes a tool that you utilize to manage retention? Is that just not something that you anticipate being an issue? Thanks.
Well, we have two obviously in the cost of the program include, first of all, parallel running. If we have to run, let's say we have a new process taking place in Mumbai, which was taking place in a city in a developed market. We're going to run those two processes in parallel for a period of time to make sure they're bedded down, plant services in place, et cetera. Secondly, we obviously watch very carefully making sure that we can retain key people during that process. As you would expect, we could have the normal approach to retention payments, et cetera, as necessary to make sure that key people, while we're making that transition, are incented to stay.
Dominic, if I could add. In the 410, there was a specific allowance for retention awards.
Okay, got it. Thank you.
Thank you. The next question comes from the line of Josh Shanker of Deutsche Bank. Sir, your line is open.
Good morning, everyone. First question is for John. Trying to understand slide three, the EPS crawl. When we are in the third quarter of 2015, crawling forward from this quarter into that earnings quarter, what is the underlying EPS number you start with? Is it $0.06? Is it $0.14? I am trying to understand. There was no foreign currency movement between 3Q 2013, 3Q 2014. How does that compare when 3Q 2014 comes to history, what will the EPS number be recorded as that it relates to 3Q 2015 earnings?
The way we do this is we take the actual results in the current year, and the prior year is effectively rebased for the currency that we are seeing. That difference between the current year and the, I will say, the rebase will be a FX adjustment reflected on the earnings walk on page three.
In Q3 2015, looking back on Q3 2014, the EPS number will be $0.06 per share? I am sorry, the underlying EPS number will be $0.06 per share?
No. It'll depend on what actually happens to the rates in the period.
I'm talking about the historical number, not the new number. There will be no currency rates at that point. Like ex-currency, it was $0.06 per share. That will be the basis for which you measure performance in Q3 2015?
Yeah. What we'll do is that foreign currency movement effectively rebases to the prior year. Then you're on a constant currency throughout the walk from one period to the next. If you'd like, we're happy to take this offline and walk you through the exact mechanics, it's your standard constant currency analysis.
Okay. I guess I'm just trying to get the number right in my model, what EPS will be reported as for posterity. The other question, last quarter I asked the question whether or not margins had bottomed. Dominic, the answer was, probably not, let's wait till the end of 2014. Listening to your answer to Jay's question, I guess margins will bottom as soon as they can, maybe you're taking a timeline away?
No. Look, I'm never going to give very specific timing on any particular quarter's revenue or cost performance in advance for the reason that we don't give guidance. I think you just have to look, as I said in answer to the question earlier, is at the trend line in our revenues this year. What you see based upon our expense actions prior to the Operational Improvement Program, and we've given you a lot of information on that in terms of how it's decelerating and what's happening to S&B costs quarter-to-quarter, and how that therefore is trending, and how we see the Operational Improvement Program flowing through. We are very confident that we're doing all the right things to have those lines cross and have been very clear on we will not be happy until we're regularly producing revenue growth, which is more than cost growth.
We think we're taking all the right actions to have that crossover happen as soon as possible.
That makes perfect sense. Is the business in as good of a shape today as you thought it would be one year ago?
I think in many ways it's in even better shape. Let me go through the elements of that. The fundamental drivers of organic growth of our strategy, which is pinned around Connecting Willis together so that we can deliver around the world our specialty capabilities through our multiple channels to our client in a coordinated way, is well advanced. We've made great strides in that. We are seeing good momentum in new business wins. Pipelines are strong. We're very happy with the way that's developing. Our expense growth management, we deliberately made investments for that strategy I've just described to you in the second half of 2013. We knew that was going to be a pig in the python problem in terms of cost comparisons during 2014, and we said that to you.
We said that we thought we would see expense growth decline during the course of 2014 as we implemented expense management activity post that investment. You are seeing that take place, and we are confident about that. We also have meanwhile continued to be able to invest in the talent to drive that organic revenue growth. We're confident about that. The Operational Improvement Program, which we only announced in April, is ahead of where we thought it would be and is getting traction, and we are confident it'll deliver ahead of the schedule we laid out in April.
Finally, we very explicitly laid out an M&A strategy focused on specialty situations which had strong franchises, high-quality firms, that we would not be going after just volume, just bulking up, but instead would be going after very specific transactions where we could engage in exclusive conversations to bring those very talented organizations as part of the Willis family. We are very pleased with the progress we've made on that and are highly excited about how it's going to play through in 2015. Actually, if you ask how do I feel about the health of Willis now compared to a year ago, I feel very good.
Thank you for the answers, and good luck in 2015.
Thank you.
Thank you. The next question comes from the line of Renita Skiff of Evercore. Your line is open.
Hi, good morning. On the organic growth, it appears that a lot of the slowdown this quarter was sort of because of one-time issues because of the construction practice. Is my understanding of that correct?
Yes. What we've highlighted that if you look at the detail behind the headline of 2.5% organic growth, you can see that Willis North America continued to grow at the trend line it's been on. Willis International had growth again of over 6%. We had some very specific issues, a number of them coincidentally in construction. Your interpretation is correct.
Just looking forward to the fourth quarter, do we have any sort of bad comps, fourth quarter of this year versus fourth quarter last year?
As we said to you last year, we did have, again, a very strong construction quarter in the fourth quarter of 2013. That would just be a tough comps. Again, we remain optimistic about the trend line in the majority of our businesses.
Sure. On the expense savings, I believe there is about $8 million of expense savings from the Operational Improvement Program. Has that already flowed through earnings this year, or do you expect that in the fourth quarter?
No, I think we laid out that we had a very, very small number in the third quarter. The majority of that number will obviously flow into the fourth quarter.
Okay. The $60 million for next year, how much do you expect to flow down to the bottom line, and how much do you expect to reinvest in the business?
Well, we've said overall that I think the majority of the savings we get will flow to the bottom line. I think the way to think about this is the different component parts that drive our expenses. Let me hand over to John to help you think about that.
Yeah. Thank you, Dominic. If you think about our cost base, it's subject to inflation somewhere between 2% and 3% based on the geographic mix. That naturally wants to increase the expense base. We have the Operational Improvement Program, the savings that we're talking about here, coming through as an offset to some of that inflation. Then there'll be select investments that continue to be able to drive positive operating margin growth, and we're going to do that, but we're going to be very specific in making sure that we get definitive paybacks on that. You can do the math based on what I just described there. Really good progress in the Operational Improvement Program. Inflation 2% to 3% is what we're seeing based on the geographic mix. Select investments, we said that the majority of the Operational Improvement Program would fall through.
Sure. One last numbers question, and I apologize for the many questions. On the other expense line, I believe, you said $14 million of that was for the foreign exchange, but the reported number was $9 million. What's the difference between the two?
The $14 million is revaluation FX. There was translation FX of about $10 million. There's a difference between the two. The revaluation FX basically takes a look at non-monetary assets and liabilities and takes the year-over-year change in the FX rate, does a reval, and that creates a P&L debit or credit charge or income. This quarter, what we saw when we compared to third quarter 2013, we saw a weakening of the euro, the Venezuelan bolivar, and the pound sterling versus third quarter 2013, where we saw a strengthening in the euro and the pound, as you'll recall. That difference created the year-over-year P&L charge of $14 million that we talked about in my script.
Sure. Thank you.
Is that helpful?
Yes. Thank you.
Thank you. The next question comes from the line of Kai Pan of Morgan Stanley. Your line is open.
Thank you, and good morning. First, a quick question on the restructuring cost. Thank you for the breakdown. You mentioned earlier about the total cost, 70% probably attributable to people and 30% to system. Is that same proportionals throughout the years for your restructuring cost?
Yeah. Broadly. Yeah.
Okay. Secondly, on the margin question, if you were thinking about because of the economic slowing down, whatever macro issues that your organic growth staying at, let's say 2%-3%-ish range, will the cost of the Operational Improvement Program enough for the savings to drive some margin expansion there, or it's difficult even with the ongoing improvements in operations?
I think we tried to be very clear and clarify this issue of what's the impact of the Operational Improvement Program as it plays through. If we were to see nominal organic growth rates of the business of the numbers you see, so the equivalent of the over 4% we've seen year-to-date. If we were to see that number at the lower end of our single-digit range, much lower than that 4% number, the Operational Improvement Program, we believe, underpins our ability to achieve our margin expansion number. If we see more robust growth at the middle or higher end of what we're seeing of our mid-single digits, obviously the Operational Improvement Program enables us to expand margin over time more than that [inaudible] . That's the explanation we've given, and that's how we see it.
Okay. That's great. Lastly, just curious about your thoughts about capital management priorities especially between now you've been very focused on some of the focus acquisition just versus share buybacks. I just wonder what you saw behind doing acquisitions or return to shareholders.
I think our position remains where it has been. We continue to focus on our capital management as follows. Obviously, we have to fund CapEx, et cetera, as we drive the business. Next, we want to be able to grow our dividend as our earnings grow. Third, we want to immunize the balance sheet on another share count for option exercises, employee option exercises. We did that in 2014, with the program we announced. We have M&A, and that's how we are thinking about our program, and obviously, managing accordingly.
Actually the buyback, just to neutralize the share creation actually ahead of acquisition. Since you've finished your program, $200 million, is there going to be another one just to offset ongoing the issuance?
We will examine what's happening to the option exercises this year and then look what's happening on the outlook and make an announcement accordingly.
Thank you so much for all the answers.
Thank you. The next question comes from the line of Bob Glasspiegel of Janney Capital Markets. Your line is open.
Good afternoon, Willis. I got some numbers questions. I apologize. Dominic, if we go back to your sort of original five-year plan to grow revenue 70 basis points faster than expenses, the math works out to about 250 basis point margin improvement from your 21.6% base of 2012. You lost 160 basis points of ground last year and you're 100 basis points behind the eight ball this year. That puts you 260 basis points behind, which gives you 500 basis points to get in the next three plus years. The optimist in me says that while they haven't updated that plan, Dominic must still have confidence that it's achievable.
The realist in me says that with the economic environment being a little less good than we thought it might be a couple of years ago, currency a little bit in your face and rates slowing to try to get 500 basis points of margin improvement in three plus years seems like it's a formidable task. Who's right, the optimist or the realist?
We'll see, Bob, won't we? I'm obviously not going to answer that question. I'm going to go back to what I said earlier, right? Which is that we have a very strong operational improvement program we put in place, which can deliver very significant cost benefits. You're right to say that our ability to drive a margin expansion, and most importantly of all, the number, as you know, you and I have talked about a number of times that I'm really focused on, which is cash flow generation, right? That's the real number we should be focused on. Our ability to do that is obviously dependent as well on how well our revenues grow, which to some degree is impacted by the economic outlook.
I would reiterate what I said earlier today, which is please do not drive a direct correlation between economic performance of the global economy and our ability to grow organic revenues. There is some correlation, of course. Of course, there is. We have shown, I think quite successfully over a prolonged period of time that in a number of our markets, we are able to outgrow nominal GDP because either we're taking share or because actually the underlying growth of brokerage of property and casualty insurance or healthcare in the commercial space is growing much faster than the underlying economy. Yes, of course, we're affected by economic output, but it's not a one-to-one type ratio.
Well, I do take solace that you haven't adjusted your 2013 plan. To me, that does convey confidence that you think you're on track. Just another question then. How does your incentive comp plan tie to your results? Your cash payments were higher this year than before because of, I assume, history, not anything related to this year or next year results. If margins aren't expanding, is there a question and maybe that number is sort of declining perspectively?
Yeah, you're right. First of all, you're right that what we referred to this year referred to an old plan. You should be very confident, and it's all available, is that the two key drivers of incentive compensation, which is our annual bonus plan and our long term incentive plan, are directly tied to the performance of revenue growth and EBITDA growth in the annual plan. On the long term plan, multi-year revenue growth and EBIT growth Over time. Yes, you're right. Our incentive programs are absolutely aligned with the things that drive cash flow generation.
Is that a potential positive in Q4 as you true up, or has that been trued up to the year in your accounting?
We true up as best we can as we go. Okay?
Don't look for that as a potential tailwind in the fourth quarter is your answer?
No, I wouldn't do that, no. We try and do our best to true up as we go.
Okay, thank you.
Thank you. The next question comes from the line of Thomas Mitchell of Miller Tabak. Sir, your line is open.
I'm a little bit curious. I understand that the Venezuelan bolivar may not be very hedgeable, it would seem that your other currency exposures are hedgeable. Is it just terribly expensive to go into the market and hedge for currencies, or have you just generally decided to live with the ups and downs?
Yeah. Good question. We've actually spent some time looking at it. There's the translation bit, which is running through the P&L. Revenue and expense, not the other income or expense line. That piece has to do with the structural mismatch in the U.K. in terms of about 60% of the revenue comes in U.S. dollars, the cost base is pound sterling. We've looked at that, and it's impossible to get a cost-effective hedge that would also hedge for the movements in the currency. It's just a really hard thing to do. We've talked to a number of bankers who've had some ideas about it, nothing that we viewed as something that we could implement.
In terms of the revaluation FX, our program there is basically what we try to do is ensure that functional currency cost and functional currency revenue are matched, thereby having a natural hedge. If there is a change in the underlying FX rate period over period, we deem that largely to be non-cash. We haven't gone through to try to hedge that. That's actually one of the reasons why we've broken out the underlying the way we've done now.
Right. Okay. That helps very much. Thank you. Now, the other question I have is a little bit more conceptual. It's about something that we all sort of think we understand, but the construction business has stops and starts. It's sensitive to different things. It's probably different in the U.K. than it is in the U.S. In general, there must be some sort of leading indicators that you have that give you an idea of whether projects are going to be started or they're going to be delayed, and how big they are and how much coverage they need when. What is the timing of this sort of thing? You have to wait until somebody breaks ground to assume that you now have a coverage initiated?
I'm going to have Steve talk about that. I think it is worth, of course, remembering that within construction, there is sort of lower ticket items going through on an ongoing basis. Of course, then these big projects, which can affect the quarter-to-quarter numbers. Do you want to talk more about the latter, Steve?
Yeah, you're absolutely right, Dominic. It is very much both. To your question, or in your question was, is there a difference between U.K. and North America? Emphatically there is. The coverage is different. In fact, the markets that provide the capacity are often different as well. I should say as well, construction for us is a strength. It's been an issue for us, as we called in terms of some specifics around Q3. We are a significant leader both in the U.K. and in North America in terms of construction business and for both of those activities. In fact, around the world from our U.K. business, this is a large and profitable activity for us. As Dominic describes, it's made up of lots of different things.
There's the continual pipeline of smaller projects, which we have significant share of and continue to come through very effectively for us. It is typically the larger projects that drive the lumpiness that you see in our performance, both positively and negatively. The lead time can be significant on, in some cases, are vast projects, $billions of TIV insured asset value in some cases. Those are very complex in terms of the way they're financed, very complex in terms of the way they're tendered. Often multiple suppliers are involved and often multiple brokers engaged in terms of providing the coverage and advice around those. Again, buried in your question, if you'll excuse the pun, it is literally when the shovel or spade goes into the ground that we know we have a contract in place and an insurable risk on many of these projects. You're right.
Well, thank you very much. It's very clear.
Thank you. The next question comes from the line of Meyer Shields of KBW. Sir, your line is open.
Great. Thank you. Good morning. If I can keep feeding on the construction issue, are there seasonal quarters where construction is a bigger or smaller portion of your overall business?
I think the answer to that is no. As I said, because there are these very significant contracts and we are particularly strong in that area, it really is about when a contract is awarded and construction begins. That, unlike other parts of the insurance world, doesn't tie around traditional renewal dates, the sort of seasonal renewal dates that you see in other parts of our business. It is when the contract is awarded. The more run-of-the-mill business, maybe you'd see more standard business as usual, if you like, you maybe see an element of that. No, it's not skewed, certainly in the U.K. and international world, and I believe that's the case in North America as well.
Okay, that's helpful. I think I have a question for Dom, but I'm not sure. You had sort of an impressive slowdown in organic expense growth from Q1 to Q4. When we consider the variable expenses associated with some of the business, though, if organic revenue growth would have been at 4.5% range, can you give us a sense of what organic expense growth would have been?
Our first cut at that is, that is not the driver here. We might have had slightly more incentive compensation because profits would have been better. I think the thing that is very important, we do not believe that the slowdown in our revenue growth is because we've been slowing expense growth. Right? We've highlighted for you specific things that have gone on in specific businesses. Meanwhile, International has been growing over 6%, North America is growing over 3%, et cetera. We might have, as I said, had some better performance. The earlier question we had about accruing bonuses, we might have had slightly higher bonus accrual. John, do you want to add?
Yeah. The only thing I would add is, when we looked at the second quarter, the year-over-year, quarter-over-quarter headcount change was about an increase of 4% in the second quarter 2014 versus second quarter 2013. That, you put on some inflation on there, and it gets you up to that 6%+ percent number we talked about. In the September results, what we're seeing is headcount increase versus September last year of only 2%. That really explains the delta in the cost. Yep.
Yep.
The increase, I appreciate what you were saying about incentive compensation, Dominic. I'm just asking more about the fundamental producer compensation. That wouldn't have been.
Same thing.
Okay.
No. In fact, North American producer compensation, because we had a perfectly good quarter in Willis North America, running at perfectly normal levels.
Great. That's very helpful. Thanks so much.
Thank you. The next question comes from the line of Brian Meredith of UBS. Sir, your line is open.
Yeah, thanks. Just a couple quick questions there. First, I was wondering if we could drill down a little bit more on free cash flow. I was wondering if you could talk about what was the actual dollar figure of the non-recurring derivatives closeout last year versus this year, so we can just get a better kind of run rate of what free cash flow kind of looks like right now? Or is this the right number to kind of think about? Is there anything else going on there? Lastly, pension. Any updated thoughts on what pension contributions look like next year?
Okay. Yeah. I will be happy to take that. There were three hedging activities that ended up coming through and creating a year-over-year difference. There was a treasury lock last year, 2013, that threw about $20 million into the P&L. There was an interest rate swap in 2013 that was about $15 million of cash. Then in the current year, related to the Max Matthiessen acquisition, there was another swap that ended up creating about a $15 million delta negative to cash. You sum those up, and you have got about a $50 million quarter-over-quarter issue. We also had, in the quarter, some working capital changes.
It seems a significant portion of that, the working capital piece, had to do with the reclassification of some businesses to assets held for sale, which is other assets, which the goodwill and intangibles or long-term assets will move up to short-term. That creates a working capital increase that drives the cash flow number, at least in terms of what you are looking at. It is really not a cash item. Matter of fact, the exit of the business will create some positive cash flow for the fourth quarter.
Pension.
Pension. Thank you, Dominic. In terms of pension, year-to-date, we are under prior year. We've contributed about $25 million this year versus $48 million in the third quarter last year. What we expect for the year is, year-over-year, pension contributions will probably be down about $20 million.
Year-over-year. Okay. Any thoughts on 2015 at this point, given where interest rates are?
No. Not at this point.
Okay. Just one last one here, just curious. I know you can't give any details with respect to Miller as far as the financial implications and stuff like that, what about your strategic rationale behind the transaction? I wonder if you could kind of give us a little bit of why?
I'm going to turn to Steve for this because obviously it affects particularly our London businesses and our position in that market.
Sure. Do I want to keep me straight not to get into any detail in terms of the transaction itself. It was a difficult question to answer without doing that. Miller's, I think people would recognize as the preeminent independent wholesaler in the London market, a company that's operated for over 100 years under the Miller brand with a very strong wholesale content. As we declared when we announced that we were in exclusive conversations around this acquisition with also some businesses that we'd move into Willis, the treaty reinsurance business, by example. We have strong credential in wholesale business in Willis and a long history in wholesale.
In fact, if you track back only to a couple of decades ago, Willis was fundamentally a wholesale broker itself until that time when it set up its retail capability internationally and in North America. To this day, we have significant wholesale capability within our existing London operation. We felt strategically that it made sense, particularly given the Connecting Willis strategy of deepening our connections across the organization around the world. We recognize the difference around wholesale, and this provides the fantastic vehicle, if we're able to conclude this deal, will allow us to operate, in fact, both models. A connected Willis organization playing with the strengths of our specialty businesses and the London market wholesale operations through the Miller brand.
Great. Thank you.
Thank you.
Thank you. No question at this time. Once again, for any questions, please press star and then one. You will be prompted to record your name. To cancel the request, press star and then two.
All right. Given that there are no more questions online, let me just close this out here because we're beyond time. I just have some very brief closing remarks. First of all, let me reiterate, there have clearly been several unusual events this quarter. Of course, it's fair to say that this is the toughest reinsurance market, for example, for over a decade. We feel we're making progress in our efforts on expense management as this quarter's outcome and expense growth illustrates. We're really encouraged by the results we're seeing in the Operational Improvement Program and what we can see that will achieve in 2015. We still have a long way to go on this, but so far so good, and we won't be distracted from our goals that we've laid out.
Looking further out, of course, economic growth in many major markets, as everyone comments and people have asked on this call, remains uneven. We, of course, are duly cautious. Our revenue performance year-to-date underscores the value of Willis' business model and the power of our portfolio and our confidence into the future. Thanks very much.
Thank you. That concludes today's conference. Thank you all for joining. You may now disconnect.