Description

While both businesses have unique characteristics, opportunities and challenges; they both generate double digit returns on capital, high teens / low twenties operating margins, and produce roughly 10%+ free cash flow conversion rates.  Currently, AON is trading for 10x run rate cash earnings (unlevered), and has several embedded call options not reflected in the current stock price.  I believe the current risk / reward to be roughly 3 to 1, which represents a very compelling investment opportunity.

Upside:               $ 63

Base Case:         $ 46

Downside:          $ 32

Investment Positives:

• 1) Inexpensive absolute valuation given business quality and balance sheet
• 2) Recurring revenue model with sustainable economic moats
• 3) Proven management team
• 4) Free call option on interest rates
• 5) Free hedge against any natural or man-made disaster

Investment Risks:

• 1) Insurance market is very soft, and continues to weaken
• 2) Almost a third of EBIT is denominated in Euros
• 3) Aon has a significantly underfunded pension ($1.7 billion gross unfunded at 12/31/09)
• 4) Lack of identifiable near term catalysts

Insurance Brokerage

Aon operates a retail insurance brokerage business (insurance company to consumer) and a reinsurance brokerage business (insurance company to insurance company).  The retail brokerage business manages Property and Casualty ("P&C") underwriting and placement for commercial customers.  Aon does not underwrite the specific policy, but provides a service to both the commercial customer and the insurance companies which ultimately bid on and underwrite the policies.

Aon's teams of salespeople, consultants and actuaries work with clients (mainly businesses that need some sort of risk management, i.e. slips and falls in a restaurant or directors & officers liability, etc.) to design an insurance policy that is then shopped by Aon to global P&C insurers.  For the business owners, Aon adds value by hiring the actuaries and by maintaining a database of instances that help optimize a policy for a specific customer need.  For the insurers, brokers add value by standardizing the policy so that competing bids are comparable.

For example, a jeweler in Missoula Montana may know that they need theft insurance, but may not know the optimal mix of total coverage and deductibles to maximize coverage and minimize costs.  Aon will determine the probability of occurrence and amount theft and design a policy that gives the most protection at the lowest price.  There is an upfront cost to crafting a policy, which is why insurance companies prefer the involvement of brokers.  Without brokers, insurance companies competing for the jewelers business would each do their own diligence and produce separate policies they believed were most appropriate.  Policies that protect against separate levels of risk would naturally be priced differently rendering them non-comparable to the jeweler.  Brokers add value by removing that inefficiency for the business owner and the insurance companies.  

There are advantages to scale in the brokerage business.  Larger brokers have more robust actuarial teams and larger databases of insurance claim occurrences which in theory allow them to better predict risk over time.  Also, larger brokers generally receive more favorable pricing from P&C bids - the theory being that larger brokers can aggregate more policies into one bid creating a larger volume discount from the insurers.

Revenue for the brokers is generally a percent of the premium paid by the businesses, but can also come in the form of fees from businesses or insurers for specific project based work.  Roughly 85% of the revenue from brokerage operations comes from policy renewals on existing customers.  That number is growing today.  In the first quarter, over 90% of brokerage revenue was customer renewals.  Generally, once policies are written they are rarely shopped, especially in a "soft market" as it takes time and energy to rebid the contracts and there is no guarantee the premiums will go down.

The soft market describes an environment where premiums are declining.  That generally occurs when a greater number of insurers enter the market and drive down prices through competitive bidding.  The reverse (or a "hard" market) occurs when premiums deteriorate past the point of sustainable profitability and insurers exit the market (driven by the price of the premium, the expected return on insurers "float" assets, and the instances of insurance claims).  Natural disasters, such as hurricanes Katrina and Rita in 2005, can cause massive unexpected losses by insurers, which ultimately lead to higher premiums.

Aon, through its acquisition of Benfield in November of 2008, is the largest reinsurance broker in the world with almost $1.5 billion in commissions last year.  Reinsurance is a much more sophisticated product which limits catastrophic risk (either through insuring a specific portfolio of risks on a specific instance or through the sale / transfer of an entire policy from one insurer to another).  Benfield almost acts as an investment bank structuring certain insurance linked securities and advising on capital alternatives including some M&A work. 

Financials

Aon's brokerage operation is a global enterprise reporting revenues in four regions: The Americas ($2.2 billion); The UK ($0.6 billion); Europe, the Middle East, and Africa ($1.4 billion); and the Asia Pacific region ($0.5 billion).

Returns in the brokerage business over time have been solid and consistent.

There are a few moving pieces in the financials of the brokerage business.  Most of the growth in 2008 and 2009 came from acquisitions.  The company hasn't really grown organically since 2006 and 2007 (due in large part to the current soft nature of insurance premiums globally, discussed later in more detail).

Aon collects premiums from customers that it aggregates and passes to the insurance companies.  The aggregation process takes about a week on average, which over time has grown to about $11 billion - Aon invests that cash in money market equivalent securities and earns investment income on the float.  Importantly, Aon never assumes the liability from the policies for which it is holding the premium - the minute a policy is signed it is the liability of the insurer.  For Aon, investment income is effectively free money.  

The first EBIT line is self-explanatory, but it should be noted that those numbers are adjusted for restructuring initiatives, which are described in further detail in another part of the report.

The second EBIT line excludes investment income to show a clearer picture of the returns earned on the core business over time.  Since 2006, margins have increased over 550 bps.  I believe the vast majority of that improvement can be attributed to management execution.

Competition

There are two primary global competitors in insurance brokerage; Willis Group Holdings (WSH) and Marsh McLennan (MMC).

Willis breaks its business down into three segments: Global / Specialty (26% of revenue, 30% of operating income); North American Retail (42% of revenue, 37% of operating income); and International Retail (32% of revenue, 33% of operating income).  Willis is roughly half the size of Aon with $3.2 billion of LTM brokerage commissions. 

Global / Specialty focuses on niche markets including Aerospace, Energy, Marine, Construction and Reinsurance brokerage operations.  It also works in fine art and jewelry.  North America and International retail brokerage are more traditional operations but do have specific areas of expertise such as construction in North America and emerging markets in the International segments.

WSH's consolidated EBITDA margin of 27% exceeds Aon's 20% by a fairly wide margin (both figures exclude investment income).  There are a few reasons for this, but the primary reason is WSH's Global / Specialty business which is a real gem and produces margins of over 33%.  The retail segments produce mid to high 20's margins over time, which is more in line with Aon's low 20's margins in brokerage.  I'm told the primary reason for the margin differential is structural in that WSH caters to smaller more niche clients while Aon tends to have more Fortune 500 business (see ADP versus PAYX).  Higher gross dollar business, but it comes at lower margins.

While I like WSH, I believe AON offers a better risk / reward.  Both WSH and AON are trading for roughly 8.5x estimated 2011 free cash flow, however AON has a cleaner balance sheet (less than 1x of net leverage versus 2.5x for WSH) and AON has more upside from increases in interest rates due to its larger float portfolio and its current yield on that portfolio (AON is earning around 50bps on ~11 billion of float versus WSH earning 275bps on ~1.7 billion of float).  At the same multiple with less debt and more optionality on interest rates, I'm a buyer of AON over WSH.

The other global insurance broker is Marsh & McLennan.  MMC, until two days ago, reported in three segments: Brokerage (50% of revenue, 63% of operating income); Consulting (44% of revenue, 33% of operating income); and Kroll (6% of revenue, 4% of operating income).

MMC generated $5.3 billion in commissions on its insurance brokerage business making it roughly 20% smaller than Aon and about 60% larger than Willis.  Margins in the brokerage operation have been improving but at 15% (operating, LTM) are still well below Aon at 20%.

On June 7^th MMC announced that it had sold Kroll for $1.13 billion.  Kroll generated $663 million in revenue and $55 million in adjusted operating income in the last twelve months.  Adjusting estimates for the sale of Kroll (which I believe has no tax implications), Marsh is trading basically at parity with WSH and AON at 8.8x 2011 cash earnings (12.4x net income, and 8x EBIT).  Also, adjusting for the sale of Kroll, MMC's leverage is roughly the same as Aon at about one turn.  Peer comparison table below:

Insurance Brokerage Profit Drivers

Insurance brokers earn commissions based on the premiums of the insurance policies the company designs.  These commissions are a percent of the premiums charged by the insurance company, therefore brokers earn more when insurance premiums are in an inflationary environment (a so called "hard market") and brokers lose more when premiums are in a deflationary environment (a so called "soft market").

Insurance is effectively a commodity with the main competitive selling point being price (not completely true in larger policies such as reinsurance where counterparty credit risk is a serious concern).  The price of a policy is generally determined by the number of insurers in the market, and those insurers expectation for losses on their portfolio of insurance policies (as well as to their expectation for investment returns over time). 

Over time, if losses are not as great as the industry expects them to be, new insurance companies will sprout up and offer insurance policies at reduced rates (basically taking the current environment and projecting it forward into perpetuity).  That competition drives rates downward.  Eventually there is a catastrophe which creates losses for insurers and forces the marginal players out of the space - the lack of supply and the fact that insurance companies need to recoup losses means that premiums increase.

The last major catastrophe that drove premiums upward was "KatRita" - hurricanes Katrina and Rita in 2005.  Since that event, P&C premiums have been in steady decline.  I have a great graph of the changes in premiums year over year sourced from Stifel Nicolaus (who sourced from Highline and AM Best I believe).  Rate declines troughed on a percentage basis in late 2007 declining in the mid teens YoY.  Through May, the decline in rates has slowed to low single digits YoY.

Despite the decline in premiums, Aon has been able to keep commission revenue relatively flat growing organically 1.7% in 2008 and declining 1% in 2009 on volume increases and market share wins.

Going forward, I have assumed no organic growth through 2011 (I believe consensus expects low single digit growth).  The assumption is that higher volumes will offset lower premiums until the market begins to harden again.

Foreign Currency Exposure (the Euro)

Aon's brokerage business had $1.4 billion of revenues in Europe / Middle East / Africa (EMEA), $650 million of revenues in the UK in the last twelve months.  The consulting segment had ~$500 million in revenue from EMEA and the UK over that same period. 

Segment level revenues from those regions are received primarily in Euros and expenses are paid primarily in Euros leaving the primary currency exposure to operating income line (which is approximately 33% of the total reported $1.35 billion adjusted LTM EBIT).

According the company's most recent 10k (page 102), Aon hedges currency exposure for up to six years.  It is unclear how much FX the company has hedged to date and what the expectation is for exposure in 2010 and 2011.  To be conservative, I have assumed the company is completely exposed to changes in FX through the end of 2010.  For 2011 I have assumed the Euro remains at ~$1.20.

The sensitivity to changes is FX roughly 20c of operating income per lost dollar of FX revenue (keeping operating margins constant given both revenues and costs are in the same currency).  A one percent change in the price of the Euro is about 1.2c today - that would reduce revenues at Aon by roughly $24 million ($2.4 billion in exposure * 0.01).  So a 1c change in the Euro would lead to a reduction in revenue of about $20 million - at 20% constant margin that reduces adjusted operating income by $4 million.  After tax that reduction is approximately $2.9 million (28% tax rate), or 1c per share (283 million fully diluted shares).

Consulting

Aon Consulting focuses on five practice areas: Health and Benefits; Retirement; Compensation; Human Capital; and HR Outsourcing.  Health and Benefits consultancy designs and administers employee benefit programs for HR departments.  Retirement uses Aon's actuarial, investment, tax and administration expertise to advise on pension policies.  Compensation consultancy does benchmarking for compensation structures and helps design incentive compensation policies.  Human capital does workforce training and leadership development.  The outsourcing group handles employee processing and benefits administration.

The company describes this segment as a natural extension of the brokerage business which is effectively a risk consulting operation.  And while there is some client overlap between brokerage and consulting, the operations use different salespeople and consultants for the two products (which is why I say they are disparate businesses).

Fundamentally the business is solid, but I believe not as interesting as the brokerage operation.  The main difference between the two is the lack recurring revenue (as you have in renewals in the brokerage business) and the absence of meaningful free float income.

The primary public competitor to Aon Consulting is Hewitt Associates (HEW).  Hewitt has three reportable segments, all of which compete with Aon: Benefits Outsourcing, HR Business process outsourcing, and Consulting.  HEW is roughly 2.5x the size of Aon's consulting group with $3 billion in trailing revenue.

Revenues for both Aon's consulting business and Hewitt are driven by a combination of professional employment levels in the US (both businesses are mostly domestic), and by HR department consulting budgets (more the former than the latter).  The main cost component is consultant salaries and commissions, which are variable in the short / mid-term and therefore these businesses typically do not have a lot of operating leverage (expense reductions in the 2009 kept profitability strong versus 2008 despite flat to declining revenues). 

From a valuation perspective - Hewitt is trading for 10x 2011 cash earnings and 11x 2011 book EPS (like the brokerage business, there is an amortization component of D&A that is not a recurring capital cost).  Side by side comparison with Aon:

Other Investment Considerations

Management Execution and Restructuring

Aon is run by a former McKinsey consultant, Greg Case, who joined the company in April 2005 as the CEO.  Greg has been doing all the right things since taking over the company.

His first major move as CEO was the announcement of a reorganization called the "2005 Restructuring Plan" that, among other things, reduced headcount by 1,800 and consolidated office space at a cost of approximately $262 million over three years (through 2007).  Greg targeted annualize savings of over $180 million from the 2005 initiatives.

Greg's next move came in 2006 when he sold the company's captive insurance subsidiary Virginia Surety Company for $800 million.  The thinking behind the sale was to eliminate the capital intensive businesses and focus on the core, very profitable, brokerage operations. 

Greg also increased his expectations for the 2005 Restructuring Plan by identifying an additional 1,800 positions to eliminate at an additional cost of $100 million.  Including that reduction, the company estimated total savings of approximately $280 million.

In 2007, the company exited the underwriting business entirely by selling $1.4 billion of net underwriting assets in two transactions for $3 billion (including a dividend received by the company prior to the sale of one unit to ACE Ltd).  Those divestitures finalized the push out of asset intensive businesses and put the focus of the company solely on brokerage and consulting.

Also in 2007 the company completed Greg's 2005 Restructuring Plan for a total cost of $366 million.  All told, the company realized $225 million of saves in 2007 and finished the year on track for annualized savings of $270 million from that initiative.

Concurrent with the completion of the 2005 Restructuring Plan, Aon announced the "2007 Restructuring Plan".  The 2007 plan was designed to eliminate another 2,700 jobs over three years at a total cost of $360 million.  At the time of the announcement the plan was estimated to save Aon approximately $240 million in expenses annually.

In 2008 the company adjusted the scope of the 2007 Restructuring Plan upward to a total cost of approximately $550 million through 2009 with estimated annual savings of $370 million to be fully recognized beginning in 2010.

With the proceeds from the insurance company divestitures, the company repurchased roughly $2 billion in stock for ~$44.50 per share (42.6 million shares, or roughly 13% of the shares).

In perhaps the biggest move since becoming CEO in 2005, Greg purchase Benfield Reinsurance in November of 2008 for $1.4 billion in cash.  Benfield is one of the largest reinsurance brokers in the world with revenues (prior to the transaction) of $675 million and $150 million of gross cash flow.  Combined with Aon's existing reinsurance operation, Aon Benfield has become the largest reinsurance broker in world with almost $1.5 billion in commissions LTM.  To fund the purchase the company used cash on hand (basically stopped buying back stock in August and used the remaining divestiture proceeds to buy Benfield).  The timing of the purchase was fortuitous (lucky) due to the structure of the consideration and the change in the value of the British Pound versus the dollar.  The original purchase price was $1.75 billion at GBp of $1.85.  By November, the GBp fell to $1.55, which saved Aon roughly $320 million (net cost of $1.4 billion).

Concurrent with the closing of the Benfield acquisition, the company announced a third expense reduction program called the "Aon Benfield Restructuring Plan".  The plan was meant to cost $185 million (of which $104 million was included in the upfront purchase price allocation, and the remaining was meant to be expensed over time), and reduce headcount by 500 to 700 by the end of 2011.  The company estimated total annualized savings of $122 million as a result of the reductions.

In 2009, the company updated expectations for the 2007 Restructuring Plan, increasing the cost of the program to $750 million (from $550 million) and the expected total savings to $536 million by the end of 2010 (from $370 million).

These changes, made primarily in the brokerage business, have led to remarkable financial performance despite a very tough (soft) insurance environment.  As you can see from the numbers below - since Greg's first full year as CEO in 2006, he has grown adjusted operating income in the brokerage business by almost $500 million, expanding operating margins by over 500 basis points in the absence of organic growth.

Pension Funded Status

Aon has an underfunded pension.  As you can see from the table below, the amount of the unfunded status has inflated in recent years due in 2008 primarily to a decline in the value of assets, and in 2009 to the low interest rate environment (i.e. higher PV of future liability).

Despite the cash contribution of $400 million (~40% of free cash flow generation) and the growth in assets versus 2008, the funded status of the pension deteriorated in 2009 versus 2008.  The primary reason for the move is the change in interest rates and the implications on the liability (seen growing by $1 billion year over year).

The company is saying that they are going to fund an additional ~$380 million in 2010 to try and close the gap.  Importantly, the funding is discretionary, and tax deductible.  Net of taxes, I calculate the liability at $1.3 billion assuming current interest rates (of effectively zero) and a tax rate of 25%.  Going forward, I assume cash contributions return to roughly $100 million per year (which I still believe is partially discretionary, depending on your view of interest rates).

Valuation

I value Aon on 2011 cash earnings, which I describe more as "normalized" due to the fact that I assume the only changes are internal (i.e. restructuring initiative completion, some share repurchases and normalized pension contributions), and that external factors (i.e. soft insurance market, FX rates, and interest rates) stay well below historic levels.

I have modeled three cases to create my valuation: Low, Base and Best.

The LOW case assumes:

• 1) No organic growth
• 2) 50 basis points float income into perpetuity
• 3) Only realize 33% of remaining targeted expense saves
• 4) $250 million of cash pension contributions into perpetuity

With those assumptions, the company generates $750 million of free cash flow (not including stock comp).  Assuming Aon only modestly repurchases shares, free cash flow per share grows in the mid-single digits and I believe would warrant a 12x multiple.

The BASE case assumes:

• 1) 1% organic growth
• 2) 100 basis points float income into perpetuity
• 3) Realize 50% of remaining targeted expense saves
• 4) $100 million of cash pension contributions into perpetuity

With those assumptions, the company generates $1 billion of free cash flow (not including stock comp).  Assuming Aon uses excess cash to repurchase shares, free cash flow per share grows in the high single digits and I believe would warrant a 13x multiple.

The BEST case assumes:

• 1) 3% organic growth
• 2) 300 basis points float income into perpetuity
• 3) Realize 50% of remaining targeted expense saves
• 4) $100 million of cash pension contributions into perpetuity

With those assumptions, the company generates $1.2 billion of free cash flow (not including stock comp).  Assuming Aon uses excess cash to repurchase shares, free cash flow per share grows in the low teens and I believe would warrant a 15x multiple.

Conclusion

Aon is a nice business trading for a relatively and absolutely attractive valuation with several free call options and ways to win.  At the current price of $39.67, I believe there is $7 of downside and potentially $23 of upside creating an attractive risk/reward ratio of over 3 to 1.

Catalyst

The second is interest rates.  As stated before, I do not believe the market is giving AON any credit for higher interest rates.  While I have no view as to timing, I believe it is a pretty good bet that at some point, interest rates will go up.  Every dollar of interest income flows straight through to the bottom line, which will improve earnings and I believe lead to a higher multiple.