Summary

AON is a high quality company with a leading position in the fairly boring, but steady and mission-critical business of insurance brokerage and benefits consulting and outsourcing. If you are looking for scorching growth from something SAASy or e-commercey, stop reading.  If you like dominant franchises that produce healthy, largely a-cyclical revenue growth, with high (and improving) returns on invested capital and strong (and improving) free cash generation, keep reading. Even better, you’re getting this company for a below market multiple with a significant M&A kicker in form of AON’s pending acquisition of Willis Towers Watson (WLTW), which is scheduled to close sometime early/mid-next year. We’ve written up WLTW and its predecessors twice before on VIC and think the deal makes a lot of sense. Including accretion from the deal, we think AON should grow cash EPS at ~17% p.a. over the next five years, fueled by mid-single digit organic revenue growth, significant cost synergies (well ahead of what management says today), and capital allocation into share repurchases.  We think the combined company can generate EPS of $23-24 in 2025. At 18x earnings, the stock could be worth approximately $430 share price by the end of 2024, implying a 20% IRR (including the ~1% dividend yield). Not too shabby for boring.

So why does this opportunity exist? We think it’s a combination of (a) macro choppiness weighing on near-term results with commercial insurance brokerage organic growth dropping from 4% to 1% sequentially in Q2-20, (b) management offering only partial guidance for H2-20 on its second quarter conference call that confused investors and led to somewhat more bearish expectations for second half performance, and (c) AON being a bit of a tweener in terms of the growth vs. value factor tug-of-war. Moreover, the company is neither a major beneficiary of, nor a recovery play on Covid-19. As a result, it doesn’t fit neatly into one of the investment community’s currently preferred style boxes. On top of this, there’s uncertainty around the WLTW deal. While the transaction was approved by WLTW shareholders on August 26 (nullifying one bear argument – that the deal would need to be recut in favor of WLTW), regulatory uncertainty remains. And the transaction isn’t likely to close for 6-9 months, an unbearably long wait for many market participants.

Business Overview

AON is a century-old firm focused primarily on insurance brokerage. Over the years, the company has shed less attractive legacy businesses such as insurance underwriting, while adding services more directly related to its core insurance brokerage franchise, notably benefits consulting and outsourcing. Revenue is 42% commercial brokerage, 16% retirement advisory, 15% reinsurance consulting, 15% health brokerage, and 11% data and analytics services for insurers and other clients with custom insurance needs.

The company’s financial profile is attractive and is improving. One-third of revenue is fee-driven and two-thirds is annual insurance purchase commissions, both of which are durable through cycles and highly recurring. Revenue historically grows MSD organically with high incremental margins, reflecting limited incremental costs for renewals. That drives high-single-digit to low-double-digit EBITDA growth. The business has minimal capital requirements so FCF conversion is high aside from periodic restructuring efforts tied to major acquisitions and some pension costs. EBITDA margins have improved from the high-teens to the low-30s, driven by operating leverage as well as improving mix and M&A.

As the following charts that management loves showing attest, this is a good business that is getting better:

The underlying ROIC math is interesting.  NOPAT grew from about $1.2 billion in 2010 to $2.5 billion in 2019.  Meanwhile, average total invested capital barely budged, inching up from $10.1 billion in 2010 to $10.6 billion in 2019.

Part of this improvement stemmed from increasing “FCF Margin” – a term the company uses but that is reasonable enough and directionally compelling:

Furthermore, the business model lends itself to M&A, where AON and competitors are active participants. AON alone has closed ~$5 billion in acquisitions and received $4.7 billion from divestitures over the last ten years. Deals tend to be highly accretive due to large cost synergies, deeper underwriter relationships, and cross-selling opportunities. An improving industry structure and greater scale for players like AON has also helped lift margins and ROIC.

WLTW Acquisition is Highly Attractive

In early March, AON announced a (long rumored) $27 billion merger with WLTW. The deal will make the pro forma company the insurance largest broker in the world. It will also make AON a true peer of Marsh & McLennan (MMC), the leading provider of insurance brokerage and benefits consulting and outsourcing for Fortune 500-type clients. While AON has long competed with MMC in insurance brokerage, it lacked a truly world class benefits franchise. The acquisition of WTLW, with its industry-leading Towers Watson benefits and consulting business, solves this problem. We expect regulators will approve the deal, though there is some risk of modest required divestments – consensus seems to be that reinsurance brokerage is most likely. We think this is manageable and should not notably impair the investment’s return profile.

Management advertises $800 million of pre-tax synergies realized over three years, but there are multiple reasons that figure is probably far too low. First, Irish takeover law permits AON to publish only provable and auditable day one cost synergies; revenue synergies, estimated future synergies and forecasted transaction benefits are not permitted. Second, the transformational nature of the deal and pending DOJ review incentivize AON to conservatively forecast synergies. Third, management has a history of under-promising and over-delivering on synergies and cost savings targets. It is worth noting that WLTW is a business we like, particularly the consulting franchise, but it has wood to chop itself. AON management makes only the vaguest attempt to hide how conservative $800 million is, guiding investors to consider its Benfield and Hewitt acquisitions when evaluating the WLTW transaction’s synergy potential. Very well; here’s what that analysis shows:

The average of the Benfield and Hewitt cost savings as a percent of combined cost bases is 14.5%, implying over $2 billion of cost savings vs. the headline $800 million figure. Our base case assumes $1.2 billion in cost savings, the average of Hewitt cost savings (likely more relevant as the larger of the two transaction comps) and the management’s announced target.

It’s worth pointing out that we think an investment in AON will do well even if the WLTW deal is scuttled. Standalone AON will probably grow cash EPS at a 12-14% CAGR barring any additional major M&A. Including the dividend, this is probably a 13-15% IRR over five years. We suspect there are some AON holders who wouldn’t mind seeing the deal fall apart so that they can more easily invest in a “clean” story. This is shortsighted in our view. Opportunities to acquire assets like WLTW don’t come along often and entail a long and painful process. Deal uncertainty and integration work are relatively small prices to pay for creating a true global insurance brokerage and benefits consulting franchise operating in a largely duopolistic market.

CEO with Great Track Record and Strong Incentives

We like management and think they are probably underrated. Since Greg Case became CEO in 2005, he exited AON’s underwriting and other non-core businesses, repurchased 32% of the company, grew cash EPS 12% annually and more than doubled returns on invested capital. Total shareholder return during his tenure is a ~16% IRR (~20% IRR the last ten years).

We like that Case owns about $230 million in stock, which is many multiples of Board-mandated minimum ownership. We also like how he is compensated: 85% of compensation is in equity and 90% is tied to performance, the most relevant driver being adjusted earnings per share (operating profit, margin and organic growth are relevant for short-term incentives).  Furthermore, this is the biggest and most important acquisition of his career – we think he’ll be highly motivated to make it succeed.

Projections

We assume combined revenue grows a little more than 4% annually from 2019, EBITDA grows 9% annually on the back of $1.2 billion in deal synergies, and management repurchases stock with capital above 2x leverage – a conservative assumption based on history. That algorithm produces cash EPS growth of 17% annually. 

To value the company, we use AON’s three-year average forward earnings multiple of ~18x, but this is arguably too conservative. AON historically trades at a ~1.2x premium to the S&P, a ~314bps spread to the 10-year and an 8% discount to MMC’s forward multiple (all three-year averages). That math suggests a multiple range of 21x to 25x. A higher multiple is also supported by improved industry structure post-WLTW deal and its increasingly similar business mix to MMC.

Applying 18x fwd to AON’s 2025E cash EPS gets a $430 stock price, suggesting a 20% five-year IRR (including the dividend), which is among the most compelling opportunities we see today, particularly on a risk adjusted basis (taking into account limited business risk, low financial leverage, etc.). In addition, AON has numerous medium-term tailwinds that we do not explicitly underwrite: (a) stronger commercial insurance pricing, (a) growth in insurable verticals that often accompanies catastrophes (and other growing verticals such as cyber security) that should support faster organic growth, and (c) the addition of WLTW’s database, which should improve monetization and accelerate AON’s evolution toward a services-based business model with higher incremental margins. Explicitly accounting for some of these tailwinds, none of which we think the market is factoring in currently, and assuming a multiple closer to MMC, the five-year IRR increases to something closer to 30%.

Our bear case builds on near-term operating softness and extrapolates negative organic growth to 2022 before rebounding to +3%. Further, we give credit to deal pessimists by assuming AON must divest 10% of revenue, only achieves the headline $800 million of synergies, and does not repurchase stock for two years. If the stock trades for 15x forward EPS, it’s worth $270 by 2025, which is still a 7% IRR. Admittedly below most hurdle rates, but not bad as downside cases go.