AON CORP AON
June 18, 2010 - 2:17pm EST by
clark0225
2010 2011
Price: 39.67 EPS $3.23 $3.39
Shares Out. (in M): 284 P/E 12.3x 11.7x
Market Cap (in $M): 11,259 P/FCF 11.0x 9.5x
Net Debt (in $M): 1,025 EBIT 1,340 1,354
TEV ($): 13,653 TEV/EBIT 9.9x 9.3x

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Description

Aon Corp operates two disparate businesses including the world's largest insurance broker (83% of revenue, 85% of operating income), and one of the largest health / benefits, retirement, and compensation consultancy firms in the US (17% of revenue, 15% of operating income).

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.

Risk & Insurance Brokerage LTM 2009 2008 2007 2006
           
Total Commissions 6,286 6,232 6,038 5,752 5,339
           
Total Investment Income 56 73 192 205 191
Average Float 10,962 10,757 10,088 4,749  
Average Interest Rate 0.51% 0.68% 1.90% 4.32%  
           
Total Revenue 6,342 6,305 6,230 5,957 5,530
           
EBIT 1,275 1,259 1,119 1,049 927
margin 20.1% 20.0% 18.0% 17.6% 16.8%
           
EBIT (ex Investment Income) 1,219 1,186 927 844 736
margin 19.4% 19.0% 15.4% 14.7% 13.8%

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.

WSH Segment Financials        
Global / Specialty LTM 2009 2008 2007
Commissions / Fees 848 822 784 750
Investment Income 12 13 30 46
Total Revenue 860 835 814 796
         
Operating income 266 255 240 224
D&A 15 14 13 16
EBITDA 281 269 253 240
         
Op Income Margin (ex Inv Inc) 30.0% 29.4% 26.8% 23.7%
EBITDA Margin (ex Inv Inc) 31.7% 31.1% 28.4% 25.9%
         
North America LTM 2009 2008 2007
Commissions / Fees 1,358 1,368 905 751
Investment Income 15 15 15 18
Total Revenue 1,374 1,386 922 786
         
Operating income 327 328 142 152
D&A 23 22 16 12
EBITDA 350 350 158 164
         
Op Income Margin (ex Inv Inc) 23.0% 22.9% 14.0% 17.8%
EBITDA Margin (ex Inv Inc) 24.7% 24.5% 15.8% 19.4%
         
International LTM 2009 2008 2007
Commissions / Fees 1,052 1,020 1,055 962
Investment Income 19 22 36 32
Total Revenue 1,071 1,042 1,091 996
         
Operating income 283 276 306 251
D&A 23 24 25 24
EBITDA 306 300 331 275
         
Op Income Margin (ex Inv Inc) 25.1% 24.9% 25.6% 22.8%
EBITDA Margin (ex Inv Inc) 27.3% 27.3% 28.0% 25.3%

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%.

Marsh & McLennan        
Risk & Insurance LTM 2009 2008 2007
Commissions 5,354 5,230 5,327 5,223
Investment Income 50 54 139 177
Revenue 5,404 5,284 5,466 5,400
         
Operating Income 846 796 460 342
D&A   153 188 214
EBITDA   949 648 556
         
Operating margin (ex Inv Inc) 14.9% 14.2% 6.0% 3.2%
EBITDA margin (ex Inv Inc)   17.1% 9.6% 7.3%

On June 7th 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:

Commissions (millions) LTM 2009 2008 2007
Aon Corp 6,286 6,232 6,038 5,752
Marsh & Mclennan 5,354 5,230 5,327 5,223
Willis Group Holdings 3,258 3,210 2,744 2,463
         
Brokerage Operating Margin* LTM 2009 2008 2007
Aon Corp 19.4% 19.0% 15.4% 14.7%
Marsh & Mclennan 14.9% 14.2% 6.0% 3.2%
Willis Group Holdings** 25.5% 25.2% 22.1% 21.6%
* excludes investment income        
** excludes corporate overhead so that its comparable to AON and MMC  
         
Fiduciary Assets (Float) LTM 2009 2008 2007
Aon Corp 10,962 10,757 10,088 4,749
Marsh & Mclennan 3,909 3,559 3,297 3,612
Willis Group Holdings 1,675 1,683 1,854 1,520
         
Yield on Float* LTM 2009 2008 2007
Aon Corp 0.51% 0.68% 1.90% 4.32%
Marsh & Mclennan 1.38% 1.63% 4.52% 5.34%
Willis Group Holdings 2.75% 2.97% 4.37% 6.32%
* calculated as investment income divided by the period ending fiduciary assets
         
Leverage Ratio LTM      
Aon Corp 0.86 x      
Marsh & Mclennan* 1.03 x      
Willis Group Holdings 2.54 x      
* Pro forma for the sale of Kroll        
         
PE Ratio LTM 2010E 2011E  
Aon Corp 11.7 x 12.3 x 11.1 x  
Marsh & Mclennan* 13.6 x 14.1 x 12.3 x  
Willis Group Holdings 11.5 x 11.9 x 10.6 x  
* Pro forma for the sale of Kroll        
         
Free Cash Flow Multiple 2009 2010E 2011E  
Aon Corp 15.5 x 9.1 x 8.4 x  
Marsh & Mclennan* 19.5 x 9.7 x 8.8 x  
Willis Group Holdings 16.9 x 11.7 x 8.5 x  
* Pro forma for the sale of Kroll        
Estimates are current consensus sourced from Bloomberg.        

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.

Consulting Financials LTM 2009 2008 2007 2006
           
Consulting 1,087 1,075 1,139 1,107 984
Outsourcing 193 191 214 236 293
Total Revenue 1,280 1,266 1,353 1,343 1,277
           
Investment Income 0 1 5 9 5
Total Revenue 1,280 1,267 1,358 1,352 1,282
           
EBIT 224 220 229 200 140
margin 17.5% 17.4% 16.9% 14.8% 10.9%
           
Total Assets   368 379 305  
roa   59.8% 60.4% 65.6%  

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.

Hewitt Associates Financials        
Benefits Outsourcing LTM 2009 2008 2007
Total Revenue 1,566 1,550 1,550 1,475
         
Operating income 395 387 365 304
         
Op Income Margin 25.2% 25.0% 23.6% 20.6%
         
HR BPO LTM 2009 2008 2007
Total Revenue 453 480 555 539
         
Operating income 25 (1) (79) (166)
         
Op Income Margin 5.6% -0.2% -14.3% -30.7%
         
Consulting LTM 2009 2008 2007
Total Revenue 1,033 1,012 1,094 946
         
Operating income 130 144 143 144
         
Op Income Margin 12.6% 14.2% 13.1% 15.2%

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:

Revenue (in millions) LTM 2009 2008 2007
Hewitt Associates 3,089 3,074 3,228 2,990
Aon Corp - Consulting 1,280 1,267 1,358 1,352
         
Operating Margin LTM 2009 2008 2007
Hewitt Associates 15.0% 14.0% 8.7% 6.1%
Aon Corp - Consulting 17.5% 17.4% 16.9% 14.8%
         
Leverage Ratio LTM      
Hewitt Associates 0.0 x      
Aon Corp - Consulting 0.9 x      
         
PE Ratio LTM 2010E 2011E  
Hewitt Associates 13.1 x 12.6 x 11.4 x  
Aon Corp 11.7 x 12.3 x 11.1 x  
         
FCF Multiple 2009 2010E 2011E  
Hewitt Associates 11.3 x 11.1 x 10.2 x  
Aon Corp 15.5 x 9.1 x 8.4 x  
Estimates are current consensus sourced from Bloomberg.        

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.

Risk & Insurance Brokerage LTM 2009 2008 2007 2006
           
Total Commissions 6,286 6,232 6,038 5,752 5,339
           
EBIT (ex Investment Income) 1,219 1,186 927 844 736
margin 19.4% 19.0% 15.4% 14.7% 13.8%

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).

Pension Exposure 2009 2008 2007 2006 2005
US Assets (not Market) 1,153 1,087 1,514 1,465 1,334
International Assets 3,753 3,107 4,478 4,075 2,942
Total Assets 4,906 4,194 5,992 5,540 4,276
           
US Obligations 2,139 2,087 1,677 1,782 1,833
Interntaional Obligations 4,500 3,628 5,298 4,921 4,202
Total Obligations 6,639 5,715 6,975 6,703 6,035
           
Funded Status (1,733) (1,521) (983) (1,163) (1,759)
           
Cash Cont in excess of SG&A (404) (105) (107) 55 (221)

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.

Valuation   Low   Base   Best
             
Insurance Brokerage Revenue   6,031   6,092   6,274
Organic Growth   0%   1%   3%
             
Brokerage EBIT   1,258   1,370   1,633
Restructuring Flow Through   33%   50%   50%
Interest Rate on Float   0.500%   1.000%   3.000%
             
Consulting Revenue   1,198   1,210   1,247
Organic Growth   0%   1%   3%
             
Consulting EBIT   207   216   229
Restructuring Flow Through   33%   50%   50%
             
Overhead (1.7% of revenue)   (125)   (126)   (130)
Consolidated EBIT   1,340   1,460   1,732
             
Interest   (95)   (95)   (95)
Taxes (28%)   (349)   (382)   (458)
Net Income   897   983   1,178
             
D&A   240   240   240
Stock comp   210   210   210
Pension contributions   (250)   (100)   (100)
Capex   (145)   (146)   (151)
Free Cash Flow   952   1,186   1,378
FCF ex Stock Comp (RSUs)   742   976   1,168
             
Per Share   $2.67   $3.51   $4.20
Multiple   12.0 x   13.0 x   15.0 x
Value   $32.01   $45.65   $63.00
Current Price   $39.67   $39.67   $39.67
Upside (Downside)   ($7.66)   $5.98   $23.33
             
Growth in FCF per year*    4.3%   8.2%   13.0%
* assumes repurchases at $50 / share            

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

There are two primary catalysts to realizing value investing in Aon.  The first is share repurchases.  In February Aon announced a $2 billion share repurchase authorization - equivalent to roughly 18% of the outstanding shares.  Without leverage, it would take the company roughly 2.5 years to buy that many shares.  With one incremental turn of debt and cash / investments on hand, the share repurchase could be completed in less than one year.

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.

Another non-quantifiable catalyst is the likelihood of a natural disaster at some point in the future.  That could be this hurricane season, or a major earthquake on the West Coast 10 years from now.  The shares are priced such that no catastrophes will ever occur again - to me that seams unlikely.
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    Description

    Aon Corp operates two disparate businesses including the world's largest insurance broker (83% of revenue, 85% of operating income), and one of the largest health / benefits, retirement, and compensation consultancy firms in the US (17% of revenue, 15% of operating income).

    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:

    Investment Risks:

    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.

    Risk & Insurance Brokerage LTM 2009 2008 2007 2006
               
    Total Commissions 6,286 6,232 6,038 5,752 5,339
               
    Total Investment Income 56 73 192 205 191
    Average Float 10,962 10,757 10,088 4,749  
    Average Interest Rate 0.51% 0.68% 1.90% 4.32%  
               
    Total Revenue 6,342 6,305 6,230 5,957 5,530
               
    EBIT 1,275 1,259 1,119 1,049 927
    margin 20.1% 20.0% 18.0% 17.6% 16.8%
               
    EBIT (ex Investment Income) 1,219 1,186 927 844 736
    margin 19.4% 19.0% 15.4% 14.7% 13.8%

    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.

    WSH Segment Financials        
    Global / Specialty LTM 2009 2008 2007
    Commissions / Fees 848 822 784 750
    Investment Income 12 13 30 46
    Total Revenue 860 835 814 796
             
    Operating income 266 255 240 224
    D&A 15 14 13 16
    EBITDA 281 269 253 240
             
    Op Income Margin (ex Inv Inc) 30.0% 29.4% 26.8% 23.7%
    EBITDA Margin (ex Inv Inc) 31.7% 31.1% 28.4% 25.9%
             
    North America LTM 2009 2008 2007
    Commissions / Fees 1,358 1,368 905 751
    Investment Income 15 15 15 18
    Total Revenue 1,374 1,386 922 786
             
    Operating income 327 328 142 152
    D&A 23 22 16 12
    EBITDA 350 350 158 164
             
    Op Income Margin (ex Inv Inc) 23.0% 22.9% 14.0% 17.8%
    EBITDA Margin (ex Inv Inc) 24.7% 24.5% 15.8% 19.4%
             
    International LTM 2009 2008 2007
    Commissions / Fees 1,052 1,020 1,055 962
    Investment Income 19 22 36 32
    Total Revenue 1,071 1,042 1,091 996
             
    Operating income 283 276 306 251
    D&A 23 24 25 24
    EBITDA 306 300 331 275
             
    Op Income Margin (ex Inv Inc) 25.1% 24.9% 25.6% 22.8%
    EBITDA Margin (ex Inv Inc) 27.3% 27.3% 28.0% 25.3%

    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%.

    Marsh & McLennan        
    Risk & Insurance LTM 2009 2008 2007
    Commissions 5,354 5,230 5,327 5,223
    Investment Income 50 54 139 177
    Revenue 5,404 5,284 5,466 5,400
             
    Operating Income 846 796 460 342
    D&A   153 188 214
    EBITDA   949 648 556
             
    Operating margin (ex Inv Inc) 14.9% 14.2% 6.0% 3.2%
    EBITDA margin (ex Inv Inc)   17.1% 9.6% 7.3%

    On June 7th 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:

    Commissions (millions) LTM 2009 2008 2007
    Aon Corp 6,286 6,232 6,038 5,752
    Marsh & Mclennan 5,354 5,230 5,327 5,223
    Willis Group Holdings 3,258 3,210 2,744 2,463
             
    Brokerage Operating Margin* LTM 2009 2008 2007
    Aon Corp 19.4% 19.0% 15.4% 14.7%
    Marsh & Mclennan 14.9% 14.2% 6.0% 3.2%
    Willis Group Holdings** 25.5% 25.2% 22.1% 21.6%
    * excludes investment income        
    ** excludes corporate overhead so that its comparable to AON and MMC  
             
    Fiduciary Assets (Float) LTM 2009 2008 2007
    Aon Corp 10,962 10,757 10,088 4,749
    Marsh & Mclennan 3,909 3,559 3,297 3,612
    Willis Group Holdings 1,675 1,683 1,854 1,520
             
    Yield on Float* LTM 2009 2008 2007
    Aon Corp 0.51% 0.68% 1.90% 4.32%
    Marsh & Mclennan 1.38% 1.63% 4.52% 5.34%
    Willis Group Holdings 2.75% 2.97% 4.37% 6.32%
    * calculated as investment income divided by the period ending fiduciary assets
             
    Leverage Ratio LTM      
    Aon Corp 0.86 x      
    Marsh & Mclennan* 1.03 x      
    Willis Group Holdings 2.54 x      
    * Pro forma for the sale of Kroll        
             
    PE Ratio LTM 2010E 2011E  
    Aon Corp 11.7 x 12.3 x 11.1 x  
    Marsh & Mclennan* 13.6 x 14.1 x 12.3 x  
    Willis Group Holdings 11.5 x 11.9 x 10.6 x  
    * Pro forma for the sale of Kroll        
             
    Free Cash Flow Multiple 2009 2010E 2011E  
    Aon Corp 15.5 x 9.1 x 8.4 x  
    Marsh & Mclennan* 19.5 x 9.7 x 8.8 x  
    Willis Group Holdings 16.9 x 11.7 x 8.5 x  
    * Pro forma for the sale of Kroll        
    Estimates are current consensus sourced from Bloomberg.        

    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.

    Consulting Financials LTM 2009 2008 2007 2006
               
    Consulting 1,087 1,075 1,139 1,107 984
    Outsourcing 193 191 214 236 293
    Total Revenue 1,280 1,266 1,353 1,343 1,277
               
    Investment Income 0 1 5 9 5
    Total Revenue 1,280 1,267 1,358 1,352 1,282
               
    EBIT 224 220 229 200 140
    margin 17.5% 17.4% 16.9% 14.8% 10.9%
               
    Total Assets   368 379 305  
    roa   59.8% 60.4% 65.6%  

    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.

    Hewitt Associates Financials        
    Benefits Outsourcing LTM 2009 2008 2007
    Total Revenue 1,566 1,550 1,550 1,475
             
    Operating income 395 387 365 304
             
    Op Income Margin 25.2% 25.0% 23.6% 20.6%
             
    HR BPO LTM 2009 2008 2007
    Total Revenue 453 480 555 539
             
    Operating income 25 (1) (79) (166)
             
    Op Income Margin 5.6% -0.2% -14.3% -30.7%
             
    Consulting LTM 2009 2008 2007
    Total Revenue 1,033 1,012 1,094 946
             
    Operating income 130 144 143 144
             
    Op Income Margin 12.6% 14.2% 13.1% 15.2%

    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:

    Revenue (in millions) LTM 2009 2008 2007
    Hewitt Associates 3,089 3,074 3,228 2,990
    Aon Corp - Consulting 1,280 1,267 1,358 1,352
             
    Operating Margin LTM 2009 2008 2007
    Hewitt Associates 15.0% 14.0% 8.7% 6.1%
    Aon Corp - Consulting 17.5% 17.4% 16.9% 14.8%
             
    Leverage Ratio LTM      
    Hewitt Associates 0.0 x      
    Aon Corp - Consulting 0.9 x      
             
    PE Ratio LTM 2010E 2011E  
    Hewitt Associates 13.1 x 12.6 x 11.4 x  
    Aon Corp 11.7 x 12.3 x 11.1 x  
             
    FCF Multiple 2009 2010E 2011E  
    Hewitt Associates 11.3 x 11.1 x 10.2 x  
    Aon Corp 15.5 x 9.1 x 8.4 x  
    Estimates are current consensus sourced from Bloomberg.        

    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.

    Risk & Insurance Brokerage LTM 2009 2008 2007 2006
               
    Total Commissions 6,286 6,232 6,038 5,752 5,339
               
    EBIT (ex Investment Income) 1,219 1,186 927 844 736
    margin 19.4% 19.0% 15.4% 14.7% 13.8%

    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).

    Pension Exposure 2009 2008 2007 2006 2005
    US Assets (not Market) 1,153 1,087 1,514 1,465 1,334
    International Assets 3,753 3,107 4,478 4,075 2,942
    Total Assets 4,906 4,194 5,992 5,540 4,276
               
    US Obligations 2,139 2,087 1,677 1,782 1,833
    Interntaional Obligations 4,500 3,628 5,298 4,921 4,202
    Total Obligations 6,639 5,715 6,975 6,703 6,035
               
    Funded Status (1,733) (1,521) (983) (1,163) (1,759)
               
    Cash Cont in excess of SG&A (404) (105) (107) 55 (221)

    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:

    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:

    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:

    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.

    Valuation   Low   Base   Best
                 
    Insurance Brokerage Revenue   6,031   6,092   6,274
    Organic Growth   0%   1%   3%
                 
    Brokerage EBIT   1,258   1,370   1,633
    Restructuring Flow Through   33%   50%   50%
    Interest Rate on Float   0.500%   1.000%   3.000%
                 
    Consulting Revenue   1,198   1,210   1,247
    Organic Growth   0%   1%   3%
                 
    Consulting EBIT   207   216   229
    Restructuring Flow Through   33%   50%   50%
                 
    Overhead (1.7% of revenue)   (125)   (126)   (130)
    Consolidated EBIT   1,340   1,460   1,732
                 
    Interest   (95)   (95)   (95)
    Taxes (28%)   (349)   (382)   (458)
    Net Income   897   983   1,178
                 
    D&A   240   240   240
    Stock comp   210   210   210
    Pension contributions   (250)   (100)   (100)
    Capex   (145)   (146)   (151)
    Free Cash Flow   952   1,186   1,378
    FCF ex Stock Comp (RSUs)   742   976   1,168
                 
    Per Share   $2.67   $3.51   $4.20
    Multiple   12.0 x   13.0 x   15.0 x
    Value   $32.01   $45.65   $63.00
    Current Price   $39.67   $39.67   $39.67
    Upside (Downside)   ($7.66)   $5.98   $23.33
                 
    Growth in FCF per year*    4.3%   8.2%   13.0%
    * assumes repurchases at $50 / share            

    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

    There are two primary catalysts to realizing value investing in Aon.  The first is share repurchases.  In February Aon announced a $2 billion share repurchase authorization - equivalent to roughly 18% of the outstanding shares.  Without leverage, it would take the company roughly 2.5 years to buy that many shares.  With one incremental turn of debt and cash / investments on hand, the share repurchase could be completed in less than one year.

    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.

    Another non-quantifiable catalyst is the likelihood of a natural disaster at some point in the future.  That could be this hurricane season, or a major earthquake on the West Coast 10 years from now.  The shares are priced such that no catastrophes will ever occur again - to me that seams unlikely.

    Messages


    SubjectWSH v. AON
    Entry06/20/2010 11:35 PM
    MemberFrancisco432
    Very good and thorough write-up. I generally agree with you, but still prefer WSH to AON for the following reasons:
     
    • Adjusted for the pensions underfunding, AON and WSH trade at comparable EV / EBITDA multiples and WSH trades at a discounted cash eps multiple.
    • WSH has consistently outperformed in organic growth. 
    • WSH's NII yield has come down and is reflected in forward estimates now as the hedges that held it up gradually roll off. Though AON would benefit slightly more on a % of EPS basis from a move in interest rates.
    • Most importantly, I think pricing is unsustainably low and WSH has a fair bit more leverage to the insurance pricing cycle than AON because of it's higher commission mix and financial leverage (occassionally leverage can be a good thing). If BP had been insured, the brokers would be much higher already, but based on the industry publications, I think it is having a secondary impact (ie: D&O prices for energy co's). It also seems as though the US and others are swinging toward an anti-business / more litigious sentiment that could also trigger a hard market or reduce the softness.
    • I would also add that the P&C industry operated at a 105% combined ratio on an accident year basis in 2009 (AM Best). Profitability is being driven by reserve releases that will eventually run out. Given that they are generating very low yields on fixed income portfolios, underwriting is generally uneconomic (insurers always say they have discipline, but never give up market share until they have to).
    So I guess my point is that I have emphasized the insurance pricing cycle over interest rates because it seemed to be a larger driver of earnings (I estimate that a 1% move in insurance prices = ~$0.08/share eps to WSH and a 100 bps move in interest rates = ~$0.08/share eps as well and that 1+% moves are more likely in in insurance pricing than interest rates, esp near term). Do you disagree with that approach?
     
    Thank you.

    SubjectRE: WSH v. AON
    Entry06/21/2010 09:28 AM
    Memberclark0225
    I don't disagree at all with your approach (or your numbers) and do agree that WSH is very interesting here. 
    Both AON and WSH have more leverage to a hardening insurance environment than they do to interest rates (WSH moreso than AON, given stronger organic growth historically as you've pointed out).  And in the case of increasing premiums, WSH has added financial leverage which in theory should increase the returns to equity. 
    Ive picked AON because of leverage to earnings in areas outside of the insurance industry (internal restructuring and interest rates), but do agree with you that when the insurance cycle turns, AON likely will underperform WSH (though both should produce excellent returns)...
    Thanks for the post!

    SubjectRE: RE: RE: WSH v. AON
    Entry06/28/2010 01:33 PM
    Memberclark0225
    I'm with you there.  I've pitched the stock to maybe 10 guys that are all smarter than me and have played the space a dozen times and they all come back either interested or believing it to be dead money (which I can't refute). 
    Talking to sell side analysts, they get very few calls on these names - all the calls are from sector analysts and they are all about premiums.  All of the call volume is geared towards the underwriters and their capital structure (either up or down).
    The working theory I have on why they are so cheap is two fold - first, it is a bit of a "show me story", meaning that a big chunk of my thesis / valuation is based on expense reductions that haven't occurred, normalization of pension cash funding (which again, hasn't occurred), and share repurchases.  Secondly, there is no timing on my catalysts - not having conviction that these stocks will rip between now and the end fo the year I think is keeping people away.
    I have yet to come across any short thesis (credible or otherwise)...

    SubjectRE: RE: Brokerage profit drivers
    Entry07/21/2010 01:24 PM
    Memberthistle933

    On this key question of how much of the $355mm of expected synergies from the Hewitt deal will be realized, I'd be interested in your reaction to the following:

    I calculate that about 50% of the "savings" from their 05 & 07 restructuring plans actually made it to the EBITDA line, with the remainder being 'reinvested.'

    I calculated the 49% as follows: subtract 2005 EBITDA of $962mm (excl charges and investment income and using "continuing operations" data from 2007 annual) from estimated 2010 EBITDA of $1,633mm (excl charges and inv income). There wasn't much organic gwth during that period, so I assume the full difference of $671mm came from either cost savings or Benfield and other acquisitions. Assuming Benfield contributed about $174mm to 2010 EBITDA and other acquisitions contributed $95mm (see note below for supporting detail), that means $402mm of savings fell to bottom line in 2010, vs declared 2010 savings from 05 & 07 restructurings of $806mm. So about a 50% flow-through of declared "savings" to actual incremental EBITDA. Since total charges invested to achieve these savings were $1,116mm, the $402mm represents a good return on that investment. But much lower than you would think if you took their 'savings' at face value. If anyone thinks acquisition-related cost synergies will have a higher flow-through rate than cost "savings" from the 05 & 07 restructurings, I am interested to hear the argument.

    My conclusions are as follows:

    - their ROIC on the Benfield acquisition seems mediocre. The original $1.75b offered for Benfield's 2010 $174mm of EBITDA means they paid about 15x fully taxed 2010 fcf; granted, they only paid $1.43b because fx shifted in their favor, but fx also reduced underlying EBITDA and any multiple compression due to fx belongs to luck rather than capital allocation competence. Since 15x is a full multiple for an insurance broker, the deal was set up to keep all the work and risk for Aon shareholders but give the synergies' value to Benfield shareholders.

    - The Hewitt acquisition modestly improves on the economics of the Benfield acquisition. Assuming they harvest roughly 50% of the 2012 $326mm targeted synergies for the Hewitt acq (and that absent an economic recovery Hewitt EBITDA does not grow apart from the synergies), they paid roughly 6.3x 2012 EBITDA for Hewitt (using consideration of $5.15b rather than $4.9b to reflect the integration charges) or about 11x 2012 unlevered fcf. They are partially using Aon stock to do so, which was trading before the deal announcement at roughly 6.8x 2012 EBITDA of $1.8b or 11.5x 2012 unlevered fcf. Unless they can deliver on the revenue synergies (which they won't quantify either for Hewitt prospectively or for Benfield retrospectively), Aon shareholders will have accepted execution risk and seen material diversion of management time for negligible incremental value relative to share repurchase.

    - Management's cost control efforts since 2005 earn it a good reputation, but this deserves qualification: (1) "Reinvested" dollars that produce no discernible revenue benefit are shifts in spending allocation, not savings. Management's disingenuousness in this respect, in my mind, compromises their credibility in any discussion of Aon's business. (2) The Benfield acquisition was a mediocre use of capital and a waste of management time; Hewitt seems only slightly better.

    In sum, management gets an A for cost control, a B for capital allocation and a C for candor. I do agree that, given the sticky high return businesses it owns, Aon is cheap - at $36 I calculate pro forma Aon Hewitt to be 11.0x unlevered 2011 fcf and 9.5x 2011 levered fcf.

     

    Note 1: The unlevered 2011 fcf multiple of 11.0x treats pension obligation as debt and adds back after-tax value of interest on pension to fcf; also, I use a 34% tax rate rather than the 28-30% most analysts use, as I assume Aon's profits from low-tax int'l operations cannot be returned to stockholders without paying full U.S. tax rates.

    Note 2: I get Benfield 2010 EBITDA contribution as follows: As of 8/08 data of acq announcement, Benfield was supposed to contribute $131mm of 09 EBITDA (deal was 10.4x 09E EBITDA including full value of 2009 synergies of $37mm but excluding integration charge). If they converted 50% of the expected 2010 synergies of $86mm into EBITDA gains but got no other growth, Benfield would be contributing $174mm in 2010. I calculate the EBITDA contribution from "other acquisitions" by totaling $663mm of acquisition spend excl Benfield 2006-2009 and assuming a 7x EBITDA multiple. This is very rough, but the range of variance would not affect the overall analysis much. 


    SubjectMMC for HEW
    Entry07/28/2010 04:46 AM
    Memberbruno677
    any thoughts on the possibility of MMC counterbidding for HEW? By how much do you think AON will/can increase its bid if it comes to a bidding war?  What does this do to AON's stock price?

    Subjecttarget operating margins for AON, MMC, and WSH
    Entry08/03/2010 10:50 AM
    Memberdanarb860
    Hi.  Thanks for a helpful write-up.  What is your view as to the target operating margins for each of the 3 companies, why your targets may be different, and why they are currently different.  I wonder if that is not important in coming to a view on where the stocks may trade relative to each other.  thanks.
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