AON CORP AON
October 20, 2010 - 5:03pm EST by
miser861
2010 2011
Price: 39.65 EPS $3.38 $3.86
Shares Out. (in M): 350 P/E 11.7x 10.3x
Market Cap (in $M): 13,878 P/FCF 8.8x 6.6x
Net Debt (in $M): 2,881 EBIT 1,932 1,861
TEV ($): 16,759 TEV/EBIT 9.0x 8.7x

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Description

 

Aon was written up four months ago by clark0225 at about the same price, but since then a transformative acquisition has made the stock even cheaper.  When the dust settles, I think new Aon trades for less than 7x 2011 earnings.  The stock is cheap because the market isn't yet giving them credit for merger cost savings.  Also the entire insurance industry trades at a low multiple because pricing is soft.

 

Aon

Legacy Aon is an insurance brokerage and risk consultancy.  This business is a slightly above average-quality business.  There are weak network effects because as the largest broker Aon has more negotiating power with carriers, and Aon has the most extensive risk database in the industry.  Aon takes a commission based on the value of premiums, so as unit pricing increases or decreases, so do commissions.  Additionally Aon benefits from a greater value of property insured.  So basically, Aon's revenue will grow at nominal GDP +/- insurance inflation/deflation.  Management targets revenue growth of nominal GDP + 2% long-term.  It's worth pointing out that unlike the carriers, the brokers don't have to take a bath before pricing firms up.  The stock actually rose after 9/11 and Katrina.  So in that sense Aon is at least worth a premium to the carriers.  Also Aon isn't long bonds as the carriers are.

 

About $300 million of legacy Aon's revenue comes from health insurance commissions, this is about 10% of pro forma EBITDA.  On 1/1/2011 new regulations will require managed care benefit ratios to be a minimum of 80% for individuals and small groups, and 85% for large groups.  To the extent that carriers look to offset increased benefits with lower commissions, health insurance commission revenue will be squeezed.  The vast majority of Aon's health business is with large groups where carriers are already writing at around 85% benefit ratios.  It's a manageable risk, but worth mentioning.

 

The Hewitt Acquisition

Hewitt is in the business of employee benefits administration (51% of revenue), employee benefits consulting (33% of revenue), and HR outsourcing (16% of revenue).  In the administration space ADP is a good comp (18x NTM earnings).  In consulting Towers Watson is a good comp (12x NTM earnings).

 

Aon paid $4.9 billion for Hewitt, 50% cash, 50% stock.  The cash was raised via three series of notes and a term loan.  The weighted average cost of the debt is 3.9%.  At the time of the merger announcement Aon was trading for 8.6x my estimate of 2010 FCF, so the cost of equity was high, but I believe it was a decent trade, as I'll demonstrate.

 

Hewitt                                   2010       2011       2012

2010 EBIT                             442         509         541

Est. Cost Savings               235         325         355

Pro forma EBIT                  677         834         896

Pro forma Int. Exp.          98           98           98

Pro forma EBT                   579         736         798

PF Net Income                  359         456         495

Levered Multiple             7x           5.5x        5x

 

So even though Aon sold cheap stock to buy another company, I think management probably still added value.  Aon initially traded off after the merger announcement, probably because the market was disappointed in the equity issuance.

 

Management

Because this story is so heavily dependent on the merger cost savings materializing, it's important to spend some time reviewing management's history with previous restructurings and how the results ended up versus initial projections.

 

Greg Case, the CEO, is a former McKinsey partner, leading the financial services practice area.  He was hired by Aon in 2005.  Since 2005 Case has undertaken two major restructurings. 

 

2005 Restructuring

Initial cost savings estimate: $180 million annualized by 2008

2007 cost savings estimate: $280 million annualized by 2008

2008 cost savings estimate: $270 million annualized by 2008

 

2007 Restructuring

Initial cost savings estimate: $240 million annualized by 2010

2009 cost savings estimate: $370 million annualized by 2010

Current cost savings estimate: $536 million annualized by the end of 2010

 

So the final results of these two restructurings exceeded the initial guidance by 50% and 120%.  Because of these data points, I'm more comfortable believing management's projected Hewitt cost savings.

 

Stock Buybacks

A big part of my thesis also relies on stock buybacks, so let's look at Case's history in that department. 

 

                                                2010       2009       2008       2007       2006

$ Repurchased (mill)       100         590         1,900     751         1,000

Average Price                  41.67     39.07     45.08     39.30     36.93

Shares Repurchased       2.4          15.1        42.6        19.1        28.4

Beg of Period Shrs.          267         274         3061       298         322

% of Shrs. Repurchased   1%          5.5%      14%        6%          9%

 

1Issued 14m shares to redeem a convertible.

 

Case has repurchased on average 8% of the shares per year from 2006-2009.  Management is authorized to repurchase an additional $2.2 billion.  The stock is at levels where management has aggressively repurchased it for the last five years, but legacy Aon EBITDA is 30% higher than in 2006.

 

Model

All numbers are pro forma for the merger.

 

 

2013E

2012E

2011E

2010E

2009

Total Revenue

  11,314

  10,984

  10,822

  10,822

 10,669

YOY

3.0%

1.5%

0.0%

1.4%

 
           

Comp. & Benefits

    6,719

    6,619

    6,570

    6,322

   6,418

Other General Exp.

    2,699

    2,659

    2,639

    2,639

   2,943

Cost Savings

       439

       411

       320

   

EBIT

    2,335

    2,116

    1,932

    1,861

   1,308

EBIT %

20.6%

19.3%

17.9%

17.2%

12.3%

Incr. Margin

66.4%

113.5%

     

D&A

       659

       659

       659

       411

      365

Stock Comp.

       293

       293

       293

       293

 

EBITDA

    3,287

    3,068

    2,884

    2,565

   1,673

EBITDA %

29.1%

27.9%

26.7%

23.7%

15.7%

Int. Inc.

         12

         12

         12

         19

        37

Int. Exp.

       191

       191

       191

       204

      249

Other Inc.

         20

         20

         20

         20

        29

EBT

    2,176

    1,957

    1,773

    1,696

   1,125

Taxes

       653

       587

       532

       512

      323

Tax Rate

30%

30%

30%

30%

29%

Net Inc.

    1,523

    1,370

    1,241

    1,183

      802

Min. Int.

         45

         45

         45

         45

        45

Net Inc. to S/H

    1,478

    1,325

    1,196

    1,138

      757

Capex

       283

       275

       271

       266

      267

% of Rev.

2.5%

2.5%

2.5%

2.5%

2.5%

FCF

    2,335

    2,122

    1,934

    1,576

      855

FCF/Shr.

      8.40

      7.12

      6.01

      4.50

 
           

Cash

       795

       795

       795

       795

 

Debt

    3,676

    3,676

    3,676

    3,676

 

Net Debt

    2,881

    2,881

    2,881

    2,881

 

Debt/EBITDA

      0.88

      0.94

      1.00

      1.12

 

Int. Rate

5.20%

5.20%

5.20%

   
           

Acquisitions

         

$

       584

       530

       484

   

Mult.

        8.5

        8.5

        8.5

   

FCF Acq'd

         69

         62

         57

   

Cumulative

       188

       119

         57

   
           

Buybacks

         

$

    1,752

    1,591

    1,451

   

Px

         87

         67

         51

   

#

         20

         24

         28

   

% of Shares

7%

7%

8%

   

SO, EOP

       278

       298

       322

       350

 
           
           

If Aon can earn $7 of FCF/share in 2012, at 14x it would trade for $100.  At less than 7x 2011 FCF, downside seems limited.  Additional upside might materialize if insurance pricing moves from a deflationary trend to an inflationary trend.

Catalyst

    sort by    

    Description

     

    Aon was written up four months ago by clark0225 at about the same price, but since then a transformative acquisition has made the stock even cheaper.  When the dust settles, I think new Aon trades for less than 7x 2011 earnings.  The stock is cheap because the market isn't yet giving them credit for merger cost savings.  Also the entire insurance industry trades at a low multiple because pricing is soft.

     

    Aon

    Legacy Aon is an insurance brokerage and risk consultancy.  This business is a slightly above average-quality business.  There are weak network effects because as the largest broker Aon has more negotiating power with carriers, and Aon has the most extensive risk database in the industry.  Aon takes a commission based on the value of premiums, so as unit pricing increases or decreases, so do commissions.  Additionally Aon benefits from a greater value of property insured.  So basically, Aon's revenue will grow at nominal GDP +/- insurance inflation/deflation.  Management targets revenue growth of nominal GDP + 2% long-term.  It's worth pointing out that unlike the carriers, the brokers don't have to take a bath before pricing firms up.  The stock actually rose after 9/11 and Katrina.  So in that sense Aon is at least worth a premium to the carriers.  Also Aon isn't long bonds as the carriers are.

     

    About $300 million of legacy Aon's revenue comes from health insurance commissions, this is about 10% of pro forma EBITDA.  On 1/1/2011 new regulations will require managed care benefit ratios to be a minimum of 80% for individuals and small groups, and 85% for large groups.  To the extent that carriers look to offset increased benefits with lower commissions, health insurance commission revenue will be squeezed.  The vast majority of Aon's health business is with large groups where carriers are already writing at around 85% benefit ratios.  It's a manageable risk, but worth mentioning.

     

    The Hewitt Acquisition

    Hewitt is in the business of employee benefits administration (51% of revenue), employee benefits consulting (33% of revenue), and HR outsourcing (16% of revenue).  In the administration space ADP is a good comp (18x NTM earnings).  In consulting Towers Watson is a good comp (12x NTM earnings).

     

    Aon paid $4.9 billion for Hewitt, 50% cash, 50% stock.  The cash was raised via three series of notes and a term loan.  The weighted average cost of the debt is 3.9%.  At the time of the merger announcement Aon was trading for 8.6x my estimate of 2010 FCF, so the cost of equity was high, but I believe it was a decent trade, as I'll demonstrate.

     

    Hewitt                                   2010       2011       2012

    2010 EBIT                             442         509         541

    Est. Cost Savings               235         325         355

    Pro forma EBIT                  677         834         896

    Pro forma Int. Exp.          98           98           98

    Pro forma EBT                   579         736         798

    PF Net Income                  359         456         495

    Levered Multiple             7x           5.5x        5x

     

    So even though Aon sold cheap stock to buy another company, I think management probably still added value.  Aon initially traded off after the merger announcement, probably because the market was disappointed in the equity issuance.

     

    Management

    Because this story is so heavily dependent on the merger cost savings materializing, it's important to spend some time reviewing management's history with previous restructurings and how the results ended up versus initial projections.

     

    Greg Case, the CEO, is a former McKinsey partner, leading the financial services practice area.  He was hired by Aon in 2005.  Since 2005 Case has undertaken two major restructurings. 

     

    2005 Restructuring

    Initial cost savings estimate: $180 million annualized by 2008

    2007 cost savings estimate: $280 million annualized by 2008

    2008 cost savings estimate: $270 million annualized by 2008

     

    2007 Restructuring

    Initial cost savings estimate: $240 million annualized by 2010

    2009 cost savings estimate: $370 million annualized by 2010

    Current cost savings estimate: $536 million annualized by the end of 2010

     

    So the final results of these two restructurings exceeded the initial guidance by 50% and 120%.  Because of these data points, I'm more comfortable believing management's projected Hewitt cost savings.

     

    Stock Buybacks

    A big part of my thesis also relies on stock buybacks, so let's look at Case's history in that department. 

     

                                                    2010       2009       2008       2007       2006

    $ Repurchased (mill)       100         590         1,900     751         1,000

    Average Price                  41.67     39.07     45.08     39.30     36.93

    Shares Repurchased       2.4          15.1        42.6        19.1        28.4

    Beg of Period Shrs.          267         274         3061       298         322

    % of Shrs. Repurchased   1%          5.5%      14%        6%          9%

     

    1Issued 14m shares to redeem a convertible.

     

    Case has repurchased on average 8% of the shares per year from 2006-2009.  Management is authorized to repurchase an additional $2.2 billion.  The stock is at levels where management has aggressively repurchased it for the last five years, but legacy Aon EBITDA is 30% higher than in 2006.

     

    Model

    All numbers are pro forma for the merger.

     

     

    2013E

    2012E

    2011E

    2010E

    2009

    Total Revenue

      11,314

      10,984

      10,822

      10,822

     10,669

    YOY

    3.0%

    1.5%

    0.0%

    1.4%

     
               

    Comp. & Benefits

        6,719

        6,619

        6,570

        6,322

       6,418

    Other General Exp.

        2,699

        2,659

        2,639

        2,639

       2,943

    Cost Savings

           439

           411

           320

       

    EBIT

        2,335

        2,116

        1,932

        1,861

       1,308

    EBIT %

    20.6%

    19.3%

    17.9%

    17.2%

    12.3%

    Incr. Margin

    66.4%

    113.5%

         

    D&A

           659

           659

           659

           411

          365

    Stock Comp.

           293

           293

           293

           293

     

    EBITDA

        3,287

        3,068

        2,884

        2,565

       1,673

    EBITDA %

    29.1%

    27.9%

    26.7%

    23.7%

    15.7%

    Int. Inc.

             12

             12

             12

             19

            37

    Int. Exp.

           191

           191

           191

           204

          249

    Other Inc.

             20

             20

             20

             20

            29

    EBT

        2,176

        1,957

        1,773

        1,696

       1,125

    Taxes

           653

           587

           532

           512

          323

    Tax Rate

    30%

    30%

    30%

    30%

    29%

    Net Inc.

        1,523

        1,370

        1,241

        1,183

          802

    Min. Int.

             45

             45

             45

             45

            45

    Net Inc. to S/H

        1,478

        1,325

        1,196

        1,138

          757

    Capex

           283

           275

           271

           266

          267

    % of Rev.

    2.5%

    2.5%

    2.5%

    2.5%

    2.5%

    FCF

        2,335

        2,122

        1,934

        1,576

          855

    FCF/Shr.

          8.40

          7.12

          6.01

          4.50

     
               

    Cash

           795

           795

           795

           795

     

    Debt

        3,676

        3,676

        3,676

        3,676

     

    Net Debt

        2,881

        2,881

        2,881

        2,881

     

    Debt/EBITDA

          0.88

          0.94

          1.00

          1.12

     

    Int. Rate

    5.20%

    5.20%

    5.20%

       
               

    Acquisitions

             

    $

           584

           530

           484

       

    Mult.

            8.5

            8.5

            8.5

       

    FCF Acq'd

             69

             62

             57

       

    Cumulative

           188

           119

             57

       
               

    Buybacks

             

    $

        1,752

        1,591

        1,451

       

    Px

             87

             67

             51

       

    #

             20

             24

             28

       

    % of Shares

    7%

    7%

    8%

       

    SO, EOP

           278

           298

           322

           350

     
               
               

    If Aon can earn $7 of FCF/share in 2012, at 14x it would trade for $100.  At less than 7x 2011 FCF, downside seems limited.  Additional upside might materialize if insurance pricing moves from a deflationary trend to an inflationary trend.

    Catalyst

    Messages


    SubjectRE: Cost cuts
    Entry10/21/2010 10:03 AM
    Membermiser861
    The cost cuts are <10% of the combined Aon/Hewitt consulting business' operating costs, so I wouldn't characterize it as spectacular.  The cuts are coming from all areas.
    The overlap is in the consulting business, they're very similar businesses.
    Compensation's a good question, I meant to include that in the writeup but forgot.  The compensation system isn't as impressive as I'd hope.  I would qualify that by saying that Case has economic exposure to $70 million of stock and options, so I think that's plenty of incentive.
    Options are granted based on hitting 3 year cumulative adjusted EPS targets.  The current 2009-2011 program's target requires hitting $9.25 of adjusted EPS to get 100% of the target grant.  In 2009 they reported $3.11 of adjusted EPS, so the 2010-2011 targets presumably won't be difficult to hit.  To get 200% of the target grant, they only have to do $10.15.  So the targets aren't very ambitious.
    Bonuses are granted based on hitting a budgeted annual EBT target.  In 2009 the target was 3.1% growth over 2008.  My interpretation of the proxy tells me they could've gotten a bonus even if they'd only achieved 85% of the target EBT.  The bonuses scale up to 300% of target.  Case's bonus last year was $3m, so again, I think the existing exposure to the stock price is far more influential to his net worth than annual bonuses and option grants.  The size of the buybacks would suggest so, because he doesn't need to do them to get his bonus, and probably doesn't even to get his option grants.

    SubjectStock comp in fcf
    Entry11/04/2010 03:09 PM
    Memberthistle933
    Miser,
    Why do you treat stock comp as a non-expense for purposes of calculating your free cash flow number?
     
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