August 13, 2002 - 2:29pm EST by
2002 2003
Price: 16.14 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 4,487 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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If it were not for the bad news last week, there would have been no news for Aon, which released its 2nd Quarter results. The stock plummeted below $14 before stabilizing at $15, and now creeping up to $16. This represents a good entry point into AOC because the market’s reaction oversold the bad news. First, let us review the negatives from the news:

1. 2nd Quarter earnings were breakeven, although Aon indicated that they earned $0.33 before special charges. This was well below consensus estimate of $0.50, even excluding the special charges.

2. Not one, but two, separate SEC investigations into Aon’s accounting. One deals with timing regarding the reporting of certain losses, and appears to have no impact. The second one deals with two off-balance sheet special purpose entities with $1.3 billion in assets and an equal amount of liabilities.

3. A managing general agent, National Program Services (“NPS”), ceased business, resulting in a charge-off for uncollected receivables and increased losses.

4. The spin-off of CSE will not take place as announced, and they will attempt to sell some or all of the insurance underwriting operations.

5. Aon will cut the dividend.

Let me provide some history. Aon Corporation started as a family-run insurance brokerage called Pat Ryan & Associates. In 1969, Pat Ryan bought Virginia Surety Insurance Company that underwrote warranties. In 1976, the operation was renamed Ryan Insurance Group; six years later, they bought a specialty accident & health insurer, Combined Insurance Company of America. There may even be some people in VIC who have written about that deal for stock market geniuses. The cash provided by the insurance companies helped Aon, a named adopted in the early 1990’s, acquire other brokers and enter into the consulting business. In the latter half of the 1990’s Aon began to focus more on the brokerage business, and began de-emphasizing the writing of insurance as it was causing more conflict than synergy. In 1996, Aon put the commercial P&C operations into run-off and sold a major part of the life insurance operations.

Last year, Aon announced that they would spin-off the insurance operations, and even filed a Form 10 for Combined Specialty (“CSE”). The spin-off was part of a major transformation effort to pare Aon down to its core business. Aon has traded at a discount to its peers, which has been attributed to the lower margin CSE operations. The argument is that a post spin-off Aon would trade closer to its peers.

CSE consists of three segments: A&H, specialty P&C (mainly warranty, which is how I will refer to it) and commercial P&C. The A&H and warranty businesses are mature businesses that will grow about 4-5% per year. While not exciting, these two operations produce a lot of cash. The combined ratio has generally been in the low 90’s (It spiked to 99.5% with WTC losses), while the operating ratio has been in the upper 80’s. For those not familiar with insurance, an operating ratio of 88% translates into $0.12 of cash flow for every $1 of earned premium.

One of the problems is that Aon has been siphoning off surplus as well cash flow from the insurance operations to service debt and fund acquisitions, and was relying on an equity offering of $400 to $600 million at spin-off to raise the capital surplus of the insurance companies. This caused delays with the various rating agencies for both credit and insurance. Another major delay was 9/11. Unfortunately, the markets and Aon’s share price have suffered significant declines that make the original spin-off unfeasible. In a mild understatement, Mr. Ryan said: “We have decided that the current market conditions are simply not conducive to raising equity capital at this time.” Unable to proceed with a spin-off, Aon now needs to sell part or all of CSE.

Of the CSE pieces, the A&H business, a.k.a. CICA, will be the most likely sold, as it has better margins and has less problems than it’s P&C kin. Whoever buys the CICA may well end up with a bargain, as being a forced seller in this market will not bring top dollar. After tax earnings on $1.3 billion premium will be around $70-$90 million this year, but normalized earnings would be around $140 million. Assigning a 10 earnings multiple, and a CICA sale might garner $1.4 billion, or after proceeds of about $700 to $900 million in a sale.

Selling the warranty business would also be an option, but details on that business are sketchier. It has an added complexity because it is written through the Combined Specialty Insurance Company (CSIC), which is also used by the commercial P&C business. Aon does not separate the warranty results. From AM Best, warranty’s 2000 net written premiums were around $400 million, with a pure loss ratio of 81.8% before expenses. Assuming a 10% margin, warranty earns around $40 million. That might fetch $400 to $500 million in a sale, or $250 to $300 million after tax. While Aon would love to sell the whole company, a buyer of the warranty business probably doesn’t want the rest of the company (and with good reason). Given the monies involved, I think a sale of the A&H business would be the desired deal, which would then allow CSIC to be spun-off.

So what does this have to do with the bad news? Most of the bad news emanates from CSE. The first SEC investigation in how Aon recorded some losses is minor. The issue is only the timing of when the losses recorded, and thus has no net impact, although the losses would have to be reassigned from the latest quarter back to the periods indicated by the SEC. The second issue regards the off-balance sheet qualified special purpose entities. If the SEC rules against Aon, the QSPE’s would have to be consolidated back into CSE’s books. The assets and corresponding liabilities would be folded back onto the balance sheet, but does not impact equity or earnings. As for the mismanaged managing general agent, that too resides with CSE. Thus, the net impact of CSE towards earnings for the first six month of 2002 has been negative.

Absent the CSE related charges and earnings, Aon’s brokerage and consulting business had pre-tax EPS of $1.38 for six months of 2002, and after tax figures, assuming a 40% rate, of $0.83. Thus, Aon is trading around 10 times 2002 earnings, 9X 2003 estimates, and 1.2X book value. Here are some comparisons to Aon’s peers:

Company___’02 P/E___’03 P/E___B/V

Keep in mind that my Aon projections are based on nothing coming from CSE, and that this doesn’t take into account any additional value accrued from a potential spin-off.

- Patrick Ryan will chair both Aon and CSE.
- Aon has a history of excuses and under-delivering.

Investment Strategy: When I first learned of the spin-off, I dismissed Aon and was only considering buying CSE. After reading the 10-12B/A, however, I have decided that Aon offers a decent return in the near-term. Patrick Ryan will benefit the most from Aon shares rising and that can be engineered slightly by how CSE is spun-off.


- Sale/Spin-off of the insurance underwriting operations (CSE)
- Trades closer to its peers
- Motivated employees (Ryan owns 11% of Aon, and employees own another 14%)
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