Description
Reading through the sell-side reports on Marsh
& Mclennan (MMC), the pessimism oozes off the page. MMC has disappointed
Wall Street three quarters in a row bringing its stock price to a weekly close two weeks ago not seen since the last credit crunch in 1998. It is at times like these
– the points of maximum pessimism – that opportunistic investors will look past
these quarterly disappointments and see a company with the following
characteristics: a 7% FCF yield, ample upside to margins, and above average
revenue growth over the long run. In addition, MMC’s extremely strong balance
sheet has significant flexibility to reward shareholders when its core business
turns up again.
While we admit that things
haven’t exactly gone MMC’s way of late, we make the following arguments:
- The core Risk & Insurance business has faced
significant headwinds over the last 3 years including the forced
abandonment of contingent commissions by the Spitzer junta; an
exceptionally soft commercial insurance rate market; the slowest growth rate
in new written premiums (NWP) over the last 37 years; and other various
internal problems, which we’ll talk about. We don’t think that R&I
should be valued at a trough multiple on trough margins during a cyclical
downturn in industry pricing.
- The obsession with everything that’s gone wrong in R&I
masks truly wonderful consulting businesses owned by MMC, which include
Mercer, Oliver Wyman, and Kroll – first class operations that generate considerable
cashflow, are growing fast, and are somewhat counter-cyclical given that
they are increasingly relied upon when the economy sputters.
- We’ll estimate normalized earnings in each of the
segments, put them together, and contend that once you account for the
value of the consulting businesses, even if you assume sub-par future
margin performance from R&I, today’s valuation yields a generous (and
growing) free cash flow coupon and fails to take into account any future positive
performance.
CONSULTING
The Consulting segment includes
two companies – Mercer and Oliver Wyman. Mercer (70% of segment revenue) is one
of the largest benefits consulting groups in the world, specializing in
retirement & investments; health & benefits; talent; and outsourcing.
Most of these areas are large, fragmented, and growing nicely. Mercer’s
competitors include Hewitt Associates and Watson Wyatt, both of whom are
smaller and less globally capable than Mercer.
Oliver Wyman (30% of segment
revenue) is a rapidly growing management consulting firm with 2% market share
in an extremely fragmented market. Wyman is truly the crown jewel of the MMC
empire – top five in the industry in revenue per consultant, unique culture, a
strong track record in bolt-on acquisitions, and top notch work in the areas in
which it specializes. Competitors include Bain, McKinsey, and BCG. Here’s a summary of the segment’s
numbers in recent years:
|
Consulting
|
2003
|
2004
|
2005
|
2006
|
|
Revenue:
|
3290
|
3637
|
3802
|
4225
|
|
Operating Income, ex-items:
|
461
|
493
|
489
|
534
|
|
D&A:
|
89
|
99
|
96
|
92
|
|
Capex:
|
70
|
55
|
83
|
88
|
|
EBITDA:
|
550
|
592
|
585
|
626
|
|
Total Assets:
|
3552
|
3858
|
3595
|
3804
|
|
Goodwill:
|
1100
|
1100
|
1700
|
1900
|
|
Operating Margin:
|
14.01%
|
13.56%
|
12.86%
|
12.64%
|
|
EBITDA Margin:
|
16.72%
|
16.28%
|
15.39%
|
14.82%
|
|
Capex Rate:
|
2.13%
|
1.51%
|
2.18%
|
2.08%
|
|
ROA*:
|
18.80%
|
17.88%
|
25.80%
|
28.05%
|
|
Sales Growth:
|
|
10.55%
|
4.54%
|
11.13%
|
|
Organic Sales Growth:
|
|
3.00%
|
3.00%
|
9.00%
|
*
ROA is defined as (operating income)/(total assets – goodwill)- You’ll notice that returns on tangible assets are
high, that the revenue growth of the last several years has almost no
relationship to the asset growth in those years, and that D&A is
consistently larger than capex. While it’s theoretically obvious that the
business is not capital intensive (only real asset in a consulting business is
the people the firm employs), we emphasize that this means that almost all after-tax
earnings end up as free cash flow.
- EBITDA margins (and the associated operating
margins) have come down over the years as Mercer and Wyman have grown and
corporate fat has been amassed. This issue has begun to be addressed in 2007, as
operating margins are up ~90bp YOY due to a combination of operating leverage
from 14.5% revenue growth and expense cuts. Still, there are expenses to cut
that MMC is in the process of cutting.
For our estimate of normalized
pre-tax operating earnings, we assume that half of capex is maintenance capex
and the other half is growth capex. Management won’t give us their breakdown
but told us that assuming 50/50 is reasonable. Also, we exclude GAAP
stock-based compensation from our discussion because we would rather account
for it by fully diluting any options outstanding in our per-share calculations
(we think that’s conservative). On 2007 revenue of ~$4.75B (consensus), a 90bp
step-up in EBITDA margins from last year to 15.7%, and assuming ~1% of sales as
maintenance capex, normalized operating earnings amount to ~$700M.
The global HR consulting market
(i.e., Mercer) is expected to grow at a 7% CAGR over the next 5 years with the
same expected CAGR for the management consulting areas in which Oliver Wyman
specializes. Given Mercer’s dominant footprint (leading market share of ~20% in
the global HR consulting marketplace) and Oliver Wyman’s reputation in its
extremely fragmented industry (Wyman has 2% share), we expect both companies to
use their strong positions to take market share and make intelligent
acquisitions in the midst of their respective markets’ solid growth. This
should translate into mid to high single digit organic revenue growth for
Mercer and double digit organic revenue growth for OW over the next few years,
plus high-return bolt-on acquisitions that the companies can plug into their
vast client base. We also expect margins to expand as operating leverage kicks
in, leading to earnings increasing at a faster rate than revenue.
RISK CONSULTING (Kroll)
Kroll is the world’s leading risk
consulting company and accounts for ~10% of total MMC revenue. Kroll has two
businesses – Consulting and Technology – each of which make up about half of
revenues. The consulting business specializes in corporate advisory &
restructuring, where Kroll is clearly the leader, having been chosen to work on
Collins & Aikman, Enron, Federal Mogul, Marconi, and other assorted train
wrecks. The consulting business also deals with other “dirty work” including
corporate investigations; fraud detection; litigation, regulatory compliance,
and security consulting; background screening, etc. Kroll Technology
specializes in electronic discovery, computer forensics, data recovery, and
other tech-related consulting. Being the leading “dirty work” firm in the world
carries some pretty fat margins. Here are recent statistics:
|
Risk Consulting &
Technology
|
2005
|
2006
|
|
Revenue:
|
872
|
979
|
|
Operating Income, ex-items:
|
121
|
151
|
|
D&A:
|
84
|
90
|
|
Capex:
|
54
|
46
|
|
EBITDA:
|
205
|
241
|
|
Total Assets:
|
2524
|
2363
|
|
Goodwill:
|
1700
|
1600
|
|
Operating Margin:
|
13.88%
|
15.42%
|
|
EBITDA Margin:
|
23.51%
|
24.62%
|
|
Capex Rate:
|
6.19%
|
4.70%
|
|
ROA:
|
14.68%
|
19.79%
|
|
Sales Growth:
|
|
12.27%
|
|
Non-Organic Sales Impact:
|
|
3.00%
|
|
Organic Sales Growth:
|
|
9.27%
|
*
ROA is defined as (operating income)/(total assets – goodwill)
The years before 2005 are not shown because
Kroll was acquired by MMC in the middle of 2004 and originally included in R&I.
Thus, 2004 pro formas for Kroll are tough to construct. Kroll was an independent
publicly traded company before that with EBITDA margins consistently in the low
20’s in the several years before its acquisition.
Again, ROIC is really high and growth capex is
not really necessary. Also, operating income is understated given the large
difference between D&A and what is likely maintenance capex (like the
consulting segment, we assume a 50/50 split in growth/maintenance capex).
EBITDA margins for 2006 are high and probably
not sustainable in the long run. In 2007, Kroll operating margins (and EBITDA
margins), are running about 225bp lower than in FY 2006. 2007, though, is
probably an uncharacteristically slow year for Kroll given that its
restructuring advisory business has only received one assignment – the AHM bankruptcy
(there should be more to come).
On 2007 revenue of ~$1B, a 21%
EBITDA margin, and $30M in maintenance capex, normalized operating income for
Kroll come in at ~$180M annually.
In terms of the markets in which
Kroll operates, you almost couldn’t ask for a better business over the next
decade. The Financial & Business Consulting (FBC) market is expected to
grow at low double digit rates in the near to medium term as the regulatory and
litigation environment around the world continues to become larger and more
complex (FBC, by the way, is the all-encompassing term for the
non-restructuring areas in which Kroll operates). As for the restructuring
business, it’s a counter-cyclical business in which Kroll is highly respected
(as illustrated by the high-profile assignments it has won in the past) and
where the macro environment can only get better looking out over the next few
years. In addition, these markets are fragmented with plenty of room for growth
for the upper echelon of players. We expect revenue at Kroll to grow at least
in line with the broad markets in which it operates, i.e. low double digits,
for the foreseeable future. Given the last few years of somewhat consistent
margins, we don’t expect much margin expansion beyond our normalized estimate.
RISK & INSURANCE SERVICES
Now, the interesting part. The
R&I segment has two main businesses: Marsh and Guy Carpenter. Marsh is
(after this year) the second largest insurance broker in the world and provides
insurance brokerage and risk management consulting services to clients ranging
from individuals in its consumer business to Fortune 100 companies in its core
broking and risk business. Marsh serves 85% of the Fortune Global 500 and
manages three or more lines of coverage for two thirds of the Fortune 100.
Guy Carpenter basically does the
same thing that Marsh does but for the reinsurance market. GC is the #1 or #2
broker for most reinsurance markets around the world.
Side Note: MMC owns interests in
private equity funds and other long term investments, which it classifies as
Risk Capital Holdings. For some reason, MMC books mark-to-market gains and
losses in RCH as revenue for R&I
(the reasons probably range from “that’s how it’s always been booked in the
past” to “it makes our operating margins look better”). For the purposes of
this discussion, we adjust the operating statistics that follow to exclude RCH
activity.
We concentrate this discussion on
the core Marsh business, because that’s where the problems are (GC, on the
other hand, has been performing quite admirably once you account for the
extremely soft insurance rate environment). We’ll talk about what went wrong,
how Marsh is trying to fix it, and how that translates into numbers. As a point
of reference, here are the relevant operating statistics:
|
|
2003
|
2004
|
2005
|
2006
|
|
Risk & Insurance
|
|
|
|
|
|
Revenue:
|
6,003
|
6,025
|
5,403
|
5,270
|
|
Operating Income, ex-items:
|
1,490
|
1,034
|
558
|
693
|
|
D&A:
|
199
|
225
|
221
|
230
|
|
Capex:
|
275
|
223
|
153
|
133
|
|
Contingent Commissions:
|
820
|
521
|
114
|
43
|
|
Contingent Commissions % of Revenue:
|
13.66%
|
8.65%
|
2.11%
|
0.82%
|
|
EBITDA, ex-items:
|
1,689
|
1,259
|
779
|
923
|
|
Operating Margin:
|
24.82%
|
17.16%
|
10.33%
|
13.16%
|
|
EBITDA Margin:
|
28.14%
|
20.90%
|
14.42%
|
17.52%
|
|
Capex Rate:
|
4.58%
|
3.70%
|
2.83%
|
2.52%
|
|
Sales Growth
|
|
0.37%
|
-10.32%
|
-2.46%
|
|
Organic Sales Growth:
|
|
-3.00%
|
-11.20%
|
-0.60%
|
|
|
|
|
|
|
|
|
2003
|
2004
|
2005
|
2006
|
|
Contingent Commission Data
|
|
|
|
|
|
Revenue, ex-CC:
|
5,183
|
5,504
|
5,289
|
5,227
|
|
Operating Income, ex-CC:
|
752
|
565
|
455
|
655
|
|
EBITDA, ex-CC:
|
951
|
790
|
676
|
885
|
|
Operating Margin, ex-CC:
|
14.51%
|
10.27%
|
8.61%
|
12.52%
|
|
EBITDA Margin, ex-CC:
|
18.35%
|
14.36%
|
12.79%
|
16.92%
|
|
Sales Growth:
|
|
6.19%
|
-3.91%
|
-1.17%
|
|
Capex Rate:
|
5.31%
|
4.05%
|
2.89%
|
2.54%
|
The numbers we put up in the first data set are
not what you’ll find in MMC’s 10-K because we adjusted the numbers to exclude
RCH gains in revenue. We’ve also assumed a 90% operating margin on that RCH
revenue, and adjusted operating income accordingly.
In the second data set, we excluded all
contingent commissions from revenues. We assumed 90% operating margins for
contingent commissions, and adjusted operating income accordingly.
ROAs for R&I are tough to pinpoint because
Marsh includes RCH assets in the asset base and we exclude those numbers from
the analysis. Still, it should be fairly obvious that a brokerage business is
not capital intensive.
Marsh Headwinds: Spitzer and the Insurance Market
Any way you look at it, Marsh
margins declined precipitously from 2003-2005. Without getting into the ethical
and legal issues surrounding contingent commissions, when Spitzer forced Marsh
(or when Marsh caved, depending on how you look at it) at the end of 2004 to
abandon contingent commissions, Marsh’s margin structure collapsed because Marsh
built a business model where a significant portion of its revenue came in as
contingent commissions (13.7% of revenue in ’03). Even more significant for
Marsh was the effect on compensation for the brokers: a) Stock options priced
at $35-65/share in the previous five years became close to worthless when the
stock fell over 40% to $25/share; and b) with the margin structure of the
business collapsed, it was unclear how/if brokers would be paid at the same
level they were being paid before. This uncertainty over compensation, together
with the reputational damage caused by the “scandal,” resulted in an exodus of
talent from Marsh through competitive raiding and voluntary defections that
Marsh has only started to recover from this
year.
To sum up: the combination of the
2004 regulatory mess and the softening P/C market led to a massive exodus of
talent and the semi-collapse of Marsh’s business model culminating in a dismal
2005, when Marsh had the worst year in its history from a margin perspective and
a double digit decline in revenues.
Stabilization and the Problems of 2007
After the contingent commission
scandal broke and MMC CEO Jeff Greenberg was forced out, Mike Cherkasky, then
CEO of recently acquired Kroll, took over. Over 2005, Cherkasky cut costs in
order to rationalize Marsh’s cost structure, and stabilized the business. We
don’t think it’s a coincidence that the stabilization came during a year when
the P/C market somewhat stabilized after
the ’05 Hurricane season (emphasis on somewhat
because the market was, and still remains, soft). 2006 exhibited higher
normalized margins than the previous two years and positive organic sales
growth excluding contingent commissions for the first time since the CC
scandal. 2007, unfortunately, has not followed in the footsteps of 2006.
At the start of ’07, on the heels
of a stable 2006, (now-former) Marsh CEO Brian Storms decided that in order to
go beyond merely stabilization of the US business and achieve Marsh’s
target operating margin of 20%, a massive organizational overhaul was
necessary. The initiatives undertaken included:
- A zone re-alignment – redrawing the Marsh
regional grid and cutting the number of US zones from nine to four.
- The overhaul of branch offices with 26 out of 65
regional offices (including the ten largest) replacing their heads.
Significantly, these branch offices are quite important to the middle market
clientele.
- Centralization of the small commercial accounts
– Marsh moved account servicing from local branches to a central facility.
- The segmentation of the business into four major
client categories: institutional, middle market, small commercial, and
consumer.
- A large capex and spending effort aimed at
overhauling Marsh’s global IT platform and starting a branding campaign.
- A significant financial investment in recruiting
and paying up for talent that would help jump-start Marsh growth in the key US market.
Now, while these initiatives may
have seemed like a good idea at the time (except for spending $35M on branding
an institutional insurance broker – that was
not a good idea), the business was still fragile (Marsh continued
to lose market share in 2006, even while stabilizing margins), and all the
adjustments actually made things in the areas that Marsh tried to jump-start –
middle market, small commercial, and US risk management – worse:
- The middle market and small commercial business
saw significant client defection as a result of branch management changes and the
account centralization initiatives. It also didn’t help broker morale and
productivity that all the re-alignments increased bureaucracy markedly and made
it hard for brokers to focus on their job as opposed to dealing with the
overhaul and all the new reporting requirements it brought. Further, margins
were being squeezed by the new hiring, which brought immediate expenses and
future payoff; and by the soft P/C market’s effect on commissions.
- On the risk management side, the key problem
remains – Marsh has not figured out how to rebuild the business in the wake of
losing contingent commissions. The old way of conducting business – where contingent
commissions would pay for the risk management expertise – is not an option.
Marsh has to figure out how to structure this business – how to charge for it,
what resources to keep on hand, and how to align its cost structure properly.
In light of R&I revenue in
the Americas
being down 4% YTD and expenses being up, both due to the aforementioned
problems, overall 2007 performance is not surprising. Another hit to margins
has come from Marsh recently deciding to accrue for bonuses for 2007, which it
originally didn’t think it would have to pay out given the performance level. In
order to retain talent, though, Marsh decided it had to pay up. The actual
financial results of all this can be seen here:
|
|
2006
|
2007
|
|
2007 vs. 2006 Q1-Q3
Comparison*
|
|
|
|
Revenue:
|
3,927
|
4,040
|
|
Operating Income, ex-items:
|
522
|
401
|
|
Expense Base:
|
3,405
|
3,640
|
|
Revenue Growth:
|
|
2.88%
|
|
Operating Margin:
|
13.30%
|
9.91%
|
*The
statistics are adjusted for revenues and operating profit from RCH and
contingent commission
The good news is that even if FY
2007 margins ex-items come out 340bp below FY 2006, we don’t think that this is
the permanent state of affairs for several reasons:
Storms has been fired, the IT and advertising
initiatives are being cut, and Marsh has found somewhere in the neighborhood of
$200M in savings by cutting base-level 2007 costs. While the company will
probably spend a third to a half of that money to on payroll, that still leaves
$100M, or ~180bp of margin expansion for next year.
While all the organizational changes of 2007
have wreaked havoc thus far, the bottom line is that Marsh has hired new talent
and put new leadership in place (they actually put brokers in charge of the brokerage
– what a novel idea!). So while there has been little productivity from new
hires in FY 2007 (even though their costs have been incurred), as these brokers
ramp up (more policies sold, increased risk management consulting, etc.),
operating leverage should meaningfully kick in.
On the other hand, if revenue does not increase
meaningfully (i.e. customers paying for risk management consulting), then Marsh
has the opportunity to cut payroll to a level that would be consistent with the
service that clients expect. If a client is not willing to pay for
best-of-breed risk consulting, then the cost structure of the business will
change. What was absolutely clear to us in conversations with management is
that the present cost structure is untenable
– it either has to be levered up with sales growth or cut if there’s no demand.
While it wouldn’t exactly count as a victory if Marsh doesn’t achieve its long
term goal of growing revenue faster than the market, it wouldn’t be the end of
the world if they had to realign their cost structure to the needs of more
thrifty clients and a market rate of growth.
We’d like to add that while we’re
unquestionably in the midst of a seriously soft cycle of P/C premium growth,
history has shown (as the chart above demonstrates) that this is not a
permanent phenomenon. Soft cycles can indeed last a long time (13 years from
1987-1999 on the last one), but over an entire
market cycle NWP growth is pretty robust. In fact, over the last 50 years
in the US,
NWP growth has grown at an 8% CAGR. So while Wall Street’s analyst community
may not know what will happen over the next year or two, they can do a Google
search to figure out what the market rate of growth is in the long run. You
don’t need to assume the historical 8% in order to like Marsh’s business. We’ll
take a mature, slow-growing cash cow at the right price any day.
We assume 15.5% normalized EBITDA
margins on 2007 R&I revenue of ~$5.4B (our definition of revenue being
ex-RCH and ex-CC) and maintenance capex of ~$80M, which comes out to normalized
operating earnings of ~$750M. Over an entire P/C cycle, and factoring in that
over 40% of Marsh’s business is now overseas and growing significantly faster
than its US
business, we think Marsh can grow its revenue mid-to-high single digits over
the medium term. We also think that there is significant room for Marsh to
increase its operating margins over time off of our 14% long term estimate,
especially since management’s goal is to get closer to 20%.
ODDS & ENDS
Adding up the three components to
normalized earnings and subtracting ~$150M in corporate costs gets us to ~$1.5B
in normalized operating earnings. We adjust that number with the following:
Over the last eight years (including the
2000-2002 bear market), RCH has churned out ~$110M in “revenues.” Assuming 90%
operating margins on that is $100M in annual operating earnings.
MMC gives out stock and stock options as
compensation. Going forward, we estimate somewhere in the $50-100M range for
annual stock-based compensation.
MMC is in the process of a corporate
restructuring (not related to the
overhauls at Marsh) that aims to save a further $215M over the near term. Once
again, we assume that half of that will be reinvested in the business and that
an extra $100M in savings will actually accrue to shareholders directly.
All summed up, we end up with a
normalized operating earnings estimate of ~$1.6B annually. Enterprise value is ~$15.75B ($2.2B in net
debt, 510M shares out, $25.50 stock price, and a $600M penalty for diluting all
the options outstanding). The Market Cap using those numbers is ~$13.5B.
VALUATION & RISKS
On an EV/EBIT basis, we think a
<10x multiple is very attractive on a business with almost no capital
intensity, large upside to margins, all the downside priced in, and an above
average growth profile with little correlation to the broad economy (or in some
of the consulting businesses, slight negative correlation). On a FCF basis,
doing the math ($13.5B market cap, 32% tax rate going forward, 6.25% weighted
average cost of debt) gets you to the 7-7.5% range for a FCF yield growing mid
to high single digits over the medium term, with a 3% dividend yield and
continued share buybacks as you wait.
Defining “risk” as permanent
impairment of capital, we see very little risk here. The main source of risk in
such a free cash flow generating business would come from stupid capital
allocation. Given the company’s comments on not acquiring anything overpriced
and its actions on the capital allocation front (using almost all FCF to buy
back shares), we think that risk is limited. That said, it’s possible that P/C
market stays soft for a long time and that Marsh’s turnaround doesn’t progress.
While we think that scenario is more than priced in and that the consulting
business at some point will start to get more attention as it becomes a bigger
part of MMC, the focus today is on the execution of the turnaround at Marsh. If
that turnaround continues to stall, we don’t really know what the market’s
reaction will be (although having the stock move up in the days after the terrible Q3 earnings release is some sort
of indication of how much negativity is priced in already).
Catalyst
FY 2008 sees revenue growth without significant expense growth, jacking up operating margins at Marsh; Consulting businesses continue firing on all cylinders overshadowing Marsh business; Potential for spinoff or buy-out given balance sheet structure and segment structure of the company.