This article is part of our Rising Star Portfolios series.
I bought insurance broking and HR services behemoth Aon (NYSE: AON ) for my Rising Star Portfolio a few months back on a simple premise: a stellar business pegged to two catalysts. Though the timing is unclear, I believe insurance rates are almost certain to improve after seven years of weakness, and unrealized earnings potential from the recently completed Hewitt acquisition and associated restructuring could really juice the combined entity's bottom line, and cash flows.
With a quarter passed and the market decline, I'm going back for more: I'm buying another slice of Aon, in an amount equal to 2.1% of my Rising Star Portfolio's first-year capital. The short of it is this: The market's reaction to Aon's quarterly earnings, and the stock price decline, make for an even better value than before.
A run of the numbers
Let's start with the obvious. Aon's second-quarter results weren't great, and the Street wasn't too thrilled. Organic revenues were flat year-over-year, and operating margins stagnant in the company's insurance broking segment. Sluggish pricing in insurance and stubbornly high unemployment contributed to the top-line weakness, and despite seemingly encouraging progress on cost-saving initiatives, operating margins were flat on investments in the broking segment's analytics infrastructure. This worried investors.
A little context is appropriate. Aon shares trade hands at 10 times my estimate of this year's free cash flow. Effectively, the market's telling us this: Aon won't grow its cash flow again. Ever. And so while the Street worries over the quarter and economy, I see this as opportunity. A quarter hardly tells the story of the bigger picture, and my thesis remains intact.
The big picture
I've said this before, and I'll say it again: After seven years of weakness, insurance pricing needs to turn higher at some point. By some accounts, insurers aren't making money. That just isn't sustainable in the long run. Second-quarter commentary from insurers Travelers (NYSE: TRV ) , Chubb (NYSE: CB ) , W.R. Berkley (NYSE: WRB ) , and HCC Holdings (NYSE: HCC ) -- which cited pricing strength on recent catastrophe incidence -- affirmed as much. Concerns over the economy's increasingly uncertain footing, and its impact on Aon's broking segment, are similarly unfounded. Insurance is a necessary cost of operation for most any business. That means Aon's broking revenues are unlikely to fluctuate too much as the economy waxes and wanes. Evidence comes in the segment's relative stability throughout the credit crisis: Revenues were flat, even as the economy nose-dived.
And while HR services (about 40% of total company revenues) are tied to the state of a very challenging employment environment -- because its outsourcing division revenues, which comprised 20% of second-quarter sales, are tied to the number of employed -- its revenues are a lot less cyclical than you'd think. Its contracts are inked on three- to five-year terms, creating a relatively consistent and recurring revenue stream. More importantly, as the shares sit at 10 times cash flow and unemployment at 9%, my sense is the segment's earnings are closer to a cyclical trough than peak, and the valuation compensates us for the risk of rising unemployment claims.
As for analysts' concern over the brokerage segment's operating margin, I don't see cause for hand-wringing. A quarter is not a trend. If flat margins were to persist, even as the company makes progress against its cost-reduction initiatives, I might call it worrisome. But on a quarter's results, after netting a few one-time costs, I don't think it amounts to more than a rounding error. A bigger picture view is in order, again. CEO Greg Case has undertaken three major restructurings in his tenure at Aon, and each time, he's delivered cost savings in excess of originally anticipated measures. So are a few basis points on a quarterly operating margin reason to worry? I don't think so.
The bottom line
I'm not about to call a turn in the underwriting cycle, when and if the economy will actually recover, or continue to harp over the Street's conclusions. More to the point, at just 10 times my estimate of this year's cash flow, we're getting the possibility of an improving underwriting market, cost savings from the Hewitt merger, and a happier economy for almost nothing.
I like those odds, and that's why I'm buying Aon shares again.