This article is part of our Rising Star Portfolios series.
It's easy to make blithe, hard-to-quantify, optimistic statements about buying into Japanese stocks, but I believe the reality's a lot more nuanced. The country already occupied a precarious economic perch, beset by spendthrift consumers, whopping debt, and a declining population. Add a massive natural disaster, and the government spending needed to rebuild from it (which means more government-issued debt), and "buy Japan" stops looking like a straightforward slam dunk.
I'd rather a moaty business with no direct exposure to the catastrophe, poised to benefit. I found all these qualities in Aon
What's good for you is good for me
Some of the world's best businesses are built on strength of a network. By offering an existing good service or good to a massive number of people, they can improve the offering in question, reduce the overall cost of doing business for end-consumers, and sell more of the product for suppliers. It's a classic win-win.
Aon works exactly the same way. Roughly 60% of its business comes from insurance brokerage, referred to as Risk Solutions, and 40% from HR services, most from the recently acquired Hewitt, which includes benefits administration, outsourced services, and consulting.
Aon is the largest insurance and reinsurance broker, and it enjoys a fabulous business here. The company acts as an intermediary between agents, who place policies, and insurance companies, who write them. There's a classic network effect here, connecting buyers and sellers to mutual benefit: Aon's able to give insurers an audience and better distribution, and grant businesses access to insurance at customized terms and better prices. Here, Aon applies its network and scale to meaningful benefit, using its market position and expertise to help clients structure very specialized contracts.
Because insurance contracts are basically needs -- and the business is an oligopoly, dominated by Aon, Marsh & McLennan
Aon’s HR solutions business, which includes recently acquired Hewitt, benefits from the same dynamic, as a provider of outsourced HR services and HR consulting. The company partners with businesses, mostly small- and medium-sized, to manage HR functions such as health-care benefits and retirement plans. These are complicated, data- and resource-intensive activities, and switching platforms is not easy. Moreover, when small businesses outsource to a capacity player like Hewitt, they're able to benefit from its scale, since Hewitt can negotiate better terms with providers.
On their own, these factors create a fairly stable and recurring revenue base. The three-to-five-year contracts customers typically sign only augment this steady stream of income. It's no surprise, then, that these businesses are also oligopolistic in nature, dominated by Hewitt, Automatic Data Processing
Brokering a deal
Despite all this, Aon is unbelievably cheap, trading for a mere 10 times my estimate of normalized cash flow. In effect, that valuation assumes Aon will never grow.
Why the bargain-basement price? Even though Aon's insurance brokering operations offer fairly recurring revenues, they're tied to the state of insurance markets. Brokers make money both on volumes and on the size of the contracts they place. Amid the global economy's downturn and a soft underwriting market, results have been passable, but hardly strong. That, and the market's failure to properly appreciate the Hewitt merger's potential, explain Aon's current stock slump.
Wall Street should think twice. Right now, three massive opportunities seem to await Aon:
Japan and Australia: In the wake of the past year's unbelievable catastrophes, including the earthquake and tsunami in Japan and the floods in Australia, that sucking sound you hear is the capital being drained from insurers' coffers worldwide. To recoup those expenditures, it's highly likely that insurers will significantly raise their rates in the years ahead. Look no further than a recent conference call, where Aon's chief brokerage officer cited insurance rates as much as 25% higher in Asia.
It'd be easy to discount this as an Asia-only phenomenon. But in truth, markets are dynamic, and the biggest insurers are global enterprises. Losses in one corner of the world affect rates everywhere else -- and industry-watchers have pegged tsunami and earthquake losses as high as $60 billion, making it the most costly natural disaster in history after Hurricane Katrina.
Reversion to the mean: We can't say for sure when underwriting markets will harden, but the seven years of declining premium volumes (and prices) just can't last. The catalysts for a near-term recovery all seem present. AIG
(NYSE: AIG), a capacity player in P&C markets and very aggressive competitor on price from the Hank Greenberg days, recently acknowledged that its competitive nature has come home to roost. It dramatically increased reserves for its P&C lines, and increased reserves mean a smaller capital base. As a consequence, AIG won't be able to write policy as aggressively or in volumes it previously had, and they’ll probably need to raise prices. Alongside the recent string of disasters, this bodes well for underwriting rates, which should mean higher revenue for Aon.
Aon's earnings power and the Hewitt acquisition: I'm normally very skeptical of acquisitions tagged as "transformative," and doubly so for restructurings. I also tend to doubt anticipated cost-savings from job cuts. Such actions rarely create value for shareholders.
But on this count, Aon boasts an impressive track record. Current CEO Greg Case, a former McKinsey partner, has undertaken three major restructurings: one in 2005, another in 2007, yet and another following the Benfield acquisition in 2008. On the first two plans, he delivered cost savings significantly in excess of previously anticipated measures, and the Benfield effort is moving ahead of plan. With the Hewitt acquisition, he's at it again, aiming to deliver $355 million in annualized cost savings by 2013, including $280 million from job cuts and consolidating leased properties.
So while I'd normally be skeptical, management's record bolsters my confidence. Note also that most of the cost savings are more concrete than the type of touchy-feely synergies we've come to expect from mergers. Furthermore, Aon's insurance brokerage and legacy consulting operations overlap nicely with Hewitt's specialties, providing excellent potential for cross-selling.
Valuation and risks
When sizing up Aon's valuation, my preferred scenario assumes that the company will average 6.5% organic revenue growth, as the underwriting market hardens and business volumes grow roughly in line with the world economy. If the company achieves 85% of its targeted cost-savings, operating margins would crest 18% in 2013. Under this scenario, I think the shares are worth $77.
The risks to this thesis are fairly straightforward. Merger integrations are challenging, and statistically speaking, most fail to realize expected benefits. While Aon's success is encouraging, it's hardly a sure thing.
Also, though there's a degree of recurrence to Aon's cash flow, premium volumes and employment fluctuate with business activity, and Aon's profitability and cash flow are tied to the health of the economy and underwriting markets. Organic revenue has hardly budged from 2008 levels, so while I think the shares' downside is relatively limited, that's far from certain. It's also possible that Aon could once again stumble into the regulatory tangles that plagued it in the past.
Still, we're not talking about advanced calculus here. Superb company + misunderstood potential = a great price. That's why I'm buying shares today. Join me at my discussion board to chat it up, or comment below.