This article is part of our Rising Star Portfolios series.
I bought insurance broking and HR services behemoth Aon
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
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.
Michael Olsen does not own shares of Aon. The Motley Fool owns shares of Aon and W.R. Berkley. Motley Fool newsletter services have recommended buying shares of Aon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.