Aon: A Stock for Risky and Uncertain Times

This company consistently grew its earnings—until 2015; what's the outlook now for the top and bottom lines?

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Dec 07, 2016
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Aon PLC (AON, Financial) is an insurance brokerage company and a consulting company. When the world gets riskier, other companies turn to insurance to offload some of that risk. When the world gets more uncertain, other companies turn to consultants for advice and solutions.

The current environment suggests these should be good times for Aon, but its share price has dipped lately. Looking at a year-to-date chart indicates this is just another blip on the upward journey of the share price, or is it?

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Theoretically, this dip may mean the stock is undervalued, perhaps even a value stock. It is, after all, on the Undervalued Predictable and Buffett-Munger screeners list. Here’s how it looks on Buffett-Munger:

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In this article, we profile the company and assess its financial experience as well as its positioning for the future.

History

1919: W. Clement Stone starts Combined Registry Co. in Detroit.

1947: After several acquisitions, the company is renamed Combined Insurance Co. of America.

1982: Merger with Ryan Insurance Co. and Patrick Ryan takes control.

1987: Name change to Aon, a Gaelic word meaning oneness.

1992: Aon buys Dutch insurance broker Hudig-Langeveldt.

1997: Acquisition of two insurance brokerage chains, The Minet Group and Alexander & Alexander Services Inc., temporarily making it the largest insurance broker worldwide.

1998: Buys Spain's largest retail insurance broker, Gil y Carvajal, and sets up Aon Korea.

2007: The company announces it is getting out of the insurance underwriting business.

2008: Buys reinsurance intermediary and capital adviser Benfield Group Limited.

2010: Acquires Hewitt Associates which adds significantly to its human resources business and provides entry into business process outsourcing.

2012: Aon reincorporates in the United Kingdom, becomes Aon PLC and moves its headquarters to London.

2016: Announces plans to acquire Stroz Friedberg, a cyber security firm, and Admix, a Brazilian health and benefits brokerage firm.

History based on information from Wikipedia.org and Yahoo.com.

Comments: A company with a nearly 100-year history but reinvented itself over the past 30 years: a heavy emphasis on acquisitions, a change of venue and new areas of specialization.

Aon’s business

Aon PLC is one of the world’s biggest players in insurance brokerage and human resources management. According to its most recent 10-K (for 2015), its operations are divided into two segments (unless otherwise noted, information in this section comes from the 10-K for 2015):

  • Risk Solutions: an adviser and insurance/reinsurance broker.
  • HR Solutions: addresses “complex human capital and related financial challenges in the areas of health, retirement and talent.”

In a strategic and major initiative, the company got out of the insurance underwriting business almost a decade ago, calling it a low-margin, high capital-intensity business (Investor Relations Overview, September 2016). In the 10-K, it says it focuses "our portfolio on higher margin, capital light professional services businesses that have high recurring revenue streams and strong cash flow generation."

It sums up its business in this excerpt from the Investor Relations Overview:

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Aon operates in 120 countries with 500 offices worldwide and 72,000 employees.

As noted in the History section, it moved to the United Kingdom in 2012. It sums up the benefits this way in its Investor Relations Overview:

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In guru comments, Southeastern Asset Management said, “Over time, the company went from being the second-largest insurance broker in the world to the largest and also built its benefits and consulting business into a leading global competitor.”

Comments: Management at Aon has taken bold steps to transform the company, both in terms of its size and its areas of expertise. It is a much bigger and differently focused company than it was at the turn of the 21st century.

Revenue

This 10-year chart shows how revenue has grown over the past decade. Note the jump in 2011, reflecting the acquisition of Hewitt Associates:

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This chart shows revenue per share, which has grown more smoothly than operational revenue.

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The company says it is operating in markets that enjoy long-term growth and are increasing in complexity (increasing complexity is good for companies that provide consulting services).

For the future it sees revenue drivers in what the rest of the economy considers threats and problems. This list, in the Investor Overview, outlines opportunities in three areas :

Risk

  • Increasing risk, both in scope and in the amount of attention it receives.
  • Insurable activity increasing with GDP.
  • So far, low uptake of insurance in emerging countries.
  • New risks and threats expected to enter the market.

Retirement

  • A need among companies to manage risks in retirement and pension plans.
  • Increasing rate of regulatory change.
  • Aligning local needs with a global workforce.

Health care

  • Changes in the U.S. health care system.
  • Increasing costs of health care in America create needs among employers.
  • Regulatory changes increasing.

Comments: Aon has a history of growing its revenues aggressively and has plans in three sectors to help it maintain that growth.

Competitors

The company reports that it faces competitive pressures in each of its segments. For the Risk segment, that competition comes from global, national, regional and local businesses. It says competition is based on “service, product features, price, commission structure, financial strength, ability to access certain insurance markets and name recognition.”

For the HR segment, competition comes from many independent firms as well as consulting companies affiliated with accounting, information systems, technology and financial services firms.

Named competitors in the 10-KÂ are Marsh & McLennan Companies Inc. (MMC, Financial) and Willis Towers Watson PLC (WLTW, Financial); Hoover’s also names Accenture PLC (ACN, Financial) as a major competitor.

This GuruFocus table sums up the respective positions of the four big companies based on their revenue and market caps:

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Comments: Aon operates in competitive sectors, with strong competitors in both the Risk and HR segments; it does, however, have the size and resources needed to compete effectively.

Moat

In early 2015, Morningstar implied that Aon had a narrow moat, saying, “We think that gradual migration to private exchanges creates a unique opportunity for Aon to widen its economic moat, primarily through the network effect.” Of course, health care reform is once again on the table, or should we say reform of health care reform is on the table. Still, the argument for a narrow moat remains.

As noted in the business profile above, Aon says its move to the United Kingdom gives it an edge over its peers and competitors who remain in the U.S. Since the United Kingdom only taxes income within its own borders, Aon has access to more cash flow than it would otherwise. Of course, this situation may change with a new administration taking the reins in Washington.

Although not nearly as large as Accenture, Aon is closing in on $12 billion of annual revenue in a business with good margins and a lower capital intensity than its old bailiwick of insurance underwriting.

Comments: The idea of a narrow moat seems plausible. While the company operates in a relatively open environment, it does have size, scope and cash.

Growth

As GuruFocus points out, revenue growth has been predictable. To which, it might be added, revenue growth is single digit and apparently slowing:

  • 12 months: 4.6% per year.
  • Three years: 5.9% per year.
  • Five years: 7.4% per year.
  • 10 years: 8.3% per year.

Speaking to the third-quarter financials (Oct. 28, 2016), CEO Greg Case said, “Looking forward, we expect a strong finish to the year as we head into our seasonally strongest quarter, resulting in improved operating performance for the full year.”

Looking beyond this year, the company says, in its Investor Overview, that it sees “substantial opportunity for further value creation.” For 2017 it expects free cash flow of $2.4 billion, a marked increase from the $1.719 billion posted in 2015. To achieve that, the company repeats it has more access to cash because it is now headquartered in the United Kingdom.

Further, it says it deploys its cash based on return on invested capital, on a cash on cash basis. “Capital allocation to M&A, dividends, organic investment, debt reduction, discretionary pension contributions or other uses of free cash flow must beat the return of share repurchase to warrant deployment.”

Over the past three and five years, EPS (earnings per share) has grown in mid-teen percentages and even gone as high as 23.7% in the past 12 months (ttm).

Comments: Further top and bottom line growth seems likely, and while revenue growth may slow, the way the company uses capital should help it generate above average bottom line results.

Other

  • Aon is incorporated in the United Kingdom and headquartered in London.
  • While results of the Brexit vote and the election of Donald Trump add uncertainty for Aon the British corporation, they should also lead to new and more business for the company, particularly on the HR side. Other corporations on both sides of the Atlantic will need more of the consulting services Aon sells.
  • 72,000 employees in 500 offices deployed across 120 countries.
  • Independent non-Executive Chairman: Lester Knight, age 57, has held this position since 2008.
  • President, CEO, Director: Gregory Case, age 53, has held these positions since 2005.
  • Chief Financial Officer, Executive Vice President: Christina Davies, age 44, has held these positions since 2008 (information on officers from Reuters.com).

Ownership

Twelve of the investing gurus followed by GuruFocus hold positions in Aon. Chief among them is First Pacific Advisors (Trades, Portfolio) with 5,469,440 shares, representing just over 2% ownership of the firm. Steven Romick (Trades, Portfolio) and Bill Nygren (Trades, Portfolio) are the second- and third-largest holders.

A very high level of institutional ownership at over 92%:

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Note, too, a very low level of short interest, less than 1%, and how it dropped off this past summer:

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A relatively high level of insider ownership is also present at more than 8%. Patrick Ryan and Shirley Ryan own 3.19% and 3.16% while Case owns 0.21% (540,266 shares).

Comments: Strong ownership by members of the family that put the modern-day company together as well as a high level of ownership by pension funds, mutual funds and other institutional investors.

By the numbers

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Comments: Share price is slightly below the 52-week high; return on equity is strong; the dividend is small, and the company bought back a significant number of shares in 2015.

Financial strength

The GuruFocus system has rated Aon as having mediocre financial strength (5 out of 10) and strong profitability and growth (9 out of 10):

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The red icons on the cash to debt line alerts us that the company’s debt levels are high compared to the industry and when compared with its own history. That shows in this 10-year chart of long-term debt:

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The company explains, in its Investor Overview, that it has a debt metric and sticks to it: Debt to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). The range it targets for this metric is 2.0 to 2.5; in other words, a range between two times and 2.5 times EBITDA. And, as EBITDA grows, the level of debt can also grow. As this chart from the presentation shows, there’s still room for slightly more debt:

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Generally, EBITDA has grown steadily over the past decade:

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Aon says, in its 10-K for 2015, “We focus on four key non-GAAP metrics that we communicate to shareholders: organic revenue, adjusted operating margins, adjusted diluted earnings per share and free cash flow.”

As noted in the Revenue section above, the company’s revenue has been increasing, most notably in 2011 with the acquisition of Hewitt Associates.

On operating margin (nonadjusted), GuruFocus reports Aon’s has ranged between 12.49% and 17.2% over the past 10 years and is currently at 17.2%. Its margin has been expanding.

The following chart shows earnings per share diluted. Note the trend line (blue):

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Free cash flow has grown as well.

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Comments: Aon’s debt has grown significantly, but management has grown it with a plan (staying within the Debt to EBITDA ratio). It has also shown growth on the four key metrics identified in the 10-K.

Valuations

Aon is a 5-Star predictability stock, meaning it has shown a high level of consistency in growing its earnings. Assuming that earnings pull share prices up, it’s reasonable to think Aon’s share price will keep rising.

The DCF calculator at GuruFocus brings in the current price as slightly overvalued.

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As this chart shows, the price-earnings (P/E) ratio is roughly in the middle of the range it has established over the past 10 years.

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This peer group comparison from GuruFocus shows Aon running in the middle of the pack for P/E and ROE (return on equity):

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Analysts followed by NASDAQ.com have a 12-month consensus price target of $116, slightly above the current price. They split mainly between Strong Buy and Hold:

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Comments: Although Aon’s share price has dipped, it still seems reasonably priced. None of the drivers examined here suggest the company is undervalued in any meaningful way.

Conclusion

While Aon is a strong and growing company, there’s little to recommend it as a value stock. So far, the pullback hasn’t gone far enough to make it attractive to value investors, particularly those who like companies with no or little debt.

Nor will it meet the needs of income investors; the dividend is just above 1%, and the payout ratio is less than 1%. There are no signs the dividend policy will change soon.

Aon is a company for growth investors. That’s clear from its results so far this year, its dividend policy and its allocation of capital. For discerning growth investors it appears to be a good candidate for short lists as the company signals it plans to keep expanding. Along with that we know the company has the experience, expertise and resources to keep growing.

Disclosure: I do not own shares in the companies listed in this article, nor do I expect to buy any in the next 72 hours.

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