We recently took a position in Aon (AON), the world’s largest insurance broker and human resource consultant/outsourcer. As a broker, Aon analyzes the insurance needs of corporations like Pepsi and Procter & Gamble and, using its virtually unrivaled global network of providers and database of transactions, matches these clients with the insurance companies that provide the best risk solutions at the lowest price.
Aon’s insurance brokerage business is excellent because, as a result of significant consolidation over the years, it is one of only two or three companies that have both the knowledge base and the network of insurance companies big enough to fulfill the needs of large global companies, resulting in pricing power and a sticky customer base. An additional benefit of Aon brokerage’s global scale, with two-thirds of revenues outside of the US and almost a third in emerging markets, is that the company should be able to grow revenues and profits for years to come as insurance needs in these areas continue to increase. In fact, because insurance premiums as a percentage of GDP stay relatively stable in developed markets and actually rise over time in underpenetrated emerging economies (with both experiencing some insurance pricing cyclicality in shorter time periods), a good way to think of Aon’s brokerage business is as a toll collector with built-in price increases on global GDP. This “toll-taker with pricing power” characteristic makes Aon’s brokerage business an excellent hedge against inflation since, as GDP rises in nominal terms, Aon’s revenue and profits should rise even faster.
A further advantage of insurance brokerage is that it’s mostly non-discretionary, leading to less cyclicality than the average business. Lastly, unlike insurance providers, which have to keep large cash reserves on their balance sheet to pay for claims, Aon takes no underwriting risk and its main costs are people and databases, resulting in very low capital requirements. This low capital intensity has allowed Aon to continue growing while, at the same time, paying back a lot of cash to shareholders in the form of dividends and share repurchases. CEO Greg Case is likely to continue this shareholder-friendly behavior, given that he owns $100 million of Aon stock and options personally.
Aon’s second business is human resource consulting and outsourcing. This business assists commercial customers with ongoing human resource and compliance requirements in areas such as health and retirement benefits and talent retention and compensation. In addition, Aon consults on special human resource projects, which are most often driven by regulatory change, like the recent U.S. healthcare legislation. Until recently, Aon’s consulting business was subscale, but the company’s mid-2010 acquisition of Hewitt Associates solidified its position as one of a few global leaders of HR consulting, further strengthening Aon’s competitive advantage. HR consulting has many of the same characteristics as insurance brokerage (low capital requirements, significant room for international growth, oligopolistic industry structure, etc.) and is complementary to insurance brokerage since, at many organizations, the same person is responsible for both risk and human resource solutions.
While Aon’s stock is priced attractively relative to the current level of earnings, we think it’s even more attractive when one considers that earnings actually understate the true level of cash flow that the business produces. As a result of accounting complexity from the Hewitt merger, free cash flow is substantially higher than earnings yet many investors still focus on earnings multiples. As free cash flow and earnings converge over time, the free cash flow multiple should expand.
Finally, not only are current earnings understated relative to cash flow, but we believe the company’s current cash flow is actually at a cyclical low point, making the stock even cheaper. Insurance rates have declined for the last eight years, and insurance premiums to GDP are now at generationally low levels. When insurance rates turn and premiums rise, as they always eventually do, this revenue upside should provide a boost to earnings. Additionally, as part of Aon’s role as a broker, Aon takes cash from its corporate customers and pays its insurance providers. While it only holds this cash for a very short time, Aon processes so many transactions that it always has a meaningful amount of customer cash on its balance sheet. Aon’s customers allow it to invest this money at risk free rates, enabling Aon to earn an extra profit. Currently, the Fed is artificially holding rates at almost zero percent, preventing Aon from capitalizing on this “float,” but if and when interest rates turn around, we anticipate another significant bump to earnings over time.
While this investment certainly doesn’t meet the standard definition of risk arbitrage, we’re sure you can see why the phrase came to mind as we were writing this article. We hope to make a profit from the business of risk for many years to come.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.