TFC - Aon Has Some Reinsurance Upside But The Value Proposition Is Lacking

Summary

• Aon's fourth quarter earnings were lackluster, with weaker organic growth than its peers and less margin leverage.
• Weaker M&A activity hit the Commercial Risk business, but a hard reinsurance market could drive better results through 2023.
• There's nothing wrong with Aon per se, but opportunities to meaningfully accelerate revenue growth and/or margin expansion seem more limited at this point in the cycle.
• Discounted cash flow suggests Aon could still be worth holding, but there doesn't seem to be much undervaluation here.

At this point in the cycle I would generally prefer to own a high-quality insurance broker than a run-of-the-mill insurance underwriter, as I expect more pressure on pricing and I don’t see recent pricing as all that strong relative to underlying loss trends. Aon plc ( AON ) is definitely a high-quality broker, but the valuation amply reflects that and I can’t work up a lot of enthusiasm for the shares beyond thinking they’re an okay place to hang out if you just have to have exposure to the space.

Lackluster Fourth Quarter Results

Aon’s fourth quarter results weren’t terrible, but they weren’t particularly good either. Not only did the company miss earnings expectations after adjusting for taxes and other items, but the growth here was noticeably slower than at rivals like Brown & Brown ( BRO ), Marsh & McLennan ( MMC ), and Truist’s ( TFC ) insurance brokerage operations.

Revenue was up 2% as reported, or 5% in organic terms, coming in a little lower than expected. Commercial Risk, which reported 4% organic growth, was the driver of the underperformance, with weaker M&A/transaction liability business in the U.S. driving the shortfall – underlying growth would have been closer to 9% otherwise, with healthy growth in Canada and Latin America, as well as in the Affinity business. Aon’s other units were stronger than expected, but weren’t enough to offset the weaker Commercial Risk results – Reinsurance was up 9%, Health was up 7%, and Wealth Solutions was up 6%.

Aon also got a nice little boost from higher fiduciary investment income, with this line-item improving almost 58% qoq on higher rates.

EBITDA rose 2% and adjusted operating earnings rose 3%, with EBITDA margin up 50bp and operating margin up 40bp. That’s a weaker result than the roughly three-point improvement seen at Brown & Brown and Marsh & McLennan. Aon actually missed by about $0.06/share on a clean adjusted operating earnings basis, though lower taxes offset by higher other items drove a $0.22/share bottom-line beat.

I should note as well that earnings quality has long been an issue with Aon. While all of the major brokers are fairly aggressive in their non-GAAP adjustments, Aon tends to be more aggressive.

Reinsurance Is A Positive, But Other Trends Are Choppy

As I said above, commercial property & casualty insurance pricing trends have been pretty mixed, with ongoing deceleration as a once-in-a-generation hard market starts to slow. Pricing has settled toward the mid-single-digits lately, and the brokers (Aon included) expect this to continue. A slower economy is likely to limit pricing power, but a lot of the pricing “strength” of late has been driven by increasing loss trends that don’t seem to really be abating.

This is relevant to Aon because brokers are paid commissions on the basis of price and volume. Weaker premium volume growth is a headwind to growth in 2023 and beyond, and I don’t see much pricing leverage in mainline P&C at this point. Still, this is a point in time where Aon’s global diversification (less than 50% of revenue from the U.S.) and its strong consulting capabilities can add some incremental volume.

I am more bullish on reinsurance, and Aon is the largest reinsurance brokerage in the world. Pricing was strong at the Jan 1 renewals (up 20% in many cases), and many clients were unable to meet their full anticipated needs at the Jan 1 renewal. Not only is strong pricing a tailwind for Aon, but I see enhanced opportunities here as clients will try to adjust to their exposures to offset the price pressure – in other words, reinsurance is getting more complex and that should suit Aon’s capabilities.

As far as the benefits businesses go, I think this is a solid long-term opportunity for Aon, and the company has strong exposure to areas like private health exchanges and pension risk transfer that should offer good growth opportunities. In the near term, though, a lot depends on where employment goes – so far the numbers have been strong, but I do see some risk later in the year.

The Outlook

Aon management guided to “mid-single-digit or better” growth in FY’23, and that was pretty much in line with everybody’s expectations. I do have some minor margin concerns here, given the fourth quarter weakness and what should have been positive momentum from the better fiduciary investment income. I don’t have an issue with management reinvesting some of the “bonus” margin back into business development, but I think Aon could have a harder time meeting/matching their traditional year-over-year improvement in FY’23 (the company has averaged around 90bp of yoy improvement since 2010) given inflationary cost headwinds and normalization of expenses post-pandemic (resumption of travel and so on).

Relative to most brokers Aon steers clear of M&A (the failed attempt to acquire Willis Towers Watson ( WTW ) notwithstanding), and I’m fine with that. The company has shown over the years that it can organically enter the markets it deems attractive, and I expect that to continue. I also expect the company to continue to leverage its large global presence as well as its large presence in the U.S. market to continue to take share from smaller, less capable brokerages. I expect around 5% to 6% long-term revenue growth, with margin improvements driving FCF margin to 30% and beyond and supporting high single-digit FCF growth.

I value brokers like Aon through a mix of discounted cash flow, EV/EBITDA, and P/E, but none of these suggest that Aon is particularly cheap today. Discounted cash flow offers a little bit of upside, with a long-term annualized potential total return in the high single-digits, but even using multiples on the high end of the historical ranges doesn’t suggest much upside on EBITDA or EPS.

The Bottom Line

I’m fine with the idea of brokers as high-quality safe havens in uncertain markets, and I do see some upside here from the reinsurance business. What I don’t see is much of a discount to multiples that are already on the high end of historical ranges at a time when the business (and the economy) is slowing. Aon may work here as a hold for some investors, but I don’t find it a particularly compelling buy.

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