A few days ago, a giant white balloon appeared in American airspace, purported to be some sort of spy vehicle. After meandering over the country for days it was finally shot down on Saturday.
The saga led to a whole lot of head scratching. What exactly is the strategy here? What is China trying to achieve? Why go low tech when technology has evolved so much further? It might take a while before we get to the bottom of this.
Speaking of strategy and the long game brings us to Aon earnings last week. Unlike the listless balloon drifting over the continental US, Aon continued to describe a clear plan of what it expects to achieve as it laid out its 2023 guidance.
Despite a couple of difficulties, some uncertainty over the economy and the setback of the WTW deal breakdown, the broker reported strong results for the quarter and the year, and indicated it expects growth across all the major KPIs over the course of the year.
The stock was down 2.9% on the report, which was just OK compared with other brokers, which traded in a range of -5.2% (Brown & Brown) to +1.4% (Marsh). As we discussed in our recent broker piece, the debate this quarter continues to focus on the broader direction of the economy as well as the impact of a slowing economy if potentially recessionary forces take hold. We also discussed whether broader broker commentary agrees with what we are hearing from the largest commercial insurers.
We looked at the results of the past quarter and year to examine how these metrics fared historically and compare it to the guidance from the call. We do note that the guidance Aon gives is directionally similar at year-end, so that should be kept in mind when reading the numbers.
Firstly, organic growth has seen a meaningful deceleration, but this is true of the whole cohort. With the economy cooling, we expect to see a continued downward trend for the group, including Aon. The company did give guidance saying it expects to be in the mid-single digits for growth in 2023, though we remain cautious on the economy and any effects this might have on its top line.
Secondly, margin expansion continues the strong trend we have seen over the past decade. Aon has consistently delivered 90 bps of margin expansion per year, and did so again this year, driven by high fiduciary investment income. The company’s guidance said to expect continued expansion in the coming year as it shifts their business to a more favorable mix.
Thirdly, Aon has a strong capital position, supported by free cashflow growth. The company’s return on invested capital (ROIC)-based strategy has led it to focus much of this capital on share buybacks, even as the stock price soars. This strategy has yielded solid returns, but we again remain cautious on the effects of a potential recession and how that would lower the ROIC related to their buybacks.
We address these ideas in more detail in the note below.
In terms of earnings, Aon had another strong quarter taking market headwinds into account. In general, metrics were up, with the exception of organic growth which slid 5 points from 10% to 5% year over year. EPS was up nearly 5%, beating street estimate of $3.67 by 6%.
Firstly, Aon’s organic growth has decelerated as part of the larger group slowdown.
The super-cycle got us all used to double-digit organic growth for brokers, but as the economy cools we are seeing a slow return to what we would have considered “normal” growth rates pre-pandemic. Rising inflation has extended the organic growth slowdown, but we have seen a clear deceleration in the group.
Aon reported 5% organic growth overall, below the peer average, with results lower in the risk segment at 4%.
It is worth noting that Aon does not include fiduciary income in its organic growth, which is the route taken by some of its peers.
The chart below shows overall organic growth for Aon vs. the top four competitors’ average, against the change in GDP for context.
Aon, and the rest of the group move more or less in sync with fluctuations in the economy, with only slight over- and underperformance for short periods. While Aon’s results were below the group these past two quarters, history would suggest this might be short-lived.
So, what forces are driving this slightly lower than average performance, and will the trend continue through 2023?
Christa Davies, Aon CFO, attributed the decline to the M&A and IPO environment. However, Davies also indicated on the call that the average organic revenue since 2010 has been 4%, which means that this quarter is mostly in line with general performance. And, taking into account the super-boost to average performance, it is actually a better result than the average we would have seen pre-pandemic.
The guidance from the call said to expect mid-single digit or better on organic growth, which gives a fair amount of wiggle room, though still clearly projects a same-or-better performance. Again, this is their boilerplate guidance, but it is also in line with the long-term trends.
We remain cautious on any guidance for the moment, as we wait to see how things play out in the Fed’s inflation battle. Any changes have the potential to significantly affect carrier top-line growth, which would in turn affect the brokers.
Secondly, margin expansion progresses steadily, and the trend will likely continue through 2023.
While Aon’s organic growth has fallen off a bit more than the peer group, the same does not hold for margins, where it continues to be a leader, topped only by Brown & Brown.
The chart below shows adjusted margins over time for the cohort, on a rolling basis to account for seasonality of the business. Aon stays near the top, but their expansion is not as fast as some of the smaller brokers, though that is of course because it has less room to maneuver.
The chart above looks at the adjusted margin overall, which is one view, but it pays to look at the individual components to understand what is driving this trend. Aon did increase its margins by 40 bps, which is great positive growth. However, this was due to 90 bps of fiduciary investment income.
If we exclude this number, the overall margin contracts. This is not to undermine the growth or its source, but simply to point out that FII fluctuates more than other factors in the margin calculation and might not have the longer-term growth effects that cost reduction etc. would have.
Again, expanding on the metrics for this quarter, Davies said Aon has delivered 90 bps of margin expansion per year for the past 12 years. This is a very strong trend and one Aon’s guidance said we should expect to continue.
Thirdly, Aon has a strong capital position, driven by its ROIC-led strategy.
During the call, Aon drew attention to their free cash flow (FCF) and free cash flow margins, both the highest of the year. For the quarter, FCF is down on a year-over-year basis. On an annual basis, the FCF is up rather than down, growing from $2.1bn to $3bn.
However, this growth rate is skewed by the $1bn breakup fee Aon had to pay to WTW in the prior year, which dragged the FCF down at the time. Without this one-off event, Aon would have been flat, the overall trend would be more stable.
We show the historical FCF trend below.
As with the other metrics, Aon has indicated it expects FCF to continue to grow double digits through 2023 as it grows operating income and improves working capital.
With the additional capital, Aon intends to continue its share repurchase program. The company says it is significantly undervalued and believes buybacks are the best direction, even at current prices.
These decisions are made primarily from the perspective ROIC and, given the stock growth, it is easy to understand why this would be a focus.
The chart below shows Aon’s repurchases over the past 10 years. It is clear repurchases are a consistent strategy, even when the stock is at a relative high. For example, the price had a peak in Q4 2021, and that is the largest capital outlay we have seen.
While this has clearly worked well for Aon overall to date, we remain cautious on the economy at large and the effect we might see on broker stocks should a recession materialize. If Aon does increase its free cash flow and continue buybacks at the current rate we may see a drop in the ROIC temporarily, despite the solidity of the choice thus far.
In summary, Aon has delivered strong results despite the economic forces at play. Organic growth may be down but this needs to be viewed in the context of the super-cycle, and 4% growth would have been considered great pre-pandemic.
The company continues to lead the cohort with respect to margin, and the continued double-digit growth in free cash flow gives it the leverage it needs to execute on its capital strategy. Guidance suggests these trends will continue in the near term, though it remains to be seen what effects a cooling economy will have on the cohort.
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