May, 2024 Update

This month's Deep Dive will be on TSMC which I'm hoping to publish sometime in the last week of this month. Following TSMC, I will spend some time out of semis for a few months and then come back to semis later in the year.

I also wanted to share some brief notes on why I have started buying Aon today.

Why I am buying Aon

I bought a ~3% position in Aon (Ticker: AON) at $282/share and am open to increase exposure if stock continues to go down.

I first covered the insurance brokers in June 2023 when I did a Deep Dive on Brown & Brown (Ticker: BRO). After owning BRO and following other insurance brokers for almost a year, I have only appreciated the simplicity of the business even more. These businesses are just as exciting as watching paint dry, but quite a few publicly listed insurance brokers have been able to keep compounding for their shareholders for decades and it’s much more likely than not that it may continue to be the case.

Aon is primarily an insurance broker that sells insurance on behalf of the carriers and gets paid largely a fixed percentage of commission on the insurance premium. I love the broker business model because a) they are capital light with ~30% operating margin and ~30% ROIC, b) there is no insurance underwriting risk and c) business is largely immune from inflation over the long-term.

However, the business is not quite immune from typical P&C cycle and revenue growth will be affected depending on where we are in the P&C cycle but for long-term shareholders, we need not fret too much over the cycle as long as we get to buy the stock at reasonable price and let the economics of the business prevail over the course of the entire cycle.

Unlike BRO, Aon primarily serves the Fortune 500 i.e. large corporate customers across 120 countries. Its revenue mix in 2023 was as follows: Commercial Risk Solutions (53%), Reinsurance Solutions (19%), Health Solutions (18%), and Retirement Solutions (11%). Revenue in terms of geographical mix in 2023 was as follows: US 44%, Americas ex US 9%, UK 14%, EMEA 21%, and APAC 12%.

Aon is quite a competitively advantaged business for serving its core customers: large corporates. Its more or less a duopoly with Marsh & McLennan (Ticker: MMC) in that segment. There’s a somewhat of a struggling  third player here: Willis Towers Watson (Ticker: WTW) which Aon wanted to acquire back in 2020 but DOJ deemed the deal to to be anti-competitive. Going through DOJ’s complaint of the deal gives you a pretty good picture of the competitive dynamics in this industry. Some key excerpts from DOJ's complaint below:

“Aon and WTW are the second- and third-largest insurance brokers in the world. Together, Aon, WTW, and Marsh McLennan (“Marsh”) tower above other firms—so much so that they are often referred to as the “Big Three.” The Big Three dominate competition for insurance broking for the largest companies in the United States, almost all of which are customers of at least one of them. The Big Three compete with each other directly on price, service, and the development of innovative solutions to the challenges these customers face. Other broking firms do not offer large customers the same quality and combination of services that the Big Three currently deliver: extensive global networks of offices, sophisticated data and analytics, a breadth of knowledge across multiple types of employee benefits and risk management strategies, strong reputations, and depth of personnel with specialized expertise. With respect to these qualities, the Big Three distinguish themselves from other firms.

High levels of concentration exist because customers view Aon and WTW—along with Marsh— as offering key advantages over other firms. First, through a mix of broad data, deep experience, knowledge, and institutional resources that outstrip smaller insurance brokers, Aon and WTW can customize their products to fit a particular client’s unique needs. Second, Aon and WTW offer, and have deep talent across, the full range of commercial risk and employee benefits products and services, allowing them to provide advice and insights that would not be possible for a smaller firm with a narrower scope. Third, Aon and WTW have extensive global networks of offices that facilitate the provision of seamless worldwide service for multinational customers. Finally, as crucial sources of business for insurance carriers, Aon and WTW are able to secure carriers’ attention on behalf of their customers more easily and promptly than could any individual customer (or smaller insurance broker).

Among large customers in the United States, Aon and WTW have a combined market share of at least 40% for broking property damage risk, third-party liability (or “casualty”) risk, and financial risk, which together account for the majority of most large customers’ commercial risk insurance expenditures.

Past attempts have shown that successful entry is difficult. For example, several years ago a number of employees from one of the Big Three attempted to start their own commercial risk broking firm with a focus on serving large customers. Despite having deep experience in the industry and existing relationships with many potential customers, this new venture failed to take much business from Aon, WTW, and Marsh. Similarly, at least one major direct-to-consumer provider spent several years attempting to expand into the private multicarrier retiree exchange market, but has since abandoned that effort due to a lack of success. This direct-to-consumer provider’s foray into private multicarrier retiree exchanges was hampered by, among other things, its lack of reputation and experience with large employers that Aon and WTW have handled for years.”

Although WTW deal didn’t go through, it didn’t quite change the reality of the competitive dynamics in this industry. WTW is still there as an independent company but AON and MMC may gradually prove to be the “the Big Two”. There’s not much of an impetus for intense price competition among the “Big Two”, so it is probably fair to assume stability in the commission structure of their core business. How about disintermediation risk?  MMC has been around for 150 years. Insurance broking is a really old business model as customers, especially large sophisticated corporate customers have always intuitively understood the inherent conflict of interest of buying non-standardized insurance products directly from the carriers. As a result, the middlemen i.e. brokers have played a key role in the insurance industry for more than a century in the US. That seems unlikely to change going forward.

One interesting thing that AON is currently trying to do is acquire its way to middle market insurance. They recently completed an acquisition of NFP for $13.4 Bn (~15x EBITDA). Success in middle market is far from guaranteed as it’s effectively a different market from large corporates. However, in case AON attains compelling economics from this deal, AON may end up being lot more acquisitive in middle market as well. If not, they may just contain themselves within large corporates. This is bit of an unknown to me, but even if Aon's foray into middle market insurance turns out to be wrong, it is unlikely to be a major setback.    

AON has organically grown its topline at ~MSD rate in the last 5-10 years and should continue to grow at nominal GDP+ 0-2% organic growth rate for years to come (again, growth can be affected by P&C cycle but this should hold true over the course of the cycle). Given the stock currently trades at ~18x P/E and they typically enjoy some margin expansion each year, we can get to LDD IRR with reasonable assumptions: ~5% organic revenue growth+ ~0-1% margin expansion+ ~5-6% earnings yield. If they manage to deploy capital at attractive ROIC by acquiring smaller middle market insurance brokers, IRR can be notched up a bit.

In the most recent quarter, AON’s organic growth lagged its peers which led to decline in AON’s multiples compared to MMC’s. Over the last 10 years, AON hardly ever traded below MMC and S&P 500 NTM EV/EBITDA multiples, but today they trade at 1-turn and 2-turn below S&P 500 and MMC NTM EV/EBITDA multiple respectively. I consider the stock to be good value.

Finally, I am writing this from Omaha. Feel free to say hello if we stumble into each other in the streets of Omaha for the next few days!

Thank you for your support.