Aon Corporation: The Only Insurance Name Worth Considering

On March 31, The Wall Street Transcript interviewed Citigroup Investment Research analyst Keith Walsh on his outlook for small- and mid-cap life insurance companies and brokers. Key excerpts follow:

TWST: Where are you pointing investors?

Mr. Walsh: Aon (AOC) is the one name I am really focusing on. As I said before, I am just shying away from the regional players. We still have some more pain there, just based on the very difficult top lines that they are going to have in 2008, maybe even heading into 2009 as well. Aon continues to be the only company that's going to grow margins and revenues at the same time in 2008, while investing $200 million plus annually within their brokerage operation. That's very powerful. Most of the other companies can't show that type of a progression in this difficult market. These guys are doing it. They have a really good management team there. The bottom line is that you are going to see them grow the top line faster than the overall market as they continue to take share from multiple competitors. It's a management-led story, which I like.

At the same time, you have a really large share buyback coming on. You are just continuing to get those expense cost saves coming through, which is getting the margin up. The reason I focus on revenue and margin is that those are the two single indicators that are going to move stock prices — organic revenue growth and margins. Aon is driving both in the right direction.

TWST: So that's what investors are going to focus on here.

Mr. Walsh: That's what investors will focus on for all these names. It's fair to say for the smaller companies that when your top line isn't growing, it is really hard to grow your margin. In fact, it's probably nearly impossible to grow your margin if you can't grow your top line at all because you have a natural inflationary cost push. It's not going to go away, because not all of your costs are variable within your compensation pool. You still have a lot of people on fixed salaries, and you have that natural push going up on the expense side. If you can't grow your revenues faster than your expenses, you are going to get margin compression. That's the problem that many of these companies face in a soft market. Aon continues to grow the top line 100 to 200 basis points faster than the bottom line.

TWST: What is it that allows them to do it? Is it purely management?

Mr. Walsh: Yes, I think this has been a work in progress for several years here. It started back in 2003 when Dave Bolger came in. He was the CFO who recently stepped down to retire, and he came in and started cleaning up this company. Aon was a consistent underperformer for many, many years. Dave Bolger came in and started to address the pension issues and added more clarity around the financial statements. Then you had Greg Case coming in 2005 from McKinsey. Greg really took it to another level by taking this great global company and adding some infrastructure around it and accountability. They have done a lot of things, much of it addition by subtraction. Frankly, they have been selling a lot of pieces of the business to make this more of a pure play broker consultant. They recently sold the remainning pieces of the insurance underwriting business. A year ago, they sold their warranty business. So they have been paring down some of their non-core assets, and at the same time, they have been investing heavily within their brokerage unit. Especially in 2007, you have really started to see it flow through. I think you will continue to see that in 2008 and 2009.

TWST: Is the restructuring pretty well done now?

Mr. Walsh: The first restructuring plan of 2005 is pretty much done. They initiated a 2007 plan as well, and they are in the beginning stages there. Based on management's ability to execute on the 2005 plan, I think most people are very confident that they can do the same with the 2007 plan. With the 2005 plan, you are looking at a run rate of $270 million of expense saves by 2008 that you will get on an annual basis. For the 2007 plan, you are going to get about $240 million by 2010 flowing through. If you think about that, the combination of those two is roughly $1 a share. We have them earning $4.15 in 2010. That's a big number, and cost saves is driving that. It is just a pretty simple blocking and tackling story. They have a new environment to adapt to. They have to cut costs and adjust to the new revenue opportunity in this environment.

TWST: Have investors been recognizing that yet?

Mr. Walsh: Yes, I think they have. You saw the stock really take off in 2007. Year to date, it has been weaker coming from the high $40s to the low $40s. But the group as a whole is off about 12% year to date. A lot of that's just driven by a tough market for all financials, but there have been a lot of news headlines around pricing. It has been a lot of negative headlines because typically in January, you get your renewal data that comes out, and that's when you get a lot of headlines about pricing. So there is no question that it's a tough top-line environment for them, but it is not anything we didn't know coming into 2008.