Aon plc
Q2 2017 Earnings Call Transcript

Published: 4 Aug 2017

[Operator:]

Good morning and thank you for holding. Welcome to Aon Plc's Second Quarter 2017 Earnings Conference Call. At this time all parties will be in a listen-only mode until the question-and-answer portion of today's call. If anyone has an objection, you may disconnect your line at this time. I would also like to remind all parties that this call is being recorded and that it is important to note that some of the comments in today's call may constitute certain statements that are forward-looking in nature as defined by the Private Securities Reform Act of 1995. Such statements are subject to certain risk and uncertainties that could cause actual results to differ materially from historical results or those anticipated. Information concerning risk factors that could cause such differences are described in the press release covering our second quarter 2017 results as well as having been posted on our website. Now it is my pleasure to turn the call over to Greg Case, President and CEO of Aon Plc.

[Gregory C. Case:]

Thank you and good morning to everyone. Welcome to our second quarter 2017 conference call. Joining me here today is our CFO, Christa Davies. I would note that there are slides available on our website for you to follow along with our commentary today as usual. Before I begin the discussion on our finance results, I'd like to spend a few minutes talking about Aon overall, on our work to continuously strengthen our firm, consistent with our record of value creation. This was an exciting quarter for Aon, as we completed significant steps to reinforce and build upon a decade-long strategy to be the leading global professional services firm, providing a broad range of risk, retirement, and health solutions enabled by proprietary data and analytics. In the second quarter, we completed the divestiture of our outsourcing platform, a natural acceleration of our strategy and a tremendous accomplishment made possible by tireless united efforts of our colleagues around the globe. The divestiture provides a further catalyst for our strategy and actions to deliver shareholder value as it reinforces our focus to provide advice and solutions and further aligns Aon's portfolio around our clients' highest priorities. This move also generates approximately $3 billion of additional capital to accelerate investment in emerging client needs and in our firm. And finally, the divestiture reinforces our return on invested capital decision making priority and emphasis on free cash flow. Overall, our optimism is built through conviction that the actions we're undertaking will substantially strengthen our firm even further, on the heels of a decade of improvement and innovation for our clients and shareholders. With this momentum, we're already seeing improvement in our growth profile, driven by new investment in high growth, high margin areas across our portfolio. For example, our organic growth has consistently accelerated in the first half of the year from 2% in 2015 to 3% in 2016, to 4% now in 2017. And we're taking further steps to unite Aon with investments to unify and progress toward a single global business services operating model, increasing Aon's efficiency and connectivity. And through one global P&L encompassing all of Aon's industry-leading capabilities, helping us achieve our commitment to deliver all of global Aon to our clients in their local market. Now, turning to the quarter on page five of the presentation. Consistent with previous quarters, I'd like to cover two areas before turning the call over to Christa for further financial review. First is our performance against key metrics we communicate to shareholders. Second is overall organic growth performance including continued areas of strategic investment across Aon. On the first topic, our performance versus key metrics, each quarter we measure our performance against the key metrics we focus on achieving over the course of the year

[Christa Davies:]

Thanks very much, Greg, and good morning, everyone. The actions we currently have underway place us in a position of strength to unlock the next wave of shareholder value creation. In the second quarter, our colleagues around the world jointly accomplished a significant step of our journey with the completion of the sale of our outsourcing business, a tremendous amount of work and dedication from the global team. Against that backdrop, in Q2, we delivered organic revenue growth across every major revenue line, strong operational improvement and double-digit earnings growth, highlighted by the repurchase of $1 billion of shares in the quarter. Turning to slide 10 of the presentation. Our core EPS from continuing operations excluding certain items increased 13% to $1.45 per share for the second quarter compared to $1.28 in the prior-year quarter. Certain items that were adjusted for the core EPS performance and highlighted in the schedules on page 11 and 12 of the press release include non-cash intangible asset amortization, which includes an impairment charge on intangible assets related to the sale of our outsourcing business, restructuring charges, charges related to certain regulatory and compliance matters and non-cash expenses related to pension (10

[Operator:]

Thank you. We will now begin the question-and-answer session. The first question comes from the line of Sarah DeWitt from JPMorgan Chase. Your line is now open.

[Sarah E. DeWitt:]

Hi. Good morning.

[Gregory C. Case:]

Hi Sarah.

[Sarah E. DeWitt:]

First on the organic growth, given all the investments you're making and that you discussed, how should we think about how much incremental organic growth those investments could drive over the longer-term?

[Gregory C. Case:]

Sure. From our standpoint, first, if you step back and think about progress, you're already starting to see in our view some leverage coming from the investments we're making, we've made historically in areas like the Exchanges, in areas like cyber, in areas like data and analytics and the work on the Risk Insight Platform. And if you think about it, Christa and I both highlighted this, in the first six months, reflecting back in 2017, 4% growth versus the first six months in 2016, which was 3% versus the first six months in 2015 which was 2%. So, in essence you're starting to see, as Christa highlighted, a portfolio which has got greater and better growth characteristics than we've had before. So, you're going to continue to see that progression. Obviously we're not going to give guidance on this other than to say we expect to see greater growth potential in Aon going forward from the investments we're making, but also from the portfolio changes we've made with the divestiture of our outsourcing business.

[Sarah E. DeWitt:]

Okay. Great. Thank you. And then just on the margin, you had strong year-over-year expansion this quarter. However, if you take out the expense savings and the pension and the E&O impact, it implies that the margins slightly contracted year-over-year. Is that just because of seasonality, where I think in the first three quarters of the year you don't have much margin expansion and then most of the underlying expansion comes in the fourth quarter or is there something else going on?

[Christa Davies:]

So Sarah, what I would say is, as you look at the first half of 2017, operating income is up $117 million, of which $54 million of that is coming from savings from the restructuring program. So, if you think about it, operating income is up 12% for the first half of the year year-over-year and then excluding savings it's up 6%. So we do see strong growth in operational performance on an underlying basis. So we feel really good with the first half performance on an underlying basis.

[Sarah E. DeWitt:]

Okay. Is there any seasonality we should be thinking about in terms of the quarterly growth?

[Christa Davies:]

Not really. I mean, as you said, Q1 and Q4 are seasonally stronger quarters for us and that continues to be true.

[Sarah E. DeWitt:]

Okay, great. Thank you.

[Operator:]

Thank you. Your next question comes from the line of Dave Styblo from Jefferies. Your line is now open.

[David Styblo:]

Hey, good morning. Thanks for the questions. I just want to talk about visibility for the rest of the year. Do you guys have stats or keep stats on how much of your expected revenue you've got locked in on this point, and maybe an update along with retention that would go towards that? And specifically, I want to ask a little bit more about the Reinsurance business. Obviously you've had some good results on the organic side. And just in canvassing the news, I'm picking up that you guys have won several accounts, especially down in Florida with People's Trust, Capitol and Argo Group outside there. Is there something – maybe those are isolated wins and it's just part of the portfolio that moves it up and down, but is there any sort of shift that you guys are seeing in terms of new wins or progress either in Florida or more broadly across that book?

[Gregory C. Case:]

Well, I'd say first of all, David, your first question around visibility into the rest of the year on revenue and organic growth, look, we continue to make investments to strengthen the firm as Sarah highlighted on the last question. Remember, this business, I highlighted in our Commercial Risk business a 93% plus retention business. So from that standpoint, a pretty sticky business. That gives us a lot of visibility into what happens in the second half and what happens throughout the year for that matter. Still, doesn't mean we don't invest heavily to try to drive that up, but we've got a lot of visibility in what that baseline looks like. So happy to come back to that, but a lot of visibility there. On the Reinsurance side, listen, to us this is just a continuation of what our team has done. We've got an exceptionally strong team on the Reinsurance side. We continue to add talent, but we start from a unique position. We're the number one player in treaty, number one player in fac, number one player in ILS. And we've encountered a number of headwinds over the years as it relates to the pricing, particularly in the U.S., particularly in U.S. property, particularly in U.S. property cat where we're number one in all those and yet our team, against that headwind over the last number of years has done nothing short of just keep investing in innovation. And you've seen us do things in mortgage; you've seen us do things in other areas that no one else has done to actually create new markets and new capacity, new opportunities, and you're seeing us be able to react to client needs around reducing volatility, improve returns and help them grow. That really is just unmatched from that standpoint. And so for us, that need from a client standpoint is very high. We keep investing to do that and you saw us in the quarter deliver what has been 6%, probably close to the highest we've been in a long, long time. But really, again, consistent with our conversation, we wouldn't look at the quarter. We'd say in the first half, we've delivered 4% in the first half and we look for continued progress on the reinsurance side. It candidly draws from the strength of the team and what we can do on behalf of clients.

[David Styblo:]

Okay. Great. Thanks. And then on capital deployment, you guys obviously stepped up the buybacks in the second quarter there. Is that maybe about as high as you'd like to go in a given quarter for the pace of buybacks and maybe it steps out a little bit in the back half of the year, or what's dictating that versus potential M&A opportunities in the pipeline that you look at? I know you guys have characterized M&A pipeline as something that you'll probably do similar deals to what you've done in the past and be selective with those. But curious how the M&A opportunities might balance what you're doing in terms of share buybacks given all the cash on the books right now.

[Christa Davies:]

Well Dave, as you know, we do think about allocating cash on a return on capital basis. That is the way we allocate cash between share repurchase, M&A, organic investment or any other use of cash. And as we think about that the highest return on capital across the firm remains share repurchase which is why you've seen us do $1 billion of share repurchase in Q2. As we think about use of cash for the balance of the year, you can see we've got $3.4 billion of cash and short-term investments on the balance sheet. We are generating substantial free cash flow in the second half of the year. It's our seasonally strongest half of the year, and so we have tremendous capital flexibility. And we do see us continuing our share repurchase given the exceptional return on capital that generates. We also have a very attractive pipeline in M&A. It's probably the most significant it's ever been historically and so we expect to continue M&A, and so I think you'll see a mix of uses across the portfolio.

[David Styblo:]

Great. Thanks.

[Operator:]

Thank you. The next question comes from the line of Kai Pan from Morgan Stanley. Your line is now open.

[Kai Pan:]

Thank you, and good morning. My first question is on the restructuring program. You spent almost like 40% of total program cost in the quarter. Can you talk a bit more in detail about the action that have been taken? I'm also wondering has this restructuring has any temporary impact in term of disruption of your business like organic growth?

[Christa Davies:]

Yeah. So Kai, what we would say is the overall purpose of the program is to create the next generation operating model for AON, bringing together everything into one operating model for AON. We call it AON United. And we're bringing together one operating model across the firm to drive greater operating leverage and to deliver additional insight, connectivity and efficiency, primarily in IT, in real estate and in people. If you think about the 40% of the restructuring charge we've used year-to-date, it's primarily been in workforce reduction and we do think about that as setting up the future operating model of Aon. Longer term, because it takes longer to come through, you'll see more IT and you'll see more real estate. We don't believe this is having a disruption to the firm. If you look at the first half revenue growth as Greg highlighted, we've accelerated revenue growth 2% in the first half of 2015, 3% in the first half of 2016, and 4% in the first half of 2017. And so we do believe actually bringing together Aon under Aon United will help generate benefits for clients, because we're bringing together a common approach for clients which we think is going to be exceptional.

[Kai Pan:]

That's great. My second question is on the regulatory front. Do you have any updates on FCA investigation, the PRA like look into the market in the London market? As well there is a recent report from FCA on investment consultant. I just appreciate your updated view on this.

[Gregory C. Case:]

Yeah, happy to talk about both of those, Kai. On the first piece, first overall, you know how seriously we take compliance and regulatory matters, and will continue to do so. Certainly focused on the FCA and what they're looking at. We took a $34 million charge in the second quarter for regulatory matters that are part of this, subject to this investigation. We obviously can't comment much further on that, but we're going to continue to work that arena very, very strongly and again, take it very, very seriously. On the asset management side on the FCA from that standpoint, this is an area they're looking at overall, and really they're evaluating fiduciary standards which we do today. What we would say and this is listen, this is any place we can create more client transparency, opportunity for more client value, we're very much in favor of and you will see us supporting in every way we possibly can.

[Kai Pan:]

That's great. Thank you so much.

[Operator:]

Thank you. The next question comes from the line of Adam Klauber from William Blair. Your line is now open.

[Adam Klauber:]

Good morning. Hi everyone. Two questions. How is the Cyber with Stroz, how is that business doing? Is it growing? And then also how's Inpoint doing?

[Gregory C. Case:]

I'm sorry. The second question, Adam was?

[Christa Davies:]

Inpoint.

[Adam Klauber:]

Oh, sure.

[Gregory C. Case:]

Inpoint. Excellent. Thank you. Got it. So, on Cyber overall and Stroz, again remember you have to take a step back. We had a very strong position in Cyber, exceptionally strong, disproportionate share of the overall placement in the market, and our colleagues said listen, although we've got this position and it's growing nicely, when you think about overall client need, it really is outstripping where the insurance industry is, and by the way, the industry, that's really all of us. So, we're not pointing fingers. We're really looking at Aon and saying how can we actually change that? And again, if you look at the reported loss in cyber or cyber-related items, it's $450 billion plus in the U.S., and by the way, the European theater is now just opening up as the regulation begins to change. So you're about to see a number which is going to get close to $1 trillion plus in cyber reported loss and yet the insurance world is about $2.5 billion to $3 billion in premium overall. And so when we looked at that we said, look, why is that? And what we saw was it was difficult and hard for balance sheets or insurance partners to actually apply capital against cyber without a better understanding of the root cause and the drivers of it. And so we went about bringing in capability and talent really to address that on top of what we have today before. And so from our standpoint, it is really a real opportunity for us to serve clients in a very, very effective way. And we're really doing a set of things in cyber that help redefine the marketplace to create opportunities to bring more capital in. So it's been exceptionally strong and we're looking forward to next steps, really in terms of what we can do on behalf of clients. So Cyber is very, very positive with lots of opportunity and a lot to do. On the second piece on Inpoint, what I'd really like to talk about is the category, which is really Data & Analytics. What we've got from that standpoint is a broad set of relationships we developed over time, many of them underpinned by true content, true insight on Data & Analytics. And what we see, and Inpoint's part of this, but really the whole category in Data & Analytic Services is really an opportunity for us to actually bring Data & Analytics to the table in a way in which you help clients understand risk differently, mitigate risk differently, understand opportunities, reduce volatility in a unique way and that's why we are so excited about the whole category of Data & Analytic Services, of which Inpoint is part of.

[Adam Klauber:]

Great. Just one follow-up, is it possible to see deals in one of those two categories, given such a bright future?

[Gregory C. Case:]

Yeah. Listen, you're going to see us invest, as Christa said before, in areas where we think we can apply capital to improve return on invested capital and serve clients. So you'll see us think about areas where we can bring in content and capability irrespective of – the revenue lines we've broken out, we're very excited about each and every one of them, all of them going through transitions and change as we invest in and around it. And you're going to see that in Data & Analytic Services, you're going to see that in Health, you're seeing that in Retirement, seeing that in Reinsurance and you're certainly going to see it on the Commercial Risk side.

[Adam Klauber:]

All right. Great. Great. Thanks a lot.

[Operator:]

Thank you. The next question comes from the line of Elyse Greenspan from Wells Fargo. Your line is now open.

[Elyse B. Greenspan:]

Hi. Good morning. I first had a question, a follow-up on the margin improvement you guys saw in the quarter. You guys saw underlying revenue growth of 3%. I calculate your underlying adjusted expenses grew about 2% in the quarter. I think what's hard for us to see is how much of the margin improvement is being driven by your revenue growth exceeding your expense growth versus just the savings program falling to the bottom line. Because I know you call out the $44 million of savings in the quarter, but how much of that hit your margins versus how much margin improvement are you seeing from your core business? And I would think, given the pickup in Reinsurance growth in the quarter, that would have been beneficial to your margin, since it's a pretty high margin business. Just a little bit of more color there?

[Christa Davies:]

So, what I would say, Elyse, is as we think about the quarter, there are lots of things that happen that are lumpy in a quarter, and I would go back to the first half of the year, because it's a much clear trend, and frankly it's much more indicative for full year 2017. And so as you look at the first half of the year, you do see operating income up $117 million, which included $54 million of savings. And so as you think about operating income growth year-over-year, 12%, excluding savings 6%, so that's giving you your underlying operating income growth. And we are getting underlying margin expansion as well, and so we do feel very good about the operational improvement in the first half of the year, which is on track for full year performance.

[Elyse B. Greenspan:]

Okay. And then is there any way – I mean, we have $100 million of expense saves coming in the second half of the year. If you could help us think through, I mean, what percent fell through, fell to the bottom line in the second quarter and how you're thinking about more saves potentially falling in the back half of the year that could lead to stronger margin improvement?

[Christa Davies:]

Yeah. So, what we have said, Elyse, is that the $44 million of savings we had in Q2 was before reinvestment. We are absolutely going to invest in high growth areas that drive expansion of margin and growth in free cash flow, and you can see those investments that we're making over the last couple of years have contributed to our accelerated organic revenue growth. And so we aren't going to give guidance in the second half of the year. We have said for full year 2017 that our savings for 2017 will be $150 million, but we haven't given guidance on what percentage we will reinvest.

[Elyse B. Greenspan:]

Okay. Can you let us know, how much shares have you guys bought back quarter to-date?

[Christa Davies:]

So, we don't give guidance on shares. What we can say is we bought $1 billion of shares in Q2. And as I mentioned on a previous question, as we think about the balance of the year, we've got $3.4 billion of cash and short-term investments sitting on the balance sheet. We're generating substantial free cash flow in the second half of the year. The second half of the year is our strongest free cash flow half. And as we invest that cash, our highest return on capital opportunity remains share repurchase. And so we expect to continue to repurchase stock in the second half of the year.

[Elyse B. Greenspan:]

Okay. Thank you very much.

[Operator:]

Thank you. Next question comes from the line of Brian Meredith from UBS. Your line is now open.

[Brian Meredith:]

Hi. Yeah. Just a couple quick numbers questions here for you. On the Reinsurance business, the capital market stuff can be really, really lumpy. Is it possible to get what the benefit to organic revenue growth was in the quarter from the cat bond and capital markets?

[Gregory C. Case:]

Brian, we really, as I said before, really don't look at it that way. And again, we're essentially helping clients to improve return on their own capital, whether it's from cat bonds or treaty or fac and all the different pieces around that. So we really look at them together and it was certainly a strong part of the quarter for us, as I highlighted, given the position we've got. We've got a very strong position in this category. But we've got strong positions in the other categories as well.

[Brian Meredith:]

Okay. And then, a second question. Christa, I'm just curious, the pension headwind that you had in the quarter, is that going to persist here for the rest of the year?

[Christa Davies:]

Yes.

[Brian Meredith:]

Great. Thank you.

[Operator:]

Thank you. Last question comes from the line of Jay Cohen from Bank of America. Your line is now open.

[Jay A. Cohen:]

Yes, thank you. Just a question. On page 12 of the slide deck, you talk about the $900 million of investments you plan on making, but then you also talk about reinvesting potentially some of the savings. What's the difference between the initial investment, $900 million, and then any potential reinvestment?

[Christa Davies:]

Well, so Jay the $900 million is really a restructuring charge. It's a one-time charge to generate the savings. So if you think about the return on capital, that you're investing $900 million in cash and you're generating $400 million of savings. So that's the way we think about the return on invested capital of that particular exercise. And there's a separate exercise which is, as we come across terrific growth opportunities, and Greg talked about several of them, whether it's data analytics, whether it's health and elective benefits, whether it's delegated investment management, then we will look at those as separate exercises and we will invest organically to get a return in those businesses. And you've seen them generate an acceleration in our organic revenue growth, they contribute to margin expansion and they particularly contribute to our double-digit free cash flow growth that we expect to do annually going forward. And so, what I would say is, we don't expect all of the $400 million of savings to fall to the bottom line, but we certainly expect the reinvestment in savings to generate accelerated revenue growth, margin expansion and free cash flow growth going forward.

[Gregory C. Case:]

One of the things, Jay, as you look at what we have done, put them in the second quarter, it really, for us, is just an example of our reinforcement of the overall game plan and that's reflected in the first half performance. If you think about the Aon of 2016 versus the Aon of the future, we believe as you look at that picture, that from two, it's a pretty compelling picture. The Aon of 2016 delivered 16% TSR for a decade, which is fine, but we expect the Aon of the future, as we go through the restructuring, as we invest, continue to invest in organic opportunities, is going to deliver the near-term EPS expectations you all have, but we're going to end up with a platform that's higher growth, higher margin, higher ROIC, higher free cash flow growth and higher operating leverage that's going to support future improvement and it's going to put us, as Christa described, fully on track to deliver double-digit free cash flow growth over the long-term. So, that's the program we've undertaken. That's what we're very excited about and we see the first half of the year fully reflecting that progress.

[Jay A. Cohen:]

Got it. That's helpful. Last question. You talk about going forward, one source of additional cash flow is a lower tax rate over time. Your tax rate is so much lower than any competitor. Clearly your structure's a bit different too, but how much lower can the tax rate go from here?

[Christa Davies:]

Well Jay, what I would point out though is what you saw with our non-GAAP tax rate in Q2 of 15.6% was that was impacted favorably by positive discretes. And so, excluding those positive discretes, the underlying non-GAAP rate would have been approximately 17.5% for Q2 and that is exactly the same as what we said, the underlying rate, underlying non-GAAP rate would have been approximately 17.5% for Q1 this year too. And so, what we do think is there is opportunity over the long-term to reduce that rate, but in addition to that, there's the timing of the cash rate and the effective tax rate over time and the cash rate is slightly above the effective tax rate today and it will come down to equally effective tax rate over time and accelerate free cash flow growth doing that.

[Jay A. Cohen:]

That's good clarification. Thank you.

[Operator:]

Thank you. I would now like to turn the call back over to Greg Case for closing remarks.

[Gregory C. Case:]

Ashley, thanks very much. Just want to say to everyone thanks very much for joining the call and we look forward to our discussion next quarter. Have a great day.

[Operator:]

Thank you. And that concludes today's conference. Thank you all for joining. You may now disconnect.