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Marsh McLennan Q3: Brokerage supercycle continues to run in a high gear

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In September 2018, shortly after commercial pricing turned positive, Marsh McLennan announced the acquisition of JLT. The transaction positioned the company for long-term growth, with Marsh buying a faster-growing revenue mix with attractive exposure to emerging markets.

However, the acquisition, which closed in 2019, led to Marsh McLennan playing defense on talent leakage and working to manage morale as is typically needed you pull the expense levers. While the company managed to improve margins, the company’s efforts fought headwinds such as organic growth lagging behind peers, particularly Aon.

At the time, management estimated the JLT adjustment period would persist for up to two years.

Fast forward over two years and Marsh McLennan’s management kept its promise. Third-quarter results included solid organic growth across all of Marsh McLennan’s segments, with a consolidated 13% (in line with Q2). But, in some respects, the tables have also turned, with the attempted Willis merger putting Aon on the defensive.

Meanwhile, rival Aon has found itself fielding tough questions on its future strategy and on the distraction the failed Willis merger may have caused amid the brokerage supercycle, while Marsh boasts about record hiring.

The chart below shows that the trailing four quarters of organic growth were slower for Marsh from 2016-20, with the pandemic and the failed Aon-Willis merger leading to an inflection point.

But the good news was largely expected, with Marsh nearly matching market consensus. Brokers are expected to report strong top-line growth, aided by insurance rates and the economic recovery, and companies reporting anything less than stellar results this quarter are likely to see an adverse stock reaction.

Marsh McLennan’s 13% growth is just ahead of Truist’s report from last week, noting organic growth of 11.9%, down from 14.8% in Q2, and still much higher than the 3%-5% widely used as a base case for intermediaries. (Truist, however, has wholesale business in the mix than Marsh McLennan where the market is hotter, giving it stronger tailwinds than the retail giant has.)

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The longer term view remains mixed, as market conditions will eventually flatten and then potentially reverse, making organic growth harder to obtain and the financial arbitrage supporting inorganic growth less attractive as interest rates rise.

At that time, the focus will shift from growth to margin expansion. In theory, Marsh appears to be preparing for this scenario, giving up margin improvement now and investment in the business to achieve longer-term margin improvement.

Hiring will undoubtedly help the company benefit from favorable conditions in the coming years. With long-term inflation and a slower economic recovery becoming a more plausible outlook, the company may be betting on an even longer brokerage supercycle than it's letting on.

This quarter, Marsh McLennan saw another quarter of double-digit growth, with margins remaining flat YoY.

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We have three additional key observations on yesterday's results.

First, the sustained P&C pricing outlook for 2022 is in line with the consensus view, but management’s tone could set the stage for rate moderation.

P&C pricing has been given a boost by the rise of social inflation and elevated catastrophe levels. Marsh McLennan management noted that 2021 has so far seen over $100bn in global catastrophe damages, with one quarter still left in the year, continuing a five-year sprint of elevated losses.

Management also warned that social inflation is dependent on the court system fully reopening post-pandemic and is likely to increase as court proceedings normalize.

On the earnings call, Marsh McLennan traditionally provides some spoilers on its Global Insurance Market Index report that is published a couple of weeks after its earnings release.

The chart below shows that last year, in the third quarter of 2020, global insurance composite rates grew at their fastest pace of the cycle – 22% YoY. Since then, rates have still been advancing, but at a moderating pace.

Rates grew by 15% YoY this quarter, matching pace with last quarter. Note, Marsh’s index skews to larger accounts, and similar dynamics have occurred in middle-market and small-market accounts, although to a lesser extent.

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Management noted that clients continue to find the market challenging, and elevated pricing has translated into higher retentions and more captives.

Nonetheless, rate increases appear to be sustainable near term, with a possible inflection point in early 2024. Although management was also bullish on rates into 2022, it noted that public D&O pricing is experiencing "settling" as rates continue to decelerate.

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Second, organic growth is starting to moderate as the economic recovery slows, with the first signs of a potential lag versus pricing.

The post-Covid economic recovery seems to have hit a few snags.

First, despite the language being commonly used – we are not quite post-Covid. The Delta variant brought with it renewed mask mandates, extended travel restrictions, and slowed hiring.

Second, the Federal Reserve’s quantitative easing reaction to the pandemic has brought with it the additional problem of elevated inflation that appears to have sticking power despite continued assurances from Fed board members that inflation would be transitory.

Third, Covid-related supply chain issues have reverberated through the global economy and exacerbated what was already a precarious situation. We addressed some of these macro factors in our earnings preview note.

Globally, these factors combined have already impacted the recovery. China’s GDP growth forecasts have been cut for the third quarter, as have those for Germany. American numbers are likely to follow, with JP Morgan cutting its third-quarter GDP growth estimate by 2pts.

Against this backdrop, the firm’s largest business unit, Marsh (50% of 2020 revenues), saw a slight slowdown of 1pt in organic growth from the second quarter to 13%, even as rates remained static.

Reinsurance broking arm Guy Carpenter grew 15% in what is typically a smaller quarter (~50% of revenues are in Q1). The consulting revenues also saw strong growth. Mercer was up 7%, and Oliver Wyman grew a vertiginous 25%.

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Against this backdrop and the tougher Q4 2020 comparison, the company could face pressure to continue reporting stellar growth next quarter.

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Third, expense spending is likely to rise once wage inflation hits and pandemic expense savings run out.

Like the rest of the brokers, Marsh McLennan has benefited from meaningful expense savings during the pandemic. According to McKinsey, the pandemic brought business travel expenses down by 90% in the second quarter of 2020, essentially eliminating a key pillar of business expenses for brokers.

Compensation and benefits expenses increased 14% in the quarter from pre-pandemic Q3 2019 (17% compared to Q3 2020), and other operating expenses are down 7% from Q3 2019 (up 6% YoY).

The company reported the largest organic hiring streak in company history, with almost 5,000 employees hired YTD or about 7% of the firm’s total headcount.

Management noted that new hires have more power to dictate salary expectations, exposing Marsh McLennan to wage inflation.

In the coming years, the added expense of additional hiring may climb even higher with stubborn inflation, as cost of living expenses potentially increases. In New York City, where Marsh McLennan is headquartered, pandemic-era rent decreases and concessions have given way as the housing market has largely recovered to pre-pandemic levels.

Nonetheless, margins have held steady despite the hiring, as the company is still seeing reduced spending. A recent Deloitte study points to travel still not returning to full capacity by the end of 2022, with fourth-quarter 2022 travel expenses projected to be 65-80% of 2019 highs – which is still four times higher than travel spending in the summer of 2021.

Management has also indicated that the company does not plan to reduce expenses in real estate, pledging to move slowly and see how and if employees choose to return to the office.

The chart below shows the gap between revenue growth and expense growth. Expense growth was higher than revenue growth prior to the pandemic but has since turned, allowing revenue to outpace expenses.

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Given its ability to take advantage of the market disruption from the abandoned Aon-Willis merger, Marsh McLennan’s hiring growth may serve it well in driving organic growth, especially in the near term as commercial pricing remains favorable.

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