Marsh's Moat Based on Scale Advantages, Sticky Client Base

Despite ongoing excess capacity issues in the reinsurance market, which continues to weigh on pricing, narrow-moat  Marsh & McLennan (MMC) posted solid third-quarter results that included modest margin expansion. Operating income at the insurance broker rose 7% year over year to $404 million, with net income increasing to $253 million (or $0.45 per share) from $241 million (or $0.44 per share) in the year-ago period. All of this was driven by a 3% increase in revenue, which reached $1.2 billion during the third quarter. While revenue growth for the first nine months remained largely in line with our projections, we believe an increase in intrinsic value for Marsh is warranted, given the growth potential that exists in its health-care consulting operations.

Demand for health-care consulting services continued to play out during the quarter as clients prepared for the rollout of the private health-care exchanges under the Affordable Care Act. Marsh continues to see a decent pipeline of clients showing interest in its consulting services. In our view, the challenges that companies face under ACA create opportunities for the insurance brokers, with companies like Marsh, which has the expertise and network available to provide client-specific solutions, seeing the biggest benefit. Although the stock trades above our fair value estimate, we continue to believe that Marsh's overall fundamentals remain attractive, with the company well positioned for additional growth.

Depth, Breadth of Services Make Marsh Stand Out
Through a series of acquisitions in the past decade, Marsh & McLennan has become one of the largest risk management and consulting firms in the world, and it stands out for the depth and breadth of its services. The company is organized around two business segments--risk and insurance services and human resources consulting--that provide clients one-stop shopping. Marsh and Guy Carpenter, which together make up the risk and insurance services segment, provide risk transfer and mitigation solutions as well as insurance brokerage services. The consulting segment, which includes Mercer and Oliver Wyman, specializes in management consulting and business outsourcing. We think the insurance brokerage and consulting businesses are fundamentally attractive and complement each other well. In our view, consulting will become increasingly important to brokerages as corporate clients demand sophisticated risk management solutions. We believe the client stickiness inherent to these businesses, scale advantages, and a global presence add up to a narrow economic moat rating.

Insurance brokers play a vital role in helping clients assess, manage, and transfer risks. Traditionally, brokerage intermediaries played the part of connecting the buyers of insurance with the providers of insurance. However, as new risks emerge because of technologies, globalization, and deregulation, buyers looking for protections now demand more tailor-made solutions. In this regard, Marsh has differentiated itself as a risk consulting provider, rather than just an insurance broker in a traditional sense. Marsh and reinsurance specialist Guy Carpenter are among the largest players in their respective fields. Insurance brokers like Marsh serve an important function in facilitating information flow between buyers and sellers of insurance, enhancing market efficiency and making pricing more competitive. Through its expertise in risk management solutions, the company helps customers navigate the intricacy of insurance and risk-sharing functions, offering high-value solutions that can only be developed through deep customer relationships. Large corporate clients that can see value in the transactions are more likely to stay with the brokers and consultants by signing multiyear engagement contracts. The deep advisory relationships and the client stickiness inherent to the business allow Marsh to gain a competitive advantage, in our opinion.

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Marsh's global scope is one of its greatest strengths. Few companies can provide risk controls at the international level because of the lack of staff and expertise. Companies consider the implementation of risk management measures abroad as one of the most important tasks of an insurance broker. Marsh's global footprint allows brokers to fully meet the risk management needs of multinational clients, and access to an international network of insurance partners is a valuable attribute of Marsh's brokers.

The Affordable Care Act is set to make sweeping changes to the way employers provide health-care benefits to their employees, and we believe it's a boon to Mercer's consultants. The company's health-care consulting team is in the forefront of helping employers understand compliance, financial, and strategic issues. At the heart of the issue is migrating participants to health-care exchanges, which are intended to help company sponsors to offer health care in cost-effective ways. However, the implementation has caused much confusion and anxiety among participants. We think the ongoing discussions on health-care reform could also open more doors for Mercer to seek out prospects and cross-sell other consulting services.

Marsh faces fierce competition from other international brokerage outfits, including Aon and Willis, which operate a similar business model but on a smaller scale. These firms are are essentially competing in the same market segments, although Marsh tends to focus on larger clients that also want the scale and the network that it can offer. However, as competitors continue to build out their platforms and move up the value chain, they could threaten Marsh's dominance in the longer term.

Several macro factors have weighed on returns for Marsh and the industry in recent years, including the weak economy, a soft insurance market, low interest rates, and regulatory uncertainty over brokerage commission practices. Brokerage commissions and fee revenue are related to trends in insurance rates for their customers, and Marsh faced significant revenue challenges as insurance rate weakness was especially marked among larger accounts. However, we think that the multiyear nature of its contracts and the global nature of the business can help smooth the bumps in revenue in a volatile market.

Insurance Brokerage Is a Relationship Business
High switching costs is the main source of the economic moat for insurance brokers. With a keen understanding of the risks inherent to their clients' business, insurance brokers establish themselves as trusted partners in risk solutions. Having a sticky client base is key to economic moats for insurance brokers, and in a bid to retain clients, Marsh has built itself into an international firm that can serve multinational companies. Such broad coverage is important to clients that need expert advice in structuring, pricing, and transferring risks, whether to the capital market or to other reinsurers. Over time, the brokers entrench themselves in their clients' business, which makes it difficult for clients to depart.

Because of the increasing complexity of risk management, as well as the emergence of new risks, insurance brokers have evolved into risk consultants that offer tailor-made solutions based on a client's unique situation and risk tolerance. This approach can only be developed through in-depth customer knowledge and close relationships with partners. The advisory relationship, in our view, has allowed insurance brokers to retain their clients. Marsh's consulting teams partner with large organizations to improve business performance by designing and implementing a wide range of HR, compensation, and talent management strategies. Client stickiness is evident in business outsourcing solutions. As soon as a client outsources its business functions to Marsh, Marsh becomes an embedded part of the client's operations. Over time, Marsh's technology becomes increasingly integrated with that of the client, and it is very difficult for the client to switch for another service provider.

Also, the brokerage business is a relatively low-risk business characterized by low capital requirements, with most of the leading brokerage firms posting historically high returns on capital.

Economy Dictates Demand
The insurance intermediary business and consulting business are generally tied to economic conditions. The demand for insurance generally falls as the overall level of economic activity decreases. HR consulting is closely correlated to the job market and government policies affecting the labor force. Reductions in workforce associated with economic downturns and corporate reactions to government policies lead to lower demand for general consulting and business outsourcing services from clients. The historical experience of brokers suggests that regulatory risk is meaningful. Additionally, the business generates some float income, which exposes the company to the interest rate environment.