|Shares Out. (in M):||138||P/E||27||23|
|Market Cap (in $M):||7,310||P/FCF||18||16|
|Net Debt (in $M):||115||EBIT||580||625|
Brown & Brown (BRO) is a diversified insurance agency with offerings across wholesale brokerage, large insurance program sales and administration, and insurance-related processing services. The company dates from 1939 and is headquartered in Daytona Beach, Florida. The company’s historical business has been as an agency, advising and selling insurance products to small and medium sized businesses for typical business coverage types such as P&C and employee benefits, but as BRO has gotten bigger it has expanded its product lineup to include customized risk management products and services.
BRO’s business model is pretty simple. Agents work with business owners who need insurance, match them up with a policy that covers their needs at a reasonable price. BRO gets paid a commission by the insurance company, which is something on the order of 30% of the value of the policy. Commissions are usually a percentage of the premium and are affected by fluctuations in rates, as well as the insurable exposure units (such as property values, payroll levels, etc) and comprise the vast majority of BRO’s revenue. In addition to straight commission, a small portion of BRO’s service revenue can come in the form of “profit sharing contingent commissions” in those cases where BRO has underwriting authority to write policies on behalf of its insurance partners. These contingent payments are usually based on underwriting profitability but may also have a volume, growth, or policy retention component to the payments. Such contingent payments are usually received and booked in the first or second quarters of the calendar year, and this type of payment has averaged about 5% of BRO’s total commission and fee revenue over the last several years. Importantly, like most insurance brokerage businesses, BRO itself takes no underwriting risk: it is basically a selling and services organization that gets paid on commission or for services rendered.
BRO’s biggest expense is naturally the employee costs: BRO’s compensation and benefits ratio is between 50-51% of sales every year, so we can basically think of this as BRO splitting half of its revenue with its employees. This cost is somewhat variable as BRO pays out commissions to its sales people roughly proportional to the amount of business they bring in. Other operating expenses are typically around 15% of revenue. BRO’s business is not capital intensive, and cap-ex has historically been in the $10-15M range most years. The result is that GAAP net income is usually around 15% of revenue.
One of the other major expenses is the non-cash accounting D&A that results from BRO’s acquisitions; since it is usually acquiring a group of people and a customer list, the value is mostly in the business goodwill, which gets amortized over time. So while reported net income is 15% of sales, actual cash flow is much higher, and in 2017 will be about 21% of sales. BRO is a cash flow machine.
The profitability of the brokerage business model at scale can be seen in the reliability of the company’s revenue and earnings over time. In fact, BRO has been an extraordinarily good business over the past 25 years. BRO has increased revenues every year from 1993 to 2017 with the exception of 2009, when revenues dropped by 1%. Revenues have grown from $96M in 1993 to $1.88B in 2017 (~14% CAGR) while net income grew from $8.1M to $270M, or ~16% CAGR.
It should be noted that the above results didn’t occur organically. To say that BRO is a significant acquirer of businesses is an understatement; rolling up small agency businesses is more or less a core function. From 1993 to 2017, BRO acquired ~500 insurance operations, not including acquired books of business, though most of these purchases have been quite small. If one was so inclined, one could use the rather pejorative description of “roll-up” to describe BRO’s grow-by-acquisition strategy, and many investors (myself included) are somewhat skeptical of companies that aggressively employ roll-up strategies and rely on acquired growth – largely because many of them take on unsustainable debt and blow up somewhere in the process. However, the truth is that some businesses are much better suited to the acquisition strategy than others, and insurance brokerage appears to be one of those businesses for which the strategy is very well suited. This can be seen not only in BRO’s long-term financial performance, but in other companies across the insurance brokerage industry, including the three major global brokers (Willis, Marsh & McClennon, and Aon) as well as another US regional broker, Arthur Gallagher (AJG). All of them have successfully used acquisitions to grow, and this is largely due to the relative ease of integration the companies have had with buying outside brokerage units and plugging them into an existing network.
The US commercial insurance brokerage industry is somewhat stratified; as of 2016, the industry itself ran about $35B per year in revenue, and two of the three major global players (Aon and Marsh) each took about 18% each, for a total of roughly 36%. Willis Towers Watson, Arthur J. Gallagher, and BRO round out the top six, and those three combine to take about 25% of the total. After you get out of the top 10 players it gets small pretty quickly, and by the time you get to #100, you are looking at about $30M in annual revenue. BRO typically also competes with AJG and the smaller players in the commercial middle market space, which BRO generally defines as businesses that pay between $25K and $300K in annual insurance premiums, from which BRO hopes to win its share of commissions. BRO’s annual commission per account is around $10-12K, which puts it well beneath the $100K/year area where the “big three” brokerages generally dominate the trade. BRO does have some big customers, but usually for smaller policies in niche areas or for specific local coverage needs of larger enterprises. Historically, BRO has reported annual renewal rates at 90% plus, which is one of the reasons the business has been so stable over time.
Though insurance brokerage is a very consistent business year-to-year relative to many other business models, there are some stretches where BRO enjoys tailwinds and some where it faces headwinds. While it is true that an insurance agency like BRO sees its commissions suffer along with its insurance partners when insurance premiums decline, in some ways it can actually benefit (in the short term) after a big insurable event that causes rates to increase because it does not have to pay for the insured losses but benefits from both the increased rates and the increased awareness of the need to be insured by business owners that large loss events tend to create. The period from 2007 through 2011 were pretty slow years for BRO (and other insurance brokerages) due to a sustained “soft market” for insurance pricing, which causes insured rates to decline as well as insured property values in the aftermath of the housing bust. Additionally, BRO has historically been very strong in the Florida market, where the company was founded and is based. Increased government insurance in Florida caused BRO some significant loss of business during that time. Also, the 2008-2009 economic down turn was hard on small and mid-sized businesses in the US, which reduced revenue for BRO. In early 2012, insurance rates began to slightly improve, and probably more importantly, “risk units” went up in value as property values recovered and business activity increased.
Let me now take you on a quick tour of the business. BRO has four main divisions. The largest, the retail brokerage unit, accounts for approximately 50% of company revenue and this business has typically produced pre-tax profit margins of about 20%. This unit includes roughly 4,000 insurance professionals which offer insurance solutions to middle market businesses and individuals. The type of coverage sold by the retail unit runs the gamut, but we are talking generally about multi-peril P&C packages, employee benefits, workers comp, professional liability, medical malpractice, builder’s risk, cyber security, and various personal insurance (home, umbrella, and specialty insurance for collectables such as antique cars, fine art, etc). BRO partners with hundreds of insurance companies and does not take underwriting risk. BRO’s stated differentiator in this business is that “our customers hear from us throughout the term of their policy and not just at renewal time. We are key business partners for our customers year round.” 85% of the retail unit revenue is commission-based. BRO has made some effort to go upstream for larger accounts in recent years, particularly in the group benefits arena, and some recent year acquisitions have helped to drive this initiative. Nevertheless, BRO generally does not compete directly with the big three in program business, instead targeting smaller opportunities in the lower middle market business arena.
The second unit is National Programs, which typically comprises about 25% of sales and has posted high teen pre-tax profit margins. In this unit, BRO functions as the managing general agent (MGA) and the insurers effectively outsource the underwriting to the company under general guidelines. BRO then underwrites, collects premiums, and often services the account and in some cases pays out claims as well. Programs are distributed through nationwide networks of independent agents and BRO retail offices. Products and services tend to be targeted and designed for specific industries, trade groups, professionals, public entities, and other niche markets. The national program business is further split into professional program and P&C program. For example, commercial line programs offer coverage such as workers comp, contractor equipment, professional sports activities, manufactured housing, and the like. Personal line programs include residential, auto, and earthquake. Specialty lines include flood coverage, commercial earthquake, habitation properties, food chains, and other specific risk policies.
The Wholesale division accounts for about 15% of total company revenue and has posted 20%+ pre-tax profit margins consistently over the years. BRO describes this business as “extending a retail agent’s marketing or placement capabilities. Working with BRO gives smaller agents access to insurance carriers and pursue business it would otherwise be unable to write.” Essentially, in this case BRO works for the independent insurance broker to help them service their clients better. In many cases, small retail agencies and brokerage firms don’t have enough volume on their own to justify a direct relationship with insurance carriers, and by working with BRO they can access the full gamut of coverage options. BRO is one of the top ten wholesale brokers in the world, with 330 brokers and over 1,000 employees in the US and the UK. BRO’s wholesale brokers are generally industry specialists, and are available either to advise the retail broker or to accompany them on their customer visit to explain the coverage options available. Also, retail brokers often approach BRO’s wholesale operation with a unique risk or coverage that isn’t offered as a standard contract or believe that isn’t well handled by carriers broadly, and BRO will work with the retail broker and carriers to find a coverage solution tailored for the situation. BRO has a significant coastal property insurance focus in the wholesale area, where premiums are most likely to increase in the next year or two after the recent hurricane activity.
The Service division is by far the smallest, accounting for less than 10% of company revenue and even less on a profit basis, as it is the lowest margin business unit and has posted pre-tax margins in the mid-teens in recent years though it has been as high as 20% in the past. Services include claims processing for flood, property, auto, social security advocacy, and other lines. BRO subsidiaries in this division include American Claims Management, Colonial Claims, Advocator Group, and ICA. These businesses are generally claims administration businesses, which are generally low-growth and lower margin but dependable.
BRO has been a family run company for three generations. Brown & Brown was founded by two cousins, Adrian Brown and Charles Covington Owen, and it was later managed by Adrian’s son Hyatt, who became CEO in 1993. His son, Powell, has been CEO since 2009, but has been a manager in the business since 1995, when he ran one of the retail brokerage offices. Powell’s brother Barrett is a senior executive at the company as well. So this is a family run company, and there are distinct plusses and minuses in all family founder companies. In BRO’s case, I think the positives outweigh the negatives. Brown & Brown does have an extremely unique, sales-oriented culture that emphasizes de-centralized decision making and a serious go-getter motif where even senior executives are expected to get out there and sell some policies.
While there is definitely a little over-the-top vibe to the older annual reports, there is also clearly a strong and productive sales culture at BRO, and while it may not be for everyone, one gets the sense that people who thrive at BRO stay there. BRO execs have said that roughly 70% of BRO employees own shares, and the company’s corporate culture is very much about bottom line productivity. The Brown family owns roughly 16% of the stock, and other officers and directors own another 1% or so such that insider ownership is greater than 17%. As mentioned above, employees and the employee retirement plan are also large owners of stock (roughly 8% each) which means roughly 35% of the stock is actually not available for public float.
BRO hired a new CFO in 2014 by the name of Andy Watts, and since his arrival BRO has been far more active in managing its non-M&A capital allocation efforts. BRO issued its first ever public debt offering in 2014 with a $500M, 10 year corporate bond. BRO also initiated its first large scale share buyback in 2014, with a $75M authorization, followed by a $200M authorization in the summer of 2014, and has been a consistent buyer of its own shares every year since. The company has raised the dividend 24 years in a row, but at roughly a 1.1% yield, this is almost a token gesture. The company’s first choice in allocating capital has always been good acquisitions at reasonable prices.
As mentioned prior in the report, historically BRO has allocated most of the ample FCF generated by the businesses into accretive acquisitions, typically paying 6-7X EBITDA for smaller agencies and brokerages and then plugging them right into BRO’s network. In his discussions on BRO’s acquisitions, Powell Brown often mentions that cultural fit is as high a priority as the financial fit when evaluating opportunities. With industry retention rates above 90%, buying competitors out at reasonable prices rather than trying to pry away the business customers has generally proven to be a very effective growth strategy. It should also be noted that BRO typically structures its acquisitions as asset purchases which offer tax benefits, such that the historical acquisition multiples are often lower than stated. BRO also gets good integration success by its format of having regional platform hubs and then doing snap-on deals to acquire smaller local agencies. Interestingly, BRO delegates the search for acquisitions largely to local and regional execs that get to know the target company and management well before bringing in the internal M&A team to close the deals.
Unfortunately for BRO in the last several years valuations have gotten quite frothy and competition has gotten fierce. BRO has found itself competing with an expanded group of buyers as many large PE firms have recognized the attractiveness of the brokerage industry and have moved aggressively to deploy capital there. In recent calls, Powell Brown has mentioned that in recent years PE firms have been willing to pay much higher multiples and use way more leverage than BRO, which has been historically conservative with debt levels. As a result, we’ve seen the first instances of BRO engaging in large scale buybacks in the company’s history.
As is the case with any business, there are some concerns and potential weaknesses to consider with BRO. I think the biggest reason for BRO’s relatively low multiple relative to larger competitors in the 2012-2015 period was the combination of low organic growth with a reduced opportunity set for M&A. Growth going forward remains an issue; I believe it will be positive but clearly the growth runway is not what it was 15 years ago. BRO’s reported organic growth in 2014 was just 2.0% but this has picked up with stronger economic activity and the outlook is pretty decent. Organic growth was 2.6% in 2015, 3% in 2016, and better than 4% in 2017.
The next topic is one that is a more difficult to assess risk factor, and it relates to both the extent and durability of BRO’s competitive advantages today, but more importantly, whether insurance brokerage is in the early innings of being disrupted by technology, as big-data armed web sites and apps conceivably could make it so easy for business owners to compare coverage and pricing of insurance to the extent that BRO’s reps are no longer as valuable. After all, people used to use travel agents to book flights and hotels, and many people no longer use accountants for tax returns, relying instead on the software solutions provided by TurboTax and other $50 solutions. While this is an important risk to monitor, it appears to me that BRO’s specialization in smaller businesses with long-standing relationships represents a difficult barrier to dislodge. Most business owners have very specific risks and are looking for policies tailored to them; this isn’t like more standardized insurance policies such as commercial or personal auto, where it’s easy to understand the terms and fast and easy to compare pricing. Policy complexity is a substantial issue when one is shopping for bespoke insurance, and business owners tend to value pre-sale advice and policy shaping, post-sales service and claims processing, and ongoing reviews as needs change over time. In general, I come down on the side that argues it would be very difficult to displace BRO’s services, at least not with anything that can really help the business owner think through what coverage needs exist and then go out and find or create solutions directly with insurance carriers as BRO’s retail brokers do. At the margins, however, there may well be a little bit of technology creeping into the competitive scene. It appears that BRO itself is not sitting idle to this threat, and probably the most immediate threat is that BRO will need to make more significant investments in the technology arms-race, to ensure that it keeps its retail brokers armed with better and timely data to help them serve clients better. For example, BRO is expected to increase its spending on technology over the next 2-3 years with an announced $30-40M IT agenda over that time period.
BRO’s brokerage business is highly diversified and does not seem to have an inordinate number of large risk factors relative to many other businesses. There is very little customer concentration risk; the largest insurance carrier typically accounts for less than 10% of BRO’s commissions in any given year.
Based on the recent price of $53, with roughly 138 million shares outstanding, BRO has a market cap of $7.3B, and with negligible net debt, the EV is $7.4B. I use FCF as my primary valuation metric for the company, given the strong cash generation and the non-cash impact of D&A on the GAAP net income numbers. BRO generated $400M in FCF in 2017, for an EV/FCF multiple of about 18X on the trailing numbers. On the surface, this strikes me as a surprisingly reasonable price for a business of this quality with the strong and reliable historical performance. But BRO will get a huge boost from the lower tax rates going forward, and the company has already stated that it expects its cash flow will go up by $50M per year given that the company has been paying a true cash tax rate in the mid-30% range in recent years.
I project that BRO should produce something like $1.90-1.92B in revenue in 2018, and I will just take 2017’s FCF and add $50M to it to get a conservative base projection of $450M. I expect BRO will benefit from some higher premiums in its home market of the Florida region, so I would not be surprised to see FCF come in a bit better than that. This drops the EV/FCF to ~16X, which I would argue is a strong relative bargain for a business this good in this market. If I were so inclined, I could easily weave some really tantalizing narrative about how BRO is an amazing “compounder with an outsider CEO” but I don’t really need to do that here, do I? This business is good enough, the management has been capable enough, and the price is reasonable enough that I don’t feel the need to embellish the narrative.