Description

Hilb, Rogal & Hobbs (HRH) is a top-flight insurance broker that makes a lot of money and has a double-digit growth rate, yet it trades for less than 13 times next year’s earnings.

For small and medium-sized businesses that are in need of property or liability insurance coverage, they can engage the services of a broker at a firm like HRH, and the broker will help them select an insurance carrier. As payment for his services, the broker will collect a commission equal to 5-15% of the premium.

Insurance brokers like HRH don’t merely shop around for “off-the-shelf” policies; they often offer their expertise to structure contracts that are customized to suit the insured. Brokers are there to lower the insured’s costs, assure the claims-paying ability of the carrier, review the contract, place difficult risks, and assist in servicing (though not paying) claims.

HRH caters largely to small business customers, who generate annual commission revenues of $60,000 on average. These customers usually don’t have someone on their staff with insurance-buying expertise, so they are dependent on their broker for designing and placing coverage.

This means that profit margins are on the large side. HRH’s operating margin (adjusted for special items, amortization, and stock options) was 25.5% for 2003. Compensation is 75% of operating expenses. Operating return on assets, defined as adjusted operating profit as a proportion of tangible assets excluding cash, has averaged 48% from 1999 to 2003. I know of very few companies in any industry that have these levels of profitability. Returns at even half this level would have people dancing in the streets.

Free cash flow is very strong. From what I’ve observed, a company that has 115 dollars coming in for every 100 dollars going out has strong free cash flow. HRH has more than 130 dollars flowing in for every 100 dollars flowing out.

A little more than four years ago, HRH started a Best Practices program under which brokers were provided with tools and training to improve service, increase sales, and improve closing rates. HRH introduced new tools for measuring brokers’ performance and for analyzing exactly how much money is being made or lost on sales, service, and support functions. The tools helped HRH better identify who is exceptional and who is underperforming. This was a smart, proactive move; one of the results has been a pickup in operating margins averaging 1.5 percentage points each year since 1999.

It’s odd that such a profitable industry would be joined with an industry, property-casualty insurance, that’s not particularly profitable. P-C companies sell a commoditized product. The industry was in a soft market for thirteen interminable years (count-'em). A hard market finally arrived in 2000 and has continued through the present. Rate increases moderated in the back half of 2003. I wouldn’t be at all surprised to see a soft market returning soon and continuing through the end of the decade.

That prospect doesn’t bother me, because when the P-C industry goes through a soft market, the insurance brokers generally experience a slowdown in earnings growth but not an actual decline in earnings.

HRH has had a couple of down years: Adjusted EPS were down 22% in 1989, 14% in 1991, and 15% in 1993. Because there were up years in between, 1993 EPS were 12% below those of 1998. The rest of the time during the period 1988-2003, however, earnings were up, compounding at 9% annually during the soft years of 1989 to 1999. In the recent hard market, from 2000 to the present, EPS advanced 30% per year. EPS were up about 20% in 2003.

The management targets 15-20% annual growth in EPS over the next few years and is optimistic that they can achieve it.

HRH has made hundreds of acquisitions of small agencies in the past ten years. HRH is by no means unique within the industry (cf. Brown & Brown’s record). From 1997 to 2003, HRH tripled its revenue while organic revenue growth was 45% (a 5.8% annual growth rate).

HRH stumbled in the second half of 2003. The acquisition in mid-2002 of Hobbs, a well-run insurance broker that serves medium-sized customers, was a big one. HRH paid $212 million, factoring in all earnout payments. This works out to about 10 times EBIT, 7.8 times EBIT including cost savings. HRH had promised big earnout payments to Hobbs personnel based on results achieved through mid-year 2003. Once earnout payments had been earned, the Hobbs people slacked off, and the result was a big dropoff in organic sales growth to a 3% rate in the second half of 2003.

It looks like this has turned out to be a temporary setback. Management expects 3-6% organic growth in ’04. My view is that if there’s anything that HRH's historical success has shown, it is that management knows how to motivate its brokers. The past record shows management’s ability to correct a mistake like this and restructure the proper incentives.

In 2003, HRH earned $81 million, or $2.22 per share, after backing out amortization of intangibles and special items, and net of stock options expense, on $556 million in revenue. The Street estimates are $2.53 for 2004 and $2.93 for 2005, as adjusted. At 36.8, the stock sells for 12.6 times next year’s earnings, an unusually low multiple for a good business.

Catalyst

Continued double-digit earnings growth combined with a low stock price;
Potential takeover by another insurance broker;
Resolution of problems with the Hobbs acquisition;
Share repurchases.