Thoughts on Brown & Brown: Stay Away!

I looked at Brown & Brown about a year ago (May 2010), here are my thoughts which are still relevant today:

Risk of growth by acquisition

Very significant portion of Brown & Brown’s (BRO) growth in the past came from acquiring brokers.  I am naturally skeptical of sustainability of this type of growth as it comes with the following risks:

• Integration risk. Although well managed companies can reduce this risk by creating strong processes to integrate acquisitions, to achieve the same percentage growth year after year BRO has to buy larger agencies or larger number of smaller agencies.  Either way integration risk increases every year as BRO gets larger.  I’ve seen this happen with banks that grew by acquisition – they were successful at buying and integrating smaller banks until they were not.
• Overpaying for acquisition and the value of BRO’s currency (stock). I don’t know a single management team that calls themselves an “undisciplined” acquirer, BRO team is no different.  Thus instead of taking management’s word for it, I looked at the price paid / revenue acquired (the only metric I could find consistently disclosed since 2003).  It increased but not sufficiently to indicate that management was an undisciplined acquirer.Also, kudos to management for using its stock to pay for acquisitions when stock was expensive: between 2000 and 2003, when BRO’s stock was trading between P/E of 21 and 26, BRO increased share count by almost 30%).  Since 2004 as P/E contracted BRO has not issued much stock and paid for acquisitions from free cash flows.Though based on company’s history, I believe this risk is small, the longer the soft insurance market drags on the greater are the chances that management (out of frustration, it has not grown earnings for years) will overpay for an acquisition and/or use cheap stock to pay for it (if acquisition is large) and thus destroy shareholder value.
• Sellers are selling their agencies that they’ve spent decades to build, for a reason – they want to monetize their single biggest asset and retire (not because they want to work for someone else).  After earn out period is over sellers’ motivation to grow the business lessens, especially since the sale turned them into multi millionaires.  This in part explains why BRO’s return on capital has been on constant decline since 2000, even before insurance industry entered soft market (ROA down from 26.9% in 2000, to 15.6% in 2006, and 10.5% in 2009).
• Nothing to buy. It is hard for sellers and buyers to agree on the price during the soft insurance market.  Though soft insurance market will not last forever, since acquisitions are at the core of BRO’s growth strategy protracted soft market will result in continuation of slow earnings growth (this problem is only compounded by impact soft insurance problem has on organic growth.)
• Growth by acquisition is not cheap. Over the last 5 years, BRO generated $1.135 billion of cumulative of free cash flows (operating cash flows less capital expenditures).  During the same time it spent $926 million on acquisitions.  Thus true (distributable) cumulative cash flows to investors were only $208 million, $171 million of which was paid out in dividends.(Also, free cash flows stagnated since 2005.   On the surface, $926 million spent on acquisition brought ZERO return to shareholders – this in part explains why ROA was on decline since 2005.  However, this on the surface analysis ignores a very important factor – negative organic growth of the core business, more on it next).

Margins

BRO margins are far superior to its competitors as it focuses on the small and lower end of the mid market customers where as AJ Gallagher, Marsh, AON and others are mainly concentrating on (higher end) mid and large markets.  Smaller customers require less service and thus are more profitable.  In addition, in small markets a significantly larger portion of broker’s revenues comes from commissions instead of fees.  In the long run brokers make more money charging commissions as commission rates are higher than fees, however, commission revenues decline more during soft insurance market.  This also explains why BRO’s margins were historically higher than competitors.

Higher composition of fees as percent of revenues is the main reason why competitors’ revenues faired so much better in this challenging economic environment than BRO’s.  In addition, significant portion of BRO”s revenues comes from markets (Southeast) that were significantly impacted by housing bubble burst and suffer high unemployment (less assets to insure).

I get a sense that small businesses are struggling more than large companies that are better diversified and have access to cheap capital.

Valuation

Combination of all these factors makes BRO’s future growth extremely sensitive to the growth of the economy.   In fact, BRO’s earnings power is completely at the mercy of the economic recovery.

If the economic recovery we are seeing today is real (not a foregone conclusion in my mind, considering an enormous amount of stimulus in the system), then insurance market will harden and BRO’s earnings will rise.  In the absence of economic recovery, or if economic recovery doesn’t lead to harder insurance pricing, margins will compress further and earning will decline.

Since 2006, soft insurance market eroded BRO’s revenues by about $255 million and earnings by between $40 to 50 million. In the absence of soft market (if pricing remained flat since 2006) BRO would have earned about $1.45-$1.50 a share, putting today’s valuation (stock price at $19.5) at about 13-13.5 times earnings – still not excitingly cheap.

Consider that if insurance prices rise 10% above 2006 level (and assuming BRO doesn’t make new acquisitions and 19% net profit margins), its earnings power will be around $1.70.  For this to happen, revenue has to rise 30% from today’s level.  If investors price the stock at 15 to 17 times $1.70 earnings, its price will be between $26 and $29 (30% and 50% upside). A lot of stars have to align perfectly for this scenario to play out.

In other words, at current valuation for this stock to deliver significant return, economic recovery has to be very robust and valuation multiple has to be rich.  (One factor worth considering that will be beneficial for BRO’s revenues – high inflation.  High inflation will inflate insurable assets and thus drive prices higher).

This stock is priced for growth! There is no margin of safety in the stock if high earnings growth doesn’t materialize.  There is also a significant risk of P/E compression, as BRO trading at 17 times 2011 estimates.  BRO’s competitors offer much higher dividend yields and are not priced for growth.  For instance, Willis (WSH) is trading at 11x 2011 earnings, has dividend yield of 3.2% (double of BRO’s).  AJ Gallagher (AJG) is trading at 15 times 2011 earnings and has a dividend yield of 5.1%.

Though BRO historically traded at premium valuation to its competitors, BRO’s lower dividend yield, inability to produce organic growth or to find suitable acquisition targets may erode the P/E premium.  If BRO’s P/E declines to Willis’s level stock will drop to $13.

Discounted cash flow model shows that today’s stock discounts about 12% revenue/cash flow growth over next 10 years (using 10-12% discount rates) – a fairly ambitious assumption.

This company doesn’t generate significant free cash flows as it is addicted to acquisitions, which bring their own set of risks as I discussed above.