“He wasn’t just saving his own soul when he donned his coat and hat after dinner and went out again to resume his work – no, it was also to save some poor son of a bitch on the brink of letting his insurance policy lapse, and thus endangering his family’s security ‘in the event of a rainy day.'” – Alexander Portnoy (in Philip Roth’s Portnoy’s Complaint)

Summary

Investing in a commercial insurance broker today is like being grounded on a summer weekend – you’re totally missing out on the spin-off/drop-down/Silicon Valley pool party. If Brown & Brown (NYSE:BRO) were there, it’d be the pallid in ochre tweed dawdling on the fringes, friendly but forgettable. But it’s got these fangs, man, you don’t even know.

Brown & Brown is a responsible consolidator in a fragmented sector with long-term compounding attributes and a strong balance sheet. Its dependable cash flow is stewarded by an opportunistic management team and Board which own 18% of outstanding shares. A value-heaping drudge free of catalysts, Brown offers a post-tax cash earnings[1] yield of 7% growing by an expected 9-10% annually[2] with low downside risk – generous, given the durability of its competitive advantages and the compensation offered by current riskless alternatives.

The Street’s myopic coverage is riveted to the following immediate challenges whose repercussions on long-term value, if considered at all, are embellished: 1) persistent coastal property insurance rate declines, 2) heightened private broker valuations that limit accretive capital deployment and 3) weakness in small group benefits. But housed in a moated cultural architecture – one that has conservatively and steadily created value over generations – are rejiggered incentives promoting organic growth and meaningful recent capital allocation initiatives that signal management’s belated effort to use its under-employed balance sheet.

A commercial insurance broker is an intermediary that matches fragmented buyers and sellers of property/casualty/health insurance – it works on behalf of businesses to find optimal coverage at favorable prices while acting as a distribution channel for insurers who ultimately carry the policies on their balance sheets.

The broker collects premium payments from customers, extracts a ~10-15% commission for itself and remits the remainder to one or more underwriters.

US commercial insurance brokerage is highly fragmented outside the top 10. The 100 largest brokers generated an estimated $32bn in US revenue in 2014, and of that, the top 10 accounted for 72%[3]; three global risk managers – Aon, Willis, and Marsh (NYSE:MMC) (pro forma for Towers Watson) – represented 43%. Below the top 100 are an estimated 35k+ sub-scale agencies and brokerages[4]… quaint, often family-run operations generating <$3mn in revenue.[5] Of that, I estimate there are around 15k independent commercial agencies generating about $15bn in non-personal lines commissions, of which ~5k agencies aggregating $10-11bn of commercial revenue fall within Brown’s acquisition purview.[6]

The average age of a small agency proprietor is late-50s and 18% of agencies have 20% owner/principals older than 65 years, up from 10% in 2012.[7] My college-aged cousin tells me mid-market insurance brokerage is no longer a cool career choice, so succession issues may increase the supply of motivated sellers in the coming years. Between $300mn+ in annual post-dividend discretionary cash flow and another $500-600mn from additional leverage – together nearly 20% of market cap – BRO has significant excess capital to deploy in a vast, fragmented landscape (more on this later).

While the Company occasionally trespasses into AON/Willis/Marsh territory, Brown mostly competes with the unwashed thousands for commercial middle-market customers, broadly defined as businesses paying $25k to $3mn in annual premiums (around $2.5k to $300k in commissions to Brown). Brown’s average annual commission per account is approximately $12,500, well beneath the ~$100k minimum interest threshold of the big three. Instances where Brown does service a Fortune 1000 account are typically relegated to niche pockets ignored by larger peers.

As a capital-light/labor-intensive business, BRO pays around half its revenue in salaries and commissions to employees who manage customer relationships and secure new business. The Company is well diversified across industries and does not meaningfully rely on a single client or carrier. Renewal rates remain at their historically stable low-to-mid 90%, yielding a reliable source of recurring cash flow. Effectively all of Brown’s revenue is dollar-denominated and comes from U.S. customers. Over the past dozen years, about 2/3 of EBITDA[8] and 1/4 of revenue has trickled down to free cash flow to the firm, reflecting persistently higher-than-peer profitability.

One reason for this is Brown’s market focus. Sandwiched between fee-heavy national accounts and pure-commission small commercial ones, lies the commission-heavy middle market, Brown’s domain. As average account sizes grow, so do their bespoke risk attributes, and the brokers who service them assume increasingly lower margin but higher dollar-profit fee-based consultative roles.

The big three brokers have acquired major consulting businesses over the years and now derive at least half their revenue from fees. Fee arrangements make less sense for smaller accounts; as the owner of one mid-sized benefits broker explained to me, the opportunity cost of the 40 hours he might typically spend winning a new $40k commission account is the $5k from a $125/hr consulting engagement and indeed, across publicly-traded insurance intermediaries, the average EBIT margins in commission-based brokerage segments significantly exceed those of fee-oriented consulting ones (21% vs. 15%).

The second explanatory factor is squishier but more important: here’s a heartwarming yarn from the current executive chairman/former CEO – in which he reminisces client visits he’d make with his father[9] – that aptly frames Brown’s relentless sales culture.

“I remember thinking as a kid that a lot of time these were two-hour conversations; and of the two-hour conversation, the first hour and 45 minutes would be about hunting, fishing, politics, the family, the children, and the last 15 minutes would be about insurance and then we left. I thought to myself, ‘I could be a lot more efficient by cutting out most of that other stuff and just talk about insurance.'”[10]

The product of hundreds of acquisitions made throughout its corporate history, Brown’s operating model is decentralized with minimal corporate overhead, in which 190 profit centers operate autonomously and adjust deftly to local market conditions without the interference of centralized, bureaucratic mandates.

Profit centers are responsible for their own P/Ls, their financial results pitted against those of others monthly; bonuses are dispensed/dispensed with according to profitability improvements/attrition. The Company is assiduously cost-conscious and fixates on meeting budget targets, with one senior producer at Brown grudgingly touting its “bare-bones” constitution.

Heavy ownership incents organizational buy-in to cash flow maximization; in addition to the 18% of the Company owned by management and the Board, an estimated 70% of rank-and-file employees collectively own[11] ~10%+ of shares outstanding, and nearly 8% of employee retirement plan assets are parked in Brown’s stock.[12]

The cringe-worthy, carnally aggressive jingles; the indoctrinating pedagogy of Brown & Brown University;[13] management’s adamant conceit of diligently prioritizing personality types over expertise; a generous program that allows employees to purchase equity at a 15% discount to market (vs. 5% at Gallagher) and rewards “winners” with stock – all merge to a weird and competitive but cohesive compound that has yielded peer-trouncing productivity.

Brown’s local market density, replicated across a national footprint, affords competitive advantages that are difficult to replicate. Scale intermediaries add value to the insurance ecosystem by enhancing liquidity in risk transfer markets, lubricating frictions arising from information asymmetries.

A broker with reach can: 1) scan pricing and risk appetite across its carrier relationship, reducing search costs for mid-sized businesses looking to place complex risks and 2) aggregate risks across industries, lines and/or exposure layers[14] to negotiate favorable pricing and terms with carriers that a single enterprise, on its own, cannot.

For carriers with limited visibility into a highly fragmented SME market, the opportunity cost of scaling direct marketing or captive agencies is prohibitive; it’s more efficient to interface with independent brokers/agents who have embedded client rosters in local markets. Most insurers rely on a small proportion of brokers for the majority of their premiums and are loath to compromise these critical relationships by adopting disintermediating alternatives.[15] A two-way feedback loop – propelled by clients seeking brokers with carrier access and carriers favoring brokers with heavy client flow – informs the benefits of scale that make it difficult for smaller agencies to effectively compete at comparable economics.

The big three brokers have woven their corporate identities around large accounts. Targeting nearly 600k U.S. middle-market businesses[16] requires local market knowledge that comes with widely distributed, nook-and-cranny coverage. Even if the global brokers wanted to aggressively pursue small and mid-sized books, the industry’s 90%+ retention rates suggest that organically dislodging incumbent relationships would be difficult. Furthermore, the $10bn roll-up opportunity is dispersed among tens of thousands of <$1mn revenue brokers, placing centralized entities that monarchically deploy capital from Manhattan, at a disadvantage to regionally organized scale players who have cultivated long-standing, personal relationships with local businesses and even competing agencies, and are better positioned to assess fold-in opportunities.

Disintermediation concerns from online platforms have plagued the brokerage industry since Gore funded ARPANET. Technology continues to snuff out the primordial inefficiencies of human agency in all sorts of industries, draining moats that have traditionally relied on high search costs (Travelocity/Expedia -> travel agencies) or complexity (Turbotax/LegalZoom/Betterment -> income tax preparation/legal filing/personal wealth management)…and certain insurance lines, those with easily stratifiable and granular risk profiles, are no different.[17]

Commercial insurance for mid-sized businesses, however, is different. Brown is more than a dumb distribution pipe for insurance carriers; its typical client has heterogeneous risk management needs and confronts unique and opaque price to coverage sensitivities. Unlike standardized personal lines documentation, many commercial policy forms differ significantly by carrier, bespoke “manuscript” policies are often drafted and policy language can be unregulated.[18] Given larger exposures, business insurance policies are chunkier for a carrier than, say, personal auto and pricing is tailored to reflect not only the insureds unique circumstance, but also a given carrier’s appetite for certain risk pools. According to a 2013 Boston Consulting Group survey,[19] the majority of polled SMEs in the US indicated that they were unwilling to purchase commercial insurance without the assistance of a broker mostly because of policy complexity. Personal lines pricing, on the other hand, is standardized and regulated, with state insurance regulators heavily scrutinizing consumer rate filings (people vote, businesses don’t).

Finally, with the cover-your-ass gravitas that accompanies responsibility for a dozens/hundreds of livelihoods,[20] established businesses tend to be less price sensitive than consumers when it comes to purchasing insurance,[21] prioritizing tailored coverage, post-sale service and claims coordination. One commercial broker explained to me that while a two-person start-up might behave like an indigent teenager, penny-pinching on insurance they’re brazenly sure they won’t need, employers at certain thresholds of commercial viability strongly prefer flesh-and-blood guidance.

My point is that large insurance markets populated with bite-sized risks are more susceptible to channel shifts; the further southwest risk exposures are on the market size and granularity plane, the harder or less profitable they are to disintermediate.

Small group benefits has recently been semi-legislated into one of those law-of-large-numbers markets and this 5.5% revenue pocket for BRO has experienced organic revenue declines as small business clients have offloaded employees onto public health exchanges.[23] Democratized health insurance has ensured greater covered lives volume for carriers and correspondingly, bigger commission pools for placing brokers. Guaranteed enrollment means that a broker need not expend resources culling through lives that ultimately don’t qualify for coverage; the promise of more assured commissions has attracted intensifying competition, notably from cloud-based intermediaries[24] – one broker commented that small group commission rates of mid-teens from just a few years ago have compressed to 5%-6%.[25] Paychex, after years of 7-9% insurance services client growth from 2009-2012, is retreating from small group benefits after growth flattened in recent years.

Management

The Brown family’s influence has seeped unimpeded through several generations into present day Board and management, as well as Southern U.S. politics and business.

J. Hyatt Brown, chairman since 1994 and 14.9% owner of the Company, took over the business from his father who founded the Company and was Brown’s CEO from 1993 through 2009. His son, J. Powell Brown, current CEO, has been at BRO in various roles since 1995; Powell’s brother, Barrett, is a Sr. VP. You get the idea.

Half the Board’s directors have been so since the ’90s[28] and are septua/octo-genarians that look more at ease in a senior citizens community; over half the Board from 2000 still remains intact. Meanwhile, 7/10ths of the management team – with an average age of 55, a comparatively younger bunch – have been with Brown since the ’80s/’90s[29] and have served as profit center leaders at some point in their careers. The freshest executive, CFO Andrew Watts, joined the Company in early 2014, replacing a retiring CFO who had been with the Company since 1992. Vesting periods for stock incentive grants of seven years – a reprieve from the 10 to 15 year vesting period prior to 2013 – speak to the Company’s long-term orientation.

But longevity is hardly an unalloyed positive. Lengthy corporate histories entwined with family lineages often come with mandatory disquieting governance anxieties, and Brown is unfortunately no exception. There are, count ’em, 12 Board members[30] whose CVs read like a “Who’s Who” of Florida/Georgia politics and business. Overlapping Board memberships and various (but mild) value-leaking related-party transactions are recurring decade-long themes.[31] I don’t love this. That said, the Brown clan has the vast majority of its wealth embedded in its 15%+ ownership of a Company that has donned its family name for nearly 80 years; it’s difficult to conceive of a more personal and economic motive for optimizing long-term value. So while management and the Board are insularity personified, on the whole, I take comfort in the same impermeable cultural bubble that has conservatively accreted value over the decades.

Continued expansion of shareholder value will depend significantly on continuing NPV+ acquisitions and share buybacks. Because industry retention rates are so high (90%-95%), meaningful organic market share shifts aren’t common and acquisitions are an oft sensible growth path.

For context, from 2004 through September 2015, Brown acquired $1.3bn in annualized revenue (nearly 3/4 of current consolidated run-rate of $1.7bn) using a combination of cash and earn-outs[32] and always staying well inside responsible leverage thresholds, perhaps to a fault.[33] The Company mostly purchases assets[34] with tax-deduction attributes and since at least 1997, BRO has not taken a single intangible asset impairment, a conceit that no other public peer can claim. Strategically, Brown has established local market density by acquiring regional platform “hubs” and folding in smaller, adjacent agencies and true to its decentralized form, rather than manage the process from HQ, Brown delegates the search for potential targets to local office leaders and regional executives before engaging its internal M&A team.

The Company’s profit obsession guides its takeout approach – the CFO explained to me that acquisitions are charged an explicit, de-escalating cost of capital[35] and that fanciful but fleeting pro-formas to hit earn-outs are disallowed. Prerequisiting every deal are joint agreements specifying sustainable post-acquisition profitability targets that ramp to profit center margins within 2-3 years, a goal that has been credibly demonstrated over time.[36]

Historically, management has been opportunistic, aggressively capitalizing on attractive multiples in 2008 before recently orienting its attention to buybacks as unprecedented globs of private equity capital have flooded the agency landscape, displacing valuations up to and somewhat above 10x. By comparison, in 2008, the Company used all of its operating cash flow to aggressively acquire small retail agencies at 5.5-6.5x EBITDA when its own stock was trading at ~8x.[37]

At 1.3x net debt to EBITDA, BRO is deeply uncool in today’s levered platform parade. Recent financial engineering feats that maximize balance sheet efficiency at the expense of redundancy that veil tricky but paramount assessments of moat depth behind precise theoretical levered returns are just the pits, really, travesties in risk management. But Brown is not that.

Given the Company’s recurring revenue base, stable cash flows and variable cost structure, it could boost leverage to the high-end of its stated 1.5-2.5x comfort band to effect accretive acquisitions and buybacks without much incremental risk to the equity: moving to 2.5x (today) means another $500mn or so in debt, bringing total interest expense to $56mn against LTM EBITDA of ~$550mn (nearly 10x coverage).

Assuming 10% organic revenue declines – worse than any decline experienced during 2008/2009 – at far-too-onerous 60% decrementals, still leaves us with $450mn in EBITDA (and ~8x coverage) with sufficient discretionary free cash flow to delever back to 2.5x within a year.[39][40]

Still, with acquisition multiples drifting towards 10x+, the foregone opportunity of repurchasing BRO’s stock at 9.5x gets costlier and management has redirected its capital allocation focus. Until recently, the company hadn’t repurchased shares for treasury since at least the ’90s; it never made sense because its stock has almost always traded at a hefty premium to smaller brokers – until now.

Over the last 1.5 years, the Company has repurchased ~4% of its shares[41] while raising its remaining authorization to $450mn (10% of shares outstanding), by far the largest in company history.[42] On November 11, the Company announced another accelerated repurchase program in the amount of $75mn (another 1.7% of market cap).

Organic Growth[43]

Broker commissions are a function of written premiums, which in turn are the product of: 1) premium rates (price of insurance) and 2) insurance exposure units (the amount of insured stuff – sales, payrolls, vehicles, inventories, properties, etc). If you look at a chart of mapping the growth rate of commercial lines net written premium growth[44] since the ’70s, you’ll see that the great preponderance of data points fall north of “0,” with mid-single digit rates punctuated by recrudescent hard markets that drive net premiums 20%+ higher for a year or two. Insurance is a market where stable demand (exposure units) intersects with touch-and-go supply (pricing). You wouldn’t know it from this graph, but eight out of the last 14 years and 21 out of the last 30 were soft markets.[45] Commercial prices today are about where they were in 2000, unadjusted for inflation.

The brokerage industry’s incessant fuss over rates disguises a more mundane but convincing exogenous arbiter of brokerage industry growth: general economic activity. Brown’s management believes that historically 2/3 to 3/4 of its organic growth has been driven by exposure unit changes as opposed to pricing. The chart below generally validates this claim[46] but with an important caveat: the influence of commercial insurance pricing on Brown’s organic growth is most pronounced during periods of sudden and dramatic rate changes (>10%). In flat to soft-ish pricing environment (-7% to +7%) like the present, insured clients mostly stick with their carriers and brokers, and organic growth hugs the green line more tightly. In any case, industry growth never quite matches rate changes as movements along the demand curve attenuate full pass-through (corporate risk managers typically stay within budget bands, reducing risk units or raising deductibles as prices elevate and vice versa).

1) Brown is struggling in small group benefits (5.5% of revenue). The public exchange disintermediation that I discussed above was recently exacerbated by regulation in the State of Washington that resulted in the termination of several health association plans,[47] impacting retail segment organic growth/EBITDA margins by at least 60bps/30 bps this year. Based on my conversation with the CFO, this was an isolated termination that will be anniversaried in 2016. As previously mentioned, I am expecting unabated small group benefits challenges; still, even eviscerating all $90mn in small group business at onerous contribution margins would only dent LTM cash earnings by around 8-9%.

2) Relative to peers, BRO is over-indexed to coastal property, an air-pocket of 15-25% rate declines within an otherwise stable P/C complex.[48] I estimate that roughly 8-9% of the Company’s core commissions are linked to coastal property, a ~1% headwind to organic growth.[49] The absence of storm activity has also hurt Brown’s third-party claims administration and Wright Flood Insurance businesses, which have operated at depleted profitability post Superstorm Sandy.[50]

While these organic growth detractors have featured prominently in sell-side reports, their combined impact on earnings power (2-4% of LTM earnings) seems rather trivial when explicitly quantified and mundane when placed in context of assorted challenges the Company has periodically encountered over the last 15 years. Nonetheless, the Company has recently taken action to combat these headwinds.

The Board recently re-engineered significant annual cash incentives that binds management compensation to newly introduced organic revenue growth targets, a refreshing pivot from past freebees. Prior to 2015, annual cash incentives were only ostensibly linked to earnings growth – executives were awarded 100% of a “target cash incentive amount” even with flat income growth, with a maximum payout of 115% and a reasonable minimum of 90%.[51] This year, the payout percentages range from 0% to 200%, so there’s far more risk and reward to missing and meeting goals. The dollar payouts are meaningful, with the portion tied to organic growth (40% weight) alone amounting to nearly 100% of the CEO’s base salary.

Finally, for what it’s worth, leading indicators[52] show accelerating economic activity in Brown’s most important markets.

Scenarios

Note: You may find it helpful to peruse Appendix: Company And Segment Overview prior to reading this.

What follows are my estimates of where the Company’s stock might trade two years out in various states of the world, an entirely different exercise than handicapping BRO’s fundamental worth. Marrying disciplined capital allocators with an annuity-like asset can create value counter-cyclically (assuming Brown’s moat remains intact); in what you might call one of them good problems, during deep cyclical downturns precipitating multiple contraction, BRO can aggressively repurchase shares and roll-up distressed competitors. In ebullient times, management can reinvest in the business and fortify its balance sheet in anticipation of the inevitable downturn. Cycles come and go, competitive advantages and resource allocation are more enduring; and for a business constantly inundated with cash, moats + management are far more pertinent to long-term value creation. In that spirit, the real downside case ties itself to the following categories:

1) Misallocation of capital: CEO J. Powell Brown has been with the Company since his late 20s. Debuting as a lowly account executive and plowing through roles of intensifying responsibility, he at least appears to have been denied the most palpable blessings of nepotism. While management has made several chunky acquisitions over the last 3-4 years,[53] they’ve been thematically consistent with adjacent platform assimilations that have nudged the Company into services, programs and wholesale lines over the decades and seem synergistically sensible. So far, the large acquisitions in recent years – Arrowhead (2012), Beecher (2013) and Wright (2014) – have generated unlevered returns in excess of capital costs, been integrated at ~Company-average margins, and have led organic growth.

The scale advantages of two-way markets, in particular, can be persistently stable until they’re suddenly unglued and it’s conceivable that competitive forays in granular, homogenous risk pools firm a base for higher-order disruptions. One potential narrative is that the Brown’s commission-loaded market-marking function is piecemeal usurped, forcing it to increasingly rely upon lower-margin consulting fees in a domino fall that looks something like: small group benefits (where it’s already happening)-> worker’s comp -> large group benefits… or personal auto -> commercial auto -> commercial property… Besides the natural forces of competition, legislatively mandated single-payer universal health care is a fat disintermediating tail and would directly jeopardize 15% of the Company’s revenue (and perhaps 20%+ of earnings power).

Technology has nay-said the Company and its industry since the first tech boom and at least up to the present, Brown has consistently demonstrated that human relationships and insurance-specific expertise remain highly relevant. Paychex and ADP, firmly embedded in outsourced automated HR/payroll functions[54] for SMEs and presumably best positioned to offer adjacent services, have had surprisingly little success brokering insurance products. Broker channel checks suggest that Zenefits is witnessing enormous churn and a recent Wall Street Journal article claims that the company has missed its $100mn revenue target by more than half while Fidelity has marked down the value of its investment by 48% between August 1 and September 30.[55]

My base case ties organic growth rates to current coincident and leading economic growth indicators in BRO’s most important states and assumes that coastal property rates continue to decline 15-20% while P/C pricing, in aggregate, remains range-bound. Coalescing management commentary from conference calls and annual reports, I’ve discerned exposure lines where possible. In aggregate, I’m expecting <3% organic growth over the next several years, translating into flat EBITDA margins. Given management’s and broker industry commentary on frothy M&A conditions, coupled with a doubling of the Company’s share repurchase authorization, I assume BRO reduces its M&A appetite from historical levels and pays dearer prices of around 10-11x EBITDA while dedicating an increasing amount of cash flow to retiring shares. Net leverage is modestly increased to 1.8x.

LTM 2017E EBITDA: $603mn

LTM 2017E cash EPS: $2.79

Exit cash ROE: 12.3%

Sept. 2017E target valuation (using average valuation multiples during periods of comparable organic growth over the last 10 years):

Implied stock price @ 15x cash earnings: $41.79

Implied stock price @ 9.5x EBITDA: $36.39

Average: $39.39

Bear Case

The economy stutter steps into a 2008/2009 style recession amidst unmitigated softness in commercial rates. The Company’s cost cuts do not quite keep up with its falling top line[57] and margins contract. Smaller brokerages reset their lofty valuation expectations, empowering BRO to opportunistically consolidate at somewhat more favorable multiples of 9x (still much higher than the ~6x seen during the last recession), somewhat buttressing organic profit declines.

LTM 2017E EBITDA: $499mn

LTM 2017E cash EPS: $2.27

Exit cash ROE: 10%

Sept. 2017E target valuation (using average valuation multiples during periods of comparable organic growth over the last 10 years):

Implied stock price @ 11x cash earnings: $24.93

Implied stock price @ 7.5x EBITDA: $20.31

Average: $22.62

Bull Case

Turbulent weather events interrupt a decade+ of depressed loss ratios, policyholder surplus is scarred, and coastal property rates reverse their downward trend, bolstering core brokerage commissions and TPA revenue while denting high-margin profit-based commissions. Better pricing, together with exposure growth, fuels organic growth to ~6.5%, driving modest EBITDA expansion.[58] BRO levers its balance sheet up to 2.4x EBITDA to acquire companies at 10x-11x and repurchase 18% of its shares.

LTM 2017E cash EPS: $3.26

Exit cash ROE: 18%

Sept. 2017E target valuation (using average valuation multiples during periods of comparable organic growth over the last 10 years):

Implied stock price @ 17x cash earnings: $55.41

Implied stock price @ 10.5x EBITDA: $46.85

Average: $51.13

Appendix

Company And Segment Overview

Retail (51% of LTM revenue; 48% of LTM EBITDA): see “Insurance Brokerage Industry Overview” segment. While the Company primarily targets small to mid-sized businesses, it has bolstered its large account presence, with a particular emphasis on group benefits. Between the acquisitions of Beecher Carlson (July 2013; $364mn), Pacific Resources Benefits Advisors (May 2014; $99mn; double-digit revenue growth over the last five years and 98% retention), and Strategic Benefit Advisors (June 2015; $64mn), I estimate that large accounts constitute nearly 7% of total BRO revenue (14% segment revenue). Management emphasized to me that within large accounts, Brown does not directly compete against AON/MMC/WSH, but instead surgically focuses on unique, commission-abundant placement engagements.

Significantly, these acquisitions bring solutions that bolster Brown’s existing middle-market capabilities. For example, Beecher’s strong cyberinsurance presence has been successfully adapted and cross-sold and its proprietary databases and predictive analytics are offered as preventative maintenance solutions to reduce future claims. Pacific Resources, meanwhile, has introduced fuller ancillary offerings to Brown’s upper-middle-market clients. Approximately 84% and 16% of segment revenue is commission and fee based, respectively.

The next two segments, National Programs and Wholesale, function as market access providers for third-party retail brokers looking to place risks on behalf of clients. Retail brokers, particularly newer and smaller ones that don’t have the minimum volume in certain specialty lines to directly interface with carriers, access these intermediaries to place client risks that fall outside their core industry focus, better enabling them to compete with larger agencies. For example, a retail broker that specializes in restaurant professional liability can place workers’ comp risk for a one-off dental practice.

The two largest businesses within Programs are Arrowhead (a standard MGA with a large presence in southern California whose insured risk pools include commercial package insurance for automotive aftermarket, architects and engineers, quake, workers comp for select industries) and Wright (a national flood underwriter), both recent acquisitions that I estimate contribute 36% and 24% of segment revenue, respectively, and have generated > segment organic growth.

Wright requires some explanation.

In May 2014, Brown acquired Wright Insurance Group for ~$550mn.[60] As the largest participant in FEMA’s “Write Your Own” Program (WYO)[61] with 19% market share, Wright Insurance, while nominally a flood insurance carrier, is economically a commission-based service provider for the National Flood Insurance Program; that is, Wright does not bear underwriting risk. Flood insurance rates have been increasing at 7% annually over the last 10 years and legislative proposals to bring rates up to actuarial sound levels portend further improvements.[62]

A class action lawsuit was filed a year ago against Wright and U.S. Forensic, a third-party engineering firm contracted by Wright to assess certain Sandy claims. It alleges that engineering reports were manipulated with the intent to underpay claims for “hundreds” of policyholders. A number of WYO flood carriers are under similar scrutiny. A panoply of questions, including who, if anyone, bears culpability (the contracted engineering firm that allegedly falsified reports, the carrier who engaged it, or FEMA) remain outstanding.

Besides the standard legal boilerplate that management has included in its filings professing immateriality of lawsuits, here are a few more assurances for you: A.M. Best reaffirmed Wright’s A- (“Excellent”)/Stable rating in July; FEMA renewed Wright’s WYO carrier status in October; and “no new legal proceedings, or material developments with respect to existing legal proceedings” have occurred through 3Q15.

Wholesale Brokerage (14%; 16%): This segment sells excess and surplus commercial insurance[65] to retail agencies on a commission-basis. Of all Brown’s segments, wholesale is most closely tied to coastal property,[66] which, in light of the 15-25% coastal pricing declines makes this segment’s high-single-digit organic revenue growth and company-leading 36% EBITDA margins that much more impressive.

Services (9%; 6%): Provides insurance services for fees that are not directly tied to general premiums. The two main businesses here are choppy, high-margin claims administration[67] revenue and fees for Medicare services. The former gifted and subsequently thieved accelerated organic revenue growth and margin expansion post-Sandy,[68] and, given the absence of major storms, currently operates at depressed levels.

Compared to BRO, the market has rewarded AJG’s faster organic growth with more generous earnings multiples in recent years while ignoring the former’s consistently superior profitability. Brown’s employees are paid a smidge less than Gallagher’s, but generate comparable productivity on lower overhead, driving a higher profit spread per employee.[69] If the last decade is any guide, Gallagher must deliver 50% more revenue than Brown to generate the same EBITDA dollars.

———————————————

[1] Brown’s amortizable intangible assets consist of purchased customer accounts and non-compete agreements from acquisitions. These are non-cash/non-economic charges that I add back to GAAP earnings to arrive at a truer measure of profitability. At ~$0.60 per share vs. $1.70 in LTM GAAP earnings, this adjustment is meaningful.

[2] Applying 80%/10%/10% weights on base/bull/bear case scenarios.

[3] 2014 Business Insurance survey.

[4] Agents technically represent insurers; brokers, insureds….but the functional distinction is blurry and I use the terms interchangeably.

[5] The 100th largest broker generated $26mn in commissions according to the 2014 Business Insurance survey.

[6] Most agencies have a mix of personal and commercial lines. I calculate the number of commercial agencies by multiplying the number of agencies in each revenue cohort by each cohort’s mix of commercial revenue – think of it as a “commercial agency equivalent” number. My dollar value estimate is calculated as the product of commercial agency equivalents and the mid-point revenue of each revenue cohort.

[7] Source: 2014 IIABA Best Practices Study. On average, for agencies that generate between $2.5mn and $10mn in revenue, the largest shareholder has close to 60% ownership and is around 57 years old.

[8] The Company estimates the fair value of earn-outs on acquisitions, which are reflected on the balance sheet as part of the purchase price. Changes in estimated value flow through the income statement as non-cash charges/gains. Historically, these changes have been nominal and I exclude them from EBITDA. I include the fair value of earn-outs in the enterprise value.

[9] Adrian Brown, who founded the Company in 1939 with his cousin Charles Owen.

[10] Roberts, Sally. “Longtime agency chief J. Hyatt Brown retires.” Business Insurance. Web. 5 July 2009.

[11] (Through grants, open market purchases, or participation in the Company’s employee stock purchase program).

[12] By comparison, management and the Board at competitor Arthur J Gallagher together own less than 1.6% of shares.

[13] Brown’s in-house sales and leadership program.

[14] For example, a broker might place construction worker’s comp up to a threshold liability with one carrier and excess layers with another.

[15] A June 2013 Boston Consulting Group Commercial-Insurance survey shows that for a typical US insurer, 80% of premiums are derived from 20% of brokers/agents.

[16] Businesses with between 20 and 1,000 employees. Brown & Brown – J.P. Morgan Insurance Conference, March 18, 2015; U.S. Census Bureau; U.S. Small Business Administration.

[17] Personal auto, for instance. With Americans logging over 3 trillion vehicle miles per year, there are robust datasets on claims experience and accident frequency across demographics and geographies.

[19] Hoying, et al. (Nov 2014). Mining the Untapped Gold in SME Commercial Insurance. The Boston Consulting Group, 7-8.

[20] A business owner who reconciles his personal taxes with Turbotax will still outsource those of his 40-person business to an experienced CPA.

[21] Hoying, et al. (Nov 2014). Mining the Untapped Gold in SME Commercial Insurance. The Boston Consulting Group, 5-6.

[22] In 2012, personal lines insurers GEICO, State Farm and Progressive were among the top 25 most advertised US brands, edging out Home Depot and Budweiser; this, according to the Ad Age Datacenter analysis of U.S. measured media spending from Kantar Media.

[23] BRO defines small group as < 100 employees. Organic declines in small group have been offset by growth in its large group business.

[24] (Who have mostly seen success in small businesses with fewer than 50 employees). Perhaps the most salient example is the hyperbolic growth of Zenefits, a San Francisco-based cloud software company that brokers health insurance for small businesses at a 5% commission rate. In California, the company is the largest Anthem broker for companies with fewer than 50 employees. Mind you, Zenefits’ growth profile says nothing about its ultimate efficacy as a business. Several brokers I contacted believe that this “software company disguised as a well-informed consultant/broker” is experiencing significant customer churn as clients become increasingly disillusioned by the lack of benefits expertise and service. With < 10% of Brown’s revenue and firmly negative profitability, Zenefits’ last funding round valued the company at $4.5bn, 85% of Brown’s total enterprise value. That I think this excessive may speak to my lack of imagination; at a similar revenue multiple, BRO would be worth…just kidding. Benefits brokers are combatting the Zenefits threat by increasingly white-labeling cloud-based interfaces of their own.

[27] Public exchanges require scale and full participation to function effectively and current estimated public exchange enrollment for 2015 of 9mn-10mn lives is well short of the Congressional Budget Office’s original estimate of 15mn. UNH recently announced that it is considering withdrawing from exchange participation after major losses from policies sold through the exchanges. From Stephen Hemsley, UNH CEO on 11/19: “In recent weeks, growth expectations for individual exchanges have tempered industry-wide, co-operatives have failed, and market data has signaled higher risks and more difficulties while our own claims experience has deteriorated…”

[28] Including Toni Jennings, who took a hiatus from 2003-2006 to serve as Lieutenant Governor of Florida.

[29] J. Powell Brown (joined in 1995); Sam R. Boone (1987); Linda S. Downs (1980); Richard A. Freebourn (1984); Robert W. Lloyd (1999); Charles H. Lydecker (1990); J. Scott Penny (1989); Anthony T. Strianese (2000); Chris L. Walker (2003); R. Andrew Watts (2014).

[30] c.f. 15 at AON and 13 at MMC, significantly larger and more complex global entities.

[31] $12k to the Chairman for business entertainment expenses and club membership dues; a forgivable $500k loan to P. Barrett Brown, an SVP and brother of the CEO; $141k in fees for corporate aircraft owned by a family managed LLC are some notable ones.

[32] BRO has not used its stock as acquisition currency since 2001.

[33] From 1989 through 2013, BRO’s net leverage ratio ranged from -1.1x to 0.7x.

[34] As you might expect given the brokerage industry’s people-heavy/asset light structure, most of the purchase price on agency acquisitions is assigned to goodwill and intangibles.

[35] He wouldn’t reveal the number, but I estimate it to be originally set at around 6%-7%, pre-tax.

[37] “2008 was the third largest in company history with $115.4 million in forward annualized revenues. Forty-three of the 45 transactions were in the property and casualty and employee benefits retail agencies. Perhaps the most important quality of these acquisitions is that the earnings performance are in line with our expectations and margins comparable to the existing operations….In 2008 we continued to strength our M&A transaction capability. We added to our staff increasing the number of individuals in our legal, financial, and quality control teams to handle an increased number of transactions given the opportunity.” – Jim Henderson, BRO COO; 4Q08 Earnings Call, 2/17/2009.

By comparison, in 2007, when Brown’s stock was trading at ~9.5x, acquisitions were executed at 6x-7x, translating into high-teens after-tax unlevered returns.

[38] Target productivity and margins reflect those of an independent agency in the $2.5mn-$5mn bucket per the 2014 IIABA Best Practices Survey.

[39] BRO’s current leverage ratio is well below peers and unlike AJG, AON, MMC and WSH, the Company has no pension liabilities.

[40] The most onerous debt covenant requires a net debt to EBITDA ratio back to 2.5x within 12 months of a leverage event.

[41] (Most have been done under accelerated share repurchase programs at a weighted average price of $32.13).

[42] (In absolute dollars and as a percent of market cap).

[43] BRO defines organic growth for core commissions and fees the same way an honest retailer defines “same store sales” growth. It excludes contingent commissions and large books of business from newly hired producers.

[44] Gross premiums less premiums ceded to reinsurers; primary rates mirror reinsurance pricing over time.

[46] Even in a soft rate environment like 2004-2005 and 1998-1999, BRO posted positive organic growth as a strong economy translated into more insured units.

[47] Association Health Plans allow small employers in the same industry to pool their risks, taking advantage of scale economies in buying to offer health benefits to their employees. To qualify, an association must meet two criteria; it must not: 1) exist solely for the purpose of selling insurance to its members (the “bona fide” association hurdle) and 2) charge different rates for different risk profiles. Early this year, the State of Washington disapproved a whole slew of these plans for violating at least one of these two rules.

[48] The precipitous price declines – a function of 1) catastrophe-absent storm seasons driving record low loss ratios and record high carrier surpluses and 2) yield-starved private equity / hedge funds capitalizing alternative insurance vehicles – have persisted for several years.

[49] An overlooked silver lining is that ~3.5% of Brown’s revenue and ~8% of EBITDA comes from high-margin profit-sharing commissions tied to carrier profitability (which, in turn, is negatively correlated with storm activity).

[50] Services segment (9% of revenue) LTM margins of 23% vs. 30% in 2013.

[51] From the Company’s Proxy filed 3/27/15: “The cash incentive amounts for Messrs. Powell Brown, Watts and Penny were calculated based on the following formula: [target cash incentive amount] times [100% plus the percentage change in earnings per share, without regard for change in acquisition earn-out payables and adjusted to exclude the net after-tax effect of those sales of offices that occurred during the fourth quarter of 2014].”

[52] Each state’s Philly Fed’s Leading Economic Indicator is meant to be to lead its Coincident Index by 6 months. Per the Philly Fed website,Leading Indicator = Philly Fed Coincident Index + state-level housing permits (1 to 4 units), state initial unemployment insurance claims, delivery times from the Institute for Supply Management (ISM) manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.

[54] PAYX and ADP have nearly 600k and 600k+ clients, respectively.

[55] Winkler, Rolfe. “Highly Valued Startup Zenefits Runs Into Turbulence.” The Wall Street Journal 12 Nov. 2015: n. pag. The Wall Street Journal. 12 Nov. 2015. Web.

[56] Green/grey/red = bull/base/bear.

[57] I assume cost cut / revenue decline ratios comparable to 2008/2009.

[58] To just 33.6%, still at the lower end of management’s nebulous long-term 33-35% target.

[59] BRO manages over 50 programs w/ 40 carriers.

[60] $120mn in annual revenue, $76mn of which represented flood insurance and resides in the Programs segment.

[61] A cooperative arrangement between the P&C industry and FEMA in which 80 participating private carriers underwrite and process claims under their own banners but cede the risk to the federal government. The carriers receive expense reimbursement and commissions for every policy it sells.

[62] Around 20% of the flood market is operating at subsidized, actuarially unsound rates.

[63] Strudevant, Matt. “Storm Sandy Insurers Battle Flood Claim Lawsuits.” Hartford Courant [Hartford] 21 Dec. 2014.

[64] Hugely reductive legal analysis, I know…I’m simply trying to scope the dimensions.

[65] (Quirky, unusual risk – excess workers’ comp, garage, inland marine, jewelry – that is hard to place in traditional markets)

[66] I estimate ~1/3 of commissions.

[67] TPAs act as an extension of an insurer’s claims department, providing critical processing capacity for claims payments and customer service during disasters, when carrier resources are strained.

[68] Segment organic growth in 2012/2013/2014 were 8.6%/12.2%/-8.1% while EBITDA margins were 26.3%/30.4%/22.8%.

[69] Brown offers employees a more generous purchase discount on stock purchase plans, which is not reflected as compensation on the income statement. Adjusting for this, however, does not make a material difference.

[70] Brokers are variable cost heavy, so the contribution margins relative to extant ones on low-to-single digit organic growth are quite nominal. Plus, drawing from AJG management comments, I believe the organic growth bogey for margin expansion is higher at AJG than it is at BRO, and even if that weren’t the case and Gallagher’s greater organic growth profile were in fact yielding strong contribution margins, it would only make my hypothesis – that AJG is acquiring companies with substantially and sustainably lower pro-forma margins than BRO – stronger.

[72] “Let’s call it what it is. There are a lot of acquirers out there, some of whom are paying what we might consider ridiculous prices in certain transactions.” – J. Powell Brown, CEO of BRO (2Q15 Earnings Conference Call

“…it is a competitive market, but I would say the difference is really when you look back four or five years ago, the multiples were lower than they are today, so it’s very important for us to understand that.” – Daniel S. Glaser, CEO of MMC (3Q15 Earnings Conference Call)

“It is true that certain assets are being priced up particularly those where the private equity industry is also a potential buyer. So, you have obviously seen some of the things going on and going around the North American regional brokerage market where you often do see very, very high prices being paid.” –Dominic Casserley, CEO of WSH (3Q15 Earnings Conference Call)