MMC - Brown & Brown Underwhelms Though Insurance Pricing Remains Healthy

Summary

• Brown & Brown had a better-than-expected quarter, but the underlying results weren't as strong, and the market didn't like the low single-digit organic growth in the Retail business.
• Insurance brokers are generally seen as defensive, but the sector is vulnerable to a slowing economy and the end of a once-in-a-generation hard insurance market.
• Industry-wide derating is a risk, despite brokers' defensive credentials, but I believe underlying cash flow, earnings, and EBITDAC support a fair value around $60 to $65.

These are interesting times for insurance brokerages. A slowing economy is generally not so supportive for these businesses and neither is the late state of a hard insurance market. On the other hand, these companies are poised to benefit from better interest rates and insurance pricing has remained pretty firm. Better still, these companies have a reputation for being more defensive and reliable through volatile times, and that would seem to fit where we are today.

Specific to Brown & Brown ( BRO ), I do think the company’s skew toward middle-market companies is a bit of a liability in a slowing economy, as is the company’s relative lack of exposure to reinsurance. On the other hand, it has less exposure to more discretionary consulting revenue streams and serving a base of smaller customers has been good for margins. Lackluster fourth quarter results and guidance for 2023 will fuel some near-term sentiment headwinds, as will concerns about the impending end of this hard market. Valuation is a toss-up – I see the shares as a little undervalued, but I do have concerns about broader derating for brokerages.

A Headline Beat, But Less Impressive Upon A Closer Look

Brown & Brown didn’t have a bad end to the year, but the results weren’t exceptional after backing out some one-time items.

Organic revenue grew almost 8% as reported, and that was a respectable beat relative to the sell side expectations (roughly 70bp in organic growth terms), but stronger results in the National Programs business did inflate that some; Brown & Brown still would have beat on adjusted numbers, but by a much narrower margin.

Reported EBITDAC (similar to EBITDA, but it also adds back changes in estimated acquisition earnout payables) rose 34%, with a margin of 31.4% (up from 28.5% a year ago and 25.1% in Q3’22). EBITDAC margin beat by 20bp, but would have missed without the one-times boosting National Programs. Likewise, while bottom-line EPS did beat by $0.04/share, lower taxes were a meaningful factor there.

Looking at the individual reporting lines, Retail was soft at 2.7% organic revenue growth, with EBITDAC up 25% (margin up about 120bp to 26.8%). That’s the weakest growth for Brown & Brown’s largest business since Q4’20, with weakness in the auto/RV business (pressured by lower vehicle inventories) and tougher comps in the benefits business.

National Programs was up almost 22%, but the results included a meaningful growth bonus and elevated results from flood insurance. Net of these, growth was 13%, while EBITDAC rose 52% (margin up 290bp to 44.1%). Wholesale saw 8% revenue growth, with EBTIDAC up 20% (margin up 70bp to 28%), while the small Services business was basically flat on the top line and saw 28% EBITDAC growth (margin up 410bp to 19.2%).

A Lot Of Cross-Currents In The Macro Outlook

Although Brown & Brown’s overall organic revenue performance was better than expected (and better than the third quarter’s results), it’s the slowdown in the Retail business that’s likely to dominate discussions of the stock in the near term. The market was already a little nervous about this sector, as growth has been slowing, and management’s guidance didn’t provide a lot of information that can anchor a more bullish outlook.

Insurance pricing remained strong in the fourth quarter, up about 3% to 7% year over year and consistent with the third quarter. P&C pricing has been slowly easing as the hard market of recent years heads towards its conclusion, but rates continue to be supported by inflation and inflated loss trends. Management did mention evidence of “rate hike fatigue” among its customers, and it’s a known phenomenon around the industry that many customers are trying to get creative with terms (modifying deductibles and coverage limits) to mitigate higher rates.

All of this matters to Brown & Brown (as well as peers/rivals like Marsh & McLennan ( MMC ), Aon ( AON ), and Arthur J. Gallagher ( AJG ) because these business are compensated through commissions tied to those premiums. While there are ways to get paid outside of commissions (including value-added services like developing specialized products, consulting services, and insurance-related services like claims administration), commissions drive the bus, so the anticipated fading of the hard market is a threat to revenue growth.

Overall macroeconomic conditions likewise impact the outlook, and the economy is starting to slow. A slower economy means fewer workers to insure, less inventory to insure, and less ability to absorb higher rates. With smaller companies likely more vulnerable to this slowdown (and with less leverage to pass through higher insurance costs), Brown & Brown is arguably more exposed here than some of its larger peers.

There’s also the question of market exposures. Brown & Brown is largely a commercial and wholesale broker, and handles relatively little reinsurance compared to MMC, AON, and AJG. The strongest rate increases now are likely to be in reinsurance, where rate hikes of 40% or more in some markets seem possible with January 1 renewals (indeed, Brown & Brown management noted property catastrophe rates up 20% to 40%).

Still, I don’t want to leave the impression that Brown & Brown (or the industry in general) is on the edge of a cliff. I still expect growth from here, though I do expect organic growth to slow toward the 3%-5% range that is more typical of the industry. Pricing is definitely slowing in some markets (including professional lines and some excess & surplus lines), and a slowing economy will have an impact.

The Outlook

I’m looking for around 8% reported growth from 2022-2025, with Brown & Brown continuing to benefit from acquisitions as well as improved investment income. Within that number I expect overall organic growth of around 4% and Retail growth closer to 5%. I don’t see much margin leverage in FY’23, but I do expect modest margin improvement through 2025 (from 32.8% to around 34%), and I expect improved free cash flows as well.

Valuation is a little challenging now, as I do think slowing growth and the eventual end of the hard P&C market will push some derating, possibly counterbalanced by the defensive reputation of this sector. The sector has a long-term average forward P/E of around 19x to 20x, while Brown & Brown’s has traditionally been a couple of points higher (a reflection, I believe, of its more profitable and defensible middle-market customer base). Still, the hard market has driven higher multiples, with a 5-year trailing average forward P/E of around 24x for Brown & Brown. Maintaining that would give me a fair value of $59 on FY’23 earnings (my estimate is a bit below the Street - $2.45 versus $2.49), but that may be a bullish call.

While they’re not often used in valuation, at least among sell-side analysts, I also see value in using discounted free cash flow and an EV/EBITDAC approach, as the latter does correlate to margin and return performance. With a long-term outlook for 6% revenue and 7% FCF growth and a 16x forward EBITDAC multiple I get a fair value range of $60 to $64.

The Bottom Line

I don’t think Brown & Brown is expensive today, but given growing macro challenges and sentiment risk (including potential derating across the group), I’m not particularly excited about the level of undervaluation. This has been a pretty good stock over the last five to 10 years, but I’d prefer to see some stabilization of growth in Retail and/or more derating before getting more aggressive on the name, as I think the defensive traits of the industry may be outweighed by tougher macro headwinds over the next couple of years.

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