WTW - Insurance Broker Comparison: Brown & Brown Has An Edge

2023-04-10 10:00:00 ET

Summary

• Insurance Brokerage consolidators have seen a tremendous outperformance as a peer group over the S&P 500 in the last decade.
• Brown & Brown's culture is a leading factor in its success.
• A peer group analysis reveals that Brown & Brown looks more attractive than its peers.

Brown & Brown (BRO) has been a leading insurance brokerage firm for over 80 years. The company has become a trusted name in the industry with a reputation for excellent customer service and innovation. Brown & Brown runs a decentralized business model with centralized corporate functions to increase focus on local decision-making, which allows its offices to be flexible and responsive to the needs of their clients. This has been a critical factor in the company's fundamental outperformance against the overall market, but peers have performed better recently. Out of BRO's peer group, only Willis Towers Watson (WTW) underperformed the S&P 500 over the last decade, while Marsh & McLennan (MMC), Aon plc (AON) and Arthur J. Gallagher (AJG) outperformed SPY and Brown & Brown considerably. Let's see if this outperformance is rational or not.

Brown & Brown business

Brown & Brown is an Insurance Brokerage roll-up with four segments. The majority of the business is in the Retail business (58%), followed by National Programs (24%), Wholesale Brokerage (13%) and Services (5%). What sets the company apart is its culture. This is evident by the insider ownership: 21% of shares outstanding are with Brown & Brown Teammates (including the Brown family, directors and insiders in the company). By leveraging a lean and highly competitive culture and a profit and growth orientation, the company is flourishing and looking to achieve its mission of being the leading insurance broker delivering innovative solutions to its customers.

Many of my favorite acquisitive businesses have a highly decentralized operating structure. This allows individual teams to continue operating as they used to, but with added centralized help for mundane tasks that aren't generating value. If companies focus more on delivering value to their stakeholders, results often improve. This is the case with companies like Constellation Software (CSU:CA), Lifco (LIFCO) or Danaher (DHR), but also for Brown & Brown! Below you can see the decentralized model that focused on decentralizing sales & services and other operating tasks while centralizing obligatory tasks like IT & Cyber security or compliance. This allows the individual brokers to focus on delivering great value and growing profits.

Let's compare results with BRO's peer group and see if these advantages translate into superior fundamentals.

Margins

If we look at EBITDA and Net Income margins, we can see that BRO consistently outperforms its peers, rarely being overtaken for a year by a peer. Having consistently high margins is a good example of a competitive advantage.

Growth

Comparing the revenues and operating cash flow growth rates, we can see that BRO consistently wins out in revenues. Still, it isn't such a straightforward situation on the operating cash flow front. BRO doesn't have a clear advantage here but still performs pretty well, with a median rolling 3-year Operating cash flow CAGR of 12.5%.

Balance Sheet health

Let's compare the balance sheets. I look at Net debt/EBITDA and EBIT interest coverage for this. We can see that, once again, BRO performs better than its peers generally. For the first time in a decade, BRO has the highest leverage. This results from a flurry of acquisitions in 2022, totaling almost $2 billion spent in a single year (10% of Enterprise Value). Around half of the debt is in bonds out many years, with one Bond maturing in 2052 at $600 million. The current 2.9x leverage is above the 0-2.5x range the company targets and I expect the company to quickly delever again within the range.

Returns on Capital

A good proxy for capital allocation is Returns on Capital/Equity. For this comparison, I removed AON's Return on Equity because it distorts the graph: AON has negative shareholder's equity and this ROE is not really usable. We can see that BRO is not performing too well here in either ROC or ROE. Generally, this comparison is tricky because these companies have immense goodwill on their balance sheet, accounting for more than half of the total capital invested in all cases. This distorts Returns on Capital.

Valuation

Lastly, let's compare valuations. We can see that, except for Willis Tower, all companies saw tremendous multiple expansions over the last decade. Right now, BRO trades at a slight discount compared to its peers on a multiple bases.

If we use an inverse DCF analysis with a 10% discount rate, we arrive at a required FCF growth rate of 10%. While it is not a bargain, it looks reasonable and in line with at least the medium-term growth expectations analysts have.

We established that BRO is better in most metrics than its peer group while trading at a slightly lower multiple. Although it's not a screaming buy, I will still assign Brown & Brown a light buy. We get a well-run business with an excellent culture for a fair price.

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