Brown & Brown (BRO) is a current pick of GuruFocus’ Historical Low P/S Companies Screener. Despite a share price that is up >50% off its lows, it’s P/S valuation has stay within its depressed range which began roughly during the financial crisis.
An educated guess would be that the company has experienced rising sales without a commensurate rise in profitability, leading to a stagnant P/S valuation despite top-line growth. A cursory look would suggest this thesis is correct, with revenue per share growing healthily over the past few years and EBIT per share barely budging.
Clearly, BRO has seen lower levels of returns and profitability despite their ability to grow the size of the business. In this article, we’ll take a look at why this has occurred and ascertain BRO’s ability to revert profitability back to historical levels, assuming giving hidden value to the company’s shares.
The business:
BRO is one the leading national mid-market insurance brokers. The firm markets and sells insurance products and services in the United States to commercial, public, professional, and individual customers.
As an insurance intermediary, the principal sources of revenue are commissions paid by insurance companies. The volume of business from new and existing customers, fluctuations in insurable exposure units (such as property values, sales, and payroll levels) and changes in general economic and competitive conditions all affect BRO's revenue.
Headwinds include industry consolidation and commoditization:
Major insurance brokerage players, such as BRO and its competitors, Marsh & McLennan (MMC), Aon (AON), Willis (WSH), and Arthur J. Gallagher (AJG), have made numerous acquisitions over the past five years to capture market share. On a percentage change basis, BRO has clearly been the most aggressive in adding revenues through M&A.
However, given the straight-forward business model (commission on insurance premiums) and limited product differentiation, competition is fierce. Operating margins for four of the five largest insurance brokers have declined since 2008, with industry leader BRO converging with the industry average suggesting increasing commoditization. The only company to improve operating margins over this time frame (MMC, Financial) merely improved from an industry-worst level to the industry average.
Additionally, a convergence and deterioration of industrywide Return on Assets also suggests a growing level of commoditization.
M&A remains key for future profitability:
Still, the brokerage space remains highly fragmented with over 40% of industry revenues controlled by companies with less than $10 million in annual revenue. Between 35,000 and 40,000 brokers and agents operate in the U.S. generating over $100 billion in annual revenues. Only seven of those brokers generate more than $1 billion in revenues. This makes the insurance sector an attractive space for M&A opportunities.
Still, with growing levels of commoditization and deteriorating pricing power, consolidators run the risk of buying increasingly less profitable revenue streams. In addition, competition for M&A (and thus prices paid for acquisitions) has been rising. Historically, strategic buyers already in the space (such as BRO) accounted for well over 90% of deal volumes. Lately however, private equity firms have shown an increased interest, driving up purchase prices. The $4.4 billion purchase of Chicago-based Hub International Ltd by Hellman & Friedman LLC in August 2013 came after similar transactions of USI Holdings Corp., Alliant Insurance Services Inc., and Confie Seguros Insurance Services. These acquisitions by outside acquirers were some of the largest in recent years.
Conclusion:
While shares trade at seemingly attractive P/S levels, paying 15x EV/EBIT for what appears to be a business lacking long-term differentiation and pricing power seems expensive. Investors are most likely better off looking for a business model with more durable competitive advantages.
For more ideas like this one, please see GuruFocus’ Historical Low P/S Companies Screener.
