Brown & Brown: Premium Rate Increases Boosting Revenue Growth; Initiate With ‘Strong Buy’

Brown & Brown (NYSE:BRO) is the sixth-largest independent insurance brokerage in the U.S., with more than 90% of revenue generated in the states. They released robust quarterly results on January 22. I am initiating a ‘Strong Buy’ recommendation with a fair value of $105 per share.

Rate Increase in Insurance

During the Q4 FY23 earnings call, they indicated that rates in the admitted market were up 5-10% for most insurance lines, and they anticipate this rate increase to remain relatively consistent in the near future. To manage the increase, buyers have the option to either reduce limits or participate in certain layers to mitigate fees.

The premium rate increase is contributing to Brown & Brown’s growth. As illustrated in the chart below, the company has experienced outstanding growth after the pandemic amid the high-inflationary environment.

I believe Brown & Brown will continue to benefit from the ongoing rate increase in the near future. During the recent earnings call, they emphasized that 2/3 of their growth is exposed to unit growth, while 1/3 is tied to rate changes. Consequently, fluctuations in rates could have a substantial impact on their earnings.

According to Swiss Re, U.S. P&C Direct premiums written (DPW) are expected to rise by another 5.5% in 2024, following a significant increase in 2022 and 2023. Historically, the insurance premium rate change has lagged behind the Consumer Price Index. Even if inflation starts to decline, the insurance industry is likely to continue experiencing rate increases. Considering the current inflation and falling commodity prices, I don’t anticipate a similar rate increase in 2024, but a more than 5% increase remains quite possible.

Successful Acquisition Strategy

Brown & Brown has allocated the majority of its free cash flow towards acquisitions, aiming to enhance complementary capabilities and specializations. According to their annual report, from 1993 through the fourth quarter of 2022, the company acquired 610 insurance intermediary operations. In FY23 alone, they completed acquisitions amounting to approximately $162 million in annual revenue.

One notable acquisition was Orchid Underwriters Agency in March 2022, for $476.2 million, aimed at enhancing their National Programs business. In July 2022, they acquired GRP for $1.84 billion, and in January 2021, O’Leary Insurances for $117 million. All of these acquisitions strategically focus on their core insurance brokerage business, representing efforts to consolidate the brokerage market and expand their own scales.

For instance, GRP, one of the top independent insurance intermediaries in the UK, services nearly half a million personal and commercial customers, generating $340 million in annual revenue. This deal enables Brown & Brown to extend its footprint in the international brokerage market.

Overall, the M&A strategy appears consistent, centered on strengthening their core business, with acquisitions serving as a vital cornerstone for the company’s growth.

Recent Financial Review and FY24 Outlook

Over the past few years, Brown & Brown has demonstrated solid organic revenue and earnings growth. The majority of their free cash flow has been allocated to strategic acquisitions. Despite this, their robust cash flow generation has allowed them to maintain a strong balance sheet, with a net debt leverage of 2.2x.

They reported their Q4 FY23 results on January 22, showing 7.7% organic revenue growth and 16% adjusted EPS growth. Remarkably, they concluded the fiscal year with a substantial 10.2% organic revenue growth, outperforming many other insurance brokers.

As usual, they haven’t provided detailed growth guidance, but they did offer some economic outlook, as shown in the slide below. I anticipate the company to deliver another year of growth, albeit at a lower rate than their impressive results in FY22 and FY23, as the rate increase approaches its end. Throughout the insurance underwriting cycle, Brown & Brown has consistently achieved an average of over 7% organic revenue growth over the past five years. I believe a 7% organic revenue growth projection is quite reasonable for the company.

Valuation

As discussed previously, I believe the company has the potential to achieve 7% organic revenue growth through the cycle. Additionally, tuck-in acquisitions are integral to their growth strategy, and assuming they allocate 8% of revenue to acquisitions, these deals could contribute another 2% to topline growth. The expansion of their margins is primarily driven by operating leverage, as operating expenses don’t need to grow at the mid-to-high single-digit rate. Moreover, the growth in workers’ compensation has begun to moderate from last year. Based on my calculations, they should be able to deliver an annual margin expansion of 10 basis points.

I’m applying a 10% discount rate, which is consistent across all my models. The terminal growth is assumed to be 4%, a reasonable level for a mature insurance broker business. Based on these considerations, the fair value is estimated to be $105 per share.

Notably, the current stock price is trading at around 20 times forward free cash flow. Given the anticipated double-digit earnings growth of the company, I consider this valuation to be quite attractive and suggest that the stock is undervalued.

Key Risks

Service Business: The Service business experienced a decline of 5.9% for the quarter, and the organic growth for the full year remained flat, negatively impacting their overall performance. On October 31, 2023, they announced the sale of certain third-party administrator businesses, completing the deal in the recent quarter. The Service business represented approximately 5% of the group’s revenue, providing services such as Social Security Advocacy and Advisory, Claims Administration, Medicare Secondary Payer compliance, Medicare Set-Aside, and others. These businesses are considered non-core, lacking operating leverage with their insurance brokerage business.

Insurance marketplaces in California, Florida, Louisiana and Texas: Insurance companies are currently grappling with challenges in these regions, where the entire industry is transitioning toward state-sponsored plans. Numerous insurance companies have exited these regions due to reported unprofitability, as highlighted by the media. Brown & Brown, as an insurance broker, would likely be affected by these industry shifts.

Conclusion

Brown & Brown is benefiting from the rate increase in the insurance brokerage industry, and I admire their high-quality growth potential. I am initiating a ‘Strong Buy’ with a fair value of $105 per share.