PORTFOLIO POINT: Austbrokers has harnessed the SME insurance market and is going for growth, with 13 acquisitions so far this year, and all funded from cash flow.
Investors could easily run a mile from insurance stocks in this market. QBE Insurance Group hasn’t needed any more natural disasters after being its own disaster this year, and it still looks overvalued to many investors after shedding one-third of its share price since August.
More natural disasters, a slowing economy and a lower interest rate environment is all further bad news for insurers, and a reason investors in QBE, AMP, Insurance Australia Group (IAG) and Suncorp Group have had more downs than ups in the past five years.
But, as so often happens, extreme bearishness can create buying opportunities for investors who look beyond market sentiment to a company’s true valuation. IAG has rallied this year, and a much smaller player, Austbrokers Holdings (ASX: AUB), is up almost 40% and winning new fans.
Austbrokers is one of those rare small-cap companies that tick higher each year with admirable consistency, and is a remarkable entrepreneurial story in its own right. With a part-time assistant, outgoing chief executive Lachlan McKeough started Austbrokers in 1985 as a complementary operation to ING’s insurance underwriting business. It was listed in 2005 through a $90 million float at $2 a share.
The prospectus should be mandatory reading for investors in Austbrokers, even though the document is seven years old. Revisiting annual reports and company prospectuses to see if management and the board stuck to the vision – and matched actions to the sales pitch – is an under-used research method in a market that is easily distracted by meaningless multiples, such as price-earnings, and incessant share-price “noise”.
Austbrokers’ strategy, business model and vision seems as valid today as it was in 2005. The opportunity to consolidate a fragmented market of insurance brokers that mostly service small and medium-size enterprises is far from exhausted. The strategy was simple and powerful, and the execution superb.
The market, of course, is well aware of Austbrokers’ strengths, and in the past years at least has been willing to value it at a significant premium to its intrinsic value. This has made Austbrokers a challenging, frustrating stock for value investors; it always looks dear, and yet it keeps rising.
Austbrokers has consistently traded well above my intrinsic valuation since 2006. After sharp gains this year, Austbrokers (at $8.19) is 27% overvalued, and well above its current intrinsic value of $5.94, which rises to $6.46 in mid-2013 and $7.14 a year later.
Either the market is too optimistic in assessing Austbrokers and has not sufficiently factored in a more challenging environment for it in 2013, or I’m conservative with my valuation. There is probably some truth in both positions, meaning Austbrokers is fully valued at current prices but a stock to watch in anticipation of a narrowing gap between the market price and intrinsic value.
The market’s willingness this year to pay a high premium (some would say inflated) for so-called “defensive growth” stocks has worked in Austbrokers’ favour. Austbrokers’ defensive qualities and earnings visibility are clear attractions in an uncertain market – to a point. Further comfort comes from the company’s scope to grow earnings through acquisitions, in what remains a favourable industry structure for Austbrokers.
It has made 13 acquisitions in calendar year 2012 alone. There have been three bolt-on acquisitions in the current financial year, and Austbrokers increased its stake in several existing businesses. The additional equity interests will lead to an increase of $12 million in net profit this financial year. Impressively, the $10.6 million spent on acquisitions so far this year were funded from cash flow rather than debt.
Small-cap companies that consistently make ‘earnings-accretive’ acquisitions or investments each year, using surplus cash flow rather than debt, are rare. Austbrokers has $20 million available for further acquisitions, more than enough to add several more firms to its network in 2013 and beyond. It has a $44-million facility with St George Bank, of which $11 million remains undrawn, and scope to secure a bigger credit line in coming years.
Total debt has been flat at $34 million for the past four years and it is covered several times over by Austbrokers’ cash and short-term investments. Moreover, its issued share base has only grown from 50 million to 56 million in five years; it is clearly not a small-cap company that treats share issuance like confetti to fund grandiose growth plans and sate management egos.
Austbrokers’ other attraction is long-term earnings consistency. Reported net profit has grown by double-digit rates each year since 2007, as have earnings per share. Austbrokers has avoided the earnings volatility inherent in other insurance stocks, principally because it focuses on the SME market. A 3.8% fully-franked dividend yield is another plus.
At its annual general meeting in November, Austbrokers reaffirmed previous guidance of 5% to 10% growth in net profit in FY13 and said it had a good start in the first three months of this financial year. In a market where earnings downgrades are the norm, small-caps that confidently stick to profit guidance – and deliver on it rather than tell market “porkies” – deserve some valuation premium.
Austbrokers is the type of investment story small-cap fund managers favour in this market: a company that can use surplus cash to make a string of lower-risk, lower-cost acquisitions in a fragmented market and maintain growth as the economy slows, and continue to drive economies of scale that improve efficiencies across the network. As performance improves, more insurance brokers want to join the network, which in turn makes it more efficient.
There is no rocket science behind this growth-by-consolidation strategy. Companies in other industries, notably M2 Telecommunications Group and Reckon, have performed well, to date, through organic growth and acquisitions, and have a focus on SMEs.
Simply put, Austbrokers’ acquisitions have helped profits tick higher each year but not led to a higher return on each dollar of shareholder equity invested. Even bigger profits are needed to lift return on equity, given the denominator – Austbrokers’ total shareholder equity – has grown from $87.5 million in FY07 to $159 million in FY12.
And there are other challenges: Business conditions, rising competition for insurance broker acquisitions and a new CEO for Austbrokers, Mark Searles (well regarded and with excellent insurance experience), from January 1 are risks to consider, analyse and reach a conclusion on.
The main challenge, however, is simply valuation: it may be too risky to chase Austbrokers higher. That is not to say it should be sold or avoided; rather, that keen investors need to watch and wait for better value.
Austbrokers has had a golden run in recent years and can still be a terrific investment in the years ahead under Searles’ leadership – but only the right price will provide the security that value investing can offer.