Austbrokers and Steadfast: Results 2014

In 2011 a string of natural catastrophes forced up premiums in Australia and New Zealand as insurers recovered the losses from an explosion in claims. Premiums generally increase following catastrophic events, like the floods in Queensland and the earthquakes in Christchurch, which were front page news, as you don’t generally care much about the price of protecting your belongings when you’ve recently been exposed to the physical and financial devastation of Mother Nature.

It’s a classic example of recency bias, where we extrapolate recent events into the future. It’s also the reason companies such as Insurance Australia Group traded at bargain prices. Most investors made any excuse not to buy insurance companies in 2011, despite the fact that it was the safest time to buy them as their share prices were depressed.

With the cyclical increase in policy prices having largely run its course, the share prices of insurance brokers Austbrokers and Steadfast fell 10% and 25%, respectively, leading into reporting season, as investors feared steady or falling premiums would depress profit growth. Trading on respective price-earnings ratios of 18 and 23, neither stock provided insurance against weak profit growth.

Both stocks have recovered following their annual results, which showed they don’t need higher premiums to increase profits. As long as the amount of money spent on insurance is expanding and they maintain or grow their market share, both companies should keep growing profits by 5–10% a year with half of that coming from acquisitions.

That’s also why we haven’t rushed into buying the pair. The biggest (or second-biggest in the case of Austbrokers) asset on their balance sheets is goodwill, which will continue to increase as they expand their network of insurance brokerage agencies.

History is littered with the corpses of highly acquisitive companies, which is why John Szangolies, owner of a $167m food and drink empire that includes Bavarian Bier Café, recently said, ‘I create goodwill. I never pay for it.’ Acquisitions usually destroy value and require large licks of debt as impatient chief executives take big risks with shareholders' money.

Small premiums

Austbrokers has bucked the trend, though. It has been patiently acquiring businesses for 30 years and its finances are in great shape. One of our biggest concerns is that the rapid expansion plans of an emboldened and well-capitalised Steadfast leads to higher acquisition prices as sellers opt for the highest bidder, but it will likely be several years before this plays out. In the meantime both companies could be growing at 10% per year, potentially allowing for a few hiccups along the way.

It's also a worry that many of the key players in the companies' insurance agencies are reaching retirement age. That’s not a problem for the few family businesses where the next generation can seamlessly take over and maintain the relationships. But there is a risk that clients will walk if the agency founder disappears.

Austbrokers and Steadfast have little interest in the day-to-day operations of a niche insurance broker. Their strength is reducing their agents’ operational costs and ensuring they’re getting the best deals and widest selection of policies from underwriters by belonging to an umbrella group.

Both companies expect to fill any management holes with up and coming managers or by using ‘hub and spoke models’ that allow one manager to manage several offices. It’s an issue worth watching, but it’s unlikely you’ll be the first to know about any problems. That’s why management of these companies is so important.

Insurance against recession

In summary, lower premiums might slow profit growth but it’s unlikely to stop it. There’s a risk of overpaying for acquisitions but Austbrokers has been patient in the past and, with both companies having tiny market shares, there seem to be plenty of targets for both players (see Hail the insurance middlemen).

The loss of retiring agents seems manageable, and clients may be happy to stick with a large broker network regardless of who they deal with. The two major remaining risks are a recession and overpaying for the stocks.

We looked at the 2009 annual reports of two of the world’s largest insurance brokers, US-listed companies Aon and Marsh & McLennan, expecting to see plenty of red ink as insurance profits tend to fluctuate with employment levels. In fact, the three biggest things to affect Aon’s 2009 result were:

1. Declining insurable risks due to decreasing asset values, including property values, shipment volumes, payroll and number of active employees;
2. Client cost-driven behavior, where clients are actively looking to reduce spending in order to meet budget reductions, and increase risk retention, as a result of prioritising their total spending; and
3. Sector specific weakness, including financial services, construction, private equity, and mergers and acquisitions, all of which have been particularly affected by the current recession.

Remarkably, in the midst of the largest financial crisis since the Great Depression, Aon’s and Marsh & McLennan’s respective underlying insurance brokerage divisions reported a 1% fall in revenue.

As Aon counts comparatively large businesses as its clients, Austbrokers and Steadfast may be more exposed to clients considering ‘self-insurance’ to cut costs.  But Austbrokers and Steadfast should be better protected in a recession than most, as most businesses won't risk operating without insurance.

Premium valuations

Austbrokers and Steadfast currently both trade on forecast price-earnings ratios of 17, which is reasonable considering their growth prospects and reliable earnings. The market also consistently undervalues high-quality businesses that have the ability to reinvest profits at high rates of return, as this pair do, but neither offers a large margin of safety.

Their valuations are almost as high as Aon’s and Marsh and McLennan’s, too, which are far better businesses, with entrenched operations around the world.

As a result, we’re leaving the Buy price for Austbrokers at $10, which would still put the company on a high forecast price-earnings ratio of 16. And we’re increasing the Buy price for Steadfast to $1.30, which would put the company on a lower forecast price-earnings ratio of 14, as it’s got more to prove than Austbrokers. With ex-QBE Insurance chief executive Frank O’Halloran as chairman of Steadfast, it's also likely to be more acquisitive and therefore riskier.

Time will tell if we missed a window of opportunity to buy this pair in July, but given their high valuations, the risks of acquisition-led strategies and the fact that the insurance cycle has peaked, we expect safer opportunities over time. Both stocks remain as HOLDs.