Brown & Brown Looks A Little More Interesting Now, But Not Quite Interesting Enough To Buy Yet

| About: Brown & (BRO)
This article is now exclusive for PRO subscribers.

Summary

Brown & Brown has gone nowhere for six months, and the company’s earnings have started to catch up with valuation.

Going forward the key drivers of profitability will be expense control and an upturn in the insurance pricing cycle which should start to appear late this year.

Brown & Brown continues to grow earnings and revenues strongly through acquisitions and the company’s new CFO brings good experience on that front.

Long-term holders could take a position in Brown & Brown now to avoid missing the eventual move higher, but I think investors may be better of waiting a few more.

I first wrote about insurance company Brown & Brown (NYSE:BRO) last September when I lamented that despite the company's solid underlying fundamentals, shares were too expensive to get excited about at that time. Since September, the insurance and reinsurance company has basically gone nowhere despite continuing to post good year over year revenue and profitability growth. The company is continuing to benefit from its decentralized business model and acquisition strategy, as both elements help to drive revenues dramatically higher over time. Organic revenues at the firm are more dependent on the state of the property and casualty insurance (P&C) market, but they are doing reasonably well at this point given the stage in the insurance pricing cycle we are at.

I would expect that sometime late this year or early next year P&C pricing should state to strengthen meaningfully, and this will help drive higher revenues and, importantly, margin expansion at BRO. Of course the degree of this margin expansion will depend critically on BRO's ability to limit compensation and operating expense increases that traditionally go higher both with revenue growth and the upturn in the pricing cycle. Once management and investors start to see signs of price firming, and in particular margin expansion at Brown & Brown, that will be the buy signal on the stock. Long-term investors can probably get in now and benefit from the company's excellent growth track-record, and the increasing pick-up in agency acquisition activity, but this is probably not enough incentive for medium term investors. Those with less than at least a two year investment horizon then should still wait a bit before buying into BRO.

The one downside I continue to see at Brown & Brown (and this has not changed since September), is the lack of exposure to the rapid market growth overseas. While there are always threats in the insurance space including the possibility of weakening economic growth, or the failure of the P&C market to turn up as expected, these are more industry concerns than concerns specific to BRO. In general, the international weakness aside, BRO deserves the slight multiple premium it holds over most peers right now thanks to its operational excellence, and it is only my lack of enthusiasm for the broader market that is holding me back from the shares right now.

I fully expect that Brown & Brown will continue to be well-run with its new CFO R. Andrew Watts joining the rest of the management team as announced at the end of February. BRO is a serial acquirer of smaller companies and so Watts' experience at Thomson Reuters (NYSE:TRI) making numerous acquisitions will be important for BRO as well. At an insurance company of course the CFO usually plays a more major role than at a traditional industrial firm, but this is particularly true for BRO. In January, the company announced that it will acquire The Wright Insurance Group for ~$640 million in cash with the deal set to close in April. This deal will help with BRO's expansion in the flood insurance market, though granted I do think the deal price was a bit rich at ~5.3X Wright's CY 2013 revenues. Nonetheless, BRO has a long history of successful and lucrative integration of acquisitions, and so I am pleased that the new CFO has experience in this regard.

Speaking of profitability, many investors were no doubt a bit disappointed when Brown & Brown's EPS came in 3 cent light of consensus last month. The company reported earnings of $0.32 a share (consensus $0.35), but frankly that was still up 10.8% YOY, with 4Q2013 revenues of $343M up 13% over 4Q2012 revenues of $302M. While we all love to see our stocks beat analyst expectations, in tough economic environment double-digit revenue and profit growth is excellent regardless of expectations. Similarly, CY2013 net income came in at $1.48 per share vs. CY 2012 net income of $1.26 (18% growth). From my point of view, investors can hardly complain here given that BRO is only trading around $30 a share (20X ttm EPS).

On the organic growth front, things aren't quite as positive for BRO with core organic premiums rising 4.5% YOY. This is a long way below 18% of course, but frankly, again this is a pretty competitive insurance market in terms of pricing, so I'm still fairly impressed that Brown & Brown is putting up positive organic growth at all. I believe it's likely that the pricing competition in both primary and reinsurance, which everyone from Travelers (NYSE:TRV) to the reinsurance crowd has alluded, to is likely to remain with us for much of this year. Given that, I think BRO will probably keep putting up mid-single digit organic revenue growth this year. That said, finding advantageous acquisitions can still be very value additive for shareholders, and so far BRO has done a good job with that.

My big question on Brown & Brown this year remains the operating margins. Revenues and EPS will surely grow significantly this year (I look for ~$1.70 in EPS for CY 2014), but the question is will expenses outpace revenue, or revenue outpace expenses? I'm sure over the long-term BRO will be a good opportunity, but the short-run will depend critically on the company giving investors reason to be exceptionally excited about profits going forward. In summary, though Brown & Brown now looks more reasonably valued after trading sideways for six months compared with when I first wrote about the stock last fall, I still view the company as needing a little more time and clarity before it becomes a strong buy investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.