Like most analysts and portfolio managers, I read and listen to a lot of quarterly conference calls. Over the years these calls seem to get more and more promotional. Somewhere along the line conference calls went from being managed by boring CFOs to the more exciting CEOs and PR departments. While some calls now resemble infomercials, other calls continue to provide very valuable information on the business, industry, and economy. Sometimes I’ll listen to calls, while other times I’ll read the transcripts. When I’m concerned about excessive spin, I’ll usually listen to the call as I like to hear management’s tone. Is the tone genuine or am I being sold? You know the “being sold” tone – that Eddie Haskell tone. When I hear the Eddie Haskell tone (usually from the CEO) I immediately raise my required rate of return and lower my valuation!
A company I’ve owned in the past and continue to follow is Brown & Brown, Inc (BRO). Brown & Brown is a market leading insurance broker that has a long operating history (founded in 1939) and generates strong free cash flow. It’s a high quality business, in my opinion. Their conference calls are light on spin and heavy on good data points and interesting information. Their CEO, Powell Brown, is no Eddie Haskell. While Mr. Brown does a good job in his prepared remarks, he typically shines in the Q&A session as most good communicators and CEOs do. I always learn something about the business or the operating environment during Brown & Brown conference calls.
Today’s call wasn’t too dissimilar from recent calls. Organic growth remains in the low single digits range at 2.6%. Management again pointed out that there remains excess capital in the insurance industry, which is putting pressure on rates. While organic growth is positive, there are some inconsistencies between locations and industries. Management also pointed out its customers were hiring at a moderate pace. All in all it was a solid earnings quarter, with top line results not too different than what one would expect in this economy (my estimate of nominal GDP is similar to BRO’s organic growth).
I thought today’s conference call was good, particularly the Q&A session. A topic that I found interesting was addressed about 52 minutes into the call when Mr. Brown discussed valuations of potential mergers and acquisitions. Valuations have been rising and are on the expensive side. This isn’t new news as it’s occurring in several industries as many mature businesses are starving for growth (a sizable acquisition can give management an entire year of sales growth and time to figure out how to make it “work” from a non-GAAP adjusted earnings perspective). I’m typically not a big fan of constant acquisitions as acquirers often overpay or fail to add value; however, over the years I think Brown & Brown has done a good job on average. In any event, what I thought was interesting on today’s call was Mr. Brown’s comments regarding who was partially responsible for driving up M&A valuations. None other than one of the better performing asset classes this cycle – private equity.
Specifically, Powell states there was “a lot of activity in the PE [private equity] space and there continues to be more money it seems…or they want to put more money to work.” This is important. As some of you know, large pension plans such as Calpers, have recently fired hedge fund managers and increased allocations to alternatives, such as private equity funds. As plans attempt to shift the good ol’ efficient frontier upward by allocating more assets to what has worked, those entities receiving inflows, such as the private equity funds, must find a home for this new capital.
Mr. Brown is pointing out that some of this capital has found its way into the insurance broker industry and has driven up prices of mergers and acquisitions. Funny how performance chasing works — new flows and excess capital drives up prices and reduces future returns (see bond market), defeating the purpose of the asset allocation shift. Asset allocators should take note and may want to make that efficient frontier adjustment with a pencil.
Mr. Brown continues, “And so like I said, remember, we just sell and service insurance at Brown & Brown and those guys are doing their financial modeling relative to shorter-term things that include a flip with a terminal value. What we look at is does it make sense financially? And the answer is a number of the ones that we have seen don’t make sense financially.” I don’t know exactly what the private equity firms are paying, but if I had to pick who knows more about the business and the appropriate price to pay for an acquisition, Brown & Brown or the private equity firms, I’ll take the market leading operator that was founded in 1939.
In conclusion, beware when private equity is deeply involved in an industry. It usually means there is either too much capital or about to be too much capital chasing too few sales, profits, or in this case M&A deals. I remember in 2014 when energy was booming there were several management comments regarding private equity firm activity in the energy service and E&P sectors. In hindsight, it was a good data point that we were approaching the peak of the cycle.