By DAN REYNOLDS, senior editor of Risk & Insurance®
New York-based financial services analysts Keefe, Bruyette & Woods forecast modest investor returns and a relatively quiet time for insurance brokerage mergers-and-acquisitions activity for the first part of 2010.
Among the larger brokerages, the analysts singled out New York-based Marsh & McLennan Cos. Inc., the parent company of brokerage Marsh, as their favorite.
Why? Because the brokerage could be in the beginning stages of an acquisition strategy, according to the KBW analysts. Though Marsh may have plenty of cash with which to purchase smaller competitors, the analysts expect Marsh to continue to trail its rivals in its ability to boost operating margin.
Better margins have been on the minds of Marsh executives for the past couple of years, and data from KBW illuminates Marsh's struggles in that realm. Analysts projected an operating margin of 18.2 percent for Marsh in the fourth quarter of 2009.
That's a few ticks behind the 20.3 percent they project for rival Itasca, Ill.-based Arthur J. Gallagher & Co. and the 21.4 percent for Chicago-based Aon Corp.
Dublin-based Willis Group Holdings trails the field in that respect with a 17.2 percent operating margin forecasted for the fourth quarter.
Marsh certainly isn't expected to outstrip its Chicago-based rival Aon in shareholder return, according to KBW analysts. KBW estimates full-year earnings per share of $3.30 for Aon in 2010 and an estimated $1.90 in earnings per share for Marsh in 2010.
Greg Case, president and CEO of Aon, in early February, said the company, which achieved a 20 percent adjusted pretax margin for the brokerage segment in 2009, was increasing that goal to 25 percent in 2010.
For 2010 and 2011 full-year earnings, KBW analysts expect Marsh could continue to struggle to best its rivals in operating margin. Marsh will register operating margins of 19.9 percent in 2010 and 20.3 percent in 2011, according to the analysts, compared to projections of 23.4 percent in 2010 and 23.9 percent in 2011 for Gallagher, and margins of between 21 percent and 22.4 percent for Aon and Willis in each of 2010 and 2011.
The larger brokerage firms have largely eschewed contingent commissions as a way of receiving compensation in the wake of the bid-rigging scandal that cost the industry hundreds of millions of dollars in fines.
Willis is phasing them out as part of its 2008 acquisition of Hilb, Rogal & Hobbs. Brown & Brown, which boasts enviable margins, accepts them, as does Arthur J. Gallagher, having been cleared to do so by Illinois Attorney General Lisa Madigan. Aon and Marsh, for now, do not accept them.
Many smaller and regional brokerages have never given up the lucrative revenue streams that come with accepting contingent commissions, which are volume-based incentives paid by the insurer to the broker.
When it comes to margins, the brokerage industry's Big Four, Marsh, Aon, Willis and Gallagher, can't really compete with the likes of Brown & Brown, a brokerage that has been almost as active over the past couple years as Gallagher has been in the acquisition space.
Brown & Brown, based in Tampa and Daytona Beach, Fla., but which sells coverage around the country, is expected to deliver an operating margin of 34.6 percent in 2010 and 35.2 percent in 2011, according to the KBW analysts,
In the past couple of years Brown & Brown has been even more aggressive than Gallagher. Brown & Brown completed 43 acquisitions in 2008, and was aiming for a similar number in 2009.
Where banks and private equity firms had done much of the buying in 2006 and 2007, some brokerages at least saw the crisis that struck the financial sector in 2008 as an opportunity to shoulder aside the banks and private equity firms and become more active in acquisitions.
With so much pressure on the insurance brokerages, that wasn't an across-the-board dynamic. KBW analysts said M&A was relatively quiet in 2009, with a "handful" of deals done by Gallagher and Brown & Brown in the fourth quarter of 2009.
Brown & Brown CFO Cory Walker told Risk & Insurance® last year that his firm at least wasn't buying other brokerages as a hedge against the ongoing soft insurance market. He said any brokerage that was doing that was going to suffer in the long term.
KBW analysts said that they expect mergers and acquisitions activity to pick up again later in 2010, but that such activity could be modest in the first half of the year. Those that are buying might never find better pricing. KBW said the property/casualty sector overall is at very low valuations.
That means that for entrepreneurs who grew a brokerage from scratch with the idea that they might sell it to one of the bigger firms and ride off into the sunset, this might not be the time for such a strategy to come to fruition.
At the end of 2009, the analysts saw the sector as trading at .85 times book value. That compares to valuations of, for example, 1.29 times book value in 2008 and more than 1.5 times book value in 2007.
Of the larger brokerages, the only one that KBW analysts feel will deliver consistent revenue growth over the next couple of years is Gallagher. The analysts see Gallagher increasing revenue by more than 5 percent in 2010 and by more than 6 percent in 2011.
It's likely, given the weak state of the economy, that Gallagher will see revenue growth in those years due to the high number of acquisitions it made in the past couple of years.
According to the company's SEC filings and press releases, Gallagher racked up 34 acquisitions in 2008, a 61.9 percent increase over 2007. But like property/casualty insurance carriers, brokers in general are flying against enormous headwinds. Any company looking for top-line growth is going to have to bide its time, because the recovery from the 2008-2009 recession is looking more and more like a slow and steady one that continues to be hamstrung by high unemployment.
December unemployment numbers rose in key states like Florida, New York and California. California alone shed more than half a million jobs in 2009, and the national unemployment rate remains above 10 percent.
"Top-line pressures continue to hurt the group, but operating margins should see modest expansion resulting from cost-cutting measures and restructuring plans enacted over the past year," the KBW analysts wrote.
March 1, 2010
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