Steadfast--opportunity knocks?

 STEADFAST—New holding

Insurance broking is a well-established global model. Many years ago there existed an argument as to who controlled the client, the risk underwriters (eg insurers like QBE, IAG or SUN) or the brokers such as SDF or AUB. That argument has been well settled.

The ability to aggregate and direct significant volumes allows the broker to arbitrage the difference between the wholesale and retail margins. These savings are shared between the client and the broker.

Clients are usually SMEs and not so much retail or enterprise size and are very sticky. For small businesses, insurance coverage can be difficult to understand regarding pricing in the market and the liabilities their business may be exposed to. The broker acts to cover these important and time-consuming activities for clients.

The bulk of the brokers' business is in the area described above. Another area is the agency business. These activities cover niche and unusual industries that may have regulatory issues, are too heterogeneous for the general insurers' models to work, or require an in-depth understanding of the assets involved (eg vintage cars) or all of the above. The broker develops expertise in the area and accesses the clients. The broker takes the underwriting proposition to the insurer who then underwrites the risk. The broker usually shares in the profitability but does not take on underwriting risk.

 

The model for aggregators like SDF is one of acquisition. The larger businesses take over smaller operators and enhance the scale benefits. The industry is not large and the acquirers usually understand the sellers and their business quality. Within a defined market that takes away some of the usual risks with “roll-up” models IMO.

When analysing the acquisitive model, the reported ROEs are usually low, just above the cost of capital, but significant capital can be deployed into growth and the acquisition is for the most part, all goodwill, there is little capital required post-acquisition. That is, incremental capital returns are high. Acquirers understand that dynamic and players need to keep their share prices high and with that, their cost of capital low, to grow profitably.

 

The underwriters' pricing cycle exhibits some cyclicality, which is critical for the insurers but is a secondary element for the brokers. Hardening markets do help but are not critical. The markets have been strong over the last few years and SDF management points out that insurers are not over earning but operating ratios are stable despite higher premiums. That is, premiums have been driven by the higher cost of claims (volume and price).

 

SDF points out that there remains a significant opportunity to grow as partly owned and associated brokers (part of the network) sell their remaining equity to the parent. There is an ongoing ownership change of the underlying businesses brought about by generational change and as the owners' circumstances change. SDF has great visibility into these businesses.

 

One of the strengths of the business is the diversity of the client base by size, product type, geography and industry. The recent move into the US broker market with a small acquisition is interesting. The US market is well picked over. SDF enters against competitors with long and in some cases very successful track records, like BRO and MMC. The commentary from SDF is to move in very cautiously and assess the market fully before deploying more capital. I am cautious about SDF’s entry into the US, as the strengths that SDF have in ANZ (knowledge and scale) are not that apparent in the US.

 

Recent Opportunity

The SDF share price fell significantly following a TV program accusing the insurance broking industry of profiteering in the strata industry. Through its brokers, SDF is a large operator in the industry. There are a couple of things to consider here.

The business process is that policies are sold to the strata managers who operate as agents for the underlying strata owners. Significant markups being incentive payments on these policies appear to be occurring that accrue to the strata agents.  

From the SDF point of view, the issues are, firstly that policies are required, it is common practice to insure a building. That is, the volumes must be done. That leads to two issues, are SDF over-charging for their policies as quid quo pro for allowing strata agents to add excessive and undisclosed commissions? Remember SDF has no contact with underlying owners. The policies go through two sets of brokers, SDF and then strata managers. The outcome, through legislative change, is likely that strata managers will have to disclose all incentives and commissions to the owners. How that impacts SDF depends on how much of their volume is over-earning or would not exist without the incentives. The impact is likely to be in the 0-5% range of total earnings, IMO. SDF disclosed that 13% of the Australian business is in strata (see above), but how much of that profit pool is over-earning? Significantly less, as the markups appear to be coming from the strata manager, not SDF brokers' policies.  The big change will likely fall on strata managers' incentives. Commissions are a common part of the industry but the size and disclosure are at issue here.

The bear case for SDF is that a significant proportion of the policies are over-earning, in the future, the renewal will be contested and undertaken at much lower prices, and maybe lower volumes.

I very conservatively (IMO) assumed a 10% cut in total SDF earnings, which gave me a $5.30 buy price. My undisturbed valuation at $5.67 with 11% eps growth (5Y) and 21X PE exit terminal (plus divs) gives an 11% compound return.

These are good businesses with low risk and steady growth, I see the recent fall as an opportunity. Remember that my previous exposure to this industry, PSC Insurance was taken over earlier this year.

 

 Please note disclosure