Brown & Brown Inc (BRO) — Q2 2018 Earnings Call Transcript

Thank you, Jennifer. Good morning, everyone. And thanks for joining us for our second quarter earnings call. I am on Slide 4. For the second quarter, we delivered $473.1 million of revenue, growing at 1.5% in total and 5.2% organically. Excluding the impact of the new revenue standard, our total revenues for the quarter grew 7.3%. As a diversified insurance broker, we're pleased that all four segments grew nicely for the quarter, and we're rapidly approaching our intermediate revenue goal of $2 billion. Our EBITDAC margin was 29.1%, which is down 320 basis points, with a 180 basis points impact from the new revenue standard. Andy will discuss the movement of our margins in detail later. Our net income per share for the second quarter of ’18 increased to $0.26 from $0.23 in the second quarter of the prior year, driven by our strong organic growth and the ongoing benefits of federal income tax reform, but was partially offset this quarter by the impact of the new revenue standard. As we've said in the past, there can be fluctuations quarter-to-quarter in our organic revenue or margin but over the year it all works out. We also completed six acquisitions with annual revenues of approximately $39 million for the quarter. We're pleased with the quarter. We had good organic revenue growth across the company and in each segment. Good earnings expanded our capabilities and increased our geographic footprint through six acquisitions. There is just a lot of positive momentum across the company. Later in the presentation, Andy will discuss in more detail our financial results, excluding the impact of the new revenue standard. I'm on Slide 5. Before we talk in more detail about our divisional performance, I want to make some overall comments about exposure units, rates, capital in the market, and our investment initiatives. One, the middle market economy is doing well. Customers feel good about their prospects going forward and are investing in their businesses through increased hiring and capital investments. This results in increased exposure units. Rates for most lines continue to be flat with the exception of automobile, which is up 3% to 7%. We're seeing workers’ compensation rates generally down 1% to 3%. Cat property rates are flattish with some downward pressure on the best accounts and upward pressure on those with poor loss experience. Carriers don't want to lose renewals but are willing to walk away from them. As it relates to the M&A space, it continues to be very competitive out there. We were very busy during the quarter and closed six transactions with annualized revenues of $39 million. Through today, we've acquired 13 companies with annualized revenues of almost $83 million. Our largest acquisition during the quarter was Servco, which operates in the Hawaiian Islands and the Pacific Northwest. With this acquisition, we are now the number two broker in Hawaii and one of the largest retail brokers in Washington State. As you know, we're always looking for and talking with companies that fit culturally and make sense financially. Our investment to launch our new Arrowhead Core Commercial program and upgrade technology continued to progress as expected. As a reminder, the technology investments are focused upon delivering a number of benefits that will support our continued growth and profitability. These include: one, standardizing certain systems across the company such as having one agency management system for all of the retail segment; two, upgrading our core infrastructure to current versions; three, reducing inefficient technology spend; and four, continuing to gain better insight into our data across the company that we can use for the benefit of our customers, our carrier partners, and our teammates, ultimately to grow our business faster. The system upgrades in our retail segment are going well and we are on a path to complete all offices over the next 3 years. Likewise, our wholesale segment is developing a new technology to simplify business for our retail customers. We're also actively engaged with many InsureTech initiatives across the company, with the goal of identifying even better ways to engage with our customers and carrier partners as well as improve our teammate experience and operating efficiencies. I'm pleased with our initiatives to leverage our data to help drive new business and retain more business, ultimately benefiting our customers and carrier partners. These are really important initiatives that will take multiple quarters to deliver, but each quarter we're making more and more progress and we're starting to realize the benefits.

Thank you, Powell. Good morning, everyone. I'm over on Slide number 7. On the following slides, we're going to discuss our GAAP results, then our adjusted results excluding the impacts of acquisition earn-outs and the impact of the new revenue standard. As a reminder, we've excluded the impact of the new revenue standard for the calculation of organic growth in order to provide a better comparison with the prior year. We'll use this format for the remainder of 2018; then, in 2019, we will be on a comparative basis. Slide 7 presents our GAAP and certain non-GAAP financial highlights. For the second quarter, we delivered total revenue growth of 1.5% and organic growth of 5.2%, driven by solid organic growth in all four segments. Our income before income tax decreased by 6.6% and our EBITDAC declined by 8.6%, both of which were materially impacted this quarter by the new revenue standard. Our net income grew by 11.8% and our diluted net income per share increased by 13% to $0.26 versus $0.23 in the second quarter of last year. The growth in our financial metrics, except for organic revenue, was impacted by the adoption of the new revenue standard this year, which we'll discuss in more detail in a few minutes. The growth in net income and diluted net income per share, in excess of revenue growth and income before income taxes, were primarily driven by our lower effective federal income tax rate that resulted from tax reform last year. For the quarter, our effective tax rate was 26.7% as compared to 38.8% last year with our effective tax rate benefiting from the 14% decrease in the statutory federal income tax rate. For the year, we've lowered the expectation for our effective tax rate to be in the 26.5% to 27% range. Our weighted average number of shares outstanding decreased approximately 1% compared to the prior year due to the stock repurchases we completed in the second half of last year. And lastly, our dividends per share increased to $0.075 or 10% compared to last year.

Over to Slide 8, this presents our results after removing the change in estimated acquisition earn-out payables for both years and the impact of the new revenue standard, resulting in the most comparative basis. For the quarter, our revenues increased by 7.3%, income before income tax increased by 4%, and EBITDAC increased by 2.6%. Our net income grew by 24.5%, and diluted net income per share was $0.31 as compared to $0.24 in the prior year, growing by 29.2%. In a few slides, we'll talk about the components of our margin change year-over-year. For the quarter, the impact of the revenue recognition standard was higher than we estimated and reduced net income per share by approximately $0.01 versus our expectations. This difference is primarily related to the timing of incentives between the second quarter and the remainder of the year. Later, we'll talk about the quarterly and full-year expectations for the new revenue standard. Let’s move over to slide number 9. This presents the key components of our revenue performance. For the quarter, we had minimal net changes in investment income and other income, resulting in our total commissions and fees increasing by 1.6% as compared to the prior year. Our contingent commissions increased $2.1 million as compared to the prior year, which was driven substantially by the adoption of the new revenue standard. As a reminder, we will now recognize contingent commissions upon the effective dates of the underlying policies throughout the year rather than when received per our previous treatment. Excluding the impact of the new revenue standard, contingent commissions increased about $1 million year-over-year as we qualified for some new contingents. Last year we provided guidance – excuse me, last quarter, we provided guidance that we expected contingent commissions to decrease for the full year about $3 million to $5 million. Based upon what we know right now, we believe this is still a good range. Guaranteed supplemental commissions were substantially flat year-over-year and were not impacted by the adoption of the new revenue standard. Our core commissions and fees increased by $5.7 million. When we isolate the $28 million impact of the new revenue standard and exclude the net impact of M&A activity, our organic revenue growth was 5.2%, driven by growth in all segments.

We will move over to slide number 10. To provide insight into the components of our EBITDAC margin, we've included a look at our quarterly EBITDAC margin from last year to this year and highlighted the main drivers. The new revenue standard negatively impacted our current quarter margin by approximately 180 basis points. As a reminder, it was a benefit in the first quarter of this year. As we discussed in the prior quarters, we are in the investment phase for our Core Commercial program that we launched in July 2017. The investment this quarter impacted our margin by approximately 60 basis points, which is in line with the expectations we previously communicated. During the quarter, we realized about a 20-basis-point impact to our margin as non-cash stock compensation costs have increased due to our incremental financial performance and higher retention of teammates. While both of these are beneficial, they will increase stock compensation costs over the coming quarters. For the current quarter, the impact of our investment in technology was about 10 basis points and less than we realized in the first quarter. Consistent with our commentary in the first quarter, we are around full spend for our technology programs and do not anticipate any material full-year impact on our EBITDAC margins as compared to last year. Please refer back to the technology slide that we included in the fourth quarter results from last year. This will give you guidance on the future projections. Other is a combination of one-time items and some business mix. Similar to our earlier comments, we may have some variability on a quarterly basis from time to time. At the half-year mark, our underlying EBITDAC margins are about flat year-over-year. On the following slides, we present the results for our business segments on an as reported basis as well excluding the impact of the new revenue standard. We've included a reconciliation by segment in the appendix to this presentation. Let's get started by looking at slide number 11 on retail. As a reminder, this segment is the most impacted by the adoption of the new revenue standard as we shifted approximately $24 million of revenues and almost $12 million of profit out of the second quarter to other quarters in the year. This movement was primarily to recognize revenues upon the binding of coverage rather than our past practice of recognizing revenue upon the later date of either billed or effective and to recognize contingent commissions throughout the year rather than when received. As a result, we've experienced a significant change in our revenues and margin for the first two quarters of the year and expect a smaller impact for the third and fourth quarters. Later in the presentation, we will provide an update. For the second quarter, our retail segment delivered total revenue growth, excluding the new revenue standard, of 7.8% and 4.3% organic revenue growth. Our EBITDAC margin for the quarter, excluding the new revenue standard, declined by 100 basis points and was driven by increased intercompany allocations for technology, as well as our investment to upgrade our agency management systems, and as we mentioned earlier, increased non-cash stock-based compensation as our equity plans are performing higher than expected, resulting in incremental costs. Excluding the impact of the new revenue standard, our income before income tax margin grew by 180 basis points, benefiting primarily from lower intercompany interest and lower changes in acquisition earn-out payables. Over to slide number 12. The primary impact for the quarter on our national programs segment, from the new revenue standard, was related to contingent commissions. For the quarter, we moved approximately $5 million of revenue and profit to other quarters. Excluding the impact of the new standard, total revenues increased by 8.7% and grew 6.4% organically. As discussed earlier, organic revenue benefited from approximately $4.4 million of revenue related to our Core Commercial program and strong growth realized by both our residential and commercial earthquake programs. EBITDAC grew by 6.3% due to the continued leveraging of our revenues, disciplined expense management, and increased contingent commissions, which all helped to partially offset the investment in our Core Commercial program. As a reminder, as of July 1st, we'll pass the one-year mark since the establishment of this program. Since we're still in the investment phase, we'll have a negative impact on margins in the third quarter, and then we'll start to improve margins in the fourth quarter and into 2019 as we scale our investment. For the quarter, our income before income tax increased 26.5%, impacted by EBITDAC drivers we just mentioned as well as lower inter-company interest expense. Move over to slide number 13. In contrast to the National Programs segment, the impact of the new revenue standard on the Wholesale segment was a decrease in revenues and operating profit of approximately $2 million. This adjustment was primarily for contingent commissions. Excluding the impact of the new revenue standard, the Wholesale Brokerage segment delivered total revenue growth of 3.5% and organic revenue growth of 5.3%. During the quarter, we continued to realize a decrease in contingent commissions as well as some timing between the first and second quarter. Our EBITDAC excluding new revenue standard decreased by 6.8% for the quarter. The decrease is attributable to additional expenses associated with inter-company technology allocations, foreign exchange, non-cash stock-based compensation, and lower contingent commissions. Income before income taxes decreased 4.5%, impacted by the same factors contributing to the EBITDAC contraction, but was partially offset by lower estimated acquisition earn-out payables. Moving over to Slide number 14. The Services segment excluding the new revenue standard delivered revenue growth of 7% and organic revenue growth was 7.1% versus the prior year. This increase was driven by strong growth in most of our businesses with some offset for lower claims activity. The impact of the new revenue standard was an increase in revenues of approximately $1.5 million and $1 million of profit. For the quarter, our EBITDAC, excluding the new revenue standard, increased 2.8% and was less than the revenue growth due to new client onboarding costs and lower claims activity. Moving over to slide number 15. We've included an updated outlook for the remaining quarters associated with the new revenue standard. We've broken down the impact between core commissions and fees, contingent commissions, employee compensation and benefits, and other operating expenses. For the second quarter, we had estimated the negative impact upon revenues to be in the range of $18 million to $23 million, and the actuals were approximately $27 million. The higher impact was driven primarily by the timing for the receipt of incentive commissions versus our expectation. We estimate the impact upon income before income taxes to be in the range of $13 million to $14 million, and the actuals were about $17 million, which equates to about $0.01 less of income per share. We’ve updated our outlook for the remaining two quarters and the full year and expect revenues to increase $4.8 million and income before income taxes to increase $5 million to $9 million as a result of implementing the new revenue standard. With that, let me turn it back over to Powell for closing comments.

Thank you, Andy. Great report. In closing, we're pleased with our performance for the second quarter and where we're positioned at the midpoint of the year. I want to thank all of our teammates for their efforts delivering the results that we've talked about. I'd like to make several broad comments about the company. We believe the economy remains on a good path and that should help drive exposure unit growth. That's a positive for Brown & Brown. As it relates to the M&A landscape, we've started the third quarter with good momentum and have already closed five transactions with annual revenues of approximately $30 million. That is in that $83 million that we talked about. We remain actively engaged with many companies and are optimistic that we'll be able to close more transactions over the coming months. But, as we've stated before, nothing is done until it's signed. From a capital allocations standpoint, we've deployed all the cash we generated during the first half of the year and utilized some of the cash from our balance sheet. The first six months we've deployed over $140 million for acquisitions and prepaid $100 million of debt during the quarter. We're well positioned with our capital structure and have accessed sufficient capital through our $800 million revolver in cash on our balance sheet to fund our growth. We remain focused upon our investments in technology and evaluating the InsureTech landscape, as we believe these initiatives will help us provide the platforms and capabilities to support our growth and profitability in the future. As you know, our company is defined by our culture, our teammates, and our discipline. It is the combination of these three that delivers our consistent financial performance. With that, I'll turn it back over to Jennifer for the Q&A segment.

Good morning. Thank you for the call. I wanted to revisit slide 10, where you discuss your EBITDAC margin walk. Firstly, there wasn't any significant mention of the five-for-five program. Secondly, considering the year-to-date results, it appears that the EBITDAC margin is running on an adjusted basis below your longer-term range of 33%-35%. As we think about the outlook for the next several quarters, can you discuss where we might see some tailwind and how some of the investments and expenses might help improve the margins going forward?

So, Greg, number one, if you're looking at Page 10 and you're specifically thinking about the other segment down there at 50 BPS, I would tell you about 40 BPS of that are what I would call one time in nature. There are some recurring BPS in there as well, but about 40 BPS of the 50 is non-recurring, that's number one. Number two, I would encourage you to know that if you think about the performance on a year-to-date basis. And if you remember, in the first quarter, we were talking about somebody had asked questions about organic growth in retail and how that should look long-term. If you look at our margins, actually year-to-date against last year, and you take out the 60 basis points for impact of Core Commercial, we're basically flat. I think we're within 20 basis points year-to-date. So having said that, we have talked about and we’ll continue to talk about making investments in our business. Five-for-five, we're very pleased with. And we're very pleased with the organic growth for retail in the quarter. But like I said, periodically and on quarter-over-quarter, we'll have some fluctuations in the organic growth and the earnings in each of those divisions. We have not revised our situation or our position on our targeted range. I will tell you this and I know you know this Greg, but when we make acquisitions, acquisitions are typically at margins that are lower than our company average, and many times they're lower than the divisional average or segment average. And so, over time, we try to bring those up to the average or in excess of the average. And so, I know that we haven't done as many acquisitions in the last couple of years, but I'm just saying that relative to the business that we've acquired and so all of that kind of rolls up into the impact on our numbers.

Okay, Greg, I wanted to add on the retail incentive program. Just as a reminder, how that program was designed and how it’s performing, the largest impact on our margin would be last year, then we are going to get a little bit of benefit in 2018 and then we get back to about breakeven by the end of ‘19. So, it's difficult to see it on any one individual quarter. It would be easier to probably measure it on a full year basis as we look through. But as what we can see underlying, last year performed right in line with our expectations, and at the half year mark it's doing the same. So, we feel really good with the program.

As just a point of clarification on the Arrowhead Core Commercial, will that be a margin headwind or tailwind in 2019?

That will actually be a tailwind in 2019. So let me just go back just to make sure we clarify this a little bit. So we started this in July of last year. So this is why we've had a benefit to the organic growth for the past four quarters, but it's also been a drag on the margins. As we make the lap here, July 1st is the organic will moderate down a little bit. We're going to have some additional expense in the third quarter, building up a platform. Then as we head to the fourth quarter, the margins start to increase a little bit and that will just continue every year thereafter. It's going to move around a little bit by quarter based upon some of the seasonality of the business underlined. So, you want to look at it on a full-year basis. But as we said before, by the time we get out to the end of ‘21, we should be at commensurate margins with National Programs. And again, it's performing right in line with expectations.

Thank you for the clarification. My second question is about organic revenue as we look at the upcoming quarters. It has been performing very well. However, I understand that at the end of last year and the beginning of this year, you benefited from some weather-related events. I wonder if we should consider those atypical, one-time occurrences when evaluating organic growth, particularly for the fourth quarter of this year and possibly the first quarter of next year.

The answer to your question, Greg, is yes. In the third and fourth quarters, you should keep that in mind. And remember, regarding the Core Commercial program, it's not included; I mean, it's inorganic growth going forward, but not organic growth because we received that previously. So, that accounts for about 100 basis points of organic growth. You need to consider that in national programs or in other segments of the business that could be adjusting claims if we don’t experience weather-related events in the third and fourth quarters.

So Greg, when you consider programs, look back at the earnings calls for the third and fourth quarters of last year, and also Q1 of this year, where we highlighted the incremental revenues. Keep those in mind when making your projections to determine an underlying figure.

Hi. Good morning. My first question I guess, just going back to one of Greg's questions on margins. So you said 40 basis points was about one time in nature this quarter. Could we get a little bit of additional color on what was one time? And then, I'm just curious, are all of those one-time expenses showing up in the other operating expense line? Because, that looked a bit higher than where it had been running.

Good morning. It resulted from one-time factors in both salary-related expenses and other areas.

Can you just, given it's like, what would put something as one time in nature that you wouldn't necessarily expect to continue from here?

Someone leaving the company.

Okay. And then in terms of the retail growth, pretty strong in the quarter. And you guys called out commercial and employee benefit growth. Is it possible to get a little bit of color in terms of the growth that both of those businesses are running at on an organic basis?

We don't break out lines of business organic growth, as you know. But, we're very pleased with the performance of the retail segment across the country. And, so like I said, we don't break that out.

Okay. But, one wasn't significantly better than the other.

No. They both were positive. But, we didn't clarify. We just highlighted because they both were positive toward the organic growth.

Okay, great. As we think about margins from here. Andy, I believe you said that non-cash stock compensation might be a little bit higher in the back half? Is there any way that you can help us quantify the potential hit to margins? I guess as we're thinking through kind of the items that you called out? It seems like you did say the core commercial would be a hit in the third and then benefit in the fourth quarter. So, in terms of the non-stock compensation, it seems like that's the only hit in the back half of the year, if I guess, the tech investment will be a benefit to come to that full year net neutral. I just want to make sure I'm thinking through the three components correctly for the back half of the year margin impact.

Sure. I guess, so I think on the non-cash stock compensation, it was with the 20 basis point impact this quarter. That's probably a good proxy for right now. And then it may move around a little bit based upon ultimate performance.

Okay. And then in terms of the IT investment, am I thinking about that correctly? So you said it will be net neutral for the full year. Do you get a benefit in the second half of the year or is there still going to be a hit to margins in the second half of the year?

Elyse, there will be minimal impact in the third quarter, which is year-over-year. There will be a slight benefit in the fourth quarter year-over-year. Overall, the full year will be about flat. Looking back at the first quarter, we experienced a 20 basis point impact and a 10 basis point impact this quarter. That will begin to reverse in the third and fourth quarters.

Okay, great. And then one last quick question. You called out, sorry, go ahead.

Just make sure you keep in mind the impact of contingent commissions on a full year and the impact on margins. I know you probably look at the guide in there, I just want to remind you of it.

Okay. And then in terms of you guys called out it was a little bit surprise, you called out currency in your Wholesale segment. I wouldn't think that would've had a major impact on margins. Was it just calling it out because it was a slight impact I guess stemming from your UK business in the quarter?

Yes, if you remember, we called it out last year. So, this is kind of a flip back to the other side. That it’s not that it's a lot, but it’s just we had one that was a debit last year, we had a credit this year. So you’ve kind of got the inverse. Generally, not a lot.

Thanks. Good morning. So on the M&A front, I guess two questions in terms of margins. One, does the pickup in deals being closed have any impact on quarterly expenses?

A little, but I would say it's not that material.

Yes, it just depends on the individual acquisition, Meyer, and what we have the way of integration costs, we have historically not broken any of those out. Just we leave them in our number coming through. So it just depends on the individual.

And can you give us a sense of the timeline, I know it varies by deal, but timeline for getting these lower margin acquisitions up to overall grow level or segment level margins?

I think the situation varies by business and relies heavily on leadership and discipline over time. Many of these businesses are S-corporations, which include several expenses related to normalizing compensation for shareholders or leaders. Our target for many of these is a 25% operating margin, and during an earn-out, there is an incentive to enhance both revenue and profitability. Going forward, our compensation plans are tied to a profit pool based on the profits from each office, meaning that increasing that profit can lead to higher compensation. However, there is no set timeframe for how long this improvement will take. While you'd like a specific timeline, factors such as geography, business classes, and the overall economy come into play. For example, if a significant portion of your business is construction-related and the economy declines, or if you operate in the property sector where rates have significantly dropped over the past three years, these elements can affect results. Generally, it will take multiple years, probably more than three, but it's difficult to provide an exact figure.

Okay. So that's fair. That's helpful. I understand the complexity. And then one final question. When we used to have more dramatic hard and soft markets, there was some pushback from the carriers in terms of overall commission rates. I know we're talking about fairly modest rate changes now, but is there any of that pressure emerging?

Let me put it this way. As you know, many insurance carriers are not known for their efficiency, so they are looking to cut expenses wherever possible. However, there is a significant amount of capital available, and many carriers are eager for the premium, which provides some cushion against any cost-cutting. I can tell you that we haven't had much discussion with our trading partners about lowering commissions. Ultimately, especially the large standard carriers in the United States are considering how to operate more effectively with fewer resources. This likely means establishing fewer but stronger relationships with their trading partners. As we continue to grow, and we are quite large in many cases, this trend works in our favor. That's our perspective on the matter. No, we haven't seen any significant pressure.

Alright. I'd like to say thanks again, everybody. And we look forward to talking to you next quarter. Have a great day. Thank you very much.