Reading between the lines

Given the dramatic events of the past year it is interesting to look back at what we wrote in 2008 – which was written long before it seemed conceivable that Lehman Brothers would go bust. Our concluding paragraph of last year’s review was: “The year ahead remains full of challenges as business confidence may fall further and will probably fall into a full blown recession. However, the fundamentals for brokers remain strong and quality businesses will continue to add shareholder value.”

Not only have we fallen into a full-blown recession but our comments on the insurance broking community have been borne out. We have seen a number of strong performers and no major crashes, as has been experienced in other financial services sectors.

The changes in the world economy did, however, have a direct impact on the industry in two very important areas: exchange rates and interest rates. This time last year the dollar was trading at around $2 to the pound. By March 2009 this had fallen to a low of $1.373 to the pound. The pound has now recovered to around $1.65.

Given the dollar exposure for many London market brokers, this was a huge fillip. In most cases the benefit was muted as a result of sensible hedging strategies, but should the pound remain stable it would represent a major long-term benefit to the London market.

What is also striking about the 2008 figures is how little investment income has come down.

In 2009 we would expect the full impact of lower interest rates to feed through as investments mature to be replaced by other fixed-rate securities at far lower yields.

What has not happened, as might have been expected in a time when capital has been in short supply, is a general increase in insurance rates. With the FTSE100 dropping to around 3,500 in March 2009 from a high since January 2008 of more than 6,500, rates might have needed to harden sharply to replenish insurers’ balance sheets. However, with the FTSE100 now trading at more than 4,500, reflecting the recovery in world markets, the long predicted significant increase in insurance rates has been deferred yet again. Our view is that people are predicting what they hope will happen and for this reason it is likely that the rating market may well continue to disappoint.

Although the business models of insurance brokers have proven remarkably robust in the face of an unprecedented global slowdown since the second world war, we have seen a sharp downturn in the level of mergers and acquisitions activity.

This has been driven by the twin pressure of lenders becoming significantly more wary of gearing levels and insurers reining in the terms of trade they ceded to their distribution partners.

Rapid growth covers a multitude of sins and, with the significant slowing of acquisitions, many of the consolidators are having to focus on making sense of what they have bought.

Given the shift of focus from growth to profitability, we have seen a number of companies showing dramatic increases in EBITDA (earnings before interest, taxes, depreciation and amortisation) while seeing little or no revenue growth.

Although EBITDA is a very important factor for determining shareholder value, it has to be placed in the overall context of the market. The greatest change is taking place in the mass personal lines market, especially in the motor segment. The aggregator market is still fast evolving as it is clear that not all of the existing players will be able to afford the marketing needed to stay in the game.

Direct Line was very much a child of a world with a smaller number of TV channels, hence the single brand. As media continues to fragment and the world of the handheld communicator explodes, niche distribution becomes ever more important. How the market develops will be driven by largely unrelated technology and evolving personal behaviours.

The segment that could see the greatest changes of value in the next five years is the personal lines sector.

Personal lines winners

2009

• ^{1) Kwit-Fit}
• ^{2) Windsor}
• ^{3) JLT}

2008

• ^{1) Aon}
• ^{2) Swinton}
• ^{3) Windsor}

2007

• ^{1) BGL}
• ^{2) RK Harrison}
• ^{3) Towergate}

2006

• ^{1) Jelf}
• ^{2) Towergate*}
• ^{2) AA*}

2005

• ^{1) Towergate}
• ^{2) RK Harrison*}
• ^{2) Hercules*}

The 2009 winners

Kwit-Fit

As the table shows, the personal lines motor sector is a tough place to be. Kwit-Fit has managed to grow income in 2008 by nearly 20% and increase EBITDA margin substantially to 25%. Many of the Top 50 brokers have grown profitability significantly in the year, but margins can be only enhanced so far. It is the combination of growth both in turnover and profitability that is crucial to build shareholder value. In growing its profitability faster than revenue, Kwit-Fit has critically pushed margins ahead, yet maintained a growth culture.

Windsor

Windsor’s EBITDA has grown by some 26%, pushing up margins to around 30%. This is a creditable effort given that it was accompanied by a growth in turnover of some 15%. Achieving a place on the podium two years in a row is a real success. The business was a PTP (public to private ownership) in early 2007 and is a good example of what can be achieved if the correct alignment can be found in a people-based business.

Jardine Lloyd Thompson (JLT)

As the sole survivor of a major UK broking operation to retain a UK quote, JLT’s share price is up on the year in absolute terms and has easily beaten the FTSE100 index. JLT has stuck to its knitting and made sensible acquisitions to support its strategic developments. Nothing stellar but many investors will have wished that they had JLT in their portfolio last year.

The best of the rest

The following have all produced results that any management team would feel proud of. Insurance broking is a mature market and every pound of profit has to be fought for. They are listed in descending size order.

Towergate

Love it or hate it, you can’t ignore Towergate. At 42% its EBITDA heads the field, up 11% on 2008. Questions remain about the sustainability of this margin. With pedestrian growth this year of 5%, Towergate may well struggle to be one of the outperformers of next year.

BGL

In addition to Budget, BGL has created Junction, an affinity insurance provider, and other brands. It has been a consistent top performer and has achieved 2008 turnover up 15% with continued margin growth. The winner in 2007, BGL has always been up with the best and we see nothing to suggest this will not continue. A class act.

Giles

In 2008, Giles showed the highest growth from the consolidators. Margins are an impressive 30%-plus, but while it has maintained the rhetoric of an active buyer it will be interesting to see if the firm can still move forward decisively in 2009.

RK Harrison

Building shareholder value can be about being the tortoise rather than the hare. This tortoise has put in a series of great results and has outstripped many a hare. Size may present an increasing challenge as it continues to grow.

Direct Group

Direct Group is the insurance operation of Brightside, the Alternative Investment Market-listed insurance and financial services business. While its share price is down on the year, it has beaten the AIM All Share index. By focusing on an unfashionable sector – white van man – it has built a real success story.

Carole Nash

If you can’t grow a business, grow its profits. Carol Nash’s turnover has not even stagnated. It has contracted by more than 5% in the past two years (or more if you take into account inflation) but has tripled its profits. Dominating a niche can mean it is hard to develop the business beyond that – defending a niche can be a nice little earner albeit rather boring for the managers. The wise shareholder ensures the managers are motivated to put up with a little boredom.

Oamps

Not a broker known to many, but this Australian-owned business has just made it into the Top 50. It is the only company to have achieved revenue and EBITDA growth of more than 30% and reported a healthy 39% margin. A great performance that promises to move Oamps up the table has been achieved by a combination of organic growth in its chosen specialist field complemented by targeted acquisitions. IT