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  • Chris Mayer

The “Structure” of a 33-Bagger (and Counting)

With news of big mergers – UTX-Raytheon, the failed (thus far) Fiat Chrysler-Renault merger – it may pay to think about the challenges of size.


Sometimes the rationale for getting bigger makes sense. In the case of Fiat Chrysler, bigger rivals outspend it on R&D several times over. Given all the technology in cars it is only a matter of time before Fiat’s cars are uncompetitive. It may be a long while, but the clock ticks. This is partly why, I think, the market does not give Fiat any multiple. The terminal value is low. (Disclosure: Woodlock House owns Exor, which owns a quarter of Fiat).


In the case of UTX and Raytheon – and many other mergers – there seems to be nothing more than a desire to get bigger.


But getting bigger brings special problems…


The Tale of the Polyploid Horse


Problems of size remind me of the tale of the polyploid horse, told by the Gregory Bateson in his book Mind and Nature: A Necessary Unity.

The story goes that a great geneticist hatched an idea for a horse twice the size of an ordinary Clydesdale. Now, in your mind’s eye, you may have no problem imagining a horse twice a big in every respect – twice as high, twice as wide, etc. But in the real world, problems of size mount exponentially.


Despite being only twice as large, the horse would be eight times as heavy. It would have to have cranes to help keep part of the weight off its legs. It would also require constant hosing off to keep it cool. The polyploidy horse would pant constantly to oxygenate its body. And it would have to eat eight times as much as a regular Clydesdale.


This fable reminds us that certain relationships are not linear. “Surface varies as the square of length,” Bateson writes, “volume varies as the cube of length, and surface varies as the 2/3rd power of volume.”


Bateson gives us another comparison to see this: a harbor porpoise and a whale. The porpoise is three feet in length and has a jacket of blubber about one inch thick. This jacket suffices to keep it warm.


The whale, by contrast, is ten times the length but requires a blubber jacket that is twelve times as thick. The whale has 1,000 times the volume of the porpoise and 100 times the surface area despite being only 10 times as long.


Thus, the tale of the polyploid horse and the porpoise-whale comparisons stand as good metaphors for the exponential effect increasing size has on other aspects of existence. As any parent with two kids will tell you, having the second kid is more than twice the work!


So we can readily imagine, then, that as companies expand in size and complexity, its problems may be far worse than imagined when smaller.


And yet size can make you stronger… if you have the right model.


Brown & Brown: 33-Bagger (And Counting)


I am reluctant to buy acquisitive companies. M&A architects are like that geneticist with his polyploid horse. They dream big. But they underestimate the problems that drag along with it.


Brown & Brown (BRO) seems to have mastered the art of getting bigger. (Disclosure: Woodlock House is long with an average price of ~$27). Below, we’ll look at some pieces of the model that make it click.


Brown & Brown is an insurance broker. And it has been a winning stock: $100 invested in BRO in 1993 when it went public would be worth $3,361 as of December 31, 2018. And it’s up another 20% year-to-date, as I write.

It’s been remarkably resilient. From the 2018 annual report:


“We have increased revenues every year from 1993 to 2018, with the exception of 2009, when our revenues dropped 1.0%. Our revenues grew from $95.6 million in 1993 to $2.0 billion in 2018, reflecting a compound annual growth rate of 13.0%. In the same 25-year period, we increased net income from $8.1 million to $344.3 million in 2018, a compound annual growth rate of 16.2%.”


It is also acquisitive. Over that time, BRO bought 513 companies (other agencies). Last year was a record in terms of revenues acquired. BRO closed 23 transactions.


Yet, it works. What are the secrets of its success? I’d argue they lie in the structure of the firm.


One of the things I’d point to is the insider ownership. BRO is family owned by the Brown family, which owns about 15% of the stock. J. Powell Brown, the grandson of the founder, is CEO. But employees – “teammates” in BRO lingo – own a bunch too. Altogether Brown and its teammates own 30% of the stock.

Here is CEO Brown at the Investor Day in May:


“So that's very unusual for publicly traded companies of this size. If you did a sort out there on public companies in the United States, there's about 4,400, and you said, how many of those have over $1.5 billion in revenue, how many of those have more than 15% insider ownership, how many there would be? There would be 25. And we're one of the 25.”


They are proud of that insider ownership. They talk about it all the time. I think it’s an important part of the culture there. And perhaps because of that, they are focused on the right things, such as free cash flow.


Here is Brown again:


“One of the things that's interesting that the analyst community is really starting to take notice of what we've talked about for a long time is our cash conversion. What that means is, if we make a dollar of revenue, not earnings, a dollar of revenue, when we do that, how much of that revenue do we convert that we can reinvest in our business. And the answer is 26% in 2018.”


That’s operating cash flow minus capex, which gets you $526 million in free cash flow for 2018. So, he’s talking real free cash flow. The stuff that sticks to balance sheets. Not EBITDA. Not adjusted whatever. It’s refreshing.


Here is the CFO Andrew Watts:


“If we can generate that level of cash, we want to think about what does it do as a percentage of our market value. So that's free cash flow yield. Our market value is about $9 billion…. that means about 7% of our market cap was delivered in free cash flow. The S&P 500, as well as the public brokers [were at] 5%. We're 50% higher on the 10-year average; and versus the S&P 500, 30% to 35%... This is also how we think about the valuation of our organization.”


I love cash flow machines. Companies that just pump out cash and – ideally – can reinvest and continue to grow that cash flow stream. BRO fits.


The business is capital-light. Only 4% of free cash flow went toward capex. They also use cash to pay a dividend, buy back stock and finance those acquisitions. They are opportunistic about buybacks, which I like. For example, in December, when the shares were down, they announced an accelerated buyback of $100 million.


Brown and Brown does not fully escape problems of size. It takes a lot of acquisitions and/or bigger acquisitions to move the needle now than in the past. CEO Brown wants to double size of the company from about 10,000 “teammates” to 20,000. Can they do it and preserve the kind of financial performance they’ve put up so far?


They think they can. Here is the CFO again:


“I mentioned before, we grew the top line 7%. But what have we been able to do over the last 5 years and over the last 10 years? Well, we grew at 6% and we grew 8% on a compounded basis. Think about what that's been able to do for us as an organization. That growth rate has allowed us to double our company since 2010. It's right there in line with all of the other public peers [and] we also outpaced the S&P 500.


“But we think if we can grow the top line, the important thing is what can we do on the margins? Last year, a little over 30%, our 5-year average 31%, 10-year average 33%. Look at the average of the peer group that's out there. We're 100% better than them, we've continued to do it every year. So while people said to us, as we get larger as an organization, there's no way that we can maintain those margins. We said, we think we've got a proven operating model that we can continue to grow our business on the top line and make sure that we can maintain the margins that are out there.”


We’ll see. Even if growth slows, there is a lot to like here. A resilient, cash flow machine managed by people with skin in the game and with good capital allocation skills. The stock is not cheap today, but I’d put in the realm of fair value.


Brown & Brown has a good model that seems to sustain high performance even as it has grown much larger.


Bucky’s Geodesic Domes


BRO shows you can beat the problems of size. Contra the polyploid horse, there are examples of structures that get stronger as they get bigger. One example is the geodesic dome:


If you know of Buckminster "Bucky" Fuller at all, you may know him as the popularizer of these domes. There are over 100,000 such domes in existence – many more if you include play structures. And with good reason: They are stronger per unit of material than any other known structure. It gets stronger as it gets bigger, supporting itself in ways that seem impossible.


Consider the steel and Plexiglas geodesic dome built for the 1967 World Fair in Montreal. Its diameter spanned 250-feet, as tall as a 20-story building. And yet it had no internal supports.


Hugh Kenner, author one of the best books on Bucky’s ideas – the well-written Bucky: A Guided Tour of Buckminster Fuller – wrote: “It is as free as a soap bubble of internal supports, the load on its foundations is less than the weight of its separate materials, and had it been a half-mile in diameter it would have been capable of drifting away.”


BRO is not quite a geodesic dome, but it seems to have gotten stronger as it’s gotten bigger. The secret seems to lie in the structure: strong alignment by way of ownership + a focus on free cash flow + smart capital allocation = years of happy returns.


Thanks for reading. Send me mail: info [at] woodlockhousefamilycapital.com.


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Published June 13, 2019

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