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Writer's pictureCharles Miller

$AUB & $DDR – Sadly it's a 'no' for both but for very different reasons. Sharing regardless.

This is not investment advice and is general in nature. Do your own research before taking any positions in the securities listed below. You should consider your financial situation and goals before making investment decisions.


#1: Big Insurance Brokers –Talk about a purple patch!

If you had just parked your investment solely in AUS Insurance brokers ($AUB & $SDF) or a US broker ($BRO and $AJG) you would have probably outperformed the market even before dividends.

So why has the been such a favourable environment for these Insurance brokers:

  • Strong insurance inflation: Re-building costs & re-insurance costs, and therefore the insurance market, have been pricing risk higher. The increase in pricing leads to a larger commission in absolute dollars

  • Return to fuller insurance levels: Full re-opening of operations post-COVID led to some sectors resuming full coverage (e.g. logistics, travel & hospitality) & more brokerage

  • Consolidation of smaller players: Both companies have leant-in on inorganic growth for this outperformance, often acquiring brokerages at very low multiples (i.e. EPS accretive)

  • Regulation won't stop commissions: QoA by Treasury suggested no risk to brokers charging commissions


Let's be specific - why $AUB vs. $SDF?

When we talk leader (e.g. REA) vs. follower (e.g. $DHG), I almost always take the leader. This time is an exception:

  • For $SDF, there is a finite runway in Aus: On a gross basis, $SDF's broker network reflects >45% of GWP. $AUB, which is less than half the size of $SDF has a greater ability to do more M&A (not just boltons) which moves the dial for EPS . By these I mean

    • Bolt-ons = small brokerages that are adjacent to their current network

    • Genuine M&A = Tysers acquisition (e.g. >A$800m)

Example of their size constraints for $SDF are below

  • Succession issues in $SDF: It's well documented that co-founder Mr Kelly at $SDF has an open-ended contract and he'll step away. This is a distraction because.

    • Mr Kelly has a 12-month notice period so the transition period will be long

    • In hiring an ex-AIG COO it would imply a gathering of pace in expanding the US and I'm not convinced of how much of the mgmt team are across this strategy/region

    • General lowering of KPIs going forward (even if they are well-structured) is not a good sign for the replacements performance hurdles

  • $AUB's Broker Margins will lift to $SDFs not vice versa (Major factor): $AUB's margins are lifting to $SDF, not the other way round

  • $AUB can expand laterally into Life Broking (Minor factor): Whilst Aus+NZ Life Insurance is a super slow growth market, $AUB can add GWP by moving into Life Insurance broking.

  • $AUB's Tysers acquisition appears ok: It is early days, but early indications for UK acquisition indicate it is going well. If indeed this is the case, it means $AUB has proven capable of its UK-expansion

For $AUB & $SDF, why is the timing not right?

  • Multiple is elevated even vs. historical average: I get you have to pay up for companies with good tailwinds, but $AUB's premium to LT averages does not seem compelling when index multiples are sliding lower

  • Recent upgrades are priced-in $SDF and $AUB very recently upgraded their FY23 guidance – so there is minimal direct upside in the immediate term

  • Elevated premiums assumed for too long: Most analyst comments are that policy growth is strong for 18-24 months, so there is a downside if this does not eventuate

  • Under-levered, but facing higher debt costs: Both companies have debt headroom, however, now rates are higher this is unlikely to be accretive to deploy

  • BizCover will hurt in a downturn: Bizcover ($AUB) services smaller clients which are more sensitive to cycles. This (10% of EBIT excl. Agency) will hurt in a downturn for this function (noting this division has a casual FTE).

Overall - these are great businesses (now they have scaled). Plus I am not convinced that tech will lead to SMEs not using insurance brokers. $AUB is my pick of the two given my fear that $SDF tries to be a hero in the US for growth. However, I cannot bring myself to pay such a premium when a) most of the upside (e.g. guidance & rosy FY24 policy prices) is priced in and b) both businesses will have to make bigger & bigger acquisitions for EPS growth. Unlike $SDF, I would consider $AUB if there was a meaningfully lower multiple


#2: Ingram Micro, Synnex & a random shop called Dicker Data


Tech Distribution - An almost moat-less industry

IT distribution is a commodity business with the following characteristics:

  • Huge economies of scale: Given the wafer-thin margins, this is the only way being an IT Distributor works

  • Needs to be a One-Stop Shop: The only 'moat', and I use that word liberally, that can be achieved is through having a lot of product/service capabilities & a big network of stores

  • Minor R&D is required, but not much: Most of the players do not invest much in R&D. Whilst this a plus for cashflow, but it is a good example of the fact that their is limited IP in this business

    • Given this high & variable cash generation, the two biggest competitors are largely PE-backed: Ingram Micro (Platinum PE owned) and TD Synnex (partly owned by Apollo)

Where $DDR fits into this

  • Better Op margins than the rest: $DDR has defied the odds, by generating margins well above what most IT distributors have ever been able to achieve.

    • $DDR Margin = 4-4.5%

    • Ingram & Synnex = 2%

    • Westcon/Tech Data = 1%

  • Without knowing their secret sauce, this was achieved by: :

    • Growing SME market share in Aus (a market Synnex and Ingram Micro were less interested in)

  • Strong management incentives led them to extract operating efficiencies; notably in G&A cost savings and gross margin

  • $DDR has made some good acquisitions (e.g. Xceed in NZ and more recently Hill Cyber security)

This is not all about valuation

So for now, $DDR is now trading at an attractive price (16x forward P/E, 5-6% dividend yield) however my issue is:

  • Unsure of software sales recurring: Even though they have moved beyond hardware to software & cyber; this is early days (c.20% of Revenue) and I am confident only niche software won't be using cloud sales or in-house sales

  • Tough to pick cash conversion levels: These businesses run big working capital cycles and this is why they have limited capacity to use the leverage

  • Higher financing costs: While year-end gearing is low (1.2x D/E) it is important to remember that the company runs revolving levels of gearing throughout the year to hold inventory

  • <4% Op Margin likely: Based on the recent FY22 miss, I don't think >4% margins are likely and I would envisage its closer to 3.5% mark

Conclusion: Whilst it is easy to critique the 'tough' business of distribution, however, what Dicker has made is truly inspirational. Nonetheless, I think the full impact of <4% Op margins, weaker cash conversion & higher finance costs have played through. I would consider buying if one of the following occurred

  • Greater software sales penetration, particularly recurring, (e.g. >30% of Rev)

  • Lower acquisition margin (e.g. <$7.50)

  • Leaner working capital cycles could be achieved by $DDR (e.g. higher Op CF generation)

However, for now, I find myself creating excuses for buying it because it edges closer to a 52-week low which is not a robust reason for buying something.

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