Hilb Rogal and Hobbs Co (NYSE:HRH) $35.80

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Overview

Hilb, Rogal & Hobbs Company (based out of Glen Allen, Virginia) operates as a network of wholly owned subsidiary insurance brokerage operations located in 26 states in the United States. The company places various types of insurance, including property, casualty, employee and executive benefits and other areas of specialized exposure with insurance underwriters on behalf of its clients. The company's client base ranges from personal to large national accounts and primarily consists of middle-market and top-tier commercial and industrial accounts. Middle-market businesses are generally businesses that do not have internal risk management departments and outsource that function to an intermediary. In January 2005, the company acquired True Benchmark Insurance Services, LLC, an excess and surplus lines broker. Its website is

The company’s fourth quarter results indicate that management has made significant strategic progress but the macroeconomic environment and insurance industry conditions have weighed down on the results and company valuation. The company is expected to face a difficult operating environment in the upcoming quarters due to legal and regulatory issues. However, the company management has undertaken cost cutting initiatives to sustain operating margin in the upcoming quarters and has restructured their sales force. Majority of the analysts maintain a neutral rating on the stock and feel that the company may face a difficult operating environment in the short-term. Analysts and potential investors have recognized the issue of loss of potential contingent commission and believe that it will lead to lower valuation multiple in the forthcoming quarters.

Key Positive Arguments / Key Negative Arguments
  • The company reported positive organic growth in 4Q 04 despite a difficult operating environment.
  • HRH has successfully focused their sales effort towards large national accounts.
  • Management is committed to continuing margin expansion, and has initiated a new cost-cutting program for the upcoming quarters.
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  • HRH has received requests for information from ten state departments of insurance and has received four subpoenas from states’ attorney generals.
  • The company’s legal and regulatory expenses have increased as a result of Eliott Spitzer’s wide ranging probe into the insurance industry.
  • The extra requirements associated with financial reporting (Sarbanes-Oxley) and verification has imposed significant costs across the industry and increased the legal and compliance costs of HRH.

The company’s fiscal year ends in December and all quarterly and annual references are to be construed accordingly.

Revenue

FY ends December ($mm) / 4Q04 / 1QE05 / 2QE05 / 2004A / 2005E / 2006E
Commissions & Fees / $156 / $176 / $165 / $610 / $681 / $753
Investment. and other Income / $4 / $3 / $3 / $10 / $11 / $11
Total Operating Revenue* / $160 / $178 / $168 / $620 / $691 / $763

* Columns do not add up to total due to rounding

The 4Q 04 Operating Revenue figure was $160 mm (12.05% YOY growth).

The company experienced a 1.0% increase in organic growth in 4Q 04 and a 1.8% increase for the year FY 04. Excluding contingent commission, HRH’s organic growth was 3.0% and 2.0%, respectively, for the quarter (4Q 04) and the year (FY 04). One analyst (Stephens Inc) has reduced the FY 05 organic growth estimate to 1.9% from 2%

Commission & Fees

The 4Q 04 commission and fees revenue was $156 mm (11.2% YOY growth).

HRH has stopped all volume-related contingent arrangements with the beginning of this year (FY 05).

One analyst (Daven Port) believes that the above will result in loss of $6 mm in contingent compensation in FY 05 if all other factors hold constant. Another analyst (Stephens Inc) believes that the company has made restructuring efforts with respect to contingent commissions and is expected to replace volume- based contingent agreements with industry standard agreements. The analyst has projected that $6mm of contingent commission lost in the last three quarters of FY 05 is expected to impact contingent revenue positively in 1Q 06.

Investment and Other Income

The 4Q 04 investment and other income revenue was $4 mm (58.33% YOY growth).

HRH has implemented a more rigorous sales process, which it has adopted from Hobbs. The company has also restructured its resources so that marketing claims advocacy, risk control, and alternative markets access are available companywide. Another component of the restructuring involves the segmentation of major accounts into distinct lines of business such as healthcare, construction, hospitality, and energy.

Please see the separately saved spreadsheet for more details

Margin

Net Operating Income
FY ends December($mm) / 4Q04 / 1QE05 / 2QE05 / 2004A / 2005E / 2006E
Digest High / $17 / $27 / $22 / $84 / $93 / $112
Digest Low / $17 / $23 / $21 / $84 / $88 / $99
Digest Average / $17 / $25 / $22 / $84 / $91 / $105

The 4Q 04 Operating Margin figure was 10.6%. One analyst (Stephens Inc) is projecting a lower EBITDA margin in FY 05 due to higher than expected legal expenses in 1H 05.

Earnings per Share

EPS
FY ends December / 4Q04 / 1QE05 / 2QE05 / 2004A / 2005E / 2006E
Digest High / $0.47 / $0.76 / $0.62 / $2.30 / $2.55 / $3.02
Digest Low / $0.47 / $0.63 / $0.57 / $2.30 / $2.36 / $2.64
Digest Avg. / $0.47 / $0.70 / $0.59 / $2.30 / $2.46 / $2.78
Digest YoY growth / -14.55% / 2.31% / 3.26% / 4.07% / 7.00% / 12.80%
Zacks Consensus / $0.47 / $0.69 / $0.58 / $2.30 / $2.43 / $2.74

Fourth quarter EPS was $0.47 compared to $0.55 in the year-earlier quarter (14.54% YOY decline). Street Consensus was $0.47. Net income for the quarter was $0.42 due to integration costs, the early extinguishment of debt and a $2.4 million decline in contingent commission.

Majority of the analysts have reduced their EPS estimates for FY 05.The estimate reduction incorporates an increase in legal expenses in the forthcoming quarters, deteriorating market conditions, projected decline in premium rates in the Property &Casualty (P&C) market and reflects the assumption of integration costs and loss in potential contingent commission.

One analyst (Merrill Lynch) has increased their EPS estimate for FY 05, which reflects the component of contingent commission added back to the bottom line or earnings. Another analyst (J.P. Morgan) has reduced their projected EPS estimate for FY 06 on the basis of decline in premium rates and potential loss of contingent income.

Please see the separately saved spreadsheet for more details.

Target Price/Valuation

The average target price for HRH is $36.

The excel spreadsheet associated with this report contains a complete breakdown of ratings, price targets, and valuation methods by individual analysts. Most of the analysts (60%) have given a Neutral rating to the stock,10% have given a positive rating and 30% have given a negative rating to the stock. For those analysts providing price targets, the range is $33 (Sandler O’ Neill) to $40(Stephens Inc). The analyst with the highest target price (Stephens Inc) rates the stock Overweight and values the share on 11x 2006 estimated EPS of $3.58. The analyst with the lowest target price (Sandler O’ Neill) has a Sell rating on the stock and values the shares on a 12.0x P/E multiple to 12 month forward (through 4Q 05) cash EPS estimate.

One analyst (Sandler O’ Neill) has increased their projected target price for FY 05, which reflects the analyst opinion that HRH’s operating fundamentals have not yet weakened considerably.

Majority of the analysts have not indicated their target price estimates for FY 05 and the average target price thus derived is indicative of the opinion of only two analysts (Sandler O’ Neill and Keefe, Bruyette).

Ratings Distribution
Positive / 10%
Neutral / 60%
Negative / 30%
Average Price Objective / $36
Number of Analysts / 10

Risks to the target price objective are the insurance pricing cycle, merger integration, financial leverage, potential loss of contingent income, and risk associated with the insurance brokerage industry.

Please see the separately saved spreadsheet for more details

Long-Term Growth

The long-term growth rates for HRH fall within the range of 10% (Keefe, Bruyette) and 15 %( Ferris, Baker Watts). Digest long-term growth rate is 12.25%.

The company has made several acquisitions in FY 04 and majority of the analysts feel that these deals will impact earnings positively in the long run. One analyst (Banc of America) believes that the Fed rate increase and potential price competition may impact book value growth and earnings adversely in the long run.

Other Discussion/ Corporate Governance/Capital Structure/Cash Flow

The company management has indicated that the company is expected to renew its annual authorization for $50 million of repurchase activity in FY 05. HRH has swapped about $50 million of its debt into fixed rate payments.

Individual Analyst Opinions

POSITIVE RATINGS

Stephens Inc-Overweight-($40) - report date-3/14/2005

The analyst believes that if HRH is able to execute on its transition plan, its multiple will expand back to peer levels in the upcoming quarters.

NEUTRAL RATINGS

Banc of America-Neutral-($36) - report date-3/11/2005

The analyst believes that premium rates are expected to decline in the P&C market and the company’s revenue growth will continue to be a challenge in the upcoming quarters. The company is facing increased legal and regulatory expenses as a result of the industry investigation, which will weigh on earnings in FY 05.

Cochran, Caronia-Market Perform- report date-2/28/2005

The analyst believes that legal expenses are expected to increase in the upcoming quarters. According to the analyst, at 6.8x2005 estimated EBITDA the shares are appropriately valued but a better entry point for potential investors would be 6.0x 2005 estimated EBITDA level.

Daven Port-Neutral- report date-2/24/2005

The analyst believes that downward pressure on insurance premium, the uncertainty pertaining to contingent commission, and some continuing expense pressure from regulatory issues creates above average earnings uncertainty. The analyst also recommends potential investors to refrain from investing the shares in the short-term.

Ferris, Baker Watts-Hold- report date-2/24/2005

The analyst holds the opinion that though HRH shares are statistically cheap the company is expected to face several problems in the short-term. The analyst feels that the uncertainty pertaining to the macro environment and margin pressure will weigh down on earnings in FY 05.

Keefe Bruyette-Market perform-($35) - report date 2/24/2005

The analyst believes that HRH has sufficient opportunities to expand market share and has restructured its sales force towards national accounts and effectively segmented them. However, the analyst feels that the decline in premium rates will weigh down on earnings.

Merrill Lynch-Neutral- report date 2/24/2005

The analyst believes that there is uncertainty pertaining to revenue growth and earnings in the upcoming quarters and feels that the shares are fairly valued at 14.0x 2005 EPS estimate.

NEGATIVE RATINGS

J. P. Morgan-Under weight- report date 2/24/2005

The analyst expects HRH to face a difficult profit outlook over the next several quarters, as lower contingent commission income and higher legal expenses remain a challenge for the company.

Legg Mason -Sell –report date 2/24/2005

The analyst believes that HRH has a well-designed long-term strategy, but the current valuation still underestimates the potential competition expected in FY 05. The analyst maintains a negative outlook for the brokers in the industry since they may have to expend more effort to attract and retain clients due to reputational damage endured by the sector on account of the Spitzer probe and other regulatory issues.

Sandler O’Neill-Sell-(33)-report date 2/24/2005

The analyst maintains a negative rating on the stock based on current valuation and moderate confidence in their FY 05 operating outlook.