Goosehead: Why Does an Insurance Agency Trade Like a Software Company?

And am I crazy to think that it might be undervalued?

Disclaimer: This newsletter is for informational purposes only — it’s just a place where I share my analysis and thoughts on interesting companies. This is not a recommendation to buy or sell securities discussed. Please do your own research before investing your money

Correction: A previous version of this post incorrectly excluded non-controlling interest associated with the LLC units. The valuation answer is VERY different when you include those units. Apologize for the error and thank you for the reader that pointed out the mistake.

Goosehead is an independent personal lines (i.e., home, auto) insurance agency. Insurance agencies are the middlemen of the insurance business — they help consumers get the right policy and coverage for their specific needs at a reasonable price; nothing crazy. The business model is centuries old and its peers trade at ~4-5x forward revenues, so why does Goosehead trade at ~35x forward sales?

The punchline is that even though the company looks optically expensive on the screen the company might be a compelling long. Investors may not appreciate the company’s durable growth potential, which is anchored by its “back-office” operations/software, disruptive franchising GTM motion, and recurring revenue profile. The company may be able to grow into its optically high NTM multiple and the same time generate ~$600mm of free cash flow (~12% of current market capitalization).

Finally, why now? The company’s financial model is an inflection point as its investments in the franchise channel and salesforce start to mature.

Industry Background

Before diving into the company specifics, it’s helpful to understand the industry structure. The personal lines insurance industry insures homes, auto, motorcycles, etc. for consumers. Policies in the industry are sold through three channels:

  1. Independent Agencies: “Independent” to any one carrier (i.e., State Farm) and sell policies on behalf of carriers they have a relationship with. Carriers pay commissions to the agents for bringing in the policies and pay them an ongoing commission if the policies renew. The agents serve as an advisor to the consumers to help consumers price shop, understand what they should cover, and understand what they are signing up for

  2. Captive Agencies: sell products for only one carrier. The carrier compensates the agents through sales commissions based on premiums sold and the on-going renewals

  3. Direct to Consumer: as the name suggests, whenever a carrier sells directly to the consumer (1-800 numbers, State Farm’s website, etc.)

Based on 2017, here’s how the channels compare by market share (national + regional = independent agencies).

Why do the insurance carriers even need agencies? Few reasons

  • Consumers want advice on the bigger ticket policies (i.e. home insurance) and they want to price shop. The insurance industry has historically not been great with DTC/online quoting so agents are an efficient way for consumers to get accurate quotes from multiple parties

  • Some lines of business (i.e., home insurance) require to develop relationships and affiliations with 3rd parties (e.g., real estate agents, mortgage loan officers) that are done at a local level

  • Legacy of the industry structure — insurance companies used to rely on agents to provide the “gut” feel about consumers to help them underwrite better

Company Background & Understanding the Secret Sauce

The company has two segments:

  1. Corporate (~52% of revenues): this is the traditional independent agency model where the company sells policies to consumers and receives a commission on the policies it sells

  2. Franchise (~48% of revenues) — the company’s franchise business. Franchisees use Goosehead’s processes, carrier relationships, systems, and back-office support team to sell insurance and manage their business. In return, Goosehead receives franchise fees and % of the commissions the agents receive

But to really understand the company, you have to understand how we got here…

Goosehead started in 2003 as a typical independent insurance agency business. Insurance agencies are good businesses with ~20-30% EBITDA margins, recurring revenues from policy renewal, and very capital-light.

Goosehead excelled as an insurance agency driven and was able to grow >40% year over year. The success the business was driven by its high-quality salesforce, technology platform that drove efficiency, and the agents’ ability to drive strong relationships with local realtors, loan officers, etc.

My background is I was a long-term Bain & Company partner, and one of my administrative responsibilities is I was Global Head of Recruiting for the last several years I was at the firm. And we just took that recruiting model and plunked it down into our business…So what we do is, we bring in, we attract people who would under any other circumstances would never be selling personal lines property and casualty insurance. And because our business model is geared to support them to be hyper-productive, these kids are able to earn really, really attractive compensation without kind of investment banking hours, so

But then, ~7 years ago, Goosehead’s CEO had his Ray Kroc moment (if you don’t get that reference, watch this scene).

Well, we built a corporate-owned agency, where we have W-2 employees that are P&C producers. About 7 years ago, I was lying in bed at night thinking, "Okay, what is it that we do really well?" And we're really good at sales. But what we were most extraordinary at is the back office. We've built a sort of service function that has the highest Net Promoter Scores of any company, of which we've been able to find in the public domain. And that has allowed our agents to be highly productive, really, really productive because they can focus all of their time on sales. And so trying to think of how can we -- how do we get more leverage out of that back office, we decided to try our hand at franchising. Market reception has been extraordinary

So a few years ago, Goosehead launched a franchise model. Franchisees can take advantage of Goosehead’s carrier relationships, customer service/support operations, back-office functions (finance, pricing, risk, etc.), and technology. Goosehead’s franchise model and software platform is basically “scale as a service” for insurance agents. In exchange for its support, Goosehead receives ~20% of year 1 commissions and ~50% of renewal commissions.

Franchising insurance agencies is an attractive/predictable business model. Revenues from policy commissions are fairly recurring (~85-88%) and Goosehead agents have a fairly predictable ability to sell new business leveraging their S&M and relationships on the local/regional level.

The franchise model is attractive to captive agents that want to go out on their own or independent agents that don’t have the scale or want the headache of managing back-office. The model has been taking share in the and will continue to be disruptive to the existing industry structure for the following reasons:

  1. The economics/capital commitment of the franchise model is attractive to sub-scale independent agents or captive agents that want to start their own business. Goosehead removes the administrative and customer support burden for agents and allows them to focus on sales/marketing their product. The G&A and support burden materially eats into the profit margins of the insurance agents (~40-70% of revenues, depending on scale)

  2. Instantly provides sub-scale agents access to significantly more products to sell / price compare. Agents can only sell products that the insurance carriers allow them to, so a sub-scale independent insurance agent may only be able to provide quotes/products from ~4-5 insurance carriers for his/her customers. With Goosehead, the insurance agent plugs into >80 insurance carrier relationships and provide quotes/products from a much richer array of options for his/her clients

  3. Captive agents and sub-scale independent agencies have a limited set of options to sell/market to their customers. Goosehead’s scale and carrier relationships solve this problem for them. Additionally, captive agents can only sell one carrier’s products, which is inhibits their ability to find the best product and more importantly compete with the independent agent down the block that provides 4+ quotes with a richer set of coverage options

  4. The company’s investments in integrated quoting technology and agent workflow tools make the agents more efficient than their peers that are still operating through email and phone. Unlike their captive and independent counterparts, Goosehead agents’ have a company that is actively investing in driving productivity efficiencies through technology as opposed to cost-cutting or shaving points off the commission every year.

The results are clear when you compare the productivity levels of Goosehead’s agents vs. their peers.

The pain-points that Goosehead is solving for agents is especially disruptive to the captive channel (~47% of industry volumes) and 2/3 of the company’s new franchise agents come from the captive agent model.

So about 2/3 of our new franchise agents are coming from the captive agent model, so State Farm, AllState and Farmers…

The pain points of low close rates because they're representing 1 product that's designed only for specific segments of the consumers. So they're not able to offer a competitive insurance solution to a high percentage of their customers. But they're also getting -- they're starting to feel the burden of the book of business that they've built. So yes, they get into the business because they're sales and marketing savvy. That's what they like to do, that's what energizes them. And the better they are at sales and marketing, the faster they work themselves out of a sales job and into an administrative role. And they're managing the ongoing book of business, and they're managing their customer service staff that's subscale. And it's a huge opportunity cost. And really, what they see is they start to see their book of business and their growth start to flatten out, their revenue starts to flatten out and their growth opportunities are more limited.

There are ~100k agents at State Farm, Allstate, and Farmers’ alone. The company is in the early days of taking market share as it recruits more and more agents to sign up its business model.

The franchise roll-out has been very successful with franchise volumes starting to overtake corporate volume.

Business Model & Financial Outlook

The company’s financial and business model is also very attractive:

  • High-quality franchise business with industry-leading NPS. Goosehead has an NPS of 91, which is 2.4x the insurance industry and higher than leading consumer/financial services brands such as USAA, Costco, Southwest, etc. This NPS is important

  • A strong base of recurring revenues. In addition to the royalty/franchise fees, ~85-88% of the company’s policy commission renew year over year and as the company bundles additional products (i.e., auto) that retention rate goes up

  • High incremental EBITDA margins. As the company’s revenue mix shifts to more renewal commissions, the company’s margins will naturally expand. The cost of service/sales on the renewal business is lower

  • Durable runway for revenue growth. Goosehead is tiny in the context of the personal line industry and has the opportunity to expand its franchising business significantly over the next decade and convert captive insurance agents into franchisees.

Financials Are Starting to Inflect…

The company is at an inflection point in its revenue/EBITDA growth. Over the last few years, Goosehead has invested aggressively in its corporate sales force and franchise expansion. These new salespeople and franchises take ~3 years to get to run-rate production volumes.

Goosehead’s agents and new franchises are starting to mature as a result, their production volumes and the company’s new business revenues should materially increase. The ramping of the corporate agents and franchisees should give the company a strong-line of sight for >40% revenue growth over the next few years. Additionally, the cohort revenue growth suggests (a) >120% net revenue retention at scale for franchisees (i.e., 2015) and (b) newer cohorts are ramping faster than the previous cohort. Finally, Goosehead has 438 franchises that have signed up but not yet deployed. The existing backlog alone should generate ~$32mm in revenues in ~3 years on a base of ~$115mm in 2020.

% of Agents/Franchisees with Less Than 1 Year of Tenure

Cohorted Franchise Revenue Growth

Recruiting Capacity Growth: The company’s recruiting and it’s franchise expansion the company has run-rate recruiting capacity to add 300-400 franchises per and ~250-300 sales agents per year for the next 4-5 years.

Franchise Growth Assumption: The franchise growth will be driven by the company’s existing pipeline of >110k potential franchise leads. The company has ~89 franchisee recruiting agents and based on historical attainment, these agents sell ~1.5 franchisees per quarter which implies the company has a recruiting capacity of ~530 franchisees per year. Combined with the existing backlog of 438 franchises, my assumption of ~400 run-rate new franchises seems undemanding and assumes no conversion improvements for a company that consistently improved its operations and production volumes.

Additionally, I assume modest production per franchise improvement as the company’s franchisees mature.

Sales Agents Assumption: Fairly straightforward, the run-rate values imply a recruiting capacity of ~250 agents. The corporate sales agents are typically 21-24-year-old college graduates so the pipeline is fairly large.

Financial Model & Valuation

The output of the assumptions is that the business should grow top-line between 35-40% over the next 5-7 years, the recurring revenue mix should be ~70% of revenues and margins should expand by ~550-700 bps over this time period. If people are interested, feel free to DM and I can share the model once I’ve done the quarterly analysis of the franchise adds.

For the valuation, here are the comps:

  • Brown & Brown: trades at 5.2x ‘21E revenues and is growing top-line ~7% y/y

  • Arthur J. Gallagher: trades at 3.8x ‘21E revenues and is growing top-line ~7% y/y

Goosehead is trading at ~35x ‘21E consensus revenues.

Risks:

The business model is not without risks. Two ones that would keep me up at night:

  • Existential business risk of purchasing moving to digital through the likes of PolicyGenius or Lemonade. In the U.K. ~80% of personal lines are purchased through price comparison sites, while only ~25% in the U.S. There’s no structural reason for this gap so while Goosehead is taking share of the industry volumes, the industry volume accessible through non-digital channel is likely going to decrease

  • The corporate agent recruiting model seems a little bit like Vector Marketing / Cutco, which causes me some discomfort. Cutco is a MLM that targets college grads to have them sell high-end knives to their friends/family

I’ll be doing more work on this one for sure because the setup is quite interesting. If anyone has thoughts feel free to DM on Twitter @investingcanon or shoot me an email. Would love know what the bear case is on this one.