Brooke Corp: Questionable Lending Practices, Inflated Balance Sheet

Brooke Corporation (BXXX-$14.75) is engaged in franchise business with a network of 827 franchised locations (as of March 31, 2007), principally operating in the states of Texas, California, Kansas and Florida. The Company’s franchisees sell property and casualty insurance, and other services to individuals and small businesses.

The philosophy of Brooke Corporation is outlined in the book titled "Death of an Insurance Salesman?" written by the company's founder, Robert D. Orr, who promulgates that the fundamental principle in selling insurance –and other related services—is more efficiently distributed by local businesses rather than by employees of large corporations.

In marketing campaigns, Brooke Corporation sells the idea to ‘mom and pop’ insurance agencies that signing onboard as franchisees combines the advantages of independent business ownership with the stability and resources of a larger organization.

Brooke Corporation can help its clients with the “wealth creation opportunities associated with independent business ownership,” while offering operational assistance of an insurance distribution company, including commissions accounting, financing, document management, and supplier access.

In exchange for initial franchise fees and a share of ongoing revenues, Brooke Franchise Corporation provides Brooke franchise agencies with access to the products of insurance companies, marketing assistance and administrative support.

To support its franchise business, the Company chartered Brooke Credit Corporation to lend monies to its franchisees to fund the acquisition of franchises or the start up of new franchises. In addition, Brooke Credit specializes in loaning money to professionals within the insurance and death care industries.

Other revenue generating businesses include (i) Brooke Brokerage Corporation, which serves as a wholesale insurance broker for its franchisees with respect to hard-to-place and niche insurance; (ii) Brooke Savings Bank, a federal savings bank; and (iii) Brooke Capital Corporation, a life insurance holding company, to enable franchisees to complement the property and casualty insurance products that they sell with the ability to offer bank, life insurance and annuity products and services to their customers.

Consolidated results of operations demonstrate that profitability and growth in recent years consists principally of adding new franchise locations, originating loans to franchisees, and commission-sharing arrangements (typically representing a percentage of insurance premiums paid by policyholders)

Net earnings for the three months ended March 31, 2007, totaled $6.81 million, or 48 cents per share, on revenues of $64.02 million, compared to net earnings of $3.53 million, or 27 cents per share, on revenues of $41.18 million for the same period in the prior year. Total earnings increased primarily as the result of increased initial franchise fee revenue from opening more franchise locations, increased loan interest revenues from a larger loan portfolio, and increased revenues from the sale of loans.

A total of 90 and 49 new franchise locations were added during the three month periods ended March 31, 2007 and 2006, respectively The amount of the initial franchise fees typically paid for basic services is currently $165,000.

Revenues from initial franchise fees for basic services are recognized as soon as Brooke Franchise delivers the basic services to the new franchisee, which includes access to a business model and the Company’s Internet-based management system, and use of the Company’s brand name.

As mentioned, a significant part of the Company’s growth strategy business strategy involves the success of its affiliate, Brooke Credit Corp., in financing franchisee origination activities and the continued sourcing of these loans. In the three months ended March 31, about 33% of operating revenue derived from interest income (from the foregoing loans) and initial franchise fees. It goes without saying that a reduction in lending opportunities would reduce the number of loans the Company originates, which would reduce profitability and the Company’s ability to grow its business.

Brooke’s dependency on these initial fees creates an incentive for management to extend credit to borrowers that may not meet stringent underwriting criteria. In fact, loans to franchisees are collateralized principally by intangible assets, such as customer lists (which may lose value if the local franchisees—borrowers—do not adequately serve their customers or if the products and services they offer are not competitively priced).

Expenses for write off of franchise balances increased to $3.05 million, for the three months ended March 31, 2007, from $0 for the prior year. Total write off expense increased as the result of the adverse affect on some franchisees of increased loan interest rates coupled with a reduction of commission revenues resulting from reduction of premium rates by insurance companies.

Of concern, too, Brooke Credit Corp. assists its franchisees by financing long-term producer development, cyclical fluctuations of commission income, receivables and payables. The Company also grants temporary extensions of due dates for franchisee statement balances owed by franchisees to the Company!

In essence, Brooke is lending money to Brooke—and booking it as interest revenue!

This extended credit, is referred to as “non-statement balances.” As of March 31, 2007, franchise statement balances totaled approximately $6.7 million, of which approximately $5.6 million was identified as “watch” balances, because the balances were not repaid in full at least once in the previous four months. Non-statement balances as of March 31, 2007 totaled $8.5 million owed to Brooke by its franchisees.

Brooke is highly leveraged, with long-term debt-to-shareholder equity of 109.1%, and this does not even include current off-balance sheet transactions (in the Lending Services segment) totaling $279.9 million!

For the three months ended March 31, insurance revenue grew 19% year-over-year to $32.7 million. A significant part of Brooke Franchise’s commission growth came from acquisitions of existing businesses that were subsequently converted into Brooke franchises.

Combined same store sales of seasoned converted franchises (twenty-four months after initial conversion) and start up franchises for twelve months ended March 31, 2007 and 2006, however, decreased .5% and 3.0%, respectively.

Management said that same store sales performance had been adversely affected by the “soft” property and casualty insurance market, which is characterized by a flattening or decreasing of premiums by insurance companies. In addition, Brooke franchisees predominately sell personal lines insurance with more than 50% of total commissions resulting from the sale of auto insurance policies and Brooke believes that the insurance market has been particularly soft with regards to premiums on personal lines insurance policies.

We believe that investors should be concerned about Brooke Corp.’s business strategy, which remains dependent on growth via its acquisition strategy. However, this roll-up strategy is founded on some questionable lending practices and a balance sheet that appears inflated (given probable reserve deficiencies).

Editor David J. Phillips does not hold a financial interest in Brooke Corp. The 10Q Detective has a Full Disclosure Policy.