Arthur J. Gallagher & Co. quarterly report, Q3 FY2020

Arthur J. Gallagher & Co. — Q3 2020 Form 10-Q

Reporting period: Three and nine months ended September 30, 2020; filed October 30, 2020. The company provides insurance brokerage and consulting, claims administration and risk-management services. Its segments are brokerage, risk management and corporate; corporate includes clean-energy investments.

Financial performance

Amounts are in millions of dollars except per-share data. Year-over-year comparisons are to the corresponding 2019 period.

Metric	Q3 2020	Q3 2019	Nine months 2020	Nine months 2019
Total revenue	$1,849.1	$1,825.2	$5,300.0	$5,473.6
Earnings before income taxes	$209.5	$114.8	$737.2	$542.1
Net earnings attributable to controlling interests	$176.6	$126.1	$676.6	$570.3
Diluted EPS	$0.90	$0.66	$3.48	$3.01
Operating cash flow	Not provided for quarter	Not provided for quarter	$1,387.6	$769.1
Dividends declared per share	$0.45	$0.43	$1.35	$1.29

Q3 total revenue rose 1.3%; nine-month revenue fell 3.2%. Brokerage growth was offset principally by lower clean-coal revenue.
Q3 earnings before tax margin was approximately 11.3%, versus 6.3% a year earlier. Nine-month margin was approximately 13.9%, versus 9.9%. These are calculated from reported GAAP revenue and pretax earnings.
Brokerage Q3 revenue increased 8% and organic revenue increased 4.2%; the company said organic growth would have been nearly 3% excluding a large life-insurance pension-funding sale. Nine-month brokerage revenue rose 6%, with organic growth of 3.2%.
Risk-management revenue before reimbursements declined 4% in Q3 and 3% for nine months; organic revenue declined 5.3% and 3.7%, respectively. Q3 segment earnings improved to $18.8 from $16.2; nine-month earnings were essentially flat at $47.8.
Management’s adjusted, non-GAAP diluted EPS was $1.08 for Q3, up 37%, and $3.85 for nine months, up 26%. Adjusted figures exclude specified items and should not be read as GAAP results.
Nine-month operating cash flow increased by $618.5. Management attributed much of the increase to timing of receivables, liabilities and client fiduciary balances; those balances contributed $298.1 to operating cash flow in 2020 versus $11.2 in 2019.

Balance sheet, debt and liquidity

At September 30, cash and cash equivalents were $629.9; restricted cash was $2,844.9 and is held for client and other restricted purposes. Total assets were $21,814.9 and stockholders’ equity was $5,818.2.
Gross corporate and other debt was $4,591.0, including $4,398.0 under note purchase agreements and $193.0 of premium-financing debt. The company reported $4,583.7 net of unamortized debt issuance costs. No borrowings were outstanding under its revolving Credit Agreement; $1,182.6 remained available.
Management reported more than $1.6 billion of available liquidity and said it believed resources and access to capital were sufficient for near- and long-term needs. It reported compliance with debt covenants.
Operating cash flow was partly supported by CARES Act-related actions, including a $28.5 tax-credit refund and deferral of $33.2 of employer payroll taxes. Capital expenditures were $79.5 for nine months; management expected approximately $100 million for full-year 2020.

Material changes and unusual items

Commissions, fees, supplemental and contingent brokerage revenues all increased in Q3. Lower interest rates reduced investment income; nine-month divestiture gains were $4.6 versus $62.3 in 2019, when a significant one-time sale gain was recorded.
Clean-coal revenue declined to $310.8 in Q3 from $386.0 and to $652.1 for nine months from $1,042.7. The corporate segment recorded a nine-month pretax loss of $261.9, narrower than $317.2 in 2019, but its net loss attributable to controlling interests increased to $76.4 from $57.9.
Q3 expense comparisons benefited from cost controls. Management estimated approximately $70 million of Q3 pretax savings versus 2019, offset by about $12 million of severance and lease-termination costs. It estimated Q4 savings of $65–$70 million, potentially offset by $5–$10 million of implementation and execution costs.
The company acquired 17 businesses in the first nine months, with approximately $151.2 of annualized revenue. Cash paid for acquisitions was $91.3, compared with $951.1 in 2019; it also issued shares as acquisition consideration. Management said acquisition activity had been reduced amid economic uncertainty.
Amortizable intangible assets were written down by approximately $49.7 during the first nine months; the company reported no goodwill impairment indicators in its September review. Q3 expense from revised earnout estimates was $14.2, while nine-month fair-value adjustments generated $77.4 of income. Maximum potential acquisition earnouts totaled $1,026.1, of which $502.5 was recorded as a liability.

Outlook, risks and contingencies

Management expected commercial property/casualty rates to continue rising through the remainder of 2020, while cautioning that deteriorating loss trends could make rates and terms more difficult. It said improving customer activity and higher premiums could offset some exposure-unit declines.
COVID-19 reduced claims arising in risk management; claims had improved from April lows but remained well below pre-pandemic levels. Employee-benefits consulting work and covered lives were also weaker, with potential further deterioration if recovery slowed.
Management estimated clean-energy investments would generate $65–$70 million of adjusted net earnings in 2020. Credits for 14 plants expired at the end of 2019; credits for 21 plants were expected to run through 2021. Production, tax-law, regulatory and operating changes could affect results and cash flows.
A ransomware incident detected September 26 disrupted internal systems; the company said it was contained and critical systems were restored. Its investigation into possible unauthorized access was ongoing. Management did not expect a material adverse effect based on its investigation to date, but noted possible claims or government action and uncertainty over insurance coverage.
The IRS has investigated the company’s micro-captive advisory business since 2013; the DOJ is conducting a related criminal investigation, and a subsidiary received a grand-jury subpoena. The company said it was cooperating, was not currently a DOJ target, and could not reasonably estimate potential loss. A related class action was dismissed, with the dismissal affirmed by the Ninth Circuit.
A patent-infringement complaint involving clean-coal technology was amended after dismissal without prejudice; the company said it believed the probability of material loss was remote. Other legal, regulatory and tax matters remain uncertain.
The company declared a Q4 dividend of $0.45 per share. It made no common-stock repurchases under its repurchase plan during the first nine months.

Important facts for investors to verify

Whether brokerage organic growth excluding the large pension-funding sale and the impact of acquisitions remains sustainable.
How COVID-19-related exposure, employee-benefits activity and claims volumes affect revenue and margins in subsequent periods.
The outcome and potential financial exposure from the ransomware investigation and the IRS/DOJ micro-captive inquiries.
The assumptions behind acquisition earnout liabilities, future earnout payments and the intangible-asset write-downs.
Clean-energy production, tax-credit availability and cash-flow implications as remaining credits approach expiration.
How much of reported cash and liquidity is unrestricted and available for corporate use, given the substantial restricted-cash balance and debt obligations.