Arthur J. Gallagher & Co. — 2018 Q3 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; filed October 26, 2018. The interim financial statements were reviewed, not audited, by Ernst & Young. Comparative 2017 figures were restated for adoption of Topic 606 revenue recognition.
Business context and results
Gallagher provides insurance brokerage and consulting, claims administration and risk-management services. Its three segments are brokerage, risk management and corporate; corporate results include clean-coal operations and related tax credits. Clean-coal revenue and costs are substantial and largely obscure the growth of the core service businesses.
| Metric | Q3 2018 | Q3 2017, restated | Nine months 2018 | Nine months 2017, restated |
|---|---|---|---|---|
| Total revenue | $1,778.5m | $1,593.7m | $5,276.6m | $4,729.6m |
| Earnings before income taxes | $90.3m | $76.9m | $436.2m | $330.6m |
| Net earnings attributable to controlling interests | $127.6m | $111.0m | $516.2m | $409.8m |
| Diluted EPS | $0.68 | $0.61 | $2.78 | $2.26 |
| Operating cash flow | Not separately provided for quarter | Not separately provided for quarter | $504.6m | $593.2m |
Q3 revenue rose 11.6% and controlling-interest earnings rose 15%; nine-month revenue increased 11.6% and controlling-interest earnings increased 26%. The reported income-tax benefit was $48.1m in Q3 and $111.9m year to date, reflecting primarily clean-energy tax credits and other tax items; therefore, reported earnings and conventional pretax margins should be read in that context.
Segments and operating trends
- Brokerage: Q3 revenue was $1,049.4m, up 12%; organic revenue growth was 6.3%. Nine-month revenue was $3,245.1m, up 11%, with 5.6% organic growth. Q3 adjusted EBITDAC margin was 26.4%, or 27.0% before the seasonal roll-in effect of recent acquisitions. Nine-month adjusted margin was 29.3%.
- Risk management: Q3 revenue before reimbursements was $199.1m, up 4%, with 4.0% organic growth. Nine-month revenue before reimbursements was $596.1m, up 9%, with 7.2% organic growth. Q3 adjusted EBITDAC margin before reimbursements was 18.0%; nine-month margin was 17.4%.
- Corporate and clean energy: Clean-coal revenue was $492.4m in Q3 and $1,327.0m year to date, against related costs of $508.8m and $1,381.8m, respectively. Management reported clean-energy after-tax earnings of $29.7m for Q3 and $96.6m year to date.
Management attributed brokerage growth to acquisitions, new business, renewal rate increases and higher supplemental revenues. It noted that Q3 brokerage contingent revenue estimates also contributed to growth; excluding that estimate change, Q3 organic brokerage revenue growth would have been 0.4 percentage points lower. Risk-management Q3 organic fee growth moderated from 8.3% in the prior-year quarter to 4.0%.
Cash flow, liquidity and debt
- Nine-month operating cash flow was $504.6m, down from $593.2m. Management cited a $30m discretionary pension contribution, higher earnout and severance payments, prepaid marketing costs, deferred taxes and timing of client-fiduciary receipts and disbursements.
- Investing cash outflow was $653.8m, including $575.5m of acquisition cash payments and $90.8m of capital expenditures. Financing cash inflow was $156.8m. Cash, cash equivalents and restricted cash totaled $2,260.5m at period end, of which $1,655.5m was restricted; unrestricted cash was $605.0m.
- Corporate and other debt was $3,537.3m gross, or $3,530.5m net of unamortized debt issuance costs, versus $3,139.1m gross at year-end 2017. The company had $130m outstanding under its revolving credit agreement and reported $653.5m of availability. It stated that it was in compliance with debt covenants.
- Interest expense was $36.7m in Q3 and $101.9m year to date, compared with $31.4m and $92.9m in the prior-year periods. The balance sheet reported total assets of $16,114.7m and total liabilities of $11,502.0m.
Outlook, accounting and notable items
- Management said it expects adequate capital to meet short- and long-term cash needs and expects to continue acquisition activity. It forecast 2018 clean-energy after-tax earnings of $113.6m–$116.6m and approximately $125m of capital expenditures. Clean-energy net cash flow is subject to production, tax-credit utilization, redeployment costs and other uncertainties.
- Management described the insurance market as stable to modestly positive, citing modest U.S. retail property/casualty rate and exposure increases, an improving Australia/New Zealand market, and growth opportunities from employment and employee-benefit consulting. It anticipated brokerage and risk-management effective tax rates of approximately 24%–26% and 25%–27%, respectively.
- The board declared a Q4 2018 dividend of $0.41 per share. The nine-month declared dividend was $1.23 per share, compared with $1.17 in 2017.
- Topic 606 adoption materially changed quarterly revenue timing and restated 2017 comparatives, although management said the annual after-tax earnings impact was not material. Revenue estimates for contingent and other variable consideration may change and could result in future reversals. Management also expected adoption of the lease standard in 2019 to add right-of-use assets and lease liabilities, without a material earnings impact.
- Material disclosed exposures include an IRS investigation of micro-captive advisory operations and audits of more than 100 client captives; Nalco patent litigation involving refined-coal facilities (Gallagher and Chem-Mod LLC are not named defendants); and uncertainty over the availability and duration of Section 45 clean-coal tax credits. The company said it could not reasonably estimate potential losses from the micro-captive investigation.
- Other risks include acquisition integration and earnout estimates, goodwill and intangible-asset impairment, foreign exchange movements, insurance-market competition, debt-related constraints and changing regulation. Goodwill was $4,501.3m at September 30, 2018. Management disclosed $6.7m of brokerage intangible-asset write-offs year to date.
Investor verification priorities
- Reconcile organic growth and adjusted EBITDAC/EPS to GAAP results, including acquisition contributions, contingent-revenue estimates and Topic 606 timing effects.
- Assess cash conversion and liquidity using unrestricted cash and available credit, while distinguishing restricted fiduciary cash and premium balances.
- Review debt maturities, interest costs, covenant headroom and acquisition funding needs as debt increased during the period.
- Track clean-coal production, tax-credit eligibility and expiration, related litigation, and management’s 2018 earnings estimate.
- Monitor IRS micro-captive matters, acquisition integration and earnout assumptions, and the potential for goodwill or intangible-asset impairment.