Arthur J. Gallagher & Co. — FY 2016 Form 10-K
Reporting period: Year ended December 31, 2016. This is an annual filing, not a standalone fourth-quarter report; Q4 figures are noted separately below. Unless indicated otherwise, amounts are in millions of dollars.
Business context
Gallagher provides insurance brokerage and consulting, third-party claims administration, and risk-management services. Its reportable segments are brokerage, risk management, and corporate. In 2016, they represented approximately 63%, 13%, and 24% of reported revenue, respectively. The corporate segment includes clean-energy investments, debt, and corporate costs; its clean-coal operations materially affect consolidated revenue and taxes.
Financial results and liquidity
| Metric | FY 2016 | FY 2015 |
|---|---|---|
| Total revenue | $5,594.8 | $5,392.4 |
| Earnings before income taxes | $356.9 | $293.5 |
| Net earnings | $445.0 | $389.1 |
| Net earnings attributable to controlling interests | $414.4 | $356.8 |
| Diluted EPS | $2.32 | $2.06 |
| Cash provided by operating activities | $622.1 | $652.6 |
| Cash and cash equivalents at year-end | $545.5 | $480.4 |
| Total assets | $11,489.6 | $10,910.5 |
| Total stockholders’ equity | $3,655.8 | $3,688.2 |
Revenue rose 3.8%; controlling-interest net earnings rose 16.1%, and diluted EPS increased 12.6%. Net earnings included substantial clean-energy tax benefits: Gallagher recognized $194.4 million of IRC Section 45 tax credits in 2016. The reported tax benefit was $88.1 million despite pretax earnings of $356.9 million. Therefore, reported net earnings and EPS reflect tax-credit effects as well as operating performance.
Segment performance: Brokerage revenue increased 6% to $3,527.9 million; organic revenue growth was 3.6%. Brokerage net earnings were $357.1 million, up 33%, and its adjusted EBITDAC margin was 26.9% versus 26.5%. Risk-management revenue declined 1% to $718.1 million; organic growth was 1.3%. Net earnings were $57.2 million, essentially unchanged, and adjusted EBITDAC margin was 17.3%, broadly stable. Corporate reported revenue of $1,348.8 million and net earnings attributable to controlling interests of $3.7 million, down from $33.2 million; its results include clean-energy tax credits and significant corporate/debt costs.
Fourth quarter: Revenue was $1,385.0 million versus $1,334.9 million in Q4 2015. Net earnings attributable to controlling interests were $95.1 million versus $62.3 million; diluted EPS was $0.53 versus $0.35.
Cash flow and investment: Operating cash flow fell $30.5 million year over year, primarily because of timing changes in client fiduciary balances. Investing activities used $569.2 million, including $327.3 million for acquisitions and $217.8 million of net capital expenditures; headquarters spending contributed $112.1 million of 2016 capital expenditures. Free cash flow is not presented as a filing measure.
Debt and liquidity: The debt note reports $2,853.6 million of gross corporate and other debt, or $2,848.2 million net of unamortized debt costs, including $2,450.0 million under note purchase agreements, $278.0 million drawn on the revolving credit agreement, and $125.6 million of premium-financing debt. Cash was $545.5 million; $1,392.1 million of restricted cash is fiduciary or otherwise restricted and is not freely available for general liquidity. The $800 million revolving facility had $500.9 million available at year-end. The company said it complied with debt covenants and believed operating cash flow and borrowing capacity were adequate for foreseeable needs. It expected to raise at least $300 million in the second half of 2017 to refinance a note maturing in August 2017.
Dividends declared were $1.52 per share for 2016. In January 2017, Gallagher announced a quarterly dividend of $0.39 per share. It repurchased 2.3 million shares for $101.0 million during 2016.
Material changes versus 2015
- Brokerage growth was supported by acquisitions and higher commissions and fees; organic growth was more modest. Acquisitions contributed $173.2 million of 2016 brokerage commissions and fees, while new business production was largely offset by lost business and renewal-rate decreases.
- Risk-management organic fee growth slowed to 1.3% from 11.3% in 2015; reported fees declined, including the impact of lost business and foreign currency translation.
- U.K. and Australian revenue translated lower in U.S. dollars amid unfavorable currency movements. Foreign-currency translation also reduced equity through a $231.8 million 2016 comprehensive-earnings loss.
- Operating cash flow decreased, while capital spending rose substantially, mainly reflecting headquarters construction and technology investments.
- Acquisition integration costs declined to $45.7 million in brokerage from $100.9 million in 2015. Management estimated 2017 integration costs for specified prior acquisitions would be less than one-third of 2016’s level.
Outlook, risks, and unusual items
- Management expected 2017 clean-energy investments to generate $117–$133 million in net after-tax earnings, versus $114.4 million in 2016, and anticipated positive net cash flow from those investments in 2017. These estimates depend on production, utility contracts, tax-credit eligibility, tax law, and plant operating conditions.
- Management described a moderately declining insurance-rate environment as a headwind, partly offset by exposure growth, employment growth, new business, client retention, and service offerings. The filing gives no consolidated earnings or revenue guidance.
- Thirty-one of 34 refined-coal plants had long-term production contracts; three were still seeking or negotiating contracts. Tax credits are scheduled to expire substantially in 2019 for the 2009-era plants and in 2021 for the 2011-era plants. Plant relocation, utility closures or fuel switching, environmental rules, and possible tax-law changes could affect returns.
- The IRS was investigating Gallagher’s micro-captive advisory services and auditing more than 100 related captive insurers for 2012. The company said it could not reasonably estimate potential losses; the IRS had not made specific allegations against Gallagher.
- Other disclosed risks include acquisition integration and earnout estimates, competition and softer insurance pricing, foreign exchange and Brexit-related uncertainty, cybersecurity and privacy, regulatory and anti-corruption compliance, and debt refinancing. Gallagher disclosed U.K. subsidiary brokerage activity related to Iran’s oil and petroleum industries under U.S. General License H, reporting approximately $1,718 in gross revenue and $309 in net profit (actual dollars).
- Gallagher disclosed a February 2017 IRS notice challenging whether certain co-investors in one refined-coal partnership could claim tax credits; the notice did not challenge Gallagher’s tax credits or its ability to use them. A ruling against those co-investors could complicate future co-investor arrangements.
- Headquarters relocation and lease-abandonment costs were expected to total approximately $8 million after tax across the first three quarters of 2017. New headquarters incentives were estimated at $60–$80 million over 15 years, subject to the relevant programs.
Most important facts for investors to verify
- How much of earnings and cash generation depends on IRC Section 45 credits, whether the credits remain available and usable, and whether clean-energy production estimates are being achieved.
- Underlying brokerage growth and retention, including acquisition contribution versus organic growth, and whether soft insurance pricing continues to pressure commissions.
- Risk-management client losses and the durability of its recent low organic fee growth.
- Debt maturities and refinancing plans, covenant headroom, and liquidity excluding restricted fiduciary cash; reconcile the filing’s approximately $2.7 billion corporate-debt description with the debt note’s $2.85 billion gross total including premium-financing debt.
- Developments in the IRS micro-captive investigation and clean-energy co-investor notice, plus any material changes in related contingencies or tax-credit assumptions.
The independent auditor issued an unqualified opinion on the consolidated financial statements and internal control over financial reporting.