Arthur J. Gallagher & Co. quarterly report, Q3 FY2015

Arthur J. Gallagher & Co. — Q3 2015 Form 10-Q

Reporting period: Three and nine months ended September 30, 2015; financial statements are unaudited and were reviewed, not audited, by Ernst & Young. Gallagher provides insurance brokerage and risk-management services and also operates clean-energy investments. Unless stated otherwise, dollar amounts are in millions.

Financial performance and key metrics

Metric	Q3 2015	Q3 2014	Nine months 2015	Nine months 2014
Total revenue	$1,454.8	$1,286.8	$4,057.5	$3,381.1
Earnings before income taxes	$105.7	$95.4	$265.1	$262.0
Net earnings attributable to controlling interests	$133.3	$93.6	$294.5	$251.9
Diluted EPS	$0.75	$0.58	$1.71	$1.67
Cash from operating activities	—	$326.5	$258.2

Q3 revenue rose about 13% year over year; nine-month revenue rose about 20%. The totals include substantial clean-coal activity: revenue was $408.1 in Q3 and $1,009.0 for nine months, with corresponding costs of $418.9 and $1,035.0.
Reported net earnings attributable to controlling interests increased about 42% in Q3 and 17% year to date. Q3 results included a $31.0 pretax gain from settling litigation with former U.K. executives and a large clean-energy-related income-tax benefit; reported earnings therefore do not solely reflect brokerage and risk-management performance.
For the combined brokerage and risk-management segments, Q3 organic growth was 4.1%; adjusted EBITDAC increased 11% and adjusted EBITDAC margin increased 30 basis points. These are management-defined non-GAAP measures. Brokerage base commission-and-fee organic growth was 2.4% in Q3 and 4.0% year to date; risk-management organic fee growth was 9.3% and 11.2%, respectively.
Q3 brokerage pretax earnings were $122.5 versus $123.8; controlling-interest net earnings were $77.3 versus $78.8. Risk-management pretax earnings were $22.4 versus $21.0, and net earnings were $13.8 versus $13.3.
Comprehensive loss attributable to controlling interests was $38.3 in Q3 and comprehensive earnings were $69.0 for nine months. Foreign-currency translation reduced nine-month comprehensive earnings by $237.9 and was a major contributor to the accumulated other comprehensive loss.
At September 30, cash and cash equivalents were $369.7; restricted cash was $1,349.6 and should not be treated as freely available liquidity. Current assets were $4,020.1 and current liabilities $3,729.2, with substantial fiduciary-related balances.
Total corporate and other debt was $2,392.6: $2,125.0 of fixed-rate notes, $153.0 drawn on the revolving credit agreement and $114.6 under the premium-financing facility. The revolver had $423.9 available, including the effect of outstanding letters of credit. The company reported compliance with debt covenants.
Dividends declared were $0.37 per share in Q3 and $1.11 per share year to date. Nine-month dividends paid were $192.5. Shares outstanding increased to 176.7 million from 164.6 million at year-end 2014, reflecting acquisition and other stock issuances.

Material changes and operating developments

2015 revenue growth reflects acquisitions as well as organic growth. Gallagher completed 29 acquisitions in the first nine months, including William Gallagher Associates; acquired businesses had approximately $184.5 of annualized revenues. Acquisition cash payments were $176.5, compared with $1,834.6 in the prior-year period, when acquisition activity was much larger.
Acquisition integration costs and amortization increased. Acquisition earnout-related expense also rose, reflecting discount accretion and revisions to estimated future performance. Recorded earnout obligations were $223.6 at quarter-end, against maximum potential obligations of $580.8.
Q3 adjusted brokerage and risk-management results improved, but reported brokerage diluted EPS fell to $0.44 from $0.49; the reported comparison includes acquisition costs, earnout charges and other items. The filing’s non-GAAP adjustments should be considered alongside, not instead of, GAAP results.
Operating cash flow increased to $326.5 from $258.2, partly because of timing differences in accrued liabilities and fiduciary receipts and payments. It was affected by foreign-currency remeasurement losses and compensation-related retention payments.
Net cash used in investing was $260.2, versus $1,910.7 in 2014, principally reflecting lower acquisition spending. Capital expenditures were $71.8 year to date.

Outlook, risks and unusual items

Management said it expected positive organic growth to continue and intended to pursue further acquisitions. It described a modestly declining insurance-pricing environment: renewal rate decreases and competition could be partly offset by exposure growth, retention and new business. No formal consolidated earnings or revenue guidance was provided.
Management expected 2015 clean-energy earnings of $102.5–$104.5 in one discussion and estimated $113.4–$115.4 of after-tax earnings from all clean-energy investments in another. These estimates appear to use different scopes; investors should verify the definitions and assumptions. Management also cautioned that plant production, tax-credit use, operating costs and capital spending affect cash generation.
Clean-energy activity and IRC Section 45 credits materially affect corporate-segment results and the consolidated tax benefit. The company recognized $144.6 of credits in the first nine months, versus $103.6 in 2014; tax credits produced in those periods were $135.8 and $107.1, respectively. Eligibility, production and the ability to use credits remain important uncertainties.
The IRS was investigating Gallagher’s micro-captive advisory services and auditing more than 100 client captives for tax year 2012. The company said no specific allegation had been made against it and that a potential loss could not be reasonably estimated; an adverse outcome could harm the business, earnings and client demand.
Other exposures include litigation and regulatory matters, professional-liability claims, and up to $32.0 of potential indemnification payments related to previously sold energy investments, plus exposure involving $109.0 of previously claimed tax credits. No liability was recorded for the latter indemnification exposure.
The U.K. litigation settlement generated a $31.0 pretax gain. Related retention arrangements are expected to cause after-tax charges of about $4.5 per quarter through June 30, 2017. The separate $31.0 settlement receipt and these continuing charges should be distinguished when assessing recurring earnings.
Gallagher planned to relocate its headquarters in early 2017; redevelopment and relocation costs could total $135. It anticipated $60–$80 of tax incentives over 15 years, dependent on meeting job requirements. The filing also identifies acquisition integration, soft insurance pricing, foreign-exchange movements, cybersecurity, regulatory compliance and clean-energy/tax-credit risks.

Important facts for investors to verify

How much of reported revenue and earnings growth is attributable to acquired businesses, clean-energy operations, tax credits and the one-time litigation gain, versus recurring brokerage and risk-management performance.
The basis and assumptions behind the two different clean-energy earnings estimates, and the sustainability and cash-conversion of Section 45 tax credits.
The outcome and potential financial consequences of the IRS micro-captive investigation and audits, and the status of other litigation and tax contingencies.
Acquisition integration progress, future earnout payments, dilution from stock-funded acquisitions, and whether expected synergies offset rising amortization and integration costs.
Usable liquidity after excluding restricted cash, future debt maturities and interest, covenant headroom, and funding needs for acquisitions, dividends and headquarters redevelopment.
Whether organic growth and adjusted EBITDAC trends persist as insurance pricing remains soft and foreign-currency translation continues to affect reported results.