Arthur J. Gallagher & Co. — Q3 2013 Form 10-Q
Reporting period: Three and nine months ended September 30, 2013; comparative periods ended September 30, 2012. Amounts are in millions except per-share data. Interim financial statements were reviewed, not audited.
Business context
Gallagher provides insurance brokerage and risk-management services through Brokerage, Risk Management and Corporate segments. Corporate includes clean-energy investments and the company’s debt. About 80% of Q3 revenue was domestic; management expected international revenue to continue growing as a share of total revenue.
Financial performance and liquidity
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Total revenue | $835.8 | $650.4 | $2,289.4 | $1,847.1 |
| Net earnings | $74.6 | $61.7 | $208.6 | $161.5 |
| Diluted EPS | $0.57 | $0.50 | $1.61 | $1.33 |
| Operating cash flow | — | $278.6 | $179.4 |
- Q3 reported revenue rose 29%, while net earnings rose 21% and diluted EPS rose 14%. Nine-month revenue increased 24%, net earnings 29% and diluted EPS 21%.
- Revenue growth included a substantial clean-coal contribution: Corporate revenue was $139.8 in Q3 versus $28.5 a year earlier, and $278.3 for nine months versus $81.7. Core Brokerage and Risk Management together generated Q3 revenue of $696.0, up 12% as reported.
- Brokerage Q3 revenue grew 14%; organic base commissions and fees grew 5.5%. Adjusted EBITDAC was $145.6, up 20%, with a 26.7% adjusted margin versus 25.5%. Risk Management revenue grew 5% and organic fees 8.5%; adjusted EBITDAC rose 5% to $23.8, while adjusted margin eased to 15.9% from 16.1%.
- For nine months, operating cash flow was $278.6, compared with $179.4. Management attributed the increase mainly to timing of accrued-liability payments and fiduciary-fund receipts and disbursements. Investing used $430.5, including $333.0 net cash paid for acquisitions and $69.8 of fixed-asset additions.
- Cash and cash equivalents were $286.9 at September 30, down from $302.1 at year-end 2012; restricted cash was $924.2. Management cautions that restricted cash and premium receivables/payables are not useful standalone measures of available liquidity.
- Corporate borrowings totaled $1,060.5: $925.0 under private-placement notes and $135.5 under the revolving credit agreement. The new $600.0 unsecured facility expires in 2018; $449.3 was available at quarter-end. The company reported compliance with debt covenants. Total assets were $5,970.2 and stockholders’ equity $1,932.2.
- Dividends declared were $0.35 per share in Q3 and $1.05 per share for the first nine months. The board announced a Q4 dividend of $0.35 per share.
Material changes and unusual items
- Seventeen acquisitions were completed in the first nine months, with recorded purchase consideration of $491.2 and annualized acquired revenue of approximately $176.4. Acquisition cash outflow was higher year over year; goodwill increased to $1,771.5 from $1,472.7.
- Bollinger was acquired in August, with recorded purchase price of $317.1, partly paid in shares. Gallagher signed an agreement to acquire U.K. broker Giles for approximately £233 million (about $370 million), subject to regulatory approval and expected to close in early November 2013.
- Clean-coal operations materially affected reported revenue and tax expense. The company reported $68.6 of clean-coal tax credits for nine months, versus $38.8 a year earlier; credits generated in the period were $65.4 and $33.0, respectively. The consolidated effective tax rate was 7.4% for nine months, primarily reflecting IRC Section 45 credits.
- Management estimated clean-energy investments would contribute $61–$63 of net earnings for full-year 2013. It expected clean-energy cash flow to turn positive in 2014, while noting deployment capital needs and operating losses could offset 2013 tax-credit cash benefits.
- Q3 included a $5.0 pretax unrealized foreign-currency derivative gain associated with the Giles purchase. The nine-month period also included a $9.6 gain from acquiring additional interests in clean-coal plants. Brokerage recorded $2.2 of intangible-asset write-offs for nine months.
Outlook, risks and contingencies
- Management expressed confidence in capital sufficiency and expected continued growth from organic operations and acquisitions, but did not provide specific consolidated revenue or EPS guidance. It anticipated Brokerage and Risk Management effective tax rates of approximately 37%–39% for the foreseeable future.
- Management cited continued, but moderating, insurance-market rate increases: the CIAB survey reported average rate increases of 3.4% in Q3, compared with 4.3% in Q2. Organic growth remains sensitive to pricing, new business and customer retention.
- Clean-coal risks include possible changes in tax-credit eligibility, host utilities reducing or stopping coal use, plant relocation downtime estimated at 12–18 months, and the need for further deployment investment. Gallagher estimated $30–$35 of additional redeployment investment after 2013, before co-investor contributions.
- Potential tax exposures include indemnification obligations of up to approximately $45.0 related to previously sold energy investments and exposure on $130.0 of previously earned tax credits. No liabilities for these contingencies were recorded; adverse tax outcomes could result in costs.
- The company faces legal actions, including employment-related matters and claims involving former employees. Outcomes and financial effects were not determinable. Its errors-and-omissions reserve was within the actuarially estimated range, but management noted future claims could materially change estimates.
- Other disclosed risks include acquisition integration and impairment, competitive and insurance-market conditions, employee retention, international and currency exposure, regulatory compliance, cybersecurity/business continuity, and debt restrictions. A 10% adverse currency movement was estimated to reduce nine-month pretax earnings by about $2.3.
Most important facts for investors to verify
- How much of reported growth and earnings is attributable to clean-coal activity and tax credits versus recurring brokerage and risk-management operations.
- Progress, funding and integration costs for Bollinger and the Giles acquisition, including Giles’ completion and financing.
- Whether clean-coal production, tax-credit eligibility, utility contracts and redeployment plans support management’s earnings and cash-flow expectations.
- Acquisition-related leverage, earnout exposure ($140.4 recorded; $400.4 maximum potential for 2009–2013 acquisitions), and remaining revolver availability.
- Cash-flow quality: operating cash-flow growth was partly driven by timing differences, while restricted cash is not generally available for corporate use.