Arthur J. Gallagher & Co. quarterly report, Q1 FY2013

Arthur J. Gallagher & Co. — Q1 2013 Form 10-Q

Reporting period: Three months ended March 31, 2013; balance-sheet comparisons are against December 31, 2012. Gallagher provides insurance brokerage and risk-management services internationally, alongside clean-energy investments reported in its corporate segment. Interim financial statements are unaudited and were reviewed by Ernst & Young.

Financial performance

Metric	Q1 2013	Q1 2012	Change
Total revenue	$674.1 million	$546.8 million	Up 23%
Earnings before income taxes	$42.3 million	$32.5 million	Up 30%
Net earnings	$40.5 million	$28.1 million	Up 44%
Diluted EPS	$0.32	$0.24	Up 33%
Operating cash flow	$51.2 million	$(49.6) million	Improved $100.8 million

Reported pretax margin was approximately 6.3%, versus 5.9%; net margin was approximately 6.0%, versus 5.1%.
Revenue growth reflected brokerage commissions and fees, acquisitions, risk-management fees, and clean-energy activity. Brokerage and risk-management revenue totaled $608.0 million, up 15% as reported; combined adjusted revenue was up 16%.
Brokerage revenue rose 18% to $454.4 million; base organic commissions and fees increased 4.8%. Brokerage net earnings were $24.6 million, up from $17.7 million. Adjusted EBITDAC rose 28% to $82.9 million, with adjusted margin increasing to 18.3% from 17.0%.
Risk-management revenue rose 9% to $153.6 million; organic fees increased 10.8%, or 6.8% excluding fees from a new international client. Net earnings were $13.9 million, up from $11.7 million. Adjusted EBITDAC increased 13% to $25.2 million; adjusted margin was 16.6%, versus 16.3%.
Corporate revenue increased to $66.1 million from $20.2 million, largely reflecting clean-coal production and related activity. Corporate reported a pretax loss of $19.8 million but net earnings of $2.0 million, versus a $1.3 million net loss, primarily because of tax credits.
Compensation expense rose to $383.9 million from $344.4 million; operating expense increased to $133.8 million from $108.3 million. Amortization increased to $29.6 million from $21.1 million, mainly reflecting acquired intangible assets. Gallagher wrote off $1.8 million of brokerage intangible assets after impairment reviews.

Cash, liquidity and debt

Cash and cash equivalents were $224.0 million at March 31, down from $302.1 million at year-end. Restricted cash was $799.1 million; it includes fiduciary funds and is not available for general corporate use.
Cash flow from operations was $51.2 million, compared with cash used of $49.6 million a year earlier. Management attributed the improvement mainly to timing of accrued compensation payments and fiduciary-fund receipts and disbursements. Investing activities used $32.8 million; financing activities used $92.2 million, including $44.2 million of dividends paid.
Corporate borrowings totaled $775.0 million: $725.0 million of private-placement notes and $50.0 million under the revolving credit agreement. The company had $434.1 million of credit availability and reported compliance with debt covenants.
Gallagher committed to an additional $200 million, nine-year private placement at 3.69%, expected to close in June 2013. The revolving credit agreement expires in July 2014. Interest expense was $11.2 million, versus $10.6 million.
Quarterly dividends declared were $0.35 per share, up from $0.34. Management stated that operating cash flow and available borrowing capacity should meet foreseeable liquidity needs.

Material changes and unusual items

The corporate segment recognized a $9.6 million gain associated with increasing ownership in clean-coal plants; it also recorded $25.6 million of fixed and other amortizable intangible assets in that transaction.
Clean-coal revenue increased substantially, but consolidated plant costs also rose. Clean-energy investments contributed $13.2 million to Q1 net earnings, compared with $7.2 million in the prior-year quarter, according to management’s segment analysis.
The consolidated effective tax rate was 4.3%, compared with 13.5%, mainly due to IRC Section 45 tax credits. The company recognized $13.7 million of credits in Q1 2013 and generated $16.0 million; recognized and generated amounts differ because quarterly accounting uses estimates of the annual credit level.
Foreign-currency translation reduced comprehensive earnings by $23.1 million, contributing to comprehensive earnings of $18.3 million versus $39.3 million a year earlier.
Four acquisitions were completed in Q1, with approximately $5.0 million in annualized acquired revenue. Acquisition earnout-related expense was $4.4 million, compared with $2.5 million.

Outlook, commentary and risks

Management expects clean-energy investments to generate $70 million to $80 million in 2013 after tax, and expects related tax credits and cash flows to support acquisitions. These expectations depend on plant production, operating conditions, tax-credit eligibility and deployment progress.
Management expects approximately $80 million of 2013 capital expenditures, principally for office moves and expansions, computer systems and equipment. It also estimated $20 million to $30 million of additional clean-coal redeployment investment during the rest of 2013, before co-investor contributions, and $30 million to $35 million after 2013.
Management described insurance pricing as firming; the cited industry survey showed average commercial account rates up 5.2% in Q1. It also noted tighter underwriting for catastrophe-exposed property risks and increased movement of business to alternative markets.
Clean-coal execution risks include plants without long-term production contracts, redeployment delays, utility changes from coal to natural gas or plant closures, and possible 12-to-18-month interruptions when plants are moved. Some plants’ production and earnings estimates are not yet estimable.
Potential tax-related exposures include up to approximately $160 million of indemnification payments, net of applicable tax benefits, relating to previously sold energy investments, and exposure on $130 million of previously earned tax credits. No related indemnification liability was recorded; adverse tax decisions could result in losses.
Other disclosed uncertainties include E&O reserve estimation, litigation with outcomes not currently determinable, acquisition integration and earnout estimates, foreign-exchange movements, competition, personnel retention, regulatory compliance, and contingent-commission variability.

Most important facts for investors to verify

Whether clean-coal production, plant redeployment and Section 45 credit eligibility support management’s $70–$80 million 2013 after-tax earnings estimate and planned cash investment.
How much of reported growth and earnings improvement is recurring brokerage and risk-management performance versus acquisitions, clean-energy activity, tax credits and the $9.6 million plant-transaction gain.
The timing and terms of the planned $200 million private placement, refinancing needs around the 2014 revolving-credit maturity, and ongoing covenant compliance.
Whether operating cash flow remains positive after accounting for working-capital timing, fiduciary funds, dividends, acquisitions and clean-energy capital requirements.
Developments in tax-credit indemnities, E&O reserves, litigation and acquisition earnout estimates, none of which has a fully certain final outcome in this filing.