Arthur J. Gallagher & Co. annual report, FY2013

Business context and reporting period

Arthur J. Gallagher & Co. filed this Form 10-K for the fiscal year ended December 31, 2013; it is an annual report, not a standalone fourth-quarter filing. Gallagher brokers insurance and administers property/casualty claims, generally without assuming underwriting risk. Its segments are brokerage, risk management and corporate. Brokerage and risk management generated approximately 77% of their combined revenues in the U.S.; the corporate segment principally reflects clean-energy investments, debt and corporate costs.

Financial performance

Unless indicated otherwise, figures are in millions of dollars. The 2013 results reflect substantial acquisition activity and a sharp increase in clean-coal activity and related tax credits; reported growth therefore does not represent solely the performance of the core brokerage and claims businesses.

Net earnings were approximately 8.4% of revenue, versus 7.7% in 2012. The consolidated effective tax rate was only 2.2% in 2013, compared with 20.5% in 2012, primarily because of IRC Section 45 clean-energy credits: $93.7 million of credits were generated and recognized in 2013, versus $43.8 million in 2012. Brokerage and risk management segment tax rates were materially higher, approximately 37% and 37%, respectively.

• Brokerage: Revenue was $2,144.3, up 17%; net earnings were $204.8, up 31%. Base organic commissions and fees rose 5.6%. Adjusted EBITDAC was $510.7, up 23%, and adjusted margin rose to 23.9% from 22.8%.
• Risk management: Revenue was $611.0, up 7%; net earnings were $46.2, up 9%. Organic fees increased 9.3%. Adjusted EBITDAC was $96.1, up 6%, while adjusted margin edged down to 15.8% from 16.0%.
• Corporate: Revenue rose to $424.3 from $121.0, largely reflecting consolidated clean-coal plant activity. The segment recorded $17.6 million of net income versus a $3.3 million loss in 2012, including $63.7 million of after-tax earnings from clean-energy investments.

Management’s non-GAAP adjusted revenues and EBITDAC exclude specified items and are not GAAP measures; comparisons should be considered alongside reported results.

Fourth-quarter results

For Q4 2013, revenue was $890.2 versus $673.2 in Q4 2012; pretax earnings were $49.3 versus $45.4; net earnings were $60.0 versus $33.5; and diluted EPS was $0.45 versus $0.27. Quarterly results are seasonal and can be affected by acquisition timing, commissions and tax-credit recognition.

Balance sheet, debt and liquidity

At year-end 2013, total assets were $6,860.5, up from $5,352.3; stockholders’ equity was $2,085.5, up from $1,658.6. Cash and cash equivalents were $298.1. An additional $1,027.4 of restricted cash was held in fiduciary or otherwise restricted arrangements and should not be treated as freely available operating cash.

Debt borrowings totaled $1,455.5: $925.0 under private-placement notes and $530.5 under the revolving credit agreement. The $600 million revolving facility had $53.5 million available at year-end after borrowings and letters of credit. Gallagher reported compliance with debt covenants. A separate $600 million senior-note placement was agreed in December 2013, with funding expected February 27, 2014; management intended to use proceeds primarily to reduce the credit line. Operating cash flow was $349.9, while acquisition spending, net of acquired cash, was $727.7. Total current liabilities exceeded current assets, but current assets and liabilities include substantial matched fiduciary premium balances.

Material changes, outlook and risks

• Acquisitions and dilution: Gallagher completed 31 acquisitions in 2013, including Bollinger and U.K. broker Giles. Acquired businesses had approximately $383.9 million in annualized revenue. Cash acquisition payments were $727.7 million and 5.1 million shares, valued at $223.1 million, were issued as acquisition consideration. Goodwill increased to $2,145.2 million from $1,472.7 million.
• Market and core-business trends: Management reported organic growth in brokerage and risk management for 12 consecutive quarters and a moderately firming insurance market, but said its durability was uncertain. The CIAB reported average rate increases of 5.2%, 4.3% and 3.4% for the first three quarters of 2013; its fourth-quarter survey was not yet available.
• Clean-energy outlook and exposure: Management estimated $65–$80 million of 2014 after-tax earnings from clean-energy investments and anticipated positive related net cash flow. Twenty-eight of 34 refined-coal plants had long-term production contracts at year-end; six were still seeking contracts. Eligibility, plant utilization, coal demand, environmental regulation, tax-credit changes and potential relocations could materially affect returns. Management estimated $30–$35 million of additional redeployment investment in 2014–2015, before co-investor contributions, in addition to $6 million already committed.
• Cost actions and spending: Fourth-quarter workforce reductions generated $8.1 million of pretax charges across brokerage and risk management; management expected annual savings of $11.3 million. Expected 2014 capital expenditures were approximately $90 million. Integration costs for the Bollinger and Giles acquisitions were expected to continue through 2014.
• Shareholder returns: Gallagher declared $1.40 per share in 2013 dividends. It announced a Q1 2014 dividend of $0.36 per share; maintaining that rate for the year would imply approximately $190.9 million of cash dividends. No shares were repurchased under the repurchase plan in 2013. The company sold 91,572 shares under its at-the-market program in Q4 for approximately $4.3 million net proceeds.
• Other material risks and contingencies: Risks include insurance pricing and commission pressure, economic weakness, acquisition integration and retention, international regulation and currency exposure, cybersecurity and privacy, litigation and claims, and debt restrictions. The company disclosed up to $45 million of potential indemnification payments, net of tax benefits, related to previously sold tax-advantaged investments and exposure on $130 million of previously claimed tax credits; no liability was recorded for those indemnifications. E&O coverage retains the first $5 million per claim. The filing describes various legal and regulatory matters but does not quantify a clear aggregate potential loss.

Management said it expected continued organic and acquisition-led growth and believed operating cash flow and borrowing capacity would meet foreseeable liquidity needs. It cautioned that future results, clean-energy credits and dividends are uncertain. The financial statements received an unqualified audit opinion; management and the auditor also concluded internal control over financial reporting was effective, although 18 of the 31 entities acquired in 2013 were excluded from the control assessment.

Important facts for investors to verify

1. How much of reported revenue and earnings growth came from core organic operations, acquisitions, and clean-energy consolidation or tax credits?
2. Whether IRC Section 45 eligibility, production contracts, plant utilization and future tax-credit assumptions support the projected $65–$80 million of 2014 after-tax clean-energy earnings.
3. Completion and use of the $600 million note financing, subsequent revolving-credit balances, debt maturities and covenant headroom.
4. Acquisition integration progress, realized cost savings, acquired-business retention and potential earnouts; maximum earnouts for 2010-and-later acquisitions were $462.3 million, of which $162.7 million was recorded at fair value.
5. Cash conversion and funding needs, including acquisition spending, capital expenditures, dividends and additional clean-coal plant redeployment investment; distinguish unrestricted cash from fiduciary restricted cash.
6. Developments in disclosed tax, legal, E&O and environmental exposures, and the financial-control integration of acquired entities excluded from the 2013 assessment.