Arthur J. Gallagher & Co. — Q2 2012 Form 10-Q
Reporting period: Three and six months ended June 30, 2012; comparisons are with the same 2011 periods. Amounts are in millions of U.S. dollars except per-share data. The interim statements are unaudited and were reviewed, not audited, by Ernst & Young.
Business context
Gallagher provides insurance brokerage and risk-management services through Brokerage, Risk Management and Corporate segments. Brokerage and Risk Management generated approximately 72% and 24% of first-half revenue, respectively; Corporate includes clean-energy investments and corporate debt. The company reported operations in 17 countries and said about 21% of Q2 revenue came from international operations.
Financial performance
| Metric | Q2 2012 | Q2 2011 | H1 2012 | H1 2011 |
|---|---|---|---|---|
| Total revenue | $649.9 | $546.1 | $1,196.7 | $993.5 |
| Earnings before tax | $91.1 | $65.9 | $123.6 | $89.4 |
| Net earnings | $71.7 | $41.7 | $99.8 | $56.9 |
| Diluted EPS | $0.59 | $0.37 | $0.83 | $0.51 |
| Operating cash flow | Not separately presented for the quarter | $63.0 | $96.3 |
- Revenue increased 19% in Q2 and 20% in H1; net earnings rose 72% and 75%, respectively. Calculated net margin was approximately 11.0% in Q2 2012 versus 7.6% in Q2 2011, and 8.3% in H1 versus 5.7%.
- Q2 Brokerage revenue was $473.5 (up 17%) and Risk Management revenue was $143.4 (up 7%). Organic commission and fee growth was 5% for Brokerage; Risk Management organic fees grew 8%. Management attributed growth to acquisitions, new business, renewal pricing and increased claim counts.
- First-half operating cash flow fell to $63.0 from $96.3, which management attributed primarily to timing of fiduciary receipts and disbursements and higher incentive-compensation and interest payments. Investing cash outflow was $82.3, including $77.1 net cash paid for acquisitions; financing cash inflow was $10.2.
- At June 30, cash and cash equivalents were $282.1, restricted cash $824.2, and total assets $5,133.6. Restricted cash relates to fiduciary funds and is not available for general corporate use.
- Corporate borrowings totaled $723.0: $675.0 of fixed-rate notes and $48.0 under the revolving credit facility. Of the $500.0 facility, $436.1 remained available after borrowings and letters of credit. The company reported compliance with debt covenants. The notes’ estimated fair value was $765.0.
- Dividends declared were $0.34 per share for Q2 and $0.68 per share for H1. Shares outstanding at June 30 were 121.0 million, versus 114.7 million at year-end 2011.
Material changes and unusual items
- Gallagher completed 27 acquisitions in H1, with aggregate recorded purchase price of $234.1 million and acquired businesses’ annualized revenue of approximately $98.9 million. H1 reported revenue included $24.9 million from 2012 acquisitions. Acquisition-related goodwill rose to $1,285.9 million from $1,155.3 million at year-end.
- Corporate clean-energy revenue increased substantially, contributing to lower consolidated tax expense. The consolidated effective tax rate was 19.3% for H1 2012 versus 36.4% in H1 2011; management cited IRC Section 45 credits. Corporate segment net earnings were $2.6 million for H1, compared with a $17.7 million loss in H1 2011. Brokerage and Risk Management segment tax rates were approximately 39%.
- Q2 included a $3.5 million noncash loss on remeasurement of Gallagher’s initial CGM interest upon increasing its ownership to 80%. The company also recorded a $3.1 million write-off of brokerage intangible assets. Acquisition earnout estimate revisions affected earnings; such estimates depend on future performance projections.
- Q2 adjusted EBITDAC, a company-defined non-GAAP measure, increased 20% for Brokerage and Risk Management combined. Heath Lambert integration continued to weigh on Brokerage margins; management expected integration to continue through 2013.
Outlook, risks and contingencies
- Management expects continued organic growth and expansion through acquisitions, and said operating cash flow and available credit should meet foreseeable liquidity needs. It provided no specific consolidated revenue or earnings guidance. It expected 2012 capital expenditures of approximately $55 million and anticipated annualized 2012 cash dividends of about $164.5 million.
- Management reported firmer insurance pricing, with the Q2 industry survey showing average rate increases of 4.3%, but cautioned that sluggish economic recovery could restrain insurance demand. Commissions also remain exposed to insurance-premium cycles and less predictable supplemental and contingent commissions.
- Clean-energy results and tax benefits depend on plant production, securing contracts and co-investors, continued eligibility for Section 45 credits, and tax and regulatory outcomes. Several plants were not operating under long-term production contracts; the company estimated additional net investment of about $2 million per plant for certain facilities.
- For previously sold tax-advantaged investments, maximum potential indemnification payments were approximately $195 million, net of the applicable tax benefit, and exposure related to previously earned tax credits was $129.2 million. No liability was recorded for these contingent exposures. Adverse tax decisions could create material obligations.
- Other risks include acquisition integration and earnout estimates, litigation, E&O claims, foreign exchange, regulation, client-data security, and future pension funding. The company’s E&O reserve was within its actuarial range; management cautioned that claim experience could differ from historical estimates. It was not required to make a minimum pension contribution for 2012 but was considering discretionary contributions and noted future minimum contributions could be significantly higher.
Important facts for investors to verify
- How much reported growth and profitability is attributable to acquisitions, organic growth, and clean-energy operations, and how comparable the company-defined adjusted measures are to GAAP results.
- Whether operating cash flow recovers as fiduciary cash timing normalizes, given dividend commitments, acquisition spending and planned capital expenditures.
- Production, contracts, co-investor funding and tax-credit eligibility for clean-energy investments, along with the potential impact of the disclosed tax indemnities and prior tax credits.
- Acquisition integration progress, dilution from share-funded deals, goodwill and intangible-asset impairment exposure, and changes in earnout estimates.
- Whether the company maintains debt-covenant compliance and adequate liquidity as borrowings, contingent liabilities and future pension obligations evolve.