Arthur J. Gallagher & Co. — Q3 2011 Form 10-Q
Business context and reporting period. The filing covers the quarter and nine months ended September 30, 2011. Gallagher provides insurance brokerage and risk-management services in 16 countries, with business conducted in more than 110 countries. Brokerage and risk management generated approximately 73% and 26% of nine-month revenue, respectively; corporate activities, including clean-energy investments and debt, accounted for the remainder. Amounts below are in millions except per-share data.
Financial performance and liquidity
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Total revenue | $562.8 | $463.2 | $1,556.3 | $1,405.1 |
| Continuing-operations pretax earnings | $71.0 | $70.4 | $160.4 | $177.2 |
| Continuing-operations earnings / net earnings | $46.7 | $46.2 | $103.6 | $117.3 / $119.4 |
| Diluted continuing-operations EPS | $0.41 | $0.44 | $0.93 | $1.12 |
| Operating cash flow | Not presented quarterly | $182.0 | $213.4 from continuing operations; $212.4 total |
- Q3 revenue increased about 22%, while net earnings were broadly flat. Nine-month revenue rose about 11%, but continuing-operations earnings fell about 12%. Nine-month 2010 net earnings included $2.1 from discontinued operations.
- Q3 consolidated pretax margin was approximately 12.6%, compared with 15.2% a year earlier; nine-month margin was approximately 10.3%, versus 12.6%. Revenue grew faster than earnings, with higher compensation, operating costs, amortization and interest contributing.
- Nine-month investing cash use was $262.7, primarily reflecting $240.0 of acquisition spending and $29.2 of capital expenditures. Financing provided $72.3, including $125.0 of new long-term notes, offset partly by $108.6 of dividends paid. Cash and cash equivalents ended at $241.4, down from $249.8 at year-end 2010.
- Balance-sheet total assets were $4,247.2 and total liabilities $3,027.9 at September 30. Restricted cash was $718.4 and should not be treated as freely available liquidity. Corporate debt was $675.0, all noncurrent; there were no credit-facility borrowings and $483.5 remained available under the $500.0 revolving facility after letters of credit. The company reported compliance with debt covenants.
- Dividends declared were $0.33 per share in Q3 and $0.99 per share for the nine months. The company announced a Q4 dividend of $0.33 per share, 3% above Q4 2010.
Material changes versus the prior period
- Brokerage revenue for Q3 rose 20% to $421.9; organic commission and fee growth was about 2%. New business was partly offset by renewal-rate decreases and lost business. Nine-month brokerage revenue rose 14%, while organic commission and fee revenue increased 2% versus a 3% decline in the prior-year period.
- Risk-management Q3 revenue rose 25% to $139.0, with organic fee growth of 12.9%; reported continuing-operations earnings increased 30%. Nine-month organic fee growth was 8%.
- Acquisition activity increased substantially: 21 acquisitions were completed during the first nine months, with approximately $234.8 of annualized revenue. The Heath Lambert acquisition accounted for $164.0 of net cash paid; acquired businesses contributed $88.7 of revenue and a $1.5 loss from continuing operations in the nine-month period. Gallagher expected Heath Lambert integration to take up to two years.
- Corporate revenue fell to $10.1 for the nine months from $69.1, primarily reflecting lower clean-coal production revenue and investment results. The corporate segment’s pretax loss widened to $52.8 from $38.2, including higher interest expense.
- Shares outstanding increased to 112.9 million from 108.4 million at year-end 2010, reflecting acquisition-related and employee-plan issuances. Higher weighted-average shares contributed to lower reported EPS despite Q3 earnings growth.
Outlook, commentary and risks
- Management stated it believed capital and operating cash flows, supplemented if needed by the revolving credit facility, would meet foreseeable liquidity needs. It expected its historically favorable trend in EBITDAC to continue and planned to pursue organic growth and acquisitions. These are outlook statements, not specific earnings guidance.
- Management cited a weak economy and flat insurance demand as headwinds, while noting that Q3 commercial property/casualty rates had turned modestly positive in an industry survey and that carriers were tightening underwriting standards. Competitive pressure and rate movements could affect commissions and client demand.
- Clean-energy results are exposed to significant uncertainty, including permits, operating performance, co-investor arrangements, regulatory and tax-credit qualification, and the company’s limited control over some facilities. Sixteen new refined-coal plants were under construction; management expected an ultimate investment of approximately $30.0 after anticipated co-investor proceeds. Projected earnings are conditional, not assured.
- Potential indemnifications relating to previously sold tax-advantaged investments were approximately $195.0, net of estimated tax benefit; the company also had exposure on $148.8 of previously earned tax credits. No related liability was recorded. The filing notes that adverse tax outcomes could trigger liability.
- Other risks include contingent and supplemental commission variability, acquisition integration and earnout estimates, foreign exchange exposure, litigation, regulation, personnel retention, and economic conditions. The company disclosed $120.9 of unrecorded earnout obligations for 2007–2008 acquisitions and $101.8 of recorded fair-value earnout liabilities for 2009 and later acquisitions.
- The interim financial statements were reviewed by Ernst & Young, not audited; the reviewer reported no material modifications needed for GAAP conformity.
Important facts for investors to verify
- Whether organic growth and segment earnings trends persist apart from acquisition contributions, and how Heath Lambert integration affects margins.
- How much of reported earnings and future performance depends on clean-energy tax credits, plant permits, utility purchase commitments and co-investor funding.
- The assumptions underlying recorded and unrecorded acquisition earnouts, including potential future cash payments and earnings adjustments.
- Cash-flow conversion and usable liquidity, distinguishing unrestricted cash from fiduciary and restricted funds; also monitor debt maturities and covenant compliance.
- Potential outcomes of tax indemnifications, previously claimed tax credits and outstanding litigation, for which the filing says outcomes or effects may be uncertain.