Arthur J. Gallagher & Co. quarterly report, Q3 FY2021

Arthur J. Gallagher & Co. — Q3 2021 Form 10-Q

Reporting period: Three and nine months ended September 30, 2021; comparisons are with the corresponding 2020 periods. Gallagher provides insurance brokerage and consulting, and third-party claims administration. Its segments are brokerage, risk management and corporate. Reported corporate revenue includes clean-coal activities, which generate substantial revenue and related costs.

Financial performance

Metric	Q3 2021	Q3 2020	Nine months 2021	Nine months 2020
Total revenue	$2,138.2 million	$1,849.1 million	$6,236.7 million	$5,300.0 million
Earnings before income taxes	$231.4 million	$209.5 million	$862.1 million	$737.2 million
Net earnings attributable to controlling interests	$225.1 million	$176.6 million	$797.4 million	$676.6 million
Diluted EPS	$1.06	$0.90	$3.88	$3.48
Cash from operating activities	Nine-month period: $1,141.2 million	Prior-year period: $1,387.6 million

• Q3 total revenue rose about 16%, while controlling-interest net earnings rose about 27% and diluted EPS about 18%. Nine-month revenue increased about 18%, net earnings about 18%, and diluted EPS about 11%.
• Brokerage Q3 revenue increased 16%; organic revenue grew 9.0%. Risk management revenue before reimbursements rose 22%; organic fees grew 16.6%. For the first nine months, organic brokerage revenue grew 7.2% and organic risk-management revenue 11.9%.
• Q3 reported pretax margin was approximately 10.8%, versus 11.3% a year earlier. Segment margins differed: brokerage net earnings margin increased to 16.9% from 16.0%; risk management’s decreased to 8.9% from 9.3%.
• Management’s adjusted, non-GAAP diluted EPS was $1.33 for Q3, up 22%, and $4.51 for nine months, up 14%. Adjusted measures exclude specified items and are not substitutes for GAAP results.
• Nine-month operating cash flow declined about 18%, partly reflecting higher income-tax payments, acquisition earnout payments, debt interest, and timing of working-capital flows. Capital expenditures were $103.2 million; cash paid for acquisitions, net of cash acquired, was $631.6 million.
• At September 30, cash and cash equivalents were $2,735.1 million; restricted cash was a separate $3,277.2 million and is not generally available for corporate use. Net corporate and other debt was $5,506.5 million; the company reported no borrowings under its main credit agreement and $1,185.8 million of remaining availability. Premium-financing debt was $234.1 million. Debt covenants were met.

Material changes and unusual items

• Gallagher announced an agreement to acquire Willis Towers Watson’s treaty reinsurance brokerage operations for initial gross consideration of $3.25 billion, plus up to $750 million tied to third-year revenue targets. The deal was subject to customary regulatory approvals and expected to close in Q4 2021. Planned funding included cash on hand, proceeds from the May share offering and 2051 notes, and potentially short-term borrowing or further capital-market transactions.
• The company issued 10.3 million shares in May, raising net proceeds of $1.438 billion, and issued $1.5 billion of senior notes. Following termination of a separate proposed Willis Towers Watson brokerage acquisition, it redeemed the $650 million 2.50% notes due 2031 in August, recording a $16.2 million debt-extinguishment loss. The remaining $850 million notes bear 3.50% interest and mature in 2051.
• Acquisition cash spending increased substantially year over year. Nine-month acquisitions had approximately $189.9 million in annualized revenue; recorded purchase consideration was $766.6 million. Acquisition earnout estimates are judgment-dependent; $578.7 million was recorded for earnout obligations at quarter-end.
• Clean-coal revenue was $357.6 million in Q3 and $919.2 million for nine months, with related costs of $366.1 million and $944.0 million. Clean-energy tax credits contributed to unusually low consolidated effective tax rates: 3.2% for the first nine months. Management estimated 2021 adjusted after-tax clean-energy earnings of $87–$95 million. Tax-credit eligibility for the 21 remaining 2011-era plants was scheduled to expire in December 2021.
• Quarterly dividends declared were $0.48 per share, versus $0.45 a year earlier. The board authorized a $1.5 billion share-repurchase plan, but Gallagher reported no company share repurchases during the first nine months.

Outlook, commentary and risks

• Management described improving client activity, higher insured exposure units, strong retention and new business, and continued insurance-rate firming. It expected property/casualty rate increases to continue through the rest of 2021 and into 2022, while noting that deteriorating loss trends could make conditions more difficult.
• Management said a continuing economic recovery could support Q4 brokerage and risk-management revenue. It also expected higher operating costs as travel, advertising, medical-plan use, wage increases, consulting and incentive compensation normalized; estimated Q4 brokerage cost increases of approximately $30 million versus Q4 2020.
• No consolidated full-year revenue or EPS guidance is provided in the supplied filing text. Management expected 2021 capital expenditures of approximately $140 million and stated it believed liquidity and access to capital were adequate.
• Key risks include completion, financing, client and employee retention, integration and expected synergies for the treaty-reinsurance acquisition; economic and COVID-19 recovery uncertainty; insurance pricing and claims trends; acquisition earnout estimates; foreign exchange and interest rates; and clean-energy production, regulation and tax-credit uncertainty.
• Gallagher disclosed an ongoing IRS audit of its micro-captive advisory business and a related criminal investigation into captive underwriters; it said it was not a target and was cooperating. A patent-infringement case involving clean-coal technology remained in discovery; the company said it believed the likelihood of material loss was remote. Other litigation and regulatory matters were not estimable from the filing.

Important facts for investors to verify

• Regulatory approval, closing timing, financing, potential additional consideration, and retention/integration assumptions for the treaty-reinsurance acquisition.
• Organic growth and margins separately from acquired revenue, currency effects, clean-coal activity and adjusted non-GAAP items.
• Cash available for corporate use versus restricted fiduciary cash, and debt maturities, interest costs and capacity after the planned acquisition.
• The impact of the 2021 tax-credit expiration on reported earnings, cash flow and management’s clean-energy estimates.
• Changes in acquisition earnout liabilities, contingent revenues, legal exposures and the outcome of IRS and patent matters.