Arthur J. Gallagher & Co. quarterly report, Q2 FY2014

Arthur J. Gallagher & Co. — Q2 2014 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2014. Figures are unaudited and in U.S. dollars unless noted. The interim financial statements received an independent accountant review, not an audit.

Business context

Gallagher provides insurance brokerage and risk-management services through Brokerage, Risk Management, and Corporate segments. It operates in 27 countries. Brokerage and Risk Management are the core operating businesses; Corporate includes clean-energy investments, debt, and related activities. The quarter included major acquisitions that expanded international operations.

Financial results and liquidity

Metric	Q2 2014	Q2 2013	Six months 2014	Six months 2013
Total revenue	$1,179.3m	$779.5m	$2,094.3m	$1,453.6m
Net earnings	$109.0m	$93.5m	$158.3m	$134.0m
Diluted EPS	$0.70	$0.73	$1.09	$1.04
Operating cash flow	—	—	$206.8m	$73.8m
Capital expenditures	—	—	$42.1m	$35.9m

Q2 revenue rose 51% and six-month revenue rose 44%. The increase largely reflects acquisitions and substantially higher clean-coal activity; reported revenue growth therefore does not represent organic growth alone.
Q2 net earnings increased 17%, while diluted EPS declined from $0.73 to $0.70, reflecting the larger share count after the April offering, among other factors. Six-month diluted EPS increased from $1.04 to $1.09.
Brokerage Q2 revenue increased 35%; organic base commission and fee revenue grew 3.1%, down from 5.9% a year earlier. Brokerage net earnings rose to $88.5m from $68.5m. Risk Management revenue rose 8%, organic fees grew 7.6%, and net earnings were $13.2m versus $12.5m. Its six-month net earnings declined to $25.3m from $26.4m.
Management-reported adjusted EBITDAC for Brokerage and Risk Management combined increased 38% in Q2 to $241.3m, with adjusted margin of 26.5% versus 24.6%. These are non-GAAP measures; management’s definitions and reconciliations should be considered.
Corporate reported a Q2 pretax loss of $50.0m and net earnings of $7.3m, versus $12.5m a year earlier. Clean-energy earnings contributed $35.0m to Q2 net earnings, including significant tax-credit effects. Corporate segment comparisons also reflect acquisition costs, interest expense, and clean-coal plant consolidation.
Operating cash flow for the first half was $206.8m; management attributed the increase from $73.8m primarily to timing of accrued-liability payments and fiduciary-fund receipts and disbursements. Cash from operations can fluctuate materially with premium and fiduciary cash timing.
At June 30, cash and cash equivalents were $973.5m, while restricted cash was $1,109.0m. Total debt was $2,517.0m, up from $1,455.5m at year-end 2013; this included $2,225.0m of note debt, $153.0m under the revolving credit agreement, and $139.0m of premium-financing debt. $425.9m remained available under the credit agreement. Debt covenants were met.
Total assets were $10.0bn, including $3.0bn of goodwill and $1.6bn of net amortizable intangible assets. Current assets were $4.44bn and current liabilities $3.88bn; reported current assets include restricted cash and insurance-related receivables.

Material changes and significant transactions

Gallagher completed 26 acquisitions in the first half, with approximately $514.9m of annualized acquired revenue. Cash paid for acquisitions, net of cash acquired, was $1.402bn.
Major deals included the U.K. Oval Group acquisition for approximately $338m and the June 16 Crombie/OAMPS acquisition for approximately $952m. The April public offering issued 21.85m shares and generated $911.4m net proceeds, used to fund acquisitions. Shares outstanding increased to approximately 159.0m from 133.6m at December 31, 2013.
On July 2, after quarter-end, Gallagher acquired approximately 89% of Noraxis for about $420m cash, financed mostly with additional long-term and line-of-credit borrowings.
Goodwill increased by $882.4m from year-end, primarily due to acquisitions and currency translation. Acquisition-related amortization and integration costs also increased; management expected integration costs of $10m–$17m per quarter in 2014, $5m–$8m per quarter in 2015, and approximately $2m per quarter in 2016.
Q2 clean-coal revenue was $262.8m, but related cost was $270.5m. These activities materially increased reported revenue without producing a corresponding operating profit in the quarter.

Outlook, risks, and contingencies

Management said it expected sufficient capital for short- and long-term needs and anticipated continued earnings growth through organic growth and acquisitions. It gave no specific consolidated earnings or revenue guidance.
Management estimated 2014 after-tax earnings from clean-energy investments, including IRC Section 45 credits, of $99m–$110m, and anticipated positive net cash flow from these investments in 2014. Credits depend on plant production, utility demand, tax eligibility, and deployment costs; credits are scheduled to expire at different times through 2019 and 2021.
Twenty-seven of 34 refined-coal plants had long-term production contracts; seven were seeking or negotiating contracts. Management estimated $30m–$40m of investment to redeploy remaining plants in 2015, before co-investor contributions. Utility fuel-switching or plant closures could interrupt production and reduce credits.
The IRS was investigating Gallagher’s micro-captive advisory services and auditing certain clients’ 2012 tax years. Gallagher said the IRS had made no specific allegations against it and that potential losses could not be estimated. A successful challenge to the captives’ tax treatment could affect clients, future earnings, and the captive business.
In July, Gallagher and related entities were sued over alleged patent infringement involving Chem-Mod technology. The company disputed the allegations and said it believed a material loss was remote; the outcome remained uncertain.
Other exposures include ordinary-course litigation and regulatory matters, E&O self-insurance reserves subject to actuarial uncertainty, and up to $45m of potential indemnification payments related to previously sold tax-advantaged investments. No liability was recorded for those indemnifications; Gallagher also disclosed exposure on $130m of previously earned tax credits.
Management reported moderate insurance-rate increases but noted slowing commercial property/casualty pricing trends. Its Q2 internal renewal survey found 35% of customers renewed at higher rates, 30% about flat, and 35% at lower rates. Foreign-exchange movements, integration execution, acquisition-related dilution and leverage, and contingent commissions are additional risks.
The board declared a Q3 2014 dividend of $0.36 per share. Management estimated that maintaining this rate throughout 2014 would use approximately $220.2m in annual cash dividends, based on June 30 shares outstanding.

Most important facts for investors to verify

How much of revenue and earnings growth is organic versus acquired, and whether organic growth can improve from the reported deceleration.
Whether acquisition integration delivers expected performance and synergies, and how the Noraxis purchase affects debt, interest expense, and per-share results.
The recurring cash generation and actual economics of clean-energy operations, including tax-credit eligibility, plant utilization, redeployment spending, and expiration schedules.
The status and potential financial impact of the IRS micro-captive investigation, related client audits, and other tax-credit contingencies.
Debt maturities, covenant headroom, liquidity excluding restricted cash, and the continuing effect of share issuance and dividends on per-share growth.