Arthur J. Gallagher & Co. — Q3 2012 Form 10-Q
Reporting period: Three and nine months ended September 30, 2012; comparisons are with the corresponding 2011 periods. Amounts are in millions except per-share data. The interim statements were reviewed by Ernst & Young, not audited.
Business context and reporting period
Gallagher provides insurance brokerage and risk-management services through brokerage, risk management and corporate segments. It operates in 17 countries, with about 80% of Q3 revenue generated domestically. Brokerage and risk management accounted for approximately 72% and 23% of nine-month revenue; corporate accounted for approximately 5%, largely reflecting clean-energy activities and corporate costs.
Financial performance and liquidity
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $650.4 | $562.8 | $1,847.1 | $1,556.3 |
| Earnings before income taxes | $76.3 | $71.0 | $199.9 | $160.4 |
| Net earnings | $61.7 | $46.7 | $161.5 | $103.6 |
| Diluted earnings per share | $0.50 | $0.41 | $1.33 | $0.93 |
| Operating cash flow | Not provided by quarter | Not provided by quarter | $179.4 | $185.6 |
| EBITDAC, non-GAAP | $127.2 | $106.4 | $336.7 | $266.1 |
- Q3 revenue increased 15.6% and net earnings 32.1%; nine-month revenue increased 18.7% and net earnings 55.9%. Diluted EPS rose 22.0% for Q3 and 43.0% year to date.
- Management-reported EBITDAC margin was 24% versus 23% in Q3 and 22% versus 21% for nine months. Adjusted EBITDAC, a non-GAAP measure, increased 20% in Q3 and 22% year to date. Non-GAAP measures are not substitutes for GAAP results.
- Brokerage organic base commission and fee revenue grew 4% in both periods; risk-management organic fee growth was 2% in Q3 and 6% year to date. Risk-management Q3 growth slowed from 13% in the prior-year quarter.
- At September 30, cash and cash equivalents were $305.2; restricted cash was $805.5. Total assets were $5,009.3 and total liabilities $3,373.1. The filing cautions that restricted cash and premium-related balances are not useful standalone measures of liquidity.
- Corporate borrowings were $725.0, up from $685.0 at year-end 2011; there were no revolver borrowings and $484.1 remained available under the $500.0 revolving facility, net of letters of credit. Debt covenants were met. Unrestricted cash less corporate borrowings was approximately $419.8 net debt.
- Nine-month cash from operations was $179.4, down from $185.6; investing used $154.4, including $137.9 for acquisitions; financing used $15.1. Cash at period end was $305.2. Dividends declared were $1.02 per share for the first nine months.
Material changes versus the prior comparable period
- Growth reflected both acquisitions and organic performance. Gallagher completed 38 acquisitions in the first nine months, with $400.5 of recorded purchase price and approximately $155.5 of annualized acquired revenue. Acquired businesses contributed $62.6 of revenue and $2.0 of net earnings during the period. Acquisition-related goodwill and net amortizable intangibles increased to $1,373.9 and $722.7, respectively.
- Compensation and operating costs rose with headcount, acquisitions and other expenses; amortization increased as acquired customer lists and other intangibles were amortized. The company recorded $3.4 of intangible-asset write-offs year to date.
- The consolidated effective tax rate fell to 19.2% for nine months from 35.4%, principally because of IRC Section 45 clean-coal tax credits. The company recognized $38.8 of such credits year to date, compared with $8.3 in 2011; credits generated were $33.0 and $6.2, respectively.
- Comprehensive earnings were $182.9 for nine months versus $89.3, including a $17.4 favorable foreign-currency translation change in 2012 compared with a $13.7 loss in 2011.
Outlook, commentary, risks and unusual items
- Management said it expected organic growth and acquisitions to support continued EBITDAC growth, believed capital was sufficient for short- and long-term needs, and expected operating cash flow and available credit to meet foreseeable liquidity needs. The filing gives no specific consolidated revenue, earnings or EPS guidance.
- Management cited firming insurance pricing: industry surveys showed average rate increases of 4.4% in Q1 and 4.3% in Q2 2012, and it anticipated similar Q3 trends. It warned that sluggish economic recovery could restrain insurance demand and offset pricing benefits.
- Clean-energy investments produced $11.0 of Q3 net earnings, supported by tax benefits, but involve operating, production, tax-credit eligibility, regulatory and counterparty uncertainties. Some plants lacked operating contracts or co-investors; the company also disclosed remaining plant investment needs and construction commitments.
- Potential indemnity payments tied to previously sold tax-advantaged investments were up to approximately $195.0, net of applicable tax benefit; the company also had exposure on $129.2 of previously earned tax credits. No liability was recorded for these contingencies. The filing notes that adverse future tax outcomes could create liability.
- Other risks include variable contingent and supplemental commissions, acquisition integration and earnout estimates, foreign exchange, litigation, E&O claims and future pension funding. E&O reserves were within the actuarial range, but management cautioned that future claims could change estimates. Maximum potential earnouts on 2009–2012 acquisitions were $314.4, of which $114.8 was recorded.
- On October 24, 2012, the board announced a Q4 dividend of $0.34 per share, 3% above Q4 2011. The revised payment schedule was expected to result in five dividend payments during 2012.
Most important facts for investors to verify
- How much of reported growth and earnings improvement is sustainable organic performance versus acquisitions and clean-energy tax benefits; also review the company’s non-GAAP reconciliations.
- Whether clean-coal plants secure and maintain production contracts and co-investors, and whether tax-credit assumptions and eligibility hold up; compare credits recognized with credits actually generated.
- Acquisition integration, acquired-asset amortization and impairment, and changes in earnout estimates and obligations.
- Debt maturities, interest costs, covenant headroom, revolver availability and cash needs for acquisitions, dividends, capital spending and clean-energy commitments.
- Developments in tax indemnities and previously claimed tax credits, litigation, E&O reserves and pension funding obligations.