Arthur J. Gallagher & Co. — Q2 2011 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2011. The company provides insurance brokerage and risk-management services. Figures are in millions of dollars unless stated otherwise. Interim financial statements were reviewed by Ernst & Young, not audited.
Financial results and liquidity
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Total revenue | $546.1 | $459.5 | $993.5 | $941.9 |
| Continuing-operations pretax earnings | $65.9 | $63.9 | $89.4 | $106.8 |
| Continuing-operations earnings | $41.7 | $41.9 | $56.9 | $71.1 |
| Net earnings | $41.7 | $44.0 | $56.9 | $73.2 |
| Diluted net earnings per share | $0.37 | $0.42 | $0.51 | $0.71 |
| Operating cash flow | — | $97.4 | $89.6 |
- Q2 revenue rose about 19%; first-half revenue rose about 5%. First-half net earnings declined about 22%. Consolidated pretax margin was approximately 12.1% in Q2 versus 13.9%, and 9.0% for the first half versus 11.3%.
- Commissions and fees grew, while supplemental commissions fell to $27.5 from $38.5 in the first half. The prior-year comparison included a $14.7 timing-related supplemental-commission item; management’s adjusted presentation removes it.
- At June 30, cash and cash equivalents were $263.2; restricted cash was $732.9 and is not available for general liquidity. Total debt was $710.0 ($675.0 fixed-rate notes and $35.0 revolver borrowings), up from $550.0 at December 31, 2010. Revolver availability was $448.5, after outstanding borrowings and letters of credit. The company reported compliance with debt covenants.
- Operating cash flow increased year over year, primarily from timing differences in fiduciary receipts and disbursements and accrued-liability payments, partly offset by higher tax payments. Investing used $220.0, including $213.0 of net acquisition payments. Financing provided $136.0. Cash ended the period at $263.2.
- Total assets were $4,581.9 and stockholders’ equity was $1,202.8 at June 30. Declared dividends were $0.66 per share for the first half, versus $0.64 a year earlier.
Material changes and operating performance
- Brokerage Q2 revenue was $403.8, up 16%; organic commission and fee growth was 2.1%. Segment pretax earnings increased to $74.5 from $62.8. Management reported adjusted EBITDAC growth of 13%.
- Risk-management Q2 revenue was $133.5, up 20%; organic fee growth was 5.9%. Segment pretax earnings declined to $9.8 from $13.4, while management-reported adjusted EBITDAC increased 19%.
- For brokerage and risk management combined, management reported Q2 organic growth of 3.7% in commissions, fees and supplemental commissions, and adjusted EBITDAC growth of 14%. These are non-GAAP measures defined and reconciled in the filing.
- Acquisitions materially expanded the business. The company completed 13 acquisitions in the first half, including Heath Lambert, acquired for approximately $163.5 net cash and expected to contribute about $158 million in annualized revenue. First-half acquired businesses represented approximately $211.3 million of annualized revenue. Acquisition-related goodwill and intangible assets increased substantially.
- Clean-coal activities made the year-over-year comparison unusual: corporate-segment revenue was $8.2 in the first half versus $68.6, and the segment’s net loss widened to $17.7 from $7.1. Lower prior-year clean-coal activity and gains contributed to the comparison; Q2 2011 also included $11.7 of clean-coal costs against $9.2 of related revenue.
Outlook, commentary, risks and unusual items
- Management said weak economic conditions and competitive insurance pricing continued to pressure brokerage rates, although industry surveys showed rates broadly stable with negligible declines in Q2. New production and acquisitions supported growth, but renewal rate decreases and lost business remained offsets.
- Management expects its historically favorable pretax-earnings trend to continue, supported by organic growth and acquisitions, and stated it believes capital is sufficient for short- and long-term needs. No specific earnings or revenue guidance was provided. Planned 2011 capital expenditures were approximately $35–$40 million.
- Heath Lambert integration could take up to two years. Its Q2 contribution included $20.6 revenue and $3.0 of integration costs; reported EBITDAC was $0.4 and adjusted EBITDAC was $3.4.
- Other notable items include a $5.8 compensation charge for an earnout obligation related to a prior acquisition, acquisition integration costs, and gains on sales of books of business. Earnout fair values involve estimates; $100.9 of earnouts was recorded, with $127.1 of additional unrecorded obligations relating to 2007–2008 acquisitions.
- Clean-coal earnings depend on permits, production, tax-credit eligibility, regulation, utility partners and other factors. Management described uncertainty around permits and production schedules and gave no assurance that facilities will qualify for Section 45 credits. Tax indemnities from previously sold energy investments had a maximum potential exposure of approximately $195.0, and $148.8 of previously earned tax credits remained exposed; no liability was recorded for those indemnifications.
- The company retained the first $5.0 of each errors-and-omissions claim, with aggregate coverage up to $175.0 above retained amounts. Its recorded reserve was within the actuarially estimated range. Litigation outcomes and reserve estimates remain uncertain. Other stated risks include economic and insurance-market conditions, contingent commissions, international and currency exposure, acquisitions, debt covenants, regulation and employee retention.
- The board announced a Q3 2011 dividend of $0.33 per share, a 3% increase from Q3 2010. If maintained through 2011, management estimated annual dividend cash use of about $148 million.
Most important facts for investors to verify
- Whether organic brokerage and risk-management growth persists as insurance pricing, renewal rates and customer demand evolve.
- Heath Lambert’s integration progress, realized revenue and profitability relative to acquisition expectations and integration costs.
- Acquisition-related leverage, earnout payments and the assumptions supporting goodwill and intangible-asset valuations.
- Clean-coal permits, operating performance and Section 45 tax-credit qualification, together with the potential tax-indemnity exposure.
- Cash-flow quality after considering fiduciary and restricted funds, and the company’s capacity to fund acquisitions, debt service and dividends.