Arthur J. Gallagher & Co. quarterly report, Q2 FY2017

Arthur J. Gallagher & Co. — Q2 2017 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2017; unaudited interim statements reviewed by Ernst & Young. Gallagher provides insurance brokerage and risk-management services, alongside a corporate segment that includes clean-energy investments. Figures below are in millions of dollars except per-share amounts.

Key financial results

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Total revenue	1,563.4	1,427.1	2,976.1	2,727.5
Net earnings attributable to controlling interests	171.9	150.0	227.6	196.5
Diluted EPS	0.95	0.84	1.26	1.10
Operating cash flow	—	—	205.4	129.4

Q2 revenue increased about 9.6% and controlling-interest earnings about 14.6% year over year. For the first half, revenue rose about 9.1%, earnings about 15.8%, and diluted EPS about 14.5%.
Q2 reported brokerage revenue was $998.1 million, up 6%; its organic base commission and fee growth was 3.6%. Adjusted brokerage EBITDAC was $309.2 million, up 11%, with a 31.0% margin versus 30.5%.
Q2 risk-management revenue was $188.7 million, up 7%; organic fee growth was 5.6%. Adjusted EBITDAC was $32.1 million, up 8%, with a 17.0% margin versus 16.9%.
For the first half, brokerage revenue was $1,876.6 million, up 6%, and adjusted EBITDAC was $524.9 million, up 12%. Risk-management revenue was $371.3 million, up 4%, while reported net earnings declined slightly to $28.7 million from $28.9 million.
Corporate clean-energy revenue increased, but its costs exceeded revenue. Corporate pretax loss widened to $176.7 million for the first half from $131.4 million; tax credits substantially offset that loss in reported net results.

Cash, debt and liquidity

At June 30, cash and cash equivalents were $587.8 million; restricted cash was $1,481.1 million. Premiums and fees receivable were $2,374.2 million and premiums payable were $3,546.4 million. Management cautions that fiduciary balances and restricted cash should not be treated as available liquidity.
Total assets were $12.57 billion and total liabilities $8.66 billion. Net corporate and other debt was $3.11 billion, compared with $2.85 billion at year-end 2016. Debt included $2.70 billion under note purchase agreements, $318 million under the revolving credit agreement and $100 million of premium-financing debt.
The company had $460.9 million available under its $800 million revolving credit facility, after borrowings and letters of credit, and reported compliance with debt covenants.
First-half operating cash flow of $205.4 million exceeded the prior-year $129.4 million. Cash used in investing was $294.5 million, including $225.2 million for acquisitions and $65.6 million of fixed-asset additions. Management says operating cash flow comparisons were affected by timing of fiduciary balances, accrued liabilities, and a $43.2 million foreign-currency remeasurement gain.
First-half financing cash flow was $119.0 million. Dividends paid were $141.6 million; declared dividends were $0.78 per share for the half. The board announced a Q3 dividend of $0.39 per share.

Material changes and business developments

Acquisition activity remained significant: 23 acquisitions were completed in the first half, with $305.4 million total recorded purchase price and approximately $105 million of annualized acquired revenue. Cash acquisition payments were $225.2 million. Acquisition-related goodwill and intangible assets increased.
Brokerage organic base commission and fee growth improved to 3.6% in Q2 from 1.8% a year earlier; first-half growth was 3.3% versus 2.7%. Management attributed revenue gains to acquisitions and organic growth. Q2 new business production was partly offset by lost business and renewal rate decreases.
Management described a moderately declining property/casualty rate environment as a headwind, citing a 2.5% average rate decline in the first-quarter industry survey. It cited exposure growth, employee-benefit activity, new business, retention and value-added services as offsets. The Q2 industry survey was not yet available at filing.
On June 27, Gallagher funded $250 million of planned private-placement notes; additional funding was expected in early August to help refinance debt maturing in August 2017. The announced offering totaled $648 million, with fixed- and floating-rate tranches.
Capital expenditures were expected to total approximately $135 million in 2017, including about $30 million for the new headquarters. Headquarters-related tax incentives could total $60–$80 million over 15 years, subject to program terms.

Outlook, risks and unusual items

Management expected clean-energy investments to generate $119–$128 million in 2017 after-tax earnings and anticipated positive net cash flow from those investments in 2017, while noting that production, costs, regulation and tax-law changes make period-specific cash flow uncertain.
Management stated it believed available capital was sufficient for short- and long-term cash needs. It expected to continue using operating cash flow and debt to fund acquisitions. No specific consolidated earnings or revenue guidance was provided.
The IRS was investigating Gallagher’s micro-captive advisory business and auditing more than 100 client micro-captives for 2012. The company said it could not reasonably estimate potential losses; adverse findings could affect client claims, future earnings and the captive business.
An IRS notice disallowed tax credits claimed by co-investors in one refined-coal partnership; the partnership planned to contest the position. The company said the notice did not challenge the validity of the credits themselves or Gallagher’s ability to use credits. Gallagher also disclosed $108.2 million of exposure to previously earned tax credits, with no reserve recorded.
Other disclosed matters include an appealed patent lawsuit, for which management considered a material loss remote; ordinary-course litigation and regulatory inquiries; and errors-and-omissions reserves subject to actuarial uncertainty.
Clean-energy tax credits are a material earnings and tax-rate factor. Federal tax-law changes, EPA rules, plant output, natural-gas prices and operating conditions could change expected returns. The relevant credit provisions substantially expire in 2019 for 2009-era plants and 2021 for 2011-era plants.
Gallagher expects the new revenue-recognition standard to affect individual financial-statement line items materially, though management did not expect as material an annual impact on operating results. Adoption was planned for Q1 2018, with full retrospective adoption anticipated. The new lease standard, effective in 2019, was expected to materially increase recognized assets and liabilities.
Other unusual items included clean-energy tax credits and $10.1 million of first-half tax benefit from vested or settled stock awards under a newly adopted accounting rule. Adjusted measures exclude specified items and are non-GAAP; they should be considered alongside GAAP results.

Investor verification priorities

Reconcile reported growth with organic growth, acquisition contributions and non-GAAP adjustments; assess whether margins and organic growth remain durable.
Track acquisition integration, acquired-business performance, earnout obligations (including $267.9 million recorded fair value and $564.1 million maximum potential obligations), and debt-funded acquisition spending.
Evaluate cash generation excluding fiduciary-balance timing and foreign-exchange effects, and distinguish unrestricted cash from restricted cash.
Monitor debt refinancing, interest expense, leverage and the planned use of the remaining private-placement proceeds.
Assess the IRS investigations, clean-energy tax-credit exposure and policy/regulatory risks, including their possible impact on earnings, cash flow and client retention.
Review the detailed GAAP-to-non-GAAP reconciliations and the timing and balance-sheet effects of revenue-recognition and lease-accounting adoption.