Arthur J. Gallagher & Co. quarterly report, Q2 FY2016

Arthur J. Gallagher & Co. — Q2 2016 Form 10-Q

Reporting period: Three and six months ended June 30, 2016; balance-sheet figures are as of June 30, 2016, compared with December 31, 2015. The company provides insurance brokerage and risk management services and reports Brokerage, Risk Management, and Corporate segments. All dollar amounts below are in millions unless stated otherwise. The interim financial statements were reviewed, not audited, by Ernst & Young LLP.

Financial results

Metric	Q2 2016	Q2 2015	First half 2016	First half 2015
Total revenue	$1,427.1	$1,371.4	$2,727.5	$2,602.7
Earnings before income taxes	$137.5	$128.5	$193.2	$159.4
Net earnings attributable to controlling interests	$150.0	$139.3	$196.5	$161.2
Diluted earnings per share	$0.84	$0.81	$1.10	$0.95
Operating cash flow	Not presented by quarter	$145.0	$88.5

Q2 revenue rose about 4% and controlling-interest earnings about 8% year over year. First-half revenue rose about 5%, controlling-interest earnings about 22%, and diluted EPS about 16%.
Revenue includes substantial clean-coal activity: $311.9 in Q2 and $606.7 in the first half. This business generated revenue but also reported related costs of $325.0 and $629.4, respectively; tax credits materially affect reported earnings.
Brokerage: Q2 revenue was $939.1 (+6%); organic revenue growth was 2.2%. Adjusted EBITDAC was $284.5, with a 30.3% adjusted margin, versus $258.0 and 29.8% a year earlier. First-half organic revenue growth was 3.6%; adjusted EBITDAC increased 13% to $475.7 and adjusted margin improved to 27.0% from 26.4%.
Risk Management: Q2 revenue fell 7% to $176.5; organic revenue declined 3.1%. Net earnings were $13.9, down 19%, and adjusted EBITDAC was $30.1, down 8%. First-half organic revenue increased 0.7%, but net earnings declined 10% to $28.9.
Reported first-half company diluted EPS was $1.10; management’s adjusted non-GAAP EPS was $1.31, versus $1.20 adjusted in the prior-year period. Adjusted measures exclude specified items and should not be treated as GAAP results.

Balance sheet, debt and liquidity

Cash and cash equivalents were $411.1, down from $480.4 at year-end; restricted cash was $1,430.9. Restricted cash is fiduciary/client-related and is not available for general use.
Total assets were $11,384.3; total liabilities were $7,728.5; total stockholders’ equity was $3,655.8.
Corporate and other debt totaled $2,736.2: $2,400.0 of private-placement notes, $235.0 drawn under the revolving credit agreement, and $101.2 of premium-financing debt. Debt was $2,457.0 at December 31, 2015. The company issued $275.0 of notes in Q2 at a weighted average rate of 4.47%.
The revolving facility was extended to April 2021 and increased to $800.0. At June 30, $543.9 remained available, after borrowings and letters of credit. The company reported compliance with debt covenants.
First-half investing cash use was $255.6, including $143.6 of net acquisition payments and $103.1 of capital expenditures. Financing cash provided was $46.1; cash declined by $69.3 overall.
First-half dividends declared were $135.8, or $0.76 per common share. A $0.38-per-share Q3 dividend was announced in July. The company repurchased $101.0 of shares during the first half.

Material changes and management commentary

Brokerage growth was supported by acquisitions and organic business, but organic commission-and-fee growth slowed to 1.8% in Q2 from 3.9%. Management cited renewal-rate decreases and the loss of one large account, partly offset by retention and new business. New business production of $97.0 was offset by $98.1 of lost business and renewal-rate decreases.
Risk Management’s Q2 organic revenue decline was the first negative quarterly organic growth in 21 quarters, according to management. Lower international performance bonus fees, lost business and lower claim counts weighed on results.
The company completed 21 acquisitions in the first half, with approximately $70.4 of annualized acquired revenue. Cash acquisition payments were higher than in the prior-year period; acquisitions were funded with operating cash, borrowings and shares.
Management expects 2016 clean-energy net earnings of $110–$120, including Section 45 tax credits, and expects to use earnings to support acquisitions. This is an estimate, not a guarantee; plant deployment, production, partner recruitment and the ability to use tax credits affect outcomes.
Management said it expects adequate resources for foreseeable liquidity needs and anticipates continuing organic growth and acquisitions. No quantified full-year revenue or EPS guidance is provided in the supplied filing text.
Management expected approximately $225 of 2016 capital expenditures, including about $103 for the new headquarters. Relocation and redevelopment costs could total $145; state and local incentives could amount to $60–$80 over 15 years, subject to job requirements. The move to Rolling Meadows was planned for early 2017.

Risks, contingencies and unusual items

Brexit: Management said the potential effect was not yet quantifiable. The U.K. generated about 22% of Brokerage and 4% of Risk Management revenue in 2015; risks include weaker activity, currency translation and possible regulatory changes.
IRS micro-captive investigation: The IRS was investigating the company’s advisory activities and auditing more than 100 client micro-captives for 2012. The company said no specific allegation had been made against it and that any potential loss could not be reasonably estimated. A successful challenge could affect client claims, future earnings and the captive business.
Clean-energy exposure: Section 45 credits and clean-coal plant operations are important to Corporate results. Credits are expected to expire substantially in 2019 for 2009-era plants and 2021 for 2011-era plants. Production, contracts, tax-credit eligibility, redeployment costs and utility demand create uncertainty.
Potential maximum acquisition earnouts were $501.3, of which $212.4 was recorded at fair value. Q2 expense for changes in estimated earnout payables was $13.2, versus $5.6 company-wide in the earnings statement a year earlier.
The company was defending ordinary-course legal matters. A patent-infringement case brought by Nalco was dismissed in April 2016; Nalco sought reconsideration and could appeal. Management considered a material loss remote but noted litigation uncertainty.
Potential indemnification payments tied to previously sold tax-advantaged investments were approximately $32.0, net of tax benefit; the company also had exposure on $109.0 of previously earned tax credits. No liability was recorded for these contingencies.
The company reported $50.3 of off-balance-sheet commitments, including letters of credit, financial guarantees and funding commitments. It also disclosed an E&O reserve within the actuarial range and noted that future claims could change required reserves.
Consolidated earnings benefited from Section 45 tax credits: $81.5 was recognized in the first half. Corporate reported a $131.4 pretax loss but a $135.3 income-tax benefit for the first half, resulting in $3.9 net earnings before noncontrolling interests.

Most important facts for investors to verify

How much of reported earnings and cash generation is attributable to clean-energy operations and tax credits, and how sustainable are they as credits expire?
Whether Brokerage organic growth stabilizes after slower Q2 growth, and whether Risk Management returns to positive organic growth.
The outcome and potential financial impact of the IRS micro-captive investigation, client audits, and Brexit-related business and currency exposure.
Acquisition integration, earnout liabilities, acquisition funding needs and the effect of increased debt on leverage and interest expense.
Actual headquarters project costs and whether the conditional $60–$80 of incentives are realized.