Arthur J. Gallagher & Co. — Q3 2010 Form 10-Q
Reporting period: Three and nine months ended September 30, 2010. Amounts are U.S. dollars in millions, except per-share data. Interim statements are unaudited and were reviewed, not audited, by Ernst & Young.
Business context
Gallagher provides insurance brokerage and property/casualty claims and risk-management services. It operates through Brokerage, Risk Management and Corporate segments. Approximately 87% of revenue was domestic; Brokerage, Risk Management and Corporate represented 71%, 24% and 5% of nine-month revenue, respectively. Gallagher acts as an intermediary and does not assume insurance underwriting risk.
Financial performance
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Total revenue | $463.2 | $439.5 | $1,405.1 | $1,294.2 |
| Continuing-operations pretax earnings | $70.4 | $63.1 | $177.2 | $180.7 |
| Continuing-operations earnings | $46.2 | $41.6 | $117.3 | $113.7 |
| Net earnings | $46.2 | $41.6 | $119.4 | $111.8 |
| Diluted EPS, continuing operations | $0.44 | $0.41 | $1.12 | $1.14 |
| Diluted net EPS | $0.44 | $0.41 | $1.14 | $1.12 |
| Operating cash flow | — | — | $212.4 | $195.6 |
- Q3 revenue rose about 5% and net earnings about 11% year over year. Nine-month revenue rose about 9%; net earnings rose about 7%, while continuing-operations pretax earnings declined about 2%.
- Q3 commissions were $251.9 (up 6%); Brokerage fees were $74.8 (down 1%); supplemental and contingent commissions were $19.7 (up 91%). Nine-month supplemental and contingent commissions totaled $82.4 versus $51.6, including timing effects from carriers’ reporting practices.
- Organic Brokerage commissions, fees and supplemental commissions declined 0.1% in Q3 and 2.3% for nine months. Management attributed pressure primarily to lower insurance rates and exposure units; nine-month new business of $102.9 was more than offset by $123.0 of renewal rate decreases and lost business.
- Risk Management revenue fell 2% in both periods; Q3 pretax earnings fell 24% and nine-month pretax earnings fell 6%. Lower claim counts and lost business outweighed new business. Brokerage Q3 pretax earnings rose 20%, but nine-month pretax earnings rose only 3%.
- Q3 Brokerage pretax margin was 21% versus 19%; Risk Management was 10% versus 13%. Nine-month Brokerage EBITDAC margin was 23% versus 24%; Risk Management was 15% in both periods. EBITDAC is a company-defined non-GAAP measure.
- Balance-sheet cash and cash equivalents were $296.3 at September 30, up from $205.9 at year-end; restricted cash was $565.4. Total assets were $3,460.7 and stockholders’ equity $1,011.4. Restricted cash represents fiduciary/client funds and is not available for general liquidity.
- Debt was $550.0, all long-term fixed-rate notes; no revolving-credit borrowings were outstanding. A new $500.0 unsecured facility runs to July 2014; $484.0 was available at quarter-end. The company reported covenant compliance.
- Cash flow from investing was negative $49.2 and financing was negative $72.8 for nine months. Acquisitions used $44.2; capital spending was $18.1; dividends paid were $99.7. Dividends declared were $0.96 per share for the period.
Material changes and unusual items
- Gallagher completed 12 acquisitions in the first nine months; recorded purchase consideration totaled $80.0, including $32.4 in shares and $26.6 cash. Acquisition activity contributed $42.2 of nine-month Brokerage commission and fee revenue. Goodwill increased to $824.4 from $742.3 at year-end.
- Acquisition earnouts remain significant: $76.7 was recorded at estimated fair value against maximum 2009–2010 earnouts of $176.3; additional maximum unrecorded earnouts for 2006–2008 acquisitions were $193.9. Q3 and nine-month earnings included $5.6 and $7.5 of income from downward fair-value revisions, respectively.
- Clean-coal activities contributed $66.1 of nine-month revenue and $64.0 of related costs. After selling interests in six facilities, Gallagher stopped consolidating those operations effective March 1 and accounts for them under the equity method; two facilities remain consolidated. The results include a $4.8 gain on sales of interests and a $1.5 write-off of an additional C-Quest investment. Clean-coal revenue is a material, unusual contributor to the year-over-year comparison.
- Q3 included a $2.7 gain on remeasurement of Gallagher’s previously held 40% interest in SBA when it acquired the remaining 60%. Nine-month discontinued-operations earnings of $2.1 mainly reflected reversal of prior lease-abandonment charges.
- On October 1, after quarter-end, Gallagher agreed to acquire GAB Robins’ third-party administrator and managed-care operations for approximately $20.0 plus assumption of certain claims run-off liabilities. Management expects annual Risk Management revenue of $45–$50 after transition.
Outlook, risks and contingencies
- No specific consolidated earnings or revenue guidance was provided. Management said it expected adequate liquidity and anticipated continued pretax earnings growth over the foreseeable future, supported by organic growth and acquisitions; it cautioned that acquisition availability and financing are uncertain.
- Management expected approximately $9–$11 of supplemental commission revenue in Q4 2010 and each quarter of 2011, assuming market conditions continue. It also expected about $30.0 of 2010 capital expenditures.
- The commercial property/casualty market remained soft: industry-reported Q3 commercial premium rates declined an average 5.2%. Management cited continued competitive pricing, a weak economy, lower client exposures, and potential reductions in coverage as pressures on brokerage commissions and claims volumes.
- Clean-coal earnings and investment recovery depend on operating performance, permits, regulatory conditions, utility partners and qualification for IRC Section 45 tax credits. Gallagher said the facilities could generate up to $10.0 of quarterly net earnings after permits and other conditions are met, but emphasized that timing, output and tax-credit eligibility are uncertain; Q4 2010 production was expected to be limited.
- Potential future payments under indemnities for previously sold tax-advantaged investments totaled approximately $210.0, net of tax benefits; Gallagher also had exposure on $155.3 of previously earned tax credits. Future adverse tax decisions could trigger costs. Net unrecognized tax benefits that could affect the effective tax rate were $42.4.
- Gallagher retained the first $5.0 of each errors-and-omissions claim; its recorded reserve was within the actuarially estimated range, which could change as claims develop. The filing also cites ongoing employment and other litigation, insurer counterparty/credit risk, foreign-exchange exposure, pension funding needs and potential credit-market disruption.
Most important facts for investors to verify
- Whether organic brokerage growth stabilizes as soft-market pricing and lower insured exposures continue to pressure renewals.
- How much reported commission growth reflects recurring business versus acquisitions and supplemental/contingent commission timing.
- Whether Risk Management can reverse declining fees and margins, including after integration of GAB Robins.
- Clean-coal facility operating permits, production, tax-credit eligibility and the potential financial exposure if assumptions fail.
- Acquisition earnout estimates and cash requirements, including the substantial recorded and unrecorded maximum obligations.
- Liquidity and capital allocation: availability of revolving credit, dividend sustainability, acquisition spending and pension contributions.
- Potential outcomes of tax-credit indemnities, tax examinations, E&O claims and other litigation.