Arthur J. Gallagher & Co. — Q3 2019 Form 10-Q
Reporting period: Three and nine months ended September 30, 2019; comparisons are with the corresponding 2018 periods. The company provides insurance brokerage and consulting, and claims administration services. Figures are in U.S. dollars; financial statement amounts are in millions unless otherwise indicated.
Financial performance
- Q3 revenue: Total revenue was $1,825.2, up 2.6%; revenue before reimbursements was $1,790.5, up 2.8%. Brokerage revenue rose 14% to $1,195.9; risk management revenue before reimbursements rose 6% to $211.6. Clean coal revenue in the corporate segment fell to $386.0 from $492.4.
- Q3 earnings: Net earnings attributable to controlling interests were $126.1 versus $127.6; diluted EPS was $0.66 versus $0.68. Adjusted diluted EPS, a non-GAAP measure, was $0.80 versus $0.77. Brokerage segment net earnings increased 24% to $151.1, while risk management segment net earnings declined 2% to $16.2. Corporate reported a $37.8 loss attributable to controlling interests.
- Nine-month results: Total revenue was $5,473.6, up 3.7%; revenue before reimbursements was $5,372.8. Net earnings attributable to controlling interests increased to $570.3 from $516.2, and diluted EPS rose to $3.01 from $2.78. Adjusted diluted EPS was $3.07 versus $2.90.
- Underlying growth and margins: Organic revenue growth was 5.8% in brokerage and 4.3% in risk management for the nine months. Q3 adjusted EBITDAC margins were 27.2% for brokerage and 18.0% for risk management; these are non-GAAP measures. Brokerage’s nine-month adjusted EBITDAC margin was 30.0%.
- Cash flow: Nine-month operating cash flow was $769.1, compared with $504.6 in 2018. Investing activities used $980.4, including $951.1 of net cash paid for acquisitions and $107.7 of capital expenditures. Financing activities provided $628.7. Cash, cash equivalents and restricted cash totaled $2,607.3 at period end, including $2,028.4 of restricted cash.
- Debt and liquidity: Corporate and other debt totaled $4,483.1 gross ($4,475.9 net of debt costs), versus $3,617.0 gross at year-end 2018. Unrestricted cash was $578.9. The revolving credit agreement had $390.0 outstanding and $793.1 available; management said operating cash flow and borrowing capacity should meet foreseeable liquidity needs. The company reported compliance with debt covenants.
- Other balance-sheet changes: Total assets were $19,173.8 versus $16,334.0 at December 31, 2018; goodwill rose to $5,314.8, primarily reflecting acquisitions. Adoption of lease accounting resulted in $384.5 of right-of-use assets and $417.9 of lease liabilities at September 30.
Changes versus the prior comparable period
- Q3 brokerage organic revenue grew 5.8%; management attributed growth to new business and renewal rate increases, partly offset by lost business. Nine-month brokerage organic revenue growth was also 5.8%.
- Q3 risk management organic fee revenue grew 5.7%; nine-month growth was 4.3%, compared with 7.2% in 2018. Management cited lower international performance bonus fees as a factor in the nine-month comparison.
- Acquisition activity increased: 38 acquisitions were completed in the first nine months, compared with 29 in 2018. Net cash paid for acquisitions increased to $951.1 from $575.5.
- Interest expense rose to $131.7 for the first nine months from $101.9, reflecting additional borrowing. Compensation and operating expenses also increased, with higher headcount, salary and incentive costs among the cited drivers.
- Clean coal revenue and associated costs both declined with lower production. The corporate segment’s nine-month pretax loss widened to $317.2 from $284.4; clean energy tax credits materially affected the company’s reported tax benefit.
Outlook, commentary, risks and unusual items
- Management expected property/casualty rates and exposure growth in 2019 to exceed 2018 and first-half 2019 levels, and described improving conditions in London Specialty, Australia and New Zealand. The Q3 industry pricing survey cited by management had not yet been published. The filing provides no company-wide earnings guidance.
- Management estimated 2019 adjusted after-tax earnings from clean energy investments of $97.5–$102.5 and anticipated positive net cash flow in 2019. It said cash flow could remain positive through at least 2025 under stated assumptions. Section 45 credits substantially expire in December 2019 for 14 older plants and December 2021 for 20 newer plants; production, tax-law and regulatory outcomes could affect estimates.
- Reported results include a one-time net gain from divestitures of $62.3 for the first nine months, equivalent to $0.17 of diluted EPS, mainly from selling a travel insurance brokerage and four smaller operations. Adjusted results exclude various items and are non-GAAP; comparisons should be considered alongside GAAP results.
- In September, the company agreed to acquire LSG Insurance Partners for approximately $174.0 cash plus a potential $72.0 earnout; the transaction closed October 15, 2019, after quarter-end. Recorded fair value of earnout obligations was $419.4; maximum potential earnouts totaled $764.7.
- Key exposures include acquisition integration and earnout estimates, substantial debt and interest-rate exposure, foreign currency movements, cybersecurity and regulatory risks, and clean energy production and tax-credit uncertainty. The IRS was investigating the company’s micro-captive advisory services and auditing more than 100 client captives; the company said potential loss could not be reasonably estimated. A related class action was dismissed after arbitration was compelled, but plaintiffs appealed. A separate clean-coal patent suit sought unspecified damages and injunctive relief; the company disputed the claims and said a material loss was remote.
- The company reported a $108.0 exposure relating to previously earned energy tax credits, with no reserve recorded. Its errors-and-omissions reserve was within the actuarial range disclosed in the filing. Disclosure controls were assessed as effective.
Important facts for investors to verify
- How much of reported growth and earnings reflects acquisitions, organic expansion, divestiture gains, and clean energy tax credits?
- Whether brokerage organic growth and risk management margins remain resilient as acquisition-related expenses and compensation costs rise.
- Debt maturities, interest expense, revolving-credit availability and the company’s capacity to fund acquisitions, dividends and other commitments.
- Clean coal production, remaining tax-credit eligibility, relocation costs and the assumptions behind management’s earnings and cash-flow estimates.
- Developments in the IRS micro-captive investigation, related appeal, patent litigation and previously earned tax-credit exposure.
- Integration results and eventual earnout payments for 2019 acquisitions, including the post-quarter LSG transaction.