Arthur J. Gallagher & Co. — FY 2018 Form 10-K
Business context and reporting period. The filing covers the fiscal year ended December 31, 2018; it is an annual report, not a standalone fourth-quarter filing. Gallagher provides insurance brokerage and consulting, plus third-party claims administration and risk-management services. It reports brokerage, risk management and corporate segments. Brokerage and risk management generally act as intermediaries and do not assume material net underwriting risk. Corporate results include debt, corporate costs and clean-energy investments.
Financial performance and liquidity
| Metric | FY 2018 | Prior comparable period |
|---|---|---|
| Total revenues | $6,934.0 million | $6,249.0 million in 2017, as restated |
| Revenue before reimbursements | $6,792.4 million | $6,113.0 million in 2017 |
| Net earnings attributable to controlling interests | $633.5 million | $481.3 million in 2017 |
| Diluted EPS | $3.40 | $2.64 in 2017 |
| Cash provided by operating activities | $765.1 million | $854.2 million in 2017 |
| Capital expenditures | $124.4 million | $129.2 million in 2017 |
| Cash and cash equivalents | $607.2 million | $681.2 million at year-end 2017 |
| Total corporate and other debt, gross | $3,617.0 million | $3,139.1 million at year-end 2017 |
Revenue and controlling-interest earnings increased approximately 11% and 32%, respectively. Reported diluted EPS rose 29%. Operating cash flow declined, with the company citing a $30 million discretionary pension contribution, higher severance and earnout payments, prepaid marketing costs, and timing of receivables, taxes and fiduciary balances. Operating cash flow less capital expenditures was approximately $640.7 million.
Brokerage revenue was $4,246.9 million, up 11%; organic revenue growth was 5.6%. Brokerage net earnings were $573.2 million, with a 13.5% reported net earnings margin; adjusted EBITDAC margin was 27.7%. Risk management revenue before reimbursements was $798.3 million, up 8%, with 7.1% organic growth. Its net earnings were $70.4 million and reported margin before reimbursements was 8.8%; adjusted EBITDAC margin was 17.4%. These segment measures are not directly comparable with consolidated margins.
Consolidated results include substantial clean-coal activity: corporate-segment revenue was $1,747.2 million, while the segment recorded a $380.5 million pretax loss and $32.3 million net earnings. The consolidated income-tax benefit was $196.5 million, largely reflecting clean-energy tax credits. Gallagher recognized $252.9 million of IRC Section 45 credits in 2018. Accordingly, reported earnings and EPS should be assessed alongside the tax-credit contribution and management’s adjusted, non-GAAP measures. Adjusted diluted EPS was $3.45, up 15%.
At year-end, total assets were $16.334 billion and stockholders’ equity was $4.570 billion. Restricted cash of $1.630 billion is largely held in a fiduciary capacity and is not available for general corporate use. The revolving credit agreement had $265 million drawn and $518 million available; the company reported compliance with debt covenants. Declared dividends were $1.64 per share for 2018.
Fourth-quarter reference: Q4 2018 revenue was $1,657.4 million, earnings before income taxes were $43.2 million, net earnings attributable to controlling interests were $117.3 million and diluted EPS was $0.63. The gap between pretax earnings and net earnings reflects the filing’s tax-credit and tax-accounting effects.
Material changes versus 2017
- Brokerage organic growth accelerated to 5.6% from 4.3%; risk management organic growth rose to 7.1% from 3.7%.
- Reported brokerage and risk-management earnings improved, while corporate net earnings attributable to controlling interests fell to $0.6 million from $18.5 million, principally amid clean-energy and tax-related effects.
- Operating cash flow decreased by $89.1 million. Cash acquisitions rose to $784.8 million from $376.1 million; Gallagher completed 48 acquisitions and reported approximately $339.8 million of acquired annualized revenue.
- Debt increased, including a $500 million private-placement note issuance. Total stockholders’ equity increased to $4.570 billion from $4.300 billion.
- Gallagher adopted Topic 606 retrospectively, restating 2017 and 2016. Adoption increased retained earnings by $125.3 million as of January 1, 2016 and shifted the timing of revenue and expense recognition, including quarterly seasonality.
Outlook, risks and unusual items
- Management expected modest property/casualty rate and exposure increases in 2019, broadly similar to 2018, and international revenue mix comparable to 2018. It anticipated brokerage tax rates of about 24%–26% and risk-management rates of about 25%–27% on adjusted results.
- Estimated 2019 after-tax earnings from clean-energy investments, including Section 45 credits, were $105 million–$115 million. Management expected positive net cash flow from these investments in 2019, while emphasizing that production, plant relocation, utility demand, regulation and tax-credit eligibility create uncertainty. Section 45 credits expire for 14 plants in 2019 and 20 plants in 2021.
- Management expected 2019 capital expenditures of approximately $128 million. A $0.43-per-share quarterly dividend was announced for Q1 2019; future dividends are not assured. The company expected to fund acquisitions with operating cash, debt, its credit facility and/or stock.
- In January 2019, Gallagher agreed to acquire U.K. broker Stackhouse Poland for approximately $350 million in cash, subject to regulatory approval; closing was expected in Q1 2019. It also sold a travel-insurance brokerage operation and expected a one-time Q1 2019 gain of $0.20–$0.23 per diluted share.
- Key risks include acquisition integration and valuation, competition and insurance pricing cycles, volatile contingent and supplemental revenues, economic and foreign-exchange exposure including Brexit, cybersecurity and data privacy, regulatory compliance, and substantial debt and refinancing needs.
- The IRS was investigating Gallagher’s micro-captive advisory services and auditing more than 100 client captives. A related class action filed in December 2018 alleges improper marketing and management; damages were unspecified and the company said it could not estimate a potential loss. Separate patent-infringement lawsuits involving licensed Chem-Mod technology seek unspecified damages and injunctive relief; neither Gallagher nor Chem-Mod was named as a defendant in those actions. Outcomes were uncertain.
- The filing identifies clean-energy tax-credit eligibility, coal demand and plant operations as material uncertainties. It also reports $108 million of exposure related to previously earned Section 29 credits; no reserve was recorded for this contingent exposure.
- Lease accounting standard Topic 842 was due to be adopted January 1, 2019. Gallagher expected right-of-use assets and lease liabilities to increase, with no material impact on earnings, cash flows or equity.
Important facts for investors to verify
- How much of earnings and cash generation is attributable to clean-energy tax credits, and the timing and usability of remaining credits.
- Whether organic growth and margin trends persist after separating acquisition contributions, one-time items and management’s non-GAAP adjustments.
- Acquisition integration and returns, particularly following 2018’s increased cash spending and the planned Stackhouse Poland transaction.
- Progress and possible financial exposure from the IRS micro-captive investigation and related litigation, as well as the Chem-Mod patent cases and Section 29 credit exposure.
- Debt maturities, refinancing capacity, covenant headroom and cash available after excluding restricted fiduciary funds.
- Effects of Topic 606 restatements and the 2019 lease-accounting adoption when comparing periods.