Arthur J. Gallagher & Co. — Q1 2016 Form 10-Q
Business context and reporting period. The filing covers the three months ended March 31, 2016. Gallagher provides insurance brokerage and risk-management services, alongside corporate clean-energy investments. Its reported results include substantial refined-coal activity; therefore, consolidated revenue and margins do not represent brokerage and risk-management operations alone.
Financial performance and position
- Revenue: $1.300 billion, up 5.6% from $1.231 billion. Brokerage revenue was $825.5 million (+10%); risk-management revenue was $179.3 million (+1%); corporate revenue was $295.6 million, down from $303.0 million.
- Earnings: Earnings before income taxes were $55.7 million versus $30.9 million. Net earnings attributable to controlling interests were $46.5 million ($0.26 diluted EPS), compared with $21.9 million ($0.13). The company reported adjusted diluted EPS of $0.34 versus $0.27, a non-GAAP measure.
- Core growth and margins: Brokerage base organic commission and fee revenue grew 3.5%; total brokerage organic growth, including supplemental and contingent commissions, was 4.8%. Risk-management organic fees grew 4.7%. Adjusted EBITDAC margins were 23.2% in brokerage and 17.6% in risk management. These are non-GAAP measures.
- Cash flow: Operating cash flow was $109.4 million, down from $113.3 million. Investing used $128.4 million, including $61.9 million of fixed-asset additions and $61.7 million of acquisition payments. Financing used $34.1 million. Cash and cash equivalents declined $55.0 million to $425.4 million; restricted cash of $1.304 billion is largely fiduciary and not available for general use.
- Debt and liquidity: Corporate and other debt totaled $2.526 billion, including $2.125 billion of fixed-rate notes, $305 million drawn under the credit agreement and $96.2 million of premium-financing debt. At quarter-end, $273.5 million remained available under the then-existing credit agreement after borrowings and letters of credit. The company reported compliance with debt covenants. Current assets were $3.940 billion and current liabilities $4.022 billion; the filing cautions that fiduciary balances and restricted cash affect interpretation of liquidity.
- Margins and dividends: Consolidated pretax margin was approximately 4.3%, versus 2.5% a year earlier, influenced by the mix of businesses and clean-coal accounting. The declared quarterly dividend was $0.38 per share, versus $0.37 in Q1 2015.
Material changes versus the prior comparable period
- Brokerage growth and profitability improved: reported segment earnings attributable to controlling interests rose to $61.4 million from $36.7 million. Management cited acquisitions, organic growth, higher supplemental and contingent commissions, and lower acquisition earnout adjustment expense.
- Risk-management earnings attributable to controlling interests were nearly unchanged at $15.0 million versus $14.9 million. Organic fee growth slowed to 4.7% from 12.2%.
- Corporate segment pretax loss widened to $68.3 million from $53.7 million, while net loss attributable to controlling interests was approximately unchanged at $29.9 million. Lower clean-coal revenue and higher compensation, including a litigation-related expense, affected results; clean-energy tax benefits offset much of the pretax loss.
- Operating cash flow decreased modestly, with management attributing the change primarily to timing of client fiduciary receipts and payments. Investing outflows increased substantially, particularly capital expenditures and acquisition spending.
Outlook, commentary, risks and unusual items
- Management said it expects continued earnings growth through organic expansion and acquisitions, and expects clean-energy investments to generate $110–$124 million of net earnings in 2016. It cautioned that actual production, tax-credit use and cash flow depend on operating and market conditions.
- Management expected 2016 capital expenditures of approximately $225 million, including about $103 million for the new headquarters. The relocation was anticipated in early 2017; city and state incentives were estimated at $60–$80 million over 15 years and depend on employment requirements.
- After quarter-end, on April 8, 2016, Gallagher amended and restated its revolving credit facility, extending maturity to April 2021 and increasing commitments from $600 million to $800 million. Management also anticipated a $275 million private placement in late Q2 2016 at a weighted-average interest rate of 4.47%.
- Clean-energy operations remain exposed to refined-coal production, coal prices, plant deployment, utility contracts and potential disallowance of IRC Section 45 tax credits. Credits recognized were $17.7 million in Q1 2016, versus $8.5 million; credits produced were $40.7 million versus $38.3 million.
- The IRS was investigating the company’s micro-captive advisory services and auditing more than 100 client captive insurers for 2012. Gallagher said the potential loss could not be reasonably estimated; an adverse outcome could affect clients, future earnings and the broader captive business.
- Gallagher disclosed other legal, regulatory and tax contingencies, including $32.0 million of maximum potential indemnification payments and exposure on $109.0 million of previously earned tax credits from former tax-advantaged investments; no liability was recorded for those indemnifications. The Nalco patent claims were dismissed on April 21, 2016, though an appeal remained possible.
- Foreign-currency movements reduced controlling-interest accumulated other comprehensive income by $12.7 million in the quarter. Management also identified acquisition integration, insurance-market pricing, competition, personnel, international operations, cybersecurity, regulation and debt as risks.
Important facts for investors to verify
- Whether organic brokerage and risk-management growth and adjusted margins continue, and how much growth depends on acquisitions and variable supplemental or contingent commissions.
- Clean-energy production, tax-credit eligibility and utilization, plant deployment, and whether the stated 2016 earnings outlook translates into cash flow.
- Developments in the IRS micro-captive investigation and audits, and any effect on client retention, earnings or potential liabilities.
- Acquisition integration, earnout obligations ($213.4 million recorded fair value; $530.2 million maximum potential obligations), capital spending and headquarters incentives.
- Debt maturities, the subsequent credit-facility amendment and planned private placement, covenant headroom, and liquidity excluding restricted fiduciary cash.
- Cash-flow variability from client fiduciary balances and exposure to foreign-exchange movements and other disclosed contingencies.
The interim financial statements were reviewed, not audited, by Ernst & Young LLP; the review report stated that the firm was not aware of material modifications needed for GAAP conformity.