Arthur J. Gallagher & Co. — 2014 Form 10-K
Reporting period: Fiscal year ended December 31, 2014; quarterly figures below include the fourth quarter. Amounts are in U.S. dollars unless stated otherwise.
Business context and reporting period
Gallagher provides insurance brokerage and consulting, and third-party claims administration. It reports Brokerage, Risk Management and Corporate segments. Brokerage and Risk Management act as intermediaries or service providers and do not assume insurance underwriting risk. Corporate includes debt, clean-energy investments and related activities. International operations represented 32% of combined Brokerage and Risk Management revenue, up from 23% in 2013, primarily reflecting acquisitions.
Financial results and liquidity
| Metric | 2014 | 2013 |
|---|---|---|
| Total revenue | $4,626.5 million | $3,179.6 million |
| Expenses | $4,359.1 million | $2,905.1 million |
| Pretax earnings | $267.4 million | $274.5 million |
| Income tax provision (benefit) | $(36.0) million | $5.9 million |
| Net earnings | $303.4 million | $268.6 million |
| Diluted EPS | $1.97 | $2.06 |
| Cash from operating activities | $402.3 million | $349.9 million |
Revenue grew 45.5%, but reported pretax earnings fell about 3%; net earnings rose 13% largely alongside a substantial tax benefit. Clean-coal activities contributed $1,029.5 million of revenue and $1,058.9 million of associated costs in 2014, materially affecting reported revenue and expense growth. The company recognized $145.5 million of tax credits, principally related to IRC Section 45 clean-energy investments.
Fourth quarter: Revenue was $1,245.4 million, pretax earnings $26.3 million, net earnings $51.5 million and diluted EPS $0.31, compared with $890.2 million, $49.3 million, $60.0 million and $0.45, respectively, in Q4 2013. The quarter’s net earnings exceeded pretax earnings because of the full-year tax benefit; the filing does not provide a standalone Q4 tax provision in the excerpt.
Segments: Brokerage revenue was $2,914.3 million (+36%); net earnings were $263.8 million (+29%). Adjusted Brokerage EBITDAC was $733.4 million (+44%), with a 25.2% margin versus 23.8%. Risk Management revenue was $664.3 million (+9%); net earnings were $41.2 million, down from $46.2 million. Adjusted Risk Management EBITDAC was $109.5 million (+16%), with a 16.5% margin versus 15.6%. Management reported organic base commission and fee growth of 3.9% in Brokerage and organic fee growth of 9.5% in Risk Management. Adjusted figures are non-GAAP measures.
Balance sheet and funding: At year-end, cash and cash equivalents were $314.4 million, restricted cash $1,367.6 million, total assets $10.010 billion and stockholders’ equity $3.229 billion. Restricted cash is held in fiduciary capacity or otherwise legally restricted and should not be treated as freely available liquidity. Total debt was approximately $2.393 billion, including $2.265 billion of corporate-related borrowings and $127.9 million of premium-financing borrowings. The company had $437.4 million available under its $600 million revolving credit agreement and reported compliance with debt covenants. Net capital expenditures were $81.5 million; cash paid for acquisitions was $1.918 billion.
2014 acquisitions included Oval, Crombie/OAMPS and Noraxis. The company issued 21.85 million shares in a secondary offering, raising $911.4 million net, principally to fund acquisitions. Year-end shares outstanding rose to 164.6 million from 133.6 million. Dividends declared were $1.44 per share for 2014.
Material changes versus the prior period
- Growth was acquisition-led: 60 acquisitions in 2014 had annualized revenue of $761.2 million; the three major acquisitions contributed $328.5 million of reported 2014 revenue.
- Clean-energy consolidation substantially increased Corporate segment revenue and costs. Corporate reported a $1.6 million net loss versus $17.6 million net income in 2013, despite $104.6 million of clean-energy investment earnings cited by management.
- Cash from operations increased to $402.3 million from $349.9 million, while cash used for acquisitions rose sharply to $1.918 billion from $727.7 million.
- Debt and goodwill increased materially: total assets rose from $6.861 billion to $10.010 billion, and goodwill from $2.145 billion to $3.450 billion, largely reflecting acquisitions.
- Foreign-currency translation reduced 2014 comprehensive earnings by $238.4 million; accumulated other comprehensive loss reached $260.6 million.
- Brokerage organic growth moderated from 5.6% to 3.9%. Commercial property/casualty rates were generally soft late in 2014; the fourth-quarter industry survey cited an average rate decline of 0.7%.
Outlook, commentary, risks and unusual items
- Management expected 2015 clean-energy investment earnings of $90–$110 million after tax and anticipated positive net cash flow from these investments, while emphasizing substantial operating, tax, regulatory and market uncertainty.
- Management expected 2015 capital improvements of approximately $120 million, including headquarters, office and technology spending. It planned to continue acquisitions using operating cash, debt and potentially equity.
- Integration costs related to acquisitions were forecast at $8–$11 million per quarter in 2015 and approximately $2 million per quarter in 2016. The next quarterly dividend announced was $0.37 per share.
- Risk Management recorded a $12.9 million charge related primarily to the New South Wales workers’ compensation contract moving to run-off; management estimated the contract would break even during 2015 run-off.
- A pension de-risking offer generated $43.3 million of lump-sum payments from plan assets, reduced the benefit obligation by about $60 million and improved underfunding by nearly $17 million. The settlement produced a non-cash pretax charge of about $12 million.
- The IRS was investigating Gallagher’s micro-captive advisory services and auditing more than 100 client captives for 2012. The company said no specific allegation had been made against it and that potential loss could not be reasonably estimated.
- IRC Section 45 credits depend on qualifying operations and tax rules; eight plants lacked long-term production contracts at year-end. Plant relocation, utility demand for coal, regulatory changes and potential credit disallowance could impair earnings and cash flow.
- Other risks include acquisition integration and goodwill impairment, competition and insurance pricing, foreign exchange, cybersecurity and privacy, regulatory compliance, litigation, debt service and refinancing. A patent lawsuit relating to clean-coal technology had its dismissal motion granted in February 2015, with the plaintiff permitted to amend its complaint.
- The financial statements received an unqualified audit opinion and management and the auditor concluded internal control over financial reporting was effective. Controls at 24 of 60 acquired entities were excluded from the assessment; those entities represented 9.1% of assets, 7.4% of revenue and 2.9% of net earnings.
Most important facts for investors to verify
- Separate recurring brokerage and claims-administration growth from acquired revenue and consolidated clean-coal gross revenue; review non-GAAP reconciliations alongside GAAP results.
- Assess the sustainability and utilization of Section 45 credits, the status of the eight plants without long-term contracts, and the projected $90–$110 million 2015 clean-energy earnings.
- Track debt maturities, covenant headroom, acquisition funding needs, integration costs and dilution following the 2014 share issuance.
- Monitor the New South Wales contract run-off, micro-captive IRS inquiry and audits, and any amended clean-coal patent complaint or other material contingencies.
- Evaluate available liquidity using unrestricted cash and borrowing availability, not restricted fiduciary cash; consider the scale of contractual debt, lease and acquisition-related obligations.