Arthur J. Gallagher & Co. — Q1 2012 Form 10-Q
Reporting period: Three months ended March 31, 2012; unaudited interim financial statements. The company provides insurance brokerage and risk management services. Ernst & Young reviewed the interim statements; this was not an audit.
Financial results and liquidity
| Metric | Q1 2012 | Q1 2011 |
|---|---|---|
| Total revenue | $546.8 million | $447.4 million |
| Earnings before income taxes | $32.5 million | $23.5 million |
| Net earnings | $28.1 million | $15.2 million |
| Diluted EPS | $0.24 | $0.14 |
| Cash used by operating activities | $47.6 million | $8.4 million |
| Cash and cash equivalents at period end | $301.8 million | $333.2 million |
- Revenue rose about 22% and net earnings about 85% year over year. Net margin was approximately 5.1%, versus 3.4%; pretax margin was approximately 5.9%, versus 5.3%.
- Reported revenue included $20.1 million from clean coal activities, compared with a $1.1 million loss in Q1 2011; related costs were $17.7 million. This unusual comparison contributed to reported growth.
- Operating cash outflow increased, primarily reflecting higher incentive compensation and interest payments, alongside working-capital movements. Management cautions that quarterly operating cash flow varies with premium and fee collections and payments. Restricted cash was $677.8 million and is not available for general liquidity needs.
- At March 31, total corporate borrowings were $767.0 million: $675.0 million of fixed-rate notes and $92.0 million drawn on the revolving credit facility. The company reported $392.1 million of remaining facility availability and compliance with debt covenants.
- Current assets were $2.225 billion and current liabilities $2.044 billion; these include substantial fiduciary-related balances. Total assets were $4.603 billion and stockholders’ equity $1.357 billion.
- Quarterly dividends declared were $0.34 per share. Dividends paid were $38.8 million. Capital expenditures were $13.4 million; management expected approximately $55 million of full-year 2012 capital spending.
Material changes and operating performance
- Brokerage: Revenue was $385.3 million, up 21%; pretax earnings were $29.5 million versus $29.1 million. Organic commission and fee revenue grew 3.2%; adjusted EBITDAC grew 27%. Acquisitions contributed substantially to reported growth.
- Risk management: Revenue was $141.3 million, up 8%; pretax earnings rose to $19.1 million from $11.3 million. Organic fees grew 7%, and adjusted EBITDAC grew 15%.
- Corporate: Reported revenue was $20.2 million, largely reflecting clean coal operations; pretax loss was $16.1 million. Clean energy investments contributed $7.2 million to net earnings after tax credits, versus a $0.4 million net loss in Q1 2011.
- The company completed 12 acquisitions, with approximately $30.6 million in annualized acquired revenue and $89.8 million in recorded purchase price. Consideration included stock, cash, escrow and earnouts. Acquisition-related goodwill rose to $1.196 billion; net amortizable intangible assets were $598.4 million.
- Shares outstanding increased to 118.3 million from 114.7 million at year-end 2011, including shares issued for acquisitions and employee plans.
Outlook, commentary, and key risks
- Management expected continued organic growth and expansion through acquisitions, while noting that competition, a sluggish economic recovery and restrained insurance demand could offset improving insurance pricing. Management reported positive organic growth in brokerage and risk management for five consecutive quarters.
- Management expected its historical growth trend in earnings before income taxes adjusted for noncash items to continue, and anticipated that IRC Section 45 clean-energy credits would reduce tax payments. These are forward-looking expectations, not guarantees.
- The company announced a second-quarter 2012 dividend of $0.34 per share, 3% higher than the prior-year quarter. It anticipated approximately $160.9 million of annualized 2012 dividend cash outflow.
- Clean coal results and tax benefits depend on plant operations, utility purchase commitments, co-investor transactions, regulatory approvals and tax-credit eligibility. Several plants were not operating or still required customers and investors. Management said the 2012 coal reference price did not trigger a tax-credit phase-out.
- Acquisition earnouts are subject to performance estimates: maximum potential obligations for 2009–2012 acquisitions were $340.6 million, of which $123.0 million was recorded at fair value. Changes in projections can affect earnings.
- Potential exposure under indemnities for previously sold tax-advantaged investments was approximately $195.0 million, net of estimated tax benefit; the company also reported exposure on $129.2 million of previously earned tax credits. No liability was recorded for those indemnities. The filing notes possible adverse tax audits or decisions.
- Other risks include insurance-premium cycles and contingent-commission variability, economic weakness, acquisition integration, foreign exchange and international regulation, litigation, cybersecurity, employee benefit costs, and clean-energy environmental or product-liability exposure. The E&O reserve was within the actuarial range, but management cautioned that future claims could change estimates.
- Management stated that it had adequate resources for foreseeable liquidity needs. It also noted potential for significantly higher future minimum pension contributions; no minimum contribution was required for 2012, and $1.8 million was contributed voluntarily in the quarter.
Most important facts for investors to verify
- How much of revenue and earnings growth is repeatable core brokerage and risk-management performance versus acquisitions, clean coal activity, tax credits, and other timing effects?
- Whether acquired businesses integrate as expected, and how acquisition earnout estimates and dilution evolve.
- Cash conversion and working-capital trends, considering the quarter’s $47.6 million operating cash outflow and the distinction between unrestricted and restricted cash.
- Clean coal plant operating status, utility contracts, co-investor closings, realized tax credits, and any change in eligibility or indemnity exposure.
- Debt levels, revolver availability, covenant compliance, dividend funding, and the company’s ability to meet lease, debt, acquisition, and pension commitments.
- Developments in litigation, E&O claims and reserves, and the unrecorded tax-indemnity exposures.