AJG

Arthur J. Gallagher & Co. - 10-Q Summary (Period Ended Sept 30, 2005)

Business Context and Reporting Period

This filing covers the quarterly period ended September 30, 2005, and the nine-month period ended on that date. Arthur J. Gallagher & Co. is a global insurance brokerage and risk management firm. The company operates through three segments: Brokerage, Risk Management, and Financial Services. The reporting period was significantly impacted by a soft insurance market, regulatory settlements regarding contingent commissions, and litigation related to synthetic fuel investments.

Key Financial Metrics

Note: Corporate related borrowings were $0 at September 30, 2005.

Material Changes vs. Prior Period

• Significant Decline in Nine-Month Earnings: Net earnings dropped 79.7% year-over-year for the nine-month period, primarily due to a $131.0 million pretax litigation charge in the Financial Services segment and a $35.0 million pretax charge in the Brokerage segment related to contingent commission settlements.
• Revenue Growth: Total revenues increased 4.2% for the nine-month period, driven by acquisitions ($55.0 million in commissions/fees) and new business, partially offset by a soft insurance market causing renewal rate decreases.
• Segment Performance:
  • Brokerage: Revenues up 11%, but pretax earnings down 34% due to the $35.0 million litigation/commission charge.
  • Risk Management: Revenues up 8% and pretax earnings up 25%, showing strong organic growth.
  • Financial Services: Reported a pretax loss of $142.3 million (vs. $0.5 million loss in 2004) due to the $131.0 million Headwaters litigation settlement charge.
• Discontinued Operations: The company sold several operations (Northshore International, Gallagher Benefit Administrators, and Florida Community Development), resulting in a net gain of $7.2 million for the nine-month period.

Guidance, Outlook, and Risks

• Insurance Market Outlook: The market remains "soft" with declining premium rates, which negatively impacts commission revenue. However, hurricane losses (Katrina/Rita) may drive rate increases in late 2005 and 2006 renewals.
• Contingent Commissions: The company entered an Assurance of Voluntary Compliance (AVC) with Illinois authorities, requiring a $27.0 million payment to a client fund. The company has ceased entering new volume-based or profit-based contingent commission agreements as a retail broker effective Jan 1, 2005, which is expected to reduce future revenues.
• Syn/Coal Tax Credits: The Financial Services segment relies on IRC Section 29 tax credits for synthetic coal, which expire Dec 31, 2007. High oil prices could trigger a phase-out of these credits. Management estimates that if oil prices average above $52.50 in 2005, credits may begin to phase out. If facilities are idled in 2006 due to phase-out risks, the segment could incur a one-time non-cash charge of ~$18 million.
• Liquidity: The company maintains a $450 million credit facility with $417.8 million available. Management expects operating cash flows and investment liquidations to cover litigation payments.

Investor Verification Checklist

• Headwaters Litigation Settlement: Verify the $131.0 million charge details and the remaining payment obligations ($70 million due Jan 2006 plus royalties).
• Contingent Commission Exposure: Assess the long-term impact of the $27 million Illinois settlement and the elimination of contingent commissions on future Brokerage segment margins.
• Syn/Coal Credit Viability: Monitor crude oil prices against the IRS "Phase-out Prices" to evaluate the risk of losing tax credits and the potential for facility idling in 2006.
• Acquisition Integration: Review the performance of the eight acquisitions made in the first nine months of 2005 to ensure they meet organic growth targets.
• Investment Portfolio Impairment: Monitor the valuation of unconsolidated investments (LIH, Alternative Energy) for potential impairment charges given market volatility.