AJG

Arthur J. Gallagher & Co. - 10-Q Summary (Period Ended June 30, 2004)

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended June 30, 2004, and the six-month period ended on that date. Arthur J. Gallagher & Co. is a global provider of insurance brokerage and risk management services. The company operates through three segments: Brokerage, Risk Management, and Financial Services. The financial statements are unaudited but include all normal recurring adjustments.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 26.5% for the six months ended June 30, 2004, compared to the same period in 2003. This was driven by a 218% increase in investment income (primarily due to the consolidation of a Syn/Coal partnership under FIN 46) and growth in brokerage commissions and fees.
• Profitability: Net earnings rose 76.7% year-over-year for the six-month period. The Brokerage segment saw a 26% increase in net earnings, while the Risk Management segment increased by 39%.
• Investment Activity: The Financial Services segment reported a net loss of $16.4 million in the prior year period due to $25.7 million in write-downs of venture capital investments. In the current period, the segment reported a net earnings of $1.6 million, aided by a $4.6 million investment gain and the reversal of previous loss reserves.
• Acquisitions: The company acquired 10 insurance brokerage firms in the first half of 2004, contributing to revenue growth and increasing goodwill and amortizable intangible assets.

Guidance, Outlook, and Risks

• Market Outlook: Management notes that the "hard market" (rising premium rates) that boosted revenues in 2002-2003 has moderated. Premium rate increases have flattened or decreased for many lines, which could negatively impact future commission revenues.
• Tax Credits: A significant portion of the company's low effective tax rate (approx. 20%) is derived from tax credits associated with Low Income Housing (LIH) and Synthetic Coal (Syn/Coal) investments. The IRS and the U.S. Senate are investigating Syn/Coal credits. While management believes its credits are valid and has insurance coverage, a disallowance could materially impact results.
• Liquidity: The company maintains a $250 million unsecured revolving credit facility with $205.1 million available as of June 30, 2004. No corporate borrowings were outstanding. Management expects to fund future acquisitions and operations through cash flow and stock issuance.
• Dividends: The quarterly dividend was increased to $0.25 per share (from $0.18 in the prior year), representing a 39% increase.

Investor Verification Checklist

• Syn/Coal Tax Credit Validity: Verify the status of the IRS and Senate investigations into Synthetic Coal tax credits and the adequacy of Gallagher's insurance coverage against potential disallowance.
• FIN 46 Consolidation Impact: Assess the sustainability of the revenue and expense increases driven by the consolidation of the Syn/Coal partnership under FIN 46 rules.
• Organic Growth Rates: Distinguish between total revenue growth and "organic" growth (excluding acquisitions), which was 4% for commissions/fees in the Brokerage segment for the six-month period.
• Investment Portfolio Exposure: Review the maximum exposure to potential losses in unconsolidated investments (LIH, Biogas, Real Estate), which totaled $94.9 million in recourse debt and carrying value for consolidated investments, plus additional exposure in unconsolidated entities.
• Contingent Acquisition Liabilities: Note the $62.3 million in unrecorded contingent payables related to acquisitions from 2002-2004, which depend on future earnings of acquired entities.