Arthur J. Gallagher & Co. quarterly report, Q1 FY2017

Arthur J. Gallagher & Co. — Q1 2017 Form 10-Q

Reporting period: Three months ended March 31, 2017; comparisons are with Q1 2016 unless stated otherwise. Gallagher provides insurance brokerage and risk-management services and also reports clean-energy investments in its corporate segment. Interim financial statements were reviewed, not audited, by Ernst & Young.

Financial results

Metric	Q1 2017	Q1 2016	Change
Total revenue	$1,412.7 million	$1,300.4 million	+8.6%
Earnings before income taxes	$52.3 million	$55.7 million	Down $3.4 million
Net earnings	$67.8 million	$57.9 million	+17.1%
Net earnings attributable to controlling interests	$55.7 million	$46.5 million	+19.8%
Diluted earnings per share	$0.31	$0.26	+19.2%
Operating cash flow	$169.7 million	$100.0 million	+$69.7 million

• Revenue included $351.8 million from clean-coal activities, versus $294.8 million a year earlier. Clean-coal costs were $366.9 million, exceeding that revenue by $15.1 million. The corporate segment reported an $88.3 million pretax loss.
• The income-tax line was a $15.5 million benefit, including $23.4 million of IRC Section 45 credits recognized and an $8.2 million tax benefit from vested or settled stock awards. The reported net-income increase therefore occurred despite lower pretax earnings.
• Brokerage revenue rose 6% to $878.5 million; organic commissions and fee revenue grew 2.7%. Brokerage adjusted EBITDAC was $215.7 million, up 14%, and adjusted margin increased to 24.6% from 23.4% (non-GAAP measures).
• Risk-management revenue increased 2% to $182.6 million; organic fee growth was 1.6%. Segment net earnings fell 5% to $14.3 million and adjusted EBITDAC declined 3% to $31.2 million.
• Cash and equivalents were $564.0 million at March 31, up from $545.5 million at year-end. Restricted cash was $1,258.0 million and is not available for general liquidity. Current assets were $4,483.2 million and current liabilities $4,784.7 million.
• Net corporate and other debt was $2,944.1 million, compared with $2,848.2 million at year-end; this includes $395.0 million drawn on the revolving credit agreement and $104.4 million of premium-financing debt. The company reported covenant compliance and $383.9 million available under its $800 million revolving facility after borrowings and letters of credit.
• Investing cash use was $178.1 million, including $145.0 million for acquisitions. Financing provided $19.9 million; dividends paid were $71.4 million. Capital expenditures were $29.3 million in the quarter.

Material changes and management commentary

• Revenue growth reflected acquisitions and organic growth. Brokerage commissions and fees included $47.0 million from acquisitions completed in the preceding 12 months; organic base commission and fee growth slowed to 2.9% from 3.9%. Management cited $75.8 million of new business production, offset by $69.4 million of lost business and renewal-rate decreases.
• Management described a moderately declining property-and-casualty pricing environment, with exposure growth partly offsetting rate pressure. It cited new business, client retention and value-added services as growth opportunities, while noting uncertainty about whether rate declines would continue.
• Gallagher completed 12 acquisitions, with annualized acquired revenue of approximately $62.5 million. Recorded purchase price was $196.8 million; maximum potential earnouts were $565.3 million, of which $268.3 million was recorded at fair value. Q1 included $11.8 million of expense from changes in estimated earnout payables.
• Management expects clean-energy investments to produce $116–$128 million of net earnings in 2017 and anticipates positive net cash flow, subject to operating, tax-credit and capital-spending uncertainties. It expects approximately $135 million of 2017 capital improvements.
• The company expected to arrange private-placement debt around August 2017, primarily to refinance $300 million maturing that month. The premium-financing facility was due to expire May 18, 2017. The board declared a Q2 dividend of $0.39 per share; no assurance was given about future dividends.

Risks, contingencies and unusual items

• The IRS was investigating Gallagher’s micro-captive advisory services and auditing more than 100 client captive insurers for 2012. The company could not estimate any potential loss; adverse outcomes could affect clients, future earnings and the captive business.
• Clean-energy earnings and investment value depend on production, utility contracts, environmental and regulatory conditions, and continuation or treatment of IRC Section 45 credits. Potential changes in U.S. tax law could reduce the value of the credits. The filing also disclosed $108.2 million of exposure to previously earned Section 29 tax credits, with no reserve recorded.
• Other litigation and regulatory matters were disclosed; management said outcomes and effects could not be determined. The filing described a patent suit dismissed at trial level but on appeal, with management assessing material-loss probability as remote.
• Q1 included $2.4 million of after-tax headquarters relocation charges; management expected additional after-tax lease-abandonment charges of about $4.0 million in Q2 and $1.5 million in Q3. Revenue-standard implementation costs were approximately $2.1 million in Q1, with similar quarterly spending expected for the next five quarters.
• ASC 606 adoption was planned for Q1 2018, with full retrospective adoption anticipated. Management expected material changes to individual financial-statement lines but not a similarly material annual impact on operating results. The new lease standard, effective in 2019, was expected to materially affect the balance sheet.
• Disclosure controls were assessed as effective as of March 31, 2017; no material change in internal control over financial reporting was reported.

Investor verification priorities

• Reconcile the reported net-income and EPS growth with the pretax decline, tax credits and stock-award tax benefit; assess the sustainability of clean-energy tax benefits.
• Track organic growth and margins in brokerage and risk management separately from acquisitions, currency effects and non-GAAP adjustments.
• Review clean-energy production, cash generation, credit eligibility, and potential tax-law or environmental changes against management’s 2017 earnings estimate.
• Monitor debt refinancing and facility renewal, acquisition spending and earnout estimates, and liquidity excluding restricted fiduciary cash.
• Follow the IRS micro-captive investigation, other legal matters, headquarters move costs, and implementation effects of ASC 606 and lease accounting.