Arthur J. Gallagher & Co. quarterly report, Q3 FY2017

Arthur J. Gallagher & Co. — Q3 2017 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2017. Unaudited interim statements were reviewed by Ernst & Young; the review is not an audit. The company provides insurance brokerage and risk-management services, alongside clean-energy investments reported in its corporate segment. Dollar amounts are in millions unless stated otherwise.

Financial results

Metric	Q3 2017	Q3 2016	Nine months 2017	Nine months 2016
Total revenue	$1,584.5	$1,482.3	$4,560.6	$4,209.8
Earnings before income taxes	$96.7	$94.9	$296.0	$288.1
Net earnings attributable to controlling interests	$130.4	$122.8	$358.0	$319.3
Diluted EPS	$0.71	$0.69	$1.97	$1.79
Operating cash flow	—	—	$459.1	$368.9

Revenue grew 6.9% in Q3 and 8.3% for the nine months. Results include substantial clean-coal activity: its revenue was $430.6 in Q3 and $1,158.8 year to date, while associated costs exceeded that revenue.
Brokerage revenue was $953.7 in Q3, up 9%; organic revenue growth was 3.5%. Nine-month brokerage revenue was $2,830.3, up 7%, with 3.5% organic growth. Q3 brokerage adjusted EBITDAC margin was 27.9%; nine-month adjusted margin was 28.0%.
Risk-management revenue was $200.2 in Q3, up 13%, with 10.2% organic growth. Nine-month revenue was $571.5, up 7%, with 5.8% organic growth. Adjusted EBITDAC margin was 17.9% for Q3 and 17.3% year to date.
Consolidated net earnings benefited from an income-tax benefit of $41.1 in Q3 and $90.0 year to date, primarily reflecting clean-energy tax credits. These benefits make pretax earnings and net earnings trends materially different.
Cash from investing activities was an outflow of $420.0 for the nine months, including $320.5 paid for acquisitions and $93.8 of capital expenditures. Cash from financing activities was an outflow of $46.6. Ending cash and cash equivalents were $564.9; restricted cash of $1,615.6 is largely fiduciary/client-related and is not available as ordinary corporate liquidity.
Total assets were $12,810.4 and total liabilities $8,638.2 at September 30, 2017. Net corporate and other debt was $3,023.1, including $2,798.0 of note purchase agreements, $75.0 under the credit agreement and $156.4 of premium-financing debt. The company reported $704.3 available under its $800.0 revolving credit agreement and compliance with debt covenants.

Changes versus prior comparable periods

Nine-month net earnings attributable to controlling interests rose 12.1% and diluted EPS rose 10.1%; Q3 controlling-interest earnings increased 6.2% and diluted EPS increased 2.9%.
Operating cash flow increased by $90.2 year over year, but management attributed part of the change to timing of fiduciary cash movements, accrued-liability payments and foreign-currency remeasurement—not solely improved underlying cash generation.
Acquisition spending rose to $320.5 from $147.0. The company completed 30 acquisitions during the nine-month period, with approximately $143.0 of annualized acquired revenue. Goodwill increased to $4,160.4 from $3,767.8 at year-end 2016.
Corporate-segment controlling-interest earnings declined to a loss of $5.9 for the nine months from earnings of $2.8. Clean-energy earnings after tax increased to $88.2 from $85.8, but higher interest, corporate, acquisition and headquarters-related costs weighed on the segment.
Corporate and other debt increased from $2,848.2 at year-end 2016 to $3,023.1. The company issued $648.0 of private-placement notes during 2017, partly refinancing a $300.0 maturity.

Outlook, commentary and material risks

Management said it believes capital is sufficient for short- and long-term cash needs; it did not provide a specific company-wide earnings forecast. It anticipated $123.0–$129.0 of 2017 after-tax earnings from clean-energy investments and approximately $135.0 of 2017 capital expenditures.
Management described a modestly declining commercial property/casualty rate environment as a headwind, partly offset by exposure-unit growth, employee-benefit opportunities, new business and retention. The cited Q3 industry pricing survey was not yet available when the filing was prepared.
Management expects adoption of the revenue-recognition standard in Q1 2018, using full retrospective transition. It expects changes to individual statement lines and quarterly timing, including a possible shift in revenue recognition toward Q1, but does not expect a material annual impact on operating results.
Clean-energy tax credits are significant to reported tax benefits and outlook. The credits depend on production, tax law, regulatory and environmental conditions, and the company’s ability to use credits. The relevant credit periods generally extend through 2019 for 2009-era plants and 2021 for 2011-era plants. IRS actions involving a partnership and co-investors could create uncertainty, although the disclosed notices did not challenge the credits themselves or the company’s ability to use them.
The IRS is investigating the company’s micro-captive advisory services and auditing more than 100 client captives for 2012. No specific allegation against the company had been made, and a potential loss could not be reasonably estimated. The filing warns adverse findings could affect clients, future earnings and the business.
Other notable exposures include litigation and regulatory matters, foreign-exchange risk, acquisition integration and earnout estimates, goodwill and intangible-asset impairment, and substantial lease and debt commitments. The company recorded $27.5 of acquisition earnout-payable expense and $6.2 of intangible-asset write-offs in the first nine months.
The board declared a Q4 2017 dividend of $0.39 per share. Management noted that future dividends are not assured. The filing also disclosed permitted Iran-related insurance brokerage activity by foreign subsidiaries under U.S. General License H, generating approximately $11,478 gross revenue and $2,296 net profit.

Most important facts for investors to verify

How much of earnings and cash generation is attributable to core brokerage and risk-management operations versus clean-energy tax credits and other corporate items.
Whether organic brokerage growth, retention and new-business production continue to offset soft insurance pricing and contingent-commission variability.
Acquisition integration, acquired-business contributions, goodwill/intangible valuations and the cash cost and variability of earnout obligations.
Debt maturities, interest costs, revolving-credit availability and liquidity after excluding restricted fiduciary cash and funding acquisitions and dividends.
Developments in the IRS micro-captive investigation, clean-energy tax-credit matters, and any related litigation or regulatory exposure.
The actual revenue-recognition transition effects, including comparative-period restatements and changes in quarterly seasonality.