Arthur J. Gallagher & Co. quarterly report, Q3 FY2016

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Arthur J. Gallagher & Co. — Q3 2016 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2016; comparative periods ended September 30, 2015. Amounts are in U.S. dollars. The interim financial statements were reviewed by Ernst & Young, not audited.

Business context

Gallagher provides insurance brokerage and risk-management services in 33 countries, with capabilities in more than 150. Its three segments are brokerage, risk management, and corporate, which includes clean-energy investments and corporate financing. In the first nine months, the segments represented approximately 63%, 12%, and 25% of reported revenue, respectively. Consolidated revenue includes substantial gross revenue and costs from clean-coal activities.

Financial performance

  • Revenue: Q3 revenue was $1.482 billion, up 1.9% year over year; nine-month revenue was $4.210 billion, up 3.8%.
  • Earnings and EPS: Q3 net earnings attributable to controlling interests were $122.8 million versus $133.3 million; diluted EPS was $0.69 versus $0.75. Nine-month controlling-interest earnings were $319.3 million versus $294.5 million; diluted EPS was $1.79 versus $1.71.
  • Cash flow: Nine-month operating cash flow was $388.4 million, up from $326.5 million. Investing used $362.0 million, including $208.2 million for acquisitions and $138.8 million of fixed-asset additions. Financing provided $31.6 million. Cash and cash equivalents ended at $531.8 million.
  • Margins and segments: Brokerage Q3 revenue rose 5% to $877.6 million; organic commission and fee growth was 2.4%. Nine-month brokerage revenue rose 7% to $2.642 billion, with 2.6% organic base commission and fee growth. Risk-management revenue fell 1% in Q3 and 2% for nine months; organic fee growth was 0.7% in both periods. Nine-month adjusted EBITDAC margin was 27.3% for brokerage and 17.1% for risk management. These are company-defined non-GAAP measures.
  • Debt and liquidity: Total corporate and other debt was $2.791 billion, including $2.400 billion in private-placement notes, $258 million drawn on the revolving credit facility, and $133.1 million of premium-financing debt. The amended revolving facility has an $800 million commitment, with $520.9 million available at quarter-end. Current assets and current liabilities were each $4.214 billion and $4.399 billion, respectively; current assets include $1.397 billion of restricted cash, which the company excludes from available liquidity.
  • Margins and dividends: Q3 consolidated pretax earnings were $94.9 million, compared with $105.7 million. Dividends declared were $0.38 per share in Q3 versus $0.37; the company announced a $0.38 fourth-quarter dividend.

Material changes versus the prior period

  • Brokerage drove operating growth, while risk-management organic growth slowed markedly from 2015. Management attributed brokerage’s lower nine-month organic growth partly to renewal-rate decreases and the loss of one large account; risk-management pressure reflected lower international performance bonuses, lost business, and decreased claim counts.
  • Corporate-segment earnings declined substantially: nine-month earnings attributable to controlling interests were $2.8 million versus $35.6 million. Clean-coal plant costs increased with production, and the comparison also reflects the prior-year U.K. litigation-settlement gain.
  • Nine-month operating cash flow improved, but client-fiduciary balances contributed $40.6 million, versus $147.7 million in the prior-year period; timing of accrued-liability payments also affected cash flow.
  • Acquisition spending and capital investment increased: cash acquisitions were $208.2 million versus $176.5 million, and fixed-asset additions were $138.8 million versus $71.8 million. Gallagher completed 28 acquisitions, with approximately $97.8 million of acquired annualized revenue.
  • Debt rose from $2.457 billion at year-end 2015 to $2.791 billion, including $275 million of new private-placement notes. The revolving facility was extended to April 2021 and increased from $600 million to $800 million.

Outlook, commentary, and key risks

  • Management said it expected 2016 clean-energy investments to generate $111 million to $119 million in net earnings and anticipated positive net cash flow from these investments in 2016, with positive cash flow expected overall through at least 2021 if key assumptions hold. Clean-energy earnings rely on IRC Section 45 credits; plant operations, deployment, utility production, tax-credit utilization, and partner recruitment create uncertainty. Credits substantially expire in 2019 for 2009-era plants and 2021 for 2011-era plants.
  • Management described the domestic insurance pricing environment as stable, while citing average commercial property/casualty rate decreases of 3.9% in the second-quarter 2016 industry survey. It saw some signs of a rate-cycle bottom in Australia and New Zealand. No specific full-year earnings or revenue guidance was provided.
  • The company expects 2016 capital expenditures of approximately $200 million, including about $110 million for its new headquarters, and anticipated moving there in early 2017. Potential state and local incentives were estimated at $60 million to $80 million over 15 years.
  • The IRS was investigating Gallagher’s micro-captive advisory services and auditing more than 100 client captives for 2012. The company could not estimate a potential loss; adverse findings could affect clients, future earnings, and financial condition.
  • Other risks include acquisition integration and earnout-estimate changes, insurance pricing and competition, foreign-exchange exposure, and clean-coal operating and tax-credit uncertainty. A patent lawsuit involving Nalco was dismissed, but Nalco appealed; management considered a material loss remote. The filing also discloses U.K. subsidiary brokerage activities involving Iran, which it said were conducted under applicable OFAC General License H.
  • Debt covenants were in compliance at September 30. A $50 million note maturity was due in November 2016; management anticipated a $100 million private placement around December 1, 2016, partly to fund that maturity. It expected operating cash flows and available borrowing capacity to meet foreseeable liquidity needs.

Investor facts to verify

  • How much future earnings and cash generation depend on clean-coal production and Section 45 tax credits, including the timing of credit expirations.
  • Whether brokerage organic growth and risk-management fee trends improve, and how renewal pricing, lost accounts, claim volumes, and contingent commissions affect results.
  • Debt maturities, the planned 2016 financing, facility availability, and the effect of acquisition funding, dividends, and capital spending on leverage and liquidity.
  • Potential exposure from the IRS micro-captive investigation and client audits, as well as the status of the appealed patent case and other contingencies.
  • Acquisition integration progress, acquisition-related costs, and the sensitivity of reported earnings to earnout estimates and non-GAAP adjustments.