Arthur J. Gallagher & Co. — Q2 2015 Form 10-Q
Reporting period: Three and six months ended June 30, 2015; interim financial statements are unaudited and were reviewed by Ernst & Young. Gallagher provides insurance brokerage and risk management services, with additional corporate-segment activity in clean energy investments. Amounts below are in U.S. dollars unless otherwise noted.
Financial performance
- Revenue: Q2 revenue was $1.371 billion, up 16% from $1.179 billion; first-half revenue was $2.603 billion, up 24% from $2.094 billion. Clean coal activities contributed $297.0 million in Q2 and $600.9 million for the first half, with related costs of $306.8 million and $616.1 million, respectively. Acquisition growth also materially increased brokerage revenue.
- Earnings: Q2 net earnings were $147.6 million versus $113.7 million; earnings attributable to controlling interests were $139.3 million versus $109.0 million. Diluted EPS was $0.81 versus $0.70. First-half net earnings were $180.0 million versus $171.5 million, and controlling-interest earnings were $161.2 million versus $158.3 million; diluted EPS declined to $0.95 from $1.09.
- Profitability and operating trends: First-half earnings before income taxes were $159.4 million, down from $166.6 million. Brokerage and risk management performed better: Q2 organic base commission and fee growth was 3.9%, while risk management organic fee growth was 13.4%. Management reported Q2 adjusted EBITDAC growth of 28% in brokerage and 21% in risk management. These are non-GAAP measures. Reported clean coal revenues and costs substantially affect consolidated revenue comparisons.
- Cash flow: First-half operating cash flow was $81.7 million, down from $222.8 million. Management cited working-capital and fiduciary-fund timing, a $59.1 million unrealized foreign-currency remeasurement loss (versus a $33.8 million gain in 2014), and retention-agreement payments. Investing cash outflow was $109.1 million, including $63.5 million net cash paid for acquisitions and $42.7 million of fixed-asset additions. Financing cash inflow was $37.2 million. Cash and cash equivalents ended at $321.7 million.
- Balance sheet and debt: At June 30, total assets were $10.716 billion and total liabilities were $7.005 billion. Corporate and other borrowings totaled $2.372 billion: $2.125 billion of fixed-rate notes, $155.0 million under the revolving credit agreement, and $91.6 million under the premium-finance facility. Revolver availability was $422.4 million, including $52.4 million available for letters of credit. The company reported compliance with debt covenants. Restricted cash of $1.444 billion is held for fiduciary or other restricted purposes and is not equivalent to unrestricted liquidity.
- Margins and dividends: Q2 adjusted EBITDAC margin was 29.6% for brokerage and 17.6% for risk management; the latter included a one-time performance fee. The declared dividend was $0.37 per share for Q2, and the company announced the same quarterly dividend for Q3.
Changes versus the prior comparable period
- Reported Q2 revenue increased $192.1 million, while first-half revenue rose $508.4 million. The increase reflected acquisitions, organic growth, and higher consolidated clean coal activity; it should not be read as equivalent growth in recurring brokerage revenue.
- Q2 brokerage revenue rose 20%, with organic base commission and fee growth of 3.9%; Q2 risk management revenue rose 10%, with organic fee growth of 13.4%. For the first half, organic base commission and fee growth was 4.1% and organic risk management fee growth was 12.2%.
- First-half controlling-interest earnings increased modestly, but diluted EPS fell because of a larger share count and weaker corporate-segment contribution. Shares outstanding at June 30 were 174.5 million, versus 164.6 million at December 31, 2014; the company issued shares for acquisitions and through its at-the-market equity program.
- Corporate-segment first-half controlling-interest results shifted to a $6.6 million loss from $11.9 million of earnings in 2014. The prior period included a noncash gain from clean-energy ownership changes; current-period results also reflect higher interest expense and clean-coal costs.
- First-half acquisition cash spending was substantially lower than in 2014 ($63.5 million versus $1.402 billion), while 2014 acquisition activity was unusually large. Gallagher completed 24 acquisitions in the first half of 2015, with acquired annualized revenue of approximately $123.5 million.
Outlook, commentary, risks and unusual items
- Management stated it had sufficient capital for short- and long-term needs and expected operating earnings, adjusted for noncash items, to continue the historically favorable trend, supported by organic growth and acquisitions. The filing does not provide a specific full-year consolidated revenue or EPS forecast.
- Management estimated 2015 after-tax earnings from clean-energy investments of $98.5 million to $107.5 million and anticipated positive net cash flow from these investments in 2015. These estimates depend on production, tax-credit eligibility, tax capacity, ownership, and redeployment or relocation costs. Section 45 credits substantially expire in 2019 for the 2009-era plants and 2021 for the 2011-era plants.
- Management expected approximately $120 million of 2015 capital expenditures, primarily for the new headquarters, office projects, and technology. Acquisition integration costs were expected to run $15 million to $20 million per quarter for the remainder of 2015. Compensation-based retention agreements were estimated to add $3 million to $4 million per quarter to compensation expense.
- On June 15, Gallagher agreed to acquire William Gallagher Associates for approximately $150 million; the transaction closed July 31, 2015, after the quarter-end and on the filing date. The target had approximately $50 million of annualized revenue.
- Key exposures include the IRS investigation of the company’s micro-captive advisory business and audits of more than 100 related captive insurers; a U.K. Financial Conduct Authority review of regulated entities; litigation involving former U.K. executives; and a patent dispute relating to clean-coal technology. Management said the patent claim’s probability of material loss was remote and did not expect the FCA review to have a material adverse effect; the IRS matter was too early to estimate a potential loss.
- Clean-energy operations carry tax-credit, production, regulatory, environmental, utility-contract, and intellectual-property risks. Twenty-six of 34 plants had long-term production contracts; the remaining eight were seeking or negotiating contracts. The company also disclosed up to $32.0 million of potential tax-credit indemnification payments and exposure on $117.0 million of previously earned credits; no related liability was recorded.
- Acquisition earnouts are judgment-sensitive: maximum obligations were $596.6 million, of which $217.4 million was recorded at estimated fair value. Other notable items include $22.4 million of Q2 acquisition integration costs and a $19.1 million Q2 income-tax benefit at the consolidated level, largely associated with clean-energy credits.
- Management described insurance pricing as competitive and modestly declining: the cited industry survey indicated average rates retracted 3.3% in Q2. Gallagher noted that carrier pricing varied by line, region, and client experience.
Important facts for investors to verify
- How much of revenue and earnings growth is recurring organic brokerage and risk-management performance versus acquisitions, clean-coal activity, tax credits, and other nonrecurring items.
- Whether cash conversion improves from the first-half $81.7 million operating cash flow, and how fiduciary cash flows, receivables/payables, foreign exchange, and retention payments affect future periods.
- The sustainability and cash realization of Section 45 credits, plant production and contract status, and the impact of their scheduled expiration.
- Acquisition integration performance, dilution from equity issuance, earnout revisions, and funding needs—including the completed WGA acquisition.
- Developments in the IRS, FCA, former-executive, patent, and tax-credit indemnification matters, as well as any effect on earnings, liquidity, or reputation.
- Debt maturities, covenant headroom, available revolver capacity, and the distinction between unrestricted cash and restricted fiduciary funds.