Arthur J. Gallagher & Co. — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014; unaudited interim statements reviewed by Ernst & Young. Gallagher provides insurance brokerage and risk-management services and reports brokerage, risk management, and corporate segments. Corporate includes clean-energy investments and debt.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Total revenue | $1,286.8M | $835.8M | $3,381.1M | $2,289.4M |
| Earnings before taxes | $87.7M | $85.5M | $241.1M | $225.2M |
| Net earnings | $93.6M | $74.6M | $251.9M | $208.6M |
| Diluted EPS | $0.58 | $0.57 | $1.67 | $1.61 |
| Operating cash flow | — | $233.2M | $278.6M |
- Reported revenue rose 54% in Q3 and 48% year to date. Acquisitions and clean-coal activity were major contributors; reported totals therefore do not represent organic brokerage growth alone.
- Brokerage revenue increased 46% in Q3 and 36% year to date. Base commission-and-fee organic growth was 4.9% in Q3 and 3.8% year to date; management attributed slower growth versus 2013 primarily to premium-rate decreases. Q3 organic growth benefited from larger-account sales and would have been about 4% at more typical levels.
- Risk-management revenue rose 12% in Q3 and 8% year to date. Organic fee growth was 11.7% and 8.4%, respectively. Nine-month segment net earnings were $38.1M versus $37.5M.
- On management’s non-GAAP adjusted basis, combined brokerage and risk-management adjusted EBITDAC increased 43% in Q3 and 37% year to date; adjusted margins were 25.1% and 23.8%, respectively. These measures exclude specified items and are not GAAP measures.
- Q3 consolidated net earnings benefited from a $5.9M income-tax benefit, compared with a $10.9M tax provision in Q3 2013. The nine-month tax benefit was $10.8M, versus a $16.6M provision a year earlier; Section 45 clean-energy credits were a key factor. Q3 comprehensive earnings were a loss of $44.3M, primarily reflecting $136.5M of foreign-currency translation losses.
Cash, debt and liquidity
- At September 30, cash and cash equivalents were $290.5M; restricted cash was $1,342.1M and should not be treated as freely available liquidity. Current assets were $3,972.4M and current liabilities $3,769.8M; fiduciary-related balances significantly affect these totals.
- Nine-month operating cash flow was $233.2M, down from $278.6M, which management attributed mainly to timing of accrued-liability payments and fiduciary-fund receipts and disbursements. Investing used $1,910.7M, including $1,834.6M for acquisitions; financing provided $1,655.8M.
- Total corporate and other debt was $2,421.2M: $2,125.0M of private-placement notes, $147.0M under the credit agreement, and $149.2M under the acquired premium-financing facility. The $600M revolving credit agreement had $432.4M available, including letters-of-credit capacity. Gallagher reported compliance with debt covenants.
- Shareholders’ equity rose to $3,256.0M from $2,085.5M, including a 21.85M-share secondary offering that generated $911.4M net proceeds. Shares outstanding increased to 161.4M from 133.6M at year-end 2013.
Material changes, outlook and risks
- Gallagher completed 45 acquisitions in the first nine months, with approximately $2.08B recorded purchase price and $693.6M in annualized acquired revenue. Major transactions included Oval, Crombie/OAMPS, and Noraxis. Goodwill rose to $3.30B from $2.15B and net amortizable intangibles to $1.77B from $1.08B. Management said integration was meeting expectations.
- Acquisition integration costs were expected to be $12M–$18M per quarter during 2014, $7M–$11M per quarter in 2015, and about $2M per quarter in 2016. Management forecast 2014 clean-energy net earnings of $102M–$107M and expected positive net cash flow from Section 45 activity in 2014, while noting that future cash flow is difficult to predict. It also expected approximately $90M of 2014 capital expenditures. No specific consolidated revenue or EPS guidance was provided.
- Management expected sufficient capital for short- and long-term needs and intended to continue acquisitions using operating cash, debt, and potentially stock. It announced a Q4 dividend of $0.36 per share; future dividends are not assured.
- Clean-energy exposure includes potential loss or interruption if utilities switch from coal, plant redeployment delays, and uncertainty over tax-credit eligibility. Seven plants were still seeking or negotiating long-term production contracts; management estimated $30M–$40M of additional investment to redeploy remaining plants in 2015.
- The IRS was investigating Gallagher’s micro-captive advisory business and auditing more than 100 client captives for 2012. Gallagher said no specific allegations had been made against it and that a potential loss could not be estimated. It warned that an adverse outcome could affect client claims, future earnings, and the business.
- A July 2014 patent-infringement lawsuit involving Gallagher, Gallagher Clean Energy, and Chem-Mod seeks damages and injunctive relief; Gallagher disputes the claims and stated it believes a material loss is remote. Other ordinary-course litigation and regulatory matters remain unresolved.
- A pension de-risking offer could produce up to approximately $73M in payouts from plan assets; management expected actual payouts of $20M–$35M and a non-cash settlement charge in Q4 2014. Gallagher also disclosed up to $32M of potential tax-credit indemnification payments and exposure on $117M of previously earned credits; no related liability was recorded.
- Foreign-currency translation reduced nine-month comprehensive earnings, and currency changes could affect results. A hypothetical 10% adverse exchange-rate move was estimated to reduce nine-month pretax earnings by about $7M.
Key facts for investors to verify
- How much reported growth and future earnings are attributable to acquisitions and clean-energy tax credits versus recurring organic brokerage and risk-management operations.
- Acquisition integration, retention, earnout obligations, and the return on the substantial increase in goodwill and intangible assets.
- Debt levels, interest expense, available revolver capacity, and the cash needs of planned acquisitions and clean-energy redeployment.
- Developments in the IRS micro-captive investigation, the patent litigation, and the pension settlement charge.
- Whether organic growth, margins, and cash conversion hold up amid softer insurance pricing and the timing variability in fiduciary cash flows.