Arthur J. Gallagher & Co. — Q2 2010 Form 10-Q
Period: Quarter and six months ended June 30, 2010. Unaudited interim financial statements were reviewed by Ernst & Young, not audited. Gallagher provides insurance brokerage and risk-management services and does not assume underwriting risk.
Financial performance
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Revenue | $459.5m | $453.6m | $941.9m | $854.7m |
| Continuing-operations pretax earnings | $63.9m | $74.1m | $106.8m | $117.6m |
| Continuing-operations earnings | $41.9m | $43.8m | $71.1m | $72.1m |
| Net earnings | $44.0m | $43.8m | $73.2m | $70.2m |
| Diluted EPS | $0.42 | $0.44 | $0.71 | $0.71 |
- Q2 revenue rose 1.3%, but pretax earnings fell 13.8%; six-month revenue rose 10.2%, while pretax earnings fell 9.2%. Revenue growth for the first half was substantially affected by clean-coal activity.
- Calculated consolidated pretax margin was approximately 13.9% in Q2 versus 16.3% a year earlier, and 11.3% for the first half versus 13.8%.
- Q2 continuing-operations EPS was $0.40 versus $0.44. Net earnings included $2.1m of discontinued-operations earnings in 2010, principally a reversal of prior lease-abandonment charges.
- Q2 commissions increased 3%, while Brokerage fees declined 7%. Brokerage organic commissions, fees and supplemental commissions declined 3.3% in Q2 and 3.4% for the first half. Management attributed pressure chiefly to lower insurance rates and exposure units; new production was more than offset by renewal-rate decreases and lost business.
- Risk Management revenue declined 2% in both periods; organic fees fell 3% in Q2 and 4% for the first half. Lower claim counts and lost business were partly offset by new business. Corporate first-half revenue included $65.1m from clean-coal activities, against $64.0m of related cost of revenue.
Cash flow, balance sheet and debt
- First-half operating cash flow was $89.6m, versus $77.6m in 2009; continuing-operations operating cash flow was $90.6m versus $76.6m. Management cited improved receivable collections and cautioned that seasonal premium receivables, payables and restricted cash can cause substantial period-to-period variation.
- Cash and cash equivalents were $230.0m at June 30, up from $205.9m at year-end. Restricted cash was a further $566.0m and is not freely available for general liquidity needs. Total assets were $3.56bn and stockholders’ equity $965.4m.
- Debt was $550.0m, all under fixed-rate private-placement notes (5.85%–6.44%); no revolver borrowings were outstanding. The notes’ estimated fair value was $602.7m. On July 15, the company replaced its $450m revolving facility with a $500m unsecured facility maturing in 2014; $484m was available after outstanding letters of credit. The company reported compliance with debt covenants.
- First-half investing cash outflow was $24.8m, including $25.0m for acquisitions; financing outflow was $40.7m, including $65.9m of dividends paid. The declared dividend was $0.32 per share per quarter.
Material changes, outlook and risks
- Gallagher completed eight acquisitions in the first half for a recorded purchase price of $52.4m; acquired businesses had approximately $44.2m of annualized revenue. Acquisition-related goodwill and amortizable intangibles increased, and $2.3m of Brokerage intangible assets was written off after impairment reviews.
- Supplemental and contingent commissions rose sharply as reported, but comparisons were affected by timing: carrier information increasingly allowed quarterly recognition, while earlier periods often recognized supplemental commissions annually. Management expected approximately $9m–$11m of supplemental commissions per quarter for the remaining two quarters of 2010 and each quarter of 2011, assuming market conditions continued.
- The property/casualty market remained soft; industry surveys cited a 6.4% average commercial premium decline in Q2. Gallagher said recession-related reductions in client exposures and coverage could continue to weigh on revenue. Management nevertheless expected pretax earnings growth over the foreseeable future, supported by organic growth and acquisitions; no consolidated numerical earnings or revenue guidance was provided.
- Management estimated clean-coal activities could generate $5m–$7m of net earnings for the remainder of 2010 under temporary permits and potentially up to $10m quarterly from 2011–2019 after permits and other conditions are met. This is highly conditional: permitting, operating performance, tax-credit qualification, regulation, utility demand, partners and intellectual-property protection are material uncertainties.
- Notable costs included a $3.5m litigation settlement in operating expenses and $2.3m of intangible-asset impairment. Q2 discontinued-operations earnings of $2.1m arose from reversing part of a 2008 lease-abandonment charge. The consolidated effective tax rate was 34.4% in Q2 and 33.4% for the first half, partly reflecting expected Section 45 clean-coal tax credits.
- Contingencies include $70.5m recorded against maximum earnouts of $160.4m for 2009–2010 acquisitions, plus $207.6m of maximum unrecorded earnouts for 2006–2008 acquisitions. Potential payments under tax-credit indemnities were approximately $210m, net of applicable tax benefit; the company also reported exposure on $155.3m of previously earned credits. Unrecognized tax benefits were $42.8m. Gallagher also disclosed unresolved litigation and uncertainty in its errors-and-omissions reserves.
Most important facts for investors to verify
- Whether underlying Brokerage and Risk Management trends stabilize, given continued organic declines, soft insurance pricing and weaker claim volumes.
- How much reported revenue and earnings growth depends on clean-coal consolidation, tax credits and commission-recognition timing—and whether clean-coal permits and tax-credit eligibility are secured.
- Whether acquisition earnouts, integration costs and acquired intangible assets lead to further cash requirements, expense or impairment.
- The potential outcome and financial exposure from tax-credit indemnities, tax examinations, litigation and E&O claims.
- Liquidity after separating unrestricted cash from fiduciary/restricted funds, and the effect of dividends, seasonal working capital and acquisitions on cash generation.