Arthur J. Gallagher & Co. — Q2 2019 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2019. Unaudited results; dollar amounts are in millions unless otherwise stated. Gallagher provides insurance brokerage and consulting, claims administration and risk management services. Its three segments are Brokerage, Risk Management and Corporate; Corporate includes clean-energy investments and corporate costs.
Financial performance
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Total revenue | $1,657.8 | $1,660.4 | $3,648.4 | $3,498.1 |
| Revenue before reimbursements | $1,624.8 | $1,625.0 | $3,582.3 | $3,427.9 |
| Earnings before income taxes | $105.5 | $103.6 | $427.3 | $345.9 |
| Net earnings attributable to controlling interests | $110.1 | $114.9 | $444.2 | $388.6 |
| Diluted earnings per share | $0.58 | $0.62 | $2.35 | $2.10 |
| Cash provided by operating activities | Not presented for quarter | Not presented for quarter | $419.6 | $313.3 |
- Q2 revenue was essentially flat year over year as higher brokerage revenue was offset by lower clean-coal revenue. Six-month revenue rose 4.3%; six-month earnings attributable to controlling interests increased 14.3%, while Q2 earnings attributable to controlling interests declined 4.2%.
- Brokerage Q2 revenue increased 13% to $1,131.2; organic revenue growth was 5.8%. Adjusted EBITDAC was $298.0, up 18%, with adjusted margin of 26.4% versus 25.9%. Risk Management revenue before reimbursements rose 4% to $209.1; organic growth was 3.0%. Its adjusted EBITDAC increased 4% to $36.6, while reported net earnings fell 12% to $15.5.
- For the first six months, Brokerage revenue increased 14% and organic growth was 5.8%; adjusted EBITDAC rose 16% to $769.9. Risk Management revenue before reimbursements increased 4%, organic growth was 3.5%, and reported net earnings declined 5% to $31.7.
- Q2 consolidated results included a $15.9 income-tax benefit despite pretax earnings of $105.5, largely reflecting clean-energy tax credits. Gallagher reported $136.3 of IRC Section 45 credits recognized in the first half, versus $142.2 a year earlier.
Balance sheet, cash flow and capital
- At June 30, cash and cash equivalents were $512.3, restricted cash was $2,034.3, and total assets were $19,200.3. Restricted cash is primarily fiduciary money and is not available for general corporate use.
- Total liabilities were $14,252.5 and stockholders’ equity was $4,947.8. Net corporate and other debt was $4,377.9, compared with $3,610.4 at year-end 2018; total corporate and other debt before unamortized debt costs was $4,385.3. Interest expense was $44.9 in Q2 versus $33.9, and $85.1 for the half-year versus $65.2.
- Operating cash flow increased to $419.6 from $313.3 in the first half. Investing used $732.8, including $733.9 of net cash paid for acquisitions; financing provided $620.1. Cash, cash equivalents and restricted cash together increased $309.8 to $2,546.6.
- Gallagher completed 24 acquisitions in the first half, with recorded purchase prices totaling $953.5 and estimated annualized acquired revenue of $265.7. It reported $393.4 of recorded fair value for acquisition earnout obligations, against maximum potential obligations of $732.6.
- The company declared $0.86 per common share in dividends for the half-year. Its revolving credit commitment was increased from $800 to $1,200 and extended to June 2024; $325.0 was drawn and $858.1 remained available at June 30. The company reported compliance with debt covenants.
Material changes, outlook and risks
- Reported first-half results benefited from a one-time $59.0 net gain on divestitures, including a gain equivalent to $0.17 of diluted EPS. Clean-coal revenue fell to $656.7 from $834.6 in the first half, primarily due to lower production; Q2 clean-coal revenue was $284.4 versus $422.4.
- Management expected 2019 clean-energy investments to generate $95–$110 of net earnings and anticipated positive net cash flow for 2019. It stated that these investments could generate positive net cash flow through at least 2025 if specified assumptions hold. Tax-credit eligibility substantially expires in December 2019 for 14 older plants and December 2021 for 20 other plants.
- Management expected modest increases in retail property/casualty rates and described insurance pricing as stable to modestly positive, with growing exposure units. It cited employment growth and healthcare-plan complexity as supportive of employee-benefits demand. The Q2 industry pricing survey was not yet published when the filing was prepared.
- Management forecast 2019 capital expenditures of approximately $125.0 and said acquisitions would be funded through a mix of debt, credit facilities, operating cash and/or stock. It expressed confidence in having adequate capital and access to capital for near- and long-term needs. No consolidated earnings or revenue guidance was provided in the supplied filing text.
- Key exposures include acquisition integration and earnout estimates, competition and insurance-market conditions, foreign exchange and interest rates, cybersecurity and regulatory compliance, and substantial debt. The filing also notes variability in contingent and supplemental brokerage revenue.
- Legal and tax matters include an IRS investigation of micro-captive advisory services and audits of more than 100 client captives, plus a related class action with unspecified damages. Gallagher said it could not reasonably estimate a potential loss. A patent suit filed July 17, 2019 named Gallagher, subsidiaries and Chem-Mod; the company disputed the allegations, intended to defend vigorously and considered a material loss remote. Other refined-coal patent litigation was pending, with trials scheduled for October and November 2019; an adverse outcome could affect results and tax-credit generation.
- The company retained the first $5.0 of each errors-and-omissions claim; its reserve was within the actuarial range disclosed. It also disclosed $108.0 of exposure relating to previously earned energy tax credits, with no reserve recorded.
- Gallagher adopted lease accounting in January 2019, recording right-of-use assets and lease liabilities. At June 30, right-of-use assets were $368.4 and total lease liabilities were $402.8. Management said the adoption had a de minimis earnings impact and no cash-flow impact.
Important facts for investors to verify
- Separate underlying brokerage and risk-management growth from acquisitions, divestiture gains, currency movements and clean-energy activity; adjusted and organic measures are non-GAAP.
- Assess the sustainability and timing of clean-energy earnings, tax credits and cash flows, including plant production, expiration dates, legal challenges and tax-law risks.
- Review debt maturities, interest costs, covenant headroom and the use of new borrowing to fund acquisitions; restricted cash should not be treated as freely available liquidity.
- Track acquisition integration, acquired-business performance, goodwill and intangible-asset balances, and changes in earnout estimates and payments.
- Monitor the IRS micro-captive investigation, class action, patent cases and the company’s disclosed inability to estimate certain potential losses.