Arthur J. Gallagher & Co. (AJG) 2003 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Arthur J. Gallagher & Co. third quarter 2003 earnings conference call. (OPERATOR INSTRUCTIONS) It is important to note that some of the comments made by Arthur J. Gallagher & Co. today may constitute forward-looking statements within the meaning of the securities laws and are subject to certain factors and risks described in their filings with the Securities and Exchange Commission, which may cause actual results to differ materially.

It is now my pleasure to hand the floor over to your host, J. Patrick Gallagher, President and CEO of Arthur J. Gallagher & Co. Sir, the floor is yours.

Thank you, Maria, and good morning all.

Thank you for coming and welcome to our conference call.

I am joined this morning by Doug Howell, our Chief Financial Officer;

John Rosengren, our General Counsel;

Rich Cary, our Chief Accounting Officer, Jack Lazzaro, our Treasurer and Chief Financial Officer of Arthur J. Gallagher Financial Services;

Jim Gault, the President of our Brokerage Services Division Retail Operation;

Dave McGurn, the President of our Specialty Marketing and International, which is our wholesale reinsurance and international operation; and Rich McKenna, the president of Gallagher Bassett Services.

In keeping with our past tradition, we will not read from the press release.

I will make some comments about the quarter, some highlights.

I will be followed by Doug Howell with some comments, and hopefully anticipating some of your questions and answers.

Then I have asked Rich McKenna to address the group about our risk management segment.

This segment is primarily comprised of Gallagher Bassett Services, our property casualty third party administrative firm.

And GBS has had an outstanding quarter, an outstanding nine months, and I have asked Rich to add a little color to that.

So then let me start with a few points on the quarter.

First and foremost, let me start with the fact that I am absolutely thrilled with the progress we have made in the quarter.

We're stronger in every place in the Company today then we were 90 days ago, or then we were at the start of the year.

Our third quarter turned out exactly as we were hoping.

In '02 I explained our strategy and the time I thought it would take to play out.

New business is strong.

Our 9 percent organic growth in a moderating market is fantastic.

And I will comment on that.

The PC growth alone, not including benefits, growth and wholesale growth was better than the 9 percent.

Our organic growth in just the PC retail operation was over 12 percent.

This is a direct reflection of our sales and service culture, which I think is a true key to our success.

We all know around Gallagher that nothing happens until somebody sells something.

The market is moderating, and what do I mean by this?

Property, especially large catastrophe exposed accounts, are definitely flat to down.

Competition is heating up in the middle market.

In earlier conference calls, I mentioned that I thought by 2004 we will begin to see what I called rifle shots, or laser shots.

And by that I meant that in a rising market, a very hard market, all accounts were going up substantially, some beyond what was reasonable.

So as an example, if we had an account that was probably under priced at 300,000, today that price at somewhere close to 1 million might not make any sense.

Now our underwriting companies absolutely, no.

They are very clear on this that they have to have low combined ratios, somewhere in the low 90s to have any real return on equity.

But that doesn't mean that an account that is overpriced can't give them a very good underwriting profit.

And they do -- and they will look at those and underwrite specifically.

So the account that was $300,000 that is now 1 million might be a great write at 700,000 and the market will take the account down below the expiring price.

Again, it does not mean there is a lack of discipline.

The general feel of the market is still one of improvement.

We still are seeing rate growth.

In particular excess casualty, and certain state's workers compensation, medical malpractice and other tough lines are still going up.

Again, all of our major markets have told us that they will be seeking additional rate in '04, at least, at the very least, to cover lost cost inflation.

And we're seeing no lack of discipline when it comes to that in the marketplace.

Now a key concern for our customers right now is carrier solvency.

With the Royal (ph) the departing United States, and Kemper disappearing, this whole aspect of a carrier not being around to meet its obligations is once again been raised.

So the higher quality, and by that I mean the more highly rated carriers, are getting more opportunities from us and from the marketplace.

Nothing is more expensive for one of our customers than to pay for insurance that ultimately can't pay the losses.

So how does this market impact us?

What do we expect of ourselves?

What should you expect of us?

Even though the rate of growth is down from '02, this is a great market for us, in particular as retailers and wholesalers.

We know that whenever the markets are in flux we do extremely well.

That is when our clients need guidance, and that is when if you have an aggressive sales team, you can truly flourish.

So we're very pleased with the quarter.

Growth continues to be what we're all about.

Just consider this over the last two years, if you just take the brokerage and risk management segment, and in the press lease and at our website we've given you, I believe, eleven quarters, so you can actually look back quarter by quarter.

But nine months from '01 compared to nine months of '03 in the brokerage and risk management segments, our revenue growth is $244 million, or up 40 percent.

Our pretax profits have grown over $42 million, or 38 percent.

We think that is outstanding and do believe we can continue the trend.

Our risk management segment has had an outstanding nine months.

A 16 percent organic growth in the quarter is fantastic, fourteen percent year-to-date.

All of this growth is organic.

And I believe this really speaks to the quality that we bring to the marketplace, as does the client retention we have, which is outstanding.

Rich McKenna will comment on that a little bit later in the conference call.

The Company continues to be a veritable cash machine.

Through nine months we have purchased over $51 million of our own stock back.

We have paid $46 million in dividends.

That is almost $100 million in nine months returned to our owners.

And we have maintained a balance sheet with over $400 million of tangible net worth.

All in all, an outstanding quarter.

Organic growth in the brokerage area of 9 percent, again I mentioned retail is stronger than that.

Our growth brokerage net income year-over-year, up 25 percent; risk management pretax, up 74 percent for the quarter.

We're thrilled with those results, and hope that our owners are as well.

With that I will turn it over to Doug Howell for some comments on the financials.

Thanks, Pat, and good morning to everyone.

As an administrative note, we intend on filing our 10-Q this Thursday or Friday.

And like Pat said, we have an 11 quarter sequential view posted on our website, which help most of you with your models.

I would like to provide some commentary on six items that may help answer some questions that typically arise.

First, let me add the past comments on cash.

In addition to using 46 million to pay dividends and 51 million to buy back stock, in the first nine months we had 18 million for capital expenditures and 25 million to pay off all of our corporate debt.

And we used $4 million dollars in acquisitions.

Also I think is important to highlight that in the first nine months of 2003 our brokerage and risk management segments generated $1.43 of cash earnings per share as compared to $1.23 of GAAP reported EPS.

That is 20 cents of additional cash EPS.

Finally, on cash and liquidity, we have no outstanding debt for general corporate purposes.

And recall in late July, we consummated a new $250 million line of credit.

My second point I want to provide some numbers that for those of you that typically track contingent commission activity and their impact on our growth.

In the third quarter of '03 we had $4.2 million worth of contingents versus 3.7 million in the third quarter of '02.

So if you do the math with or without contingents, our growth rate in the brokerage segment was 12 percent either way.

For the first nine months of '03 contingents were 24 million versus 18 million in the same period of '02.

Again with or without contingents, our growth rate is about 16 percent year-to-date.

Next I would like to provide an update on our syn fuel tax credit.

You probably noticed that our effective tax rate for the quarter was 24 percent.

This is a point lower than previous quarters because we sold more sinkhole (ph).

But as a result, financial services segment had slightly more pretax expense.

Despite a small loss in the financial services segments, we're encouraged by the increased production and lower tax rates.

Now concerning the status of the IRS review on the syn fuel industry, I've made some note about how we remain confident in our tax position in the private letter rulings received.

And our confidence was strong, because all along we have used some of the best tax and legal advisers.

We use highly qualified technical experts.

We have excellent independent testing facilities.

And we have administered a robust quality assurance and compliance process.

We have coordinated a revenue agent review that has yet to produce any adjustments or proposed actions by the service.

We have worked closely with industry groups in Washington D.C.

All of these things kept our confidence very high.

Now, I don't know if many of you have seen this, but there was early morning news that the IRS' national office will not take any adverse action regarding the private letter ruling related to Progress Energy.

We're just thrilled about this.

We think this is an indication that our credits are strong, and that we remain confident in them.

Right now it is difficult for us to assess at this time how the development will impact our ability to monetized future projects.

So for the time being, we will continue to monitor monetized our older projects, and we plan to complete our in process projects.

If we can monetized them, we will.

If not, we will use them for our own accounts.

If we use them for our own accounts, this means that for the entire year of 2004 our financial services segment should break even overall, and our overall tax rate will again be in the mid-20s.

However, we're still working with our partners on quarterly production schedules, which will show us how pretax production expenses and tax credits will play out on a quarter by quarter basis.

I am going to repeat myself here, because it is a lot of information.

For 2004, if you assume that we have a mid 20s effective tax rate, because we're bringing forth (ph) for own accounts, then you should assume the financial services segment will break even on a pretax basis.

My fourth comment relates to FIN 46, which we implemented in the third quarter.

Although eleventh hour actions by the FASB would allow us to differ implementation of FIN 46 until the end of the year, we're done with our analysis, and we have elected to early adopt the new accounting standard.

In the end, truthfully, implementing FIN 46 was a big nothing for Gallagher.

We only needed to consolidate one of our core partnerships within our financial services segment.

You can see the impact on our press release, a gross up 21 million in both revenues and expenses, and a gross up on the balance sheet of about 34 million.

Here's what you should glean from that information.

First, FIN 46 do not have impact on Gallagher's net income or stockholders equity.

Second, the balance sheet gross up is found mostly in fixed assets and other liabilities.

Third, this gross up did not put any additional debt in Gallagher's books.

Most all of the liability line relates to minority interest, because this partnership is only owned by 5 percent by us and 95 percent by external parties.

Fourth, Gallagher's exposure to loss is no different today that it was before.

We are, and were, only exposed to our net carrying value, and not to the total amount of assets or liabilities.

Finally, we're pleased that FIN 46 is behind us, but the accounting world continues to wrestle with this new accounting standard either, and there could be additional guidance in the future that may result in a different presentation.

Fifth, a few words on our acquisition strategy.

Our team has had the discipline to avoid deals that are too big or too expensive, or worse yet, the wrong fit.

We are in this business for the long haul, and we will pay a fair price for merger partners if we see the deal over the long-term win-win for both.

But we do have a duty to our current and future stockholders not to overpay for the wrong deal.

That said, we believe the deal market will likely return to more reasonable pricing, and we intend to be active acquirers, but they won't be too big, too expensive are the wrong fit.

My fifth and final comment relates to 2004.

I know that most of you are beginning to work on your models, so here are some thoughts for you -- or one thought for you.

Please remember that our brokerage segment has significant seasonality.

Accordingly, when you build your models for brokerage, we strongly encourage you to do it by quarters.

For assistance, please refer to the 11 quarter sequential view that we posted on our website.

It should come as no surprise to any one that, historically, our margins have been lower in the first and second quarters than they are in the third fourth quarters.

Those are my six comments.

Back to you, Pat.

Thanks, Doug.

Now I would like Rich McKenna, President of Gallagher Bassett Services to make just a few comments on GB.

You'll remember that '02 was tough for Gallagher Bassett.

Our claim counts dropped significantly after the 9/11 disaster.

Rich and his team have done an outstanding job of selling and servicing their way out of that hole, and I would like him to add to some color to that.

Rich?

Thanks, Pat.

As Pat mentioned earlier in his remarks, the Gallagher Bassett has enjoyed a very good financial performance year to date '03.

Our numbers are continuing within the risk management services segment of our reporting.

Our new business sales production in '03 has already exceeded the prior annual records for annual sales.

And this, combined with the existing client renewals which are very strong, has given us revenue growth for Gallagher Bassett year to date of about 16 percent.

Our revenues come primarily from claims management activities in the TPA sector.

Ninety percent of our business is North American-based.

And 10 percent of it is coming from our international operations.

We have claims furnishings in the UK and Australia, and all are reporting a growth in revenues and pretax profit.

We are very positive about our market.

We're very positive about our position in the market and the direction of it.

For any TPA one of the prime indicators of strength is the claim count.

How may claims are coming in the door?

How many assignments are arising in any day, week, month or year?

Pat has mentioned in prior communications, and he just alluded to it as well, about the effect of the 9/11 recession.

It affected our client base directly.

And all of the clients that were affected by the 9/11 recession are returning to vitality as we speak.

We have a diverse book of business, but we have significant sector components such as hotel chains, airlines, truckers, and fast food retailers.

All of these people were directly impacted by 9/11.

To illustrate that point using claim counts, in August of '01, the last full month before the 9/11 tragedy, our clients sent us 39,000 claims to handle.

By December of '01 that number had dropped to 27,000, and that was the low point.

Throughout '02 those counts steadily improved.

And now in '03, we're receiving an average of 43,000 claims per month.

We project we will receive, set up and handle 500,000 claims in '03, which is up 15 percent from the claim count in '02, and up about 23 percent from the claim count in '01.

Throughout the hard market we have seen significant growth in our captive business, and this is a point that we want to stress.

We have contracts to handle claims and loss control services for a number of large captives.

And these captives have seen tremendous growth as good insurance risk migrate from traditional insurance and enter the alternative market.

And this is good for us, because companies which are good risks generally do not abandon the alternative market once they form or join a captive.

They generally realize that they have much greater control of their risk when they are, in fact, their own insurer.

This is a positive for Gallagher and Gallagher Bassett, even if the P&C market should soften sometime in the future.

One font final point, if I could.

In May of 2000, GB, Gallagher Bassett, introduced riskfacts.com (ph), which is an Internet-based inquiry product wherein our clients have complete access to their claims data on a real-time basis, 24 hours a today, 365 days a year.

This has proven to be a very successful innovation.

We now have 7,300 licensed client users.

And last month there were nearly 13 million page viewings in riskfacts.com.

Our clients have embraced this product, and they use it to fulfill their data information needs.

Riskfacts is a very successful application and we continue to enhance it to the benefit of our clients.

Thanks, Rich.

An outstanding quarter.

I mentioned earlier that we have always viewed ourselves as a growth Company.

I believe over 20 years we have proved that as second to none.

We have taken this Company from a $59 million market cap at the end of '84 to over $2.4 billion.

We have grown our operating revenues in the last two years through nine months over 40 percent.

And growth is the focus that we will maintain and that we will always have.

Our merger pipeline is strong.

Doug alluded to the fact that we have been cautious in doing deals, but this pipeline itself is very, very strong.

Our sales culture, the culture of the Company is strong.

Together, our niche marketing is working terrifically.

Our retail operation is up over 12 percent organically.

We remain strong in the alternative risk transfer market, both as a TPA and as a broker.

I believe we have assembled a team that is second to none in the marketplace.

We have a relentless pursuit of growth, and I think that bodes well for the next quarter, as well as for many years to come.

And I would now like to turn this over to questions and answers.

Maria?

(OPERATOR INSTRUCTIONS) Allison Jacobowitz, Merrill Lynch.

I'm going to attempt this anyway, even though I know you don't typically -- it is not your policy to give these kinds of answers, but I am going to try.

I was looking at my model on the brokerage segment, and I hear what you are saying about the sequential margins for this segment.

And if I remember correctly at some point a while back you said your goal was a 52 to 53 percent compensation ratio as a percentage of commissions and fees.

So working with those two facts, should we expect to see maybe the first and second quarter above that 52 to 53 percent range?

And maybe the third and the fourth quarter closer in that goal?

Or is there any way you can maybe put a tighter comment around that?

I will start, Allison.

This is Pat.

I will comment on it, and Doug can pipe in if he wants.

I think you're reading it exactly right.

You're going to see a higher compensation ratio in Q1 and 2, because if you look at those quarters, you'll see that we come into those quarters with pretty much fixed expenses, primarily in salary and fringes, and have lower revenue bases in those quarters.

Our larger quarters seasonally are the third and fourth quarter.

And if you recall, what I said over a year ago is that I believe that we could get to 52 or 53 percent, salary and fringe to revenue by the fourth quarter of this year on a quarterly basis.

So in essence, we made that about a quarter early.

Now next year you do have to do your models, and we're not going to do this for you.

And we're not going to give you strict guidance.

Doug has given you guidance on the financial services.

But next year salary and fringes percents will be higher than Q4 in and Q1 and 2.

Nick Siskin (ph), Stevens Inc.

Can you walk us through -- given the favorable news out of progress -- can you walk us through what facilities you have left to sell, and quantify the size of them?

And then comment on the market to monetized them, and give us an idea of what you can get for them.

We have said all along that we have five facilities right now that we currently monetize.

We told you that we added another one really in the late or in the early second quarter, so that got us to six.

There are a couple of other ones that we working on that we have arrangements with.

So that adds a couple more.

When it comes to the actual capacity of the plants, that is not something I'm comfortable in discussing right now.

Second of all, this news came out an hour and a half ago with regard to the IRS's actions with respect to Progress, and we would like to have little time to digest this and figure out what exactly it means to us.

We have always been confident in our credits and our plants and our testing facilities, but give us some time to digest exactly what is means.

I can't predict right now how much of interest there will be from other parties to jump into this credit opportunity at this time.

But for our case, we have more than enough capacity to burn for our own account that should keep our tax rate down in the mid-20s next year.

Is it safe to say though that the market has been pretty stagnant, i.e., there haven't been anybody monetizing over the last, say, a 3, 6 months giving you a Progress issue?

Yes, Nick, that is very safe to say.

On the new hires, you had given us some information last quarter that they added 41 million, and it ran a small profit.

Can you give us an update on how that went in the third quarter?

I will let Jim Gault comment on the new hires because these are primarily Brokerage Services new hires and retail salespeople.

We track them quarter by quarter.

And first quarter this year we lost a little bit.

We made a little bit the second quarter, and third quarter our numbers show that they nicely turned into the black just as we had predicted a year ago.

We felt that on average they would have been on board for anywhere from a year and a half to two years by now, which is what we felt it would take for them to turn the corner, since most of them have non-compete contracts, and it takes at least that long to rebuild a book of business and to be in a profit position.

Jim Gault Is that expected to continue to improve?

Yes, those people still, I believe, have more capacity.

They're not all -- not all of them have turned the corner, but as a group they have.

Jim Gault So if I look in following Allison's question, Q4 comps should probably go down on a sequential basis?

Well, we haven't given any guidance on that, Nick.

I said a year ago that I really hoped by Q4 this year that with the new hires on board and everybody else, we would still be somewhere around 53 to 52 percent, and I will stand by that.

Jeff Thompson of KBW Inc.

Very good quarter.

Thank you very much.

We are pleased with it.

I had a question.

Your comments on midmarket pricing, you said you are seeing more of a slowdown.

Can you quantify that a little for us?

I don't have an actual rate quantification.

Here's what we see.

In general terms pricing is still going up.

And we measure this every month in most of our branches.

And you are talking about midmarket right now?

Midmarket.

It is still going up.

What you're seeing creep into the market is from time to time, and we're telling our people that they have got to be very close to their clients.

They've got to control the renewal process, because they are the ones, our people are the ones who should now if there is a juicy midmarket account that should not be getting a renewal increase.

They've got to be the ones that go into the market and make sure that we get sure we get the client what the client deserves.

Now this is not, this is not a soft market comment, Jeff.

I mean we're not having companies in here saying, roll the book and we will do it for 20 percent less, and we will pave a bonus on top of it.

That is not happening.

But you do have accounts, as I mentioned in my comments, that maybe we're paying 300,000 in '00, which was ridiculously low, paying $1 million today that have very good track record.

These companies can make a ton of money at 700,000.

And they will plumb a little bit to find out where that price should be.

Now what they won't do is take the thing to 400,000 when all along it should have been at least 500,000.

As when we talked about how the rates were going up, I'm not going to sit here and say rates are going down 4 percent, because rates are not going down.

Rates are still going up.

Okay.

That helps.

And then just a follow-up on the synthetic fuels tax credits.

It for some reason you can't sell (technical difficulty) If for some reason you can't sell them, can you use the tax credit yourself, or are you overproducing for that?

No.

In answer to that, yes and no.

We're not overproducing.

We will not overproduce.

We will always run a little bit short so we don't overproduce.

But we do have capacity to produce more than what we need.

So if you can't sell them, can we expect the tax rate to go down more, or how should we look at that?

I think right now, our objective right now is to try to produce enough to keep our tax rate at the 25 percent rate, in the mid-20s range someplace.

And if we can monetize, then we will, but we will put another one online and try to keep our rate down.

Some of this is a little bit of a sequencing issue.

If I get a plant online and then somebody immediately wants to monetized it, I will go ahead and do that.

And that may cause our tax rate to jump up a little more until we get another plant online.

Erin Braun (ph), Willow Creek Capital.

Actually it is Marcelo Visio with Willow Creek.

Can you just comment on your litigation with Headwaters (ph) and what your potential total liability would be if you have an adverse ruling?

Thanks.

I will let John Rosengren comment.

We are still working that litigation.

We would really don't have any quantification of the exposure that we can discuss with you at this time, because litigation is still so flexible.

And I would say developments -- but we continue to be confident in our position in the case.

But we really haven't gone into and really can't go into quantification of the amounts that are in controversy.

And it all ties again into syn fuel and production, so it is a very flexible influx kind of situation that we would have to evaluate.

Does the ruling for progress this morning -- if Headwaters can go ahead and produce synthetic fuel, does that help their case or does that harm their case?

I really don't see any connection between those two.

There is no amount at all that you can bracket for us for potential --?

I'm sorry, I really can't.

Bob Glasspiegel, Langen McAlenney.

Two questions, one brokerage and one on financial services.

On the brokerage side, you were able to get to your compensation expense ratio target, I guess, earlier -- actually it was below 52.

I get 51 8 this quarter -- with only "9 percent commission growth".

12 percent commission growth.

Right.

Organic.

We grew 12 percent.

Right.

How are you able to achieve faster than expected progress there with much slower revenue growth?

I think that, first of all, we mentioned to everybody in the third quarter last year that we had hired up, and that we were going to be very cautious about continuing to hire.

And in the brokerage sector we have a few less bodies with us today than we had one year ago.

Jim Gault, Dave McGurn, and their respective team teams have done a great job.

As I mentioned when we hired 550 people, I would very much like to say that we hired 558 players.

And that is probably never going to be the case.

So there has been some rationalization.

People that didn't make it along the way, we measured that and track it.

We have no bones about -- make no bones about saying, if you're not cutting it, we will help you to another home.

And by the same token, many of those people that came on, and many of the people that are already here have just an outstanding job of selling.

So we have been very cautious in replacing and adding people.

That is the bottom line.

Okay.

Just from the guidance, Doug, maybe for you on financial services, you are suggesting breakeven in financial services with a mid-20 tax rate.

This quarter we lost a little bit, but you said you produced more.

Are you saying that your guidance assumes less robust production in the fourth quarter level?

And I guess, if you continue with the fourth quarter rate, would that be sort of losses for financial services and lower tax rates?

Is that the right dynamics?

I think that, Bob, we should be pretty close to breakeven in the fourth quarter in financial services.

And we should have a tax rate somewhere around 24 to 25 percent in the third production level.

If we get a little more production, it will be closer to 24.

If we get a little less, it will be closer to 25.

And the expenses will move around a little bit.

Some of our expenses are also dependent on transportation costs to get the coal there.

There are a couple of mines that went out of business in Kentucky, and we had to bring coal in from a little further away.

So that causes some of our costs to go up.

But overall, mid-20s and about breakeven is pretty close to where we will be.

So close to breakeven?

So a small loss, is that what you said?

Yes, Bob.

The vagaries of the weather and the cost of the transportation fuel, I can't predict it within a penny.

The third quarter is sort of a good run rate into looking into the future, is what you're saying?

No, I think what we're saying, Bob, is go breakeven with a 25 percent tax rate.

Okay.

Close to breakeven, you said?

I couldn't hear you?

I said go with breakeven, Bob.

Go with breakeven.

Okay, thank you.

Jay Gelb, Prudential Equity Group.

I was hoping you could delve in a little deeper on the organic growth trend in brokerage.

When you were on the last call, it seemed that you were looking for perhaps the low teens brokerage organic growth rate, and 9 percent is clearly below that.

So I'm trying to get a better feel of what happened over the course of the quarter?

Let me try to address that.

And we're not going to break these out.

We have our segments, and you know what is in those segments.

But in the brokerage segment we have really have three businesses.

We have our property casualty retail operation, which are our branch offices around the country.

They are very focused on the niches and our general production of retail accounts.

We've got our specialty marketing operation, which is all wholesaling, reinsurance, and our international brokerage operations, including Bermuda and London.

And then we also have our benefits brokerage operation, which is a smaller piece of the pie, but clearly a piece of the pie.

If you look at those three, and again I'm not going to give you specific numbers because we're not going to break out segments within segments, our retail property casualty brokerage operation was nicely over 12 percent in organic growth.

We've had an outstanding nine months.

We've had some shortfall on the reinsurance side, primarily due to two large programs that were simply not renewed.

I won't tell you the carriers.

I won't tell you the programs, but they were very meaningful to us.

And the carriers in each case just decided to take the risk themselves.

We also have not as robust a growth in our London operation.

So when you add it altogether the segment grew 9 percent organically.

But from the perspective of looking at the various businesses, I couldn't be happier with what I see.

We would have had great results in reinsurance if we had just renewed those two accounts.

London, I believe, is kind of a timing issue.

But the PC retail business, which is really our largest core business, is just performing at an outstanding level.

So that 9 percent, is that a good run rate?

Given your comments, and my understanding, that we are in the back half of a hard market, is it reasonable to say that it is going to be tough for that to go up from here from 9 percent?

I think that is reasonable.

Okay.

With regard to brokerage on the margin side, you said that nine months the pretax margin was about 19 percent.

Any feeling in terms of whether you can -- where that is headed from here directionally?

Now wait a minute.

If you take a look at the segment that we reported, our pretax profit margin for three months in the quarter ended was 24 percent.

I was talking about the nine months.

Talking about which?

The nine months.

I'm sorry, nine months. 19 percent.

No, I don't have a comment specifically as to where that will go, because we haven't given any kind of guidance specifically for fourth quarter.

But I will turn over to Doug, if he wants to make a comment.

Yes, I would think I would stick with Pat's comments there.

We are always shooting to balance our growth with our investment in our people, which primarily runs through the expense line up through the capital expense line, or capital expenditure line.

And we've said all along that we want to maintain a margin in our business that is conflicting with past levels.

So we have given some thoughts on the compensation ratio.

I don't see any big bump coming out of the operating expense ratio.

So I think you guys can do the math on that, and get to what you think it is for next year.

That is helpful.

And then finally on the acquisition front, you mentioned that it looks like going forward the pricing trends may moderate a bit.

And I was just trying to get a little bit better understanding of why that may be the case?

Well, I just think -- I'm sorry, repeat the question.

Why is that the case?

Yes.

Well, if in fact rate environments are moderating, and organic growth rates are not as strong, doing the pro forma with people their expectations come online.

In terms of the competitors out there, in terms of some of the newly, more -- companies that have gone public, the brokerage companies and the banks, do you see any shifts there?

No, we really don't see any shifts.

And the banks in particular are still oftentimes what I would comment as unreasonable competition.

But you have to be a person who wants to be part of a bank.

And we kind of start or discussions right there.

If the idea here is to simply get the highest price at this moment in time -- now remember, we still prefer to use stock in our transactions.

We are trying to build a partnership here.

It is all I have got.

It is all the guys around this table have got, is this (technical difficulty).

And if you are not willing to take a big chunk of the purchase price in our diamonds, our gems, which we're going to grow and grow and grow, then you're probably not the partner for us.

So the early discussions kind of shift this out right away as to whether or not someone is going to be someone that is going to sell to a bank.

Now when you get to our other competitors, we compete with all of the smaller competitors for acquisitions.

And depending on what the situation is, what the niche the person is in, what kind of aspirations they have, those come down our way sometimes, they go to our competitors other times.

Nick Pursos, Sandler O'Neill.

Just had a couple of questions.

First, clarification on a number.

I think, Doug, you had indicated that year to date you paid $4 million for acquisitions, was that --?

We used cash of $4 million.

We use stock for the lion's share of them.

But there was $4 million of cash used in acquisitions.

Through June 30, we basically used no cash in any of the acquisitions.

Great.

And then, Pat, maybe you just gave us an update, I think, on the 550 number of hirees.

What is with the Company today?

I don't have that number off the top of my head, Nick.

OK, maybe I can call back later.

Sure.

Hugh Warns, J.P. Morgan.

Isn't it good to see that a whole $2.5 billion enterprise can get boiled down to one number?

I think I might take a different tack here.

That is a good comment.

And it is also interesting to see a $2.5 billion market cap company have everybody dying on what is going to happen in the last 90 days.

I hear you.

Is Jim Durkin there?

No, he's not.

Can someone talk about the benefits world for me for a minute.

Just overall, just trying to get an assessment on kind of what we're seeing on the benefits side.

Obviously this is a business that has been hurt from the economic situation.

I am just trying to get a sense for underwriters' appetites, markets, kind of just a broad overview of what is going on there?

You're right on, when you look about business as being a business that has been hurt over the last three years.

And it has been hurt for a number of reasons.

Primarily, the economy and the reduction of workforce has played havoc in the benefits world.

That is number one.

Number two, the price increase, or the cost increase of health care in particular is absolutely wreaking havoc on our clients.

And I know that because I am one.

And we sat down yesterday and went through the numbers, and it is absolutely appalling the rate of inflation in health care.

And that puts a squeeze on us too, because when prices are going up substantially, and as you know any ERISA plan we always have to, and we do, disclose our compensation.

So that becomes an issue in the discussion.

Now we're also trusted advisers that the people need us because it is very complicated to work plan design.

The cost to the employer is a function of how much cost shifting goes to the employee, and how much -- and that is generated not just by contribution by the employee, but also by the design itself, the plan design.

So you're working both sides of the scale.

So there has been tremendous pressure on that business in terms of its growth rate over the last two years.

Now why I am so bullish on the business is, I think it is the sweet spot of America's biggest problem after the war on terror.

This is going to be huge election issue.

I don't think people are even seeing it, it hasn't surfaced at.

We've got millions of people uninsured in this country.

That is a problem, but the inflation rate in this thing is absolutely crazy.

Have you started to see any early signs of any recovery in that business?

I mean it has been a tough business for about a year and a half.

No, I haven't.

Because I guess we are all kind of just trying to wait-and-see.

And it seems likely we need more on the job creation side.

I don't think there's any doubt.

What is going to help that business is two things that have always helped it.

You have to have job creation.

And frankly, you have got to have a little bit of inflation.

And not just cost inflation in the price of health insurance or in the service health insurance, you have got to have price inflation in employee payrolls and things like that.

Not is this a situation where for the ERISA plans, where you have to disclose your fee, is that a lot more pressure on your fee, because you are seeing a 12 percent increase in the cost of these benefits on average?

Absolutely, yes.

All right.

Good enough.

I think you answered my question on Woods (ph).

It sounded like it was decent except for a couple of large programs.

Yes.

That has been won the best acquisitions we've ever done.

It is has put us in a place that we simply weren't before the acquisition, with the ability to talk now to our retail insurance market about the fact that we do offer professional reinsurance broking skills.

And we believe that if we are going to be growing partners putting retail premium into the system, we ought to be growing partners taking retail -- taking reinsurance placements out the backside.

And by the way we're getting very good reception from our markets on that.

It is like anything, the market wants choice.

Even in -- with the two nonrenewals, you still had positive organic growth there?

Yes.

Absolutely.

I know we talked about this a lot, but use of cash.

Obviously, you bought back a lot of stock in the quarter.

And, Doug, I will call you off-line get your average cost for some of these historical things to go backwards to help me out.

But trying to think of the cash side, you're still toning down on the investment portfolio.

You are starting to buy back more stock.

Is the buy back of the stock simply because the private guys multiples are still outrageous?

Is that the way you're looking at this?

No.

Here's how we're looking at it and then Doug can jump in.

We've said all along we want a strong balance sheet.

We believe we have built, over the last 20 years, one of the strongest balance sheets in the business.

And we do understand that there are people out there that would like us to lever up, to be more efficient, blah, blah, blah.

We're not doing that.

We've got $400 million in tangible net worth and that gives us a tremendous amount of protection as an enterprise.

It also gives us the cash we need at some point in time if there is one of our larger competitors that comes available for sale, I want to have the cash to move and that doesn't mean we're looking to do a big deal, but there are properties out there that have historically never been for sale.

Most of you know the names -- I won't give them to you -- that we would love to talk to about joining our Company.

Having said that, we believe that $400 million is plenty.

And we generate a boatload of cash which we will do three things with the cash.

First and foremost we do use cash and acquisitions, albeit we would like to use as little as possible because we want people holding the stock; we want them to be our partners.

So we will put stock out.

That dilutes shareholders.

We buy that stock back in.

And then we have excess cash for additional buybacks with dividends.

Was there anything, Doug, in the quarter from the share side, from the diluted shares outstanding outside of the M&A?

Was there any employee stock purchase programs or something that would have diluted the large buy back you're just completed?

Well, we have our annual option grant and that occurs in July that would have put out more options.

But remember, we have a ten-year vesting on our options here.

It is not like a three-year vesting like most companies.

So the amount of dilution that that produces is not all that big.

We did have the price escalated this quarter slightly.

So that produces some dilution.

But basically there is nothing remarkable that would have caused our out of pattern that causes the initiative to stop.

I might comment to you while I have got you that a big use of that, I should've been a little stronger on this, a big use of that cash is for dividends.

We've got a great dividend paid track record.

And we're not paying anywhere near 50 percent of our earnings.

And we've got a lot of room to keep that dividend moving, and we intend to do that.

Stephen Calios (ph), Dreyfus.

I'm wondering if we could talk in a little more detail within the Brokerage Services.

And without giving numbers that you don't want to give, can we talk about any differences that you are seeing in your growth opportunities, sort of small account, mid-account, larger accounts, since you do play across that spectrum?

I will let Jim touch on that.

Differences in -- I'm not sure I understand the question?

Differences compared to why?

Really looking at what your growth opportunities are, both in terms of units available and, of course, pricing.

We have heard from some of the smaller brokers like the Brown and Browns and Hillbrooks (indiscernible) of the world have had very weak organic growth.

And Marshall McClinton (ph) on the larger account side has had stronger organic growth.

And you guys play sort across the spectrum, so I think it would be interesting to hear from you whether you're seeing differences in rates and/or organic growth opportunities within those different size ranges?

Let me take a whack at that, Steven.

This is Pat here.

Where we are seeing I think our greatest opportunity has been the mid strategy that we rolled out about three or four years ago.

And there are now about 22 specific niches, or client categories if you will, that we believe we are stronger than anybody.

And these are primarily middle market.

And we define middle market as being, say, 25,000 in commission income all the way up to $1 million in commission income, or maybe up to 400, 500,000 in total revenue to the brokerage unit.

And this has been the something that I think has really given us a leg up on the competition, because the culture that we have been able to maintain truly does allow us to work across the profit center silos.

We still maintain silos.

The branches are profit centers.

But within the niche, each niche has a managing director, who has authority and responsibility that cuts across all the silos.

It is matrix management approach, which is typically very difficult for brokers to do.

We have been lucky.

And the fact that we have been lucky with this, and that it has worked so well has added fuel to the fire.

So we end up getting stronger in the niche by virtue of the fact that we are adding more people.

That helps us with our acquisitions.

It helps us with new accounts.

And we find that these areas, these 21 or 22 are in fact growing faster than our general book of business.

Now on our general book of business, if you do it by item count, and you're right, we play across the entire spectrum.

We do very, very large accounts, and we do them very well in competition with our larger competitors.

And we do accounts all the way down into the low middle market.

The average account probably that we write in any given branch averages 15 to 20,000 in new commissions.

Those accounts, it is slog it out in the field every single day.

And basically I would say that the middle market is where you're going to compete most of the time.

The large account market is still more difficult right now.

There is no doubt about it.

You can see that in Marsh's (ph) numbers, to some degree in our numbers.

It is still difficult when you got huge risk management accounts.

There just aren't a lot of players out there to take these risks.

When you start -- you get done naming AIG, Ace, Travelers, St. Paul, Fireman's Fund, CNA you're running out of names.

And I don't know if that answers your question or not.

It does.

Just to clarify, when you said large account market difficult, you meant difficult to place -- pricing is tough?

Yes.

I just wanted to make sure.

Thanks, Pat.

That was very helpful.

(OPERATOR INSTRUCTIONS) John Francois Trimble (ph), Credit Suisse First Boston.

I have got a question regarding FIN 46.

And I'm sorry if it was addressed.

I was in (indiscernible) during the call.

Now you have consolidated one of your partnerships.

If we look back maybe six months ago, looking at the definition of balance sheet entities, we could have anticipated more partnerships to be consummated.

So I would like first to understand your process.

And also I would like to now to what extent can we be sure that the story is over with FIN 46?

Have you done all the consolidations that you think you're going to have to do, or is there some more coming for you yet?

Here's the answer to that.

First of all, as you know, we invest in low income housing projects.

And initially low income housing projects were going to be subject to FIN 46 in a manner that we thought may end up on our financial statement.

There was clarification that came out of the accounting guidance that after the first quarter of this year, sometime in the summer, that took those low income housing projects out of consideration for consolidation accounting.

It doesn't mean all of them, but certainly the ones we have and the way that we own pieces of it, it didn't require those to be consolidated.

So that was one big number that was moved off our book.

The other thing too, you have to go back to understand FIN 46 and what the source of the accounting is.

It says that for -- in effect, and I am generalizing here for everybody because it is very complex, that if you have an extremely, thinly capitalized entity then you have to consider that for consolidation, if it meets some other criteria.

Well, most of our partnerships that we are in our not thinly capitalized.

So as a result, they don't qualify as a VIE.

Remember what this was trying to solve.

It was trying to solve shell companies that were basically moving debt off of a company's books, but really the entity had no substance in and by itself.

So when FIN 46 was -- when we looked at it, most of our partnerships that we have investments in, they're really not thinly capitalized.

And then for many of them we don't have the lion's share of the profits that come off of those, and therefore, we're not considered to be the consolidating entity.

So again, going back to why it is that we didn't have to consolidate so much.

First, change in some other guidance with respect to low income housing.

Second, our partnerships, the lion's share of them are not thinly capitalized.

And then third, we don't have the lion's share of the profits that come off of them, so somebody else consolidated them, not us.

So then it is over for now, so we don't have to expect more consolidations by year end?

Listen, we've had our auditors sign off on this in terms of a quarterly review.

They had not been involved with this every step along the way.

We wouldn't have implemented it, if we felt there was guidance out there that would cause a different answer.

Now that doesn't mean they're not going to change the rules in the next few months, because this is an evolving standard.

But from what we know now, I think that we're done with it.

Mark Dwelle, Ferris Baker.

Terrific quarter.

I think your strategy has been validated.

Two questions, and they really are -- they're probably mainly directed for Doug.

Related to the FIN 46, in the quarter you put up about 20 million of revenue, about 20 million of expenses.

It is that a run rate that we can expect, or was there some catch up in those numbers?

I think that is pretty close to a run rate on that property.

We only own 5 percent of that partnership, but we have to consolidate it because of the way that we did that partnership.

We receive fees that come off that, and we kind of got the lion's share of the credits that come off of that.

So even though 95 percent of it is by our partners, we end up with it on our books.

But it is pretty close to a run rate.

The second question is related to the various acquisitions both in the quarter and recently announced.

Can you give us a sense of an annualized average revenue or estimated revenue from these deals?

No.

Let me tell you why.

The one thing we are not going to do around here is get ourselves committed to a topline purchase amount in any given year.

Each one of these deals is in and of itself virtually like a marriage.

And we spend a lot of time -- 99 percent of our due diligence is done on culture.

The simple fact is we're a long time dead, let's work with people we can really enjoy and do well with.

If you do that well, you keep the people engaged, even if they run into some rocky roads after the deal in terms of their business, they will fight and kill to get the thing fixed for you.

And you do well long-term.

So every deal, we're constantly looking in the marketplace from a number of different angles to get people interested in joining us.

But we have never given any guidance on an amount.

And we don't set a goal for ourselves.

We don't say, God, if we don't do $50 million this step.

The worst thing we could do is to get to the end of the quarter and do a bad deal so that we would have some sort of revenue growth that was in line with expectations.

We're not been to do that.

A maybe I phrased my question poorly.

I was really more thinking in terms of just a general size range of what has been done.

Are these one million debt dollar guys?

Are they $3 million guys?

Are they $20 million guys?

I will be glad to give you that range.

And of course, when you go to the Q you can see this.

But if you typically look at the deals we're doing, you are looking at businesses that have revenues that are anywhere from 2 to $10 million.

That is our general range.

Ira Zuckerman (ph), Nutmeg Securities.

Just for future reference, I don't know whether those figures are available, or whether you want to release it, but is there any way of getting for your brokerage segment premium price?

We have never given that number out.

We actually accumulate that by market once a year.

It is not something we ran every month or every quarter.

It is not a number that we have actually disclosed.

I don't know why we haven't, I don't know if I have been asked that before.

I don't know that it has been asked either, but it would be an interesting number for us, help us build our model a little bit.

We will consider that in our next call.

Our last question is coming from Bob Glasspiegel of Langen McAlenney.

Pat, you peaked my interest on the dividend discussion that you gave.

Over the past, I guess, 20 years you have averaged 20 percent increase in dividends.

The last five years or so, I think it has been closer to 15 percent.

But December announcement, I guess, is normally where you -- where the Board announces the increase. (multiple speakers) I'm sorry?

Those are due in January.

Yes, but you announce it in December for January, I believe.

We will announce a dividend payment in December for a January payment.

We announce any increases in the quarterly dividends after our January Board meeting.

Okay.

Well, if you were handicapping, in light of the dividend, you said you were going to look at the impact of the dividend tax changes.

Should we be looking for more than normal increases, or normal increases in light of how good things are going?

(indiscernible) normal, Bob.

I'm sorry?

It would be fair to say normal increases.

Normal increases.

Okay.

Thank you very much.

Thanks.

I think that is pretty much the time limit here.

Maria, how are we doing?

Yes, sir, it is the time limit.

All right then if that is really pretty much all the questions, I would like to thank everybody once again for coming this morning.

I think you can tell that we're excited about what is going on here.

We think that -- I appreciate the comment that our strategy has been validated.

We do believe that.

I would like to really comment on the fact that we're working very, very hard.

We've got a turned on team.

We really are looking forward to continued success.

And we do appreciate those shareholders that support us.

So thank you very much.

Maria, I guess that is it.

Thank you for your participation, ladies and gentlemen.

This does conclude today's teleconference.

You made disconnect your lines at this time, and have a wonderful day.