Arthur J. Gallagher & Co. (AJG) 2006 Q4 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Arthur J. Gallagher & Co. year end 2006 earnings conference call. [OPERATOR INSTRUCTIONS] It is important to note that some comments made by the 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 its filings with the Securities and Exchange Commission which may cause actual results to differ materially from those expected.

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

Thank you, Tony, and good morning, everyone, and welcome to our year end conference call.

We appreciate your being here with us this morning.

This morning I'm joined by Doug Howell, our Chief Financial Officer, John Rosengren, our General Counsel, as well as our operating division heads.

As is our custom, I am not going to read our press release.

Instead what I'd like to do this morning is make comments on 2006.

In the fall of 2005, going into December and January of '06, we had committed to moving to an entirely new business model.

We are going to go transparent, we were giving up millions of dollars in contingent commissions.

It was really kind of difficult at the time to predict the outcome of these changes.

Would there be margin decreases beyond on the contingents?

People saying more transparency, more client push back, less margin.

We just weren't sure.

We were a bit apprehensive .

We prepared ourselves.

We did have a plan.

We practiced.

We knew our value proposition.

And in 2006 I believe our team really delivered.

The new compensation approach, total transparency, has not only been accepted by clients, but it's been embraced.

I've mentioned many times that we are very proud of the sales culture that we have here at Gallagher.

Our sales and account management teams did a great job in '06.

Top line growth of 10%, 6% of that organic.

Transparency has actually become a sales advantage and client retention improved in the year.

Our team really adapted, and as I said, delivered.

We also settled the federal class action lawsuit in 2006.

Remember, we came into 2006 with the industry facing numerous class action suits.

These were all more or less combined into the federal class action suit in the New Jersey jurisdiction.

This lawsuit could have had a really significant impact on our company.

First, our legal team gave me estimates of upwards of $50 million to $20 million a year in legal fees alone to defend ourselves.

Secondly we anticipated tens of thousands of man hours of effort in the defense.

Thirdly, the litigation could have taken three to four years and who knows whether we would have won or whether the industry would lose.

If the industry loses this case, and we had not settled our potential requested award could have been several times larger than the settlement that we got, and it could have been joint and several.

Someone else can't pay, we get to pay more.

It's not certain if this class will be certified.

It's not certain if the class will win.

But we wanted the certainty of this settlement.

Of course, our settlement is still subject to the court's approval.

Let me make a number of comments on our operations.

Our brokerage segment is composed of three operating divisions and each division contributed to our success in '06.

Our brokerage services division, which is our retail proper cash U.S.-based business now operates from 60 plus branches throughout the U.S.

We concentrated very hard on margin improvement in 2006 in almost everyone of our regions contributed to a higher margin.

Our niche marketing, which we believe is a strong differentiator on the street continues to prove itself as a growth driver.

We can state very clearly what we want to be in the market and who we have the expertise to handle.

Our clients love this approach.

In particular, our midwest region head quartered here in Illinois and our south central region out of Baton Rouge grew up very nicely in '06.

Gallagher Benefit Services, our employee benefits arm, had a very strong year.

Including acquisitions and excluding contingent matters, our benefits operations grew pretax profits over 30%.

Our eastern region, head quartered in Boca Raton had a great year, as did our south central region, both being up nicely.

In our wholesaling reinsurance and international business we performed well in '06.

Our London wholesale and reinsurance arms contributed to pretax growth.

This was a nice turnaround from '05.

RPS, which is risk placement services our U.S. wholesaler, which you will remember we started from scratch in 1997, now produces over $100 million of revenue and has strong operating margins.

Risk Management Partners, also based in London and focused on the U.K. public sector, grew substantially in 2006.

The brokerage results came in spite of a market that continues to soften.

In '06, postal exposed, wind exposed, or earthquake exposed property saw rate increases.

Virtually every other line of coverage was off.

2006 looks like it's going to shape up to be the best underwriting year in the PC business since the '50s.

Capital and surplus will be up substantially.

The counseled insurance agents and brokers reported average price declines in the fourth quarter of 9.6%.

In my opinion, this rate decline can only gather momentum.

Record results, helped by virtually no catastrophe losses of any size, is producing rate competition now across all lines and all geographic locations.

And we still see capital coming into the market.

I don't know how deep or how fast these rates will decline, but right now on the street almost anything can happen.

Our mergers and action submissions '06, acquisitions were very strong.

We closed 11 deals bringing in over $55 million of annual revenue.

What's also nice to see is that the acquisitions were completed in all three of our brokerage divisions.

Our retail property casualty acquisitions pipeline rebounded after a significant slow down in '05.

You remember in '05, industry turmoil, lack of contingent commissions, moving to transparency all made it tough to bring acquisitions to the table in '05.

Already in '07 our merger and acquisition activity looks like it will out paced '06.

We announced two deals include ago very exciting deals with Lowndes Lambert and Canada Our pipeline is very robust and very active.

We are excited about our new partners, we welcome them to the company and we know we will see great things from them in the future.

So, let me just recap.

Overall brokerage results.

Revenue for the year up 10%, pretax up 31%, margin up 2.5%.

All in all a satisfying result.

Let me now move to address our Risk Management Segment.

We told you repeatedly that we are targeting a 15% to 16% margin in this business.

We did 14% in 2006.

We had revenue growth of 8%, all of which was organic.

We fell short of our targets.

On the revenue side, Gallagher Bassett is facing three specific challenges.

Number one I mentioned in past calls that the renewing book of business is not experiencing any claim count growth.

In fact ,claims fell -- claim counts fell 1% in the fourth quarter.

Note this is is not unique to Gallagher Bassett.

We are actually seeing increase in claim activity across the whole industry.

Secondly, a soft market, especially California Workers' Compensation, has created composition in which carriers use lower premiums through bundled their claim work.

Soft markets have an impact on their business, too.

Thirdly, the California market has become increasingly difficulty with employment costs exceeding what we are seeing in the rest of the country.

But, please note we've seen slow downs in this business before.

G. B.s growth and I've said this repeatedly is never a smooth 15% up quarter to quarter.

You recall after 9/11 we had a significant slow down in claim counts.

And in '94, '95 when California opened their rating in workers' comp. the same thing occurred.

Every time we face these issues we've successfully navigated them.

Over the last five years we doubled the pretax profit at Gallagher Bassett.

We continue to concentrate on new business, client retention and expense management.

Gallagher Bassett has to hire ahead of its claim activity.

From time to time we will see margins dip.

What we see that the world continues to move more and more to business process outsourcing and that's what Gallagher Bassett does very, very well.

In Financial Services, we made very nice progress newer continued efforts to reduce our noncore investments.

I won't read the press release, but you can see that the team was exceptionally busy in the fourth quarter.

Our Financial Services team has been working very hard for four years to move many of these investments.

Thanks to these efforts we have only a few items remaining that need work.

All in all I'm pleased with how 2006 turned out.

We go into 2007 with a number of challenges behind us.

Obviously, we have a number of challenges in front of us.

One, we will cost to work on our margins in both operating settle.

Secondly, we will continue to work hard on acquisitions.

Thirdly, we will continue to build our reinsurance arm.

We are bullish about our future.

Doug, you want to take our numbers.

Sure.

Thanks, Pat.

And good morning, everyone.

A couple of administrative points before I give you my comments.

We expect to file our 10(K) before the end of the week and please remember to use the spreadsheet we provide on our Web site to understand the quarterly seasonality patterns in our business as you build your 2007 and later models.

Okay.

To my six comments.

First, related to cash.

During 2006 we used about $117 million to pay dividends, about $32 million for CapEx, $81 million in acquisitions and earnouts and about $33 million to buy back stock.

Second, like Pat said we made tremendous progress in reducing our assets in our Financial Services segment.

To summarize, during 2006 and even through last week, we sold off $123 million of assets, eliminated nearly $110 million of debt and eliminated substantially all of our off balance sheet letters of credit and financial guarantees.

Third, we believe our balance sheet is very well-positioned with no debt and no unfunded pension obligations.

Recall that we have an unused $450 million unsecured line of credit that adds an extra $100 million accordion feature.

Further, beginning in 2008, we should begin to realize cash flows of about $30 to $50 million a year, as we begin to utilize our $300 million deferred tax asset.

Fourth, during 2006 we did not grant options other than for acquisitions and hiring purposes.

Management and the board are working hard on modernizing our shared based incentive plans and will likely make changes in our long-term plans later in 2007.

Let me go back to the Risk Management Segment again.

Pat framed the situation very well.

In a nutshell, because of decreased claim frequency, we slightly over shot on our staffing which caused us about a margin point for the year, or about $4 million pretax.

For those of you who follow us closely, we've always said it's tough to perfectly match our staffing with our claim count.

But, just to show you the sensitivity following me on this math.

In our Risk Management Segment we incurred about $233 million of compensation related to about 3,500 employees and about 110 offices around the world.

That math produces about $65,000 per person per year.

So, when we say that we missed our mark by $4 million that means we ran about 60 people heavy for the year.

That's 60 people for the year.

In other words, that's about a half of a full-time equivalent extra in each of our offices around the world.

Don't misunderstand.

We are not happy we missed it, but this is a stair-step nature of a decentralized staffing model.

We understand our challenges and we're ready to work hard in 2007 to grow into this excess capacity.

Six, back to our Brokerage Segment.

Like Pat said earlier, three years ago we had several branches or units that were struggling.

Now when I look down into the branch and unit level numbers, we only have a couple that still need turnaround-like attention.

I'm encouraged that we have narrowed our watch list.

Excluding these two units, our 2006 pretax margin would have approached 18%.

Also I think it's important for everyone to understand that we are making substantial investments into our Brokerage Segment operations.

During 2006 we spent a full margin point on operational improvement initiatives that will not begin to deliver productivity and efficiency gains until late 2007 or early 2008.

A similar level of spending is planned for 2007.

Let me close by saying how pleased we are that our Brokerage Segment made meaningful progress this year.

We grew 10%, 6% of those organic, pretax earnings were up 31%, pretax margins expanded by 2.5% and EBITDA margins expanded 2.8%.

This is quite encouraging results for a year without contingent commissions and substantial challenges seen in our industry.

Okay.

Those are my comments.

Back to you, Pat.

Thanks, Doug.

Operator, I think we are ready to take questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Chris Neczypor of Goldman Sachs.

Please go ahead.

Thanks, good morning.

Good morning, Chris.

Pat, I was hoping to get your view, however preliminary it might be on Chubb's new compensation program for its agents and brokers.

You've always been one of the more outspoken critics of the so called uneven playing field.

Do you see this as having any near term effect in the market, or do you think it will take awhile for the full effects to be realized, given it's only one or two companies that seem to be going down that route at this point?

Chris, my opinion is that from the model that we have to operate in now the Chubb model is very good news, and the fact that St. Paul Travelers is moving in that direction, I think those are very big changes in the way that the industry is going to be compensated by two significant players.

As you know, over the last 14 months or so we've worked very hard with these companies to try to negotiate terms that were different than contingent commissions, but were conditional commissions on an up front basis.

I think some of what we have done over the last year or so has helped Chubb, St. Paul Travelers and others to see that there is another way to compensation the distribution system without having to make it contingent.

And I do believe that there will be some momentum to move in that direction.

Do you have any sort of preliminary estimate to how much participation in these programs might add to your revenue in '07?

No, I don't because, number one, I'm not clear on exactly what the Chubb model is.

We do have an arrangement with Chubb that we put in place in 2006.

What I will say is this.

In almost every instance where we went to talk to the CEOs and leadership teams of every markets that we do business with, and there were about 12 markets that supported us that would help us with our loss contingent commission.

In almost every instance, managements were not trying to suck this revenue back in their operating results.

They did see this as an important part of supporting their distribution network.

So, I think there will be a lot of work in regards to what the model actually ends up looking like.

On the benefit side it's become clear in three instances that the AG in New York has approved, was basically a compensation model that is just strictly based on how much volume someone does.

So, there is one rate if you are producing this much premium, there is another commission rate if you are producing more, and there is a final commission rate if you are one of their larger providers, not contingent on any other kind of results.

I don't know what kind of models are going to end up developing on the PC side but there's going to be some major change over the next year or so.

Okay.

That's great.

Thanks.

And then, given all the moves you made during the fourth quarter with your Financial Services assets I was wondering if you might be able to give us an update what the plan is for the remainder of the portfolio and any sort of time line associated with that plan?

Yes, Chris, if you look at the supplemental schedule we provide in the earnings release, the investment schedule, when you look at those, the only assets that really remain are our investment in hedge fund manager and you will see in there that half of that matures during 2007.

Then there's the synthetic coal properties and those will naturally expire at the end of 2007 when the tax credit law expires at the end of '07.

And when you get down to the consolidated assets, we already sold off the cargo airplanes.

That happened last week.

We put that in the press release.

And the only remaining investment there is a little bit of a Syn/Coal property that we consolidated.

So by and large by the end of 2007 nearly all of these assets will be off our books.

Okay, that's great.

Thanks, guys.

Thank you.

Our next question is coming from Brian Delaney of EnTrust

Good morning, guys, how are you?

Pat, I was wondering if you could maybe talk a little bit more about where you are in turns of the turnaround at Gallagher?

I would be glad to do that.

We are trying to manage this operation on a global basis, but it does have operations in the United States primarily and the U.K.

Our U.K. operation broke nicely into the black this year.

Our U.S. operation continues to struggle.

It's an investment.

So, we are seeing good progress, but the operation is not pretax accretive.

Okay.

A couple of weeks ago NYMEX issued a press release saying they were creating an index with Gallagher Re called the 'Re-Ex Index', provides sort of live time speculation if you will on catastrophe damage.

Could you give us an idea, it sounds really neat and innovative on your part, can you maybe speak about how you guys are actually going to make money off of this?

Yes.

I will jump in there, Brian, this is Doug.

Basically this product is -- we are providing service to non-medics to tag the lost data and for that we will accept a fee for that information.

But basically, it's a typical future or almost like a commodity trade, where somebody on one side of the transaction is going to bet how much is catastrophe loss is going to be in Florida, and if there's a named storm that's going to come out and it's $10 billion worth of losses and one side of the trade is going to lose and the other side of the trade is going to win.

Gallagher takes no risk with respect to this.

It's really providing the pricing data and it created the idea with NYMEX, and so we will take a trading fee off.

I think that's the thing that everybody should understand.

What we are excited about here is basically it was our idea.

It was our idea.

It's our people at Gallagher Re approaching NYMEX with the concept that we would provide them with other support.

What the actual ultimate cost of a named storm was.

And again, the trader will trade around that just like an oil commodity trade and everything else and we get a fee per transaction.

Got you.

I guess, last question for you, Pat.

The new hires that you made since 2005, are they yet accretive at this point?

Yes, yes, nicely.

Great.

Thanks a lot.

Thanks, Brian.

Thank you.

Our next question is coming from Dan Johnson of Citadel Investment Group.

Please go ahead.

Good morning, Dan.

Good morning.

I just have one question for you.

On the fee income in brokerage and I apologize if you've covered this and I missed it, but it's been quite robust over the last couple of years even through the first half of this year, at almost 20% and then kind of 10% last quarter and then the third quarter, and then just 2% in the fourth quarter.

Can you just give us a little color as to what's going on the fee line?

Yes.

Sure.

I think if you'll notice over the last few years the percentage of our brokerage revenue that comes to us in fees, as opposed to commissions, is increasing.

I used to say, it's just a number of years ago was probably 90% was commission and 10% was fees and we are seeing that shift.

Part of this just strictly the outcome of transparency.

You walk in and you say to somebody, on are on this transaction you are going to spend $250,000 and I am going to get a $25,000 commission and that creates a discussion on compensation and sometimes people say, if you're going to do -- I am just as happy to pay you on a fee.

Most of our large risk management business is already on a fee.

That's kind of the preferred model in the large risk management business.

Also, I think what you are seeing is an attempt on our part to offset some decreases in commission levels by adding fees to accounts.

If we are working hard for someone and their pricing is going down nicely, it's legitimate for us to say to them, I don't think I should have to take a pay cut.

Okay.

Great.

I, that explains the strength I guess over the last couple of years and into this year.

All the more interesting than why it would appear that at least this quarter that that strength is not there.

I don't know.

Dan, when you get to what happened in the individual quarter by account I don't really have a comment on that.

You've got to look at the general trend.

Okay.

Let's see if I have anything else on the list.

No, nothing that's important.

Thanks.

Thanks, Dan.

Thank you.

Ladies and gentlemen, as a reminder, the floor is still open for questions. [OPERATOR INSTRUCTIONS] Our next question is coming from Brandon Young of Bear Stearns.

Good morning.

Good morning, everyone.

Thanks for the call.

One question, it appears that your pretax income per employee seems to have dipped down a little bit in the quarter and the employee count has gone up.

I was just wondering whether you might discuss the progress the three acquisitions you guys made in the Q.

That's a -- Brandon you kind of lost me about that one.

You talk about the headcount growth, are you talking about combined risk management and brokerage, or are you talking about the Brokerage Segment, which --

I'm talking about the overall headcount growth.

Well, number one we had headcount growth in the Risk Management Segment that we addressed in the discussion.

Secondly, you're correct in saying that headcount growth primarily in the Brokerage Segment is coming from acquisitions.

And for the specific question of why in the quarter our revenue per employee dipped, I don't have an answer right now.

Maybe you could --

One thing is, were were staffing up, we picked up a large client in our Risk Management Segment effective the first of the year and we were staffing up in order to handle that large client, so that would have an impact on the numbers you are looking at there Brandon.

Okay, thanks, Doug.

Any more questions, Tony?

There appears\ to be no further questions at this time.

I would now like to turn the floor back over to management.

Great.

Then, I would like to make a few quick remarks for everybody if I could.

I am very happy with the brokerage results in 2006.

We came through a tough year.

We did a great job.

We are selling truthfully around the globe.

We are working very hard on retaining our clients.

Our niche marketing strategy is not just part of our culture it's normal operating procedure.

Our risk management division needs to grow into capacity.

We need to work hard to get our margin back to 15 plus.

Our culture, though, which I believe is our real differentiator, remains very, very strong.

We embraced transparency the past year.

Our clients liked it.

We've moved to a new business model.

Our results reflect the loss of contingent revenue except when we do it with an acquisition.

We've settled a federal class action suit and most of our competitors have yet to face these issues.

One more thing I hope all you listeners are still there because my Uncle Bob if I were here would be very disappointed if I didn't close this call with a very strong, Go Bears!

Thanks for being with us everybody.

Thank you.

This does conclude today's teleconference.

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