Arthur J. Gallagher & Co. (AJG) 2007 Q1 法說會逐字稿

(OPERATOR INSTRUCTIONS) Good morning, ladies and gentlemen and welcome to the Arthur J.

Gallagher & Company first quarter 2007 earnings conference call.

At this time all participants have been placed in a listen-only mode.

The call will be open for your questions following the presentation.

It is important to note that some of the comments made by Arthur J.

Gallagher & Company 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 hand the floor over to your host, J.

Patrick Gallagher, Jr., Chairman, President and CEO of Arthur J.

Gallagher & Company.

Sir, the floor is yours.

Thank you very much, Elsa.

Welcome, everyone, to our first quarter conference call.

Appreciate your being here this morning, this morning I am joined by Doug Howell our Chief Financial Officer, John Rosengren our General Counsel as well the division heads of our operating businesses.

As is our custom I'm not going to sit here this morning and read the press release to you.

I think we got that out in time for everybody to have a chance to digest it, but I do want to offer some flavor on the first quarter.

There are some things I am pleased with in the quarter and there are some that I know we need to do better, a lot better, and believe me, in those areas, we are working hard on improvement.

Let me mention three specific areas that we are focused on for improvement as we go forward with the next three very important quarters.

First, our reinsurance operations continue to put pressure on our margin.

Tremendous amount of new business activity in our reinsurance brokerage arm, lots of opportunities.

We continue to believe that we have an opportunity to build a world-class reinsurance brokerage operation.

We are committed to growing this, and it is an important investment, but it is margin dilutive.

Secondly, our retail property casualty business, the pretax was down slightly in the first quarter.

And we never like to see that.

We are a sales and marketing company.

1% organic growth is not our norm regardless of what's going on in the market.

We are a growth company, and we always expect growth of ourselves.

We are very focused on margin improvement.

Our margins slipped in the quarter and we are very dedicated to expense control.

We have a number of initiatives that Doug will mention in a moment.

On the new business side, we are focused on -- on production efforts, recruiting production talent, account retention, and mergers and acquisitions.

The market is presenting some real challenges to us.

I think by now, most of you are familiar with the Council of Insurance Agents and Brokers survey for the first quarter, which they reflected about 11.3% reduction across most lines that they were surveyed.

In our experience, rates are down in every class across the entire company.

Now we are even seeing softening in Florida catastrophe coverage.

This also creates a very frothy market which has hurt our client retention which is something we are always focused on.

I hate to lose business and our client retention was less than we'd like to see in the quarter.

The market is very, very competitive and anecdotally, we can tell you many stories that when one of our clients goes to market sometimes you can really get surprised.

Our compensation ratio improved quarter-over-quarter, but headcount control is something that we will continue to focus on for the remainder of '07.

I might add that many of our brokerage offices did perform extremely well and I would like to congratulate them but we are working on the ones that we know need focus.

Thirdly, risk placement services, which is our property casualty wholesaler is also navigating through the softening market.

I think you're all aware as a wholesaler we are involved in difficult-to-place risks.

And when the market softens, retailers will often just go directly to the underwriting company for placement.

So we are very clear on where we have to focus our improvement efforts.

Now having said that, there were a number of good things that were going on in the quarter, and let me mention four of them: First, mergers and acquisitions, our best quarter ever.

Seven deals closed.

I am very pleased with that.

About $40 million in revenue that was purchased.

Getting seven deals done is not easy.

We spend an awful lot of time in due diligence and studying and making sure that the cultures are right of the companies we are bringing aboard.

90% of our due diligence time is spent virtually on culture.

Great companies joined us during the quarter and remember, all of these merger partners had a choice.

I am very proud that they chose Gallagher to join with.

And I want to welcome all of our new colleagues to their first conference call.

I am also pleased that our deals were spread among all three of our operating divisions that are active in the merger and acquisition process.

Our retail property casualty, wholesale as well as benefits and the pipeline for acquisitions continues to be robust.

Secondly, within the brokerage segment, Gallagher Benefit Services which is our benefits consulting arm had a very strong first quarter.

Revenue spurred by solid new business and '06 acquisitions were up over 20%.

Pretax profits were up over 35%, and as I've already mentioned, merger and acquisition activity looks very, very strong.

Thirdly, Gallagher Bassett, our risk management segment, had a good start to the year, good first quarter.

I am pleased with top-line organic growth of 9% and that our margin returned to the targeted levels.

However, I do want to caution, Gallagher Bassett is also battling in this soft market.

Carriers offering to rebundle -- in other words, take the claim work back from us as well as fewer companies entering the alternative market can present a challenge for GB.

Our revenue was up nicely in the quarter, mostly on strong new business and great International growth, but as I've mentioned, the environment is tough, so for the rest of '07, we are cautiously optimistic about our Risk Management business.

Fourthly, Financial Services.

We've made good progress in exiting our noncore assets.

But even with an expected 13% phase-out in our synfuel projects, our tax rate for the whole company in the quarter was 8%.

We are projecting 14% for the year.

So all in all, some good things going on in the quarter.

And some clear areas that we know we need to improve.

And these are locked in and getting a great deal of attention.

Doug, why don't you take them through some of the numbers.

Thanks, Pat.

And good morning, everyone.

A couple of administrative items - we expect to file our 10-Q before the end of the week and please remember to use the spreadsheet we provide on our website to understand the quarterly seasonality patterns in our business as you refine your 2007 and later models.

Okay, today I have six comments.

First, like Pat said, our first quarter is our smallest quarter for the year in terms of earnings and cash flow.

Regardless, we went ahead and used our line of credit to close seven acquisitions for about $75 million, $15 million to repurchase shares, and about $10 million to front-end some of our coal production activity.

In addition from operations, we used about $29 million to pay dividends and about $9 million for capital expenditures.

Second, in our earnings release, this quarter, we have given you a table showing our quarterly earnings guidance for our Financial Services segment.

During our last conference call we told that you we forecasted about $0.30 to $0.40 for the year.

We still believe we will close the year about in that range.

Third, also in our last call, I told that you we are investing about a full margin point on operational improvement initiatives.

And those initiatives will not begin to deliver productivity and efficiency gains until late 2007 or early 2008.

As a result, some of you have asked for some flavor around our efforts.

I am not going to give you the dollar amount invested in each project because there is always overlap but here's a laundry list of the projects.

First, we completed installing a new global financial system, and that system is fully into production.

The new system includes new general ledger and associated modules such as accounts payable tools, an automated travel and entertainment system and a comprehensive budget and planning tool.

This new system will allow us to centralize more of the routine accounting, finance and cash management activities into lower-cost labor locations thereby improving our efficiency, productivity and cash flows.

One by one over the course of 2007 and into 2008, each of our locations around the world will roll onto these new systems.

Number two, we also installed a new Human Resource management system, and that system is also up and running in all of our domestic locations.

International will follow in 2008.

Our employees can now self--service their HR and benefit needs and more importantly the system allows Gallagher to provide a substantial rack of valued benefits and services to our employees.

The costs associated with installing these financial and HR systems were not insignificant.

It took dozens of employees and external consultants to get the systems up and running and they are now working everyday on developing new work flows and procedures to get payback from our investment.

Number three, we have recently completed our pilot testing of a new document management system and it is ready for rollout across our retail brokerage operation.

Again, dozens of people have been working on this effort, and we are optimistic about rolling this out over the next 18 months.

Number four, we have moved past the proof of concept phase on middle office and back office functions that can be done in centralized and lower-cost labor locations.

Our centers are up and running and in production; however, nearly all of this labor and facility costs are still redundant and will continue to be redundant until we have a more spread -- more widespread rollout later this year and into 2008.

For my fourth overall comment, recently one of our shareholders asked me about what Gallagher does to reduce the risk to shareholders from errors and omission losses that are systemic in the insurance brokerage space.

To reduce the risk of of E&O losses, Gallagher has made substantial investment into developing a robust set of professional standards.

In 2003 and 2004, we completed a major overhaul, which has produced a meaningful reduction in frequency.

Then again in late 2006 we made further improvements.

We know that these changes will decrease our losses and improve the quality of our service offerings to our customers.

In addition, we go to great lengths to buy E&O insurance.

We believe our investments in this area and the insurance we buy substantially reduces our risk profile and provides significant value to our shareholders.

But the cost for us to buy E&O insurance and the internal cost of our programs and personnel reduce our margin by nearly 2%.

For my fifth point, let's go to the Risk Management segment.

Like Pat said, we are encouraged by the margin rebound in the first quarter as compared to the trend we saw in the last three quarters of 2006, but I am also still concerned about sustainability.

If we continue to see flat or declining claim counts on our existing customer base, we could see margin pressure return later in 2007.

Six, let's go back to our reinsurance operation.

I told in our last call that investments into our reinsurance unit eroded our full -- full-year 2006 brokerage margins by about 1.8%.

For the first quarter of 2007, the unit again eroded brokerage margins by about 2%.

Despite these results, there is growing momentum in the operation and we continue to see nice orders on the horizon.

We remain committed to this operation.

Okay, Pat, those are my comments.

Back to you.

Elsa, let's go now to questions and answers.

Thank you, the floor is now open for questions.

(Operator Instructions) Our first question is coming from Rob Glasspiegel with Langen McAlenney.

Please go ahead.

Good morning.

Pat, reading between the lines, it sounds like you think the operating environment is getting incrementally tougher as opposed to just a dribble-down scenario.

You are commenting about increasing competition and your need to freeze headcount or control headcount I think is a more accurate statement.

Is that a fair characterization?

Or am I misreading the hidden message you were --

Well, let me try to clear this up in terms of a hidden message.

There is no hidden message here.

And I have usually not been a good predictor, but I have publicly predicted for over a year now that this market is going to get very, very soft, the results of the underwriting companies are outstanding.

Capital and surplus is up.

And so this is no reading between the lines.

What we are into is -- in my opinion, is just an unbelievable softening which I predict will only get worse.

Okay and --

Did I give you the flavor you are looking for?

Yeah.

So you are taking, you know, soft-market expense strategy into your planning --

Oh, yeah.

-- into your planning process for '07.

Yes, absolutely.

Headcount control is absolutely in place.

No one in our company hires anybody that's a new body into our company without the division head signing off on it pre-hire.

Okay.

If I could just dig into the Financial Services area.

Doug, is a third-quarter spike just sort of related to matching with your pretax earnings in Brokerage?

Or is there something seasonal in the business that -- that causes the seasonality in that line?

The former, Bob, it matches with our emergence of pretax earnings.

It also has to do with when we are allowed to book the credits that we generate as a result -- the tax credits that we generate as a result of running the plants.

It is not a smooth quarterly emergence of credits under the accounting rules.

You have to wait until the pretax income shows up in order to book the credits.

Okay.

And as we look to '08, the Financial Services operation, what -- what will it look like?

Is there any freed up -- is there any capital allocated to that line of business currently?

Is that going to be a discontinued operation?

What's left in '08?

Well, I think the best way to do that is we still provide the investment exhibit at the back of our press release on page 7 of our -- or excuse me, page 8 of our press release.

In there, we're going to have a few remaining small investments.

We will have a little bit of ownership interest in an asset alliance deal.

All of our energy projects will be substantially gone at that point.

Most of the assets that are on the balance sheet right now, Bob, that you see on -- on page 8 there are receivables that will be paid off by about May of 2008.

Basically we produce tax credits, and then we get repayment from our partners, and there is usually a quarter to 6-month delay in getting those cash payments.

So by that time, the Financial Services segment will have very little left in it, and will have to review the accounting rules about whether that will be presented as discontinued ops.

As of now it is already down in its own segment so it wouldn't have a significant impact on the Brokerage or Risk Management segment.

Are we talking a black or red line in '08?

A black or red line?

Is it profitable or unprofitable in aggregate?

Oh, no, in '08 it should be somewhere around break-even.

Because all the activities in it substantially are done by the end of --

There is no capital allocated with that line of business?

Not really.

We have a deferred tax asset associated with it, but that runs down -- I said before that runs down over the next four years or so.

But that's just cash and that's not, that doesn't take any capital.

This business has no capital in it.

Okay.

Thank you very much.

Thank you.

Thank you.

Our next question is coming from Adam Klauber with CCW.

Please go ahead.

Good morning, Adam.

Hi, Pat, how are you?

Great, how are you?

Good.

First question on acquisitions.

Definitely you've had a nice pickup there.

I guess two questions.

Can you give us -- I guess any idea of how that pickup has occurred, number one?

And number two, do you think the pipeline is still pretty solid out there for further acquisitions?

The ones that occurred -- I've said this many times.

This is a lumpy process.

You know we are out talking to people all day, every day.

Our division heads and myself are working very, very hard to get people interested in Gallagher and their future.

We spend an awful lot of time as I mentioned in my comments, the due diligence is 90% on culture and people and fit because that's what we are.

You almost can look at this as close to an organic hiring methodology, and so sometimes you have opportunities where you can kind of clear the deck and get a bunch of deals done.

They sort of hit at the same time, and other times they sort of straggle in, but we worked very, very hard to get these people to choose Gallagher, because as I said, they had choice.

So, you know, I think that -- I would not if I were you project out in the second or third quarter a level of activity that is equal to the first quarter.

I think we will have a very solid year.

$40 million in the first quarter is probably our best quarter ever, and, yes, the pipeline is -- is very, very full.

I mean we are constantly talking to a great number of potential -- of potential sellers, and they are in every stage from just meeting them and saying hello to a prepared letter of intent and a signed letter of intent moving to closing.

And it is all over the board.

But I think that, you know, we are back to doing acquisitions probably at the level and pace that we were prior to the -- the contingent commission controversy.

Okay.

Follow-up question.

How much of your business is wholesale, I believe it's PRS.

How much of that is your business.

Is that business seasonally lumpy at all?

In other words, is one quarter bigger than another?

Yes, it's -- it is called RPS.

OH, RPS, sorry about that.

Risk Placement Services.

And it is -- it is lumpy.

Last year's revenues were probably on the order of about $125 million.

And the third quarter is clearly their heaviest quarter.

RPS places a tremendous amount of catastrophe property stuff in particular in Florida.

Okay.

To the extent that the property cat market is softening, will that impact their revenues?

I think so far this year we have seen there, Adam, that clients are buying more insurance, which is a good thing.

I think that the revenues for '07, I am not expecting a huge falloff even with the rate.

There was a lot more demand for property cover in the last two years than was available, and so clients are buying up.

Okay.

And then finally, how -- how is your reinsurance brokerage business doing?

You know, it's -- it's a tough slog, probably tougher than we had anticipated, but it's a great business.

The people that we've got in that business are tremendous resources, and we are making projects -- we are making progress, rather.

And we think that it's -- you know, that's the best natural investment in our industry left for the Company.

Okay.

Thank you very much, Pat.

Thank you.

Our next question is coming from David Bilik with Sound Shore Management.

Please go ahead.

Hi, good morning.

Good morning, David.

I was just wondering if you could give any sense for -- you mentioned your client retention rate was down.

And I was wondering were there any particular competitors that you felt were taking more business from you than usual in the quarter?

No.

There was no single person that I looked at and said, my gosh, where are they coming from?

What you've got now is the classic soft market situation, David.

In this kind of market anyone can hang a shingle out, call themselves an insurance broker and go get a cheap quote.

So it is tough out there.

Thank you.

Thank you.

Our next question is coming from Brian Derubio with U.S.

Trust.

Good morning, guys.

Good morning, Brian.

How are you doing?

Good, how are you?

All right.

Pat, two questions for you and Doug, one question for yourself.

Pat, where do you stand on the proposed Chubb and Traveler's compensation schedule?

I'm sorry, state the question again, Brian?

I missed it.

Where do you stand on the proposed compensation schedule that has been put forward by Chubb and Travelers with regards to paying more for production in prior years?

I think you know this, Brian.

We have been very up-front and out-front in the effort to develop supplemental commission arrangements with our primary carriers.

The loss of about $30 million in contingent commissions really hurt us, and over the last year, we have been pretty successful with over 20 companies in creating agreements that are disclosable up-front to our clients and that are not contingent in any way on growth or profitability.

In the instance of Chubb and Travelers, we have actually gone to the Attorney General in the state of Illinois who is the person that we have our Assurance of Voluntary Compliance, and they have agreed that if these agreements have passed muster with the AG's office in New York, then Illinois will agree that they pass muster as well.

Our key with Travelers and Chubb is just to make sure that in the agreement there is no mention of anything that would be contingent based on growth or profitability.

That it would simply be a remuneration that would be fixed for the year and disclosable up front.

When we finally get through the discussions of those contracts, it's our -- it's our belief that they will be in order for us to sign and we will be able to accept the supplemental commission.

Great.

And then one of your competitors yesterday was complaining about the market.

He was seeing a lot of cancel and rewrites.

Are you experiencing that also in your business?

We are seeing some of that, and we think that may accelerate in the second quarter.

As we get toward hurricane season, with the softening market and with more capacity available, there will probably be some acceleration to that.

Okay.

And we will actually -- we will be watching that carefully as we go into this next few months.

Okay.

And, Doug, for you, on -- you know the overall corporate tax rate is obviously very low because of the tax credits from synfuel.

But once they go away what can you do to lower your corporate tax rate from where it is today?

A lot of your competitors have tax rates that are 2.5 points lower than yours.

Yes, let's - good question.

First and foremost, one of the reasons why many of the larger competitors have lower tax rates than ours is because they have a substantial -- a different mix of international operations that have a lower tax burden on them.

So, that naturally lowers it.

Some of our state tax planning, we happen to be doing business in some high state tax locations and so there are some tax-planning strategies we can do there.

And those are the two main issues, is foreign operations that have lower taxes and then try to do more business out of high state tax locations.

But not much in terms of your ability to substantially lower that over the next two years?

Substantially, probably no, I mean unless there is a rebirth of Section 29 credits or something like that and they extend the law.

That would do it.

Those are permanent reductions in it, but that's -- that would be the state --- the state tax and the foreign tax angle.

Okay.

Thanks a lot, guys.

Thanks, Brian.

Thank you.

Our next question is coming from Chris Neczypor with Goldman Sachs.

Please go ahead.

Hi, good morning, everyone.

Good morning, Chris.

Just a couple of follow-up questions.

As it relates to the acquisition pipeline, what are you seeing in terms of private equity coming in to compete for the same guys you are?

Are they more maybe below where you guys would typically look to acquire?

Or is there -- is there any sort of adverse competition that you guys are seeing from them?

Actually, Chris, we have seen zero competition when it comes to our acquisitions.

You know -- if you look at our acquisitions, typically, they range from 3 to $15 million in revenue.

That's why we refer to them very much as tuck-ins.

And we have literally not seen a private equity player in any of the deals we have done in the last year.

Okay.

Thanks, that's helpful.

And then just to follow up on the reinsurance question from before.

I was wondering if you could give a little more color as to the build-out of the reinsurance and maybe just help us understand if you are focusing more on specific areas or geographies and just from a more general standpoint, how do you actually grow to compete with the larger players given the consolidated nature of that part of the industry?

You know, is it hiring teams or competing on price or maybe just a little bit more color around that?

Let me give you a little history.

I mean, first of all, we have been in the reinsurance business not necessarily as a separate unit for 30 years, and so we had good experience in London, and we did an acquisition in the United States a number of years ago that really gave us a platform.

Going forward, it is a matter of recruiting the right teams.

We took a position in the London market about three years ago.

Brought over a very dynamic, strong, well thought-of team.

That team, by the way.

is in the black and producing and we continue to build out with teams across the United States.

We are now in Singapore, Australia, and what have you.

So the first cost is getting the right people on the bus.

The second, the second thing then is -- is producing and writing business.

And what you've got is very large commission accounts that can make a huge difference one way or another.

In our quarter we had, this year, in the first quarter, we had two clients that opted out of purchasing catastrophe coverage for their property exposures.

These were significant revenue amounts of renewal commission.

These are professional players who decided frankly to guts it for the year and just not -- just not renew their reinsurance.

So when that happens, it really catches you.

But what you have to have is the right teams in place because this is a very competitive environment, and our carrier customers expect tremendous expertise.

So it is all about getting the right people.

Okay.

Thanks for the answers.

Thank you.

There appears to be no further questions at this time.

I would like to turn the floor back over to Mr.

Patrick Gallagher for any further or closing remarks.

Yes, thank you, Elsa.

I would just make a couple quick remarks.

Doug mentioned it in his comments, I think everybody remembers that the first quarter is our smallest quarter.

Clearly a lot of discussion in the questions and answers about the market.

The market is very tough and it is softening quickly.

Nonetheless, we have a clear picture of where we need to focus to improve, and I want everybody to understand that we are doing that.

We want to get clearly back on track with new business efforts, improve our 1% organic growth rate, and continue to execute on our mergers and acquisitions.

And, if we do that, we do feel we will have a growth year in 2007.

So thank you for being with us this morning.

We appreciate your questions.

And we look forward to the rest of the year.

Thank you for your participation, ladies and gentlemen.

This does conclude today's teleconference.