Arthur J. Gallagher & Co. (AJG) 2007 Q2 法說會逐字稿

Good morning, ladies and gentlemen.

Welcome to the Arthur J.

Gallagher & Co.

second quarter 2007 earnings conference call.

At this time, all participants have been placed on 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 & 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 & 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 & Co.

Sir, the floor is yours.

Thank you very much.

Welcome, everyone, and thank you for joining us this morning.

I'm joined this morning by Doug Howell, our Chief Financial Officer; Walt Bay,our General Counsel; as well as the operating heads of our operating divisions.

As I said in our press release yesterday afternoon, I'm happy with our second quarter results.

Revenue growth of 14% in our brokerage segment, 5% of that being organic in a really difficult trading environment is a credit to our brokerage production teams.

Pretax growth of 19% and a full margin point improvement is in line with our stated growth goals.

Please remember that if you look at the 2006 second quarter, it was a very strong quarter.

So, comparing favorably with last year presented a challenge.

A challenge our brokerage and risk management team met by having the best second quarter we've ever had.

The team did a very good job.

Driving this growth are five key elements of our growth strategies.

Number one, new business sales, number two, client retention, number three, organic recruiting, number four, mergers and acquisitions, and number five, margin expansion.

Let me touch on each one of these elements of our strategies.

Number one, Arthur J.

Gallagher is a sales and marketing company.

Every day we get up and push hard for new business.

Our culture at Gallagher is to have everyone be involved in selling and servicing our clients.

New business is our lifeblood.

Everyone understands that nothing happens until someone rings the cash register and we did a very good job of that in the second quarter.

Number two, this market place is unbelievably competitive.

Prices are coming down.

The recent CIAB survey showed that premiums are down anywhere from 10% to 30% for the quarter.

This means our clients have people calling them every day asking for a chance to replace us.

We put our clients' interests first.

We work with them transparently.

We work hard to help them manage their cost of risk.

We're rewarded for this by over 90% of our clients renewing their insurance and risk management programs with us.

Number three, even in a soft market, we're always recruiting sales talent.

We've had success recently attracting strong seasoned talent and we continue to grow our own.

Our internship is presently underway.

We have over 150 young people who are learning about our great industry.

Hopefully many of them will choose insurance as their career.

The war for talent is never ending.

Number four, our mergers and acquisitions have really helped fuel our growth.

'06 was a good merger and acquisition year.

'07 is shaping up to be a great year.

11 deals so far.

$50 million in annualized revenue.

If you divide that, you get about $4.5 million on average of revenue per deal.

If you think about that, that's as close an organic hiring strategy as you can have and still call it mergers and acquisitions.

One thing I would note is every one of those firms that chose to join us had a choice.

I'm very proud that they chose to join Gallagher and I know that they're going to help us build a stronger company.

Number five, margin expansion efforts are going on throughout all of our operations.

If we stay very focused on these five things, our growth will meet our expectations.

Let me make just a few more comments on the brokerage segment.

As I said, our retail/wholesale property casualty businesses are working the market with significant rate declines.

However, our niche strategy continues to prove itself.

In our very focused niches, I believe we're better, stronger, and more knowledgeable than our competitors.

This strategy also helps us in our recruiting organically and in our merger and acquisition efforts.

Today, approximately 80% of all of our retail property casualty revenue falls into one of these niches.

Our London Global Risks business continues to grow nicely.

For the last six years, Arthur J.

Gallagher U.K.

has been the fastest growing Lloyd's broker.

We continue to see expansion opportunities in the London market.

Our benefits brokerage consulting business had another very, very strong quarter.

This business is doing extremely well for us.

Our benefits team helps our clients deal with some of their toughest, most challenging problems.

The costs associated with employee benefits are on every CEO's mind.

Our team helps clients work through those issues and as I said, our benefits brokerage saw strong top and bottom line growth in the quarter and year-to-date.

Our wholesalers help independent agents and brokers place difficult risks.

This business is very susceptible to a declining rate environment.

As primary carriers broaden their risk appetites, retailers will often move business away from wholesalers.

Even given this environment, our wholesale operations grew their business in the quarter.

Let me turn for some brief comments to our risk management segment, our Gallagher Bassett services firm.

GB also is dealing with the effects of a soft market.

Insurance companies will compete to keep their claim work by lowering their premium prices.

In some instances, clients will return to first dollar insurance programs that can now compete with self-insurance.

A 10% top line growth in the quarter was driven almost 100% by new business production.

Remember, all 10% of that growth is organic.

Year-to-date, GB's margin is at 14%, about 1 point short of our goal.

I'm hopeful that by year end, we'll be back to our goal of 15%.

I'll let Doug talk about financial services in a moment.

So just to wrap up on a combined basis, which is how I look at our business, brokerage and risk management combined, our operating units had a top line growth in the quarter of 13%, 11% year-to-date.

Pretax profit growth of 19% in the quarter.

11% year-to-date.

It feels good to be back on a growth track.

The next six months will not be easy.

We know we have to work very hard these next two quarters to finish '07 strong but we're about that every single day.

Doug?

Thanks, Pat.

Good morning, everyone.

Today I have four short comments.

First, let's spend a minute on our seasonality.

Most of you know by now that our first and second quarters are typically our smallest two quarters of the year.

Last year, we told you that we sensed that some of our clients were shifting their renewal dates from the third quarter into the second quarter to get ahead of the storm season.

While we are seeing some of that again this year, it is not a major shift.

We estimate that it fueled this quarter's growth by about only 1 point.

Second, you can see that we're into our line of credit by about $230 million.

We use this to do brokerage deals and to repurchase nearly 5 million shares of our stock in the first six months of the year.

The Board also reloaded our share repurchase program yesterday.

Please note that we're under no obligation to repurchase any shares.

Third, oil prices increased during the quarter which reduces the amount of tax credits we get from our synthetic coal operations.

As a result, you can see that our corporatewide 2007 projected tax rate is up and we have adjusted downward our guidance for the financial services segment.

However, this did not impact our brokerage and risk management segments because all of the tax credits show up in the financial services segment.

For my fourth point, let's go back to the risk management segment.

While our year-to-date margins are near our target of 15%, we lost some ground here in the second quarter.

I'm hopeful for a better third and fourth quarter.

We're still watchful about the impact of flat or slow growing claim counts on our existing customer base.

This could cause some margin pressure in the last half of 2007.

As a wrap-up, it wouldn't be right to stop without commending the brokerage and risk management segments on combined organic growth of 7% and the brokerage unit for their second quarter numbers.

To be up 14% in revenues, 24% in pretax earnings and improving margins by 1.5 points is, in a tough market is really good work.

Congratulations to the team on a good second quarter.

Okay, Pat.

Those are my comments.

Back to you.

We're ready to go right into questions and answers.

thank you.

The floor is now open for questions.

(OPERATOR INSTRUCTIONS) Our first question is coming from Keith Walsh of Citigroup.

Please go ahead.

Good morning, everyone.

Congrats on a nice organic growth quarter.

Thank you, Keith.

First, for Doug, if you could just remind us of the financial metrics applied to M&A, what are sort of the margins you're looking for in year one, et cetera?

Then I have a follow-up for Pat.

First and foremost, we buy pretax or EBITDA earnings.

So, when you look at the metrics, pricing on these deals, we've always said is anywhere from six to eight times pretax earnings provided they can show some good growth.

We use a typical NPB model that discounts, we use a discount rate from 12 to 15% even though our cost to capital is somewhere in the 8.5 to 9.5% range and so we just use a discounted cash flow model.

These brokers don't have large CapEx requirements.

They don't have large working capital amounts.

There is nothing exotic in their assets, we typically buy assets, not the shells.

So, the metrics that we apply are the standard metrics that you would see in any type of NPB pricing model.

Then for Pat, I know you get asked this every quarter but on the supplemental al commission issue, maybe if you can just update us on the progress of this and how big of an opportunity do you view this as?

Well, as I've said, since the -- our settlement with the Illinois Attorney General, we have approached all of the major trading partners that we have, the insurance companies and have requested that they create a supplemental compensation program for us based on the fact that we're no longer taking retail contingents unless you're an acquisition partner.

We've been successful with probably about 20 to 25 of those.

Let me reiterate though, Keith, it is important that in every instance, these are not contingent on anything.

They're not contingent on growth.

They're not contingent on profitability.

They're completely, 100% disclosed to our clients and we feel, in that regard, that we're right in taking them.

How many more -- how far are you through this process, I guess, you said about 20, 25 companies you've got agreements with.

How much further -- are you a third of the companies you deal with?

We're probably done.

That's the sum total of any real major trading relationship that we've got.

Great.

Thank you very much.

Sure.

Thank you.

Our next question is coming from Alison Jacobowitz of Merrill Lynch.

Good morning, Alison.

Hi.

I'm not sure it came out exactly in the comments.

But I was wondering if you could talk a little bit more about -- we haven't talked about the expense initiatives, cost containment initiatives in the brokerage segment and there is a nice improvement in the margin in the quarter, what you're thinking about, the sustainability of that kind of trend going forward for the brokerage segment.

Alison, we're a long way along in a lot of our margin improvement initiatives.

We're not seeing any of that yield fall to the bottom line yet.

Because the investment cost that we're making into that is consuming any of the savings that we've seen thus far.

We think there's opportunity there.

We're in a soft market here and we're running up and down escalators, some of those cost saving initiatives get lost and by the time you get the pretax margin.

But there is good work going on in all of the operations right now.

Like I said before, we're hoping to see that some of that show up in the fourth quarter of this year and into next year.

So, that's where we are in the process.

Also, if you look at the brokerage segment, Alison, there's some structural changes that benefited the margins this quarter and will going forward.

One is the change in our pension plan.

The other is the stock-based compensation that's coming down.

The change in our medical plan, you're seeing that in there, too.

If you recall, last year we switched medical plan providers.

We're starting to see that show up in our numbers now.

So, to some extent relative to the year-ago quarter, the brokerage segment should continue to some extent to have margins improve.

There is enough going on here where we should see that.

We hope so.

Then, I was wondering, as a follow-up, if you could give some more color on market conditions, maybe a little bit by segment or business or anything of interest you're seeing out there.

Well, to me, it is just incredible.

This is my fourth go around of the cycle.

Every time we get to 2001 and prices are going up and clients are clamoring about what's happening to me and this can't happen again.

Management is smarter and all the rest of it.

I think you'll probably hear from my insurance company counterparts that they are holding rate, they'll probably be telling you that they're doing extremely well in that regard.

The truth is on the Street it is a bloodbath.

Prices are down -- in a heavy competitive situation, in almost every line with the exception of California Quake and Coastal property, in a very tough, competitive situation, prices are off over 20%.

Do you know as soft as could be, Umbrella stuff is soft.

Anything that's excess in surplus is coming down substantially.

Even Coastal property is coming off.

It is not coming off like the rest of the market but we're right back in the middle '80s or middle '90s.

Thanks a lot.

Thank you.

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

Pat, congratulations on making it through four cycles and you may make it through a fifth and possibly even a sixth one successfully.

If they keep going ten years, Bob, I don't know.

If I could microscope retail contingent commissions, which I assume are your -- as you said, your acquired partners for three years that you can keep on board, is there some seasonality to when these things are going to pop through and can this build from the current levels?

Well, first of all, there's seasonality in the sense that those are typically paid, as you know, in the first half of the year.

Right.

So you're not going to see that continuing third and fourth quarter.

And yes, based on our acquisition pipeline, which I think is as robust as we've ever seen, the acquisition pipeline in all three businesses that we're acquiring firms, our retail PC, our benefits as well as our wholesale and MGA operation all have a very good pipeline.

That contingent commission will build over time.

I assume the supplementals were immaterial within commissions above that line in Q2?

Say again, Bob.

I assume the supplemental commissions were insignificant or immaterial within the--?

Yes.

The commission line above?

Correct.

When they become material, do you plan to spike them out or is that just part of your ongoing business and no need--?

Just part of our ongoing commission line.

We won't be able to follow your success in the numbers prospectively.

Correct.

Okay.

And finally, just on competition, anything different this time around on where it is coming from, is it just all over the place?

And there's no bad guys?

At regionals, nationals, new Bermuda companies coming into the U.S.?

If you take a look at the PC carriers results last year and what looks to be shaping up as terrific first half of this year, they're making very, very good returns.

They're solidly profitable.

And that is going to fuel competition.

That's what's happening.

Okay.

So there's no sort of naive, dumb pocket of irrationality, you think this is just a natural migration of the current profitability?

Correct.

Okay.

Thank you very much.

Thanks, Bob.

Thank you.

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

Please go ahead.

Good morning.

How are you guys?

Great.

Just a quick follow-up on the supplemental commission question.

I understand you're not going to split them out explicitly, but once they do kick into full gear, will you be recognizing them smoothed out over the year given that they're supposedly going to be a known fixed number or will they be recognized more on like a one quarter type basis?

When the predictability pattern and our ability to accrue those supplemental commissions becomes known and our systems can monitor it, we'll probably book those on an -- in the quarter when they're earned.

Currently, we're treating them more as a, like we historically have contingent commissions when they pass we book them.

But that will take a year or so for the contracts to be ferreted out, for the system to be built and for the follow through on the carrier's part to happen then we'll start booking those in the quarter we are.

Some of these, by the way, Chris, are agreements that we have that our production force has to make sure that the underwriting desk follows through on.

They're agreements to increase commission at that level.

And so it is all over the board.

Our production force is also empowered to negotiate with an underwriter so if that producer wants to cut his comp, cut his commission rate to get the deal done, they can do that.

So, some of the stuff is impossible to track.

Got you.

Okay.

That's helpful.

Thanks.

And then if I could just follow-up on the risk management points that you made in the press release, I think you said that the strong, domestic production was attributable largely to a new client.

Is that the same new client that we talked about in the first quarter or is that an incremental?

That's the same one.

It is the same one.

Okay.

Then we also talked about the -- I think you called it the stabilizing claim count activity.

Could you maybe just give a little bit more color?

Sure.

Here's what's happening which probably three quarters or four quarters ago I said was an anomaly and it seems to be still the case.

That is our renewing book of business is especially in a robust economy has historically always provided us with activity increases, sometimes as much as 3, 4, 5%.

As their businesses have grown, their claim counts have grown and then you add to that new business that we write and that's how we averaged for many years about 12 to 15% top line growth.

What we've seen over the last eight quarters or so and this actually is a good thing for our clients, is that our clients that are existing clients are actually having claim count declines.

If you pay attention to Allstate, State Farm, and some others, they've seen that very same phenomenon in the auto claim activity in the United States.

And we attribute this primarily to work comp loss prevention efforts that clients have undertaken.

Our clients are running safer organizations and even though they're growing, we're not seeing a lot of claim count growth.

We believe that that's got to plateau and rebound at some point.

If you're a large manufacturer and you add a third shift, typically you're going to have more claims from more people working more hours.

At some point, claim counts are not going to stay stable and go down but at this point in time, we're getting very little growth in claim activity from our existing book of business.

Okay.

Thank you.

Thank you.

Our next question is coming from [Brian Derubio] of U.S.

Trust.

Please go ahead.

Good morning, guys.

Good morning, Brian.

How are you doing?

Good.

How are you?

Just a couple of questions for you.

A little bit of (inaudible) following up on a few others from prior, Doug, how far along are you with the lease rationalization program?

We're still working through it right now.

We had one small one in the quarter in the U.K.

that cost us about $1 million to get out of.

That ran through this quarter.

But truthfully we'll probably peel it off one or two a quarter and when we're sitting on a portfolio of 300 leases, it takes awhile to get through them.

Obviously.

But I would say by the end of 2008, most of them should be rationalized.

Okay.

And the one FAS 123-R charge that you talked about.

Do you know what the amount is going to be for this year and next year.

I know it starts dropping off pretty quickly.

I don't have the number here in front of me.

I can get that to you but I think that the stock-based compensation -- let me see here -- we add it back in the reconciliation to--.

Okay, is that all stock base or just the catch up?

Are you talking about the carry over, our ten year options?

Yes.

That number is probably -- it is coming down each year.

And I'm guessing the number somewhere in the $6 million range at this point.

Okay.

Great.

And could you just give us an update on the progress on your offshoring efforts?

Good things are happening there.

New projects are being initiated and we're starting to roll out -- we've got most of our policy checking is over there now.

And the accounting operations are still in development.

Okay.

And three just quick questions that are somewhat all interrelated.

What is the fully diluted share count at the end of the quarter?

Posted at 96?

The filly diluted -- at the end of the quarter?

At the end of the quarter.

It would be about 96.8 million.

98.6 million.

No.

That was for the quarter, at the end of the quarter.

At the end of the quarter it would be somewhere around 96.8.

You happen to use a credit line to buy back shares.

As we think about debt in the corporate structure, is that going to be a more permanent or sort of a temporary change?

Say that to me again, Brian.

I am still looking for the number on the diluted shares.

What was your question?

Just with the use of corporate debt, should we consider that more permanent change in the cap structure or is that just temporary?

Well, we've got 230 million in the structure right now and the first two quarters of the year are our smallest cash flow quarters.

You're going to see some -- there will be debt in the structure at the end of the year just because we don't have cash flows to pay that off by the end of the year.

Okay.

Just finally, the DTA that starts rolling off next year, can you just remind me what that roll-off will be for like the next two or three years?

I think if you assume that it will be positive cash flows of 30 million to 40 million a year that is about where you get.

Thanks a lot, guys.

Thanks, Brian.

Thank you.

Our next question is coming from Dan Farrell of FPK.

Please go ahead.

Good morning.

Good morning, Dan.

Can you just talk a little bit about some of the trends you're seeing in the reinsurance brokerage business?

It has been a tough business for us.

As you know, we're building out.

We're pleased with the traction we've gotten there.

But what we're seeing is a very interesting transition.

The reinsurance business has been transactional historically, literally going out and placing lines of coverage.

It's turning much more into an advisory business that does, of course, need transactional capabilities.

A lot of analytics.

What we're seeing there is that our people are heavily involved in helping insurance companies really plan out their capital structures.

And there is also, at present, there's been less of an appetite in our experience for the purchase of reinsurance.

An awful lot of the successful underwriting companies out there now are taking more and more of the risk net themselves.

So, it is an interesting, kind of an interesting time of transition in that industry.

Okay, great.

Then just where do the revenues stand now for that business for you guys?

About $60 million.

50.

Okay.

60.

Oh, 60, okay.

Then just one follow-up question on your balance sheet and your debt.

It is nice to see the increased leverage and also the increased share repurchase.

What would be your comfort level to go higher on debt leverage and maybe if you could try an put some numbers around it?

Well, that's really a discussion that we need to have with the Board and everything but I think that historically, any time -- any time I get more than two times an annual EBITDA, I get a little uncomfortable with that.

So, there's substantial opportunity here at Gallagher for that.

Okay, great.

Thank you very much.

Thanks, Dan.

Thank you.

Our next question is coming from Mark Dwelle with Ferris, Baker Watts.

Please go ahead.

Good morning.

I was wondering if you could characterize in terms of -- you obviously had a good production level of new business.

Are you seeing that coming from any particular segments of the market like large business, reinsurance, Lloyd's, if you could just characterize that a little bit/

Sure.

On the retail side, it is coming from our niche activities.

As we've said many times, the fact is that about 80% of our business falls into an area where we manage ourselves across the country in very focused niche operating groups and that is proving to be a successful strategy and that business that we're producing is coming from all of our competitors.

There's not one competitor out there that we're taking big market share from.

But if you compete with us, let's take a higher education risk.

If you're a medium-sized regional broker and you happen to have a college or university and we tangle with you, you're going to have a problem.

And vice versa if we're on a college or university and you're a regional or local broker, you come to tango with us you're not going to be very successful.

Now, if you're one of our larger competitors, we stand toe to toe with you.

You can't really say that you're better, stronger, bigger than we are in higher ed.

It is just not true.

We have a great following there.

So, if you look at that, that's really what I think has taken root over the last seven to eight years in our company that is significantly different than our competition.

And I think it is a way of operating day in and day out that differentiates us and I think it is proving out in the market place.

Just building on that a little bit, again with respect to new business, is most of that coming from recent hires and new producers?

Is it leveraging off your acquisitions or is it a little bit of everything?

All of the above.

When we do an acquisition, the thing that's most exciting to our acquired partner, the fact that we're bringing him all kinds of capabilities and opportunities to expand their business.

Remember, when you look at our acquisitions, 90% of our due diligence time is spent on the culture and the people.

Are these people that are going to work just as hard or harder after the deal than they did when they owned the business themselves and we find people like that that are excited to build their platform, build their business and with the capabilities we bring them, we get significant leverage from that.

They're known in their communities.

They're respected in their communities and we can take them to another level.

By the same token, we are having success recruiting new production talent, both young talent out of our internship as well as seasoned talent.

Those production resources are doing a good job for us.

So, there's no one strategy.

There's no one silver bullet.

You just got to be out after it hard every single day.

One more question.

This is a more broad market related question.

When you talk about prices being down 10 or 20% or whatever the case may be, is that a function of actual reductions in sales price or is that a function of allowing more coverage or higher limits for similar premium prices, if you follow the question.

It is both.

And I think that, when you hear underwriters say they're maintaining rate, they may be maintaining rate but in many instances they're giving it all away in coverage.

Okay.

So, a lot of times when somebody is speaking of a 10% decline, that doesn't necessarily imply that the amount of written premium is going to be down 10%.

It is just on an apples to apples basis it would have been down 10% had it been the same coverage.

That's correct.

Our guys are out hard selling more insurance.

So, in a hard market, you'll take limits down.

You'll eliminate coverages.

When the market softens, now you're talking to your clients about expanding their portfolio.

Are you seeing more one way than the other?

In terms of price versus limits?

I don't have a measure on that.

Okay.

That's all of my questions.

Thank you.

Thank you.

Ladies and gentlemen, as a final reminder, the floor is still open for questions.

(OPERATOR INSTRUCTIONS) Our next question is coming from Meyer Shields of Stifel Nicolaus.

Thanks.

I came on a little late.

I apologize if you've covered this.

Good morning, I'm sorry.

Other than supplementals, are you seeing movement in carriers paying higher core commission rates?

That's negotiated at the underwriting desk.

Every single day.

The benefit or the beauty of our production force being basically paid on a production formula is that they've got to ask underwriters for as much commission as they can negotiate deal by deal.

And yes, we're seeing some expanded commissions from underwriting -- from the underwriting partners.

Okay.

Can you quantify that at all?

No, I can't.

And frankly I can't because even though we have supplemental arrangements, did I say this earlier, in an earlier comment, our production team is empowered at the underwriting desk to make a deal with that underwriter and oftentimes that may entail cutting commissions so account by account, it is virtually all over the board.

Okay.

Looking forward, do you think that's going to be a material trend as the market softens further?

Let's put it this way.

As the market softens further and a production force that understands that they get paid on what they basically bring into the door, I think that they'll get as much commission as the underwriters are willing to give.

Okay.

That's helpful.

Switching gears, when you talk about reinsurance becoming increasingly advisory, what does that imply for margins?

If I understand it correctly, reinsurance brokerage typically had higher margins that retail.

Is that changing?

My prediction over the next ten years is margins will be halved.

Okay.

And one last question if I can.

When you talk about broadening coverage in terms of conditions being loosened, does that itself have any implications for claim counts within risk management?

No.

Okay.

Thank you.

Great.

Any further questions?

There appear to be no further questions at this time.

Great.

Then let me just make a few quick wrap-up comments.

First of all, again, thanks for your questions and thanks for joining us this morning.

As I said, I am pleased with the second quarter but I do want to caution everybody our team realizes there is a long way to go in '07.

We're not to the end of this year yet.

We're very focused on selling, servicing, recruiting, merging, and becoming more efficient.

The next six months are going to be a challenge.

Remember our third quarter is seasonally our largest quarter but we remain focused and very positive on growing our company.

Thank you for being with us this morning, everybody.