Arthur J. Gallagher & Co. (AJG) 2008 Q1 法說會逐字稿

Good morning, ladies and gentlemen and welcome to the Arthur J.

Gallagher and Co.

first quarter 2008 Earnings Conference Call.

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

Your lines will open for questions following the presentation.

As a reminder, today's call is being recorded.

If you have any objections, you may disconnect at this time.

Some of the comments made during this conference call including answers given in response to questions may constitute forward-looking statements within the meaning of the securities laws.

These forward-looking statements are subject to certain risks and uncertainties described in the Company's reports filed with the Securities & Exchange Commission.

Actual results may differ materially from those discussed today.

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.

Good morning, everyone.

Thank you very much for joining us for our first quarter conference call.

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

I'll make a few comments on the quarter by segment.

Doug will have some comments and then we'll move rather quickly to questions and answer and get to what the things are that you're interested in.

So let me start with the brokerage segment.

Revenue up 11%.

EBITDA, 13%.

Pretax profit up 10%.

Earnings per share up 24%.

1% of that growth was organic.

I'm pleased with that result.

As you know, our first quarter is difficult to compare and many years we don't have a start that's as strong as that.

We are also, as you all know, trading in a very, very competitive market.

Given any kind of competition on an account, rates are falling anywhere between 15 and 35% or 40%.

In particular, our property casualty retail business is fighting a very strong market headwind.

If rates continue to slide at this pace, it will be tough to grow organically in 2008.

But let's remember this is good for our customers.

Our brokerage results were helped by a strong quarter for our wholesaling and MGA business.

Both the U.S.

and the U.K.

contributed to that growth.

Risk placement services, our U.S.

wholesale operation had strong results that were aided nicely by our performance bonuses from our MGA activities.

Our benefits brokerage and consulting business continued to post strong revenue gains.

A real bright spot for the Company continues to be our merger and acquisition activity.

11 deals, $31 million in revenue purchased and literally a pipeline with more opportunities than I've ever seen in our history.

Remember, many of these are small, what we call tuck-in acquisitions that are really as close to organic hiring as you can get.

The merger and acquisition activity really is a key strategy for our growth.

And I really, really like our position.

Think about this.

We believe that there are 25,000 agencies and brokerage firms across America.

We believe that most of those, better than 50%, probably better than 70%, are run by baby boomers.

They're my age or slightly older.

Ultimately, these people have to do something to capitalize their life's work.

They just have to do something.

And we offer a very, very unique culture.

We've been at this for 20 years.

We're good at it.

We believe we're a very, very good choice.

Our culture is entrepreneurial.

We're very sales-driven.

We're team-oriented, niche focused.

And at the end of the day, we're a brokerage run by brokers.

We're also not asking these people to come aboard and cut a whole bunch of costs.

What we're trying to do is be additive.

One plus one can equal five.

In essence, can we grow faster together than either of us could grow alone.

As I said, it is working.

We have a 20 year history of doing acquisitions successfully.

The fun thing is that whenever we're talking to a potential partner, we always offer to give them the list of our recent and not so recent deals.

We simply say call them.

Just call them and talk to them.

These are smart, great business people who will tell you exactly the good, the bad and the ugly.

Our pipeline has never been stronger and when we get people calling those past merger partners, in essence, we have merger partners selling others on joining us.

We have five people dedicated full-time to recruiting, pricing and closing deals and I think it is a very exciting strategy and something we're good at.

These are difficult times but the silver lining is our opportunity to convince partners to join us.

The new partners expand our talent pool, they expand our geographical footprint and they bring us great new clients that strengthen our niches.

I want to welcome all of our new partners and thank them for joining Gallagher.

As you all know, they did have choice.

I was very pleased to complete our Gallagher Re transactions at the beginning of this year.

This was actually a series of three transactions, one in the U.S., one in the U.K.

and one in Singapore.

It is never easy to exit a business.

But we know that it was the right decision.

We can now focus ourselves on competing in areas where we have real strengths.

We'll continue to put our efforts and investments in places that we know we can win.

And we are continuing to invest in our business.

We continue to believe this is a great business.

Think about it.

People have to buy insurance every single year.

They need us!

So, as the second quarter gets underway, we're looking forward to the 160 or so interns who will join us starting in June.

Let me turn to the risk management segment.

I'm disappointed in our start in the first quarter in this segment.

We had okay revenue growth of 9% but our cost structure got out ahead of us a little bit in the quarter.

We'll build a little bit of excess capacity in the field that will absorb as claim counts rise.

Quarterly comparisons in the risk management segment are tough.

You have to remember, when claims come in the door, we have to have the people to handle them.

So, we're constantly trying to maintain the right balance between how much capacity and how much work.

Let me also point something out.

In the first quarter, we're off our pretax target of 15% by $3.6 million.

So, we still feel if we can maintain the top line momentum, we can control expenses and we should have a good growth year.

As I said, this is one tough trading environment.

But frankly, I've told our team I expect this to even get tougher.

Rates are going to continue to fall.

We're in the fourth year of a soft market.

And really, who knows how long these rate cuts can continue.

I believe we're going into or are in a recession.

As our clients start to cut back in sales and payrolls fall, we'll be faced with lower premiums based on exposure units.

Of course, a recession will also strain our benefits and our risk management business.

So, we're pleased to have the first quarter behind us.

We just emphasize that this is a very, very difficult and competitive operating environment but our acquisition pipeline is a bright light which is really robust.

Doug?

Thanks, Pat.

Good morning, everyone.

Today I have six comments.

First, a comment about funding our acquisitions.

As you can see, during the last couple of quarters, we have been favoring acquisitions over stock repurchases in terms of allocating our free cash.

We expect to again favor acquisition over share repurchases throughout 2008.

Further, because there are so many opportunities, we might return to using stock in more of our deals.

Second, some of you have asked from time to time about our IT platform and its ability to handle our growth.

We are nearly finished with a year-long project to replatform our data center, our global network and our corporate IT infrastructure.

These new platforms make us industrial strength and they can easily handle all of our new applications that I've discussed before, Such as our up and running new financial and human resource applications and the roll-out of our new document management systems.

In addition, this new platform supports fast and stable workloads with our offshore service centers.

In a nutshell, these new systems can now easily handle nearly unlimited organic business and hundreds and hundreds of new branch locations.

For my third point, a quick update on our head count reduction and expense savings initiatives that we announced at the end of January.

In addition to the reductions associated with the sale of our reinsurance operations, through mid April, we are down about 70 people, nearly all from attrition.

Dollarwise, we didn't see much savings in the first quarter because most of the heavy activity came later in the quarter.

Given that we implemented this initiative in late January, and there were replacement hires pending in the pipeline at that time, we're satisfied with these early efforts and we remain focused on reducing our back office head count by about 400 people over the course of 2008.

On the expense front, we rolled out our new prerequisite travel and entertainment expense programs in our retail P&C and our wholesale and corporate units effective March 31st.

We expect our retail benefit brokerage and our risk management units to be done by the end of the second quarter.

My fourth point relates to our financial services segment.

Remember that all of our Section 29 credits -- credit projects ceased to operate on December 31, 2007.

And most of the post-production matters have been wound down over the past couple of months.

Over the next couple of months, we'll settle up on the final cash and dissolve the partnerships.

We do not expect the wrap-up matters to have any significant financial impact.

So, other than these wind down activities, you can see there is not much going on in our financial services segment and it continues to evolve into a corporate segment.

Going forward, this segment will continue to manage down -- to manage down the handful of remaining investment, house our interest expense and absorb about $4 to $6 million of direct administrative costs to associated with managing the investments and corporate overhead allocations.

My fifth point is simply a repeat of what I said in January but it is an important point as you're preparing your cash flow models.

At December 31, 2007, we have deferred tax assets associated with our Section 29 tax credit projects totaling approximately $218 million.

This asset will be realized by paying less cash taxes in the future.

So when you do your future cash flow models, compute what you think we'll pay in taxes, then reduce your estimate by about $30 million to $40 million for each of the next five to six years.

That way your models will reflect a reasonable estimate of the effective monetization of this deferred tax asset.

Also, remember that the monetization of deferred tax assets does not impact our affected tax rate.

Accordingly, like we say in the press release, expect our companywide tax rates to be in the 39 to 41% range in 2008 and later years.

My sixth and last point is really just a few housekeeping-like items.

Remember that our first quarter is seasonally our smallest quarter.

Note that we intend on filing our 10-Q early next week and hopefully it is helpful that we post a downloadable five-year quarterly spread on our web site that can help you see the longer term trends and the seasonality as you build your models.

Okay, Pat.

Those where my comments.

Back to you.

I think we're ready for questions and answers.

Questions, anyway.

Thank you.

The floor is now open for questions.

(OPERATOR INSTRUCTIONS) Our first question is coming from Bob Glasspiegel from Langen McAlenneny.

Good morning, Bob.

Pat, good to talk to you.

On the acquisition analysis guidance that you were giving, Doug, it sounds like you're saying share count should trend up over the year, that stock used for acquisitions will exceed buyback.

Is that a fair summation?

Really, what I'm saying is that our pipeline is very full right now.

We will use as much cash as we have and then to the extent that we have more opportunities in cash then we'll probably favor using some stock in those deals as we get later in the year.

Okay.

So, no guidance in share count.

Just some soft factors.

Yes, I don't know, Bob, exactly when the opportunities will arise or how it will be timed with our cash flows.

But I am telling you that we're favoring acquisitions and that if we need to, we'll use the stock to complete the rest of our deal.

Okay.

I think you've answered this question but I just want to be double sure I'm interpreting correctly.

You're using stock instead of cash.

It is being driven by your out of cash to do it.

Not that the PE is -- this isn't a hidden statement about where the earnings are and the PE is higher and stock is more advantageous.

I guess said a different way, how do you value the cost of equity in doing an acquisition versus cash?

The way you say that first is correct, is that we view this as a way to fund our acquisitions and this is not a signal of whether we think the stock is fairly valued, overvalued or undervalued.

I think it is undervalued.

That's a big surprise.

Thanks, Pat.

Thank you.

Our next question is coming from David Small with Bear Stearns.

Please go ahead.

Hi, Pat.

This is actually [Sal Sema] on behalf of David Small.

Hello, Sal.

How is it going?

Good.

Quick question for you.

At the beginning of the call, you mention how the acquisition pipeline is very strong.

This differs somewhat from what we heard yesterday from HRH as they said that they're seeing quality shops take themselves off the market as these shops aren't able to maximize their value in the current rate environment.

Are you not seeing this trend and if not, at what point in the pricing cycle you believe you'll start to see this trend and how far are we from that point?

Those are are series of questions that are difficult.

Let me start with where we're coming from in terms of our pipeline.

Our pipeline is -- as I said, it has never been this robust.

It is as strong as it has ever been.

In terms of letter of intents being prepared, firms coming in to see us, we have seen absolutely no falloff whatsoever.

I will say that we're also not seeing huge declines in valuations and at some point, that may occur and then people may be coming off the market.

But from our activity, we see strong, strong opportunities.

Talking to more people today at very serious levels than we've ever had in our history.

When will that fall off?

Sal, that's a good question.

You know what, as I said, the motivation for selling is multifold.

These people recognize that in all likelihood, capital gains taxes are going to change.

These are smart buyers who also realize that given the competitiveness of the market, it is likely that their revenue base without some assistance and some other opportunities to grow might begin to slip.

Chances are contingents are probably at all-time highs and the outlook for the future is cloudy.

So, I think that now is actually a very good time for sellers to be contemplating this.

What we have to do and what you can be assured we are doing is maintain our discipline.

The rules for us are very clear and very simple.

We do not buy turnaround projects.

That's not what we're in the business of doing.

We're buying successful entrepreneurs who are good in our business who love this business and want to stay in the business.

And we're not interested in helping people retire or, frankly, financial institutions exit.

That's not the business we're in.

We will not dilute.

So, even for the platform agency that really is a terrific location, we are not going to dilute.

So, basically, we follow those rules.

We find strong entrepreneurs and there are plenty of them who want to join us.

Great.

Thanks.

And just on a different note, the MGA -- MGU performance income is up around 66% year-over-year.

Can you provide some additional details into that and the margin impact?

Well, first of all, most of that goes directly to the bottom line.

But as you know, if you're running an MGA or MGU, all of our profitability comes from profit share commissions.

You're basically getting a subsistence living from the underwriting company to do the underwriting for them.

You cover your costs, but where you make your money is when you've done a good job of underwriting for them and we've had strong results from the MGAs and MGUs.

Great.

Thanks.

Thank you.

Our next question is coming from Keith Walsh with Citi.

Please go ahead.

Good morning, everybody.

Good morning, Keith.

Pat, you guys seem to have a real discipline around your M&A strategy, average deal size has been between $3 million and $5 million of revenues.

Whereas some of your competitors have gone upmarket with some of the deals they've done.

I just wondered if you could give us some broad comments about some of the challenges in maybe integrating some larger deals on why you choose to stick in that sort of sweet spot, $3 million to $5 million range then I have a follow-up.

Well, Keith, thank you for the comment.

Part of our discipline around that is that there are more opportunities at that level.

But the integration issue is clearly a part of the whole desire to stay in the not huge deals.

I mean, would we look at a deal that was $25 million in revenue?

Sure.

Have we looked at deals that were $100 million in revenue?

Not really.

And would we look at deals that are bigger than that?

Not likely.

We've got a mantra that there's no reason to make a big mistake.

You can get your hands around the culture and the people of a smaller deal much more easily than you can a large deal.

So number one, there are more opportunities because there's more of them.

Number two, we do favor them.

Now, as I said from time to time, there are little bit bigger agencies that become available and we'll take a very serious look at those.

Those are very successful entrepreneurs that have built some of the companies.

But by in large, you're going to see us stick to the sweet spot to $3 million to $5 million to $10 million.

We can do that all day long.

Your follow-up?

If you can just talk broadly again about valuing a business in this soft market.

I mean you're looking at a business and maybe it's got $3 million of revenues.

Do you factor in that it could potentially shrink when you're doing your valuation and how do you think about supplementals that they generate as well?

Absolutely do we factor that in.

You got to look -- that's another reason that some of the smaller ones are easier.

You can get your hands around their accounts.

Oftentimes, most times, in a firm that's $3 million to $5 million, the top 20 accounts are all the pretax.

Add in contingents or supplementals to that.

So, you have to factor in the industry that they're in, the accounts they have and what's going on in the market place around those accounts.

And also what's interesting to us, the smaller guys out there have actually been showing some growth.

They tend to be niche focused and they tend to do very well even in a soft market.

Great.

Thank you.

thank you.

Our next question is coming from.

[Guy Fleminger] with Stifel Nicholas.

Please go ahead.

Good morning.

Good morning.

You said you had 1% organic growth in brokerage, do you have a breakdown between the resale and wholesale segments for that?

I don't have that.

Okay.

And the supplementals, did they impact at all the organic growth rate in a year-over-year basis?

Yes, there is a slight fueling of the organic growth as a result of supplemental commissions but it is not more than a point.

Okay, fine.

And other than supplementals, are you having any successes in pushing for higher commissions in either retail or wholesale?

Yes.

And in fact, we allow our production team, our production people to negotiate their deals at the underwriting desk deal by deal.

And as you know, by in large, our production force is on a revenue formula.

So, at every opportunity, they're asking the local underwriter to give consideration to additional commissions and where there's room in the deal, they're getting them.

Okay.

And then just lastly, as far as wholesale M&A pipeline, given unusual pressures in that segment, are you seeing bargains for sale at lower prices?

No.

And we're being cautious about straight open market wholesale.

What you'll see our activity in the wholesale arena be primarily MGAs and MGUs.

All right.

Thank you very much.

Thank you.

Our next question is coming from [Brian De Rubio] with U.S.

Trust.

Please go ahead.

Good morning, guys.

Good morning, Brian.

How are you?

Good.

How are you?

Okay.

Just a couple of housekeeping questions.

At the end of the quarter, I think you had about $185 million in cash on the balance sheet that was yours but you still opted to draw down the revolver.

Give me a sense as you're thinking about it, your decision to keep -- what kind of cash do you want to keep in the bank, how much do you want to draw the revolver and why are you holding all of this cash when you can use it to make the acquisitions?

Brian, first of all, the nature of the cash in the balance sheet, a big piece of that number is international.

And we're doing domestic acquisitions, so rather than bringing it back to the U.S., we leave it internationally and over there because of the tax situation there.

Second of all, a lot of that $185 million while technically free cash for us to use as we would like, it is really relating to our customer's funds, not technically in a premium trust account so we tend to keep that cash as if it were in a premium trust account.

So, we don't use our customer's cash in order to fund acquisitions.

That's a good thing.

I think they appreciate that.

We could technically but it is not something we've ever done and I don't see us doing it.

No problem.

The IT system, you mentioned that you're sort of getting up and running on all the various systems you've been implementing over the past few years.

There's been added costs due to those system upgrades.

Where do we stand in terms of the cost -- added costs of those and are we going to see any of that abate in the second half of this year as we go on-line?

Like I've said before, our improvement initiatives have cost us probably a margin point each year for the last couple of years.

That's the way it is running here in 2008 also.

We expect that with our head count control initiatives and with our offshoring initiative, that we'll begin to see payback on that toward the end of the year.

Great.

Thanks, guys.

Thanks, Brian.

Thank you.

[OPERATOR INSTRUCTIONS]

Elsa, I think we're at the end of the questions-and-answer period here.

We do have one final question.

Would you like to take it?

I would be glad to.

Our final question is from Jay Gelb from Lehman Brothers.

Please go ahead.

Good morning.

I was hoping, Pat, maybe you could reconcile the statements on the risk management segment where you anticipate claims counts could go up but at the same time the country could be headed in a recession.

My recollection was that a meaningful portion of the risk management segment was driven by economically sensitive sectors.

That's a very good question.

And you're absolutely right on.

If you remember back to 2001 after 9/11, when we really had a slowdown in transportation and the light claim counts dropped precipitously.

In a normal recession, we don't see claim counts dropping off precipitously.

They tend to go down slowly.

And right now, we have such a strong new business pipeline that we're pretty confident that for at least the first half of this year, we'll see claim counts grow.

I remember you used to also give actually the claim count numbers.

Can you -- I don't know if you have those handy or if you can give sort of the percentage change.

What you saw in the first quarter.

We're up 3% in claim count in the first quarter over last year.

And what was that number for perhaps all of 2007?

Well, the claim counts through all of '07 were up about 5% and the total claim counts, I'll ask Rich McKenna to speak up.

We brought in about 600,000 claims in the U.S.

market in '07 and that's about -- that was a 5% increase over '06.

Okay.

And then just so we can square our models a bit.

What should we anticipate the impact being on the sale of the reinsurance business going forward?

My recollection was that was sort of a break-even business.

What could the impact be on margins?

We lost about $12 million pretax last year in that business.

I think, Jay, the best thing to do is we carved out all of the reinsurance operations.

Go to the five year quarterly spread on the web site.

We pushed all of the reinsurance business out of the brokerage segment.

It's in one line in discontinued ops and in the course of discontinued operation accounting so you can get the good run rate there.

If you look at that web site and true it up, that spreadsheet on our web site, you can true your models up to that.

That's probably the safest way for me to answer the question.

That's helpful.

Thanks very much.

Thanks, Jay.

Thank you.

Mr.

Gallagher, we do have two more questions in the queue.

Sure.

Let's take them.

Our next question is from Nick Pendergrast from Signal Hill.

Good morning, guys.

Good morning, Nick.

I just had a question in regard to your risk management section.

As far as looking at our model, you guys came in line with our revenues, the expenses were a little bit higher.

I know you had mentioned that head count is a pretty sensitive issue given that you need to have the capacity in place in case claims come through.

I was just curious, have you guys hired more people in that segment?

Yes.

Yes, you have?

Okay.

And presumably, I assume you're hiring because you expect to see increased claim activity throughout the year?

We're up about 27 people in that segment.

Okay.

And for the year.

That's off of December 31.

And here's how it works, Nick.

We tried to predict, as closely as we can, the claims that will arise in the future.

So when you write a new piece of business, let's say you've got a piece of business that is going to give you 5,000 claims, literally try to predict when and where those claims are going to hit.

Understood.

And you better just in time hire right because you have claims coming in and they're not adjusted, you've got a big problem.

I see.

I see.

Okay.

Well, thank you for that little bit.

Also, my other question regards to the discontinued operations and I notice you guys give an income statement of -- a little breakout of what the components are of that.

Was there anything that came as a surprise in any of those line items to you guys?

I don't think so.

We gave our -- when we did the deal in our early -- when we announced the deal, we were pretty close to where we are.

As a reminder, we still have the lease termination costs that will probably hit in the third quarter which will probably be about $15 million.

Some of that cash, some of it noncash.

Okay.

Well, thank you very much.

Thanks, Nick.

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

Please go ahead.

Good morning.

Good morning, Mark.

Two questions.

And they're both pretty simple.

With respect to discontinued operations, when you take the lease termination charge as well as any settle-up on the sort of an earnout payment, that will all be below the line, which is to say nonoperating whenever that occurs?

Correct.

It will all be in the discontinued line item that is not in the brokerage segment nor in the risk management segment.

Okay.

That's what I figured.

Just wanted to be sure.

And with respect to the risk management segment, the international unit has been growing pretty nicely.

Can you tell us what the split is between domestic revenues and international revenues at this point?

Excuse me, our international revenues are 15% of our total revenues.

Okay.

That's all of my questions.

Thank you.

Thanks, Mark.

Thank you, at this time I would like to turn the floor back over to you for any further closing remarks.

Yes, I do have a few closing remarks.

First and foremost, thank you all of you for joining us this morning.

It is very, very competitive out there.

But we, as an organization, as a management team are focused on five very specific dominant priorities.

Number one, increasing our organic growth, we are a sales and marketing company and we get out and get after new business every single day.

Secondly, aligning our service deliverables with our compensation.

In other words, we've got to get paid properly for what we do.

Three, increasing our productivity and our margins.

Fourth, hiring and retaining the right people, frankly the best people because we are a people business.

And fifth, continuing to drive our merger and acquisition opportunities.

If we deliver on these five areas, we'll continue to grow and build the company and we're confident that we can do that.

Thank you, everybody for joining us this morning.

We appreciate it.

Thank you for your participation.

Ladies and gentlemen, this does conclude the today's teleconference.

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