Arthur J. Gallagher & Co. (AJG) 2008 Q2 法說會逐字稿

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

Gallagher & Co.

Second quarter 2008 earnings conference call.

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

Your lines will be 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 the conference call including answers given in response to the questions may constitute forward-looking statements within the meaning of the Securities law.

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

Sir, the floor is yours.

Thank you very much, Judith.

Good morning, everyone, and thank you for joining us on our second quarter conference call.

We appreciate your being with us today.

This morning I'm joined by Doug Howell, our Chief Financial Officer, Walt Bay, our General Counsel, as well as the division heads that run our operating businesses.

I will add some color to the quarter.

Then Doug will add some comments and we'll get pretty quickly to questions and answers.

I think it's no secret to anyone who is doing any kind of business out today that it is tough.

You just can't pick up a newspaper without reading about a Company or a industry that is in dire straits.

When I see what is going on in the global credit markets, the airline business, the automobile business, the home building business, many of those, by the way, are clients of ours, it's really, really difficult.

So when I look at the environment and I step back and I think about how we performed, I think we did well in the quarter.

Revenue grew 6%, EBITDA grew 8%, net earnings grew 9%, and we had one point of margin improvement in the brokerage segment.

And that is pretty good facing the difficulty we are in the marketplace.

Let me get into the individual segments.

Our brokerage segment was really a mix of varying results.

Over the years we have built the brokerage segment and we are lucky, I think, to have built a balance.

We have our PC retail business.

We have our benefits retail business, our wholesaling and our MGAs and MGUs.

Our retail benefits operation, you will recall, had a fantastic 2007 and our momentum is continuing to build nicely through the first half of 2008.

We will have another very, very strong growth year in benefits this year.

Another bright spot in the segment was our wholesaling and MGA business.

Surprisingly, even in this soft market our open market wholesale group was essentially flat in revenue and in pre-tax.

The MGA and program business received underwriting profit sharing bonuses that lifted all of our wholesaling operations to actual growth over prior year.

Our retail PC operations had a tough quarter and a tough first half.

Year-to-date we are slightly ahead of last year in revenues but we are essentially flat in EBITDA.

The market is just unbelievably competitive.

The Counsel of Insurance Agents and Brokers does a survey that I know most of you are aware of every quarter.

The last survey 77% of the respondents said that they felt the market was down 10% to 20%.

12% of the respondents said that they felt the market was down 20% to 30%.

And I won't give you too many illustrations and too many details on by line of coverage or what have you, let me just give you one illustration.

Even, we are finding even in catastrophe exposed areas, places that are exposed to wind and earthquake, large accounts, I'm talking about multibillion schedules, that need virtually the entire property market to complete are down 20% this year.

It's unbelievable slide.

Add to the rate deterioration the fact that the economy is slowing, virtually every sector we work in with the exception of oil and gas is slowing.

Construction on infrastructure projects continues, but other than that there is very little construction.

Our clients are really, really being challenged in this business environment.

So as I said, the business we have achieved in our brokerage segment I think served us well in the quarter and the first half and, frankly, showing growth in this environment came with a lot of really hard work in the field.

I'm proud of what the people have accomplished out there.

Let me turn to the merger and acquisition front.

We are off to our best start in our history.

We have done 20 deals, and remember last year we did 21 all in, for $58 million in revenue so far this year.

And we are going to continue to aggressively build our Company with new partners.

You can also see 20 deals averaging $3 million per deal in terms of revenue is as close to an organic hiring strategic as we can get and still call it acquisitions.

These new partners are choosing Gallagher because they believe they and their colleagues will have great opportunities to prosper and grow at Gallagher.

We welcome our new partners and as I say every quarter, thank you.

We are proud you chose to join us.

I'd like to make a comment on the state of New York's hearings over the past few weeks on the contingent commission issue.

I've personally been very, very vocal on this issue.

I think dual regulation, one set of rules for one group and a different set for another, is patently unfair.

I applaud New York for opening up this topic to industrywide discussion.

As I've said very often, the issue simply should be transparency, complete open discussion with clients on our renumeration.

Once you are transparent and the client decides how to pay you, then any form of compensation is appropriate.

I hope that New York levels the playing field.

We should all have to play by the same rules.

Let me turn now to the risk management segment.

Our risk management segment is also being slowed by market forces.

I will focus on three specific areas, the soft market in PC, in the property casualty business, existing client claim count growth and the economy.

As for the soft market, when the market is soft there's just fewer opportunities to move people to self insurance or what we refer to as the alternative market.

People tend to stay put in first dollar coverage.

Rebundling also occurs.

That is the [carriers] with the keep clients will actually get them to rebundle their claim service by offering cheaper premiums.

Our existing clients claim counts are not growing.

We need our existing clients' businesses to grow.

Expanding employment usually causes claim counts to go up and we are just not seeing this happen.

We are not seeing the frequency of claims arising that we expected.

Our clients' safety and lost control efforts are creating safer work environments.

And frankly, this is a good thing.

It's good for our clients and it is good for their employees.

The economy is clearly starting to hurt us.

All employers seem to be cutting back.

Fewer people moving, fewer new hires.

All this adds up to a tough environment to grow Gallagher Bassett, which is a very labor intensive business.

A bright spot for Gallagher Bassett is our international growth.

International is up 26% in the quarter.

We now have 500 people, about 500 people in Australia and tremendous growth opportunities there.

In the UK we have about 200 people and now over 50% of our UK business is coming from commercial accounts.

You will recall that just a few years ago virtually all of Gallagher Bassett's UK business was related to the public sector.

So as I said our comments will be brief.

Let me just kind of summarize.

Soft market, slow economy, those are headwinds.

But I step back from the second quarter and especially when I concentrate on the brokerage unit I see 11% growth EBITDA, 11% growth in EPS, a one point margin improvement.

I think that is good.

Those are respectable results.

Also note on a combined basis, in our core operating businesses, that's brokerage segment and risk management together, we had a record quarter in earnings and in EBITDA.

And in fact, this is our largest EBITDA quarter ever.

Our niches are growing.

Our new sales are strong.

Retention is good.

I'm very proud of our sales culture.

I'm proud of the work that our sales people do every day, getting out and getting after new business and holding on to clients.

Everyone at Gallagher understands that we are a sales and marketing Company.

We are proud of that.

Everyone understands that our clients comes first.

Everyone understands that nothing happens until we ring the cash register.

That is a very important part of our culture.

Our internship was a big success this summer.

We had over 170 college interns who really energized the Company.

My dad started this program 40 years ago.

The last three to four years we have had over 150 interns participate per year.

This is a big part of our commitment to our future.

Organic recruiting for production talent was good globally.

London, California, New York, Chicago and others all put some nice seasoned talent on.

And finally, mergers and acquisitions are coming in at a record rate and our pipeline is the best it's ever done.

So we do continue to fight the market forces.

There is no getting around that.

But I'm pleased to show growth in the quarter and I believe we will show growth for the year.

Doug?

Thanks, Pat, and good morning, everyone.

Today I have seven comments.

First let's go back to our merger and acquisition activity.

Clearly the number of deals is increasing but we are still at manageable levels.

Remember, we are sticking to our knitting by doing deals with brokers that have between $2 million to $10 million of revenue, right in our sweet spot.

In terms of integration, these deals are being spread across our four brokerage units, domestic P&C, domestic employee benefits, domestic wholesaling and and our London based international unit.

Each unit has their own dealmakers and integration support.

These deals are quality shops and they are ran by solid brokers that have developed a culture in their offices that is a terrific match with our sales and service culture.

All of these points help us join forces and integrate quickly.

For my second point a few comments on funding acquisitions.

If our current pace continues, we will likely supplement internally generated cash with long-term borrowings and common stock.

So if your models assume robust acquisition activity, just assume that we will use about one third internally generated cash, one third long-term borrowings and one third common stock.

A blend of these three sources should allow us to fund acquisitions well into the future.

In connection with using more common stock, it is time for us to update our shelf registration.

Accordingly, after we file our 10-Q we intend on filing an S4 to register 10 million shares of common stock that can be used for acquisitions over the coming years.

My third point is an update on our headcount reduction and expense savings initiatives.

Through mid July back office attrition in our brokerage units has allowed us to contract staffing by about 150 people and we are on pace to reduce our back office headcount by about 400 by the end of 2008 or early 2009.

In addition, during the second quarter we completed the rollout of our new perquisite and out-of-pocket travel and entertainment expense programs in all of our units.

A large portion of our brokerage segment's 1.1 point improvement in EBITDA margin is as a result of these initiatives.

For my fourth point a short update on our other operational improvement initiatives.

Most of you know that we continue to invest substantial time, energy and resources into improving the quality and reducing the cost of our systems and operations.

These projects are moving along very nicely and I'm pleased with our progress.

This quarter let me give you one example of how these longer term projects can deliver important payback.

In 2004 and 2005 we invested heavily in our policy review and policy issuance workflows within our brokerage units.

Since then, as a direct result of this improvement exercise, our E&O experience has improved dramatically, both in terms of frequency and severity and in total cost.

More satisfying, we are being told by E&O markets that our client service levels and professionalism is producing the best experience they've seen in our industry.

This is a great accomplishment by our field, our producers, our client service folks and a win/win for our clients and our shareholders.

My fifth point relates to our financial services segment.

Remember that all of our Section 29 tax projects ceased to operate on December 31, 2007 and most all of the post production matters have been wound down in the last six months.

We only have a couple partnerships left to dissolve and we should tidy that up here in the next few months.

So our financial services segment continues to evolve into a corporate segment that will house our remaining investments and investment income, our debt and interest expense and annually it will absorb about $4 million to $6 million of expenses related to managing these items, our income taxes and our corporate related activities.

For my sixth point remember that we have a substantial deferred tax asset that we'll be realizing over the coming years.

When you do your future cash flow models, compute what we think we 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 an estimate of the cash flows coming in from the realization of our deferred tax asset.

My seventh and last point is just a few housekeeping items.

We intend on filing our 10-Q later this week and shortly thereafter we will file our S4 shelf registration.

Also don't forget that our website has a downloadable five year quarterly spread that helps you see trends and seasonality and we think that is useful as you build your annual and quarterly models.

Okay, Pat, those are my comments, back to you.

Judith, if you would go to questions and answers, we would appreciate it.

Thank you.

(OPERATOR INSTRUCTIONS) Your first question is coming from Keith Walsh of Citi.

Good morning, everybody.

First question I guess for Doug on brokerage.

I see EBITDA margin of 110 bps but gross margin actually flat.

Maybe if you can give us some color on why depreciation and amortization rare increased year-over-year.

And then I have a follow up for Pat.

Amortization is going to increase year-over-year because of the deals that we are putting on.

If you remember we are amortizing about 60% to 70% of the purchase price of acquired entities.

So that's a piece of it.

As for appreciation, most of the additional depreciation is coming from our system initiatives that we put in place.

We spent about $10 million on that over the last year and a half and that depreciates pretty rapidly.

Okay, great.

I guess the second question for Pat and it sort of relates to Doug's comments on issuing stock for robust M&A, if we are assuming that in our models going forward.

Just on dividend philosophy, I see your payout ratio has expanded very sharply over the last five years and this makes me infer you have slow internal growth prospects.

If you could comment on that and then just maybe comment on why wouldn't shareholders be better served using this cash to grow commissions and fees through M&A versus a dividend, thanks?

I'll let Doug pile in as well, Keith, but I think if you look at our dividend distribution history, we've essential returned to shareholders either through stock buybacks or dividends about a third of our free cash a year.

And we did that -- we bumped the dividend up at a time prior to the attorney general's efforts to eliminate contingent commissions.

So we probably ran a little bit ahead of what would be the norm in terms of paying out something on the order of 50% of our EBITDA.

So you'll see that the dividend increases have essentially been about $0.01 a quarter for the last couple of years, so that we have kind of slowed the increase there, but we believe very strongly in keeping the dividend solid and maintaining that dividend.

In terms of how our stockholders get served and what have you, it's offers a very nice return, I think, while they wait around for an explosion in the market.

Doug do you want to comment on that?

I think what Pat said is exactly right.

We tend to -- historically we returned two-thirds of our cash to our clients, either through dividends or through purchases.

Sorry, shareholders.

Shareholders, I'm sorry, and so we just made a decision a few years ago that we'd more more heavily weight on dividends then we would on share repurchases..

I think we are comfortable with that level.

I think it does provide a meaningful return while shareholders wait for the hard market to return.

So I think that it still leaves us plenty of capacity to move forward.

We are under leveraged and we feel it's a good use of our cash for our shareholders.

Just a follow-up on that.

When I think about return on cash, with the way the market has changed and it assumes you guys are doing a great job on the M&A front, wouldn't it be better -- wouldn't you get a better return on your dollar doing more acquisitions than dividends necessarily?

Isn't the environment changed, can't you change your philosophy with it, I guess is the question?

Sure we could, but we have elected not to do that at this point.

Keith, I've been very vocal with shareholders and I have been asked this many, many times, sorry this is Pat, as to whether or not that dividend is safe and my answer has been from the very beginning that the answer to that question is yes.

Okay.

Thank you very much.

Thank you.

Your next question is coming from Dan Farrell of Fox-Pitt Kelton.

Please go ahead.

Good morning.

Good morning.

A couple questions.

Firstly, can you just comment on what you are seeing on pricing of deals currently?

And then secondly, you've had to increase your leverage to fund some of these deals.

I think you are at around 40%, 41% debt to cap.

What level of leverage are you comfortable with if you are going to continue to have a pretty active M&A either in terms of debt to cap or debt to EBITDA or whatever measure you can quantify?

Dan, first of all we've been paying six times EBITDA for our deals plus or minus a little bit from that, maybe more like 6.3 times EBITDA.

And that's been fairly consistent over the last couple of years.

We are seeing -- it's holding in there but we are seeing a slight drop in it but nothing that I consider to be meaningful at this point.

In terms of what we feel comfortable in leverage, when we get around two times EBITDA, that's where we start looking at using common stocks, so until we get to about two times EBITDA, I think that we have got some debt capacity there.

Okay.

And just one additional question.

Can you talk a little bit about efforts on the supplemental commission front and I don't know if you can quantify how much is flowing through results this quarter versus say the year ago or anything you can add there?

Well, I can tell you, Dan, this is Pat, the efforts have been -- we have worked very, very hard since we made our deal with the attorney general on getting supplemental commissions from our insurance Company partners, and I will tell you that we are very, very careful to disclose each and every one of them.

It's difficult for me to give you the dollar amount and part of the reason is some of these arrangements are paid literally account by account at the underwriting desk.

We do have some that are paid at the corporate level.

In terms of what we have kind of in a percentage basis recovered, we gave up about $30 million in contingent income, call is $27 million to $30 million in the 2004 settlement.

I think that it would be fair to say that we are probably somewhere on the order on an annualized basis of getting a third of that to maybe a half of it back.

Yes, Dan, quarter-over-quarter doesn't have any impact on our growth numbers.

Okay, great.

Thanks guys.

That was helpful.

Thank you.

Your next question is coming from Meyer Shields from Stifel Nicolaus.

Good morning, all.

Good morning, Meyer.

I guess relative to the three larger brokers, you have a much larger domestic presence as a percentage of revenues.

Are you looking at all at international expansion into markets where the economies are growing more rapidly?

That's a great question.

The answer to that is yes.

We will be very cautious, but last year, for instance, we did a deal where we pick up 40% of the largest broker in Jamaica and Barbados.

It is a really nice deal because we've been able to be very additive to their business, the niches and what have you that we bring, our benefits capabilities have helped them grow their business.

And at the same time, we have opened a very significant trading relationship with them in our London operation.

So there were great synergies there and, to your point, they are growing faster than the domestic market.

We will see efforts to expand in Asia, probably Australia, some of the emerging markets of Europe, and I think you'll see those -- and Singapore as well.

I think you'll see that expansion again.

It will be cautious.

It will be with partners that we know and it will have to have synergies for our London and domestic operations as well.

But we have good opportunities there.

That's good to hear.

And switching gears, if I can, should we expect headcount reduction within risk management if claim counts are going to be depressed by the economy?

Would you say that again, Meyer?

I'm sorry.

Within risk management should we expect headcount reductions if claim counts are expected to be depressed by the economy?

If the actual claim counts were to go down, then yes, you would expect headcount reduction.

But what we are seeing is the existing -- my point in my comments was that existing clients, those that are renewing, in order for the GB model to really work, we have to have those existing clients have growth in their claim counts.

That is really a big driver, typically, historically of part of our top-line revenue.

But the new business that Gallagher Bassett is writing does actual meet, does create additional claim counts.

So our claim counts are growing, they are just not growing at the pace we had hoped.

But you feel like your staffing is at the right level now?

The truth, Meyer, I think I'd say we are probably a tad over staffed.

The problem is that over staffing or that capacity falls into 100 offices domestically and probably five in the UK and four or five in Australia and I can't go around and get bits of people out of the system.

Got it.

Okay, thanks so much.

Thanks, Meyer.

Thank you.

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

Please go ahead.

Thanks.

My connection wavered a second, I just wanted to check on that number you threw out for the financial services segment, the $4 million to $6 million.

Was that a new number or is that something that we've been including all along?

4 to $6 million of costs are being shown in the corporate/financial services segment.

That is consistent with the last couple of years, Alison.

That's just what is staying down in that segment.

That is the cost of a lot of our corporate activities, our tax activities our investment activities, cost associated with running the debt and that is pretty consistent with where it's been for the last few years.

And also, right after that at the same point there was like statics on my line.

The cash flow discussion you were having, the $30 million, that too is related to the synthetic fuel facilities that we'd been talking about all along as well?

Yes, same number.

I think that was an update of the stuff I talk about in the last three or four quarters.

Perfect.

Thank you very much.

Thank you.

(OPERATOR INSTRUCTIONS) You have a follow-up question coming from Keith Walsh of Citi.

Please go ahead.

Thanks, again.

Pretty interesting comment before, I thought, on how softness in the economy.

We know about pricing.

If you can maybe give me a little more color behind that.

If you have a renewal coming up and like say a client of yours shrunk 10%, maybe their business is declining, would the insurance program or the amount of placement that you are making on their behalf shrink with that basically?

Is that like a one for one correlation between the two?

In general terms, Keith, the answer to that would be yes.

I'll share with you, I'm very worried about the economy.

We have not really seen a full impact for what's, what I think is going on out there.

And remember, all insurance premiums and pricing are predicated on exposure units, whether it's payroll, sales, the value of your buildings, the new buildings you are putting up, automobiles, adding automobiles and what have you.

And if you come to a renewal and a client says to you look my payrolls are coming down 10%.

Immediately their Workers' Compensation premiums are down 10%.

If he says my sales are going down 10%, immediately his general liability premium is coming down 10%.

So I'm really fearful about what that means in terms of headwinds in the future.

That's very helpful.

And just the last question.

With the Willis HRH integration, does that present any interesting opportunities for you guys to steal some business?

Well, I think that we thrive on change and so I would hope there would be opportunities there but we are not seeing anything at this point.

Okay, thank you very much.

Thank you.

Your next question is coming from David Lewis of Raymond James.

Question for you.

MarketScout also put out a survey that June was the first deceleration and downward pricing trends, I guess down 11% by their aggregate number.

Do you see any sense that people are starting to become, or the insurers are starting to become a little more concerned about the likely deterioration in ROEs and maybe we could see some stabilization developed in '09.

Absolutely not.

I will tell you that the market is, I'd call it frothy and I saw that, a similar comment on the CIAB survey that looked like the rate of decline was slowing.

We are not feeling -- let me just put it this way.

We are not feeling that.

Okay.

So your guess is that we are probably -- I know Bill Berkley kind of threw out that you might see some stabilization at least develop by 2010.

What is your gut feel given your experience in the industry?

David, this is my fourth cycle, my fourth soft market.

I've been the worst predictor in each cycle.

I will give you my perdition, but in the last soft market which started in '86 and went to 2001, I kept saying that when we saw a major insurer get into some real trouble that everybody would kind of get religion and we would see some firming.

And I don't need to go through the litany of carriers that disappeared through the decade of '86 to -- the 15 years from '86 to 2001.

It's an unbelievable list of companies that disappeared because the discipline it is almost impossible.

It's a supply and demand driven market.

So I do think 2010, when we do our discussions around the table here, we kind of think that it looks like 2010 could be the year.

I've heard reports that this year's deterioration in combined loss and expense could be the worse single year deterioration in the history of the industry.

We'll wait to see.

They've had two of the greatest, the underwriting comp communities had two of their most successful years back to back since the 50s.

So we just have to wait and see.

I understand.

Thanks for your thoughts.

Sure.

Thank you.

(OPERATOR INSTRUCTIONS) You have a follow-up question coming from Meyer Shields of Stifel Nicolaus.

Thanks, two quick follow ups.

One, is there a rough breakdown on an annual basis in terms of within brokerage segment how much is retail, how much is wholesale and how much is benefits?

I think that we haven't really given specific numbers on that, but if you really look at the whole unit, our retail units are going to comprise 80% and our wholesaling units are going to comprise 20%.

Benefits would be within retail?

Yes.

And second, is it safe to take it as a given that if New York definitely calls for complete transparency and there's a relaxation of the contingent ban that Illinois will sign on to that?

Well, I cannot speak for our attorney general, but let's just say that I will be in the office suggesting that that would be an appropriate decision.

Okay.

That's perfect.

Thank you.

Thank you.

There appears to be no further questions at this time.

I'd like to turn the floor back over to your host for any closing remarks.

Yes, I have just a very brief wrap up comment.

Everyone knows that it's a tough environment out there.

In fact I think it's as tough as I've ever seen in my career and I mentioned already today that I'm proud of the efforts our people are putting in out there.

I think our results really are a credit to the hard work in the field.

But as we fight the headwinds of this market and the economy, we are continuing to build our Company.

And we are going to continue to recruit organically and we'll continue, with the help of merger partners, to build what I believe is a world-class franchise, whose whole focus is on our customers and on growing this business, which I do believe we'll continue to see in 2008.

So thank you for being with us this morning and everybody have a great day.

Thank you for your participation.

Ladies and gentlemen, this does conclude the teleconference.

You may disconnect your lines at this time.

Have a wonderful day.