Arthur J. Gallagher & Co. (AJG) 2008 Q3 法說會逐字稿

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

Gallagher and Company third 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.

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 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 and Company.

Sir, the floor is yours.

Thank you very much.

Good morning everyone.

And thank you for joining us this morning.

We appreciate your being here.

This morn I am joined by Doug Howell, our Chief Financial Officer, Walt Bay, our General Counsel, as well as the Heads over our operating divisions.

I think it is clear we know what is happening in the financial markets.

I have to say that I am feeling very blessed to be in this business.

I can tell you one thing is for sure, that is clients will continue to buy their insurance.

I won't spend time on the financial markets I will just instead just jump into our market.

I would like to start with our brokerage segment.

We continue to fight the headwinds of rate reductions, you can see that in our results.

Rates in quarter according to Council of Insurance Agents and Brokers survey, were off again about 11% in the commercial market.

But even with that continuing softening, our results EBITDA up 11%, EPS up 9%, margins holding steady.

We think these are very good results given the environment.

Holding our margins steady, growing revenues 8% in the face of negative organic growth of 2% I believe, shows that our strategies are working.

We have closed 28 acquisitions this year for almost $100 million of revenue, and believe that will continue in the fourth quarter.

Our pipeline frankly has just never been better.

Also think about our position.

Presently there are only two publicly traded strategic buyers, with an appetite for the deals the size that we are doing.

We believe that there are 18,000 to 20,000 agencies in America, most of them are run by baby boomers.

Eventually they have to capitalize their life's work.

I am excited by the teams that have joined us, and I want to again thank each of them for joining our Company.

In every instance they had a choice to be with Gallagher or someone else, and they chose us, and we are proud of that.

Now let me address some of the components of the brokerage segment.

The retail PC market is tough, but our management team has responded well to this environment.

We have a vice grip on head count and personnel replacement, we are scrutinizing every expense and watching our costs.

Yet we continue to invest in production talent.

Our domestic wholesaling and MGA business are performing well overall.

Our domestic open market wholesaling, this is where we place hard to place accounts for various agents and brokers in the marketplace, this business is down as I would expect it to be.

As you know, this business by its nature, floats with market rates.

On the other hand, our MGAs, those are our underwriting operations, are performing incredibly well.

Our international wholesaling business, primarily in London, has continued to expand globally, and we see good revenue and profit growth there.

We completed an acquisition of an MGA in London, ended the quarter we took a minority position in the retail broker in Western Australia.

Our benefits business is a real highlight.

This continues to be our strongest growth business in the group.

We are seeing organic growth in this business and our acquisitions, continue to add revenue and pretax monthly.

We continue to believe the employer will play a key role in the benefits business, under either the McCain or Obama benefit plans.

Remember we are also building product offerings that go way beyond just health and welfare.

2008 is going be another great year for our benefits team.

Let me turn now to the risk management segment.

Although revenue grew 8%, claim counts from our existing businesses, our existing clients went down again in the quarter.

The soft market makes new business sales tough, but client retention has been excellent.

When claim counts go down on existing renewals, we feel the pressure on our margin.

Remember margins were also impacted by foreign exchange, our fastest growing part of the segment is international.

So as we grow and currencies fall, we actually build a bigger headwind for ourselves.

It is a very labor intensive business, that continues to be impacted by the soft market.

The market continues to soften, and as I have said before, we have a soft market play book that we are following very closely.

Our fundamental strategy continues to be #1 cost control, we are watching all expenses, mergers and acquisitions, #2, and #3, hiring production talent.

When I look at our business I really don't see any surprises we have to continue to focus and execute.

While the market continues to soften there are interesting statistics that are developing, one report said third quarter property casualty combined loss and expense ratios are approaching 116%, including catastrophes.

Another report projects that 8%, or some $42 billion of surplus, would come out of the PC industry in the third quarter, and could decline by 15%, or $80 billion by year end, if investments don't recover.

Hurricane Ike is turning in losses far exceeding most estimates.

Tort costs continue to rise, the economy is in trouble, investments will be marked down, and we have seen unprecedented layoffs, which sometimes can result in a higher number of work comp claims.

So, we are in a pretty interesting part of the cycle.

As I said, no surprises at Gallagher.

We have a strong balance sheet, strong cash flow, a great dividend, our strategic position is better than ever, and I continue to be very, very bullish on our business.

Doug?

Thanks, Pat.

Good morning, everyone.

Today I have six comments.

First a couple of quick housekeeping items.

We are going to file our 10-Q later this week, and don't forget on our website, we have a five year quarterly spread, that helps you see trends and seasonalities that is useful when you build your models.

Second, let's jump into some comments on the financial services and corporate segment.

As you can see there are many ins and outs this quarter, but here is a short cut way to think about it.

Interest expense was about $0.05, and normal administrative and overhead costs in this segment run about $0.01 a share.

So a normal quarter would be about $0.06 of loss, but in this quarter we took some further actions to wrap up many of our historical investments, and those wrap up activities cost us about $0.04 a share.

But overall we made some really nice headway there.

Then we also put several federal and state tax matters behind us, which gave us about a net $0.08 of income.

So as you read the narrative, here is the simple math.

$0.06 of loss from normal interest and administrative expenses, $0.04 of loss related to wrapping up many of our investments, and then an offset of $0.08 of income from tax matters.

That gets you to the reported $0.02 of loss in this segment.

Since we are talking about taxes, let me go to my third point.

I still get a few questions on how to model additional cash flows from realizing our deferred tax asset.

The short cut answer I have given before, is for you to just compute what you think we will pay in taxes the normal way when you do your cash flows, then reduce your estimate by about 30 to $40 million for each of the next five to six years.

Fourth we had another great M&A quarter.

These are terrific new partners, who are outstanding insurance professionals.

Most of these fall right into our sweet spot of doing deals that have between 2 million and $10 million of revenues.

Given the state of the credit markets, we intend on using more stock to fund our acquisitions in the next few months.

At the same time, we are tightening terms and conditions as we partner with those rational sellers, that understand that in today's world, even when multiples are falling, sellers if they choose can hold our stock, and reap the benefits when multiples improve.

Fifth, through mid-October back office attrition in our brokerage units has allowed us to reduce staff by about 140 people.

We made little progress this quarter because attrition is down dramatically.

Clearly this is an indication of the country's weak economy.

Accordingly, our efforts to reduce staff will stretch well into the first half of 2009.

In addition if attrition doesn't increase, we will look at some targeted outplacements to reach our goal.

We remain confident that the new tools, the new technology and new techniques that we have developed will help reduce our staff, yet still improve our client service levels.

Sixth, I have told you before, that many of our expense savings initiatives are bearing fruit, but it is too bad the soft market is masking the hard work of our team.

That said, given the state of the economy, we are looking for new ways to postpone and eliminate costs.

These efforts are simply prudent, preventive measures in tough economic times.

Our cash flows remain strong, we remain confident in our business model, we have confidence in our management team, and we believe we can navigate these troubled times that are all around us.

These cost containment exercises are simply added assurance to keep Gallagher strong.

Okay, Pat.

Those are my comments.

Back to you.

Thanks Doug.

Brandy, we are ready for questions if you are.

Would you open the lines, please?

Thank you.

(OPERATOR INSTRUCTIONS).

Thank you.

Our first question is coming from Keith Walsh of Citi.

Please state your question.

Good morning, everybody.

Thank you.

Morning, Keith.

I guess first, for Doug, just on pension expense, obviously with the decline in plan assets, we have seen, I am assuming year-to-date and probably higher discount rates, I know that these assumptions are set on December 31st, but if you can just giver us a little color on incremental gap pension expense, how that is going to change for you guys, if the year ended today?

Then I have a follow up for Pat.

Thanks.

First to set the stage, we froze our pension plan if you will recall three years ago.

So we have a frozen plan.

The assets in that plan were overfunded last year.

They are slightly underfunded this year.

We think it will drive between 2 and $3 million of additional expense into our '09 numbers, compared to our '08 numbers.

Great.

Okay.

So pretty modest headwind there.

Right.

And then, just for Pat, lots of talk about pricing going up.

Okay.

Just what is your take, what is the reality of this, on 10/1 renewals, and what do you think about 1/1 renewals, any color you that you are seeing out there?

Thanks.

We are not seeing that, Keith.

Certain areas of the market heavy marine, that type of thing, stuff that really hit by Ike, you might see pricing improvement there, but by and large where we play, pricing is still going down and was going down at 10/1.

As for the first of the year, my crystal ball would be more of the same.

Okay.

Do you think that is something that is just maybe more geared toward where you play in the market, relative to maybe some of the other, maybe larger brokers out there, or is that something just overall you are seeing?

I think it is overall.

We are all playing in the same playing field.

Okay.

thanks a lot.

Sure.

Our next question is coming from Meyer Shields of Stifel Nicolaus, please state your question.

Thanks, good morning everybody.

How are you?

Good morning Meyer.

How are you?

Can you talk about how you see the AIG scenario, not in terms of what happens with the Company, but how is that affecting business and maybe commission levels for the broker standpoint?

Well, obviously, for a period of about three weeks, it was a significant impact on our people.

Our clients were very, very concerned especially as the news was coming out that week before the loan from the federal Government or the days before.

Every single client was calling in our brokers were trying to do everything they could to communicate with them.

I think AIG did a very good job of communicating through their broker network to their clients, in terms of what was going on.

When the loans were solidified I think that took a lot of pressure off.

I would also have to say that the state regulators, both in New York and Illinois, spent a lot of time and effort.

If you go to our website you can click on and listen to the Illinois Director of Insurance, Michael McRaith, who did a conference call for our people and our clients, and I think they really calmed the waters as best they could, relative to what is happening there.

The rating agencies continue to be solidly behind the insuring enterprises of AIG, but to say that it has caused some real consternation in the market, and AIG is our biggest trading partner, and I think they are doing everything they can to weather the storm, but it is difficult.

You don't see it presenting any particular challenges or opportunities for 2009, do you?

No, I really don't.

I think it will create a lot more work, as we do everything we can to communicate with our clients, as to what the outgoing situation is there.

Okay.

That is helpful.

If I can turn quickly to benefits, you talked a little bit about how the employment sector is probably going to get worse, and it's implications on potential workers compensation claim volume.

How is it going to affect benefits revenue growth?

It is real simple, Meyer.

If we are in a deep recession and people start letting people go.

As you know, all benefits is predicated on employee counts.

It is just going be a headwind for us for sure.

Do you adjust head count for that?

We will, absolutely.

Okay.

Thanks so much.

You bet.

Our next question is coming from Dan Farrell with FPK.

Please state your question.

Good morning.

Morning.

Can you talk a little bit about the performance of the acquisitions that you have done over the last 12 months, maybe just some broad comments on the growth of those, and the revenues there, versus the existing book and then also maybe the margin impact from the acquisitions, given the significant activity?

I will let Doug talk about the margins, and what have you.

We are very, very happy with the deals we have done over the last two years.

I would go back three or four years we are happy with the deal.

Every six months we take our board through a reflection of what are the internal rate of returns on each deal as they go forward.

As you can, I am sure you are aware, as they season, it becomes a better and better number.

But I think we are buying really terrific units, and as I have said many times, the due diligence on an acquisition, 95% of the due diligence is on the people.

Are we going to get along.

Are we excited, are there things we are going to bring to the table?

We are not downsizing and right-sizing these things.

We are trying to help them recruit production talent, get into niches we are in, bring certain benefit programs to them, that they wouldn't be able to sell themselves.

So across each division that is doing acquisitions, every time we do one, we are hoping that one plus one is going to equals five.

I have to tell you that some of the people that joined us this year, and I get comments from the field from our competitors, many, many times during the year, I was surprised that so and so sold their business, congratulations you got a great operation.

And those things are proving out.

Doug do you want to comment on the numbers?

Yes.

I think overall the comment is good.

I think that on it is better on the ones that we, the real true tuck-ins, where we can roll them into our shop, and they join our teams, and they start working with our staff, and have done outstanding.

They simply are tremendous financial wins for us.

The one that is are stand alone, obviously they are suffering the same pressures we are, but I wouldn't say it is any different.

Their fighting the headwind of the soft market, but their teams are turned on, and we are not having lots of early exits, from people bailing out.

So overall we are pleased with the margins they are contributing, and I would say it is no different than in the past.

Can you refresh us roughly on the mix of cash and stock that you were using for deals and where that mix goes to?

Yes.

Historically in 2007 and early 2008 we were using almost 100% cash, and throughout the mid-part of 2008 we are going to more like 60% cash and 40% stock on a blended basis, and now we are going to favor stock a little bit more, as we go into the early part of next year.

Again, multiples need to come down in terms of what we are paying.

We are working on that and if the sellers want to participate, in the recovery of the multiple, they will have the opportunity to do that by holding our stock.

There is no prohibition for them selling it right after they get it, but if they want to ride up as brokers recover, moving into a hard market they have the opportunity to do that with our stock.

Great.

Thank you.

Thanks.

(OPERATOR INSTRUCTIONS).

Our next question is coming from Mark Dwelle of RBC Capital Markets.

Good morning.

Good morning, Mark.

A couple of questions.

Did you provide, you often do, the trailing amount of acquired revenue during the quarter?

What we have is we say that we bought $41 million worth of annualized revenue.

That is what I meant.

The bottom, other information at the press release.

I am sorry, I missed it.

Second question, within the risk management unit, what portion of that revenue is foreign, or FX exposed as compared to the domestic portion?

15%.

15, 1-5.

Yes.

Okay.

You have noted in the past that is the growing portion.

Is the growth both UK and Australia, or are there other components to that?

UK and Australia, both operations are doing very well.

Okay.

You had commented on a prior question, in terms of your words were doing a whole lot more work related to AIG-related quotes, and just servicing your customers during a difficult segment.

Is there an actual cost to your business related to that, or are you really just leveraging the telephones and people that you already have in place?

We are basically leveraging the telephones and people we have in place.

It just adds to the work load.

That is all.

Okay.

That is not anything unusual for us.

When we have had other carriers that have run into problems, our brokers were there.

That is what they do.

When there is disruption in the carrier marketplace, our brokers understand the program, they understand who will be able to pick it up, or they will sit down and talk to our clients about staying where they are.

This is not an unusual behavior for our brokers out there.

Okay.

And the last question on a couple of the prior conference calls, we talked about some changes, or some things that may be in the works with respect to contingent commissions, have you heard any updates related to that?

No.

I think, Mark, the state of New York held hearings on the subject over the summer, and we have really heard nothing from those hearings, in terms of a change or an affirmation of the status quo.

I have been very verbal and I have been very public, about the fact that I think it is abhorrent to have two sets of rules if you are regulators.

I don't know how they justify that.

So make the rules one way or the other, we can play by whatever the rule book is, but having two sets of rules is just, it is just doesn't make any sense at all, and I think that is what New York is looking at.

Okay.

Very good, thanks for your help.

Thanks, Mark.

Our next question is coming from Justin Maurer, Lord Abbett.

Good morning, guys.

Good morning, Justin.

Just a question on AIG.

You have been saying, it is important to get out there, and stay in front of people, and communicate what is going on.

Is any potential dislocation or movement toward others beneficial to you guys, or is it just kind of out of one pocket into the other so to speak?

Out of one pocket into the other.

Great.

Thank you.

At this time, there are no further questions.

I would like to turn the call back over to J.

Patrick Gallagher Jr.

for any closing remarks.

Thanks Brandy.

I will make just a very brief couple of remarks here.

Let me reiterate that I really think that this quarter shows that even in a soft market, our strategies are proving to be sound.

The brokerage business EBITDA is up 11%, our EPS is up 9%, our margins are holding.

So as we go forward, there are going be five things we continue to focus on.

One we are going to maintain a conservative balance sheet.

Two, we are going to continue to roll on acquisitions, our pipeline is terrific, three, we are going to watch our costs.

We understand it is time to be frugal.

Four, we are going to constantly recruit producers that we believe can sell, and fifth, we will continue to focus on maintaining our unique culture.

We really do think we are building a unique Company, and we see a bright future.

Thank you for being with us this morning.

We really appreciate it.

That is it.

Thank you for your participation, ladies and gentlemen.

This does conclude today's teleconference.

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