Arthur J. Gallagher & Co. (AJG) 2011 Q2 法說會逐字稿

Good morning.

Welcome to Arthur J.

Gallagher & Co second-quarter 2011 earnings conference call.

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 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 introduce J.

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

Gallagher & Co.

Mr.

Gallagher, you may begin.

Thank you, Rob.

Good morning, everybody, and welcome to our second quarter conference call.

We appreciate you being with us this morning.

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

As is our custom, I am going to offer my views on the quarter, Doug will make some comments, and we will get pretty quickly to questions and answers.

As I said in the press release, I'm extremely pleased with our second quarter.

The results I think were terrific, and the team really came through in the quarter.

Brokerage adjusted revenues up 16%; EBITDAC in the brokerage side up 13%; 2.1% organic growth.

And if I added our supplemental commissions to the organic number, it would have been 3.1% in the brokerage segment.

Risk management adjusted revenue up 20%.

EBITDAC up 19%, with 5.9%, almost 6% organic growth.

If you combine the our 2 operating segments, we produced about 3.7% organic growth in the quarter.

Everywhere I look around our enterprise, our numbers are improving.

Most of our businesses across the globe contributed to the quarter.

I'm really proud of the work our team did this quarter.

And I think that these results show that the strategies we have to grow our Company are working.

I want to remind the listeners that all of our strategies essentially fall into 4 main categories.

First thing we are out after every day is organic growth.

Secondly, mergers and acquisitions; thirdly, we are focused on operational excellence and productivity improvement; and fourthly, we want to maintain what we believe is a very unique corporate culture.

Let me touch on each of these categories briefly.

Let me talk about the drivers of organic growth this quarter.

Driving these results was about a 1 to 2 point increase in new business over 2010, and about a 1 to 2 point improvement in our loss business numbers over 2010, an incredibly competitive market out there.

And to improve new business and loss business in the face of that competition is really an achievement.

Also I would comment our niche focus I think continues to pay results that clients want to do business with those who truly understand their business.

We have made good progress in the quarter implementing our sales management software, and I hope that this will help us maintain our new business momentum.

Rates actually showed some flattening on the PC side in the quarter.

Catastrophe exposed property -- that's Florida wind, California earthquake, some of the property in the middle of the country where there were bad tornado losses this quarter, are all showing signs of increases.

Workers compensation in many of the states are also showing increases.

Now, Main Street and middle market accounts are still receiving some reductions especially when there is competition.

But in many instances, we are finding markets are not willing to cut their prices at renewal.

As I said, if there is competition on a good account, we are still going to see reductions, and there continues to be a difference in the underwriters' view between new business and renewals.

But the whole market is no longer one of automatic cuts for the clients.

Our organic growth shows great work by our team, we work in an incredibly competitive environment as I said, and I am proud of what we have done.

Mergers and acquisitions, our second category of strategic growth -- for 25 years we've sought to attract the best firms in our industry to our Company through the acquisition process.

The second quarter was a great merger and acquisition quarter.

We closed 9 deals, bringing $180 million of annualized revenue to the Company.

Our Heath Lambert acquisition in the UK brought us 1,200 new associates, and $158 million of annualized new revenue.

This acquisition fit our international growth strategy extremely well; you will recall Gallagher had a modest retail presence in the UK market, which is the 3rd largest retail market in the world.

The Heath team is a great fit from a business standpoint.

But just as importantly, the culture of the firm fit extremely well.

We are excited to have our new teammates aboard, and already we are seeing that in many numbers of ways, our 2 organizations will be stronger together than we were apart.

This acquisition adds additional strength to our global operations.

We are building a much stronger international presence.

Remember, we have been trading with a network of independent brokers for many years.

This has presented us with opportunities to continue to buy and/or take equity positions in brokers outside the US.

Recall that over the last few years, we've expanded into the Caribbean, Australia, Brazil, Singapore, Canada, and the UK.

On the risk management side, we have been growing outside the US since the mid 90's in Australia, the UK, and Canada.

The fastest growing part of our brokerage and risk management segments are our international operations.

Today, roughly 0.25 of our revenues and people are outside of the US.

Gallagher is building out a strong international platform.

We are a global player, with plans in place to continue our global expansion.

Of course, you will continue to see us be very active in the United States, but you will see additional activity outside the US, where two-thirds of the world's premiums are generated.

In our risk management segment, Gallagher Bassett Services made great headway in the quarter, continuing with the integration of GAB Robins.

The business has been consolidated; we have had excellent account retention.

The change in offices and personnel is virtually complete.

All the GAB accounts will be converted to our [risk FAC] system by the end of September.

All in all, a very successful deal.

As I say every quarter, all of these merger partners had choices.

I'm glad they chose Gallagher, I think that is a testament to our culture, and I'd like to extend a very warm welcome to all of them.

The next category is operational excellence and productivity.

We worked hard on expense control again this quarter, and we continue to build out our service centers outside the United States.

The progress I mentioned with the GAB integration also illustrates our success at operational excellence.

Finally, our culture.

We continue to believe that our unique culture, based on teamwork, putting our clients first, and bringing new business in the door every day is a significant strategic advantage.

It's our culture that helps us attract new resources to our team, and merger partners to our Company.

Our sales culture is very strong.

We presently have about 150 interns learning about this great business, and we hope to recruit many of them as producers to our Company.

So, the second quarter is in the books.

I'm always glad when the first half is over.

We feel good about the first half of the year.

I believe we have good momentum going into the second half of the year.

We are on track to post more than $2 billion in revenue this year, which is a key milestone for our Company.

We did our first billion, you'll recall, in 2002, our 75th anniversary.

The exciting thing to me is that, if you talk to our team, I believe that everyone would tell you -- we are just getting started.

Doug?

Thanks, Pat.

Good morning, everyone.

Today I have 5 comments.

My first point relates to the Heath Lambert acquisition.

You heard Pat say, and I certainly agree, we think this is a great deal for us as we expand internationally.

To help you incorporate Heath into your models, on page 4 of the earnings release we give you the standalone pro-formas that we used when we struck the deal.

As we integrate Heath and our other UK operations into 1 unit, it will be nearly impossible to track these operations on a standalone basis in the future.

We won't be able to update that information in the future, but we hope it's helpful as you build out your models.

Next on voice overs on the 2 nearly offsetting items related to acquisition earn outs.

On one hand, we booked about $4.4 million of income as we adjusted downward our estimate of the amount that we will ultimately pay for the 2009 deal with Liberty.

This accounting arises because in 2009 we estimated the ultimate earn-out obligation a little above the midpoint of the range, but now it looks like we will come in a little below the midpoint.

Regardless of our estimates, this is really turning out to be a fantastic deal.

And it also illustrates why it was so important for to us put nearly 70% of the purchase price on an earn out.

On the other hand, we booked about a $5.8 million of earn-out related compensation expense related to a different deal.

The $5.8 million gets charged to comp expense rather than to goodwill because the sellers will in turn pay their earn out or a portion of their earn out to employees that came with the deal.

So, that gets recorded as comp expense, not goodwill.

Moving to the corporate segment, my third point is an update on our clean energy efforts.

We are making headway on getting 3 more operations that run our chem-mod technology, and getting them their permanent permits.

Those operations are in the same state that has already issued permanent permits for some of our other operations which also use the chem-mod technology.

We believe it's just a matter of time.

In addition, nearly a dozen other states are granting or moving closer to granting permanent permits to other utilities to use the same chem-mod technology.

Many of these utilities would like to get plants into service prior to December 31, 2011, thereby qualifying for federal tax credits.

Accordingly, in the third quarter, we may consider building some additional plants.

If we do, we will do it just like we did in 2009.

We'll build the plants and then quickly sell off about 70% of the plants, bringing our net cash in the plants down to a fairly modest amount.

So, my 4th point is some modeling help for the overall corporate segment.

For the second quarter, we posted results right in line with what I told you at the end of the first quarter.

So, looking toward the third quarter, we think you should just assume a repeat of the second quarter.

And that will get you close.

As for the fourth quarter, again, model a repeat of the second quarter, but add a penny or 2 of profit for our clean energy efforts under the assumption that we will get permanent permits for our other 3 plants.

My 5th and final comment relates to the financial supplement we posted on our website.

Recall during the first quarter, we overhauled the supplement to present both reported and adjusted numbers for the last 3-plus years.

We believe conforming your models to follow that similar format will really help you see the true underlying comp and operating expense ratios, and also other trends and seasonality of our business.

Those are my 5 comments.

In the end, it's nice to have a good quarter.

Back to you, Pat.

Thanks, Doug.

Rob, we are ready to open it up for questions and answers -- hopefully answers.

Thank you.

The call is now open for questions.

(Operator Instructions).

Our first question is coming from the line of Adam Klauber with William Blair & Company.

Please state your question.

Good morning, guys, thanks.

Morning, Adam.

How are you?

2 or 3 questions.

1 on organic growth, what was the growth in international versus US roughly?

About half came from international and half came from domestic.

Okay, that means the domestic actually did better this quarter than the last few quarters, is that right?

Absolutely.

Okay, that's great to see.

Domestic we are in positive territory.

Yes, that's great, that's great.

On Heath Lambert, that schedule you laid out is very helpful, Doug.

What is the timing of the profitability?

Will it take a while for it to ramp up next year for, particularly because, the first half is big for Lambert, will the margin be pretty high from the get go?

While it is skewed more to the first half of the year, it won't distort the margin that much compared to the whole year, Adam.

So, it is a little toward the first part of the year but not, not -- it won't really move the needle that much.

In terms of the profitability, we lay out the integration costs for the next 3 years or 2.5 years and we think by '13, when we put these 2 operations together, we think that both of the operations together could be approaching kind of a combined brokerage operation margins in total.

So, we think there is further opportunity in '14 versus these numbers here.

Okay.

And could you give detail, where are the cost cuts coming from?

This is a deal where we are really pleased with the people.

There is more opportunity -- if you really look at the comp and operating margins of Heath compared to our operations, comp is pretty well in line.

Operating shows some opportunities.

So, most of the synergy savings will come from reducing operating cost and will come from additional London market commissions.

The compensation line will probably hold in there pretty tight.

Thank you very much.

Thanks, Adam.

Thanks, Adam.

Thank you.

Our next question is coming from Teague Sanders of Citigroup.

Please state your question.

Hi, good morning everyone.

Good morning, Teague.

Morning.

I just have a quick question around organic growth, which is positive in the quarter but is kind of offset by some If you margin compression.

If you can just help me understand the available leverage you have to hold margins going forward and what we saw, why we saw compression in the quarter?

First and foremost when you look at the operating margin on 3 of 13, the adjusted EBITDAC margin, second quarter '10 was 26%, adjusted EBITDAC margin second quarter '11 is 25.4%.

Just the margin dilution caused by the Heath deal caused 40 basis points of that differential.

So, when you look at 25.4% you understand that 40 basis points of that comes from -- is lower because of the Heath acquisition because of the nature of their margin.

That gets you to 25.8% and there is a handful of other little small items that eroded the other 20 basis points.

But overall, even with the Heath dilution, year to date we are actually up 10 basis points in margin in the brokerage segment.

Okay, great.

And then, just a second question on the supplementals and contingents.

Can you just kind of help us understand the drivers of each and just where we might see some loss revenue as we are seeing some of the underwriters experience some profitability decreases here?

If you look at page 2 of 13 in there, we show you that -- we actually are continuing to grow our supplementals.

We think that the carriers are interested in doing that with us so we're using that.

On the contingent, we are starting to see some of our contingent, especially in the wholesaling business, contract a little bit as loss ratios move up.

Most of our wholesaling business is loss ratio driven, so you can see it pull pack.

We were down about a $1.8 million in the quarter.

Year to date we are down $3 million.

The lion's share of our contingent commissions are behind us for the year, at this point.

So, we might have a little pull back in the third quarter and fourth quarter but nothing that is that meaningful that we can see right now.

Hi Teague, this is Pat.

There is a natural ying and yang here and your are right to be thinking about this.

When underwriters results begin to fade, these numbers will begin to change.

Got you.

Okay, thanks so much.

Our next question is coming from the line of Sara DeWitt with Barclays Capital.

Hi, good morning.

Morning, Sarah.

I wanted to follow-up about your comments on the pricing environment.

Can you talk about what your view is on the sustainability of rate improvements given that there is still a lot of excess capacity and particularly if we don't have an active hurricane season this year?

Yes, I think we all recognize there is good capacity out there.

But, I think that what you got is, the CEO's of insurance companies that I talked to, often, really do understand the better point in the cycle that they've got to start to hold the line.

They have got good information systems.

These are smart people, they know where they are making money and not making money and they are doing just exactly that trying to hold the line.

Now, as I said in my comments, the simple fact is if you have a good account with a good clean loss record and one that is out shopping, they are going to see a reduction.

It's just not going to be as great a reduction as it has been the last few years.

And I have seen this before where markets get spotty.

It's not unusual to see a line of coverage have a spike in terms of its hard market.

I think you're going to see that with catastrophe property.

There's no doubt about it, it 's gone up.

Large schedules that are exposed to that stuff are going to pay more money and we are seeing that right now.

So, it's one of these places where I think the market is kind of in a spot where underwriters do know what they've got to do.

Yes, there is an excess amount of capital, it's going to chase premium.

That does put pressure on rates to go down and we are seeing that, but I would say that the rate of rate decrease has slowed considerably from what it was just a year ago.

Okay, great that's helpful.

And then, can you talk a little bit about what you are seeing in terms of the acquisition pipeline and how big do you think you plan to get in international?

Well, I mean, right now the international operations are one of our fastest growing.

And I think we are beginning to see opportunities that we didn't, before we built the platform.

For instance, part of the Heath thing that is so exciting, the more we got great teammates to join us, it's going to be a great franchise for us.

But it will allows us, in the UK, to do exactly what we have done for 25 years in the United States.

We're already seeing teams of people and operations in the UK that are talking to us about wanting to come aboard.

So, bolt-on acquisitions in the UK can now become a better strategy in the retail side with the Heath platform.

Two thirds of the premium in the world is outside the United States.

And we've been trading in that community for literally 40, 50 years and know a ton of people out there.

Just like in the United States, many of these organizations, brokers outside the US, are run by baby boomers.

Over time, families and individuals will seek to take some equity and some money off the table.

They also are seeing a growing brand in Gallagher.

Gallagher is a recognized international player.

So, I think you will see us continue to grow.

Now, can international outstrip the US?

You asked about the merger and acquisition pipeline, it's absolutely stronger than it has ever been.

We have hundreds of organizations that we are talking to.

The merger and acquisition process is very much of a long-term sales cycle.

We've talked to people for years.

They get warm to the idea.

They come aboard.

It's not like we open up a discussion in September and close the deal in October.

That doesn't happen very often.

But, when you look at the brokerage world, there is 30,000 plus Agents and Brokers that we've identified, that actually [Pales] and Associates have identified, in the United States alone.

And most of these are run and owned as I said, by baby boomers.

The opportunity for us on the acquisition front, it's just never been greater.

Okay great.

Thanks for the answer.

Thank you.

Our next question is coming from Mark Hughes of SunTrust.

Please state your question.

Thank you.

On the risk management business, very good organic growth.

How sustainable is that where there is specific upticks in business or contracts wins that you're going to anniversary at some point here to make that a little tougher?

Mark, I think if you look at the bottom of page 3 of 13, we intentionally break out adjusting fees related to international disasters.

That relates to, mostly to the New Zealand earthquake situation.

We believe that, that's going to be around for '11 and '12 but it'll, I think it will be pretty well done by the end of 2012.

That's why we broke it out last quarter.

That's why we're going to do it going forward here.

It's -- that number is great organic growth but I think it will be something that the team has to grow by the time they get to '13.

Alright, we'll worry about that then.

The claims freque--

We're worried about it now.

(laughter)

I understand.

Finally, the claims frequency in risk management, the underlying workers comp claims frequency and I'm thinking here in the US, any comments there?

We are seeing about 2% increase in our claim activity through the second quarter which relates, interestingly enough, directly, I believe, to the economy.

Thank you.

Thank you.

Our next question is coming from Meyer Shields of Stifel Nicolaus.

Please go ahead with your question.

Thanks, good morning, everyone.

Morning, Meyer.

Let me follow up on that last question if I can.

Are you seeing companies retain more?

We are getting at least some rhetoric about workers compensation rates starting to turning upwards.

Is that affecting insurance line behavior yet?

Not that we have seen yet.

When rates go up in workers compensation, it will over time push more people into the alternative market and we'll benefit from that.

But there is no rush to the alternative market right now.

Okay, with regard to contingents, fairly recently got back into the contingency game, are there any contracts or -- I'm sorry, let me ask this differently, is there any opportunity for new contingents that don't exist this year to be paid next year?

No.

Okay, so you are at a full run rate.

Yes.

Lastly, can you talk a little bit about whether we're seeing any signs, early signs, whatever, of specialty risks moving back in specialty markets?

I would say no to that.

I would say, the market is still soft to the extent our wholesalers are doing a good job on what would typically be an E&S business.

There is still probably some drag back to the standard markets from E&S but it slowed.

Okay, and if I can throw in one more for Doug.

You talked a little bit about compensation in the brokerage business being down.

Is there any such incentive compensation in the second half of 2010 that we should adjust for?

Here's the thing, when you really stack it up and you look at our incentive compensation it's down a couple million bucks compared to the same quarter last year.

Approaching a half billion dollars a payroll as it rolls up, there is nothing unique in that.

I don't see it as being something that's going to be different in the second half of last year.

When I look at it, the second quarter of last year, we did pretty well.

Incentive compensation was up a little bit more relative to this quarter, but there's nothing unusual in that.

It just happens, by the time you add it up to be a couple million bucks.

Okay, thanks very much.

Thanks, Mark.

Thank you.

Our next question is coming from the line of Alex Ducharme of Temujin Fund Management.

Please state your question.

Hi, good morning.

I, just first, financial question.

Wanted to understand the trends in business insurance expenses.

I noticed they were a bit of a headwind in the brokerage business, a bit of a tailwind in the Gallagher Basset business.

Yes, you know in the quarter we did book a couple million dollars related to resolving a disa -- not a disagreement, a difference of opinion between us, a client and a market.

You know, I think that the thing there is every once in a while you are stuck in a spot where you just better step-up and do the right thing for the client.

Okay.

So, some of that was a sort of a 1 off expense in the quarter.

It was.

Okay, that's helpful.

And then, secondly, I wanted to get some detail around the organic growth trends you are seeing in the brokerage business, specifically what you are seeing in domestic PNC retail versus wholesale versus employee benefits.

I think what you have to look at is the trend, all of them are improving.

I think that you'd have -- so, as a result, what I'm particularly pleased at, if you just look at our broad based retail PNC brokers that have been fighting 8 years of soft market and 3 years of, almost 4 years now, economic downturn you are really seeing that starting to march forward.

Pat said that we're doing a little bit better on new business, we're doing a little bit better on lost business.

Rate isn't hurting us quite as much, that's still negative overall across the US retail platform.

But it's just nice steady improvement that is reversing trends that we saw going negative, really, from starting about 2004.

So, it's just improving trends across all fronts.

And while we are not seeing a large number of full-time employee growth in any of our businesses out there, I would say that we are seeing more stabilization in our client's businesses.

And, as I've said all along we're lagging indicator.

We're going to get healthy when our clients get healthy and they're stabilizing.

Okay, thank you.

I just wanted to go back to the business insurance question.

Can you quantify how much was a 1 off in the quarter?

I think that in compared quarter over quarter last year you need to think about $2 million.

Thank you.

Remember, any time you have these type of things, you got to get them resolved and they hit at different times and we're going to have these things from time to time.

Okay, appreciate it, thank you.

Thanks, Alex.

Thank you.

Our next question is from the line of Dan Farrell of Stern, Agee.

Please state your question.

Hi, good morning.

Morning, Dan.

Just a question on the clean energy ventures.

You mentioned potentially making some additional investments in new plants.

Can you comment on what the potential cash flows from those additional plants could be if you decide to make those investments?

Are they going to be the small ones that -- is 3 that are already in place, that are smaller, are some others that are coming on there larger?

I'm just trying to get a sense of what the potential benefits could be?

I'm not at all prepared to discuss what the benefits could be at all because I don't have an idea about the demand for the plant.

We are talking between 1 and 10 type plants, this isn't like 50 or 100 new plants.

For us to build a plant regardless of whether they go into a big location or a small location, for us to go through that first phase before the utilities and the monetizers take down, it costs $1 million to $1.2 million a plant, something like that.

So, we're not talking about huge amounts of cash going out.

Frankly I don't know, but there just has been a change in the last 60 days that is saying that there is substantial demand for our CHEM-MOD technology.

If we have to build plants to get them up and running they can use CHEM-MODs then we will look at that.

Okay, and then just a numbers question on free cash at the end of the quarter.

It was a bit higher than I would have thought, given the amount of acquisition activity you had.

Can you comment on any seasonality that might have been coming through or are we looking at normal cash flow and also within that 263, how much of that is cash that you could use today for acquisitions if you wanted to?

Spread around the world, we think there is probably $75 million of free cash in our balance sheet right now that could be used for acquisitions.

That number is probably going to grow a little bit as we grow internationally because I don't want to bring the money back to the US and pay the additional tax big of it here.

We will probably let it sit there.

So, if we can do deals in those jurisdictions where we have the free cash then we will.

Otherwise, we may have some growing in our free cash balances around the world.

Those opportunities will arise.

We had free cash flow in the UK and we obviously used that.

Okay.

Thank you very much.

Thanks, Dan.

Thank you.

Our next question is from the line of Brian DiRubbio with Y.

Capital Management.

Please proceed with your question.

Morning guys, how you doing?

Good, Brian.

How are you?

Okay.

Doug, following up on that last question regarding where your cash is, thinking about your international expansion, what happens to your segment tax rates going forward?

Can we expect them to trend down?

Well, I think that, like in the UK, the tax rate is 27% going to 26% for their -- but you have back tax over there and you've got other things.

I think the back tax doesn't hit the tax rate line, it goes more through the operating expense line but you still pay tax there.

It's not like it's any cheaper.

You could have our tax rates moving a little bit lower in the brokerage segment as we increase our international expansion.

Heath will bring it down a little bit but we're still primarily a domestic company.

Got you.

And Pat, for you, looking at the number of acquisitions that you have done and obviously the dollar amount, too, and all the employees that you have taken on, what is your bandwidth to do similar amount of acquisitions that you did last year second half, this year second half, does that have to naturally slow down a bit?

Brian, that is a great question.

Let me answer in a little bit lengthy way.

If you go back a number of years and you look at our acquisition activity, it was primarily driven by our PC retail operation here in the United States.

That was one team of people, they were out talking to folks all the time and trying to bring about acquisitions.

If you step back now and look at where we are today, we have our PC retail operation in the United States with an acquisition team doing very good work.

We've got our wholesale MGA business in the United States, which is doing acquisitions and has got a separate team and doing great work.

We have our employee benefits consulting operation that we have built out with acquisitions over the years and they have a very, a very good pipeline and a very good team of people doing acquisitions.

Now for the first time starting last year, Gallagher Basset, our risk management segment has proved that there are opportunities out there to bring others aboard and to consolidate them and have them work well and our international activity is far more robust.

If you really look back a decade, we've expanded our bandwidth by a factor of 5 times.

Each of those teams are out constantly looking for the right private firms to join the company.

I can't give you an idea of the number we're going to do or when we're going to close them because it really is a long cycle sales process.

I can tell you that, the activity that we have in that area is great.

If you take the Heath deal out, Brian, I think you'd see that we are kind of in line with what we have been doing in the past.

Then you'd have 8 deals and it wouldn't be $200 million, it would be $158 million less.

Now I think opportunities like Heath will come our way.

Remember, Heath represents about 8% of our overall corporate revenues.

Now, it's not a huge deal once you take a look at the size of Gallagher today versus what we were just a few short years ago.

I think the bandwidth has increased.

The opportunities have also increased.

I have been saying over and over for years that the baby boomers are going to have to do something.

We are seeing a lot more activity in that regard in particular here in the US We are seeing people that are 59, 60, 62 getting to a point where they've got to realize that -- they have to realize their investment in their life's work.

I am very excited about where we sit.

As I said before, you have 36 or 30,000 plus of these in the US, thousands more outside the US and essentially there is 5 strategic players that are public players competing for them.

We all have pipelines that are incredibly robust.

Got you.

I may have missed this in the press release so I apologize if I did, but did you guys use more cash in the M&A activity this quarter than you used to have?

Yes, Brian, I mean the entire Heath deal was done 100% with cash.

Okay.

Is that something you see doing more of?

I know you have additional mix, free flow.

We try to target 25% cash, 75% stock.

If our cash flow is there, we will bring that number down closer to 50-50.

Got you.

Now, final question, this is sort of longer term, but Doug, what is the end game with CHEM-MOD?

CHEM-MOD is a tremendous product.

We think it has great opportunity.

Strategy right now is to penetrate those utilities that are using Section -- or that want to build plants by the end of the year using Section 45.

And then it has -- then we'll have a plant in place to demonstrate mercury emission control, mercury emission control law will go into effect as currently drafted in 2014.

So, we think it produces opportunity.

We will have to sit down and do a strategic alternatives review of what CHEM-MOD, what we really want to do with CHEM-MOD here after the first of the year.

But our surge right now is to deliver CHEM-MOD's technology to as many utilities that can put plants in place by the end of this year and then next spring we will do a strategic alternatives review on it.

Great, thanks a lot, guys.

Thanks, Brian.

Thank you.

(Operator Instructions)

Our next question is from Bob Glasspiegel with Langen McAlenney.

Please state your question.

Hello, good morning, everyone.

Good morning, Bob.

On the risk management segment if we can dig a little deeper.

Pat, your commentary and EBITDAC numbers are very impressive, yet the gap earnings are still way below where they were 2 to 3 years ago.

When do the gap earnings catch up to your enthusiasm?

( Laughter)

As soon as we can get them there, Bob.

So, what is -- what is the -- it does sound -- am I right that you are more upbeat about that segment than you've been in your commentary?

Yes, I think that's fair, Bob and I'll tell you why.

The head winds that GB has brought over the last few years are related in large part to claim counts and claims arising.

As our client's businesses began to falter and you had the recession, when you go from 3 shifts to 2 shifts, you never like to see people get hurt but there will be fewer claims to manage.

We went through that at a time when the recession was very difficult.

We also had a couple of situations in previous years where we had some very nice bumps, very nice winds that did add a big impact.

But I think what you've got now in both businesses is a pretty good stabilization of the client base.

Interesting developments in that space too, Bob, that make me more bullish.

If you take a look at the number of competitors there were just a year ago and now the consolidation that is occurring, there's far fewer competitors that can actually take on a large self-insured account and adjust claims for them across the United States.

There is even fewer if you want to add the UK, Australia and Canada to that mix.

GB is growing to a size now where there are many markets out there that we do more claim work than they do.

So, the expertise there, the ability to customize for the clients, the fact that competition is consolidating, it's a long-term very positive view, a business we've said we liked for many, many years.

Okay.

Softer question, if I might, you talked about culture being important and a real edge and clearly as someone that followed the company for a long time, I appreciate the asset that you have there.

But, you talk about international expansion, years ago I remember you saying you were only looking at places that speak English and I understand the distinction on your reinsurance, sort of, misstep where it was scale more than culture that got you off track in that, but the state street go to other languages better now or how does the Chicago culture go internationally broadly.

Are we still talking English only or are we more --

No, I think we have changed that, Bob.

We are cautious in our acquisition activity everywhere in the world.

Outside of the United States we typically want to trade with somebody for an extensive period of time.

Many of these are family businesses.

They want to know the Gallagher's, they want to know what we're all about.

They trade with us.

In a number of the instances, the acquisitions we've done have actually secured a good trading book in the London market.

We are very happy to take a smaller equity piece, let everybody get comfortable with each other and with the exception of Heath, most of our acquisitions outside of the UK and the United States have been relatively small.

You will remember that we did an acquisition in Australia of SBA.

The added Perth, we took a 35% or 40% equity position.

We all agreed that we'd go, we'd would work together for 3 or 4 years, see how that was working and decide if we wanted to go to 100%.

We liked those folks and they worked with us so well we went to 100% much quicker than that.

Great opportunity there for some young people to take over the operation.

We broadened that firm now into Sydney.

And, again, we will be looking at more bolt-on acquisitions in Australia.

We opened with a very small shop that we are pleased with in Brazil.

We took a small position also in Singapore.

I would say that we are willing to venture beyond English speaking countries but we are also always cautious and want to know the people we are trading with.

What non english speaking countries that you're not in are most attractive?

Central and South America.

But broader Asia is an emphasis?

Not right now.

Okay.

Thank you very much.

Thanks, Bob.

Our next question is coming from Scott Heleniak from RBC Capital Markets.

Please state your question.

Hi, good morning.

Morning, Scott.

Not to beat the international pulp too much but you mentioned the 25% of the mix by the end of the year being international.

Where do you see that headed 3 to 5 years from now?

Obviously you have come a long way.

Some of your peers are more like, right around 50% percent.

Could you see it getting that high?

Where do you see that down the road.

We would be glad if it was about a third of our business.

Right now it's 25%.

But, our acquisition activity in the United States is ramped up very nicely.

I don't think international will outstrip that.

Okay.

M&A, we noticed that just overall not really to you guys but overall M&A deal activity in the brokerage space dropped off a little bit in June and July.

So, based on your comps, it sounds like -- do you think that's temporary and do you think there is any change in seller's appetites just because of obviously we are seeing better pricing domestically the past 2 or 3 months there.

Is there any change in seller's mentality because of more favorable trends?

People waiting a little bit.

No.

No, we don't.

Okay.

And then finally, on Health Lambert, can you give what percent of the business is fee -- fee business?

I don't have that right here in front of me but -- Let me see if I can find it, go on to another question and maybe we can come back to you while I'm looking for it.

Sure, just the only other thing -- Just broadly speaking on Heath Lambert, wondering if you can touch on the -- just the reception that you have had from clients and retention of accounts, any kind of disruption, everything as planned?

You know Scott, I'm really, really proud of the work our people did in terms of the early start to integration.

And we are -- the reception is beyond what we expected.

First of all, you've got a company that was a large publicly traded company just a decade ago that has gone through an awful lot of change in that decade to becoming a private company, exiting most of the wholesale work, becoming very focused on their UK retail.

Maintaining a very good brand in the market during that whole period of time.

And yet being in a position where -- very different, couldn't do acquisitions, didn't have the cash flow for that, didn't have a lot of money to invest in almost anything and the management team I think did a really good job of building that company.

Actually shrinking that company to a point where it was successful.

So, I think the hearts and minds of the Heath people really are embracing the Gallagher culture, the fact that we are a sales and marketing organization.

This may not play well with the investment community but they like the fact that they are working for a Broker run by Brokers.

I think what we are seeing are a tremendous number of teams that are sticking their toe in the water right now to see if Gallagher would be interested in having them join as a bolt-on acquisition or a team coming over.

Clients have been -- again, I felt very good about the way the clients react.

I can tell from you doing acquisitions all these years, clients will react in line with the tone of the merged organization's leadership.

We have never done an acquisition and had full scale revolt by clients saying we don't like that.

If their account executive teams are happy and feel that it gives them more opportunity to serve the client, the clients are generally very positive and embracing and we are seeing that in England, as well.

35% of it is fee.

Okay, that's all I have, thanks.

Thanks, Scott.

Our next question is from the line of Richard [Martel] of Piper Jaffray.

Please state your question.

Hi, good morning.

Good morning, Richard.

Can you talk about the risk management segment.

It looks like you're running into a 15% margin.

How significant is the reinvestment there in terms of the margin?

Are we talking 2%, 3%?

I don't know if I necessarily understand what you meant by the reinvestment's, but, let me see if I can answer the question.

We try to target that business to run 15 points of EBITDA and whatever they need to reinvest in the business, they do within the 15 points.

It's not a real heavy CapEx business for us.

There isn't a lot of reinvestment if that's what you are talking about.

Yes, I was just referring to systems and maybe office build out.

No, it's pretty -- we spend basically what we depreciate.

Okay.

Then, the fees from the natural disasters looked like it was up a little bit from last quarter.

How volatile is that going to be over the next 4 to 8 quarter's that plays out?

It will be steady for the next 4 quarters and I think you will see it ramping down in quarters 5 through 8 following.

Okay.

Thank you very much.

That's all I had.

Thank you, Richard.

Thank you.

Our next question is from Ken Billingsley of BGB Securities.

Please state your question.

Thank you, good morning.

Good morning.

I just wanted to ask you a couple of questions 1 on the corporate side.

The 2 operations that you currently own 90% of, I know you say, that there is no operating site for those.

What is the cost -- what is the annual cost of owning that, if there is no actual physical location for it?

Our CapEx in that, we spent $1.9 million on those 2 machines.

That is what is sitting in the warehouse.

There is nothing to carry the cost of it until we get them a place.

Got it.

But it's $1.9 million for both machines?

Yes.

Okay.

The other question I had, on the letter of credit, line of credit draw down about $35 million, was that to fund Heath Lambert?

It's more -- our first quarter as you know is our seasonally lowest quarter.

Going into the line has something to do with doing the Heath Lambert deal.

And it's also just our first quarter is the lowest cash quarter we have.

I expect to be out of that here hopefully by the end of even this month.

Very good.

Thank you.

Thanks.

Thank you.

Our next question is a follow-up from the line of Meyer Shields from Stifel Nicholas.

Please state your question.

Thanks.

This is, I think, a big picture question that is probably difficult to answer but.

If we start to see rates go up by 1%, is there any rule of thumb in terms of how much those 100 basis points will fall to Gallagher's bottom line?

Remember what we've always said, if we have organic growth of negative 1 to positive 2, something like that, holding margins would be good work for the franchise in light of inflationary pressures and new opportunities to do things.

So, if you get 1 point of rate positive rate, we see rates still being done 3%.

We will see what the CIAB comes out with later this week but overall, if you get an incremental 4% that, if you assume that it all translates to the bottom line and you take our 3 points of organic right now and add 4 more to it and you get 7% of organic growth.

You can get a good piece of that falling to the bottom line.

Remember, we pay approximately 25% to a third of our revenues to our producers.

There are some additional back office costs that do come along with increased volumes but if it's just rate and it doesn't produce a lot of additional work, it can be pretty high geared revenue that comes to us.

Okay, great.

Thank you.

Thank you.

We have time for one more question.

Our last question is coming from the line of Mark Hughes of SunTrust Robinson, follow-up.

Please state your question.

Thank you very much.

Any commentary on the employee benefits business, organic growth trend there and any thoughts about the impact of health care reform on that business going forward?

Yes, mark, this is Pat.

Thank you for your question.

It's a good one.

We have said all along that we were not -- we were not in favor of that law and we still believe that the law is a nightmare for commercial America.

But we are the beneficiary of the difficulty in understanding the law.

What we are seeing is tremendous amount of questions from our clients relative to what the impact of this law is going to be.

These are complicated calculations and they are very complicated answers over many years and, as you know, the regs themselves are not written yet but many of the stuff in the law is already changing.

So, you see McDonald's and others come up and want there mini benefits plans to be approved even though in the original law they weren't.

So, the point is, it's a moving target.

Organic growth and our benefits operation is exceeding our property, casualty and wholesale operations in the United States.

I believe a large part of that is driven by the fact that clients now recognize they need a stronger and bigger player to help them navigate through the labyrinth of that law.

So, we're picking up new business there, we're seeing a stronger organic growth there and I think it is driven by that law.

Thank you.

Thank you.

Mr.

Gallagher, I would like to turn the floor back to you for closing comments.

Yes, thank you, Rob.

Everybody, thanks for being with us on the call today.

We appreciate it.

6 months in, I am pretty happy with where we stand.

Our adjusted brokerage revenue is up 13%.

EBITDAC in the brokerage side is up 14%.

Risk management adjusted revenue up 19%, adjusted EBITDAC up 14%.

First 6 months we have done 13 acquisitions brought in over $200 million of annualized total revenue.

Organic growth in the quarter, I think, speaks volumes for the sales culture.

I feel good going into the second half of the year.

Our Board, as you know, reaffirmed the $0.33 quarterly dividend last week and I believe 2011 is just shaping up to be an outstanding year.

Thanks for being with us this morning.

This does conclude today's conference call.

You may disconnect your lines at this time.