Arthur J. Gallagher & Co. (AJG) 2012 Q2 法說會逐字稿

Good morning and welcome to Arthur J. Gallagher & Company's second quarter 2012 earnings conference call.

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, 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 that will be discussed on this call and which are also described in the Company's report 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 & Company.

Mr. Gallagher, you may begin.

Thank you, Claudia, and good morning, everyone.

Welcome to our second quarter conference call and thank you for being for with us this morning.

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

As we usually do, I'll add some color to the quarter, Doug will make some additional comments, and we'll move quickly to questions and answers.

As I said in our press release, I am really very pleased with the performance in the quarter and frankly year-to-date.

I feel like we're hitting on all cylinders.

All of our operating divisions contributed to our growth in the quarter.

Adjusted brokerage revenues up 18%, 5% organic is a solid result.

Adjusted brokerage EBITDAC up 21% is simply outstanding, 72 basis points of margin improvement illustrates the leverage that this business enjoys.

Year-to-date we've completed 32 acquisitions which will bring in over $130 million of revenue.

All in all, a strong quarter in brokerage.

Our risk management segment was also very strong this quarter, revenues up 7%, base organic fees up over 8%, adjusted EBITDAC up 11% and our margin expanded by 50 basis points.

So, all in, when I put both our operating segments together, brokerage and risk management, we had adjusted revenue growth of 15% and adjusted EBITDAC growth of 20%.

These results don't just happen, they happen because our great team gets up every day everywhere around the world and works hard for our clients.

I could not be prouder of the team.

Our unique Gallagher culture is alive and well as we continue to grow our business.

Remember, every single day at Gallagher we focus on four strategic areas.

The first is organic growth.

We have over 140 interns that are winding up their internship this week, very exciting summer.

Secondly, we focus on mergers and acquisitions.

We've had a solid six months.

Thirdly, operational excellence and productivity.

We had margin expansion again this quarter.

Fourthly, our culture which we believe we have a very unique team oriented global culture that we continue to foster.

The organization performed nicely the first half of this year in all four key strategic areas.

Let me add some more color to our operations.

Property casualty retail continues to show organic growth around the world and in the United States.

We continue to see rate increases.

The Counsel of Insurance Agents and Brokers' quarterly survey came out this week.

The major lines that we place, work comp, property, commercial, auto, general liability, and umbrella are up approximately 5.3% for the quarter or a sequential gain of 60 basis points over Q1.

This is not -- this is very important, this is not a classic hard market.

Frankly, that's a very good thing for us, our clients, and our markets.

This is my fourth cycle.

We don't want to see 100% rate increases and big cutbacks in coverage.

The industry is not reacting to balance sheet problems but rather to income statement and loss ratio concerns.

An environment of incremental rate growth is ideal for us.

If we had a 4% rate gain per quarter per year for a number of years, that would produce an opportunity for organic growth each and every quarter.

New business was strong in the quarter.

Our retention remains nicely in the mid 90%s and I think that speaks volumes about our aggressive sales and service capabilities and we continue to see our customers businesses stabilizing to growing slightly.

We do not see our clients adding employees, so there is still caution in the marketplace, but we are seeing additional premium audits which is a good sign.

Our wholesale and MGA business had a very solid quarter with solid organic growth.

This reflects business moving back to the excess and surplus markets and an increase in small business formations.

Our benefits business continues to be helped by the new health law.

Now that the Supreme Court has ruled, our customers and prospects know they need our help.

The compliance issues alone in this law are very difficult for our customers to deal with, so they need our expertise.

Mergers and acquisitions in the brokerage segment has been a key strategy at Gallagher for over 26 years.

We're thrilled that our new partners chose Gallagher.

Each of the firms that joined us had a choice, and we want to welcome to our growing family.

Our mergered acquisition pipeline remains very strong and we contemplate a number of additional transactions will close before year end.

Our international brokerage is also showing improving results.

Our acquisition of Heath Lambert in the UK last year is proving to be a significant strategic move in the UK.

We're growing the business with some very nice account wins and some additional acquisitions outside of London.

These acquisitions are doing what we thought.

We're recruiting people we couldn't have and doing acquisitions in the UK, three so far this year, which we wouldn't have been able to do it Heath and Gallagher had not joined forces.

Let me move to our Risk Management business.

As I said, a strong financial quarter, great client retention, and globally good new business propelled the quarter.

Underlying our organic growth we saw existing client claim counts were up about 1.5% and we are getting about 2% in rate increases.

As our clients' businesses expand, we will also benefit.

Our International Risk Management business had another great quarter, primarily in the UK and Australia.

I am convinced that Gallagher Basset continues to gain recognition as the best provider of claims management services in the marketplace.

I'm pleased with our progress and I'm glad two quarters are in the books, as an aside we are up double digits on almost all important measurable metrics.

Doug.

Thanks, Pat, and good morning, everyone.

It's nice to post another strong quarter.

Let's start on the first page of the earnings release in the brokerage segment.

First, you'll see $0.02 of Heath Lambert integration costs and $0.01 of severance.

That's in line with our comments from our last conference call and you heard Pat mention that we're on track and progressing nicely with integrating that merger.

Looking forward, we're still seeing -- we're still forecasting integration and severance to run about $0.02 to $0.03 per quarter through mid 2013 and then we should be done with that.

Next, you'll see we picked up $0.02 from acquisition-related adjustments.

We adjusted our estimated earn outs on 12 deals which totaled about $7 million of adjustments and we wrote off about $3 million of intangibles relating to three historical deals.

Those net to $4 million which, after tax, is $0.02.

Finally, you'll see we booked $0.02 because we prevailed on a tax position related to one of our foreign brokerage operations.

So, while there are some ups and downs, it all washes out to about $0.01.

Let's look to the second page to the brokerage organic revenue table.

There is some flavor behind the 5% organic growth on our basis commission and fee line.

Our domestic P&C units, that's our US retail and wholesale units, posted mid 5% organic growth, our international operations organic was up in the upper single digits, and our US employee benefits unit posted organic of about 3%.

Moving down the table to supplementals and contingents, let me give you some help in modeling the third and fourth quarter.

As of now, we are seeing total supplemental and contingents of about $20 million to $22 million in the third quarter.

That's down a few million from 2011 mostly because of deteriorating loss ratios on a couple of wholesale programs and another $1 million or so will get pushed back to 2013.

As for the fourth quarter, we are seeing total supplementals and contingents of about $16 million to $18 million which is about flat with that last year.

So, it's backing up to be another good year for contingents and supplementals for us.

Moving to page 3, you will see that we added tables that show adjusted compensation and adjusted operating expense ratios, and both of those have nice improvement this quarter.

We have added the tables to put the computations next to the commentary and it also allows us to eliminate the full adjusted P&L columns from the back pages of our earnings release.

However, please note we are still providing the adjusted P&Ls on pages 5, 8 and 13 in our investor supplement that we post on our website.

We really encourage you to use that supplement when building your models, especially the adjusted pages.

Moving to the bottom page 3 to the brokerage segment margin table.

You heard Pat talk about, but we are really pleased to again post market expansion in this environment.

Similar to the first quarter, we were up 60 to 70 basis points or up about a full point without [heat].

About 50% of the favorable up side was from additional supplementals and contingents and the other 50% was from compensation and expense discipline.

Next, moving to page 4 to the risk management tables.

Organically, we are seeing really nice growth in our base fee line.

You can also see that we had solid performance bonus revenues this quarter, and you can see that our work on the New Zealand earthquake is running down quickly.

So, when modeling future quarters, we suggest you apply your organic growth pick to the base fee line only, then assume about $2 million to $3 million of bonus revenues in each of the third and the fourth quarter, and then assume next to nothing related to the New Zealand earthquake claims.

Moving down on the page we have included the comp and operating tables like we did in the brokerage segment.

Both of those had -- we had nice improvement on our comp ratio, but we got stung by about $1 million in additional litigation costs this quarter which hurt our operating expense ratio a little bit.

While it's unfortunate, these things can happen sometimes.

Moving down to the EBITDAC margin table, we still believe we can post 16 points of margin for the second half of the year.

Finally, when you get done building your models for the risk management segment, step back for a minute and make sure you have contemplated that the third and the fourth quarters of 2011 each had about $0.01 of earnings from the New Zealand earthquake claims and, remember, that program is effectively over.

Next, let's turn to page 5 to the corporate segment, and here's an update as you build your models.

All of these amounts our after tax.

First, assume about $7 million of interest in banking costs per quarter.

Assume about [$1.5 million] (corrected by company after the call) of acquisition costs per quarter.

Then, assume about $2 million to $3 million of corporate costs per quarter.

And, finally, assume about $12 million to $14 million of clean energy investment earnings in the third quarter and about $7 million to $9 million of earnings in the fourth quarter.

When you get done, the corporate segment should show about $0.02 to $0.03 of earnings in the third quarter and should about break even in the fourth quarter.

Clearly, those are approximate and a lot can change, especially when it comes to ramping up and rolling out our clean energy investments.

Speaking of which, we continue to work out the kinks related to those plants operating under long-term contracts and you can read that we are making steady progress on getting three more plants deployed.

As for the other plants, we feel like our prospect list for deploying those other plants is developing very nicely.

That said, these things take a while to deploy and especially as you're putting new plants in to utility, so we measure that in terms of quarters, not weeks.

As a wrap-up comment, like Pat said, we had an excellent six months on all fronts and the team, in my opinion, is hitting it out of the park.

If inflation stays in check, if rates continue to firm and the economy doesn't sputter, we are well positioned to deliver solid results.

Okay, Pat.

Those are my comments.

Thank you, Doug.

Claudia, we'd like to open it up for questions now.

Thank you.

(Operator Instructions) Our first question is coming from the line of Greg Locraft with Morgan Stanley.

Please state your question.

Hi.

Good morning and very nice quarter.

Thank you, Greg.

Good morning.

Just wanted to get a sense.

With the top line doing as well as it's doing, and it sounds like there's some good visibility there as well if current trends hold.

Can you talk about the margin potential for each of your businesses?

How high can it go?

I think a better way to answer that, Greg is saying that we believe in an environment of plus 3% organic growth you'll see some margin expansion in the brokerage space.

And when you look at the risk management is going to take a plus 5% environment to continue to grow margins.

In risk management, I wouldn't expect any margin expansion over 16 points for the remainder of this year, and the brokerage space, when we have 60 to 70 basis points of margin expansion incrementally, that probably could hold true for another couple quarters.

In this environment with low inflation you can get maybe 60 or 70 basis points of expansion.

Okay.

So just to reiterate.

The threshold is a 3% on the brokerage side and then a 5% on the claim side?

Right.

Okay.

Perfect.

Thank you very much.

Thanks, Greg.

Our next question is coming from the line of Mark Hughes with SunTrust Robinson Humphrey.

Please state your question.

Yes.

Thank you very much.

The Supreme Court decision, once that got settled did you see an uptick in activity in the benefits area?

Yes, Mark, we did.

I think there were an awful lot of clients that just weren't going to spend a lot of time and effort on this if the whole law was going to be found to be unconstitutional.

We heard that repeatedly.

And now that they know this law is in fact going to place, there's an awful lot of effort that clients have to go through to get ready for it.

And then on the clean energy business, Doug, did I hear you correctly, break even in the corporate segment in the fourth quarter?

Yes.

$0.02 to $0.03 in the third quarter and break even in the fourth quarter for the total corporate segment.

Right.

And then how do we think about that going into 2013 in terms of run rate?

I think that our 2013 position will be better than it was in 2012 as we get more plants deployed.

Give me till October to give you kind of a firm number on that, but I see the second quarter as being a little illustrative of what -- probably illustrative of what 2013 would look like each quarter.

Thank you.

Thank you.

Our next question is coming from the line of Brian DiRubbio with White Cap Management.

Please state your question.

Good morning guys.

How are you doing?

Great, Brian.

How are you this morning?

Doing well.

Just a quick question.

I think you took your ownership stake in CGM up from 38.5% to 80% in the quarter.

Is that business meaningful enough to have any impact on end-year results?

It's not of the size that would cause any change in any of our organic or top-line numbers of significance and we do not include any of it in our organic number.

So, moving from a 30% to an 80% does not feel any of our organic numbers.

Got you.

And just on the Chem-Mod, Doug, any thoughts about your ability to monetize some of that investment in the actual company by year end or early next year?

I don't know if I can comment necessarily on the timing of it, but I still remain with my earlier comments that there will be a time where we would like to monetize our Chem-Mod ownership interest.

If you recall, we are now five years into -- or six years into our ownership of Chem-Mod.

As a matter of fact, a notable point is in June if you add up all the cash that we've deployed on all of our clean energy investments since 2005 till June 30 of this year, and you look at all the cash flows that have come back to Gallagher, we are now in positive territory.

The entire clean energy program is in positive cash flow territory at this point.

We're getting good success on rolling out our plants and we think that Chem-Mod has a demonstratable product now that could position it to be better owned by somebody else.

Great.

And I guess just final question.

With the cash now that you are bringing in from Chem-Mod and obviously the better operational results that you guys are posting, do you see the potential for you guys to be using more cash rather than shares for acquisitions going forward?

Yes, I think two things.

I think our pipeline is so strong right now that we will be using stock in the new future.

I think cash flows that come off of our clean energy investments are exactly for that purpose.

Remember, those cash flows are to go out and have us expand our core operations and that certainly would reduce the amount of stock that we'd need to use in the future.

Perfect.

Thanks guys.

Thanks, Brian.

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

Please state your question.

Hi, good morning.

Good morning, Sarah.

Wondering if you could just talk about your view of the cycle and to what extent you think rate increases will persist, particularly if we don't have any hurricanes this season?

Well, I'll do that and it will be a great forward-looking statement that nobody knows if I will be right or not.

This is as I said in my remarks, my fourth cycle, and it's completely different in its feel and its look than any I have seen before.

And I think in many respects that could be a very positive thing.

What we are seeing right now is, I think, disciplined management recognizing that at present rates with no investment income to speak of, that they have to improve the pricing of the product that they sell in the marketplace in order to have any kind of return to shareholders.

That is driven primarily by two lines, workers compensation is a real nightmare for underwriters across the United States and property continues to be problematic.

I think underwriters would tell you that three or four years ago they felt that the place where they could really get nicked on property was probably the Coast with wind and earthquakes.

In the last few years, the center of the country has really bitten them.

So, there is an environment that I believe is sustainable in terms of getting rate increases across the book and there's not a balance sheet need here that says we have to dump all our clients or cut back on coverage or what have you.

There's simply a discipline.

Now, I will make another side.

This is the first time in four cycles in my experience that what the CEOs of the trading partners we have, the insurance companies are saying is exactly what we are seeing from the underwriting desk and there is significant discipline and I think there's just better information today than there ever has been in the past in this market.

And our people on the street are finding that they have to take these rate increases out to our clients.

Now, let's recall.

Rates today are probably at par or lower than they were before the last market turn in 2001.

So, when we're asking clients to consider -- not asking them to consider, actually telling them that they don't have a choice because the market is what it is, to consider the fact that there's a 4% to 5% to 7% or 9% increase, they understand that.

Are they thrilled about it?

No, they don't want to see increases, but at the same time they do understand.

And the carriers I think are proving that this time around they can get these increases incrementally.

Great, thank you.

And then on acquisitions going forward, how should we be thinking about the acquisition revenues now that the Heath deal has lapsed?

I'll speak to the pipeline and I'll let Doug speak to the numbers.

I couldn't be more pleased with the pipeline that we have.

I've said that quarter after quarter and we continue to crank out just incredible work.

Completing 30 plus deals so far this year, the team is working extremely hard.

I mean, that's not easy to close, as you know, an acquisition and whether it's $2 million or $8 million the work is still the same.

We have got our human resource people in place.

We've got to integrate these operations into our family and we're really, really good at this.

And we now have -- if you look at our investor slide at our website, we've got numerous operations that are expert in sourcing, helping us price and bring aboard acquisition partners.

And the partners that we brought aboard this year are excited, they are turned on, and the ones we brought in previous years are still with us.

So, I think it's just a -- we're in a really, really good place as it relates to the pipeline and the opportunities to grow our business through acquisitions.

Doug, you want to hit on the numbers?

Yes.

A couple things.

As you're thinking about the numbers, obviously you can see in the press that we've done 27 for around $100 million.

You heard Pat say we've done 5 since then that adds another $30-some million.

I would say that we'll continue to be strong through the end of the year.

In terms of the numbers, one of the things about our acquisition program, it's going to add more amortization, so every time we do a deal the departure between cash earnings and GAAP earnings gets bigger.

And that's one of the things that I would encourage everybody on the call to do is make sure you understand that amortization is going to be going up, that we're going to be using shares in acquisitions, so we're going to have share (inaudible).

But by and large the deals we are doing right now are nice, strong, individual team-type acquisitions.

They are nice tuck-in mergers with us.

We're getting great production talent.

They're profitable organizations.

We always say around here if they're not making money for their family, they will never make money for the collective Gallagher organization.

And we're really excited to have them join forces with us.

They are seeing the need for our expertise.

And so the numbers are generally pretty good performers.

You see margins in excess of -- EBITDAC margins of excess of 20%.

And they have some nice growth prospects ahead of them.

Okay.

Great.

Thanks for the answers.

Our next question is coming from the line of Dan Farrell with Sterne, Agee.

Please state your question.

Thanks and good morning.

Good morning, Dan.

Pat, I thought you made a good point of gradual organic over multiple years being in a good environment for brokers.

I was curious when we think about margin in successive years, if the multiple years of gradual organic have a ramping impact on the margin?

I guess what I'm trying to get at is this year you talked about 3% organic being the threshold to start to get margin improvement.

I'm wondering as you get successive years of organic if that threshold maybe drops to 2.5% or 2% because you're always reinvesting, but you need to reinvest at the same pace or kind of slow a bit.

I think -- Dan, I think you're right.

I think you're on point there that if we had five years of 3% organic growth, I believe in this current inflation environment, in the current work force environment, you would have margin expansion even at a 2% or 3% level.

We're still working very hard to improve our quality and our productivity and we're having some significant wins on those fronts still.

We've got an engaged workforce at this point that I believe has been fairly compensated.

We've been given raises along the way.

If a workforce inflation problem doesn't develop, you would have margin expansion going forward in this current environment, but looking too much further than six months is pretty tough for us to do at this point.

No.

Understood.

And then just on the unrestricted cash, can you tell us how much is in the international versus US subsidiaries?

$120 million.

Is it international?

Correct.

$120 million is in our international operations.

We probably will not bring that home.

We'll probably use that to fuel our acquisition pipeline in the UK and Australia which is where most of that cash sits right now.

Okay.

And I'm guessing did you feel as favorable on the international pipeline as the US as well?

I know you've done some more recent US deals, but does that pipeline still look good as well?

Yes, Dan.

In my comments, that's why I mentioned the Heath deal.

We would not have had the pipeline building in the UK that we have today had we not done the Heath acquisition.

In Australia, we have a very nice pipeline developing and so I think you'll see us be active in both those markets over the next six months and in the years beyond.

Great opportunities.

Excellent.

Thank you much.

Thanks, Dan.

(Operator Instructions) Our next question is coming from the line of Brett Huff with Stephens.

Please state your question.

John Campbell in for Brett Huff.

Good morning.

Good morning, guys.

So, I was just wondering on the share count, it looks like that accelerated a bit from 1Q and, Doug, I believe you briefly touched on this in a previous question, but was that share count increase more of just excess shares used over cash used in acquisitions or more a product of just less shares repurchased in the quarter?

And then just a little further on that, just give us a sense of what the Company is thinking about for share repurchase going forward if you were to assume the stock kind of stays at these current levels?

All right.

Let's work backwards.

We're assuming no share repurchases and we haven't been active in that arena in the last three or four years.

The amount of shares that we're using in acquisitions tends to be between 50% and 75% of the acquisition purchase price.

We're putting shares in our merger partner's hands.

In terms of the share growth in the second quarter, we used about 1.6 million shares for acquisitions, we used about 200,000 in earn-outs and we used about 600,000 related to option exercises and just dilution as the result of our stock price inflating, for outstanding options that are unexercised.

So, you can see that year-to-date we've used about 3.7 in acquisitions and about 1.7 million came from option exercises.

Okay.

Great.

Thanks.

And then just on the international organic growth.

That seems like it's tracking along pretty nicely in the high single digits.

Given the weak UK economy, do you guys see that kind of continuing and then further on that, if you guys could break out by country kind of what you're seeing.

Well, most of our global brokerage business is in the UK and in Australia.

We do have some brokerage business of course in Canada and Bermuda, but the lion's share of it is in the UK and Australia and both those markets are performing in that high single digit area and we think that will continue.

We're having some really good success with hiring teams, especially in the Heath deal right now.

I think there's an appetite to join our operations over there in the UK, and so we're doing a pretty good job of picking up some nice producers.

I think that there's sort of a feeling, at least when I visit the offices in the UK, that there's somebody fresh in the market place.

We're not positioning ourselves as a blue fin or tower gate roll-up company.

We're positioning ourselves to do in the UK what we did in the United States, bolting on smaller acquisitions, giving people career path, trying to recruit the best producers in the cities that we're in.

In Australia, we're very strong in Perth and Sydney.

Lots of opportunities to look at Melbourne and Brisbane for acquisitions as well as in Sydney and Perth, so I think that in both countries we're kind of looked at as a fresh face in the marketplace.

Okay.

Great.

Thanks for taking our questions.

You bet.

Have a great day.

Our next question is coming from the line of [Chris Lakam] with William Blair.

Please state your question.

Hi.

Good morning.

Just a quick follow up on the clean energy side.

I saw that Doug mentioned the volatility over the next two quarters versus the run rate right now.

Is that a product of the investments going on or is there some seasonality in the cash flows and the clean energy side that we should be aware of?

There is seasonality in the cash flows and particularly the reason why the fourth quarter is lower than our expectation of the third quarter is that we're not going to be running one of our plants in the fourth quarter as we look at it right now as we take that down for further testing, for maintenance.

I say that now, but if we have an extremely warm fourth quarter, maybe we won't be taking that plant down.

And it's really not our decision to take the plant down, it's the utility's decision, but that's our best view right now.

So, I would say that it's just normal operational running of the plants that we just don't think it's going to be quite as strong in the fourth quarter right now.

Okay.

Great.

Thanks.

And then on the acquisition side, I saw you guys did debt placement in July.

Is that sort of an additional option on the table in terms of deal financing, how do you sort of weigh that versus additional shares and cash going forward?

We thought it was a good opportunity to pull down $50 million.

We had a maturity opening eight years from now that we filled in with the $50 million and we just saw that our acquisition pipeline is so strong, just taking that extra $50 million seemed to make sense.

Okay.

Great.

Thanks a lot.

Appreciate it.

Our next question is a followup from the lind of Brian DiRubbio with White Cap Management.

Please state your question.

Thanks.

Just one final question.

Pat, with your comments about workers comp and property lines being sort of the focus of price increases, do you see any opportunity for unbundling to occur with claims management, so -- ?

Any time the market firms at all, Brian, it gives us opportunity for that.

For instance, a lot of our captive activity we have an operation we call R-Tech's Captive Management.

Seeing a lot more success.

A number of our school and public entity pools are adding members again.

So, any time there is some price move, people are interested in the alternative market and we get the benefit of that.

Now, 4% and 5% aren't going to drive the kind of jump that we see in the alternative market when the market slams up 100% and there is no coverage available.

But any time there is movement to the positive, people are very interested in alternatives, and the benefit of being part of Gallagher, frankly, is that we've got great expertise in that area and we've built terrific alternatives.

Great.

Thanks a lot, guys.

There are no further questions at this time.

I would now like to turn the floor over to Mr. Gallagher for closing remarks.

Thank you, Claudia, and thanks, everybody, for being with us this morning.

We appreciate it.

We know there's a number of other calls going on.

I think our Company has performed across all divisions extremely well for the last two quarters.

As Doug mentioned in his remarks, if the economy continues to show improvement and rates continue to move up even slightly, we believe we are on track for a great year.

The team is really turned on.

We are winning.

We're having fun building a world-class company and, you know what, all of us around here are excited because we believe we're just getting started.

Thanks for being with us and have a great day.

Ladies and gentlemen, this does conclude today's conference call.

You may disconnect your lines at this time.