Arthur J. Gallagher & Co. (AJG) 2012 Q4 法說會逐字稿

Good morning and welcome to Arthur J. Gallagher & Co.'s fourth-quarter 2012 earnings conference call.

Participants have been placed on a listen-only mode.

Your lines will be opened 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 that will be discussed on this call and which are described in the Company's reports filed with the SEC.

Actual results may differ materially from those discussed today.

It is now my pleasure to introduce J. Patrick Gallagher, Junior, Chairman, President and CEO of Arthur J. Gallagher & Co.

Mr. Gallagher, you may begin.

Thank you, Christine.

Good morning, everyone, and welcome to our fourth quarter and year-end earnings conference call.

Today I am joined by the division heads that run our businesses as well as Doug Howell, our Chief Financial Officer.

Before I get into my prepared remarks, I want to thank the sell side that are listening today.

I think many of you have probably seen the December '12 and January '13 issue of Institutional Investors, and in that magazine the sell side voted Doug Howell the best CFO in the insurance business, and I think that's well deserved.

Today we're going to talk about the quarter and the year end.

Another record quarter and a record year and I'll tell you it feels really, really great.

Our team hit on all cylinders throughout all of 2012.

Our growth came from all operations across all geographies.

I couldn't be prouder of the team and our results.

We're going the Company for our shareholders, year in and year out, quarter after quarter.

We're getting stronger in our capabilities to deliver services to our clients and to attract new business.

In the fourth quarter, we did 21 acquisitions bringing in $76 million of projected revenue.

Our legal teams, our HR teams, all the support groups, seamless efforts to put these people on the books, incredible, incredible work.

The fourth quarter was also a testament to our sales culture and the strategy we focused on for years.

Everyday we focus on four things, and I've mentioned on this call many times.

The first is organic growth.

Everyone in this Company knows that nothing happens until somebody rings the cash register.

The second thing we're after is mergers and acquisitions and attracting the best entrepreneurial talent in the marketplace to our growing family.

Third is productivity and quality.

We're always looking to do a better job for our clients and to improve our margins along the way.

And fourth, we work hard everyday at maintaining our unique team oriented Gallagher culture.

Thinking about these four things every day has served us well and those are the four things we're going to stay focused on as we go into 2013 and beyond.

When you look at our Brokerage segment and Risk Management segments together, adjusted revenue was up 14% in the quarter, 15% for all 2012.

Adjusted EBITDAC was up 17% for the quarter and 20% for the full year and margins expanded in the quarter and for the full year.

All in all an excellent quarter, another record year for Gallagher.

Our production force is winning, they're turned on and really providing great results.

The fourth quarter is our eighth quarter in a row that we have posted positive organic growth.

So many of the things that succeeded for us in 2012 we believe will carry over into 2013 and continue to prove successful for us again.

In 2012 we completed 60 acquisitions bringing an annualized projected new revenues of $232 million.

We project $130 million of that will hit our books in 2013.

This is again across all divisions, across all geographies and our pipeline still remains strong.

These firms added greatly to the niche expertise we talk often about and to our geographic footprint.

They brought us a couple of hundred new producers who now are armed with our capabilities and who we expect will produce significant new business in 2013.

Think about it, we give the production force greater opportunities to grow their book of business and to make more money.

Our Risk Management segment, Gallagher Bassett for 2012 had revenue growth of 7%, adjusted EBITDAC was up 11%, organic growth and base domestic and international fees for the quarter was 2.9%.

But importantly the way we handle our clients is recognized.

Gallagher Bassett was recognized by business insurance readers as the top TPA for both small and medium-size companies and this is the fifth consecutive year we've been recognized by the readers of business insurance.

Again the sales culture is strong, new business was excellent throughout 2012, but was especially strong in the fourth quarter.

In addition, we continue to have strong business retention, our account retention across both segments is nicely in the mid 90s.

Our sales teams are doing a fantastic job of explaining the value proposition that Gallagher has to offer through the entire insurance spectrum.

Let me move to a number of individual operations and I'll start with the Brokerage segment.

In property casualty retail, we continue to see rates increasing.

It feels as we start 2013 very similar to what we felt in 2012.

Most lines are experiencing mid single-digit increases.

Catastrophe exposed property especially the Northeast looks like it's going to be up a little more than that.

And workers compensation could be a bit higher across the country as well.

We are not experiencing a traditional hard market, but rates are moving up consistently across all lines.

And as I mentioned workers comp is a line in many states that's in distress and we are seeing increases excess of 10% most of the time in that line.

Again, this is not a balance sheet driven correction.

These are income statement driven corrections, carriers realize they're getting no investment income and lost costs are continuing to rise.

With costs inflating, a flat renewal is actually a step backwards for the carrier.

The senior managers at the insurance companies we trade most with remain resolute that their team has got to get them increases.

We have not seen the discipline abate during the quarter.

So by and large, rates are continuing in positive territory.

I want to emphasize that I believe steady increases handled over time are much better for our clients than a dramatic change.

Adjusting to low single-digit increases after virtually eight years of rate decreases is much more manageable for clients.

Nobody wins when rates jump 50% to 100% and insurance is difficult to buy.

And also remember, you have to recognize that rates are now still at levels we saw in 1999 which was before the last really hard market.

As it relates to the economy, I believe that fiscal cliff and lack of clarity around taxes negatively impacted our clients businesses especially in the second half of 2012.

But as we come into 2013 and there's more clarity around what's going to happen in that regard, we believe our clients businesses are showing a little bit of improvement because we're seeing this in some positive audits.

If we can see a continuation of positive rates and a little improvement in the economy, we believe we've got really good momentum going into 2013.

Let me touch on our international Brokerage, with a very strong quarter and a very strong 2012.

The acquisition a year ago of Heath Lambert has given us a great platform to bring a whole new opportunity to our merger and acquisition efforts.

Our pipeline continues to be strong, we completed seven acquisitions internationally, four in the UK, one in Australia, one in the Caribbean, and we purchased 21.3% of Grupo CP in Mexico which cements what was already an excellent relationship going back well over a decade with the Casanueva family in Mexico City and it opens up great new opportunities for us in Central and Latin America.

Our wholesale and MGA business had a strong finish to the year.

New business was strong, our hit ratios improved on submissions, our submission growth was solid.

We saw continued organic growth in the business which we feel really good about.

Business is moving back to the excess and surplus markets and we have a team of professionals that know these markets inside and out.

On the MGA side, where according to Business Insurance, we're the largest Firm.

We saw an improvement in new business startups which also helped us to grow organically.

Let me move to our benefits business and I want to spend a little time here.

The benefits business is in a really, really good position.

I think we are positioned to do extremely well on behalf of our clients in what is a real changing environment.

Our benefits operation did 33 acquisitions in 2012.

And I think this is another example of our efforts to be prepared for the new healthcare law, those efforts really paying off.

These new firms will bring in a projected annualized revenue of $82 million.

Now what this is showing me again, and I've mentioned this to many of you, I believe that independent benefits brokers need much stronger consulting expertise in order to deal with the changing environment.

I expect pressure to continue to build in that regard because as we get closer to 2014, many of the laws provisions go into affect.

So during 2012, we also announced the formation of a private exchange and partnership with liaison.

We can now help our clients whether they prefer to continue with the defined benefit approach or defined contribution approach.

Still, too many clients are sitting on the sideline thinking that they're just going to maintain what they've got and deal with the law down the road some time.

I had a long conversation with a sizable client just last evening, and I couldn't get him off the dime as it relates to being prepared for 2014.

I think that's going to create a tremendous opportunity for us.

In the near and long term, we have built the expertise to be able to deal with this changing environment.

So go back to our total M&A efforts this past year, 60 acquisitions, $232 million of new projected annualized revenue, our pipeline is strong and clearly a key part of our growth strategy is to continue to attract strong entrepreneurs into our Firm and to give them additional capabilities to grow.

As I do every quarter, I want to stop and just thank those who joined us.

I know you had choices and we're very, very glad you chose us.

Welcome to our expanding family and I know you'll contribute substantially in 2013 and beyond.

Let me move now to our Risk Management segment.

Another solid quarter, another great year.

We've now completed our wind down of the New Zealand earthquake activity and we've ramped up our operation in South Australia.

Think about this, in two to three months we hired a 185 people.

We got them situated, trained and ready to pay claims in two to three months, unbelievable work by the team.

Our international operations contributed greatly in 2012 and they'll even do a greater amount of contribution in 2013 especially with the addition of South Australia.

We've invested over the past year a new IT tools that we refer to as the analytical work bench.

These continue to be well received by our clients, and we're continuing to invest in client facing products and services which should keep us in a really strong position both for renewals and for developing new business.

And even with ongoing investments in our service offering, we've maintained our target margin of 16%.

I continue to be very excited about the power the Company is building to help our clients in this really risky world.

Our culture as I mentioned before is strong.

And I can't emphasize this enough, we're client focused, team oriented, upbeat and winning.

All of us are involved in selling and servicing our clients, and we firmly believe as an enterprise we're just getting started.

Over to you Doug.

All right thanks, Pat, and good morning, everyone.

Let's jump in and start on the second page of the earnings release with the Brokerage segment.

The first item you're used to seeing is the Heath Lambert integration cost.

The end is in sight and we're on track to wrap up the integration in mid 2013.

So you'll see just $0.02 of integration costs in the first and second quarter and then about $0.03 in the third quarter.

The third quarter actually reflects the cost to consolidate most all of our London operations into new space near Lloyd's which will be the caps down on nearly two years of hard work by the team to put these organizations together.

The next item is a $0.05 charge relating to contacting our middle and back office.

We took these actions at a time of strength because it was the proactive step to realize savings from our process improvement initiatives, increase utilization of our operational service centers and our investments in improving technologies.

It's also a prudent step to offset the impact of medical cost inflation, to reduce the financial impact of our frozen pension plan and most importantly allow us to continue to recognize and reward the broader workforce.

And the third item in the Brokerage segment is we resolved some tax items in the fourth quarter that cost us $0.02.

We called it, we resolved some tax items in the second quarter that generated $0.02 of earnings.

So while it create some noise between quarters, for the year they offset and have no impact on our annual numbers.

Moving slightly down to Risk Management, I've already hit on the severance cost item and the next item is the ramp up efforts to on board our new client in Australia, that Pat discussed.

And as a reminder, that client should generate about $20 million of annual revenues here in 2013.

Let's move on to page 3. The Brokerage segment had a terrific organic growth quarter, up 5.2%.

That's excellent work by our production folks especially given they were also up nearly 5% in the fourth quarter of 2011.

Looking across our units, each of them posted excellent growth.

We saw about 5% organic in our domestic P&C operations, a touch over 5% in our domestic benefit units and a little over 6% internationally.

So strong work across the table.

Turning next to the top of page 4 to the Brokerage segment margin table.

We're really pleased to continue to post margin expansion here in the fourth quarter.

Looking at it on an annual basis, for margins to be up 70 basis points on 4% organic growth is really, really good work by the team.

And more importantly, because we took the proactive steps to offset workforce related benefit and compensation inflation, we are well positioned to control our compensation cost coming into 2013.

Next while we don't normally spend time in these calls on the non-EBITDAC items, let me pause for a second and give you some thoughts related to modeling depreciation, amortization and change in acquisition earn outs in 2013.

For depreciation, assume about $8 million of expense per quarter.

For amortization, assume about $27 million of expense per quarter, plus you'll need to make a guess for amortization from new M&A activity that arises in 2013.

And finally, for change in acquisition earn outs assume about $3 million of expense per quarter and that will cover the amortization of the discounted earn out payables.

Also, as my annual reminder, please use our investor supplement that we post on the website to build your models.

The adjusted pages remove difficult to compare items which is helpful when you set your baseline.

It also highlights how seasonally small we are in the first quarter, which like I said last year has become even more pronounced because Heath Lambert is also seasonably smallest in the first quarter.

Okay move down on page 4 to the Risk Management organic table.

The temporary revenues related to the New Zealand earthquake claims are all but gone.

And without those, we posted nearly 3% organic.

This is down a bit from previous quarter and we believe that is an anomaly for two reasons.

First, we eased back a bit on new business in Australia as the team ramped up for the new $20 million account.

And we did lose a decent account which unfortunately happens from time to time in the competitive business, but we believe that's an anomaly.

That said, looking to post 5.7% organic for the full year is really good work in an economy that isn't seeing much employment growth.

As we look towards 2013, we are seeing an organic growth environment similar to what we saw in 2012, plus we'll add about $5 million per quarter of revenues from our new Australian client.

Moving to the middle of page 5 to the Risk Management margins.

Recall last year at this time, the team set out to push its adjusted EBITDAC margins up about 50 basis points to 16% and also cover about full margin point of cost to develop some exciting client centric tools and resources.

And, you can see that they delivered.

It was great work by the team.

This investing will continue in 2013 yet with productivity gains we are still targeting 16 points of margin.

All right, let's move to the bottom of page 5 to the shortcut table for our Corporate segment.

For the fourth quarter we posted a loss of $0.05, which was right in line with our $0.04 to $0.07 loss that we forecasted in our third-quarter call.

For the year, we came in at $0.03 versus a loss of $0.26 in 2011, virtually all of that improvement came from our -- from clean energy investment earnings.

As for 2013, rather than rattling through a lot of numbers on this call, we've expanded page 14 of our investment supplement on the website to include our current best guess range for each of these Corporate segment line items.

The punch line from that schedule is that the Corporate segment should post between $0.17 and $0.34 of earnings in 2013 versus $0.03 of loss here in '12.

Page 14 also shows quarterly ranges because there is pronounced seasonality in our clean energy investment earnings.

So please use that page when building your quarterly models.

As a last thought on clean energy investments, it's important to remember that it was only 13 months ago that the team built and placed into service 15 new plants.

Now when you read page 6 of the earnings release, you'll see that we are only left with a few uncommitted plants.

Then when you look at page 14 of the supplement, you'll see that we can make between $75 million and $90 million in 2013 from these investments.

And if we continue to have success in ramping up the other plants, that could bode well for even better earnings in 2014.

The important take away on all of this is that these investments could generate substantial cash flows which we will use to continue to fund our M&A program.

That leads me to my wrap up commentary on capital management and funding our M&A growth.

In our last earnings call, I said we would not use much stock to do M&A in the fourth quarter and we did not.

As we look towards 2013, we intend to again favor cash and more debt to fund our M&A activity and avoid using stock.

We currently have about $160 million of cash in the bank and we're also working on another $200 million of 10-year notes.

All that said, if M&A activity exceeds last year and realized from time to time we must use stock and tax for exchanges, than we might need to use some shares.

But we are currently favoring cash and debt.

So those are my comments, it's been a really exciting year but it's time to put 2000 on the shelf -- 2012 on the shelf and focus on delivering some excellent results here again in 2013.

Okay back to you, Pat.

Thank you, Doug.

And Christine we're ready for questions, hopefully some answers.

(Operator Instructions)

Mike Nannizzi, Goldman Sachs.

I have one question on the charge, trying to understand what came first, was it the expectation that you would have that $35 million expense or was it the expectation that you would incur these workforce savings?

Trying to understand the thought process around the determination of that number.

Thanks.

Good question.

Just to clarify, we took $12 million severance and related cost of charges and we expect to save about $35 million, of which much of that will be offset by what we refer to as just workforce inflation.

Those were planned reductions based on our work in August and September to look at our staffing levels in light of the ramp up of our offshore centers of excellence, looking at our technologies and looking at our productivity gains.

So it was a necessary step in order to harvest the savings that we expect as a result of the investments and getting better at what we do every day.

But if we were to peel that out, peel that piece out for a second, the second part which is the increased medical cost, reduced discount rate on the pension plan, salary increases, performance-based compensation, long-term incentive, did you know that was -- is that new or was that the results of a study or was that something that you expected that you would be incurring any way down the road?

Those costs are always inflated, medical cost is going up, I think the decline in pension yields has been there and we've known about that, and giving raises to -- and incentive comp to our broader workforce is something that is in our numbers every year.

So this is something we took a -- we saw it but there was no surprise there at all.

Got it.

Great, thank you.

[Rush Salome], Stifel Nicholas.

I wanted to clarify on Doug's comment on the M&A financing, would it be fair to assume that it would be roughly 75% cash and debt and then 25% stock, is that a fair breakdown?

No, we intend to use 100% cash and debt to fund our M&A program, unless for some reason in the structure of a deal, we need to use stock in order for tax -- to be a tax free exchange.

And if we have a merger partner that is -- that has a strong desire to hold stock, we would consider giving them stock in that transaction.

But by and large we're going to favor cash and debt.

And that should continue into 2014 also, that logic?

Yes, it should but again if our acquisition appetite grows we would have to use stock in the deal.

We're trying to keep our debt somewhere south of 2 times debt to EBITDA.

So at some point if we really have a strong M&A pipeline, we'd be back to using stock towards the end of the year.

Okay, great.

And then my other question, in terms of monetizing Chem-Mod, is there any update in terms of the timing on that or --

We had talked about that last year trying to be ready by the end of '12 on that.

We think it's more of a mid-2013 exercise at this point.

2013.

Okay and then lastly, in terms of the health exchanges, I know you have the partnership with Liaison, are you guys also looking to form other partnerships with other exchange platforms or do you think that's going to be the primary partner for the next -- over the next 12 to 24 months?

We're entertaining partnerships with other providers as well.

Okay.

All right, great.

Thank you so much.

Gregory Locraft, Morgan Stanley.

Wanted to pursue, I guess I'll -- the core operations looked great.

Just on the coal side, very helpful chart in the supplement where you give forward guidance.

Can you go backwards though and talk a bit about what the guidance was versus what the actual came in at for clean energy and why the differences?

Fourth-quarter guidance we guided $0.04 to $0.07 of loss for the Corporate segment.

The clean energy production in the fourth quarter wasn't quite as high as I had probably guided generally due to warmer weather in a couple of the locations where we have plants.

So and compared to the fourth quarter, we're a little short in that but still not too bad.

Okay so what you really want us, Doug, to do is to focus on the Corporate segment guidance all in not on the component parts as much.

Because obviously we're -- we keep cutting finally the numbers and there' going to be puts and takes.

What I'm trying to understand is $75 million to $91 million on clean energy, how baked in the cake is that?

What's the difference between $75 million, what's the difference between $91 million, that kind of thing?

I understand your question.

We're highly dependent on the activities of the utility to dictate how much they actually burn of refined fuel or clean coal.

So we sit down and we go through with each of our utility partners and we get their best guess with respect to production for the next year.

And we do suffer from weather issues, from plant maintenance issues, so I would say that our $70 million to $90 million is our best guess at this point based on what we know now.

And so I think it's a range that we feel reasonably comfortable with.

Okay and any of these contracts that you talk about in the release that could come through mid-year, is that all upside?

We have taken our best guess with respect to ramp up of all of the plants that we disclose in page 6. But it does not include any of our best guess for the plants that have not been put into the construction phase at this point.

Okay, perfect, great.

And then jumping to the M&A side, just an awesome year, as you mentioned, it seems like people are choosing you as the destination.

So -- but what I'm trying to do is model it and so -- and I think you've been very upfront in saying, take all free cash flow.

Do we then add an additional amount due to the clean energy funding, so say $75 million on top of free cash and then that becomes effectively the budget for M&A in 2013 and forward?

Yes.

Perfect, okay.

Any incremental debt you'd add because you did mention less than 2 times and you could squeeze some in there?

In my comments I said we're right now looking at adding $200 million.

Okay, I missed that.

So we've got $160 million in the balance sheet, we've got free cash flows that we'll develop this year plus $200 million of debt.

So we have a lot of money to spend on acquisitions this year.

Great, and then what's the rough revenue range at which you buy these things at, or how should we think about backing into what you think you can get in the market?

Our multiples of EBITDA have been between 6 and 8 times historically.

Okay, perfect.

So we don't buy on revenues, we buy on EBITDA.

Yes, of course.

Okay, that's great on that.

And then last one for me is the organic is above that 3% threshold where I think you guys have said at least in the past I think you get margin expansion above that level.

So it seems like we should continue to -- we're running at a good clip there and no break in trend, so should we expect what we've been seeing going forward on the Brokerage side?

Well we feel like the environment this year is a lot like last year at this time.

When it comes to margin, I've always said that if you expand, don't expect much margin expansion greater than 3 -- unless we have organic -- greater than 3% in the Brokerage side and 5% in the Risk Management.

But with the proactive steps we've taken to control our compensation and benefit -- the natural inflation in that, we feel good about our prospects for holding and expanding margin in 2013.

Okay, great.

Actually I'll squeeze one last one in for Pat.

Your view on the cycle, you mentioned quite bullish comments on pricing and where it's heading.

Do you see an acceleration in rate of change or do you think we're more in a unique world where we're in call it 5% to 10% depending on the line for the next few years?

I think we're in a unique situation.

This is my fourth cycle and it's completely different than anything I've ever seen before.

I do think it's in that 5% to 8% continual pressure to push rates up.

Okay, multi-year?

Well we're going into the third one right now.

Okay, great.

Thanks, guys, nice year.

Thanks, Greg

Sarah DeWitt, Barclays.

I was wondering if you could elaborate on what drove the acceleration in Brokerage organic growth versus the third quarter and maybe if you could break that down between what you're seeing in terms of rate versus exposure versus new to lost business?

That would be really helpful.

Well let me -- I'll give you a general comment, let Doug comment on the breakout if he can.

We just had a great fourth quarter in new business and retention.

I mean frankly, coming into the fourth quarter and December in particular, you know what your pipeline looks like and you don't know what your orders are going to look like.

It's an aggravating quarter, an aggravating month for me, to be perfectly honest, because you can get hurt by one big loss, you can be -- you can really be helped by various operations doing well.

And this is just a time we're in the fourth quarter, and in December in particular, across every geography, so our international operations had an incredible quarter, our MGAs and wholesalers strong organic growth.

I already commented on our benefits operation and our straight PC retail folks knocked it out of the park in the quarter.

And it really comes down to incrementally keeping a better rate of retention and adding more new business.

And in Doug's comments, this is the thing that I'm really proud of, it was a tough quarter to compare.

Last year if you recall in the fourth quarter we also did 5% organic and didn't see that level of organic growth again for the three next quarters.

And to have a big quarter last year and then to do it again this year, is just solid work by the team.

Yes, I think that Pat hit it.

I mean basically we didn't get a lot of lift this quarter from economy and we didn't get a lot of lift from rate.

It was a little better new business and a little less lost business, so that's where we're seeing it.

The rate increases that we talk about by the way, I should comment on this, the rate increases that we're talking about by account by account, we're working very hard to offset those for our clients.

So we're seeing about 1% impact on our revenues from rate.

So don't be thinking that just because the carriers are getting an 8% rate increase that necessarily our clients are paying that.

They'll take higher deductibles, they'll move to self-insurance, they'll -- if it's really in a situation where they're squeezed economically they'll reduce coverage, and overall impact in our numbers is just 1% from rate.

Great, that's helpful.

And then on the Risk Management business, could you talk about what you're seeing in terms of claims trends there?

And based on your comments, is it right to think about the right run rate for organic growth around the 6% range in that business?

Well we thought that the lower run rate for organic in the fourth quarter was an anomaly and frankly we did have some impact there, negative impact from a bit of a slower economy.

So yes, I would think that our more normalized run rate would be something along the lines of 5% to 6%.

Okay and finally if I could squeeze one more in.

On the Australia business, is that business running around the 16% margin as well or something different?

No, about 16%.

Great, thanks for the answers.

Mark Hughes, SunTrust.

Pat, did you say how the workers comp claims are looking within Risk Management?

Did I say how they're looking?

Yes.

We didn't mention it, but I can tell you, we're not seeing claim count growth because we're not seeing employment growth.

And what we are seeing is the same thing that the insurance carriers are finding is that we're seeing medical inflation within the comp line to a point where the medical costs are growing much faster than the indemnity costs.

How about the -- you had mentioned I think that new business startups were looking better.

Could you elaborate on that a little bit?

Yes, especially in our MGA book business, Mark, that's very sensitive to that.

So when the economy tanked in '09 and '10, and there really -- for that business to do well, we need bars and taverns and tattoo parlors and people like that to start businesses.

And when they do, they end up in the excess and surplus market and in the specialty programs.

And so we are seeing -- we have over the last really three quarters seen some improvement in business start up which is helping us in our MGAs.

Final question touching on the margin issue again, Doug, the 5% organic but 40 basis points in margin in the Brokerage, should we expect a bit more than that if you're able to hold this organic growth or is that an appropriate number?

No, I think -- listen I think there's -- behind the 40 basis point expansion of margin this quarter, there's a couple of subtleties that I think you should think about.

First is margins would have expanded probably another 20 basis points but our 2012 tranche of acquisition -- M&A partners, happen to be seasonably smaller in the fourth quarter.

Just like Heath Lambert is smaller in the first quarter, this tranche of acquisitions tends to have smaller margins in the fourth quarter.

We also spent about another 25 basis points on more travel this quarter.

Half of that was related to the M&A activities, so maybe 12 basis points of expansion.

About 6 basis points were related to our efforts to harvest the productivity improvements that we've talked about that led to our workforce contraction.

And then maybe another 6 basis points related just more to organic travel to get out there and see our clients and pick up new business.

So I'm not saying that those are one timers, but they did have an impact on margin expansion in the quarter that, had we not had the seasonality and maybe a little less M&A activity, we probably would have expanded another 20 to 40 basis points.

I knew I could count on the level of detail from the award-winning CFO.

There you go, Mark.

I'll intrude by asking one, how do those things look when you look at 1Q, the seasonality, the travel, the productivity issues et cetera?

Are they -- is the impact similar, slightly dilutive in 1Q or should it be more positive in 1Q?

I think that the organic travel for new business and for our -- for new business and our existing clients will be there in the first quarter, but that was only 6 basis points of cost.

I don't -- I think there's always a natural slowdown in M&A activity in the first quarter.

There's generally, if you look at M&A activities when you do 60 deals, the first quarter people are catching their breath and then they target to get stuff done before the end of the year.

So we always say we do a years worth of acquisitions in nine months, so that should not be there next quarter.

Thank you.

Adam Klauber, William Blair.

Good year, good quarter.

Thank you.

Contingents and supplementals were up pretty good in 2012.

How much of that is having new carriers come into the program or how much of that is normal growth and what do you expect for 2013?

I'll touch on where it's coming from and let Doug touch on what we're forecasting for next year.

This is more about having new partners through the merger and acquisition process than it is new carriers coming in.

Most of our supplementals and contingents are coming from the same partners that we worked with in building those programs over the last four or five years.

And it's building more volume with the carriers that support us essentially with those revenues.

Yes, contributing to that Adam is that we've spent a lot of time on carrier analysis and compensation analysis and that's starting to pay some benefits there.

As we look into 2013, frankly the teams are hard at work, working with the carriers right now to come up with fair supplemental and contingent commission agreements, so I really won't have a big feel on that until the April call.

Overall, if you modeled it equal to we did this year, you wouldn't be too terribly far off.

And then also, we are starting to see a few carriers start talking about moving back from supplementals into contingents.

That would create a timing issue perhaps that we'd normally accrue it during the year but we might get it next March.

So I'll give you more guidance on that in April on our call.

Okay.

In the benefit business, there has been pressure on commissions for smaller businesses, 50 lives and less even 100 lives and less, is there any movement by the health insurers to push that up past that 100 to 50 lives?

Adam, for us its really -- that's a non event to be honest.

We don't do an awful lot of business in the under 100 life case area.

What we do is primarily above that level.

And when you get over 100 lives, whether -- even if the client chooses to pay it by commission, it's a disclosed negotiated and a discussed fee.

And so it comes through our books as commission but it's really what the client agrees.

And we have for a decade now made it very clear to clients that in essence under [ERISA] for 20 plus years we've been transparent with our clients.

If we have a certain level of cost, we need to cover that to do the work for the client, and we're very transparent about that, we're very open.

And so the pressure on insurance companies to reduce commissions is not really impacting our benefits book of business at all.

Okay.

Can you give us an idea, what was organic in the benefit business this year, in 2012?

It is almost the same as what it was for the whole Company.

Okay, so pretty solid year.

And also in that same vein, how is organic in the London operations in Heath?

It's good, I think that -- I'm actually pretty pleased with the revenue retention there.

I think that we are culling out some of that book of business as we look at it to say if we can't make money we'll put it out.

But they're doing a good job of holding in there and we picked up some nice accounts over there too.

I think that--

We picked up some very nice Risk Management accounts with their risk management team and the team that we had in the London before the acquisition.

We've done an excellent job of holding onto books of business in both the affinity, which is small business programs that we have, as well as middle market and in the branches around the UK.

And as I said we've bolted on four acquisitions that we never would have been able to do if we hadn't done the deals.

So all in all, organic growth is strong there and M&A growth is strong there and the team has done a really good job of integrating that business.

Just as an example of how difficult that is.

You can imagine Heath Lambert's benefits programs were substantially different than Arthur J. Gallagher's benefits programs.

Harmonizing those is really difficult and our team did a fantastic job of working through that so that we're all now one Company, one set of benefits across the entire platform.

That's just one example of the work that had to be done.

Great and one last question, what was the end of period shares, if you haven't said that?

Let's see, let me pull it out here, it was 125.6 million.

Okay, well thank you very much.

Brian DiRubbio, Yield Capital.

Pat, question for you or maybe if Scott Hudson is there maybe he can answer it.

If I heard you correctly a few moments ago you said you didn't see much in terms of the claim count growth in Gallagher Bassett, was that correct?

Organic claim count growth, yes.

They are.

So how should we think about employment growth, and the ADP numbers were pretty good this morning, how that translates into potential claim -- account growth.

Is there any correlation that we can look to?

It is very correlated.

Gallagher Bassett is incredibly sensitive to the economy.

When you're working three shifts and you take that down to one shift, you're going to have more than -- you're going to lose two thirds of your claim count.

But Scott go ahead, comment.

We look at two things.

I mean there's the overall claim counts growth which is influenced by the new business we bring on.

And then we also breakout existing claim count growth and that's the part that we can correlate to the economy specifically.

And that part of it is -- we are talking about 5% to 6% claim count growth overall, the part that is influenced by the economic growth is the existing clients is about 1% to 2%, it's still relatively low.

And so until we see an uptick in the economic activity, that part of it won't go much above that.

I'd also comment Brian, we're not seeing FTE hires in our benefits book either.

Our clients are not hiring people.

Their businesses are getting a little better, but they're not stepping up and hiring people.

Okay.

Next question and it's probably both answerable by Pat, yourself and Doug, so inflation, there are signs that inflation is moving up higher.

You're seeing it in the yields of the 10-year treasuries most notably.

So I guess the two-part question, Pat for you, how do you see that affecting pricing in the business in general?

And for you Doug, I know you talked about raising $200 million in debt this year, but with your 6.25% notes due in about 18 months from now, would it make more sense for you to lever up a little bit more so you're locking in a lower rate for a longer period of time for when that bond matures in 18 months?

Well let me take the first half of your question, Brian, and then Doug can talk about the capital management secondly.

What I am really impressed with in this cycle, and I think this is both an information situation as well as just strong management.

Senior management at the insurance companies know where they're making money, they know by line, by city, by country, by state, they really have information at their fingertips.

As I've said before this is one of the first times in my career were what I'm hearing from the senior executives at insurance companies is actually happening exactly as they're saying it on the street.

There's usually a bit of a disconnect as you're getting towards the end of a cycle.

And they know exactly what's happening to their cost structure.

And if costs are inflating, which tort is in fact inflating and medical is in fact inflating, they recognize lost costs are going up and they know exactly what percent that is and what the impact will be on the next year.

And they are going to try to cover that lost costs with the rate increases.

And it's actually quite impressive, they're doing a very good job.

And I think our people are getting better and better at explaining that to clients because when it first came about, about three or four quarters ago, maybe six quarters ago, frankly all the people we had hired for eight years, all they'd ever done is sell cheaper insurance with broader terms.

And all of the sudden they're explaining to clients that carriers have no return and they're getting to -- they're having to become more sophisticated in how they explain how insurance works to clients.

And it's been quite impressive and I do think that as long as yields remain suppressed, you're going to see carriers that fight hard to try to cover their cost of capital.

Yes in terms of debt, Brian, I think that let's get those $200 million put to bed and then we need to look at it a little bit over the long term.

It doesn't pay right now to do that at this point.

But if we have a little bit of a trough in rates still for the rest of the year, we'd look at do something with our 2017 tranche.

Okay, got you.

thank you.

(Operator Instructions)

Bob Glasspiegel, Janney Montgomery Scott.

Pat, in light of your expense cuts, are you changing the dynamics of the 3% organic being the breakeven of margin hurdle?

Bob, great question and yes you should look at that.

If in the past I've said that it takes 3% to cover the natural inflation that goes on inside of our books, if we believe we've cut that natural inflation by this reduction in force, than it would stand to reason that we probably could have margin expansion at less than 3%.

So you're providing the linkage there.

I've never seen a recovery from restructuring charges so dynamic, 200% plus ROI, how does that phase in?

It's immediate.

So it's $35 million -- I mean how much in -- I didn't know whether that was an annual cost or a cumulative cost recovery.

No, that's our one-time severance cost, we expect it to harvest $35 million of savings.

$35 million cumulative or $35 million a year?

I guess that's what I was--

Year, per year.

$35 million per year.

Which will offset additional costs, Bob.

Don't drop that into pre -- don't drop that into EBITDA.

No, I wasn't.

But I just wanted to make sure I understood your recovery.

So that's evenly in the first quarter, your run rate is down by $8.5 million a quarter and you're going to spend some of that on inflation?

Correct.

On the -- it sounded like, Pat, for yours and my fourth cycle that we've had together, you're more bullish for this cycle than I've heard you on the environment, is that a correct read or--?

Yes, Bob, if I can get mid single-digit increases in rate, and if our clients businesses can recover to even a 2% economic growth, with our new business machine, we will show very solid organic growth which is what showed up in the fourth quarter.

And if you give me 5% to 8% organic growth, and I'm not predicting 8% right now, but if you see a real change in the economy and rate stay firming, you can show some real growth at the profit line.

Okay, well good luck to your 2013 and appreciate the call.

Ray Iardella, Macquarie.

Just a couple of numbers questions because I know a lot of the topics have been covered already, but Doug can you talk about the tax rate on the core business?

I know we spent some time talking about the clean energy initiative, but it seems like you guys maybe are expecting a lower tax rate going forward.

Yes, good question Ray.

Yes, if you read in our press release in the income tax section we have moved historically we'd say 39% to 41% and we're south of that now.

That has to do the mix of our international business, as we grow internationally, the tax rates in those jurisdictions are less than what we have here and so that does have a tendency to bring down the rate.

Okay, thank you for that.

And then I know you mentioned the one large client on the Risk Management side, margins around 16%, but any other drag you guys expect in the first quarter from bringing some of those hires online?

No, I think actually we should hit the ground running with respect to our South Australia clients, I don't expect a drag.

Okay, that's helpful.

And then international versus domestic cash, if you have that?

Yes, we have about $40 million free in the US and about $120 million internationally.

So when I gave the $160 million of free cash, it's about $40 million in the US and $120 million internationally.

Okay, and then I think I missed the number at the very beginning, Pat, in your prepared remarks where you talked about $232 million of acquisitions that you guys did in 2012, but what was the expectation for 2013 for those acquisitions?

$130 million.

Okay.

The rollover, Ray.

That's rollover.

Yes, okay thanks again.

Joshua Shanker, Deutsche Bank.

Yes, thank you very much.

Doug, can we talk a little bit about pace of plants coming online throughout 2013 comparing the early part of the year to the late part of the year?

Say your question again, I -- you beeped out on the first part of the question.

Sorry, pace of -- expectations for the pace of plants coming online.

The pace that we have in here is, if you add up the ultimate numbers on page 6, you get a number higher than what we have on page 14 of the investors supplement.

So what that would imply is that the pace is probably a three-month setback.

So if you think about the pace of these plants coming on, not going through each one of them, but we have two that we think is going to be in mid-2013 and then the ones that we're currently, we've selected as a finalist, those would come up in the fourth quarter, if that works.

So I think the pace on 6 rather than going through each one is our best guess, but we've given ourselves a few month cushion in each of those pieces.

Okay, thank you.

And Pat, you said a word that I talked about a lot but I don't hear a lot, self-insurance as a protection for your clients to avoid paying higher rates.

To what extent can you see now and forecasting if we are in this continuous rate environment that self-insurance becomes a larger part of the pie?

Every single cycle.

Every single cycle it does and in particular the workers compensation line.

Workers compensation is running very high, combined loss expense ratios for the industry as a whole, something probably north of 115%.

That's going to create a natural push from the carriers to increase workers comp premiums and those will be offset by people who will join pools, find together to create ways to self-insure.

It'll take individual clients that will form captives or group captives.

And you'll also see individual clients that are on the cusp taking more risk themselves, working hard at loss prevention and trying to not pay the premium but pay the losses themselves.

This is our wheel house, this is what built our Company.

We got into this in the 60s and every single cycle this is what expands for us greatly.

And it really benefits Gallagher Bassett as well as the Brokerage side.

Now remember, part of that is a little bit of -- part of that is a little bit self-defeating on the Brokerage side because if we're writing an account with a very high commission that then takes self-insurance and takes a huge retention, our commissions actually come down.

The fees on the Gallagher Basset side are new fees that we didn't have, but those are a little bit lower in terms of margin.

Nonetheless, it's the right thing to do for our clients and we're really good at it.

And thank you, that was perfect.

I was going to ask you about margins afterwards, but you got it.

I appreciate all the answers.

Brett Huff, Stephens.

Good morning and congrats on a nice quarter again.

Thanks, Brett.

Two questions, Pat you said all in you guys end up squeezing the rate down to 1% on Brokerage, is that -- should I do the math and that implies a 4% in terms of unit growth?

Yes.

Okay and the second one and you mentioned Doug a little bit on this in terms of the acquired revenue seasonality and in terms of little bit lower margins.

And I don't know if Doug or Pat is the best one for this, but more generally in the really big push you guys have done on M&A, have those new businesses you've acquired come in at a lower margin?

And if so, what is your expectation for expanding that margin to get back to a higher level or your average level or whatever?

Can you give us a sense of that?

I think as a portfolio of acquisitions, if you look over time, they come in not that dissimilar to us, all right.

So I wouldn't say that they fuel margin or depress margin.

You can get some quarterly anomalies that we talked about here, but by and large they look a lot like us.

And that's an important strategy of our M&A strategy.

When it comes to most of these deals we want to buy successful growing entrepreneurs that know how to run a business to make money for themselves.

And because want them to make money for us together as a combined organization.

We try not to ever buy a small deal that's a turnaround.

We try not to buy retirements, we want to buy people that want to continue to produce for us and that they've shown that they can make money for their family.

Because if they don't make money for their family, they're never going to make money for us when they come in.

So by and large, these are successful entrepreneurs that run margins that are on par with ours.

In some instances better than ours.

And there's nothing about this, the tranche that you guys, the big tranche you guys acquired this year that's better or worse than that historical view?

No.

No, it's just that the tranche that I'm talking about they were seasonably smaller in the fourth quarter, full year they're on par with us.

Okay, that's what I needed.

Thanks again.

Christine, is that it for questions?

We have no further questions at this time.

Great, let me just make a brief wrap up comment than again.

Thank you, all of you, for being on the call with us this morning, we appreciate it.

As you can tell we're pleased with our 2012 results, we're excited about 2013.

We believe we got a solid strategy, we have a team that we believe is second to none, and we look forward to continuing to grow the enterprise in 2013 and beyond.

So thank you again for being with us.

Thank you, Christine, and that'll end our call today.

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

You may disconnect your lines at this time.