Arthur J. Gallagher & Co. (AJG) 2018 Q2 法說會逐字稿

Good afternoon, and welcome to the Arthur J. Gallagher & Co.'s Second Quarter 2018 Earnings Conference Call.

(Operator Instructions) 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 security laws.

These forward-looking statements are subject to certain risk and uncertainties discussed on this call or described in the company's reports filed with the Securities and Exchange Commission.

Actual results may differ materially from those discussed today, and the company undertakes no obligation to update these statements.

In addition, for reconciliations of the non-GAAP measures discussed on this call as well as other information regarding these measures, please refer to the most recent earnings release and other materials in the Investor Relations section of the company's website.

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

Mr. Gallagher, you may begin.

Thank you very much.

Good afternoon.

Thank you for joining us for our Second Quarter 2018 Earnings Call.

With me today is Doug Howell, our Chief Financial Officer as well as the heads of our operating divisions.

Today, I'm going to start with some general comments on the quarter, then Doug and I are going to touch on the 4 key components of our strategy to drive shareholder value.

I'll address 2 of the 4: organic growth, including the results of our midyear rate survey; trends in the employee benefits market; and claim counts within Gallagher Bassett.

And then I'll talk about our true differentiator: our culture.

After my comments, Doug will address the other 2, which are growing through mergers and acquisitions and improving our productivity and quality.

Frankly, the team crushed it this quarter, delivering on all measures.

For the quarter, our combined Brokerage and Risk Management segments generated organic revenue growth of 6.6%.

Adjusted EBITDAC margin expanded 89 basis points and adjusted EBITDAC increased 14%.

In addition, we completed 12 mergers in the quarter, which should add about $145 million of annualized revenue.

I would like to extend a very warm welcome to all of our new merger partners.

And we really had a strong clean energy performance as well.

These are outstanding results from the team and the outcome of hard work, dedication and execution from our nearly 30,000 Gallagher professionals all around the world.

Let me dive a bit deeper behind the organic growth numbers and provide some data points on the rate environment based on our midyear rate survey and internal data.

First in our Brokerage segment.

5.9% all-in organic, reflecting strong growth across all of our divisions globally.

Within this, we believe improving rates and exposures contributed about 60 basis points of that number.

Our internal midyear rate survey indicated a continued trend of increasing property/casualty pricing and exposure growth around the globe.

Let me start with the United States.

Our retail property/casualty brokerage business generated about 5.5% organic in the second quarter, and pricing is positive across almost all lines of business.

For example, both property and commercial auto pricing are up about 5%.

Casualty and specialty lines are flat to up a point or 2. Workers' compensation is the only major line down, and even that this only weaker by a point.

Staying in the United States.

Our wholesale organic was around 6% with average pricing a point higher than in the retail business.

Property lines in total were up 7% with catastrophe-exposed property up about 10%.

Most casualty lines, including specialty lines, are up between 2% to 4%.

In the U.K., I was there in June, and I'm really pleased with how our business has come together, and I'm excited about the team's performance.

Our U.K. retail organic was over 4% in the quarter, and pricing is up about 1.5%.

Commercial property pricing is flat.

Casualty lines, including specialty classes, are up 2% to 3%.

Our U.K. wholesale organic was 7%, and rates are flat.

Pricing in most classes appears to have bottomed, and we're cautiously optimistic for rates to firm in the future.

In Australia and New Zealand, organic was about 7% and rate is up mid-single digits.

Property rates were up 8% to 9%.

Casualty and specialty lines were up 4% to 6% on average.

So when I sum it up around the world, PC rates in a growing economy are providing a tailwind to organic growth, which means we should be able to post better organic in 2018 than we did in 2017.

Okay.

Moving on to our employee benefits operations.

Our benefits business had a fantastic quarter, generating all-in organic revenue growth of around 7%, similar to both in the U.S. and internationally.

Employment growth across the U.S., the U.K., Australia and Canada, our major benefits footprints, continues to trend higher.

Average employment growth in these countries over the past 12 months is close to 2%, an increase over the previous 3-year average of 1.5%.

This past quarter, I also attended our annual IBIS Academy conference in Berlin.

The conference has been running straight for 48 years, making it the longest running international HR conference in the world.

The 3-day conference had hundreds of attendees with numerous breakout sessions focused on the top issues facing global HR and benefits professionals today.

This is just one example of how we leverage the best minds in the industry to deliver value-added insights to our clients and prospects.

Our thought leadership, tools, high-quality service combined with a modest tailwind from employment growth positions our benefits business very well for the future.

Next, I'd like to move to our Risk Management segment, which is primarily Gallagher Bassett.

Second quarter organic growth was a stellar 10.1%.

It was helped by $2 million of additional Australian performance bonus fees and a $2.5 million ramp-up fee also in Australia.

Excluding these 2 items, organic was up about 8%, still an excellent performance.

In the U.S., organic growth was 7% in the quarter.

Our insurance carrier business continues to grow nicely, and we are beginning to see a modest pickup in claim counts.

Both workers' comp and liability claim counts in the U.S. have been creeping higher this year.

And total claim counts are up about 1.5% year-to-date versus the flattish environment last year.

Internationally, we had a great quarter.

And even after excluding the additional client ramp-up fees, organic growth was 14%.

I also visited our U.K. and Australian operations this quarter, and I continue to be impressed with our international Gallagher Bassett team.

The organic growth in the first half of the year has been fantastic.

Everywhere around the globe, clients are realizing more and more that Gallagher Bassett can deliver superior claim outcomes, and our new business and organic growth are a reflection of that.

I'll close my comments today talking about our true differentiator, our culture.

We believe our culture is unique and that it delivers better results.

Our mission statement is 4 simple philosophies: be passionate and professional in our craft, all the while placing our customers first; be the best employer and take care of our associates; be excellent trading partners with the underwriting communities, striving for win-win delivery of our advice and service; and deliver excellent and consistent return to shareholders.

Every day, all our teammates get up and work diligently to maintain our culture, to promote our culture and deliver our culture.

Okay.

An outstanding quarter on all measures, a tremendous first half on all measures.

I'll stop now and turn it over to Doug.

Doug?

Thanks, Pat, and good afternoon, everyone.

As Pat said, what a truly terrific second quarter.

And combined with our excellent first quarter, we're in really great shape here halfway through the year.

Today, I'll first make some comments referencing the CFO Commentary document that we post on our website, and I'll move back into the earnings release.

Okay, some takeaways from Page 2 of the CFO Commentary document.

To the foreign exchange line.

It's consistent with what we published at our June 13 Investor Day, and it's still looking like we'll get a small tailwind from FX this year based on current exchange rate.

On the integration line.

We didn't have any during the first half of this year, but looking forward, we forecast that we'll have about $0.01 a quarter as we integrate Pronto and Coverdell.

Turning to Page 3 to the Corporate segment, to the interest and banking line.

Our second quarter results were right in line with the midpoint of the estimates we provided in our June Investor Day.

As we look forward, our estimates are not just a little less for the third and the fourth quarter.

On the clean energy line, you'll see that we have a strong quarter, coming in at $0.015 above the midpoint of our June 13 estimates.

And looking forward, we have revised upward our estimates for the third and the fourth quarter.

However, as (inaudible) with caution, predicting the weather plays a big part in our estimates.

So these estimates are never really locked in stone.

On the M&A line, we're up a little this quarter due to the recent acquisitions of Pronto and Coverdell but no change in our estimates for the third and the fourth quarter at this time.

From a corporate line, we came in $0.01 below our June 13 estimates.

One reason.

We concluded that we might be on soft ground related to new interpretations of our 2016 VAT tax matter in the U.K. So we booked a $1.7 million reserve this quarter.

We don't have that issue in 2017 nor in 2018 or even going forward.

So consider this a one-timer.

Looking forward, not much change in our third and fourth quarter estimates from what we provided in June.

And the final line in the Corporate segment is the impact of U.S. tax reform.

Recall from our first quarter call, this line is where we're tracking the impact from digesting the new tax legislation both on our initial December 31, 2017, balance sheet estimates as well as the ongoing impacts, such as nondeductible compensation and entertainment expenses and as well as a portion of our foreign earnings.

We guided that we would have some, but we were not in a position to give estimates during our first quarter call or our June IR Day.

We've had more time to review.

We're long ways along in preparing our tax returns.

So we're now providing an estimate for the third and the fourth quarter.

But as we said then and we say now, these items are effectively just book expense items, and they will not cause us to pay more cash taxes because we have an abundance of tax credits.

In the end, we believe tax reform has been a really terrific outcome for Gallagher.

While it does eliminate some small deductions and it does cause a portion of foreign earnings to be taxed, those amounts are peanuts when compared to the rate reduction and the fact that it preserved both our AMT and our clean energy tax credits, which totaled over $750 million at June 30.

And it also preserved our ability to generate future tax credits through our clean energy investments.

And at current production levels, that may total another $700 million through 2021.

These credits are extremely valuable, and they should reduce our cash taxes paid for the next decade.

They could also help us reduce the friction cost as we repatriate more cash from around the world.

All that said, I do appreciate that modeling our tax credits can be difficult.

Perhaps the best way is to arrive at -- when you're computing free cash, when you're building your models is to assume that we're going to pay global taxes of only about 3% to 4% of our core Brokerage and Risk Management EBITDAC for the next 3 years and then bulk that up from 6% to 9% in the next 5 to 7 years.

And I think that will get you close.

Of course, lesser taxes paid allows us to fund our M&A strategy.

Through today, in 2018, we have closed 26 mergers, 24 in Brokerage and 2 in Risk Management for total annualized revenues of about $240 million.

That's already more revenue than we purchased in all of 2017.

And what's more important, we've completed these at fair pricing that gives us a nice arbitrage to our trading multiple.

And we've done it with nearly all free cash and debt.

Looking forward, we have a full pipeline of attractive tuck-in merger opportunities.

Right now, we have about 60 term sheets either signed or being prepared for about $300 million of annualized revenues.

Clearly, we don't expect all of these acquisitions to close; however, we believe we'll get our fair share.

At June 30, we had about $350 million of available cash on our balance sheet.

So that plus our expected free cash flow in the second half of the year should fund our M&A strategy as we sit today for the remainder of 2018.

Let's move to some comments on productivity and quality.

If you turn now to the bottom of Page 5 of the earnings release to the Brokerage segment adjusted margin table.

We're up 80 basis points in the second quarter at 5.9% organic.

That's really nice work by the team to optimize our real estate footprint, to harmonize our agency management systems and to automate and ship work to our lower-cost operating centers.

Looking forward, the third quarter is historically the quarter we show very little margin expansion.

This arises because we give our raises midyear.

In addition, this year, 2 of our recent mergers have seasonally lower EBITDAC margins in the third quarter.

So that will make margin expansion just a bit harder, too.

But like we say and when you look out a year, we still believe that it's difficult to expand margins below 3% organic but much more likely if organic is over 4%.

Next, let's turn to Page 7 of the earnings release to the Risk Management adjusted margin table at the top of the page.

Up 139 basis points to up 17.7%.

However, that is influenced by the 2 revenue items Pat mentioned earlier.

So when you level-set these revenue items and their associated expenses and incentive compensation, our Risk Management segment would have delivered margin a bit over 17%, which is still nicely up over 70 basis points compared to prior year.

Looking forward, we're still targeting margins over 17% for the rest of the year in our Risk Management segment.

So those are my comments.

An outstanding quarter, an outstanding first half.

I think we're in terrific position to continue our success in the second half of 2018 and beyond.

Back to you, Pat.

Thank you, Doug.

Operator, I think, we're ready to take some questions.

(Operator Instructions) Our first question comes from the line of Kai Pan from Morgan Stanley.

So my first question on organic growth.

And first, how have you achieved 6%?

So you almost don't have to go to work in the second half to achieve the full year 4.4% that you achieved last year.

I assume you won't do that.

So my question is really, why second half organic growth would not be better than the first half?

Kai, I think we're in a pretty good spot here through 2 quarters, and I'm very proud of the team.

We really are writing a lot more new business, which means we're taking share primarily from the littler players.

We know that 90% of time when we compete in the marketplace, we're not competing with our bigger competitors.

We're competing with the local competitors.

And I think our guys and gals in the field are just doing a good job of explaining the value proposition we bring.

And I don't think I'd want to get myself out on a limb and say second half is going to be much better than a half that looks as good as this one.

Yes, sales can be almost streaky sometimes, too, Kai.

So we're pretty happy where we're thus far year-to-date, and we hope we bring it in better for the second half, too.

Is there tougher comp in the second half compared with 2017?

I don't know if there's any tougher comparisons necessarily.

Our first half of the year is our strong half now under the new revenue recognition where so much more is recognized in the first quarter.

So in the second half -- second 2 quarters, it'll be lesser in total.

But I don't recall anything of substance in there that would cause a difficult compare.

Great.

My second question on margin front.

In the press release, you mentioned about headcount controls.

I was wondering -- could you elaborate a little bit more on that?

You also mentioned earlier to say second half, because the wage raise in the midyear, so the expansion in second half might not be as strong as the first half.

So just want to see, is that still going to be true going forward?

Yes, I think it's a terrific question.

First of all, production staff, most of them are on a formula.

So that doesn't really influence it.

When you look at our nonproduction, nonformula both, there's about 17,000 of them around the world.

And giving annual raises to those folks is something we try to do and for the performers.

So yes, you'll see that coming into the -- generally, those happen in the third quarter, we give that away.

When it comes to headcount controls, we're up 290 people on 16,000 in the first half there, and that's on existing businesses.

Our headcount has grown with our acquisitions, but the team's doing a really great job of controlling our headcount.

Part of that is building out a service center here in the U.S. We're up to about 150 people there.

So when you just look at the true discipline of not hiring, and the team is doing a terrific job of that, and that is contributing to our margin expansion.

Okay.

Last one, if I may, on the acquisition.

Looks like the multiple you're paying is a little bit higher in the second quarter than the first quarter.

Is there more competition for the deals?

And also, will these deals, given the magnitude of them, create a margin drag on your overall book?

Or are they actually going to be accretive to your margins?

Yes, good question.

The bottom of the Page 2 in the CFO Commentary, we were -- at this quarter, we're at 8.9x.

We say that had we not done one -- a little bit larger acquisition, we would have been in the quarter at 7.5x and 7x year-to-date.

So this one acquisition was slightly larger.

Now that's as a multiple of EBITDA.

The important thing is that's a U.S. acquisition, okay, and we have the ability to use our cash credits against that company's earnings.

So on a tax-adjusted basis, it's even lower than the numbers that we're showing here.

So we're pretty happy to have that one onboard, and it did drive it up a little bit in this quarter.

Going forward, yes, there's price competition out there, but the folks that are really valuing our capabilities, our resources and know they can be better together with us, they're still taking fair multiples on it.

And I think there's a fair arbitrage for what we bring to the deal and what they bring to the deal.

We also give them a fair chance for an earn-out.

And the other thing is, I would say -- reiterate kind of what Doug said, there's a lot of competition for deals.

If people want to put a book together and just see how many bids they can get, they'll get a lot.

So it's really important that we pick our partners carefully with the understanding that we expect to be living together for a long time.

And if it's not exciting to be part of the organization with our capabilities, what we're doing around the world, when we can sit with some of these smaller competitors and tell them join us and you could write any account of any size anywhere in the world, well, if it's all just about the next bite on the apple and I'm going to go to private equity and flip it, you're not going to fit here anyway.

So I think we're finding really, really solid partners.

Just follow up.

Would these deals create a margin drag for your [portfolio overall]?

Kai, I did say in my prepared comments, and in the third quarter, there's 2 of them that have margins that are slightly below 20%.

That can have a little bit of an impact on our third quarter margins.

But by and large, that probably would impact margin expansion in the third quarter but not necessarily annual margin expansion.

Also, there's a lot of -- just as we've become more profitable, a lot of the smaller brokers have become more profitable, too.

So by and large, we're not buying organizations that are margin dilutive to us on an annual basis.

The next question comes from the line of Elyse Greenspan from Wells Fargo.

My first question, you guys mentioned that improving rates and exposure growth was benefiting organic by about 60 basis points in the quarter.

Would you expect that to continue or pick up from that level as you think about the balance of 2018 and even into 2019 at this point?

Elyse, this is Pat.

I think we'll see a similar situation as we finish the year.

You've heard me say this many, many times.

When we're getting a 60 basis point lift from exposure and rate, I mean, it's better than a 60 point -- 60 basis point decrease.

But -- I mean, let's be honest, that's a flat market, in my opinion.

When we see it up a point, down a point, sideways 2, up 1.5, I mean, if you go back in history and look at what hard and soft markets were really like, go pull our numbers from 2001/2002 after 9/11, I mean, rates were jumping 20%, 21%.

So I -- this flattish market, up slightly with a little tailwind, is nirvana for us because, now, we're not going out against the smaller player that all of a sudden out of nowhere comes up with some quote we can't believe and we can't compete with.

The market is essentially flat to up 2, let's say, across all lines.

That's when our capabilities really shine.

That's when our team has a -- just a decided advantage, 90% of the time quoting against somebody smaller.

So then a follow-up.

So you guys saw that a 90 basis point acceleration in organic growth sequentially.

So what's been the greater contributor in the second quarter versus the first quarter?

Is it just mix in terms of what was written?

Is it getting greater price, more new business?

Or are you writing more?

Are your clients purchasing more coverage?

I'm just trying to kind of understand what's been the driver of the pretty strong organic growth if we're kind of in this about flat market?

The answer to your question is yes.

All of those.

We've had a little less lost business, a little bit more new business.

Each ship is rising around the world.

I have to say, again, a lot of credit to the field in that they've -- the Gallagher playbook that we have on organic growth is paying dividends around the world.

So kind of all ships are rising right now.

And really rate is one thing, but exposure units, we get a -- if the economy continues to heat up, exposure unit growth actually contributes more to organic than rate does because, on rate, they can take up some of the deductibles or bring down the limits a little bit.

And so I think that as the economy continues to get better, 60 basis points now, I wouldn't expect it to go to a full point, but it might be 80 basis points.

Okay, great.

And then in terms of your margin commentary, going back for -- the past 3 or 4 quarters-or-so, you guys started talking about 3% organic, below that, you might not expand margins.

And over 4%, you would see even better margin expansion.

I know there's been a lot of talk about that.

But do you see that as any kind of shift in your business?

Or it's kind of reemphasizing, I guess, how you always saw your business running in terms of the organic's ability to generate margin expansion.

I would say it's similar commentary.

I think that, in a perfect world, maybe under 3.5%, it's a little harder to expand margin.

And over 3.5%, you'll get margin expansion.

But we're always talking about that 3% level.

So -- and over 4%, we do have great opportunity.

Now remember also, we're making a lot of investments into the business under (inaudible) too.

You have to understand that 450 young folks in our internship program this summer.

We've got nice IT efforts underway to -- both to distribute better but also to service better.

So there's a lot of investment going on inside of Gallagher.

But we still are having the ability to expand margins, especially when you're over 5%.

Okay, great.

And then one just last numbers question.

Doug, I think you mentioned about the ability of your clean energy plans to generate about another $700 million of credits between now and 2021.

Was -- did I catch that correctly?

Is that what you were kind of implying?

Yes, that's right.

And I think that over the next -- for the rest of '18, for '19, '20 and '21, you could see a number of another $700 million of credits.

Our next question comes from the line of Ryan Tunis from Autonomous Research.

First question on -- I guess, on the CAT-exposed business, it sounds like it was renewing with a pretty good rate.

Can you just give us a reminder on, I guess, the seasonality of that and where that's kind of a bigger part of the brokerage mix?

Is it kind of the biggest contributor in the second?

Or is it also -- is it equally big in the third quarter?

Second and third are the biggest 2 quarters on property renewal, so we did get some lift for it.

But as a percentage of our book coastal-exposed property, I don't have the numbers right off the top of my head, but of our $1 billion of revenue this quarter, maybe there's $60 million that's coastal-exposed property.

Did it look like that 3Q for the coastal-exposed property, too?

Say it again.

It's only about $38 million in the third quarter.

So it's down quite a bit.

Okay.

Got you.

And then, I guess, one question I had was, obviously, organic is accelerating.

We're seeing margin expansion.

Does that -- I guess, internally, relative to how you're budgeting expenses earlier in the year and all that, does seeing the better organic maybe change your view that, hey, like maybe there's some places we could invest we weren't thinking about.

Is there a thought process there where you're adjusting your -- way you're thinking about investing because you're seeing better organic?

Well, it may be in a way, but I think a better way to say it is if we saw organic struggling at 1% or 2%, maybe we'd be stopping investing in what we're doing.

But it's not just because we've got more organic or we're more willing to fund internal projects.

Folks, they still have to sing for their supper on that.

And so that -- it's probably a bit opposite side of your question is how much can we pull back in investing.

If we ever got into a 1% or 2% organic growth environment, there's $20 million to $30 million or $40 million investment happening all around the world, but that's what you would stop.

We've been doing that all along.

We think it's important to invest in the business.

Right.

We've got -- it's nice to have a nice quarter.

Don't get me wrong.

It's nice to have a great first half.

And I think we've probably strung together 6 or 7 years of pretty good results.

But you don't do that without investing in your business.

And you've got to look at the long term.

We don't ratchet in investments quarter-by-quarter.

Okay, keep going now, we're into the third quarter.

No.

I mean, so we've got to make our plans and follow through.

Understood, that's helpful.

And then just, Doug, I guess, I just wanted to maybe give you guys an opportunity to comment on what you think that the free cash flow potential -- or generation potential issue at Gallagher and, I guess, how you think we should think about having free cash flow grow relative to operating earnings over the next few years.

I think that -- probably the best thing to do is project EBITDA, reduce our interest expense, take 3% to 5% of our EBITDA in taxes and then about 10% invested in -- maybe not even that, 8% in CapEx and you'll get pretty close.

Our next question comes from the line of Greg Peters from Raymond James.

Doug, I think on the cash flow, you also meant to include the dividend expense.

But I had 2 cleanup questions for you.

First of all, on the tax credits, maybe this is important notetaking, but from your management meeting earlier this year, I had $550 million by 2021.

So maybe that excluded '18 or -- the number hasn't changed, I guess, is what I'm -- want to confirm.

It might have been bad notetaking on whoever's notes you were copying.

I wasn't copying.

It's bad note taking on my part.

So...

I think to Ryan's question on -- when we talk about free cash flow, yes, we do pay a dividend, but that comes back to our shareholders.

So free cash flow for acquisition, yes, you would've adopted the dividend then.

Well, in the past when you provided free cash flow guidance, you have included the dividend as a takeaway.

Just -- but this is nitpicking.

The other cleanup question, then I have a question.

The cleanup question around M&A.

And I know you're not going to opine on your competitors, but it does seem like Brown & Brown and your company has had a little more success in 2018 through the first half in closing transactions than the year-ago comparison.

And I'm curious if the private equity component or the other buyers in the marketplace are having less success.

Or if you could have any opinion around that?

Yes.

I think we are having more success because I think that people are understanding that life after the sale can be better with a strategic than a PE.

I think there is an awareness that's developing on there that what sounds good when you're signing the documents might not necessarily sound so well.

So we're talking about the M&A environment.

And you're saying you're having a little more success on -- compared to the PE's.

I'm wondering -- I know there is -- within the tax file, there was an effect on deductibility of interest.

Do you think that's come in to play a little bit?

I don't think so yet.

I think that -- I think there's a lot of good merger partners.

Each of them have an appetite.

They may fit better with Brown.

They may fit better with Gallagher.

They may fit better with PE.

So I would say that it might be just -- there's more opportunities that are out there.

And also I think that we're doing a really good job of showing how life after the signing of the documents can be really terrific at Gallagher when you see our capabilities.

So I think that's probably the reason why.

Doug's right on, Greg.

This is Pat.

I was on a panel not too long ago with one of the main consulting firms in this space.

And if you want to cross that stage, there were 5 very different philosophies.

Equisure has probably done twice as many acquisitions this year as we have.

And they just have a completely different philosophy than we do.

So I think the real test or the real trick is making sure like, in any sales environment, you get to enough people and you find a fit and you build some excitement.

And also remember, our closings can be lumpy.

We'll have a string like we've had this year, which is great, which we already purchased more revenue this year than we did in the full year last year.

And those are people we didn't start talking to a month ago.

So I wouldn't want to make it sound like we're doing better than the competition.

Great.

Thanks for the clarity on those 2 cleanup questions.

So I'm sitting here, watching on the screen and today was off a little bit.

But the remarkable success of this newly minted "insurance broker Goosehead." And I know at your management meeting, you spoke about a growing business that you acquired, Pronto.

And I was wondering if you could provide us an update on what's going on there, Pronto, and what your outlook is for that business?

And that was my principal question.

Right.

That's a -- by the way, thanks for bringing up Pronto, for those that may not know, is our business in Texas, Florida and California that serves the nonstandard auto market, primarily Spanish language customers.

And we have an operating model that's very similar that we have our storefront as a consumer product.

We provide service very quickly.

We provide it fairly priced.

And it is growing very well.

Now we've only had it for a few months now -- for really about 40 days, I think, it is if my memory is here.

And -- but we think it's a terrific opportunity.

I think that -- actually, I think the Goosehead trading shows the value there is in brokers and in distribution.

So we'd sure like to see a multiple like that on our EBITDA.

So just as a cleanup on the Pronto situation.

When -- I think you said in your management meeting, it was about $100 million of annualized premium -- or revenue, excuse me.

And as it's growing from the date you bought, you're not accounting for that as organic growth.

It's acquired growth until the transaction anniversaries, correct.

Right.

Actually -- and I believe that our organic growth is consistently understated because, when we buy somebody, if they go out and sell something in that first year, that doesn't ever count in our organic.

We've talked about that a lot at our Investor Days.

Our next question comes from the line of Mark Hughes from SunTrust.

Your investment income was good in this quarter.

Was anything unusual there?

Is that sustainable?

I think -- make sure that you back out the book gains on that, Mark.

I'd have to look at what you're looking at.

But that's what we put.

If we sell off a little book of business, I think on an adjusted basis, I'll get that -- I think it was pretty dead flat quarter-over-quarter for last year.

Okay, right.

Do you have the cash that you paid for acquisitions in the quarter?

Did you say that?

Say again.

Do you have the amount of cash that you paid for the acquisitions in the quarter?

I don't have that, sorry, in front of me.

And then talked about the insurance carrier business growing nicely within Risk Management.

Any observations there?

Is there a bigger theme of carriers outsourcing claims?

Or are you just taking share?

No.

I think there's a bigger theme.

I think people are realizing that -- a couple things.

We can help carriers enter a market where you don't have to build a bunch of infrastructure to be able to underwrite.

We can help carriers enter a new line, same point, not having to back it up with infrastructure and boots on the ground.

And then also we believe that we're getting more and more proof of the concept, that if you outsource to Gallagher Bassett, your claim outcomes will be better.

And so that's one of our fastest-growing areas, and that's on a global basis.

So I think it's an exciting play for us.

Then finally, you talked about claim counts growing a little faster than last year.

Any observations about inflation?

Do you do think there's some inflation building up in the system?

I don't.

I think what you've got is just -- as people go back to 3 shifts, you get more claims.

Our next question comes from the line of Robert Glasspiegel from Janney Montgomery Scott.

On the acquisition front, you're seeing a pickup from last year's pace.

Brown & Brown did as well from a smaller base.

Is it possible that the level-izing and the tax rate versus PE is starting to make a difference?

Or am I stretching on that?

You're stretching.

I think you're stretching a little bit at this point.

What do you think's -- you're just hitting on some?

Or it's just random noise?

It's lumpy, Bob.

You've seen us for 100 years.

It's a -- we had a real good run in the first half.

We've got -- every quarter, I tell you our pipeline is outstanding.

I mean, the pipeline is truly outstanding.

And I've mentioned the fact that most of these that we're buying are run by Baby Boomers.

You and I aren't getting any younger.

And so capitalizing your life's work and bringing your next generation into a place where they can have a career path, there's a lot of people thinking this way.

I talked to a merger partner today, was incredibly excited.

And the thing he's probably most excited about is bringing his son into a firm where he knew had a great potential career opportunity.

He's towards the end of his carrier, and his son was a big driver in the deal.

So I see that over and over again.

Doesn't mean that there's anything wrong with the PE approach, and they're very good competition.

But it's lumpy.

Pat, you were able to work my age twice into that answer.

Well played.

Thanks, Bob.

I'm always trying to be the nice guy here, you know.

So you're back from London.

A lot going on there between Brexit, euro, tariff battles, which may or may not be solved.

But what's the overall feel for the economy there?

I mean, you gave a pretty optimistic outlook for what's going on in the U.S. But what are the Brits saying about the world?

It's interesting because there's more consternation now than there was a year ago.

A year ago, Brexit is going to happen.

It's going to be okay.

We'll make a trade deal with Europe.

My English friends, when I have a chance to sit around and talk about what this means, they have some real concerns because their fear is that Europe basically wants to say, if you want the free trade, then follow our rules.

Well, if they follow their rules and do the Brexit, then they don't have any -- even any representation at the rule-making table.

So I think there's concern in where are you going to be located.

How are you going to trade in Europe?

Now we don't have a huge European trade, nor does Lloyd's have a really huge European trade.

But we will be making sure that we're set up properly in Europe.

Lloyd's is going to do that.

The financial services industry, I think, has got some real concerns.

So it's a different picture than a year ago, for sure.

So slower growth, but no recession.

Is that sort of the expectations in U.K.?

I'm not an economist.

I would say still London is booming.

So when you're over there, like I do many times and don't get out of the city, you leave the U.K. thinking, my God, this place is on fire.

But I've been told, if you get up out of the city and into England and Wales and Scotland, that it is a bit slow.

Our next question comes from the line of Mike Zaremski from Credit Suisse.

I guess, a follow-up on Bob's last question.

There was a management change overseas.

Anything we should think into that in regards to the transition, or I don't know, anything -- not that was unexpected or planned because I believe the leader is still kind of working for a subsidiary that you guys have a partial interest in.

That's exactly right.

So you'll recall, we had a bit of a departure 3.5 years ago.

Grahame Chilton, Chily, stepped into the role as CEO for us.

He was our -- he was the founder along with his other founders of Capsicum Re.

So he handed the baton on Capsicum Re to his associate and stepped in.

That was always meant to be temporary.

We have announced that Simon Matson, as of this fall, will take over the leadership, the CEO role.

And I'll tell you what, it's been a very, very smooth transition already.

And Chily is not going anywhere.

He'll be back basically full time at Capsicum.

And I believe we'll see him as a part of the team in various roles for many, many years ahead.

Okay, great.

That's helpful.

Next, organic growth in Risk Management clearly has been tremendous.

It also seems to come somewhat in waves or maybe streaky, as Doug mentioned earlier.

Can you remind us the equation in terms of the operating leverage in that segment?

I don't think it's the same 3.5% to 4% that you guys speak to overall.

But I could be wrong.

So it doesn't seem like there's been as much margin improvement there as maybe I would have expected.

Yes, it's not as leveraged business on that.

And we've said in the past, really going back, we probably haven't discussed it in a couple years, but you've got to be above 5% to get margin expansion in that business and maybe that's closer to 6% now with a little bit of wage inflation.

So it's not quite as heavily geared as -- favorably geared as the Brokerage segment.

It's also a segment that has to have an awful lot of tech investment.

You're constantly building out your tech offerings.

Everything wants to go mobile now.

Everything's got to be on every device.

There's always a big spend on that.

So the CapEx for this segment would be, I don't know, 2x the rest of the segment?

Or is there kind of a high-level...

No, I wouldn't say that.

I would say the proportion to revenues, it might be running more like, let's say, 3%, 4% versus what we're spending is 2% in the Brokerage side, something like that.

Okay, got it.

And lastly, I have a high-level kind of forest from the trees question on M&A.

I know the pipeline is strong.

You guys have done an excellent job integrating, and this year has been stronger.

I also recall you said in the past that you've increased the -- maybe the number of feet on the ground, people on that team.

But there are kind of a lot of shovels in the sandbox, per se.

And I'm just curious, if we think out longer term beyond the next 1, 2, 3 years, you guys have doubled in size as well over the past 5 years.

So is there a point in time where there's -- the opportunities aren't going to be able to kind of feed the engine as much?

Well, I mean, number one, we're getting bigger all the time.

And if you take a look at Business Insurance's article from the broker issue from this July, the #1 100th largest broker in the United did $28 million in total revenue in 2017.

Now one of the most prominent consultants in our business says that he believes there are 39,000 agents and brokers in America.

That's America.

That's not globally.

And that's not people.

That's firms.

He also believes that for every one that gets consolidated, another one starts so that there's a never-ending supply.

And I think that he's probably accurate, which means that there's 38,900 brokers and agents across America that do less than $28 million.

So the supply and the fragmentation of the market is absolutely -- it's unquenchable.

For as far forward as you can see, we will not have a lack of supply.

Now we'll have to figure out a way to continue to ramp up the numbers to continue to move the needle, because at $5 billion, $4 billion whatever, it's harder to move the needle on $2 million and $3 million and $4 million deals.

But they're out there.

Our pipeline is phenomenal.

And we are continually adding to that pipeline.

So I just don't see any end in sight.

Our next question comes from the line of Yaron Kinar from Goldman Sachs.

Just a couple of questions.

First on the M&A front.

So can you give us a sense of what kind of maybe margin headwind M&A creates when it's brought on and then maybe how long it takes to get the margins through to the company standards, specifically for Brokerage?

Yes, Yaron, I said earlier, I don't believe that we're buying businesses at this point that are margin dilutive.

They can have quarterly seasonality, but when you look at it on an annual basis, they run margins that are similar to ours.

And one of the reasons why that is, is we typically don't buy turnarounds.

We don't buy dying books of business.

We don't buy retirements.

We try to merge with people that earn money for their own families so that when they join our family, they earn money for our family, right.

It's just that if they can't make money to pay for their own food, they're not going to do very well for the community dinner table.

And so that's important for us.

And so it doesn't move the needle one way or another except for maybe have some quarterly seasonality.

If you go back when we did the -- some of the acquisitions in Australia and New Zealand, there were some significant quarterly seasonality in their earnings.

And so you'll find that from time-to-time and -- even in smaller brokers, but not on an annual basis.

Many times, their margins are accretive.

So I guess, maybe going back a second to Doug's comment.

So does that -- actually why you're only calling out the third quarter as a potentially margin headwind from these -- the 2 acquisitions that you mentioned?

Yes.

I think that I looked at it and I think that there's 20 to 30 basis points margin compression on that from those in the third quarter.

And it's not integration.

These are -- most of the deals -- the mergers that we do, there's very little integration cost to them.

And that seasonality then would still continue into out years as well, right.

Yes.

Sometimes, it will.

The other thing too is that if we move customers to different renewal dates, as they change their mix of business, it can be -- it tends to level out with time, too.

Okay.

And the other question I have was just on the cash tax rate, which I think is a little bit lower.

There's a number you offered.

We're a little bit lower than previous estimates you gave.

And I was just curious as to what brought that cash rate down?

Say the question again.

The cash rate on the taxes...?

Yes.

So I think you were talking like 3% to 5% for the next couple years and then maybe 6% to 9% beyond that.

And I think in the past, you talked about 5% and 8%.

Yes, I think that -- here's the reason why.

In the earlier years, we did a refund of AMT credits.

So that -- credits that we were not going to receive in cash until, let's say, 2027 or 2028, are going to be refunded to us over the next couple years.

So that will drive it down earlier.

And then just as the -- as our EBITDA grows in the future, we'll have more taxable income and then basically the same amount of credit.

So the rate will actually creep up a little bit.

But between AMT rate and just the growth in our business, that's what will contribute to getting that.

And I see that in that, like I said, in that 6% to 9%, 7% to 9% range for at least 5, 6, 7 years afterwards.

Our next question comes from the line of Ian Gutterman from Balyasny.

Actually, I had a couple of numbers questions.

But first if I can just follow up on that question from Yaron about the acquisitions.

I guess, Pat, it was surprising a little bit about saying that you buy things that have similar margins to you.

Is -- you've talked a number of times over recent years about the capabilities you can bring now as you've gotten bigger, essentially letting you, in my words, I don't think these are yours, but run circles around these smaller brokers.

And I would have thought that those advantages, which I think make a lot of sense, would mean that you have much higher margins than them.

So could you just help me reconcile that.

I guess, I got a little confused by that.

Yes, I think you're thinking about it for the opposite sense is that most of the time when we buy a smaller broker that may have been underinvesting in the resource and facilities.

So it's kind of the opposite side of the thought process there.

And typically, when we come in, our benefit plans might be better.

Our expectation of using more robust technologies and more secure technologies may put cost into the structure to them a little bit.

Same thing is, is that -- well, you don't expect them to do interns, maybe have -- producer hires that they weren't willing to do, so it moderates a little bit higher -- underinvested margin will be pulled down with some investment into those businesses.

Okay.

But then the growth that you can bring in them allows them to leverage back up and recapture that spending and maintain the margin, basically?

That's right.

Okay.

Got it.

So Doug, I had a couple of numbers on.

Just one might be -- I might be doing something really dumb, but I'm just having a hard time.

When I look at the Brokerage segment adjusted EBITDA, it's greater than the reported EBITDA, right.

But when I look at the adjusted EPS on Page 1, it is less than the reported EPS for brokerage.

What am I missing?

All right.

Let me just add -- let me see if I can track to your question on Page 1. Can we -- where are you looking at?

I'm sorry, just trying to track it.

Yes, so the Brokerage shows adjusted earnings of $0.67 versus reported at $0.68.

Yes.

Right.

So it looks like they were negative adjustments.

But when you go to the EBITDA page for Brokerage, the adjusted EBITDA is a few million higher than the reported.

Right?

Is there something else that's negative that I can't find.

So I can't get my model to square.

Yes, the noncash items, primarily the change in acquisition earn-out that we adjust out, those will not impact EBITDA.

Got it.

Okay.

So there's adjusted earn-out.

Okay, I'll go back and look at that again.

And the other one, a little on the sort of similar note is, can you just explain for me one more time, because I think I forgot the explanation from last quarter, and I just couldn't quite get it this quarter.

Trying to juggle a bunch of releases here.

The tax reform impact through Corporate, what exactly is causing that or why is it going through Corporate and not allocated?

All right.

So this is -- first of all, the biggest one that's coming through there is the theoretical repatriation of earnings that causes a GILTI tax or an elimination of a foreign tax credit.

So (inaudible) all those.

So that would be, in theory, if we repatriate money -- any of the tax-related impacts of treasury management or moving monies around the world, we capture in the Corporate or Corporate segment.

And what we do is we fully tax the Brokerage and Risk Management segment at the statutory rates in those countries that produced the income.

And also, we don't allocate the credits up into the Brokerage and Risk Management space, even though that's really the income that's benefiting.

So if we went out and bought annuity bonds and we weren't paying taxes, that would mean a lower tax rate in the Brokerage and Risk Management segment.

So we kind of penalize ourselves there.

These items, $4 million a quarter, something like that, they're peanuts and will offset our tax credits on it.

And so it's just -- they give us on the rates and they take up the way a little bit on some of deductions.

And there's just -- I know you said it'll continue in the second half.

Is it just a 2018 thing?

Or this a permanent thing we should put in our models?

I think you should put $4 million a quarter in for the -- going forward.

And that's a book expense.

It won't change our cash taxes paid.

But that might be our estimate going forward.

The first 3 quarters are a little heavier because of some tweaking we did to our initial December 31 balance sheet estimates because of the tax reform.

But going forward, if you assume $4 million, you won't be too far off.

To tell you the truth, it's more like $3 million in the second half of this year.

Our next question comes in the line of Meyer Shields from KBW.

Just a couple of quick ones.

I guess, Pat, you talk about workers' compensation rate decreases and an acceleration of growth in claims filing.

Is that a -- I don't think that happens -- is that a problem for the workers' compensation carriers, if not Gallagher's, is the question?

Well, it's -- our claim counts are up.

But no, I don't think it's a problem for the carriers because with the robust economy, they're getting more exposure units as well.

So as they're collecting more premium, their claim counts are going to rise as well.

But that doesn't necessarily lead to any greater extent of severity.

And the results of the worker's comp line have been solid.

And so it always drives in more competition.

Yes, true.

Okay.

Second, and this is more of an [earnest] question.

In general -- or sorry, when we look forward to wage inflation or operating expense inflation, is that picking up?

Should we model slightly higher growth rates for those going forward?

There is wage inflation out there that's happening, especially in some of the highly skilled service layers and professional layers.

We have the -- in our case, because we have, over the last 13 years, made such a significant commitment to our offshore centers of excellence, we can control that by continuing to shift work off to our associates in those centers of excellence.

So we do have a little bit of a safety valve on that, but it is something that we look at.

Replacement hires can be a little higher than those that exit.

And also just the annual raise, we -- if we give raise on 12 months or 14 months or 15 months, there is -- that is slightly higher this year than it has been in previous years.

Full employment does have an impact.

I mean, there's no question that -- you talk forever about the war for talent, and we're talking about that around this table a lot.

Yes, we didn't have that.

When -- if you're doing 5.5% organic growth, you probably have higher margin expansion than the 80 basis points.

Our next question comes from the line of John (sic) [Josh] Shanker from Deutsche Bank.

I just want to follow on a couple questions that cap it off a lot of this talk about acquisitions and fragmentation.

And you compete with people who are smaller than you and whatnot.

One of your competitors announced a very large transaction earlier this morning.

They confirmed it.

And I think they bought the 33rd or 32nd biggest insurance company in brokerage in the United States.

And you talked about always [buying] companies that are smaller than you because they just can't compete.

Why do you need to buy the companies that can't compete.

Can't you just take the business over time and buy back your shares and take the business?

What are the barriers taking that business?

Like you guys did 7% organic growth this quarter.

You guys are taking business just fine.

How should I think about those 2 things?

Because the brokerage business is a very relationship-driven business.

And these guys and gals that we buy have terrific -- the reasons they exist is because they can convince those owners that -- of businesses that they can do the job for them.

And this business is fragmented because that works.

So when we buy someone, remember, we're getting 2 things.

Yes, we are getting revenue stream and we're getting an earning stream.

But as Doug likes to say all the time in front of our team, we're getting great resources.

We're getting people that have fought folks like us and have been able to win.

And so these firms that come up for sale -- and don't make any bones about it.

We're out there telling them they should be thinking about selling to us all the time.

We're creating some of the demand.

But they come up once and they're gone.

So you take a -- take the likes of a Wortham, the brand recognition, the strength of that franchise, my hat's off to Marsh.

It was a great acquisition.

And we'll do that thing all day.

Yes.

And the other thing too, Josh, is the firm -- if we're buying it at 7.5x, when we get -- versus just buying our own shares back at 12x, and that's saying our shares are overvalued.

Don't interpret that.

But there is an arbitrage here.

And the other thing too is when you get a really great broker that comes in, they'll pick up more customers because of our capabilities.

The next thing you know, they're trading with our other organizations around the globe.

If I just -- if we just buy in a share of Gallagher stock, that share of stock sits on the shelf, and it doesn't produce another piece of business ever.

It never grows.

The gearing just doesn't -- we model both ways.

Just buying shares back does not produce greater shareholder value than buying smaller brokers at an arbitrage and then having them grow.

And so you can model that out yourself.

It works.

All right.

And then one thing that's just probably impossible to quantify, but I'll try.

If you look at the market of opportunity for you in the United States, what percentage of the market out there is being controlled by a broker who's offering something differentiated to their client versus the market that's just there for the taking, but they just haven't met the right broker yet?

50% is not offering a distinguished product.

Well, that was easier than I thought.

Yes.

We do some work around here every once in a while.

So that's our guess.

Any other questions?

There are no further questions at this time.

Great.

Then let me make just a few brief wrap-up comments here.

As we said at the beginning, we had a terrific second quarter and a great first half to 2018.

This is a direct result of the hard work and dedication from all of our employees across the globe.

2018 should be another great year for Gallagher as we execute on our strategy to create sustainable shareholder value.

We will grow organically.

We will grow through mergers and acquisitions.

We will work to improve our productivity and quality.

And we will promote our unique culture, fulfilling our mission statement, guided by the 25 tenets of The Gallagher Way.

Thank all of you for being with us this afternoon.

We appreciate it.

Have a great evening.

This concludes today's conference call.

You may disconnect your lines at this time.