Arthur J. Gallagher & Company (AJG) — Q4 2015 Earnings Call Transcript

Thank you, Brenda. Good morning, everyone, and thank you for joining us on our fourth quarter and year-end conference call. We appreciate you being with us this morning. This morning, I am joined by Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. Today, I am going to comment on total company financial results, make some comments on our merger and acquisition program, and then I'll move into each segment's results and provide a bit of a wrap-up after Doug's comments, and about really an amazing recognition we received by JD Power & Associates, and then we'll get to your questions. We had a great quarter, capping a great year. Total company, strong finish to an excellent 2015. Our combined brokerage and risk management core operations in the fourth quarter posted 4.2% total organic growth, 10% total adjusted revenue growth, adjusted EBITDAC was up 12%, and we expanded our adjusted margins by 46 basis points. For the year, on a combined basis, we posted 5.1% total organic growth, that's 5.1%, 17% growth in total adjusted revenues, surpassing $4 billion in revenues; 22% growth in adjusted EBITDAC, and we expanded our adjusted margins by over 90 basis points. And to top it all off, we topped the $100 million net earnings mark from our clean energy investments, that's up from less than $4 million net earnings in 2011. What an amazing run and we've got more of that to come in clean energy. Let me move to some comments on our merger and acquisition program. We completed 15 mergers, totaling $46 million of new annualized revenue in the fourth quarter. For the year, we did 44 mergers, two of which were in the risk management segment totaling about $230 million of new revenues. Let me break that down a bit, $195 million of that was in the United States, split half property/casualty and half employee benefits. $15 million was in Australia and New Zealand, $15 million in the U.K., and about $5 million in Canada. That averages out to about $5 million in revenue per merger. We paid a weighted average price to EBITDAC of 7.6 times. As I do every quarter, I'd like to thank all of our new partners for joining us and extend a very warm welcome to our growing family. Two further comments on mergers and acquisitions. First, since July 2014, when we did our last big deal, Noraxis in Canada, we returned to our program of doing smaller tuck-in mergers as we forecasted in every conference call and investor meeting since then. Further, for these mergers, we're still paying fair prices and only slightly more than what we were paying for smaller tuck-in deals prior to 2014, consistently in the 6.5 range to 7.5 range. So when I look forward, I see a merger and acquisition program in 2016 as being very similar to the last 18 months. Our merger pipeline remains very strong, particularly in the United States, and we are also seeing good opportunities in Canada, New Zealand, and Australia. With having platforms in those locations now and most of our integration efforts behind us, merger prospects now see Gallagher as a partner with vast capabilities and they want to join us. Further, we do not have any large deals on our plate right now, neither domestic nor international, and based on our current pipeline, we do not see the need to use stock to fund mergers in 2016. And second, final comment on mergers, one of the first things we do when we complete a merger is to quickly collect and analyze their client and carrier data. Today, we have nearly all of our data from every client and carrier globally in one spot. We use this data to help our carrier partners develop better programs for our clients and we use this data to help our clients match up with the right carrier based on their needs. This value-add, to both our carriers and to our clients, gives us the opportunity to enhance our compensation. We see tremendous opportunities for that in 2016 and beyond. Let me move now to the Brokerage segment. Brokerage fourth quarter results were very strong, adjusted revenues up 11%, 2.8% in total organic growth. Adjusted EBITDAC is up 12% and our adjusted margins expanded by 30 basis points. Brokerage results for the year were terrific. For the full year, adjusted revenues were up 19%, 3.6% total organic. Adjusted EBITDAC, up 22% and adjusted margins expanded 70 basis points. And in 2015, we posted adjusted EBITDAC margins of 26.1%, that's up over 400 basis points since the full year 2011. Four full points of margin expansion. What a fantastic accomplishment and it shows our Brokerage business is really, really healthy and vibrant. So, let me drill down a bit into each of our Brokerage operations around the world. First, domestically in the United States, that's our retail property/casualty, our retail employee benefits consulting and our wholesale operations, which for the year, combined for about $2.1 billion of our $3.3 billion of Brokerage segment revenues. In the fourth quarter, these units combined to post 3.5% organic and expanded their margins by about 80 basis points. For the year, they posted 3% organic growth and expanded margins by 120 basis points. These units all have annual adjusted margins in the very high 20%s, about 28% and each unit is nearing the upper end of our margin expectations. To put this into perspective, over a four-year period, as I said just a moment ago, margins in these units are up over 400 basis points, which is really nice work. Looking towards 2016, we're seeing domestic retail and wholesale property/casualty units having a slight rate headwind, on average down about 5%. Property off more like 10%, with casualty a little less than flat, but we are seeing increases in exposure units offsetting that a little bit, and we also continue to have nice new business growth and our retentions are holding. So, we see 2016 a lot like 2015 in our domestic retail wholesale property/casualty units. As for our retail employee benefits business, we're seeing more activity in 2016. Our clients and prospects are now having to deal with the complexities of the ACA, much of that happens in the second half of the year, but we still see organic growth better in 2016 than in 2015 in our benefits units. Next, our international operations, that's our property/casualty brokerage operations in Australia, Canada, New Zealand, and the U.K., which for the year they combined for a little over $1.2 billion of our $3.3 billion Brokerage segment revenues. Combined, they posted 4% organic growth for the full year and expanded margins by 50 basis points. In aggregate, they are posting mid-20%s annual adjusted margins. And I think it's worthwhile for me to touch on each country for just a moment. So, I'll start with Canada. About $125 million of annualized revenues, fourth quarter organic was in the mid-2% range. Margins are similar to our U.S. operations, in the very high 20%s. So, also near the top of our margin expectations. When I look at our January 1 renewals, rates are fairly stable to even slightly a bit positive. As for exposures, while we are not really significantly exposed to energy risks, the broader Canadian economy is suffering because of the knock-on effect of those businesses reliant on the energy sector. But despite all this, the team is in the final push of integration efforts to convert to our systems and they haven't missed a step. So, I see a similar 2016. Next, moving to Australia and New Zealand, about $265 million of annualized revenue. Fourth quarter organic was near 2%. Of the two units, New Zealand performs better in terms of organic and margins, which is in line with what we saw when we did the acquisition in 2014. Both countries have been faced for several years with soft renewal rates, especially in property and their economies are weak, but starting to show a bit of recovery with their weaker currencies. In addition, our January 1 renewals are starting to show a bottoming of the cycle. Both New Zealand and Australia are effectively finished with their integration efforts. It's important to note, in aggregate, margins are nicely in the very high-20%s, which is a touch better than what we expected when we purchased them in mid-2014. So, while we do have some modest opportunity for margin efficiencies on Australia, in 2016 our real focus is to energize the sales culture in Australia. I was there in the fall and I can tell you the Australian team is working with their counterparts in the U.S. and New Zealand to build a similar sales and service culture. Finally, let me move to the U.K. About $775 million of annualized revenues, $360 million of that is retail property/casualty, that's our branch network, $325 million is London and Bermuda specialty, and about $90 million is underwriting and programs. All together, about 1% organic growth in the fourth quarter and a little over 3% for the full year. Aggregate margins are a little bit over 20%, and so let me make a couple of comments on the three units. U.K. retail, we posted flat organic in the quarter and full-year 2015, and margins are in the very high teens. We're seeing rates flat to slightly down, and we're not seeing much growth in exposures due to the stable economic conditions in the U.K. But posting flat organic is actually quite an accomplishment given this unit is going through most of the integration work that's remaining from our larger deals. Remember, we are pushing four different retail organizations together and we've become a top-five retailer in the U.K. in just two years' time. These retail branches are going through the similar processes that we did in the U.S. over the last five years. Those are standardization, simplification, using common technologies, migrating work to our offshore centers of excellence, using our niches and adapting Gallagher's sales culture and learning our retail playbook. 2016 will be the year where we evolve from a unit going through integration to a unit focused on harvesting synergies, and executing on our sales and service plans. Accordingly, we should see a little margin improvement in 2016, and then hopefully much more in 2017. U.K. underwriting, underwriting program is about $90 million in revenues, about 10% margins, which is similar to prior years. Organic growth was flat for the year, but our efforts to improve this business showed promise in the fourth quarter and we posted over 5% organic growth. This is a collection of underwriting businesses, many of which came with the retail acquisitions of Heath, Giles, and Oval. We have reconstituted management and these businesses have a line of sight towards improvement in 2016 and 2017. To recap our Brokerage segment, in 2016, while we see retail property/casualty rates as a headwind, we do see property/casualty exposure growth offsetting this partially. We also see employment growth and complexity surrounding the Affordable Care Act, as tailwinds for our employee benefits units. In addition, our history of strong new business generation, solid retention and enhanced value-added services for our carrier partners should all result in further organic growth opportunities around the world. Integration efforts related to our larger mergers we did in the U.S., Australia, New Zealand and Canada are effectively done and we expect our integration efforts in the U.K. to be nearly done by the end of 2016. Integration costs in 2016 should be less than half of our 2015 amounts. Margins are excellent in most of our units around the world, with some further opportunities for efficiencies in Australia and our U.K. retail and underwriting businesses. So, let me move to our Risk Management segment, essentially Gallagher Bassett Services. Risk Management finished the year with an outstanding fourth quarter. Adjusted organic growth of 10.5%, adjusted EBITDAC grew 17% and margins improved 140 basis points. For the full year, we posted over 11% organic growth, 18% growth in EBITDAC, surpassed 17% of adjusted margins, and we expanded margins by 120 basis points. Gallagher Bassett is now over $700 million of annual revenue. And since we embarked on our retooling efforts five years ago, it has shown consistent, excellent, top and bottom-line results, and we see it continuing to gain momentum. In fact, 2015 was the third year in a row where we posted around 10% organic growth and also hit or exceeded our annual margin targets, up nearly two full margin points since 2011. The 17% EBITDAC margin is our 2016 margin target and near the top of our expectations. Our U.S. claims management business is about $575 million in annualized revenues, and posted especially strong double-digit organic growth for the quarter, and full-year margins, as I said earlier, of around 17%. We've been successful in developing new and improved services for our clients. Following last quarter's introduction of Luminos, which is Gallagher Bassett's acclaimed risk management information system for clients, we rolled out GBGO, the first of a suite of mobile technology products designed specifically for use on smartphones and tablet devices. In addition, new medical management products and approaches together with broader adoption of GB products by clients has led to improved claim outcomes as well as increased revenue for Gallagher Bassett. Strong performance in state-administered workers' compensation schemes in Australia pushed Gallagher Bassett's operations to well over $130 million in revenue in 2015, or roughly 20% of the segment's revenue, also posting organic growth of about 10%. GB's international operations are expected to make a strong contribution again in 2016, with investments in our self-insured and carrier segments scheduled to come online later this year. So, really, truly a remarkable year on all measures, which is a testament to an incredibly strong sales and service culture. These results don't just happen, our team gets up every day and works relentlessly to service our clients and to aggressively demonstrate our capabilities to new prospects. A great quarter, a great year, I couldn't be prouder of our colleagues' efforts and what we've accomplished. Over to you Doug.

Thanks, Pat, and good morning, everyone. Before I start, some housekeeping. Starting with this quarter, you'll see on our investor website two documents, plus our earnings release. One is the supplemental quarterly data document. That's the one that we've been providing for over a decade, but you'll now see that it contains only historical reported and adjusted information. The other is a new document, it's called CFO Commentary, it is this document that contains our forward-looking items. In other words, it summarizes both the commentary I typically provide in these calls, plus it has the corporate segment earnings forecast that were previously at the back of the supplement. We hope this CFO Commentary document makes it more investor friendly and easier to use, rather than having to dig out my comments from the conference call transcripts and back pages of the supplement. Okay. On to my comments, and like Pat said, an excellent quarter to end a terrific year. Yes, the fourth quarter is a little noisy on the face, but all items are right in line with the forecast we gave you in our October earnings call and then again at our December Investor Meeting. Two additional items we didn't forecast back then. In the Brokerage segment, you'll see a $0.02 one-time tax item gain. That benefit results from the newly enacted lower statutory rates in the U.K., related to our net deferred tax obligations on our balance sheet related to our U.K. operations. The other item is in the corporate line of the Corporate segment in the tax column. We had a favorable tax item of about $4 million in the fourth quarter. We were a little conservative in our estimates in the first three quarters of 2015 when we estimated certain permanent items, so when we trued up those estimates in the fourth quarter, it added a couple of pennies of gain in the fourth quarter, but it has no impact on the full year. As for adjustments in 2016, when you digest the information in the new CFO Commentary document, two items will stand out. First, you'll see FX in 2016 being half the headwind that we saw in 2015, and second, you'll see that we are forecasting integration costs in 2016 to be less than half of the 2015 levels. I'm really pleased that we are effectively done integrating the larger mergers like Bollinger, OAMPS, Crombie Lockwood, and Noraxis, and by year-end 2016, we should be nearly done with Oval and Giles in the U.K. Now, let's turn to page three of the earnings release to the Brokerage segment organic table. You'll see supplementals way up and contingents way down in the quarter. Ignore the geography, as we simply had a couple of contracts that had some slight language modification that is causing the flip between lines. Rather, I suggest that you look at supplementals and contingents in total and you'll see we're up organically 10% in the quarter and up 8% organically for the full year. Based on current conditions, we expect in 2016, that these lines will organically grow better than the core commissions and fee line. At the bottom of that same page three, you'll also see that we used next to no stock this quarter to fund M&A and you'll see at the bottom of the CFO Commentary, first page, we don't anticipate using stock to fund M&A in 2016 either. I'll hit some cash flow comments more in a minute. On pages five and six of the earnings release, you'll see that we had nice margin expansion in the Brokerage and Risk Management segment. In the CFO Commentary, you'll see that we still believe margin expansion for the Brokerage segment is difficult if we don't have 3% organic growth, and you'll also see that we're moving up our Risk Management target in 2016 to 17% from our target of 16.5% in 2015. Let's move to page seven to the clean energy line on that page. I'm really pleased that we crossed the $100 million of net earnings mark this year which came in right at the mid-point of what we forecasted a year ago. That's really great work by the team. I also want to point out, we've added some more convenient disclosure. On page 12 of our earnings release, on the deferred tax asset line in our balance sheet, we've had a parenthetical disclosure showing that $342 million of our deferred tax asset relates to credits that we've generated, but not yet deducted from our tax returns. Think about it this way, it's effectively a cash receivable from the government as it will reduce our cash taxes paid in the future. I've said before, our goal is to pay about 10% of our global EBITDAC in taxes and these credits are a big part of that strategy. Looking forward to 2016, you'll see on the second page of the CFO Commentary document that we're forecasting about a 15% step up in earnings in 2016 for clean energy investments, that's if we hit the mid-point of the range, about $116 million of net after-tax earnings. When we were preparing our 2016 estimates for clean energy, we worked closely with our host utility partners and we assessed the ever-present risk surrounding these investments, things like fuel source substitution, are they going to burn coal or natural gas? We looked at governmental, regulatory, and IRS laws and policy changes. We looked at plant shutdowns during the year, both temporary and permanent. We looked at the location of the plants and the power grid utilization curve. We looked at our supply-chain distribution, so on and so forth. In the end, as we sit today, we've digested these risks and we feel comfortable with our 2016 estimates. In addition, our 2016 estimate makes a provision for continued warm winter and then reverts to more of a normal spring, summer, and fall. Finally, let me move to GAAP and free cash. First free cash, we have about $275 million of free cash in the balance sheet. As I said last quarter, all of that is technically free cash of that $275 million, but until we complete our integration efforts to consolidate legal entities in the U.K., about $100 million of that cash is hard to access, because it is in hundreds of smaller bank accounts that need minimum balances. We have plans to free up most of those balances over the course of 2016. Second, you'll see in the CFO Commentary that we're at about 2.5 times debt to EBITDAC ratio. That was down substantially from around 2.9 times to 3 times at the end of 2014. We believe 2.5 times is about the right level going forward. Third, you'll also see in the CFO Commentary that we might go into the debt markets and raise another $200 million to $300 million. We might do that for several reasons. We can pay off the line, which is currently about $200 million, we can use it for M&A, we have a strong pipeline, or we can use it to have cash-on-hand to repay the $300 million tranche, which carries a 6.44% interest rate and comes due next year, or we can do a combination of all three. So finally let me put all together. If you assume 2.5 times debt, if you assume that we use no stock used in acquisitions earnout, if you assume that we continue to do mergers at that 7.5 weighted average multiple just like we did in 2015, we will have ample cash to fund our M&A program in 2016, similar to the level that we did in 2015. Okay. Those were my comments. Back to you, Pat.

Thank you, Doug. Before we go to questions and answers, I just want to make a quick comment about the Gallagher culture. It's as strong as it's ever been, we see it in our successful integration efforts, we see it in our branding efforts around the world and we see it in our service to our clients. In December, J.D. Power announced that Arthur J. Gallagher & Company ranks as the highest in customer satisfaction among brokers for large commercial insurance. This is on top of the fact that earlier in the year, we were recognized as one of the World's Most Ethical Companies by the Ethisphere Institute for the fourth straight year. The Gallagher culture is alive and well and developing and growing year-in and year-out. With that, Brenda, we'll go to questions and answers.

Hey, thanks. Good morning.

Good morning, Ryan.

I think, my first question is probably for Doug. In his CFO deck, I think, he said it would be difficult to expand margins if organic is below 3%. I'm just kind of curious under what conditions do you think you could keep margins at least stable and not necessarily expansion, but flat margins, is it 2%, is it 2.5%, is there a wriggle room on the expense side, just curious on that?

Listen, good question. We're always looking for opportunities to get better. I mean, our service quality is pretty darn high if you look at what J.D. Power says, but we have opportunities to continue to improve that. When you are in the 2% to 3% range, I think that we can hold margins pretty well where they are, below that might get a little tough.

Okay. Understood. And I guess my follow-up is probably for Pat, just thinking back to his comments in December, the 1.5% to 2% organic growth, just some clarity on what that entailed? I know Doug mentioned that supplementals are supposed to probably run north of that level or is that just U.S. P&C, is that all in true organic growth, is that just base commissions and fees, what exactly again were you referencing there Pat? Thanks.

Well, Ryan, to be perfectly blunt, I was coming off of a more pessimistic view given the October/November results, and I was really pleased with what we did in December and finishing up the quarter. My comments were mostly around U.S. domestic property/casualty as well as Australia and New Zealand property/casualty. But I think, given December and the end of the quarter, I'm a little bit more optimistic. Remember, organic growth is comprised of, you mentioned the supplementals, but it's also retention, new business, so there are a lot of components that go into that and we just really had a strong quarter.

Hi. Good morning. So, just following up a little bit on the last question in terms of the organic growth outlook for this year. Since you said you are a little bit more optimistic, I mean, how do you see the Brokerage organic growth shaking out in 2016, kind of maybe a ballpark number? And then, digging down into that a little bit, do you see some seasonality by quarter in terms of starting off stronger and then getting weaker towards the end of the year, anything that might impact the numbers as we go through 2016?

Well, I'll let Doug speak about the seasonality, then I'll come back to my view on organic.

Now, actually good reminder, yes. For those of you that have been on this call for years, we are a highly seasonal company. Our first quarter is by far our smallest quarter. Our second quarter and third quarter are about the same and then December comes in just a step below that. So, we are a seasonal company, so, that's why if you look at our margins, we have 26.1% margins for the entire year. And I think if you go back to the first quarter, in the Brokerage segment, they were in the high teens, low-20%s, I don't know if I can pull that out. So, we are a highly seasonal company.

So, let me address your issues around – or your question rather, which is a good question around organic. Again, what comprises organic? We go out every single day, we try to get new business. We're fighting every single week to keep the business we've got, and that's an ongoing battle. But frankly, we know that 90% plus of the time when we go out to compete, we're competing with someone who is smaller than we are and doesn't have our resources. I think the ACA is beginning to show an opportunity to have expanded organic growth in our benefits units. Our wholesale units have been very, very strong in terms of organic growth. So I'm a little bit more bullish than I was in December. As I said, I was coming off a weaker October/November than I liked. I was very, very pleased with what we did in December, and if we can carry on with that kind of level of new business growth and hold on to our clients, we should do a little better. I would put that in above 2.5% to 3%, 3.5%.