Arthur J. Gallagher & Company (AJG) — Q1 2019 Earnings Call Transcript

Thank you, Jeremy. Good afternoon. Thank you for joining us for our first quarter 2019 earnings call. With me today is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. As we do each quarter, today Doug and I are going to touch on the four key components of our strategy to drive shareholder value. Those are number one, organic growth. Number two, growing through mergers and acquisitions. Three, improving our productivity and quality. And number four, maintaining our unique culture. The team delivered on all four of our operating priorities to begin the year, resulting in a great first quarter. Let me give you some highlights. Our core brokerage and risk management segments combined to deliver 14% growth in revenue, 5.5% all-in organic growth, and adjusted EBITDAC margin expansion of 75 basis points. We also completed 11 tuck-in mergers during the quarter, and our culture was recognized again by the Ethisphere Institute as one of the world’s most ethical companies. I couldn't be prouder of the team; just a great performer. My comments today will be focused on revenue growth, insurance pricing, and our dynamic culture. Doug will go into greater detail on productivity, quality, clean energy, and capital management. So let me start with our brokerage segment. First quarter all-in organic growth was 5.7%, including base commission and fee growth pushing 5% and strong contingent and supplemental revenue growth. Organic was solid across all of our divisions globally. Let me give you some more detail. In the US, our retail brokerage operation generated around 6% organic in the first quarter, with benefits a bit lower and property casual a bit higher. Domestic retail property and casualty pricing was positive across all our major lines of business except for workers' compensation. For example, property and commercial auto pricing were up over 5% and casualty and specialty lines were up a couple of points. Within our domestic wholesale property and casualty business, organic was about 4% and relative to retail pricing, was similarly stronger across most lines of business. Moving to the UK, our organic was around 5% in the quarter, with retail a bit lower and wholesale a bit higher. Our retail property and casualty pricing in the UK is up 3% on average, with professional liability pricing up over 5% and most of the lines up a point or two.

Thanks, Pat. And good afternoon, everyone. As Pat said, another really excellent quarter of top-end line results and a strong way to start off 2019. Today I'll make a few comments referencing the earnings release. I'll then move to the CFO commentary document we post on our website and I'll wrap up with some comments on cash and M&A. Okay, let's turn to page two of the earnings release to the brokerage segment. You'll see that we posted $1.45 of adjusted earnings per share. As you compare our results to your models, it looks like there are about three puts and takes compared to consensus. First, it looks like contingents came in better than most of you thought. Call it an additional $8 million or about $0.02 after incentive compensation and taxes. However, there are two offsetting items. First, it looks like your picks for M&A rollover revenues were above our March 12 guidance by about $8 million or $9 million. And second, non-controlling interest tax were lower than our March 12 guidance by about $2 million to $3 million, combined that $10 million to $2 million or about $0.03 after expenses and taxes is going the other way. So net, net these items about offset, bringing us back to about a $1.45 of EPS or even $1.46. One last comment on page two of the earnings release, only one significant non-GAAP adjustment this quarter, a one-time $0.17 net gain from divesting some smaller brokerage operations in the first quarter. It's a bit of old news given we discussed the largest one during our January earnings release and conference call. But you can see it there now. Otherwise, a very clean quarter. Next, let's turn to page three of the earnings release to the brokerage segment organic table at the top of the page and then go down a little bit to the contingent revenue section. That's where you'll see contingents being organically up $8 million in the first quarter, as I just mentioned. About half of that rise is because it developed more favorably than previously estimated. The other half is due to new agreements and a slightly more bullish outlook for 2019 based on our view of premium growth and rate increases.

Thanks, Doug. Jeremy, I think we can go to questions.

Hi, thanks. My first question going back to just the organic guide for the year, you guys would say about 5%. So was that guide all-in or is that the four impact of contingent and supplementals? And I guess as part of that answer, I believe at your March investor day you guys said that Q1 is seasonally weaker on organic. Is that still the case? Would you expect the remaining three quarters to be above the first quarter? And is that a comment both before and after considering contingency supplementals?

All right. A lot of questions there, and I'll jump in on that, and Pat wants to add again. I think that when it comes to the base contingents – excuse me, base commissions and fees, somewhere in the 4.5% to 5% range – 5.5% range seems about right now. When it comes to contingents and supplementals, the positive development we have from last year and then our board - a little bit more bullish outlook here in the first quarter. I would hope that would continue for the rest of the year or that it all stack up, maybe a brokerage total organic between 5% and 6%. Does that help?

Yes. And then in terms of the margin guide, or maybe just some color going forward. So 60 basis points this quarter, and then you did point to a negative impact from some of the recent deals that you've done, which I would assume should benefit margins during the out quarter. So can you give us a sense of just the type of margin improvement we should expect to see just given if organic remains in line, kind of that 5%, 5.5% range? What kind of margin improvement could we see in brokerage?

I think that, I guess I think that for the full year if we post between 5% and 6%, maybe the full year will come in at 50 basis points of margin expansion for the full year. It gets a little harder later in the year when raises go in. As for the impact of M&A, it's mostly pronounced in the first quarter; in this case, the acquisitions that are rolling in right now don't have big seasonality in them, like we had last year in the third quarter. So we – because we posted nearly 36 points of margin this quarter, the impact will be more dramatic in the first quarter. When you get to the second and third quarter maybe it's 10 basis points, something like that.

10 basis points negative or positive?

It should be a little positive in those quarters.

Thanks. And then my last question on, in the U.K. a couple of things going on, we've had some of the wholesale and other reviews going on that have kind of been settled and I know in the past I felt like you guys insinuated that however those are views on kind of shook out that this could be an opportunity for Gallagher to take advantage. And so could you comment on what's going on over there? And then also there has been a sizable deal by one of your peers. And I would think if there is any kind of shakeout that maybe you guys could benefit is in the U.K. or other area. So you're seeing that impact your U.K. opportunities as well?

I mean, start with the TLT aerospace. That was a great opportunity. That came to us because of the EU and the competitors getting since then. So yes, I think there's going to be great opportunities frankly globally and we just will take them one at a time, we'll take a look at them and we'll be cautious that it will not just be London focused by any means. IN terms of the London market and how we trade, we are confident from the beginning that the way the wholesale business was run and managed was going to come through a review and it's just fine. And that's in fact what happened. So what you're going to see is business as usual, but it does get more costly to operate in London, regulatory pressure is greater and greater. And that gives us opportunities on the M&A side and the team recruiting side. So really Gallagher's in a very good spot in London around the UK and globally to take advantage of some of the dislocation.

Okay, that's great. Thanks so much. I appreciate the color.

Thanks, Elyse.

Hey, good evening. First question is on probably Pat on the pricing commentary. Any thoughts on what the impetus of why pricing is increasing? Do you think it has momentum and maybe also any bifurcation in pricing between small, middle or large accounts?

So if you take a look at our results, and this is I've said this probably almost every quarter. Typically we've said rate and exposures contributed something like 1% of our organic growth. In this quarter it was probably closer to 2%. So when you hear my commentary on the rates around the world, don't take them to mean that we're facing a firming hard market. There's offsets to that, when DNO goes up, workers compensation is likely to go down. If you look at the last probably 11 or 12 years and you look at a graphic of what's happened to property casualty rates, they'll go up two, they'll come down three, they'll go up four, the high flat . That is a really good market for us. I grew up in an environment where every 10 years there was total dislocation, rates were jumping 50% to 70 %. Insurance was a complete seller's market and clients were really unhappy. The market would then start to soften, and anybody that had a license could beat you on a price sometimes very substantially just by getting to a market that nobody thought even had appetite. So with a market like this, our skill set really makes a difference. No one out there can just run to X Y Z company get this crazy low vote. I mean it does happen from time to time, but it's just not a general rule. So when we're working in the 2%, 5%, 3% up, 4 % down environment, then the skill set makes all the difference in preparing the risk management approach for the client. So this is really a good environment. A little firmer and that's really what I wanted my remarks to say, that don't go out and say wow we're going into a hard market, a little firmer. And I think that's probably justified by cat losses and by some capacity shrinkage in particular in the London market and by other disciplined underwriters. You saw Traveller's results, I mean, those guys are smart underwriters.

That's helpful. Maybe for Doug, the restructuring initiatives you took last year or some of the charges. Is there kind of a rule of thumb on a payoff for those, and just ’19, I don't know if there's a go, is it a one for one or 50% payoff you get in the subsequent year?

I think that in terms of what we did for the - for some of the headcount reductions that we took last year, we actually reinvested that into data and marketing, in some of our system needs, including cyber. So the actual payback on the displacements directly was pretty high. The payback came probably within about nine months, but we turned around and reinvested that into our data initiatives, which are really taking off well. I think that you're seeing it, we've got another service center that's really paying benefits there. So we reinvested it, but the payback on that actual take out was pretty fast.

Okay. Got it. If I could just sneak one last one, just curious maybe it's too early, but as you know if the intern class which is ‘19 or is growing versus last year?

Yes, that’s going to grow a bit. I mean, we're kind of getting to the stretch point with 450 young people coming in to learn about our business, but it'll be up a little.

Thank you very much.

Thank you.

Good evening, guys. First I had a couple for Doug on contingents. First of all, should we think about, I mean the upside it's being driven, I think you should 8 mil? Is that pretty much 100% margin or is there a cost associated with that variance?

First, answer that is typically the contingent commission line is what helps fuel the incentive compensation for field leadership. So I would not say it's 100%. It's probably more in the 60% range that would hit the bottom line.

Okay. And then I was a little bit - I think a malicious question, Doug, it sounded like you thought that there might be a possibility for more dis-favor with development over the remainder of the year. Could you just give me some idea of what exactly was driving that in Q1 and what potentially could make that continue to be out of this in the coming quarters?

Yes, I understand your question. If I recall correctly, we had approximately $90 million in contingent commissions last year. So, when we're discussing tightening that $90 million estimate by about $3 million, that's essentially what’s happening. It's not a significant difference in the overall picture. Additionally, we have several hundred contracts contributing to the contingent commission, with some being larger and others smaller. So, the change in estimate per contract is quite minor. Looking ahead, if we perform well in 2018 on these contracts and the development improves, it stands to reason that we might see better outcomes for 2019, assuming our loss ratios don’t worsen significantly by the end of the year. As we enter the first quarter and try to project a year forward, we might feel a bit more optimistic than we were at the same time last year. It could be a couple million dollars, but I wouldn't say there's a significant trend; it's more about refining our estimates across a wide range of contracts.

Understood, okay. And then one on the M&A pipeline. I think you said there's $350 million in the pipeline. Just curious how much is that. Give us some idea of how much of that is from these bigger type of acquisitions? I mean Stackhouse is obviously very big or is most of that turned 50 mil the much smaller deals that we were more accustomed to?

When you take a look at the number of acquisitions that are in the pipeline, the dominant number are small tuck-ins. But you're right, there are one, two, three, four in there that are sizable, that would be substantially bigger than even a number of the tuck-ins combined. So it's a very eclectic mix. It's across the entire set of our geographies. As you know, Stackhouse was in the UK. There are others in there that are a little bit sizable that are in the US, but by item count and as we do our announcements and put out press releases, most of those are going to be tuck-ins.

When we say final, we're talking about $20 million to $50 million type revenue shops too.

So Pat, do you think we'll see another $100 million plus deal this year?

Yes.

Thanks, guys.

Thanks.

Hi, good afternoon. It's far too Doug's answer to Elyse's questions on margins. Did I understand correctly that you were thinking that the margin expansion will be in the 10 basis point range in the second or third quarters?

No, that would be the impact of the Rowan acquisitions on the margin expansion in the second quarter and third quarter.

Okay, that's helpful. And then we're leaving. And can you maybe talk a little bit about some of the other puts and takes that would go into margin expansion throughout the rest of the year?

One of the things that we're - wage inflation does exist, but we've been fortunate since 2005 to have invested substantially in our journey on creating some lower-cost labor locations. Right now we have six locations around the world; we're pushing 5,000 employees there. And so as a result of that, we have a little bit of a safety valve on wage inflation. So we think that our productivity lifts, not only using our offshore centers of excellence but also new technology investments that we're making can help offset that natural wage inflation that you're seeing up there in the market. Competition for talent is getting tougher. But we do believe that we have a safety valve for that. So, pressure is on the margin. We're going to come wage inflation; you're seeing real estate costs are going up. So that's in there. But we have techniques in order to better utilize our real estate footprint. And then also just the amount of money that's necessary to have a rock-solid cyber platform, in order to be able to deliver that technology needs. That's an expensive proposition. So now, looking at margin expansion, we have 5% organic growth that we can do 50 basis points of margin expansion. It's really good especially when we're talking about 450 interns that are coming and we're talking about cyber, we're talking about wage inflation, we're talking about other the services that are so necessary for our clients and the placement of their insurance, and then also paying their claims. That's really good work for us to build a harvest that kind of margin expansion.

Got it. And you know when you look at some of the larger acquisitions, I think you said there may be something in the $100 million or more range coming in or the JLP aerospace business. Are those immediately margin accretive or are they dilutive and you need to do a little bit of integration there? How should we think about that?

Well, that depends on the nature of the business. I mean we're not afraid to go out and buy a really well-run shop that's for some reason is running 20 points of margin, even though we're coming into the high 20s in terms of the brokerage margins. If there's something about the way their business is run and what the clients need for service, we would not be afraid to buy a 20-point margin business just because it would roll into our business and maybe be slightly dilutive on margins. The point is it's about the growth. What is their EBITDA doing? How do we have an opportunity better together? So most of the ones we're looking to tuck-ins, they come in pretty close to what we're at.

I would say that. And I would say some of the big ones, I think they'll come in - they'll come in close to our margin. Once we've had them on board for a bit, when we bring in a sizable property casual or benefits operation and then get them moved to as Doug was talking about our centers of excellence where our lower cost labor is, we impact those margins favorably. So I think you should look at them as probably coming in pretty close to what we've got.

Got it. Thank you.

Yes, thank you. Good afternoon.

Hi, Mark.

I'll ask the usual question about the workers' comp. I'm curious, Pat, you've, I think you've expressed in some recent quarters that you've seen an uptick, but we don't seem to see that flowing through to any of the carriers losses or really describing any sort of uptick in frequency?

No, no. I've I have not said an uptick in comp. I've said just the opposite. We've seen decreases in comp all year.

I'm thinking - I'm thinking the claims frequency. I'm sorry. Yes, I was thinking the claims frequency, just sort of curious to get your latest thoughts on that?

Yes, we are seeing about a 2.5% increase in the claim count that's coming through Gallagher Bassett with existing business. I think that's because the economy is robust. You do have more people working and they're working longer hours. You also have the whole distracted driver thing which is really driving a big part of the auto market being very tough. But it also is leading over into some of the losses in the comp world. And so I think that's a natural thing. And we go into some form of a recession, our claim counts generally dropped pretty substantially because our clients are reducing workloads and closing down shifts. Now shifts are pretty robust and you have a little bit more. And hopefully, our clients lost control that we assist on can help mitigate that. So that uptick in claims is a good thing but a bad thing. And we'd rather be on the side of preventing that than counting them.

Seems like the risk management growth, the 4%, is still good organic but you've had very strong and stronger growth in the past. Is there anything to restrain on the growth and you've got a tough comp in the second quarter? But aside from that, anything holding the growth back there?

No, in fact, I think what's happening is, Mark, there's even going to be more and more differentiation around outcomes, and that's what we're out in the marketplace talking about. Two things that I think you're going to make a huge difference over time in that business. The idea that you could adjust as a risk manager or as a buyer these services just keep pushing down the price and get the same work for cheaper, cheaper, cheaper. That's a cheap thrill and it's going to start to show up very, very clearly in outcomes. The other thing is I think you're going to find more and more carriers and captives outsourcing their work either in lines of cover that they want to get into, geographies they want to get into and in some instances full-on situations like their entire risk management book. It's becoming a much more relevant approach. So I think the really good providers in the claims business globally have an unbelievably future. 4.1% was a very nice quarter given the comparable to last year.

Now I think Mark, if you look at it, we had 4% in ‘17, we had 7% in ‘18 organic growth. Some of that - some of the business that comes into our risk management segment can be kind of elephant hunting as we pick up some larger work compensation or work cover schemes down in Australia and some of these larger governmental programs. And then as carriers do tend to find that our claim outcomes are pretty compelling, so they start bringing work. So it wouldn't surprise me that this is a business that you see 5% one year and you see 8% or 9% another, and there is a little bit of the impact on that this year. If we can bring it in at 5% between 4% and 6%, I think it would be a pretty good year coming off a total of 7% last year.

Thank you.

Thanks, Mark.

Thank you, Jeremy. Thank you again for being with us this afternoon. We had a great first quarter and I would like to personally thank all of our employees across the globe for their hard work and our clients for their continued support. 2019 should be another great year for Gallagher. Look forward to speaking with you at our June 13th Investor Day and have a great rest of the evening. Thank you for being with us.